What counterparty credit risk is · RiskAtoms Academy

By the end you will be able to

1Explain how counterparty credit risk differs from lending: it is two-way, and the exposure moves with the market and is unknown in advance.
2Measure a trade's exposure today as its replacement cost, max(V, 0), and the loss after recovery.
3Tell pre-settlement risk from settlement risk and size each on an FX forward.
4Find your way around the Module 3.4 book: four counterparties, eight trades, one netting set each.

Why it matters

RiskAtoms Bank has just agreed a seven-year interest rate swap with Halvergate Manufacturing on £100m. Today it is worth nothing to either side, so nothing is at risk. Yet in a year, in about half of the bank's simulated futures, Halvergate will owe the bank money on it: on average £1.94m, and in one future in twenty more than £7.95m. If Halvergate fails then, the bank loses most of it. A £100m loan has a known exposure of £100m. A £100m swap has an exposure nobody can know in advance, and it can point either way.

Core explanation

Credit risk that moves with the market

Counterparty credit risk (CCR) is credit risk on a trade rather than a loan. You met it in L2.2.03: Credit and counterparty risk: a derivative's value moves with markets, and if the side that owes you defaults, you lose what the trade was worth to you. This module measures that risk and the tools that shrink it: netting, collateral, margin, central counterparties and CVA.

A loan against a swap

	A £100m loan	A £100m swap
Amount at risk today	£100m	Its value: £0 at the start
Amount at risk later	Known: the balance outstanding	Unknown: depends on rates
Who can lose	Only the lender	Either side, whichever is owed
Size relative to notional	100%	A few per cent, usually
Measured by	EAD (drawn plus undrawn)	A distribution of future values

Two features make a derivative different. First, the exposure is two-way. A swap is an asset to one side and a liability to the other, and which is which depends on the market. Second, it is unknown in advance. The notional of a swap is never paid; what is at stake is its mark-to-market value, which starts near zero and wanders as rates move.

Replacement cost

Suppose Halvergate defaults when the swap is worth $V$ to the bank. The trade is terminated. If $V > 0$ , the bank has lost a valuable contract: to keep its hedge it must find a new counterparty and pay $V$ for an identical swap. That is the replacement cost. The bank claims $V$ from Halvergate's estate and, like any unsecured creditor, recovers a share (L3.3.08: Loss given default and recovery). If $V < 0$ , the bank owed Halvergate; it must still pay what it owes to the estate and makes no gain. So the bank's exposure is $\max(V, 0)$ : it keeps the downside of default and never the upside.

Below are 30 of the 2,000 simulated paths of the Halvergate swap's value over its seven years. Paths above zero are exposure to Halvergate; paths below are exposure Halvergate has to the bank. The bold line is the average exposure on each date. The fan widens as rates have more time to move, then narrows as fewer payments are left to swap.

30 simulated pathsBank's average exposure to HalvergateHalvergate's average exposure to the bank (shown below zero)

In a year the swap is an asset to the bank on 49.6% of the paths. Across all 2,000 paths its value then ranges from −£14.9m to £16.9m. Its average exposure peaks at £2.96m after about 3 years. Measuring this distribution is the subject of L3.4.02: Exposure measures.

Pre-settlement and settlement risk

Counterparty risk while a trade is alive is pre-settlement risk, measured by replacement cost. On the day a trade settles, a second, shorter risk appears. When Halvergate's FX forward settles, the bank pays about £49.8m and receives $65m. If it pays its pounds and Halvergate fails before the dollars arrive, the bank loses the whole $65m, not just the forward's value. That is settlement risk, or Herstatt risk after the German bank whose 1974 failure left counterparties unpaid mid-exchange (L2.2.03: Credit and counterparty risk). It lasts hours, not years, but the amounts are whole notionals. It is managed by settlement systems that pay both legs together, payment versus payment, and by settlement limits.

Sort itWhich risk is it?

Sort each case into pre-settlement counterparty risk, settlement risk, or neither (another risk, or no loss for the bank).

A hedge fund defaults. It had bought an index put from the bank, and the put is now worth £2m to the fund.
A corporate client defaults while its pay-fixed swap with the bank is worth £6m to the bank.
The bank pays ¥5bn in Tokyo for dollars due in New York that afternoon. The other bank fails in between.
Rates jump and the bank's unhedged bond portfolio loses £3m. Every issuer keeps paying.
A repo counterparty defaults; the bonds it gave the bank as collateral are worth less than the cash the bank lent.

The book for this module

Illustrative dataRiskAtoms Bank plc's OTC derivatives book

Eight trades with four invented counterparties, in pounds, on one made-up valuation day, valued on 2,000 simulated paths (seed 34040) of a flat GBP rate (4.00% today), GBPUSD (1.30) and an equity index (8,000) every half month out to ten years. The firms, trades and market model are made up for teaching; none is real data. The same book runs through every lesson in Module 3.4, so the figures agree.

Recovery is assumed at 40% for every counterparty.

