Financial Engineering

Module Number: 01

Module Name: Introduction to Financial Eng. & Risk Management

Introduction to Financial Eng. & Risk Management
AIM:
To provide outlook of Financial engineering and knowledge of related fields

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Introduction to Financial Eng. & Risk Management
Learning Objectives
Understanding the use of mathematical models on financial instruments and knowledge of
innovative tools of financial engineering.
.
Elaborate the necessary skills to design (and reverse-engineer), value, and hedge derivative
contracts.
Understanding the analytical arguments in the (increasingly) technical publications that deal with
innovations in these contracts

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Introduction to Financial Eng. & Risk Management
Learning Outcomes
Formulate appropriate solutions to financial problems with particular emphasis on understanding
.
new risks, which the changing scenario of finance is creating for individuals and firms.
Develop skills in forming effective strategies to cope with the changing risk environment.
Plan & evaluate innovative financial products.

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Contents

1. Changing environment and increasing price risks

2. Fin. Analysis VS fin. Eng.
3. Fin. Eng. As a response to increased risk
4. Knowledge base of financial engineer – math. & Stat. Skills, modelling skills, product knowledge,
knowledge of relevant technology, accounting, tax and legal
5. Types of risk
6. Risk mgt tools
7. Discussion on existing financial instrument.

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Introduction to Financial Eng. & Risk Management
Introduction
“Not taking risks one doesn't understand is often the best form of risk management.” ― Raghuram G. Rajan.

In current internet-dependent global economy, the rapid change in business environment forces decision
making riskier. Under open economy regime price fluctuation (volatility) is constant. Rapid technological
change is reshaping the business landscape and emerging new businesses and industries are redefining
business models and the fundamentals of competition.

The rapid pace of change in the business environment has increased the uncertainty in the outcomes of
management decisions and placed a greater emphasis on risk management. Assessing that uncertainty using
both qualitative and quantitative techniques is the fundamental objective of risk analysis.

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Risk Analysis purposes:

Pricing – valuations of different Financial Instruments
Hedging – best possible measure(s) taken for risk mitigation.

Risk Managers and traders who perform hedge and portfolio revisions on daily basis are relying on
mathematics & computer generated simulation to minimise their risk.

Successful risk management can only be done through accurate valuation, which is the prime focus of
Financial Engineering.

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What is Financial Engineering (FE)?

The discipline of financial engineering includes applications of

mathematical, statistical modeling and computational technology
to problems in the financial industry and financial management of
non-financial organizations. Finance

FE involves design and development of financial products,

FE
strategies, and systems to meet the needs of financial institutions,
corporations, governments, and households. IT Engineering

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Financial Engineering Application Areas

Financial risk management for financial institutions, corporations, and public institutions
(from hedging risks of individual transactions to enterprise-wide risk management systems)
Derivative securities (contract design, pricing & valuation, investment, trading, and hedging
applications)
Modeling stochastic dynamics of stock prices, interest rates, foreign exchange rates and
commodity.
Asset/liability management technology for corporations, banks, pension funds
Credit risk modeling and management and credit derivatives.
Real options: valuing businesses and strategic managerial decisions by applying option
pricing technology
Portfolio Management

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Driving forces for Financial Engineering
Increasing Volatility of Financial Markets and the Need for Risk Management
Volatility of equity prices, foreign exchange rates, commodity and energy prices, and interest
rates increased dramatically over the past three decades
Higher volatility increases risk (as well as more opportunities)
Risk Management is crucial to the survival and competitiveness of organizations

Global Nature of Financial Markets

Multinational firms produce, market, and obtain financing globally
Every multinational firm has significant risk exposures to foreign currencies, domestic and
foreign interest rates, energy and commodity prices, and global equity prices

Information Technology
Real-time worldwide information and data collection, analysis, decision-making, and trading are
made possible.
Securities trading goes electronic and moves from exchange floors into cyberspace.
Banks are the biggest users of information technology.
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Financial Analysis & Financial Engineering

Financial Engineering begins where Financial Analysis ends.

