The New Lombard Street, Merhling (2011) quotes Fischer Black(1970) in saying: Th

Question

The New Lombard Street, Merhling (2011) quotes Fischer Black(1970) in saying: Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk; and one would bear the risk of default. The last two would not have to put up any capital for the bonds, although they might have to post some sort of collateral.

How does the separation of risk work? What financial instruments are needed? Give an explanation so
that someone with no training in economics could understand.

Explanation / Answer

The cost of transferring the bond themselves under these circumstances would be absolutely zero. The material consequences for the liquidity and cash flow of such a bond is transferable. Risk and transfer costs are said to make an asset illiquid. The risk of an asset is seperable from its assets but the transfer costs are associated with the risk of the asset. Liquidity in financial assets has nothing to do with cash flows. Cash transfers are completely independent of risk transfers, and liquidity is associated with risk transfers rather than cash transfers.

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