COUNTERPARTY RISK

Definition

Counterparty risk, also called default risk, is the risk that the other party in a financial transaction will fail to fulfill their contractual obligations, resulting in financial loss to the non-defaulting party.

It is a credit risk that applies to OTC derivatives, loans, bonds, forward contracts, swaps, securities lending, and even regular trade transactions.

Origins

The concept of counterparty risk has long been a factor in financial transactions, but it gained unprecedented prominence in modern finance following the 2008 global financial crisis. The collapse of Lehman Brothers highlighted the systemic dangers that can arise from a major counterparty failure in deeply interconnected markets.

Usage

• Banking – Loan default risk.

• OTC Derivatives – Swaps, options, and forwards without a clearinghouse.

• Bond markets – Risk that issuers fail to make interest or principal payments.

• Trade finance – Import/export agreements with nonpayment risk.

• Securities lending & repo – Risk the borrower won’t return the collateral or securities.

How a Counterparty Risk Works

1. Transaction Initiation – Two parties agree to exchange cash, securities, or commodities.

2. Performance Period – The deal has a settlement or maturity date in the future.

3. Possible Default – One party fails to deliver goods, securities, or payment.

4. Loss Realization – The other party suffers a financial loss or incurs costs to replace the transaction.

Types of Counterparty Risk

• Credit Default Risk – Counterparty fails to repay a debt.

• Settlement Risk – One party delivers but the other does not (e.g., Herstatt risk in FX).

• Replacement Cost Risk – The cost of replacing a defaulted trade at current market prices.

• Liquidity Risk – Counterparty can’t meet obligations due to cash flow issues.

Key Takeaway

• Exists in any bilateral agreement—not just in finance.

• Higher in OTC markets where no clearinghouse guarantees performance.

• Managed through collateral, netting, diversification, and credit limits.

• Can become systemic risk when major financial institutions fail.

Context in Financial Modeling

Counterparty risk impacts:

• Derivative pricing – CVA adjustments to reflect credit risk.

• Risk-weighted asset (RWA) calculations – Basel III capital requirements.

• Stress testing – Assessing exposure under extreme but plausible scenarios.

• Portfolio risk models – Incorporating correlations between counterparties.
  
  

Nuances & Complexities

• Collateral agreements (CSAs) can reduce risk but not eliminate it.

• Netting agreements can reduce exposure by offsetting gains and losses across trades.

• Wrong-way risk occurs when exposure to a counterparty increases as their credit quality worsens.

• Regulatory frameworks (Basel III, EMIR, Dodd-Frank) require capital and reporting for counterparty exposures.

Mathematical Formulas

Counterparty risk is often measured as Expected Exposure (EE) and Credit Valuation Adjustment (CVA).

Expected Loss (EL) formula:

$$EL = PD \times LGD \times EAD$$

Where:

• $PD$ = Probability of Default

• $LGD$ = Loss Given Default (percentage of exposure not recovered)

• $EAD$ = Exposure at Default (monetary amount at risk)

CVA formula:

$$CVA = (1 - RR) \times \sum_{t} DF_t \times EE_t \times PD_t$$

Where $RR$ = Recovery Rate, $DF_t$ = Discount Factor at time $t$.

Related Terms

• Credit Risk

• Settlement Risk

• Collateral Management

• Credit Valuation Adjustment (CVA)

• Wrong-Way Risk

• Default

Real-World Applications

Example 1: Lehman Brothers 2008

Lehman’s bankruptcy left counterparties exposed to billions in unfulfilled trades and unsettled contracts.

Example 2: OTC Swap Agreement

Two companies enter into a 5-year interest rate swap. Midway, one defaults, forcing the other to replace it at unfavorable market rates.

Example 3: Trade Finance Risk

An exporter ships goods but the importer’s bank defaults before payment is made.

References & Sources

• BIS: Counterparty Credit Risk Guidelines – BIS.org

• Basel Committee on Banking Supervision: Capital Requirements for Counterparty Credit Risk