Counterparty credit risk

What it means

The risk that the other side of a derivative defaults before settling, when the contract has positive value to you.

The exam angle

Two-sided and stochastic, unlike a loan: exposure moves with the market, so it must be modelled over time rather than measured once.

Where it appears in the syllabus

• Credit Risk Measurement & ManagementFRM Part II · exam weight 20% · Merton and reduced-form models, credit VaR, counterparty risk, CVA, CDOs.
• Financial Markets & ProductsFRM Part I · exam weight 30% · Institutions, market structure, futures, swaps, options, rates, FX, MBS.

See it worked through

• Credit valuation adjustment (CVA): a worked exampleWhat counterparty credit risk costs on a derivative, step by step.

There is also a short video: watch it on YouTube.

Related terms

• NettingOffsetting positive and negative exposures with the same counterparty so that only the net amount is at risk.
• Adverse selectionThe problem that arises when the party with better information self-selects into a transaction, leaving the…
• CollateralAssets pledged to secure an exposure, reducing loss if the counterparty defaults.
• Credit default swapA contract in which the buyer pays a periodic premium and receives compensation if a specified borrower suffers a…
• Credit spreadThe extra yield a borrower pays over a risk-free benchmark of the same maturity, compensating for default and…
• Credit valuation adjustmentThe reduction in a derivative’s value to reflect the possibility that the counterparty defaults.