Gold

Mahesh Babaria
maheshb@ghallabhansali.com

FINANCIAL ENGINEERING FINANCIAL ENGINEERING

OR OR FINANCIAL DESTRUCTION ??? FINANCIAL DESTRUCTION ???
6th March, 2009

Ghalla Bhansali Stock Brokers Pvt. Ltd.

Mittal Dharod
mittald@ghallabhansali.com

INTRODUCTION Much has been said and written about the meltdown in financial markets. What has happened is so large in scale and the import for emerging economies like India so serious that more debates and comments will continue for a long time. Investment banking, at least of the Wall Street kind, is dead. Is it a disaster or a blessing in disguise for the emerging markets? Probably the latter. Is there a lesson from it all? Yes, most certainly -- go back to fundamentals and grandpas simple logic and approach. The financial sector is supposed to play a supplementary role to the real economy. At the end of the day, people cannot eat, wear, stay in, travel in, or be medically looked after by money. Human beings fundamental needs are met by the real economy consisting of manufacturing and core services. Financial sector is meant only to facilitate and enable the real economy function smoothly. In the last few decades, however, finance and banking became too big and important for anybodys good. A system, which was meant to help the real players manage risk, was itself spawning huge varieties of risks and unleashing these on unsuspecting real sector companies. Maybe financial engineering was taken too far, far beyond what was necessary for business. Financial engineering like any other engineering has brought several new products and solutions to the market. It has completely changed the financial market today. Its main contribution is to split the risk and return into several components and allow investors of financial markets to decide the combination that is most suitable to them. Such innovations are seen in bonds, equity, derivatives, and also in other fields like merger, acquisition and corporate restructuring. It also provides mechanism to price such combinations by developing various pricing models for futures and options. Some of the models are Cost-of Carry model, Binomial model, BlackScholes Option Pricing Model etc. Today, it is possible to quantify risk and return of any new products and also price them with the help of these models. FACTORS CONTRIBUTING TO FINANCIAL ENGINEERING : There are eleven factors responsible for fi nancial innovation. These factors are 1) Tax Advantage 2) Reduce Transaction Cost 3) Reduces Agency Cost 4) Risk Reallocation 5) Increased Liquidity 6) Regulatory or Legislative Factors 7) Level and Volatility of Interest Rates 8) Level and Volatility of Prices. 9) Academic Work

www.ghallabhansali.com

Gold

FINANCIAL ENGINEERING FINANCIAL ENGINEERING

OR OR FINANCIAL DESTRUCTION ??? FINANCIAL DESTRUCTION ???
6th March, 2009

Ghalla Bhansali Stock Brokers Pvt. Ltd.

10) Accounting Benefits 11) Technological Development and Other Factors

THE PROCESS OF FINANCIAL ENGINEERING : Firms follow different processes for developing new value added product and services. Financial engineering is not different from that process. Identifi cation or realisation of a need is the starting point of the process. Such needs are to be identifi ed in the context of market and to bring out new value added products or services or solutions which suits the users requirements. Car manufacturers are adding new and innovative types of features in their products so that it can add more value to customers need and wants. Similarly mutual funds managers have to constantly look for ways to innovate new products that are appealing to investors and at the same time achieve certain additional objectives. For example, an open-end fund gives liquidity compared to closeend funds but still investors have to fulfi ll so many formalities to get the money. The various stages are depicted below

www.ghallabhansali.com

Gold

FINANCIAL ENGINEERING FINANCIAL ENGINEERING

OR OR FINANCIAL DESTRUCTION ??? FINANCIAL DESTRUCTION ???
6th March, 2009

Ghalla Bhansali Stock Brokers Pvt. Ltd.

FINANCIALLY ENGINEERED PRODUCTS : Debt and equity are two plain vanilla products. They can be places at two extremes of a risk-reward line. Debt carries low risk and hence low return where as equity carries high risk and high return. Many financially engineered products are between these two extremes or decomposing the risk and return or changing them to the level user wants. This is shown in the figure.

FINANCIAL ENGINEERING IN DERIVATIVES : The contribution of fi nancial engineering on derivatives is substantial. In fact, every derivative instrument is the outcome of financial engineering. To appreciate the contribution of financial engineering on managing risk through derivatives, let us go back to the origin of such developments. Market is a place where goods, products or services are exchanged. Normally, such exchange takes place when the parties transact and such trades are called cash market trades. However cash market transactions creates certain problems. For example, a food processing company may not be in a position to buy its entire one-year requirement of wheat and wheat producer may not be in a position to supply entire quantity of wheat. Both parties are exposed to price risk, if they decide to transact periodically, say one in a month-that is producer will supply one month wheat every month based on the price prevailing in the market. To manage price risk producers and consumers have started transacting in forward market.
3

www.ghallabhansali.com

Gold

FINANCIAL ENGINEERING FINANCIAL ENGINEERING

OR OR FINANCIAL DESTRUCTION ??? FINANCIAL DESTRUCTION ???
6th March, 2009

Ghalla Bhansali Stock Brokers Pvt. Ltd.

