INTRODUCTION

The financial risk faced by companies has increased tremendously over the last two decades and the payoffs of managing risk successfully are very high. In response to this increased risk and the incentive to manage it, older instruments of risk management such as forwards and futures have been expanded in scope, and many new instruments devised. The process of adaptation of existing financial instruments and processes to develop new ones, in order that financial market participants can effectively cope with the changing situation, is known as financial engineering. Financial engineering is well on the way to becoming an independent discipline with its own professional bodies. An example is the American Association of Financial Engineers (AAFE), set up in 1991.

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, Sometime called the consumer, level. These include such things as adjustable rate mortgages, cash management accounts, NOW accounts, IRAs and Keoghs, and various new forms of life insurance.

Financial engineering is practiced at 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 engineer’s solutions for corporate clients often regard their financial engineer 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 department 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 finical pages of newspapers.

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Closely related to financial engineering in corporate finance is financial engineering in merger and acquisitions. Merger and acquisition teams engineer deals all the time. The most dramatic example of 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. During the decade of the eighties alone, hundreds of billions of dollars of junk bonds were sold 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 can involve opportunities across space, time, instruments, risk, legal jurisdictions, or tax rates. Recent innovation involving arbitrage across space include linkages between future 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 situations in which the return from a strategy exceeds the cost of carry provides such potential and engineers continuously seek out 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 the 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 funds, sweep systems, and the repo market to mention just a few. They have also developed system for transforming high risk investment instruments into low risk investment instruments through such ingenious devices as repackaging and overcollateralization.

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DEFINITIONFinancial engineering is often defined in different ways depending on the perspective of the

person who is offering a definition. In general, practitioners have used the term financial

engineering to mean: risk management, trading algorithm design, corporate finance deal

structuring, investment banking tenders to the primary markets, project finance,

securitization, and the design of structured financial products including convertible debt,

warrants, exotic options, hybrid securities, floating-rate notes, credit default swaps, and

equity-linked notes.

Financial Engineering is employing theoretical finance and computer modeling skills to make

pricing, hedging, trading and portfolio management decisions. Utilizing various derivative

securities and other methods, financial engineering aims to precisely control the financial risk

that an entity takes on. Methods can be employed to take on unlimited risks under certain

events, or completely eliminate other risks by utilizing combinations of derivative and other

securities.

The soul of finnerty’s definition is captured by the word 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 bonds, 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. Example includes the use of exisisting products to reduce a firm’s financial risks, to reduce the firm’s financial engineering, to gain some accounting or tax benefit, or to exploit market inefficiency.

It is often difficult 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 exploits price discrepancies between the cash market for equities and stock-index futures. The basic arbitrage strategy itself, i.e. buying (selling’s) cash asset while selling (buying) a future contract, is very old. In fact, it has been practiced in the grain trade for over a century. But, the extension of the strategy to encompass cash equities and stock- index future 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

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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 vs. Financial Analysis

A Financial Engineer is a person engaged in the practice of financial “Engineering”.

And Engineering is the process of formulating and implementing a new instrument, a

new process, or a creative solution to a problem.

Financial Engineering refers to the bundling and unbundling of securities.

This is done in order to maximize profits using different combinations of equity,

futures, options, fixed income.

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Financial engineering is a cross-disciplinary field which relies on computational

intelligence, mathematical finance, numerical methods and computer immolations to make

trading, hedging and investment decisions, as well as facilitating the risk management of

those decisions

Utilising various methods, practitioners of computational finance aim to precisely determine

the financial risk that certain financial instruments create.

Areas of application:

Investment banking

Forecasting

Corporate strategic planning

Securities trading and financial risk management

Derivatives trading and risk management

Investment management

Pension scheme

Insurance policy

Credit default swap

Market mechanism design

Financial analysis

A Financial Analyst is a person engaged in the practice of financial ”Analysis”. And Analysis

is defined as the process or method of studying the nature of something in order to determine

its essential features and their relationships.

Financial analysis refers to an assessment of the viability, stability and profitability

of a business, sub-business or project.

It is performed by professionals who prepare reports using ratios that make use of

information taken from financial statements and other reports.

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These reports are usually presented to top management as one of their bases in making

business decisions. Based on these reports, management may…

Continue or discontinue its main operation or part of its business;

Make or purchase certain materials in the manufacture of its product;

Acquire or rent/lease certain machineries and equipment in the production of its

goods;

Issue stocks or negotiate for a bank loan to increase its working capital;

Make decisions regarding investing or lending capital;

Financial analysts often assess the firm's stability, Profitability, Liquidity and

Solvency to compare financial ratios:

1. The starting point of financial engineering is financial analysis.

2. The basis for financial analysis is the financial statements of a company.

3. The job of financial engineering starts after a proper analysis of business and financial

performance of a company.

4. The areas of operations of financial analysis and financial engineers may be

summarized as follows.

Financial Analyst Financial Engineer

LIQUIDITY:

Verification of current ratio , quick ratio, and

changes in working capital position.

Understand liquidity risk and suggest

innovative solutions either to eliminate or

minimize liquidity risk.

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Financial Risk:

Analyze the financial risk through financial

leverage and analyze the impact of financial

leverage on the value of shares.

Suggesting the scope and methods of altering

the financial leverage and thereby,

minimizing financial risk.

INTEREST RATE RISK:

Analyze the scope for interest risk on the

basis of past experience.

Suggest or develop innovative securities to

safe guard investors from interest rate risk.

