What is counterparty risk?

Varying degrees of counterparty risk exist 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.

Which financial products carry 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.

Does a derivative business have a lot of counterparty risk?

In derivatives businesses, where notional outstandings are measured in the trillions, that means a lot of counterparty risk is going uncounted and unmitigated. And that is only derivatives; other banking businesses house much more counterparty risk.

Can a bank's counterparty risk management approach be valid?

While much of a bank’s counterparty risk-management approach can be valid, a missing link between the suspicions of the front office or the risk department and the payment processes in the back office can lead to significant losses.