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Financial Engineering : Is it a nuclear option?"
Stavros A. Zenios"University of Cyprus"
The Wharton Financial Institutions Center"
MIE Distinguished Seminar Series!University of Toronto! April 2013!
2
OUTLINE"
• The issue!• Three applications:!
– Products with Guarantees and Personal Financial Planning!
– Collateralized Mortgage Obligations !– European Stability Bonds!
• Reflexivity of financial engineering!
When does financial engineering backfire"
– Errors are magnified through optimization!• Constraints ignored or mis-specified!• Data errors!
– Response!• robust optimization, stochastic programming,
scenario optimization!!
– Create a reflexive world!• When successful and large-scale!• Success and large-scale may hurt you!
– Response!• ???!
3
4
Products with guarantees"
• Financial innovation: insurance + investment!• Minimum guaranteed return: “Smoothing”!
– Pension funds!– Life insurance policies and mutual funds !– Investment side of commercial Banks!– Personal financial planning!
• Fixed income securities can hardly yield the guarantee!• Regulatory restrictions!
5
Participating policies"
• Sum insured payable if event occurs!• Otherwise the insured sum capitalized at the
rate of an asset portfolio!– bonus policy"
• Minimum guaranteed rate of return!• Lapse option to surrender the policy!
6
0
0.02
0.04
0.06
0.08
0.1
0.12
1 2 3 4 5 6 7 8 9 10 11 12
Portfolio Retuns Policy Returns
Suffer shortfall
Build buffer
7
0.5
1
1.5
2
2.5
3
1 2 3 4 5 6 7 8 9 10 11
Time period
Cu
mu
lati
ve
re
turn
sFloor Asset returns Policy returns Lifted floor
8
Bonus Policies"• Italian firms:!
– Bonuses are contractually specified!– Policyholders receive a fixed percentage of excess returns!
• UK firms:!– Flexibility in determining the bonus policies!– Can reduce bonuses if asset portfolio performs poorly!– Policyholders’ Reasonable Expectations (PRE)!
9
Modeling issues"
• Pricing the options!– guarantee (bond)!– bonus (European option)!– lapse (American option)!
• Brennan and Schwartz (1976), Boyle and Schwartz (1977)!• Grosen and Jorgensen (1999), Bacinello (1999)
Giraldi et al. (2000), Siglienti (2000)!
10
Further modeling issues"
• Capitalizing the product!• Satisfy regulatory requirements!• Design competitive policies!
11
Enterprise Wide Risk Management"
• Design new product!• Integrate disparate sources of risk!• Financial risks and business risks!
Simulation + Optimization!!Holmer and Zenios, Integrated financial product management,
Operations Research, Vol. 43, 1995. !
12
Stochastic Programming"
• Optimization under uncertainty !• Dynamic: decisions are revised with time
as more information is received!• Anticipate uncertainty and adapt with itG.B. Dantzig (1955), R. J-B. Wets (1966)J.R. Birge and F. Louveaux (1997) Y. Censor and S.A. Zenios (1997)Parallel Optimization: Theory, Algorithms and Applications,Oxford University Press.S.A. Zenios and W.T. Ziemba (2006)Handbook of Asset and Liability Modeling, North-Holland.!
13
Scenario tree"
0.013
0.015
0.017
0.019
0.021
0.023
0.025
0.027
0.029
0 2 4 6 8 10 12 14
Month
Inte
rest
rate
0.00
0.02
0.04
0.06
0.08
0.10
0.12
0.14
0.16
0.51 0.52 0.53 0.54 0.55 0.56 0.57 0.57 0.58 0.59 0.60 0.61 0.62 0.63 0.64 0.65 0.66 0.66 0.67 0.68 0.69 0.71
Exchange rate
Pro
ba
bil
ity
0.013
0.015
0.017
0.019
0.021
0.023
0.025
0.027
0.029
0 2 4 6 8 10 12 14
Month
Inte
rest
rate
0 T 1
April 19, 2013 14
The PROMETEIA model:Integrate option pricing problem with asset allocation problem "
15
The PROMETEIA model"
16
The PROMETEIA model"
April 19, 2013 17
Bonus Policies"
• Italian policies:!
• UK policies:!!
!
)))(,0max(1(1 gRgLL Pttt −++= − α
)1)(1( 11 −− ++= ttt RBgLL
reversionary bonus set at the discretion of the firm"
18
Results for the Italian insurance industry"
• Does it pay to integrate risk decisions? !
• How far can the industry push its policies?!• Design competitive policies
!• 23 stock indices and 3 bond indices (IT)!• Stock and bond indices (UK, USA, JP)!• Corporates (USA)!
19
Are mean-variance portfolios efficient?"
