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Investment banking > Financial Innovation > Flashcards

Financial Innovation Flashcards

1
Q

What is financial innovation?

A

The act of creating and popularising:
- new financial instruments
- new financial technologies
- IBs and financial markets

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2
Q

How is financial innovation achieved?

A

1) Product innovation
2) Process innovation
3) Instititutional innovation

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3
Q

What is the purpose of financial innovation?

A
  • For individuals:
    1) Enable new choices for investment & consumption
    2) Lower cost of raising & deploying funds
  • For companies:
    1) Enable raising capital in larger amounts/lower costs
    2) Source financing that would not normally have been possible
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4
Q

How do IBs faciliate financial innovation?

A

1) Recognition of demand for particular set of CFs
2) IBs can create profit for themselves & fulfil needs for investors

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5
Q

What did Lerner and Tufano (2011) find on consequences of financial innovation?

A

Similar to other innovation:
1) Expensive & difficult to develop (eg navigating legal and regulation barriers)
2) Risky: vast majority do not lead to substantial increases
3) Difficult to protect intellectual property

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6
Q

What challenges did Lerner & Tufano identify relating to FI?

A

1) Financial system tightly interconnected
2) Financial innovations highly dynamic (potentially disruptive)
3) Regulation is complex and dynamic

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7
Q

What is the circular connection between regulation and innovation?

A
  • innovation as result of changing regulation, taxation etc
  • but regulation as results of new innovation
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8
Q

What was the role of innovation in the global financial crisis?

A

“Concept of financial innovation fallen on hard times… once held as solution now more often perceived as problem!” - FED chairman (2009) BERNANKE

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9
Q

What is good innovation?

A

Innovation that increases transparancy and decrease risk: find new ways to direct capital into beneficial areas

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10
Q

What is bad innovation?

A

Intentionally opaque financial instruments designed to speculate or deceive
- ALSO; financial innovation often accompanied by a ‘frenzy’ or ‘irrational exuberance’: e.g. junk bonds, crypto, spacs

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11
Q

What are areas with potential for financial engineering?

A
  • hedging purposes
  • funding requirements
  • arbitrage
  • yield enhancement
  • tax purposes
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12
Q

What are credit derivatives?

A

Helps banks and investors manage credit risk of their investment as it insures against adverse movements in credit quality of issuer

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13
Q

What are currency swaps?

A
  • treasury departments to offset risk of currency fluctuation
  • synthetic forwards to offset monety market volatility and subsequent FFX rates impacts on your trading
  • support companies in managing foreign exchange rate risk
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14
Q

What are interest rate swaps?

A

Used to hedge against interest rate risk

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15
Q

What are new funding sources for IBs

A

1) HY bonds:
- gives smaller companies access to corp debt market
2) Asset securisation:
- packages illiquid individual loans & other debt instruments into securities
- increase credit rating (diversification effect)
- products more marketable to investors
3) A debt issue (bond) structured with currency swaps
4) Convertible bonds:
gives investors exposure to equity enhancement opportunities

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16
Q

What are high-yield bonds (HY)?

A
  • quick and easy
  • junk bonds
  • unrated corp bonds:
    (usually included in JB cat., large variation in quality among JBs)
  • lucrative underwriting spreads
17
Q

What is the history of HY bonds?

A

1901: first reported: JPM 8 steel companies merge and $570m in HY debt to finance
Depression (1930’s): massive increase in JBs
- number of fallen angels exploded
1977: Junk Bond revolution: Micheal milken
- less volatile in terms of p movements than stocks
- more senior in cap struc
- DREXEL BURSHAM LAMBERT (specialist IB 5th largest) (banktrupt 1990)

18
Q

What are types of HY bonds?

A

1) Plain vanilla (fixed periodic coupons cash to maturity/call date)
2) Split-coupon (change ir after couple of years; eg step-up)
3) ‘Payment-in-kind’ (issuer option to pay ir with equity as opposed to cash)
4) Floating-rate or increasing-rate notes (ir based on BM)

19
Q

How much has the default rate varied across history?

