FINANCIAL INNOVATION AND ENGINEERING IN RELATION TO

INVESTMENT
Financial engineering refers to the design, development and implementation of innovative
financial instruments and processes and the formulation of innovative solutions to financial
decision making problems.
Financial engineering is a broad field involved in almost all areas of modern finance, ranging
from portfolio management and derivatives, to fund management, value at risk analysis, and
credit risk management. It uses a wide range of methodological tools (management
science/operations research, probability theory and stochastic calculus, statistics, econometrics,
etc.) to analyze financial decision-making problems and to facilitate the construction of
innovative solutions and financial products that meet the decision-makers’ goals.
Reasons for the Emergence of Financial Engineering
a. There are a number of theories about the reasons for the existence and development of
financial innovation, which is the basis of financial engineering but can be summed up in
as a response to certain restrictions hinder achievement of economic goals such as:
liquidity, profit and reduce risk. This may be legal restrictions, such as preventing or
contracts legally certain transactions, or technical restrictions such as the difficulty of
transporting certain products, or convert one material to another or social restrictions,
such as preference for a particular type of product to another.
b. Information Technology and the concept of the broad market the emergence of networks
in particular helped to transform multiple global markets and separate to the financial
market with a large, no temporal and spatial barriers and range up to the arrival of the
information transmitted. Because there different needs in different parts of the world
interconnected by these networks has become easier to design requirements and
interviewed based on a broad base and wide of the participants in this market Big World,
and of course, the greater the number of participants in these markets, the more able
creators and designers securities and financial instruments work economically acceptable,
that is, they find ample space for movement and whenever designed or invented a new
tool and found it requested and accepted
c. Efficiency and effectiveness were taking on greater importance in the case of the
expansion base of participants, and markets generally directed towards high degrees of
improving service delivery to customers. Therefore, this type tools or financial means
(such as interest rate swaps) replace relatively old methods of financing such as
refinancing loans.

d. Other factors:
- Increase the number of markets the new organization:
Increasing the number of new regulated markets for the future and shares innovations in
communications and computer technology in recent years to reduce the cost of trade and
financial instruments stereotype is very large, and then increase the use of financial engineering
areas are widely used. As a result, it became possible to produce customized financial contracts
and at a reasonable cost.
- Increasing risk and the need to manage:
Fluctuations in prices (commodity prices and interest rates and exchange rates and stock prices
and bond), especially after the global trend to floating exchange rates, as well as raising barriers
to capital flows across geographical boundaries, political and rapid development in
communication and transition and economic transformation of focus for labor economics
knowledge-intensive, all this led to large swings and unexpected in the ocean of global economic
whole, which form a major threat to businesses as threatened its existence and the consequent
extension need to produce new financial products and the development of high capacity to
control the financial risks and. This led to the trading of these products and new financial
instruments in the current markets of banknotes in the capital markets, as well as new markets.
Financial engineering include three types of activities. Namely:
a. Design innovative financial instruments, such as credit cards, and new types of bonds and
stocks, and the design of innovative hedging contracts;
b. The development of financial instruments, which meet these innovative tools to the needs
of the new financing, or radical change in the existing contracts to increase the efficiency
with respect to risk  and term to maturity and yield.
c. The implementation of innovative financial instruments, any innovation innovative
operational procedures that will be low-cost, flexible and practical.
Factors contributing to the growth of financial engineering:
The factors contributing to the growth of financial product and process innovations through
financial engineering are intensified international competition, tax asymmetries and tax
advantage, reduction in the transaction cost due to increased operational efficiency, increase in
the price and interest rate volatility, advances in the financial theories, reduction in agency cost,
regulatory and legislative changes, increased liquidity, increased competition due to
globalization, liberalization and deregulation, the explosive growth in information technology,
accounting benefits, increased customer involvement to choose the right instrument among the
myriad of products

