FINANCIAL ENGINEERING 1st lecture.

Financial engineering is the lifeblood of Financial Innovation- the process that seeks to
adapt seeks to adapt existing financial instruments and processes and to develop new
ones so as to enable financial market participants to cope more effectively with the
changing world in which we live.
Financial Innovation, as a discipline, has not, until recently been taught as a formal
component in MBA and doctoral Programs in Finance.
Rather it was included in the discussion on Corporate finance, investments, commercial
banking, or investment banking, derivative securities.
These courses tend to concentrate on standard applications of existing products rather
than the creative development of new products, new uses of existing products, and new
strategies for adding value.
Major handicap to the formal study of financial engineering has been the lack of a well
structured text book.
Why do we need financial engineering ?
Financial engineering help in the development and application of financial technology
to solve financial problems and the creation of value by the identification and
exploitation of financial opportunities.
This is the reason financial engineering means different things to different people.
Scope of Financial Engineering
John Finnerty defines financial engineering as
Financial engineering involves the design, the development, and the implementation of
innovative financial instruments and processes, and the formulation of creative
solutions to problems in finance.
Creativity
1. The first Swap.
2. the first mortgage backed products
3. the first zero coupon bond
4. the introduction of junk bonds to finance leveraged buy outs.
Junk bonds was first used to denote outstanding bonds issued by firms suffering
current financial troubles. Many of these firms (Fallen angels) were financially strong
when the bonds were originally issued but had encountered difficulties that made
bond default a strong possibility.

Today junk bonds refer to all speculative grade debt, regardless of the financial
condition of the issuing firm. Speculative grade bonds are those with ratings below
BBB-(Standard & Poors) or Baa (from Moodys). These rating are also assigned to
those new firms who do not have an established performance record.
Earlier such new firms have been denied access to bond market because of their low
ratings and hence rely solely on equity finance or bank borrowings. Junk bon market
has given such firms a new financing alternative.
Leveraged buyout The acquisition of one company by another through the use of
borrowed funds. Usually the acquiring company or individuals use their own assets as
security for the funds. The intention is that the loans will be repaid from the cash flow
of the acquired company.
Creativity could also involve a novel twist on an old idea.
1. Extension of futures trading to a commodity .
2. The introduction of Swap variant
3. Creation of a mutual fund with a new focus.
i.e piecing together of existing products and processes to fit a particular set of
circumstances.
Innovations represent a quantum leaps and those which involve novel twist on old ideas.
For Example Program trading seeks to exploit price discrepancies between the cash
market for equities and stock index futures.
Program trading was a novel twist on an old idea. But if we focus on the complex
modeling, the development of the software, and the introduction of the computer
linkages to make the whole thing work, then we can say that program trading was a
quantum leap.
Financial Engineering is practiced at both commercial banks and investment banks.
Financial engineers are involved in a number of important areas including corporate
finance, trading, investment and money management, and risk management.
In corporate finance financial engineers are required to develop new instruments
to secure the funds necessary for the operation of large scale businesses
for example recent introduction of junk bonds and bridge financing to secure the
funds necessary for takeovers and leveraged buyouts(LBO)
, Mergers and Acquisitions
Financial engineers are also employed in securities and derivative trading. Ie in
developing trading strategies of an arbitrage nature of quasi arbitrage nature.

Arbitrage across instruments explains many new developments which have given rise
to synthetic instruments and repackaging of cash flows.
Synthetic Instruments- Two or more transactions that have the effect of a financial
instrument.
For example-a fixed rate bond combined with an interest rate swap can result in a
synthetic floating rate instrument.
Asymmetries in risk, asymmetries in market access, and asymmetries in tax exposure
create opportunities for financial engineers.
Financial Engineers have played an important role in development of high yield
mutual funds, sweep system (sweep account whereby a service provided by a
depository financial institution to invest on an overnight basis all or a portion of a
customers idle balances), and the repo market (short for repurchase agreement) .
Financial Engineers have also developed systems for transforming high risk investment
instruments into low risk investment instruments.
Financial engineers are involved in Risk Management. Infact it is generally agreed that
the term financial engineer was introduced by London banks which beganin the mid
1980s where the risk management departments would peddle structured solutions to
corporate risk exposures.
The risk management teams worked together with the clients firm to
(1) Identify the risks,
(2) Measure the risks, and
(3) Determine the kind of outcomes the firms management would like to achieve.
Upon completion of analysis the team fires up its financial engineering skills.ie from
existing basket of instruments like swaps, futures, rate caps, rate floors, forward rate
agreements, and so on would be pieced together to give a structured deal to give a
desired outcome.
The first impulse of a financial engineer when told something cannot be done would
be why not?
Quant Jocks- Some are number crunchers who make discoveries and develop
strategies through tedious and detailed examination of historical relationship and
complex mathematical equations.
Opportunists- They look for exploitable situations and seize any opportunity which
presents itself

A duet (a rapid fire opportunist working closely with a superb quant jock) would be
called rocket scientist in market slang.

Tools of a Financial Engineer

Two Broad categories
1 Conceptual
2 Physical
Conceptual Tools involve the ideas and concepts which underlie finance as a
formal discipline.eg valuation theory, portfolio theory, hedging theory, accounting
relationships, and tax treatment under different forms of business organization.
Physical Tools- include the instruments and the processes which can be pieced
together to accomplish some specific purpose.
Instruments include fixed income securities, equities, futures, options, swaps, and
dozens of variants on these basic themes.
Processes include electronic trading, public offerings and private placements of
securities, shelf registration, and electronic funds transfer.
Financial Engineering Versus Financial Analysis.
Many of those engaged in financial engineering still hold the official job title, or at
least have a job description that includes the word Analyst.
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. For example like a
geneticist who is an expert at decomposing an organisms genetic material into its
component genes and mapping the locations of these genes on the organisms
chromosomes.ie he or she examines the nature of the genetic material in order to
understand its essential features and their relationships
Engineering is the process of formulating and implementing a new instrument,
and new process of formulating and implementing a new instrument, or a creative
solution to a problem. For example a genetic engineer takes the knowledge available
together with certain physical tools and extracts the genes of one organism for
recombination in another organism, the end product is an altered organism or in the
extreme m an entirely new form of life.
Analyst often become a resident expert to offer a solution to a financial problem.
In case of a highly volatile cash flow stream .

The firm requires to know1. The sources of the volatility 2 how to remove the
volatility.
The firm hires a financial analyst to decompose the historic cash flow like secular
trend, a seasonal component, an exchange rate component, and a small random
component. Each component is measured and isolated.
But analysis does not solve the problem ie of elimination of volatility- Structured
Solution.
A financial engineer goes one step beyond that of the Analyst.