Credit and risk management staff watch how the value of transactions moves, work out how much they could lose on each counterparty, and hold that amount down with limits and collateral.

What you lose when a counterparty fails

YesNoDid the counterpartyfail before settlementwas complete?No loss onthistransactionYesNoAt failure, is the amountyou would receive forending the tradepositive?No loss (youonly pay theterminationamount)The part of the amountyou would receive thatyou cannot recover is theloss
Figure 1Deciding whether a counterparty's failure causes a loss
Figure description

The figure checks whether a failure occurred and then the sign of the value at the time of failure, in that order. If the counterparty did not fail, its failure causes no loss. If it did, go on to the sign of the value. Here the value is the amount you would receive by terminating the transaction (if negative, the amount you would pay). When a counterparty fails, the transaction is terminated at its value at that time, which is called close-out. If the value is negative (or zero), you only pay the termination amount to the counterparty and have no loss. If it is positive, that amount becomes a claim you can make against the failed counterparty, and whatever you cannot recover is the loss. The sign of the value can flip when market variables such as interest rates or exchange rates move. The table below for Company A and Bank I shows how the same transaction gives different results depending on the party.

Counterparty credit risk is the risk that, when a counterparty fails, you do not collect the value of a transaction whose value is positive1. The value of a transaction is the amount you would receive (or pay, if negative) if the transaction were terminated at that moment. When a counterparty fails, the transaction is settled at its value at that time. The party with a positive value claims that amount from the failed counterparty, and whatever it cannot recover is a loss. The party with a negative value simply pays the settlement amount to the counterparty and has no loss2.

Consider a hypothetical example in which Company A (a nonfinancial company) and Bank I enter into a five-year interest rate swap with a notional amount of 10 billion yen. Company A pays a fixed rate of 1% and receives a floating rate from Bank I. On the trade date, the value is 0 from both sides. Interest rates then move, and the value becomes +400 million yen from Company A's side (−400 million yen from Bank I's side). Applying the figure's decision, Company A is on the side that answers yes to both questions and incurs a loss if Bank I fails, and Bank I is on the side that stops at the second question if Company A fails. The section "How to work out replacement cost" below shows market rates that produce +400 million yen. The Interest Rate Swaps page explains how the payments on an interest rate swap work.

Party that fails at that point Company A's loss Bank I's loss
Bank I Up to 400 million yen (less any amount recovered) (the failed party)
Company A (the failed party) 0 yen (it pays the settlement amount of 400 million yen to Company A)

The amount you could lose if a counterparty fails is called exposure. In this example, Company A has an exposure of 400 million yen to Bank I, and Bank I's exposure to Company A is 0.

How it differs from the credit risk of a loan

Unlike with a loan, the exposure on a derivative changes with the market. When market variables such as interest rates or exchange rates move, the value of the transaction moves, and the positive part of that value is the exposure. Counterparty credit risk therefore combines the credit risk of the counterparty failing with an element of market risk from changes in value3.

The other difference is which party bears the risk. If Bank I lends 10 billion yen to Company A, only the lender, Bank I, can lose money if the other party fails. The borrower, Company A, has nothing to lose on this loan if Bank I fails. With a swap, both parties remain affected by market moves after the trade, and the failure of either one leads to settlement at the transaction's value. If the sign of the value flips, the party bearing the risk flips too4.

Point of comparison Loan (Bank I lends to Company A) Interest rate swap (Company A and Bank I)
Party bearing the risk Only the lender, Bank I The party with a positive value (can be either Company A or Bank I)
Amount that could be lost The principal lent and unpaid interest The positive part of the value at that point
What determines the amount Set by the contract and barely moves with the market Rises and falls with market moves such as interest rates
Amount on the start date 10 billion yen 0 yen (if the trade starts at a value of 0)

How to work out replacement cost

Replacement cost is the cost, when a counterparty fails, of entering into the same transaction again at current market prices5. Suppose Company A used this swap to fix the interest rate on its borrowing. If Bank I fails and the transaction disappears, Company A still needs the rate fixed. So Company A enters into a new swap with another bank, and the fixed rate on that swap is set by the current market.

Go back to the example and consider the point one year later, with four years remaining. Compare three cases for the market fixed rate on a swap with four years remaining. Assume the floating-rate payments are the same on the original transaction and the replacement, and ignore discounting.

