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Of the range of valid means of performing a [[contract]], the one that will cost you the least and irritate your customer the most should you choose it. | Of the range of valid means of performing a [[contract]], the one that will cost you the least and irritate your customer the most should you choose it. | ||
==== | ====Credit derivatives ==== | ||
{{drop|A|r some point}} in the 1990s someone came up with the idea of credit derivatives. These are derivative contracts — principally the [[credit default swap]] — that allow investors to manage credit risk to debt instruments. | {{drop|A|r some point}} in the 1990s someone came up with the idea of credit derivatives. These are derivative contracts — principally the [[credit default swap]] — that allow investors to manage credit risk to debt instruments. | ||
[[Debt instrument]] s are funny in a number of ways: there is generally little upside volatility — they repay at par, so offer little scope for trips to the moon — a lot of potential downside volatility — they can go to zero, if the debtor fails — they come in all shapes and sizes: bonds, medium term notes, bilateral loans, syndicated loans, deposits —and due to the term nature of debt, no two debt instruments are economically (let alone legally) fungible. Each instrument treads its own, albeit correlated, value path. | [[Debt instrument]]s are funny in a number of ways: there is generally little upside volatility — they repay at par, so offer little scope for trips to the moon — a lot of potential downside volatility — they can go to zero, if the debtor fails — they come in all shapes and sizes: bonds, medium term notes, bilateral loans, syndicated loans, deposits —and due to the term nature of debt, no two debt instruments are economically (let alone legally) fungible. Each instrument treads its own, albeit correlated, value path. | ||
As such, the market is generally opaque and, “sticky”: debt instruments are illiquid in a way equities, which generally have none of those limitations, are not. By the same token some debt instruments — publicly quoted senior bonds — are a lot more liquid and transparent than others. | As such, the market is generally opaque and, “sticky”: debt instruments are illiquid in a way equities, which generally have none of those limitations, are not. By the same token some debt instruments — publicly quoted senior bonds — are a lot more liquid and transparent than others. | ||
You might be able to buy a put on quoted bond | You might be able to buy a put on quoted bond at a reasonable price, but good luck with a privately negotiated term loan. | ||
Since, except in a [[tail event]] disaster scenario, debt values are fairly stable this usually doesnʼt matter much — but when it ''does'' matter, it matters ''a lot''. | Since, except in a [[tail event]] disaster scenario, debt repayment values are fairly stable (compared with equities or commodities) and as long as your borrower doesnʼt blow up you will eventually get your money back this usually doesnʼt matter much — but when it ''does'' matter, it matters ''a lot''. | ||
The [[credit default swap]] emerged is a neat way of managing that risk. To cover against the loss I could buy credit | The [[credit default swap]] emerged is a neat way of managing that risk. To cover against the loss on my private bilateral loan I could buy a credit derivative which would pay out if the borrower defaulted on its quoted debt (a public event I donʼt need to prove) and my counterparty must pay me a sum calculated on the estimated market price of a range of observable liquid instruments. A proxy for my loss: not perfect, but good enough | ||
====Trades are zero-sum games==== | ====Trades are zero-sum games==== | ||
Where a contract can be fully understood in monetary terms, expect the parties to do the utter bare minimum to discharge it. | Where a contract can be fully understood in monetary terms, expect the parties to do the utter bare minimum to discharge it. | ||