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M S RAMAIAH INSTITUTE OF TECHNOLOGY

(AUTONOMOUS INSTITUTE, AFFILIATED TO VTU) M S R I T POST, BANGALORE – 560054

SEMINAR ON

“Financial Innovations – 2000’s”

BYPANKAJ SHARMA

1MS10MBA33

Under the guidance of Dr P V Ravindra

ProfessorDepartment of MBAMSRIT, Bangalore

Coordinated ByMrs.A.Mahalakshmi

Asst. Professor,Department of MBAMSRIT, Bangalore

FINANCIAL INNOVATIONS – 2000’s

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CONTENTS

Innovation (Meaning)

Financial Innovation (Definition)

Financial Engineering

Process of Financial Engineering

Financial Products and Services

Reference

Learning experience

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InnovationThe term innovation derives from the Latin word innovatus, which is the noun form of innovare "to renew or change," stemming from in—"into" +novus—"new". Although the term is broadly used, innovation generally refers to the creation of better or more effective products, processes, technologies, or ideas that are accepted by markets, governments, and society. Innovation differs from invention or renovation in that innovation generally signifies a substantial positive change compared to incremental changes.

Financial InnovationThere are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.

Why does financial innovation occur?Economic theory has much to say about what types of securities should exist, and why some may not exist (why some markets should be "incomplete") but little to say about why new types of securities should come into existence.

One interpretation of the Modigliani-Miller theorem is that taxes and regulation are the only reasons for investors to care what kinds of securities firms issue, whether debt, equity, or something else. The theorem states that the structure of a firm's liabilities should have no bearing on its net worth (absent taxes, etc.). The securities may trade at different prices depending on their composition, but they must ultimately add up to the same value.

Furthermore, there should be little demand for specific types of securities. The capital asset pricing model, first developed by Markowitz, suggests that investors should fully diversify and their portfolios should be a mixture of the "market" and a risk-free investment. Investors with different risk/return goals can use leverage to increase the ratio of the market return to the risk-free return in their portfolios. However, Richard Roll argued that this model was incorrect, because investors cannot invest in the entire market. This implies there should be demand for instruments that open up new types of investment opportunities (since this gets investors closer to being able to buy the entire market), but not for instruments that merely repackage existing risks (since investors already have as much exposure to those risks in their portfolio).

If the world existed as the Arrow-Debreu model posits, then there would be no need for financial innovation. The Arrow-Debreu model assumes that investors are able to purchase securities that pay off if and only if a certain state of the world occurs. Investors can then combine these securities to create portfolios that have whatever payoff they desire.

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The fundamental theorem of finance states that the price of assembling such a portfolio will be equal to its expected value under the appropriate risk-neutral measure.

Academic LiteratureTufano (2003) and Duffie and Rahi (1995) provide useful reviews of the literature.

The extensive literature on principal-agent problems, adverse selection, and information asymmetry points to why investors might prefer some types of securities, such as debt, over others like equity. Myers and Majluf (1984) develop an adverse selection model of equity issuance, in which firms (which are trying to maximize profits for existing shareholders) issue equity only if they are desperate. This was an early article in the pecking order literature, which states that firms prefer to finance investments out of retained earnings first, then debt, and finally equity, because investors are reluctant to trust any firm that needs to issue equity.

Duffie and Rahi also devote a considerable section to examining the utility and efficiency implications of financial innovation. This is also the topic of many of the papers in the special edition of theJournal of Economic Theory in which theirs is the lead article. The usefulness of spanning the market appears to be limited (or, equivalently, the disutility of incomplete markets is not great).

Allen and Gale (1988) is one of the first papers to endogenize security issuance contingent on financial regulation—specifically, bans on short sales. In these circumstances, they find that the traditional split of cash flows between debt and equity is not optimal, and that state-contingent securities are preferred. Ross (1989) develops a model in which new financial products must overcome marketing and distribution costs. Persons and Warther (1997) studied booms and busts associated with financial innovation.

The fixed costs of creating liquid markets for new financial instruments appears to be considerable. Black and Scholes (1974) describe some of the difficulties they encountered when trying to market the forerunners to modern index funds. These included regulatory problems, marketing costs, taxes, and fixed costs of management, personnel, and trading. Shiller (2008) describes some of the frustrations involved with creating a market for house price futures.

Historical examples of financial innovationExamples of spanning the market

Some types of financial instrument became prominent after macroeconomic conditions forced investors to be more aware of the need to hedge certain types of risk.

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The development of interest rate swaps in the early 1980s after interest rates skyrocketed. The development of credit default swaps in the early 2000s after the recession beginning

in 2001 led to the highest corporate-bond default rate in 2002 since the Great Depression.

Examples of mathematical innovation

The market in options exploded after the development of the Black–Scholes model in 1973.

The development of the CDO was heavily influenced by the popularization of the copula technique (Li 2000).

Flash trading exists since 2000 at the Chicago Board Options Exchange and 2006 in the equities market. In July 2010, Direct Edge became a U.S. Futures Exchange. Nasdaq and Bats Exchange, Inc created their own flash market in early 2009.

Futures, options, and many other types of derivatives have been around for centuries: the Japanese rice futures market started trading around 1730. However, recent decades have seen an explosion use of derivatives and mathematically-complicated securitization techniques. MacKenzie (2006) argues from a sociological point of view that mathematical formulas actually change the way that economic agents use and price assets. Economists, rather than acting as a camera taking an objective picture of the way the world works, actively change behavior by providing formulas that let dispersed agents agree on prices for new assets.

Examples of innovation to avoid taxes and regulation

Miller (1986) places great emphasis on the role of taxes and government regulation in stimulating financial innovation. Modigliani and Miller (1958) explicitly considered taxes as a reason to prefer one type of security over another, despite that corporation and investors should be indifferent to capital structure in a fractionless world.

The development of checking accounts at U.S. banks was in order to avoid punitive taxes on state bank notes that were part of the National Banking Act.

Some investors use total return swaps to convert dividends into capital gains, which are taxed at a lower rate.

Many times, regulators have explicitly discouraged or outlawed trading in certain types of financial securities. In the United States, gambling is mostly illegal, and it can be difficult to tell whether financial contracts are illegal gambling instruments or legitimate tools for investment and risk-sharing. The Commodity Futures Trading Commission is in charge

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of making this determination. The difficulty that the Chicago Board of Trade faced in attempting to trade futures on stocks and stock indexes is described in Melamed (1996).

In the United States, Regulation Q drove several types of financial innovation to get around its interest rate ceilings, including Eurodollars and NOW accounts.

The role of technology in financial innovationSome types of financial innovation are driven by improvements in computer and telecommunication technology. For example, Paul Volcker suggested that for most people, the creation of the ATM was a greater financial innovation than asset-backed securitization. Other types of financial innovation affecting the payments system include credit and debit cards and online payment systems like PayPal.

These types of innovations are notable because they reduce transaction costs. Households need to keep lower cash balances -- if the economy exhibits cash-in-advance constraints then these kinds of financial innovations can contribute to greater efficiency. Alvarez and Lippi (2009), using data on Italian households' use of debit cards, find that ownership of an ATM card results in benefits worth €17 annually.

These types of innovations may also have an impact on monetary policy by reducing real household balances. Especially with the increased popularity of online banking, households are able to keep greater percentages of their wealth in non-cash instruments. In a special edition of 'International Finance' devoted to the interaction of electronic commerce and central banking, Goodhart (2000) and Woodford (2000) express confidence in the ability of a central bank to maintain its policy goals by affecting the short-term interest rate even if electronic money has eliminated the demand for central bank liabilities, while Friedman (2000) is less sanguine.

Financial engineering Financial engineering is a multidisciplinary field relating to the creation of new

financial instruments and strategies, typically exotic options and specialized interest rate derivatives.

The field applies engineering methodologies to problems in finance, and employs financial theory and applied mathematics, as well as computation and the practice of programming.

Computational finance, also called financial engineering, is a cross-disciplinary field which relies on computational intelligence, mathematical finance, numerical methods and computersimulations to make trading, hedging and investment decisions,

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as well as facilitating the risk management of those decisions. Utilising various methods, practitioners of computational finance aim to precisely determine the financial risk that certain financial instruments create.

Process of Financial Engineering

Engineering is the application of science by using knowledge, mathematics and practical experience applied to the design of useful processes. 

Engineers are concerned with the implementation of solutions to practical problems.

Engineers want to know how to solve a problem and how to implement a solution.

Engineers create solutions to problems or improve upon existing solutions.

Engineers understand the relevant constraints in order to produce a successful result.

Financial Products and Services

1. Forward ContractIn finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets. Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures - such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded OTC; forward contracts specification can be customized and may include mark-to-market and daily margining. Hence, a forward contract

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arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.

