I can’t even comprehend Bloomberg’s story about the Greece-Goldman swap-debt-whatever kaboodle, so let’s talk about the philosophy of derivatives for a minute. First the story:
Greece’s secret loan from Goldman Sachs Group Inc. (GS) was a costly mistake from the start. On the day the 2001 deal was struck, the government owed the bank about 600 million euros ($793 million) more than the 2.8 billion euros it borrowed, said Spyros Papanicolaou, who took over the country’s debt-management agency in 2005. By then, the price of the transaction, a derivative that disguised the loan and that Goldman Sachs persuaded Greece not to test with competitors, had almost doubled to 5.1 billion euros, he said.
There are at least three reasons to use derivatives. First you could be into some actual informed shifting of risks from those who want to pay to get rid of them to those willing to be paid to bear them, or from those who have Risk X and want Risk Y to those who etc. Boy are there a lot of textbooks that talk about this. And I suppose it even happens sometimes. You could imagine that a vanilla interest rate swap entered into by a corporation on its bonds or credit facility could qualify as this. I guess people who trade listed options to do covered-write strategies or speculate on takeovers or whatever fall in this category, maybe modulo the “informed.” (Sometimes!)
Then there’s tax and regulatory arbitrage. This is time-honored and much of it, particularly the stuff with the best names, is focused on tax dodging, but there are also various other regimes – securities laws, accounting, whatever – that you might want to get around with derivatives. Paying $10 for CDS with a maximum payout of $10 purely to lower your capital requirements is a recent amusing/egregious example.
The thing that wasn’t mentioned in the CFA Level I derivatives primer is principal-agent arbitrage. This is … first of all, let’s say this isn’t a derivatives issue, or a financial-industry issue, it’s like a life issue. (Some would say it’s why there’s an M&A business, for instance.*) Read more »