Financial Analysis primarily focuses on analysis of different financial statement viz, Income Statement,
Balance sheet, Cashflow statement and Cost statement. It relies on the ex-post data available. It assumes
the history repeats itself, company will perform the same in future under the same factor constraints.

Financial Engineering perform accurate financial analysis then begins the possible future events using
statistical modelling and probability. Valuation of financial instruments and application of risk
minimisation strategies are the two main purpose of financial engineering.

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Basis Financial Analysis Financial Engineering

Fundamental position Evaluation of financial statements to Evaluates nature of business

of Business understand the current position of the considering current macro & micro
business or firm economic condition and suggest the
future course of action aligned to
business goals.
Diagnostic Performs different ratio analysis to After performing the ratio analysis,
Performance check the health of the business. finds out the causes of problem (if
exists) & suggests the possible solution.
Business Risk Analysis Perform risk analysis using different Formulating different strategies for
ratios and compare with industry business risk mitigation.
peers.
Exchange rate risk Analyse the scope of Exchange rate Measures volatility and suggest or
risk on the basis of past volatility develops innovative securities like
Forwards, Futures & Swaps to safe
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Basis Financial Analysis Financial Engineering

Portfolio Analysis Analyse risk – return relationship in Analyse, form & optimise portfolio of
capital market instruments. investments. Further propose different
hedging strategies to minimise
portfolio risk.
Interest Rate Risk Analyse the scope of Interest rate risk Develop appropriate hybrid products to
based on past experience curb interest fluctuation.
Inflationary Risk Analyse degree of inflation and its Suggest appropriate measures and
impact on different business segment innovate securities for minimise
and overall economy inflationary risk.

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Financial Engineering for increased Risk
Corporate Engineering – Venfin (Case Study)

In Venfin’s interim financial report for the six months ended 31 December 2002, the following was reported:
“On 31 December 2002, VenFin exercised the put option acquired from Merrill Lynch International in respect
of 51,858,000 Richemont depositary receipts held by VenFin. The total cash proceeds realised by VenFin as a
result of exercising the put option amounted to R945.2 million. A capital surplus of R348 million was realised
and is accounted for as an exceptional item.”

“VenFin acquired from Hosken Consolidated Investments Limited (HCI) an additional 1.5% interest in
Vodacom with effect from 31 December 2002 for a total consideration of R450 million. The proceeds from the
Richemont transaction were in part used to settle this amount. At 31 December 2002, VenFin’s interest in
Vodacom was 15.0%”.

N.B. R= South African Rand

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Corporate Engineering – Venfin (Case Study)
“During April 2000 VenFin granted an indirect, interest-free loan of R281.8 million to Sabido (Proprietary)
Limited (Sabido), the holding company of e-tv. An additional R38.6 million was advanced to HCI for e-tv
during the 2002 financial period. During January 2002, VenFin advanced a further loan of R280 million to
HCI. This loan was interest bearing and fully secured. During September 2002 R199.4 million of this
interest-bearing loan was converted into an interest-free loan to HCI for e-tv. The balance of the loan was
repaid on 31 December 2002. If the interest-free loans to Sabido and HCI were to be converted into equity
in Sabido on 31 December 2002, VenFin’s indirect interest in e-tv would be 33.1%”.

Three corporate action announcements were made on 29 August 2002, 9 September 2002 and 16 January
2003.
The 9 September announcement stated “VenFin has acquired a put option from Merrill Lynch International
(MLI) in respect of 51,858,000 Richemont depositary receipts held by VenFin; and MLI has acquired a call
option from VenFin in respect of 51,858,000 Richemont depositary receipts held by VenFin”.

