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"Financial Engineering "

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Posted On 26 November 2009 at 18:57 Report Abuse

 

Financial Engineering
 
 
Financial engineering is, in essence, the phenomenon of product and/or process innovation in the financial industries - the development of new financial instruments and processes that will enhance shareholders', issuers' or intermediaries' wealth. In the New Palgrave finance dictionary, John Finnerty lists countless recent financial innovations - from adjustable rate preferred stock to zero-coupon convertible debt - but these all can be classified into three principal types of activities: securities innovation; innovative financial processes; and creative solutions to corporate finance problems.
 
 
All these innovations are implemented using a few basic techniques, such as increasing or reducing risk (options, futures and other more exotic derivatives), pooling risk (eg. MUTUAL FUNDS), swapping income streams (interest rate swaps), splitting income streams ('stripped' bonds), and converting long-term obligations into shorter-term ones or vice versa (maturity transformation). But to be truly innovative, a new security or process must enable issuers or investors to accomplish something they could not do previously, in a sense making markets more efficient or complete.
 
 
Finnerty describes ten forces that stimulate financial engineering. These include risk management, tax advantages, agency and issuance cost reduction, regulation compliance or evasion, interest and exchange rate changes, technological advances, accounting gimmicks and academic research.
 
 
The emergence of financial engineering has also been influenced by the realization on Wall Street in the early to mid-1990s that there was a need for a new kind of graduate training. The financial institutions wanted people with heavy mathematics skills and some finance training, and had previously been fed from a haphazard network of different programs. Universities began to respond to the demand by setting up masters programs in financial engineering - and they were helped by the fact that the physics job market was at an all-time low due to the end of the Cold War.
 
 
What is Financial Engineering?
 
 
There are numerous definitions of financial engineering, but most revolve around managing and reducing financial risk. A few definitions from popular books and web sites include the following:

 

 
 
 
"The process of financial engineering can be ... viewed as the 'fine-tuning' of an existing financial product to improve its return or risk characteristics in light of changing market conditions. It can be considered as a process which allows existing financial products to be overhauled and restructured to take advantage of changed taxation, legal or general economic climate."
 
 
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.
 
 
As defined by John Finnerty, “Financial engineering involves the design, the development, and the implementation of innovative financial instruments and processes, and the formulation of creative solutions to


 
"Financial engineering refers to the application of various mathematical, statistical and computational techniques to solve practical problems in finance. Such problems include the valuation of derivatives instruments such as options, futures and swaps, the trading of securities, risk management and regulation of financial markets. No single set of mathematical tools, computational techniques or financial theory describes financial engineering. Rather, it is the synthesis of a variety of these elements. Financial engineering is a practical field and a practitioners’ field by its nature. It is driven in large part by practical problems that arise in the course of daily business; the nature of the problems demand that practitioners draw from as broad a palate of tools as possible to find the best solutions to their problems. A second, related definition is that financial engineering is the use of financial instruments such as forwards, futures, swaps, options, and related products to restructure or rearrange cash flows in order to achieve particular financial goals, particularly the management of financial risk."

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Posted On 26 November 2009 at 18:58

 

problems in finance”. The soul of Finnerty's definition is captured by the words innovative and creative. Sometimes this innovation and creativity involves a quantum leap in our thinking. This is the kind of creativity involved in the introduction of a revolutionary new product such as the first swap, the first mortgage-backed product, the first zero coupon bond, or the introduction of junk bonds to finance leveraged buy outs. At other times, it involves a novel twist on an old idea. This is the kind of creativity involved in the extension of futures trading to a commodity or a financial instrument not previously traded in a futures pit, the introduction of a swap variant, or the creation of a mutual fund with a new focus. At still other times, it involves the piecing together of existing products and processes to fit a particular set of circumstances. This latter dimension is often overlooked in animated discussions of financial engineering, but it is of at least equal importance. Examples include the use of existing products to reduce a firm's financial risks, to reduce the cost of a firm's financing, to gain some accounting or tax benefit, or to exploit market inefficiency.
 
 
It is often not very easy to distinguish between those innovations which truly represent quantum leaps and those which involve novel twists on old ideas. A ready example is that form of program trading which seeks to exploit price discrepancies between the cash market for equities and stock-index futures. The basic arbitrage strategy itself, i.e., buying (selling) the cash asset while selling (buying) a futures contract, is very old. In fact, it has been practiced in the gram trade for over a century. But, the extension of the strategy to encompass cash equities and stock-index futures required complex mathematical modeling, high-speed computing, and electronic securities trading in order to work. If we focus on the basic strategy, we must conclude that program trading was a novel twist on an old idea. If, on the other hand, we focus on the complex modeling, the development of the software, and the introduction of the computer linkages to make the whole thing work, we must conclude that program trading involved a quantum leap.
 
