Counterparty Risk
OTC derivatives can lead to significant risks. Especially counterparty risk has gained particular emphasis due to the credit crisis in 2007. Counterparty risk is the risk that a counterparty in a derivatives transaction will default prior to expiration of the trade and will not make the current and future payments required by the contract. There are many ways to limit counterparty risk. One of them focuses on controlling credit exposure with diversification, netting, collateralisation and hedging.
The International Swaps and Derivatives Association suggested five main ways to address the credit risk arising from a derivatives transaction, as follows:
- avoiding the risk by not entering into transactions in the first place;
- being financially strong enough and having enough capital set aside to accept the risk of non-payment;
- making the risk as small as possible through the use of close-out netting
- having another entity reimburse losses, similar to the insurance, financial guarantee and credit derivatives markets
- obtaining the right of recourse to some asset of value that can be sold or the value of which can be applied in the event of default on the transaction
Read more about this topic: Over-the-counter (finance)
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