Anyone who has ever taken even a basic finance or economics course is well aware of the term; “counterparty”
As a refresher…
Counterparty:
The other party that participates in a financial transaction. Every transaction must have a counterparty in order for the transaction to go through. More specifically, every buyer of an asset must be paired up with a seller that is willing to sell and vice versa.
Further explanation
All trades require some sort of counterparty. For example, the counterparty to the option buyer would be the option writer. One of the risks involved in any transaction is counterparty risk, which is the risk that the counterparty will be unable to fulfill his or her duties. However, in many financial transactions the counterparty is unknown.
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Then we have the term “contagion”.
In the context of the problems the Mediterranean nations are experiencing at the moment, this term has been widely used by Mainstream Media
As a refresher…
Contagion:
The likelihood of significant economic changes in one country spreading to other countries. This can refer to either economic booms or economic crises.
Further explanation
An infamous example is the “Asian Contagion” that occurred in 1997 and started in Thailand. The economic crisis in Thailand spread to bordering southeast Asian countries and then eventually spilled over to Latin America.
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Which leads us, inexorably, towards the fusion term; “Counterparty contagion”
Let’s see if we can construct a definition. Jorion & Zhang contend that;
Standard credit risk models cannot explain the observed clustering of default, sometimes described as “credit contagion”
Ah, there’s a hint here of where this might be going, so let’s look a little more closely. Jorion & Zhang continue;
On average, creditors experience severe negative abnormal equity returns and increases in CDS
spreads. In addition, creditors are more likely to suffer from financial distress later.
These effects are stronger for industrial creditors than financials. Simulations calibrated
to these results indicate that counterparty risk can potentially explain the observed excess
clustering of defaults. This suggests that counterparty risk is an important additional
channel of credit contagion and that current portfolio credit risk models understate the
likelihood of large losses.
OK, maybe we have enough to construct a reasonable “working definition” of our lovely new buzzword “Counterparty contagion”
“In a credit derivatives market dominated by too few banks, a crisis affecting one affects many (all?) of the counterparties, because of the complex interlayered relationships between the counterparties themselves. Hence an “outbreak” of counterparty risk default by one, produces a knock on effect of all participants in assuming counterparty risk on a synthetic derivative”
As a definition, it sucks. It’s not pedantic, nor is it (sufficiently) anal retentive. Then again to be fair, I took 15 minutes to think about this. I didn’t write a peer-reviewed paper, and didn’t submit a draft to a thesis adviser for early commentary and/or theoretical guidance either. Thus my definition IS [ahem] BY definition, NOT a definition at all.
Thank you, you’ve been a lovely audience. Good Night.
We’re going to be celebrating World Toilet Day 2009 today!