FINANCIAL ENGINEERING
Unit I: Introduction to Financial Engineering- Scope- Tools- Financial Engineering Vs.
Financial Analysis- Factors contributing to the growth of financial engineering.- Innovative
Products of the Last twenty years- present changing scenario of securities industry.
Unit I: Introduction to Financial Engineering
Unit I see the prescribed Text book. Unit II is OK
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
Money vs. Finance
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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, and swaps.
• They apply theoretical finance and computer modeling skills to make
pricing, hedging, trading and portfolio management decisions.
Financial Engineers are prepared for careers in:
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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.
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.
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Unifying Principles of Finance
• No arbitrage
• Preference
• Optimization
• Market in equilibrium
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
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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.
What’s the purpose of securities?
For the Holder
• Investment: Debt securities generally offer a higher rate of interest
than bank deposits, and equities may offer the prospect of capital
growth.
• Collateral: Purchasing securities with borrowed money secured by
other securities.
Equity and Debt
Traditionally, securities are divided into debt securities and equity.
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.
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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.
Weighted average cost of capital
The Weighted Average Cost of Capital (WACC) is used in finance to measure
a firm's cost of capital.
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.
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.
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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.
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:
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 The starting point of financial engineering is financial analysis.
 The basis for financial analysis is the financial statements of a
company.
 The job of financial engineering starts after a proper analysis of
business and financial performance of a company.
 The areas of operations of financial analysis and financial engineers
may be summarized as follows.
JOB OF FINANCIAL ANALYST JOB OF FINANCIAL ENGINEER
LIQUIDITY: Understand liquidity risk and
suggest innovative solutions either to
Verification of current ratio , quick
eliminate or minimize liquidity risk.
ratio, and changes in working capital
position.
Financial Risk: Suggesting the scope and methods of
altering the financial leverage and
Analyze the financial risk through
thereby, minimizing financial risk.
financial leverage and analyze the
impact of financial leverage on the
value of shares.
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JOB OF FINANCIAL ANALYST JOB OF FINANCIAL
ENGINEER
INTEREST RATE RISK:
Analyze the scope for interest risk on Suggest or develop innovative
the basis of past experience. securities to safe guard investors from
interest rate risk.
INVESTMENT RISK:
Analyze risk return relationship in Suggest appropriate derivative
investments in financial markets. instruments.
Page  13
JOB OF FINANCIAL ANALYST JOB OF FINANCIAL
ENGINEER
Inflationary risk:
Analyze the degree of inflation and its Suggest appropriate measures and
impact on the return of various financial innovative or develop securities for
instruments. minimizing inflationary risk.
EXCHANGE RATE RISK:
Analyze the fluctuations of major Suggest innovative swaps, futures,
currencies in the globe and establish the forwards and other financial
rate of risk of one currency in relation to instruments for minimizing the
exchange rate of another risk. financial risk.
Page  14
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Unit II: The Physical Tools of Financial Engineer- Product Development- A Model for New
Product development- directions- design-testing-instrument preview.
Unit II: The Physical Tools of Financial Engineer
New Product Development and Product Life-Cycle Strategies
Causes of New Product Failures
• Overestimation of Market Size
• Product Design Problems
• Product Incorrectly Positioned, Priced or Advertised
• Costs of Product Development
• Competitive Actions
• To create successful new products, the company must:
– understand it’s customers, markets and competitors
– Develop products that deliver superior value to customers.
New Product Development Process
• Idea Generation and Screening
• Concept Development and Testing
• Marketing Strategy
• Business Analysis
• Product Development
• Test Marketing
• Commercialization
New Product Development Process
Step 1. Idea Generation
Systematic Search for New Product Ideas
Internal sources
Customers
Competitors
Distributors
Suppliers
Step 2. Idea Screening
• Process to spot good ideas and drop poor ones
• Criteria
– Market Size
– Product Price
– Development Time & Costs
– Manufacturing Costs
– Rate of Return
–
Step 3. Concept Development & Testing
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1. Develop Product Ideas into Alternative Product Concepts
2. Concept Testing - Test the Product Concepts with Groups of Target
Customers
3. Choose the Best One
Step 4. Marketing Strategy Development
Marketing Strategy Statement Formulation
Part One - Overall:
Target Market
Planned Product Positioning
Sales & Profit Goals
Market Share
Part Two - Short-Term:
Product’s Planned Price
Distribution
Marketing Budget
Part Three - Long-Term:
Sales & Profit Goals
Marketing Mix Strategy
Step 5. Business Analysis
Step 6. Product Development
Step 7. Test Marketing
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Standard Test Market
Full marketing campaign in a small number of representative cities.
Controlled Test Market
A few stores that have agreed to carry new products for a fee.
Simulated Test Market
Test in a simulated shopping environment to a sample of consumers.
Product Life Cycle
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