 
Financial engineering is not limited to corporate and institutional applications. Many of the most creative financial innovations in recent years have been directed at the retail, sometimes called the consumer, level in the USA. These include such things as adjustable rate mortgages, cash management accounts, NOW accounts, IRAs and Keoghs, and various new forms of life insurance. Some of these are also introduced in the Indian financial markets.
 
 
While financial engineering is practiced at both commercial banks and investment banks, the activity, at least from the corporate end user's perspective, is more closely related to the traditional role of investment banks. Indeed, commercial banks involved in engineering solutions for corporate clients often regard their financial engineers as part of their investment banking operations. For this reason, we will often use the term investment bank loosely to include traditional investment banks, commercial banks involved in financial engineering, and other parties involved in structured deal-making and risk-management activities. We specifically exclude from this definition, however, financial engineers and financial engineering departments employed on the corporate side. We view the corporate side as the end user of the financial engineer's services; although we will, to a lesser degree, also consider retail-level end users.
 
 
From a practical perspective, financial engineers are involved in a number of important areas. These include corporate finance, trading, investment and money management, and risk management. In corporate finance, financial engineers are often called upon to develop new instruments to secure the funds necessary for the operation of large-scale businesses. This is not to say that traditional, off-the-shelf, instruments cannot accomplish the desired result. Quite often they can. But, at other times, the nature of the financing required or cost considerations dictate a special instrument, a collection of special features to be attached to an instrument, or a combination of instruments to be used in concert. This is where the financial engineer comes into the picture. He or she must understand the nature of the desired result and must piece together an appropriate solution. The frequency of innovation of this type is readily apparent to anyone browsing through the tombstones which appear daily in the financial pages of newspapers.
 
 
Closely related to financial engineering in corporate finance is financial engineering in mergers and acquisitions (M&A). Merger and Acquisition teams engineer deals all the time. The most dramatic example this engineering skill in recent years was the introduction of junk bonds and bridge financing to secure the funds necessary for takeovers and leveraged buyouts (LBOs). During the decade of the eighties alone, hundreds of billions of dollars of junk bonds were sold in the USA to finance hundreds of such deals.
 
 
Financial engineers are also employed in securities and derivative products trading. They are particularly adept at developing trading strategies of an arbitrage nature or quasi-arbitrage nature. These arbitrage strategies can involve opportunities across space, time, instruments, risk, legal jurisdictions, or tax rates. Recent innovations involving arbitrage across space include linkages between futures exchanges so that trades made in U.S. markets can be offset by trades made in foreign markets. These global linkages are very exciting developments and have ushered in a new world of 24 hour trading. Numerous innovations in recent years have involved arbitrage across time. The best known example is probably program trading, but any situation in which the return from a strategy exceeds the cost of carry provides such potential and engineers continuously seek out




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Posted On 26 November 2009 at 18:59

 

such situations. Arbitrage across instruments explains many new developments which have given rise to "synthetic" instruments and "repackaging" of cash flows. Synthetic options, zero-coupon bonds, and collateralized mortgage obligation bonds (CMOs) are all examples of this kind of activity. Asymmetries in risk, asymmetries in market access, and asymmetries in tax exposure also create opportunities. These asymmetries explain the advent of swaps, much of the use of preferred stock, and the proliferation of special purpose partnerships.
 
 
Financial engineers have played a tremendous role in investment and money management. They have developed new investment vehicles such as "high yield" mutual funds, money market is, sweep systems, and the REPO market to mention just a few. They have also developed systems for transforming high risk investment instruments into low risk investment instruments through such ingenious devices as repackaging and over-collateralization.
 
 
Finally, financial engineers have been heavily involved in risk management. This equating of concepts stems in part from the origins of the term financial engineer. It is generally agreed that the term financial engineer was introduced by London banks which began, in the mid-1980s, to build risk management departments consisting of teams of experts who would peddle structured solutions to corporate risk exposures. These teams took a new strategic approach to risk management. That is, they carefully examine all of the financial risks to which a firm is exposed. Some of the exposures are readily apparent to all, but some exposures are indirect and not at all apparent. Furthermore, risk exposures are sometimes offsetting and at other times mutually reinforcing.
 
 
The teams work with the client firm to:
1.     Identify the risks,
2.     Measure the risks, and
3.     Determine the kind of outcomes the firm's management would like to achieve.
 