A

1981: 0.156%
1991: >9%
1981-2003 avg: 4.6%
2009: 151 issuers defaulted

20
Q

What are index futures?

A

“A legal agreement to buy or sell a particular instrument at a predetermined price at a specified future date”
- s&P500 index: most widely traded future index
- allow investors to participate in broad market movements w/o actually “buying/selling” large amounts of stock
- used by asset managers to “construct” indexed portfolio (instead of holding all actual stock in index): Synthetic exposure

21
Q

What is the theoretical price?

A

= the “theoretical” price of an index futures contract
= cash market price + [CMP * (financing-cash yield)]

22
Q

What strategy is more preferable: 1)purchase stock or 2) purchase s&P500 contracts and T-bills

A

1&2) yield same return in all 3 scenarios (up/down/same)

strategy 2 yields exact same return IF:
- expected divs realised
- futures contract is “fairly priced”

Transaction costs considerably less for 2)

23
Q

What are swaps?

A

An agreement between 2 parties to exchange CFs in future
- agreement stipulates dates when cfs are to be paid (incl. way in which they are to be calculated)

24
Q

What is a forward contract?

A

simple example of a swap:
forward is a “customised” contract between 2 parties to buy or sell asset at specified price at future date”

25
Q

What is difference between forward and swap?

A

forward = exchange assets at future date
swap = several future dates for various transactions

26
Q

What is a plain vanilla interest rate swap?

A
  • A pays B “fixed rate interest”: national principal, specific dates, specified period of time
  • B pays A “floating rate interest”: same np, sd, spot
  • same currency
  • specified pmt dates = settlement dates
27
Q

What is the role of the intermediary in SWAPs?

A
  • reality: companies dont arrange SWAP
  • deal with financial intermediary
  • fee: dependent ‘standing of counterparties’ & complexity of swap
  • PVswaps: 5-10bps per transaction
    -act as market makers as unlikely 2 companies want to take opposite positions at same time
  • quantify and hedge risk: bonds, forward rate agreements (FRAs), interest rate futures
28
Q

Why are swaps so popular?

A
  • 2022: $4.5tr globally
  • Comparative advantages:
    allow companies to capitalise on range of loan types w/o breaking rules&requirements about their own assets&liabilites
  • Can TRANSFORM liabilities or asset:
    eg limit r risks receiving/payinig fixed-r pmts instead of variable r
29
Q

What are credit default swaps (CDS)?

A
  • provides insurance against risk of default by particular company “reference entitity”
  • buyer of insurace (CDS):
    makes claim from ‘insurance’ (debt investor) and passes ownership of bonds to insurer if a ‘credit event’ occurs
  • buyer makes periodic pmts to seller until end of life CDS
  • used for hedging, speculation or abitrage
30
Q

What are asset backed securities (ABS)?

A

-provides access to new sources of capital at lower costs even afetr analysis, structuring and credit enhancement costs factored in.
- rated on own merit
independent of issuing company’s financial standing and helps busineses with lim access to other forms of credit
- asset types used: mortgages, car loans, credit card receivables

31
Q

What are structured Notes?

A

debt securities:
- have embedded option (or other derivative)
- payouts depend on formulas and terms specific to that security

32
Q

What are floaters (structured notes)?

A
  • r% tied to LIBOR, t-bill r or commodity price
  • oil refinery example
33
Q

What are inverse floaters?

A

r moves inversely with market rates

34
Q

What are step-ups?

A

coupons ‘step-up’ at a pre-specified date if issue not called
i.e. notes may have an embedded call option where the issuer can redeem early

35
Q

What is a repurchase agreement (repo)?

A

typical transaction:
- a dealer obtains cash loan then offers “liquid securties” like stock collateral and agrees to repurchase the securities at a future date for a slightly higher price (“interest-bearing” loan)

36
Q

What is a reverse repo?

A

where you can buy securities with agreement to sell them back at higher price in future

37
Q

What is the anatomy of a repo?

A

1) HF obtains cash by selling bond & promise buyback at higher p in near future
2) bank finds a buyer for bond often MMF
3) MMF sells bond back at agreed higher p making small profit

Investment banking (8 decks)

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