Counterparty risk is a credit risk where one of the parties in a financial contract either defaults or fails to fulfill their contractual obligations. The risk directly draws up between two parties in a contract or where an intermediary plays the role of the counterparty.
Counterparty risk can be better illustrated with an example. For instance, you’ve bought a corporate bond from a specific company. In this situation, you expect to receive certain coupon payments and the nominal value of your bond at the maturity period. So, in this transaction, you are exposed to a certain risk that the company cannot pay the coupons (or the decided nominal value) at the given point of time. This risk is called the counterparty risk.
We can also take an example of counterparty risk from the derivatives market. Here, the industry/exchange’s clearing house will be considered as the counterparty of every purchase/sales in the future contract. This in turn, reduces the possibilities of loss of goods in the transaction, either by the buyer or the seller. The clearinghouse will also protect itself from the risk by asking the market participants to meet the minimum requirements once again. It should be noted that no such protection is applicable in the unlisted derivatives market (OTC) that deals with the arrangement of forward and swaps.
Where is counterparty risk experienced?
Counterparty risk is widely experienced in the financial markets, and it is faced by almost all kinds of investors. In fact, all corporate investors take a counterparty risk while they invest in the corporate bonds. As most of the fixed informed investors are aware of this, they tend to make a more informed decision for taking this extra credit risk.
The big institutional investors use equity options, swaps and the swaps linked with inflation to protect their market risks. They execute their transactions in the OTC market as their listed markets do not come with the right kind of hedging tools for the business.
Can counterparty risk be mitigated?
As large institutional investors and banks cope with counterparty risk, it is indeed quite easy to hedge counterparty risk. All that you have to do is follow a ‘structured approach’ for the mitigation. This approach involves;
- Counterparty selection
- Collateral arrangement
For the first step, you have to thoroughly analyze the counterparties based on their credit ratings, credit spread and their experience in trading a specific equipment/good.
After short listing the prospective counterparties, documentation has to be drafted following the format of International Swaps and Derivatives Organization (ISDA). The right documentation is extremely crucial for successfully mitigating counterparty risk.
The third step will be based on the performance of the collateral management. This step can only be conducted after the formulation of the ISDA document, and the execution of the related transactions are completed. One has to continuously monitor and timely report the counterparty risks as a part of the collateral management.
Thus, if counterparty risk is aptly addressed with the proper processes in place, it can be easily mitigated even under extreme market circumstances.