financial innovtion nnd risk management

8/8/2019 Financial InnovTION Nnd Risk Management

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Financial Innovation

(a survey study)

Author: Peter Tufano

Sylvan C. Coleman

professor at HBS



Outlines

This paper provide a survey which covers

a wide range of fields:

±G

eneral equilibrium analysis ± Legal and policy

± Industrial organization

± Clinical studies of individual innovations

± Empirical studies of innovations process

R efer to Page 3



Outlines

Discussions:

± Taxonomy of financial innovations:classification by functionalities is probably

the best way ± Reasons for financial innovations

± Identity of innovators

± Private and social implications of theseinnovations

± New means of protecting the intellectualproperty

R efer to



Agenda

Definition of Innovation

History of Innovation

Functions of financial innovations Tufano¶s Taxonomy

Identities and Returns to innovators

The Impact of innovations to socialwelfare

Future Studies

To complete the incomplete

markets

To address agency concerns and

info. asymmetries

To minimize transaction cost

Response to taxes or regulations Response to globalization and risk

Stimulated by technological shocks



Definition of Innovation

Example of innovations: Derivatives, risk transfer

products, ETFs, tax-deductible equity

Innovate: to introduce as or as if new

Innovation= Invention (R&D)

+ diffusion (adoption)

Classification by the targets of innovations

± Products, e.g. derivatives, structured notes ± Process, e.g. pricing mechanism or platform, setting

new means of distributing securities,«

Refer to Page 4,5



History of Innovation

1694 innovative product: Million Adventure

(bond plus a lottery ticket, Allen and Gale, 1994)

258 innovative securities on 17 pages (Graham

and Dodd ,1934)

± financial innovation is an on going evolutionary

process.

1836 new security codes from 1980 to 2001

(financial database, done by Tufano)

± a normal pattern: when a security is created, later it

may be modified slightly by competitors.

Refer to ,7



Taxonomy of financial innovations

Merton, 1992

1. Moving funds across times

and space

2. Pooling of funds

3. Managing risk

4. Extracting information to

support decision making

(VIX index)

5. Addressing moral hazard

and info. asymmetry

6. Facilitating sale and

purchase of goods

Finnerty, 19921. Reallocating risk

2. Reducing agency cost

3. Increasing liquidity

BIS, 19861. Transferring risk

2. Enhancing liquidity

3. Supporting credit

Refer to Page 9,10



Taxonomy of financial innovations

The drawbacks of these taxonomy

± Even a simple innovation is likely to address

multiple functions these functional

dimensions lack discriminating ability

± E.g. using Merton¶s scheme, an asset

securitization invokes 3 functions: pooling the

promise + reducing risk + increasing liquidity(moving funds)

Refer to Page 10



6 functions of financial

innovations1. To complete the incomplete markets

2. To address agency concerns and info.

asymmetries3. To minimize transaction cost

4. Response to taxes or regulations

5. Response to globalization and risk6. Stimulated by technological shocks



1. to complete the incomplete markets

(1/2)

Duffie and Rahi (1995) ±

± Review the relationship between market

incompleteness and innovations

± They suggest that hedging function of

innovations exists.

Refer to



1. to complete the incomplete markets

(2/2)

± Black (1986) Exchange-traded contracts

Viability (trading volume) vs. completeness

(correlation with some risks) ± Grinblatt and Longstaff (2000)

STRIPS (zero-coupon bonds)

Primary Incentive is to complete the market

± Allen and Gale(1988) In a short sale restricted market

It may be optimal for firms to provide multipleclasses claims generating values from differentinvestor preferences and needs

Refer to



2. To address agency concerns and

information asymmetries (1/2)

Design contract from the principal-agent theory

± Harris and Raviv(1989)

± Allen and Gale(1994) (book) Theoretical proposition on more derivative

beyond stocks and bonds

± Haugen and Senbett (1981): embedded options

± Lerner and Tufano (1993) and Berger andMagliolo(1995): R&D financing vehicles reduce

interest conflicts

Refer to



2. To address agency concerns and

information asymmetries (2/2)

Ross(1989)

± Agency problem borrowing cost increases

± Agency considerations interact with marketingcosts to produce innovations

Dewing(1919, 1934)

± 19 century, using innovations to squeezeinformation from firms

± e.g. assemble stock (pg13), covenant term(pg14), income bond (pg14)

Refer to ,14



3. To minimize transaction, search, or

marketing cost

Merton(1989) ± Equity swap is efficient to

multinational investors

McConnell and Schwartz(1992) ± Merrill Lynch¶s LYONs no cost for

rolling over their notes

Ross(1989), Madan and

Soubra(1991) ± Techs reduce cost. e.g. ATM, smartcard, ACH, e-401k

± Web e.g. Instinet, Open-IPO, Ebay(pg15)

