Give examples and explain the techniques financial

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Give examples and explain the techniques. Financial Engineering: o Junk Bonds (bonds with less than investment grade ratings)- 2 problems, poor liquidity and losses due to bankruptcy Solved: for liquidity Drexel became the market maker. For bankruptcy losses, Drexel added a degree of “relationship” lending by doing everything in its power to help borrowers. (relationship financing) Drexel gets underwriting fees BUT, Drexel had to exit the market so many firms were no longer able to benefit from the relationship aspect of lending and default Guarantees and Insurance: o Municipal bonds- issued by state and local government They came with insurance; insurance companies can guarantee payment (for a fee) Securitization: o Money market dealing with high-risk borrowers Pool is set up to purchase the debt of the high-risk borrower, pool finances purchase by issuing its own investment grade paper, back by the debt it has purchased B. Read “Opening up the credit-rating club?” (14.1), “Rated F for failure” (14.6), “Undue credit” (14.7) and answer the following: 1. On what information are credit ratings based? Is it surprising that the downgrade of Enron’s debt came so late? Rating is based on information that is made public o History of borrowing and paying off debts- missed payments and defaults will decrease rating o Future economic potential o General creditworthiness
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It is surprising BUT, the rating is only based on public information- Enron kept its financial situation under wraps until the very end. Also, the market was extremely volatile so the credit quality Enron varied rapidly 2. Given their poor record of predicting problems, why are they making so much money? Who pays for the ratings? What are they paying for? Ratings are valuable not because they are accurate, but because they unlock markets; they allow money to flow. o Also, the corporations are the ones paying these companies for ratings, so even if the ratings are bad corporations are still getting investors. It’s the investors that need to stop relying on ratings for the cycle to stop Corporations pay for these companies to evaluate their bonds They’re paying for marketing essentially, they better their credit rating- the more institutional investors they will get Institutional investors rely on ratings o They will keep getting money even if they are not required because, investors can’t hope to assess the creditworthiness of thousands and thousands of securities They are paying for contracts Derivative payments depend upon the credit rating that Moody (etc.) give 3. Would institutional investors rely on ratings even if they were not required to do so? Would you expect hedge funds to rely on them?
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