-15-

Example 4: Use of Swaps by Banks with Claims on Developing Countries

In this example, we consider how a set of market participants
(international banks) have used a certain type of innovative financial
arrangement (the swap) to solve a global financial problem (the
involuntary lengthening of maturities of developing-country debt). This
example illustrates earlier observations about the changing character of
the international money and credit markets, specifically their
increasingly multi-currency and multi-country character. Note that new
provisions in some multi-year rescheduling agreements that allow banks a
one-time conversion of the debt into their own currency offer an
alternative solution to this same problem.

The involuntary lengthening of the maturity of loan portfolios
of banks with claims on troubled debtor countries has added considerable
complexity ‘to their problems of exposure management. This is par zicu-
larly true for banks without dollar funding bases because of the dollar
denomination of much of the original debt.

Consider a non-U.S. bank that has a large portfolio of
short-term dollar-denominated loans to borrowers in troubled debtor
countries. To minimize foreign exchange exposure, the bank funded these
loans with wholesale dollar deposits obtained on international markets
at floating-rates; the bank's primary funding source is fixed-rate,
home-currency deposits. The lengthening of part of its portfolio
limited the bank's option to reduce its interbank borrowing in dollars
should its standing in the wholesale deposit market deteriorate, or

should the cost of these funds rise for systemic macroeconomic reasons.


-9-
financing needs and span the open arbitrage, neither firms' endowments
and expectations nor national characteristics are static. That is, the
dynamics of the underlying economic processes lead to revisions of
firms' financing imperatives that, as a result, open new arbitrage
possibilities -- ongoing renewal of the forces generating financia‘

innovation.
III, STYLIZED EXAMPLES

In the following section, we present five examples that are
designed to show how the franework outlined above can capture a wide
range of actual financing problems and financing decisions. In the part
that follows, we link these decisions to general observations on the
changing character of international money and credit markets.

To clarify the firm's decision-making framework, we have
constructed two examples using stylized facts from public presentations
by senior corporate financial officers of how their firm derived and
satisfied its financial imperatives. In the first example, the firm's
exposure management problem involves a long-dated foreign exchange risk
and other concerns associated with the changing spread between long-term
and short-term interest rates. In the second example, the firm's
exposure derives primarily from differentials between short-term
interest rates. The fact that there are several financial packages that
resolve the financial imperative points to the conclusion that not only
are initial exposures important for the firm's financing choice, but

that expectations for asset price movements and appetite for risk are


-19-
implies that the desired instruments for exposure management should be
much more "targeted," that is, have a very specific interest rate,
exchange rate, or other financial exposure characteristic. Second, a
greater desire by multinational market participants to manage foreign
exchange risk suggests a wider currency denomination of market
instruments. Finally, the greater ability and return to piercing
domestic regulatory structures point to an increasingly multi-country
character to the market.

The evidence of the first concept, that of targeted exposure
management, is considerable. One of the significant innovations in the
new financial contracts is that many represent an “unbundling" of
existing contractual structures. For example, a ten-year, fixed-rate,
dollar loan contract "bundles" a specific maturity, interest payment
stream, and currency, each of which represents a specific financial
exposure. Over time, the borrower may come to want only one of these
characteristics for its financial plan -- say the term. A financ‘al
swap contract might allow the borrower to rebalance currency and
interest rate exposures without renegotiating the covenants of the
original contract.

Another example of the targeted exposure management technique
is the separate and simultaneous negotiations of a swap contract and a
Eurobond issue. The contract to issue the Eurobond specifies the
interest rate, currency, and maturity, which are presumably those
desired by the lender, while the swap that is negotiated at the same
time generates the desired exposure of the borrower. The existence of

the swap makes it more advantageous for the market participant to enter


-~-3-
The following parts of this paper (1) discuss the economic
foundations of the process of financial innovation, (2) examine stylized
examples drawn from public presentations by corporate officers, and then
(3) offer several observations on how financial innovation changes the

character of the international money and credit markets.
II. ECONOMIC FOUNDATIONS

Environment. One of the most important results of the recent
wave of financial innovation is the considerable expansion of available
financing techniques for making investments and obtaining credit. At
the sane time, and potentially more important, market Participants now
have many more alternatives that implicitly or explicitly give them the
choice of which financial exposures (risks) to cover or bear. The
introduction of these new financial market capabilities is, in large
part, in response to "events" that encouraged the development of
internal financial risk management functions within firms’ oraniza-
tional structures that more closely scrutinize financial exposures and
alternative financing options. 2

Among the notable events that encourage increased attention to

the management of exposures are (1) the high volatility by historical

lReaders interested in the macroprudential aspects of recent
innovations should see the BIS (1986).

