Handbook of Finance: Financial Markets and Instruments

Chapter 7. Securities Innovation

JOHN D. FINNERTY, PhD

Professor of Finance and Director of the MS in Quantitative Finance Program, Fordham University Graduate School of Business

Managing Principal, Finnerty Economic Consulting, LLC

Abstract: Securities innovation is the process of developing positive net present value financing instruments. Securities innovation improves capital market efficiency by offering more cost-effective means of transferring risks, increasing liquidity, and reducing transaction costs and agency costs. It is a profit-driven response to changes in the economic, tax, and regulatory environment. It involves the design of financial instruments that are better in that they either provide superior, previously unavailable risk-return combinations or furnish the desired future cash-flow profile at lower cost than existing instruments. This often includes combining new derivative products with traditional securities to manage risks more cost effectively. The key to developing better risk-management vehicles is to reallocate risk more cost effectively. Innovations thrive when they provide real value. A new financial instrument is truly innovative only if it makes issuers and investors better off than they were before the new security was developed.

Keywords: securities innovation, risk reallocation, financial engineering, agency costs, clientele effect, asset securitization, debt innovations, preferred stock innovations, convertible securities innovations, common equity ...