Market fixed rate for the remaining 4 years Difference from the original 1% (percentage points per year) Difference × notional of 10 billion yen × 4 years Company A's replacement cost if Bank I fails Bank I's replacement cost if Company A fails
2.0% +1.0 +400 million yen 400 million yen 0 yen
1.0% 0 0 yen 0 yen 0 yen
0.5% −0.5 −200 million yen 0 yen 200 million yen

If the market rate rises to 2.0% and Bank I fails, Company A has to pay 2% instead of 1% on the replacement swap. The 1 percentage point difference is 100 million yen a year, or 400 million yen over four years. That is Company A's replacement cost, and it equals the value of the original transaction from Company A's side (ignoring discounting). Conversely, if the market rate falls to 0.5% and Company A fails, Bank I can receive only 0.5% instead of the 1% fixed rate, so it faces a replacement cost of 200 million yen over four years. For the party with a negative value, replacing the transaction actually gives better terms, so its replacement cost is taken as 0.

The positive part of the current value (0 if negative) is called current exposure (CE)6. CE equals the replacement cost worked out above7. In practice, the value is calculated by discounting the future payments.

Pre-settlement risk and settlement risk

You can lose two kinds of amounts to counterparty credit risk: the replacement cost and the full principal to be delivered. The risk of losing the replacement cost is called replacement-cost risk, and the risk of losing the full principal is called principal risk. Replacement-cost risk mostly arises as pre-settlement risk, from a counterparty failing before the settlement date. Principal risk mostly arises as settlement risk, when only one side of the exchange is completed on the settlement date5.

Suppose Company A enters into an FX forward with Bank I to pay 10 billion yen and receive dollars on the settlement date. If Bank I fails before the settlement date, Company A loses the replacement cost arising from the difference between the contracted rate and the current rate. For example, if the dollar has risen 5% above the contracted rate, the loss is about 500 million yen (ignoring discounting). But if Company A has already paid the 10 billion yen on the settlement date and Bank I fails before paying the dollars, Company A loses the full amount of dollars it was due to receive (worth about 10.5 billion yen at the current rate). Because principal risk covers the full amount of the transaction, the loss can be far larger than the replacement cost8.

Principal risk is eliminated by using a settlement method in which one payment is completed only if the other is also completed. For an exchange of two currencies, this is called payment versus payment (PvP). For an exchange of securities and cash, it is called delivery versus payment (DvP)9.

Ways to measure, reduce, and manage the risk

The basic measures are CE at the current point and potential future exposure (PFE), which shows how far the value could swing upward at a given future point6. The definitions and calculations of these measures are in Exposure Measures: CE, PFE, EE/EPE and EAD.

The ways to reduce the risk include close-out netting and collateral. Close-out netting is an arrangement, set out in the master agreement, under which all transactions with a failed counterparty are terminated together and their values are offset against each other for settlement10. In a collateral arrangement, the parties set the terms of delivery in a credit support annex (CSA), and the party with a positive value covers that amount with collateral it receives from the counterparty11.

Another option is to bring the transaction to a central counterparty. The central counterparty steps in between the parties and becomes the buyer to every seller and the seller to every buyer, so each party's counterparty is replaced by the central counterparty12.

One way to manage the risk is to set a credit limit for each counterparty and keep the exposure within it13. Measures such as PFE are compared against the limit14.

Another is the credit valuation adjustment (CVA), which reflects the counterparty's creditworthiness in the value of the derivative. Once it is part of the value, it can also be hedged15. Separately, bank capital adequacy regulation requires capital for both the risk of counterparty failure and the risk of changes in the value of CVA16.

Credit quality and exposure worsening together

Exposure to a counterparty can grow just as that counterparty's creditworthiness falls. This is called wrong-way risk. In the 2008 financial crisis, when Lehman Brothers failed, counterparties' probabilities of default rose while exposures to them increased or the value of collateral fell. The regulatory framework at the time did not adequately capture this risk18.