Through these announcements we learnt that Venfin used equity derivatives in these corporate action
events. These events were also linked.
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Corporate Engineering – Venfin (Case Study)
History
In 1993 the then Rembrandt Group invested 100 million into a new company called Vodacom. Vodacom
successfully tendered to obtain one of only two cell phone licenses issued by the South African
government. This investment secured 15% shareholding in Vodacom for Rembrandt. The other
shareholders were Telkom (50%) and Vodafone from the United Kingdom (35%).

In 1995 Rembrandt sold 1.5% and Vodafone 3.5% of their shareholding in Vodacom to a black
empowerment company called Hosken Consolidated Investments Limited (HCI). Rembrandt received R90
million for its 1.5% stake.

On 26 September 2000, Rembrandt Group split into Remgro Limited and Venfin Limited. Venfin inherited
2% of Richemont’s share capital with the split. This shareholding was non-stategic. Venfin also inherited
the 13.5% shareholding in Vodacom.

During 2002 HCI has drawn loan funding from Venfin of some R600 million to recapitalise e-tv.
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Corporate Engineering – Venfin (Case Study)
Sound Investments and associated Risks
Venfin realized the potential of e-tv and wanted to obtain a shareholding there-in. Venfin also wanted to
increase its shareholding in Vodacom that was, at that point of time, extremely successful and profitable.
The loan of some R600 million to HCI set a series of transactions in motion during August of 2002 to
achieve these goals by 31 December 2002.

Venfin used the loan to cash-strapped HCI as an effective negotiating tool in convincing HCI to part with
its 5% stake in Vodacom and to convert the loan into equity. After the conversion Venfin owned 33.1% of
e-tv (indirectly through Sabido Investments).

Venfin needed to raise R450 million to fund the 1.5% of Vodacom that it wanted to buy from HCI. Venfin
had various options like taking a loan from a bank. However, it had the non-strategic stake in Richemont
that it could use. A simple solution could have been to sell shares at beginning of September 2002, put the
proceeds on deposit and buy the 1.5% stake on 31 December 2002.

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Corporate Engineering – Venfin (Case Study)

However, Venfin knew that Richemont was going to declare a dividend during September 2002 – they did
not want to compromise that tax-friendly income. Venfin needed to find a way to sell the Richemont shares
and secure their dividend income at the same time. Venfin was also fully aware of the risk that negotiations
might fail – they needed to consider that risk as well.

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Corporate Engineering – Venfin (Case Study)
An Innovative Funding Structure

Instead of selling the shares outright, Venfin put a

zero cost collar in place. They bought a put on
51,858,000 Richemont shares from Merrill Lynch
International. The put was struck at R18.22. Venfin
then wrote an out-the-money call on the same
Richemont shares – the call’s strike price was
never disclosed. The expiration date of the
structure was 31 December 2002. Venfin’s final
payoff diagram is depicted by the red profile in
This can be written as

Fig: Venfin’s payoff profile by using a structured derivative

Collar = shares + put - call . approach to funding.
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Knowledge base of Financial Engineer

Financial Engineering, at its core, is the study of applying math, statistics, computer science, economic
theory, and (any) other quantitative methods to analyzing and modelling markets.

These fields are comfortable with building models and have strong backgrounds in math, statistics, and
sometimes programming. Ultimately, Financial Engineers work at the intersection of Data Science and
Finance.
Financial Engineers use these tools to model markets and drive decision making. They are mostly seen in
institutions where understanding risk and analyzing data to drive policy and decision making

Matrix Theory / Linear Algebra, Probability and Statistics, Calculus are used very frequently in Financial
Engineering

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Knowledge base of Financial Engineer
Programming Proficiency
Basic C++ Programming
Advanced Excel
Advanced R (Advantageous)
Advanced Machine Learning with Python (Advantageous)

Quantitative Background Training in Finance

Calculus Corporate Finance and Financial Analysis.
Linear Algebra Money and Capital Markets.
Partial Differential Equations Investments.
Statistics Macroeconomics.
Numerical Analysis

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Introduction to Risk Management

The term Risk & Uncertainty is being used interchangeably though they have distinct meaning altogether.
Risk is a situation when there are a number of specific probable outcomes but not certain which outcome
will happen.
Uncertainty is where even the probable outcomes are not known.
Risk management is concerned with understanding and managing the risks that an organization faces in its
attempt to achieve its objectives. These risks will often represent threats to the organization – such as the
risk of heavy losses or even bankruptcy.

