Counterparty Risk

Counterparty risk refers to the risk of default of one party in a particular transaction. Credit ratings can be used to evaluate counterparty risk. For example, a party with a AAA credit rating represents a lower counterparty risk than a party with B credit rating. The lower the counterparty risk, the lower a particular product or commodity will be priced in a transaction. Indeed, although counterparty risk cannot be precisely quantified, in pricing a transaction or an investment product, a counterparty risk premium is often included to reflect the cost of added risk taken by the creditor. Collateral requirement provisions can also be included in transactions to decrease a creditor's exposure due to counterparty risk. Counterparty risk can also be mitigated by using a credit derivative such as a credit default swap. Another term for counterparty risk is default risk.