July 28, 2011
By Zachary Karabell
Wednesday’s plunge in the markets signaled that the impasse over the debt ceiling, if it continues, will eventually trigger a substantial market sell-off. Until now, there had been surprising complacency among investors, who seemed to assume that after all the noise and haggling there would, of course, be a deal. That belief itself should have been a warning sign; when investors dismiss what is known as “tail risk,” only trouble ensues.
But largely overlooked throughout this drama is a robust trade in financial derivatives tied to the results of the debt debate — and those are beginning to tell a story of their own. Unlike in 2008 and 2009, when these shadowy financial instruments almost destroyed the global financial system, derivatives this time may actually fulfill their intended role of reducing risk.