Financial Engineering in Corporate Finance: An Overview Author(s): John D. Finnerty Source: Financial Management, Vol. 17, No. 4 (Winter, 1988), pp. 14-33 Published by: Blackwell Publishing on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665764 Accessed: 15/01/2009 11:03 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=black. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with the scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that promotes the discovery and use of these resources. For more information about JSTOR, please contact email@example.com. Financial Management Association International and Blackwell Publishing are collaborating with JSTOR to digitize, preserve and extend access to Financial Management. http://www.jstor.org A Special Issue on Financial Engineering Financial Finance: John D. Finnerty Engineering in An Corporate Overview John D. Finnerty is Executive Vice President and Chief Financial Officer, College Savings Bank, Princeton, NJ, and is a Professor of Finance, New York,NY. Fordham University, * Financial innovation over the past two decades has rapidly brought about revolutionary changes in financial instruments and processes. Almost daily the financial press carries yet another tombstone advertisement featuring a new security.A variety of factors, among the more important of which are increased interest rate volatility and the frequency of tax and regulatory changes, have stimulated the process of financial innovation. The deregulation of the financial services industry and increased competition within investment banking have undoubtedly placed increased emphasis on being able to design new products, develop better processes, and implement more effective solutions to increasing- ly complex financial problems. Financial engineering is the lifeblood of this activity. Financial engineering involves the design, the development, and the implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in finance. The term "innovative"is used here to describe a solution that is nontrivial. Innovative financial solutions may involve a new consumer-type financial instrument, such as IRA and Keogh accounts; a new security, such as money market preferred stock; a new process, such as the shelf registration process; or a creative solution to a corporate finance problem, such as the design of customized security arrangements for a project financing or a leveraged buyout. The definition of corporate financial engineering distinguishes three types of activities. The first, securities innovation, involves the development of innova14 The author would like to thank James Ang, Laurence Booth, Marek Borun, Dennis Logue, and the anonymous referees for helpful comments on earlier drafts of the paper. Earlier versions of the paper were presented at Florida State University, the University of Toronto, and the 18th Annual Meeting of the FMA in New Orleans, LA, October 22, 1988. I. Scope of FinancialEngineering IN FINNERTY/FINANCIAL ENGINEERING CORPORATE FINANCE 15 tive financialinstruments, includingthose developed for applicationssuch as new primarily consumer-type new typesof bankaccounts, formsof mutualfunds,new and typesof life insurance products, newformsof residential mortgages.Innovativefinancial instruments alsoincludethosedevelopedprimarily corporate for finance applications such as new debt instruments; options, futures, and other new risk management vehicles;new types of preferredstock; new forms of convertible and securities; new typesof commonequity instruments. The secondbranchof corporate financialengineerinvolvesthe developmentof innovativefinancial ing processes.These new processesreducethe cost of effecting financial transactions,and are generallythe resultof legislative regulatory or changes(forexample, the shelf registration process),or of technologicaldevelopments(electronicsecuritytrading). The thirdbranchinvolvescreativesolutionsto corporate finance problems.It encompassesinnovative cashmanagement strategies,innovativedebt management strategies,and customizedcorporatefinancing structuressuch as those involvedin variousforms of asset-based financing. 1I.The Process of Financial Innovation Miller,Silber[46, 47, 48], andVan Horne  characterize processof financialinnovationin difthe ferentterms.1Millerfindsthat regulatory taxfacand tors have providedthe major impetus for financial innovationover the past 20 years.He describesfinancial innovationsas "unforecastable in improvements" the array available of financialproductsandprocesses that came into being as a result of unexpectedtax or regulatory impulses[38, p. 460]. Zero coupon bonds providea good exampleof how a taximpulseled to innovation. Priorto the passageof the TaxEquityandFiscalResponsibilityAct of 1982 (TEFRA), an issuer of zero the couponbondscould haveamortized originalissue discount-the differencebetweenthe face amountof the bondsandtheirissueprice-on a straight-line basis for taxpurposes.Being able to deductthe interestexpense faster than the interestimplicitlycompounded on the bondsproducedsignificanttax benefits,which weregreaterthe higherthe bond'sofferingyield.And, 1Othernoteworthy contributions the literature financialinto on novations beenmadebyAtchison, have and DeMong, Kling,Black andScholes,Darrow Mestres,andFriedman and . the higherthe bond'sofferingyield,the deeperthe discount. When interest rates rose sharplyin 1981 and 1982,therewas a flood of zero couponbond issues to exploit this tax loophole. (See Fisher,Brick,and Ng , and Yawitz and Maloney .) Zero coupon bondswere not a new financialinstrument; took an it externalshock (rising interest rates that greatlyenhancedthe potentialtaxbenefits)to spurtheiruse. Zero coupon bonds also illustratethe interaction betweenKane'sregulatory dialecticandfinancialengidialec[31,32, 33].Kanedefinesthe regulatory neering tic as a cyclicalprocessin whichthe opposingforcesof regulationand regulateeavoidanceadaptcontinually to one another.Finnerty describeshow U.S. corporationsrespondedto TEFRA's closing of the domestictaxloopholebytheirissuingzero couponbonds to Japaneseinvestors orderto exploita Japanesetax in The Japaneseregulatory authorities firstreloophole. to this activityfirst by imposingquantitative sponded restrictions Japanese on and purchases, thenbythreatto close the taxloophole. ening Silber [46, 47, 48] views the process of financial innovationdifferentlyfrom Miller. He characterizes innovativefinancialinstruments and processesas attempts by corporationsto lessen the financialconstraintsthey face. In his view, firms maximizeutility some of whichare subjectto a numberof constraints, and imposedbygovernment regulation, the balanceof whichare imposedeitherby the marketplace by the or firm itself. Innovativeactivityrespondsto economic impulsesthat increasethe cost of adheringto a particular constraint.The increasedcost stimulatesinnovative activityto relax the constraintand thereby reducethe cost of adheringto it. For example,banks are capital-constrained. Considerable effort has gone into designingcapital notes, which are debt instrumentsthatqualifyas "capital" bankregulatory for purnotes enablesbanksto increase poses. Issuingcapital the degreeof leverageanyparticular amountof common equitywould otherwisesupport.As a secondexvolatile interest rates raised the ample, increasingly cost of adheringto a policy of investingin fixed-dividend-ratepreferredstock, which stimulatedthe innovativeactivity led to the development various that of formsof adjustable preferred rate stock. Both Ben-Horimand Silber  and Silber remodelof innovaport that Silber'sconstraint-induced tion explains a large percentageof new commercial bankproductsintroduced duringthe 1952-1982period. Nevertheless, Silber's modelprovides onlya partial of the processof financialinnovationbeexplanation 16 1988 FINANCIAL MANAGEMENT/WINTER cause it focuses almost exclusivelyon the securities issuerand leaves investorswith an essentiallypassive role. Van Hornetakesa morecriticalviewof the process of financialinnovationthaneither Milleror Silber.In Finance his 1984presidential address the American to Van Hornearguesthat in orderfor a Association, newfinancial instrument processto be trulyinnovaor tive, it must enable the financialmarketsto operate more efficientlyor make them more complete.If the financialmarketswere perfect and complete, there for financialinwouldbe no opportunities (nontrivial) can novation.Greaterefficiency be achieved reducby ing transactioncosts, which innovationssuch as the shelfregistration processandelectronicfundstransfer or have accomplished, by reducingdifferentialtaxes and other "deadweight" losses. The financialmarkets a canbe mademorecompletebydesigning newsecurity whose contingent after-taxreturnscannot be repliof catedby anycombination existingsecurities. Van Horne also notes the excesses that have resultedfromthe innovative process,citing"innovations" whose only apparent benefit is some sort of desirable accountingtreatment(for example,in-substancedesubstantial feasance)and pointingout the apparently fees that investmentbankersand other promotersof Howthe innovator innovations havereaped.2 financial sharesin the rewardsto innovationis an interesting empiricalquestionthat deservescarefulstudy.In paron ticular,howdo the underwriting spreads innovative securitiesvaryas additionalissuersenter the market? of How is the net advantage financialinnovationalloand catedamongthe variouspartiesto the transaction, does this allocationchangeas the innovativesehow curitybecomes seasoned and as imitatorsenter the et On market? thislastpoint,Winger al. foundthat rate preferred in the case of adjustable stock,later istermsthanthe initialismorefavorable suersachieved suers. The Miller,Silber,and Van Horne paperssuggest that the factors responsiblefor financialinnovation canbe classifiedinto 11categories: taxasymmetries (i) that canbe exploitedto producetaxsavingsfor the is2Ricks  notes that the SEC is concerned that certain innovative financial products have been misrepresented to investors, for example, the index option has been marketed to retail investors as a conservative hedging product. Ricks raises an interesting issuewhether the evolution of financial instruments has outstripped the ability of brokers to understand what they are selling and of brokerage firms to provide adequate supervision. or suer,investors, both,thatarenot offsetbythe added tax liabilities of the other; (ii) transaction costs; (iii) to costs;(iv) opportunities reducesomeformof agency riskor to reallocateriskfrom one marketparticipant to anotherwho is either less riskaverseor else willing to to bearthe riskat a lowercost; (v) opportunities inor creasean asset'sliquidity; regulatory legislative (vi) change;(vii) level andvolatilityof interestrates;(viii) level and volatilityof prices;(ix) academicwork that in resultedin advances