A version of this blog post was originally published on the Chartis RiskTech Forum.
It’s 2007. Imagine a small-cap company, such as a family-run farm, and imagine the farmer needs to renew a loan he has with his bank. The bank salesman thinks in terms of rolling over a swap, and proposes a structured product protecting his client from rising interest rates. The downside is the collateral flow if interest rates hike south. The farmer, not as concerned about falling interest rates as he is about borrowing money, looks to the upside of protection if interest rates go up and perhaps doesn’t understand that a loan could carry risk if interest rates go down. He does not ask, and it’s pretty obvious he does not fully understand the product he is buying. But he trusts his banker. From the farmer’s viewpoint, the bank is a trusted institution with the best interests of its clients at heart.