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Counterparty risk is the risk that the person or institution with whom you have entered a financial contract - who is a counterparty to the contract - will default on the obligation and fail to fulfill that side of the contractual agreement.
In other words, counterparty risk is a type of credit risk. Counterparty risk is the greatest in contacts drawn up directly between two parties and least in contracts where an intermediary acts as counterparty.
For example, in the listed derivatives market, the industry's or the exchange's clearinghouse is the counterparty to every purchase or sale of an options or futures contract. That eliminates the possibility that the buyer or seller won't make good on the transaction.
The clearinghouse, in turn, protects itself from risk by requiring market participants to meet margin requirements. In contrast, there is no such protection in the unlisted derivatives market where forwards and swaps are arranged.
- Browse Related Terms: Cash market, Contango, Counterparty, Counterparty risk, Foreign exchange (FOREX), Forward contract, futures, options, Past Due Item, Spot market, Spot price