Counterparty Credit Risk

Counterparty credit risk arises in financial markets when players enter financial transactions that give rise to future payment obligations.

For example, in an outright securities transaction, one party agrees with another to provide the securities in return for payment. Outright transactions are typically settled within one or a few days of the agreement, depending on the settlement period. The credit risk is, therefore, limited. In a derivative transaction, however, the underlying security is provided against the funds at a future date.

The date on which funds and securities are exchanged is called the settlement date. In some financial transactions, there’s a settlement date both at the beginning and end of the transaction, while in others, there’s only one settlement happening at the end of the term.

The Main Sources of Counterparty Credit Risk

Pre-settlement risk

Pre-settlement risk is the potential future credit exposure that has not yet materialised. It is also sometimes referred to as trading exposure or potential future exposure. The transacting parties have agreed to exchange securities and funds at a future date. There is, therefore, a time-large during which price movements may affect how much one counterparty owes the other.

For example, let’s assume Party A agreed with Party B to sell Security XYZ a year from now for $100. Party B will pay Party A $100 at maturity, and Party A will deliver Security XYZ to Party B.

If the market value of Security XYZ increases to $120 over the next year, Party B will still only pay $100 for that security. If Party A owns the security, it could have sold it outright for $120 but is now obliged to sell it at a below-market price of $100. If Party A does not own the asset, it will have to source it in the market for $120 and then sell it to Party A for $100. Regardless, Party A will effectively lose $20 on the transaction, while Party B will gain $20 (i.e., $120--$100). 

Before the settlement date, Party A is “out of the money” because the transaction's market value is –$20. In contrast, Party B is said to be “in the money” because the transaction's market value is +$20 in its favour. It also means Party B is taking that credit risk on Party A.

Settlement risk

Settlement risk arises due to the time difference between the delivery and receipt of assets, such as cash and securities, between two parties on the agreed settlement date.