Counterparty Risk Management

Adam Baker, Dominic Smallwood

WHAT IS COUNTERPARTY RISK AND WHERE DOES IT ORIGINATE?

Counterparty risk arises from the potential of one of the involved parties in a transaction to default, resulting in replacement risk for the non-defaulting party. Replacement risk can be broken down into a variety of components (see Figure 14.1).

    • Mark-to-market exposure: As part of the close-out process, there may be realised mark-to-market exposure on the underlying contract.
    • Liquidity risk: There is a risk in sourcing sufficient liquidity in the market to fully replace the original transaction that has been closed out.
    • Operational risk: There is an operational process that must be followed for the close-out of a position. This involves notification around an event of default, replacing the transaction in the market, handling any collateral or margin payments, managing settlement amounts and dealing with any disputes arising from the process. Risk can arise via the potential for imperfect results from any of these processes.
    • Legal risk: There may be a risk arising from the legal enforceability of contracts, particularly around netting and collateral enforcement.
    • Collateral risk: Upo

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