financialtheoriesor betterunof characteristics existof derstanding the risk-return benefits(which (x) ing classesof securities; accounting may,andoften do, haveat best an ephemeraleffecton shareholder wealth);and (xi) technologicaladvances and other factors. Exhibit 1 lists a broad varietyof financial innovationsand identifies the factors prifor marilyresponsible each. Financial III.Consumer-Type Instruments financial Exhibit1 lists 14innovative consumer-type withinthe past 20 years.Broinstruments introduced whichpermitindividukercashmanagement accounts, als to earnmoneymarketratesof intereston fundsnot investedin securities; moneymarketmutual currently funds and money marketaccountsoffered by banks, which pay currentmarketinterest rates on invested whichareinterest-bearNOWaccounts, cashbalances; and debit cards,which enable ing checkingaccounts; bank depositorsto shift money between accountsor withdraw cashfromaccountsat remoteteller stations; all owe theirexistenceat least partlyto risinginterest rates,which increasedthe opportunitycost of mainor checking passtainingfundsin non-interest-bearing book accounts.In particular,money marketmutual the funds circumvented outmodedRegulationQ interestrateceilings.MoneymarketaccountsandNOW restricaccountsresultedalso fromrelaxedregulatory the typesof accountsbankscould offer. tions on Municipalbond funds, IRA/Keoghaccounts,and were initiatedby legislation.Mucertificates all-saver investors nicipalbondfundsenablesmallerindividual more to achievea degree of portfolio diversification cheaplythanthey could on their own. IRA/Keoghacto countsconveyed specialtaxadvantages self-directed retirementaccounts.All-savercertificatesprovideda whichfaced fundsin thrifts, taxincentiveto depositing at broughton byhighinfundingproblems leastpartly terestrates. to was Theequityaccessaccount designed enableinthe equitybuiltup in their to dividuals borrowagainst ENGINEERING CORPORATE IN FINANCE FINNERTY/FINANCIAL 17 Exhibit1. FactorsPrimarily Responsiblefor FinancialInnovations Innovation FactorsPrimarily Responsible* 7 2,4,6 6,7 1,6,8 2,7,11 4,8 7 Securities Innovation FactorsPrimarily Responsible* 6,7 6,7 6,7 2 1,6 1,7,8 2,7 Financial Instruments Consumer-Type accounts Brokercashmanagement bondfunds Municipal certificates All-saver Equityaccessaccount Debitcard Tuitionfutures s rate Variable adjustable mortgages or Deep discount/zero couponbonds Floatingratenotes notes ratetax-exempt Floating Realyieldsecurities notes Puttable-extendible Interestrateresetnotes notes Extendible tenderbonds Puttable/adjustable Euronotes/Euro-commercial paper Medium termnotes bonds Mortgage-backed Collateralized mortgage obligations Receivable-backed securities bondcreditsupport Letterof credit/surety Interestrateswaps Interestratecaps/floors/collars bonds Foreign-currency-denominated Dual currency bonds bonds Commodity-linked Goldloans Exchange-traded options Interestratefutures Optionson futurescontracts to bonds Warrants purchase stock Convertible adjustable preferred Remarketed stock preferred rate Singlepointadjustable stock Variable cumulative stock preferred rate debt Adjustable convertible Puttable convertible bonds convertible debt Synthetic resetdebentures Convertible Masterlimitedpartnership Americus trust Puttable commonstock Shelfregistration Discountbrokerage terminals Point-of-sale Electronic fundstransfer/ automated houses clearing Moreefficientbondcall strategies Stock-for-debt swaps Preferred dividend rolls Leveraged buyoutstructuring Projectfinance/lease/ asset-based financial structuring * funds ket Moneymark mutual ket Moneymark accounts nts NOWaccou C] Bull/Bear Ds accounts IRA/Keogh or life Universal variable insurance or Convertible mortgages reduction optionloans debtsecurities Stripped Floatingrate,ratingsensitivenotes Auctionratenotes/debentures DollarBILS rate Increasing notes notes Annuity notes Variable renewable coupon/rate duration notes Variable Universal commercial paper CDs Negotiable Mortgage pass-throughs securities mortgage-backed Stripped bonds Realestate-backed rate Yieldcurve/maximum notes Currency swaps Remarketed resetnotes bonds Eurocurrency Indexed currency optionnotes/ rate Principal exchange linkedsecurities High-yield (junk)bonds futures Foreigncurrency Stockindexfutures Forward agreements rate rate stock Adjustable preferred Auctionratepreferred stock Indexed stock floatingratepreferred Statedrateauctionpreferred stock Convertible exchangeable preferred Zero couponconvertible debt contract notes Mandatory convertible/equity auctionpreferred Exchangeable bonds Participating Additional class(es)of commonstock Pairedcommonstock Financial Processes 1,4,7 4,5,7 4,5,7 2,4,5,8 2,3,4 3 2,4 2,4,7 2,4 2 1,4,7 3,4,5,7 2,3,4,7 4,7 3 11 2,4,6 4,7 4 2,5 2,4,5 4 4,5 4,6,7 4,6 2,3,4 7 4,6,7 2,5,7,9 4 2,4,5 4,5 4,11 4,6,7 4,7 4,7 4,6 4,6,8 4,8 4,9 4,9,11 4,8,9 4,7 1,4,5,6,7 1,4,5,7 1,4,5,7 1,3,4,5,7 4,7,9 4,7,9 4,7 1,4,5,7 1,4,5,7,11 1,2,4,5,7 1,2,3,4,5,7 1,10 3,4,7 1,2,10 1,11 1,6 1,2,4,5,7 3,4 1,10 3 1 4,6 3,4,10 2,6,7 2,6 11 4 11 7,11 Financial Strategies/Solutions Directpublicsaleof securities Automated tellermachines Electronic security trading CHIPS(samedaysettlement) Cashmanagement/sweep accounts Debt-for-debtexchanges In-substance defeasance Hedgeddividend capture Corporate restructuring 2,6 2,11 2,11 7,11 7,11 1,7,10 7,9 1,7,10 1 1,9,11 4 1,7,10 1 1,9,11 of of and factors; levelandvolatility interestrates;8, levelandvolatility prices;9, academic 7, legislative work;10,accounting benefits; 11,techand nological developments otherfactors. Notation: 1, tax advantages; 2, reduced transaction costs; 3, reduced agency costs; 4, risk reallocation; 5, increased liquidity; 6, regulatory or 18 FINANCIAL MANAGEMENT/WINTER 1988 own homes.The Tax ReformAct of 1986 limitedfull interestdeductions mortgage to interest,whichstimulated the use of this vehicle.Bull and bear CDs pay a variable interest rate that is tied to changes in the Standard Poor's500 Index.Theygive individuals & an indirectwayof participating the marketfor options in on the S&P500 Index.Tuitionfuturesenablefamilies to prepaythe futurecost of an undergraduate educacost inflationrisk to the tion, whichtransfers college sellerof the tuitionfuturescontract. The remaining threeproducts all by-products are of the higherlevel andvolatilityof interestrates.Universal life insurance variablelife insurance and providea wider choice of investmentoptions than traditional wholelife insurance, whileretaining taxdeferral the of investmentearningsthat life insuranceproductsprovide.Universallife insurance policiesbuildcashvalue at a statedfixedrate,or according a statedinterest to rate formulathat the insurancecompanyguarantees. Variablelife insurancepolicies are reallyfamiliesof mutualfundswrapped withina life insurance contract. Current valuearetied directly to yieldandredemption the particular mutualfund aroundwhichthe policyis Variablerate and adjustable mortgages rate wrapped. allow the mortgageinterestrate to adjustover time, whichfacilitatesthriftasset-liability in management a volatile interestrate environment. Convertible mortto gages(also referred as reductionoption loans) give borrowers option to fix the interestrateon a varithe able rate or adjustable rate mortgageon one or more specifiedmortgagerate reset dates, providedthe "index"rate has fallen more than two percentagepoints sincethe mortgage's issuedate.To exercisethe option, the borrower a fee whichis typically smallerthan pays the cost of refunding originalmortgage. the used other investcompaniesthat have traditionally mentbankers. successful A is innovator usuallyawarded a mandateto sell the new securityon a negotiated basis,ratherthan havingto bid for securities"offthe shelf'as is the casewithconventional debtinstruments. Investment banksthereforehavea strongfinancialincentiveto engineerinnovative securities[26, 34]. A new securityis truly "innovative" only if it (i) enablesan investorto realizea higherafter-tax risk-adrate of returnwithout adverselyaffectingthe justed issuer'safter-tax of funds,and/or(ii) enablesan iscost suer to realizea lower after-tax cost of fundswithout than had been possible adverselyaffectinginvestors, prior to the introductionof the new security.A new securitycan accomplishthis only if it makesthe markets moreefficientor morecomplete.It is not enough for a new securityjust to be different;there must be some realvalue addedto the issuingcompany's shareholders. A. Sources of Value Added IV.Securities Innovation Therehasbeena moreor less steadyflowof security in innovations recentyears.The investment bankswho the new securitiesheraldeach new product's develop introduction and alongwith its advantages, the financialpressdutifully them [18,37]. However,the reports processis not withoutits detractors 53]. [45, In additionto the factorsdiscussedin Section II, a environment changein the industry helps accountfor the revolutionin securitiesinnovation. recentyears, In the investment businesshasshiftedawayfrom banking what is knownas "relationship and banking" become morecompetitive, hence,moretransactional. and Dean innovativesecurityprovides an opporveloping tunityforthe financial engineerto solicitbusinessfrom The purposeof securitiesinnovationis to develop mechanisms positive-net-present-value financing . framework inthat Finnerty developsananalytical  dicatesthreeprincipal sourcesof valueaddedthrough securitiesinnovation:features that reallocateor reduce riskand in so doingreducethe requiredoffering that yield,characteristics leadto lowerissuanceexpenses duringthe period the financialobligation is intendedto remainoutstanding, featuresthatcreate and a tax arbitrage the issuerand investors(at the exfor pense of the InternalRevenueService).The resulting value addedwill be allocated among the company's of the shareholders, purchasers the innovative security, andthe underwriters the through pricingof the innovative securityand the setting of underwriting commissions. If a companycan repackagea security'spayment streamso that it eitherinvolvesless riskor reallocates riskfromone classof investorsto one that is less riska sensitiveandthusrequires smallerriskpremium, and does so in a mannerthat investorscannotduplicateas cheaply by utilizing existing securities, then shareholdervaluewillbe enhanced. Collateralized mortgage seandstripped obligations(CMOs) mortgage-backed If can curitiesareexamples. a company issuea security againsta diversified portfolio of assets, it can reduce the investor'sriskand hence the required yield.If the thanthe investhis issuercanaccomplish morecheaply for tor can by himself,thereis opportunity gain.Some are mortgagepass-throughsecurities and examples FINANCE IN ENGINEERING CORPORATE FINNERTY/FINANCIAL 19 Exhibit2. SelectedDebt Innovations Security Adjustable Rate Notes and Floating Rate Notes Distinguishing Characteristics Coupon rate floats with some