Financial engineering

Section A

Definition of financial engineering: involves designing, development and

implementation of innovative financial instruments and processes, and the formulation
of creative solutions to problem] ms in finance.

Financial engineering is the application of mathematical methods to the solutions of

problems in finance.

Financial engineering involves utilization of mathematical techniques in solving

financial problems. This process uses tools and knowledge from the fields of
economics, statistics, applied mathematics and computer science. These tools not only
assist in solving the prevailing financial issues but also help in devising innovative
financial products. Financial engineering is also known as quantitative analysis.
Investment banks, commercial banks and insurance agencies use this technique.

HOW FINANCIAL ENGINEERING WORKS?

Financial engineers create, design and implement new financial models and processes
in order to find solutions for problems. They always seek new financial opportunities.
Preparing such models requires a great deal of research and they rely on in-depth data
analysis, simulations, risk analysis and stochastics. Financial engineers possess
knowledge in fields such as economics, statistics and corporate finance. These
engineers work in banking, consulting agencies, securities and financial management.

Tools Required for Financial Engineering:

In relation to tools requirement of financial engineering process, basically, two types

of tools are used named

Conceptual Tools

Physical Tools

Conceptual Tools:
This category involves the combination of concepts and ideas that can be used in
finance studies and are considered as formal disciplines. Mostly these types of tools
are taught in business programs especially at graduation level. For instance,
accounting relationships, hedging theory, valuation of theory, and portfolio theory are
considered in curriculum.

Physical Tools:

Special process and instruments that are used by Financial Engineers in combination
to gain a specific task or purpose are called as physical tools. The examples include
variants, securities, futures, swaps, options, and equities.

Factors Influencing Financial Engineering:

Just like tools, two types of factors contribute to the growth process of financial
engineering; environmental factors and intra firm factors

Environmental Factors:

The factors which are not controllable by any firm and are part of external
environment are included in this category. Though they are external to business but
they have direct impact on your business. Usually, PEST analysis is used to evaluate
these factors and impact on any business. Most common examples are
competitiveness, technological advancements, and new inventions, political and
economical changes. Some environmental factors are:

 Price volatility: Interaction of demands by consumers and supplies by producers

ultimately decides market clearing price and quantities. If the demands and the supplies
for a thing change rapidly over short period of time then market clearing price can change
dramatically. This is referred to as Price Volatility.

Consider four scenarios of Price Volatility:

 If demand increases and supply remains unchanged then price increases.

 If demand decreases and supply remains the same then the price decreases.
 If supply increases and demand remains unchanged the price decreases.
 If supply decreases and demand remains the same even then price increases.

In today’s financial world the financial information is readily available about any given
company and its current and future investments projects and this keeps changing hence
the price of stock remains volatile.
  Globalization of the markets:

 Currency exchange rate: companies operating on global basis selling their goods
and services in various economies face of risk of ultimate profits because of
currency volatilities i.e. when profits in one economy are converted back to mother
currency then devaluation or accretion happens because of exchange rate
volatilities.
 Debt capital markets: different economies offer different interest rates on debt and
hence the loan taken in one economy to fund operations in another economy can
create a risk of interest rate loss/gain as well as currency exchange loss/gain.
 Equity risk factor for companies operating in many countries would be difficult to
judge as in different economies the cost of equity would be different .

 Tax asymmetries: some industries are granted special tax exemption to

encourage their development and growth, different countries charge different
tax rates and more importantly some countries charge domestic and foreign
firms differently.
 Technological advancement: the development of technology in terms of
computers, networks, internet, spreadsheets, various models, data bases and
enhanced methods of data entry and analysis.

 Advance in financial theories: various financial theories of different scholars

such as markwitz port folio theory, William sharpe and jhon lintner capital
asset pricing theory, option pricing model by fischer black and Myron schools
etc had contributed to financial engineering.
 Regulatory change
 increased competition:
 Transaction Costs: 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 1980’s.

Intra Firm Factors:

All those factors of the company which can directly progress the financial engineering
process are included in intra firm factors. Likewise, agency costs, accounting policies,
risk aversion and liquidity needs are included in this type.

 Liquidity needs: The degree to which an asset or security can be bought or

sold in the market without affecting the asset's price. Liquidity is characterized
by a high level of trading activity. Assets that can by easily bought or sold, are
 known as liquid assets. The ability to convert an asset to cash quickly. Also
known as "marketability".

Degree of liquidity can be determined by using various financial engineering

tools like Markov Chain Monte Carlo methods.

 Risk aversion: description of an investor who, when faced with two investments with a
similar expected return (but different risks), will prefer the one with the lower risk. With
the advancement of technology new methods of determining risk and volatility are
developed. These methods are advanced computer software based and can be easily used
to perform extensive analysis. Some of these methods are GARCH, ARCH, FARIMA
and ARIMA.

