What is Counterparty Risk?
Counterparty risk is referred to the risk of potential expected losses that would arise for one counterparty on account of default on or before the maturity of the derivative contract by another counterparty to such derivative contract. It is prevalent in all types of transactions when they are undertaken through a centralized counterparty or if the trades are undertaken in the over-the-counter (OTC) market; however, the quantum of risk is comparatively very high in the case of OTC derivate contracts.
Examples of Counterparty Risk
ABC Bank invested in the non-convertible debentures of ray housing finance, which have a maturity of 10 years and pays a semi-annual coupon of 5% per annum. If ray housing finance fails to make payment of coupon and principal amount, the risk arising from that for ABC Bank is counterparty risk.
Alpha bank entered into an interest rate swap (IRS) agreement with the beta bank to pay a fixed interest of 5% on a notional amount of $ 25 million payable semi-annually and receive a floating rate based on 6-month LIBOR.
To account for the risk arising from such an IRS contract, Alpha bank is required to calculate its exposure at default through a method known as the current exposure method, which is based on the maturity of the derivative contract, type of contract (interest or forex contract) and credit rating of the counterparty, i.e., Beta bank and accordingly need to keep a certain amount of capital as provision for the default arising from such counterparty risk.
Let’s undertake calculations based on some hypothetical data.
Calculation of Provision for Counterparty Risk by Alpha Bank
|Type of Contract||Interest Rate Swap|
|Notional Amount||25 Million Dollars|
|Time to Maturity||5 Years|
|Date of Initiation||01.01.2019|
|Date of Maturity||01.12.2023|
|Credit Rating of Counterparty i.e. Beta Bank||AA|
|Credit Conversion Factor (Based on Type of Contract and Residual Maturity)||2%|
|Mark to Market Value of the Contract on 30.09.2019||-0.12 Million Dollars|
|Potential Future Exposure||0.5|
|Exposure for Calculation of Provision||0.38 Million Dollars|
Thus 0.38 million dollars is the amount of provision alpha bank will account for the counterparty risk arising out entering into an interest rate swap agreement with the beta bank.
How to Reduce It?
- One of the most effective ways to reduce counterparty risk is to trade only with high-quality counterparties with high credit ratings such as AAA etc. This will ensure better CRM and decreasing the chances of future losses.
- Netting is another useful tool to reduce this risk. Usually, there are multiple trades undertaken by the financial between them, such as between two counterparties. There may be various; some will have a positive value (MTM gain), and some will have a negative value (MTM loss). By netting such positions, the loss can be reduced drastically, and counterparty risk can be reduced substantially.
- Collateralization is another useful tool to reduce this risk and involves placing high-quality collateral such as cash or liquid securities, reducing net exposure.
- Diversification is another handy tool to reduce if not necessarily to eliminate the risk. By trading with multiple counterparties, there won’t be a single counterparty with significant exposure, which will facilitate a single counterparty.
- This risk is to shift from bilateral trades to centralized trades. All transactions are undertaken with a centralized counterparty (such as exchanges and clearinghouses), which eliminate the specific risk but give rise to systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”..
This is very important and goes beyond credit risk and is prevalent in most of the transactions undertaken.
#1 – Repo Transactions
These are short term trade agreements between financial institutions, which are usually secured by liquid collateral securities on which haircut is applied to mitigate counterparty risk.
#2 – OTC Derivative
As mentioned above, these are bilateral trades between two counterparties and mostly take the form of interest rate swapsInterest Rate SwapsAn interest rate swap is a deal between two parties on interest payments. The most common interest rate swap arrangement is when Party A agrees to make payments to Party B on a fixed interest rate, and Party B pays Party A on a floating interest rate. (IRS).
#3 – Forex Forwards
Such contracts are usually for more extended periods and involve an exchange of notional amounts and carry a high amount of counterparty risk.
Comparison Between Counterparty Risk and Credit Risk
|Counterparty Risk||Credit Risk|
|This also originates from inability or failure to make a payment; however, the amount of exposure is not predetermined.||Credit risk is the possibility of loss on account of default due to the inability or unwillingness of a borrower to meet its liability. In this case, the amount of loss is predetermined.|
|It is most relevant in derivatives marketsDerivatives MarketsThe derivatives market is that financial market which facilitates hedgers, margin traders, arbitrageurs and speculators in trading the futures and options that track the performance of their underlying assets. and especially OTC trades.||Credit risk finds its relevance in loans and advances given by banks and financial institutions.|
|This is a subset of credit risk.||It includes counterparty risk as well.|
|Risk Exposure on account varies based on the MTM position on the date of default.||Credit risk exposure is mostly predetermined and doesn’t vary.|
This is a significant risk that needs to be well monitored and involves complex computation due to its inherent complexity and multiple factors. It is observable in derivative instruments, which are itself ever-evolving, adding more to its complexity. Financial institutions, including banks, run a massive position in derivative exposure, which attracts counterparty risk and needs to manage it effectively. Past events have shown this risk to have a catastrophic impact on the global financial markets.
This has been a guide to What is Counterparty Risk & its Definition. Here we discuss the importance of counterparty risk and how to reduce it along with examples. You can learn more about from the following articles –