Conceptual tools of financial engineering

Most common examples are competitiveness, technological advancements, and new inventions, political and economical changes. 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. In conclusion, for an optimal success in finance management of a company, these tools and factors should be taken under consideration.

You are commenting using your WordPress. You are commenting using your Google account. You are commenting using your Twitter account. You are commenting using your Facebook account. Notify me of new comments via email. Notify me of new posts via email. Skip to content Financial Engineering is vast field of study and is seen as very important expertise necessary for proper financial management.

Have you ever heard about financial engineering before? If not, this article will help you understand its meaning and importance in brief. Financial engineering is a broad, multidisciplinary field of study and practice that, essentially, uses engineering approaches and methodologies to study and practice finance. It integrates and utilizes information from various fields, including economics, mathematics, computer science, and financial theory.

It combines scientific theories from financial economics, mathematics, statistics, physics, and econometrics with methods and tools from engineering and computer science to solve the problems of investment finance. An important part of financial engineering consists of putting financial theories into practice in the financial world.

Excellent background in mathematics has an excellent chance of helping you make a successful career in this field at large investment banks and other financial institutions. With the effort and professionalism involved in this profession, one is rewarded with recognition and wealth.

One needs to follow a certain channel to enroll in this course. The basic eligibility criteria to admit into this program is as follows:. The field of Financial Engineering has a huge significance. Some of the points depicting the importance of the course are listed below:. Financial Engineering course is offered at various levels.

The following list entails various courses at numerous levels:. The three-and-a-half-year course prepares students comprehensively in IT, mathematics, finance, and financial modeling, essential to success in the finance tech industry. Students will gain an understanding of strategic technology in business finance and build financial acumen through the program.

The course includes fundamental financial subjects like Principles of Finance, Investments, Financial Derivatives, and Mathematics for Finance. To produce graduates who are highly skilled and competitive, financial fundamentals are augmented with fintech-related courses.

Tech Hons in any core engineering field and an M. Tech in Financial Engineering degree can be obtained through this program. Those pursuing this program will have to complete the M. Tech in Financial Engineering after three years of completing the B. Tech Hons. The fundamental goal of this program is to prepare students with strong background knowledge and skills in quantitative finance.

Financial engineers run quantitative risk models to predict how an investment tool will perform and whether a new offering in the financial sector would be viable and profitable in the long run, and what types of risks are presented in each product offering given the volatility of the markets. Financial engineers work with insurance companies, asset management firms, hedge funds, and banks. Within these companies, financial engineers work in proprietary trading , risk management , portfolio management , derivatives and options pricing , structured products , and corporate finance departments.

While financial engineering uses stochastics, simulations and analytics to design and implement new financial processes to solve problems in finance, the field also creates new strategies that companies can take advantage of to maximize corporate profits. For example, financial engineering has led to the explosion of derivative trading in the financial markets. Since the Chicago Board Options Exchange CBOE was formed in and two of the first financial engineers, Fischer Black and Myron Scholes, published their option pricing model , trading in options and other derivatives has grown dramatically.

Through the regular options strategy where one can either buy a call or put depending on whether they are bullish or bearish , financial engineering has created new strategies within the options spectrum, providing more possibilities to hedge or make profits.

The field of financial engineering has also introduced speculative vehicles in the markets. For example, instruments such as the Credit Default Swap CDS were initially created in the late 90s to provide insurance against defaults on bond payments , such as municipal bonds. However, these derivative products drew the attention of investment banks and speculators who realized they could make money from the monthly premium payments associated with CDS by betting with them.

In effect, the seller or issuer of a CDS, usually a bank, would receive monthly premium payments from the buyers of the swap. The value of a CDS is based on the survival of a company—the swap buyers are betting on the company going bankrupt and the sellers are insuring the buyers against any negative event.

As long as the company remains in good financial standing, the issuing bank will keep getting paid monthly. If the company goes under, the CDS buyers will cash in on the credit event. Although financial engineering has revolutionized the financial markets, it played a role in the financial crisis.

As the number of defaults on subprime mortgage payments increased, more credit events were triggered. Credit Default Swap CDS issuers, that is banks, could not make the payments on these swaps since the defaults were happening almost at the same time. Concepts borrowed from the financial markets will help TVA value its OPAs, compare them with the traditional alternative building plants , and manage the risk of an options portfolio. Perhaps as important, the information that electric power markets will provide to both producers and consumers will allow managers to make better investment decisions, even about traditional bricks-and-mortar projects.

When investors shy away from a stock, it is probably because they think that the risks of investment are too high relative to the likely return. The managers whose stocks are avoided, however, may believe that such judgments are unwarranted or ill informed.

One way to achieve this community of interests and to motivate workers is to tie compensation to stock price performance through executive stock ownership or employee stock ownership plans. Although companies can, of course, give stock to employees, they obviously would prefer that employees purchase shares. But they may find it difficult to persuade them to buy, especially when the prevailing business culture has made workers risk averse and there is no tradition of employee stock ownership in any form.

