| Final
Exam
1. (15 points each; no more than one page each) Answer any
four of the questions below:
- Why might a bank want to securitize its loans?
- Why do firms with debt tend to take excessive risk? How does convertible
debt solve the problem of excessive risk-taking?
- How does the financial system decentralize the collection of information?
- What is the problem with making an actively-managed ETF work? How
can the problem be solved?
- Why are MBSs riskier than ordinary bonds?
- What are some of the ways in which financial innovations can improve
economic welfare?
2. ( points) Read
the excerpts below from various media articles and answer any two of the
questions posed (no more than one page each):
The risk of default (from "At the
risky end of finance" in The Economist of April 19, 2007)
Credit derivatives are financial instruments that “derive”
their value from the bond market. They can cover any bonds that are not
issued by governments—that is, where investors face the risk that
the borrower may not repay.
Their rapid growth stems from three market quirks. The first is that
a traditional corporate bond bundles together a whole group of risks.
A bond price might fall because investors are generally demanding higher
yields for all fixed-income assets (interest-rate risk), because investors
prefer bonds of one maturity date to another (duration risk), or because
they think the company that issued the bond will have trouble repaying
it. Derivatives separate this last factor—credit risk—from
the other two.
This allows investors to insure themselves against the risk of default
or, alternatively, to speculate that a default will occur. The instrument
that does this is a credit-default swap or CDS (agreement whereby one
party makes a series of payments to another in return for compensation
in the event of a bond default). Hence A agrees to pay a series of premiums
to B; who agrees to compensate A if the bond defaults.
This allows investors to speculate on default without owning the bond
itself. Those who buy protection could make substantial profits if the
company gets into trouble, since the value of the swap will rise sharply.
Plenty of speculation occurs and CDS positions are sometimes much larger
than the bonds outstanding.
To date, the insurers have tended to do better than the speculators.
This partly reflects today's benign economic conditions (few companies
have gone bust), but also relates to the second quirk in the market. The
highest-rated bonds (known as investment grade) tend to have delivered
better returns than were necessary to compensate investors for the risk
of default. In other words, someone who insured such bonds against default
would have, on average, made money (conventional insurance companies,
which insure against fire or theft, have not always done so well).
The third quirk of credit derivatives is that they allow corporate bonds
to be sliced and diced on the basis of risk. Some investors (such as banks
and insurance companies) may prefer to own the highest-rated (AAA) debt
for regulatory or solvency reasons. Others, such as hedge funds, may want
to take more risk and earn higher returns.
...
However, credit derivatives create a moral hazard. Someone has to lend
money in the first place. If they know they will sell on that loan or
bond within weeks, they may not worry whether the borrower will repay
in five years' time. Indeed, if they get paid a fee to make the deal,
they will care more about quantity than quality.
In addition, if risk is too diversified, who will monitor credit quality
closely? This is the “toddler by the swimming pool” problem.
If one parent is in charge, he will never take his eyes off the moppet.
But if both parents and others are around, all may assume someone else
is on guard. Everyone may be reading their newspapers when they hear the
splash.
- Explain how credit derivatives complete markets.
- Explain how credit derivatives allow for more efficient risk sharing.
- Why should monitoring of borrowers suffer if default risk is held
by a large number of investors?
3. (20 points) Read the series of three news releases below and answer
the following questions in English; answer part a. or b. and part c. or
d. (no more than one page each)
- What are the information asymmetry problems involved in lending to
finance research and innovation? (In your answer to this question, I
will be looking to see if you understand the meaning of information
asymmetry and its relevance in obtaining financing.)
- What are the moral hazard problems involved in lending to finance
research and innovation? (In your answer to this question, I will be
looking to see if you understand the meaning of moral hazard.)
- How is the RSFF planning to alleviate specifically these two problems?
(Note: I can only see one brief line in the following material that
addresses this issue -- you may see more.)
- How would you resolve these problems two problems if you were in charge
of managing this program at the RSFF?