 
Everything up to this point constitutes analysis. Upon completion of the analysis, the team fires up its financial engineering skills. From a basket of existing products, including swaps, futures, rate caps, rate floors, forward rate agreements, and so on, the team will piece together a solution, sometimes called a structured deal, to achieve the desired outcome. This "building block" approach to risk management became the cornerstone of those financial engineers engaged in financial risk analysis and management. For their services, financial engineers sometimes charge engineering fees. But, more often, they earn their reward indirectly by executing the "deal" with the team's bank. The bank, in turn, is a market maker in many of the instruments employed in structuring the deal. As such, it profits from its bid-ask spread.
 
 
Financial engineers basically serve three roles: deal makers (marketers), idea generators (innovators), and loophole exploiters (outlaws). The deal makers structure a deal to serve the client's needs and then sell the client on the idea. The deal is the best one if and only if the deal accomplishes the client's objectives at the least possible cost with no hidden surprises. The innovators are the ones which create new products and processes. They often work with the deal makers to custom design a new product if the client's needs cannot be met with existing products and processes. The outlaws look to exploit loopholes. They are thoroughly versed in accounting and tax law and find ways to arbitrage asymmetries wherever they find them. Quite often, the activities of this latter group serve to expose loopholes. Were it not for the ability of the engineers to ferret out such loopholes, taxing authorities could often be unaware of them. As a general rule, when the exploitation of a loophole becomes general knowledge, legislation is eventually proposed to close it. But the adoption of legislation is a slow process and the exploitation can go on for some time.
 
 
Successful financial engineers are always well versed in the financial theories, which are relevant to their trade and the mathematical relationships which make their deals work. They tend to grasp ideas quickly, and easily see through the details to the basic components of a structure. They also tend to be intellectual liberals who are encouraged to avoid the kind of "boxed" thinking which stifles creativity. Unlike most, they do not view the financial world as consisting of a set of givens. When told that something cannot be done, their first impulse is to ask why not. They tend to view every problem as a personal challenge.
 
 
Despite these general similarities, financial engineers are anything but clones of one another. Some are number crunchers who make discoveries and develop strategies through tedious and detailed examination of historical relationships and complex mathematical equations. These are the "quant jocks" of the trade. Others are opportunists. They look for exploitable situations and seize any opportunity which presents itself. They move quickly and decisively before prices have had an opportunity to change, before a necessary counterparty is lost, or before someone else with a better idea can think of it. The truly extraordinary of both groups are often described, in market slang, as "rocket scientists." In truth, however, a rocket scientist is often a duet (a rapid-fire opportunist working closely with a superb quant jock).



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Posted On 26 November 2009 at 19:01

 

such situations. Arbitrage across instruments explains many new developments which have given rise to "synthetic" instruments and "repackaging" of cash flows. Synthetic options, zero-coupon bonds, and collateralized mortgage obligation bonds (CMOs) are all examples of this kind of activity. Asymmetries in risk, asymmetries in market access, and asymmetries in tax exposure also create opportunities. These asymmetries explain the advent of swaps, much of the use of preferred stock, and the proliferation of special purpose partnerships.
 
 
Financial engineers have played a tremendous role in investment and money management. They have developed new investment vehicles such as "high yield" mutual funds, money market is, sweep systems, and the REPO market to mention just a few. They have also developed systems for transforming high risk investment instruments into low risk investment instruments through such ingenious devices as repackaging and over-collateralization.
 
 
Finally, financial engineers have been heavily involved in risk management. This equating of concepts stems in part from the origins of the term financial engineer. It is generally agreed that the term financial engineer was introduced by London banks which began, in the mid-1980s, to build risk management departments consisting of teams of experts who would peddle structured solutions to corporate risk exposures. These teams took a new strategic approach to risk management. That is, they carefully examine all of the financial risks to which a firm is exposed. Some of the exposures are readily apparent to all, but some exposures are indirect and not at all apparent. Furthermore, risk exposures are sometimes offsetting and at other times mutually reinforcing.
 
 
The teams work with the client firm to:
1.     Identify the risks,
2.     Measure the risks, and
3.     Determine the kind of outcomes the firm's management would like to achieve.
 
 
Everything up to this point constitutes analysis. Upon completion of the analysis, the team fires up its financial engineering skills. From a basket of existing products, including swaps, futures, rate caps, rate floors, forward rate agreements, and so on, the team will piece together a solution, sometimes called a structured deal, to achieve the desired outcome. This "building block" approach to risk management became the cornerstone of those financial engineers engaged in financial risk analysis and management. For their services, financial engineers sometimes charge engineering fees. But, more often, they earn their reward indirectly by executing the "deal" with the team's bank. The bank, in turn, is a market maker in many of the instruments employed in structuring the deal. As such, it profits from its bid-ask spread.
 
