What is Counterparty Risk
Counterparty risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk is 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.
BREAKING DOWN Counterparty Risk
For example, if Joe agrees to lends funds to Mike up to a certain amount, there is an expectation that Joe will provide the cash, and Mike will pay those funds back. There is still the counterparty risk assumed by both parties. Mike might default on the loan and not pay Joe back, or Joe might stop providing the agreed-upon funds.
Varying degrees of counterparty risk exist in all financial transactions. If one party has a higher risk of default, then a premium is usually attached for the other party. In retail and commercial financial transactions, credit reports are often used to determine the counterparty credit risk for lenders to make auto loans, home loans, and business loans to customers. If the borrower has low credit, the creditor charges a higher interest rate premium due to the risk of default on the debt, especially on uncollateralized debt.
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 category as a gauge of the level of counterparty risk. Bonds with higher counterparty risk offer higher yield premiums. When counterparty risk is minimal, the premiums or interest rates are low, such as with money market funds.
When the counterparty risk is miscalculated and a party defaults, the impending damage can be severe. This was a major cause of the real estate collapse in 2008 following the default of so many collateralized debt obligations (CDO). Mortgages are securitized into CDOs for investment and backed by the underlying assets. The major flaw prior to the economy crash was that subprime and low-quality mortgages composed of many faulty CDOs that were given the same high grade ratings as corporate debt. This allowed for institutional investment, since funds are required to invest only in specific highly rated debt. When borrowers started to default on mortgage payments, the bubble burst, leaving the investors, banks, and re-insurers 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.