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1st Unit: Financial Engineering
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1st Unit: Financial Engineering






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    1st Unit: Financial Engineering 1st Unit: Financial Engineering Presentation Transcript

    • Introduction • What is Finance? • What is Financial Engineering? 2
    • What is Finance • Finance is about the bottom line of business activities • Every business is a process of acquiring and disposing assets – Real asset –tangible and intangible – Financial assets • Objectives of business – Valuation of assets – Management of assets • Valuation is the central issue of finance 3
    • Money vs. Finance Monetary Economics vs. Financial Economics Money / Credit Return / Risk Creation Allocation Money & International Corporate Investments Banking Finance Finance (Capital Markets) Central Commercial Non-Bank Bank Banking Financial Money Control Liquidity Sector 4
    • What is Financial Engineering? • 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, swaps. • They apply theoretical finance and computer modeling skills to make pricing, hedging, trading and portfolio management decisions. 5
    • Financial Engineers are prepared for careers in: 6
    • What is Finance? • Money & Banking — Monetary Economics • International Finance — International Economics 7
    • Multinational International Corporate Financial Financial Finance Engineering Market Corporate Capital Market Finance (Investments) Financial Economics 8
    • What is Financial Engineering? • Generalizing: 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. • Specializing: Financial Engineering is risk management via creative structural tools. 9
    • Type of Asset Exp. R of R Risk Level 1 Bank accounts 2.5-3% No risk of deposit loss. Inflation risk. 2 Money-market deposit 3.5-4% No risk of deposit loss. Rates geared to accounts inflation 3 Money-market funds 4.5-5% Very little. Rates vary with inflation. 4 Special 6-month 5% Early withdrawals subject to penalty. Rates certificates geared to expected inflation. 5 High-quality corporate 8-8.25% Very little if held to maturity. Rate geared to bonds expected long-run inflation rate. 6 Diversified portfolio of 9% Moderate to substantial. In any one year, the blue-chip common stocks actual return could be negative. Diversified (e.g., index fund) portfolios have at times lost 25% or more of their actual value. 7 Diversified portfolios of 9-10% Substantial. Diversified portfolios have at risky stocks such as times lost 50% or more of their actual value. aggressive growth mutual funds 8 Real estate similar to Cannot be sold quickly. Hard to diversify. common Good inflation hedge if bought at reasonable stocks price levels. For long-term investors. 9 Gold unpredictable Substantial. Believed to be a hedge against hyperinflation. Can help to balance a diversified portfolio. 10
    • Unifying Principles of Finance • No arbitrage • Preference • Optimization • Market in equilibrium 11
    • Principle of Financial Engineering • No arbitrage • Principles of Financial • Market in Engineering equilibrium • Preference • Principles of Finance • Optimization 12
    • Unifying Equation of Valuation • P=E(mx) – Where m is state-dependent discount factor – X is the state dependent payoff (cash flow) • Consequence of no arbitrage equilibrium – Conservation law of value of cash flow: the whole is equal to the sum of components – Composition and de-composition of cash flow 13
    • Financial Engineers are prepared for careers in: 15
    • Suggested Background Generally, Financial Engineers are strong on the following fields: • Statistics/Probability • C++ Programming • Basic Business Finance Theory 16
    • What is a security? A security is a fungible, negotiable instrument representing financial value. Securities are broadly categorized into debt and equity securities such as bonds and common stocks, respectively. 17
    • What’s the purpose of securities? For the Issuer 18
    • What’s the purpose of securities? For the Holder 19
    • Equity and Debt Traditionally, securities are divided into debt securities and equity. 20
    • Debt Debt securities may be called debentures, bonds, notes or commercial paper depending on their maturity and certain other characteristics. The holder of a debt security is typically entitled to the payment of principal and interest, together with other contractual rights under the terms of the issue, such as the right to receive certain information. Debt securities are generally issued for a fixed term and redeemable by the issuer at the end of that term. 21
    • Equity An equity security is a share in the capital stock of a company (typically common stock, although preferred equity is also a form of capital stock). The holder of an equity is a shareholder, owning a share, or fractional part of the issuer. Unlike debt securities, which typically require regular payments (interest) to the holder, equity securities are not entitled to any payment. Equity also enjoys the right to profits and capital gain. 22
    • Weighted average cost of capital The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital. 23
    • Formula The cost of capital is then given as: Kc = (1-δ) Ke + δ Kd Where: Kc The weighted cost of capital for the firm δ The debt to capital ratio, D / (D + E) Ke The cost of equity Kd The after tax cost of debt D The market value of the firm's debt, including bank loans and leases E The market value of all equity (including warrants, options, and the equity portion of convertible securities) In writing: WACC = (1 - debt to capital ratio) * cost of equity + debt to capital ratio * cost of debt 24
    • The Modigliani-Miller Theorem The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle. 25
    • Proposition y = C0 + D/E (C0 – b) * y is the required rate of return on equity, or cost of equity. * C0 is the cost of capital for an all equity firm. * b is the required rate of return on borrowings, or cost of debt. * D / E is the debt-to-equity ratio. 26