Practical Financial Optimization: Decision Making for Financial Engineers

Chapter 8

Designing Financial Products

We should be just as concerned with “the dog that didn't bark” – that is, the security or institution that did not get introduced.

Franklin Allen and Douglas Gale,

Financial Innovation and Risk Sharing

8.1 Preview

In this chapter we introduce the notion of financial innovation and discuss its drivers. Several innovative financial products are then described. A general framework for the design of new products is discussed, and optimization models for financial product design are introduced. The general discussion is followed by a concrete example for designing bonds with embedded call options.

8.2 Financial Innovation

Financial innovation – the unforecastable and unanticipated changes in financial instruments – has been occurring for several thousand years. There is evidence that the most primitive type of a financial arrangement – the loan of goods or money from one person to another – was available in many early civilizations. Bankers in ancient Greece accepted deposits and lent money, and they would also issue bankers' acceptances, that is, they would provide written promise to pay a given amount at a specified date. In modern times financial innovation is even associated with the printing of paper money as a reaction to the British government's prohibition of the minting of coins by the North American colonies.

However, it was in the 1980s that financial economics was revolutionized by the many significant and successful innovations in ...