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Few examples of Financial Disasters:

In 1993, Germany’s Metallgesellschaft AG lost $1.3 billion in oil futures trading, and
In the following year the US municipality, Orange County, was forced to file for bankruptcy following
massive losses from speculating on derivatives.
In 1995, Barings Bank in the UK failed due to unauthorized derivatives trading by an offshore
subsidiary.
In 1998 the hedge fund Long Term Capital Management (LTCM) collapsed – demonstrating that having
two Nobel Prize-winning finance experts on its board of directors offered only limited protection from
financial risks.
Then there was the fall of Enron in 2001 and the accompanying collapse of Arthur Andersen, the major
accounting firm that acted as Enron’s external auditors.
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Different Types of Financial Risk
Financial risks create the possibility of losses arising from the failure to achieve a financial objective. The
risk reflects uncertainty about foreign exchange rates, interest rates, commodity prices, equity prices, credit
quality, liquidity, and an organization’s access to financing.

Financial Risk

Market Risk, Credit Risk. Financing /

Eg: Equity Risk, Eg: Customer Risk, Liquidity Risk.
Interest Risk, Exchange Supplier Risk, Partner Eg: Financing, Market
Risk, Commodity Risk Risk Liquidity, Cashflow.

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Market Risks:
These are the financial risks that arise because of possible losses due to changes in future market prices or
rates. The price changes will often relate to interest or foreign exchange rate movements, but also include
the price of basic commodities that are vital to the business.

EXAMPLE: CADBURY’S SCHWEPPES’ EXPOSURE TO FOREIGN EXCHANGE RATE RISK

The confectionery giant, Cadbury Schweppes, recognized in its 2007 annual report that it has an exposure
to market risks arising from changes in foreign exchange rates, particularly the US dollar. More than 80%
of the group’s revenue is generated in currencies other than the reporting one of sterling. This risk is
managed by the use of asset and liability matching (revenue and borrowings), together with currency
forwards and swaps.

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Credit Risks:
Financial risks associated with the possibility of default by a counter-party. Credit risks typically arise
because customers fail to pay for goods supplied on credit. Credit risk exposure increases substantially
when a firm depends heavily upon a small number of large customers who have been granted access to a
significant amount of credit.
EXAMPLE: AMAZON’S CREDIT RISKS
Amazon, the global online retailer, accepts payment for goods in a number of different ways, including
credit and debit cards, gift certificates, bank checks, and payment on delivery. As the range of payment
methods increases, so also does the company’s exposure to credit risk. Amazon’s exposure is relatively
small, however, because it primarily requires payment before delivery, and so the allowance for doubtful
accounts amounted to just $40 million in 2006, against net sales of $10,711 million.
EXAMPLE: CREDIT RISK MANAGEMENT IN THE BANK OF AMERICA
In its 2007 annual report (p.69), Bank of America states that it manages credit risk “based on the risk profile
of the borrower or counterparty, repayment sources, the nature of underlying collateral, and other support
given current events, conditions and expectations.” Additionally, the bank splits its loan portfolios into
consumer or commercial categories, and by geographic and business groupings, to minimize the risk of
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excessive concentration of exposure in any single area of business.
Introduction to Financial Eng. & Risk Management
Financing, Liquidity And Cash Flow Risks:
Financing risks affect an organization’s ability to obtain ongoing financing. An obvious example is the
dependence of a firm on its access to credit from its bank.
Liquidity risk refers to uncertainty regarding the ability of a firm to unwind a position at little or no cost,
and also relates to the availability of sufficient funds to meet financial commitments when they fall due.
Cashflow risks relate to the volatility of the firm’s day-to-day operating cash flow.