index, such as the 91-day Treasury bill rate. Risk Reallocation/ Yield Reduction Issuer exposed to floating interest rate risk but initial rate is lower than for fixed-rate issue. Coupon based on length of interest period, not on final maturity, Enhanced Liquidity Price remains closer to par than the price of a fixed-rate note of the same maturity. Reduction in Agency Costs Reduction in Transaction Costs Tax Arbitrage Other Benefits Auction Rate Notes and Debentures Interest rate reset by Dutch auction at the end of each interest period. Designed to trade closer to par value than a floating rate note with a fixed interest rate formula. Interest rate each period is determined in the marketplace, rather than by the issuer or the issuer's investment banker. Intended to have lower transaction costs than repeatedly rolling over shorter maturity securities. Bonds Linked to Commodity Price or Index Interest and/or principallinked to a specified commodity price or index. Issuer assumes commodity price or index risk in return for lower (minimum) coupon. Can serve as a hedge if the issuer produces the particularcommodity. Reduction in prepayment risk to classes with prepayment priority. Designed to appeal to different classes of investors; sum of the parts can exceed the whole. Reduced yield due to greater liquidity. More liquid than individualmortgages. Most investors could not achieve the same degree of prepayment risk reduction as cheaply on their own. Attractive to investors who would like to speculate in commodity options but cannot, for regulatory or other reasons, purchase commodity options directly. Collateralized Mortgage Obligations (CMOs) and Real Estate Mortgage Investment Conduits (REMICs) Mortgage payment stream is divided into several classes which are prioritized in terms of their right to receive principalpayments. Commercial Real Estate-Backed Bonds Nonrecourse bonds serviced and backed by a specified piece (or portfolio) of real estate. Issuer's obligation to pay is backed by an irrevocable letter of credit or a surety bond. More liquid than individualmortgages. Appeals to investors who like to lend against real estate properties. Credit-Enhanced Debt Securities Stronger credit rating of the letter of credit or surety bond issuer leads to lower yield, which can more than offset letter of credit/ surety bond fees. Enables a privately held company to borrow publicly while preserving confidentiality of financial information. Useful for hedging and immunization purposes because Dollar BILS have a zero duration when duration is measured with respect to the specified index. Dollar BILS Issuer assumes Floating rate zero reinvestment risk. coupon note the effective interest rate on which is determined retrospectivelybased on the change in the value of a specified index that measures the total return on long-term, highgrade corporate bonds. Issuer has foreign currency risk with respect to principal repayment obligation. Currency swap can hedge this risk and lead, in some cases, to yield reduction. Dual Currency Bonds Interest payable in US dollars but principalpayable in a currency other than US dollars. Euroyen-dollar dual currency bonds popular with Japanese investors who are subject to regulatory restrictions and desire income in dollars without principal risk. Corporations invest in each other's paper directly rather than through an intermediary. Investor has a put option, which provides protection against deterioration in credit quality or below-market coupon rate. Lower transaction costs than issuing 2 or 3-year notes and rolling them over. Euronotes and Euro-commercial Paper Euro-commercial Elimination of interpaper is similar to mediarybrings savings US commercial paper. that lender and borrower can share. Interest rate adjusts Coupon based on 2-3 year put date, not on final maturity. every 2-3 years to a new interest rate the issuer establishes, at which time note holder has the option to put the notes back to the issuer if the new rate is unacceptable. Extendible Notes 20 FINANCIALMANAGEMENT/WINTER1988 Security Distinguishing Characteristics Risk Reallocation/ Yield Reduction Issuer exposed to floating interest rate risk but initial rate is lower than for fixed-rate issue. Enhanced Liquidity Price remains closer to par than the price of a fixed-rate note of the same maturity. Reduction in Agency Costs Reduction in Transaction Costs Tax Arbitrage Other Benefits Floating Rate, Coupon rate resets Rating Sensitive Notes quarterlybased on a spread over LIBOR. Spread increases if the issuer's debt rating declines, Floating Rate Tax-Exempt Revenue Bonds Coupon rate floats with some index, such as the 60-day highgrade commercial paper rate. Investor protected against deterioration in the issuer's credit quality because of increase in coupon rate when rating declines. Investor does not have to pay income tax on the interest payments but issuer gets to deduct them. Issuer exposed to floating interest rate risk but initial rate is lower than for fixed-rate issue. Effectively, tax-exempt commercial paper. When such notes are issued in connection with a bridge financing, the step-up in coupon rate compensates investors for the issuer's failure to redeem the notes on schedule. Increasing Rate Notes Coupon rate increases Defers portion of interest by specified amounts expense to later years, at specified intervals. which increases duration. Indexed Currency Option Notes/ PrincipalExchange Rate Linked Securities Issuer pays reduced principalat maturity if specified foreign currency appreciates sufficiently relative to the US dollar. Investor assumes foreign currency risk by effectively selling the issuer a call option denominated in the foreign currency. Attractive to investors who would like to speculate in foreign currencies but cannot, for regulatory or other reasons, purchase or sell currency options directly. Interest Rate Caps, Floors, and Collars Investor who writes Seller assumes the risk an interest rate cap that interest rates may rise above the cap (fall (floor/collar) contract agrees to below the floor/fall outmake payments to side the collar range. the contract purchaser when a specified interest rate exceeds the specified cap (falls below the floor/falls outside the collar range). Interest rate is Reduced (initial) yield reset 3 years after due to the reduction in issuance to the agency costs. greater of (i) the initial rate and (ii) a rate sufficient to give the notes a market value equal to 101% of their face amount. Two entities agree to swap interest rate payment obligations, typicallyfixed rate for floating rate. Effective vehicle for transferring interest rate risk from one party to another. Also, parties to a swap can realize a net benefit if they enjoy comparative advantages in different international credit markets. Issuer bears market price risk during the marketing process. Agents' commissions are lower than underwriting spreads. More liquid than individualmortgages. Investor is compensated for a deterioration in the issuer's credit standing within 3 years of issuance. Interest Rate Reset Notes Interest Rate Swaps Interest rate swaps are often designed to take advantage of special opportunities in particularmarkets outside the issuer's traditional market or to circumvent regulatory restrictions. Medium-Term Notes Notes are sold in varying amounts and in varyingmaturities on an agency basis. Investor buys an undividedinterest in a pool of mortgages. Mortgage PassThrough Certificates Reduced yield due to the benefit to the investor of diversificationand greater liquidity. Most investors could not achieve the same degree of diversificationas cheaply on their own. Negotiable Certificates of Deposit Certificates of Issuer bears market More liquid than nondeposit are registered price risk during negotiable CDs. and sold to the public the marketing process. on an agency basis. Agents' commissions are lower than underwriting spreads. IN FINANCE ENGINEERING CORPORATE FINNERTY/FINANCIAL 21 Security Bondsand Puttable Tender Adjustable Securities Distinguishing Characteristics Issuer can periodicallyreset the terms, in effect rolling over debt without having to redeem it until the final maturity. Risk Reallocation/ Yield Reduction Coupon based on whether fixed or floating rate and on the length of the interest rate period selected, not on final maturity. Enhanced Liquidity Reduction in Agency Costs Reduction in Transaction Costs Tax Arbitrage Other Benefits Investor has Lower transaction costs a put option, than having to perform a series of refundings. which provides protection against deterioration in credit quality or below-market coupon rate. Put options protect against deterioration in issuer's credit standing and also against issuer setting below-market coupon rate or other terms that might work to investor's disadvantage. Puttable-Extendible Notes At the end of each Coupon based on length of interest interval, interest period, the not on final maturity. issuer may elect to redeem the notes at par or to extend the maturity on terms the issuer proposes, at which time the note holder can put the notes back to the issuer if the new terms are unacceptable. Investors also have series of put options during initial interest period. Issuer exposed to Coupon rate resets inflation risk, which quarterly to the of (i) change in may be hedged in the greater consumer price index CPI futures market. plus the "RealYield Spread"(3.0% in the first such issue) and (ii) the Real Yield Spread, in each case on a semiannual-equivalentbasis. Real Yield Securities Real yield securities could become more liquid than CPI futures, which tend to trade in significant volume only around the monthly CPI announcement date. Investors obtain a longdated inflation hedging instrument that they could not create as cheaply on their own. Real yield securities have a longer duration than alternative inflation hedging instruments. Receivable PayThrough Securities Investor buys an Reduced yield due to More liquid than undividedinterest in a the benefit to the individualreceivables. of receivables. investor of diversipool fication and greater liquidity.Significantly cheaper for issuer than pledging receivables to a bank. Interest rate reset at Coupon based on the end of each length of interest interest period to a period, not on rate the remarketing final maturity. agent determines will make the notes worth par. If issuer and remarketing agent can not agree on rate, then the coupon rate is determined by formula which dictates a higher rate the lower the issuer's credit standing. Designed to trade closer to par value than a floating-rate note with a fixed interest rate formula. Security purchasers could not achieve the same degree of diversification as cheaply on their own. Remarketed Reset Notes Investors have a put Intended to have lower option, which protects transaction costs than against the issuer and auction rate notes and debentures, which require remarketing agent periodic Dutch auctions. agreeing to set a below-market coupon rate, and the flexible interest rate formula protects investors against deterioration in the issuer's credit standing. Stripped MortgageBacked Securities Securities have unique Mortgage payment stream subdivided option characteristics into two classes, (i) that make them useful for hedging purposes. one with belowmarket coupon and Designed to appeal to the other with above- different classes of market coupon or (ii) investors; sum of the parts one receiving interest can exceed the whole. only and the other receiving principalonly from mortgage pools. Yield curve arbitrage; Coupons separated from corpus to create sum of the parts can a series of zero exceed the whole. coupon bonds that can be sold separately. Coupon rate varies Coupon based on 1-year termination date, not on weekly and equals a fixed spread over the final maturity. 