Definition
Counterparty risk is the risk that the other party will fail to perform. It matters where payments or deliveries are still due and the value of obligations can change. The size of the risk depends on the party’s financial condition, contract structure, collateral and close-out procedures.
Example
If a company agrees with a bank on a future exchange transaction, the contract may have positive value for the company on the settlement date. If the bank fails to perform, the company must seek a replacement under new market conditions. The loss is not necessarily the whole notional amount: actual exposure and possible recovery matter.
Distinction and limitation
Do not mix counterparty risk with an ordinary market-price change. Clearing and collateral can reduce certain risks but do not eliminate them. Before a transaction, understand who is legally obliged to pay, which assets provide collateral and what procedures apply after default or a dispute.