Counterparty risk: a tool to protect against financial losses
Financial activity has its own specifics, in one way or another, associated with risk. And it affects representatives of all parties, so it is important to weigh each action – not only your own but also that of your partner. There is such a concept as counterparty risk, which depends on how stable the financial situation of all parties to the transaction is. The assessment of this parameter is used for most lending or investment options. It is based on an analysis of the likelihood of whether the parties will be able to comply with all the terms of the agreement.
Assessment of the risk level of the counterparty is a mandatory procedure when granting loans. Banks take into account the financial situation of the borrower and, on this basis, make predictions about the borrower’s ability to pay in the future. In this case, those wishing to obtain a loan who have a low counterparty risk have an advantage. This means that the issuance of the loan will not incur large losses for the financial institution.
In investment transactions, it is also important to assess all risks. For example, when dealing with options, in addition to the price stability of the asset, you must also consider the financial stability of the seller. Before you buy stocks or bonds, you should carefully analyze the company to determine its financial stability and its ability to fulfill specified obligations. The lower the counterparty risk, the more favorable the investment transaction.
The terms of many financial contracts include clauses to protect the parties from counterparty risk. For example, in the case of a futures contract, it contains clauses that become effective if one of the parties fails to fulfill its obligations. However, it must be borne in mind that any financial transaction carries some form of risk, so market participants must try to minimize them to operate successfully.
There is an option where one party to the contract has a higher level of risk than the other. To compensate for the latter inconvenience, the deal is made with a risk premium.
Loans take into account a person’s credit rating, which usually ranges from 300 to 850. The higher the score, the more reliable the borrower is considered by the bank. A poor credit rating is considered to be under 550, and from 550 and 649. Next are levels of satisfactory, good, and excellent. When analyzing this parameter, it takes into account payment history, availability of debt and amount, length of credit history, and other conditions. If the credit rating is low, the counterparty risk increases, and then the financial institution may raise the interest rate as a safety net. If a person is often late with payments, the bank may also increase the interest rate on the loan.
