Managing counterparty exposure is another pivotal aspect of risk management in finance. When we enter a trade or deal with another entity, there's always a chance, however small that they might default or fail to make their obligations. That's our counterparty risk. Let's paint a simple picture to understand this better. Imagine we've entered into a derivative contract with another institution. This contract has the potential to provide us with significant profits based on market movements. However, if this was the case, but our counterparty on this transaction faces financial troubles, they may not be able to fulfill their end of the deal, which means we might not see the profits we're anticipating. That's where we face counterparty risk.

To manage this exposure, we continually assess the credit worthiness of our counterparties. We might ask for collateral, adjust our positions or even opt not to trade with entities that have a high risk of defaults.

Counterparty risk can be significantly reduced, if not completely mitigated by getting specialized clearing houses involved. They act as a central counterparty to a trade and become the buyer for the seller and the seller for the buyer. In this way, if one counterparty defaults on the replications, the clearing house will ensure that the other counterparty does not suffer a loss.