Conflicts in the credit-derivatives market threaten to undermine it

SHAKESPEARE WAS a fan of the quibble. His plots often hinge on the gap between word and intended meaning. Macbeth was supposed to be invincible because he could be harmed by “none of woman born”—but his killer, Macduff, was delivered by Caesarean section. In “The Merchant of Venice” Portia saves Antonio by arguing that though he agreed to forfeit a pound of flesh to Shylock if he defaulted on a loan, he did not agree to lose blood.

Traders in credit-derivative markets are keen on quibbles, too. Credit-default swaps (CDSs) are insurance-like derivatives designed to compensate lenders when a company goes bust. A simple enough aim, you might think, but there are plenty of devilish details. A company can go bust in many ways: it can close and have its assets sold off, or restructure its debt and keep operating. And CDS contracts pay out the difference between a bond’s face value and the price of the cheapest bond available, even though the underlying...

via The Economist: Finance and economics Business Feeds

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