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
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
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
Non-linear Macro Risk Buildup
Firm/Mortgage Debt Guarantee Bank Deposit GuaranteeG
B ' BA
' BG
G
B BA
' CG
CG
' CA
A
C CG
Copyright © 2011 by Robert C. Merton
' C
A
A
C ' CD
CD
Firm/Mortgage Debt CD
Corporate/Household Sector
Liability
Banking System
Liability
Government
Liability
Corporate/Housing Assets, A C Bank Assets, ABCorporate /Housing Assets, AC
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.
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
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
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
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
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)
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
11
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
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
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.
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
15
Copyright © 2011 by Robert C. Merton