Financial Engineering

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

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

Definition
Principles and strategies for developing innovative financial solutions

Characteristics
Principles: Goals and rules for economic transactions Strategies: methods and techniques Innovative: New and novel Solutions: Satisfy real needs and create added value

Financial Engineers are prepared for careers in:

Investment Banking Corporate Strategic Planning Risk Management Primary and Derivatives Securities Valuation

Financial Information Systems Management

Portfolio Management Security Trading

Suggested Background
Generally, Financial Engineers are strong on the following fields: Statistics/Probability and PDEs Stochastic Processes C++ Programming Basic Business Finance Theor

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.

Whats the purpose of securities?

For the Issuer Rise New Capital: Depending on the pricing and market demand, securities might be an attractive option. Repackaging: Achieve regulatory capital efficiencies.

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

Weighted average cost of capital

The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital

Formula
The cost of capital is then given as: Kc = (1-) Ke + Kd Where: Kc The weighted cost of capital for the firm Ke Kd D E The debt to capital ratio, D / (D + E) The cost of equity The after tax cost of debt The market value of the firm's debt, including bank loans and leases 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

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

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

FINANCE

F.E. I.T.
ENGINEERING

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