Content
Financial system
Financial innovation
Financial engineering
Benefit of financial innovation
Social value
International dynamics
Securities innovation
Future implications
The structure of interest rate
Duration and convexity
Financial System
Functional perspective
Allocation and deployment of resources in an uncertain environment
Across time and spatially
Basic cash-flow cycle: household savings to investments by firms to investment returns for consumption and new savings.
Payment system
Pooling of funds
Risk-pooling and risk-sharing opportunities: bigger firms or projects, mutual funds
Price discovery
Key source of information for coordinating decentralized decision-making
Deal with information asymmetry*
Through capital markets composed of
Money
Fixed-income
Equity
Derivatives
Served by financial intermediation
The process of transforming financial assets from one form into another
Underwriting & synthesizing: input/output production
Financial Innovation
Areas
Creation of new types of securities
While options and futures may not be entirely new, the proliferation of organized trading market in both equity and fixed-income derivative securities during the past two decades is unprecedented.
Development of standardized markets was absolutely essential for the subsequent creation of a wide range of financial products.
Development and evolution of new financial
Changes in institutional structure evolve toward
improvements in the performance of the functions of the financial system.
Institutional perspective hinders economic efficiency (institution preservation)*
The functional perspective views financial
innovation as the engine driving the financial system toward its goal of economic efficiency.
Even national governments are increasingly acting more like competitive institutions in this domain.
Means for implementing innovation
The process of tailoring financial instruments and
organizational structure to improve the profitability of customers
Steps
Diagnosis: nature and source of the problem
Analysis: finding the best solution
Design: new instruments or intermediary
Production: underwriting or synthesizing or both
Pricing: cost and profit margin
Customization: tailoring to the specific needs.
Financial engineering
Embodies the skills, techniques, and processes of innovation
Technologies
Pricing and hedging concept
Support more comprehensive derivative-securities markets and risk-management systems.
Computer speed and capacity
Enable systems to securitizes assets and monitor thousands of trading positions in real time.
Communication systems
Facilitate simultaneous actions needed to exploit transient arbitrage opportunities.
Risk Management
Selling the source
Hedging: moving from risky to riskless
Futures, forward contracts, and swaps
Diversification
Basket cash-market securities and index futures
Buying insurance
Retention of the upside while deleting downside
Options (on aggregate portfolios)
Example: Insured-equity product
Equivalent to a protective-put option strategy: buying the stock or index and its put option
Chase Manhattan Bank: market-index (S&P 500) certificate of deposit
Swiss Bank: guarantee-return-on-investment securities (GROIS)
• Not appropriately named, does not guarantee ROI but principal
Merrill Lynch: market index target term securities (MITTS)
LOR: supertrust and supershares
Underwriting
Creating a unit trust: buying the stock or index (ETF) and treasury bills with a face value equal to the guaranteed amount
Serving as an agent of the trust by issuing two classes of securities: Class A the insured-equity product with payoff = max (stock price, TB) and Class Z the residual = min (stock price, TB)
Class Z happens to have the same structure as a junk bond.
Otherwise, Class Z must be regarded as cram-downs 填塞 reflecting the lack of natural investor demand for its pattern of payoffs, and must be sold on discount to bargain hunters.
Synthesizing
As principle owner (not agent of the trust)
Finance the difference between the cost of two assets and the proceeds from sale of the insured-equity product with equity capital.
Potentially significant agency and tax (dead weight 淨負荷 ) costs of equity capital of firms.
Owner of the stock may have an incentive to sell Class A with a higher price and retain Class Z.
Synthesizing or dynamic-trading to replicate the payoff structure in the least-cost way with an initial investment without further infusion of capital (self-financing, riskless arbitrage)
Assembling customer-tailored products with a single (static) replication of the aggregate payoff.
Clerical error, model misspecification, credit risk of the intermediary.
Benefits of Innovation
Efficient resource allocation
Lowering transaction costs
Completing markets
Making prices more informative
Form of benefits
Lowering costs of raising funds
Managing risk exposures more precisely
Enhancing investment returns
Coping with changing tax and regulatory regimes
Social Value
Performance appraisal
Effectiveness of the financial system
Improved opportunities for households to receive efficient risk-return tradeoffs and more effective tailoring to individual needs over the entire life cycle.
Expanded economic or managerial flexibility
Solving long-standing and vexing problems of corporate finance, financial services, investment management, and public policy.
Negative
Ex ante distortions of capital allocation
Unrealistic expectations of greater expected returns with less risk fueled by financial-services firms and organized exchanges that see huge profits from the vast activity .
