Financial InnovationHow it Affects the

Macroeconomy

P.V. ViswanathSummer 2007

How Financial Innovations improve economic performance

Completing markets: expanding opportunities for o risk-sharing o risk-pooling o hedgingo intertemporal or spatial transfers of resources

lowering transactions costs or increasing liquidity

reducing “agency” costs caused byo asymmetric information between trading partieso principals’ incomplete monitoring of agents’

performance.

Financial System Functions

Payments system for the exchange of goods.Mechanism for the pooling of funds for large-scale indivisible enterprises.Transfer of economic resources through time and across geographic regions and industries.Management of uncertainty and control risk.Provision of price information to coordinate decentralized decision-making.Managing “agency” costs.

Financial System Functions

Payments system

Decreasing the cost of processing payments for transactions

E.g. SWIFT, CHIPS

Increasing the speedDecreasing the possibility of fraudExamples: Credit cards, debit cards

Mechanism for the pooling of funds to create large-scale indivisible enterprises.

Creating a mechanism for pooling capital in a low-cost way and/or minimizing related agency problems.

Example: Limited Liability Companies, hedge funds, mutual funds, private equity funds

Financial System Functions

Pooling of funds

Financial System Functions

Resources transfer through time and space

Investors need ways of transferring savings from the present (when they are not needed) to the future (when they will be needed).They might also need to transfer resources through space.The same applies to borrowers as well.Examples: All securities, e.g. Bonds, Currency Swaps.

Financial System Functions

Risk ManagementReducing the risk by selling the source of it.

In general, adjusting a portfolio by moving from risky assets to a riskless asset to reduce risk is called hedging; this can be done either in the post cash market or in a futures or forward market.

Examples: Securitization (ABS, GNMAs)

Financial System Functions

Risk ManagementEven if aggregate risk is not reduced, the risk of an individual investor’s position can be reduced by diversification

Examples: Mutual funds, Index funds, SPDRs.

Financial System Functions

Risk Management

Reducing the risk by buying insurance against losses.Selling part of the return distribution; the fee or premium paid for insurance substitutes a sure loss for the possibility of a larger loss. In general, the owner of any asset can eliminate the downside risk of loss and retain the upside benefit of ownership by the purchase of a put option. Examples: Options, Range floaters

Financial System Functions

Information for decentralized decision-

makingDecision makers need information about demand and supply and prices in their own and in other sectors of the economy. This might involve the collection of data from many individuals.Examples: Futures markets, stock markets

Innovations and Information

Portfolio Insurance was developed as a means of synthetically creating a put, so that there would be a lower bound on the value of a portfolio.Unfortunately, the lack of an actual market where such puts were traded meant that information was not aggregated and provided to market participants.The Oct. 1987 liquidity crunch and market meltdown was due partly to this.

Financial System Functions Managing

agency costs Investors and Issuers may be unwilling to trade because of concerns as to whether the other party to the trade is informed or not.The benefits to trade might decrease if the relationship is long-lived and there are negative incentives for the participants in the trade.Examples: Puttable stock, convertible debt

The Impact of Government on Financial Markets

The primary role of government is to promote competition, ensure market integrity (including macro credit risk protections), and manage “public good” type externalities.

Other government functions that affect

financial marketsAs a market participant following the same rules for action as other private-sector transactors, such as with open market operations. As an industry competitor or benefactor of innovation, by supporting development or directly creating new financial products such as index-linked bonds or new institutions such as the Government National Mortgage Association.

How governments affect financial markets

As a legislator, by setting/ enforcing rules and restrictions on market participants, financial products, and markets such as margins, circuit breakers, and patents on products.

This can encourage financial innovation by setting and enforcing rules for property rights to innovation.

As a negotiator, by representing its domestic constituents in dealings with other sovereigns that involve financial markets.

This can encourage innovations intended to promote international flows of resources.

How governments affect financial markets

As an unwitting intervenor, by changing general corporate regulators, taxes, and other laws or policies that frequently have significant unanticipated and unintended consequences for the financial services industry.

