Counterparty risk
Family XII · Other terms
Not to be confused with forex risk.
Counterparty risk is the risk that the other side of a trade or contract defaults before settling its obligations. It arises whenever performance is promised for a future date, such as in derivatives, repurchase agreements, or unsecured loans. The risk is bilateral in some contracts and unilateral in others, depending on the structure.
How it arises and is managed
Counterparty risk appears when a contract creates a future obligation. In over-the-counter derivatives, each party faces the other's potential default. In exchange-traded products, a clearing house interposes itself and becomes the counterparty to every trade, which mutualises and manages the risk through margin and default funds.
Common mitigants include collateral agreements, netting arrangements, and credit limits. The effectiveness of these measures varies by jurisdiction, market, and the creditworthiness of the parties involved.
Worked example
Suppose a trader enters a forward contract to buy 100,000 units of a commodity at a fixed price. Before settlement, the market price rises, making the contract valuable to the trader. If the counterparty defaults, the trader must replace the contract at the higher market price.
Distinction from forex risk
Counterparty risk is the risk of default by the other party to a contract. Forex risk is the risk of loss from changes in currency exchange rates. They differ in source: one is credit-related, the other is market-related. The visible sign is that counterparty risk involves a default event, while forex risk involves price movements.
Often confused with
- forex risk
- Counterparty risk is the risk that the other party defaults on a contract, whereas forex risk is the risk that exchange rates move adversely; the visible sign is that counterparty risk requires a default, while forex risk requires only a price change.