Counterparty risk is a term in finance. It means, quite simply, that
the party you traded with (the counterparty) won't keep it's end of the
deal. When this happens, it will likely cost you money.
With this definition out of the way, let's ask the really important
question here:
Do I have counterparty risk?
There are some rather easy rules of thumb. If you just buy
shares, futures, options or bonds in the
exchange, you don't have counterparty risk. In other words, if you sold your
shares to someone who goes bankrupt tomorrow, you still get your money. This
is incidentally one of the reasons you pay fees. Of course, you are
still exposed to credit risk in the thing you bought: if you bought shares
in a company that goes bankrupt, you have typically lost your
investment.
So, how do I get counterparty risk? Well, one way of getting it is being
a big trading firm, calling another big trading firm, and making a deal
without involving the exchange to save costs. If you are a big
trading firm, I suppose you are smart enough to work out yourself how to
deal with it; if not, well, you won't be a big trading firm for long, so
that problem is solved then as well. Another way of getting a very nasty
counterparty risk is with so-called structured
products. For instance, those funny little investments in which you are
guaranteed to get your money back, or 90% of it, and still profit from 50%
of the increase in the S&P 500. In the tiny print, it will say
"Guaranteed by BNP Paribas". Or "Guaranteed by HSBC". Or "Guaranteed by
Lehman Brothers". If you catch my drift.
I have counterparty risk. Am I in trouble?
Well, normally, no. In the vast majority of cases, banks just pay back
what they owe you. However, you might still take a loss for two different
reasons
The obvious reason is that your bank fails and you don't get paid back.
Normally, a large percentage of the value of your structured product is in a
liquid asset, like a bond or an index, so it should be possible to sell it
and get most of the money out. However, you have no guarantee, and might be
left with nothing.
The second reason is more insidious. Imagine you have your structured
product, and the rest of the world thinks the issuer may not be able to
pay up. Now, if I think I may not get my money out in the end, I'm very
inclined to pay less for the product. Maybe not nothing, but less. The
market will find an equilibrium price, which may be less than the
guaranteed price 1. So, if you sell at this point, you lose money due to
your counterparty risk
What is somewhat nasty about counterparty risk is that it is normally
close to 0, but can suddenly explode. This makes it easy to ignore and
easy to forget, and that is exactly why it is so dangerous: nothing happens,
until something happens, and then it's usually catastrophic.
Put differently, you know stocks are risky, and you probably keep
that in mind when investing, and don't gamble with money you can't miss.
Your counterparty getting into trouble is something you might not have
considered when investing, and you might lose money you can't miss
In summary, counterparty risk is the risk that your counterparty won't
honor his agreement. Normally, this risk is small. Furthermore, trades over
the exchange may (this is not always guaranteed) shield you from
counterparty risk. However, if you do have counterparty risk, and your
counterparty gets into trouble, you might lose a very large amount of
money.
Footnote
- Interest (i.e. the fact you won't get your money back in a while) can
also cause this to happen.