1.1 PayoffsThe value of a forward position at maturity depends on the relationship between the delivery price (K) and the underlying price (ST) at that time.

For a long position this payoff is: fT = ST − K For a short position, it is: fT = K − ST

1.2 How a Forward Contracts works? Suppose that Bob wants to buy a house a year from now. At the same time, suppose

that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract.

At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000.

The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract.

In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say $114.4 million USD at the current rate—these two amounts are called the notional amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created, which is typical in derivative contracts.

1.3 Example of how forward prices should be agreed upon?

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Continuing on the example above, suppose now that the initial price of Andy's house is $100,000 and that Bob enters into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk free. So Andy would want at least $104,000 one year from now for the contract to be worthwhile for him - the opportunity cost will be covered.

1.4 Spot – forward parityFor liquid assets ("tradable"), spot-forward parity provides the link between the spot market and the forward market. It describes the relationship between the spot and forward price of the underlying asset in a forward contract. While the overall effect can be described as the cost of carry, this effect can be broken down into different components, specifically whether the asset:

pays income, and if so whether this is on a discrete or continuous basis incurs storage costs is regarded as

an investment asset, i.e. an asset held primarily for investment purposes (e.g. gold, financial securities);

Or a consumption asset, i.e. an asset held primarily for consumption (e.g. oil, iron ore etc.

1.4.1 Investment assetsFor an asset that provides no income, the relationship between the current forward (F0) and spot (S0) prices is

F0 = S0erT

Where r is the continuously compounded risk free rate of return, and T is the time to maturity. The intuition behind this result is that given you want to own the asset at time T, there should be no difference in a perfect capital market between buying the asset today and holding it and buying the forward contract and taking delivery. Thus, both approaches must cost the same in present value terms. For an arbitrage proof of why this is the case.

For an asset that pays known income, the relationship becomes:

Discrete: F0 = (S0 − I)erT

Continuous: F0 = S0e(r − q)T

Where is the present value of the discrete income at time t1 < T, and q% p.a. is the continuous dividend yield over the life of the contract. The intuition is that when an asset pays income, there is a benefit to holding the asset rather than the forward because you get to receive this income. Hence the income (I or q) must be subtracted to reflect this benefit. An example of an asset which pays discrete income might be a stock, and

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example of an asset which pays a continuous yield might be a foreign currency or a stock index.

For investment assets which are commodities, such as gold and silver, storage costs must also be considered. Storage costs can be treated as 'negative income', and like income can be discrete or continuous. Hence with storage costs, the relationship becomes:

Discrete: F0 = (S0 + U)erT

Continuous: F0 = S0e(r + u)T

Where U = Uer1ti is the present value of the discrete storage cost at time t1 < T, and u% p.a. is the storage cost where it is proportional to the price of the commodity, and is hence a 'negative yield'. The intuition here is that because storage costs make the final price higher, we have to add them to the spot price.

1.4.2 Consumption assetsConsumption assets are typically raw material commodities which are used as a source of energy or in a production process, for example crude oil or iron ore. Users of these consumption commodities may feel that there is a benefit from physically holding the asset in inventory as opposed to holding a forward on the asset. These benefits include the ability to profit from temporary shortages and the ability to keep a production process running, and are referred to as the convenience yield. Thus, for consumption assets, the spot-forward relationship is:

Discrete storage costs: F0 = (S0 + U)e(r − y)T

Continuous storage costs: F0 = S0e(r + u − y)T

Where y% p.a. is the convenience yield over the life of the contract. Since the convenience yield provides a benefit to the holder of the asset but not the holder of the forward, it can be modeled as a type of 'dividend yield'. However, it is important to note that the convenience yield is a non cash item, but rather reflects the market's expectations concerning future availability of the commodity. If users have low inventories of the commodity, this implies a greater chance of shortage, which means a higher convenience yield. The opposite is true when high inventories exist.

1.4.3 Cost of carryThe relationship between the spot and forward price of an asset reflects the net cost of holding (or carrying) that asset relative to holding the forward. Thus, all of the costs and benefits above can be summarized as the cost of carry, c. Hence,

Discrete: F0 = (S0 + U − I)e(r − y)T

Continuous: F0 = S0ecT, where c = r − q + u − y.

2. Floating Rate Notes (FRNs)

Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a spread. The spread is a rate that

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remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months, though counter examples do exist. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate  for that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%.

2.1 IssuersIn the U.S., government sponsored enterprises (GSEs) such as the federal Home Loan Banks, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are important issuers. In Europe the main issuers are banks.

2.3 VariationsSome FRNs have special features such as maximum or minimum coupons, called capped FRNs and floored FRNs. Those with both minimum and maximum coupons are called collared FRNs.

Perpetual FRNs are another form of FRNs that are also called irredeemable or unrated FRNs and are akin to a form of capital.

FRNs can also be obtained synthetically by the combination of a fixed rate bond and an interest rate swap. This combination is known as an Asset Swap.

Perpetual Notes (PRN) Variable Rate Notes (VRN) Structured FRN Reverse FRN Capped FRN Floored FRN Collared FRN Step up recovery FRN (SURF) Range/corridor/accrual notes Leveraged/Deleveraged FRNA deleveraged floating-rate note is one bearing a coupon that is the product of the index and a leverage factor, where the leverage factor is between zero and one. A deleveraged floater, which gives the investor decreased exposure to the underlying index, can be replicated by buying a pure FRN and entering into a swap to pay floating and receive fixed, on a notional amount of less than the face value of the FRN.

Deleveraged FRN = Long Pure FRN + Short (1 - Leverage factor) x Swap

A leveraged or super floater gives the investor increased exposure to an underlying index: the leverage factor is always greater than one. Leveraged floaters also require a floor, since the coupon rate can never be negative.

Leveraged FRN = Long Pure FRN + Long (Leverage factor - 1) x Swap + Long (Leverage factor) x Floor

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2.4 RiskFRNs carry little interest rate risk. A FRN has a duration close to zero, and its price shows very low sensitivity to changes in market rates. When market rates rise, the expected coupons of the FRN increase in line with the increase in forward rates, which means its price remains constant. Thus, FRNs differ from fixed rate bonds, whose prices decline when market rates rise.

As FRNs are almost immune to interest rate risk, they are considered conservative investments for investors who believe market rates will increase. The risk that remains is credit risk.

2.5 TradingSecurities dealers make markets in FRNs. They are traded over-the-counter, instead of on a stock exchange. In Europe, most FRNs are liquid, as the biggest investors are banks. In the US, FRNs are mostly held to maturity, so the markets aren't as liquid. In the wholesale markets, FRNs are typically quoted as a spread over the reference rate.

2.6 ExampleSuppose a new 5 year FRN pays a coupon of 3 months LIBOR +0.20%, and is issued at par (100.00). If the perception of the credit-worthiness of the issuer goes down, investors will demand a higher interest rate, say LIBOR +0.25%. If a trade is agreed, the price is calculated. In this example, LIBOR +0.25% would be roughly equivalent to a price of 99.75. This can be calculated as par, minus the difference between the coupon and the price that was agreed (0.05%), multiplied by the maturity (5 year).

2.7 Simple MarginThe simple margin is a measure of the return of a FRN.

We first compute the "effective spread"

Which gives a measure of the "effective spread" over the variable coupon rate. Here the capital gain (or loss) of the FRN is taken into account, and divided over the total number of years until maturity.

The simple margin is calculated as this "effective spread" adjusted for the fact that we buy the FRN at a discount or premium to the nominal value:

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3. Yankee Bond

1. A Yankee bond is a US dollar denominated bond issued in the US by a foreign issuer.

2. The reasons for issuing a Yankee bond are much the same as for other foreign currency bonds, but:

The size of the US bond market makes it attractive to borrowers who wish to raise very large amounts. These include countries issuing sovereign debt.

The size of the US economy and the common use of the dollar in international trade means that many companies have dollar income streams with which to pay dollar debt.

3. Issuing and trading bonds in the US makes the issuer subject to US regulation. Complying with this is very expensive. This is one reason for the issue of, and trading in, US dollar bonds off-shore.

4. Finacle Finacle universal banking products are designed to address the core banking, e-banking, Islamic banking, treasury, wealth management and CRM requirements of retail, corporate and universal banks. It is developed by Infosys, and is one of the major players in the arena of core banking in Indian and Asian banking domains. T.V. Mohandas Pai was closely associated with it.

4.1 ServicesProviding support & services is typical in such huge software implementations. Services provided by Infosys for the maintenance of the application include.