± Reduced cost stimulates innovations Refer to ~16



4. response to taxes or regulations

Miller(1986): ³The major impulses to

successful innovations over the past 20

years have come, I am saddened to have to

say, from regulation and taxes.´ ± e.g. zero coupon bonds or Eurodollar

Eurobonds not to trigger immediate capital

gains

Tufano(1997b),Santngelo andTufano(1997)

Equity-linked structures delay paying capital

gain taxes

Refer to Page 16,17



5. response to globalization and risk

Globalization exchange rate, interest rate,

political risk Interamerican Development Bank

innovations embed currency convertibility

Mason, Merton, Perold and Tufano(1995)

± Risk from deregulation of gas volumetric

production payment contracts

Masson and Stratton(1938)

± Risk from inflation (1830 - 1930) currency choice

bonds

Cleverland(1920)

± legal tender = {gold, silver, currency} Refer to Page 20,21



6. Stimulated by technological shocks

(1/2)

A ³supply-side´ explanation for the timing

of innovations.

e.g. folioFN

,O

penIPO

White(2000): technological view of

financial innovations

Refer to Page 15,22



6. Stimulated by technological shocks

(2/2)

Tech of pricing mechanism

± B&SMerton hedging contracts

Techs of information and internet support...

± Risk management systems

± On line retirement planning

± Real option

Refer to Page 15,22



A case study: no ³one´

explanation works

Innovations in 1970s

± ³Market´ funds (i.e. index fund, e.g. Equally-

weighted S&P 500 fund, Value-weighted fund)

± Complete market + reduce traction cost+

stimulated by tech no single one

explanation can explain the development of

index fund.

Refer to Page 23



Tufano¶s Cases

Innovations in 1990s

± ETFs, TIPs, SPDRs, HOLDERs

± Above are ³index funds´ but provide moreattractions

Reducing transaction cost

Tax-deductible (or tax timing advantage)

Innovations in 2000s ± folioFN: Web based Personal funds

Small denomination

Tax-timing advantageRefer to Page 24~26




± Ross(1988)

Investment banks max profit by bundling securities

± Boot and Thakor(1997)-pg27

Lower innovations in a ³universal banking system´

Greater competition leads to increased innovation

± Silber(1983) - pg28

Constrained (small, weak) firms would be morelikely to innovate because they benefit more from

innovations

This can not be observed in empirical studies

Refer to Page 27,28




± Tufano(1989)

Underwriting spreads of the 1st innovator were not

higher

± Carrow(1999) As rivals increase, the spreads decrease

Underwriting spreads of the 1st should be higher

O

ther benefits ± Profit from enhanced reputation by innovation

± Increasing the quality of staffs (personal

involvement, career progression«)

Refer to Page 27




Empirical Thesis

± Tufano(1989)

Larger investment banks more innovations

± Matthews(1994)(book)

Self-reinforcing cycle

± Small institution has higher willing (larger

gradient for its utilization). However, smallinstitution has smaller feasible region for

innovative products to span.

innovation

SizeMathhhew,1994

Refer to Page 29




Innovations of diffusion (adoption)

± Which organizations adopt innovations and

how quickly they do so? ± Hannan and McDowell (1987), ATM

± Saloner and Shepherd (1995), ATM

± Akhavein, Frame and White(2001), Credit scoring

± Lerner (2002), patterns

± Molyneux and Shamroukh(1996),Obay (2000), off-balance ± Molyneux and Shamroukh(1999), junk bond

Larger firms have innovated more rapidly

Refer to Page 30




Although innovations usually bring benefits

to issuers (Geanuracos and Millar, 1991),

investors may endured slightly increasingbenefit while bearing much higher risk

(Tufano, 1996)

Refer to Page 30,31




wealth impact of innovations: some

Innovations were used to take advantages

of investors:

± Nanda (1996), poison put in CB

± Rogalski and Seward (1991), currency

warrants

± Jarrow and O¶Hara (1989), Primes andScores

Refer to Page 31



The Impact of innovations to

social welfare

Positive opinions

± Merton (1992)

± Shilling (1989)

± Sirmans andBenjamin(1990)

± Jameson, Dewan and

Sirmans (1992)

Negative opinions

± Terence (1995)

± Peter (2000)

± Innovations increasevolatility

Refer to Page 32,33



We cannot directly measure whole

social welfare, thus«

Innovations in mortgage loan lead to lower

mortgage rate charged to borrowers

Innovation leads to complexity that in turn leads

to bad business decisions and social costs (e.g.misuse of derivatives)

Specific innovations contribute to high market

volatility

The completeness of the market may make all

agents worse off! See Elul (1995)

Refer to Page 34



How to protect intellectual property?

Keep secrecy ± Product secrecy is impossible to hold

± Process secrecy is possible

Patent ± However, US Pattern office¶s point of view :

Financial innovation is ³business process´ which is hard topatent

opportunity ± 1998, Signature Financial sued State Street Bank on

Federal Circuit Court

± Will patenting encourage or discourage innovations?

Refer to Page 36

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