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Counterparty risk

Counterparty risk, also known as default risk, is the risk that an organisation will not be able to pay out on a credit derivative, credit default swap, credit insurance contract, or other trade or transaction when it is meant to. Even the purchase of credit insurance does not ensure against such risk, as the insurer may also be unable to pay, either due to temporary liquidity issues or longer term systemic issues.

Large insurers are counterparties to many transactions, and thus this is a risk which prompts financial regulators to act, as for example in the bailout of insurer AIG.

On the methodological side, counterparty risk can be affected by wrong way risk, namely the risk that different risk factors be correlated in the most harmful direction. Including correlation between the portfolio risk factors and the counterparty default into the methodology is not trivial.

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