You are on page 1of 16


Full Text:
The last three decades have witnessed a phenomenal growth in innovations in financial markets.
This is of interest to all financial intermediaries including commercial and corporative banks,
insurance companies and other financial institutions. Globalization, Liberalization and
Privatization have added both the risk and rewards to these innovations. This paper investigates
various new financial innovations in the field of banking, insurance, capital market and mutual
funds in the last one year in India. We have also tried to figure out the salient features,
advantages and disadvantages of the various financially engineered products and processes. The
paper also tries to discuss the way ahead for India in the field of financial innovations.
Keywords: Crisis, Innovation, Banking, Insurance, Capital Market, Mutual Funds
Jel: G01, G21
With the daily newspapers carrying advertisements featuring new securities, India as a country is
witnessing revolutionary changes in financial instruments and processes. The following passage
from Miller (1986) is typical "... the word revolution is entirely appropriate for describing the
changes in financial institutions and instruments that have occurred in the past twenty years".
Financial engineering has been most comprehensively defined by Finnerty (1988) as design,
development and implementation of innovative financial instruments and processes, and
formulation of solutions to the problems in finance. Innovative financial solutions may include
new financial instruments (such as payment card, reverse mortgage product, arbitrage fund,
Jeevan Aastha, Micro Insurance and many more) or new processes such as (Mobile payment
service, DMA facility, ABSA process, NOW trading gateway, etc.). The paper endeavors to track
the growth of new financial instruments, new forms of mutual funds, new types of life insurance
products, new form of residential mortgages and new risk management instruments introduced in
Innovative financial products which were mismanaged by the bankers and customers are often
criticized and held responsible for the Global financial crisis (2008). It should however be noted
that financial engineering is a profession which is to be governed by the conduct of
professionals. The passion to succeed and greed to earn supernormal profits marred the foresight
of the professionals form estimating the risks associated with financially innovated products. To
service the bonds backed by sub prime mortgages, the banks started using the income stream of
their prime/default free mortgages. This laid the foundation for financial crisis. Hence, there was
collapse of many big players including Freddie Mac, Fannie Mae, AIG, Lehman Brothers and

Merrill Lynch. Hence the crisis can be linked to the bad performance of a large number of top
executives in the financial engineering profession and not to the profession of financial
engineering itself. The solution to the current global financial crisis will be there only by using
the financial innovations intelligently and by incorporating the objective of social welfare in
mind. For example, for solving liquidity problem that arose in September 2008 the US Federal
Reserve extended financially innovated currency swap arrangements to other central banks to the
tune of $180 billion to fund the extra liquidity operations.
The paper has been divided into X sections. Section I introduces the reader to the concept of
financial engineering. Section II discusses the relationship between the globalization, financial
engineering and the current financial crisis. Section III gives the plan of the paper. Section IV
discusses the existing literature in India and abroad. Section V throws light on financial
engineering in India. Section VI presents the recent financial innovations in the Indian banking
sector. Section VII gives the new financially engineered products in the insurance sector. Section
VIII discusses the innovations in the Indian capital market in the recent past. Section IX presents
the innovation in the mutual fund industry and Section X concludes the paper.
To counter inflation Modigliani and Lessard (1975) discussed CPI linked home mortgage
instrument, Blinder (1976) discussed instruments that can hedge inflation risk related to
commodities and finally Merton (1992) suggested indexing retirement annuities to aggregate per
capita consumption. Merton's suggestion is based on the lifetime household optimizing
behaviour model. The product is only conceivable for Indian markets if there is partnership
between the government and the private sector to make this type of product possible.
Dufey and Giddy (1981) in their theory of innovation in international market found that
innovations in international market arise usually when the financial institutions are able to fulfill
one of the four functions: (a) Liquid and standardized instruments for payments in individual
currencies; (b) Mechanism for conducting monitory exchange between currencies; (c)
Institutions and market for channeling savings internationally; and (d) As a mechanism for
allocating, diversifying and compensating for risk.
Silber (1983) identified the exogenous cause for financial innovations in US for a period from
1970-82. He found that inflation (level of interest rates, general price level and tax effects),
volatility of interest rates, technology, legislative initiatives and internationalization are the
factors responsible for financial innovations. He found that out of all exogenous forces,
technology and legislative initiatives are the most important forces. In India also the two factors
are responsible for majority of financial innovations. Silber through his empirical research
concluded that financial innovations improved the ability to bear risk, lower transaction cost and
circumvent outmoded regulations. It was established by him that financial innovations tend to

