Counterparty risk

economic-dictionary

Counterparty risk is that which refers to the possibility that the other agent in a transaction will default on its commitment.

Viewed another way, this risk is always assumed when closing a contract or transaction. This is due to the probability, even if it is minimal, that the counterpart is unaware of or is unable to honor the agreement assumed.

For example, in the case of a buyer, the counterparty risk would be that the seller does not deliver the purchased merchandise. This would happen, for example, if the customer paid in advance.

Also, for the seller, the counterparty risk is that the buyer will not pay off his debt. This happens, for example, in sales on credit.

One way to protect yourself against counterparty risk is by purchasing credit insurance. This type of policy allows the insured to demand, within the limits of the law and the respective contract, compensation in the event of the insolvency of his debtor (s).

Measuring counterparty risk

One way to measure counterparty risk is by taking your credit quality as a reference. This is calculated, in international markets, by rating agencies, such as Moody’s, Standard & Poor’s and Fitch IBCA.

These agencies usually group the entities, companies or countries analyzed into different categories. Thus, the best payers could be classified as A +, while those with the highest probability of default are considered in group C-. As a detail, it is important to indicate that each rating agency has its own categories.

It should be noted that governments are those agents that tend to offer less counterparty risk. However, there are some nations with high external deficits or debt and that represent a high risk for investors who are interested in acquiring, for example, sovereign bonds issued by that country.

Another point to note is that agencies usually analyze various factors such as the economic and political situation, or the financial statements and the capacity of managers in the case of companies.

Counterparty risk and credit risk

It is important to differentiate counterparty risk from credit risk. The latter refers to the possibility that a debtor has of not fulfilling his obligations to a creditor.

In contrast, counterparty risk not only encompasses the probability of default by a debtor, but is also broader. Thus, it includes the possibility of any of the parties to the contract breaching their commitment. For example, it may be that a supermarket supplier delivers a product that does not meet the characteristics established in the agreement.

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