Financial Engineering Strategy

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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 approach
• GAPRSA-RSL
• GAP gaping period
• RSA market value of rate-sensitive assets
• RSL market value of rate-sensitive liabilities
• ?NII(GAP)(?r)
• ?NII Net interest income
• GAP gaping period
• ?r 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

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(C)Beta, Stock Measures

• A beta measure of the companys equity value to
  change in interest rates, foreign exchange rates
  and commodity price
• rate of return on firms 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(PL).
• 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. OBrien, 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
  ARMAGARCH model of the banks PL.

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C.Managing Financial RiskA 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

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(B) Building blocks

• Using the building blocks to manage an exposure

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(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 issuers 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
  investors 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 subsidiarys 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