What Is Counterparty Risk in an OTC Derivatives Transaction?

Counterparty risk is the financial risk that the other party to a contract will fail to fulfill their contractual obligations. In an Over-The-Counter (OTC) derivatives transaction, like a forward contract, this risk is high because the agreement is private and not guaranteed by a central exchange or clearinghouse.

If the counterparty defaults, the non-defaulting party may suffer a financial loss. This lack of centralized oversight is a major difference between OTC and exchange-traded derivatives.