FORWARD : Forward is a plain vanilla instrument that gives birth to derivatives through financial engineering. Forward performs almost all requirements of both parties of transactions but there are certain limitations. For instance, if one of the parties wants to get out of the contract before the settlement date, both parties have to negotiate for the reversal; of the contract, which often will be expensive. In other words, there is no easy way for getting in and getting out of the forward contract. However futures, which are derivative instruments, offer this facility. FUTURE : Future is standardized forward contract entered between two parties and traded in exchange. Because of standardization, it is possible to trade in organized exchanges and because it is traded in exchanges, it is easy to get in and get out of the contract. Today, futures are highly liquid and available on large number of financial products like stocks, bonds, currencies and commodities like coffee, cotton, plantation, etc. They are also available on metals and energy products. While future resolve basic problem of liquidity while allowing parties to lock-in the price today so that there is no price risk, the parties forgo the opportunity to exploit the price advantage. For instance, the buyer will continue to pay higher price even the current market price is much lower. Of course, the producers gain in such situation. On the other hand, if the prices move up, the producers continue to sell at lower price while buyers gain in such a situation. Hence when the prices move up or down, one of the parties gain and other incur loss. OPTIONS : Financial engineers designed options contract which allows buyer of the option to retain the benefi t of price movement while avoiding loss. Consumers buy call option, which gives them a right to buy at a predetermined price. They exercise the right only when the price is more than the predetermined price. Producers buy put option, which gives them a right to sell at a predetermined price and producers exercise their right when the price moves downward. Option contracts split the risk into positive and negative and allow parties to take whatever they like. Buyers of option, who take positive side of the risk, are expected to pay a price or premium to seller of option, who take negative side of the risk.

www.ghallabhansali.com

Gold

FINANCIAL ENGINEERING FINANCIAL ENGINEERING

OR OR FINANCIAL DESTRUCTION ??? FINANCIAL DESTRUCTION ???
6th March, 2009

Ghalla Bhansali Stock Brokers Pvt. Ltd.

PROBLEMS ASSOCIATED WITH FINANCIALLY ENGINEERED PRODUCTS: Interest rate influences the price of almost all products of the economy and of course interest rate in turn is influenced by several factors. Volatility in interest rates creates problem for several players in the market but there are people who like volatility of interest rates and hence want to assume additional risk. Financial engineering can help these two parties to swap their risk appetite on their rate volatility. Derivatives increase risk not only for their users but also for the whole system. The fears of micro and macro financial crises have ballooned with the growth of derivatives. They cause wild fluctuations in assets prices by disrupting the market for those assets. The expansion of derivatives market may reduce the volume of business on the new issue market. Such complicated products also lead to other problems. It is very difficult to regulate such products. Basel II document for capital adequacy for banks is very voluminous and very complex even for seasoned professionals. Similarly, operating manuals for such products tend to be very voluminous and complicated. As regards regulation, the west typifies the form over substance syndrome. Reams of paper, intimidating manuals and battalions of legal eagles cannot save the situation if the fundamental substance that should underpin every financial transaction, viz. the right intent, fairness and prudence, is absent. CONCLUSION: In conclusion, as long as the issues of poor risk management and needless complexity are resolved, there will be more problems with our financial system in the future. They may come in different forms, but the outcome will be similar.It is time for all market constituents -- the lenders, borrowers, intermediaries, the regulators and the government to learn from these mistakes and go back to fundamentals and increasingly opt for simplicity.

www.ghallabhansali.com

Gold
Disclaimer:

FINANCIAL ENGINEERING FINANCIAL ENGINEERING

OR OR FINANCIAL DESTRUCTION ??? FINANCIAL DESTRUCTION ???
6th March, 2009

Ghalla Bhansali Stock Brokers Pvt. Ltd.

This document has been prepared by Ghalla Bhansali Stock Brokers Pvt. Limited(Ghalla Bhansali ) . This document does not constitute an offer or solicitation for the purchase or sale of any financial instrument or as an official confirmation of any transaction. The information contained herein is from publicly available data or other sources believed to be reliable, but we do not represent that it is accurate or complete and it should not be relied on as such.Ghalla Bhansali or any of its affiliates/ group companies shall not be in any way responsible for any loss or damage that may arise to any person from any inadvertent error in the information contained in this report. This document is provided for assistance only and is not intended to be and must not alone be taken as the basis for an investment decision. The user assumes the entire risk of any use made of this information. Each recipient of this document should make such investigation as it deems necessary to arrive at an independent evaluation of an investment in the securities of companies referred to in this document (including the merits and risks involved), and should consult his own advisors to determine the merits and risks of such investment. The investment discussed or views expressed may not be suitable for all investors. This information is strictly confidential and is being furnished to you solely for your information. This information should not be reproduced or redistributed or passed on directly or indirectly in any form to any other person or published, copied, in whole or in part, for any purpose. This report is not directed or intended for distribution to, or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction, where such distribution, publication, availability or use would be contrary to law, regulation or which would subject Ghalla Bhansali and affiliates/ group companies to any registration or licensing requirements within such jurisdiction. The distribution of this document in certain jurisdictions may be restricted by law, and persons in whose possession this document comes, should inform themselves about and observe, any such restrictions. The information given in this document is as of the date of this report and there can be no assurance that future results or events will be consistent with this information. This information is subject to change without any prior notice. Ghalla Bhansali reserves the right to make modifications and alterations to this statement as may be required from time to time. However, Ghalla Bhansali is under no obligation to update or keep the information current. Nevertheless, Ghalla Bhansali is committed to providing independent and transparent recommendation to its client and would be happy to provide any information in response to specific client queries. Neither Ghalla Bhansali nor any of its affiliates, group companies, directors, employees, agents or representatives shall be liable for any damages whether direct, indirect, special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information. Past performance is not necessarily a guide to future performance. The disclosures of interest statements incorporated in this document are provided solely to enhance the transparency and should not be treated as endorsement of the views expressed in the report. Ghalla Bhansali Stock Brokers Pvt. Limited generally prohibits its analysts, persons reporting to analysts and their family members from maintaining a financial interest in the securities or derivatives of any companies that the analysts cover. The analyst for this report certifies that all of the views expressed in this report accurately reflect his or her personal views about the subject company or companies and its or their securities, and no part of his or her compensation was, is or will be, directly or indirectly related to specific recommendations or views expressed in this report.

www.ghallabhansali.com