Counterparty risks are understood to be the type and degree of risks associated with each party in a contractual arrangement. Essentially, the counterparty risk addresses the financial stability of each party involved. Assessing the degree of risk involved with most forms of loans or investment purchases is considered routine, as the expectation is that both parties will be able to honor their obligations.
When it comes to financial loans, assessing the counterparty risk is very important for the party extending the loan. By evaluating both the current financial status of the recipient of the loan and his or her projected ability to repay the balance due in full, it is possible to calculate the chances that the loan will go into default. Ideally, a lender will seek to make loans where the amount of this type of counterparty risk is relatively low, and thus presents very little threat of a loss for the loan institution.
Investment transactions are another example of how the principle of counterparty risk comes into play. With an option contract, the option buyer will determine the stability of not only the stock, bond or other option that is being purchase; the financial stability of the issuing institution will also be considered. The idea is to ensure that the corporation issuing the stock, or the municipality issuing the bond, is financially strong enough to honor the terms and conditions associated with the transaction. A lower rate of counterparty risk means a better investment deal for the buyer.
Various types of financial contracts often include some degree of protection and counterparty risk for both parties. A forward contract may include provisions that activate in the event that either party defaults, offering some additional avenues of recourse. Futures contracts also often contain provisions that help to provide each party with some type of protection in the event the other party cannot or will not meet the obligations of the contract. While just about any type of transaction will contain some degree of counterparty risk, the ideal situation is to have that risk be at a minimum for all parties concerned.