The risk that a counterparty to a contract or agreement will not live up to its obligations.
Example:
A manufacturing firm signs an exclusive five-year global distribution agreement, with the understanding that the distributor (the counterparty) will fully support product sales in all regions.
Downside Scenario:
It turns out that the distributor is not well represented in Asia, and this severely affects sales in the region. The manufacturing firm is unable to utilize the services of a better distributor in the region due to the exclusivity clause protecting the incumbent distributor. Sales fall behind schedule, severely affecting the manufacturing firm’s growth and performance.
Upside Scenario:
The distributor turns out to be a perfect match for the manufacturer, and quickly develops new business in previously inaccessible territories. Both firms prosper.
Related terms:
Moral Hazard Risk
The risk that a counterparty will not act in good faith or will have the incentive, based on the agreement’s language, to act in bad faith.
Adverse Selection Risk
The risk that the terms or language of an agreement or that the circumstances of an experiment will lead to a filtering of people, results, or outcomes in biased fashion.