[Company name]

[Document title]
[Document subtitle]

Kazi Rafiqul Islam

[Date]
Table of Contents
Topic 3: Explain the factors contributing to the growth of financial engineering.....................2

Introduction............................................................................................................................2

Factors Influencing Financial Engineering............................................................................2

Factors contributing the growth of Financial Engineering....................................................2

1. Financial management.............................................................................................3

2. Difficulties of External Financing...........................................................................3

3. Risk management.....................................................................................................4

4. Capital market..........................................................................................................4

5. Price Volatility.........................................................................................................5

6. Globalization of the market.....................................................................................5

7. Role of Corporate governess....................................................................................6

8. Technological Advances..........................................................................................6

9. Advances in Financial Theories...............................................................................6

Conclusion..............................................................................................................................7
Topic 3: Explain the factors contributing to the growth of
financial engineering
Introduction

Financial system is a conglomerate of various institutions, markets, instruments and operators

that interact within an economy to provide financial services. The significance of finance and
financial system in the drive for economic growth and development is well established and
generally accepted. The availability of adequate financial resources and regular acquisition in
proper mix of the needed funds from alternative sources for investment purposes are part of
derivable benefits from an efficient financial system.

Financial engineering enunciates robust financial economic with systemic financial

renaissance and branded financial market growth. It stirs derivatives and entrench framework
for proper financial market system.

Factors Influencing Financial Engineering

The following are the factors that influence the growth process of financial engineering:

a. Environmental Factors

These are the factors which exist in the external environment. Environmental factors have
a direct impact on the firm. These factors are not controllable. Political, Economic, Social
and Technological analysis can be conducted to determine these factors and their impact
on the business. Common examples of environmental factors are technological
advancements, new inventions, competitiveness and political and economic changes.

b. Intra-firm factors

These factors are controllable by the firm and directly affect the financial engineering
process. Examples of intra firm factors are accounting policies, risk aversion, agency
costs and liquidity needs.

Factors contributing the growth of Financial Engineering

All the factors that influences financial engineering are interconnected. In todays complex
economy, these factors lead to the growth of the financial engineering. The growth in
financial engineering is contributed by the different fields including capital management,
financial management, risk management globalization of market, technological advances, etc.
The necessity of proper financial and risk management is created and lead by these. The
factors are discussed below.

1. Financial management
Business has grown extremely quickly in the past two decades. This improved height and
width of marketplaces and also tremendously improved competitors. At first, investment
banks were the only types which may offer numerous solutions concerning risk management.
Deregulation of the economic markets possesses attracted new entrants into the financial
markets have aggressively competed with the conventional banking industry, by introducing
a brand new product and services. In return, banks were compelled to come out with
innovative methods by using the option of off-balance page deals.

A firm exists in order to increase the wealth of its owners, in general the management of the
firm is concerned with knowing that products and services are needed. then it produces and
distributes those products and services are needed. Then it produces and distributes those
products and services to customers. Financial management is concerned with the financial
decisions that must be made to maximize the wealth of the owners. The accounting system
provides financial information. Accounting is subdivided in to financial accounting and
managerial accounting. Finance has traditionally been thought of as the area of financial
management that is responsible for the acquisition and disposition of the financial resources.

2. Difficulties of External Financing

All firms need, at varying times, to obtain capital and to do so, they must either borrow the
money (debt financing), sell a portion of the firm (equity financing), or both. How a firm
raises capital depends a great deal on the size of the firm, its life cycle stage, and its growth
prospect. The understanding of difficulties in the way of external financing enables us to see
why financial markets are organized the way they are. The nature and degree of problem
depends on the form of financing. Any direct lending through the financial markets face three
main problem of reliance on promises, incentive problems, and liquidity.

From the point of providers of fund with debt financing, the borrower may default on his
obligations. Once default becomes a real possibility, the incentives of the borrower become
distorted and will have little to lose. This means lender needs to know if there is substantial
increase in the probability of default, and for this, it is necessary to monitor the borrower to
prevent misbehavior in this way. Default is a real possibility with risky debt; therefore, the
arrangements to deal with it are very important and will affect lenders’ willingness to provide
financing. In equity financing there is no question about default, but the big problem for the
provider is to ensure that the recipient does not abuse his discretion over the size and timing
of payments to the provider. As a protection, equity financing gives the provider a right of
control over the management of the enterprise. However, exercise of this right of control is
fraught with problems and involves considerable effort and cost. In addition, equity is even
harder to price than risky debt due to two unknown factors of risk and future payments.

These services, among others, include resource mobilization and allocation, good corporate
governance, laws, financial intermediation and facilitation of foreign exchange transactions to
boost international trade.

