31-07-2012, 12:51 PM
Financial Engineering and Innovation as Risk Management Tools
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Introduction
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.
Financial engineering is all pervasive. Its presence spans across areas like design of innovative
financial instruments, financing Mergers & Acquisition (M&A) deals, corporate restructuring,
derivative trading strategies, etc. Financial engineering and innovations are seen in bonds,
equity, derivatives and in fields like mergers, acquisitions and corporate restructuring.1 Some
of the innovations in the Indian financial market are debt-oriented schemes of mutual funds,
interest rate futures, interest rate swaps, currency swaps, floating rate bonds, money market
mutual funds, etc.
Objectives
The main objectives of this paper are:
• To identify the process of financial engineering;
• To find out the development in engineering part of different asset classes like equity,
debt, mutual funds, etc.;
• To find out the role played by investment banks and stock exchanges in financial
engineering;
• To find out the rationale behind application of financial engineering; and
• To study the role of financial engineering in global financial crisis.
The scope of the study is limited to financial engineering in asset classes and developments
in Indian Financial market (in terms of innovation).
Research Methodology
The methodology is based on the empirical research using BSE 200 companies for two years
during 2007-09, where the Indian economy went through a multidimensional paradigm shift.
Only secondary data based on Bombay Stock Exchange (BSE), National Stock Exchange (NSE)
and company websites have been used here. The process included:
• A classification of financially engineered products in terms of financially engineered
equity, debt, hybrid instruments and financially engineered mutual funds;
• To study developments in Indian Financial market like launch of interest rate futures;
Review of Literature
Financial innovations play an important role in increasing cost-efficiency by reducing
transaction costs. However, the by-products of financial engineering like securitization,
Collateralized Debt Obligations (CDOs) and Collateralized Mortgage Obligations (CMOs), were
blamed for the present economic turmoil and global financial crisis. But does it hold true?
Financial engineering alone is not responsible for whatever has happened. There are some other
reasons like ignorance among investors, counterparty credit risk, liquidity risk and regulatory
failings. These factors also contributed to financial crisis. Cole et al. (2009) opine that financial
engineering provides potential in reducing consumption fluctuations and lower adoption of risk
management technology during select seasons. Mauri and Conti (2007) have found that
corporate financial risk management has been practiced by banks and companies alike by using
financial engineering products like that of derivatives and the accounting and regulatory
framework are also being redone.
Employee Stock Option Plan
It is offered to employees and directors of the company to give them a sense of ownership of
the company and to encourage them to participate actively in the management of the company.
This plan is voluntary and employees opting for such plan gets an option to subscribe to the
company’s shares at discounted price in future date. This option is exercised by swapping the
salary of the employee with equity.
Futures
Futures are just an extension of forward contracts. It is a standardized contract between two
parties wherein one party agrees to buy/sell predetermined quantity at predetermined future
price on future date. As it is standardized contract, it is exchange traded. It is marked-to-market
to avoid loss to clearing corporation as it acts as counterparty in futures transactions. Both
parties to contract have to pay upfront margin. At the same time, there are three contracts
trading near month, 2-month, 3-month (on stock exchange). The example of futures could be
stock futures, index futures, currency futures which are traded on National Stock Exchange.
Options
Options give its holder right but not an obligation to buy/sell contract. There are two types of
options: Call options and Put options. Call options give its holder right but not an obligation
to buy underlying at future date at predetermined price. The holder of call option gains when
stock price goes above strike price. Put option entitles its holder with right but not an obligation
to sell underlying at predetermined price on future date. In option contract, there are two
parties: One taking positive side and another taking negative side. Those having bullish outlook
about the market buy call option while those having bearish outlook go long on put option.
An example of it could be stock options and index options.