What is Risk?
The world of financial transactions is fraught with a myriad of uncertainty, which we commonly call “risk”.
Risk is classified into two basic categories: systematic and unsystematic.
Systematic risk is the risk that exists throughout the entire system. This type of risk affects an entire market or section of the market, and this risk affects all investments.
Unsystematic risk is often referred to as residual risk, particular risk, or diversifiable risk. It is unique to a particular company or industry.
Within these two categories, there are particular forms of risk that every investor should be aware of.
- Credit Risk
- Country Risk
- Political Risk
- Reinvestment Risk
- Interest Rate Risk
- Foreign Exchange Risk
- Inflationary Risk
- Market Risk
In this article, we look at one of the significant risks, that is counterparty risk.
What is Counterparty Risk?
Counterparty risk is the danger of the other party to a financial contract defaulting on its commitment. All financial transactions involve some degree of counterparty risk. The term “counterparty risk” is also used to refer to default risk. Default risk is the possibility that businesses or people will be unable to meet their debt obligations. Counterparty credit risk is a subject of consideration for both parties while considering a contract.
If one party faces a greater risk of default, the transaction is typically subject to a premium to compensate the other party. The risk premium is the premium added as a result of counterparty risk.
Creditors frequently use credit reports to assess the counterparty’s credit risk in retail and commercial financial transactions. Credit scores of debtors are assessed and tracked to determine the creditor’s risk level. It’s the numerical representation of an individual’s or business’s creditworthiness calculated using various characteristics.
Numerous elements affect a credit score, including a client’s payment history, total debt, credit history duration, and credit utilisation, which is the proportion of a borrower’s total available credit that is presently being used. The numerical value assigned to a borrower’s credit score indicates the lender’s or creditor’s level of counterparty risk meaning a borrower with a credit score of 750 carries little counterparty risk. Still, a borrower with a credit score of 450 carries a lot.
If a borrower has a lower credit score, the creditor will almost certainly demand a higher interest rate or premium to compensate for the increased risk of debt default.
Counterparty Risk in Different Investment Types
Securities, options, bonds, and derivatives all involve some level of counterparty risk. Bonds are assessed by rating organisations such as Moody’s and Standard and Poor’s to indicate their level of counterparty risk, ranging from AAA to junk bond status. Bonds that involve a greater degree of counterparty risk yield more. When counterparty risk is low, such as with money market funds, the premiums or interest rates are low.
For instance, a corporation that issues junk bonds will offer a high yield to compensate investors for the increased risk of defaulting on its obligations. On the other hand, a US Treasury bond has little counterparty risk and is rated higher than corporate debt and junk bonds. On the other hand, Treasury bonds often return less than the corporate debt due to the lower risk of default.
Credit default swaps, a prominent counterparty risk derivative, are frequently exchanged directly with another party rather than on a centralised exchange. Due to the contract’s direct connection to the other party has a larger risk of counterparty default. Neither party has complete information of the other’s financial health (and their ability to cover obligations). This is distinct from products that are traded on an exchange. The exchange, not the single firm on the other side of the trade, is the counterparty in this scenario.
Counterparty Risk Is Inherent in a Credit Derivative. While a loan carries the risk of default, a derivative carries the risk of counterparty default. Counterparty risk is a subclass of credit risk and refers to the risk of a counterparty defaulting on a contract in a variety of derivatives. Consider the risk of counterparty default in comparison to the risk of loan default. Bank A charges a yield of Rs. 1cr loan to Customer X that includes default risk compensation. However, the exposure is self-evident; it is about equal to the Rs. 10cr financed. However, a credit derivative is a bilateral contract that is unfunded. Apart from the collateral pledged, a derivative is a contractual promise that may be breached, exposing the parties to risk.
Examples of Counterparty Risk
- Broker Default: Imagine you’re trading stocks with a brokerage firm. If the brokerage suddenly goes bankrupt or can’t fulfil its promises, you might struggle to get back your money or complete your trades.
- Supplier Insolvency: Picture you running a business relying on a main supplier for important materials. If that supplier goes out of business or doesn’t deliver as agreed, it could disrupt your operations, causing financial losses and hurting your reputation.
- Loan Default: Think about lending money to a friend. If they don’t pay back the loan, you risk losing your money and straining your relationship.
- Credit Derivatives: In finance, there are tools like credit default swaps used to protect against loan defaults. But if the party providing the protection doesn’t hold up their end in a default situation, the protection might not work as expected.
- International Trade: When doing business internationally, you might face risks with foreign suppliers or customers. Factors like currency changes, political issues, and different laws can make it harder to get paid or stick to contracts.
These examples show how counterparty risk can show up in everyday situations, stressing why it’s important to understand and manage these risks carefully.
Difference between Credit Risk and Counterparty Risk
The terms’ credit risk’ and ‘counterparty credit risk’ refer to the same sort of risk, namely the hazard that the counterparty to a contract would default on its repayment obligations.
However, ‘credit risk’ is typically used in the context of traditional loans, i.e. for practitioners, ‘credit risk’ is associated with lending money to someone. In this case, your total risk is known at the beginning of the transaction, i.e. if you lend 1 million dollars to a company, you cannot theoretically lose more than 1 million dollars. Whereas ‘counterparty credit risk’ will be utilised primarily on the OTC derivatives business, where a contract’s value may be either an asset or a liability during the contract’s life, and at its expiration, i.e. we have no idea how much we may lose for the contract’s life. To quantify ‘counterparty credit risk,’ it boils down to estimating how much you may potentially lose if the counterparty fails to pay at a particular point in the contract’s life – a calculation that is more difficult than in the case of ordinary loans/guarantees.
Wrapping Up!
Understanding counterparty risk is essential for anyone engaged in financial transactions, as it addresses the danger of the other party defaulting on their commitments. From trading securities to international business, the impact of counterparty risk is vast and varied.
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