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to split the risk and return aspect of financial instruments and to develop an innovative solution to cater the need of users particularly investors of financial market. Such innovations are seen in bonds, equity, derivatives, and also in other fields like merger, acquisition and corporate restructuring. There are several financial engineering products in the financial market like- preference shares, convertible debentures, call and put options, futures, swaps, etc. In India, being capital market factors, interest rates, prices of the commodities, etc. highly volatile there is a continuous need to innovate a financial solution to minimize risk for investors. This paper will find the financial engineering solutions which are used by Indian Financial Institutions for managing risk arisen in the present global economic scenario. Keywords: Financial Engineering, risk, global meltdown, financial innovations
Ms. Jyoti Assistant Professor, DoBA K. P. College of Management Navalpur, Agra Ph. No. 09897775590 Mail-Id : email@example.com, firstname.lastname@example.org
which can be used either in isolation or in conjunction with the first two options. This involves careful balancing of assets and liabilities. Such innovations are seen in bonds. is innovate. But this is viable only for certain type of risks such as credit risks. The second approach refers to asset liability management (ALM). credit risk and forex risk (Figure 1). Since risk is embedded in the business of financial institutions. It is an exercise towards minimizing exposure to risks by holding the appropriate combination of assets and liabilities so as to meet earnings target of the firm.Introduction Risk is an inherent quality in the business of commercial banks and financial institutions. risk profile of these financial entities has further broadened. derivatives-the financially engineered solutions to manage risks. The third option. The most prominent financial risks to which these entities are exposed are classified into interest rate risk. Figure 1 There are three different but related ways of managing financial risks. liquidity risk. The first is to purchase insurance. which arise if the party to a contract defaults. With the widened resource base. service range and client base. 2 . equity. its efficient management holds key to their performance.
the development and the implementation of innovative financial instruments and processes. Such needs are to be identified in the context of market and to bring out new value added products or services or solutions which suits the users¶ requirements. It has completely changed the financial market today. Its main contribution is to split the risk and return into several components and allow investors of financial markets to decide the combination that is most suitable to them. Financial engineering like any other engineering has brought several new products and solutions to the market. and the formulation of creative solutions to problems in finance. These factors are as follows: y y y y y y y y Tax Advantage Transaction Cost Agency Cost Risk Reallocation Increased Liquidity Regulatory or Legislative Factors Level and Volatility of Interest Rates Level and Volatility of Prices. Technological Development Academic Work 3 y y . Financial engineering is not different from that process. Financial engineering involves the design. Factors Contributing to Financial Engineering: There are several factors responsible for financial innovation.Firms follow different processes for developing new value added product and services. Identification or realization of a need is the starting point of the process.
With the changing role in today¶s scenario. Interestingly. y y Exhibit 1: Financial Innovations in India PRINCIPAL FACTOR Tax Advantage Pricing and Interest rate regulation under the Capital Issue Control Act Tax Benefi t Perceived Volatility of Interest rates Volatility of equity prices 4 Financially Engineered Solutions Debt-oriented schemes of Mutual Funds Partially Convertible Debentures and fully Convertible Debentures Deep Discount/Zero Coupon Bonds Puttable and Callable Bonds Stock Index Futures . Exhibit 1 summarizes various financial innovations with their principal motivating factors in India during last two decades. such financial innovations are growing which would be of great help to FIs to share and transfer their risks with other institutions operating in the market.y Accounting Benefits Risk management is uniquely important for financial institutions (FIs) because. This has necessitated the creation of new instruments and solutions by financial institutions and regulatory authorities to protect and mitigate losses to FIs arising from such risks. the risks faced by financial institutions have four major inter-related components: Credit risk Environmental and financial risk which arises from changes in the macroeconomic environment. in contrast to firms in other industries. FIs are working on the strategy of diversification through dividing the risks into various parts and evolving a solution for that type of risk. management and market risks whenever they assume credit risks by granting loans to traders and industrialists. the Indian Financial Institutions are exposed directly and indirectly to various trade. Typically. their liabilities are a source of wealth creation for their shareholders. interest rate fluctuations and market exposures.
By allowing banks to trade in these derivatives the government and regulators reckon that they would be able to better cope up with the interest rate differentials. This will also bring a more liquid and efficient debt market in India.bond with a semiannual coupon of 7% introduced jointly by Reserve Bank of India and Securities and Exchange Board of India.Restriction under forward trading Havala Transactions RBI restrictions Volatility of interest rates Volatility of Interest rates Volatility of foreign exchange rates Volatility of Interest rates Technology Technology Volatility of Interest rates Technology Volatility of Interest rates Investor preference Volatility of stock prices Risk sharing Badla Transactions Ready Forwards Restrictions under the portfolio management scheme Interest rate caps/fl oors/collars Interest rate Swaps Currency Swaps Forward rate Agreements Automated Teller Machines Screen-based Trading Floating rate bonds Electronic funds transfer Money market mutual funds Specialized mutual funds Exchange-traded options Project Finance Interest Rate Derivatives Recently. Interest rate futures are derivatives contract with an interest bearing security as an underlying instrument. Sharp fluctuations in the interest rates and the volatility in interest rates impact financial institutions and companies particularly banks who hold large stocks of government securities. India¶s financial system regulators have launched exchange traded interest rate futures again in the market to help financial institutions better manage risks arising from interest rate fluctuations. insurance companies and other financial sector players to hedge their interest rate risk. Interest rate derivatives would help institutions such as banks. 5 . This future contract is based on ten-year government.
as a consequence of the global liquidity squeeze. Troubles in the mortgage market spread to the financial derivatives markets first. Also. consequently. insurers. money market. in their search for substitute financing.Mergers and Consolidations Public sector banks are looking at consolidation as a serious option in order to reduce risk to financial stability and face competition.had all come under pressure from a number of directions. corporate withdrew their investments in domestic money market mutual funds (MFs). 6 . This substitution of overseas financing by domestic financing brought both money markets and credit markets under pressure. forex market and credit market .. and soon it became clear that the entire US financial sector. FIs can fund large deals. then banks. achieve financial inclusion with more sharpness. invest higher in technology and survive better during downturn. obscure and famous. First. reported huge losses in subprime related investments led by rising foreclosures and delinquencies on home loans as priced in the once-overheated housing market began crashing. India's financial markets -equity market. were in the grip of unpredicted credit crisis. a string of companies. non-banking financial companies (NBFCs) where the MFs had invested a significant portion of their funds came under redemption pressure. pension funds. In October 2007. big and small. Indian corporates found their overseas financing drying up. then investment banks. etc. from there it went to hedge funds. and proposed a merger of these associates. State Bank of India currently has six associate banks. and Europe and other parts of the world as well. With the help of large size. This would really increase the size which means large balance sheets and good risk management. forcing corporates to shift their credit demand to the domestic banking sector.
Second. Both these factors put downward pressure on the rupee. 7 . The real channel was transmission of the global cues to the domestic economy has been quite straight forward ±through the slump in demand for exports. Simultaneously. the Reserve Bank's intervention in the forex market to manage the volatility in the rupee further added to liquidity tightening. corporates were converting the funds raised locally into foreign currency to meet their external obligations. Third. the forex market came under pressure because of reversal of capital flows as part of the global deleveraging process.
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