Application development and maintenance Application management Independent validation Migration services Performance tuning Software performance engineering System integration Value mining

4.2 Awards

Judges’ Special Achievement Award : Banking Technology Awards 2008 ‘Highly Commended’ in the ‘Best Core Banking Product’ category for the Banking

Technology Readers’ Choice Award : Banking Technology Awards 2008 CII - EXIM Bank Award For Business Excellence 2008

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Asian Banker award for best core banking implementation - 2008 Asian Bankers 2007 IT Implementation awards Commended in the Back-office Retail Banking Project category by the Banker

Technology Awards 2007 Asian Bankers Awards 2006 for large and mid size core banking implementations Winner in CRM Category - The Banker Technology Awards 2005

4.3 Recognition

Positioned in the Leaders Quadrant in the Gartner Magic Quadrant for International Retail Core Banking Solution - 2010

Positioned in the Leaders Quadrant in the Gartner Magic Quadrant for International Retail Core Banking Solution - 2009

Leader in the January 2009 report, “The Forrester Wave: Global Banking Platforms, Q1 2009”

Positioned in the Leaders Quadrant in the Gartner Magic Quadrant for International Retail Core Banking Solution - 2008

Positioned in the Leaders Quadrant in the Gartner Magic Quadrant for International Retail Core Banking Solution - 2006

Finacle from Infosys emerges as a leader in retail banking platform study

5. Index FundAn index fund or index tracker is a collective investment scheme (usually a mutual fund or exchange-traded fund) that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.

5.1 Tracking

Tracking can be achieved by trying to hold all of the securities in the index, in the same proportions as the index. Other methods include statistically sampling the market and holding "representative" securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities are purchased or sold and is therefore a form of passive management.

5.2 Fees

The lack of active management generally gives the advantage of lower fees and lower taxes in taxable accounts. Of course, the fees reduce the return to the investor relative to the index.

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In addition it is usually impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is known as the "tracking error" or informally "jitter".

Index funds are available from many investment managers. Some common indices include the S&P 500, the Nikkei 225, and the FTSE 100. Less common indexes come from academics like Eugene Fama and Kenneth French, who created "research indexes" in order to develop asset pricing models, such as their Three Factor Model. The Fama-French three-factor model is used by Dimensional Fund Advisors to design their index funds. Robert Arnott and Professor Jeremy Siegel have also created new competing fundamentally based indexes based on such criteria as dividends, earnings, book, and sales.

5.3 Origins

In 1973, Burton Malkiel wrote A Random Walk Down Wall Street, which presented academic findings for the lay public. It was becoming well known in the lay financial press that most mutual funds were not beating the market indices.

John Bogle graduated from Princeton University in 1951, where his senior thesis was titled: "Mutual Funds can make no claims to superiority over the Market Averages." Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelson's 1974 paper, "Challenge to Judgment", Charles Ellis' 1975 study, "The Loser's Game", and Al Ehrbar's 1975 Fortune magazine article on indexing. Bogle founded The Vanguard Group in 1974; it is now the largest mutual fund company in the United States as of 2009.

Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being "un-American" and the fund itself was seen as "Bogle's folly". Fidelity Investments Chairman Edward Johnson was quoted as saying that he "[couldn't] believe that the great masses of investors are going to be satisfied with receiving just average returns".  Bogle's fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor's 500 Index. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999; this astonishing increase was funded by the market's increasing willingness to invest in such a product. Bogle predicted in January 1992 that it would very likely surpass the Magellan before 2001, which it did in 2000.

John McQuown and David G. Booth at Wells Fargo and Rex Sinquefield at American National Bank in Chicago both established the first Standard and Poor's Composite Index Funds in 1973. Both of these funds were established for institutional clients; individual investors were excluded. Wells Fargo started with $5 million from their own pension fund,

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while Illinois Bell put in $5 million of their pension funds at American National Bank. In 1971, Jeremy Grantham and Dean LeBaron at Batterymarch Financial Management "described the idea at a Harvard Business School seminar in 1971, but found no takers until 1973. For its efforts, Batterymarch won the "Dubious Achievement Award" from Pensions & Investments magazine in 1972. Two years later, in December 1974, the firm finally attracted its first index client."

In 1981, David Booth and Rex Sinquefield started Dimensional Fund Advisors (DFA), and McQuown joined its Board of Directors many years later. DFA further developed indexed based investment strategies.

Wells Fargo sold its indexing operation to Barclay's Bank of London, and it now operates as Barclays Global Investors; it is one of the world's largest money managers.

5.4 Economic Theory

Economist Eugene Fama said, "I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information." A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always 0 (Grossman and Stiglitz (1980))." A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed marginal costs (Jensen (1978)). Economists cite the efficient-market hypothesis (EMH) as the fundamental premise that justifies the creation of the index funds. The hypothesis implies that fund managers and stock analysts are constantly looking for securities that may out-perform the market; and that this competition is so effective that any new information about the fortune of a company will rapidly be incorporated into stock prices. It is postulated therefore that it is very difficult to tell ahead of time which stocks will out-perform the market. By creating an index fund that mirrors the whole market the inefficiencies of stock selection are avoided.

In particular the EMH says that economic profits cannot be wrung from stock picking. This is not to say that a stock picker cannot achieve a superior return, just that the excess return will on average not exceed the costs of winning it (including salaries, information costs, and trading costs). The conclusion is that most investors would be better off buying a cheap index fund. Note that return refers to the ex-ante expectation; ex-post realization of payoffs may make some stock-pickers appear successful. In addition there have been many criticisms of the EMH.

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5.5 Indexing Methods

5.5.1 Traditional Indexing

Indexing is traditionally known as the practice of owning a representative collection of securities, in the same ratios as the target index. Modification of security holdings happens only when companies periodically enter or leave the target index.

5.5.2 Synthetic Indexing

Synthetic indexing is a modern technique of using a combination of equity index futures contracts and investments in low risk bonds to replicate the performance of a similar overall investment in the equities making up the index. Although maintaining the future position has a slightly higher cost structure than traditional passive sampling, synthetic indexing can result in more favorable tax treatment, particularly for international investors who are subject to U.S. dividend withholding taxes. The bond portion can hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing.

5.5.3 Enhanced Indexing

Enhanced indexing is a catch-all term referring to improvements to index fund management that emphasize performance, possibly using active management. Enhanced index funds employ a variety of enhancement techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies. The cost advantage of indexing could be reduced or eliminated by employing active management. Enhanced indexing strategies help in offsetting the proportion of tracking error that would come from expenses and transaction costs. These enhancement strategies can be:

lower cost, issue selection, yield curve positioning, Sector and quality positioning and call exposure positioning.

5.6 Advantages

5.6.1 Low costs

Because the composition of a target index is a known quantity, it costs less to run an index fund. No highly paid stock pickers or analysts are needed. Typically expense ratios of an index fund ranges from 0.15% for U.S. Large Company Indexes to 0.97% for Emerging Market Indexes. The expense ratio of the average large cap actively managed mutual fund as of 2005 is 1.36%. If a mutual fund produces 10% return before expenses, taking account of

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the expense ratio difference would result in an after expense return of 9.85% for the large cap index fund versus 8.64% for the actively managed large cap fund.

5.6.2 Simplicity

The investment objectives of index funds are easy to understand. Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly. Managing one's index fund holdings may be as easy as rebalancing every six months or every year.

5.6.3 Lower turnovers

Turnover refers to the selling and buying of securities by the fund manager. Selling securities in some jurisdictions may result in capital gains tax charges, which are sometimes passed on to fund investors. Even in the absence of taxes, turnover has both explicit and implicit costs, which directly reduce returns on a dollar-for-dollar basis. Because index funds are passive investments, the turnovers are lower than actively managed funds. According to a study conducted by John Bogle over a sixteen-year period, investors get to keep only 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners.

5.6.4 No Style drift

Style drift occurs when actively managed mutual funds go outside of their described style (i.e. mid-cap value, large cap income, etc.) to increase returns. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolio's diversity and subsequently increase risk. With an index fund, this drift is not possible and accurate diversification of a portfolio is increased.

5.7 Disadvantages

5.7.1 Possible tracking error from index

Since index funds aim to match market returns, both under- and over-performance compared to the market is considered a "tracking error". For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the market.

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According to The Vanguard Group, a well run S&P 500 index fund should have a tracking error of 5 basis points or less, but a Morningstar survey found an average of 38 basis points across all index funds.

5.7.2 Cannot outperform the target index

By design, an index fund seeks to match rather than outperform the target index. Therefore, a good index fund with low tracking error will not generally outperform the index, but rather produces a rate of return similar to the index minus fund costs.

5.7.3 Index composition changes reduce return

Whenever an index changes, the fund is faced with the prospect of selling all the stock that has been removed from the index, and purchasing the stock that was added to the index. The S&P 500 index has a typical turnover of between 1% and 9% per year.