.
Financial Engineering Products
Financial engineering and mutual funds:
Mutual fund is a financially engineered product which comprises of the characteristics and
benefits of direct stock market investments. It is an investment tool through which investors can
achieve diversification at low investments and with lower cost of fund management. Mutual
funds have diversified investments spread in calculated proportions among securities of various
economic sectors. In Indian financial markets, some of the mutual funds provide the life
insurance cover to the investor.
Financial engineering and banks:
Banking sector has brought not only the product/ service innovation but also organizational and
technological innovations, which has replaced the traditional portfolio of the banks. Consumers
have started to demand anytime-anywhere delivery of financial services along with an increased
variety in deposit/investment and credit products. Severe competition forces the banks to focus
on customer relationship management by delivering the sophisticated services with the use of
technology. E-banking services, mobile banking, electronic mode of payment methods, ATM,
platform automation, PC banking, reverse mortgage etc. are the revolutionary innovations which
can be termed as financial process engineering, have taken place in the banking sector.
Financial engineering and Stock exchanges:
With the increased awareness and increased participation of direct investment in the capital
markets, stock exchanges have brought in innovation in terms of technology, processes and
introduction of trading of new securities. To overcome the limitations of physical handling of the
securities, dematerialization of the securities has been done. With the introduction of the same
there was a need to create another financial institution/body, which can take the custody of the
securities, facilitate the trading between the parties etc. As a result of these, NSCCL,
Depositories, Depository participants and other intermediaries came into existence and which has
replaced traditional brokers. Exchanges also stared the trading of the new investment tools like
ETFs, Gold ETFs, and REITs.
Financial Innovation
Financial innovation is a dynamically evolving process affecting functioning and development of
the global financial markets. Financial innovation with the inherent characteristics of risk and
uncertainty contribute to the efficiency of the global markets.
The concept of financial innovation is broadly explained by Eugenio Domingo Solans of
European Central Bank as: “It refers both to technological advances which facilitate access to
information, trading and means of payment, and to the emergence of new financial instruments
and services, new forms of organizations and more developed and complete financial markets”.
Peter Tufano (2002) in Financial Innovation mentioned: “Innovation includes the acts of
invention (the ongoing research and development function) and diffusion (or adoption) of new
products, services or idea.”
Financial innovation is the fact of creating and popularizing new financial instruments as well as
new financial technologies in the markets. This definition includes approaches to
conceptualization and management of the same. The broad types of innovations can be
distinguished: product and process innovation. Product innovations are various offering for
investment in savings, derivative contracts, mortgage backed securities, risk management tools
etc., those basically investors buy; whereas process innovation includes finding the new ways of
distributing the financial products and services, processing transactions, or pricing the
transactions, which is an organized system for delivering one or more products in an efficient
and effective way.
Example(s) of this products and process innovation in Kenya include;
Kickstart
KickStart identifies profitable business opportunities for very poor, then designs, manufactures
and mass markets simple tools that unlock these opportunities. One of the bestselling products is
a metal, pedal- powered irrigation water pump. KickStart leveraged on M-PESA and developed a
mobile layaway program that enables farmers to save in small amounts (from as low as US$1.25)
towards purchasing a pump. The automated layaway program has reduced the payment period
from twelve to three months and has had a payment completion rate of over 90%.
M-Kopa
M-Kopa has creatively bundled an affordable solar home system with M-PESA. The system is
aimed at individuals excluded from the formal electricity supply. After an initial deposit, clients
make regular MPESA payments for a period of at most one year towards the purchase of the
system. Unlike KickStart, clients begin to use the system once they make the deposit. The system
has a SIM card embedded to it, enabling M-Kopa to remotely monitor its physical location and
control its functioning depend
Grundfos
LifeLink Grundfos LIFELINK supplies, installs and services the turnkey water solutions. In
partnership with local stakeholders such as community groups and NGOs, Grundfos installs
water dispensing machines to boreholes and enables the tapping of water to be handled entirely
by the users by mobile money transfer from a smart card. The dispensers are installed with an
electronic smart reader. Customers load their smart cards with electronic money through M-Pesa.
Community water systems are assigned pay bill numbers, while the customers use the unique
number assigned to their smart cards. The dispenser automatically debits the electronic value
from the smart card as water flows. The cost of water is determined by the community project
under the guidance of Grundfos. Using remote monitoring, Grundfos offers to maintain the
dispenser and meter upon payment. The technology has streamlined operations, reduced
corruption and increased transparency.
Musoni
Musoni (‘M’ for Mobile and ‘Usoni’ for future) is a young but promising micro-finance
institution in Kenya. The MFI was established in 2009, with a vision is to substantially improve
the quality and availability of financial services to low income, unbanked and under-banked
individuals in the developing world through the establishment and support of best-practice MFIs
with an emphasis on efficiency, transparency and client focus. Musoni is considered the first
MFI to offer 100% mobile based services to clients. Musoni has successfully integrated its back
office with M-Pesa, enabling seamless processing of all transactions and thus able to offer a
flexible and convenient alternative to the traditional time-consuming and manual microfinance
processes. Though cash-less, the MFI has branches which enable customers to visit and engage
with staff.

