Financial Innovation Flashcards
What is financial innovation?
The act of creating and popularising:
- new financial instruments
- new financial technologies
- IBs and financial markets
How is financial innovation achieved?
1) Product innovation
2) Process innovation
3) Instititutional innovation
What is the purpose of financial innovation?
- 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
How do IBs faciliate financial innovation?
1) Recognition of demand for particular set of CFs
2) IBs can create profit for themselves & fulfil needs for investors
What did Lerner and Tufano (2011) find on consequences of financial innovation?
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
What challenges did Lerner & Tufano identify relating to FI?
1) Financial system tightly interconnected
2) Financial innovations highly dynamic (potentially disruptive)
3) Regulation is complex and dynamic
What is the circular connection between regulation and innovation?
- innovation as result of changing regulation, taxation etc
- but regulation as results of new innovation
What was the role of innovation in the global financial crisis?
“Concept of financial innovation fallen on hard times… once held as solution now more often perceived as problem!” - FED chairman (2009) BERNANKE
What is good innovation?
Innovation that increases transparancy and decrease risk: find new ways to direct capital into beneficial areas
What is bad innovation?
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
What are areas with potential for financial engineering?
- hedging purposes
- funding requirements
- arbitrage
- yield enhancement
- tax purposes
What are credit derivatives?
Helps banks and investors manage credit risk of their investment as it insures against adverse movements in credit quality of issuer
What are currency swaps?
- 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
What are interest rate swaps?
Used to hedge against interest rate risk
What are new funding sources for IBs
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
What are high-yield bonds (HY)?
- quick and easy
- junk bonds
- unrated corp bonds:
(usually included in JB cat., large variation in quality among JBs) - lucrative underwriting spreads
What is the history of HY bonds?
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)
What are types of HY bonds?
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)
How much has the default rate varied across history?
1981: 0.156%
1991: >9%
1981-2003 avg: 4.6%
2009: 151 issuers defaulted
What are index futures?
“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
What is the theoretical price?
= the “theoretical” price of an index futures contract
= cash market price + [CMP * (financing-cash yield)]
What strategy is more preferable: 1)purchase stock or 2) purchase s&P500 contracts and T-bills
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)
What are swaps?
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)
What is a forward contract?
simple example of a swap:
forward is a “customised” contract between 2 parties to buy or sell asset at specified price at future date”
What is difference between forward and swap?
forward = exchange assets at future date
swap = several future dates for various transactions
What is a plain vanilla interest rate swap?
- 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
What is the role of the intermediary in SWAPs?
- 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
Why are swaps so popular?
- 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
What are credit default swaps (CDS)?
- 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
What are asset backed securities (ABS)?
-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
What are structured Notes?
debt securities:
- have embedded option (or other derivative)
- payouts depend on formulas and terms specific to that security
What are floaters (structured notes)?
- r% tied to LIBOR, t-bill r or commodity price
- oil refinery example
What are inverse floaters?
r moves inversely with market rates
What are step-ups?
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
What is a repurchase agreement (repo)?
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)
What is a reverse repo?
where you can buy securities with agreement to sell them back at higher price in future
What is the anatomy of a repo?
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