2a thorough discussion and description of one major banking firm's
adaptations in offerings and organization may be found in Morgan (1986).


- 16-
In other words, a stable spread between the float ing-rate earnings and
the wholesale deposit expense could not be approximated.

Given this typical set of circumstances for non-U. S, banks,
they were attracted to the exposure management properties of the
Cross-currency swap contract. The bank could use its fixed-rate home-
currency deposit base as the foundation for a swap into floating-rate
dollars which would fix (over the duration of the swap) the net spread
on the floating dollar loans.

While the involuntary lengthening of the developing-country
debt is the centerpiece of this example, it is clear that a larger
number of desired lending or funding strategies that take the bank out
of its home currency and alter the interest-rate basis of its net
exposure is now possible. The bank has the means to disengage financial
decisions for the two sides of the bal ance sheet. Because such
contracts as the swap are now available, it is clear that interest rate
and exchange rate exposures can be more closely managed to desired ends.
As noted earlier, these ends May or may not mesh with those desired by
regulatory authorities.

From these examples, it would appear that the emergence of
marke:s for new financial products should be attributed, in large part,
to the heightened awareness, greater motivation, and increased ability
of firms to manage their financial exposures, combined with aggressive
exploitation of technological changes and historical compar ative
advantage by the financial intermediaries Creating the products.

However, an even greater source of incentives for financial innovation


- 22 -
intimate relationship between the multi-currency and multi-country
aspects of the market, the two can be separated because fundamentally a
convertible currency is not bound by its national borders. The
increasingly multi-country character of the market comes primarily from
the increased ability of market participants to pierce domestic
regulatory structures, in part through the use of the currency of that
country and in part, because of the existence of new financial contracts
that readily transform exposures,

The diversification of currency exposures potentially
accommodated by financial innovation may affect the sensitivity of
exchange rates to "news." A wider audience has emerged for capital
market products denominated in what were up-to-now "exotic" currencies
(such as the Australian dollar) among market participants whose needs
for residual exposure management Suggest advantages of assuming
Positions based on exposure to the movements in the exchange rates of
such currencies. The potential for such deepening of the markets may
imply a general reduction in exchange rate volatility and in the demand
for certain vehicle currencies as news is more widely dispersed through
the exchange markets by a wider variety of heterogeneous agents.
Moreover, the growth of futures and options markets in a wide variety of
currencies may further reduce the impact of news by dispersing its
effects across the time dimension.

Instruments such as futures and swaps increasingly link
domestic markets and individual participants across the time dimension.
Deep markets in cross-currency and interest rate swaps link the term

structure across countries, tightening the relationship between


- 18 -

(4) Large classes of Japanese institutional investors were
effectively bound by limits on the amount of foreign credits in their
Portfolios. Such restrictions did not apply to their holdings of the
foreign currency bonds of Japanese issuers.

The liberalization of qualifications in December was followed
by several months of intense issuance activity. The inducement for this
activity was undoubtedly the premia that constrained Japanese portfolio
managers were willing to pay for the dollar bond offerings of Japanese
issuers. In turn, such Japanese issuers were able to swap their
dollar-denominated interest and principal payment obligations with
non-Japanese issuers of Euroyen bonds. That is, the liberalization of
qualification accommodated a bridging of the regulatory structure by
expanding the pool of eligible counterparties for currency swaps but it
did not provide the inducement. The April 1985 removal of the
withholding on interest payments on Euroyen bonds of Japanese issuers to
non-Japanese investors signaled the acquiescence of Japanese authorities
to the freer access of Japanese borrowers to international capital
markets,

IV. GENERAL OBSERVATIONS ON THE CHARACTERISTICS OF
FINANCIAL MARKETS

Abstracting from individual market participants and
generalizing across their actions, what are some of the aggregate
impacts of financial innovation on international money and credit
markets? Three seem to stand out. First, the ability of individual

Participants to disengage various decisions about their balance sheets


-B-
adverse change in circumstances), The facility puts a cap on the firm's
net intermediation cost and therefore puts a floor under the net return
on its assets.

