Financial Engineering / Concepts and Definitions:

Many of the most innovative new products trading in the capital markets and
derivative instrument markets today originated as the financial engineering solution
to fit a specific client needs and situation. Financial engineering is perhaps the
latest terminological addition to the world of finance and this is a new example
of invasion of social thinking by technology.
The term Financial Engineering came into use after the discovery of the BlackScholes Option Pricing Model in the 1973. Their scientific discovery led to a new
methodology to solve practical financial problems. Regardless of how todays
environment came about, two things are certain. First, the volatility of market rates
has created ever increasing demand for clever financial products to manage
financial risks. Second, current technology has made it possible for financial
institutions to create, price, and hedge products specifically designed to neutralize
these financial risks. From these foundations, financial engineering was born.
Financial engineering is not a new phenomenon. For centuries the solving of
financial problems and explanation of opportunities for making profits or reducing
tax liabilities has occupied the mind of entrepreneurs and others.
However, recent years have witnessed a growth in the field of financial
engineering on a scale which has not been seen before. The process of
financial engineering can be described in a number of ways:
It can be regarded as the creation ab initio of a financial product to deliver
a defined financial payoff to an end-user at a fixed point in time or a set of periodic
payoffs over time.
It can also be viewed as the fine-tuning of an existing financial product to
improve its return or risk characteristics in light of changing market conditions.
It can be considered as a process which allows existing financial products
to be overhauled and restructured to take advantages of a changed taxation,
legal or general economic climate (29, pp.1).
Definition of financial engineering: Financial engineering is the design of new types
of security to fill needs not satisfied by existing securities.
Galitz explain financial engineering as the use of financial instruments to
restructure an existing financial profile into having more desirable properties.
John Finnerty has defined financial engineering as the design, the
development, and the implementation of innovative financial instruments and
processes, and the formulation of creative solutions to problems in finance.
Financial engineering is the application of financial economics, mathematics,
computer technology, and the scientific method to the optimal sourcing,
utilization, and protection of financial assets.
Factors Contributing to the Growth of Financial Engineering
The explosive growth in financial engineering over the last decades is the
consequence of a number of factors. Each of these factors has stimulated one or
more aspects of financial engineering, made some form of financial
engineering possible, or, when combined with other factors, formed an
environment conductive to financial engineering.
Finnerty describes ten forces that stimulate financial engineering. These include risk
management, tax advantages, agency and issuance cost reduction, regulation

compliance or evasion, interest and exchange rate changes, technological

advances, accounting gimmicks, and academic research. In general, the factors can
be divided into two groups. The first consists of those factors that characterize
the environment in which the modern corporation operates. The environmental
factors may be regarded as external to the firm and over which the firm has
no direct control, but they impact the firms performance and so are great
concern to the firm. The second group consists of those factors that are internal to
the firm and over which the firm has at least some control. These factors are
considered as intrafirm factors.
The environmental factors
These factors include such things as increased price volatility, globalization of
industry and financial markets, tax asymmetries, technological development,
advances in financial theories, regulatory change, and intensified competition, etc.
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 (Brigham, 1990:604). 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.
Price volatility has three dimensions including the speed of price change, the
frequency of price change, and the magnitude of price change. Most markets
have experienced increases in the speed, frequency and magnitude of price
changes since the mid-1970s. Commodities and financial market have become
more volatile because of following factors:
Inflationary forces which disrupted the markets during the 1970s
Breakdown of traditional institutions and international agreements
Globalization of the markets
Rapid industrialization of many underdeveloped countries
Greater speed in acquiring, processing, and acting upon information
All these together have exposed investors, especially equity holders to more
price risk. To a considerable degree, price risk can be decreased by diversification,
but diversification alone is not sufficient. In recent years, volatility has been
increased by a more rapid flow of information and those who are threatened
by must manage the risks it poses.
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 (Marshall, 1992:658).
Globalization has the size of markets and greatly increased competition exposing
the modern corporations to significant risks and, in many cases, cutting profit
margins. Increased size of markets has led to more use of debt in capital structures
and increasing reliance on leverage to enhance returns. Multinationals were