In effect, the index, and consequently all funds tracking the index, are announcing ahead of time the trades that they are planning to make. As a result, the price of the stock that has been removed from the index tends to be driven down, and the price of stock that has been added to the index tends to be driven up, in part due to arbitrageurs, in a practice known as "index front running". The index fund, however, has suffered market impact costs because they had to sell stock whose price was depressed, and buy stock whose price was inflated. These losses can be considered small, however, relative to an index fund's overall advantage gained by low costs.

5.8 Diversification

Diversification refers to the number of different securities in a fund. A fund with more securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces volatility by decreasing the impact of large price swings above or below the average return in a single security. A Wilshire 5000 index would be considered diversified, but a bio-tech ETF would not.

Since some indices, such as the S&P 500 and FTSE 100, are dominated by large company stocks, an index fund may have a high percentage of the fund concentrated in a few large companies. This position represents a reduction of diversity and can lead to increased volatility and investment risk for an investor who seeks a diversified fund.

Some advocate adopting a strategy of investing in every security in the world in proportion to its market capitalization, generally by investing in a collection of ETFs in proportion to their

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home country market capitalization. A global indexing strategy may outperform one based only on home market indexes because there may be less correlation between the returns of companies operating in different markets than between companies operating in the same market.

5.9 Asset allocation and achieving balance

Asset allocation is the process of determining the mix of stocks, bonds and other classes of investable assets to match the investor's risk capacity, which includes attitude towards risk, net income, net worth, knowledge about investing concepts, and time horizon. Index funds capture asset classes in a low cost and tax efficient manner and are used to design balanced portfolios.

A combination of various index mutual funds or ETFs could be used to implement a full range of investment policies from low risk to high risk.

5.10 Comparison of index funds with index ETFs

In the United States, mutual funds price their assets by their current value every business day, usually at 4:00 p.m. Eastern time, when the New York Stock Exchange closes for the day. Index ETFs, on the other hand, are priced during normal trading hours, usually 9:30 a.m. to 4:00 p.m. Eastern Time.

5.11 U.S. Capital gain tax consideration

U.S. mutual funds are required by law to distribute realized capital gains to their shareholders. If a mutual fund sells a security for a gain, the capital gain is taxable for that year; similarly a realized capital loss can offset any other realized capital gains.

Scenario: An investor entered a mutual fund during the middle of the year and experienced an overall loss for the next 6 months. The mutual fund itself sold securities for a gain for the year, therefore must declare a capital gains distribution. The IRS would require the investor to pay tax on the capital gains distribution, regardless of the overall loss.

A small investor selling an ETF to another investor does not cause redemption on ETF itself; therefore, ETFs are more immune to the effect of forced redemptions causing realized capital gains.

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6. New Jeevan Suraksha I

6.1 Features

6.1.1 Product summary: These are Deferred Annuity plans that allow the policyholder to make provision for regular income after the selected term.

6.1.2 Premiums: Premiums are payable yearly, half-yearly, quarterly, monthly or through Salary deduction, as opted by you, throughout the term of the policy or till earlier death. Alternatively, the premium may be paid in one lump sum (single premium).

6.1.3 Tax Benefits:Tax relief under Section 80ccc is available on premiums paid under New Jeevan Suraksha I (Table No.147). The premiums paid under New Jeevan Dhara I (Table No.148) qualify for tax relief under Section 88.

6.1.4 Bonuses:These are with-profit plans and participate in the profits of the Corporation’s annuity / pension business. Policies get a share of the profits in the form of bonuses. Simple Reversionary Bonuses are declared per thousand Sum Assured annually at the end of each financial year.  Once declared, they form part of the guaranteed benefits of the plan. Final (Additional) Bonuses may also be payable provided policy has run for a certain minimum period.

6.2 Benefits

6.2.1 On vesting:

The Notional Cash Option together with Reversionary Bonuses and Final additional Bonuses ( if any ) with or without 25% commutation will be compulsorily converted into annuity having following options.

Annuity for life.

Annuity for life with guaranteed period of 5, 10, 15, 20 years.

Joint life and last survivor annuity to the annuitant and his/her spouse under which annuity payable to the spouse on death of the purchaser will be 50% of that payable to the annuitant.

Life annuity with return of purchase price.

Life annuity with annuities increasing at a simple rate of 3% per annum.

T he annuity rates will be that available under the version of the New Jeevan Akshaya Plan current at the date of vesting. A rebate of 3% will be available on the purchase

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price of the New Jeevan Akshaya Policy. Option for the annuity type is to be exercised at least 6 months before the date of vesting.

6.2.2 During Deferment:

A term rider option will be available. On the death of the policyholder who has opted for the term Assurance rider ( provided the policy is in-force), the Term Assurance Sum Assured along with all premiums ( excluding term Assurance premium and extra premium if any ) paid up to the date of death accumulated at the rate of 5% p.a. compounding or at such rates as decided by the Corporation from time to time will be paid to the nominee. When the policy is not in-force, only return of premiums with interest as stated above will be available.

For those not opting for the Term Assurance Rider, in respect of policies which are in-force or in a paid up condition, all premium accumulated at 5% p.a. compounding or at such rates as decided by the Corporation from time to time, will be paid to the nominee. Term Rider Option will be available only on the Annual Premium Plan.

6.2.3 Rebates:

Premium will be payable yearly, half-yearly, quarterly or monthly (including SSS) or by single premium. Mode rebates @ 2.6%, 1.3% and 0.5% of the tabular annual premium will be available for yearly, half- yearly and quarterly premiums.

For large cash option the rebates available are:

AMOUNT (Rs)>=1,00,000 < 2,00,000

>=2,00,000 < 5,00,000

>= 5,00,000

Rebates Available for Single Premium

3% 4% 5%

Rebates Available for Annual Premium

6% 7% 8%

Both rebates will be applied separately on the Tabular Premium and not after the other has been applied.

6.2.4 Paid up, Guaranteed and Special Surrender Value.

For Annual Premium Plans: The Guaranteed Surrender Value will be equal to 90% of all premiums paid excluding the first year premium, all Term Assurance premium and extra premium ( if any). This will be allowed after at least two full years’ premiums have been paid and will be available after two full years have been completed from the date of commencement. However, the policy can not be surrendered after the annuity vests.

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For Single Premium Plan: The Guaranteed Surrender Value will be 90% of the single premium paid. Surrender will be allowed 2 years after the commencement of the policy.

Special Surrender Value: For Annual premium policy this will be available at least two years after date of commencement and during deferment period if at least two full years’ premium have been paid.

Note: For Single premium policies, this will be available one year after the date of commencement and during the deferment period. The special surrender value will be quoted separately. Surrender value will not be available for the Term Rider Benefit.

6.2.5 Days of Grace:

The days of grace will be one calendar month but not less than 30 days under the yearly, half-yearly and quarterly modes of payment of premium. For monthly mode, the days of grace will be 15 days.

6.2.6 Non-forfeiture regulations:

Paid up benefits:

If, after at least two full years premiums are paid in respect of this policy, any subsequent premium be not duly paid, the policy shall not be wholly void, but the amount of Notional Cash Option shall be reduced to such a sum as shall bear same ratio to the original, as the number of premiums actually paid shall bear to the total number of premiums originally stipulated for in the policy. The policy so reduced will thereafter be free from all liabilities for payment of the within mentioned premiums but shall not be entitled to participate in future profits. The existing vested Bonus additions will attach to the reduced paid up policy and this will determine the reduced annuity payable on vesting. The option of commutation of 25% pension will also be available on the vesting age. If however the annuity payable is less than the minimum of Rs. 250/-, the Corporation will have the right to change the mode of payment of annuity to yearly, half-yearly or quarterly or to pay a lump sum subject to deduction of tax if any, at source as per the prevailing taxation rules. In the event of non-payment of the premiums within the days of grace the life cover will cease.

Note: Paid up benefits are not available for the Term Rider Option.

The days of grace will be one calendar month but not less than 30 days under the yearly, half-yearly and quarterly modes of payment of premium. For monthly mode, the days of grace will be 15 days.

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6.2.7 Non-forfeiture regulations:

Paid up benefits:

If, after at least two full years premiums are paid in respect of this policy, any subsequent premium be not duly paid, the policy shall not be wholly void, but the amount of Notional Cash Option shall be reduced to such a sum as shall bear same ratio to the original, as the number of premiums actually paid shall bear to the total number of premiums originally stipulated for in the policy. The policy so reduced will thereafter be free from all liabilities for payment of the within mentioned premiums but shall not be entitled to participate in future profits. The existing vested Bonus additions will attach to the reduced paid up policy and this will determine the reduced annuity payable on vesting. The option of commutation of 25% pension will also be available on the vesting age. If however the annuity payable is less than the minimum of Rs. 250/-, the Corporation will have the right to change the mode of payment of annuity to yearly, half-yearly or quarterly or to pay a lump sum subject to deduction of tax if any, at source as per the prevailing taxation rules. In the event of non-payment of the premiums within the days of grace the life cover will cease.

