Evaluating Counterparty Risk

Evaluating counterparty risk is a key component of any firms’ action plan when dealing with new clients.  Whilst financial modelling and data analytics work is Sapling’s main area of expertise, risk assessment and mitigation remain a recurring topic on a variety of projects that have been undertaken. Counterparty risk evaluation varies from firm to firm, but a few core considerations when assessing risk include:

Macroeconomic landscape: Researching data, indicators, and market trends is essential to gain an understanding of the landscape in which the firm is operating. Metrics in this section can be broad (e.g., creating different scenarios for high/low interest rate effects, researching seasonality effects on sales or production, competitor impacts, or capturing the effects of employment level growth). Macro risk assessment can also be done on a more granular level, dialing in on specific locations or finding indicators that are more detailed or relevant to the counterparty as opposed to using national level metrics.

Financial history: By using historical financial statements from the party being evaluated, one can delve into more quantifiable means of assessing risk. Financial ratios can be benchmarked to industry standards available from reputable sources including Statistics Canada or the National Bureau of Economic Research, as well as more specialized providers depending on the field being profiled.

Company structuring: Executive and board committee structuring can also be studied to discern areas of possible risk. For example, complex board structures may result in a situation where structuring is less clear, thus resulting in the possibility of fund mismanagement across operational sectors. Other areas of consideration that may prove beneficial include the examination of internal and external auditing processes, management’s track history, and the depth of company succession plans.

Project level due diligence: Examining past project decisions and their outcomes is another aspect in the creation of a robust risk assessment framework. Previous projects the firm has undertaken can be inspected to see if target levels have been achieved or if these targets are refreshed at appropriate timeframes. Likewise, historical projects can serve as a benchmark to predict the success of future plans.

Counterparty risk assessment may include even more granular approaches to discern proper risk profiles. While exact risk levels are nearly impossible to predict with absolute certainty due to asymmetric information between parties, following a layout that captures a wide variety of factors is essential in laying groundwork in the evaluation of counterparty risk.

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