Afinancial contract is a pattern of promises between the counterparties.

Indeed, the great majority of financial contracts link to counterparties. The roles of the counterparties are different and well defined in each contract. In a loan, for example, the lender agrees to provide principal capital at the current time to a borrower in exchange for the principal and interest cash flows at future times; in a guarantee contract, however, the guarantor agrees to fulfill the obligations of an obligor, e.g., the lender, in case the obligor defaults; in a credit derivative, the counterparty who plays the role of protection seller agrees to cover any losses arising from another counterparty default or downgrade credit event.

Counterparties have their own qualitative and quantitative descriptive characteristics where some of them can be unique but others are fairly standard. For instance, counterparties have a unique name, could belong and operate in a certain industry, have a defined income, profit, and expenses. We must consider their descriptive characteristics because they can be very useful in identifying their expected credit behavior and correlation among counterparties. Promises given by counterparties are not always kept. Thus, there exists counterparty credit risk and this should be identified, measured and considered in both value and liquidity analysis. The main counterparty risk factors are the default probability, the credit ratings, the probability of the ratings to change, and the credit spreads. Counterparties influence each other. Moreover, the current and future market conditions also influence counterparties. Therefore, counterparty and credit analysis is integrated with market risk factors. Figure 7.1 illustrates all the main elements considered in counterparty analysis that this chapter will focus on, namely the types and roles of counterparties, their descriptive characteristics, default probability, credit ratings, credit spreads, and links and correlations among the different counterparties.

7.1