Note: Paid up benefits are not available for the Term Rider Option.

6.2.8 Loans/Assignment:

There is no provision for loans or assignments under this plan.

6.2.9 Revival:

Policies with Term Assurance Rider:Rules relating to the revival of the Term Assurance Rider will apply.

Policy without the Term Assurance Rider:Policies can be revived at any time on payment of all arrears of premiums with interest @ 10.5% p.a. compounding half yearly. This rate of interest is likely to change from time to time.

i) For Term Assurance Option:Maximum Term Assurance Sum Assured would be equal to twice the Notional Cash Option subject to a maximum of Rs. 25,00,000 (overall limit on riders on all plans).

Minimum Term Assurance Sum Assured : Rs. 1,00,000

Maximum age at entry 50

Minimum Term 10 years.

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Maximum Term 35 years.

Note: Term Assurance Rider cover ceases at age 60 years.

6.2.10 INCOME TAX PROVISIONS UNDER NEW JEEVAN SURAKSHA –I PLAN

1. New Jeevan Suraksha-I is a scheme approved by IRDA as envisaged in Section 10(23 AAB) of the Act.

2. The income of the fund maintained under this pension scheme is totally exempt from income tax being a fund maintained under section 10(23 AAB) of the Act.

3. The deduction under Section 80CCC is available up to a sum of Rs.10,000/- to the assessee, who is an individual in respect of any sum deposited by him into the above plan.

4. The deduction under Section 80 CCC is not available to a Hindu Undivided family.

Note: As such the amount of premium paid by an individual for a policy under New Jeevan Suraksha-I Plan will be eligible for income tax deduction as per rules under Section 80CCC.

6.3 Benefit Illustration

Statutory Warning:“Some benefits are guaranteed and some benefits are variable with returns based on the future performance of your insurer carrying on life insurance business.  If your policy offers guaranteed returns then these will be clearly marked “guaranteed” in the illustration table on this page.  If your policy offers variable returns then the illustrations on this page will show two different rates of assumed future  investment returns.  These assumed rates of return are not guaranteed and they are not upper or lower limits of what you might get back as the value of your policy is dependent on a number of factors including future investment performance.”

Illustration 1Table No. 147/148 Age at entry: 35 yearsPolicy Term: 25 yearsPremium paying term: 25 yearsSum Assured: Rs. 1,00,000/-Yearly Premium: Rs. 3,130/-

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Year

Total premiums paid till end of year

Benefit on death payable at the end of year (Rs.)

GuaranteedVariable Total

Scenario 1 Scenario 2 Scenario 1 Scenario 2

1 3130 3130 79 188 3209 3318

2 6260 6260 238 576 6498 6836

3 9390 9390 479 1174 9869 10564

4 12520 12520 804 1996 13324 14516

5 15650 15650 1216 3055 16866 18705

6 18780 18780 1716 4366 20496 23146

7 21910 21910 2308 5943 24218 27853

8 25040 25040 2992 7803 28032 32843

9 28170 28170 3771 9961 31941 38131

10 31300 31300 4648 12438 35948 43738

15 46950 46950 15568 37222 62518 84172

20 62600 62600 29027 74718 91627 137318

25 78250 78250 78250 168913 145787 247163

 

Maturity Guaranteed Variable Total

   Scenario 1

Scenario 2

Scenario 1

Scenario 2

25 78250 100000 53000 156500 153000 256500

Illustration 2:Table No. 147/148 Age at entry: 35 yearsPolicy Term: 25 yearsSum Assured (Rs.): 100000Single Premium (Rs.): 41,327

 

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Year

Total premiums paid till end of year

Benefit on death payable at the end of year (Rs.)

Guaranteed

Variable Total

Scenario 1

Scenario 2

Scenario 1

Scenario 2

1 41327 41327 1033 2479 42360 43806

2 41327 41327 2092 5108 43419 46435

3 41327 41327 3177 7894 44504 49221

4 41327 41327 4290 10847 45617 52174

5 41327 41327 5431 13978 46758 55305

6 41327 41327 6599 17296 47926 58623

7 41327 41327 7798 20813 49125 62140

8 41327 41327 9026 24542 50353 65869

9 41327 41327 10285 28494 51612 69821

10 41327 41327 11575 32683 32683 74010

15 41327 41327 27910 72695 69237 114022

20 41327 41327 40905 118595 82232 159922

25 41327 41327 82878 241699 124205 283026

Maturity Benefit

 Benefit Payable at Maturity

Guaranteed

Variable Total

Scenario 1

Scenario 2

Scenario 1

Scenario 2

25 41327 100000 36500 216500 136500 316500

i) This illustration is applicable to a non-smoker male/female standard (from medical, life style and occupation point of view) life.

ii) The non-guaranteed benefits (1) and (2) in above illustration are calculated so that they are consistent with the Projected Investment Rate of Return assumption of 6% p.a.(Scenario 1) and 10% p.a. (Scenario 2) respectively.  In other words, in preparing this benefit illustration, it is assumed that the Projected Investment Rate of Return that LICI will be able to earn throughout the term of the policy will be 6% p.a. or 10% p.a., as the case may be.  The Projected Investment Rate of Return is not guaranteed.

iii) The main objective of the illustration is that the client is able to appreciate the features of the product and the flow of benefits in different circumstances with some level of quantification.

iv) Future bonus will depend on future profits and as such is not guaranteed. However, once bonus is declared in any year and added to the policy, the bonus so added is guaranteed.

v) The maturity sum shown in the illustration is to be annuitized. However, the policyholder can opt to take up to one-fourth of the maturity sum as a tax-free lump sum.

7. Government Securities (G-Sec):In India G- Secs are issued by the Central Government, State Governments and Semi Government Authorities such as municipalities, port trusts, state electricity boards and public sector corporations.  The Central and State Governments raise money through these securities to finance the creation of new infrastructure as well as to meet their current cash needs.  Since these are issued by the government, the risk of default is minimal. Therefore, interest rates on these securities often serve as a benchmark for the level of interest rates in the economy. Other issuers may price their offerings by `marking up’ this benchmark rate to reflect the credit risk specific to them.

These securities may have maturities ranging from five to twenty years.   These are fixed income securities, which pay interest every six months.  The Reserve Bank of India manages the issues of the securities. These securities are sold in the primary market mainly through the auction mechanism. The RBI notifies issue of a new   tranche of securities. Prospective buyers submit their bids. The RBI decides to accept bids based on a cut off price.

The G -secs are primarily bought by the institutional investors. The biggest investors are commercial banks who invest in G-secs to meet the regulatory requirement to maintain a certain percentage of Statutory Liquidity Ratio (SLR) as well as an investment vehicle. Insurance companies, provident funds, and mutual funds are the other large investors. The Primary Dealers perform the function of market makers through buying and selling activities.

The Government of India also borrows short term funds for up to one year.  This is through the issue of Treasury Bills which are sold at a discount to the face value and redeemed at the full face value.

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8. Weather DerivativesWeather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. The difference from other derivatives is that the underlying asset (rain/temperature/snow) has no direct value to price the weather derivative.

8.1 Overview of usersFarmers can use weather derivatives to hedge against poor harvests caused by drought or frost; theme parks may want to insure against rainy weekends during peak summer seasons; and gas and power companies may use heating degree days (HDD) or cooling degree days (CDD) contracts to smooth earnings. A sports event managing company may wish to hedge the loss by entering into a weather derivative contract because if it rains the day of the sporting event, fewer tickets will be sold.

Heating degree days are one of the most common types of weather derivative. Typical terms for an HDD contract could be: for the November to March period, for each day where the temperature rises above 18 degrees Celsius keep a cumulative count of the difference between 18 degrees and the average daily temperature. Depending upon whether the option is a put option or a call option, pay out a set amount per heating degree day that the actual count differs from the strike.

8.3 ValuationThere is no standard model for valuing weather derivatives similar to the Black-Scholes formula for pricing European style equity option and similar derivatives. That is due to the fact that underlying asset of the weather derivative is non-tradable which violates a number of key assumptions of the BS Model. Typically weather derivatives are priced in a number of ways:

8.3.1 Business pricingBusiness pricing requires the company utilizing weather derivative instruments to understand how its financial performance is affected by adverse weather conditions across variety of outcomes (i.e. obtain a utility curve with respect to particular weather variables). Then the user can determine how much he is willing to pay in order to protect his/her business from those conditions in case they occurred based on his/her cost-benefit analysis and appetite for risk. In this way a business can obtain a 'guaranteed weather' for the period in question, largely reducing the expenses/revenue variations due to weather. Alternatively, an investor seeking certain level or return for certain level of risk can determine what price he is willing to pay for bearing particular outcome risk related to a particular weather instrument.

