1. the Evolution of Risk Management Produ

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Introduction to Financial

Innovation


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Financial innovations are activities1. to create new financial products with payoffs

desired by the customers ( productinnovations ),

2. or to provide new financial services.(process innovations )

e.g. ATM, cash card, combo card etc.

What is Financial Innovation


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Definition of Financial Engineering

Financial engineering is the use of financial

instruments to restructure an exiting financial profileinto having more desirable properties . (Galitz) Financial engineering is the process of tailoring financial instruments and organizational structure toimprove the profitability of intermediaries customers.(Mason etc.)

The relationship between FinancialInnovation, Financial Engineering, and

Risk Management


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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 creativesolutions to problems in finance.(John Finnerty)

From the above definitions, it is clear thatfinancial innovations are the crucial part of financial engineering.


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Definition of Risk ManagementRisk management is to manage the risks faced by

firms using various tools, including financialproducts.

Business risk (generally difficult to hedgeand manage by using financial instruments)

Financial risk

One main purpose of financial innovations (orfinancial engineering) is to help firms to dothe risk management.


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The Evolution of Risk

Management Products


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Unpredictable movements in exchange rates, interestrates, and commodity prices not only can affect a firmsreported quarterly earnings but even may determine

whether a firm survives. Over the past two decades,firms have been increasingly challenged by suchfinancial 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


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The World Becomes a Riskier Place

There is a general agreement that the financialenvironment 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 exchangerate system.

Fixed exchange rate system of Bretten Woods

Floating exchange rate system after 1970sFigure1-3


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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 PriceRisk 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 PriceRisk on Firms

Virtually every firm considers accounting-basedexposure those exposures that would be reflecteddirectly in the firms financial statement. Within theseaccounting-based exposures, transaction exposures receive the most attention. A transaction exposure exitswhen 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 QTransaction 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 thedirect effects of a price change that would be reflectedin the firms balance sheet is referred to as a translation

exposure . A translation exposure reflects the change inthe value of the firm as foreign assets are converted tohome currency.


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Moving beyond the strict accounting-basedexposures, some firms have begun to considertheir economic exposures also referred to ascompetitive exposures. It measures theindirect effect of a price change.


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

Revenues British poundsExpenses US$ (they bought new DC-10s)In 1981, the US$ strengthened, the FX

transaction exposure became evident asLakers expenses increased.

Whats worsen is the economic exposure! British

vacationers decreased as the US$ strengthened.Therefore their revenues were declining aswell.


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Caterpillars FX Whammy

The strong dollar is a prime factor inCaterpillars reduced sales and earnings

This is a typical example of economicexposure.

The reversed story appears in A Summer of

Discontent for Japanese Manufactures


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Two examples of Interest Rate Riskexposure

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

Inherent Exposures to Interest Rates:Residential Construction


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

Enjoy benefits from upward sloping yieldcurve in 1970s

The profits of S&Ls are not affected byparallel 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 interestrate 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 fromAugust to October in 1990 because Iraq invadedKuwait.

The fuel cost for Continental Airlines in Octoberwere $81 million higher than they had been in June.

Continental Airlines files for Chapter 11 protection from itscreditors on December 3, 1990.


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The Markets Response:Tools to Manage Financial Price Risk

Exchange Rate Risk Management ProductsFigure1-6

Interest Rate Risk Management ProductsFigure1-7

Commodity-Price Risk Management ProsuctsFigure1-8


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How Much Is Really New?

Futures contract can be traced back to1600s in Japan.

Forward contract can be found in the 12thcentury.

Options were traded in the 17 th century inAmsterdam.


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Concluding Remarks

Financial innovation is a demand-drivenphenomenon.

Its better to manage risk actively rather than to try to predict price movements.


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Documents

1. the Evolution of Risk Management Produ