Remarks divided into five parts

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Observations on the Future of Financial Innovation and Engineering:

Addressing Financial Challenges of the Economy

Robert C. Merton

2011 Princeton Lectures in Finance

Lecture 3: Financial Innovation in Government’s Role in the

Financial System: Identifying Systemic Risks, Oversight,

Stabilization, Market Completion, and Social Security

September 29, 2011

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Remarks divided into five parts

Macrofinancial risk propagation: structure of credit-risk

propagation and integrated risk balance sheet for evaluating

policy

Systemic risk: capital-infusion and-takeover vs. bankruptcy

approach to financial institution failure

Innovation: Comparative advantage vs diversification:

managing country risk

Innovation: Automatic stabilization , market completion and

Social Security

Systematic risks from the inevitable incompleteness of

models.

2

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Functional Description of Being a Lender or Guarantor of Debt

When There is Risk of Default

3

Copyright © 2011 by Robert C. Merton

RISKY DEBT + GUARANTEE OF DEBT = RISK-FREE DEBT RISKY DEBT = RISK-FREE DEBT - GUARANTEE OF DEBT

A = D + E

IN DEFAULT, THE HOLDER OF THE GUARANTEE RECEIVES PROMISED VALUE OF THE DEBT MINUS VALUE OF ASSETS RECOVERED FROM DEFAULTING ENTITY = MAX [0, B – A]

VALUE OF GUARANTEE = PUT OPTION ON THE ASSETS OF BORROWER

CREDIT DEFAULT SWAPS ARE GUARANTEES OF DEBT AND THEREFORE ARE PUT OPTIONS ON THE ASSETS OF THE BORROWER

Corporation

Operating Assets, A Debt (face value B), D Common Stock, E

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Non-linear Macro Risk Buildup

Firm/Mortgage Debt Guarantee Bank Deposit Guarantee

G

B ' B

A

' B

G

G

B B

A

' C

G

C

G

' C

A

A

C C

G

Copyright © 2011 by Robert C. Merton

' C

A

A

C ' C

D

C

D

Firm/Mortgage Debt C

D

Corporate/Household Sector

Liability

Banking System

Liability

Government

Liability

Corporate/Housing Assets, A C Bank Assets, AB

Corporate /Housing Assets, AC

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Destructive Feedback Loops: Guarantors writing

Guarantees of their Own Guarantors

Guarantor writes a guarantee in which its assets will not be

adequate to meet its obligations precisely in those states of the

world in which it will be called on to pay.

Federal Deposit Insurance Corp debt held by FDIC-insured

banks.

The Pension Benefit Guarantee Corp investing in the equities

of the companies whose pensions it guarantees.

A corporation writing a CDS contract on its own debt.

Funding a corporate pension fund with the plan sponsor’s own

stock.

A company writing put options on its own stock.

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Government: Economic-Risk Balance Sheet

Assets Liabilities

$ Bn $ Bn

Present Value of Incomes from: Present Value of Non Discretionary Expenses on:

### TAXES 1130.7 SOCIAL DEVELOPMENT 653.0

### Income 573.6

5% Assets 83.7 SECURITY & EXTERNAL RELATIONS 600.6

0% Customs 1.1

### Excise & GST 220.4 ECONOMIC DEVELOPMENT 193.4

4% Motor Vehicles 80.9

9% Others-Tax 171.0 GOVERNMENT ADMINISTRATION 70.7

### FEES 84.8 Balances of:

0% Sales of Goods 4.9 MONETARY BASE TBD

1% Rental 26.4

3% All other Fees 53.5 GOVERNMENT DEBT OUTSTANDING TBD Foreign Currency

Local Currency

7% SEIGNORAGE TBD PENSION LIABILITIES TBD

0% Balances of: Contingent Claims (Implicit Guarantees)

