<p>Counterparty risk is the possibility that the other party in a financial transaction will fail to fulfill its contractual obligations, leading to a loss for the exposed party. It is a core component of credit risk and arises whenever two entities enter into agreements such as loans, derivatives, repurchase agreements, or securities trades.</p>

<h2>How It Works</h2>
<p>When a trade is executed, each side assumes that the counterparty will honor the agreed‑upon terms at settlement or maturity. If the counterparty defaults—due to insolvency, liquidity shortfall, or operational failure—the non‑defaulting party may not receive the expected payment, collateral, or asset delivery. The magnitude of the loss depends on the exposure at default, which is the current market value of the position plus any potential future changes, reduced by any collateral held.</p>
<p>Key mechanisms that influence counterparty risk include:</p>
<ul>
<li><strong>Credit quality</strong> of the counterparty, often assessed via ratings or internal scoring models.</li>
<li><strong>Netting agreements**, which allow offsetting of mutual obligations to lower net exposure.</li>
<li><strong>Collateral management**, where margin or security deposits are posted and revalued regularly.</li>
<li><strong>Central clearing**, where a clearinghouse becomes the counterparty to both sides, mutualizing risk.</li>
</ul>

<h2>Why It Matters</h2>
<p>Counterparty risk directly affects the profitability and stability of financial institutions. A sudden default can trigger losses that exceed expected credit losses, impair capital, and contagiously affect other market participants. For example, during the 2008 financial crisis, the collapse of Lehman Brothers exposed numerous banks to substantial counterparty risk in over‑the‑counter derivatives, leading to massive write‑downs and a liquidity crunch.</p>
<p>Managing this risk is essential for prudent trading, regulatory compliance (e.g., under Basel III’s counterparty credit risk framework), and maintaining confidence in the financial system. Effective mitigation—through rigorous credit analysis, collateralization, netting, and use of central clearing—helps firms pursue market opportunities while limiting potential losses from counterparty default.</p>