Notes

  1. Financial Services Agency and Bank of Japan, "バーゼル委市中協議文書 カウンターパーティ・リスクの取扱いの強化の概要" (Overview of the Basel Committee consultative document on strengthening the treatment of counterparty risk) (January 2010), "１．カウンターパーティ・リスクとは" (1. What is counterparty risk), page 2 (in Japanese). The document covers OTC derivatives and securities financing transactions such as repos. ↩

  2. 内田善彦, "カウンターパーティー・リスクの管理とCVAの活用" (Managing counterparty risk and using CVA) (workshop presentation, Center for Advanced Financial Technology, Financial System and Bank Examination Department, Bank of Japan, June 2010), "CCRとは" (What is CCR), page 5 (in Japanese). The document states that it reflects the author's personal views and not the official views of the Bank of Japan. ↩

  3. "バーゼル委市中協議文書 カウンターパーティ・リスクの取扱いの強化の概要" (January 2010), "１．カウンターパーティ・リスクとは" (1. What is counterparty risk), page 2 (in Japanese). ↩

  4. 内田善彦, "カウンターパーティー・リスクの管理とCVAの活用" (June 2010), note on "CCRとは" (What is CCR), page 5 (in Japanese). ↩

  5. Committee on Payment and Settlement Systems of the BIS and Technical Committee of the International Organization of Securities Commissions, "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation; April 2012), paragraph 2.5 (page 24) (in Japanese). The English original is CPSS-IOSCO, "Principles for financial market infrastructures" (April 2012), which uses the same paragraph numbers. ↩ ↩2

  6. 内田善彦, "カウンターパーティー・リスクの管理とCVAの活用" (June 2010), "CCR量の評価" (Measuring the amount of CCR), page 17 (in Japanese). ↩ ↩2 ↩3

  7. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation; April 2012), footnote 41 (page 50) (in Japanese). ↩ ↩2

  8. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation; April 2012), paragraph 3.12.1 (page 107) (in Japanese). ↩

  9. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation; April 2012), paragraphs 3.12.1 and 3.12.2 (page 107) and the list of abbreviations (page iii) (in Japanese). ↩

  10. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation; April 2012), footnote 27 to paragraph 3.1.7 (page 31) (in Japanese). For the master agreement, see 内田善彦, "カウンターパーティー・リスクの管理とCVAの活用" (June 2010), "CCR管理手法" (Methods for managing CCR), page 15 (in Japanese). ↩

  11. 内田善彦, "カウンターパーティー・リスクの管理とCVAの活用" (June 2010), "CCR管理手法" (Methods for managing CCR), page 15 (in Japanese). For covering the amount with collateral, see Financial Services Agency and Bank of Japan, "バーゼル銀行監督委員会「カウンターパーティ信用リスク管理に関するガイドライン」について" (On the Basel Committee on Banking Supervision's "Guidelines for counterparty credit risk management") (April 2025), page 10 (in Japanese). ↩

  12. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation; April 2012), paragraph 1.13 (pages 11–12) (in Japanese). ↩

  13. "バーゼル銀行監督委員会「カウンターパーティ信用リスク管理に関するガイドライン」について" (April 2025), "Limits（信用枠・リミット）" (Limits (credit limits)), page 15 (in Japanese). ↩

  14. Algorithmics (セオドロス・スタンポリス), "カウンターパーティー・リスク把握の現状と方向性" (Current state and direction of counterparty risk measurement) (workshop presentation, Center for Advanced Financial Technology, Financial System and Bank Examination Department, Bank of Japan, June 2010), "1. 歴史" (1. History), page 3 (in Japanese). ↩

  15. 内田善彦, "カウンターパーティー・リスクの管理とCVAの活用" (June 2010), "CCRとCVA" (CCR and CVA), page 6, and "CCRのヘッジとCVA" (Hedging CCR and CVA), page 18 (in Japanese). ↩

  16. Financial Services Agency and Bank of Japan, "「信用評価調整（CVA）リスクの最低所要自己資本」の概要" (Overview of "minimum capital requirements for credit valuation adjustment (CVA) risk") (February 2018), "１．これまでの経緯" (1. Background), page 2 (in Japanese). ↩

  17. "バーゼル委市中協議文書 カウンターパーティ・リスクの取扱いの強化の概要" (January 2010), "マージン・ピリオドの強化" (Strengthening the margin period) under "９．担保管理の強化④（IMM行）" (9. Strengthening collateral management (4) (IMM banks)), page 23 (in Japanese). ↩

  18. "バーゼル委市中協議文書 カウンターパーティ・リスクの取扱いの強化の概要" (January 2010), pages 5 and 25 (in Japanese). For the failure of Lehman Brothers in 2008, see 内田善彦, "カウンターパーティー・リスクの管理とCVAの活用" (June 2010), page 12 (in Japanese). ↩