Financial Innovation:Risk Management

P.V. ViswanathSummer 2007

Risk ManagementDifferent individuals have different propensities to take riskIndividuals have endowments of assets with different risk characteristics.

Addition of a given asset can reduce one person’s overall risk profile, whileAddition of that same asset can increase another person’s risk profile

Risk ManagementExample I:

Suppose one individual has a portfolio of stocks of large firms inherited from his father.Addition of a portfolio of small, growth-oriented technology stocks could reduce his overall risk profile.The return on large-firm stocks is to some extent uncorrelated with small tech stocks.

Risk ManagementExample 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 ManagementIndividuals 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 TakeCurrency Gamble in Loans,” WSJ, May 29, 2007A 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 Rate

Floater Inv Floater

Sum

8% 4 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 dropWhen 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.

SecuritizationPackaging of cashflows in a tradeable form.First week of Sep. 1999, Nationsbank issued asset-backed bonds backed by investment-grade 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).

MBSBecause 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.

TIPSU.S. Treasury Inflation-Protected (Indexed) SecuritiesTheir 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 FundsA 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 DiversificationSPDRs (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 ETFsA 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 maturitiesEliminates 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 groupAllows 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 DerivativesA 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 10-year 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 DerivativesFor 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 receivablesRisk assumed in relation to contractors where pre-payment is requiredproject finance located in emerging markets, with exposure to sovereign riskexposure 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 BondsIssued 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 BondsTwo kinds: senior bonds (junk) and junior bonds (unrated). Maturity: three yearsIf 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 0.25colder, returns drop to 10%; if 0.25warmer, 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 BondsCatastrophe 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 workThey 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.