 
Financial engineers basically serve three roles: deal makers (marketers), idea generators (innovators), and loophole exploiters (outlaws). The deal makers structure a deal to serve the client's needs and then sell the client on the idea. The deal is the best one if and only if the deal accomplishes the client's objectives at the least possible cost with no hidden surprises. The innovators are the ones which create new products and processes. They often work with the deal makers to custom design a new product if the client's needs cannot be met with existing products and processes. The outlaws look to exploit loopholes. They are thoroughly versed in accounting and tax law and find ways to arbitrage asymmetries wherever they find them. Quite often, the activities of this latter group serve to expose loopholes. Were it not for the ability of the engineers to ferret out such loopholes, taxing authorities could often be unaware of them. As a general rule, when the exploitation of a loophole becomes general knowledge, legislation is eventually proposed to close it. But the adoption of legislation is a slow process and the exploitation can go on for some time.
 
 
Successful financial engineers are always well versed in the financial theories, which are relevant to their trade and the mathematical relationships which make their deals work. They tend to grasp ideas quickly, and easily see through the details to the basic components of a structure. They also tend to be intellectual liberals who are encouraged to avoid the kind of "boxed" thinking which stifles creativity. Unlike most, they do not view the financial world as consisting of a set of givens. When told that something cannot be done, their first impulse is to ask why not. They tend to view every problem as a personal challenge.
 
 
Despite these general similarities, financial engineers are anything but clones of one another. Some are number crunchers who make discoveries and develop strategies through tedious and detailed examination of historical relationships and complex mathematical equations. These are the "quant jocks" of the trade. Others are opportunists. They look for exploitable situations and seize any opportunity which presents itself. They move quickly and decisively before prices have had an opportunity to change, before a necessary counterparty is lost, or before someone else with a better idea can think of it. The truly extraordinary of both groups are often described, in market slang, as "rocket scientists." In truth, however, a rocket scientist is often a duet (a rapid-fire opportunist working closely with a superb quant jock).



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[ Scorecard : 3061]
Posted On 26 November 2009 at 19:02

 

Like any engineer, the successful financial engineer needs a toolkit. We find it convenient to divide the tools of the financial engineer into two broad categories: conceptual and physical. The conceptual tools involve the ideas and concepts which underlie finance as a formal discipline. Many of these conceptual tools are taught as part of modern finance curriculum in graduate-level business programs. They are generally not, however, organized or presented in such a way as to readily lend them to a systematic study which engineering. Examples of the conceptual tools with the engineer must be at home are valuation theory, portfolio theory, hedging theory, accounting relationships, and tax treatment under different forms of business organization.
 
 
The physical tools of the financial engineer include the instruments and the processes which can be pieced together to accomplish some specific purpose. At a very broad level, the instruments include fixed income securities, equities, futures, options, swaps, and dozens of variants on these basic themes. The processes include such things as electronic securities trading, public offerings and private placements of securities, shelf registration, and electronic funds transfer. By combining the physical tools in different ways, the financial engineer is able to custom design solutions to an incredible array of seemingly bewildering problems.
 
 
Financial Engineering Versus Financial Analysis
 
 
Most of the currently practicing financial engineers entered the field as some sort of financial analyst—although many may not have held the formal title of analyst. Indeed, many of those engaged in financial engineering still hold the official job title, or at least have a job descripttion, that includes the word analyst. For this reason, it is important to distinguish between the role of the financial analyst and the role of the financial engineer.
 
 
A financial analyst is a person engaged in the practice of financial "analysis." Analysis is defined as the process or method of studying the nature of something in order to determine its essential features and their relationships. A financial engineer is a person engaged in the practice of financial "engineering." As we have already defined it, engineering is the process of formulating and implementing a new instrument, a new process, or a creative solution to a problem. The confusion between the roles of the analyst and the engineer stems from the fact that many analysts become involved in engineering without realizing it. This is particularly true at the corporate level. For example, the financial analyst is confronted with the task of deciphering a situation. In the process, the analyst comes to understand the situation. If a problem is involved, the analyst may be called on as the resident expert to offer a solution-The analyst may or may not be sufficiently trained, possess the intellectual skills, or have sufficient knowledge of available products to offer a viable solution. Nevertheless, in such a situation, most analysts will attempt to offer a solution. Without a sufficient knowledge base however, the solution offered may be far from optimal. 
 