EXAMPLE: A CREDIT TRIGGER

Banks often impose covenants within their lending agreements (e.g., a commitment to maintain a credit
rating), and access to credit depends on compliance with these covenants. Failure to comply creates the risk
of denial of access to credit, and/or the need to take action (and costs involved) to restore that rating.
For example, the 2005 annual report of Swisscom AG shows that the company entered into a series of
cross-border tax lease arrangements with US Trusts, in which sections of its mobile networks were sold or
leased for up to 30 years, and then leased back. The leasing terms included a commitment by Swisscom AG
to meet minimum credit ratings. In late 2004, however, a downgrading by the rating agencies took the
company’s credit rating to below the minimum specified level. As a result, Swisscom AG incurred costs of
Swiss Francs 24 million to restore that rating.
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Risk Management Framework
Establish risk management
group and set goals Identify risk areas

Review and refine Understand and

process and do it again access scale of risk
Information
For decision
making
Implementation and
monitoring of controls Develop risk
Response strategy

Implement strategy and

allocate responsibilities
Source: Risk Management: A Guide to Good Practice, CIMA, 2002. 28
Introduction to Financial Eng. & Risk Management
The core elements of a financial risk management system are:
I. Risk identification and assessment
The first stage is to identify the risks to which the
organization is exposed. Risk identification may
be carried out via questionnaires, surveys,
brainstorming sessions, or a range of other
techniques such as incident investigation,
auditing, root cause analysis, or interviews.
Secondly, the scale of each identified risk is
then estimated, using a mix of qualitative and
quantitative techniques.

After this, risks are prioritized. A commonly

used approach is to map the estimated risks
against a likelihood/impact matrix

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II. Development of a risk response
Then we need to respond to the risks has been identified. An example would include setting out a policy
defining the organization’s response to a particular risk, and explain how that policy fits in with its broader
objectives. It would also
(a) set out the management processes to be used to manage that risk,
(b) assign responsibility for handling it, and
(c) set out the key performance measures that would enable senior management to monitor it
The possible responses can be categorized into three categories,
Internal strategies imply a willingness to accept the risk and manage it internally within the framework of
normal business operations
Risk sharing strategies relate to strategies that mitigate or share risks with an outside party.

Risk transfer involves paying a third party to take over the downside risk, while retaining the possibility of
taking advantage of the upside risk.

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Risk Strategies and Tools

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III. Implementation of a risk control strategy and the associated control mechanisms
Having selected a risk response, the next stage is to implement it and monitor its effectiveness in relation to
the specified objectives. Implementation includes allocating responsibility for managing specific risks. We
need to constantly update the risk exposure in terms of Cash flows and risk return ratio.

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IV. Review of risk exposures (via internal reports) and repetition of the cycle
The control loop is closed when the effectiveness of the risk controls is evaluated through a reporting and
review process. This then leads to a new risk identification and evaluation process. This process itself has
three main components:
Review process: This should include a regular review of risk forecasts, a review of the management
responses to significant risks, and a review of the organization’s risk strategy.
Internal reporting: to the board or senior management group: This might include a (a) review of the
organization’s overall risk management strategy, and (b) reviews of the processes used to identify and
respond to risks, and of the methods used to manage them.
External reporting: External stakeholders should be informed of the organization’s risk management
strategy, and be given some indication of how well it is performing.

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TOOLS AND TECHNIQUES TO MITIGATE RISK

Knowing the potential scale and likelihood of any given financial risk, management needs to decide how to
deal with it. This means deciding whether it wishes to accept, partially mitigate, or fully avoid the risk.
Different tools exist for each of these choices and for each risk type

Choosing the most appropriate tool depends upon the risk appetite, level of expertise in the business, and
the cost effectiveness of the particular tool.