Ex post excessive volatility in capital market prices
Faulty expectations not realized.
Positive
Development of a national mortgage market in the 1980s along with a wide range of MBS
Transformed residential housing finance from fragmented, local- based sources to a free-flowing, international base of capital.
Derivative markets
Made it possible for business firms to hedge effectively against financial risks.
Mutual funds
Directly benefit households around the world.
Should be evaluated within the context of the managerial or public-policy decisions to which it is applied.
Example: international stock-returns swaps
Diagnosis & Analysis
International diversification has not yet evolved in many smaller, developed countries.
• Capital controls to prevent flight of domestic capital and to reduce the risk of inadequate domestic investment.
High transaction cost offsets any diversification benefits
Domestic physical investment is driven to become more diversified than necessary
• International diversification is more efficient than domestic diversification.
Proposed solution
Separating the capital flow effects of investment from the risk-sharing aspects.
Design
Swap
The total return per dollar on the small country’s domestic stock market is exchanged annually for the total return per dollar on a market-value weighted-average of the major world stock markets.
Through domestic mutual funds or financial intermediaries
Foreign investors benefit by avoiding the costs of trading in
individual securities in the local markets and by avoiding some tax complications.
Exchange of returns could be in a common currency or adjusted to different currencies with currency-swap agreements.
In notional or principal amount of the swap.
No initial payment by either party.
Settlement involves only the difference between the total returns on the two stock market indices. The small-country investors make net payments out precisely when their local market has outperformed the world markets.
Trading and ownership of actual shares remain with domestic investors.
Institutional Dynamics
Dynamics
While the functions of the financial system are stable, the ways in which they are performed are not.
Commodization
Temporal pattern: the “successes” of new financial products migrate from intermediaries to markets
Once they are seasoned and perhaps after some information asymmetries are resolved.
From opaque (financial companies) to translucent (funds) to transparent (markets)
Credit insurance replaced by put option on bonds (CDS)
Securitization
Agent-type institutions compete with principle-type institutions
Financial-innovation spiral
Financial intermediaries create and test new products, then move to market after standardization.
The proliferation of new trading markets makes feasible the creation of new custom-designed financial products that improve market completeness.
Example
Eurodollar futures market
Provides organized trading in standardized LIBOR deposits at various dates in the future.
Provides financial intermediaries with a way to hedge more efficiently custom-contracted interest-rate swaps based on a floating rate linked to LIBOR.
Eurodollar futures market becomes a great financial success.
Swaps with relatively standardized terms began to move to the market.
These pure vanilla swaps expands the opportunity structure for intermediaries to hedge, and to enable them to create more customized swaps.
Security Innovations
An immutable set of financial functions
Why innovation?
History from 1973 to 1993
Open interest on exchange-traded option contracts from 0.25 mln to 25 mln
From virtually no junk bonds issued to 50 bln outstanding in mid-1980s and to over 200 bln outstanding
From no swaps market in 1980 to 3 tln in interest-rate swaps
From 6 bln in MBSs outstanding to 2 tln
I. Costs
1. Marketing
Identifying and educating buyers and sellers are labor- and information-intensive
Defined-benefit pension systems clientele: long-maturity CMO tranches, zero-coupon bonds, portfolio insurance.
Interest-rate swaps and basis (difference between LIBOR and the prime rate) swaps to commercial banks.*
2. Manufacturing
Raw materials
Using index futures rather than trading stock basket to replicate put for portfolio insurance
Assessable stocks: due to lack of information, shareholders provide committed cash to the firm only after regular
assessments (milestone payments, secured debt, bond covenants).
Technologies
Computing, telecommunication and financial engineering theory (dynamic replication): portfolio insurance, securitization
(thousands of small and constantly changing receivables), cross- border arbitrage.
Legal: no loophole to circumvent the original intent.
3. Taxes and regulations
ARPPS & MMP: debt-like return with intercorporate dividend exclusion
Tax-deductable equity
US Banks offer Eurodollar CDs to circumvent reserve requirements
Insurance companies purchase index-linked bonds to circumvent regulatory constraints.
Perpetual floating rate note to meet capital standards.
Deregulation of the natural gas market lead to Enron Gas Service’s natural gas derivatives market.
II. Changing demands
1.Life cycles
College costs linked investments
Venture leases: sales-leaseback of patents for biotech firms.
LBO: deferred-cash-flow instruments.