8.3.2 Historical pricing (Burn analysis)The historical payout of the derivative is computed to find the expectation. The method is very quick and simple, but does not produce reliable estimates and could be used only as a

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rough guideline. It does not incorporate variety of statistical and physical features characteristic of the weather system.

8.4 Index modelingThis approach requires building a model of the underlying index, i.e. the one upon which the derivative value is determined (for example monthly/seasonal cumulative heating degree days). The simplest way to model the index is just to model the distribution of historical index outcomes. We can adopt parametric or non-parametric distributions. For monthly cooling and heating degree days assuming a normal distribution is usually warranted. The predictive power of such model is rather limited. A better result can be obtained by modelling the index generating process on a finer scale. In the case of temperature contracts a model of the daily average (or min and max) temperature time series can be built. The daily temperature (or rain, snow, wind, etc.) model can be built using common statistical time series models (i.e. ARMA or Fourier transform in the frequency domain) purely based only on the features displayed in the historical time series of the index. A more sophisticated approach is to incorporate some physical intuition/relationships into our statistical models based on spatial and temporal correlation between weather occurring in various parts of the ocean-atmosphere system around the world (for example we can incorporate the effects of El Niño on temperatures and rainfall).

8.4.1 Physical models of the weatherWe can utilize the output of numerical weather prediction models based on physical equation describing relationships in the weather system. Their predictive power tends to be less or similar to purely statistical models beyond time horizons of 10–15 days. Ensemble forecasts are especially appropriate for weather derivative pricing within the contract period of a monthly temperature derivative. However, individuals members of the ensemble need to be 'dressed' (for example with Gaussian kernels estimated from historical performance) before a reasonable probabilistic forecast can be obtained.

8.4.2 Mixture of statistical and physical modelsA superior approach for modelling daily or monthly weather variable time series is to combine statistical and physical weather models using time-horizon varying weight which are obtained after optimization of those based on historical out-of-sample evaluation of the combined model scheme performance.

9. Reverse MortgageA remortgage is a form of equity release (or lifetime mortgage) available in the United States. It is a loan available to seniors aged 62 or older, under a Federal program administered by HUD. It enables eligible homeowners to access a portion of their equity. The homeowners can draw the mortgage principal in a lump sum, by receiving monthly payments over a specified term or over their (joint) lifetimes, as a revolving line of credit, or some combination thereof. The homeowners' obligation to repay the loan is deferred until owner

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(or survivor of two) dies, the home is sold, they cease to live in the property, or they breach the provisions of the mortgage (such as failure to maintain the property in good repair, pay property taxes, and keep the property insured against fire etc). The owner can be out of the home for up to 364 consecutive days (i.e., into aged care).

In a conventional mortgage the homeowner makes a monthly amortized payment to the lender; after each payment the equity increases by the amount of the principal included in the payment, and when the mortgage has been paid in full the property is released from the mortgage. In a reverse mortgage, the home owner is under no obligation to make payments, but is free to do so with no pre-payment penalties. The line of credit portion operates like a revolving credit line, so a payment in reduction of a line of credit, increases the available credit by the same amount. Interest that accrues is added to the mortgage balance.

Title to the property remains in the name of the homeowners, to be disposed of as they wish, encumbered only by the amount owing under the mortgage

If a property has increased in value after a reverse mortgage is taken out, it is possible to acquire a second (or third) reverse mortgage over the increased equity in the home in some areas. However most lenders do not like to take a second or third lien position behind a reverse mortgage because its balance increases with time. It is rare to find reverse mortgages with subordinate liens behind them as a result. A reverse mortgage may be refinanced if enough equity is present in the home, and in some cases may qualify for a streamline refinance if the interest rate is reduced.

A reverse mortgage lien is often recorded at a higher dollar amount than the amount of money actually disbursed at the loan closing. This recorded lien is at times misunderstood by some borrowers as being the payoff amount of the mortgage. The recorded lien works in similar fashion to a home equity line of credit where the lien represents the maximum lending limit, but the payoff is calculated based on actual disbursements plus interest owing.

9.1 Reverse mortgage proceedsThe amount of money available to the consumer is determined by five primary factors:

The appraised value of the property, whether any health or safety repairs need to be made to the house, and whether there are any existing liens on the house.

The interest rate, as determined by the U.S. Treasury 1 year T-Bill, the LIBOR index or 1 Year CMT.

The age of the senior (The older the senior is, the more money he/she will receive). Whether the payment is taken as line of credit, lump sum, or monthly payments. Line of

credit will maximize the money available, while lump sum provides the cash immediately, but the interest fees are the highest. Monthly payments may be set up as "Tenure" payments, which are paid to borrowers for the rest of their lives, no matter how long they live, or "Term" payments, which last for a predetermined period.

The value of the property, and whether that value is higher than the national loan limit set by HUD.

All these factors contribute to the Total Annual Lending Cost (TALC) as defined by the US Federal Government Regulation Z, the single rate which includes all the loan costs. The specific formulas to calculate the impact of the factors listed above can be found in Appendix 22 of the HUD Handbook 4235.1.

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There are reverse mortgages for homes valued over the maximum limit. These are called "Jumbo" reverse mortgages, and are generally offered as proprietary reverse mortgages. For homeowners of higher-valued homes, a Jumbo loan can provide a larger loan amount. However, these loans are currently uninsured by the FHA and their fees are often higher.

The money received (loan advances) from a reverse mortgage is not taxable and does not directly affect Social Security or Medicare benefits. However, an American Bar Association guide to reverse mortgages explains that if borrowers receive Medicaid, SSI, or other public benefits, loan advances will be counted as "liquid assets" if the money is kept in an account (savings, checking, etc.) past the end of the calendar month in which it is received. The borrower could then lose eligibility for such public programs if his or her total liquid assets (cash, generally) is then greater than those programs allow.

It is important to note that the homeowner must ensure that taxes and insurance are kept current at all times. If either taxes or insurance lapse, it could result in a default on the reverse mortgage.

Once the reverse mortgage is established, there are no restrictions on how the funds are used. In addition to the tenure monthly payments, the borrower has the option of moving the entire amount of money into investments, or they can simply take the money and spend it as they wish.

Among the options of interest bearing instruments, the borrower can keep them with the lender and (These accounts grow by the same percentage as the interest rate of the loan), move the funds to a directed account with a financial specialist (This option is risky unless you direct the investment options of the financial specialist), or withdraw the funds and manage their investment themselves.

9.2 HECM for PurchaseThe Housing and Economic Recovery Act of 2008 provided HECM mortgagors with the opportunity to purchase a new principal residence with HECM loan proceeds—the so-called HECM for Purchase program, effective January 2009. The program was designed to allow seniors to purchase a new principal residence and obtain a reverse mortgage within a single transaction by eliminating the need for a second closing. The program was also designed to enable senior homeowners to relocate to other geographical areas to be closer to family members or downsize to homes that meet their physical needs, i.e., handrails, one-level properties, ramps, wider doorways, etc. Texas is the only state that does not allow for reverse mortgages for purchase.

9.2.1 Costs and interest ratesThe cost of getting a reverse mortgage from a private sector lender may exceed the costs of other types of mortgage or equity conversion loans. Exact costs depend on the particular reverse mortgage program the borrower acquires. For the most popular type of reverse mortgage in the U.S., the FHA-insured Home Equity Conversion Mortgage (HECM), there will be the following types of costs:

1. Mortgage Insurance: 2% (of the appraised value)2. Origination Fee: The cap is $2500 or 2% of the first $200,000 and 1% thereafter,

whichever is more, with an overall cap of $6000.3. Title Insurance (varies)

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4. Title, Attorney, and County Recording Fees (varies)5. Real Estate Appraisal $300–$5006. Survey (may be required) $300–$500

In addition, a monthly service charge (between $25 and $35) is usually added monthly to the balance of the loan.

In all of these cases, except the Real Estate Appraisal, the costs of a reverse mortgage can be financed with the proceeds of the loan itself.

Interest rates on reverse mortgages are determined on a program-by-program basis, because the loans are secured by the home itself, and backed by HUD, the interest rate should always be below any other available interest rate in the standard mortgage marketplace for an FHA reverse mortgage. Prior to 2007, all major reverse mortgage programs had adjustable interest rates. Such adjustable rate reverse mortgages are still being offered which are adjusted on a monthly, semi-annual, or annual rate up to a maximum rate.

Several lenders now offer FHA HECM reverse mortgages that have fixed interest rates. Some fixed rate reverse mortgages limit the cash proceeds to half of that offered by adjustable rate reverse mortgages. The borrower(s) will be required to take out the entire amount offered at closing.