yield economic benefits which are equal in welfare sense to the improvements in physical
technology, as both contribute in increasing the standard of living.
Finnerty (1988) identified 11 factors contributing to the growth of financial engineering. The
factors include tax advantage, reduced transaction cost, reduced agency cost, risk reallocation,
increased liquidity, regulatory and legislative factors, level and volatility in prices and interest
rates, accounting benefits and technological developments. Finnerty has also analyzed how each
of the factor contributes to the growth of the selected debt innovations, selected preferred stock
innovations, selected convertible debt / preferred stock innovations and selected common equity
Bodie (1990) found that pension funds have contributed significantly in the development of new
debt and equity securities and derivative instruments. A pension plan generally tends to offer
annuities providing a guaranteed flow of return. The sponsor to provide for the flow return must
undertake immunization strategy to hedge their liabilities. The use of immunization and
contingent immunization strategy has led to emergence of market for zero coupon bonds,
Guaranteed Investment Contracts (GICs), Collateralized Mortgage Obligations (CMOs), options
and futures.
Verghese (1990) concluded that the Indian financial system consists of gaps and deficiencies
which need to be filled in. India can not afford rapid proliferation of financial products. The
systemic risk arising from regulated financial innovations is significant and hence can't be
ignored. Financial innovation provides opportunities for hedging risk and reducing individual
transaction cost but at the same time exposes economic units to additional costs and risk by
creating new risk and sometimes resulting in ballooning of transactions.
Merton (1992) saw financial innovations performing six very important functions including
moving funds across time and space, pooling of funds, managing risk, extracting information to
support decision making, addressing moral hazard and asymmetric information problem and
facilitating sale or purchase of goods and services through a payment system.
Frame and White (2004) surveyed and summarized existing empirical literature on financial
innovations. They found that regulations tend to spur a series of financial innovations. There
exists a positive relation between adoption and diffusion of new technologies and institution size.
There also exists a positive relationship between individual's education and income and use of
the new financial technology by consumers. Financial innovators tend to gain by first mover
advantages and are compensated well for their efforts. Financial innovations tend to generate
welfare effects normally.
India as an emerging nation is seeing a spate of innovations in the area of financial engineering.
These financial innovations are a result of number of Government regulations, tax policies,

globalization, liberalization, privatization, integration with the international financial market and
increasing risk in the domestic financial market. Alternative financial institutions including
nationalized banks, commercial paper houses, insurance companies and investment banks play a
significant role in creation, development and dissemination of new financially engineered
products in the society. The following section discusses the recent innovations in Indian banking
Financial engineering in the banking sector tries to ensure that the banking becomes competitive
and performance oriented. The recent innovations in the Indian banking sector have been
discussed below:
6.1. Rollover Overdraft
In 2008 the brokers developed a perfectly legal process by which they remain afloat without
having to pay. In this circuitous transaction a broker avails the overdraft facility from bank A
with a provision that it has to be repaid in 5 days. Normally on day 4 the broker will issue a
cheque to bank A from his account with bank B. During current liquidity crisis the broker may
have insufficient funds in that account. To overcome this problem of insufficient funds the
brokers have innovated a new financial process whereby the broker, bank A and bank B come
together to overcome the liquidity crisis. The process is applicable only for high value cheques
and if RTGS facility is offered by bank A and bank B. On day 4 being a high value cheque it is
cleared on the same day by bank A which accept the cheque and agrees to cancel the outstanding
overdraft amount even before the cheque has been encashed. As soon as the outstanding
overdraft is cancelled, bank A issues another overdraft to the broker for the same amount. The
fund is then transferred to the broker's account with bank B using RTGS. This ensures that funds
are there in the account of the broker with bank B at the time when bank A presents the brokers
cheque for clearing. This is similar to evolving a new financial instrument/ process of having a
rollover overdraft.
6.2. Electronic Fund Transfer
RTGS/NEFT facility enables customers to transfer fund from one bank to the other within a very
short time. It has the advantage of making a customer closer to his own funds. There exists three
mode of electronic payment: Real Time Gross Settlement (RTGS), National Electronic Fund
Transfer (NEFT) System and Electronic Clearing Service (ECS). NEFT is available for
transaction below 1 lakh while RTGS is available for transaction over 1 Lakh.
6.3. Prefunded Cheque
India is a country of large number of festivals involving exchange of gifts. Financial engineering
has been innovatively combined with Indian culture of frequently giving gifts using prefunded

