Financial Innovation How it Affects the Macroeconomy

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Financial InnovationHow it Affects the
Macroeconomy

• P.V. Viswanath
• Summer 2007

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How Financial Innovations improve economic
performance

• Completing markets expanding opportunities for
• risk-sharing
• risk-pooling
• hedging
• intertemporal or spatial transfers of resources
  lowering transactions costs or increasing
  liquidity
• reducing agency costs caused by
• asymmetric information between trading parties
• principals incomplete monitoring of agents
  performance.

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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.

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Financial System Functions Payments system

• Decreasing the cost of processing payments for
  transactions
• E.g. SWIFT, CHIPS
• Increasing the speed
• Decreasing the possibility of fraud
• Examples Credit cards, debit cards

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Financial System FunctionsPooling of funds

• 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

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Financial System FunctionsResources 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.

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Financial System FunctionsRisk Management

• Reducing 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)

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Financial System FunctionsRisk Management

• Even if aggregate risk is not reduced, the risk
  of an individual investors position can be
  reduced by diversification
• Examples Mutual funds, Index funds, SPDRs.

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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

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Financial System Functions Information for
decentralized decision-making

• Decision 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

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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.

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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

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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.

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Other government functions that affect financial
markets

• As 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.

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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.

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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

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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 filings
• distortions 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.

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The dynamic of financial innovation

• Aggregate Trading Volume expands secularly
• Trading is increasingly dominated by institutions
• Further 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.

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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.

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Implications

• Liquidity 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.

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Production Technologies

• Underwriting
• Synthesizing

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Underwriting Method
The 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).
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Expected Price Progression Over Time
Underwriting Method
The object in this example is to create a
security with a floor value, beginning with
another security that has no floor.
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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
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Underwriting Method

• Advantages
• Transparent payments flow through trust
• No need for dynamic adjustment
• No need to make assumptions regarding future
  progression of stock prices.
• Disadvantage
• Need to find a buyer for residual security
• More Risk Capital Required

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Synthesizing Method - 1
At Year 0
70,000 Buy 704 shares XYZ _at_100/share
35,915 Short-term cash investment _at_ 5
106,315 Total Investment
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Synthesizing Method - 2
At Year 1 If S90, sell 454 shares _at_ 90 Value
Before Value After
63,360 704 shares XYZ _at_100
37,711 Cash and Interest
101,071 Total Investment
22,500 250 shares XYZ _at_90
78,571 Cash investment _at_ 5
101,071 Total Investment
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Synthesizing Method - 3
At Year 1 If S115, buy 96 shares _at_ 115
Value Before Value After
80,960 704 shares XYZ _at_115
37,711 Cash and Interest
118,671 Total Investment
92,000 800 shares XYZ _at_115
26,671 Cash investment _at_ 5
118,671 Total Investment
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Synthesizing Method 4
At Year 2 If S 70
If S 110
17,500 250 shares XYZ _at_70
82,500 Cash and Interest
100,000 Total Investment
27,500 250 shares XYZ _at_110
82,500 Cash and Interest
110,000 Total Investment
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Synthesizing Method 5
At Year 2 If S 90
If S 140
72,000 800 shares XYZ _at_90
28,000 Cash and Interest
100,000 Total Investment
112,000 250 shares XYZ _at_110
28,000 Cash and Interest
140,000 Total Investment
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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.

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Synthesizing Method

• Advantages
• No residual security to sell
• No intervening institution (trust)
• Lower Amt of Risk Capital Reqd
• Disadvantages
• Highly dependent on technology
• Must make distributional assumptions for price.
• Complicated hence more subject to error