Introduction to Financial Innovation

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Introduction to Financial Innovation
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What is Financial Innovation

• Financial innovations are activities
• to create new financial products with payoffs
  desired by the customers (product innovations),
• or to provide new financial services. (process
  innovations)
• e.g. ATM, cash card, combo card etc.

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The relationship between Financial Innovation,
Financial Engineering, and Risk Management

• Definition of Financial Engineering
• Financial engineering is the use of financial
• instruments to restructure an exiting financial
  profile into having more desirable properties.
  (Galitz)
• Financial engineering is the process of tailoring
  
• financial instruments and organizational
  structure to
• improve the profitability of intermediaries
  customers.
• (Mason etc.)

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• Definition of Financial Engineering
• Financial engineering involves the design, the
  development, and the implementation of innovative
  financial instruments and processes, and the
  formation of creative solutions to problems in
  finance. (John Finnerty)
• From the above definitions, it is clear that
  financial innovations are the crucial part of
  financial engineering.

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• Definition of Risk Management
• Risk management is to manage the risks faced by
  firms using various tools, including financial
  products.
• Business risk (generally difficult to hedge and
  manage by using financial instruments)
• Financial risk
• One main purpose of financial innovations (or
  financial engineering) is to help firms to do the
  risk management.

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The Evolution of Risk Management Products
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The World Becomes a Riskier Place

• Unpredictable movements in exchange rates,
  interest
• rates, and commodity prices not only can affect a
  firms
• reported quarterly earnings but even may
  determine
• whether a firm survives. Over the past two
  decades,
• firms have been increasingly challenged by such
• financial price risks. Its no longer enough to
  be the firm with the most advanced production
  technology, the cheapest labor supply, or the
  best marketing team price volatility can put
  even well-run firms out of business.

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The World Becomes a Riskier Place

• There is a general agreement that the financial
• environment is riskier today than it was in the
  past.
• Inflation risk (retail prices)
• Figure1-1
• Figure1-2

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Volatility of Foreign Exchange Rates

• The exchange rate risk is associated with the
  exchange rate system.
• Fixed exchange rate system of Bretten Woods
• Floating exchange rate system after 1970s
• Figure1-3

10
Volatility of Interest Rates

• The interest rate risk increased probably due to
• The volatility of the exchange rate spill over
  into money market
• Changes in the policy of Central Bank
• Figure1-4

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Volatility of Commodity Prices

• The crude oil prices became volatile after 1973.
• Figure1-5
• Other commodity prices have similar patterns.

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The Impact of Increased Financial Price Risk on
Firms

• Firms are exposed to two kinds of exposures.
• 1. Accounting-Based Exposure
• transaction exposure
• translation exposure
• 2. Economic Exposure

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The Impact of Increased Financial Price Risk on
Firms

• Virtually every firm considers accounting-based
• exposure those exposures that would be
  reflected
• directly in the firms financial statement.
  Within these
• accounting-based exposures, transaction exposures
  
• receive the most attention. A transaction
  exposure exits
• when a change in one of the financial prices will
  change
• the amount of a receipt or an expense.

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• Receipt or expense P ? Q
• Transaction exposures focus on only the direct
  effect of
• a price change the impact of price changes on
  quantity
• is ignored.
• A parallel exposure one that also focuses only
  on the
• direct effects of a price change that would be
  reflected
• in the firms balance sheet is referred to as a
  translation
• exposure. A translation exposure reflects the
  change in
• the value of the firm as foreign assets are
  converted to
• home currency.

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• Moving beyond the strict accounting-based
  exposures, some firms have begun to consider
  their economic exposures also referred to as
  competitive exposures. It measures the indirect
  effect of a price change.

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Laker Airlines an FX Risk (p.7-8)

• Revenues British pounds
• Expenses US (they bought new DC-10s)
• In 1981, the US strengthened, the FX transaction
  exposure became evident as Lakers expenses
  increased.
• Whats worsen is the economic exposure! British
  vacationers decreased as the US strengthened.
  Therefore their revenues were declining as well.

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Caterpillars FX Whammy

• The strong dollar is a prime factor in
  Caterpillars reduced sales and earnings
• This is a typical example of economic exposure.
• The reversed story appears in A Summer of
  Discontent for Japanese Manufactures

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Two examples of Interest Rate Risk exposure

• From Money Machines to Money Pits
• U.S. savings and loan association (SLs)
• Inherent Exposures to Interest Rates Residential
  Construction

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From Money Machines to Money Pits U.S. SLs

• Enjoy benefits from upward sloping yield curve in
  1970s
• The profits of SLs are not affected by parallel
  movements in interest rates.
• In the 1980s the yield curve inverted!!

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Inherent Exposures to Interest Rates Residential
Construction

• Residential Construction are exposed to interest
  rate risk economically!
• When interest rates go up, the house prices go
  down and the demand for housing also declines.

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A Gulf War Casualty Continental Airlines

• Jet fuel price had more than doubled from August
  to October in 1990 because Iraq invaded Kuwait.
• The fuel cost for Continental Airlines in
  October were 81 million higher than they had
  been in June.
• Continental Airlines files for Chapter 11
  protection from its creditors on December 3, 1990.

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The Markets Response Tools to Manage Financial
Price Risk

• Exchange Rate Risk Management Products
• Figure1-6
• Interest Rate Risk Management Products
• Figure1-7
• Commodity-Price Risk Management Prosucts
• Figure1-8

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How Much Is Really New?

• Futures contract can be traced back to 1600s in
  Japan.
• Forward contract can be found in the 12th
  century.
• Options were traded in the 17th century in
  Amsterdam.

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Concluding Remarks

• Financial innovation is a demand-driven
  phenomenon.
• Its better to manage risk actively rather than
  to try to predict price movements.

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