Hello
These two weeks, I read 3 different papers about innovations in finance.
One big question is that, why did these innovations take place in last decades?
The answer is:
The surge in inflation in the late seventies and the concurrent increase in the volatility of interest rates created the first wave of innovation in debt securities, with floating rate debt becoming a viable choice for most borrowers.
Debt / equality securities:
Debt positive points: Tax advantage.
Debt negative points: greater risk of bankruptcy for the firm (because the obligation to make fixed payment remains even when there is no earning for the firm).
Here I think it is useful to know about the optimal debt ratio:
Optimal debt ratio → where the net difference between the tax benefits and the expected bankruptcy cost is maximized:
Debt ratio = pv of tax benefits - pv of expected bankruptcy costs
Value of levered firm = value of unlevered firm + debt ratio
For being secure we can reduce the expected bankruptcy cost and increase both the optimal debt ration for a firm and the total firm value at special leverage by considering on borrowing money on a security where interest payments are not fixed but vary as earnings vary.
Now by looking at these figures we will understand it better:
This figure provides the time series of firm value for a hypothetical firm, where all of the changes in firm value are assumed to occur as a result of changes in macro economic variables:
In this figure we can see that where value of debt is fixed but value of firm is changeable by macroeconomic situations there is a risk for being bankruptcy when firm value is less than value of debt.
And as we know the situation outlined above is not really improbable for firms.
In this figure you can see that value of debt is changing by macroeconomic variables, so since debt value and firm value move together here the possibility of bankruptcy is reducing.
Now it is more clear for us that why did financial innovations take place in the last decades
Some of the most important innovations which is used now a days are as follows:
.Commodity bond : where the coupon payments on the bond are linked to the price of a specific commodity, such as gold or oil.
.Catastrophe bond : where coupon payments and principal payments can be reduced or suspended in the event of a specified catastrophe (such as an earthquake or a flood).
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Finally I found this chart from a site which is mentioned bellow in references:
have a nice time
References:
. Aswath Damodaran, Financial innovations and capital structure choices, stern school of buisiness, New York city.
. Franklin, innovations in finance