Some state and local governments offer low-cost reverse mortgages to seniors. These "public sector" loans generally must be used for specific purposes, such as paying for home repairs or property taxes, but most of them often have more favourable interest rates and fewer or no fees associated with them. These programs are typically very restrictive in terms of qualification and location, and many regions, states, and areas do not have such programs at all.

9.2.2 HUD counselingTo apply for an FHA/HUD reverse mortgage, a borrower is required to complete a counselling session with a HUD-approved counsellor. The counsellor will explain the legal and financial obligations of a reverse mortgage. After the counselling session, the borrower receives a "certificate of counselling" that is required before the loan application can be processed.

9.3 When the loan comes dueThe loan comes due when the borrower dies, sells the house, or moves out of the house for more than 12 consecutive months. Once the mortgage comes due the borrower or heirs of the estate will have an option to refinance the home and keep it, sell the home and cash out the equity, or turn the home over to the lender. If the property is turned over to the lender the borrower or the heirs have no more claims to the property or equity in the property.

The lender has recourse against the property, but not against the borrower personally nor against the borrower’s heirs, referred to as "non-recourse limit." Once all borrowers on a reverse mortgage pass away the heirs are granted 6 months to sell the home, refinance it, or to make the decision to turn the home over to the lender.

9.4 Volume of loans

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Home Equity Conversion Mortgages account for 90% of all reverse mortgages originated in the U.S. As of May 2010, there were 493,815 active HECM loans. As of 2006, the number of HECM mortgages that HUD is authorized to insure under the reverse mortgage law was capped at 275,000. However, through the annual appropriations acts, Congress has temporarily extended HUD's authority to insure HECM's notwithstanding the statutory limits.

Program growth in recent years has been very rapid. In fiscal year 2001, 7,781 HECM loans were originated. By the fiscal year ending in September 2008, the annual volume of HECM loans topped 112,000 representing a 1,300% increase in six years. For the fiscal year ending September 2011, loan volume had contracted in the wake of the financial crisis, but remained at over 73,000 loans that were originated and insured through the HECM program.

Loan volume is expected to grow further as the U.S. population ages. The U.S. senior population is expected to increase from 35 million in 2000 to 64 million in 2025, and seniors are expected to make up a larger share of the population.

10. Credit DerivativeIn finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself. This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt. Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity.

The parties will select which credit events apply to a transaction and these usually consist of one or more of the following:

bankruptcy (the risk that the reference entity will become bankrupt) failure to pay (the risk that the reference entity will default on one of its obligations such

as a bond or loan) obligation default (the risk that the reference entity will default on any of its obligations) obligation acceleration (the risk that an obligation of the reference entity will be

accelerated e.g. a bond will be declared immediately due and payable following a default) repudiation/moratorium (the risk that the reference entity or a government will declare a

moratorium over the reference entity's obligations) Restructuring (the risk that obligations of the reference entity will be restructured)...Where credit protection is bought and sold between bilateral counterparties, this is known as an unfunded credit derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.

This synthetic securitization process has become increasingly popular over the last decade, with the simple versions of these structures being known as synthetic CDOs; credit linked notes; single tranche CDOs, to name a few. In funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different slices of credit risk according to their risk appetite.

10.1 Market size and participants

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Credit default products are the most commonly traded credit derivative product and include unfunded products such as credit default swaps and funded products such as collateralized debt obligations.

The ISDA reported in April 2007 that total notional amount on outstanding credit derivatives was $35.1 trillion with a gross market value of $948 billion (ISDA's Website). As reported in The Times on September 15, 2008, the "Worldwide credit derivatives market is valued at $62 trillion".

Although the credit derivatives market is a global one, London has a market share of about 40%, with the rest of Europe having about 10%.

The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporate.

10.2 TypesCredit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit derivatives. An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract (i.e. payments of premiums and any cash or physical settlement amount) itself without recourse to other assets. A funded credit derivative involves the protection seller (the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events. However, the protection buyer is exposed to the credit risk of the protection seller, in which case the protection seller fails to pay the protection buyer under the event of the protection seller's default. It is also known as counterparty risk.

Unfunded credit derivative products include the following products:

Credit default swap (CDS) Total return swap Constant maturity credit default swap (CMCDS) First to Default Credit Default Swap Portfolio Credit Default Swap Secured Loan Credit Default Swap Credit Default Swap on Asset Backed Securities Credit default swaption Recovery lock transaction Credit Spread Option CDS index productsFunded credit derivative products include the following products:

Credit linked note (CLN) Synthetic Collateralised Debt Obligation (CDO) Constant Proportion Debt Obligation (CPDO) Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI)

10.3 PricingPricing of credit derivative is not an easy process. This is because:

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The complexity in monitoring the market price of the underlying credit obligation. Understanding the creditworthiness of a debtor is often a cumbersome task as it is not

easily quantifiable. The incidence of default is not a frequent phenomenon and makes it difficult for the

investors to find the empirical data of a solvent company with respect to default. Even though one can take help of different ratings published by ranking agencies but

often these ratings will be different.

10.4 RisksRisks involving credit derivatives are a concern among regulators of financial markets. The US Federal Reserve issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations for credit derivatives trades. These backlogs pose risks to the market (both in theory and in all likelihood), and they exacerbate other risks in the financial system. One challenge in regulating these and other derivatives is that the people who know most about them also typically have a vested incentive in encouraging their growth and lack of regulation. Incentive may be indirect, e.g., academics have not only consulting incentives, but also incentives in keeping open doors for research.)

11. Credit SwapA credit default swap (CDS) is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default. Generally, the agreement is that in the event of default the buyer of the CDS receives money (usually the face value of the loan), and the seller of the CDS receives the defaulted loan (and with it the right to recover the loan at some later time).

However, there is a significant difference between a traditional insurance policy and a CDS. Anyone can purchase a CDS, even buyers who do not hold the loan instrument and may have no direct insurable interest in the loan. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.

Credit default swaps have existed since the early 1990s, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion, falling to $26.3 trillion by mid-year 2010.

Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (ISDA), although some are tailored to meet specific needs. CDSs have many variations. In addition to the basic, single-name swaps, there are basket default swaps (BDSs), index CDSs, funded CDSs (also called a credit-linked notes), as well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include a special purpose vehicle issuing asset backed securities.

CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007-2010 financial crisis the lack of transparency became a concern to regulators, as was the multi-trillion dollar size of the market, which could pose a systemic risk to the economy.

Credit default swaps and other derivatives are unusual--and potentially dangerous--in that they combine priority in bankruptcy with a lack of transparency.

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A number of financial professionals, regulators, and the media have begun using credit default swap pricing as a gauge of the riskiness of corporate and sovereign borrowers, and U.S. Courts may soon be following suit.

11.1 RiskWhen entering into a CDS, both the buyer and seller of credit protection take on counter party risk:

The buyer takes the risk that the seller may default. If AAA-Bank and Risky Corp. default simultaneously ("double default"), the buyer loses its protection against default by the reference entity. If AAA-Bank defaults but Risky Corp. does not, the buyer might need to replace the defaulted CDS at a higher cost.

The seller takes the risk that the buyer may default on the contract, depriving the seller of the expected revenue stream. More important, a seller normally limits its risk by buying offsetting protection from another party — that is, it hedges its exposure. If the original buyer drops out, the seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party. Depending on market conditions, that may be at a lower price than the original CDS and may therefore involve a loss to the seller.

In the future, in the event that regulatory reforms require that CDS be traded and settled via a central exchange/clearing house, such as ICE TCC, there will no longer be 'counterparty risk', as the risk of the counterparty will be held with the central exchange/clearing house.

As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk. If one or both parties to a CDS contract must post collateral (which is common), there can be margin calls requiring the posting of additional collateral. The required collateral is agreed on by the parties when the CDS is first issued. This margin amount may vary over the life of the CDS contract, if the market prices of the CDS contract changes, or the credit rating of one of the parties changes. Many CDS contracts even require paying an upfront at the beginning (also referred to as "initial margin").

Another kind of risk for the seller of credit default swaps is jump risk or jump-to-default risk. A seller of a CDS could be collecting monthly premiums with little expectation that the reference entity may default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers. This risk is not present in other over-the-counter derivatives.

11.2 UsesCredit default swaps can be used by investors for speculation, hedging and arbitrage.

11.2.1 Speculation

Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of market indices such as the North American CDX index or the European iTraxx index. An investor might believe that an entity's CDS spreads are too high or too low, relative to the entity's bond yields, and attempt to profit from that view by entering into a trade, known as a basis trade, that combines a CDS with a cash bond and an interest-rate swap.