born after corporations learnt to tap the capital markets of host countries.
Multinationals have considerable exposure to exchange rate risk and interest rate
risk and managing of these risks are essential to their successfully operations.
The efforts at foreign financing was aided by development of Eurodollar market
in the 1970s and the integration of the world capital markets brought about the
introducing of new financial instruments capable of bridging the markets.
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 (Das, 1989:170).
Tax asymmetries exist if two firms are subject to different tax rates, and these are
often exploitable by financial engineers. Much financial engineering is inspired by
tax asymmetries. Tax asymmetries exist for number of reasons:
Granting special tax exemption to some industries.
Existence of different tax burdens in different countries and even different tax law
for domestic and foreign firms doing business within a country.
Nature of past performances has left some firms with sizable tax credits and
write offs which effectively eliminate any tax obligations for some years to
come.
Financial engineering does not assist firms in the evasion of taxes. Rather,
financial engineers that arbitrage tax asymmetries help firms to avoid taxes.
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 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.
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. Technological advances have motivated a great
deal of financial engineering. Many of technological breakthroughs involve the
computer, high speed processors, powerful desk-top units, network systems,
and enhanced methods of data entry, and so on. Closely related to advances
in computer technology are advances in telecommunications which are critical
to certain forms of financial engineering. Improvements in communications allow
for instantaneous worldwide conferencing and data transmission. There have been
tremendous advances in software programs at the same time.
Advent of
spreadsheet programs has allowed modeling of complex financial deals.
Technological developments have contributed to the growth of financial engineering
in other important ways.
Technological advances have brought about more
volatility due to facilitating of information transmission. In fact, better flow of

information is manifested in more rapid and larger absolute changes in prices in

short-run. Therein lays a role for financial engineering. It can be used to help firm
manage the price risks inherent in market economy. To the extent that technological
developments increase volatility, the risk management role of financial engineering
is much more important.
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.
Finance, as a formal discipline, is concerned with value and risk and financial
engineering can not be used effectively without a solid foundation in financial
theory. From the finance theory prospective there have been a number of
landmarks. Perhaps most notable of these are evidenced by the works of
Markowitz (1952) who laid the basis for modern portfolio theory (33), Sharpe
(1964) whose Capital Asset Pricing model provided a deeper insight into risk
(34), Black and Scholes (1973) whose seminal work on option pricing
revolutionized the way in which contingent claims could be valued (35), and
some adopted models to multi-period interest rate and exchange rate options,
introduced in the late1980s.
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 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.
Much of financial engineering activity has been fostered by an atmosphere of
deregulation of industry and encouragement of entrepreneurial experimentation.
Deregulation fed competition and forced once protected industries to become
more efficient or to close down, and thus release their resources to more
productive ends.
The increased competition pressures coupled with the 1980s atmosphere of
deregulation led to efforts to end much of the regulation heaped on industry and
circumvent existing regulation. For example, prohibitions against interstate
banking in the US, broke down, commercial banking become increasingly
involved in investment banking activities, and so on. Transactional nature of
investment banking increased due to competition among investment banks. At the
same time, the cost of information, on which many transactions feed and the cost
of transaction itself declined significantly during the 1980s- continuing a trend
which was already well established by the close of 1970s. These trends were
largely an outgrowth of enormous technological developments that be
highlighted earlier. Many of financial engineering activities, particularly those
involving arbitrage and multi-instrument structured deals are dependent on
minimizing transaction costs and information costs.
Development of new markets and market linkages:

