As the title reads, what is the difference between credit risk and counterparty credit risk? What are the key differences?
Credit risk is the risk for holding a risky bond. Counterparty risk is the risk that the counterparty will not be able to meet its contractual obligations if the credit event occur. For example, if you have a bond on AAPL and want to buy CDS to protect in case of bankruptcy (note you buy CDS from another counterparty -i.e. AIG- not the company), then credit risk reflects the possibility AAPL will not fully repay the bond, counterparty risk reflects the risk your counterparty (AIG) will not be able to pay you the amount it owes you if AAPL goes bankrupt.
Both 'credit risk' and 'counterparty credit risk' refer to the same type of risk, i.e. the risk that the opposite side of a contract will not honor its obligations to repay.
But 'credit risk' will be typically used in the context of traditional loans business, i.e. for practitioners 'credit risk' will be associated with lending a money to someone - here your total risk is known at the onset of a transaction, i.e. if you lend 1M USD to a company, then you cannot basically lose more than 1MM USD.
Whereas 'counterparty credit risk' will be used especially in OTC derivatives business where a contract value might be an asset or a liability over the lifetime of a contract and at the expiry, i.e. we do not know how much we could potentially lose over the life of a contract. To measure 'counterparty credit risk' boils down to finding an estimate on how much you could potentially lose assuming the counterparty does not pay at a given moment of contract life - this estimation is more challenging than in case of typical loans/guarantees.
References could be found in books of Brigo and Gregory.
I think the accepted answer gives the right insight, but I would like to add a further consideration: the difference between credit and counterparty risk is related to the main risk you are seeking compensation for when entering a trade. Indeed:
- We might speak of credit risk when you enter a trade for which you are seeking compensation primarily for the risk that your counterparty might not pay you back: this is the case of a corporate bond for example, in which case you are first and foremost taking a view on the credit quality of the issuer.
- We might speak of counterparty risk when you enter a trade for which you are seeking compensation primarily for some risk other than credit (equity risk, rate risk, etc.) but for which you are nonetheless exposed to the credit quality of a counterparty: this would be the case of any derivative transaction for example, in which you might be taking rate risk (e.g. interest rate swap) or equity risk (e.g. stock option) but which remains nonetheless a contract with a party which has to pay you at maturity $-$ hence subject to the risk the counterparty might default and not pay what they own you.
There is no significant difference between the two. Both can be considered a financial risk, although credit risk appear to have a slightly broader view. You might also hear the term default risk used.
I suppose technically you could argue credit risk relates specifically to the extension of credit (a one sided risk), and counterparty risk relates to the risk in two sided transactions (e.g. credit swaps).
Ultimately, both are used to consider the loss due to opposing party in any transaction failing to live up to their obligation(s) on the basis of either ability or willingness.
You might also want to look into settlement risk, a non-financial risk also know as Herstatt Risk, which relates to the failure of a counterparty to deliver after you've delivered on your obligation.
This is my take on the matter:
- Credit risk
** - this can be defined as the risks of default on financial obligations from the extension of credit directly to a counterparty or indirectly through an instrument.
- Counterparty risk
** - this can be defined as the risk of default from (i) the extension of credit or (ii) agreed contractual performance, which in most cases will carry financial obligations to the affected party/ies.
On this basis, it can be surmised that counterparty risk is a subset of credit risk.