Importance of Financial Innovation

a. Innovation exists to complete inherently incomplete markets.
b. Innovation persists to address inherent agency concerns and information asymmetries
c. .Innovation exists so parties can minimize transactions, search or marketing costs.
 d. Innovation is a response to taxes and regulation
e. Increasing globalization, Technological shocks and risk motivate innovation

1. ALTERNATIVE INVESTMENT VEHICLES

 Investment is deferred consumption. Any outlay of cash made with the prospect of receiving
future benefits might be considered an investment.
 Thus they are any investment other than a stock, bond, or cash. Examples include derivatives,
hedge funds, real estate, and commodities. Most of the time, institutional investors and high net-
worth individuals are the main holders of alternative investments. This is because they are
subject to fewer regulations and are consequently riskier than most other investments.
Alternative investments are rarely required to publish independently verifiable financial
information. They also have particularly high minimum investments, which discourage casual
investors. Alternative investments are controversial in many quarters. Because of the
comparative lack of regulation and disclosure, they are subject to scrutiny from politicians and
economic analysts. However, they often have high (sometimes very high) returns.

These investment vehicles include:

a. Real Assets (including real estate, real estate investment trusts, land, and infrastructure)
b. Hedge Funds
c. Commodities
d. Private Equity (including mezzanine and distressed debt)
e.  Structured Products (including credit derivatives)

a. Real estate

The category of real assets focuses on investments in which the underlying assets involve direct
ownership of nonfinancial assets rather than ownership through financial assets such as the securities of
manufacturing or service enterprises. Real assets tend to represent more direct claims on consumption
than common stocks, and they tend to do so with less reliance on factors that create value in a
company, such as intangible assets and managerial skill. So while a corporation such as Google holds real
estate and other real assets, the value to its common stock is highly reliant on perceptions of the ability
of the firm to create and sell its goods and services.

