Equity v credit derivatives showdown: Difference between revisions

The {{eqdefs}} were published in 2002 and, while not perfect, do a serviceable enough job at describing what is essentially, and usually, a fairly straightforward product, though they get a bit gummed up about dividends. The product traded is for the most part a [[delta-one]] exposure to shares, share baskets and indices and, while hedging can be fraught in times of dislocation, and hedging costs get passed through to end users, the basic notional value of an equity derivative is not: the market price if a listed share: you can see it printed in 6 point font in the Financial Times every day.

As the saying goes, “if it ain’t broke, don’t fix it” and the market has remained loyal to the 2002 Equity Derivatives Definitions booklet despite a noble attempt by {{icds}} detachment [[Flight 19]] to overhaul them in 2011. We have quite a bit of fun at their expense in these pages. As far as we know not a single trade has ever been documented under the [[2011 Equity Derivatives Definitions]]. If you happen to know of one, please ''don’t'' write in to tell us: that would spoil an impression of sad calamity we are quite happy labouring under.

The {{cddefs}} are for the connoisseur [[ISDA ninja]]. Their original abstract intellectual purity has long since evaporated, brutalised repeatedly by savage real-world market dislocation. They are now a fearful, paranoid, jabbering wreck. It is as if the winsome fever dream of some JP Morgan brainboxes, strained through the gusset of the [[First Men]] and wrung through some [[Potts Opinion|QC opinions]] has taken root, allowed to flourish, run wildly out of control, threatened life as we know it and then been mercilessly beaten, bent and twisted by a community of embittered banking regulators, themselves branded by the white-hot iron of civilisation-threatening financial disaster.  

Indeed, that is pretty much what ''did'' happen.

The product emerged in the 1990s, the brainchild of JP Morgan boffins, became highly fashionable, by 2003 had earned its own definitions booklet, and as the [[CDO]] mania of the noughties reached fever pitch, it began to standardise. Legions of chancers, grifters and joiner-inners flooded the market and before you knew it there were all kinds of “exotic” structures, each more convoluted and less plausible than the last. Growth was periodically set back by actual credit events in the market, each it's own life lesson about the multifarious ways in which over-engineered, too-clever-by-half structured products can surprise their Inventors by finding unexpected ways to fail.  The real “come-to-Jesus” moment for credit derivatives was the [[credit crunch]] of 2007 and then 2008’s full blown [[global financial crisis]],  which between them revealed the degree to which nice ideas in theory don’t hold up in the sweaty throes of market panic.  There was a ''lot'' of litigation about misfiring — or allegedly misfiring — credit derivatives. That has never really changed. The road to hell is, as they say, wallpaperered with [[CDS]] Confirmations. The credit derivatives have always been a bit of a moving feast.

As a result of their categorical failure to accommodate the various failures of the [[global financial crisis]] the {{cddefs}} were, monstrously overhauled in 2014, and at the same time the product standardised yet further, moving away from single name, bilateral, privately negotiated deals and towards cleared, standardised, broad-based index products. There are still some privately negotiated deals but, compared with equity swaps, which are the bedrock of hedge fund equity long/short strategies, not many. More than ten trades a week on a given Reference Entity rates special mention in ISDA’s credit market summary.  

Practitioners will tell you part of their lack of popularity is the sheer complication of the {{cddefs}}. Unlike the {{eqdefs}}, the 2003 Credit Derivatives Definitions really didn’t work, the move away was propelled by regulator angst and infrastructural imperative, so there was not the option of flat-out ignoring them, as the market did to the ill-fated [[2011 Equity Derivatives Definitions]]. Even though now impenetrable, they are ''still'' finding snafus needing quick fix patches.

In any case visiting the credit derivatives now after a few years away, is like visiting a long lost friend now institutionalised for her own good, straight jacketed, and fed cold soup through a straw. Occasionally she still manages to shout something outrageous and upset the common room.

{{Eqderiv}} are means of gaining exposure — positive or negative— to an instrument without owning it. The basic point of the contract is to replicate exactly the economic features of the [[Underlying|underlier]], minus the physical, reporting and funding aspects of being on the register. You buy or sell an {{eqderiv}} ''instead of'' buying or selling the [[Underlying|underlier]].

{{Cderiv}} assume you already own the [[Underlying|underlier]], but want to hedge away a specific embedded tail risk: namely, that it blows up. While you needn’t own the underlier to buy or sell {{Cderiv}} — the Robin Potts opinion is at great pains to stress that a [[Credit derivative|CDS]] is not a contract of insurance — generally speaking you ''will''.

{{cderiv}} address the market value of public, quoted, usually senior unsecured debt obligations — for this discussion, let’s call them “{{cddprov|Bond}}s” while [[equity derivatives]] address the value of public, quoted common shares.  

The instruments have very different qualities: Bonds repay principal and return income, equities return capital. Unless something really catastrophic happens, the return on a {{cddprov|Bond}} is predictable — interest and principal — and values will be as affected by prevailing interest rates as by deterioration (or improvement) in the Issuer’s creditworthiness. That one really catastrophic thing is the Issuer’s failure: its ''{{cddprov|Bankruptcy}}''.