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FINANCIAL ENGINEERING

Unit I: Introduction to Financial Engineering- Scope- Tools- Financial Engineering Vs. Financial Analysis- Factors contributing to the growth of financial engineering.- Innovative Products of the Last twenty years- present changing scenario of securities industry.

Unit I: Introduction to Financial Engineering


Unit I see the prescribed Text book. Unit II is OK 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

Money vs. Finance

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What is Financial Engineering? Financial Engineering refers to the bundling and unbundling of securities. This is done in order to maximize profits using different combinations of equity, futures, options, fixed income, and swaps. They apply theoretical finance and computer modeling skills to make pricing, hedging, trading and portfolio management decisions. Financial Engineers are prepared for careers in:

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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.

Type of Asset
1 Bank accounts 2 Money-market deposit accounts 3 Money-market funds 4 Special 6-month certificates 5 High-quality corporate bonds 6 Diversified portfolio of blue-chip common stocks (e.g., index fund) 7 Diversified portfolios of risky stocks such as aggressive growth mutual funds 8 Real estate

Exp. R of R
2.5-3% 3.5-4%

Risk Level
No risk of deposit loss. Inflation risk. No risk of deposit loss. Rates geared to inflation Very little. Rates vary with inflation. Early withdrawals subject to penalty. Rates geared to expected inflation. Very little if held to maturity. Rate geared to expected long-run inflation rate. Moderate to substantial. In any one year, the actual return could be negative. Diversified portfolios have at times lost 25% or more of their actual value. Substantial. Diversified portfolios have at times lost 50% or more of their actual value.

4.5-5% 5%

8-8.25%

9%

9-10%

similar to common stocks

Cannot be sold quickly. Hard to diversify. Good inflation hedge if bought at reasonable price levels. For long-term investors.

9 Gold

unpredictable Substantial. Believed to be a hedge against hyperinflation. Can help to balance a diversified portfolio.

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Unifying Principles of Finance No arbitrage Preference Optimization Market in equilibrium

Principle of Financial Engineering


No arbitrage Market in equilibrium Preference Optimization Principles of Financial Engineering Principles of Finance

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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

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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 Holder Investment: Debt securities generally offer a higher rate of interest than bank deposits, and equities may offer the prospect of capital growth. Collateral: Purchasing securities with borrowed money secured by other securities. 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.

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Equity An equity security is a share in the capital stock of a company (typically common stock, although preferred equity is also a form of capital stock). The holder of an equity is a shareholder, owning a share, or fractional part of the issuer. Unlike debt securities, which typically require regular payments (interest) to the holder, equity securities are not entitled to any payment. Equity also enjoys the right to profits and capital gain. Weighted average cost of capital The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital.

Financial Engineering Vs. Financial Analysis


A Financial Engineer is a person engaged in the practice of financial Engineering. And Engineering is the process of formulating and implementing a new instrument, a new process, or a creative solution to a problem. Financial Engineering refers to the bundling and unbundling of securities. This is done in order to maximize profits using different combinations of equity, futures, options, fixed income. Financial engineering is a cross-disciplinary field which relies on computational intelligence, mathematical finance, numerical methods and computer immolations to make trading, hedging and investment decisions, as well as facilitating the risk management of those decisions Utilising various methods, practitioners of computational finance aim to precisely determine the financial risk that certain financial instruments create.

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Areas of application: Investment banking Forecasting Corporate strategic planning Securities trading and financial risk management Derivatives trading and risk management Investment management Pension scheme Insurance policy Credit default swap Market mechanism design

Financial analysis A Financial Analyst is a person engaged in the practice of financial Analysis. And Analysis is defined as the process or method of studying the nature of something in order to determine its essential features and their relationships. Financial analysis refers to an assessment of the viability, stability and profitability of a business, sub-business or project. It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other reports. These reports are usually presented to top management as one of their bases in making business decisions. Based on these reports, management may Continue or discontinue its main operation or part of its business; Make or purchase certain materials in the manufacture of its product; Acquire or rent/lease certain machineries and equipment in the production of its goods; Issue stocks or negotiate for a bank loan to increase its working capital; Make decisions regarding investing or lending capital; Financial analysts often assess the firm's stability, Profitability, Liquidity and Solvency to compare financial ratios:

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The starting point of financial engineering is financial analysis. The basis for financial analysis is the financial statements of a company.

The job of financial engineering starts after a proper analysis of business and financial performance of a company. The areas of operations of financial analysis and financial engineers may be summarized as follows. JOB OF FINANCIAL ANALYST LIQUIDITY: Verification of current ratio , quick ratio, and changes in working capital position. Financial Risk: Analyze the financial risk through financial leverage and analyze the impact of financial leverage on the value of shares. JOB OF FINANCIAL ENGINEER Understand liquidity risk and suggest innovative solutions either to eliminate or minimize liquidity risk.

Suggesting the scope and methods of altering the financial leverage and thereby, minimizing financial risk.

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JOB OF FINANCIAL ANALYST


INTEREST RATE RISK: Analyze the scope for interest risk on the basis of past experience.

JOB OF FINANCIAL ENGINEER


Suggest or develop innovative securities to safe guard investors from interest rate risk.

INVESTMENT RISK: Analyze risk return relationship in investments in financial markets.

Suggest appropriate derivative instruments.

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JOB OF FINANCIAL ANALYST


Inflationary risk: Analyze the degree of inflation and its impact on the return of various financial instruments.

JOB OF FINANCIAL ENGINEER


Suggest appropriate measures and innovative or develop securities for minimizing inflationary risk.

EXCHANGE RATE RISK: Analyze the fluctuations of major currencies in the globe and establish the rate of risk of one currency in relation to exchange rate of another risk.

Suggest innovative swaps, futures, forwards and other financial instruments for minimizing the financial risk.

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Unit II: The Physical Tools of Financial Engineer- Product Development- A Model for New Product development- directions- design-testing-instrument preview.

Unit II: The Physical Tools of Financial Engineer


New Product Development and Product Life-Cycle Strategies Causes of New Product Failures Overestimation of Market Size Product Design Problems Product Incorrectly Positioned, Priced or Advertised Costs of Product Development Competitive Actions To create successful new products, the company must: understand its customers, markets and competitors Develop products that deliver superior value to customers. New Product Development Process Idea Generation and Screening Concept Development and Testing Marketing Strategy Business Analysis Product Development Test Marketing Commercialization New Product Development Process Step 1. Idea Generation Systematic Search for New Product Ideas Internal sources Customers Competitors Distributors Suppliers Step 2. Idea Screening Process to spot good ideas and drop poor ones Criteria Market Size Product Price Development Time & Costs Manufacturing Costs Rate of Return Step 3. Concept Development & Testing
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1. Develop Product Ideas into Alternative Product Concepts 2. Concept Testing - Test the Product Concepts with Groups of Target Customers 3. Choose the Best One Step 4. Marketing Strategy Development Marketing Strategy Statement Formulation Part One - Overall: Target Market Planned Product Positioning Sales & Profit Goals Market Share Part Two - Short-Term: Products Planned Price Distribution Marketing Budget Part Three - Long-Term: Sales & Profit Goals Marketing Mix Strategy Step 5. Business Analysis Step 6. Product Development

Step 7. Test Marketing


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Standard Test Market Full marketing campaign in a small number of representative cities. Controlled Test Market A few stores that have agreed to carry new products for a fee. Simulated Test Market Test in a simulated shopping environment to a sample of consumers. Product Life Cycle

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