Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest

  Courses/ EDHEC: Financial Innovation  
Pace University
Fin EDHEC: Financial Innovation
Summer 2007
Prof. P.V. Viswanath

Final Exam

1. (15 points each; no more than one page each) Answer any four of the questions below:

  1. Why might a bank want to securitize its loans?
  2. Why do firms with debt tend to take excessive risk? How does convertible debt solve the problem of excessive risk-taking?
  3. How does the financial system decentralize the collection of information?
  4. What is the problem with making an actively-managed ETF work? How can the problem be solved?
  5. Why are MBSs riskier than ordinary bonds?
  6. 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.

  1. Explain how credit derivatives complete markets.
  2. Explain how credit derivatives allow for more efficient risk sharing.
  3. 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)

  1. 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.)
  2. 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.)
  3. 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.)
  4. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. Financial innovations can improve economic welfare in many ways:
    1. through completing markets and allowing investors to share risk, hedge and transfer resources over time and space
    2. by reducing information asymmetry and moral hazard and thus encouraging trade, and
    3. by smoothing payments and thus encouraging trade


  1. 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.
  2. 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.
  3. 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.


  1. 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.
  2. 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.
  3. 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.