Is credit risk the same as counterparty risk?
A counterparty credit risk is simply a subtype of a credit risk. The term “credit risk” covers all types of economic loss, including both counterparty and issuer credit risks. It's a term often used when talking about banks loaning money or corporate bonds.
Credit risk, also known as default risk, is a way to measure the potential for losses that stem from a lender's ability to repay their loans. Credit risk is used to help investors understand how hazardous an investment is—and if the yield the issuer is offering as a reward is worth the risk they are taking.
Counterparty risk is one of several types of risk that banks routinely encounter in their commercial activity (Exhibit 1). We define it as one of two kinds of credit risk. The better-known form, at least for corporate banks, is what we call “issuer risk”—the risk that a borrower will default on his obligations.
Unlike a firm's exposure to credit risk through a loan, where the exposure to credit risk is unilateral and only the lending bank faces the risk of loss, CCR creates a bilateral risk of loss: the market value of the transaction can be positive or negative to either counterparty to the transaction.
Counterparty risk is the probability that the other party in an investment, credit, or trading transaction may not fulfill its part of the deal and may default on the contractual obligations.
Credit risk is the possibility of a loss happening due to a borrower's failure to repay a loan or to satisfy contractual obligations. Traditionally, it can show the chances that a lender may not accept the owed principal and interest. This ends up in an interruption of cash flows and improved costs for collection.
Counterparty credit risk is the risk arising from the possibility that the counterparty may default on amounts owned on a derivative transaction. Derivatives are financial instruments that derive their value from the performance of assets, interest or currency exchange rates, or indexes.
A bank borrows a security from a counterparty and posts cash to the counterparty as collateral (or undertakes a transaction that is economically equivalent, such as a reverse repo). The bank is exposed to the risk that its counterparty defaults and does not return the cash that the bank posted as collateral.
Consider buying CDS or credit insurance to hedge against counterparty credit risk. These instruments can help transfer risk to other parties, acting as a form of insurance against defaults.
In other words, CVA is the market value of counterparty credit risk. This price adjustment will depend on counterparty credit spreads as well as on the market risk factors that drive derivatives' values and, therefore, exposure. It is typically calculated under a simulation framework.
What is the role of counterparty credit risk?
The Counterparty Credit Risk (CCR) team is primarily responsible for assessing the financial stability of DTCC's member firms by interpreting financial documents of banks, broker-dealers, and other ...
Counterparty risk is the risk of one or more parties in a financial transaction defaulting on or otherwise failing to meet their obligations on that trade. Counterparty risk is especially relevant to derivatives markets, where notional values can far exceed the size of the underlying securities.
Financial institutions face different types of credit risks—default risk, concentration risk, country risk, downgrade risk, and institutional risk.
Credit risk is determined by various financial factors, including credit scores and debt-to-income (DTI) ratio. The lower risk a borrower is determined to be, the lower the interest rate and more favorable the terms they might be offered on a loan.
Lenders also use these five Cs—character, capacity, capital, collateral, and conditions—to set your loan rates and loan terms.
It binds the information collected into 4 broad categories namely Character; Capacity; Capital and Conditions. These Cs have been extended to 5 by adding 'Collateral', or extended to 6 by adding 'Competition' to it (Reference: Credit Management and Debt Recovery by Bobby Rozario, Puru Grover).
Usually, instruments with a credit rating below AA are considered to carry a higher credit risk.
- Probability of default (PD): The probability that the counterparty will default.
- Exposure at default (EAD): The total amount of exposure on the counterparty at default.
The factors include payment history, the value of debt, period of credit history, and quantum of credit utilisation (percentage of credit available actually utilised). The number on the credit report reflects the degree of counterparty risk for the lender or creditor.
Each exchange of funds, goods, or services in order to complete a transaction can be considered as a series of counterparties. For example, if a buyer purchases a retail product online to be shipped to their home, the buyer and retailer are counterparties, as are the buyer and the delivery service.
What is the credit risk theory?
The Credit Risk Theory
In general, the higher the risk, the higher will be the interest rate that the debtors will be asked to pay on the debt. (Owojori, Akintoye & Adidu, (2011).
This risk arises due to reasons like fall or loss of income of the borrower, change in market conditions, loan given out to borrowers without proper assessment of the borrower's creditworthiness or history, sudden rise in interest rates, etc.
Type 1 aims to cover exposures primarily of the sort that might well not be diversified and where the counterparty is likely to be rated (e.g. reinsurance arrangements), whilst Type 2 aims to cover exposures primarily of the sort that are usually diversified and where the counterparty is likely to be unrated (e.g. ...
In contrast, forward contracts carry counterparty risk since the performance depends heavily on the financial stability of both parties involved, particularly true for a long-term forward contract or one with a large value. Liquidity: Forward contracts have lower liquidity than futures contracts.
A counterparty credit limit (CCL) is a limit that is imposed by a financial institution to cap its maximum possible exposure to a specified counterparty. CCLs help institutions to mitigate counterparty credit risk via selective diversification of their exposures.
