What is Counterparty Risk?

A business thrives with a partnership and mutual understanding between the parties. But there is always some kind of risk that a business has to deal with. One such risk is Counterparty risk, which basically measures how the other party associated with the contract may not fulfil its obligations. In case a business at the time of default has a positive economic value with a counterparty, it can experience financial loss. So, getting an idea about the risk is important before making a deal. In this blog, we will discuss what is counterparty risk, its types, and the factors affecting it.

What is Counterparty Risk? This is a question that pops into every investor’s mind.  Let’s understand it together. “ Counterparty Risk” is the chance that the other party associated with the financial contract may not meet its obligations. It can happen in bonds, securities, trading and more. One can counter the risk in different ways, but is often faced in bonds and equity. 

Let’s try to understand it with the help of an example. Imagine this scenario:

You are trading shares with a brokerage firm. One day, the brokerage firm suddenly announced bankruptcy and refused to fulfil its obligations. You might not get your money or complete your trades in this case.  

This shows how unpredictable counterparty risk is. So, it is crucial to analyse and manage this risk carefully.

What Factors Influence Counterparty Risk?

Numerous factors influence or affect the Counterparty Risk. Both quantitative and qualitative factors are considered. Some of these factors are as follows: 

1. Credit Risk:  If one party faces a greater risk than the other at default,  the transaction is generally subject to a premium to compensate the opposite party.  This can be calculated by noticing the counterparty’s credit standing and probability of default.

2. Collateral: A quality collateral presented by the counterparty can reduce risk. This is because collateral is provided as security and can be used in case of defaults by counterparty.

3. Financial Strength: Figuring out the economic health of the other party is essential. This consists of the credit rating, debts, financial statements, and other statements indicating financial stability. 

4. Settlement Risk: If any party fails to carry out its obligations at the agreed time, then there is a risk of the other party bearing the loss. 

5. Industry Reputation: Always be aware of the counterparty’s reputation within their industry. This provides insights into how reliable and trustworthy they are. 

Counterparty Risk​ in Different Investment Types

Counterparty Risk is visible in numerous investment types, including bonds, securities, derivatives, options, etc.  Credit Default Swaps (CDS) are a significant counterparty risk derivative. These are constantly exchanged directly with another party without any centralised exchange. However, the contract’s direct connection to the other party has a more significant risk of counterparty default.

Next is Bonds, which rating agencies like ICRA Limited, CRISIL, and IRRPL evaluate and assign ratings from AAA (means low risk) to Junk Status (means high risk). Generally, bonds with junk status offer high returns as there is a significant chance that the issuer might default.

In the case of credit derivatives and loans, counterpart risk is inherited. Loans have default risk, which is the probability that the borrower might not repay the loan. On the other hand, derivatives include counterparty risk in which the other party might not meet the obligations. Here, the risk is higher as the value of derivatives also changes.

Examples of Counterparty Risk

Counterparty Risks show up in everyday life scenarios. A few common examples are as follows:

1. Broker Default

Suppose you are trading shares with a brokerage firm. One day, the brokerage firm suddenly announced bankruptcy and refused to fulfil its obligations. You might not get your money or complete your trades in this case.  

2. Loan Default

Assume a bank lending money to you. The amount is around Rs. 1,00,000. But for some reason, you fail to repay the amount. So, the bank will face the loss of money. 

3. Supplier Insolvency

In this case, think about you running a business and you count on a supplier for materials. Uncertainly, the supplier may go out of business or cannot deliver the required materials as agreed.  This can severely affect your business, leading to financial loss and damaging your reputation.

4. Credit Derivatives

Tools, like credit default swaps in finance, are used to protect against loan default.  If the party holds CDS, they will receive compensation if the borrower defaults or fails to repay the amount. But, if the organisation that issued the CDS fails to meet obligations when a default happens, the protection expected from CDS will not show. 

5. International Risks

When dealing with international clients, you might face risks with them. A few major factors that affect are political instability, currency changes, and different law systems, making it more challenging to get paid or abide by contracts. 

The above few examples demonstrate how, in everyday situations, counterparty risks can show up. Instead of worrying about the risks, it is crucial to understand and manage them carefully. 

Also Read: Margin of Safety: Its Calculation, Meaning, and Example

Counterparty Risk Vs Credit Risk

Counterparty Risk and Credit Risk both indicate the possibility that the other party involved in the contract may default on their obligations. However, they have unique characteristics, so they are used in different contexts. The table below shows the significant differences between the two:

Conclusion

Before investing, understanding counterparty risk is important as it indicates the probability of the other party not meeting their obligations. Contracting with reliable and trustworthy counterparties is an easy and effective way to minimise counterparty risk. Check out the risk premium for high-risk transactions to minimise potential losses, as some organisations choose to attach risk premium to high-risk transactions to protect both the party taking the risk and to motivate them to work with the party offering the work.