Counterparty Credit Risk

A stock trade settles almost instantly, no lingering promise from either side. A derivative contract is different: it's a promise stretched over time. You buy a five-year swap, it moves in your favor, and now you're owed money you won't actually collect until the counterparty pays it. Counterparty credit risk is the possibility that when the bill comes due, the other side can't pay it.

Why it isn't the same as ordinary credit risk

Lend someone $100 and your exposure is simple: $100, full stop, known from day one. A derivative's exposure is not fixed at inception — it changes every day as the market moves, and it can even flip sign. A swap that owes you money today might owe the other party money next month if rates move. Your exposure to a counterparty's default is therefore a moving target, and what actually matters is the exposure on the day they default, not the exposure today.

This is the core object risk managers track: expected positive exposure, roughly "on average, across possible future paths, how much would we be owed if this counterparty defaulted at each future date." It gets larger the longer a contract has left to run and the more volatile the underlying market is, since both give the contract more room to move deep in your favor before a default.

Wrong-way risk

The sharpest version of this problem is wrong-way risk: when a counterparty's chance of default is correlated with how much they'd owe you. The textbook case is buying credit protection (a CDS) on a company from a bank whose own health is tied to that company's sector — if the reference company defaults, the same shock that triggers your payout may be exactly what pushes your protection-seller toward default too, right when you need them most.

Wrong-way risk is, structurally, a positive correlation between two series you'd rather see uncorrelated: exposure and default probability. The explorer below plots two correlated series and fits a line through them — drag the correlation slider toward 1 and watch the points march together into the top-right corner, which is exactly the shape of a wrong-way-risk relationship. Toward 0, the same exposure numbers tell you nothing about default risk, which is the safer, ordinary case.

Right-way risk is the mirror image and is generally welcome: exposure that shrinks exactly when the counterparty is more likely to default, for example collateral held that appreciates as the counterparty weakens.

Worked example: netting and CVA

A bank has two trades with the same counterparty: it is owed $8m on one swap and owes $3m on another. Without a netting agreement, if the counterparty defaults, the bank must still pay the $3m in full while lining up in bankruptcy court for the $8m — total exposure at risk is the full $8m gross. With a legally enforceable netting agreement, the two trades offset first: the bank's real exposure is $8\text{m} - 3\text{m} = 5\text{m}$, or $5m, a 37.5% reduction, purely from paperwork.

Banks price this residual risk into every derivative quote as a credit valuation adjustment (CVA): roughly, expected exposure at each future date, multiplied by the counterparty's default probability over that period, multiplied by the loss given default, summed across the life of the trade. If the counterparty's expected exposure is $5m on average and its annual default probability is 1.5% with a 60% loss given default, a rough one-year CVA estimate is $5\text{m} \times 0.015 \times 0.60 \approx 0.045\text{m}$, or roughly $45,000 — a real cost baked into the price, not a hidden one.

What this means in practice

• Central clearing exists to shrink this problem. A clearinghouse novates trades so each side faces the clearinghouse, not each other, and enforces daily margining so exposure never grows large before it's collateralized.
• Collateral doesn't eliminate the risk, it delays it — there's still a gap between when a counterparty stops posting collateral and when the position can actually be closed out, which is exactly the exposure CVA is pricing.
• A counterparty's own funding stress can trigger the loss even before default, tying this directly to Funding Liquidity Risk: a counterparty that can't fund its margin calls behaves, from your side, almost identically to one that has defaulted.