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Risk Management
Tools for Different
Categories of
Financial Risk

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Market Risk Tools
Internal Strategies
Natural hedging is internal to a business and
takes advantage of the fact that different risk
exposures may offset each other.
Uses: primarily used in managing foreign
exchange and interest rate risks.
USING NATURAL HEDGING TO MITIGATE
EXCHANGE RATE RISK
A Canadian company is sourcing supplies of household textiles
in India, and is therefore exposed to the risk of movements in
the exchange rate between the Canadian dollar and the Indian
rupee. At the same time, the business is developing a new retail
business in India.
Natural hedging means that it could use the rupee denominated
retail income to fund the payments to its local textile suppliers.
In this way, the currency risk on an asset is matched by an
opposite (and potentially exactly equal) currency risk on a
liability. Consequently the overall exposure is eliminated or, at
the very least, reduced.
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USING NATURAL HEDGING TO MITIGATE INTEREST-RATE RISK

A US aircraft manufacturer is uncertain about whether interest rates will rise or fall in the
medium term, and is concerned because the bulk of its borrowing is through variable rate loans.
The company has long-term contractual commitments from customers, which require the
granting of medium-term credit lines. The risk of an increase in interest rates can be internally
hedged by ensuring that the credit lines granted to customers are linked to interest rates. In this
way, if the manufacturer’s own liabilities increase because of a rise in interest rates, the value of
accounts receivable will also increase. The match will not be perfect but will reduce costs.

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Internal netting: This is a form of natural
hedging.
Uses: to manage multiple internal exposures
across a range of currencies.
INTERNAL NETTING AS A NATURAL HEDGE
Some divisions of huge global businesses, such as those in
the car manufacturing business, end up in net debt, while
others carry net assets in a range of currencies. If Treasury
operations are centralized, the assets and liabilities in each
currency can offset one another, so that the global
organization faces only the net exposure. A decision can
then be taken whether or not to use other tools to further
hedge this exposure.
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Risk Sharing Strategies
Forwards are contracts made today for
delivery of an asset at some specified
future date, at a pre-agreed price.
Uses: to protect against possible rises in
asset prices most commonly either
commodities or currencies.
USING FORWARDS TO HEDGE COMMODITY
PRICE RISK
In the five years to 2007-08, the cost of aviation fuel has
trebled. Such cost increases create risks that require
decisions to be made in relation to hedging. In its 2007-08
Annual Report, British Airways reports that it uses around
6 million tonnes of fuel per year, and that changes in the
related costs can significantly affect the company’s
operating results. In response, the company hedges part,
but not all, of its risk through purchasing forward contracts
for oil and petroleum. The hedges are imperfect, however,
because changes in aviation fuel prices do not fully mirror
the movements in underlying oil prices.
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CADBURY SCHWEPPES AND COMMODITY
FUTURES
Futures: Futures contracts are a form of
standardized forward contract that are
Cadbury Schweppes uses commodity futures contracts to
traded exclusively on organized exchanges.
hedge against adverse cash flow or profit and loss
movements arising from changes in the prices of sugar,
Uses: In principle, futures may be used to
cocoa, aluminium, and other commodities. It is easy to
protect against changes in any asset or
understand why Cadbury Schweppes use commodity
commodity price, interest rate, exchange
futures, because between the end of 2000 and June 2002,
rate, or any measurable random variable
for example, the price per metric tonne of cocoa increased
such as temperature, rainfall, etc.
from $800 to $2200. Such a huge increase within a
relatively short time implies that a failure to hedge such an
exposure would potentially have dramatically affected their
profits. Similarly, the oil price rises of 2008 have seriously
affected the profits of small haulage firms that chose to
accept the price risk rather than to hedge their exposure.