RiskAtoms Bank plc's derivatives desk has four counterparties. Each has signed one ISDA Master Agreement with the bank, so all its trades form one netting set (L3.4.04: Netting). Three have a credit support annex (CSA) for collateral (L3.4.05: Collateral and the CSA).

Counterparty (one netting set each)	Rating	5y CDS	CSA
Halvergate Manufacturing plc HALUK corporate, hedging a floating-rate loan and US dollar sales	BBB	180bp	None
Corriemoor Bank AG COREuropean bank, interdealer trades	A	70bp	threshold £0, MTA £0.50m
Saltney Capital LP SALHedge fund	BB (internal)	250bp	threshold £0, MTA £0.25m, IM £3m
Ebbsworth Pension Trustees Ltd EBBUK defined-benefit pension scheme, liability hedging	AA (internal)	40bp	threshold £10m, MTA £1.00m

Trade: what the bank does	Counterparty	Value to the bank today
T1 Receive-fixed swap, £100m, 7 years at 4.00%	HAL	£0.00m
T2 Buy $65m for pounds in 1 year (at market)	HAL	£0.00m
T3 Pay-fixed swap, £250m, 10 years at 4.00%	COR	£0.00m
T4 Receive-fixed swap, £150m, 5 years at 4.00%	COR	£0.00m
T5 Sell $130m for pounds in 3 years (at market)	COR	£0.00m
T6 Long 2-year index put, strike 7,200, 5,000 units at £10 a point	SAL	£18.98m
T7 Pay-fixed swap, £80m, 5 years at 4.00%	SAL	£0.00m
T8 Pay-fixed swap, £300m, 10 years at 4.00%	EBB	£0.00m

Every trade except Saltney's index put is at market, worth zero today. The bank paid Saltney the put's premium up front, so the put is an asset to the bank and already an exposure to Saltney. The exposures, CVA and capital in the rest of the module all come from simulating these eight trades.

The formal version

Let $V(t)$ be the value of a trade (or of a netting set) to the bank at time $t$ , at market prices. To the counterparty it is worth $-V(t)$ . If the counterparty defaults at time $\tau$ and the bank recovers a fraction $R$ of its claim:

\begin{aligned} E(t) &= \max\bigl(V(t),\,0\bigr) && \text{the bank's exposure} \\ E^{\text{cpty}}(t) &= \max\bigl(-V(t),\,0\bigr) && \text{the counterparty's exposure to the bank} \\ E(t) - E^{\text{cpty}}(t) &= V(t) && \text{at most one of them is non-zero} \\ \text{Loss} &= (1 - R)\,E(\tau) && \text{if the counterparty defaults at } \tau \end{aligned}

Today $V(0)$ is known, so current exposure $E(0)$ is a number. For any later date $V(t)$ is random, and so is $E(t)$ : it is zero with some probability and positive otherwise. Counterparty risk is measured by summarising that distribution at each future date, which is what the next lesson does. For a netting set, $V$ is the sum of the trades' values, netted before the max is taken.

Try it

Pick a trade, move the clock and the market, and see who would be owed money if the other side failed. Notice that the same move makes one side exposed and the other not.

Try itWho owes whom?

Trade

Receive-fixed swap, £100m, 7 years at 4.00%. Counterparty: Halvergate Manufacturing plc.

Years from today0.50 years

GBP swap rate then4.00%

The bank owes HALHAL owes the bank

Value to the bank£0.00m

Bank's exposure: max(V, 0)£0.00m

Bank's loss if HAL defaults now (recovery 40%)£0.00m

HAL's exposure to the bank: max(−V, 0)£0.00m

Illustrative: the book's closed-form prices on a flat curve. The other market levels stay at today's values. A trade that has matured is worth nothing to either side.

Worked example

Halvergate defaults in six months

Six months from now the GBP swap rate has fallen to 3.25% and the pound to $1.20. Halvergate, squeezed by a weak order book, defaults. Both trades sit under one master agreement.

Replacement cost and loss

Step 1 of 4

1
The swap (T1)
The bank receives 4.00% fixed. With the market at 3.25%, a new swap would pay it only 3.25%, so the old one is valuable: 0.75% a year on £100m for the remaining payments.
$\begin{aligned} A &= \textstyle\sum_{k=1}^{7} (1.0325)^{-(k - 0.5)} = 6.2715 \\ V_1 &= \text{£}100\text{m} \times (4.00\% - 3.25\%) \times 6.2715 = \text{£}4{,}703{,}620 \end{aligned}$

Not one scenario but thousands

This was one future. On the book's 2,000 simulated paths, the Halvergate netting set's value in six months exceeds £9.48m with 5% probability. Turning the paths into exposure measures is the job of L3.4.02: Exposure measures.