 Management training: With the birth of software like SAS, Matlab, Mathematica it
has become relatively much easier to perform the most complex analysis is least possible
time. Moreover it doesn’t require a manager to understand whole fundamental theories
behind the modeling and all the manager is required to understand are relevant
assumptions and interpret results.
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 Agency Costs: type of internal cost that arises from, or must be paid to, an agent acting
on behalf of a principal. Agency costs arise because of core problems such as conflicts of
interest between shareholders and management. Shareholders wish for management to
run the company in a way that increases shareholder value. But management may wish to
grow the company in ways that maximize their personal power and wealth that may not
be in the best interests of shareholders. The biggest example of Agency Cost analysis is
EVA Model which uses financial engineering fundamentals to come up with concept of
shareholder value maximization.

Financial engineering strategies:

1. Assets and liability management strategy: Asset-liability management is all about

matching liabilities to assets. This means we need to understand how cash flows of any
given company vary over time. Holding the appropriate combination of assets and
liabilities to meet firm’s objectives and simultaneously minimizing the firm’s risk. Assets
and liability management is the art and science of choosing the best mix for assets and
liabilities portfolio. Following are some factors that play an important role in
assets/liabilities management strategies:
 Liquidity
 Interest rate sensitivity
  Default risk: it is the risk when debtor is unable to repay the principal and/or interest.

2. Hedging and related risk management strategies:

3. Corporate restructuring: it refers to any kind of change in operations, capital structure

or and/or ownership.

Corporate restructuring involves 3 different but related activities:

 Expansion: in the form of merger, acquisition, joint venture etc

 Contraction: in the form of sell off, liquidation etc
 Ownership and control: including stock repurchase, going private etc.

4. Arbitrage: the simultaneous buying and selling of securities, currency, or commodities

in different markets or in derivative forms in order to take advantage of differing prices
for the same asset.
5. Asset allocation strategy: it is the allocation of investment funds across various classes
of assets.

What Is a Relative Valuation Model?

A relative valuation model is a business valuation method that compares a company's value to
that of its competitors or industry peers to assess the firm's financial worth.

One of the most popular relative valuation multiples is the price-to-earnings (P/E) ratio. It is
calculated by dividing stock price by earnings per share (EPS), and is expressed as a company's
share price as a multiple of its earnings. A company with a high P/E ratio is trading at a higher
price than its peers and is considered overvalued. Likewise, a company with a low P/E ratio is
trading at a lower price and is considered undervalued.

Steps in relative valuation model:

Step I. Select the Universe of Comparable Companies: The selection of a universe of

comparable companies for the target is the foundation for performing trading comps.

In order to identify companies with similar business and financial characteristics, it is first
necessary to gain a sound understanding of the target. At its base, the methodology for
determining comparable companies is relatively intuitive. Companies in the same sector (or,
preferably, “sub-sector”) with similar size tend to serve as good comparables.

Key Characteristics of the Target for Comparison Purposes

 Sector: Sector refers to the industry or markets in which a company operates (e.g.,
chemicals, consumer products, healthcare, industrials, and technology). A company’s sector
can be further divided into sub-sectors, which facilitates the identification of the target’s
closest comparable.

Within the industrials sector, for example, there are numerous sub-sectors, such as aerospace
and defense, automotive, building products, metals and mining, and paper and packaging.
For companies with distinct business divisions, the segmenting of comparable companies by
sub-sector may be critical for valuation

 Products and services: A company’s products and services are at the core of its business
model. Accordingly, companies that produce similar products or provide similar services
typically serve as good comparables. Products are commodities or value-added goods that a
company creates, produces, or refines.
 Customers and End Markets:

Customers: A company’s customers refer to the purchasers of its products and services.
Companies with a similar customer base tend to share similar opportunities and risks. For
example, companies supplying automobile manufacturers abide by certain manufacturing and
distribution requirements, and are subject to the automobile purchasing cycles and trends.

End Markets: A company’s end markets refer to the broad underlying markets into which it
sells its products and services. For example, a plastics manufacturer may sell into several end
markets, including automotive, construction, consumer products, medical devices, and
packaging. End markets need to be distinguished from customers. For example, a company
may sell into the housing end market, but to retailers or suppliers as opposed to homebuilders

 Distribution Channels: Distribution channels are the avenues through which a company
sells its products and services to the end user.

 Geography / location

 Size: Size is typically measured in terms of market valuation (e.g., equity value and
enterprise value), as well as key financial statistics (e.g., sales, gross profit, EBITDA, EBIT,
and net income). Companies of similar size in a given sector are more likely to have similar
multiples than companies with significant size discrepancies.

For example, companies with under $5 billion in equity value (or enterprise value, sales) may
be placed in one group and those with greater than $5 billion in a separate group. This
tiering, of course, assumes a sufficient number of comparables to justify organizing the
universe into sub-groups.

 Growth profile:
  Return on investment
 Credit profile

Step II. Locate the Necessary Financial Information:

Step III. Spread Key Statistics, Ratios, and Trading Multiples.

Step IV. Benchmark the Comparable Companies.

Step V. Determine Valuation.

Options

Option are financial instruments whose value is derived from other underlying assets (such as
stock, bond, currency etc) and give the right but not the obligation to the holder to buy/sell the
asset at stated price within specific time period.

