Counterparty credit risk is the risk that the party receiving credit will not meet its financial obligations. Lenders mitigate this risk by using collateral or conducting extensive credit checks. Derivatives increase this risk, but exchange-traded derivatives lessen it.
Counterparty credit risk is the risk in a financial transaction involving credit that the party receiving the credit will not meet its financial obligations. This is the risk that lenders incur that the issued loan will never be repaid. Because lenders can suffer serious financial damage from loans in default, they are generally very careful to carefully review their borrowers’ ability to repay their loans. Also, counterparty credit risk comes into play with derivatives, which are investment agreements between two parties where the contract requires a transaction to take place at some point in the future.
Much of the modern business world takes place when one party issues some form of credit to another. This means that a borrower can make a purchase or receive a loan while promising to pay at a later date. Of course, there is a risk that the borrower may never repay the loan. This is known as counterparty credit risk, which is a major concern for lenders of all stripes.
Lenders can mitigate counterparty credit risk. One way is to have a third party on hand who witnesses the loan agreement and agrees to mediate the loan process. This method of loan brokerage is often used in conjunction with collateral, which is something of value that the borrower offers as security for the loan. If the loan is not paid, the third party mediator can step in and claim the collateral on behalf of the lender.
Some lenders want to offer unsecured loans, which means that no collateral is offered. As such, these lenders must find alternative ways to decrease counterparty credit risk. The most common way to accomplish this is to conduct extensive credit checks on potential borrowers. By knowing the past credit history of a specific borrower, a lender can determine the likelihood that that borrower will repay the loan. A credit check may cause the lender to decline a loan or offer one with higher interest payments to balance the risk.
In the investment world, derivatives are investments that most often bring counterparty credit risk into play. This is because derivatives are typically contracts to perform a transaction involving some underlying security at a future date, which increases the chance that one party will default on the predetermined date. Exchange-traded derivatives, which are traded through a central regulatory exchange, lessen this risk for traders. By contrast, derivative contracts traded in the so-called over-the-counter market have a mediated exchange and therefore incur much higher credit risk.
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