cheques. Under this facility one can gift the prefunded cheques to any of his/her relatives or
friends who can encash it. One of the advantages is that it can be gifted to anyone and is less
expensive than a banker's cheque or a demand draft. It also provides safety as the sponsor of the
gift does not require carrying cash for giving the gift. They have an upper limit inscribed on them
and can be used as gift cheques, travelers cheques or as a normal cheque. In India, it is being
used primarily during the festivity of Rakhi, Bhai Dooj and Dusshera.
6.4. Cheque Truncation System (CTS)
Banks have extended the CTS facility of same date clearing to cheques of even smallest
denominations. Currently this facility is only available to high value cheques. It will replace the
current Magnetic Inc Character Recognition (MICR) technology which requires physical
movements of cheques. It will add huge value to the customers as it saves 1-2 days in getting
collections through banking channels. Currently it is being tried on a pilot basis. However, there
remain issues in up scaling the volumes on account of lack of standards for physical instruments,
account number, positioning of various fields on the physical instrument and the uniform size
and background of the instruments.
6.5. Biometric ATMs for National Rural Employment Guarantee Act (NREGA)
Financial engineering and Biometric technology have been combined very innovatively to
implement disbursement under the NREGA (2005). To reduce corruption, the rural people under
NREGP can get their thumb impression registered at the biometric ATM and can subsequently
withdraw money using the thumb impression. It will greatly benefit large number of illiterate and
simple Indian rural citizens. Hence, in India, financial and technological innovations are being
used to achieve the objective of social welfare. Apart from this, general biometric ATMs provide
secure and convenient transactions and have the benefits of security pin as well.
6.6. Mobile Payment Service by Banks In 2008 banks have been permitted by RBI to provide
mobile payment services, which enable customers to transfer up to Rs. 25,000 per transaction.
Mini statements, checking of account history, alerts on accounts activity, passing of set
thresholds, monitoring the term deposit, access to card statement, mutual funds/equity statement,
insurance policy/ pension plan management and many other account information services
provide the flexibility of anywhere, anytime banking and reduce transaction cost.
6.7. Fixed Deposit (FD) Products
6.7.a. New Deposit cure Investment Product
A fixed deposit scheme with envisages investment of interest earned on term deposit in an equity
mutual fund by a way of systematic investment plan. This has an advantage of giving safety on
the principal invested in this fixed deposit and a possibility to earn additional return on interest

6.7b. Gold Deposit

In this deposit one can ensure safety of idle gold and earn interest on it. Certain banks (like SBI)
are accepting gold in any form with restriction of minimum gross quantity and thereby issuing
interest bearing certificates against deposits. The certificates have fixed maturity period and
premature payment is permitted only after certain lock in period. The product has an inbuilt
option of redemption of principal in pure gold or equivalent cash. Certain banks also club in
nomination, transfer and loan facilities in the certificates. The income on this certificate is
exempt from Income tax, Wealth tax and Capital Gains tax. This product has been designed for
individuals, temples and trusts.
6.8. Dual Facility on Single Card
There already exists credit card which offers a line of credit to the user with a condition that the
credit amount will be paid back within a specified time period. On the other hand there exists
Debit cum ATM card which allows an individual to use funds available in his bank account.
Banks have innovated the dual facility on single card option whereby the user will have debit as
well as credit facility in a single card. The card will reduce the cost, improve efficiency and free
the user from the requirement of carrying multiple cards. The disadvantage arises in the
operational working of such card. A user of such card can make the most often used mode as his
default option and intimate the bank when he wants to exercise the other option. If this is not
handled properly it can result in a lot of confusion and default expenses.
6.9. Reverse Mortgage Product
The reverse mortgage scheme available in India enables monthly payment against the mortgage
of the home, so long as one continues to live at home. There is no repayment obligation on the
owner, as the loan will become due only on the death of the owner or the last surviving spouse.
This loan product does not have any income criteria to be met. The legal heirs will have the right
to repay the loan. In case the legal heirs do not repay the loan the bank will sell the property and
set off the outstanding loan amount. The surplus will be given to the legal heirs. The banks do
tend to put certain condition as to the minimum and maximum amount of loan, tenure of the
loan, interest rate and the age at which one can avail of reverse mortgage scheme.
The pace of financially engineered innovations in the insurance industry continues to pick up
even in the light of lagged overall growth. There is a sense of urgency for innovations in the
insurance sector. The insurance industry at this stage also has an appetite for change. Rightly
created and implemented innovation strategies can help insurance companies emerge stronger
during the current global financial crisis. The following paragraphs discuss the innovations in
this sector.

