Explain counterparty risk in derivatives and how it's mitigated.

Counterparty (credit) risk on a derivative is the risk the counterparty defaults while the trade is in-the-money to you, so you lose the replacement value (and, mid-settlement, potentially principal). It's bilateral and varies with market moves. Mitigants: an ISDA Master Agreement with close-out netting (so on default all trades net to a single amount, not gross); a CSA requiring daily variation margin/collateral to keep net exposure near zero; counterparty credit limits and diversification across banks; and central clearing of standardized derivatives through a CCP (mandated for many products under EMIR/Dodd-Frank), which novates the trade to the clearing house and largely removes bilateral exposure. You monitor net post-collateral exposure (not gross notional), and CVA prices in the residual default risk. The discipline is measuring true net exposure after netting and collateral, and not concentrating with a single counterparty.