The firm's evaluation of the bank's proposal must take into
account both the commitment fee and the firm's conditional expectation
that it may need to draw on the facility. The greater the probability
of a reduction in the firm's creditworthiness, or the likelihood of any
other situation that might cause its funding costs to rise relative to
that of the government, the greater the value of NIF. However, the
bank's proposed pricing reflects not only its expectations for general
money-market conditions and specific conditions affecting its own cost
of funds, but also its views of the firm's prospects and on the expected

value of requiring specific financial covenants of the firm.

Example 3: Financial Innovation, the Financial Intermediary, and
Market Structure

In the following example, we discuss how changes in the market
for the provision of financial intermediation services affect the
behavior of the financial firm and change the kinds of risks it may
decide to take on. The example further suggests that the interplay of
the demand for new financial instruments with the role desired by the
financial organization may lead to a change in market structure.

The firm underwrites securities. It established and maintains
a deep distribution network so as to make a market and take positions in

those securities through secondary market transactions. The


-6-
alternative financial contracts. The most recent period has exhibited
high and volatile asset prices and exchange rates; therefore, it should
come as no surprise that new financial contracts appeared in the
marketplace as floating-rate agreements, swaps, and interest rate caps,
that specifically alter interest rate, term structure, and foreign
currency risks. 4

One outgrowth of such innovations, many of which take the form
of off-balance-sheet transactions, is the growing inability to glean
from financial statements what financing strategies are in fact being
employed. Historically, firms' financial statements reflected bus iness
characteristics and could provide clues as to residual financial
exposures. For example, firms in capital intensive industries often
chose to finance capital spending with long-terin fixed-rate debt so as
to minimize the volatility of reported return on equity. Consequently,
heavy reliance on floating-rate debt by such a firin traditionally would
nave been considered in a market evaluation as evidence of the firm's
inability to obtain long-term debt and therefore would be a negative
signal of its creditworthiness. However, off-balance sheet exposures
transform on-balance sheet exposures; therefore, their use has reduced
the information content of standard financial statements. For example,
reported floating-rate financing by a capital-intensive firm might now
reflect the involvement of that firm in a long-term interest rate swap

contract.

4an interest rate cap is an option under which a buyer pays a
premium to receive compensation if a particular interest rate index
rises above a certain level.


- 25 -
REFERENCES

1. Bank for International Settlements, Recent Innovations in
International Banking, Basle, 1986.

2. Jensen, Michael and C. W. Smith, Jr. "Stockholder, Manager and
Creditor Interests: Applications of Agency Theory," in E. Alzman
and M. Subrahmanyam, eds., Recent Advances in Corporate Finance,
1985, pp. 93-131.

3. J.P.Morgan and Co., 1985 Annual Report, 1986.


Firm Specific

-4a-

Chart 1

General Schematic:

A Framework for Selecting
and Generating Financing Options

National

Endowments
yield
Exposures
given
Expectations
lead to

Financing
Imperatives

National Characteristics

translate into:

Characteristics Characteristics
Of Country — eeeeeneecanenee| Of Country

A Zz

provide
opportunities
for:

Domestic
Arbitrage

Domestic
Arbitrage

A Zz

Cross-National
Arbitrage

satisfied by
—

Financing
Options



-4-
standards of financial asset prices and the persistence in the trend
movements in these prices, (2) the change in quality of an unprecedented
amount of both international and domestic banking credits already on
banks' books with the resulting concern over bank capital, and (3)
technological developments. This latter factor is associated with
advances in computers, software, and telecommunications technology that
increased the availability of information on financial opportunities and
reduce the cost of assessing and analyzing that information. Technology
also allows the ready adaptation of highly complex financing packages to
specific circumstances; in particular, it makes possible the timely
valuation (based on current market prices of standard financial
contracts) of possible solutions to specific financing problems. For
example, a firm may wish to convert floating rate New Zealand dollar
exposure to fixed rate German mark exposure. While no direct
(bilateral) swap market exists for this transaction, active markets for
swaps of both currencies into U.S. dollars assure the "efficient
pricing" of the cross transaction. 3

The Framework. Chart 1 shows an overview of the economic
foundations of the process of originating and evaluating financial
products and packages. It shows how two sets of economic factors, those

associated with firms and those associated with national structures,

3A swap is a financial arrangement in which counterparties agree to
exchange streams of payments over time according to a predetermined
rule.


-14-
distribution network gives the firm the Capacity to alter quickly its
position in response to Changes in asset prices, actual or expected.

