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What is counterparty risk?

Any business operation involves a level of collaboration, co-operation, and partnership with other parties. Put simply, counterparty risk measures how likely it is that the other person may default on its obligations. This is often considered in terms of costs and payment, but it can also refer to delivery of services, actions, and other commitments. It’s important that you assess the counterparty risk ahead of making any business deal, so that you understand the potential costs to your business.

What’s the difference between credit risk and counterparty credit risk?

You may have heard these terms used interchangeably, and their similarity can cause confusion. A counterparty credit risk is simply a subtype of a credit risk. The term “credit risk” covers all types of economic loss, including both counterparty and issuer credit risks. It’s a term often used when talking about banks loaning money or corporate bonds.

Counterparty credit risk comes in two forms: pre-settlement risk and settlement risk. The former applies during a transaction while the latter applies thereafter. Settlement risk can then be further divided into default risks – i.e., a complete non-fulfilment of an obligation – and settlement timing risks, such as late performance.

How do you design a counterparty risk model?

There are a number of different ways to approach modelling counterparty risk, and the method you choose will likely depend on the type of business you’re working in and the biggest risks to your organisation. There are some important numbers that will apply to all models, such as the probability of a default and the loss likely to be incurred if there is a default. Similarly, there may be influences that go beyond the businesses involved in the transaction, such as the general economy.

Of course, some of these numbers can be difficult to quantify. There have been attempts to standardise risk factors through the Basel Accords, a series of regulations (including the liquidity coverage ratio) that are backed by major global banks.

What factors influence counterparty risk?

The specific factors that are relevant to each business in measuring counterparty risk vary. There will be both quantitative and qualitative factors to be considered, including financial strength, industry reputation, and collateral.

It is then essential to decide whether a risk is worth taking – high or not. Again, the variables that go into making this call will be dependent on your organisation, but potential profits and your business’s ability to withstand loss will be significant factors.

What are some examples of counterparty risk?

Counterparty risk comes in many different forms but is often referred to in relation to equity and bonds. Investors are exposed to counterparty risks when they invest in bonds – and the risk often correlates with the potential returns.

How can you limit counterparty risk?

The most obvious way to limit counterparty risk is to work with stable and reliable counterparties. The more secure the counterparty to a transaction is, the less likely it is they will default on the contract. It’s important to understand the relative market positions of your organisation and those you’re dealing with in order to put the transaction into proper context.

Some businesses opt to attach a risk premium to high-risk transactions – both to protect the party taking the risk and to incentivise them to work with the party presenting the risk. This is most often seen in the form of high interest rates for investments in less stable or less established companies.

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