Cotton Forward Contract: Credit Risk and Payment Explanation

B

In this scenario, Pamela Burke, a cotton farmer in Texas, wants to protect herself from potential price fluctuations in cotton. She approaches Brooke Anderson, a derivatives dealer, to negotiate a forward contract. The purpose of the forward contract is to eliminate Burke's exposure to the price of cotton by fixing the price in advance.

The contract between Burke and Anderson is a nondeliverable forward contract, which means physical delivery of the underlying asset (cotton) is not required. Instead, the settlement is made in cash based on the difference between the contracted price and the actual price of cotton at the time of settlement.

The contract price of the nondeliverable forward is set at $47. This means that Burke has locked in the price at which she will sell her cotton in three months, regardless of any changes in the market price during that period.

Now, let's consider what happens if the price of cotton is $49 in three months, which is higher than the contracted price of $47.

Since the actual price of cotton has increased, Anderson, the counterparty to the forward contract, will have to pay Burke the difference between the contracted price and the actual price. In this case, the payment would be $49 - $47 = $2.

In terms of credit risk, credit risk refers to the risk that one party in a contract may default on their payment obligations. In this scenario, the party exposed to greater credit risk would be the counterparty who is obligated to make a payment.

In this case, Anderson would be exposed to greater credit risk because if the price of cotton is higher than the contracted price, she would be required to make a payment to Burke. This payment represents a credit risk because there is a chance that Anderson might default on this payment obligation.

Therefore, the correct answer to the question is:

B. Anderson will be exposed to greater credit risk, and Burke will make a payment.