Counterparty risk

Counterparty risk is defined as risk arising due to non-performance of contracts by the suppliers or customers. Examples are:

• Cotton supplier not shipping when cotton prices increase sharply;
• Customer not opening L/C when cotton prices drop.

There are two main ways to manage counterparty risk: 

• Classification of counterparties. Counterparties should be classified into risk category buckets based on the following factors:
  • Location of the company (thereby taking into account country risk);
  • Availability of financial information and rating from external agencies;
  • Track record of dealing with the company and assessment of the party’s ability to bear losses.
   
• Fixed price quantity limit. For non-futures products this is the only limit that needs to be monitored. For futures products, fixed price quantity limits includes fixed price contracts as well as differential contracts that have been price-fixed by the buyer or supplier in the futures terminal. The fixed price quantity limit for the counterparty is set taking into account the following factors:
  • Risk category for the counterparty as classified above;
  • Estimated annual trading volume of the counterparty and the expected margins from it;
  • Ability of the product to enforce claims.