Counterparty risk

Every contract has two sides, and each side is relying on the other to perform. Counterparty risk is the chance that the other side does not.

The workbook's definition: the risk of an economic loss from the failure of the counterparty to fulfil its contractual obligation. It notes that this is also called default risk or credit risk.

The uncomfortable part is when default happens. A counterparty rarely defaults at random. He defaults when performing has become expensive — when the market has moved against him and walking away is worth more than honouring the deal. A party may default on his obligation if there is an incentive to default. That is exactly the moment you most need him to perform.

How much counterparty risk you carry depends entirely on the structure of the contract:

In OTC markets generally, Chapter 1 adds that management of counterparty (credit) risk is decentralised and sits within individual institutions, with no formal centralised limits on positions, leverage or margining.

On an exchange, the clearing corporation interposes itself through novation and guarantees financial settlement. It protects that guarantee with initial margin, daily mark-to-market settlement and the Core Settlement Guarantee Fund.

That is why the Risk Disclosure Document in Chapter 10 says counterparty risk is generally not applicable to clients trading in exchange-traded equity derivatives.

The workbook's rice example, with the arithmetic spelled out.

A and B sign a bilateral agreement: A will buy 100 kg of rice from B at Rs 40 per kg after 6 months. Contract value: 100 × 40 = Rs 4,000. A is B's counterparty, and B is A's.

Scenario 1 — rice rises to Rs 50.

Market value of 100 kg = 100 × 50 = Rs 5,000
B receives under the contract     = Rs 4,000
B's incentive to default          = Rs 1,000

B may decline to deliver. A must then buy in the market at Rs 5,000 — the Rs 1,000 he thought he had locked in is gone.

Scenario 2 — rice falls to Rs 35.

Market cost of 100 kg = 100 × 35 = Rs 3,500
A pays under the contract     = Rs 4,000
A's incentive to default      = Rs 500

Now A may buy from the market instead of honouring the contract, leaving B with unsold rice.

Whichever way the price moves, one side has a reason to walk away. Move the same trade onto an exchange as a futures contract and neither A nor B faces the other: each faces the clearing corporation, which has collected margin from both.

Chapter 1, section 1.7, lists counterparty risk first among the risks of derivatives trading. Chapter 3, section 3.1, gives the rice example as one of the two major limitations of forwards (with liquidity risk), and section 3.5 puts it in the forwards-versus-futures table. Chapter 10, section 10.2, repeats it inside the Risk Disclosure Document with the qualification that it generally does not apply to exchange-traded equity derivatives.

• Counterparty risk and liquidity risk are two separate limitations of forwards. Questions ask for them individually.
• Default follows incentive. The party the price has moved against is the one likely to default — the seller when prices rise, the buyer when they fall.
• Exchange-traded does not mean risk-free. It means the counterparty risk has been transferred to, and managed by, the clearing corporation.
• The workbook treats default risk and credit risk as other names for counterparty risk. Do not pick an answer that presents them as a different risk.