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Chapter 5

Financial Engineering Strategy

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A. Identified Financial Risk

(A)Interest rate risk

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(A)Interest rate risk

Assets: Long-lived assets e.g. fixed-rate mortgage

Liability: deposits

Interest rate Assets Lia.(0)

mismatch of assets and liabilities

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(B)Foreign exchange risk

U.S. importers

Assets: Orders of Deutsche Machine

Liabilities: Payment of DM in 90 days

Foreign exchange rate changes

DM Assets(0), Liabilities ( )

Mismatch of Assets and Liabilities

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( C ) Commodity price risk

Airline company

Revenue: Fixed fee

Expenses: Oil price

Oil price Revenue (0),Assets(0)

Expenses( ),Liabilities( )

Mismatch of Assets and Liabilities

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B.Measuring Financial Risk

(A)GAP, “Maturity Gap” approachGAP=RSA-RSL GAP: gaping period RSA: market value of rate-sensitive assets RSL: market value of rate-sensitive liabilities

ΔNII=(GAP)*(Δr) ΔNII: Net interest income GAP: gaping period Δr: changes in the interest rate

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(B) Duration, ”Duration Analysis”

Duration: A measure of when on average the present value of the financial instrument is received

or

r

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v

Duration

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(C)Beta, “Stock Measures”A beta measure of the company’s equity value to change in interest rates, foreign exchange rates and commodity price

: rate of return on firm’s equity : percentage change in the price of a one year T-bill : percentage change in the price of DM

: percentage change in the price of oil

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(D)Value-at-Risk(VaR)

Value-at-Risk(VaR) is a lower tail percentile for the distribution of profit and loss(P&L).VaR models have been sanctioned for determining market capital requirements for large banks by U.S. and international banking authorities through the 1996 Market Risk Amendment to the Basle Accord.

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(D) Value-at-Risk(VaR)GARCH is the most important model. (R.f. J. Berkowitz and J. O’Brien, How accurate are value-at-risk models at commercial banks, JF 57, 2002)The VaR forecasts for six large commercial banks did not outperform forecasts based simply on an ARMA+GARCH model of the banks’ P&L.

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C.Managing Financial Risk:A Building Block Approach

On-balance-sheet Method

Off-balance-sheet Method Forwards Futures Swaps Options

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(A)Blocks

The relations Futures can be built by snapping together a package of

forward Swap can be built by putting together a package of

forward Synthetic options can be constructed by combining a

forward with a risk less security Options can be combined to produce forward contract Forwards can be pulled apart to replicate a package of

options

(B) Building blocksUsing the building blocks to manage an exposure

(B) Building blocks

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D.Financial Innovations(B)Debt Innovations

Risk reallocation Risk transfer

Transfer risks away from issuers or investors to other better able to bear them Eg1. Oil producers issue oil-indexed debt issue with

interest payment that rise and fall with the level of oil prices (oil price risk)

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(B)Debt Innovations

Managing reinvestment risk

Eliminate the risk of reinvest interest payments received on standard debt securities e.g.: Zeros (effectively reinvest and compound)

Managing prepayment risk

Shift the risk of prepayment to invest at lower rate collateral mortgage obligation (CMO) and stripped mortgage-backed securities

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(B)Debt Innovations

Managing interest rate risk

Adjusting volatile interest rate E.g Adjusting rate notes and floating rate notes

Interest rate risk: Lenders Borrowers

Inverse Floaters: carry an interest rate that decreases as interest rate rise Yield curve notes and maximum rate notes

Long duration Immunization

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(B)Debt Innovations

Managing price and exchange rate risks

Response to the rising and increasing price volatility E.g Dual currency bond, index currency option

notes

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(B)Debt Innovations

Enhanced liquidity

Securitize a loan public trade low cost E.g CMO, credit card receivable backed

securities stripped mortgage back securities, loan backed securities

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(B)Debt Innovations

Reductions in agency costs securities innovation reduce agency cost low cost

E.g1 Interest rate reset notes Drop in issuer’s credit standing Adjust the

coupon to a current market rate E.g2 Put bonds Change in corporate control put option

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(B)Debt Innovations

Reductions in transactions costs

Reduce underwriting cost lower cost E.g Extendible notes, variable coupon

renewable notes, put notes (extend maturity )

Mortgage pass-through certificates, credit card receivable back securities ( Reduce investor’s transaction costs )

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(B)Debt Innovations

Reduced in taxes

Reduce the total amount of taxes by companies and investors Low cost E.g Zeros

Taxes: straight-line amortization of discount

Effective: maturity

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( C ) Preferred Stock Innovations

Managing interest rate risk adjust dividends E.g1 Adjustable rate preferred stock Adjust dividend rate as interest rate change

E.g2 Convertible adjustable preferred stock (CAPS) Making the security convertible on each dividend payment date into each shares to make the securities worth its par value

E.g3 Remarketed preferred stock Pays a dividend that is reset at the end of each dividend period to a dividend rate that a specified remarketing agent determines will make the preferred stock worth par

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(D)Common Equity Innovations

Reallocation risk E.g1 Americus trust

Offer common stockholders to strip each of their common shares into a PRIME component, which carries full dividend and voting right and limited capital appreciation right, and a SCORES component, which carries full capital appreciation rights above a threshold price

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(D)Common Equity Innovations

E.g2 Callable common stock Common stock issued by a subsidiary company, that

is sold by the parent company subject to a stock purchase option agreement

Option agreement Periodic step-ups in the call price Relive the parent company to exercise all

outstanding purchase option if any are exercise Give the parent company the right to reacquire

the subsidiary’s shares at a pre-specified price

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(D)Common Equity Innovations

E.g 3 Put common stock Sales of put options along with a new issue of

common stock Option agreement

Give the investors the right to put their shares back to the firm at a price no less than the price they paid