3.1 Introducing Counterparty Credit Risk

...probably the single most important variable in determining whether and with what speed financial disturbances become financial shocks, with potential systemic traits

Counterparty Risk Management Policy Group (2005)

Counterparty credit risk (often known just as counterparty risk) is the risk that the entity with whom one has entered into a financial contract (the counterparty to the contract) will fail to fulfil their side of the contractual agreement (e.g., they default). Counterparty risk is typically defined as arising from two broad classes of financial products:

  • OTC (over-the-counter) derivatives, some well-known examples being
img interest rate swaps,
img FX forwards, and
img credit default swaps.
  • Securities financing transactions, for example
img repos and reverse repos,
img securities borrowing and lending.

The former category is the more significant due to the size and diversity of the OTC derivatives market and the fact that a significant ...

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