91-day T-bill rate. Each 91 days the maturity extends another 91 days. If put option exercised, spread is reduced. Lower transaction costs than issuing 1-year note and rolling it over. Designed to appeal to money market mutual funds, which face tight investment restrictions, and to discourage put to issuer. Stripped Treasury or Municipal Securities Variable Coupon Renewable Notes 22 FINANCIALMANAGEMENT/WINTER1988 Security Variable Rate Renewable Notes Distinguishing Characteristics RiK Reallocation/ sk Y ield Reduction Enhanced Liquidity Reduction in Agency Costs Reduction in Transaction Costs Lower transaction costs than issuing 1-year note and rolling it over. Tax Arbitrage Other Benefits Designed to appeal to money market mutual funds, which face tight investment restrictions. Coupon based on 1-year Coupon rate varies monthly and equals a teermination date, not on nal fixed spread over the fil maturity. 1-month commercial paper rate. Each quarter the maturity automaticallyextends an additional quarter unless the investor elects to terminate the extension. Issuer is effectively selling a covered call option, which can afford investors opportunities not availablein the traditional options markets. Might reduce yield relative to conventional debt when coupled with an interest rate swap against LIBOR. Warrants to Purchase Warrant with 1-5 Debt Securities years to expiration to buy intermediateterm or long-term bonds. Yield Curve Notes and Maximum Rate Notes Interest rate equals a specified rate minus LIBOR. Useful for hedging and immunization purposes because of very long duration. Zero Coupon Bonds (sometimes issued in series) Non-interest-bearing. Issuer assumes reinvestPayment in one lump ment risk. Issues sold in sum at maturity. Japan carried below-taxablemarket yields reflecting their tax advantage over conventional debt issues. Straight-lineamortization of original issue discount pre-TEFRA. Japanese investors realize significant tax savings. debt backedby a portfolioof automobilereceivables. If a companycan securitizea loan so that it becomes the risk tradeable, lender'sliquidity is reduced, publicly yield.Negotiablecertifiresultingin a lowerrequired cates of deposit and nonrecoursenotes (i.e., mortreal gages)securedbycommercial estateareexamples. unBothcanbe tradedin the publicsecurities markets, certificates depositandmostcomlikeconventional of If mercialmortgages. a companycan designa security arise thatreducesthe agencycoststhatwouldnormally in connectionwith a conventionalfinancing,for exbetween asymmetries amplecostsdueto informational the issuer and investors,a lower offeringyield can result.Floatingrate, ratingsensitivenotes, whose interest rate increaseswhen the issuer'sdebt ratingdecreases,are an example. a can Second,if a company structure securitiesissue commissionsare reduced,shareso that underwriting Extendible notes arean holdervaluewill be enhanced. Their maturitycan be extendedby mutual example. betweenthe issuerandinvestors, effectively agreement overthe noteswithoutadditional underwriting rolling a commissions. Third,if a companycan structure new so as to reduceinvestortaxeswithoutincreassecurity valuewill be ing corporateincometaxes,shareholder For enhancedas a resultof this taxarbitrage. example, can a a companythat is not currently taxpayer create such an arbitrageby issuing auction rate preferred in investors lieu of comstockto fullytaxable corporate mercialpaper[1, 54]. Fourth,if a companycan structure a new securityso as to increasethe presentvalue the to taxshieldsavailable the issuerwithoutincreasing valuecanagainbe tax investors' liabilities,shareholder For enhancedthroughtaxarbitrage. example,the sellinvestorsbeing of zero coupon notes to tax-exempt becausethe fore TEFRAresultedin suchan arbitrage issuer could deduct the originalissue discount on a did basis.Thistaxtreatment not adversely straight-line investors. balanceof thissection The affecttax-exempt listedin Exsecurities a of describes number innovative hibit 1 in greaterdetail. B. Debt Innovations Most of the financialinnovationsin recent years haveinvolveddebt securities.Some,suchas zero coupon bonds,wereissuedin largevolumefor a periodof time but have becomeveryrare,either becausechanor ges in tax law eliminatedtheir advantages because them.Otherdebt morerecentinnovations superseded innovationssuch as extendiblenotes, medium-term notes, and collateralizedmortgageobligations have hada morelastingimpact.Yet others,suchas indexed durationnotes,certain currency optionnotes,variable andannuity notes,havebeen bonds, commodity-linked FINANCE ENGINEERING CORPORATE IN FINNERTY/FINANCIAL 23 introduced disappeared and quickly,in some cases afterjust a singleissue.Exhibit2 listsseveralof the more significantdebt innovationsand classifieseach innovation'svalue-enhancing features. Risk Reallocation/Yield Reduction Most of the debtinnovations Exhibit2 involvesomeformof risk in to debt instrureallocationas compared conventional ments or some other form of yield reductionmechanism.Involving reapportioning interestraterisk, the of creditrisk,or someotherformof risk,riskreallocation is beneficialwhen it transfers fromthose who are risk less willingto bearit to those who are morewillingto bear it, in the sense that they requirea smalleryield premiumto compensatethem for bearingthe risk.A an yield reduction(or equivalently, increasein the net proceedsthat can be realizedfrom the sale of a given debt servicestream)resultswhen repackaging para ticulardebt servicestreamand selling the component partsyields greaterproceedsthan selling the original debt servicestreamintact. Serial zero coupon bonds, strippedU.S. Treasury securities,and strippedmunicipalsecuritiesillustrate that the sum of the partscan exceedthe whole when a debt and particular servicestreamis subdivided its constituentpartsare sold separately. example,stripFor bond createsa serialzero ping a bearerU.S. Treasury issue.Eachzero couponbondin the seriescan coupon be sold to the highestbidder.Becausethe U.S. Treasurydid not issue zero couponbonds,securitiesfirms created them by strippingbearerTreasurysecurities and earnedan arbitrage profitfor theireffort.As one would expect,the substantial arbitrage profitsearned the securitiesfirms initially involvedin stripping by were eliminatedover time as competitorsenteredthe market. certificatesand receivableMortgagepass-through backedsecuritiescan be sold in the marketplace a at loweryieldthanthe assetsthatbackthembecausethey that provideinvestorsa degreeof diversification many (smaller) investorscould not achieve as cheaplyon theirown.In addition,the issueroften retainsa subordinatedinterestin the collateralpool so that muchof the apparent resultsfromthe investors' yieldreduction seniorpositionwith respectto mortgageor receivable pool cash flows. Collateralized mortgageobligations securitiesil(CMOs) and strippedmortgage-backed lustratethe benefitsthat can resultfrom repackaging mortgagepaymentstreams. Most mortgagesare at after prepayable parat the option of the mortgagor somebriefperiod.Thiscreatessignificant prepayment riskfor lenders.CMOspackagethe mortgage payment stream froma portfolioof mortgages severalseries into of debt instruments-sometimesmorethana dozenwhichare prioritized termsof their rightto receive in In the simplestformof CMO,each payments. principal series mustbe repaidin full before anyprincipalpaymentscan be madeto the holdersof the next seriesin orderto reduceprepayment Thus,CMOs uncertainty. mayserveto make the capitalmarketmore complete by producingspecific payoff streamsthat were preThis viouslyunavailable. occursespecially achieving by a specificallocationof prepayment acrossthe difrisk ferent tranches.Strippedmortgage-backed securities dividethe mortgage paymentstreaminto two separate streams claims,in the extremecase,one involving of interest paymentsexclusivelyand the other involving The introduction of principalrepayments exclusively. these securitiesalso enhancedmarketcompleteness becauseof theirduration convexity and characteristics. The apparentfailureto understand fully the riskiness of these securitiesled to a substantial highlypuband licizedfinancialloss by a majorbrokerage house . rate Adjustable notes andfloatingratenotesexpose the issuerto floatinginterestrate risk but reducethe investor's risk. principal Thisinterestrateriskreallocation can be of mutualbenefit to issuerswhose assets are interest-ratesensitive, such as banks and credit and DollarBILS companies, certaintypesof investors. area specialtypeof floatingratenote, one thathaszero duration whenduration measured is withrespectto the indexto whichthe floatingrate is tied. specified A recentlyintroducedmechanismfor transferring interestrate riskgoes by two differentnamesbecause it has two differentsponsoringsecuritiesfirms.Yield curvenotes and maximum rate notes, collectively"inverse floaters,"carryan interest rate that increases as (decreases) interestratesfall (rise) [28,39,49].Typically,the incentivein issuingan inversefloater is to fix the couponbyenteringinto aninterestrateswapagreement.The two transactions togetherbenefitthe issuer whentheyresultin a lowercost of fundsthana conventional fixed-rateissue. Investorsfind inversefloaters usefulfor immunization becauseof theirvery purposes long duration,which may exceed the maturityof the security[28, 39,49]. Threeotherclassesof debtinnovations Exhibit2 in also involvesome formof riskreallocation. Credit-enhanceddebt securitiesinvolvecreditrisk reallocation throughbank letters of credit or insurancecompany suretybonds.Whenthe letter of creditor suretybond fee is less than the resultingreductionin the yield rethe quiredto sell the securities, creditriskreallocation 24 FINANCIALMANAGEMENT/WINTER1988 is beneficialto the issuer.Dualcurrency bonds,indexed currencyoption notes, and principalexchangerate linked securitiesillustratetwo