Financial Innovation:
Risk Management
P.V. Viswanath
Summer 2007
Risk Management
Different individuals have different
propensities to take risk
Individuals have endowments of assets
with different risk characteristics.
Addition of a given asset can reduce one
person’s overall risk profile, while
Addition of that same asset can increase
another person’s risk profile
Risk Management
Example I:
Suppose one individual has a portfolio of
stocks of large firms inherited from his
father.
Addition of a portfolio of small, growthoriented technology stocks could reduce
his overall risk profile.
The return on large-firm stocks is to some
extent uncorrelated with small tech stocks.
Risk Management
Example II:
Consider an individual working for a small
firm developing technology to move large
amounts of data cheaply.
Since his income is highly dependent on
the success of the technology and
(negatively) on threats to the digital
economy, adding tech stocks will only
increase his exposure to those shocks.
Risk Management
Individuals or companies might want to
have selective exposure to risk that
they can either diversify or deal with
otherwise, in a more efficient fashion.
For example, a firm selling abroad
might want to hedge foreign exchange
risk.
Hedging
“Homeowners Abroad Take
Currency Gamble in Loans,” WSJ, May 29,
2007
A Hungarian homeowner who chooses to
borrow in Swiss Francs at 5.75%, rather than
in forints at 14% can be hit hard if the
Hungarian forint drops in value.
He would be better off if he could hedge
against foreign exchange fluctuations.
Floaters and Inverse Floaters
A floater is a bond whose interest rate
is variable and a function of interest
rates.
Normally with a floater, the coupon to
be paid by the borrower is increasing in
the short term rate.
With an inverse floater, as interest rates
rise, the coupon falls.
Floater Example
Consider a 3 year floater with rates set
every six-months and the coupon equal
to the prevailing six-month T-bill rate at
the reset date.
An example of an inverse floater would
be a corresponding bond with a
(annualized) coupon rate equal to 18%
less the annualized floating rate.
Cash flows per $100 per 6 mths
Annual Int Floater
Rate
8%
4
Inv Floater Sum
5
9
9%
4.5
4.5
9
10%
5
4
9
11%
5.5
3.5
9
12%
6
3
9
Pricing and Risk Sensitivity
The sum of the prices of the floater and
the inverse floater equals that of two
9% coupon bonds.
P(f) + P(I) = 2P(9)
Duration, which measures the interest
rate sensitivity of a bond is
approximately linear.
D(I) = 2D(9) – D(f)
Duration of Inverse Floaters
In the limit, if the coupon reset occurs
sufficiently often, the price would never be
far from zero. As a result, the duration of the
floater would be very small, close to zero.
At an initial market rate of 8% p.a., the
duration would be about 2.7 for the fixed 9%
coupon bond.
Hence the duration of the inverse floater
would be about 5.4 (or 2x2.7 – 0.0)
Duration of Inverse Floaters
In practice, rates are reset only every six
months. Hence durations for floaters are
greater than zero.
E.g. in our previous example, if we start with
an annual interest rate of 8%, and assume
the rate moves up an instant after bond issue
to 8.1%, the implied durations of the three
bonds would be, approximately 0.5, 5 and 2.8
respectively for the floater, the inverse floater
and the fixed-rate bond.
Inverse Floaters and Hedging
Hence inverse floaters can have durations
greater than their maturity.
There are two reasons for this:
When rates increase, coupons drop
When rates increase, present value of future
cashflows drop.
This means that inverse floaters are very
volatile. Hence inverse floaters can be
convenient to leverage up a portfolio.
Conversely, a short position in an inverse
floater can be useful for interest-rate
hedging.
Securitization
Packaging of cashflows in a tradeable form.
First week of Sep. 1999, Nationsbank issued
asset-backed bonds backed by investmentgrade loans made to customers.
About 1,000 commercial loans valued at about $6
billion were put into a bankruptcy-remote master
trust. Then the trust sold $2 billion of 3-year and
$2 billion of five-year triple-A-rated debt, about
$110 million of single-A rated debt and $120
million of triple-B rated paper. The security is
called a collateralized loan obligation (CLO).
Goal: to get low-return assets off balance
sheet, so the bank could use its capital in
more profitable ways and boost ROE.
Collateralized Loan Obligations
CLOs are funds that buy existing or new
loans. The funds then sell securities which
offer varied rates of return and credit risk.
