You Can Buy, But You Can’t Sell, And Vice-Versa

Be sure and check out this article from the Wall Street Journal.  Derivatives being private contracts between two parties, they can’t easily be traded.  To eliminate a position prior to maturity, one can do three things:

  1. Sell it back to the party you bought it from.
  2. Sell an equivalent contract to a third party.
  3. Sell your interest in the contract to a third party.

In situation 1, the exposure goes away, but the negotiation can be tough because they know they are the only ones that can eliminate the exposure in entire.  In situation 2, the exposure goes away, but one still has counterparty risk, in that they have bought and sold the same item to two different parties.  If one party defaults while owing money, the other obligation does not go away.

In situation 3, the exposure goes away if it can be done.  Sometimes the derivatives prohibit such a trade, because they don’t want the possibility of diminished creditworthiness.

So, as the WSJ points out: derivatives, even crdit and equity derivatives can’t be traded like stocks.