What is Financial Engineering?
Financial engineering as the name suggests is a marriage of two critical age-old concepts finance and engineering, which uses mathematical techniques, financial theories, engineering tools and advanced programming techniques to solve critical and complex financial problems like inconsistent cash flows generation, restructuring illiquid assets into liquid ones, creating perfect hedge on the derivatives, etc.
Example of Financial Engineering
It involves multiple fields like financial products, statistics, programming, etc to come up with innovative but structured products. One of such examples is securitization.
Securitization is the process of changing an illiquid asset or group of such assets and converting them into new structured products that can be attractive to investors and hence can be more liquid than the assets from which they have originated. A typical example is Mortgage-backed securities (MBS). Here the typical real estate projects which were lying vacant and were avoided by investors were restructured and sold as MBS. Once these individual units were packaged into a pool (MBS), they became liquid and were the darling of investors in the early 2000s.
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How to use Financial Engineering?
Follow below steps for financial engineering.
- Need Identification
The first and foremost step is to do a primary analysis and come up with a hypothesis that there are a need and demand in the market.
- MVP Creation
Based on the research (both primary and secondary) conducted in step 1, a minimum viable productA Minimum Viable ProductA minimum viable product (MVP) is a particular product version representing sufficient features for early customer satisfaction to collect exclusive customer feedback for proper product development as per customer requirement and remove unwanted attributes, reducing the risk of failure following wrong assumptions.read more is created based on basic demands. This product will be refined further as per feedbacks received.
- Complex Model Designing Workshop
Based on the feedback and suggestions received from the users, designers, and developers, a workshop is conducted to brainstorm and a detailed discussion is carried out to include the complexities and design a new scope for the product.
- Product Quality Assurance
The inculcated complexities need to be tested making sure that the crux of the product is much more useful and robust.
- Perfect Product
The product thus created can be called as a perfect one as it has undergone the transformation from MVP to a final product.
- Pricing
Now the sales team has to come up with the pricing of the product based on multiple factors like the ability to disrupt, need in the market if it caters to a niche market.
- Marketing
The success of any product depends on how the product is marketed as the end-users have to be taught about its capabilities and usefulness. This becomes more important if the product caters to a niche market.
- Product Launching
How the product is launched and what distribution channels are utilized to implement go to market strategy is the final but one of the most important steps.
Types of Financial Engineering
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#1 – Repackaging Structured Products
This makes use of mathematical techniques such as stochastics, simulations, and analytics to design and implement new approaches to explore solutions to problems in finance. In the procedure of finding new solutions, new strategies can also be developed for the benefit of the company to maximize corporate profitsCorporate ProfitsCorporate profit, or ‘profit after tax, is the net income received from the business after deducting direct expenses, indirect expenses and all the applicable taxes from the total revenue generated by the company during the year.read more.
#2 – Options Trading
An interesting fact that dates back to 1973 is that two financial engineers Fischer Black and Myron Scholes came up with an option pricing model, which was popularly known as the Black Scholes model. To this day it is one of the best models and traders across the globe use it to price the option premiums and plan their hedging strategies, entry and exit strategies and to calculate implied volatilityCalculate Implied VolatilityImplied Volatility refers to the metric that is used in order to know the likelihood of the changes in the prices of the given security as per the point of view of the market. It is calculated by putting the market price of the option in the Black-Scholes model.read more. In fact availability of some simple and yet useful has made trading in options so easy that there has been an unprecedented increase in the option trading volumes for both financial and commodity products.
Advantages
- With the help of the techniques that comprise mathematical modeling and computer engineering, one can test, analyze, find new approaches and tools for investment analysisInvestment AnalysisInvestment analysis is the method adopted by analysts to evaluate the investment opportunities, profitability, and associated risks in their portfolios. In addition, it helps them to determine whether the investment is worth it or not.read more, debt structuring, investment options, trading strategies, financial modelsFinancial ModelsFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact.read more, etc.
- Any future date events such as contracts or investments have high risk involved due to uncertainty attached to it. In such cases, It helps corporates reduce risk in investments or contracts involving future delivery of services or commodity futures with its calculation techniques for future returns.
- This concept is to analyze the worth of each balance sheet and profit and loss accountProfit And Loss AccountThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization's revenue and costs incurred during the financial period and is indicative of the company's financial performance by showing whether the company made a profit or incurred losses during that period.read more item for the future benefit of the business. This can help corporates to clean up adverse items and focus more on profitable items. These activities also result in better tax assessments for firms.
Disadvantages
#1 – Speculation
It has also given rise to various speculative practices in the market. This is also given markets different viewpoints and outlooks.
#2 – New Products without Understanding the Risks Leading the 2008 Crisis
To provide insurance against defaults on bond payments credit default swap were developed to speculate the estimated losses if any. These newly designed complex products grew very popular among the front-end traders and investment bankers as they provided a technique to generate consistent cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more with minimum leverage. Such was the marketing and distribution that there was no due diligence and many of the perils like high correlation, huge leverage, no collateralizationCollateralizationCollateralization is derived from the term "collateral," which refers to a security deposit made by a borrower against a loan as a guarantee to recover the loan amount if s/he fails to pay.read more and restructuring of junk bonds into high graded bonds were completely ignored.
This lead to an increased level of speculative trades as traders were able to generate a fixed income based on premiums and huge leverage. Everyone was happy as investors were getting good returns, traders were getting fat pay cheques and investment firms were growing exponentially leading to a bubble that burst in 2008 leading global economy into the biggest recession of all time. Such a sad end to a beautiful start
Conclusion
This can help individuals to assess and analyze the total risk and returns of their portfolio. With the help of this analysis, strategies can be formulated to reduce the total risk to the minimum possible level. Further, it can be used in various fields such as corporate finance, derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more pricing, financial regulation, portfolio management, risk management, valuation of options, etc.
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