The first CLO, launched by Britain's National
Westminster Bank, appeared in 1997.
They can be sold to a broad range of
investors. Pension and insurance fund
managers can buy CLO securities without
being "experts in the bank loan market.“
Mortgage-backed securities
A mortgage-backed security (MBS) has
cash flows backed by the principal and
interest payments of a set of mortgage
loans.
Residential mortgagors have the option
to pay more than the required monthly
payment (curtailment) or pay off the
loan in its entirety (prepayment).
MBS
Because curtailment and prepayment
affect the remaining loan principal, the
monthly cash flow of a MBS is not
known in advance, and therefore
presents an additional risk.
Prepayment tends to occur when
interest rates drop.
This means that cash flows to the
investor are highest when returns on
reinvestment are lowest.
Principal Only (PO)/Int Only (IO)
The cash flows from MBS securities are split up in
different ways; e.g., one set of investors might only
get interest payments (IO), while another might get
principal payments (PO) alone.
When interest rates go up, prepayments drop. Hence
interest payments on the underlying mortgages
continue – IO securities go up in value.
When interest rates drop, prepayments go up and
hence interest payments dry up – IO securities drop.
Most fixed income securities drop in value when
interest rates rise; hence IO securities are useful to
hedge interest rate risk of fixed income portfolios.
TIPS
U.S. Treasury Inflation-Protected
(Indexed) Securities
Their returns are adjusted for changes
in the price level.
Hence their returns are defined in “real”
terms.
Help investors hedge against inflation
risk.
Exchange Traded Funds
A fund that tracks an index, but can be
traded like a stock.
ETFs represent claims on portfolios that
replicate indexes.
Arbitrageurs can exchange an ETF for
the underlying index portfolio.
This ensures that the ETF value keeps
close to the value of the underlying
portfolio.
ETFs and Diversification
SPDRs (Based on Standard & Poor's 500
Composite)
WEBs (Based on 17 country-specific
series of securities)
Diamonds (Based on the Dow Jones
Industrial Average)
Introduced on the Amex in 1993 (Spiders)
The idea was to combine the benefits of
closed-end funds, which can be traded,
and open-end funds, whose price reflects
their net asset value.
Hedging Actively Managed
Portfolios
If you hold an actively managed portfolio,
can you hedge it?
''If your style is similar to that of a certain
fund manager, more than likely he's looking
at the same stocks you're looking at; if you
sell short on him you get a better hedge,''
Such an option would be more convenient
and cheaper than shorting individual stocks.
Enter Actively Managed Exchange Traded
Funds
Actively Managed ETFs
A fund with a specified benchmark that would
trade actively and try to beat the benchmark,
rather than try to precisely mimic it.
Advantages:
There could be a lot of price impact when passive
ETFs try to track the index, especially since there
are many ETFs tracking the same index.
Since ETFs only have redemption-in-kind, this can
reduce the capital gain distributions to taxable
shareholders which occur when mutual funds sell
to meet in-cash redemptions
Structure of actively managed ETFs
If the entire portfolio of a fund is revealed,
arbitrageurs can trade ahead of the fund.
An actively managed ETF could
disseminate precise portfolio values less frequently
than index ETFs do.
have creation and redemption baskets that consist of
only settled or reported holdings of the fund.
could publish supplementary hedging information for
market makers and anyone else who wants it to
describe the risk characteristics of the rest of the
portfolio without revealing its exact contents.
Extendible Commercial Notes
Similar to regular notes, but the
addition of a time period that allows the
issuer to extend its maturities
Eliminates the risk to the issuer that the
issue cannot be remarketed at desirable
rates when the previous issue matures.
Now issued by municipalities as well,
e.g the State of Wisconsin.
Captive Insurance Companies
A large firm can establish an equity captive to
underwrite its risk and assume a portion of its
own losses in hopes of making a profit.
The firm goes into the insurance business,
attempting to control its own losses and lower
its net cost of insurance through the return of
underwriting profit and investment income.
The insuring firm has greater incentives to
engage in risk-reducing activities, since it is
insuring itself.
Differs from self-insurance in that the insured
sets aside funds and invests them in order to
reduce chances of inability to pay claims.
Rent-a-captive insurance cos.
Rent-a-captives are created, funded, and
rented by insurers, brokers or groups of
affiliated businesses.