 
An example of the roles of the financial analyst and the financial engineer should reinforce the distinction. Consider a firm with a highly volatile cash flow stream. The firm would like to know (1) the sources of the volatility, and (2) how to remove the volatility. The firm hires a financial analyst to decompose the historic cash flow stream. Let's suppose that the analyst determines that the cash flow stream contains a secular trend, a seasonal component, an exchange rate component, and a small random component. Each component is measured and isolated. At this point the analyst has finished his work. He has explained the components of the firm's cash flow and the sources of the firm's risk. But, as important a step as the analysis is, the analysis alone does not solve the problem—i.e., the elimination the volatility. It is time to bring in the financial engineer. The financial engineer picks up where the analyst leaves off. The financial engineer structures a solution to the volatility problem. The solution is likely to consist of several separate parts—each designed to eliminate the volatility components—hence, the term structured solution.
 
 
It is not the case that financial engineers do not need to understand financial analysis. Also it is not true that the financial engineer can leave the financial analysis entirely to others—although this is sometimes the case. Rather, the financial engineer goes one step beyond that of the analyst. But, in order to do so, he or she must first understand financial analysis and be proficient at the appropriate methodologies.
 
 
Tools of Financial Engineering
 
 
One interesting way to trace the evolution of this industry is by observing one of the most subtle but interesting trends. This is quite simply the name we call this business. Prior to the creation of financial futures, this industry consisted of firms, professional traders, and individuals who engaged in futures transactions where the underlying asset was a physical commodity. Accordingly, the business was called commodity futures, with an occasional attenuation to just futures.
 
 
In the early 1970s the first futures contracts on something other than a commodity were introduced. These were the foreign currency futures. A few years later the first futures on a pure financial instrument, GNMA mortgage-backed security futures, were introduced. Although some people said that money was the ultimate commodity, the term “commodity futures” just did not seem all that appropriate for these instruments. Thus, they were called


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Posted On 26 November 2009 at 19:03

 

financial futures. When one wanted to collectively describe the futures business, it was commonly just called “futures.” The term “financial futures” seemed to encompass foreign currency futures, but to make a distinction between futures on currencies and futures on GNMAs as well as those that soon followed on Treasury bills and Treasury bonds, the term interest rate futures was invented. With futures on widely traded government securities now available, we began to start seeing the first evidence that the securities business – Wall Street in New York – and the futures business – LaSalle Street in Chicago – had something in common.
 
 
Let us keep in mind that listed options were created in 1973, when the Chicago Board Options Exchange was formed as an outgrowth of the Chicago Board of Trade. This was the second step in the process of linking Wall Street to LaSalle Street. Options on individual stocks were integrally tied to the underlying stocks, and one could not realistically trade options without occasionally trading the stock. Of course, one could trade stocks without trading options, but gradually more dyed-in-the-wool stock traders began looking at and occasionally trading options. The options and futures exchanges in Chicago, however, were not well coordinated, a result of some bitter blood between the CBOT and its estranged child, the CBOE. Thus, the futures industry and the options industry were almost separate for many years, even though they resided in the same city.
 
 
In 1982 the CFTC granted permission to allow trading on futures contracts on stock indices. This was truly a watershed event. The ability to trade the market, at very low transaction costs and very high leverage with stock index futures, was very enticing to Wall Street. Soon stock index arbitrage was widely executed by Wall Street and LaSalle Street firms, thus completing the integration of these separate markets. The introduction of stock index options in 1983 completed the cycle by fully integrating stocks, futures on the stock market, and options on stocks as well as on the market. As if anything else were needed, options on futures on the stock market were also created. The industry began calling itself futures and options, or depending on whose perspective you heard it from, options and futures.
 
 
A parallel development in the late 1980s was the creation of the swap as a mutation of an old pair of transactions called parallel loans. By the mid 1980s institutions were doing a lot of business in these over-the-counter, private unregulated transactions. It did not take long before these institutions realized that if you could create swaps in an over-the-counter market, why could you not also create options and forwards? Indeed you could and indeed they did, to the tune of trillions of dollars of notional principal. You could now no longer call the industry “options and futures.” The new name: derivatives.
 
 
The derivatives revolution spawned a lateral development. Institutions discovered that it was possible to create very sophisticated instruments. Exotic variations and mutations of the basic, sometimes called “plain vanilla,” instruments began to flood the market. In some cases these were attractive solutions to complex problems, such as hedging the risk of foreign interest rate changes without bearing the currency risk (solution: the “diff swap”). In some cases, these were simply complex instruments that may have served no obvious purpose other than they sounded pretty cool. To create these instruments, financial institutions hired hundreds of the proverbial rocket scientists. Following the fall of communism in the Soviet Union, we began to find a number of Russian mathematicians working on Wall Street.
 
 
The process in which sophisticated techniques in mathematics and physics were used to model the financial markets and create complex financial instruments became known as financial engineering. Let us emphasize that this name was not used to describe the entire business, but only a part of what is done in this business.
 
