Capitalist
30-05-2004, 02:59 PM
Philosopher Robert Tracinski asked his readers to name the top ten innovations that transformed human life in the 20th century. He compiled his own list, which I have posted below, and commented that he was sure financial innovations should be on it, but this was not his area of expertise.
An intelligent person replied thus, which may be of interest to those who hypocritically denounce merchant bankers but take advantage of the products of their brains:
The "Fundamental Derivatives"
In the subject of financial innovations, I would mention these several, along with some commentary as to their essential features and the nature of their importance.
The first is "interest rate swaps." A subset of the category "derivatives," interest rate swaps are in a real sense their progenitor. The swap market provides prices at which (corporate) debt of varying maturities (due in one year, two years, and so on) can be interchanged. Example, if you borrow on the basis of the rate on your loan varying monthly at, say, 2%, you can convert this to a five year fixed rate of, say, 5%.
What this allows is a relatively effortless way for entities to match (and rebalance as needed) the repayments for, and the useful lives of, their assets. The result is to substantially enhance the containment of risk, and at a reduced cost.
This product was invented in the early 1980s by Citibank, by a very small group in their London office. The basic idea was to make a market in rendering explicit and trading upon the prices that the extant notes of varying maturities (had) implied (all along).
And now, within the span of 20-25 years, one would be hard pressed to find a Fortune 500 company (that has debt--a very few do not) that does not employ these swaps as a central feature of its capital structure. This also provides the basis for consumer products (such as mortgages) to be similarly backed (by the mortgage companies).
The other fundamental derivative product is: stock options (puts and calls) as traded on the Chicago Board of Exchange (CBOE). The driver of this market was the development of a credible pricing method--the Black-Scholes model. While the inherent statistics are (very) complicated, and not completely verifiable (as with most statistics), the model provided a consistent approach to the pricing of these instruments. From there, firms could diverge, based on their own judgments as to the trading ranges--with the final arbiter being the making and losing of money based on the actual performance of the underlying stocks. The net effect was to bring more money to the equity market as these instruments offered a further way in which investors could either mitigate risk or enhance returns.
And lastly, outside the sphere of derivatives, is the product of "junk bonds" developed by Michael Milken. These instruments provided funding to marginally profitable firms who could not raise traditional debt or equity. The key was the high interest rates to offset the risk. These high debt rates provided the equity-type returns required by the investors, contractually as opposed to the investors' having to "lobby in the board rooms" for dividends or other forms of return of capital. And not incidentally, the interest was tax deductible (by the firm) as compared to an equity return, which is not.
An intelligent person replied thus, which may be of interest to those who hypocritically denounce merchant bankers but take advantage of the products of their brains:
The "Fundamental Derivatives"
In the subject of financial innovations, I would mention these several, along with some commentary as to their essential features and the nature of their importance.
The first is "interest rate swaps." A subset of the category "derivatives," interest rate swaps are in a real sense their progenitor. The swap market provides prices at which (corporate) debt of varying maturities (due in one year, two years, and so on) can be interchanged. Example, if you borrow on the basis of the rate on your loan varying monthly at, say, 2%, you can convert this to a five year fixed rate of, say, 5%.
What this allows is a relatively effortless way for entities to match (and rebalance as needed) the repayments for, and the useful lives of, their assets. The result is to substantially enhance the containment of risk, and at a reduced cost.
This product was invented in the early 1980s by Citibank, by a very small group in their London office. The basic idea was to make a market in rendering explicit and trading upon the prices that the extant notes of varying maturities (had) implied (all along).
And now, within the span of 20-25 years, one would be hard pressed to find a Fortune 500 company (that has debt--a very few do not) that does not employ these swaps as a central feature of its capital structure. This also provides the basis for consumer products (such as mortgages) to be similarly backed (by the mortgage companies).
The other fundamental derivative product is: stock options (puts and calls) as traded on the Chicago Board of Exchange (CBOE). The driver of this market was the development of a credible pricing method--the Black-Scholes model. While the inherent statistics are (very) complicated, and not completely verifiable (as with most statistics), the model provided a consistent approach to the pricing of these instruments. From there, firms could diverge, based on their own judgments as to the trading ranges--with the final arbiter being the making and losing of money based on the actual performance of the underlying stocks. The net effect was to bring more money to the equity market as these instruments offered a further way in which investors could either mitigate risk or enhance returns.
And lastly, outside the sphere of derivatives, is the product of "junk bonds" developed by Michael Milken. These instruments provided funding to marginally profitable firms who could not raise traditional debt or equity. The key was the high interest rates to offset the risk. These high debt rates provided the equity-type returns required by the investors, contractually as opposed to the investors' having to "lobby in the board rooms" for dividends or other forms of return of capital. And not incidentally, the interest was tax deductible (by the firm) as compared to an equity return, which is not.