Factors FE

7/27/2019 Factors FE

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Harsha Malhotra

Rohit Oberoi


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Financial Engineering 2

Factors

Environmental

Factors

Intrafirm

Factors


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Environmental Factors

Factors external to the firm and over whichfirm has no direct control but which are

nevertheless of great concern to the firm

because they impact the firms performance.

Increased price

volatility

General

globalization of

industry & fin.

markets

Tax assymetriesTechnological

advances

Advances in fin.

theory

Regulatory Change

Increased trans.

cost and

competition


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Financial Engineering 4Financial Engineering 4

Intrafirm Factors

Factors internal to the firm and overwhich firm has at least some

control.

Liquidity NeedsRisk Aversion among

managers and ownersAgency Costs

Greater levels ofquantitative

sophistication amonginvestment managers

Formal Training ofSenior Level

personnel


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PriceVolatility

Interest Rate Exchange Rate

Equity

Capitalization RateMore Abstract

Price of Equity as

Rupees per share

Rate of Return of

Equity(CAPM)

Consists of

Dividend Rate and

Capital Gain Rate


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Prices are determined by MarketForces

Demand SupplyStable-

Price Stability

Changes Rapidly-Price Volatility

Speed of Price

ChangeFrequency of

Price Change

Magnitude of

Price Change


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Change in Cost ofProduction

Change in price ofother goods

Expectations

about futuredemand and

supply conditions

Size of market

Other Factors


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InflationaryForces

Breakdownof Intl

Agreement

and

Institutions

like Bretton

WoodsAgreement

Globalizati-on of

Markets

RapidIndustrializ

ation of

many

under

developed

countries

GreaterSpeed in

acquiring ,

processing

and acting

upon info


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Globalization

Cheap Labor

Better accessto raw

materials

Reduced

TransportationCosts

Overseas

Subsidiaries for

potentialmarkets


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Globalization also leading to

greater use of debt in capitalstructures causing increasing

leverages and higher risksthereby paving way for devt.

Of Financial Engg.instruments


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Tax Assymetry

A situation in which two parties to

a transaction pay different tax rates.This may affect what one party orthe other desires about the

timing, price, or other factorsregarding the transaction.


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Example of Tax Assymetry

Financial engineers that arbitrage tax assymetrieshelps firms to avoid taxes- a practice ruled by the

courts to be a constitutionally guaranteed right.

Financial Engineers do not assist inaversion of TAXES


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Devt in

Communications

Advent of Spreadsheet

programs

Leading to design andintroduction of stock

index futures(Program

Trading)

Look down Satellites

Technological Advances


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Advances in Financial Theory

Extensive theoretical contributions from academicians to financialtheories formed the backbone of new financial instruments and theirusage.

Development of financial theory capable of explaining the valuation ofstock Index futures contracts led to Order matching computer systemon NYSE Known as Designated Order Turnaround (DOT) system.

Elaborate research on mathematical relationship which exploitdiscrepancies in market price led to program trading or future-casharbitrage causing short run volatility.

15Financial Engineering


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By Irving Fisher in 1896Valuation

Theory

By Harry Markovitz in 1952PortfolioTheory

By Leland Johnson andJerome Stein in 1960

HedgingTheory


Advances in Financial Theory


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Regulatory Change and Increased

Competition

Increased competitive pressures, better riskmanagement techniques, coupled with the 1980s

atmosphere of deregulation led to efforts torepeal much of regulation heaped on the industry.

Massive failures in the thrift industry acted ascatalyst for deregulation.

Interstate banking broke down, commercial banksbecame increasingly involved in investment

banking.



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Regulatory Change and Increased

Competition

Competition among banks became so fierce, to keepexisting clients investment bank would engineer

unique instruments to fit the clients.

The complexity of these products was to the degree, thatthe client firm did not understand the products

engineered on its behalf.

Many of the financial products innovated in the 1980s blewup in the faces of the clients firms soon it were issued.



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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.

Unlike today under 1970s transaction cost, arbitrage

opportunity does not exist.

Ex. The per share cost of transacting a share of say $100 has

declined from something on the order of $1.00 at the start of

1970s to under 2 cents by the start of 1990s.19Financial Engineering


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Intra- Firm factors

Liquidityneeds Agency cost

QuantitativeSophistication

Risk Aversion

Formal Trainingof Senior-Level

Personnel


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Liquidity Needs

Liquidity has many facets;

Ease of conversion of cash, or put cash to work,

Degree to which market can absorb sale andpurchase without imposing excessive cost,

Size of bid-ask spread.

Financial innovations help corporation andindividual to meet these needs



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Liquidity Needs (Example)

Money Mkt acct, Sweep Accts, Electronic fund transfer,

Certificate of deposit(CD) market, Repo market were designedto provide access to cash or put unneeded cash to work.

Instruments such as floating rate notes, adjustable rate

preferred stock are long term securities whose values do notdeviate to nearly the same degree as traditional fixed coupons.



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Risk Aversion

Although corporate managers have becomeincreasingly aware of their risk exposures,

These managers are also uncomfortable withthe instruments of modern risk management.

They often fail to understand the intricacies ofthese modern instruments.

Hence Formal Training of Senior-LevelPersonnel has become a serious issue.



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Risk Aversion Instruments

Interest RateFutures

Interest RateOptions

Stock IndexFutures

Stock IndexOptions

CurrencyFutures

CurrencyOptions

Forward rateAgreements

ForwardExchange

AgreementsSwaps



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Agency cost

An agency cost is an economic concept that relates to the costincurred by an entity (such as organizations) associated with

problems such as divergent management-shareholder objectivesand 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 theirown benefit)

The costs of techniques used to mitigate the problems associated withusing an agent

(e.g., the costs of producing financial statements or the use of stockoptions to align executive interests to shareholder interests).



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Agency cost (Example)

In a M&A activity by assumingownership, management eliminates the

agency relationship and presumably,

most of the costs associated with thatrelationship entails.

This helps in increasing the share value,and justifying for the excess payment

made.



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Quantitative Sophistication andmanagement training

In very few areas isquantitative

sophistication moreimportant than ininvestment arena.

By deciphering complex

situations through tediousmathematical techniquescould enhance returns bya respectable number of

basis points.

Hence firm expend hugesums on training of

management inquantitative

sophistication .


Example: Institutional Investors such as Mutual Funds, Insurance Companies,

Pension Funds, Trust Managers, Security Dealers and Arbitragers uses these

techniques.


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