 
Innovation in Finance
 
Invention is the act of finding new ways to do useful or profitable things usually in a cheaper and more efficient way. Innovation is the act of putting an invention into practice. Every invention makes one or more innovations feasible, but one can always identify an innovation lag. Before an invention can be adopted commercially, the opportunities it opens up must promise enough after-tax profits to counter balance the costs of overcoming institutional inertia, the investor psychology and the resistance associated with changing established ways of doing things. Such innovative and/or creative acts in the finance industry are termed as financial engineering.

The process of creating innovative financial securities in terms of technical aspects and derivative pricing that offers new pay-offs to investors is called financial engineering. John D Finnerty puts financial engineering as one that involves design, development and implementation of innovative financial instruments and processes and the formulation of creative solutions to the problems in finance. Financial engineering facilitates the development, refinement, and broad-based adoption of derivative securities such as futures, options, swaps and other contractual agreements. Financial innovations related to these products have improved their efficiency by expanding opportunities for risk sharing, lowering transaction costs and reducing information and agency costs. If financial engineering is to be viewed as financial innovation, it has to be accepted that financial engineering is as old as financial markets. Financial markets are as old as investments and investments date back to the first day of paper currency's existence. However, the recognition of the concept as such and a mention of it was done only in the early 1980s.




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Posted On 26 November 2009 at 19:05

 

Financial innovation is a central force driving the financial system toward greater economic efficiency with considerable economic benefit accruing from the changes over the past several decades. John D Finnerty in this context lists countless recent financial innovationsfrom adjustable rate preferred stock to zero-coupon convertible debt. These can be classified mainly into three types of activities viz., securities innovation, innovative financial processes and creative solutions to corporate financial problems. All these innovations are implemented using a few basic techniques, such as increasing or reducing risk, pooling risk, swapping income streams, splitting income streams, and converting long-term obligations into short-term ones or vice versa.
 
 
 
Some characteristics of Financial Engineering
 
 
The financial engineering, in essence, is the phenomenon of product and/or process innovation in the financial industries, the development of new financial instruments and processes that will enhance shareholders', issuers', or intermediaries' wealth. The increasing significance of financial engineering is attributable to five factors. They are:
·         Increase in complexity of the financial systems.
·         Increase in the need for quantitative modeling of financial markets.
·         Advent of newer technologies and computing programs and data collection efficiencies.
·         Unending financial sector reforms.
·         Globalization of the financial markets.
 
 
Finnerty describes 10 forces that stimulate financial engineering. They are the risk management for assets or projects held by either the issuer or the investor or by both without resulting in any disadvantage for either tax advantages in terms of postponement of the liability or reduction of tax liability or shifting of the tax liability, agency costs reduction, issuance cost reduction, convenient compliance with the regulation, interest rate changes favorable to both the issuer and investor, exchange rate changes addressing the problem of fluctuations of exchange rates, technological advances, accounting gimmicks essentially benefitting the issuers, and the promotion of academic research. However, the level of stimulation of each of the forces depends on a number of variables.
 
 
While the above discussed forces stimulate financial engineering, it is the advantages for the investors that matter more as innovation of financial securities mainly concerns the flow of additional funds into the financial system because of the attraction of the innovated securities. Hence, financial engineering related to securities innovation focuses the following aspects only.
 
·         Return on investment frequency of return, rate of return, mode of return.
·         Safetygrade assigned by rating agencies, security, potentiality of investment.
·         Volatilityvolatility of volume, volatility of price.
·         Liquidity.
·         Convenience of investing.
·         Tax aspects.
·         Investment period.
·         Financing source.
·         Securitization scope (to pledge, and/or to raise funds on investments).
 
 
Financial engineering relating to securities innovation by focusing on the most vital aspects of investment viz., return, risk, safety, and convenience, helps the household investors as they seek benefits mainly with respect to these aspects. While issuers use financial engineering for mobilizing the required funds, institutions use financial engineering to create complex derivative instruments so as to institutionalize the flow of funds in the financial markets by hedging the core risks. The process may include:
 
·         Designing a derivative instrument which will appeal to one or more of the institutional clients.
·         Developing a hedging strategy for the portfolio of assets or liabilities which will support that instrument.
·         Pricing the instrument based on the anticipated cost of hedging strategy.
·         Implementing the strategy once the instrument has been sold.
 
 
As already mentioned, issuers use financial engineering to tap additional sources of funds and facilitate additional investments flow into the financial markets. As a result, of the new financial instruments and additional investment flows, financial markets grow and develop fueling an easier and faster growth of financial engineering process. In fact, there is a linear relationship between the two. As a result, financial markets become more efficient and get nearer to perfection.
 
