BY M.

PARTHIBAN VMM 683

 

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

DEFNITIONS


The First definition of Financial Engineering Combining or carving up the existing financial instruments to create new financial products is known as financial engineering. -By Prof Campbell R. Harvey

The Second definition of Financial Engineering Financial Engineering is the application of mathematical tools commonly used in physics and engineering to financial problems , especially the pricing and hedging of derivative instruments. -By Prof Neil D Pearson

The Third definition of Financial Engineering Financial engineering is the use of financial instruments such as forwards , futures, swaps, options and related products to restructure or rearrange cash flows in order to achieve particular financial goals , particularly the management of financial risk

FINANCE

F.E.
I.T.
ENGINEERING

  

SECURITIES PRICING RISK MANAGEMENT OPTIMIZATION

SECURITIES PRICING:  PRICING OF RISKS  PRICING OF DERIVATIES

We can typically identify two classes of securities: primitive securities and derivative securities. Examples of primitive securities are stocks and bonds whereas options, futures and swaps are examples of derivative securities.

It is probably fair to say that financial economics is more concerned with pricing primitive securities, usually using equilibrium arguments (e.g. supply = demand) to do so. Financial engineering is typically more concerned with pricing derivative securities and uses arbitrage arguments to do so. This distinction is not hard, however, and sometimes it is necessary to use equilibrium arguments when pricing derivative securities. Moreover, some models such as the Capital Asset Pricing Model (CAPM), are equilibrium-based models that are of fundamental importance to both financial economists and financial engineers.

RISK MANAGEMENT: Risk management requires the identification of the risks to which the firm is exposed, quantification of these exposures - wherever possible, determination of the desired outcomes, and engineering a strategy to achieve these outcomes. There are three fundamental ways of managing risk:  Insurance,  On-balance sheet asset/ liability management,  Hedging.

OPTIMIZATION

 Utility Maximization  Dynamic programming  Portfolio Optimization At the most basic level, portfolio optimization is the problem of choosing a trading strategy with the goal of optimizing some objective function that measures the performance of the portfolio.

ENVIRONMENTAL FACTORS
PRICE VOLATILITIES GLOBALIZATION TAX ASYMMETRIIES TECHNOLOGICAL ADVANCES ADVANCEMENT IN FINANCIAL THEORIES INCREASED COMPETITION REGULATORY CHANGES TRANSITION COST ARBITRAGE OPPORTUNITIES

COMPLETING MARKETS STANDARDIZATIONS LOW DOCUMENTATION COSTS

INTRA-FIRM FACTORS
LIQUIDITY NEEDS AGENCY COSTS QUANTITATIVE SOPHISTICATION RISK AVERSION AMONG MANAGERS FORMAL TRAINING OF SENIOR LEVEL PERSONNEL

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

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). These instruments and their ever-expanding markets also seem to be playing a role in increasing efficiency in capital markets. In summation, we note that financial engineering as a major discipline within finance is playing an important role and has come to stay.