0.004
0.005
0.006
0.007
0.008
0.009
0.01
0.011
0.012
0.013
0.006 0.011 0.016 0.021 0.026 0.031Standard deviation
Exp
eted
ret
urn
A
B
G
20
Cost of guarantee and CEexROE of mean-variance portfolios "
0.06
0.065
0.07
0.075
0.08
0.035 0.037 0.039 0.041 0.043 0.045 0.047 0.049 0.051 0.053 0.055
Cost of min. guarantee
Ne
t C
Ee
xR
OE
G
A
B
H
21
How far can the industry push its policies?Cost of min. guarantee vs net CEexROE "
0
0,02
0,04
0,06
0,08
0,1
0,12
0,14
0,16
0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9 1Cost of minimum guarantee
Ne
t C
Ee
xR
OE
m.g. = 0.01
m.g. = 0.04
m.g. = 0.07
m.g. = 0.12Mean-v ariance efficient portfolios for 4% minimum guarantee products
H
The v alue of the integrativ e modelfor 4% minimum guarantee products
22
Comparisons with benchmark portfolios"
0
0.02
0.04
0.06
0.08
0.1
0.12
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16
80/20
23
How far can the industry push its policies?Net CEexROE vs min. guarantee"
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09 0.1
0.11
0.12
0.13
Minimum Guarantee
Net C
EexR
OE
UKItaly
24
Shareholders vs Policyholders "
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0 0.1 0.2 0.3 0.4 0.5 0.6
Cost of the Guarantee
Net C
EexR
OE
UKItaly
0
0.05
0.1
0.15
0.2
0.25
0.3
0 0.02 0.04 0.06 0.08 0.1
Standard Deviation
Mea
n Re
turn
UKItaly
Shareholders"Policyholders"
April 19, 2013 25
Web based financial services
26
27
28
Argentinean 2001 debt restructuring!$81.8 billion!
!!
100,000 Italian pensioners !loose their pension !
29
Collateralized Mortgage Obligations"
B
AA
AAA
AA Debt
First Loss Position
CDO
NINJA loans
Region Total 3Q08 2Q08 1Q08 4Q07 3Q07
Worldwide 516,3 18,1 115,1 168,0 167,9 47,2
America 263,0 18,1 70,3 69,3 75,9 29,4
Europe 229,5 0,0 41,3 89,3 81,3 17,6
Asia 23,9 0,0 3,4 9,4 10,7 0,4
Loan write-offs in billions (DZ Bank research publication, 2008)
Total Mortgage Originations
(Billions)
Subprime Originations
(Billions)
Subprime Share in Total
Originations (% of dollar value)
Subprime Mortgage Backed
Securities (Billions)
Percent Subprime
Securitized (% of dollar value)
2001 $2 ,215 $190 8.6% $95 50.4%
2002 $2,885 $231 8.0% $121 52.7%
2003 $3,945 $335 8.5% $202 60.5%
2004 $2,920 $540 18.5% $401 74.3%
2005 $3,120 $625 20.0% $507 81.2%
2006 $2,980 $600 20.1% $483 80.5%
The bubble
!
S&P/Case-Schiller Home Price Index
European Stability Bonds"• Blue bonds-red bonds!• Debt redemption fund!!!!!!
32
Debt/GDP ratio"
Debt/GDP ratio"
Borrowing rate"
Borrowing rate"
European Stability Bonds"• Pool sovereign bonds and collateralize!
– European Safe Bonds –ESBies!– European Junior Bonds –EJBies!
• ESBies have no country risk!• ESBies create reserve currency!
• Flight from EJBies to ESBies!
• No EU institutional or Treaty arrangements!!!!!!
33
European Stability Bonds"
Suspiciously similar to CMOs!!!!!! 34
35
Discussion: can financial engineering destroy the financial system"
• Ulrich Beck, 1992 -Risk society. !• Anthony Giddens -Duality of structure !• George Soros, 2008 -reflexivity of the markets!
• Peter Bernstein 1996–Against the gods!
• Modeling errors –Fallibility!– Know within limits!– Uncertainty in data!
• Modeling uncertainty in data!
• Modeling success –Reflexivity!– Model creates uncertainty!– Uncertainty reflects back on model!
Discussion: can financial engineering destroy the financial system"
• Use reflexivity to make money!
• Can destroy the system:!– LTCM!– Equitable Insurance!– Sub-prime crisis!
• Reinhart and Rogoff excel error!
Discussion: can financial engineering destroy the financial system"
Conclusion"
Financial engineering:""
Fertile Fallacy"
38
• Karl Marx !“Society poses itself only such problems
as it can solve” !• John F. Kennedy
!“Our problems are man-made, ! therefore they can be solved by men”!
• Stavros A. Zenios amendment !“Our problems are man-made, ! therefore they can be solved by women”!
Conclusion"