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Finally, an investor might speculate on an entity's credit quality, since generally CDS spreads increase as credit-worthiness declines, and decline as credit-worthiness increases. The investor might therefore buy CDS protection on a company to speculate that it is about to default. Alternatively, the investor might sell protection if it thinks that the company's creditworthiness might improve. The investor selling the CDS is viewed as being “long” on the CDS and the credit, as if the investor owned the bond. In contrast, the investor who bought protection is “short” on the CDS and the underlying credit. Credit default swaps opened up important new avenues to speculators. Investors could go long on a bond without any upfront cost of buying a bond; all the investor need do was promise to pay in the event of default. Shorting a bond faced difficult practical problems, such that shorting was often not feasible; CDS made shorting credit possible and popular. Because the speculator in either case does not own the bond, its position is said to be a synthetic long or short position.

For example, a hedge fund believes that Risky Corp will soon default on its debt. Therefore, it buys $10 million worth of CDS protection for two years from AAA-Bank, with Risky Corp as the reference entity, at a spread of 500 basis points (=5%) per annum.

If Risky Corp does indeed default after, say, one year, then the hedge fund will have paid $500,000 to AAA-Bank, but then receives $10 million (assuming zero recovery rate, and that AAA-Bank has the liquidity to cover the loss), thereby making a profit. AAA-Bank, and its investors, will incur a $9.5 million loss minus recovery unless the bank has somehow offset the position before the default.

However, if Risky Corp does not default, then the CDS contract runs for two years, and the hedge fund ends up paying $1 million, without any return, thereby making a loss. AAA-Bank, by selling protection, has made $1 million without any upfront investment.

Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its position after a certain period of time in an attempt to realise its gains or losses. For example:

After 1 year, the market now considers Risky Corp more likely to default, so its CDS spread has widened from 500 to 1500 basis points. The hedge fund may choose to sell $10 million worth of protection for 1 year to AAA-Bank at this higher rate. Therefore, over the two years the hedge fund pays the bank 2 * 5% * $10 million = $1 million, but receives 1 * 15% * $10 million = $1.5 million, giving a total profit of $500,000.

In another scenario, after one year the market now considers Risky much less likely to default, so it’s CDS spread has tightened from 500 to 250 basis points. Again, the hedge fund may choose to sell $10 million worth of protection for 1 year to AAA-Bank at this lower spread. Therefore over the two years the hedge fund pays the bank 2 * 5% * $10 million = $1 million, but receives 1 * 2.5% * $10 million = $250,000, giving a total loss of $750,000. This loss is smaller than the $1 million loss that would have occurred if the second transaction had not been entered into.

Transactions such as these do not even have to be entered into over the long-term. If Risky Corp's CDS spread had widened by just a couple of basis points over the course of one day, the hedge fund could have entered into an offsetting contract immediately and made a small profit over the life of the two CDS contracts.

Credit default swaps are also used to structure synthetic collateralized debt obligations (CDOs). Instead of owning bonds or loans, a synthetic CDO gets credit exposure

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to a portfolio of fixed income assets without owning those assets through the use of CDS. CDOs are viewed as complex and opaque financial instruments. An example of a synthetic CDO is Abacus 2007-AC1, which is the subject of the civil suit for fraud brought by the SEC against Goldman Sachs in April 2010. Abacus is a synthetic CDO consisting of credit default swaps referencing a variety of mortgage backed securities.

11.2.2 HedgingCredit default swaps are often used to manage the risk of default that arises from holding debt. A bank, for example, may hedge its risk that a borrower may default on a loan by entering into a CDS contract as the buyer of protection. If the loan goes into default, the proceeds from the CDS contract cancel out the losses on the underlying debt.

There are other ways to eliminate or reduce the risk of default. The bank could sell (that is, assign) the loan outright or bring in other banks as participants. However, these options may not meet the bank’s needs. Consent of the corporate borrower is often required. The bank may not want to incur the time and cost to find loan participants. If both the borrower and lender are well-known and the market (or even worse, the news media) learns that the bank is selling the loan, then the sale may be viewed as signalling a lack of trust in the borrower, which could severely damage the banker-client relationship. In addition, the bank simply may not want to sell or share the potential profits from the loan. By buying a credit default swap, the bank can lay off default risk while still keeping the loan in its portfolio. The downside to this hedge is that without default risk, a bank may have no motivation to actively monitor the loan and the counterparty has no relationship to the borrower.

Another kind of hedge is against concentration risk. A bank’s risk management team may advise that the bank is overly concentrated with a particular borrower or industry. The bank can lay off some of this risk by buying a CDS. Because the borrower-the reference entity-is not a party to a credit default swap, entering into a CDS allows the bank to achieve its diversity objectives without impacting its loan portfolio or customer relations. Similarly, a bank selling a CDS can diversify its portfolio by gaining exposure to an industry in which the selling bank has no customer base.

A bank buying protection can also use a CDS to free regulatory capital. By offloading a particular credit risk, a bank is not required to hold as much capital in reserve against the risk of default (traditionally 8% of the total loan under Basel I). This frees resources the bank can use to make other loans to the same key customer or to other borrowers.

Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension funds or insurance companies, may buy a CDS as a hedge for similar reasons. Pension fund example: A pension fund owns five-year bonds issued by Risky Corp with par value of $10 million. To manage the risk of losing money if Risky Corp defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million. The CDS trades at 200 basis points (200 basis points = 2.00 percent). In return for this credit protection, the pension fund pays 2% of $10 million ($200,000) per annum in quarterly instalments of $50,000 to Derivative Bank.

If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million back after five years from Risky Corp. Though the protection payments totalling $1 million reduce investment returns for the pension fund, its risk of loss due to Risky Corp defaulting on the bond is eliminated.

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In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue or a basket of similar risks as a proxy for its own credit risk exposure on receivables.

Although credit default swaps have been highly criticized for their role in the recent financial crisis, most observers conclude that using credit default swaps as a hedging device has a useful purpose.

11.2.3 ArbitrageCapital Structure Arbitrage is an example of an arbitrage strategy that utilizes CDS transactions. This technique relies on the fact that a company's stock price and its CDS spread should exhibit negative correlation; i.e., if the outlook for a company improves then its share price should go up and its CDS spread should tighten, since it is less likely to default on its debt. However if its outlook worsens then its CDS spread should widen and its stock price should fall. Techniques reliant on this are known as capital structure arbitrage because they exploit market inefficiencies between different parts of the same company's capital structure; i.e., miss-pricings between a company's debt and equity. An arbitrageur attempts to exploit the spread between a company's CDS and its equity in certain situations. For example, if a company has announced some bad news and its share price has dropped by 25%, but its CDS spread has remained unchanged, then an investor might expect the CDS spread to increase relative to the share price. Therefore a basic strategy would be to go long on the CDS spread (by buying CDS protection) while simultaneously hedging oneself by buying the underlying stock. This technique would benefit in the event of the CDS spread widening relative to the equity price, but would lose money if the company's CDS spread tightened relative to its equity.

An interesting situation in which the inverse correlation between a company's stock price and CDS spread breaks down is during a Leveraged buyout (LBO). Frequently this leads to the company's CDS spread widening due to the extra debt that will soon be put on the company's books, but also an increase in its share price, since buyers of a company usually end up paying a premium.

Another common arbitrage strategy aims to exploit the fact that the swap-adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. Misalignments in spreads may occur due to technical reasons such as:

Specific settlement differences Shortages in a particular underlying instrument Existence of buyers constrained from buying exotic derivatives.The difference between CDS spreads and asset swap spreads is called the basis and should theoretically be close to zero. Basis trades can aim to exploit any differences to make risk-free profit.

11.4 Pricing and valuationThere are two competing theories usually advanced for the pricing of credit default swaps. The first, referred to herein as the 'probability model', takes the present value of a series of cash flows weighted by their probability of non-default. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds.

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The second model, proposed by Darrell Duffie, but also by John Hull and White, uses a no-arbitrage approach.

Learning Experience I got to know about various new financial products and services.

If the company wants to get high returns, it must take higher risk so better option is to invent new financial products.

Risk Transfer.

Various technologies and methods to innovate new product.

How to identify the needs of the customer.

Referenceshttp://en.wikipedia.org/wiki/Innovation

http://en.wikipedia.org/wiki/Financial_innovation

http://www.investopedia.com/terms/f/financialengineering.asp

http://www.investopedia.com/terms/f/financialengineering.asp

http://www.investopedia.com/terms/f/financialengineering.asp

http://www.bizterms.net/term/Yankee-bonds.html

http://www.infosys.com/finacle/pages/index.aspx

http://www.nseindia.com/content/indices/ind_indexfunds.htm

http://www.licpensionplan.com/

http://en.wikipedia.org/wiki/Government_bond

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