Financial Innovation: Risk Management

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Financial InnovationRisk Management

• P.V. Viswanath
• Summer 2007

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Risk Management

• Different individuals have different propensities
  to take risk
• Individuals have endowments of assets with
  different risk characteristics.
• Addition of a given asset can reduce one persons
  overall risk profile, while
• Addition of that same asset can increase another
  persons risk profile

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Risk Management

• Example I
• Suppose one individual has a portfolio of stocks
  of large firms inherited from his father.
• Addition of a portfolio of small, growth-oriented
  technology stocks could reduce his overall risk
  profile.
• The return on large-firm stocks is to some extent
  uncorrelated with small tech stocks.

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Risk Management

• Example II
• Consider an individual working for a small firm
  developing technology to move large amounts of
  data cheaply.
• Since his income is highly dependent on the
  success of the technology and (negatively) on
  threats to the digital economy, adding tech
  stocks will only increase his exposure to those
  shocks.

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Risk Management

• Individuals or companies might want to have
  selective exposure to risk that they can either
  diversify or deal with otherwise, in a more
  efficient fashion.
• For example, a firm selling abroad might want to
  hedge foreign exchange risk.

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Hedging

• Homeowners Abroad TakeCurrency Gamble in
  Loans, WSJ, May 29, 2007
• A Hungarian homeowner who chooses to borrow in
  Swiss Francs at 5.75, rather than in forints at
  14 can be hit hard if the Hungarian forint drops
  in value.
• He would be better off if he could hedge against
  foreign exchange fluctuations.

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Floaters and Inverse Floaters

• A floater is a bond whose interest rate is
  variable and a function of interest rates.
• Normally with a floater, the coupon to be paid by
  the borrower is increasing in the short term
  rate.
• With an inverse floater, as interest rates rise,
  the coupon falls.

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Floater Example

• Consider a 3 year floater with rates set every
  six-months and the coupon equal to the prevailing
  six-month T-bill rate at the reset date.
• An example of an inverse floater would be a
  corresponding bond with a (annualized) coupon
  rate equal to 18 less the annualized floating
  rate.

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Cash flows per 100 per 6 mths
Annual Int Rate Floater Inv Floater Sum
8 4 5 9
9 4.5 4.5 9
10 5 4 9
11 5.5 3.5 9
12 6 3 9
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Pricing and Risk Sensitivity

• The sum of the prices of the floater and the
  inverse floater equals that of two 9 coupon
  bonds.
• P(f) P(I) 2P(9)
• Duration, which measures the interest rate
  sensitivity of a bond is approximately linear.
• D(I) 2D(9) D(f)

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Duration of Inverse Floaters

• In the limit, if the coupon reset occurs
  sufficiently often, the price would never be far
  from zero. As a result, the duration of the
  floater would be very small, close to zero.
• At an initial market rate of 8 p.a., the
  duration would be about 2.7 for the fixed 9
  coupon bond.
• Hence the duration of the inverse floater would
  be about 5.4 (or 2x2.7 0.0)

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Duration of Inverse Floaters

• In practice, rates are reset only every six
  months. Hence durations for floaters are greater
  than zero.
• E.g. in our previous example, if we start with an
  annual interest rate of 8, and assume the rate
  moves up an instant after bond issue to 8.1, the
  implied durations of the three bonds would be,
  approximately 0.5, 5 and 2.8 respectively for the
  floater, the inverse floater and the fixed-rate
  bond.

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Inverse Floaters and Hedging

• Hence inverse floaters can have durations greater
  than their maturity.
• There are two reasons for this
• When rates increase, coupons drop
• When rates increase, present value of future
  cashflows drop.
• This means that inverse floaters are very
  volatile. Hence inverse floaters can be
  convenient to leverage up a portfolio.
• Conversely, a short position in an inverse
  floater can be useful for interest-rate hedging.

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Securitization

• Packaging of cashflows in a tradeable form.
• First week of Sep. 1999, Nationsbank issued
  asset-backed bonds backed by investment-grade
  loans made to customers.
• About 1,000 commercial loans valued at about 6
  billion were put into a bankruptcy-remote master
  trust. Then the trust sold 2 billion of 3-year
  and 2 billion of five-year triple-A-rated debt,
  about 110 million of single-A rated debt and
  120 million of triple-B rated paper. The
  security is called a collateralized loan
  obligation (CLO).
• Goal to get low-return assets off balance sheet,
  so the bank could use its capital in more
  profitable ways and boost ROE.

