Counterparty Risk

From Open Risk Manual
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Counterparty Risk denotes as specific type of Credit Risk that is associated with bilateral Derivative and repo transactions. The counterparty legal form is typically a limited liability corporation

Credit Risk

Derivatives can be of very long duration. Over the life of the transaction, if the underlying market moves against the counterparty position (e.g. receiving floating rate and paying fixed rate and the floating rate drop to zero) the contract creates exposure to the counterparty.

This credit risk is a type of corporate credit risk, namely the legal entity that may default on the derivative contract is a corporation, typically with limited liability. The obligations and legal framework that is applicable in the case of default or bankruptcy are determined by the laws governing the responsibilities of commercial entities engaging in derivative transactions.

In common with other credit risk types, counterparty credit risk can be decomposed into Default Risk and Recovery Risk. The unique characteristic of counterparty risk (CRR) is that exposure is variable (market dependend) and exposure at default cannot only be estimated on the basis of modeling assumptions

Issues and Challenges