Counterparty Risk
Short definition
Counterparty risk is the loss of a hedge, a collection or a deposit when the other side fails. It is the credit-risk face of derivatives and bank deposits.
Detailed explanation
On a derivative, mark-to-market becomes a receivable; CSA collateral and netting shrink it. Bank deposits and L/Cs are also counterparty risk: “we have cash” is not “cash at that bank”.
Concentration — one bank or one customer over the limit — means protection vanishes in the stress year. A rating is a crude PD proxy; it fails together with country and sector shocks.
Why it matters for the CFO
A hedge dies if the counterparty dies. Parking the deposit in one bank ties the cash buffer to that bank’s liquidity.
How to read it
The limit input is net MTM plus potential future exposure, not gross notional. Uncollateralised OTC is not cleared futures.
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Definitions are educational. They are not investment, credit or tax advice.