Updated Jun 16, 2018
Counterparty risk is the risk associated with the other party to a financial contract not meeting its obligations. Every derivative trade needs to have a party to take the opposite side. Credit default swaps, a common derivative with counterparty risk, are often traded directly with another party, as opposed to trading on a centralized exchange. Since the contract is directly with the other party, there is a greater risk of counterparty default since both parties may not have full knowledge of the financial health of the other (and their ability to cover obligations). This differs from products listed on an exchange. In this case, the exchange is the counterparty, not the single entity on the other side of the trade.
Counterparty risk gained visibility in the wake of the global financial crisis. AIG famously leveraged its AAA credit rating to sell (write) credit default swaps (CDS) to counterparties who wanted default protection (in many cases, on CDOtranches). When AIG could not post additional collateral and was required to provide funds to counterparties in the face of deteriorating reference obligations, the U.S. government bailed them out.
Regulators were concerned that defaults by AIG would ripple through the counterparty chains and create a systemic crisis. The issue was not only individual firm exposures but the risk that interconnected linkages via derivativecontracts would jeopardize the whole system.
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While a loan has default risk, a derivative has couterparty risk.
Counterparty risk is a type (or sub-class) of credit risk and is the risk of default by the counterparty in many forms of derivative contracts. Let's contrast counterparty risk to loan default risk. If Bank A loans $10 million to Customer C, Bank A charges a yield that includes compensation for default risk. But the exposure is easy to ascertain; it's roughly the invested (funded) $10 million.
A credit derivative, however, is an unfunded bilateral contract. Aside from the posted collateral, a derivative is a contractual promise that might be broken, thus exposing the parties to risk. Consider an over-the-counter (OTC) option sold (written) by Bank A to Customer C. Market risk refers to the fluctuating value of the option; if it is daily-mark-to-market, its value will be a function largely of the underlying asset price but also several other risk factors. If the option expires in-the-money, Bank A owes the intrinsic value to Customer C. Counterparty risk is the credit risk that Bank A will default on this obligation to Bank C (for example, Bank A might go bankrupt).
Let's assume two banks enter into a vanilla (non-exotic) interest rate swap. Bank A is the floating-rate payer and Bank B is the fixed-rate payer. The swap has a notional value of $100 million and a life (tenor) of five years; it is better to call the $100 million notional instead of principal because the notional is not exchanged, it is merely referenced to compute the payments.
To keep the example simple, assume the LIBOR/swap rate curve is flat at 4.0%. In other words, when the banks begin the swap, spot interest rates are 4.0% per annum for all maturities.
The banks will exchange payments at six months intervals for the swap's tenor. Bank A, the floating-rate payer, will pay six-month LIBOR. In exchange, Bank B will pay the fixed rate of 4.0% per annum. Most importantly, the payments will be netted. Bank A cannot predict its future obligations but Bank B has no such uncertainty. At each interval, Bank B knows it will owe $2 million: $100 million notional * 4% / 2 = $2 million.
Let's consider counterparty exposure definitions at two points in time - at swap inception (T = 0), and six months later (T = + 0.5 years).
At the Start of the Swap (Time Zero = T0)
Unless a swap is off market, it will have an initial market value of zero to both counterparties. The swap rate will be calibrated to ensure a zero market value at swap inception.