What is counterparty risk?

Counterparty risk refers specifically to the risk that one party involved in a financial transaction will fail to fulfill its contractual obligations, typically by defaulting on a payment or failing to deliver an asset as promised. This risk is particularly pertinent in derivatives and trading activities, where one party may rely on the other to perform their part of the trade.

Understanding counterparty risk is crucial for financial institutions and investors because the repercussions of a default can propagate through the financial system, leading to significant losses, reduced liquidity, and increased volatility. Effective risk management practices such as using collateral, credit risk assessments, and netting agreements are often employed to mitigate counterparty risk.

The other options address different types of financial risk. Fluctuating interest rates relate to interest rate risk, large-scale financial fraud pertains to operational or fraud risk, and liquidity crises mainly involve liquidity risk, all of which are distinct from counterparty risk.