Suppose there is someone with an investment horizon of 10 years (Retired Bob), and another person with an investment horizon of 30 years (Hungry Joe). Retired Bob doesn't want to take risk, but Hungry Joe does. So they figure Retired Bob should loan 50K to Hungry Joe at an interest rate of 2%, which Hungry Joe invests into riskier asset.
However, Retired Bob and Hungry Joe both want to limit counter party risk, so they concoct the following derivative contract instead:
- Retired Bob invests the cash into the riskier asset
- Every 6 months, if the total market value of that investment goes below 50K, Hungry Joe transfers the shortfall to Retired Bob in cash
- Vice versa, every time the market value of the investment goes above 50K, Retired Bob transfers the surplus to Hungry Joe in cash
- After 10 years, Hungry Joe owes Retired Bob capital + 2% interest, while Retired Bob owes Hungry Joe the capital gain + dividend, and they clear the difference
The point of this as opposed to just Bob lending cash to Joe is to limit counter party risk. Had Bob just lent the cash to Joe, and the investment was 50% underwater after 10 years, and then Joe dies in an accident, Bob could be left with a large loss. Vice versa, if the investment went up 200% and Bob dies, and for whatever reason Joe can't get to the money, he will miss out on the gain.
By balancing the accounts frequently, the loss can be limited on both sides (while admittedly the loan's value is decreased, because it's like a rolling short-term loan.
Does this make sense? Or am I missing something?