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.
· 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