Real estate focuses on land and improvements that are permanently fixed like buildings. Real
estate was a significant asset class long before stocks and bond became important. In times prior
to the industrial age, land was the single most valuable asset class. Only a few decades ago, real
estate was the most valuable asset of most individual investors because the ownership of a
primary residence was more common than ownership of financial investments.
Finally, while some descriptions of real assets limit the category to tangible assets, we define real
assets to include intangible assets, such as intellectual property (e.g., patents, copyrights,
trademarks, and music, film, and publishing royalties).
 b. Hedge Funds
Hedge funds represent perhaps the most visible category of alternative investments. While hedge
funds are often associated with particular fee structures or levels of risk taking, it’s defined as a
privately organized investment vehicle that uses its less regulated nature to generate investment
opportunities that are substantially distinct from opportunities offered by traditional investment
vehicles, which are subject to regulations such as those restricting their use of derivatives and
leverage. 
Hedge funds represent a wide-ranging set of vehicles that are differentiated primarily by the
investment strategy or strategies implemented.
c. Commodities
Commodities are investments distinguished by their emphasis on futures contracts, their
emphasis on physical commodities, or both. Commodities are homogeneous goods available in
large quantities, such as energy products, agricultural products, metals, and building materials.
Futures contracts refer to traditional futures contracts, as well as closely related derivative
products, such as forward contracts and swaps. Futures contracts are regulated distinctly and
have well-defined economic properties. For example, the analysis of futures contracts typically
emphasizes notional amounts rather than the amount of money posted as collateral or margin to
acquire positions.
Commodities as an investment class refer to investment products with somewhat passive (i.e.,
buy-and-hold) exposure to commodity prices. This exposure can be obtained through futures
contracts, physical commodities, natural resource companies, and exchange-traded funds
d. Private Equity
The term private equity includes both equity and debt positions that, among other things, are not
publicly traded. In most cases, the debt positions contain so much risk from cash flow
uncertainty that their short-term return behavior is similar to that of equity positions. In other
words, the value of the debt positions in a highly levered company, discussed within the category
of private equity, behaves much like the equity positions in the same firm, especially in the short
run. Private equity investments emerge primarily from funding new ventures, known as venture
capital; from the equity of leveraged buyouts (LBOs) of existing businesses; from mezzanine
financing of LBOs or other ventures; and from distressed debt resulting from the decline in the
health of previously healthy firms. 
Venture capital refers to support via equity financing to start-up companies that do not have a
sufficient size, track record, or desire to attract capital from traditional sources, such as public
capital markets or lending institutions. Venture capitalists fund these high-risk, illiquid, and
unproven ideas by purchasing senior equity stakes while the start-up companies are still privately
held. The ultimate goal is to generate large profits primarily through the business success of the
companies and their development into enterprises capable of attracting public investment capital
(typically through an initial public offering, or IPO) or via sale of the companies to other
companies.
Leveraged buyouts refer to those transactions in which the equity of a publicly traded company
is purchased using a small amount of investor capital and a large amount of borrowed funds in
order to take the firm private. The borrowed funds are secured by the assets or cash flows of the
target company. The goals can include exploiting tax advantages of debt financing, improving
the operating efficiency and the profitability of the company, and ultimately taking the company
public again (i.e., making an IPO of its new equity).
Mezzanine debt derives its name from its position in the capital structure of a firm between the
ceiling of senior secured debt and the floor of equity. Mezzanine debt refers to a spectrum of
risky claims including preferred stock, convertible debt, and debt that includes equity kickers
(i.e., options that allow the investors to benefit from any upside success in the underlying
business, also called hybrid securities).
Distressed debt refers to the debt of companies that have filed or are likely to file for bankruptcy
protection in the near future. Even though the securities are fixed-income securities, distressed
debt is included here because the future cash flows of the securities are highly risky and highly
dependent on the financial success of the distressed companies and thus share many similarities
with common stock. Private equity firms investing in distressed debt tend to take longer-term
ownership positions in the companies after converting all or some portion of their debt position
to equity. Some hedge funds also invest in distressed debt but they tend to do so with a shorter-
term trading orientation.
e.  Structured Products
Structured products are instruments created to exhibit particular return, risk, taxation, or other
attributes. These instruments generate unique cash flows resulting from a partitioning of the cash
flows from a traditional investment or by linking the returns of the structured product to one or
more market values. The simplest and most common example of a structured product is the
creation of debt securities and equity securities in a traditional corporation. The cash flows and
risks of the corporation’s assets are structured into a lower-risk fixed cash flow stream (bonds)
and a higher-risk residual cash flow stream (stock). The structuring of the financing sources of a
corporation creates option like characteristics for the resulting securities.
The resulting instruments may be considered alternative investments.
Collateralized debt obligations (CDOs) and similar instruments are among the best-known
types of structured products. The CDOs partition the actual or synthetic returns from a portfolio
of assets (the collateral) into securities with varied levels of seniority (the tranches).
Credit derivatives, are often individually negotiated. Credit derivatives facilitate the transfer of
credit risk. Most commonly, credit derivatives allow an entity (the credit protection buyer) to
transfer some or all of a credit risk associated with a specific exposure to the party on the other
side of the derivative (the credit protection seller). The credit protection seller might be
diversifying into the given credit risk,
REFERENCE
1. David M. Weiss (2009). Financial Instruments: Equities, Debt, Derivatives and
Alternative Investments.
2. H. Kent Baker and Greg Filbeck (2013). Alternative Investments: Instruments,
Performance, Benchmarks and Strategies. John Wiley & Sons
3. Wiley. (2012) CAIA Level I: An Introduction to Core Topics in Alternative Investments..