Credit Risk Management Practice Exam

How does counterparty risk differ from lending risk?

1. Counterparty risk is uncertain, while lending risk is certain

2. Counterparty risk applies only to large institutions, lending risk does not

3. Counterparty risk involves market risks, while lending risk does not

4. Counterparty risk is a type of operational risk

The correct answer is: Counterparty risk is uncertain, while lending risk is certain

Counterparty risk refers to the risk that the other party in a financial transaction might default on their contractual obligations, which makes it inherently uncertain. This uncertainty arises because it can be difficult to predict the future financial conditions of the counterparty, and thus the potential for default varies significantly based on market conditions and the specific circumstances surrounding the counterparty. In contrast, lending risk is often considered more predictable because it usually involves a defined framework where terms and conditions, including interest rates and payment schedules, are clearly established. This makes lending risk more quantifiable, allowing lenders to assess the likelihood of repayment based on the borrower's creditworthiness and historical payment behavior. The distinction is primarily about the nature of the risks: counterparty risk resides in the potential for unexpected default in transactions between parties, while lending risk is tied to the anticipated ability of the borrower to repay the loan as agreed. This fundamental difference is what makes the aspect of uncertainty in counterparty risk stand out compared to the more calculable nature of lending risk.