Counterparty Risk

What Is Counterparty Risk?

Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.

Understanding Counterparty Risk

Varying degrees of counterparty risk exists in all financial transactions. Counterparty risk is also known as default risk. Default risk is the chance that companies or individuals will be unable to make the required payments on their debt obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. Counterparty risk is a risk that both parties should consider when evaluating a contract.

Counterparty Risk and Risk Premiums

If one party has a higher risk of default, a premium is usually attached to the transaction to compensate the other party. The premium added due to counterparty risk is called a risk premium.

In retail and commercial financial transactions, credit reports are often used by creditors to determine the counterparty's credit risk. Credit scores of borrowers are analyzed and monitored to gauge the level of risk to the creditor. A credit score is a numerical value of an individual's or company's creditworthiness, which is based on many variables.

A person's credit score ranges from 300 to 850, and the higher the score, the more financially trustworthy a person is considered to be to the creditor. Numerical values of credit scores are listed below:

Many factors impact a credit score including a client's payment history, the total amount of debt, length of credit history, and credit utilization, which is the percentage of a borrower’s total available credit that is currently being utilized. The numerical value of a borrower's credit score reflects the level of counterparty risk to the lender or creditor. A borrower with a credit score of 750 would have low counterparty risk while a borrower with a credit score of 450 would carry high counterparty risk.

If the borrower has a low credit score, the creditor will likely charge a higher interest rate or premium due to the risk of default on the debt. Credit card companies, for example, charge interest rates in excess of 20% for those with low credit scores while simultaneously offer 0% interest for customers that have stellar credit or high credit scores. If the borrower is delinquent on payments by 60 days or more or exceeds the card's credit limit, credit card companies usually tack on a risk premium or a "penalty rate," which can bring the interest rate of the card to over 29% annually.

Investors must consider the company that's issuing the bond, stock, or insurance policy to assess whether there's default or counterparty risk.

Investment Counterparty Risk

Financial investment products such as stocks, options, bonds, and derivatives carry counterparty risk. Bonds are rated by agencies, such as Moody's and Standard and Poor's, from AAA to junk bond status to gauge the level of counterparty risk. Bonds that carry higher counterparty risk pay higher yields. When counterparty risk is minimal, the premiums or interest rates are low, such as with money market funds.

For example, a company that offers junk bonds will have a high yield to compensate investors for the added risk that the company could default on its obligations. Conversely, a U.S. Treasury bond has low counterparty risk and therefore; rated higher than corporate debt and junk bonds. However, treasuries typically pay a lower yield than corporate debt since there's a lower risk of default.

Examples of Counterparty Risk

When the counterparty risk is miscalculated and a party defaults, the impending damage can be severe. For example, the default of so many collateralized debt obligations (CDO) was a major cause of the real estate collapse in 2008.

Subprime Risk

Mortgages are securitized into CDOs for investment and backed by the underlying assets. One of the major flaws of CDOs before the economic crash was that they contained subprime and low-quality mortgages, whereby the CDOs were given the same high-grade ratings as corporate debt.

The high credit rating for CDOs allowed them to receive institutional investment since funds are required to invest only in highly rated debt. When borrowers began defaulting on mortgage payments, the real estate bubble burst, leaving the investors, banks, and reinsurers on the hook for massive losses. The ratings agencies received a lot of blame for the collapse, which eventually led to the financial market meltdown that defined the bear market of 2007–2009.

AIG and Insurance Risk

AIG or American International Group offers insurance products for real estate, businesses, and individuals. The company needed a bailout from the U.S. government during the financial crisis. For those who were insured by AIG, they suddenly faced an increase in counterparty risk. As a result, investors must consider the company that's issuing the bond, stock, or insurance policy to assess whether there's counterparty risk.