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Collateralized Loan Obligations

• CLOs are funds that buy existing or new loans.
  The funds then sell securities which offer varied
  rates of return and credit risk.
• The first CLO, launched by Britain's National
  Westminster Bank, appeared in 1997.
• They can be sold to a broad range of investors.
  Pension and insurance fund managers can buy CLO
  securities without being "experts in the bank
  loan market.

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Mortgage-backed securities

• A mortgage-backed security (MBS) has cash flows
  backed by the principal and interest payments of
  a set of mortgage loans.
• Residential mortgagors have the option to pay
  more than the required monthly payment
  (curtailment) or pay off the loan in its entirety
  (prepayment).

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MBS

• Because curtailment and prepayment affect the
  remaining loan principal, the monthly cash flow
  of a MBS is not known in advance, and therefore
  presents an additional risk.
• Prepayment tends to occur when interest rates
  drop.
• This means that cash flows to the investor are
  highest when returns on reinvestment are lowest.

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Principal Only (PO)/Int Only (IO)

• The cash flows from MBS securities are split up
  in different ways e.g., one set of investors
  might only get interest payments (IO), while
  another might get principal payments (PO) alone.
• When interest rates go up, prepayments drop.
  Hence interest payments on the underlying
  mortgages continue IO securities go up in
  value.
• When interest rates drop, prepayments go up and
  hence interest payments dry up IO securities
  drop.
• Most fixed income securities drop in value when
  interest rates rise hence IO securities are
  useful to hedge interest rate risk of fixed
  income portfolios.

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TIPS

• U.S. Treasury Inflation-Protected (Indexed)
  Securities
• Their returns are adjusted for changes in the
  price level.
• Hence their returns are defined in real terms.
• Help investors hedge against inflation risk.

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Exchange Traded Funds

• A fund that tracks an index, but can be traded
  like a stock.
• ETFs represent claims on portfolios that
  replicate indexes.
• Arbitrageurs can exchange an ETF for the
  underlying index portfolio.
• This ensures that the ETF value keeps close to
  the value of the underlying portfolio.

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ETFs and Diversification

• SPDRs (Based on Standard Poor's 500 Composite)
• WEBs (Based on 17 country-specific series of
  securities)
• Diamonds (Based on the Dow Jones Industrial
  Average)
• Introduced on the Amex in 1993 (Spiders)
• The idea was to combine the benefits of
  closed-end funds, which can be traded, and
  open-end funds, whose price reflects their net
  asset value.

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Hedging Actively Managed Portfolios

• If you hold an actively managed portfolio, can
  you hedge it?
• ''If your style is similar to that of a certain
  fund manager, more than likely he's looking at
  the same stocks you're looking at if you sell
  short on him you get a better hedge,''
• Such an option would be more convenient and
  cheaper than shorting individual stocks.
• Enter Actively Managed Exchange Traded Funds

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Actively Managed ETFs

• A fund with a specified benchmark that would
  trade actively and try to beat the benchmark,
  rather than try to precisely mimic it.
• Advantages
• There could be a lot of price impact when passive
  ETFs try to track the index, especially since
  there are many ETFs tracking the same index.
• Since ETFs only have redemption-in-kind, this can
  reduce the capital gain distributions to taxable
  shareholders which occur when mutual funds sell
  to meet in-cash redemptions

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Structure of actively managed ETFs

• If the entire portfolio of a fund is revealed,
  arbitrageurs can trade ahead of the fund.
• An actively managed ETF could
• disseminate precise portfolio values less
  frequently than index ETFs do.
• have creation and redemption baskets that consist
  of only settled or reported holdings of the fund.
  
• could publish supplementary hedging information
  for market makers and anyone else who wants it to
  describe the risk characteristics of the rest of
  the portfolio without revealing its exact
  contents.

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Extendible Commercial Notes

• Similar to regular notes, but the addition of a
  time period that allows the issuer to extend its
  maturities
• Eliminates the risk to the issuer that the issue
  cannot be remarketed at desirable rates when the
  previous issue matures.
• Now issued by municipalities as well, e.g the
  State of Wisconsin.

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Captive Insurance Companies

• A large firm can establish an equity captive to
  underwrite its risk and assume a portion of its
  own losses in hopes of making a profit.
• The firm goes into the insurance business,
  attempting to control its own losses and lower
  its net cost of insurance through the return of
  underwriting profit and investment income.
• The insuring firm has greater incentives to
  engage in risk-reducing activities, since it is
  insuring itself.
• Differs from self-insurance in that the insured
  sets aside funds and invests them in order to
  reduce chances of inability to pay claims.

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Rent-a-captive insurance cos.