Types of options

 American options: can be exercised any moment prior to maturity.

 European options: can be exercised only at expiration time.

 Bermudan options: can be exercised on “FEW Specific Dates” prior to expiration

Cash flow charts of long call, long put, short call and short put
Credit Rating: Credit Rating is an assessment of the borrower (be it an individual, group or
company) that determines whether the borrower will be able to pay the loan back on time, as per
the loan agreement.
It is a rating given to a particular entity based on the credentials and the extent to which the
financial statements of the entity are sound, in terms of borrowing and lending that has been
done in the past.

The rating is given to entities by the credit rating agencies after analysing their business and
finance risk. The agencies prepare a detailed report after taking into consideration some
additional factors such as the ability to repay the debt. Banks and lenders use a credit rating as
one of the factors to determine whether to lend money.

Importance of credit rating:

For The Money Lenders

1. Better Investment Decision: No bank or money lender companies would like to give
money to a risky customer. With credit rating, they get an idea about the credit
worthiness of an individual or company (who is borrowing the money) and the risk factor
attached with them. By evaluating this, they can make a better investment decision.
2. Safety Assured: High credit rating means an assurance about the safety of the money and
that it will be paid back with interest on time.

For Borrowers

1. Easy Loan Approval: With high credit rating, you will be seen as low/no risk customer.
Therefore, banks will approve your loan application easily.
2. Considerate Rate of Interest: You must be aware of the fact every bank offers loan at a
particular range of interest rates. One of the major factors that determine the rate of
interest on the loan you take is your credit history. Higher the credit rating, lower will the
rate of interest.

Steps Involved in Credit Rating

 Request from issuer and analysis: The first step to credit rating is that the enterprise applies
to the rating agency for the rating of a particular instrument. Thereafter, an expert team
interacts with the firm’s those charged with governance and acquires relevant data. Factors
which are considered includes:
 Historical performance
 Financial Policies
  Business Risk profile
 Competitive Position, etc.
 Rating Committee: Based on the information gathered and evaluation performance, the
presentation of the report is made by the expert’s team to the Rating Committee, in which the
issuer is not permitted to take part.
 Communication to management and appeal: The decision of the rating is shared with
the issuer and if he/she does not agree with the decision, then an opportunity of being
heard is given. The issuer is required to provide material information, so as to appeal
against the decision. The decision is reviewed by the committee, but that does not make
any change in the ratings.
 Pronouncement of the rating: When the issuer agrees to the rating decision, the agency
make a public announcement, of the rating.
 Monitoring of the assigned rating: The agency which rates the issue, overlooks the
performance of the issuer and the business environment in which it operates.
 Rating Watch: On the basis of continuous critical observation undertaken by the rating
agency, it may place a rated security on Rating Watch.
 Rating Scores: Rating scores are given by the credit rating agencies like CRISIL, ICRA,
CARE, FITCH.
Credit Rating is of great help, not just in investors protection but to the entire industry, as it
directly mobilizes savings of the individuals.

Effect of sovereign and country risk, industry risk and financial risk on credit analysis?

Sovereign risk: Sovereign is one of many risks that an investor faces when holding forex
contracts. Foreign exchange traders and investors face the risk that a foreign central bank will
change its monetary policy so that it affects currency trades. Sovereign risk also impacts personal
investors. There is always risk to owning a financial security if the issuer resides in a foreign
country. For example, an American investor faces sovereign risk when he invests in a South
American-based company. A situation can arise if that South American country decides to
nationalize the business or the entire industry, thus making the investment worthless.

What is Country Risk?

Country risk refers to the uncertainty associated with investing in a particular country, and more
specifically the degree to which that uncertainty could lead to losses for investors. This
uncertainty can come from any number of factors including political, economic, exchange-rate,
or technological influences. In a broader sense, country risk is the degree to which political and
economic unrest affect the securities of issuers doing business in a particular country. such as
political instability can affect the investments in a given country Thus, when analysts look
at sovereign debt, they will examine the business fundamentals—what is happening in politics,
economics, general health of the society, and so forth—of the country that is issuing the debt.
 What Is Financial Risk?
This risk is the danger or possibility that shareholders, investors, or other financial stakeholders
will lose money. Financial risk is a type of danger that can result in the loss of capital to
interested parties.

Principles of options

 Diversify. Take at least two or three positions and try to always own both calls and puts. With
the recent swings in the market, playing both sides will improve your chances in the long run.
Don't forget this.
 Minimize your risk. Pay as little as possible for each option and always be ready to cut your
losses.
 be patient. Don't invest everything right away. Decide how much you want to risk in options
during the next twelve months and spread your purchases over that time frame.
 Plan before you play. If you do not have a game plan that tells you when to take profits and
when to cut losses you will have a very difficult time making a profit.
 Maximize your leverage. Try to buy options that will increase in value by at least 100%.
Buying cheap options is the first step in this strategy.
 Buy options on high volatility stocks.
 In general, buy out-of-the-money options. These options normally have lower prices, and less
risk.