 
Financial engineering is leveraged to take advantage of the silence of legal provisions resulting in breach of the spirit of regulation. In the recent past one large-sized Indian company announced issue of fully-paid secured debentures as bonus to its shareholders, and a good number of large-sized companies too have contemplated to follow the same route. In this context, it is to be noted that the issue of any type of securities as bonus



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Posted On 26 November 2009 at 19:06

 

amounts to capitalization of reserves. Interestingly and surprisingly Indian Companies Act and other related enactments are silent on this vital issue. Needless to mention, the issue of bonus debentures calls for several regulatory compliance in terms of general reserves, statutory reserves, debenture trust deed execution, creating a charge and debenture redemption reserve. Innovation of a new strategy/product by taking undue advantage of the silence of the legislation is not only unlawful but also an attempt to weaken the spirit of the regulatory legislation. In this connection it becomes imperative to acknowledge that financial engineering is used, though not by all, as a tool to circumvent regulatory provisions and avoid tax. As a result, financial markets tend to grow in terms of efficiency not necessarily becoming perfect always. Notwithstanding financial engineering doesn't concern itself with creation of tailor-made innovative investment avenues. On the other hand, it involves creation of structured financial instruments for the markets, in general.
 
 
New Instruments for Hedging
 
 
Financial engineering creates financial instruments on a continual basis. When many drawbacks are found in the existing instruments, new instruments are engineered to replace or supersede the existing financial instruments. When a product/service/contract is engineered before a need for the engineered features is felt, it is a hard sale. It takes quite a long time for the product to come into extensive use in the financial markets. However, when engineering is applied as a cure for the nagging limitations of the existing products, markets certainly welcome, adopt and absorb such innovations. Further, this would bring about a change in the attitude of the households in such a way they desire to invest more. This attitudinal change on the part of the households may even persuade the government to restructure or even privatize the public sector financial institutions. While such things have been increasing the complexity of the financial system, there has been a growth in general economy, variety of financial transactions, sums and risks involved, and the number of market participants. The quantitative modeling has been replacing the hunch or intuitive modeling in the financial markets. The unending reforms of the economies and the financial sector in particular have started plugging the existing loopholes at a faster pace. Lastly, globalization of most of the financial markets is demanding newer financial products, services, and contractual concepts.
 
 
As a result, financial engineers after a thorough research developed innovative instruments such as profit-linked interest rate securities, optionally dual currency bonds, rating-linked interest rate bonds, and special incorporation equity and so on. Instruments that offer security with a fixed interest rate coupon and a percentage of the profits derived on the projects are being designed with numerous benefits to the investors. Optionally, dual currency bonds can be purchased in any of the two currencies specified and can be redeemed as per the indenture at the intervals provided in any of the two designated currencies. Theories of finance and practice of credit rating reveal that coupon rates of securities are influenced by the rating assigned by the rating agencies and the coupon rates are fixed in tune with the rating at the time of issue of securities. If there is a change in the grade of rating assigned from time to time, the impact of the change in rating will be on the pricing of security but the coupon payment remains fixed. Of late, financial engineers are designing securities bearing variable interest rate. These rates, though fixed, change in response to a change in the rating. Yet another instrument is special incorporation equity. This is a venture capital investment with a sort of buyback arrangement at the market price plus a fixed monetary premium. In case the issuer company is not financially capable of buying back the designated part of equity at the specified premium, it issues additional equity shares equivalent to the premium amount.
 
 
John D Finnerty compiled an informative list of the financial innovations and factors that are primarily responsible for innovation. The compilation covered consumer type financial instruments, securities, financial processes, and financial strategies/solutions based on the tax advantages, reduction of risk of volatility in interest rates, reduction of academic work, reallocation of risk, technological development, reduction of transaction and agency costs, increase in liquidity etc.
 
 
Benefits of Financial Engineering
 
 
The benefits of financial engineering are multifold. Financial engineering is found everywhere. The changes in the existing financial products, services and contracts take place first in the developed countries but after spreading to the developing countries, the changes stay long because developing countries need more funds circulation exercise to improve their poor financial markets. This dictum goes together with the fact that there is no developed country with poor financial markets and there is no developing country with a strong financial market. The contribution of financial engineering to the developed countries will be to sustain the existing financial markets while to the developing countries it will be to develop them.
 