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Joint ventures imply that an organization is
willing to accept a given level of risk, but it
may wish to share that risk with another
party.
Uses: expansion into new markets where
shared knowledge, as well as shared costs,
helps to reduce risks.
JOINT VENTURES TO SHARE RISKS
The CW television network in the USA, which was
launched in the September 2006 season, is a joint venture
owned in equal parts by CBS Corporation and Warner
Brothers. The network is specifically targeted at a
narrowly defined market group – 18-34 year old females.
Launch risks are reduced by sharing the investment costs,
but this also reduces the upside gains from risk taking
because the resulting profits are also shared.
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Swaps: A swap is a contract to exchange the
difference between two cash flows at one or
more agreed future dates.
Uses: management of interest rate and
exchange rate risks. More recently, markets
in commodity and credit risk swaps have
developed. Swaps can be used to (a) reduce
funding costs, arbitrage tax, or funding
differentials, (b) gain access to new financial
markets, and (c) circumvent regulatory
restrictions.
AN INTEREST-RATE SWAP
A fixed-for-floating interest rate swap enables a firm to
arrange with a swap dealer to swap the difference between
a fixed and a floating rate of interest. Such an arrangement
effectively allows an organization to convert a position in a
floating rate loan into a position in a fixed
rate one, and vice versa.
LXN’s Treasurer has negotiated a fixed rate of 6% or
Euro Libor +1.5% variable rate for a loan of €1.8 million.
The counterparty is a swap dealer, MGV, who has agreed
to convert the fixed rate debt into synthetic floating rate
debt via a swap arrangement in which the two companies
will share the quality spread differential (QSD) equally.
The counterparty can borrow at 7.2% fixed or Euro
Libor + 2.5% variable. Euro Libor is currently 5%.
(continued)
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Comparing the cost of fixed rate borrowing between LXN and MGV, we see that LXN has a comparative
advantage equal to 1.2% (7.2% - 6.0%). In the floating rate market, LXN also has a comparative advantage
of 1% ( LIBOR +2.5% - LIBOR + 1.5%). The gap between the relative benefit in the fixed versus floating
markets is termed the QSD, and in most swaps this is shared equally between the two parties. In this case
the QSD equals 0.2%.
The result is a net saving to both parties of 0.1% interest on the terms that they could otherwise have
obtained, i.e., LXN pays 6.4% instead of 6.5% variable, and MGV pays 7.1% fixed instead of 7.2%. This
saving has to be offset against the additional risk arising from the swap because of the counterparty risk.
LXN faces the risk that MGV will not make the cash payments on time, and that any default losses would
have to be covered.
The detailed workings for the swap are shown below:
LXN MGV
Borrows at 6% Borrows at Euro LIBOR + 1.4%
Receives from MGV (6.4%) Receives (6.8%)
Pays to MGV 6.8% Pays to LXN 6.4%
Net Interest Cost Euro LIBOR +1.4% Net Interest Cost 7.1% 43
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Risk Transfer Strategies
Options: An option is a contract that gives the
holder the right to buy or sell an underlying
asset at an agreed price at one or more
specified future dates. The agreed price is
known as the strike or exercise price. An
option that involves the right to buy is known
as a call option and one that involves the right
to sell is a put option.
FOREIGN EXCHANGE OPTIONS TO HEDGE
EXCHANGE RATE RISK
Therefore, suppose that an US company has a net cash
outflow of €300,000 in payment for clothing to be
imported from Germany. The payment date is not known
exactly, but should occur in late March. On January 15, a
ceiling purchase price for euros is locked in by buying 10
calls on the euro, with a strike price of $1.58/€ and an
expiration date in April. The option premium on that date
plus brokerage commissions is $.0250, or a unit cost of
$1.6050/€. The company will not pay more than $1.6050/
€. If euros are cheaper than dollars on the March payment
date, the company will not exercise the call option but
simply pay the lower market rate of, say, $1.52/€.
Additionally, the firm will sell the 10 call options for
whatever market value they have remaining.
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Insurance: Many risks, such as risk of loss of or damage to buildings or contents by fire,
are best managed by traditional insurance. The payment of a premium secures the
purchaser against losses on the insured asset.
The purchase of insurance is often obligatory, either for legal reasons or as
precondition for credit – as is the case with mortgages.