Regulatory lens

The Basel Framework defines counterparty credit risk as “the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows” and notes that, unlike a loan, it “creates a bilateral risk of loss”, because the market value can be positive or negative to either side (CRE50.1). The same framework covers repos and other securities financing transactions. Banks hold capital for the default risk, using the standardised approach (SA-CCR) or internal models, and separately for CVA risk, the risk of losses as counterparties' credit spreads, and the market prices that drive the trades' values, move. Settlement risk on currency trades is handled separately, by supervisory guidance on FX settlement. The capital rules are in M4.4: Counterparty, operational and large exposures; exposure simulation and XVA in M6.6: Counterparty risk and XVA.

Spark Atoms

Spark Atom$846 trillion of promises, $21.8 trillion of value

At end-June 2025 the notional amount of OTC derivatives outstanding worldwide was about $846 trillion, but their gross market value was about $21.8 trillion, under 3% of it (BIS OTC derivatives statistics). Notional sets the size of the payments; only the market value is at risk if a counterparty fails.

Spark AtomHerstatt risk has not gone away

CLS, which settles both legs of currency trades together, began in 2002. Yet in April 2025 more than $1.4 trillion a day of FX settlements, about 10% of the total, were still settled gross and bilaterally, fully exposed to settlement risk (BIS Quarterly Review, June 2026).

Key takeaways

Counterparty credit risk is credit risk on trades: the counterparty defaults while the trade is worth something to you.
Exposure is max(V, 0): the replacement cost. If you owe the defaulter, you still pay and gain nothing.
The risk is two-way and unknown in advance: a swap worth nothing today can be an asset to either side later.
On Halvergate's £100m swap the expected exposure in a year is £1.94m, a few per cent of notional; a loan's would be the full £100m.
Settlement risk is the whole payment for a few hours on settlement day; pre-settlement risk is the replacement cost over the trade's life.
The module's book: four counterparties, eight trades, one netting set each, simulated on 2,000 paths.

Reaction

Check what stuck

Question 1 · objective 2

A swap is worth +£4m to the bank when its counterparty defaults. Recovery is 40%. What does the bank lose, in £m?

£m

Question 2 · objective 2

Another swap is worth −£3m to the bank when the counterparty defaults. What is the bank's exposure on it, in £m?

£m

Question 3 · objective 3

On settlement day the bank pays £50m for $65m. GBPUSD is 1.25. The counterparty fails after the bank has paid and before the dollars arrive. How much is at risk, in £m?

£m

Question 4 · objective 1

Why can't the bank know today how much it stands to lose on a five-year swap with a corporate client?

AThe swap's value, and so the exposure, depends on where interest rates go over the five yearsBThe notional amount will changeCThe client's credit rating is not publicDSwaps are not marked to market

Question 5 · objective 1

A swap is worth £8m to the bank today. Who has counterparty credit risk on whom?

AThe bank on the client, now; the client on the bank only if rates move the other wayBOnly the client on the bankCBoth sides, by £8m eachDNeither, because swaps start at zero

Glossary

Counterparty credit risk (CCR): Counterparty credit risk: the risk that the other side of a derivative, repo or similar trade defaults before the trade's cash flows are finally settled, while the trade is worth something to you.
Mark-to-market value: Mark-to-market value: what a trade is worth today at market prices, to one side. The other side's value is the same amount with the opposite sign.
Replacement cost: Replacement cost: what it would cost to replace a defaulted trade with an identical one at today's prices. For the surviving side it equals max(V, 0).
Exposure: Exposure: what the bank would lose before any recovery if the counterparty defaulted at a given date, max(V, 0) for a single trade.
Two-way exposure: Two-way (bilateral) exposure: either side can end up owed money, depending on how markets move, so each side has credit risk on the other.
Pre-settlement risk: Pre-settlement risk: the counterparty defaults during the life of the trade, before the final exchange. The loss is the trade's replacement cost.
Settlement (Herstatt) risk: Settlement risk: on the settlement date one side has paid and the other has not yet paid. The amount at risk is the whole payment due, not just the trade's value.
Payment versus payment (PvP): Payment versus payment: a settlement method in which each side's payment is made only if the other side's is made too, which removes settlement risk.
Netting set: Netting set: the trades with one counterparty under one legally enforceable netting agreement. On default they collapse into one net amount.

Deep Dives & Origins

Deep Dives

J. Gregory, The xVA Challenge: Counterparty Risk, Funding, Collateral, Capital and Initial Margin, 4th ed., Wiley, 2020, the chapters on counterparty risk and exposure. Intermediate.
M. Drehmann, P. McGuire, T. Shirakami, M. Conway and N. Lovell, “Uncovering FX settlement risk: new measures from the 2025 BIS Triennial Survey”, BIS Quarterly Review, June 2026. Intermediate.

Origins

Basel Committee on Banking Supervision, Basel Framework, CRE50: Counterparty credit risk definitions and terminology, BIS.
Bank for International Settlements, OTC derivatives statistics at end-June 2025, December 2025.
M. Drehmann et al., “Uncovering FX settlement risk: new measures from the 2025 BIS Triennial Survey”, BIS Quarterly Review, June 2026.

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