Definition
Counterparty risk is the possibility that your contract partner fails to honor the agreement. It is most significant in OTC derivatives where there is no exchange guarantee. Central counterparty clearinghouses (CCPs) were mandated after 2008 to reduce systemic counterparty risk. Credit Valuation Adjustment (CVA) quantifies and prices counterparty risk into derivative valuations.
lightbulb Example
In 2008, Lehman Brothers' bankruptcy created massive counterparty risk. Banks that had bought CDS protection from Lehman were left unhedged. Post-crisis reforms mandated central clearing for standardized swaps to prevent similar cascading failures.
Warning
Always assess counterparty creditworthiness for OTC trades. Even strong counterparties can fail during systemic crises.
verified_user Key Points
- Major risk in OTC derivatives
- Central clearing reduces but doesn't eliminate risk
- CVA pricing adjusts for counterparty creditworthiness
- Collateral agreements (CSAs) mitigate exposure