The counterparty risk on a forward currency contract is the risk that the counterparty fails to meet their obligations. The counterparty on a forward currency contract is generally a large bank with international operations. Because typically no money changes hands at the outset of a forward currency contract, the counterparty risk is limited to the profit or loss on the contract; it is not the notional value of the contract. Counterparty risk may be best illustrated in an example:
Assume an investor enters into a forward currency contract today to purchase 1 million Australian dollars (AUD) at an exchange rate of 0.9000 in one month’s time. Assume also that in one month the AUD appreciates 1% to 0.9090. In one month the investor is obligated to purchase AUD at 0.9000 (and the counterparty is obligated to sell AUD at this rate). The investor can then sell AUD at 0.9090, pocketing the difference ($909,000 – $900,000 = $9,000). This profit is also the extent of the counterparty risk as, should the counterparty fail to sell AUD at 0.9000, since no money changed hands at the outset of the contract, the investor’s $9,000 profit is at risk.
Note, should the above example result in a loss (if the AUD declines in value over this timeframe), the counterparty in this transaction bears the counterparty risk that the investor does not purchase AUD at the contracted higher rate.
If multiple forward currency contracts are open with the same counterparty, the counterparty risk is typically the net profit (loss) of all open positions.
At times, especially for leveraged transactions, collateral may be posted.