The firm's initial involvement in the Swap market was to
broker swaps between members of its distribution network. However, such
a limited involvement was short-lived as customers demanded the greater
timeliness and flexibility that could be provided by an organization
that acted as principal. What ensued was an internal assessment of the
strategic value to the firm of full participation in the swap market.

The assessment focused on the need to evaluate and price
credit risk appropriately, on the one hand, versus the opportunity to
exploit a well-developed ability to manage price risk and to employ
technology, on the other. Acting as principal in swap transactions
requires the firm to make long-term unsecured credit extensions,
something that it historically had not done. Therefore, resources would
have to be expended to create and maintain a formal and on-going credit
review and pricing apparatus. In addition, there was some concern
about the cost to the firm of having its own credit standing affected by
credit judgments on the quality of its portfolio of swaps.

The firms's decision to participate in the swap market was
based on the view that such participation would allow it to exploit its
existing capabilities in distribution, assessing asset price risk, and
arranging financial packages. That is, the firm concluded that such
capabilities needed to be leveraged to retain market presence as a

securities underwriter.


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- 20 -
into the Eurobond contract; without the Swap the cost of the Eurobond in
terms of required exposure tradeoff might not have been acceptable.
However, with the two Parallel negotiations, the two components of the
overall package are unbundled -- the extension of credit and the desired
Characteristics to the lender, and the tailoring of the attributes of
the bond to the particular needs of the borrower. As a result of this
unbundling, the market has become more efficient in the provision of
credit.

The magnitude of swap activity on the market attests to the
growing ability of participants to explicitly or implicitly unbundle
financial contracts for targeted exposure management. Swaps and other
innovative financial contracts are critically important for targeted
exposure management for the individual market participants, on the one
hand, and for weaving together market participants into a whole fabric
that is the international money and credit markets, on the other.

While this deepening of the financial markets that results
from financial innovation is undeniable, the question of whether the
allocation of net exposure across participants in the financial system
is more or less socially optimal or efficient cannot be easily answered.
Financial intermediaries are often accorded a special role in financial
systems; they have a somewhat different set of prudential regulations
than those faced by non-financial firms; in addition, they may have
implicit or explicit official support (including access to official
credit facilities and favorable tax treatments). The interaction of the
general motivations for financial innovation with this set of prudential

regulations and official licenses makes it difficult to determine


International Finance Discussion Papers
Number 283

June 1986

A FRAMEWORK FOR ANALYZING THE PROCESS
OF FINANCIAL INNOVATION

by

Allen B. Frankel and Catherine L. Mann

NOTE: International Finance Discussion Papers are preliminary materials
Circulated to stimulate discussion and Critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpubl ished
material) should be cleared with the author or authors.


-7a-

Chart 3

Breakdown of General Schematic:
National Model

National Characteristics

Legal/Regulatory Structures
Fiscal Structures
Social Contracts

Macroeconomic Management

translates into:

Characteristics Characteristics Characteristics Characteristics
of of of of
Country Country samme | Country Country
A B Y Zz
provide
opportunities

for:

Arbitrage in
Domestic Market
in

Country

Arbritrage in
Domestic Market
in
Country

Arbritrage in

Domestic Market
in

Country

A

B

Y

Cross-National
Arbitrage in
International

Market

Financing
Options

Arbritrage in
Domestic Market

in
Country

Zz



-7-

To some observers, the claimed persistence of such “profit-
able" opportunities to Manage firms' financial imperatives Suggest
marketing efforts by intermediaries intent on building trading volumes.
However, in an environment in flux that continually changes economic
exposures, the presence and persistence of arbitrage should not be
perplexing, especially when preferential access to some markets by some
actors continues to be accepted and encouraged by national authorities.

National Financial Structures. Countries! national

Characteristics are embodied in their legal and regulatory systems,
fiscal (tax) mechanisms, and macroeconomic management techniques and
goals, as shown in Chart 3. These characteristics Create arbitrage
Opportunities both within the domestic market and across domestic
markets that are exploited by the existing financial instruments and
generate financial innovations where no appropriate instrument exists.
Hei ghtened sensitivity to the differences among and inconsistencies
across national structures has been fundamental to financial innovation
and the resulting increasingly internat ional ized Capital and money
markets. Moreover, the recent surge in the development of cross-
national financial arrangements has induced significant Changes to
Purely domestic regulations. By contrast, in earlier Periods, cross-
national financial arrangements came as a byproduct of resolving
inconsistencies within the domestic system.

