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====Credit derivatives ==== | ====Credit derivatives ==== | ||
{{drop|A|r some point}} in the 1990s someone came up with the idea of credit derivatives. These | {{drop|A|r some point}} in the 1990s someone came up with the idea of [[Credit derivative|credit derivatives]]. These contracts — principally the [[credit default swap]] — allow investors to manage the credit risk to those who owe them under [[Debt security|debt instruments]]. | ||
[[Debt instrument]]s | [[Debt instrument]]s come in all shapes and sizes — [[bond]]<nowiki/>s, [[Medium term note|medium term notes]], [[Loan|bilateral loan]]<nowiki/>s, syndicated loans, [[deposit]]<nowiki/>s — and have a number of characteristics: they have a stated term, at which they repay a fixed amount. Therefore, they offer little scope for “trips to the moon” but since, if the debtor fails, they can go to zero they do offer a lot of potential ''downside'' risk. Due to their term nature, no two debt instruments of the same debtor are economically (let alone legally) fungible. Each debt instrument treads its own, albeit correlated, value path. | ||
As such, the market is generally opaque and | As such, the market for debt instruments is generally opaque and “sticky”: debt instruments are illiquid in a way equities, which have none of those limitations, are not. | ||
Now, some debt instruments, such as publicly quoted senior bonds, are a lot more liquid and transparent, and therefore hedgeable, than others: you can buy a “[[Put option|put]]” on a listed bond at a good price, but good luck doing that with a private loan. | |||
But since debt repayment values are predictable then, as long as your borrower doesnʼt blow up, you will eventually get your money back, so it usually doesnʼt matter much that you canʼt — but when it ''does'' matter, it matters ''a lot''. So when you buy debt repayment protection you are necessarily hedging against a crash — not just a change in value.<ref>this is why, despite referencing an instrument further down the capital structure, [[equity derivatives]] are curiously '' less '' concerned with default than are [[credit derivatives]]. </ref> | |||
The [[credit default swap]] emerged as a neat way to manage that risk. To cover against losses on an illiquid private bilateral loan, you could buy a [[credit derivative]] referencing a publicly quoted debt instrument (whose failure, being public you did not need to prove) and your counterparty must pay you a sum calculated on the estimated market price of a range of observable liquid instruments. This is to be sure, only a proxy for your actual loss, but a lot better than nothing. | The [[credit default swap]] emerged as a neat way to manage that risk. To cover against losses on an illiquid private bilateral loan, you could buy a [[credit derivative]] referencing a publicly quoted debt instrument (whose failure, being public you did not need to prove) and your counterparty must pay you a sum calculated on the estimated market price of a range of observable liquid instruments. This is to be sure, only a proxy for your actual loss, but a lot better than nothing. |