A renting corporation shares the
administrative set-up of a captive with other
“renters.”
Allow firms without the necessary capital to
use captive insurance as well as providing
additional diversification.
Companies use a captive to write long tail
insurance business, e.g. workers’
compensation, general liability, automobile
liability, and professional liability.
Variations on Captive Insurance
Reciprocal risk-retention group
Allows firms to pool their insurance risks
without having to form their own
subsidiary.
Needs less capital as well as providing
additional diversification.
Can be used by entities like municipalities
that are not allowed to have subsidiaries.
Credit Derivatives
A class of derivatives, where the underlying
asset is the spread for securities of a given
credit risk.
e.g. the BBB spread index for a ten-year
industrial is arrived as follows: Spread = Yield
on the 10-year BBB Corp Index minus the 10year U.S. Treasury Yield.
The spread depends solely on default risk.
It is now possible to write options on this
spread index, with cash settlement at
maturity.
How a credit default swap works
A credit default swap is a bilateral
contract between a protection buyer
and a protection seller whereby the
buyer pays a periodic fee in return for a
contingent payment by the seller upon
a credit event affecting the reference
entity.
Thus, if a bond issued by A defaults,
then the protection buyer might be
entitled to a payment by the seller.
Users of Credit Derivatives
For fixed-income institutional investors,
participating in the credit derivative market
can provide a cheaper way to synthesize a
credit:
A treasury managers can create a money-market
investment linked to the risk of the industry that
he knows best: a one-year bond tied to a basket
of companies can turn expert knowledge into
income.
Alternatively, a treasury manager may seek to
diversify existing credit exposures by creating an
investment in an uncorrelated portfolio of names
with which he or she is nevertheless comfortable.
Credit Derivatives for Hedging
Credit derivatives are also effective in
hedging portfolio credit risk and
enhancing portfolio yields.
Examples of credit exposure:
selling goods via trade receivables
Risk assumed in relation to contractors
where pre-payment is required
project finance located in emerging
markets, with exposure to sovereign risk
exposure to a major customer or supplier
on whom the firm relies in its business
operations.
Credit Derivatives: Hedging by
Borrowers
Treasury managers can buy protection
against an increase in their own credit
spread (the premium to the riskfree
rate that lenders demand as
compensation for extending credit to
them).
Question: Is there a moral hazard
problem here? How would you deal
with it?
Weather Bonds
Issued by Koch Industries (underwriter:
Goldman Sachs) and Enron Corp.
(Merrill Lynch) in November 1999.
Bonds serve as insurance for the firms.
If the weather is colder, they have to
buy extra energy at higher prices on the
open market to serve clients.
Koch Weather Bonds
Two kinds: senior bonds (junk) and junior
bonds (unrated).
Maturity: three years
If temperatures in 19 cities serviced by Koch
remain close to the historical average, senior
bond investors will get 10.5%.
If average winter temperatures are 0.250
colder, returns drop to 10%; if 0.250 warmer,
returns rise to 11%.
If av. temps stay at historical average, junior
bonds make 30%.
Aspects of Weather Bonds
Questions:
Why not weather futures or derivatives?
Who would hold these bonds?
Value for purposes of diversification?
Similarity to catastrophe bonds.
Catastrophe Bonds
Catastrophe bonds are risk-linked securities
that transfer a specified set of risks from the
sponsor to the investors. They are often
structured as floating-rate corporate bonds
whose principal is forgiven if specified trigger
conditions are met.
For example, if an insurer has built up a
portfolio of risks by insuring properties in
Florida, then they might wish to pass some of
this risk on so that they can remain solvent
after a large hurricane.
How cat bonds work
They could sponsor a cat bond, by creating a
special purpose entity to issue the cat bond.
Investors would buy the bond, which might
pay them a coupon of LIBOR plus anywhere
from 3 to 20%.
If no hurricane hits Florida, then the investors
would make a healthy return on their
investment.
But if a hurricane hits Florida and triggers the
cat bond, then the principal initially paid by
the investors is forgiven, and is used by the
sponsor to pay their claims to policyholders.
CatEPuts
These are Catastrophe Equity Put
Options.
This is a derivative contract giving the
insured the right to sell new shares at a
fixed price, with the investor pledging
to buy them in the event of a
catastrophe.