Counterparty risk.

In plain English

Counterparty risk shows up in any agreement that settles later, including swaps, forwards, repos, and over-the-counter options, and it is managed with collateral, netting, or by routing the trade through a clearinghouse. The exposure is not fixed, because it grows as the contract moves in your favor and shrinks as it moves against you. Firms measure it as current exposure plus an estimate of how much it could grow before the contract matures. Collateral agreements require the losing side to post assets as the position moves, which caps how large the exposure can get between calls. Central clearing replaces one counterparty with the clearinghouse, which concentrates the risk in an entity built to manage it.

01Why it matters

A hedge or an insurance-like contract only protects you if the other side can actually pay, which is why the strength of who you are dealing with matters as much as the terms you negotiated.

02The math, step by step

Say you hold a swap worth $8 million in your favor and the other side posts $7 million of collateral. Your uncollateralized exposure is $1 million. If they default and the position is replaced at a $500,000 worse price, the collateral plus that gap decides your actual loss.

Illustrative example. The amounts here are hypothetical, chosen to show how the math works, not real quoted rates or figures.

03What this is NOT

04Receipts

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