formsof currency risk reallocation. Bondsthatmakeinterestand/or principal paymentsthat are linkedto a specifiedindexor commodity,suchas the priceof oil or the priceof silver,are to attractive institutionsthat are not permittedto invest directlyin commodityoptions and can serveas a of hedgeforanissuerwhois a producer the commodity. Reduced Agency Costs Five of the debt innova- tions in Exhibit2 aredesignedat leastpartlyto reduce rate agencycosts. Increasing notes,when used in connection with a bridgefinancing,providean incentive for the issuerto redeemthe notes (out of the proceeds of a permanentfinancing)on schedule.Interestrate in resetnotes protectagainstdeterioration the issuer's to the resetdate.Puttable-extendcreditstanding prior ible notesprovidea seriesof put optionswhichprotect against deteriorationin the issuer'scredit standing. The protectionthatsuchan option affordsinvestorsis not readilyavailablein the options marketsbecause market does not exist a well-organized therecurrently for long-termcorporatebond options. Remarketed resetnotesincludea putoption,whichprotectsagainst the issuer and remarketing agent conspiringto set a and a flexibleinterestrate below-market couponrate, formula(in the event the issuer and the remarketing agent cannot agree on a rate), which providesfor a higherinterestratethe lowerthe issuer'screditstandfloatingrate,ratingsensitivenotes bear ing. Similarly, a coupon rate that varies inverselywith the issuer's creditstanding. Reduced Issuance Expenses Extendible notes, investmentrestrictions that moneymarket regulatory mutualfundsface.3 In anotherrefinementof the extendiblenote concept,puttablebonds,adjustable tender securities,and remarketedreset notes give the issuerthe flexibilityto reset the termsof the security These securitiesoffer the issuergreater periodically. thanextendiblenotes in the choice of terms flexibility of on whichto extendthe maturity the debt issue. Euronotes and euro-commercial paper represent the extensionof commercial paperto the Euromarket cost savingsresultbecausecorpora.Transaction tions investdirectlyin one another'ssecurities,rather as than throughbanksand other intermediaries, was the case previously. Tax Arbitrage Zero coupon bonds,as previously noted, provided a form of tax arbitrageprior to the passage of TEFRA. In addition, the investor bears no reinvestment risk, because interest is compounded over the life of the debt issue at the yield at whichthe investor the purchased bond. C. Options, Futures, and Other Interest Rate Risk Management Vehicles Options,futures,and other interestrate risk manwho are agementvehiclesenablemarketparticipants averse to certain risks (such as foreign currencyrisk, interest rate risk, or stock market risk) to transfer that riskto otherswho areless riskaverse,on certainspecifor fied termsin exchange a fee. Millercites financial futures as the most significant financial innovation of the past20years.BlockandGallagher andBooth,  Smith,and Stolz  catalogthe manyuses to which interestrate futuresmaybe put for risk management purposes. variablecouponrenewablenotes, puttablebonds,adresetnotes, and remarketed justabletendersecurities, euronotesandeuro-commercial paperareall designed to reduceissuanceexpensesandother formsof transnotes typically actioncosts. Extendible providefor an interestrate adjustment every2 or 3 years,although intervalsare possible,and thus repother adjustment to resentan alternative rollingover2 or 3-yearnote isadditionalissuanceexpenses. sueswithoutincurring Variable coupon renewable notes represent a refinement of the extendible note concept. The maturity of the notes automatically extends 91 days at the end of each quarter-unless the holder elects to terminate the automatic extension, in which case the interest rate spread decreases. A holder wishing to terminate the in- debtsecurities,an innovative Warrants purchase to form of debt option, have been more popularin the than Euromarket in the domesticmarket. Theytypicaltake the form of an option to buy an intermediately termor long-termbond,and generallyhavea termof expiration between 1 and 5 years. The warrant issuer is effectively writing a covered call option on the issuer's own debt. Issuing the warrantrepresentsa form of hedging by the debt issuer, and it affords investors vestmentwould avoidthe reductionin spreadby sellGoodmanandYawitz ingthe notesin the marketplace. how these featuresweredesignedto meet explain 3Variable coupon renewable notes have a nominal maturity of one year,which is the maximummaturitypermitted money marketmutual fund investments. Also, because of the weekly rate reset, variable coupon renewable notes count as 7-day assets in meeting the 120-day upper limit on a money marketmutual fund's dollar-weightedaverage portfolio maturity. IN FINANCE ENGINEERING CORPORATE FINNERTY/FINANCIAL 25 opportunitiesnot availablein the traditionaloptions markets. vehicles includeinInterestrate risk management terestratefutures,optionson interestratefutures,forwardrateagreements, interestrateswaps,interestrate caps,interestratefloors,andinterestratecollars[3, 6, within 13].The interestrateswapmarkethasexploded the past five years,andswapactivitycurrently exceeds $400 billion per year.Bickslerand Chen  describe the marketimperfections can createcomparative that in borrowers the fixed-rate advantages amongdifferent debtandfloating-rate debtmarketsandacrossnational boundaries,and therebyprovideeconomic incentives to engage in interestrate swaps.Arak et al.  rationalefor swaps.They state providean alternative that swapsenableborrowers fix the risk-free to rateso that borrowerswho believe their credit standing is about to improvehave an incentiveto borrowshortterm fundsand swapinto fixed payments. Brownand Smith  describethe innovativenatureof interest ratecaps,floors,andcollars,all of whichimposelimits on an entity'sexposureto floating-interest-rate risk. Miller  questionswhetherdiminishingreturns to financialinnovation havealready in. Muchof the set innovativeactivity in recent years has involved the developmentof new futuresproducts.Reportsin the financialpresshavestatedthat 80%to 90%of newfufail turesproducts andargued the financial that futures industryhas alreadydeveloped perhaps as much as 90% of the potentiallyuseful futures products. Millernotes that the ChicagoBoardof Tradeand the ChicagoMercantileExchangespent a combinedtotal of $5 to $6 milliondevelopingtwodistinctfuturescontractsfor over-the-counter stocks,both of whichfailed in the marketplace. economicsof futuresinnovaThe tion is one areaof investigation mightyieldat least that a partialanswerto Miller'squestion. D. Preferred Stock Innovations Preferred stock offers a tax advantage over debt to who arepermitted deductfrom to corporateinvestors, theirtaxableincome70%of the dividends theyreceive fromunaffiliated corporations. Corporate moneymanstock agershavea tax incentiveto purchasepreferred ratherthancommercial debt paperor othershort-term the instruments intereston whichis fullytaxable. Howof ever, the purchasing long-termfixed-dividend-rate stock exposesthe purchaser the riskthat to preferred risinginterestratescould lead to a fall in the price of the preferred stockthatwouldmorethanoffsetthe tax saving.Exhibit3 lists a varietyof new securitiesdesignedto dealwith this problem. rate stockwasdesignedto lessAdjustable preferred en the investor'sprincipalriskby havingthe dividend rate adjustas interestrateschange.The dividendrate adjustsbasedon a formula.At times the spreadinvestorshaverequired valuethe securitiesat parhasdifto feredsignificantly fromthe fixedspreadspecifiedin the to formula, causingthevalueof the security deviatesigfromits faceamount.Winger al. docuet nificantly ment the high volatilityof adjustablerate preferred returnsrelativeto those of alterstockholding-period nativemoney-market investments. Convertible stock(CAPS)was adjustable preferred to eliminate this deficiency. CAPS have designed tradedcloserto theirrespectiveface amountsthanadjustable rate preferredstocks. However, there have only been a few CAPS issues, probablybecauseprospective issuers have objected possibly to having to issue commonstockor raisea largeamountof cashon shortnotice. Auction ratepreferred stockcarriedthe evolutiona step further. The dividend rateis resetby aryprocess Dutch auction every 49 days, which representsjust enough weeks to meet the 46-dayholdingperiod refor received deducquiredto qualify the 70%dividends thissecurity, tion. (Onevariation of statedrateauction rate stock,fixesthe dividend for severalyears preferred beforethe regularDutch auctionscommence.)Alderson, Brown, and Lummer document the tax arstockaffordsunder bitragethat auctionratepreferred currenttax law.There are variousversionsof auction rate preferredstock that are sold underdifferentacPreferred; AMPS,Aucronyms (MMP,MoneyMarket tion MarketPreferred Stock;DARTS,DutchAuction RateTransferable AucSecurities; STAR,Short-Term tion Rate;etc.) coinedby the differentsecuritiesfirms that offer the product.The names may differbut the securitiesare the same. In an effort to refine the adjustable rate preferred stockconceptfurther,therehavebeen at least two atbut temptsto designa superiorsecurity, only one was successful. ratestock(SPARS) Singlepoint adjustable has a dividendratethat adjustsautomatically every49 to a specifiedpercentage the 60-dayhigh-grade of days commercial paperrate.The securityis designedso as to affordthe same degree of liquidityas auctionrate costs since stock,but with lowertransaction preferred no auctionneed be held. However,the fixeddividend rateformulainvolvesa potentialagencycost thataucwill tion ratepreferred stockdoes not. Investors suffer 26 FINANCIALMANAGEMENT/WINTER1988 Exhibit3. SelectedPreferred StockInnovations Security Adjustable Rate Preferred Stock Distinguishing Characteristics Risk Reallocation/ Yield Reduction Enhanced Liquidity Reduction in Agency Costs Reduction in Transaction Costs Tax Arbitrage Designed to enable shortterm corporate investors to take advantage of 70% dividends received deduction. Other Benefits Issuer bears more Quarterly dividend Security is designed to rate reset each interest rate risk than trade near its par value. a fixed-rate preferred quarter based on maximumof 3-month would involve. Lower yield than commercial T-bill, 10-year Treasury, and 20-year paper. Treasury rates plus or minus a specified spread. Dividend rate reset by Issuer bears more Security is designed Dutch auction every interest rate risk to provide greater 49 days (subject to a than a fixed-rate liquiditythan maximumrate of preferred would convertible adjustable involve. Lower yield preferred stock. 