Our analysis is as follows. First, debt and leverage cause fragility; they leave less room for errors as the economic system loses its ability to withstand extreme variations in the prices of securities and goods. Equity, by contrast, is robust: the collapse of the technology bubble in 2000 did not have significant consequences because internet companies, while able to raise large amounts of equity, had no access to credit markets. Second, the complexity created by globalisation and the internet causes economic and business values (such as company revenues, commodity prices or unemployment) to experience more extreme variations than ever before. Add to that the proliferation of systems that run more smoothly than before, but experience rare, but violent blow-ups. ... Third, debt has a nasty property: it is highly treacherous. A loan hides volatility as it does not vary outside of default, while an equity investment has volatility but its risks are visible. Yet both have similar risks. Thus debt is the province of both the overconfident borrower who underestimates large deviations, and of the investor who wants to be deluded by hiding risks. Then there are products such as complex derivatives, which in the name of "modern finance" make the system even more fragile.
Second, the complexity created by globalisation and the internet causes economic and business values (such as company revenues, commodity prices or unemployment) to experience more extreme variations than ever before. Add to that the proliferation of systems that run more smoothly than before, but experience rare, but violent blow-ups.
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Third, debt has a nasty property: it is highly treacherous. A loan hides volatility as it does not vary outside of default, while an equity investment has volatility but its risks are visible. Yet both have similar risks. Thus debt is the province of both the overconfident borrower who underestimates large deviations, and of the investor who wants to be deluded by hiding risks. Then there are products such as complex derivatives, which in the name of "modern finance" make the system even more fragile.
A loan hides volatility as it does not vary outside of default, while an equity investment has volatility but its risks are visible.
There are two (good news/bad news) points to consider when dealing with the discontinuous payoff options. The bad news is that almost all available hedges in the market are continuous payoff products, therefore creating imperfect or unstable hedges. There may be constructions that provide an accurate hedge (such as vertical spreads), but these constructions are too costly to execute and generally are unavailable. The good news is that the bet option has small bite. It is a relatively harmless product for those who trade it as it shold be traded - as a bet. Dynamic hedging is to be avoided in these situations.