Regulatory avoidance continues to be a major factor in
financial innovation. A simple example will develop this argument.
Consider a Country which, for expressed reasons of macroprudential

Policy, has a ceiling on the interest rate that savings institutions may


IFDP
NUMBER
271

270

269

268

267

266

265

264

263

262

261

260

259

258

257

256

-27-

International Finance Discussion Papers

TITLES

Elections and Macroeconomic Policy Cycles

Assertion Without Empirical Basis: An
Econometric Appraisal of Monetary Trends
in... the United Kingdom by Milton Friedman
and Anna J. Schwartz

Canadian Financial Markets: The Government's
Proposal for Reform

Was It Real? The Exchange Rate Interest
Differential Relation, 1973-1984

The U.K. Sector of the Federal Reserve's
Multicountry Model: The Effects of
Monetary and Fiscal Policies

Optimal Currency Basket in a World of
Generalized Floating: An Application to
the Nordic Countries

Money Demand in Open Economies: A Currency
Substitution Model for Venezuela

Comparing Costs of Note Issuance Facilities
and Eurocredits

Some Implications of the President's Tax
Proposals for U.S. Banks with Claims on
Developing Countries

Monetary Stabilization Policy in an Open
Economy

Anticipatory Capital Flows and the Behaviour
of the Dollar

Simulating Exchange Rate Shocks in the MPS
and MCM Models: An Evaluation

Trade Policy for the Multiple Product
Declining Industry

Long Memory Models of Interest Rates, the
Term Structure, and Variance Bounds Tests

Currency Substitution and the New Divisia
Monetary Aggregates: The U.S. Case

The International Transmission of Oil Price
Effects and OPEC's Pricing Policy

AUTHOR(s)

Kenneth Rogoff
Anne Sibert

David F. Hendry
Neil R. Ericsson

Garry J. Schinasi
Richard Meese
Kenneth Rogoff

Hali J. Edison

Hali J. Edison
Erling Vardal

Jaime Marquez

Rodney H. Mills

Allen B. Frankel

Marcus H. Miller
Arnold Kling
Arnold Kling
Catherine Mann
Gary S. Shea
Jaime Marquez

Jaime Marquez


IFDP
NUMBER

283

282

281

280

279

278

217

276

275

274

273

272

- 26 -

International Finance Discussion Papers

TITLES

1986

A Framework for Analyzing the Process
of Financial Innovation

Is the ECU an Optimal Currency Basket?

Are Foreign Exchange Forecasts Rational?
New Evidence from Survey Data

Taxation of Capital Gains on Foreign
Exchange Transactions and the Non-neutrality
of Changes in Anticipated Inflation

The Prospect of a Depreciating Dollar
and Possible Tension Inside the EMS

The Stock Market and Exchange Rate Dynamics

Can Debtor Countries Service Their Debts?
Income and Price Elasticities for Exports
of Developing Countries

Post-simulation Analysis of Monte Carlo
Experiments: Interpreting Pesaran's (1974)
Study of Non-nested Hypothesis Test Statistics

A Method for Solving Systems of First Order
Linear Homogeneous Differential Equations
When the Elements of the Forcing Vector
are Modelled as Step Functions

International Comparisons of Fiscal Policy:
The OECD and the IMF Measures of Fiscal
Impulse

An Analysis of the Welfare Implications of
Alternative Exchange Rate Regimes: An
Intertemporal Model with an Application

1985
(partial listing)

Expected Fiscal Policy and the Recession
of 1982

AUTHOR(s)

Allen B. Frankel
Catherine L. Mann

Hali J. Edison

Kathryn M. Dominguez

Garry J. Schinasi

Jacques Melitz
Michael K. Gavin
Jaime Marquez

Caryl McNeilly

Neil R. Ericsson

Robert A. Johnson

Garry Schinasi

Andrew Feltenstein
David Lebow
Anne Sibert

William H. Branson
Arminio Fraga
Robert A. Johnson

Please address requests for copies to International Finance Discussion
Papers, Division of International Finance, Stop 24, Board of Governors of

the Federal Reserve System, Washington, D.C.

20551.


