What is Counterparty Risk
In our prior definition of forward contract we had Sam Jackson, a small Black farmer growing sweet potatoes in Georgia, contracting with Lizzy Jackson a local pie making restaurateur. It brings up the next step on our way to investing: what if Sam couldn’t produce as large a crop as usual, due to the weather. Or what if Lizzy’s sales lagged in the last quarter and she cannot produce the purchase money. This is called counterparty risk.
The risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk as a risk to both parties and should be considered when evaluating a contract.
In most financial contracts, counterparty risk is also known as “default risk”.
Because A is a counterparty to B and B is a counterparty to A both are exposed to this risk. For example if Sam agrees to lends funds to Lizzy up to a certain amount, there is an expectation that Sam will provide the cash, and Lizzy will pay those funds back. There is still the counterparty risk assumed by them both. Lizzy might default on the loan and not pay Sam back or Sam might stop providing the agreed upon funds.
The risk that the other party in an agreement will default. In an option contract, the risk to the option buyer that the writer will not buy or sell the underlying as agreed. In general, counterparty risk can be reduced by having an organization with extremely good credit act as an intermediary between the two parties.
In options, the risk that the option holder will not exercise the option. This may be good if the price moves in the option writer’s favor, but counterparty risk is small in that situation.
More generally, the risk that one party in a contract will default or otherwise not fulfill his obligations. Counterparty risk can be diminished when one party mandates a co-signer or highly-rated guarantor.
Counterparty risk is the greatest in contracts drawn up directly between two parties and least in contracts where an intermediary acts as counterparty.
For example, in the listed derivatives market, the industry’s or the exchange’s clearinghouse is the counterparty to every purchase or sale of an options or futures contract. That eliminates the possibility that the buyer or seller won’t make good on the transaction.
The clearinghouse, in turn, protects itself from risk by requiring market participants to meet margin requirements. In contrast, there is no such protection in the unlisted derivatives market where forwards and swaps are arranged.