Credit Risk

Credit risk is one of the most prevalent risks of finance and business. In general, credit risk is a concern when an organization is owed money or must rely on another organization to make a payment to it or on its behalf. The failure of a counterparty is less of an issue when the organization is not owed money on a net basis, although it depends to a certain degree on the legal environment and whether funds are owed on a net or aggregate basis on individual contracts. The deterioration of credit quality, such as that of a securities issuer, is also a source of risk through the reduced market value of securities that an organization might own.

Credit risk increases as time to expiry, time to settlement, or time to maturity increase. The move by international regulators to shorten settlement time for certain types of securities trades is an effort to reduce systemic risk, which in turn is based on the risk of individual market participants. It also increases in an environment of rising interest rates or poor economic fundamentals.

Organizations are exposed to credit risk through all business and financial transactions that depend on the payment or fulfillment of obligations of others. Credit risk that arises from exposure to a counterparty, such as in a derivatives transaction, is often known as counterparty risk.

Default Risk

Default risk arises from money owed, either through lending or investment, that the borrower is unable or unwilling to repay. The amount at risk is the defaulted amount, less any amount that can be recovered from the borrower. In many cases, the default amount is most or all of the advanced funds.

Counterparty Pre-Settlement Risk

Aside from settlement, counterparty exposure arises from the fact that if the counterparty defaults or otherwise does not fulfill its obligations under the terms of a contractual agreement, it might be necessary to enter into a replacement contract at far less favorable prices. The amount at risk is the net present value of future cash flows owed to the organization, presuming that no gross settlements would be required. Potential future counterparty exposure is a probability estimate of potential future replacement cost if market rates move favorably for the hedger, which would result in a larger unrealized gain for the hedger and larger loss in the event of default. The amount at risk is the potential net present value of future cash flows owed to the organization.

Counterparty Settlement Risk

Settlement risk arises at the time that payments associated with a contract occur, particularly cross payments between counterparties. It has the potential to result in large losses because the entire amount of the payment between counterparties may be at risk if a counterparty fails during the settlement process. As a result, depending on the nature of the payment, the amount at risk may be significant because the notional amount could potentially be at risk. Because of the potential for loss, settlement risk is one of the key market risks that market participants and regulators have worked to reduce.

Settlement risk also exists with exchange-traded contracts. However, with exchange-traded contracts the counterparty is usually a clearinghouse or clearing corporation, rather than an individual institution.

Sovereign or Country Risk

Sovereign risk encompasses the legal, regulatory, and political exposures that affect international transactions and the movement of funds across borders. It arises through the actions of foreign governments and countries and can often result in significant financial volatility. Exposure to any nondomestic organization involves an analysis of the sovereign risk involved. In areas with political instability, sovereign risk is particularly important.

Concentration Risk

Concentration is a source of credit risk that applies to organizations with credit exposure in concentrated sectors. An organization that is poorly diversified, due to its industry or regional influences, has concentration risk. Concentration risk is most effectively managed with the addition of diversification, where possible.

Legal Risk

The risk that a counterparty is not legally permitted or able to enter into transactions, particularly derivatives transactions, is known as legal risk. The issue of legal risk has, in the past, arisen when a counterparty has suffered losses on outstanding derivatives contracts. A related issue is the legal structure of the counterparty, since many derivatives counterparties, for example, are wholly owned special-purpose subsidiaries.

The risk that an individual employed by an entity has sufficient authority to enter into a transaction, but that the entity itself does not have sufficient authority, has also caused losses in derivatives transactions. As a result, organizations should ensure that counterparties are legally authorized to enter into transactions.