Counterparty Risk
What Is Counterparty Risk?
Counterparty risk is the probability or likelihood that one of those engaged with a transaction could default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.
Figuring out Counterparty Risk
Changing degrees of counterparty risk exists in every financial transaction. Counterparty risk is otherwise called default risk. Default risk is the chance that companies or people will not be able to make the required payments on their debt obligations. Lenders and investors are presented to default risk in practically all forms of credit extensions. Counterparty risk is a risk that the two players ought to consider while assessing a contract.
Counterparty Endlessly risk Premiums
On the off chance that one party has a higher risk of default, a premium is generally connected to the transaction to repay the other party. The premium added due to counterparty risk is called a risk premium.
In retail and commercial financial transactions, credit reports are frequently utilized by creditors to decide the counterparty's credit risk. Credit scores of borrowers are investigated and observed to check the level of risk to the creditor. A credit score is a mathematical value of a person's or alternately company's creditworthiness, which depends on numerous factors.
A person's credit score goes from 300 to 850, and the higher the score, the more financially dependable a person is viewed as to the creditor. Mathematical values of credit scores are listed below:
- Fantastic: 750 or more
- Great: 700 to 749
- Fair: 650 to 699
- Poor: 550 to 649
- Awful: 550 and below
Many factors impact a credit score including a client's payment history, the total amount of debt, length of credit history, and credit utilization, which is the percentage of a borrower's total accessible credit that is right now being used. The mathematical value of a borrower's credit score mirrors the level of counterparty risk to the lender or creditor. A borrower with a credit score of 750 would have low counterparty risk while a borrower with a credit score of 450 would carry high counterparty risk.
In the event that the borrower has a low credit score, the creditor will probably charge a higher interest rate or premium due to the risk of default on the debt. Credit card companies, for instance, charge interest rates in excess of 20% for those with low credit scores while at the same time offer 0% interest for customers that have stellar credit or high credit scores. In the event that the borrower is delinquent on payments by 60 days or more or surpasses the card's credit limit, credit card companies as a rule tack on a risk premium or a "penalty rate," which can bring the interest rate of the card to more than 29% every year.
Investors must consider the company that is giving the bond, stock, or insurance policy to evaluate whether there's default or counterparty risk.
Investment Counterparty Risk
Financial investment products like stocks, options, bonds, and derivatives carry counterparty risk. Bonds are rated by agencies, like Moody's and Standard and Poor's, from AAA to junk bond status to check the level of counterparty risk. Bonds that carry higher counterparty risk pay higher yields. When counterparty risk is insignificant, the premiums or interest rates are low, for example, with money market funds.
For instance, a company that offers junk bonds will have a high yield to remunerate investors for the additional risk that the company could default on its obligations. On the other hand, a U.S. Treasury bond has low counterparty risk and in this manner; rated higher than corporate debt and junk bonds. Be that as it may, treasuries regularly pay a lower yield than corporate debt since there's a lower risk of default.
Instances of Counterparty Risk
When the counterparty risk is erred and a party defaults, the looming damage can be extreme. For instance, the default of so many collateralized debt obligations (CDO) was a major reason for the real estate collapse in 2008.
Subprime Risk
Mortgages are securitized into CDOs for investment and backed by the underlying assets. One of the major blemishes of CDOs before the economic crash was that they contained subprime and low-quality mortgages, by which the CDOs were given similar high-grade ratings as corporate debt.
The high credit rating for CDOs allowed them to receive institutional investment since funds are required to invest just in highly rated debt. At the point when borrowers started defaulting on mortgage payments, the real estate bubble burst, leaving the investors, banks, and reinsurers on the hook for gigantic losses. The ratings agencies received a ton of fault for the collapse, which in the long run prompted the financial market meltdown that defined the bear market of 2007-2009.
AIG and Insurance Risk
AIG or American International Group offers insurance products for real estate, organizations, and people. The company required a bailout from the U.S. government during the financial crisis. For the people who were insured by AIG, they unexpectedly confronted an increase in counterparty risk. Thus, investors must consider the company that is giving the bond, stock, or insurance policy to survey whether there's counterparty risk.
Highlights
- Investors must consider the company that is giving the bond, stock, or insurance policy to evaluate whether there's default or counterparty risk.
- Counterparty risk is the probability or likelihood that one of those engaged with a transaction could default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.
- The mathematical value of a borrower's credit score mirrors the level of counterparty risk to the lender or creditor.
