Discussion in 'P1.T1. Foundations of Risk (20%)' started by email@example.com, Jan 16, 2011.
How do we differentiate default vs counterparty risk
In the typical typology, both are sub-classes of credit risk; i.e., credit risk > counterparty risk, credit risk > default risk.
But I am not sure they are exacting, self-contained terms; e.g., we often read of "counterparty default risk"
.. and then, while not common to speak this way, even traditional lending (default) risk can be argued is a sort of counterparty risk.
But in terms of connotations, I think the key distinction is funding. That is, default risk is associated with (connotes) the "lending risk" associated with a bond or loan (or obligation) that the investors fund and the investor's funds are going forward at default risk. Compare to counterparty risk which connotes unfunded bilateral contracts (derivatives) where you do not have invested funds at risk of default, but rather the risk that your counterparty will not pay if your future credit exposure is positive.
... both are types (subclasses) of credit risk. Arguably, both are default risk.
... but the difference isn't semantic: traditional lending (default) exposure is much much easier to measure (exposure at default) but counterparty expsosure, as measured by CVA, is subject to the complexities of bilateral valuation (FRM says we need to simulate counterparty risk, basically).
Hope that is helpful,
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