TOPIC 4 FINANCIAL ENGINEERING

INTRODUCTION
Financial engineering is a cross-disciplinary field which relies on computational intelligence, mathematical finance, numerical methods and computer simulations to make trading, hedging and investment decisions, as well as facilitating the risk management of those decisions. It is a multidisciplinary field involving financial theory, the methods of engineering, the tools of mathematics and the practice of programming. The first degree programs in financial engineering were set up in the early 1990s. The number and size of programs has grown rapidly, so now some people use the term financial engineer to mean someone who has a degree in the field. An older use of the term "financial engineering" that is less common today is aggressive restructuring of corporate balance sheets. It is generally (but not always) a disparaging term, implying that someone is profiting from paper games at the expense of employees and investors.

FACTORS INFLUENCING FINANCIAL ENGINEERING

Environmental Factors Intra-firm Factors ENVIRONMENTAL FACTORS Price Volatilities Globalization Tax Asymmetries Technological Advances
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 Advancement in Financial Theories Regulatory Changes Increased Competition Transaction Cost Price Volatilities: Price is what one pays to acquire something of value or the use of something as value. Interaction of demands by consumers and the supplies by producers ultimately decides market clearing price and quantities. If the demands and supplies for a thing change rapidly over short period of time then market clearing price can change dramatically, is referred as Price Volatility. Elements of Price Volatility

Frequency of Price Change

Speed of Price Change

Magnitude of price change

Globalization of the markets: In the 1960s wage rate disparities between US and other countries led firms to start overseas production of low technology product which can be easily transported. Development of Eurodollars in 1970s gave rise to Multinationals, who introduced new financial instruments, which were the product of revolutionary financial engineering. Increased competition due to globalization has forced MNCs to incorporate high degree of leverage in their capital structure making them vulnerable to Exchange rate and Interest rate risk.

Tax Asymmetries: Tax asymmetries exist if two firms are subject to different effective Tax Rate, which is cleverly exploited by Financial Engineers. Reason for Tax Asymmetries 1. Some industries are granted special Tax Exemptions. 2. Different countries impose different Tax burdens. 3. Past performance has left some firms with sizable Tax credits and write-offs Technological Advances: Improvement in Computer Technology along with advances in Telecommunication led to high speed data transmission. Synergy of these technologies with software programming led to advent of spreadsheet programs. With the introduction of spreadsheet programs currency and interest rate swap blossomed Advances in Financial Theory: Extensive theoretical contributions from academicians to financial theories formed the backbone of new financial instruments and their usage. Development of financial theory capable of explaining the valuation of stock Index futures contracts led to Order matching computer system on NYSE Known as Designated Order Turnaround (DOT) system. Elaborate research on mathematical relationship which exploits discrepancies in market price led to program trading or future-cash arbitrage causing short run volatility. Regulatory Change and Increased Competition: Increased competitive pressures, better risk management techniques, coupled with the 1980s atmosphere of deregulation led to efforts to repeal much of regulation heaped on the industry. Massive failures in the thrift industry acted as catalyst for deregulation.
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Interstate banking broke down; commercial banks became increasingly involved in investment banking. Drawbacks Competition among banks became so fierce, to keep existing clients investment bank would engineer unique instruments to fit the clients. The complexity of these products was to the degree, that the client firm did not understand the products engineered on its behalf. Many of the financial products innovated in the 1980s blew up in the faces of the clients firms soon it were issued. Transaction and Information cost: Enormous technological development decreased the cost of information, on which many transactions feed. Thus, the cost of transacting itself, declined significantly during the decade of 1980s.

INTRA-FIRM FACTORS

Liquidity needs

Agency cost

Quantitative Sophistication

Risk Aversion among managers

Formal Training of Senior-Level Personnel

Liquidity Needs: Liquidity has many facets; Ease of conversion of cash, or put cash to work, Degree to which market can absorb sale and purchase without imposing excessive cost, Size of bid-ask spread.

Financial innovations help corporation and individual to meet these needs Risk Aversion by managers Although corporate managers have become increasingly aware of their risk exposures, these managers are also uncomfortable with the instruments of modern risk management. They often fail to understand the intricacies of these modern instruments. Hence Formal Training of SeniorLevel Personnel has become a serious issue. Agency cost An agency cost is an economic concept that relates to the cost incurred by an entity (such as organizations) associated with problems such as divergent management-shareholder objectives and information asymmetry. The costs consist of two main sources: The costs inherently associated with using an agent (e.g., the risk that agents will use organizational resource for their own benefit) and The costs of techniques used to mitigate the problems associated with using an agent (e.g., the costs of producing financial statements or the use of stock options to align executive interests to shareholder interests).