7.1. Jeevan Aastha

In the light of current global financial crisis Life Insurance Corporation of India (LIC) launched
a hybrid product called "Jeevan Aastha" which combines features of Fixed Deposits/Debt, equity
and life insurance product. Jeevan Aastha is a closed ended single premium product which offers
guaranteed benefits to the customer on maturity and death whichever is earlier. The product
offers a simple interest of 10% per annum for a ten year period and a simple interest of 9% per
annum for policies with a five year term. The product also offers risk coverage equal to the basic
sum assured plus guaranteed addition in the first year of the policy. If the policy holder dies after
the first year then double the maturity sum assured and guaranteed addition will be payable.
However, in the scenario of death during the last year of the policy, twice the maturity sum
assured along with guaranteed addition and loyalty addition would be payable to the nominee.
The minimum risk coverage that can be availed is Rs. 1.5 lakh. No upper limit has been fixed.
The product has been bundled with income tax benefits under section 80C and section 10(10D)
making this product attractive for Indian middle class. However the maturity amount will be tax
free. The product has also incorporated the feature of pledging the policy for undertaking a loan.
A loan can be undertaken against the policy after completing one policy year. The surrender
value in no case is less than 90% of the single premium paid. The surrender value will be
calculated as the discounted value of the maturity sum assured and accrued guaranteed addition.
To provide flexibility, the policy also provides "Cooling off Period" whereby one can also return
the policy within 15 days if one is not satisfied with the terms and conditions of the policy.
7.2. Market Linked Pension Product
It enables policy holder to increase premiums with the rising income. This will enable the policy
holder to accumulate larger wealth and beat eroding factors like inflation. Being a market linked
pension product it provides performance over the long term and ensures good living standard
after retirement. It has an inbuilt risk in case the market plummets in the long run.
7.3. Insurance Linked Education Loan
The Indian Banks' Association has engineered a model education loan product which provides
for a higher quantum of loan. In this product the insurance premium will be a part of the
expenses for the loan. The product will come with a provision of top up loan for students for
further studies up to Rs. 4,00,000 of the loan amount. A cap or rate of interest which will not
exceed benchmark prime lending rate (BPLR) has been fixed. For loans above Rs. 4,00,000 the
rate of interest will not be more than 100 basis point over the BPLR. In this product life
insurance policies and mutual funds units will be treated as permissible securities for the loan.
Now banks can offer multiple loans to a single family after the introduction of this product. The
product will although increase the cost of the loan but at the same time enhances the security for
the bank. The life insurance policy will enable banks to recover the amount of loan in the
eventuality of death of the student availing the education loan. Moreover, the same life insurance

policy has become permissible as security for the loan. This product now enables students to
avail education loan even if their family does not own real assets like Land and Building.
7.4. Customized Insurance Policies
Insurance Regulatory and Development Authority (IRDA) has permitted customization of non
life insurance policies. For example, in motor insurance policy now one can have facilities like a
temporary replacement of car in case it breaks down or complete reimbursement of damages,
even if vehicle is over five years old. The insured will have to pay extra premium for such
customization. This regulatory change will give rise to large number of financially engineered
innovative non life insurance products.
7.5. Insurance Policies with Terrorism Cover
In the light of terror attacks in Mumbai, Delhi and other metropolitan cities Optima insurance
launched a free insurance policy which provides a cover of rupees one lakh in the event of death
in terrorist attack. There is no premium charged for subscribing to this policy. However
registration with the company is a must for availing the compensation in event of death. It is a
non commercial program and is using financial innovation for fulfilling responsibilities of
corporate India towards society.
7.6. Insurance Cover on Lost Credit Cards
Plus Extended Protection Plan is a unique product which provides credit card customers lost card
insurance for the period prior to reporting the loss. The insurance policy will cover
reimbursement of up to Rs 50,000 per occurrence on any of fraudulent transaction occurred on
the lost card up to 12 hours prior to the customer reporting the loss to the bank. Payment and
debit card or credit card can be registered for this cover. It also offers ATM assaults and robbery
insurance, lost wallet protection and purchase protection. The purpose of this policy is to
encourage the confidence of the people who use debit or credit card. With increasing crime rate,
this product reduces the risk of the policy holder.
7.7. Insurance for Poor
The Universal Health Insurance Scheme (UHIS) shows the utilization of financial engineering by
Indian Government for providing hospitalization cover for 10 lakh people from families below
the poverty line. It will also provide medical care in rural India. The annual premium under the
UHIS is Rs. 300 for an individual, Rs. 450 for a family of five and Rs. 600 for a family of seven.
One can get insurance for maturity benefits and preexisting disease up to the age of 70 years.
7.8. Micro Insurance Products
These are financially innovated insurance product in the area of health, personnel accident cover,