INVESTMENT RISK:

Analyze risk return relationship in

investments in financial markets.

Suggest appropriate derivative instruments.

Inflationary risk:

Analyze the degree of inflation and its impact

on the return of various financial instruments.

Suggest appropriate measures and innovative

or develop securities for minimizing

inflationary risk.

EXCHANGE RATE RISK:

Analyze the fluctuations of major currencies

in the globe and establish the rate of risk of

one currency in relation to exchange rate of

another risk.

Suggest innovative swaps, futures, forwards

and other financial instruments for

minimizing the financial risk.

JOB OF FINANCIAL ANALYST JOB OF FINANCIAL ENGINEER

B OF FINANCIALANALYST JOB OF FINANCIAFINANCIALANALYST JOB OF

FINANCIAL

ENGINEER

Tools of financial engineering

The successful financial engineers need a toolkit. We find it convenient to device the tools of financial engineering into two broad categories.

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Conceptual

Physical

Conceptual

The conceptual tools involve the ideas and concept which underlies finance as a formal discipline. Many of these conceptual tools are taught as part of modern finance curricula 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 of financial engineering. Examples of the conceptual tools with which the engineer must be at home are valuations theory, portfolio theory, hedging theory, accounting relationships, and tax treatment under different forms of business organization.

Physical tools

The physical tools of financial engineer include the instruments and the processes which can be pieced to gather to accomplish some specific purpose. At a very broad level, the instrument includes fixed income securities trading, public offerings and private placements of securities, shelf registrations 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.

REASON FOR RAPID GROWTH IN FINANCIAL ENGINEERING

Since the 1950s and 1960s, and particularly in the last decade, the global

and financial environment has changed rapidly. In particular, the breakdown of the

Bretton Woods agreement in 1972 which ultimately led to floating exchange rates, has

led to major increases in volatility and competition Technology has improved

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dramatically in this period. Government debt has also increased in most countries. Has

classified the causes of increasing risk into two:

Environmental and

Intra-firm

Environmental factors

Environmental factors are those factors that external to the firms but which neverthe less impact on the firm performance. The environmental factor include such thing as price volatility, globalization of market, tax and accounting rule, technological development, advance in the financial theory, and so on.

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1. Price Volatility

2. Globalization

3. Advancement in Financial Theory

4. Increased Competition

5. Tax asymmetries

6. Advances in technology

7. Transactions Cost

Increase in price volatility:

The term "price" here includes the price of money, foreign exchange, stocks, and commodities. The currency floats have meant that the stability of exchange rates is a thing of the past. Interest rates have been very volatile too, e.g., in June 1982; AA bonds were yielding 15.3 percent. In May 1986 the same bonds yielded 8.9 percent and in April, 1989, 10.2 percent. Oil prices are the best example of dramatic commodity price volatility, and the October, 1987 stock crash illustrates the volatility in stock prices. There was also a major volatility in overall prices, i.e., inflation, over the past three decades. This all-round increase in volatility has led to tremendous increases in the risks which companies face, and enhanced the need for hedging the risks.

Globalization of the world economy and competition:

Commerce has grown very rapidly in the past two decades. This has increased the size of markets and greatly enhanced competition.

Advances in financial theory: Developments in finance theory have contributed immensely to the development of new hedging techniques. The OPM is a case in point.

Deregulation and increase in competition:

Initially, investment banks were the only ones which could offer various services regarding risk management. Deregulation of the financial markets has brought in new

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entrants into the financial markets, particularly NBFIs, who have aggressively competed with the traditional banking sector, by introducing new products and services. In return, banks were forced to come out with innovative ways to compete with NBFIs by taking recourse to off-balance sheet transactions.

Tax asymmetries:

Taxes differ across industries and countries, over time. Also, some firms have sufficient tax credits/ write-offs which give them an advantage over other firms. For example, zero coupon yen bonds were treated liberally in Japan. In the USA, the abolition, in 1984, of the withholdings tax on interest payments to overseas investors in the domestic securities of the USA influenced the growth of interest rate swaps.

Advances in technology and communication:

Funds can be transferred from ATMs and telephones now. Computers have entered the field of finance in a big way.

Dramatic decline in information and transactions costs: There has been a tremendous decline in transaction costs and spreads, e.g., the cost of transacting a share of $100 has declined from $1 in the 1970s to under 2 cents in the 1990s. Computerized databases of financial transactions are available to subscribers. Information asymmetry has considerably declined.

INTRA FIRM FACTORS:

The intra firm factor include such things as liquid needs, risk aversion among mergers and owners, agency cost, greater level of qualitative sophistication among investment managers, and more formal training of senior level personnel.

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Liquidity needs:

Companies need liquidity of their "free cash flows". To make use of funds temporarily not needed, money markets and sweep markets have developed rapidly. The same purpose in the longer term is served by FRNs (floating rate notes), adjustable rate preferred stock, etc.

Risk aversion:

The risk aversion of firms to the increasing risks has been an important driving force in motivating innovations.

Agency costs:

shows how leveraged buyouts were motivated by the desire to reduce agency costs. The financing of such activity required new forms of financing, including junk bonds.

Quantitative sophistication of management training:

The increase in the quantitative skills possessed by managers has led to a demand for better tools of financial management.

Accounting objectives:

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At times, financial innovation has been fuelled by the desire to improve accounting figures.

Many forms of financial innovation, including Eurobonds, Eurodollars, electronic funds transfer, etc., have arisen from these factors. The development of financial engineering is perhaps the most important of the outcomes of the changes discussed above.

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