FINANCIAL INNOVATION

There 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 Jack L. Treynor and William F. Sharpe, 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. 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 literature

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

The extensive literature on principalagent 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 the Journal 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 regulationspecifically, 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 innovation

Examples 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.

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 BlackScholes 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

stock 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 corporations 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.[1]

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 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 innovation

Some 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.[2] 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 balancesif 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 affect 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.

Criticism

Some economists argue that financial innovation has little to no productivity benefit: Paul

Volcker states that "there is little correlation between sophistication of a banking system and

productivity growth,"[2] that there is no "neutral evidence that financial innovation has led to

economic growth",[3] and that financial innovation was a cause of the financial crisis of 2007

2010,[4] while Paul Krugman states that "the rapid growth in finance since 1980 has largely been

a matter of rent-seeking, rather than true productivity."[5]

India is on board towards robust growth to achieve the position within top 5 economies of the

world. In order to achieve that benchmark, India requires massive development in infrastructure,

industrial & manufacturing front. Hence there is a significant need for financial innovation in the

Indian industries, which is a key to the development. However, Indian Companies have been

using a wide range of innovative financial instruments to raise their required capital for

achieving the broad corporative goals and objectives. They have the potential to help Indian

companies to overcome the severe financing constraints they have been experiencing over a long

period of time. Companies in their quest of reducing the cost of capital, put a premium on such

instrument which will help in achieving such an objectives. Also the introduction of new

instruments of finances have provided opportunities to Indian Companies in designing

instruments which could give them the freedom to address their varying needs of investors group

to make an attempt to lower the cost of capital. Introduction of new financing increased the

chances for more and more investor's participation in future offerings of companies. This may

enhance the chances for raising more and more funds. The introduction of such new instruments

will definitely fetch many benefits to the companies and the investors. In this paper the authors

spotlight the essence of financial innovations and also the various innovative financial products

that have great impact on the capital market.

Key words: Financial innovation, Product innovation, Process innovation, spot market, index

funds, index futures, index options, etc

 INTRODUCTION

Financial innovation has been a continuous and integral part of growth of the capital markets.

Greater freedom and flexibility have enabled companies to reinvent and innovate financial

instruments. Many factors such as increased interest rate, volatility, frequency of tax and

regulatory changes etc. have stimulated the process of financial innovation. The deregulation of

financial service industry and increased competition within investment banking also led to

increased activities to design new products, develop better processes, and implement more

effective solution for increasingly complex financial problems. Financial instrument is a

combination of characteristics such as promised yield liquidity, maturity, security and risk. The

process of financial innovation involves creating new instruments and technique by unpackaging

and rebinding the same characteristics in different fashion to suit the constantly changing needs

of the issuers and the investors. At times it leads to introduction of revolutionary new products

such as swap, mortgage, and zero coupon bonds to finance leveraged buyouts. Some times it

involves the piecing together of existing products and process to fit in a particular set of

circumstances. Many companies consider the types of securities (debt and equity), and a handful

of simple financial institutions (banks or exchanges). However, there is a range of financial

products, types of financial institutions and a variety of processes that these institutions employ

to do business.

'Financial innovation' is the act of creating and popularizing new financial instruments as well as

new financial technologies, institutions and markets. The "innovations" are classified into

1. Product innovation- The product innovations may be represented by new derivative contracts,
new corporate securities or new forms of investment products.

2. Process innovation- The process improvements can be represented by new means of

distributing securities, processing transactions, or pricing transactions.

In terms of financial innovations, securities innovations include instruments such as debt,

preferred stock, convertible securities, and common equities. They help in reallocating risk,

increasing liquidity, reducing agency costs, transactions costs, taxes and sometimes

circumventing regulatory constraints.

FUNCTIONS OF FINANCIAL INNOVATIONS

The financial innovations help in

moving funds across time and space;

pooling of funds;

managing or reallocating risk;

extracting information to support decision-making;

addressing asymmetric information problems;

facilitating the sale or purchase of goods and services through a payment system;

reducing agency cost, and enhancing liquidity

 INNOVATIONS IN FINANCIAL PRODUCTS

After the liberalization measures were announced in 1991, Indian Company under took issuance

of new instruments seriously in order to attract large section of investors. Essar Steel used

convertible debentures with warrants and loyalty coupons, Tata Iron and Steel Company Limited

issued secured Premium Notes with warrants, Flex Industries issued partly convertible

debentures and non convertible debentures with warrant attached to each instrument DLF aments

issued multiple option bonds, Essar oil issued optionally fully convertible debentures and

Reliance Petroleum issued triple option convertible with equity warrant and Esab India issued

partly convertible debenture. This burst of innovation has seen a typical shift in the design and

development of new instrument. The classic conversion is that of debt in to equity. Offering the

investor the option of conversion keeps the cost of his convertible debt lower than straight debt,

thus minimizing the cash out flows during the gestation period. Once the project yields steady

profits, the equity conversion results in a relatively- expensive dilution. The use of fectures like

warrants makes the equity and convertible less expensive for the investor. It creates possibilities

for their full subscription by the investors and also turns out to be cheaper for the issuing

company.