crop insurance and insurance for equipment for low income groups like farmers and craftsmen in
the unorganized rural sector. By paying a premium of Rs 200 to Rs. 500 one can get coverage of
Rs 5,000 to 50,000. Indian government has launched Aam Aadmi Bima Yojana and Rashtriya
Swasthya Bima Yojana as micro insurance products.
7.9. Micro Insurance for Women
Life Insurance Corporation (LIC), Punjab National Bank (PNB) and Govt. of India have used
financial innovation to provide life and permanent disability cover for credit linked women Self
Help Groups (SHGs) linked to PNB. This life insurance scheme will have an annual premium of
Rs 200 of which 50% will be paid by the insured and the rest will come from the social security
fund of the Central Government. This product will benefit approximately 30 lakh SHGs. LIC and
PNB will benefit with the increase in the number of people insured.
With the increased volatility in the capital market, there is a need of new financial innovations in
this sector to hedge risk and increase returns. The recent financial innovations in the area of
capital market in India are discussed below:
8.1. Currency Futures
August 2008 saw the launch of currency derivatives at National Stock Exchange. A currency
future is a futures contract where the underlying is a specific foreign currency and amount.
Profits and losses depend on the relative movements of the two currencies. This enables the
market participants to hedge their risk in the currency market.
8.2. Direct Market Access (DMA) Facility
DMA facility has enabled broker to offer their client direct access to the trading system of the
exchange through the broker infrastructure without manual intervention of the broker. It offers a
direct control of the client over orders, reduced time lag in execution of client orders, reduced
errors caused by manual order entry, greater transparency, enhanced liquidity, lower cost for
large orders and gainful use of speedily executed arbitrage strategies. The disadvantage of DMA
is that several severe conformity provisions under the Securities Contract (regulations) Act 1956
have been laid down for the broker. The brokers are also expected to adhere to the stringent
model agreement developed by the exchanges.
8.3. Applications Supported by Block Amount (ASBA) Process
ASBA is an application for subscribing to an issue which contains an authorization to block the
application money in the applicant's bank account. This facility has been introduced for resident
retail individual investors. It has an advantage the applicant's does not lose interest for the period

the money remains blocked. It has saved the banks from first transferring the money form the
bank to the company and back to individual applicant's account. Hence, the ASBA process has
increased the operational efficiency and reduced the transaction costs. The disadvantage of this
process is that the applicant will not have the option to revise the bid. In other words it provides
only a single option as to the number and price of the shares to bid for. It can be undertaken only
at self certified Syndicate Banks. This makes the availability of ASBA facility limited to only
selected banks.
8.4. NOW Trading Gateway
Now one can access NSE cash, NSE future and option, NSE currency derivative and NCDEX
commodity derivatives using the NOW terminal. It helps increasing and managing users and
their roles, multi segment front-end for trading, real time access to live market data and online
reports, creation of multiple hierarchy and products. It provides real time pre-trade and rule
based risk management. It is advantageous as it ensures a secure and reliable trading gateway. It
has lower cost and greater operational efficiency. In terms of security features it uses 128 bit SSL
encrypted secure transaction and comprehensive audit trail.
8.5. Long Term Option Contract (LTOC)
To mitigate risk Security and Exchange Board of India (SEBI) permitted use of LTOC on S&P
CNX Nifty for trading in Future and Option segments from January 2008 onwards. The
advantage of LTOC introduction on Nifty is that all the existing risk management measures used
for index option contract such as initial margins, short option minimum change position limit and
including the right of clearing corporation to close out positions can apply to LTOC on S&P
CNX Nifty also.
8.6. India VIX-The Volatility Index
India VIX is a volatility based index based on Nifty 50 option prices. The purpose of the index is
to capture the implied volatility embedded in option prices. It shows the amount by which the
underlying index is expected to fluctuate in the near future. It is based on the order book of the
underlying index options. The disadvantage is that no tradable product exist which is based on
India VIX.
8.7. Creation of Stock Exchange for Small and Medium Enterprises (SMEs)
SME have been playing a very significant role in the development process of Indian economy.
They contribute around 20% to the GDP and generate an employment for 25 million people.
Moreover, SMEs are not able to access funds from angel investors, venture capitalists and
private equity players. The purpose of such an exchange would be to provide better focused and
cost effective service to the SME sector. Security and Exchange Board of India (SEBI) is already
deliberating on the issue.

