Counterparty risk
What is Counterparty risk?
Counterparty risk is the risk that the other party to a trade or financial contract fails to make a payment, deliver an asset, return collateral, or otherwise perform as agreed.
Why counterparty risk matters
Derivatives, repurchase agreements, securities lending, deposits, and unsettled trades create claims on counterparties. Exposure can increase as markets move in the portfolio's favor, precisely when replacing the contract may be expensive. Counterparty failure can also trap collateral, interrupt hedges, and create operational or liquidity problems beyond the expected credit loss.
How it is measured
Current exposure reflects positive replacement value after enforceable netting and collateral. Potential future exposure estimates how that value may grow before close-out. Analysis also considers default probability, recovery, wrong-way risk, settlement terms, collateral quality, thresholds, minimum transfer amounts, and legal enforceability. Central clearing changes the exposure but does not eliminate it.
Example
A fund enters a currency forward that gains value after a large exchange-rate move. The dealer now owes the fund at settlement, creating exposure. Daily variation margin can reduce the amount outstanding, but delays, valuation disputes, collateral haircuts, or an unenforceable netting agreement can leave a meaningful loss if the dealer defaults.
How to interpret it
Aggregate exposures across legal entities only where netting is legally enforceable, and distinguish gross notional from replacement exposure. Review concentration by counterparty group and the relationship between counterparty health and the underlying trade. Wrong-way risk is especially important when exposure rises under the same conditions that weaken the counterparty.
Limitations
Potential-exposure models depend on market assumptions and contract details. Collateral reduces credit exposure but can introduce liquidity, custody, valuation, and concentration risks. Credit ratings may lag, while market indicators can be noisy. Close-out timing and recovery during a systemic event are uncertain, and several counterparties may become stressed together.
Practical checklist
Maintain complete legal-entity and agreement data, confirm netting opinions, and reconcile trades, valuations, collateral, and disputes. Set limits using current and stressed exposure, not notional alone. Diversify counterparties where practical, monitor credit and market indicators, test default during adverse markets, and maintain a plan for replacing hedges and accessing collateral after a failure.
Also known as: counterparty credit risk