• Rent-a-captives are created, funded, and rented
  by insurers, brokers or groups of affiliated
  businesses.
• A renting corporation shares the administrative
  set-up of a captive with other renters.
• Allow firms without the necessary capital to use
  captive insurance as well as providing additional
  diversification.
• Companies use a captive to write long tail
  insurance business, e.g. workers compensation,
  general liability, automobile liability, and
  professional liability.

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Variations on Captive Insurance

• Reciprocal risk-retention group
• Allows firms to pool their insurance risks
  without having to form their own subsidiary.
• Needs less capital as well as providing
  additional diversification.
• Can be used by entities like municipalities that
  are not allowed to have subsidiaries.

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Credit Derivatives

• A class of derivatives, where the underlying
  asset is the spread for securities of a given
  credit risk.
• e.g. the BBB spread index for a ten-year
  industrial is arrived as follows Spread Yield
  on the 10-year BBB Corp Index minus the 10-year
  U.S. Treasury Yield.
• The spread depends solely on default risk.
• It is now possible to write options on this
  spread index, with cash settlement at maturity.

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How a credit default swap works

• A credit default swap is a bilateral contract
  between a protection buyer and a protection
  seller whereby the buyer pays a periodic fee in
  return for a contingent payment by the seller
  upon a credit event affecting the reference
  entity.
• Thus, if a bond issued by A defaults, then the
  protection buyer might be entitled to a payment
  by the seller.

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Users of Credit Derivatives

• For fixed-income institutional investors,
  participating in the credit derivative market can
  provide a cheaper way to synthesize a credit
• A treasury managers can create a money-market
  investment linked to the risk of the industry
  that he knows best a one-year bond tied to a
  basket of companies can turn expert knowledge
  into income.
• Alternatively, a treasury manager may seek to
  diversify existing credit exposures by creating
  an investment in an uncorrelated portfolio of
  names with which he or she is nevertheless
  comfortable.

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Credit Derivatives for Hedging

• Credit derivatives are also effective in hedging
  portfolio credit risk and enhancing portfolio
  yields.
• Examples of credit exposure
• selling goods via trade receivables
• Risk assumed in relation to contractors where
  pre-payment is required
• project finance located in emerging markets, with
  exposure to sovereign risk
• exposure to a major customer or supplier on whom
  the firm relies in its business operations.

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Credit Derivatives Hedging by Borrowers

• Treasury managers can buy protection against an
  increase in their own credit spread (the premium
  to the riskfree rate that lenders demand as
  compensation for extending credit to them).
• Question Is there a moral hazard problem here?
  How would you deal with it?

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Weather Bonds

• Issued by Koch Industries (underwriter Goldman
  Sachs) and Enron Corp. (Merrill Lynch) in
  November 1999.
• Bonds serve as insurance for the firms. If the
  weather is colder, they have to buy extra energy
  at higher prices on the open market to serve
  clients.

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Koch Weather Bonds

• Two kinds senior bonds (junk) and junior bonds
  (unrated).
• Maturity three years
• If temperatures in 19 cities serviced by Koch
  remain close to the historical average, senior
  bond investors will get 10.5.
• If average winter temperatures are 0.250 colder,
  returns drop to 10 if 0.250 warmer, returns
  rise to 11.
• If av. temps stay at historical average, junior
  bonds make 30.

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Aspects of Weather Bonds

• Questions
• Why not weather futures or derivatives?
• Who would hold these bonds?
• Value for purposes of diversification?
• Similarity to catastrophe bonds.

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Catastrophe Bonds

• Catastrophe bonds are risk-linked securities that
  transfer a specified set of risks from the
  sponsor to the investors. They are often
  structured as floating-rate corporate bonds whose
  principal is forgiven if specified trigger
  conditions are met.
• For example, if an insurer has built up a
  portfolio of risks by insuring properties in
  Florida, then they might wish to pass some of
  this risk on so that they can remain solvent
  after a large hurricane.

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How cat bonds work

• They could sponsor a cat bond, by creating a
  special purpose entity to issue the cat bond.
• Investors would buy the bond, which might pay
  them a coupon of LIBOR plus anywhere from 3 to
  20.
• If no hurricane hits Florida, then the investors
  would make a healthy return on their investment.
• But if a hurricane hits Florida and triggers the
  cat bond, then the principal initially paid by
  the investors is forgiven, and is used by the
  sponsor to pay their claims to policyholders.

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CatEPuts

• These are Catastrophe Equity Put Options.
• This is a derivative contract giving the insured
  the right to sell new shares at a fixed price,
  with the investor pledging to buy them in the
  event of a catastrophe.