Reviewed by Aug 27, 2020| Updated on
Counterparty risk refers to the probability or possibility of default by one of the counterparties in a contract. The risk is of default in performance of their contractual obligation and can exist in any transaction including investment, trading and credit transactions. The different degree of counterparty risks are based on the nature and type of financial transactions.
Understanding Counterparty Risk
- Counterparty risk, also known as default risk, is the chance that a party to the contract will fail to fulfil obligations or make payments in a monetary arrangement or purchase arrangement. In financing arrangements, lenders and investors carry exposure to default risk in different forms of credit arrangements. Each party should evaluate the counterparty risk before entering into a contract.
- In case of high risk arrangements, a premium is often put on the contract value to compensate for the risk. The premium is known as risk premium. There are many ways to ascertain risk profile of a contracting party such as their credit score, existing loans or credit facilities, collaterals offered and so on.
- In business transactions, commercial or retail, credit reports from lenders or banks can be of value and help ascertain the risk of default. Financing companies, credit card companiaes, banks often analyse the credit scores of the prospective borrower to figure out the level of risk of entering into a contract.
- A credit score refers to a numerical value which indicates the creditworthiness of an individual or a company and is based on different factors and variables. In a case where a person's credit score is anything between 300 to 850, or a higher score, the less is the risk of default by the person. Normally, a person having a credit score of 750 and above is in the excellent category.
There are several factors which bear an impact on the credit score. The factors include payment history, value of debt, period of credit history and quantum of credit utilisation (percentage of credit available actually utilised). The number on the credit score reflects the degree of counterparty risk for the lender or creditor. A borrower having a credit score of 750 is a low counterparty risk, and a borrower having a credit score of 450 is a high counterparty risk.