Counterparty risk, also known as credit risk, refers to the likelihood that the other party in a financial transaction (the counterparty) will not fulfill their obligations as agreed. This could involve failing to make payments, defaulting on a loan, or not delivering on a contract.

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Essentially, it’s the risk that the entity you're doing business with won't meet its contractual obligations, potentially leading to financial losses.This risk is common in various financial markets, such as in trading, lending, or derivatives contracts. Counterparty risk is often managed through due diligence, collateral, and other risk mitigation strategies.

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For example: Suppose an investor enters into a forward currency contract to purchase 1 million Australian dollars (AUD) at an exchange rate of 0.9000 in one month's time. If, after one month, the AUD appreciates to 0.9090, the investor stands to make a gain because they can buy AUD at the previously agreed lower rate. However, if the counterparty (the seller of AUD) defaults at settlement-perhaps due to bankruptcy or liquidity issues-the investor will not receive the AUD as agreed. The investor may then have to buy AUD at the prevailing higher market rate (0.9090), resulting in an immediate financial loss equal to the difference between the contract rate and the market rate, multiplied by the notional amount.

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