-5-
jointly create and differentiate financial product markets and influence
financing choices. The first set of factors includes those involved in
a firm's decision-making process, in which interest rate, price level,
and exchange rate expectations interact with existing exposures (that
are generated, broadly speaking, from the firms' business) to yield
financial risk management problems that may be resolved by selecting
among various financing techniques (existing or potential). The second
set of factors, those associated with a nation's macro policy and micro
regulatory environment, identifies the national characteristics that
provide the basis for market opportunities that may be exploited by
financial instruments. Fruitful market opportunities arise not just
fron firms' ability to arbitrage across different financial juris-
dictions (thereby minimizing the cost associated with taxation and
regulation), but more importantly, firms seek protection against asset
price uncertainties generated by possible changes in different
countries' monetary and fiscal policies.

Firm's Financial Imperatives. Broadly speaking, it is the

nature of the firm's business that is the foundation for the financing
imperative. As seen in Chart 2, such "endowments" as physical assets,
production techniques, and financial contracts yield exposures to
inflation, term structure, exchange rates, income volatility, and
technological change. Given that the firm may be treated as an
organization that is seeking to maximize the value of a specified
objective function, these exposures lead to financing imperatives.

Thus, given a knowledge of its exposures, its expectations for movements

in asset prices, growth, and its objective function, the firm can rank


-1W-
may be the interaction of international markets and national financial

structures.

Exanple 5: Internationalizing the Yen

Financing techniques often originate as responses to
changes in regulatory or tax structures. In recent years, cross-
national effects have been more prominent elements of altered patterns
of financial behavior; this has been particularly true for changes in
yen-based financing practices.

There has been a reorientation of the Japanese financial
system in order to assure that it places greater reliance on market
processes for the determination of interest rates. However, in an
effort to bring about a smooth transition between regimes, the Japanese
authorities chose to seek to control, through calculated liberaliza-
tions, the rate of integration of yen-based money and capital markets
with international ones. These control efforts have, on occasion, been
undercut as unanticipated arbitrage opportunities emerged and were
exploited by market participants. The background facts, as they epplied
in late 1984, for one example are as follows:

(1) Qualifications for non-Japanese issuers of Euroyen bonds
were liberalized in December 1984 to include corporate borrowers.

(2) A 20 percent withholding tax continued to be applicable to
interest payments by Japanese, and not non-Japanese, issuers of Euroyen
bonds.

(3) From April 1984 on, the Japanese authorities had

permitted the swapping of foreign currency bond issues into yen.


- 23 -
countries' policy choices and accentuating the spillover of domestic
events to the international markets. A greater recognition of these
linkages by individual market actors must impact how aggregate
expectations for asset prices are formed, resulting perhaps in a
tightening distribution of expectations for future asset price

movements.

V. SUMMARY

Using illustrative examples, we have analyzed the economic
fundamentals of how an individual market participant chooses a financial
arrangement. The firm must weigh the explicit transactions costs of
purchasing an exposure management package against the implicit and
expected costs of unmanaged exposures to interest rate and exchange rate
trends and volatility.

It is the interaction of national financial structures that
creates an environment in which firms increasingly are motivated to
manage financial exposures. Simple arbitrage opportunities may
originate and prompt response; but more importantly, differing and
Changing macroeconomic policies and goals lead to a world of greater
financial uncertainty to which market actors are compelled to react.

Financial innovation is the endogenous result of these two
forces acting together with technology. Technology not only reduces the
cost of arranging existing types of financial contracts, but also
importantly it reduces the cost of systematically pricing packages of

various financial contracts.


-2-

and (3) the presence of fruitful cross-market arbitrage opportunities
based on differing national jurisdictions and structures. Financial
innovation results from individual market participants managing
financial exposures derived from the interplay of changes in financial
asset market prices and firms' expectations for those prices. Changes
to the environment, both technological and macroeconomic, underlie this
process.

For banks and other financial intermediaries, this process of
financial innovation causes substantial changes in the profitability of
whole categories of financial services thereby changing the basis of
traditional customer relationships and traditional product offerings,
which together form the foundation for market share rivalry. The
introduction of new financial contracts and packages of contracts
suggests that financial intermediaries are forging new customer
relationships, are taking on new responsibilities, and are changing
competitive rivalries in response to the opening of new global markets.
But, the remarkable recasting by financial intermediaries of their
product lines is not only in response to customer demands, but also to
their own demands, for more effective protection against the uncertainty
generated by unexpected movements in interest rates and exchange rates.
This inference is buttressed by numerous observations of declines in
fees for both traditional and innovative intermediation services charged
by banks to their most creditworthy customers and the increasingly
blurred line between the type of intermediation services provided by
commercial banks, investment banks, insurance companies, and other

financial firms.


- 10 -
also crucial. That is, the firin's Managers operate as if they are

charged with managing exposures because "shareholders" do not.

