What is Counterparty Risk?

Examples of Counterparty Risk

Example #1

ABC Bank invested in the non-convertible debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more of Ray housing finance, which have a maturity of 10 years and pays a semi-annual coupon of 5% per annum. If Ray housing finance fails to make payment of coupon and principal amount, the risk arising from that for ABC Bank is counterparty risk.

Example #2

Alpha bank entered into an interest rate swap (IRS) agreement with the beta bank to pay a fixed interest of 5% on a notional amount of $ 25 million semi-annually and receive a floating rate based on a 6-month LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more.

To account for the risk arising from such an IRS contract, Alpha bank is required to calculate its exposure at default through a method known as the current exposure method, which is based on the maturity of the derivative contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more, type of contract (interest or forex contract) and credit rating of the counterparty, i.e., Beta bank and accordingly need to keep a certain amount of capital as provision for the default arising from such counterparty risk.

Let’s undertake calculations based on some hypothetical data.

Calculation of Provision for Counterparty Risk by Alpha Bank

Thus 0.38 million dollars is the amount of provision alpha bank will account for the counterparty risk arising out entering into an interest rate swap agreement with the beta bank.

How to Reduce It?

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Importance

This is very important and goes beyond credit risk and is prevalent in most of the transactions undertaken.

#1 – Repo Transactions

These are short-term trade agreements between financial institutions, usually secured by liquid collateral securities on which a haircut is applied to mitigate counterparty risk.

#2 – OTC Derivative

As mentioned above, these are bilateral trades between two counterparties and mostly take the form of interest rate swapsInterest Rate SwapsAn interest rate swap is a deal between two parties on interest payments. The most common interest rate swap arrangement is when Party A agrees to make payments to Party B on a fixed interest rate, and Party B pays Party A on a floating interest rate.read more (IRS).

#3 – Forex Forwards

Such contracts are usually for more extended periods, involve an exchange of notional amounts, and carry a high amount of counterparty risk.

Comparison Between Counterparty Risk and Credit Risk

Conclusion

Financial institutions, including banks, run a massive position in derivative exposure, which attracts counterparty risk and needs to manage effectively. This is a significant risk that needs to be well monitored and involves complex computation due to its inherent complexity and multiple factors. It is observable in derivative instruments, which are ever-evolving, adding more to their complexity. Past events have shown this risk to have a catastrophic impact on the global financial markets.

This has been a guide to Counterparty Risk and its definition. Here we discuss the importance of counterparty risk and how to reduce it, along with examples.You can learn more about it from the following articles –

  • Check Sheet DefinitionRisk Rating DefinitionUnsystematic Risk DefinitionPolitical RiskFull-Form of LIBOR