INVESTMENTS 688.0 GUARANTEES TO BANKS AND NON-BANKS TBD Pension Fund 160.0 GUARANTEES ON RETIREMENT INCOME TBD

### Wealth Fund 528.0 GUARANTEES ON SOCIAL WELFARE TBD

TBDCASH 112.3

General Balance

6% INFRASTRUCTURE TBD (Economic Assets in excess of Economic Liabil 708.1

TBDGovernment-owned Enterprises TBD TBDCURRENCY RESERVES 204.0 REAL ESTATE TBD OTHER ASSETS 6.0 ### TOTAL 2225.7 TOTAL 2225.7 TRUE

Note: Economic Balance Sheet integrates central bank

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Dale Gray 2011

Unified Macrofinance Framework

Targets: Inflation, GDP,

Financial System Credit Risk, Sovereign Credit Risk

Sovereign CCA Balance Sheet Model Monetary Policy Model

Interest Rate Term Structure Financial System Credit Risk Indicator Financial Sector CCA Model • Fiscal Policy Debt Management Reserve Management Policy Rate Liquidity Facilities Quantitative Actions Capital Adequacy Financial Regulations Economic Capital

Fiscal and Debt Policies:

Guarantees

Financial Stability Policies:

Sovereign Credit Risk Indicator Monetary Policies: Household CCA Balance Sheet(s) Corporate Sector CCA Balance Sheet(s)

Sovereign Equity Claims (from Capital Injections)

Global Market Claims on Sovereign Central Bank Sovereign Debt Risk Liquidity Risk Exposure 7

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Dale Gray 2011

Traditional Flow and Accounting Framework

No Risk-Adjusted Balance Sheets (Asset Volatility = 0)

No Credit Risk or Guarantees; No Risk Exposures

Government Accounts Flow of Funds Interest Rates Bank Accounting Balance Sheets • Fiscal Policy Debt Management Reserve Management Policy Rate Liquidity Facilities Quantitative Actions Capital Adequacy Financial Regulations

Fiscal and Debt Policies:

Financial Stability Policies:

Monetary Policies: Household AccountingBal ance Sheet(s) Corporate AccountingBal ance Sheet(s) Capital Injections Global Market Flows Credit Flows Central Bank Monetary Policy Model 8

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Systemic Risk Differences:

Capital-Infusion-and-Takeover versus Bankruptcy

LTCM (1998) versus Lehman (2008)

Default triggers cross-default provisions in securities and

contractual agreements

Collateral seizures and sales or replacement of contractual

agreements cause a worsening of original net position

exposure

Typically counterpart for long-side is not the same for

short-side of position

With capital infusion, risk exposure is to

net

positions

With bankruptcy, risk exposure is to

gross

positions

Depending on character of position, gross risk can be up to

40

times larger than net risk

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Takeover vs. Bankruptcy: Net versus Gross Risk

Institution

A

Bond #1

(chit from

B)

(chit to

Bond #2

C

)

Loan

(to

C

)

(from

Loan

B

)

Bond #1

(collateral)

(chit to

Bond #1

A

)

Loan

(to

A

)

Equity

Cash

(collateral)

(from

Loan

A

)

Bond #2

(chit from

A

)

Equity

Equity

Counterpart B

Counterpart C

Risk (default A)

Risk (default A)

Vol (Bond #1 – Bond #2)

Risk (default A)

Vol (Bond #1)

Vol (Bond #2)

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Comparative Advantage vs. Efficient Risk

Diversification: Managing Country Risk

Before:

Taiwan Return = Return World Chip Industry + Return Taiwan-Specific Chip

Concentrated generic risk Comparative-advantage risk

Enter into a total-return Swap contract where Taiwan

Pays: Return World Chip Industry

Receives: Return World all Industries

After:

Taiwan Return = Return World All Industries + Return Taiwan-Specific Chip

Diversified generic risk Comparative-advantage risk

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Relative Advantage of Country Swaps for Diversifying Risk

Minimizes Moral Hazard

of Expropriation or Repudiation

Locals perform

industrial governance, trading in shares in local market, receive

benefits/losses of local-country-specific component of industry returns, thus

avoids political risk of “selling off the crown jewels of the country”

Credit Risk

: no principal amounts at risk; set frequency of payments (.25, 0.5, 1.0

years); “right-way” contract [pay when country is better able]; potential for credit

guarantee and/or two-way-marked-to-market collaterali

Policy is non-invasive

: doesn’t require change in employment patterns and

behavior, changes in industrial structure or changes in financial system design

Policy is reversible

by simply entering into an off-setting swap

Robust

with respect to local financial system design: works with capital controls,

pay-as-you pension system, or no local stock market at all

How to measure country risk

: Patterned after BIS model for banks

Potential Gains

: From 1972-2001, a gain of 600+ b.p. in average return for same

risk level by efficient diversification. Much smaller from 1972-2010.