Quantitative Sophistication and management training In very few areas is quantitative sophistication more important than in investment arena. By deciphering complex situations through tedious mathematical could enhance returns by a respectable number of basis points. Hence firm expend huge sums on training of management in quantitative sophistication.

ROLE OF FINANCIAL ENGINEERS

The rapidity with which corporate finance, bank finance, and investment finance have changed in recent years has given birth to a new discipline that has come to be known as financial engineering. As with most disciplines in their early stages of development, the field of financial engineering has attracted people with an assortment of backgrounds and perspectives. The term financial engineering means different things to different people like commercial bankers, investment bankers, corporate treasurers, corporate recruiters, financial engineers, financial analysts, and others. This is not surprising. The field is not yet very well defined and each practitioner tends to view his or her own body of experience as the crux of that which constitutes the discipline.

APPLICATION OF FINANCIAL ENGINEERING

The main applications of financial engineering are as follows:

Corporate finance Derivatives pricing Execution Financial regulation Portfolio management Risk management Structured products Trading

1. CORPORATE FINANCE
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Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value.[1] Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

2. DERIVATIVES PRICING A derivative is a financial instrument whose value is based on one or more underlying assets. In practice, it is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties. The most common types of derivatives are: forwards, futures, options, and swaps. The most common underlying assets include: commodities, stocks, bonds, interest rates and currencies. Derivatives are used by investors for the following:

Provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative

Speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level)

Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out

Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives)

Create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level).

3. EXECUTION The process of completing an order to buy or sell securities. A broker who buys and sells shares on the instructions of clients but who offers no advice about what to buy and sell. Self-directed investors who want to make their own decisions are most suited to this service, and will probably be attracted by the lower dealing costs. Investors who want advice will need to use the services of an advisory of discretionary broker. The website of The Association of Private Client Investment Managers and Stockbrokers provides a list of brokers and the services that they offer. 4. FINANCIAL REGULATION Financial regulation is a form of regulation or supervision, which subjects financial institutions to certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial system. This may be handled by either a government or non-government organization. The objectives of financial regulators are

Market confidence - to maintain confidence in the financial system

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Financial stability - contributing to the protection and enhancement of stability of the financial system

Consumer protection - securing the appropriate degree of protection for consumers.

Reduction of financial crime - reducing the extent to which it is possible for a regulated business to be used for a purpose connected with financial crime.

5. PROTFOLIO MANAGEMENT Portfolio is none other than Basket of Stocks. Portfolio Management is the professional management of various securities (shares, bonds and other securities) and assets (e.g., real estate) in order to meet specified investment goals for the benefit of the investors. It may refer to:

Investment management, handled by a portfolio manager IT Program management IT portfolio management Project management Project portfolio management

Investment management Investment management is the professional management of

various securities (shares, bonds and other securities) and assets (e.g., real estate) in order to meet specified investment goals for the benefit of the investors. Investors may be institutions (insurance companies, pension funds, corporations, charities, educational establishments etc.) or private investors (both directly via
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investment

contracts

and

more

commonly

via collective

investment

schemes e.g. mutual funds or exchange-traded funds). A portfolio manager is either a person who makes investment decisions using money other people have placed under his or her control or a person who manages a financial institution's asset and liability (loan and deposit) portfolios. On the investments side, they work with a team of analysts and researchers, and are ultimately responsible for establishing an investment strategy, selecting appropriate investments and allocating each investment properly for a fund- or assetmanagement vehicle. 6. RISK MANAGEMENT Risk management is the identification, assessment, and prioritization

of risks (defined in ISO 31000 as the effect of uncertainty on objectives, whether positive or negative) followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities. Risk management also faces difficulties in allocating resources. This is the idea of opportunity cost. Resources spent on risk management could have been spent on more profitable activities. Again, ideal risk management minimizes spending (or manpower or other resources) and also minimizes the negative effects of risks.

7. STRUCTURED PRODUCT In finance, a structured product, also known as a market linked investment, is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps. The variety of products

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just described is demonstrative of the fact that there is no single, uniform definition of a structured product.

8. TRADING In finance, a trading is an exchange of a security for "cash", typically a short-dated promise to pay in the currency of the country where the 'exchange' is located. (securities such as stocks, bonds, commodities, currencies, derivatives or any valuable financial instrument) CONCLUSION Financial engineering is somewhat controversial, and some believe that it increases any economy's systemic risk instead of decreasing it. Financial

engineering sometimes also refers to the strategies companies use to maximize profits or other important performance metrics.

REFERENCE
en.wikipedia.org/wiki/Financial_engineering

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