European Commission and EIB launch new instrument to finance
research and innovation (http://www.eib.org/news/press/2007/2007-050-european-commission-and-eib-launch-new-instrument-to-finance-research-and-innovation.htm)
Today the European Commission & the European Investment Bank (EIB)
sign a cooperation agreement establishing the new risk-sharing finance
facility (RSFF) to support research & innovation in Europe. This new
instrument will help to make more financing available for promoters of
research & innovation projects, which often face more difficulties
than traditional business sectors in accessing finance, due to the relatively
high levels of uncertainty & risk inherent to their activity. The
RSFF, part of the EU's 7th Research Framework Programme (FP7) & EIB’s
programme for Research & Innovation, will partially cover the financial
risks assumed by the EIB when financing this type of activity. The contribution
of €1 billion each from FP7 & the EIB will therefore unlock billions
of additional financing in this area.
Traduction: La Commission européenne
et la BEI créent un nouvel instrument pour financer la recherche
et l'innovation
La Commission européenne et la Banque européenne d'investissement
(BEI) signent aujourd'hui un accord de coopération qui crée
un nouveau mécanisme de financement du partage des risques (MFPR)
pour soutenir la recherche et l'innovation en Europe. Ce nouvel instrument
permettra de mettre davantage de fonds à la disposition des responsables
de projets de recherche et d'innovation; en effet, ceux-ci sont souvent
confrontés à des difficultés plus grandes pour accéder
aux financements que les responsables des secteurs d'activités
traditionnels, en raison du niveau relativement élevé d'incertitude
et de risque inhérent à leur activité. Le MFPR, qui
relève du 7ème programme-cadre communautaire de recherche
(PC7) et du programme de la BEI pour la recherche et l'innovation, couvrira
en partie les risques financiers supportés par la BEI lorsqu'elle
finance ce type d'activité. L'UE et la BEI apportent chacune une
contribution d'un milliard d'euros, qui permettra de débloquer
des financements supplémentaires se chiffrant en milliards dans
ce domaine.
Risk Sharing Finance Facility (RSFF) (http://www.eib.org/rsff/index.htm)
Objectives of RSFF
Investment in Research, Development and Innovation (RDI) has been identified
as a key factor to improve competitiveness and ensure long term economic
growth and employment in Europe. Under the Lisbon Strategy established
in 2000, Europe has set itself the goal to become the most competitive
and dynamic knowledge-based economy in the world.
Finding private funding sources for RDI projects can be difficult due
to their nature:
* complex products and technologies
* unproven markets
* intangible assets
* information difficult to evaluate by the financial sector.
The European Commission and the European Investment Bank (EIB) have joined
forces to set up the Risk Sharing Finance Facility (RSFF). RSFF is an
innovative scheme to improve access to debt financing for private companies
or public institutions promoting activities in the field of:
* Research, Technological Development Demonstration, and
* Innovation investments.
RSFF is built on the principle of credit risk sharing between the European
Community and the EIB and extends therefore the ability of the Bank to
provide loans or guarantees with a low and sub-investment grade risk profile
(involving financial risks above those normally accepted by investors).
The scheme also provides a wealth of opportunities for new and innovative
EIB financing solutions directed at the private sector and the research
community as a whole.
Traduction: Mécanisme de financement
avec partage des risques (MFPR)
Objectifs du MFPR
Les investissements dans la recherche, le développement et l'innovation
(DRI) ont été identifiés comme étant un facteur
clé permettant d'améliorer la compétitivité
et de garantir, sur le long terme, la croissance économique et
l'emploi en Europe. Dans le cadre de la stratégie de Lisbonne qui
a été adoptée en 2000, l'Europe s'est fixé
pour objectif de devenir l'économie de la connaissance la plus
compétitive et la plus dynamique au monde.
Trouver des sources de financement privées pour les projets de
RDI peut s'avérer une tâche difficile en raison de la nature
même de ces projets:
* produits et technologies complexes ;
* marchés entièrement nouveaux ;
* actifs incorporels ;
* information difficile à évaluer par le secteur financier.
