Investing 101: Counterparty Risk

What is Counterparty Risk

In our prior definition of forward contract we had Sam Jackson, a small Black farmer growing sweet potatoes in Georgia, contracting with Lizzy Jackson a local pie making restaurateur. It brings up the next step on our way to investing: what if Sam couldn’t produce as large a crop as usual, due to the weather. Or what if Lizzy’s sales lagged in the last quarter and she cannot produce the purchase money. This is called counterparty risk.

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”.

Because A is a counterparty to B and B is a counterparty to A both are exposed to this risk. For example if Sam agrees to lends funds to Lizzy up to a certain amount, there is an expectation that Sam will provide the cash, and Lizzy will pay those funds back. There is still the counterparty risk assumed by them both. Lizzy might default on the loan and not pay Sam back or Sam might stop providing the agreed upon funds.

The risk that the other party in an agreement will default. In an option contract, the risk to the option buyer that the writer will not buy or sell the underlying as agreed. In general, counterparty risk can be reduced by having an organization with extremely good credit act as an intermediary between the two parties.

In options, the risk that the option holder will not exercise the option. This may be good if the price moves in the option writer’s favor, but counterparty risk is small in that situation.

More generally, the risk that one party in a contract will default or otherwise not fulfill his obligations. Counterparty risk can be diminished when one party mandates a co-signer or highly-rated guarantor.

Counterparty risk is the greatest in contracts drawn up directly between two parties and least in contracts where an intermediary acts as counterparty.

For example, in the listed derivatives market, the industry’s or the exchange’s clearinghouse is the counterparty to every purchase or sale of an options or futures contract. That eliminates the possibility that the buyer or seller won’t make good on the transaction.

The clearinghouse, in turn, protects itself from risk by requiring market participants to meet margin requirements. In contrast, there is no such protection in the unlisted derivatives market where forwards and swaps are arranged.

Please visit my legal website: Las Vegas DUI Lawyer
See me on YouTube: Seattle Cop Punches Black Teenage Girl
Follow @Kevin_Cardinale

The Stock Market is a Zero Sum Game

Zero Sum Game

A zero-sum game is any set of operations with two or more players, which when it is over, there are winners and losers, and the total points awarded to the winners exactly matches the total points the losers lost by.   The NASDAQ glossary defines the term as a situation in which one participant’s gains result only from another participant’s equivalent losses. The net change in total wealth among participants is zero; the wealth is just shifted from one to another.

I am going to show you how the stock market is indeed a zero sum game.  There are many that want to argue that it is not so.  There are many that wish to argue that it is not so.  But, let’s take a look at those people.  Who are they?  Brokers?  Self-styled market gurus?  Sure, they have a vested interest in you not realizing that the market is a zero-sum game.  If you get out of the market, where are they going to make their profits?

Stock Market

The stock market is a zero-sum game like a Ponzi scheme. There is no Uncle Sam to come riding in and bail out the losers. Every dollar that some investor wins in a stock market investment, some other investor lost — or will lose. The stock market is also a zero-sum game like an evening of poker. There are many hands (many listed companies), many opportunities for individual wins and losses, but the bottom line is the bottom line: every dollar of profit that any investor earns on the sale of stock was put into the market by another investor hoping to win.

Many people will readily admit that “zero sum game” is properly applied to options and futures markets because every contract has two parties, and for every dollar that one person makes the other loses a dollar.  But, they always stop at stocks.  NOOOOO not stocks.  There aren’t buyers and sellers for … stocks?  Wait. 

The term “zero sum game” does not apply to the stock market because at any given time there are more people long a stock than short the stock.

Oh really? So, there is not a buyer and seller?

The question is not “Is there a buyer for every seller?” but “Is there a short position for every long position?” to determine if it is a zero-sum game.  As long as there is a short position for every long position, every time one person makes a dollar someone else loses a dollar. That makes the total average return (before expenses) zero.  With a stock, there can never be as many short positions as long positions. When a company first issues shares there are no short positions. After that, every time someone shorts a share one new long share is essentially created, so there will always be more long shares than short shares. That, in turn, means when the price of the stock goes up more money is made than lost, so it is not a zero-sum game.

Oh, what tangled webs we weive, when we practice to deceive. So this person is saying that “don’t look at the buyers and sellers, that doesn’t matter.”  Instead he wants you to look at the long positions versus the short positions.  He then presents as evidence, the IPO of a stock.  Surely at the IPO a stock can never fall right?  RIGHT?  NEVER?  Uh, who is he trying to fool, and who would be so dumb to fall for that as being even a logical example.  Keeping it simple reveals the truth.  Accounting for time, there is always a buyer and seller.

Let’s take his example.  A company has an IPO.  People buy the stock.  People trade the stock.  The stock finally declines.  The company goes out of business and closes its doors.  Exactly the same amount of people that traded those stocks remain the same.  There were buyers to every seller.  The company being the original seller.

Zero Sum with The Federal Reserve

There should be no reason why the average public citizen should be a stock investor while the federal reserve bank is still in operation.  The very business of the federal reserve manipulates the value of the dollars that you are trading stock in.  The federal reserve has continually devalued the dollar at the expense of the investor and U.S. citizen alike.  How can you trade stocks when you must continually pay in debased currency.  To brake even, you must make someone else lose.

Let’s take the latest headline: “Small Investors After Market Drop: I told you so”  The article illustrates that there never was any volume in the market.  It was simply the “professional” investors who were trading stocks.  There never was this massive volume.  And, what is a “professional” investor?  Those huge brokerage firms.  They were simply trading stocks with each other and fluctuating the price.  They did not care if they made or lost money in the process, the game was simply to get you, the “small” investor to take the bait.  Luckily, most small investors were not so stupid.  I think a better price rule would be that there must be volume behind it, to even garner a change.

So, as you can see stocks, futures and options are all zero sum games.  There is no difference.  Don’t believe me?  Then go ask Professor Lawrence Harris is chairman of the Dept of Finance at the University of Southern California and Chief Economist of the Securities and Exchange Commission.  [yes, I always have an ace up my sleeve, and you should too]

 Please visit my legal website: DUI
See me on YouTube: Shakaama Live
Need a Notary in Las Vegas Nevada Notary Public Nevada