The worldwide financial industry is filled with innovative product design. New financial

products become popular because people find them useful. New products like index funds, index

futures, index options, etc., became internationally successful because they fulfil basic economic

objectives of people in the economy.

The relationship between the underlying spot market, index funds, index futures and index

options: are explained as follows:

 The prerequisites for an index fund are program trading facilities and an index where all

components are liquid and convenient to trade. Index funds fulfilling these conditions

have now come to exist in India.

Index funds make it possible for people to sell options on the index while being covered

this could happen on exchanges which trade index options or over the counter.

Index futures make the implementation of index funds easier.

Index funds generate an order flow for index futures markets, and help make them more

liquid.

Index futures markets enable index options markets.

Access to index futures and index options make index funds more attractive, since users

can couple their investments in index funds with risk management using the futures and

options.

Index options make possible innovative new products like 'guaranteed return funds'.

TECHNOLOGY DRIVEN FINANCIAL INNOVATIONS

Advancements in Information Technology have facilitated a number of innovations, such as

new methods of underwriting securities

assembling portfolios of stocks

 new markets for securities

new means of executing security transactions

New intellectual technologies, such as derivative pricing models, are credited with stimulating

the growth and popularization of a variety of new contracts. Many new forms of derivatives have

been made possible because business people could have some confidence in the methods of

pricing and hedging the risks of these new contracts. Various forms of innovations such as new

risk management systems and measures, on-line retirement planning services and new valuation

techniques were clearly facilitated by both intellectual and information technology innovations.

CLASSIFICATION OF FINANCIAL PRODUCTS

The classification of the Financial Products is illustrated as below:

Sl.No Product Elements

1 Payment products Retail, corporate and trade-related products, and financial/securities

products.

2 Trade finance bills of exchange, collection bills, letters of credit, factoring, forfeiting,

performance/bank guarantee, and export and import bills

3 Commercial lending overdrafts, cash-credits, open loans, goods loans, hypothecation of

stock-in-trade facilities, medium-term loans, syndicated loans, financial

guarantees, acceptance instruments, etc

4 Structured finance commercial and real-estate finance, project and start-up finance or

equity loans, buy-outs of management or leveraged buy-outs,

subordinated debts, etc.

5 Equipment finance project loans or long-term acceptance bills, leasing and hire purchases

6 Money market products certificate of deposits, commercial paper, treasury receipts/bills and

repurchase agreements and also, money market mutual fund units

7 Capital market products bonds and debentures, government bonds/gilt-edged securities, equities

of all types, including preference and ordinary

8 Derivative products & foreign exchange forward covers, rate agreements, financial futures,

Risk Management swap and options

products

9 Consumer products personal loans, housing loans, car loans, hire-purchase and lease

arrangements, mutual and pension-related funds and Credit/debit cards/

other types of cards

Indigenous products both local and ethnic financial products such as chit funds and benefit

funds

Postal products National Saving schemes

Some of the innovative financial instruments used by the companies in the Indian Financial

Market are explained as follows:

1) TRIPLE OPTION CONVERTIBLE DEBENTURES (TOCD):

First Issued by Reliance Power Limited with an issue size of Rs. 2,172 Cr.

There was no outflow of interest for first five years.

Equity increase was in phases.

No put option to investors and no takeover threat.

Reduced dependence on the financial institutions.

The expenses for floating the issue was just 2.62% of the issue size which was very less

when compared to the 10-12% for a general public issue.

2) DEEP DISCOUNT BONDS:

The investor got a tax advantage and could eliminate the re-investment risk.

From the issuer's point of view also, the issue cost was saved as it involved no immediate

service cost and lower effective cost. The refinancing risk was also eliminated.

3) FLOATING RATE NOTES:

 First issued by Tata Sons with a floor rate of 12.5% and a cap of 15.5% and a reference

rate of 364 T-Bill yield, which was 9.85% at the time of issue.

The investors would get a minimum return of the floor rate and the maximum return was

the cap rate. They would get higher than floor rate depending upon the fluctuations in the

reference rate.

4) ZERO COUPON BONDS:

It did not involve any annual interest on the bonds. But it had a higher maturity value on

the initial investment for a particular time period.

5) CONVERTIBLE AND ZERO COUPON CONVERTIBLE BONDS:

Similar to the zero coupon bonds except that the effective interest was lower because of

the convertibility.

6) SECURED PREMIUM NOTES (SPNS):

First issued by TISCO in July, 1992.

These financial instruments were secured against the assets of the company but the

investors had to pay a premium over the market price for these types of instruments.

7) EQUITY WITH DIFFERENTIAL VOTING RIGHTS:

Issued by Tata Motors, in which the shares were classified as "Ordinary Shares" and "A

Ordinary Shares".
 The ordinary shares were issued at Rs. 340 per share, had a voting right of one vote per

share.

On the other hand, the A ordinary shares were issued at Rs. 305 per share but the voting

rights were limited to one vote for every 10 shares. In addition, they were paid extra

dividend of five percentage points.