Example 1. Long-dated Foreign Exchange and Term Structure of Interest
Rates

The initial exposure problems facing the firm are a long-term
contract for periodic receipt of fixed Payments in foreign currencies.
A recent acquisition by the firm has, through its impact on the firm's
debt to equity ratio, increased the cost of issuing long-term,
fixed-rate debt in the public bond markets. However, the firm assures
itself of long-term access to home-currency denominated, floating-rate
financing by making payments to a bank syndicate for a line of credit.

One financing option available to the firm is to fund itself
exclusively with its bank facility. However, in doing so, it is
choosing to finance long-term foreign currency receivables with
floating-rate, home currency debt. Therefore, it leaves uncovered risk
associated with changes in the level of interest and foreign exchange
rates. The firm's target return on equity may not be achieved if a
higher than expected short-term domestic interest rate occurs, or if the
home currency value of its foreign currency receivable falls.

Therefore, choosing to leave these exposures unmanaged is consistent
only with expectations of lower short-term interest rates and a weaker
home currency than are currently reflected in the market's yield curve
and forward exchange rates, or with significantly different expectations
for the variance of those asset prices than are reflected in the market.

If the firm's managers do not have these expectations for the movement


-12-
reflect its tolerance for volatility in return, the strength and
direction of its expectations for interest rates and exchange rates, and
transactions costs of purchasing the several instruments. Most
importantly, while Characteristics of the initial exposures are critical
to this example, the choice of arrangement itself alters the firm's
exposures, which then together with subsequent changes in the
environment and expectations, make the problem of exposure management an

on-going concern.

Example 2: Exposure to Short-term Interest Rate Differentials

The firm in the second example must purchase all eligible
governinent-guaranteed floating-rate loans offered to it. The firi's
gross return on assets equals the yield on short-term government debt
plus a loan-service fee. Thus, even if it matched the maturity profile
of its borrowings to that of its assets (the loans), the firm remains
exposed to the risk that its funding costs could rise relative to those
of the governinent.

A bank suggests a note issuance facility (NIF).© In
effect, the bank proposes to organize a syndicate for the purpose of
writing a conditional put option. Should the borrower be unable to fund
itself at or below a given spread above the government rate, the
syndicate assumes the burden of the higher funding cost so long as the

firm meets the agreement's financial covenants (including material

SE quivalent facilities have been referred to as revolving
underwriting facilities (RUFs) and note Purchase facilities.


A Framework for Analyzing the Process of
Financial Innovation

by

Allen B. Frankel and Catherine L. Mann*

I. INTRODUCTION

The following note presents a framework for analyzing the
process of financial product innovation. The framework attempts to
illustrate how characteristics of an economic system and its
participants motivate financing needs and encourage innovations in
financing techniques. We use stylized examples to explore several
different manifestations of this process and we offer general
observations on how financial innovation may change the character of
international money and credit markets. By taking an overview, we hope
to focus the analysis on the economics of the process of financial
innovation and not on the characteristics of individual financial
instruments. In doing so, we hope to integrate the most recent
innovations in banking instruments into the broader context of the
changing structure of international financial relationships.

New sets of financial contracts are the joint product of (1)
changes in technology and in the international macro environment of
asset prices; (2) the interplay of individual market participant's

existing financial exposures with their expectations for those prices;

*International Finance Division, Federal Reserve Board. This paper
represents the views of the authors and should not be interpreted as
reflecting the views of Board of Governors of the Federal Reserve System
or members of its staff.


- 21 -
whether financial intermediaries, as both providers of new contracts and
market participants, and individually or in aggregate, might become more
exposed to asset price fluctuations or act to redistribute risks
throughout the international financial system.

Proper management of foreign exchange risk has become much
more important since the floating rate period began. However, over the
last five and one-half years, with the dollar's substantial appreciation
and quick depreciation, the potential impact of foreign exchange gains
and losses on participants' profit and loss statements has been much
more significant. Firms increasingly seek financial contracts in a
variety of currencies. We see evidence of this desire in the greater
variety of publicized currency denominations for open-market financial
contracts.

There is a growing pool of non-dollar denominated Eurobonds.
There is a widening set of currencies in which foreign currency options
contracts are quoted, and not all options are quoted with respect to the
dollar. The European Currency Unit (ECU) is being used for loans, bond
denomination, and options. Some European market participants are
converting their entire financial statements to ECUs. Many of the
innovative financial contracts make it easier to finance and pay in
currencies other than the home currency of the market participant. But,
the currency characteristics of other available contracts mean that
firms need not remain exposed to "excess" foreign exchange risk.

