Crunch time for LOBO derivatives

13 November 2023/No Comments
By Nick Dunbar

There are two kinds of options in finance. There are those traded as financial instruments, and priced using the Black-Scholes formula or more complex equivalents. Then there are options embedded in financial contracts, which are not traded and have to be modelled.

At the 50th anniversary of Fischer Black and Myron Scholes’ ground-breaking paper in 1973, the first kind of options have become background noise in the financial system, with trillion dollar trading volume and market size. But the second kind of option only rears its head when something unexpected happens – not the volatility that is priced by the market, but a sea-change in conditions that affects everything. The kind of change that makes people ask, ‘what are my options?’

Right now, that change is rising interest rates, which has had a massive impact on anyone who owns bonds or investments that resemble them. The longer dated the bond, the worse it gets. A UK gilt that was issued at the start of 2022, maturing in 2073, has lost two thirds of its value. It’s hard to believe that UK institutions have liabilities longer than that but they do.

Unlike gilts, these liabilities are no longer being created. They are ‘legacy assets’, more accurately dogs of the financial system that no-one wants to talk about any more.

Ever since 2014, I’ve been looking at a kind of bank loan once popular in UK local government: the Lender Option Borrower Option or LOBO loan.

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