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Counterparty risk is the financial risk associated with another party failing to meet their contractual obligation. Companies often fail to meet their obligations if they become insolvent.
There are many positions that can create counterparty risk. Lenders assume counterparty risk when they trust a borrower to make payments in the future. Additionally, contracts and derivatives may lose value if counterparty risk rises, indicating a higher likelihood of the counterparty being unable to meet their obligations.