1 Chapter 5 Financial Engineering Strategy

2 A. Identified Financial Risk (A)Interest rate risk

3 Assets: Long-lived assets e.g. fixed-rate mortgage Liability: deposits Interest rate Assets Lia.(0) mismatch of assets and liabilities

4 (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

5 ( 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

6 B.Measuring Financial Risk (A)GAP, “Maturity Gap” approach GAP=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

7 (B) Duration, ”Duration Analysis” Duration: A measure of when on average the present value of the financial instrument is received or

8 (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

9 (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.

10 (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.

11 C.Managing Financial Risk: A Building Block Approach On-balance-sheet Method Off-balance-sheet Method Forwards Futures Swaps Options

12 (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 blocks Using the building blocks to manage an exposure

(B) Building blocks

15 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)

16 (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

17 (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

18 (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

19 (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

20 (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

21 (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 )

22 (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

23 ( 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

24 (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

25 (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

26 (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