Financial Engineering

Disparate investor demands elicit a supply of exotic securities. Creative security design often calls for bundling primitive and derivative securities into one composite security. One such example appears in Figure 1.3. The Chubb Corporation, with the aid of Goldman, Sachs, has combined three primitive securities—stocks, bonds, and preferred stock—into one hybrid security. Chubb is issuing preferred stock that is convertible into common stock, at the option of the holder, and exchangeable into convertible bonds at the option of the firm. Hence this security is a bundling of preferred stock with several options.

Quite often, creating a security that appears to be attractive requires unbundling of an asset. An example is given in Figure 1.4. There, a mortgage pass-through certificate is unbundled into two classes. Class 1 receives only principal payments from the mortgage pool, whereas class 2 receives only interest payments. Another example of unbundling was given in the discussion of financial innovation and CMOs in Section 1.4.

Figure 1.4 Unbundling of mortgages into principal- and interest-only securities.

CONCEPT CHECK ^ QUESTION 6

Trtis announcement appears as a natter of record only.

$200,000,000* Federal National Mortgage Association

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