Next Generation Financial Architecture. Part 2 - Tranched Futures and Options.
- 2. Next Generation Financial Architecture Page 2 of 8 Introduction The Financial sector should be in the service of the real economy and not vise versa. The needs of the real economy as opposed to the needs of financial institutions should drive financial innovation. Understanding and addressing the needs of the real economy should be the focus of the next generation financial architecture. For-profit and nonprofit organizations across all industries worldwide face two classes of market risks: the risk of market volatility and the risk of rare event. The risk of market volatility exposes organizations to ordinary fluctuation of prices and rates in capital, commodities, labor, property, and other markets. The risk of rare event exposes entities to extraordinary jumps in prices and rates that threaten the very existence of those organizations. The current arsenal of financial instruments is based on two fundamental building blocks: options and forwards that are not adequately tailored to deal with each class of risk separately. This inefficiency comes from one-size-fit-all payoffs and poor liquidity which result in high cost of hedging. Understanding that fixing the building blocks will simplify or eliminate altogether more complex financial instruments we shall embark on developing the next generation financial architecture. Objectives An important objective of the next generation financial architecture is to enable the real economy to properly hedge its risks using efficient tool set specifically tailored for the need. The ideal financial instruments for this tool set should feature the flexibility of OTC markets and the simplicity, transparency, and efficiency of Exchanges. The building blocks underlying such financial instruments should have granular payoffs tailored for each class of risk and maturity maximizing flexibility of the hedging horizon, liquidity and operational efficiency.
- 3. Part 2 – Tranched Futures & Options Page 3 of 8 Financial Instruments Like structured products, forwards and options can be tranched to create the desired risk profiles. Tranched futures and options have the flexibility of dealing with each class of risk separately. Tranching payoffs according to volatility of the underlying asset would allow the segregation of rare event risk and volatility risk with a three Sigma cutoff. Tranched Futures Future agreements with capped payoff according to risk appetite expressed in standard deviations of returns of the underlying asset. The known maximum payoff significantly reduces collateral requirements. These building blocks would allow flexible hedging strategies previously impossible or impractical. Figure 1: Isolating Volatility Risk in Futures
- 4. Next Generation Financial Architecture Page 4 of 8 Non-financial organizations typically use financial hedging against market volatility risks such as transaction risk and sometimes translation risk, and industrial hedging against rare events risks such as economic risk. Thus the focus should be on tailoring futures to various levels of market volatility risk. Depending on the exposure horizon and financial stability, some organizations may choose to accept or self-insure risk of low market fluctuations, while others may take the opposite view and hedge high probability risk only. To accommodate such preferences, volatility risk can be further sliced into three standard tranches of one Sigma each. Figure 2: Tranching Volatility Risk in Futures
- 5. Part 2 – Tranched Futures & Options Page 5 of 8 The resulting instruments would be simple, yet powerful tools for implementing flexible, and elaborate hedging strategies. Firms with strong Free Cash Flows may choose to hedge 3rd Sigma price (or rate) fluctuations or not to hedge at all, while firms with weak Free Cash Flows will have a choice of hedging starting from 1st Sigma fluctuations up. Figure 3: First Sigma Future Figure 4: Second Sigma Future Figure 5: Third Sigma Future
- 6. Next Generation Financial Architecture Page 6 of 8 Tranched Options Options with capped payoff according to risk appetite expressed in standard deviations of returns of the underlying asset. The known maximum payoff significantly reduces option price. Tranching payoffs according to volatility of the underlying asset allows segregation of rare event risk with a three Sigma cutoff. Figure 6: Isolating Volatility Risk in Options Options are used both for hedging and leveraged investments. Options on rare event risk make financial hedging of economic risk a viable short term alternative. Options on volatility risk can be further sliced into three standard tranches of one Sigma each to accommodate various hedging and investment choices. Figure 7: Tranching Volatility Risk in Options
- 7. Part 2 – Tranched Futures & Options Page 7 of 8 Tranched options are effective building blocks in combination with tranched futures or in isolation for implementing sophisticated hedging and investment strategies. Payoffs of tranched call and tranched put options are similar to bull spread and bear spread strategies. A combination of tranched call and tranched put options would allow investors to adopt butterfly and corridor strategies which are impractical using regular options. Figure 8: First Sigma Option Figure 9: Second Sigma Option Figure 10: Third Sigma Option
- 8. Next Generation Financial Architecture Page 8 of 8 Maturities Since “God blessed the seventh day and made it holy” 1 people’s lives have revolved around a 7 day cycle. Personal and business lives from daycare to college to work are dominated by weekly schedules. Week is the most intuitive, the most convenient, and the most operationally efficient maturity. Concentrating liquidity in one, standard, weekly maturity opens a number of possibilities that were previously cost-prohibitive. Weekly maturity brings frequent reset of strikes and quantities, allowing flexible entry, rolling, and exit strategies. Rolling over weekly contracts becomes a practical alternative to standard, exchange-traded maturities and offer flexibility of replicating OTC trades using exchange-traded instruments. Various rolling strategies of weekly, tranched futures and European options can be used to replicate longer-dated American or Bermudan options, swaps, swaptions, caps, floors, and other exotic instruments. Conclusions 1. Tranching allows segregation of volatility risk and rare event risk. 2. Finite payoffs reduce collateral requirements and option prices. 3. Limited number of tranches and maturities concentrates liquidity in fewer instruments. 4. Weekly maturities offer flexibility of frequent resets of strikes, tranches and quantities. 5. Frequent entry and exit points allow dynamic positions that replicate long-dated and exotic instruments. 6. Tranched options and futures offer new, cost-efficient hedging and investment strategies. 1 Genesis 2:1-3