2. Volatility (exogenous shocks)
Lowers marketing cost
Increases the dispersion of beliefs and the potential for arbitrage
Broadening of the potential market
Cessation of governmental control
Inflation-indexed bonds
Legal tender bonds: gives the payer the option of paying in any kind of legal tender
III. Experimentation
An evolutionary story of innovation, learning and experimentation
Legal language cannot fully define all rights or the interpretation of rights
Virtually no patent protection (reverse engineering)
Regulators close the loopholes
Income bonds
Failure to pay interest was a condition of default only if the firm had sufficient profits
Provide financing for distressed firms
Enjoy tax advantages of debt without threatening financial distress.*
But the non-cumulative feature allows firms to shift income to the detriment of bondholders (concentrating income in one period and no income for all other periods)
Accounting manipulation by expensing capital investments even if cumulative.
Subsequent income bonds added cumulative features and carefully prescribed methods of computing earnings, even participation features and voting rights.
Early warrants
Securities designed to sell investors the upside, bonds with warrants.
No protection against cash and stock dividends or splits.
Modern preferred stocks
Provide investors with a substitute for commercial paper, but was structured as equity to enjoy dividend income exclusion by corporations.
Assured of virtually no potential principal losses from interest rate risk.
Adjustable-rate perpetual preferred stock (ARPPS): paid a market rate of dividends, adjusted every 49 days (minimum holding period to obtain favorable tax treatment).
But credit of the issuer could deteriorate or credit spreads could widen.
Counter factors
Product proliferation may make it more costly to sell new products
Availability of exchange-traded products may stifle traditional innovation
Well publicized disasters could lead to a backlash against innovation
Future Implications
Financial institution
Forces: lower costs & increasing global competition
Lay the foundation for a substantial increase in both the frequency and the magnitude of the changes in the institutional structure.
Applies also to the regulatory bodies that govern financial firms.
The long-run role of regulatory change as an
exogenous force for financial innovation is limited.*
Participants
Corporations
Sophisticated hedging and risk management will become an integrated part of the corporate capital budgeting and financial management process.
The posting and careful monitoring of collateral is likely to be more widely adopted as the primary means for ensuring counterparty performance.*
Households
Move away from direct trading in individual stocks or bond where they have the greatest comparative disadvantage
(diversification, trading cost, information) toward aggregate bundles of securities
Cause liquidity to deepen in the basket/index securities while individual stocks to become relatively less liquid.
Less need for the traditional regulatory protections and other subsidies of the costs of retail investors.
The emphasis on disclosure and regulations will tend to shift up the security-aggregation chain to the interface between investors and investment companies, asset allocators, insurance and pension products.*
Regulators
Policies and regulations should facilitate the requisite changes in structure instead of attempting to protect and preserve the existing ones.
Explicit recognition of the interdependence between product and infrastructure innovations and of the inevitable conflicts that arise between the two.
At times, the imbalance could become large enough to jeopardize the functioning of the financial system.
Change the format of regulation from institutional to functional.
Promoting competition
Ensuring market integrity including macro credit risk protections (market breakdown)
Managing public-good type externalities*
International issue of the tradeoff between the benefits of regulatory cooperation and the benefits of regulatory
competition.
The Structure of Interest Rates#
• Yield curve
– How the yields on U.S. government debt obligations vary with maturity.
• The yield has little to do with any rate of interest that can actually be realized in the market.
– Has to assume the same constant reinvest rate.
1 / 1 2
(1 ) (1 ) (1 ) ...
2 2 2 2 2
N d dc N N
b b b
r C r C r
P
• Strip yield curve
– The actual structure of interest rate
• Yields on debt obligations promising a single future payment (pure discount or zero coupon bonds).
– Can actually be earned if held to maturity.
– Coupon bonds can be thought of as a bundle or portfolios of pure discount bonds.
1 2 3 4
1 2 3
4,
Let , , , be four coupon bonds with maturities 0.5, 1, 1.5, and 2 years as well as coupons , , , and respectively. Let denote strip yield. We knows
P P P P
C C C
C r
– Yield to maturity is actually a complex
average of strip yields. The schedule of strip yields implied by the prices of coupon bonds is called the spot yield curve.
– The explicit yields associated with the STRIP market are referred to as the strip yield curve.
– If the spot curve is rising (falling), then yield
2 2
1 1 2 2 2
1 2
3 3 3
3 2 3 3
1 2 3
/ 2 / 2 100
Then . Solve to get ,
(1 / 2) (1 / 2)
/ 2 / 2 / 2 100
to get and so on.
