Credit Risk Management Practice Exam

Which of the following transactions poses counterparty risk?

1. Securities borrowing and lending

2. Retail payment processing

3. Inventory management systems

4. Insurance underwriting

The correct answer is: Securities borrowing and lending

Counterparty risk refers to the risk that the other party in a financial transaction will not fulfill their obligations as specified in the agreement. In the context of the provided options, securities borrowing and lending inherently involves a reliance on the other party to return the borrowed securities or settle the transaction as per the terms agreed upon. If the counterparty defaults or fails to deliver the securities as promised, it can lead to significant losses for the lending party. This risk is particularly pronounced in securities transactions where the value of the borrowed assets can fluctuate, and the ability to replace those securities might be hindered by market conditions. Hence, the nature of securities borrowing and lending transactions directly exposes participants to counterparty risk, making this option the most relevant in the context of the question. In contrast, retail payment processing typically involves established networks and protocols that protect against counterparty risk through secure fund transfer methods. Inventory management systems focus more on the management and tracking of stock rather than exposure to risk from counterparty failures. Insurance underwriting may involve some level of credit risk regarding the insured's ability to fulfill policy terms, but it does not primarily revolve around immediate transactional counterparty risk as seen in securities transactions.