Counterparty risk, also known as credit risk, is the risk that one party to a financial transaction may default or fail to meet its contractual obligations. It arises in various financial transactions where two parties are involved, such as in lending, borrowing, derivatives trading, and other contractual agreements.

Key points about counterparty risk:

1. **Default Risk:** Counterparty risk is primarily concerned with the risk of default, where a party fails to fulfill its financial obligations as specified in the contract. This could involve failing to make a payment, deliver securities, or meet other contractual commitments.

2. **Financial Transactions:** In financial transactions, counterparty risk is inherent. For example, in lending, there is a risk that the borrower may default on repayment. In derivatives trading, there is a risk that the counterparty may not meet its obligations related to the derivative contract.

3. **Creditworthiness Assessment:** Assessing the creditworthiness of counterparties is crucial in managing counterparty risk. This involves evaluating their financial stability, credit history, and ability to meet their obligations.

4. **Collateral and Risk Mitigation:** Parties may use collateral agreements to mitigate counterparty risk. Collateral acts as a form of security, providing compensation in the event of a default. It can be in the form of cash, securities, or other assets.

5. **Netting and Novation:** Netting involves offsetting obligations between parties to reduce exposure. Novation is a process where one party to a contract is replaced by a third party. Both netting and novation are risk management strategies to reduce counterparty risk.

6. **Derivatives Markets:** Counterparty risk is particularly significant in derivatives markets, where financial instruments such as swaps, options, and futures are traded. Central clearinghouses play a role in mitigating counterparty risk by acting as an intermediary and guaranteeing transactions.

7. **Legal Agreements:** Legal agreements, such as master agreements in derivatives trading (e.g., ISDA Master Agreement for swaps), often include provisions that address how counterparty risk is managed, including close-out and netting provisions.

8. **Systemic Risk:** In times of economic stress or financial crises, counterparty risk can become more pronounced, leading to systemic risk. The failure of a major financial institution can have cascading effects on other market participants.

Effective risk management practices, due diligence, and the use of financial instruments and agreements designed to mitigate counterparty risk are essential in the financial industry. Regulators also play a role in establishing guidelines and standards to enhance the stability of financial markets and reduce the potential impact of counterparty defaults.