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Securitization: The conversion of financial
assets (such as credit cards, bank loans, and
mortgages) or physical assets into financial
instruments that can be traded, often through
the use of special-purpose vehicles.
Uses: creating the potential to increase the
scale of business operations through
converting relatively illiquid assets into
liquid ones.
SECURITIZATION OF PENSION LIABILITIES
Companies can now opt to onward sell the liabilities and
the associated risks relating to their final salary/defined
benefit pension schemes to the UK insurance company
Paternoster via an OTC deal that represents a specialized
form of securitization. Paternoster purchases the
liabilities. In so doing, it assumes the responsibility for
paying future pensions. This type of securitization
protects firms against the risk of uncertain escalation of
their pension liabilities, thereby allowing them to focus
on their core business
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Introduction to Financial Eng. & Risk Management
Document Links

Topics URL Notes

Introduction to Financial http://math.isu.ru/ru/chairs/me/files/materials201 Read about Financial Markets

Engineering 0/01-Introduction.pdf and derivative products
https://originmarkets.com/origin-hosts-issuer-roundtabl
Origin of Derivatives e-in-parallel-with-the-25th-annual-euromoney-global-b
orrowers-conference-3/
Overview of concepts of
https://shodhganga.inflibnet.ac.in/bitstream/10603/3225/9/09_
financial markets chapter%202.pdf
And financial engineering

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Introduction to Financial Eng. & Risk Management
Document Links

Topics URL Notes

Financial Risk https://www.cimaglobal.com/Documents/ImportedDocum

Management ents/cid_mag_financial_risk_jan09.pdf

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Introduction to Financial Eng. & Risk Management
Video Links

Topics URL

Financial Risk https://www.youtube.com/watch?v=pRrMcq_J0M0

Financial Engineering https://www.youtube.com/watch?v=_ste9e2Rzro
Interest Rate Swap https://www.youtube.com/watch?v=aLiUUoJ3Djo

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Introduction to Financial Eng. & Risk Management

Bibliography
❑ Chatterjee. R., Practical Methods of Financial Engineering & Risk Management,
Springer publications
❑ https://towardsdatascience.com/intro-to-financial-engineering-7668ca1a01cc
❑ https://mfe.haas.berkeley.edu/admissions/prerequisites#Programming
❑ Management Accounting Guideline Financial Risk Management for Management
Accountants, Jan 2009.
❑ Horcher, K. A., Essentials of Financial Risk Management, Wiley & Sons Inc.

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Introduction to Financial Eng. & Risk Management

Assignment
Q1. Tata Motors has acquired JLR on 2008 all in cash transaction for $2.3 billion from Ford Motors.
Being a Indian Auto manufacturer what are the risk did Tata Motors was exposed into? Support your
views.

Q2. Nagarjuna Mills Ltd. a renowned fabric manufacturer who imports raw cotton from Egypt and also
sources from domestic vendors. This year the Meteorological Department of India (MDI) has
forecasted a late monsoon for India. To mitigate this type of risk what strategy can they formulate.
Support your views

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Introduction to Financial Eng. & Risk Management

Summary

In this rapid changing global economy decision making is riskier day by day. High volatility in
Financial Markets force managers to be more accurate and quant dependent.
Financial Engineering is a multi-disciplinary area where mathematics & statistical application in
finance domain is required. It is a blend of IT, Engineering & Finance altogether.
Financial Engineering is applicable to mitigate risk in all forms. But due to our course structure we are
limiting it to Financial risk management.
Risk & uncertainty is not the same. We can evaluate risk and for all risk we formulate different
strategies to mitigate the same.

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