This can spur innovation to try and get around the intended effects of government legislation

How governments affect financial markets

These activities can have potential costs that can be classified as follows:

direct costs to participants, such as fees for using the markets or costs of filingsdistortions of market prices and resource allocations transfers of wealth among private party participants in the financial markets.transfers of wealth from taxpayers to participants in the financial markets

 Financial Innovations are sometimes geared to avoidance of these regulatory costs.

The dynamic of financial innovation

Aggregate Trading Volume expands secularlyTrading is increasingly dominated by institutionsFurther expansion in round-the-clock trading permits more effective implementation of hedging strategies.Financial services firms will increasingly focus on providing individually tailored solutions to their clients’ investment and financing problems.

The dynamic of financial innovation

Sophisticated hedging and risk management will become an integrated part of the corporate capital budgeting and financial management process.Retail customers (households) will continue to move away from direct, individual financial market participation such as trading in individual stocks or bonds and move to aggregate bundles of securities, such as mutual funds, basket-type and index securities and custom-designed securities designed by intermediaries.

ImplicationsLiquidity will deepen in the basket/index securities, while individual stocks will become less liquid.There will be less need for the traditional regulatory protections and other subsidies of the costs of retail investors trading in stocks and bonds.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, and insurance and pension products.

Production Technologies

Underwriting

Synthesizing

Underwriting MethodThe method involves creating two or more securities or security classes from a single cash flow stream.

E.g., a Collateralized Mortgage Obligation, with an underlying fixed-rate pass through can have a tranche split into a floating-rate class and a corresponding inverse-floating rate class.

If the coupon rate for the original tranche had been 7.5% fixed, the coupon rate for the floating-rate class could be 1mth LIBOR +50 basis points, while the coupon rate for the inverse floater could be 28.50% - 3x(1mth LIBOR).

Expected Price Progression Over Time

$100

$115 $90

$110 $70 $140 $90

Year 0

Year 1

Year 2

Underwriting Method

The object in this example is to create a security with a floor value, beginning with another security that has no floor.

Underwriting Method

XYZ Stock Price

Class A Insured Equity

“Class B Residual Claim

XYZ Trust

$70 $100,000 $70,000 $170,000

90 $100,000 $90,000 $190,000

110 $110,000 $100,000 $210,000

140 $140,000 $100,000 $240,000

Underwriting MethodAdvantages:

Transparent; payments flow through trustNo need for dynamic adjustmentNo need to make assumptions regarding future progression of stock prices.

Disadvantage:Need to find a buyer for residual securityMore Risk Capital Required

Synthesizing Method - 1

At Year 0:

$70,000 Buy 704 shares XYZ @$100/share

$35,915 Short-term cash investment @ 5%

$106,315

Total Investment

Synthesizing Method - 2

At Year 1: If S=$90, sell 454 shares @ $90

Value Before Value After

$63,360 704 shares XYZ @$100

$37,711 Cash and Interest

$101,071

Total Investment

$22,500 250 shares XYZ @$90

$78,571 Cash investment @ 5%

$101,071

Total Investment

Synthesizing Method - 3

At Year 1: If S=$115, buy 96 shares @ $115

Value Before Value After

$80,960 704 shares XYZ @$115

$37,711 Cash and Interest

$118,671

Total Investment

$92,000 800 shares XYZ @$115

$26,671 Cash investment @ 5%

$118,671

Total Investment

Synthesizing Method: 4

At Year 2:

If S = $70 If S = $110

$17,500 250 shares XYZ @$70

$82,500 Cash and Interest

$100,000

Total Investment

$27,500 250 shares XYZ @$110

$82,500 Cash and Interest

$110,000

Total Investment

Synthesizing Method: 5

At Year 2:

If S = $90 If S = $140

$72,000 800 shares XYZ @$90

$28,000 Cash and Interest

$100,000

Total Investment

$112,000

250 shares XYZ @$110

$28,000 Cash and Interest

$140,000

Total Investment

Portfolio Insurance

Value of portfolio is never less than $100,000.This is achieved by shifting out of the risky security into the riskless security as the stock price drops.Exposure to risk is dynamically managed.Synthetically creates a put.

Synthesizing MethodAdvantages:

No residual security to sellNo intervening institution (trust)Lower Amt of Risk Capital Reqd

Disadvantages:Highly dependent on technologyMust make distributional assumptions for price.Complicated; hence more subject to error