110%,or under certain circumstances than commercial paper. of the 60-day "AA" 125%, Composite Commercial Paper Rate). Dividend is paid at the end of each dividendperiod. Issue convertible on Issuer bears more dividendpayment interest rate risk than a fixed-rate preferred dates into variable number of the would involve. issuer's common Lower yield than commercial paper. shares, subject to a in market cap, equal value to the par value of the preferred. Dividend rate each period is determined in the marketplace,which provides protection against deterioration in issuer's credit standing (protection is limited by the dividend rate cap). Auction Rate Preferred Stock (MMP/DARTS/ AMPS/STAR) Designed to enable shortterm corporate investors to take advantage of 70% dividends received deduction. Convertible Adjustable Preferred Stock Security is designed to provide greater liquidity than adjustable rate preferred stock (due to the conversion feature). Designed to enable shortterm corporate investors to take advantage of 70% dividends received deduction. Remarketed Preferred Stock (SABRES) Issuer bears more Perpetual preferred Security is designed to stock with a dividend interest rate risk trade near its par value. rate that resets at the than a fixed-rate end of each dividend preferred would involve. Lower yield than period to a rate the commercial paper. remarketingagent determines will make the preferred stock worth par (subject to a maximum rate of 110%,or under certain circumstances 125%,of the 60-day "AA" Composite Commercial Paper Rate). Dividend periods may be of any length, even 1 day. Different shares of a single issue may have different periods and different dividend rates. Dividend rate reset every 49 days as a specified percentage of the high-grade commercial paper rate. Issuer bears more Security is designed to interest rate risk trade near its par value. than a fixed-rate preferred would involve. Lower yield than commercial paper. Security is designed to save on recurring transaction costs associated with auction rate preferred stock. Remarketed preferred Designed to enable short-term corporate stock offers greater investors to take flexibilityin setting the terms of the issue than advantage of 70% dividends received auction rate preferred deduction. stock, which requires a Dutch auction for potentially the entire issue once every 49 days. Single Point Adjustable Rate Stock Designed to enable short-term corporate investors to take advantage of 70% dividends received deduction. Stated Rate Auction Preferred Stock Initialdividend period of several years duringwhich the dividend rate is fixed. Thereafter the issuer can elect to have the dividend rate reset every 49 days by Dutch auction. Issuer bears more interest rate risk than a fixed-rate preferred would involve. Security is designed to trade near its par value after the initialdividend period has elapsed and the Dutch auctions determine the dividend rate. The maximum permitted dividend rate, expressed as a percentage of the 60-day "AA"Composite Commercial Paper Rate, increases according to a specified schedule if the preferred stock's credit rating falls. The maximum permitted dividend rate, expressed as a percentage of the 60day "AA"Composite Commercial Paper Rate, increases according to a specified schedule if the preferred stock's credit rating falls. Security is designed to save on transaction costs the issuer would otherwise incur if it wanted to change from auction reset to remarketing reset or vice versa. Designed so as eventually to enable short-term corporate investors to take advantage of 70% dividends received deduction. Variable Cumulative Preferred Stock At the end of any dividendperiod the issuer can select between the auction method and the remarketingmethod to have the dividend rate reset. Issuer bears more interest rate risk than a fixed-rate preferred would involve. Lower yield than commercial paper. Security is designed to trade near its par value. Security is designed to Designed to enable short-term corporate enable the issuer to select at the end of each investors to take dividendperiod the advantage of 70% method of rate reset it dividends received deduction. prefers. ENGINEERING CORPORATE IN FINANCE FINNERTY/FINANCIAL 27 a loss if the issuer'smanagerstake actionsthat cause the issuer'screditstandingto deteriorate, becausethe dividendformula is fixed. Primarilyfor this reason, therehavebeen at most only a few SPARSissues. Remarketed stockhasa dividend that rate preferred is resetat the end of eachdividend periodto a dividend ratethata specifiedremarketing will agentdetermines makethe preferred stockworthpar.Suchissuespermit the issuerconsiderable in flexibility selectingthe length of the dividend period,whichmaybe of anylength,even 1 day.Remarketed preferredalso offersgreaterflexiin selectingthe other termsof the issue;in fact, bility each share of an issue could have differentmaturity, dividendrate,or other terms,providedthe issuerand holdersso agree.Remarketed has preferred not proven as popularwithissuersas auctionratepreferred stock, but that could change due to the greater flexibility remarketed affords. preferred As a resultof the controversy overwhetherauction ratepreferred stock or remarketed stockrepreferred sults in more equitable pricing,variablecumulative stockwas inventedin orderto let the issuer preferred decideat the end of each dividendperiodwhichof the two resetmethodswill determinethe dividend ratefor the followingdividendperiod. E. Convertible Debt/Preferred Stock Innovations Convertible debt innovations share a dominant theme:the creationof additional deductions(while tax the ameliorationof moral hazard,which preserving conventional convertible bondsachieve).The creation of additionaltax deductionsinvolvesa form of tax arbond investors bitragebecause80-90%of convertible are tax-exempt. Exhibit4 describesseven recent innovationsinvolvingconvertiblesecurities. Convertibleexchangeable preferredstock consists of convertible stockthatthe issuer perpetualpreferred is permitted exchange anissueof convertible to for subordinateddebt,havingthe sameconversiontermsand an interest rate that equals the dividendrate on the convertiblepreferred.The exchangefeature enables the issuerto reissuethe convertiblepreferred conas vertibledebtshouldit becometaxable the future,but in withouthavingto payadditional commisunderwriting sions. A largevolume of such securitieshavebeen issuedbycompanies werenot currently that for taxpayers federalincome tax purposes.Similarly, exchangeable auctionpreferred stockpermitsthe issuerto exchange auctionrate notes for auctionrate preferred stock on anydividendpaymentdate. rateconvertible debt is a security with a Adjustable The securityrepresented an purportedtax advantage. attemptto packageequityas debt.The InternalRevenue Servicehas ruledthat the securityis equityfor tax purposes,therebydenyingthe interestdeductionsand the Zero couponconrendering securityunattractive. vertibledebt reflectsa similartheme . If the issue is converted, both interestandprincipalareconverted to commonequity,in whichcasethe issuerwill haveeffectivelysold common equitywith a tax deductibility feature. Debt with mandatory commonstockpurchase contractsrepresentsdebt that qualifiesas primary capital for bank regulatorypurposes because conversionis In mandatory. the meantime,the issuergets a stream of interesttax deductionsthat simplysellingcommon stock would not afford.Finnerty and Jones and Mason  describehow to packagea unit consisting of debt and warrantsinto syntheticconvertibledebt, the featuresof which mirrorthe featuresof conventional convertibledebt. Syntheticconvertiblebonds relativeto a comparable convertenjoya taxadvantage ible debt issuebecause,in effect,the warrant proceeds aredeductible taxpurposesoverthe life of the debt for issue. Lastly, convertible reset debentures protect holdersagainstdeteriorationin the issuer'sfinancial prospectswithintwo yearsof issuancethroughan interestrate resetmechanism. F. Common Equity Innovations There are four principalcommon equity innovations:additional class(es)of commonstockwhosedividendsare tied to the earningsof a specifiedsubsidiary of the issuer,the AmericusTrust,the masterlimited and partnership, puttablecommonstock.Exhibit5 indicatesthe principalbenefitsresultingfrom these innovations. The creationof a new class of commonstock that reflectsthe financialconditionand operatingperformanceof a subsidiary best illustrated the General is by MotorsCorporation ClassE CommonStock.ClassE Stock holdersare entitled to only one-halfa vote per share,and their dividendsare dependenton the paidin surplusattributable that particular to classof stock and to the separatenet income of General Motors' ElectronicData SystemsCorporation Such subsidiary. a class of stock enablesthe marketplace establisha to while ensurseparatemarketvalue for the subsidiary ing that the parentcompanyretains100%votingcontrol andthusthe rightto consolidatethe subsidiary for 28 FINANCIALMANAGEMENT/WINTER1988 Exhibit4. SelectedConvertible StockInnovations Debt/Preferred Security Adjustable Rate Convertible Debt Distinguishing Characteristics Risk Reallocation/ Yield Reduction Enhanced Liquidity Reduction in Agency Costs Reduction in Transaction Costs Tax Arbitrage Effectively, tax deductible common equity. Security has since been ruled equity by the IRS. Other Benefits Portion of the issue carried as equity on the issuer's balance sheet. Debt the interest rate on which varies directlywith the dividend rate on the underlying common stock. No conversion premium. Convertible preferred stock that is exchangeable, at the issuer's option, for convertible debt with identical rate and identical conversion terms. Convertible bond the interest rate on which must be adjusted upward, if necessary, by an amount sufficient to give the debentures a market value equal to their face amount 2 years after issuance. No need to reissue convertible security as debt-just exchange it-when the issuer becomes a taxpayer. Convertible Exchangeable Preferred Stock Issuer can exchange debt for the preferred when it becomes taxablewith interest rate the same as the dividend rate and without any change in conversion features. Appears as equity on the issuer's balance sheet until it is exchanged for convertible debt. Convertible Reset Debentures Investor is protected against a deterioration in the issuer's financial prospects within 2 years of issuance. Debt with Mandatory Notes with contracts that Common Stock obligate note purchasers Purchase Contracts to buy sufficient common stock from the issuer to retire the issue in full by its scheduled maturitydate. Exchangeable Auction Preferred Stock Auction rate preferred stock that is exchangeable on any dividend payment date, at the option of the issuer, for auction rate notes, the interest rate on which is reset by Dutch auction every 35 days. Debt and warrants package structured in such a way as to mirror a traditional convertible debt issue. Non-interest -bearing convertible debt issue. Issuer bears more interest rate risk than