8.8. National Spot Exchange Limited (NSEL)

The cost of intermediation in the commodity futures market is high there by reducing the
marketing efficiency and gains made by a farmer. The NSEL helps in reduction of costs and
enables farmers to realize better price for their produce. It is advantageous as in future market
trades happen for big volumes, in tons, whereas in spot market the trading happens for 1 quintal
trading lot for one farmer. Moreover, farmer does not need pan card number, ration card and
other formalities, which are necessary in future trading. In future market the delivery is not
guaranteed but in the spot market, the contracts are designed with compulsory delivery on T+1
and T+3 basis. However, forward contract, future contract and options will not be available on
National Spot Exchange. The spot exchange for agricultural commodities is expected to offer
better price discovery and correct the aberrations that exist in Local Mandi's and sometimes in
future market. This is the first spot exchange for agriculture commodities in the world.
8.9. Short selling in Government Securities
To enhance liquidity in G-Sec market it was permitted to undertake the cover leg of short sell
transaction even outside the Negotiated Dealing System-Order Matching (NDS-OM) Platform.
Earlier the sell leg as well as the cover leg of the transaction was to be executed only on NDSOM Platform. It means that transaction to cover short position can be undertaken either on NDSOM platform or on the telephone market or via purchases in primary issuance market. The
disadvantage that the sell leg of the short sell transaction would have to be undertaken on NDSOM Platform would however continue.
8.10. Extension of Circuit Breaker to Index based Market
Circuit breakers are normally applied to individual scripts to suspend trading in case they show
excessive volatility. The same concept has been financially engineered for the exchange in case
of the index movement either way at 10%, 15% and 20% with respect to some base level. The
advantage of Index based market wide circuit breaker is that it provides stability to the index and
enhances investor's protection.
With sharp fall in the stock market in 2008 the mutual fund industry has tried to use financial
innovations as the basis for fighting the current market turmoil. For example, J. M. Financial
launched a multi strategy fund which is an open ended equity oriented fund which will be
flexible to adopt a host of strategies depending upon fund manager's view of market. The
following paragraphs discuss innovations in mutual fund sector.
9.1. Arbitrage Fund

Even with crashing equity markets, Arbitrage Funds have been able to generate positive returns.
They are equity and derivative funds providing an ideal way of realizing reasonable returns from
equities with risk hedged by derivatives. The Arbitrage Fund tries to capitalize on the stock price
differences between the spot market (cash segment) and the derivative market (F & O segment).
The fund tries to generate returns by availing the arbitrage opportunities that arise in case there
are mispricing between the spot and derivative market. The returns can be generated irrespective
of the overall market movement. The stock prices in the spot and the derivative market tend to
coincide on the settlement day of the derivative segment. Hence the fund manager can reverse
his position by buying a contract in the future market and selling off his equity holding in the
spot market. The main concern is how efficiently the assets are balanced between the spot and
the derivative market. Empirically they have shown better results then debt or income funds.
They provide good returns during volatile periods.
9.2. Collective Investment Vehicle
Various art funds can now be floated in the market after obtaining approval from SEBI. In this
people can pool-in funds to fund the purchase of the art and sell it later at a premium. The return
would then be divided amongst the investors. This product may be suitable for High Net worth
Individuals (HNIs) and institutional investors but not for the retail investors. This product raises
art as a credible asset class. Art has a very low correlation with equity markets making it ideal for
a large portfolio. Till date not even a single entity has registered with SEBI as collective
investment vehicle.
9.3. Commodity based Mutual Funds
With situation turning from bad to worse to gruesome in the equity market; the mutual funds
have innovatively tried to reap the benefits of the commodity bull run. In India in 2008 many
commodity based funds like Mirae Asset Global Commodity Stock Fund, ING Optimix Global
Commodities Fund and the AIG World Gold Fund and many others were launched. In India, we
however, do not have funds which combine equities, commodities and bonds within one fund.
This type of mutual funds gives an advantage of reduced risk and high returns to an investor. It
also gives a choice to an investor to look for mutual funds which invest in varied asset classes
within India. The major disadvantage is the nascent stage of commodity market in India and the
lack of investor knowledge in the area of commodities. Singh, Agarwal and Harilal (2008) have
shown the innovative way in which equities, commodities and bonds in Indian stock market can
be combined for creating efficient funds.
9.4. Mutual Funds and Derivative Strategy
To beat the market in current global financial crises financial engineers have innovated an equity
linked fixed maturity plan mutual fund which involves taking position with minimal market risk.
The fund buys one stock (or its derivative) and sells another (or its derivative). This is done by
identifying the trend i.e. benefiting one company and at the same time detrimental to another. For

