Many websites do not distinguish between these two concepts. However, there is a difference between them, and it is an important one. For example, in the context of a wheat futures contract, we cannot talk about credit risk, but rather counterparty risk. In this case, counterparty risk refers to the fact that the person who sold the contract (which entitles the buyer to a ton of wheat in three months, for example) may not be able to honor it on time, in which case the buyer will not receive the promised ton of wheat.
These two concepts are sometimes interchangeable, and sometimes not. Instead of dwelling on the difference in definitions, let’s take a simple example to distinguish between these two cases. Imagine that we want to buy a Spanish Treasury bond, but also want to hedge against the risk of Spain defaulting. We therefore purchase a CDS (Credit Default Swap, a contract that acts as insurance against a possible default) as a supplement. In this case:
– we can talk about counterparty risk as well as credit risk (we tend to use the latter term) for the Spanish bond: this corresponds to the fact that Spain may default and not repay us all the funds we have lent it.
– We can only talk about counterparty risk on the CDS: the bank that sold us this CDS is supposed to compensate us in the event of Spain’s default, but it may not have all the funds necessary to compensate us to the extent provided for in our CDS contract. This is what happened with AIG during the crisis.
J.P.