There has been an explosive growth of futures and options exchanges worldwide.
24-hour trading has become possible on futures and options exchanges across the
globe. The Chicago Exchange has developed a computer system on which trade can
now be carried out at any time, replacing human activity on the floor (Marshall,
1992:665).
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 (Marshall,1992:38). Computerized databases of financial
transactions are available to subscribers. Information asymmetry has considerably
declined.
Arbitrage opportunities:
The globalization of the financial markets has meant that arbitrage opportunities
across different capital markets could be identified and exploited. In theory,
exploiting these differentials through arbitrage should eventually lead to their
disappearance.
Completing markets:
Often there have been gaps in the financial markets which have been identified and
filled up with new kinds of instruments. For example, at one time there were no
interest rate forward contracts; interest rate swaps were then designed to fill this
gap. Thus, swaps complete markets (Smith, 1986).
Standardization: There has been an increasing standardization of financial
instruments, e.g., in futures, options and swaps. This has expanded the market.
Low documentation costs:
Many of the new financial instruments require little documentation, and no
prospectus, etc. This has made them attractive to companies.
Intra-firm factors:
Intra-firm factors include such things as liquidity needs, risk aversion among
managers and owners, agency costs, greater levels of quantitative
sophistication among investment managers, and more formal training of senior
level personnel.
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
(Marshall, 1992:39). The same purpose in the longer term is served by FRNs
(floating rate notes), adjustable rate preferred stock, etc.
Liquidity has many faces and meaning in finance. It is often used to refer to the
ease with which an asset can be converted to cash or ability to raise cash in hurry,
or the degree to which a securitys value will deviate from par as economic
conditions change, the degree to which a market can absorb purchases and
sales of securities without imposing excessive transaction costs. Both individuals
and corporations have liquidity needs and many of financial innovations over the
last decades have targeted these needs and concerns.

Risk aversion:
The risk aversion of firms to the increasing risks has been an important driving force
in motivating innovations.Risk aversion is considered a fundamental tenet of
financial theory that rational individuals have an aversion to financial risk, means
individuals are only willing to bear risk if they are adequately compensated for
doing so. Nowadays, there are wide varieties of innovative instruments capable to
limit the risk (e.g. adjustable rate debt, adjustable preferred stock,
collateralized mortgage obligation bonds, etc.). These products expose their
holders to considerably less risks. Besides all these instruments there has been
introduction of very efficient risk management instruments like interest rate
futures, interest rate options, stock index futures, and so many other
instruments. Among the risk management strategies developed or improved over
the last decades we can refer to asset/liability management techniques, better
risk
assessment
and measurement
techniques, and
development
and
improvement of hedging strategies.
Agency costs:
Marshall (1992:42) 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.
Agency cost is another motivating force behind much financial engineering. This
asserts the fact that structure of modern corporate ownership and control is in such
a way that corporate managers simply do not always have the best interest of the
firms owners. The cost to the firm from the separation of ownership and control are
not generally apparent and is difficult to measure, but market for the firms stock
will often tell the tale. Many of financial innovations during 1980s were due, at least
in part, to their ability to reduce agency costs. LBOs are a clear example. Securing
the capital to make LBOs possible required new forms of financing, inspiring still
other innovations, for example, junk bond market (30, pp.19-62).
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:
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.
CONCLUSION:
Financial engineering has proved extremely effective in managing the
increased financial risk witnessed over the past few decades, and particularly in the
last decade. "It's rare that a day goes by in the financial markets without hearing of
at least one new or hybrid product" (Smith, 1990:64). Using a building block

approach, it appears that almost all requirements of risk management can be met
by a suitable product. These instruments and their ever-expanding markets also
seem to be playing a role in increasing efficiency in capital markets. Cox (1976) has
suggested that "futures trading increases market information and thereby increases
the efficiency of spot prices. By "efficiency" he meant that spot prices provide more
accurate signals for resource allocation when the given commodity has a futures
market" (Martin, 1988:546).
In summation, we note that financial engineering as a major discipline within
finance is playing an important role and has come to stay.
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