a fixed-rate instrument would involve. Security is designed to trade near its par value. Issuance of auction rate notes involves no underwriting commissions. Notes provide a stream of interest tax shields, which (true) equity does not. Commercial bank holding companies have issued it because it counted as "primary capital"for regulatory purposes. Appears as equity on the issuer's balance sheet until it is exchanged for auction rate notes. Issuer can exchange notes for the preferred when it becomes taxable. Synthetic Convertible Debt In effect, warrant proceeds are tax deductible. Warrants go on the balance sheet as equity. Zero Coupon Convertible Debt If issue converts, the issuer will have sold, in effect, tax deductible equity. If holders convert, entire debt service stream is converted to common equity. federalincome tax purposes.It can also prove useful for an employeestock option plan or other incentive compensationschemesfor employeesof the subsidiary. The first AmericusTrustwas offeredto ownersof American common Telephone& Telegraph Company stock on October25, 1983 . Since then, more than two dozen other AmericusTrustshave been formed. An Americus Trustoffersthe commonstockholders of a company opportunity stripeach of theircomthe to mon sharesinto a PRIMEComponent, whichcarries full dividendandvoting rightsand limitedcapitalap- preciationrights,and a SCORE Component,which carriesfull capitalappreciation rightsabovea threshold price.PRIMES SCORES and appearto expandthe of securities available inclusion investment for in range portfolios.4 4The AT&T Americus Trust was formed prior to the breakup of AT&T. The trust therefore provided an opportunity for investors to acquire units representing shares in pre-reorganization AT&T (i.e., proportionate interests in post-reorganization AT&T and in the seven regional holding companies AT&T spun off) perhaps more cheaply than they could by accumulating the shares of the different entities on their own. IN FINANCE ENGINEERING CORPORATE FINNERTY/FINANCIAL 29 Exhibit 5. Selected Common Equity Innovations Security Additional Class(es) of Common Stock Distinguishing Characteristics Risk Reallocation/ Yield Reduction Enhanced Liquidity Reduction in Agency Costs Reduction in Transaction Costs Tax Arbitrage Other Benefits Establishes separate market value for the subsidiarywhile assuring the parent 100%voting control. Useful for employee compensation programs for subsidiary. A company issues a second class of common stock the dividends on which are tied to the earnings of a specified subsidiary. Americus Trust Stream of annual total Outstanding shares of a particular returns on a share common of stock is separated company's stock are contributed into (i) a dividend to a five-year unit stream (with limited investment trust. capital appreciation Units may be potential) and (ii) a (residual) capital separated into a PRIME component, appreciation stream. which embodies full dividend and voting rights in the underlying share and permits limited capital appreciation, and a SCORE component, which provides full capital appreciation above a stated price. A business is given the legal form of a partnership but is otherwise structured, and is traded publicly, like a corporation. Issuer sells a new issue of common stock along with rights to put the stock back to the issuer on a specified date at a specified price. Issuer sells investors a put option, which investors will exercise if the company's share price decreases. The put option reduces agency costs associated with a new share issue that are brought on by informational asymmetries. PRIME component would appeal to corporate investors who can take advantage of the 70% dividends received deduction. SCORE component would appeal to capital-gain-oriented individualinvestors. PRIME component resembles participating preferred stock if the issuer's common stock dividend rate is stable. SCORE component is a longer-dated call option than the ones customarily traded in the options market. Master Limited Partnership Eliminates a layer of taxation because partnerships are not taxable entities. Puttable Common Stock Equivalent under certain conditions to convertible bonds but can be recorded as equity on the balance sheet so long as the company's payment obligation under the put option can be settled in common stock. are Masterlimitedpartnerships publicly tradedlimited partnerships operatemuchlike corporations that exceptfor theirlegalstatus,andmanyare listedon the New York StockExchange. partnership The structure eliminatesa layerof taxation.However,if an entity is profitableandneeds to retainthe bulkof its earnings, the limitedpartners owe taxon theirrespective will pro rata shares of the partnership's income. Collins and Bey  show that the master limited partnership structureis best suited for companieswith high tax rates and low retentionrates, i.e., companiesin "mature"industries, is poorlysuitedfor companiesin but industries. "growth" Puttablecommonstockinvolvesthe sale of put options along with a new issue of common stock. The packageof securitiesis comparableto a convertible bond .The put option reducesthe agencycosts associatedwith a new shareissue andcouldproveuseful in reducing,or perhapseven eliminating,the underpricingof initialpublicofferings. V. InnovativeFinancialProcesses The innovative financialprocesseslisted in Exhibit 1 reflectthreebasiccausalfactors:(i) effortsaimedat reducingtransactioncosts, (ii) steps taken to reduce idle cashbalancesin responseto higherinterestrates, and (iii) the availability relativelyinexpensive of comto facilitatequicker financial transacputertechnology tions. The shelf registrationprocess, extended to a broadrangeof corporateissuersby the Securitiesand ExchangeCommissionin 1982, has streamlinedthe processof issuingcorporatesecurities.Kidwell,Marr, 30 FINANCIAL 1988 MANAGEMENT/WINTER and Thompson  document the reduction in flotation costs that has resulted from this innovative offering process. Similarly,the direct sale of securities to the public, as evidenced by Green Mountain Power Company's sale of debt securities to its ratepayersbeginning in 1970 and Virginia Electric and Power Company's sale of common stock to its ratepayersbeginning some ten years later, also reduce transaction costs because the securities are not sold through securities firms. Such offering methods have the potential for reducing a company's cost of capital by appealing to a natural clientele for the company's securities. Discount brokerage, which resulted from the elimination of fixed commission rates by the Securities and Exchange Commission on May 1,1975, has substantially reduced brokerage commission charges below the commission rates the "full-service"brokerage houses charge. Essentially, brokerage services have become unbundled. As a result of discount brokerage, individuals can pay separately for transaction execution. Electronic security trading and automated teller machines were also intended to reduce transaction costs. Electronic security trading, automated teller machines, point-of-sale terminals, electronic funds transfer, CHIPS (Clearinghouse Interbank Payment System), and cash management/sweep accounts have all been made possible by the availability of inexpensive computer technology. The last three were also motivated by a desire to speed cash collection, to speed check processing, and to ensure the investment of excess cash balances, respectively, all in order to reduce idle cash balances, whose opportunity cost increases with rising interest rates. Gentry  provides a comprehensive review of recent developments in corporate cash management. It seems likely that further technological advances will lead to more efficient systems for effecting financial transactions and for managing cash balances. VI.CreativeSolutions to Corporate FinanceProblems Although it does not seem reflected in the relativesmall number of items listed in that category in Exly hibit 1, finding creative solutions to corporate finance problems is an important undertaking. For example, considerable practitioner and academic effort has been expended trying to develop the most efficient strategy for calling high-coupon debt when interest rates decline . Volatile interest rates have also created opportunities for companies to extinguish debt at a discount from its face amount, which produces accounting benefits. Developing techniques for accomplishing this tax-free illustrates the interaction between financial engineering and Kane's regulatorydialectic. The Bankruptcy Tax Act of 1980 eliminated several widely used strategies for obtaining the gain tax-free. Such a gain is the difference between the face amount of the debt and the repurchase price. Investment bankers first developed debt-for-lower-coupon-debt exchanges, and later developed stock-for-debt swaps, in order to achieve tax-free treatment. But the Tax Reform Act of 1984 made the gain realized in such transactions taxable and thereby virtually eliminated all remaining possibilities for refunding discounted debt profitably . Nevertheless, investment bankers came up with in-substance defeasance as a means for extinguishing discounted debt in a tax-free manner. However, Peterson, Peterson, and Ang  correctly point out that such transactions are unlikely to enhance shareholder wealth. Bankers and corporate treasurers have also expended considerable effort to come up with more tax-effective cash management strategies, including preferred dividend rolls (see Joehnk, Bowlin, and Petty ) and hedged dividend capture (see Brown and Lummer  and Zivney and Alderson  and references therein) in addition to the new forms of floating-rate preferred stock discussed earlier. The third major area of activity encompasses leveraged buyout structuring, corporate restructuring, and project finance/lease/asset-based financial structurings. All involve, among other things, the crafting of contractual and other security arrangements that allocate financial risks and rewards among shareholders and one or more classes of creditors. For example, a leveraged buyout typically involves multiple layers of equity and multiple layers of debt, each with its own particular security arrangements.The capital structure must be engineered to suit the risk-return characteristics of the portfolio of operating assets, to satisfy the risk-return preferences of the various classes of investors, and to minimize potential agency costs. Recent research has documented the substantial increases in shareholder wealth-on the order of 30%accompanying the announcements of leveraged buyouts and leveraged recapitalizations [7, 35, 52]. Financial engineering in such cases involves estimating the cash flow stream available to service debt and preferred stock, determining the most appropriate capital structure (including the examining of the advantagesof using