A defining feature of counterparty risk arises from the asymmetry of potential losses with respect to the value1 of the underlying transaction(s). In the event that a counterparty has defaulted, an institution may closeout the relevant contract(s) and cease any future contractual payments. Following this, they may determine the net amount owing between them and their counterparty and take into account any collateral that may have been posted. Note that collateral may be held to reduce exposure but any posted collateral may have the effect of increasing exposure.
Once the above steps have been followed, there is a question of whether the net amount is positive or negative. The main defining characteristic of credit exposure is related to whether the effective value of the contracts (including collateral) is positive (in an institution's favour) or negative (against them), as illustrated in Figure 8.1.