Liquidity
Looping risk
Nothing about a loop is exotic. It is a spread trade, and it fails in the four ways spread trades fail.
Every one of these is a consequence of the same arithmetic that makes the loop attractive in the first place. Leverage does not change the direction of a risk, only its size.
| Risk | What actually happens |
|---|---|
| Spread inversion | If the borrow rate climbs past the fixed return, every unit of leverage subtracts instead of adds. |
| Early exit | The fixed return is only fixed at maturity. Unwinding early realises PT’s market price, multiplied by the leverage. |
| Collateral value | PT priced down, even temporarily, tightens the loan against it — precisely when exiting is most expensive. |
| Depth | Leverage multiplies size, and thin books multiply the cost of moving that size. |
The common thread#
Three of the four only bite if you need to get out before the date. A loop held to maturity in a market whose borrow rate stays put resolves exactly as the arithmetic said it would. The risk is concentrated almost entirely in being forced to act early.