3. Risk management
Money and capital market are components of any economy. Financial engineering is also
intended to split risk and return components of financial products/instruments and offering
the combination which is best suited to Investor’s risk-return profile. Banks provide financing
for commercial enterprises, basic financial services to broad segment of the population and
access to payments systems. It essential to note that some banks are expected to make credits
and liquidity available in difficult market conditions and however have strong financial
engineering with quality corporate Governance, best practices and high ethical standard in
their operations. Capital Market on the other hand, is a market for longer term funds and
securities whose tenure extends beyond one year. It is the prime motor that drives any
economy on its path to growth and development because it is responsible for long-term-
growth capital formation. Part of the way that financial engineering removes risk is by
employing complex investment techniques like derivatives, which base their value on the
value of underlying instruments and can be used to hedge risk. In addition, financial
engineering can be used to devise computer programs that can react to trading opportunities
very quickly. The advantage gained from such split-second trading can also help to manage
risk.

4. Capital market
The capital market is a complex of institutions and mechanisms through which intermediate
funds and long-term funds are pooled and made available to business, government and
individuals and instruments already outstanding are transferred. These institutions which
traditionally play one role or the other in the transfer of funds from savers to users include
stock exchanges, stock registrars, issuing house, stockbrokers and underwriters and the
Securities and Exchange Commission.

5. Price Volatility
A price is what one pays to acquire or use something of value. The objects having value
maybe commodities, local currency or foreign currencies. The concept of price is clear to
almost everybody when we discuss commodities. There is a price to be paid for the purchase
of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons
money is called interest rate. And the price one pays in one’s own currency for a unit of
another currency is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers have ‘demand’ and
producers, or suppliers have ‘supply’, and the collective interaction of demand and supply in
the market determines the price. These factors are constantly interacting in the market
causing changes in the price over a short period of time. Such changes in the price are known
as ‘price volatility’. This has three factors: the speed of price changes, the frequency of price
changes and the magnitude of price changes.

This price volatility risk pushed the use of derivatives like futures and options increasingly as
these instruments can be used as hedge to protect against adverse price changes in
commodity, foreign exchange, equity shares and bonds.

6. Globalization of the market

Earlier, managers had to deal with domestic economic concerns; what happened in other part
of the world was mostly irrelevant. Now globalization has increased the size of markets and
as greatly enhanced competition .it has benefited consumers who cannot obtain better quality
goods at a lower cost. It has also exposed the modern business to significant risks and, in
many cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness
of products vis-à-vis depreciated currencies. Export of certain goods from India declined
because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of
steel from south East Asian countries. Suddenly blue chip companies had turned in to red.
The fear of china devaluing its currency created instability in Indian exports. Thus, it is
evident that globalization of industrial and financial activities necessitates use of derivatives
to guard against future losses. This factor alone has contributed to the growth of derivatives
to a significant extent.

7. Role of Corporate governess

Corporate governance is the relationship among various participants in determining the
direction and performance of corporations. the essence of good corporate governance is to
protect shareholders value and assure market integrity through greater vigilance by
regulators, enforcement and compliance of market rules and regulations, introduction of
greater internal controls etc.

8. Technological Advances
A significant growth of derivative instruments has been driven by technological break
through. Advances in this area include the development of high speed processors, network
systems and enhanced method of data entry. Closely related to advances in computer
technology are advances in telecommunications. Improvement in communications allow for
instantaneous world wide conferencing, Data transmission by satellite. At the same time there
were significant advances in software programmed without which computer and
telecommunication advances would be meaningless. These facilitated the more rapid
movement of information and consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the economy as a whole resources
are rapidly relocated to more productive use and better rationed overtime the greater price
volatility exposes producers and consumers to greater price risk. The effect of this risk can
easily destroy a business which is otherwise well managed. Derivatives can help a firm
manage the price risk inherent in a market economy. To the extent the technological
developments increase volatility, derivatives and risk management products become that
much more important.

9. Advances in Financial Theories

Advances in financial theories gave birth to derivatives. Initially forward contracts in its
traditional form, was the only hedging tool available. Option pricing models developed by
Black and Scholes in 1973 were used to determine prices of call and put options. In late
1970’s, work of Lewis Edeington extended the early work of Johnson and started the hedging
of financial price risks with financial futures. The work of economic theorists gave rise to
new products for risk management which led to the growth of derivatives in financial
markets.
Conclusion

Financial Engineering examines the explanations why the rise in risk and also leading
advancements in finance, taken with each other, created the appropriate environment for
rapid growth in an economic mechanism. It might be regarded as the elements external to the
solid and also over which the firm does not have any direct management but that are
nevertheless of a terrific issue to the simply because they impact the firm’s performance. It
may include, rise in cost fluctuation. The phrase “price” here includes the cost of money,
forex, shares, and goods. Advancements in finance theory added greatly to the development
of new hedging techniques. Income taxes differ across industries and countries, over time.
Also, certain firms have enough income tax credits which give them an advantage over
additional firms. There was an increasing standardization of economic instruments, e.g., in
futures positions, choices and swaps. This extended the marketplace. Most of the new
financial instruments need small documentation, without any prospectus, etc. in this situation
Financial Engineering was inevitable to manage the risks of the big firms.