Copyright © 2011 by Robert C. Merton

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EG

: Derivative Security to Replicate Central Bank Open Market Operations

Suppose that the government issues 10 million units of a Squiggle Bond, which is a perpetual (maturity = infinity) bond with a $50 coupon payment annually and $1,000 face value and 5 years from now, its owner has the option to exchange this bond for cash equal to its $1,000 face value. Thus, the Squiggle Bond is a perpetuity with a 5% coupon on face value, which can be exchanged for what is now a 5-year bond with a 5% coupon on face value. The Squiggle is equivalent to owning a perpetual bond with a 5% coupon on face value plus a 5-year European put option on that bond. Suppose further that the current 5-year par-coupon interest rate is 5%, so that the 5-year bond price is $1,000, and that the annual standard deviation of the price of a perpetual bond with a 5% coupon on face value divided by the price of a 5% coupon bond that matures five years from now is 10%. The following demonstrates that the issuing of the Squiggle Bond is functionally equivalent to an open-market stabilizing policy of buying long-dated bonds and replacing them with shorter-term bonds when long-term interest rates rise and selling long-dated bonds and buying back shorter-term bonds when long-rates fall. Bold denotes case when Perpetual Bond Price equals face value.

Long-Term Perpetual 5% 5-Year Squiggle Delta Effective Quantity

Interest Rates Bond Price Put Price Bond Price Put Perpetual Bonds Issued 3.0 % $ 1,667 $ 0.0 $ 1,667 -.000 10.00 million 4.0 % $ 1,250 $ 1.4 $ 1,251 -.013 9.87 million 4.5% $ 1,110 $ 4.9 $ 1,115 -.040 9.60 million 5.0% $ 1,000 $ 13.0 $ 1,013 -.110 8.90 million 5.5% $ 909 $ 27.2 $ 936 -.211 7.89 million 6.0% $ 833 $ 47.7 $ 881 -.340 6.60 million 7.0% $ 714 $ 103.6 $ 818 -.610 3.90 million 8.0% $ 625 $ 167.1 $ 792 -.808 1.92 million 9.0% $ 556 $ 227.0 $ 783 -.919 0.81 million 10.0% $ 500 $ 280.0 $ 780 -.969 0.31 million 13

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On Mathematical Models in Finance Practice

“ Even this brief discourse on the application to finance practice of

mathematical models in general and the options-pricing model in particular

would be negligently incomplete without a strong word of caution about

their use. At times we can lose sight of the ultimate purpose of the models

when their mathematics become too interesting. The mathematics of

financial models can be applied precisely, but the models are not at all

precise in their application to the complex real world. Their accuracy as a

useful approximation to that world varies significantly across time and

place. The models should be applied in practice only tentatively, with

careful assessment of their limitations in each application.”

R.C. Merton, “Applications of Option-Pricing Theory: Twenty-Five Years

Later,”

N

obel Lecture, 1997.

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Models are Always Abstractions from Complex Reality:

Implications for Ratings Agencies and Regulators

Credit Evaluation

:

1) Probability of Default

2) Expected Recovery Rate in Default

3) Degree of Procyclicality in Default

Ratings Agencies (S&P and Fitch)

1)

Ratings based on Probability of Default only

Incomplete model for ratings induces bias in assets selected for structures

Behavior:

Maximize value, subject to meeting ratings constraint

Minimize cost, subject to meeting ratings constraint

Prediction of bias in asset choices

Low Expected Recovery Rate in Default

High Procyclicality (“Beta”) in Default

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Copyright © 2011 by Robert C. Merton

Figure

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