 
The beneficiaries of more and more financial products, innovations, services and contracts are industry, government and households. However, financial engineering in the financial services sector benefits households more than anyone else. Likewise, financial engineering in the banking sector benefits the government more than anyone as the Central Bank of the economy can influence the flow of funds of banking



Member (Account Deleted)


[ Scorecard : 3061]
Posted On 26 November 2009 at 19:07

 

sector in a short duration while the flow of funds into the other sectors cannot be influenced immediately. But, in an economy, among the three beneficiaries of the financial engineering viz., industry, households, and government, government's benefits are with respect to its state finances management. Restructuring various public financial institutions to lessen the burden on the part of the state is made possible as for instance in the major transitions required for restructuring financial institutions both in EMU Europe and in Japan. Financial engineering may prove useful in finding alternatives that allow for coordinated policies as well as measuring the costs of implementing one policy over another. However, it is the issuers who try to engineer innovative financial securities to raise funds for their investment activity. Financial engineering in the primary market segment will benefit industry as the investors may bypass the banking channel and investments are directly made in the industry. This may even lead to disintermediation. However, because investments savings in non-banking sector are not perceived as risk-free, they are driven by the trends of the capital markets. Hence, if and only when capital markets are in an upward trend, the industry benefits. When capital markets are down, neither the bypassed channel of banking sector may not be restored to its full measure nor will the industry get funds through the disintermediation route. Financial engineering cannot just mean creating innovative financial instruments. It is much more than that. It has to fill the persisting gaps in the financial markets, address the preferences of investors, and offer new pay-offs that investors want. Investors include issuers. Even issuers who raise funds through few financial instruments would find few other innovative financial instruments worth investing in that have been a creation of financial engineering. In this whole process, issuers get benefited as they can raise funds at a competitive cost, markets benefit as they grow in both absolute and real terms and investors get benefited as they enjoy the facility of having their desired features for their financial investments. Thus, financial engineering, without causing a loss to the current benefits, enables short, very short, medium, short-medium, average medium, long, and very long-term periods for locking, interlocking and unlocking of the funds making the financing activity a continuous one in reality like those of production and selling.
 
The advantages that the financial system enjoys with the financial engineering are as follows:
 
·         Channelizes the financial surplus of the society into the avenues of financial assets.
·         Enables the deregulation of financial sector.
·         Facilitates the financial reforms.
·         Improve financial markets in terms of perfection as the investment opportunities and financial assets are available to all types and kinds of savers.
·         The amount of financial intermediation may increase or decrease depending on the nature of financial engineering. But the costs will reduce drastically.
·         Transparency in the financial transactions will increase.
·         Accounting standards and tax procedures will be amended.
·         Price negotiations will become efficient.
·         Under subscripttion and underwriting will disappear over a period of time.
·         As of now only debenture holders enjoy the benefit of providing funds for specific and selective projects than for the company as a whole. But equity shareholders cannot fund a specific project. They have to fund the company as a whole. With the ongoing financial engineering, project-wise equity funding may be possible.
·         Discourages tax evasion, violation of regulatory provisions, window dressing, non-disclosure etc.
·         Causes spread of the organized financial markets to the rural areas.
 
 
Financial engineering facilitates designing, maintaining and fine tuning of financial system with SOFT hands with loads of SOFT skills. However, the attrition rate in the turbulent field of finance is ever elusive. Perhaps, this is one factor that is inhibiting the rate of financial innovation as it involves top heavy investments in the very process of engineering per se and that too on a product/process/strategy/solution whose impact on the bottom line of the company is certainly uncertain. It cannot be ignored that there have been financial incidents, and even crises, that invite questions about innovations and the soundness of the financial science theories used to engineer them. These questions enjoyed support, as there have been few faulty financial engineering designs and faulty implementations of those designs. Though the very basis of such questions cannot be nullified, the allegations made can certainly be. The fact is that whether it is a perfect or faulty financial engineering, every such engineering has caused the financial system become more robust and has even extended the existing financial infrastructure. Of late, the distinctions between fundamental, technical and qualitative have evaporated as all the three approaches to financial decision-making are now subsumed by the term financial engineering. It may be the kind of creativity involved in the introduction of a revolutionary new product such as the first swap, the first mortgage backed product, the first zero coupon bond, or the introduction of junk bonds to finance leveraged buyouts. At other times, it may be a novel twist on an old idea. This is the kind of creativity involved in the extension of futures trading to a commodity or a financial instrument not previously traded in a futures pit, the introduction of a swap variant, or the creation of a mutual fund with a new focus. At still other times, it may involve the piecing together of existing products and processes to fit a particular set of circumstances to reduce firm's financial risks, to reduce the cost of a firm's financing, to gain some accounting or tax benefit, or to exploit a market inefficiency.
 



sivaram
Asst Mgr-Finance


[ Scorecard : 5026]
Posted On 27 November 2009 at 08:41

gr8



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