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Introduction to Financial Innovation

What is Financial Innovation

Financial innovations are activities 1. to create new financial products with payoffs desired by the customers (product innovations), 2. or to provide new financial services. (process innovations) e.g. ATM, cash card, combo card etc.

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.)

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.

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.

The Evolution of Risk Management Products

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.

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

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

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

Volatility of Commodity Prices

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

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

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.

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.

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.

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.

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

Two examples of Interest Rate Risk exposure

From Money Machines to Money Pits: U.S. savings and loan association (S&Ls)

Inherent Exposures to Interest Rates: Residential Construction

From Money Machines to Money Pits: U.S. S&Ls

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

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.

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.

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

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.

Concluding Remarks

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