What Is Counterparty Risk and How Much of Your Portfolio Is Susceptible
What Is Counterparty Risk?
Counterparty Risk is defined as the likelihood or possibility that those involved in a financial transaction might default on their contractual obligation. This can happen with actual investments as well as credit and trading transactions. It’s even possible with government-backed stocks and bonds.
A quick and easy example of counterparty risk just slightly outside of the investment game can be found in a number of southern states where more and more insurance companies have become insolvent and are forced to default on their obligations to clients. Counterparty risk in this particular instance is a result of increasing extreme weather risk along the now more frequently battered gulf coast.
An example of investment counterparty risk can be found in bonds as they are rated by agencies such as Moody’s and Standard and Poor’s. Bonds that carry higher counterparty risks will reward with higher paying yields. Low risk bonds, such as money market funds, result in lower premiums or return on investments.
How Much of Your Investment Portfolio is Susceptible to Counterparty Risk?
While your exposure to counterparty risk with your portfolio is minimal, varying degrees of potential counterparty defaults exist in most every financial transaction. This includes investment products such as stocks, bonds, options, and derivatives. The overall point is that, as it comes to money, there is always risk. Whether you choose to invest or simply store your cash in a shoe box, potential loss of that money always exists.
This also works in reverse. As an example, your credit rating is established so that financial institutions can gauge counterparty risk as it comes to lending or providing financial services. So, counterparty risk is a two-way street.
How Do You Avoid or Limit Counterparty Risk?
Counterparty Risk can be somewhat mitigated by paying very close attention to your investments and counterparty reputation and responsibilities. This includes fully documenting and realizing your point of sale or investment risk, fully understanding the potential for default and considering how to provide for collateral management.
A common practice in Europe is to transfer agreed-upon collateral into an external investor’s account so that it is properly protected from potential risk. One can also seek out professional risk managers for counterparty risk expertise. Since the economic bailout more than a decade ago, investors and corporate entities alike have realized that firm, staunch investment opportunities and financial institutions can literally fall out at a moment’s notice. As a result, the risk management industry has become an increasingly popular choice for individual and corporate investors.
To summarize, if an investor would like to avoid or limit counterparty risk, said investor should research possible risk management solutions either by way of diligent documentation and collateral alternatives or by hiring third-party managers to oversee contracts for the sake of properly executed financial or investment agreements. Precious metals fit this bill for many, who feel more comfortable owning something tangible with inherent value that can increase significantly during financial downturns. Now is a great time to consider ways in which to limit counterparty risk to your investment portfolio so that your hard-earned money stays with you.
About The Author
Jake HaugenFollow @herobullion
Hero Bullion provides an environment that is informative and safe for those looking to own physical gold and silver bullion as an investment. We love helping folks at all stages throughout their bullion journey making progress towards acheiving their financial goals. Whether you are a seasoned bullion investor or brand new to the game of gold and silver bullion ownership, we're here to help and serve you in any way we can.