example JP Morgan Alpha fund uses this strategy.

9.5. Shariah Complied Securitized Market Financing
Merrill Lynch (London) and Bemo Securities (Beirut) made a sale of $166 million debt like
certificates for natural gas producer East Cameron Gas (Houston). It was the first Shariah
complied securitized market financing of US assets. It was structured in such a manner that the
Islamic investors effectively get a fixed rate of return while considering themselves owner of the
underlying assets. This was in conformity with Islamic rule which prohibits the earning of
interest. The instrument was considered to yield only the returns which were lawful. Shariah is
the Islamic law based on teaching of Koran. The rule prohibits involvement in alcohol, gambling,
human cloning, conventional banks and some forms of entertainment. In India we have the S&P
CNX Nifty Shariah. Across the globe there exist S&P 500 Shariah, S&P Europe 350 Shariah,
S&P Japan 500 Shariah and FTSE Shariah Japan 100. The index continues to eliminate such
companies which get involved in any of the activities not permitted by Shariah rules. Using
financially engineering, the world has been able to increase the flow of investments across
continents keeping into account the religious sentiments of the investors.
9.6. Fund of Funds
To achieve maximum diversification, the mutual fund industry innovated a very noble way for
achieving it. The Asset Management Company (AMC) develops a mutual fund which derives its
value from a pool of mutual funds which are under the management of the same company. By
this, maximum diversification is achieved and risk is reduced to minimum.
9.7. ULIP Variants
The idea of providing an insurance cover along with mutual funds was started by DSP Merrill
Lynch in 2005. Nowadays in Indian Mutual fund sector many variants of ULIPs have been
financially engineered. They combine features of mutual funds, pension funds and insurance
policies. ULIP variants offer a range of products appealing to different types of customers.
However, this tends to increase complexity and makes it difficult for an investor to make
The current research has made a noble attempt to discuss the application of financial engineering
in the banking, insurance, capital market and mutual fund sector in India. Internationalization
leads to a spurt of financial innovations in India and the world. The harm that has been caused by
securitized instruments backed by subprime mortgages has been widely discussed in existing
literature. The current paper discusses the adaptation and innovation shown by the banking,
insurance, capital market and mutual fund sector to overcome the international financial liquidity
crisis of 2008. The review of literature discusses the factors that have contributed to the growth

