Credit Contagion from Counterparty Risk




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    • Jorion is with the Paul Merage School of Business, University of California at Irvine, and Zhang is with the College of Business Administration, University of Missouri at St. Louis. The paper has benefited from comments and suggestions from participants at the NBER Conference on the Risk of Financial Institutions, the FDIC's Center for Financial Research Workshop, the 2nd Bank of Canada Conference on Fixed Income Markets, the 2008 WFA annual meeting, and the 2008 FMA annual meeting, and from Richard Cantor, Pierre Collin-Dufresne, Vicente Cunat, Sanjiv Das, Kay Giesecke, Jean Helwege, Robert Jarrow, as well as the editor. We thank the Markit Group Limited for providing the CDS data. Gaiyan Zhang gratefully acknowledges financial support from the FDIC's Center for Financial Research.


Standard credit risk models cannot explain the observed clustering of default, sometimes described as “credit contagion.” This paper provides the first empirical analysis of credit contagion via direct counterparty effects. We find that bankruptcy announcements cause negative abnormal equity returns and increases in CDS spreads for creditors. In addition, creditors with large exposures are more likely to suffer from financial distress later. This suggests that counterparty risk is a potential additional channel of credit contagion. Indeed, the fear of counterparty defaults among financial institutions explains the sudden worsening of the credit crisis after the Lehman bankruptcy in September 2008.