Remarks divided into five parts

Transcription

1 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

2 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. Copyright 2011 by Robert C. Merton 2

3 Functional Description of Being a Lender or Guarantor of Debt When There is Risk of Default RISKY DEBT + GUARANTEE OF DEBT = RISK-FREE DEBT RISKY DEBT = RISK-FREE DEBT - GUARANTEE OF DEBT Corporation Operating Assets, A Debt (face value B), D Common Stock, E 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 Copyright 2011 by Robert C. Merton 3

4 Non-linear Macro Risk Buildup Firm/Mortgage Debt D C Corporate/Household Sector Liability D C ' D C Corporate/Housing Assets, A C Firm/Mortgage Debt Guarantee Banking System Liability ' AC AC Bank Deposit Guarantee Government Liability G C G B ' G C ' G B G C G B ' AC AC ' A B A B Bank Assets, A B Copyright 2011 by Robert C. Merton Corporate /Housing Assets, AC 4

5 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. Copyright 2011by Robert C. Merton 5

6 Government: Economic-Risk Balance Sheet Assets Liabilities $ Bn $ Bn Present Value of Incomes from: Present Value of Non Discretionary Expenses on: ### TAXES SOCIAL DEVELOPMENT ### Income % Assets 83.7 SECURITY & EXTERNAL RELATIONS % Customs 1.1 ### Excise & GST ECONOMIC DEVELOPMENT % Motor Vehicles % Others-Tax GOVERNMENT ADMINISTRATION 70.7 ### FEES 84.8 Balances of: 0% Sales of Goods 4.9 MONETARY BASE TBD 1% Rental % 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 GUARANTEES TO BANKS AND NON-BANKS TBD Pension Fund GUARANTEES ON RETIREMENT INCOME TBD ### Wealth Fund GUARANTEES ON SOCIAL WELFARE TBD TBD CASH General Balance 6% INFRASTRUCTURE TBD (Economic Assets in excess of Economic Liabil TBD Government-owned Enterprises TBD TBD CURRENCY RESERVES REAL ESTATE TBD OTHER ASSETS 6.0 ### TOTAL TOTAL TRUE Note: Economic Balance Sheet integrates central bank Copyright 2011 by Robert C. Merton 6

7 Unified Macrofinance Framework Targets: Inflation, GDP, Financial System Credit Risk, Sovereign Credit Risk Financial Stability Policies: Monetary Policies: Fiscal and Debt Policies: Capital Adequacy Financial Regulations Economic Capital Policy Rate Liquidity Facilities Quantitative Actions Fiscal Policy Debt Management Reserve Management Household CCA Balance Sheet(s) Corporate Sector CCA Balance Sheet(s) Financial Sector CCA Model Financial System Credit Risk Indicator Liquidity Risk Exposure Monetary Policy Model Central Bank Interest Rate Term Structure Sovereign Credit Risk Indicator Sovereign Debt Risk Sovereign CCA Balance Sheet Model Global Market Claims on Sovereign Guarantees Sovereign Equity Claims (from Capital Injections) Dale Gray

8 Traditional Flow and Accounting Framework No Risk-Adjusted Balance Sheets (Asset Volatility = 0) No Credit Risk or Guarantees; No Risk Exposures Financial Stability Policies: Monetary Policies: Fiscal and Debt Policies: Capital Adequacy Financial Regulations Policy Rate Liquidity Facilities Quantitative Actions Fiscal Policy Debt Management Reserve Management Household AccountingBal ance Sheet(s) Credit Flows Corporate AccountingBal ance Sheet(s) Bank Accounting Balance Sheets Monetary Policy Model Central Bank Interest Rates Government Accounts Flow of Funds Global Market Flows Dale Gray 2011 Capital Injections 8

9 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 shortside 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 Copyright 2011 by Robert C. Merton 9

10 Takeover vs. Bankruptcy: Net versus Gross Risk Institution A Counterpart B Bond #1 (chit from B) Bond #2 (chit to C) Counterpart C Bond #1 (collateral) Loan (to A) Bond #1 (chit to A) Equity Loan (to C) Loan (from B) Equity Cash (collateral) Bond #2 (chit from A) Loan (from A) Equity Risk (default A) Risk (default A) Risk (default A) Vol (Bond #1) Vol (Bond #1 Bond #2) Vol (Bond #2) Copyright 2011 by Robert C. Merton 10

11 Before: Comparative Advantage vs. Efficient Risk Diversification: Managing Country Risk 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 Copyright 2011 by Robert C. Merton 11

12 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 , a gain of 600+ b.p. in average return for same risk level by efficient diversification. Much smaller from Copyright 2011 by Robert C. Merton 12

13 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 shorterterm 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, million 4.0 % $ 1,250 $ 1.4 $ 1, million 4.5% $ 1,110 $ 4.9 $ 1, million 5.0% $ 1,000 $ 13.0 $ 1, million 5.5% $ 909 $ 27.2 $ million 6.0% $ 833 $ 47.7 $ million 7.0% $ 714 $ $ million 8.0% $ 625 $ $ million 9.0% $ 556 $ $ million 10.0% $ 500 $ $ million 2011 Robert C. Merton 13

14 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, Nobel Lecture,

15 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 from good behavior Low Expected Recovery Rate in Default Copyright 2011 by Robert C. Merton High Procyclicality ( Beta ) in Default 15