employee stock ownership plans or other specialized forms of financing to effect the transaction ), designing the terms of each issue of securities so as to IN ENGINEERING CORPORATE FINANCE FINNERTY/FINANCIAL 31 allocaterisksand returnsappropriately minimize and incentivecompencosts,andcrafting potentialagency for sation arrangements managersto ensure sharebehavior. Mostattentionin holder-wealth-maximizing the financialpresshas been focusedon the restructuring of financially healthycompanies,but the same issues arise,andare potentiallymorechallenging, when a troubledcompanyis involved(as for examplein the of of reorganization First CityBancorporation Texas into a recapitalized bankholdingcompanyand a collectingbank,the latterbeinggiven$1.79billionof nonperforming, past due, and other lesser qualityassets that were removedfrom First City Bancorporation's books ). VII.Conclusion One of the moreimportant questionsraisedbyMiller is whetherthe processof financialinnovationhas reachedthe point of diminishingreturns.If the tax regimeremainsstatic,if interestrates stabilize,if the solidifies,andso on, diminishing regulatory landscape returns to financial innovation are bound to set in But eventually. to the extentthat financialinnovation occurs in responseto unexpectedeconomic,tax, and shocks,suchshockscan keep the processof regulatory financialinnovationgoing indefinitely withoutdiminreturnsnecessarilysetting in. Financialinnoishing vations symbolizethe profit-drivenresponse to the environchangesin the economic,tax, and regulatory ment.As this environment and as consolidachanges, tion within the financialservicesindustryintensifies competition, market participantswill seek out new moreefficiently. waysto conductfinancialtransactions The rapidpaceof financialinnovation thereforeseems to continue. likely While much has been writtenabout the processof financialinnovation,there has been little empirical of analysis the process.Futureresearch mightfruitfully eitherof twobasiclines of inquiry: pursue possiblefurtherfinancialinnovations the economicsof finanand cial innovation. Withregard the firstline of inquiry, to one area that seems particularly fruitful for further securitiesinvestigationis that of mortgage-related specifically, developingthe meansfor furtherreducing the investor's risk, prepayment andperhapseventually combining a portfolio of mortgages with options and/orfuturesand/orinterestrateswapsso as to eliminate prepayment entirely.Otherareasincludethe risk securitization additional of classesof assetsandfurther of futuresandoptionsto customizesecuapplications ritiesissuesto suit issuerandinvestorpreferences better. With regardto the economicsof financialinnovaof tion, the principalissues concern the profitability securitiesinnovationand how the processof financial innovation how operates.Inparticular, arethe rewards to securitiesinnovationallocatedamongthe financial institutionthatdevelopsthe innovative the security, isand investors? Are the innovator's excessuer, profits sive, as Van Horne seems to suggestthey mighthave been in somecases,or aretheycommensurate the with costs and risks of the process that Miller and others havenoted?How are the rewards the innovatorafto fected as competitorsintroducesimilar productsor refinements?Who are the principalinnovators:securitiesfirms,banks,securitiesissuers,the academic community,or others?The answersto these and related questionswill promoteour understanding fiof nancialengineering, activity playsa crucialrole an that in promotingmarketefficiency. References 1. M.J.Alderson, K.C.Brown, S.L.Lummer, and "Dutch Auction Rate Preferred Financial Stock," Management (Summer 1987), pp. 68-73. 2. Americus TrustforAT&TCommon SeriesA, ProspecShares, tus, October25, 1983. 3. M.Arak,A. Estrella, Goodman, A. Silver,"Interest L. and Rate FinancialManagement Swaps:An AlternativeExplanation," (Summer 1988),pp. 12-18. 4. M.D.Atchison,R.F.DeMong,andJ.L.Kling, NewFinancial Instruments:A Descriptive Guide, Charlottesville, VA, Financial ResearchFoundation, 1985. Analysts 5. M. Ben-Horim W. Silber,"Financial and Innovation: Linear A ProgrammingApproach,"Journal of Bankingand Finance (Sep- tember1977), 277-296. pp. 6. J. BickslerandA.H. Chen,"AnEconomicAnalysisof Interest Rate Swaps,"Journal of Finance (July 1986), pp. 645-655. 7. B.S.BlackandJ.A. Grundfest, "Shareholder GainsfromTakeoversand Restructurings between1981and 1986:$162 Billion is a Lot of Money,"The ContinentalBankJournal ofApplied Corporate Finance (Spring 1988), pp. 5-15. 8. F. BlackandM. Scholes,"From ProTheoryto a New Financial Journal Finance(May1974), 399-412. duct," of pp. 9. S.B.BlockandT.J.Gallagher, "The of Interest Use RateFutures andOptionsbyCorporate Financial Financial ManManagers," agement (Autumn 1986), 73-78. pp. 10. J.R.Booth,R.L.Smith, R.W.Stolz,"The of Interest and Use Futures by Financial Institutions,"JoumalofBank Research (Spring 1984), 15-20. pp. 32 FINANCIAL 1988 MANAGEMENT/WINTER 11. W.M.BoyceandA.J.Kalotay, BondCalling Reand "Optimum 36-49. Interfaces funding," (November 1979), pp. 12. K.C.Brown S.L.Lummer, Reexamination the Covered and "A of CallOptionStrategy Corporate for CashManagement," Financial Management (Summer 1986),pp. 13-17. 13. K.C.Brown D.J.Smith, and in "Recent Innovations Interest Rate Risk Management the Reintermediation Commercial and of Banking,"in this issue of Financial Management. 14. R.F.Bruner, ESOPsandCorporate "Leveraged Restructuring," The Continental Bank Journal of Applied Corporate Finance Journal Money,Credit AgainstSelectiveCreditAllocation," of andBanking 55-69. (February 1977), pp. 32. , "Accelerating and Inflation, Innovation, Technological theDecreasing Effectiveness Banking of Journal of Regulation," Finance(May1981), 355-367. pp. 33. and Forcesin the Develop, "Technological Regulatory Journal Fiing Fusionof Financial-ServicesCompetition," of nance(July1984), 759-772. pp. 34. D.S.Kidwell, M.W.Marr, G.R.Thompson, and Rule415: "SEC The Ultimate Competitive Bid,"Journal of Financial and QuantitativeAnalysis (June 1984), pp. 183-195. (Spring1988),pp.54-66. 15. A.H.ChenandJ.W.Kensinger, A "Puttable Stock: NewInnovationin EquityFinancing," Financial Management (Spring 1988), pp. 27-37. 16. J.M.CollinsandR.P.Bey,"The Limited An Master Partnership: Alternative the Corporation," to Financial Management (Winter 1986), 5-44. pp. 17. P.H. Darrowand R.A. Mestres,Jr., Creative in Financing the NewYork,Practising Institute, 1983. Law 1980s, 18. J. Dutt, "What's Dealers' Digest Hot, What'sNot,"Investment (March 17,1986), 20-28. pp. 19. J.D. Finnerty, "ZeroCouponBondArbitrage:An Illustration of the Regulatory Dialecticat Work," FinancialManagement 13-17. (Winter1985), pp. 20. DiscountedDebt: A Clarifying , "Refunding Analysis," Journalof Financial and QuantitativeAnalysis(March 1986), pp. 35. R.T. Kleiman, "TheShareholder GainsfromLeveraged CashOuts: Some Preliminary Evidence,"The ContinentalBank Journal of Applied CorporateFinance (Spring 1988), pp. 46-53. 36. J.J.McConnell E.S. Schwartz, and "LYON Journal of Taming," Finance(July1986), 561-576. pp. 37. G. Miller,"TheKnockoffArtists," Institutional Investor (May 1986), 81ff. p. 38. M.H.Miller, The "Financial Innovation: LastTwenty Yearsand the Next,"Journal of Financial and QuantitativeAnalysis (De- 21. 22. 95-406. , "TheCase for IssuingSyntheticConvertible Bonds," Midland CorporateFinance Journal (Fall 1986), pp. 73-82. cember1986), 459-471. pp. 39. J.P.Ogden,"An of Journal Fiof Analysis YieldCurveNotes," nance(March1987),pp.99-110. 40. P. Peterson,D. Peterson,and J. Ang, "TheExtinguishment of Debt ThroughIn-Substance FinancialManageDefeasance," ment(Spring 1985), 59-67. pp. 41. W. Power,"Many 1987's of New Trading Products Are Failing WallStreet Journal(January 4, Despite SpiritedMarketing," 1988), 26. p. 42. Recent Innovations in InternationalBanking, Bank for Interna- Framework Evaluating for In, "An Securities Analytical novations,"Journal of CorporateFinance (Winter 1987), pp. 3- 18. 23. FirstCityBancorporation Texas,Inc.,Proxy of JanStatement, uary26, 1988. 24. L. Fisher,I.E.Brick,andF.K.W. "Tax Incentives Finanand Ng, cialInnovation: Caseof Zero-Coupon OtherDeep-DisThe and countCorporate Financial Review Bonds," (November 1983), pp. 292-305. 25. B. Friedman, in Financial Mar"Postwar Changes theAmerican kets," in M. Feldstein (ed.), The American Economy in Transi- tionalSettlements, April1986. 43. T.E. Ricks, "SECChief Calls Some FinancialProducts'Too for Wall Journal Investors," Street Dangerous' Individual (January7,1988),p. 46. 44. A.C.Shapiro, "Guidelines Long-Term for Corporate Financing Midland CorporateFinance Journal (Winter 1986),pp. Strategy," of tion,Chicago, Press,1980. University Chicago 26. W.K.H. andA. Rudd,"Pricing Corporate New BondIssues: Fung Journalof An Analysisof Issue Cost and SeasoningEffects," Finance(July1986), 633-643. pp. 27. J.A.Gentry, "State the Art of Short-Run of Financial ManageFinancial ment," Management 1988),pp. 41-57. (Summer in 28. L.S.GoodmanandJ.B.Yawitz,"Innovation the U. S. Bond Market,"InstitutionalInvestorMoney ManagementForum (De- 6-49. 45. D. Shirreff, "Down Innovation!," with Euromoney 1986), (August p. 23ff. 46. W.L.Silber(ed.),Financial Innovation, MA,LexingLexington, ton Books,1975. 47. and , "Innovation, Competition, NewContract Designin Futures Markets,"Journal of FuturesMarkets (No. 2, 1981),pp. 123-156. EcoAmerican , "TheProcessof Financial Innovation," 89-95. nomicReview pp. (May1983), 49. D.J. Smith,"The of Pricing BullandBearFloatingRateNotes: AnApplication Financial in of Engineering," thisissueof Finan48. cial Management. 50. J. Spratlin and P. Vianna, An Investor's Guide to CMOs, New cember1987), 102-104. pp. and Dividend 29. M.D.Joehnk, O.D. Bowlin, J.W.Petty,"Preferred Rolls: A Viable Strategyfor CorporateMoney Managers?," Financial Management (Summer 1980), pp. 78-87. 30. E.P.JonesandS.P.Mason, Midland CorDebt," "Equity-Linked porate Finance Journal (Winter 1986), pp. 47-58. 31. E.J. Kane,"GoodIntentionsand UnintendedEvil:The Case Brothers May1986. Inc, York,Salomon Times 51. J. Sterngold, NewYork of Loss," "Anatomy a Staggering (May11,1987), Dlff. p. 52. K. Torabzadeh W. Bertin,"Leveraged and BuyoutsandStockholder Journal Wealth," (Winter 1987),pp. ofFinancialResearch IN FINANCE ENGINEERING CORPORATE FINNERTY/FINANCIAL 33 313-321. 53. J.C. Van Home, "Of Financial Innovations and Excesses,"Journal of Finance (July 1985), pp. 621-631. 54. B.J. Winger, C.R. Chen, J.D. Martin, J.W. Petty, and S.C. Hayden, "Adjustable Rate Preferred Stock,"Financial Management (Spring 1986), pp. 48-57. 55. J.B. Yawitz and K.J. Maloney, "Evaluatingthe Decision to Issue Original Issue Discount Bonds: Term Structure and Tax Effects,"Financial Management (Winter 1983), pp. 36-46. 56. T.L. Zivney and M.J. Alderson, "Hedged Dividend Capture with Stock Index Options," Financial Management (Summer 1986), pp. 5-12.