La Commission européenne et la Banque européenne d'investissement
(BEI) se sont associées pour créer le Mécanisme de
financement avec partage des risques (MFPR). Cet instrument est un mécanisme
novateur destiné à améliorer l'accès au financement
par l'emprunt pour les entreprises du secteur privé ou les institutions
publiques qui développent des activités dans le domaine
:
* de la recherche, du développement technologique, de la démonstration
* et des investissements d'innovation.
Reposant sur le principe du partage des risques de crédit entre
la Communauté européenne et la BEI, le MFPR renforce la
capacité de la Banque d'accorder des prêts ou des garanties
en faveur de projets dont le profil de risque est faible ou inférieur
à celui d'une valeur d'investissement (impliquant des risques financiers
supérieurs à ceux habituellement acceptés par les
investisseurs). Ce mécanisme offre également un large éventail
de possibilités en matière de solutions de financement nouvelles
et innovantes élaborées par la BEI, qui s'adressent au secteur
privé et au secteur de la recherche dans son ensemble.
How RSFF works (http://www.eib.org/rsff/how-rsff-works/index.htm)
RSFF is based on an innovative idea of leveraging Community Budget funds
available under the Seventh Community Framework Programme (FP7) through
EIB financing.
The European Community will allocate up to EUR 1bn of funds available
under the Seventh Framework Programme (2007-2013) to RSFF. In parallel,
the EIB is contributing up to EUR 1bn from its own resources. Together,
these funds will be used to back up financing operations with a higher
risk profile than the average EIB lending portfolio. Given that each EUR
of FP7 and EIB contribution to RSFF will, on average, translate into 5
EUR of RSFF loans and guarantees, RSFF will increase the overall capacity
of the EIB to finance higher-risk, yet creditworthy, Research, Development
and Innovation (RDI) projects by up to EUR 10bn.
Under RSFF, the EIB will open new ways to add value:
* By providing long-term financing with potentially subordination elements
(financing ranking behind debt provided by senior lenders), the EIB can
strengthen the promoter's financial profile, thereby increasing his capacity
to attract additional funding for his investments.
* Risk sharing with the banking sector will alleviate existing risk management
related lending constraints, boosting the financial community's overall
capacity to support RDI activities particularly in the area of Small and
Medium sized Enterprises.
* RSFF will enhance the Bank's ability to develop new financial products
in order to overcome the market's weakness to cover the requirements of
the targeted sectors and promoters.
Traduction: Comment fonctionne le MFPR?
Le MFPR repose sur une idée novatrice qui consiste, à
travers les financements de la BEI, à donner un effet de levier
aux ressources budgétaires communautaires disponibles au titre
du septième programme-cadre de recherche de l'UE (7e PC).
La Communauté européenne mettra à disposition du
MFPR une dotation de 1 milliard d'EUR au maximum au titre du septième
programme-cadre de recherche (2007-2013). Parallèlement, la BEI
y apportera une enveloppe de 1 milliard d'EUR au maximum sur ses ressources
propres. Combinées, ces ressources serviront à soutenir
des opérations de financement dont le profil de risque est supérieur
à la moyenne du portefeuille de prêts de la BEI. Compte tenu
du fait que chaque euro provenant du 7e PC et des ressources de la BEI
se traduira, en moyenne, par 5 EUR mis à disposition sous la forme
de prêts ou de garanties au titre du MFPR, ce mécanisme portera
à 10 milliards d'EUR au maximum la capacité globale de la
BEI de financer, dans les domaines de la recherche, du développement
et de l'innovation (RDI), des projets plus risqués, mais présentant
une solvabilité satisfaisante.
À travers le MFPR, la BEI sera en mesure de proposer de nouveaux
outils générateurs de valeur ajoutée:
* En accordant des financements à long terme assortis d'éventuels
éléments de subordination (financements d'un rang inférieur
à ceux de bailleurs de fonds de premier rang), la BEI pourra consolider
le profil financier des promoteurs, accroissant ainsi leur capacité
d'attirer des ressources supplémentaires en faveur de leurs investissements.
