Counterparty Risk
Derivatives create two-sided credit risk that must be netted, collateralized, and valued.
Counterparty risk is credit risk that moves with the market: a derivative’s exposure tomorrow depends on tomorrow’s prices, making the amount at stake random and bilateral. Netting agreements collapse offsetting trades into a single claim, and collateral terms under a credit support annex demand margin as exposure grows, turning credit risk into liquidity demand. Wrong-way risk, where exposure and the counterparty’s credit quality fall together, is the feared corner case. Valuation adjustments price this: CVA charges for the counterparty’s default, DVA credits the firm’s own, and FVA charges funding the collateral. These adjustments now sit inside desk profit and loss, tying market-risk tools to credit models.