of financial engineering and the lessons India can learn from international experience. While
discussing the innovations in the banking sector the paper has discussed 10 innovations in this
sector (see figure 1). The banking innovations aim at making customers closer to their funds,
reduce cost, improve efficiency and provide safety (see table 1). The paper has presented 9
innovations in the Indian insurance sector (see figure 1). In the insurance sector, new innovative
products provide the features of guaranteed return, safety against inflation, social security,
reimbursement of medical and hospitalization expenses (see table 2). The paper discusses 10
products and processes in the Indian capital market (see figure 1). The capital market innovations
have the feature of investor protection, transparency, enhanced liquidity, reduced cost and
mitigation of risk (see table 3). For the mutual fund industry 7 innovations have been discussed
(see figure 1). The mutual fund innovations have the feature of diversification, risk reduction and
superior return in the volatile market (see table 4). The existing innovative financially engineered
products lack the protection against inflation. In India, there is a great need of innovations
especially for senior citizens, poor people, women, rural people as well as a large middle class.
There remains scope for development of insurance exchanges, credit reinsurance market, carbon
market, property future, weather derivatives, freight derivatives and inflation derivatives. As long
as human ingenuity challenges its present for a better tomorrow, there will always exist the scope
for financial engineers and financial innovations
The authors gratefully acknowledge the technical support of Indian Institute of Finance. We
would like to convey our special thanks Prof. J. D. Agarwal (IIF Delhi); Prof. Manju Agarwal
(MLNC, DU); Prof. Madhu Vij (FMS, DU); Prof. Aman Agarwal (IIF Delhi); Ms. Yamini
Agarwal (IIF Delhi); Prof. K. K. Aggarwal (OR Dep't., DU); Prof. Deepak Bansal (IIF Delhi);
Prof. Pushpender Singh Raghav (IIF Delhi) and Dr. Amba Jindal (IIF, Delhi) for their review
comments on this paper.
The views and reviews presented in the paper are views and opinions of the authors, based on
our research and experience and do not depict institutional or countries views or of the
institutions the authors are associated with. All errors and omissions are our own.
Agarwal Aman, Yamini Agarwal and Saurabh Agarwal (2006), "The Changing Structure of
World Investment, Trade, Capital Flows and its Impact on Global Integration and Regional
Cooperation", Finance India, Vol. XX, No. 2, June 2006, 471-490.
Bajwa, K. S. (2008), "Cheque Truncation System", Banking Frontiers, Vol. 7, No. 3, 18.
Blinder, A. S. (1976), Indexing the Economy through Financial Intermediation, Princeton

University Economic Research Program, Research Memorandum No. 196.

Bodie, Zvi (1990), "Pension Funds and Financial Innovation", Financial Management, Vol. 19,
No. 3, 11-22.
Dufey, Gunter and Ian H. Giddy (1981), "Innovation in the International Financial Markets",
Journal of International Business Studies, Vol. 12, No. 2, 33-51.
Finnerty, John D., (1988), "Financial Engineering in Corporate Finance: An Overview",
Financial Management, Vol. 17, No. 4, 14-33.
Frame, W. Scott and Lawrence J. White (2004), "Empirical Studies of Financial Innovation; Lots
of Talk, Little Action?", Journal of Economic Literature, Vol. 42, No. 1, 116-144.
Guru, Anuradha (2009), "Indian Derivative Markets: Some Policy Issues", NSE News, 11-21.
Merton, Robert C. (1992), Continuous-Time Finance, Cambridge, Mass.; Oxford, Basil
Merton, Robert C. (1992), "Financial Innovation and Economic Performance", Journal of
Applied Corporate Finance, Vol. 4, No. 4, 12-22.
Miller, Merton H. (1986), "Financial Innovation: The last Twenty years and the Next", Journal of
Finance & Quantitative Analysis, Vol. 21, No. 4, 459-471.
Modigliani F. and D. Lessard (1975), "New Mortgage Designs for Stable Housing in Inflationary
Environment", Federal Reserve Bank of Boston, Conference Series No. 14.
Mutual Funds Insight (2008), Mutual Fund Insight: Value Research, Vol. 5, No.11, July-August,
National Stock Exchange (2008), NSE Circular NSE/ CMO/32/2008 dated June 30.
Reserve Bank of India (2008), RBI circular IDMD. DOD. NO. 3165/11.01.01(B)/2007-08 dated
Jan. 01.
Securities Exchange Board of India (2008), SEBI Discussion paper on Developing a Market for
Small and Medium Enterprises in India, May 26, 2008 and SEBI Legal Framework, November
Securities Exchange Board of India (2008), SEBI/CFD/DIL/DIP/31/2008/30/7/ dated July 30.
Silber, William L. (1983), "The Process of Financial Innovation", American Economic Review,

Vol. 73, No. 2, 89-95.

Singh, Y. P., Saurabh Agarwal and S. L. Harilal (2008), "Portfolio Creation using Markowitz's
Portfolio Selection Model Involving Equities, Commodities and Bonds in Indian Securities
Market", Euro-Mediterranean Economics and Finance Review, Vol. 3, No. 3, 212-236.
Singh, Y. P., Saurabh Agarwal and S. L. Harilal (2009), "A Utility Approach for Portfolio
Selection Decision", Forecasting Financial Markets in India, Allied Publishers Pvt. Ltd., 12-21.
Verghese, S. K. (1990), "Financial Innovation and Lessons for India", Economic and Political
Weekly, Vol. 25, No. 5, 265-272.
Indian Institute of Finance, India
Rajdhani College, University of Delhi, India
Indian Institute of Finance, India
Department of Operational Research, University of Delhi, India
Table 1