Counterparty Risk

At any moment only one party to a derivative contract is exposed. If the contract has a positive mark-to-market value to you, the counterparty owes you that amount and its default would cost you; if the value is negative, you are the one who owes, and the counterparty's failure causes you no loss on the position itself. Because the underlying price, rate or spread moves continuously, the direction of exposure can reverse over the life of the trade: a feature that distinguishes derivatives from a loan, where the lender is exposed throughout.

Practitioners therefore split the measure in two. Current exposure is simply the replacement cost of the contract today, floored at zero. Potential future exposure estimates how large that replacement cost could become before maturity, given the volatility of the underlying and the time remaining. Long-dated swaps on volatile underlyings carry modest current exposure but substantial potential exposure, which is why tenor matters as much as present value.

Bilateral markets manage the problem in layers. A master agreement allows close-out netting, so that on default all trades between the two parties collapse into a single net amount rather than the defaulter cherry-picking profitable contracts. A credit support annex then requires the out-of-the-money party to post variation margin as values move, with initial margin held against the gap between the last margin call and final liquidation. Thresholds, minimum transfer amounts and rating-linked triggers determine how quickly cash actually changes hands.

Central clearing goes further by substituting a clearinghouse as counterparty to both sides through novation, backed by daily or intraday settlement of gains and losses, member margin and a default fund. Residual exposure does not vanish: it is concentrated in the clearinghouse and in the member through whom the client clears. Dealers also price the remaining risk explicitly as a credit valuation adjustment, reducing the value of a derivative asset to reflect the counterparty's default probability.

Forwards, forward rate agreements, interest rate and currency swaps, total return swaps and credit default swaps are all bilateral by construction, so each carries counterparty risk unless cleared or collateralised. Option positions are asymmetric: the buyer, having paid the premium, holds a contract that can only be an asset and therefore bears the risk, while the writer faces none after the premium is received. Repurchase agreements and securities lending blend counterparty risk with collateral quality, since recovery depends on the value of the pledged securities at the moment of default.

On bank financial statements the exposure appears in derivative assets and liabilities, in the disclosure of amounts subject to enforceable netting arrangements, and in the credit valuation adjustment recognised through earnings. Regulatory reform after 2008 pushed standardised contracts onto clearinghouses and imposed margin requirements on those that remained bilateral, shifting the market's centre of gravity away from uncollateralised dealing.

Expect to identify, for a described position, which party is exposed and why. That requires working out the sign of the contract's value: the party with the unrealised gain is at risk. Be ready to explain how a forward and an equivalent futures position differ, not in payoff at expiry but in the accumulation of exposure between trade date and settlement, and to state precisely how daily settlement and margin compress that exposure without abolishing it.

You should also be able to rank arrangements by residual risk (uncollateralised bilateral, netted and margined bilateral, cleared) and to name the mechanisms responsible for each reduction. Finally, connect counterparty risk to pricing: an entity perceived as weak pays more to enter derivative contracts, or is required to post more collateral, which is the market's way of charging for the credit component embedded in every bilateral trade.