1 / 2 (1 / 2) (1 / 2)
s b s
s s
s
s s s
C C
r r P r
r r
C C C
P r
r r r
– In practice, the spot curve and the strip curve may differ for a number of reasons including taxes, bid-ask spreads or non-market prices.*
• Forward rates
• Strip yields are actually geometric average of the current spot rate and forward rates. When forward rates are rising (falling), strip yields will also be rising (falling).
2 2
2 1
3 2 3
3 2
3 2 1
2 3
Implicit forward rates can be drived from strip yields.
(1 ) (1 ) (1 ), and
2 2 2
(1 ) (1 ) (1 ) (1 ) (1 ) (1 )
2 2 2 2 2 2
is simialr to a 6x12 FRA and a 12x18 FRA.
s s f
f f f
s s s
f f
r r r
r r r
r r r
r r
– The implicit forward rates may not be equal to the expected future spot rate unless the unbiased expectation hypothesis holds.
• Case
– COUGARs (79-86)
• Arbitrage among yield curve, spot yield curve, strip yield curve, and forward rates with all-in costs.
1 2
2
2 1 1 2
1 2 2
Let be the six month strip yield six month from now, if the Expectation Hypothesis holds, then
(1 ) (1 ) [1 ( )], hence, ( )
s
s s s
s f
r
r r E r
E r r
Duration and Convexity
• Duration
– PVs of cash flows weighted average time
• Linear approximation to a bond’s price-yield curve.
• For zeros, the maturity is the “average life”.
• Longer-lived bonds are more sensitive to rate changes than shorter-lived bonds.
2T t Ct /(1 rb / 2)t D
2 2
1
1 1
2
1
(1 ) , (1 ) ,
2 2 2
/(1 / 2)
/ /(1 / 2)
2
* (modified duration)
(1 / 2)
Hedging a long position of a 9-year bond by selling short a 3-yea
T T
t t
b b
t t
t b t
T t
t b
b b t
b
r P t r
P C C
r
C r
P P t
r P r
D D
r
9 9 3
9 3 9 3
3 9 3
r bond, the hedge ratio is
(assume b = b ) , P P P ,
r r P h P h
P P P
– Shortcomings of the duration hedge ratio
• The yield curve does not always shift in parallel fashion, i.e., it is not true that changes in short-term and long-term rates are equal.
• Rates sometimes jump (convexity)
– The hedge will be imperfect for large rate movements, even if the rates on both bonds change identically. One bond may have a curvier price-yield profile than the other.
– Addressing the convexity issue is of crucial importance in dealing with bond options and other instruments that
contain option features (mortgage and callable bonds*).
9 3
9 9 3 3
9 3
9 9 9 9 3 3 3
3 9 3
* *
9 9 3
9 3
3
9
If but both are subject to the same
single factor , then ,
/ /
,
,
hence, /
/
b b
b b
b b
b b b b
b b
b
r r
r P r P
r h
r r r r
r P P r r P r
r P P h r P
r P r
D h D
r P r
r r P
h r r
*
9 9
*
D P D
• Convexity
– Explanation for an inverse yield curve
• Expectations for inflation in the distant future may be less than those for the near future.
• The relative demands for different maturities may be
determined by institutional factors and, because players don’t like to move out of their preferred maturity, e.g., insurance companies need to hedge their positions on long-term
retirement contracts; treasury debt retirement policies that reduce the supply of long bonds (preferred habitat). Reduced demand for long-term funds for consumption and investment.
• Artifact of monetary policies: Fed reduces interest rate to expand the economy pushing up inflationary expectation and vice versa.
• The yield to maturity may not show all the gains that can be realized from holding a long bond.
– The convexity of a long bond relates to yield volatility.
A delta neutral portfolio can be put together for long maturity bonds to benefit from volatility shifts.*
– Research findings for inverse yield curves
• The end of an economic boom and the start of an economic bust? Not a sufficient condition.
– Recession followed 4-6 quarters later.
– 10-year vs. 2-year TB rates (early signal), 10-year vs 3- month TB rates (best forecaster) , and 10-year TB rate vs. Federal fund rate (reflecting monetary policies, not a very good indicator).
• Exceptions
– Credit crunch (1967) caused short-term rates to jump temporarily.
– Russian financial crisis (1998) caused investors to seek safer US long-term TBs.
• False exception
– Budget surplus in 2000 reduced US TB supply, but turn out to be a recession.