* Le partage des risques avec le secteur bancaire permettra d'alléger
les contraintes de prêt actuelles liées à la gestion
des risques, ce qui renforcera la capacité du secteur financier
dans son ensemble de soutenir des activités de RDI, plus particulièrement
dans le secteur des petites et moyennes entreprises.
* Le MFPR renforcera la capacité de la Banque de développer
de nouveaux produits financiers pour pallier les faiblesses du marché
en ce qui concerne la couverture des besoins des secteurs et promoteurs
ciblés.
Solution to Final Exam
1.
- A bank might want to securitize its loans in order to free up capital,
with which to make more loans. This would increase its profit, since
it would be able to keep its loan origination fees.
- Shareholders of firms with debt often take excessive risk because
they can keep the upside gains, while being able to turn over the firm
to the bondholders in as satisfaction of their debt obligations if the
firm value went too low. This asymmetry makes it worthwhile for shareholders
to increase firm risk, which increases upside gains as well as downside
losses. Convertible debt resolves this problem to some extent by giving
bondholders the ability to participate in the upside by converting their
debt to equity -- this reduces the asymmetry referred to above.
- By having securities traded on an exchange, information on the value
of the securities and their underlying assets is generated, whenever
somebody chooses to buy or sell that security. Since this affects the
security price, which is visible to everybody, information is collected
and disseminated to everybody. Further, this is done in a decentralized
way, since each intending buyer or seller acts independently.
- There are several problems with ETFs based on actively managed funds.
One is that arbitrage to keep the price of the ETF equal to the value
of the underlying portfolio is made more difficult since the manager
of the actively fund would not want to make the fund holdings public.
Another problem is that investors don't know what they are holding because
actively managed funds are managed out of the public view.
- MBSs are riskier than bonds because usually there is prepayment risk
-- homeowners are allowed to prepay their loans, which they would tend
to do if interest rates dropped and they could refinance their loans
more cheaply. This is undesirable for the holders of the MBSs that contain
these loans because they are obtaining these prepaid funds at a time
when they would be able to reinvest them only at a lower rate.
- Financial innovations can improve economic welfare in many ways:
- through completing markets and allowing investors to share risk,
hedge and transfer resources over time and space
- by reducing information asymmetry and moral hazard and thus encouraging
trade, and
- by smoothing payments and thus encouraging trade
2.
- Credit derivatives complete markets by creating securities with positive
payoffs in states of the world where a given party is in default. Investors
who are exposed to such default risk can hold these derivatives to create
securities of reduced risk.
- This default risk can be shared more efficiently because through the
use of credit derivatives, the default risk can be held by individuals
who are more willing to bear that risk; the original investors in the
business of the party that is in risk of default can provide financing
without having to bear the risk of default. Default risk is separated
from interest rate risk and duration risk. Furthermore, through the
creation of liquid securities embodying this default risk, investors
can diversify their exposure to default risk and also dispose of it
at low cost whenever they desire.
- If default risk is held by a large number of investors, monitoring
of the borrowers suffers because no one party is affected by the suboptimal
action of the borrowers and hence there is less of an incentive to monitor
the actions of the borrower.
3.
- Information asymmetry reduces opportunities to trade because both
parties to the trade do not have the same access to information about
the value of the item to be trade. This creates uncertainty in the minds
of each party about the motivations of the other party to the trade.
In the case of investments in R&D, we are talking about a complex
product that is difficult for financial investors to evaluate from a
technical point of view. Hence they are less willing to invest in R&D.
- Moral hazard in the case of an investment has to do with the possibility
that the party managing the R&D might take suboptimal actions to
reduce the value accruing to the investor. This fear is particular present
in the case of an R&D investment where the financial investor may
not be able to appreciate the technical factors involved in the management
of the R&D and may not be able to monitor the R&D manager properly.
- One of the ways in which the RSFF can address these issues is by having
the EIB provide financing that is subordinate to outside debt investors.
This will increase the trust that these investors have in the value
of the R&D. The press release also mentions unspecified financial
products that the EIB plans to develop in order to overcome the markets'
weakness to cover the requirements of the R&D sector.
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