The biggest risk any organization could take is that of not taking any risk. There is always a high chance of the counterparty defaulting or failing to meet its obligations in a transaction, which can also be termed as Counterparty Risk. In all financial transactions, there are varying degrees of counterparty risk. It can also be called Default Risk. This is normally used in terms of a financial transaction. It can exist in trading, credit, and investments transaction. This risk should be weighed by both sides during the contract assessment.
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Default risk has to be always kept in mind by both parties while signing a contract. It is the likelihood of businesses or entities not being able to pay their debts. Although it’s impossible to know who is going to default. The severity of the loss can be reduced by assessing and analyzing the counterparty before giving them the required amount. For example, XYZ bank invested in a non-convertible debenture of a housing finance company having a maturity of 10 years with an annual coupon of 7%. If the housing finance company fails to pay the annual coupon and the principal amount at maturity then XYZ bank faces a counterparty risk.
Causes of Counterparty Risk:
In recent times, understanding of the threats and risks of counterparties, in general, has significantly increased. A significantly increased credit spreads, downward changes to credit ratings, and the increase in the number of bankruptcies and acquisitions in the financial markets demonstrate the current prevalent understanding of counterparty risk. Some of the other causes are:
- When the majority of the money is given to a specific sector may be a problem for the party, if that sector is not doing too well then there are high chances of default.
- The company may not have assessed the borrower’s repayment capability properly before lending the money.
- Financial investment products like stock, bonds, options, and derivatives bring counterparty risk to the firm.
- The economy goes into a period of depression as well as a boon. The party must also take into consideration the creditworthiness of the counterparty in case of depression.
Types of Transactions Involving Counterparty Risk:
The counterparty risk in financial markets is prevalent and is a risk faced both by large and small numbers of investors. If a party has a higher chance of default then a premium is added to the transaction in order to compensate in case of default. The premium that is added is called the risk premium. Some common transactions involving counterparty risks are described below:
- Counterparty risk usually comes into the picture when bonds are issued. Bonds in the non-investment grade have a higher chance of default thus the rating is checked before the bond is purchased.
- The American insurance group offers insurance to real estate, businesses, and individuals. The company needed to get financial assistance from the US government hence those who had insurance with them faced counterparty risk.
- Corporations and businesses, including accounts receivable and payable by financial brokers.
- Trade guarantees and short-term lending, including letters of credit, banker’s acceptances, unfunded commitments, and revolving credit lines.
- Repurchase agreements and reverse repurchase agreements, as well as securities lending arrangements.
- Derivatives, including currency forwards, interest rate swaps, asset swaps, credit default swaps, total return swaps, and options on swaps
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Consequences of Counterparty Failure:
There has been a counterparty failure if a company fails to obtain financial benefits as negotiated. Pledged asset collateral or government intervention can often lead to a complete or partial recovery of losses, but only after a lag. At other times, due to the highly leveraged and high-risk aspect of financial intermediaries, there could be no recovery. Note that it does not always require the investor to bear a loss on a counterparty default. Often for reasons other than financial reasons, the counterparty can fail to deliver for a time consuming and expensive legal procedure for the recovery of funds. Corporations must also determine the readiness and the willingness of the counterparty to pay.
How to Reduce It:
- One of the most effective ways is to only trade with counterparties having high quality with a high credit rating like AAA. It will decrease the future chances of losses.
- Collateral which means placing high-quality assets when a debt is taken from a party can be used as another way to reduce counterparty risk.
- There should be diversification while trading so that there is no concentration of the money and hence the losses can be reduced.
- Another way to mitigate the counterparty risk is netting which means lowering the net amount by excluding a non-net amount like taxes which will lead to the counterparty having to pay less and thus reduce the risk.
- Instead of trading with another nation, a party should trade with the market maker who centralizes the trade and hence reduce the counterparty risk.
Counterparty risk is a significant risk any organization will face thus needs to well monitored and also involves complex computation due to its multiple factors. It can have a catastrophic impact on the global financial market if not dealt with in the right way. If adequately handled and sufficient procedures are in place, the counterparty risk can easily be minimized to a low level.
Author -Sanjana Rau
About the author- Started my journey of self even when the odds were against me, keen observation, a cool temper, and sports worked the best for me.