The third general observation of the aggregate impact of
innovative financial contracts on international money and credit markets

is their increasingly multi-country character. While there is an


ABSTRACT

Tne following note presents a framework for analyzing
financial management techniques and financial Product innovation. The
framework attempts to illustrate how Characteristics of the economic
system and its participants motivate financing needs and encourage
innovations in financing techniques. New sets of financial contracts
are the joint product of (1) changes in technology and in the inter-
national macro environment of asset prices; (2) the interplay of
individual market participant's existing financial exposures; and (3)
the presence of fruitful cross-market arbitrage opportunities based on
differing national jurisdictions and structures. We use stylized
exainples to explore several different manifestations of this process and
we offer general observations on how financial innovation may change the
character of international money and credit markets. Finally, in
thinking about official attitudes toward the Process of innovation
policies, it is necessary to form a view of the counterfactual wor Id.

How would the world economies have functioned without innovation?


- 24 -

Introducing forward-looking contracts in a variety of
Currencies, and contracts with asymmetric payoffs, will likely affect
how expectations for asset prices are formed, how explicit policy
choices and domestic spillovers affect other countries, and how both
international and domestic markets react to exogenous events.

It appears that financial innovation increases the market's
efficiency in the provision of credit. However, because there are
differences in the roles, regulations, and official involvement with
financial firms, as opposed to those of non-financial firms, the
efficiency of the resulting allocation of risk is not clear. Finally,
in thinking about official attitudes toward the Process of innovation
and in contemplating restraining policies, it is necessary to form a
view of the counterfactual world. How would the world economies have

functioned without innovation?


-8-

Pay on retail deposits; retail deposits are the most common form of
household financial investment. It is understood by the national
authorities that if this ceiling becomes binding, it must be supple-
mented by other regulations (including exchange controls) to discourage
depository institutions from exploiting the low cost funds for their own
benefit as opposed to the benefit of the officially designated
beneficiaries. Such behavior might be the lending of funds raised in
the domestic retail market to international borrowers at a higher open
market interest rate. Even with strict capital controls, there are
Clear incentives to undertake financial transactions that are the
economic, but not the regulatory, equivalent of prohibited diversions of
credit. Historically, such activities might be booked as forward
foreign exchange transactions because the thinness of long-dated foreign
exchange markets made it difficult for financial regulators to detect
and prove that specific transactions were violations of credit control
regulations. Thus currency swap activities may, in some instances, be
appropriately viewed as an updated means by which a bank would increase
the covered return on its core deposits while avoiding regulatory
limitations on their deployment. However, even with strict adherence to
the spirit of regulations by financial firms, the plethora of national
tax and accounting practices and the diversity of national market
structures provide ample motivation for innovative cross-national
financial arrangements.

There is a key endogeneity not captured by our charts. While
unsatisfied financing imperatives and unexploited national arbitrage

opportunities generate financial innovations that resolve the immediate


-ll-
in interest rates and exchange rates (or are not responsible for forming
them), alternative financing plans should be considered. 9

The firm could entertain plans for two alternative
arrangements. Package 1 might include an interest rate swap (into a
fixed-rate obligation) and a long-dated foreign currency put option
(although such options are not often available longer than three years).
Package 2 contains only a cross currency swap that fixes the firm's net
return on its anticipated receipts of foreign currency. It assures the
home currency purchasing power of the foreign currency receivables and
no exposure to interest rate changes remains. By contrast, the first
package allows the firm to benefit from a weakening of its home currency
while protecting it from an appreciation. Therefore, in choosing the
first package, the firm only places a floor under its net return. A
minimum return on its investment is not only assured, but any volatility
serves only to increase the average return.

If the firm expects the home currency to weaken more than is
reflected in the market's forward rate, it probably makes sense to
purchase the first package. If the management of tne firm or the stock
market is very sensitive to volatility in the firm's earnings, the
second package might be preferred. No one of the two alternatives is

necessarily the best choice. The firm's actual financing choice will

SWe believe that it would be fruitful to extend our general
analysis to take into account the agency costs of the new financing
techniques. Such analysis would consider the conflicts arising from the
financial restructuring among the interests of a firm's creditors,
managers and shareholders. Jensen and Smith (1985) provide a possible
framework for such an extension.