Equity v credit derivatives showdown: Difference between revisions

Equity v credit derivatives showdown (view source)

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 Because there are literally no expectations about what they will pay — not even a redemption date — equities pogo around, depending on the issuer’s quarterly performance, paranoia, market sentiment, geopolitical currents, internet memes, Reddit, whatever Elon tweets about and whatever the madness of collected action believes to be germane to the business of, well, business.  Equities could quite easily be up 200% or down 70% over a six-month period with neither making a tremendous statement as to the basic creditworthiness of the Issuer.
-so oddly, while you would expect equities to be about corporate default and credit derivatives to be about relative performance in the absence of default, it is the other way around. Credit derivatives, like Bonds, tend to have a fixed term and while you can mutually terminate them at market price, there is no right to in the absence of a catastrophic failure. Equities tend to be exercisable at any time.
+So oddly, while you would expect equities to be about corporate default and credit derivatives to be about relative performance in the absence of default, it is the other way round. Credit derivatives, like Bonds, tend to have a fixed term and a fixed premium and, while you can mutually terminate them at market price, there is no ''right'' to do so in the absence of a catastrophic failure — any exit is negotiated and dependent on prevailing liquidity. Equity swaps tend not to have a tenor (they may ''have'' one, but it doesn’t ''mean'' anything)  and to be terminable on the client side at any time.
+==Buy side and sell side==
+Like all swaps, CDS and equity swaps are optically bilateral and a customer can take a short or long position. But there is still almost always a “[[buy side]]” investor looking to the swap to ''take'' a position, or to hedge an existing exposure, and a “[[sell side]]” swap dealer looking for a commission or premium, who will therefore hedge away the market risk presented by the swap.
+An investor buys a swap to put on a hedge; a dealer buys a hedge put on a swap. The investor seeks to change its market position with derivatives, the dealer seeks to keep its position flat.
+This is a deep, profound market feature, and the [[JC]] thinks it gets misunderstood too often, and talked about not nearly enough. [[Regulatory margin|Bilateral margin regulations]], for example, were introduced in ignorance of, or disregard for, this distinction. [[When regulatory margin attacks|They have already contributed to catastrophic loss]].
 ==Vibe==
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 You can set an ''arbitrary'' return — a hypothetical limit — and measure equity performance against ''that'' but this is not ''protection'' but ''speculation''. It is to buy or sell an {{eqprov|option}}: a true derivative. Equity swaps are in this sense genuinely derivatives, and no one hit up Robin Potts Q.C. for an opinion just to check they weren’t disguised insurance contracts.
-Because they have all those deterministic features — due principal, due income, due date — the debt obligations ''are'' intrinsically insurable. They are also far less prone to market fluctuation, and their volatility tends to zero as maturity approaches. There is a lot less call for speculation, therefore (not ''none'', to be clear, just a lot less, and it tends to be highly levered) and a lot more call for protection against those deterministic features. Credit events are not interested in market value fluctuations, therefore, but indicators that a Reference Obligation really will not pay the whole amount it is scheduled to pay on the day it is scheduled to pay it. This is binary: indicators that it is merely less likely to be able to do that — ratings downgrades, Equity price triggers and so on — will not trigger a Credit Event. To be sure, they may influence “CDS spreads” — the premium one must pay to buy credit protection on the Reference Entity — and may lead to gains or losses in the mark-to-market value of a credit default swap, but these gains will reflect the present value of that spread differential against the original traded price,
+Because they have all those deterministic features — due principal, due income, due date — the debt obligations ''are'' intrinsically insurable. They are also far less prone to market fluctuation, and their volatility tends to zero as maturity approaches. There is a lot less call for speculation, therefore (not ''none'', to be clear, just a lot less, and it tends to be highly levered) and a lot more call for protection against those deterministic features.
+Credit events are not concerned with capricious market value fluctuations, therefore, but only portents of utter destruction: indicators that a {{cddprov|Reference Obligation}} really will not pay the ''whole amount'' due on the ''day'' it is due. This is binary:  market indicators that a {{cddprov|Reference Entity}} is merely ''less likely'' to be able pay in full on time — ratings downgrades, [[common equity]] breaching price triggers and so on — should ''not'' trigger a {{cddprov|Credit Event}}. To be sure, they may cause “CDS spreads” to spike — the premium one must pay to buy credit protection on the Reference Entity for new contracts will increase, so the replacement cost of existing trades will have a value — and may thus lead to gains or losses in the mark-to-market value of a [[credit default swap]], but these gains will reflect the present value of that spread differential against the originally traded price, and not anything more profound than that. As long as the {{cddprov|Reference Entity}} does in time repay its debt (or at least not indicate finally that it ''won’t'' before the credit protection expires) then the credit derivative will expire unexercised.
+Thus {{cddprov|Credit Events}} cross over with, but are different to {{isdaprov|Events of Default}}, and are more relentlessly focussed on non-payment in full and on time: {{cddprov|Bankruptcy}},  {{cddprov|Restructuring}},  {{cddprov|Repudiation/Moratorium}},   {{cddprov|Obligation Acceleration}},  {{cddprov|Governmental Intervention}}.