Counterparty risk exposure is the financial measure of performance risk in any contract.
Many contract exposures are managed through operational or legal means; this article focuses on financial risk management.
A comprehensive credit risk management policy addresses counterparty initiation and monitoring, contracting standards, credit authorities and limits, the transaction approval process, credit risk reporting, and reserving and capital policy.
Credit insurance can fit the exposure perfectly, but may be costly.
Credit default swaps are linked to credit events and payments that may not correspond exactly to counterparty exposures, but may be cheaper than credit insurance.
Defining Counterparty Risk
Counterparty risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations; it is otherwise known as default risk.
Counterparty risk relates closely to performance risk. It arises whenever one entity depends on another to honor the terms of a contract. If a parts supplier fails to provide steering wheels to General Motors, GM will be damaged because of its inability to deliver complete cars. The resulting profit reduction is defined as the exposure that GM runs to its supplier. Similarly, GM runs a credit exposure to its customers who have not yet paid for their cars. This would include dealers and end customers who are financed by GMAC, GM’s financing subsidiary.
Normally, performance risk is managed operationally—i.e., GM would use alternative suppliers, reserve supplies of steering wheels, and contractual nonperformance remedies to manage its performance risk. Also, to manage risk to its dealers, it may retain title to vehicles, verify insurance coverage, obtain some advance payment, and use legal means to minimize their collections risk. In addition to these counterparty risk situations, GM will experience counterparty risk from its derivative contracts.
Suppose GM wanted to purchase steering wheels on an ongoing basis from a European supplier, and protect itself from devaluation of the US dollar. It would likely enter a foreign exchange swap transaction with a bank. After entering the contract, rates would continue to change, bringing the contract in-the-money to either GM or the bank. If the dollar were to devalue, the contract would move in-the-money to GM, which would expose GM to the possible failure of the bank to honor its contract. Conversely, if the dollar were to strengthen, the bank would have an in-the-money contract with GM, and subsequently become concerned about GM’s possible default risk.
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