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Counterparty risk - Sovereign Risk - Definitions

Wiki DefinitionCounterparty risk

Counterparty risk, otherwise known as default risk, is the risk that an organization does not pay out on a credit derivative, credit default swap, credit insurance contract, or other trade or transaction when it is supposed to.[2] Even organizations who think that they have hedged their bets by buying credit insurance of some sort still face the risk that the insurer will be unable to pay, either due to temporary liquidity issues or longer term systemic issues.[3]

Large insurers are counterparties to many transactions, and thus this is the kind of risk that prompts financial regulators to act, e.g., the bailout of insurer AIG.

On the methodological side, counterparty risk can be affected by wrong way risk, namely the risk that different risk factors be correlated in the most harmful direction. Including correlation between the portfolio risk factors and the counterparty default into the methodology is not trivial, see for example Brigo and Pallavicini[4]

CFTC Definition (Commodity Contracts)

  • The risk associated with the financial stability of the party entered into contract with. Forward contracts impose upon each party the risk that the counterparty will default, but futures contracts executed on a designated contract market are guaranteed against default by the clearing organization.

Another Definition

  • Exposure to a loss resulting from a default on a payment due. Also known as credit risk.
Counterparty Risk
What Does Counterparty Risk Mean?
The risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk as a risk to both parties and should be considered when evaluating a contract.

In most financial contracts, counterparty risk is also known as "default risk".
Investopedia explains Counterparty Risk
Because A is a counterparty to B and B is a counterparty to A both are exposed to this risk. For example if Joe agrees to lends funds to Mike up to a certain amount, there is an expectation that Joe will provide the cash, and Mike will pay those funds back. There is still the counterparty risk assumed by the both. Mike might default on the loan and not pay Joe back or Joe might stop providing the agreed upon funds.

Sovereign risk

Sovereign risk is the risk of a government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees.[5] The existence of sovereign risk means that creditors should take a two-stage decision process when deciding to lend to a firm based in a foreign country. Firstly one should consider the sovereign risk quality of the country and then consider the firm's credit quality.[6]

Five macroeconomic variables that affect the probability of sovereign debt rescheduling are: [7]

  • Debt service ratio
  • Import ratio
  • Investment ratio
  • Variance of export revenue
  • Domestic money supply growth

The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance of export revenue and domestic money supply growth. Frenkel, Karmann and Scholtens also argue that the likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Saunders argues that rescheduling can become more likely if the investment ratio rises as the foreign country could become less dependent on its external creditors and so be less concerned about receiving credit from these countries/investors.[8]

Tangible Asset
What Does Tangible Asset Mean?
An asset that has a physical form such as machinery, buildings and land.
Investopedia explains Tangible Asset
This is the opposite of an intangible asset such as a patent or trademark. Whether an asset is tangible or intangible isn't inherently good or bad. For example, a well-known brand name can be very valuable to a company. On the other hand, if you produce a product solely for a trademark, at some point you need to have "real" physical assets to produce it.

paper asset

An asset that is not readily usable or convertible to cash.