Introduction to Financial
Innovation
What is Financial Innovation
Financial innovations are activities
1. to create new financial products with payoffs
desired by the customers (product
innovations),
2. or to provide new financial services. (process
innovations)
e.g. ATM, cash card, combo card etc.
The relationship between Financial
Innovation, Financial Engineering, and
Risk Management
Definition of Financial Engineering
• Financial engineering is the use of financial
instruments to restructure an exiting financial profile
into having more desirable properties. (Galitz)
• Financial engineering is the process of tailoring
financial instruments and organizational structure to
improve the profitability of intermediaries’ customers.
(Mason etc.)
Definition of Financial Engineering
• Financial engineering involves the design,
the development, and the implementation of
innovative financial instruments and
processes, and the formation of creative
solutions to problems in finance.
(John Finnerty)
From the above definitions, it is clear that
financial innovations are the crucial part of
financial engineering.
Definition of Risk Management
Risk management is to manage the risks faced by
firms using various tools, including financial
products.
• Business risk (generally difficult to hedge
and manage by using financial instruments)
• Financial risk
One main purpose of financial innovations (or
financial engineering) is to help firms to do
the risk management.
The Evolution of Risk
Management Products
The World Becomes a Riskier Place
Unpredictable movements in exchange rates, interest
rates, and commodity prices not only can affect a firm’s
reported quarterly earnings but even may determine
whether a firm survives. Over the past two decades,
firms have been increasingly challenged by such
financial price risks. It’s 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
There is a general agreement that the financial
environment is riskier today than it was in the past.
Inflation risk (retail prices)
Figure1-1
Figure1-2
Volatility of Foreign Exchange Rates
The exchange rate risk is associated with the exchange
rate system.
Fixed exchange rate system of Bretten Woods
Floating exchange rate system after 1970s
Figure1-3
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
Volatility of Commodity Prices
The crude oil prices became volatile after 1973.
Figure1-5
Other commodity prices have similar patterns.
The Impact of Increased Financial Price
Risk on Firms
Firms are exposed to two kinds of exposures.
1. Accounting-Based Exposure
• transaction exposure
• translation exposure
2. Economic Exposure
The Impact of Increased Financial Price
Risk on Firms
Virtually every firm considers accounting-based
exposure – those exposures that would be reflected
directly in the firm’s financial statement. Within these
accounting-based exposures, transaction exposures
receive the most attention. A transaction exposure exits
when a change in one of the financial prices will change
the amount of a receipt or an expense.
Receipt or expense = P  Q
Transaction 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 the
direct effects of a price change – that would be reflected
in the firm’s balance sheet is referred to as a translation
exposure. A translation exposure reflects the change in
the value of the firm as foreign assets are converted to
home currency.
Moving beyond the strict accounting-based
exposures, some firms have begun to consider
their economic exposures – also referred to as
competitive exposures. It measures the
indirect effect of a price change.
Laker Airlines an FX Risk (p.7-8)
Revenues – British pounds
Expenses – US$ (they bought new DC-10s)
In 1981, the US$ strengthened, the FX
transaction exposure became evident as
Laker’s expenses increased.
What’s worsen is the economic exposure! British
vacationers decreased as the US$ strengthened.
Therefore their revenues were declining as
well.
Caterpillar’s FX Whammy
The strong dollar is a prime factor in
Caterpillar’s reduced sales and earnings…
This is a typical example of economic
exposure.
The reversed story appears in “A Summer of
Discontent for Japanese Manufactures”
Two examples of Interest Rate Risk
exposure
• From Money Machines to Money Pits:
U.S. savings and loan association (S&Ls)
• Inherent Exposures to Interest Rates:
Residential Construction
From Money Machines to Money Pits:
U.S. S&Ls
• Enjoy benefits from upward sloping yield
curve in 1970s
• The profits of S&Ls are not affected by
parallel movements in interest rates.
• In the 1980s the yield curve inverted!!
Inherent Exposures to Interest Rates:
Residential Construction
• Residential Construction are exposed to interest
rate risk economically!
• When interest rates go up, the house prices go
down and the demand for housing also declines.
A Gulf War Casualty:
Continental Airlines
• Jet fuel price had more than doubled from
August to October in 1990 because Iraq invaded
Kuwait.
• The fuel cost for Continental Airlines in October
were $81 million higher than they had been in June.
• Continental Airlines files for Chapter 11 protection from its
creditors on December 3, 1990.
The Markets’ Response:
Tools to Manage Financial Price Risk
Exchange Rate Risk Management Products
Figure1-6
Interest Rate Risk Management Products
Figure1-7
Commodity-Price Risk Management Prosucts
Figure1-8
How Much Is Really New?
• Futures contract can be traced back to
1600s in Japan.
• Forward contract can be found in the 12th
century.
• Options were traded in the 17th century in
Amsterdam.
Concluding Remarks
• Financial innovation is a demand-driven
phenomenon.
• It’s better to manage risk actively rather
than to try to predict price movements.