Engineering is the practical application of mathematical or scientific principles to solve problems or design useful products and services. Engineers of all sorts get similar formal training in mathematics, then move on to their respective specializations. Civil engineers use their understanding of materials science and mechanics to design bridges; chemical engineers use their knowledge of chemical properties and interactions to design new compounds or make chemical processing plants more efficient.

When designing a bridge, the civil engineer works within physical and budgetary constraints: Will the bridge support 50 trucks at once?

Will it withstand extreme lateral forces of wind? Will it survive a once-a-century earthquake? How much will it cost? In designing a security or a risk-management strategy, the financial engineer also works within physical and budgetary constraints: Will this structure deliver the desired result even if the market moves suddenly and severely?

How will it perform under current and future tax and accounting rules? To succeed, both types of engineers must find optimal solutions within many different and often conflicting constraints. These varied constraints lead to different solutions. Just as civil engineers can design various kinds of bridges, so financial engineers can design different kinds of financial instruments or strategies to produce a payoff.

Robert C. Three are products in which traditional financial intermediaries act as principals and offer payoffs that closely mimic the leveraged stock position; the actual products are structured as bank certificates of deposit, indexed notes, or variable-rate annuities. Each of the 11 products or trading strategies can give the investor exposure to the stock market, and each produces functionally similar payoffs.

The multitude of solutions exist because of the differing constraints facing the financial engineer. Whereas derivatives have been traded for centuries, stretching back to the option contracts traded in Amsterdam in the seventeenth century, the modern field of financial engineering leaped forward in , when Fisher Black, Myron Scholes, and Merton developed an approach to creating and valuing option contracts.

Following these pioneering steps in theory and practice, the past two decades have witnessed an explosion in research and in the understanding of how to structure, price, and manage the risks of derivative instruments. Bridges occasionally collapse, sometimes because of poor engineering and other times because of bad luck.

Except in extreme cases, it is often hard to distinguish between the two. Suppose that a bridge designed to withstand an earthquake of a certain size crumples after suffering a slightly larger shock. Is this calamity the result of poor engineering because the specifications should have been tighter, or of bad luck because an extremely improbable event occurred? Financially engineered products also sometimes fail, and examining their wreckage to determine culpability is equally difficult.

Some would contend that in , portfolio insurance—a trading strategy designed to provide institutional investors with downside protection—failed because it provided less than absolute protection. In the aftermath of the crash, financial engineers have searched for alternative ways to deliver insurance.

The debate may never be resolved, but one can safely wager that clever financial engineers are working on ways to create alternative hedging strategies to avoid the problems that this incident exposed. How could they meet both those goals? If the company performed poorly, employees would not suffer any loss, and if it did well, they would gain, although not as much as they would have had they held regular shares.

Neither wanted to bear the risk of the guarantees if share prices fell. Here, too, they turned to their financial intermediaries, who assumed responsibility for managing the risk of the employee portfolio in financial markets.

The financial engineers who structured the deal and managed the portfolio profited from the transaction while attracting praise and new business with their novel proposal. Nor did the rank and file have to understand that they were financing the purchase of a put option by selling calls. Virtually every manager at one time or another believes that his or her stock is undervalued.

If a company is using its stock to acquire other companies or if executive compensation is based on stock-price appreciation, undervaluation may be especially troublesome. Consider the case of Cemex, the largest cement producer in the Americas and the second-largest industrial company in Mexico.

In , when Cemex announced its strategic acquisition of two Spanish cement manufacturers, its stock fell dramatically in response. The market undervaluation was both extreme and crippling. What could Cemex do to communicate its confidence to investors? Morgan then suggested an alternative that would comply with Mexican law while achieving the same purpose as a buyback: Instead of buying its stock, Cemex could sell investors an option the right but not the obligation to sell their stock back at any time over the next year for a fixed price.

In effect, it would commit to buy back its shares, guaranteeing a minimum price to any investor who bought the put. Whereas companies sometimes quietly sell or write puts in conjunction with their stock-buy-back programs, J. Morgan, however, were willing to issue and back the securities, called equity buyback obligation rights EBORs , themselves. The proposal was a classic example of financial engineering: The specialists could price the EBORs and manage their risks in the financial markets.

It is impossible to tell whether the response was caused by the public signal sent by Cemex, the trust implied by J. Regardless of the cause, financial engineering in this case, the sale of puts offered a viable alternative to communicating confidence in stock through press releases and straight buybacks. For the thousands of mergers and acquisitions consummated in a given year, there are probably thousands more that never get completed.

Although some of those deals fail because of big differences in the perceptions of buyer and seller, others fail even though the gaps between the two parties are quite small. In early , a proposed transaction that would help both Amoco Corporation and Apache Corporation achieve their strategic goals looked as if it might bust. So it created a new organization, MW Petroleum Corporation, as a freestanding exploration and development entity with working interests in 9, wells in more than producing fields.

Amoco and its financial adviser, Morgan Stanley Group, then marketed MW Petroleum to potential international and domestic buyers.

Apache was an aggressive acquirer of oil and gas properties whose strategy was to acquire properties that majors like Amoco believed were marginal and then use its expertise and low-cost operations to achieve substantially higher profits. The scraps are pretty good for someone with our particular mission.