Nicholas Paul Piquito Thesis

FINANCIAL PRODUCT DEVELOPMENT: A STRATEGICALLY
COMPETITIVE SYSTEM ENGINEERING APPROACH TO

INNOVATIVE RISK BASED FINANCIAL ENGINEERING
by
Nicholas Paul Piquito
Thesis
submitted in partial fulfilment of the requirements for the degree of
DOCTOR INGENERIAE
in
ENGINEERING MANAGEMENT
in the
FACULTY OF ENGINEERING
at the
RAND AFRIKAANS UNIVERSITY
Promoter: Professor L. Pretorius

Co-Promoter: Professor A. Strauss
October 1999
ABSTRACT
It is said that the development of innovative new products is set to become the
economic battleground of the twenty-first century. Specifically, the innovative
identification, development and subsequent marketing of financial products
designed in order to allow organisations to manage their financial risk profiles will
assume increased importance as volatility within the global business environment
and capital markets increases. The discipline responsible for the development of
such financial products, financial engineering, will increase in importance as
financial services organisations compete to be the first to satisfy the needs of the
market.
The ultimate aim of financial engineering, as with any product development

process, must be to develop the required product in an optimal manner at a
minimised economic life-cycle cost to the organisation. Simultaneously, if
correctly applied, the process of financial engineering can be a significant source
of competitive advantage to the financial services organisation in an industry
characterised by intense competitive pressures and exponentially increasing
complexity and volatility. The financial services organisation which is able to
successfully combine these two elements will have the capability to position itself
as a leader in the identification and development of innovative financial products,
a capability critical for success within the financial services industry.
The science of engineering has within it a special subset devoted to the

optimisation of the process of product development. This discipline, known as
system engineering, has been extremely effective in the enhancement of product
development processes within a traditional manufacturing environment. Tangible
benefits of the application of system engineering include a reduced product
development cycle, increased product adherence to client specifications, and a
reduction in the economic life-cycle cost of the product.
Within this thesis the author suggests that the optimal development of financial
products in an increasingly competitive environment requires a two-pronged
approach. In the first instance the financial services organisation must choose to
develop the product which best promotes the medium to long-term strategic aims
of the organisation. This is the concept of strategic fit. In the second instance the
financial services organisation must have the capability to develop this product
more effectively, and more efficiently, than its competitors.
As an implementation mechanism the author develops a Financial Product

Development Model based on system engineering principles chosen for their
applicability to the process of financial product development. Simultaneously, the
author develops a Competitive Strategy Framework, a collection of five strategic
elements designed to ensure that the financial product development decision
displays a measure of correlation to the strategic aims of the organisation. This
Competitive Strategy Framework is implemented within the Financial Product
Development Model via the use of a Strategic Circuit Breaker, a concept
developed by the author and based on the concept of trading circuit breakers as
used on the world's major stock exchanges.
The aim of the Financial Product Development Model proposed within this thesis
is to enhance the process of financial engineering and in so doing provide the
financial services organisation with a means of improving its strategic
competitiveness within the financial markets.
The proposed Financial Product Development Model is validated via the practical
application of the model. The results of this validation indicate that significant
benefits may be obtained by correctly implementing the model. In addition the
author conducts a limited scope industry survey designed to determine the opinion
of financial services professionals to the major concepts underlying the model.
The favourable results of this survey indicate that (1) the proposed model is
practical and applicable within the financial services industry, and (2) the financial
services industry in general is unaware of the importance of the process of product
development and the manner in which system engineering can be used to enhance
this process. By implication the financial services organisation that is able to
differentiate its financial product development process from its competitors stands
to achieve a significant competitive advantage.
Opsommirrng
Daar word beweer dat die ontwikkeling van innoverende nuwe produkte die
ekonomiese mededingingselemente van die een-en-twintigste eeu gaan word. Dit
is spesifiek die innoverende identifikasie, ontwikkeling en gevolglike bemarking
van finansiele produkte wat ontwerp is om organisasies in staat te stel om hul
finansiele risikoprofiele te bestuur, wat toenemend belangrik sal word as gevolg
van vloeibaarheid binne die globale sake-omgewing en kapitaalmarkuitbreidings.
Die dissipline wat verantwoordelik is vir sodanige finansiele produkte, naamlik
finansiele ingenieurswese, sal belangriker word aangesien finansiele
diensorganisasies meeding om eerste te wees om in die behoeftes van die mark te
voorsien.
Die hoofdoel van finansiele ingenieurswese, soos met enige

produkontwikkelingsproses, is om die verlangde produk op 'n optimale wyse te
ontwikkel teen 'n geminimaliseerde, ekonomiese lewensikluskoste vir die
organisasie. Binne hierdie konteks behoort finansiele ingenieurswese 'n
belangrike bron van mededingende voordeel vir die finansiele diensorganisasie te
wees, veral met betrekking tot die geweldige mededingende druk en toenemende
eksponensiele kompleksiteit van moderne markte. Die finansiele diensorganisasie
wat in staat is om hierdie twee elemente suksesvol te kombineer, sal in staat wees
om homself as 'n leier te posisioneer in die identifikasie en ontwikkeling van
innoverende finansiele produkte, 'n kritiese noodsaaklikheid vir sukses binne die
finansiele diensindustrie.
Die wetenskap van ingenieurswese het 'n spesiale onderafdeling wat gemik is op
die optimering van die produkontwikkelingsproses. Hierdie dissipline, wat as
stelselingenieurswese bekend staan, is uiters doeltreffend in die optimering van
produkontwikkelingsprosesse binne tradisionele vervaardigingsomgewings.
Meetbare voordele van die toepassing van stelselingenieurswese sluit kenmerkend
in: 'n verminderde produkontwikkelingsiklus, verhoogde navolging van kliente se
spesifikasies vir produkte, en 'n verlaging van die ekonomiese lewensikluskoste
van die produk.
In hierdie proefskrif stel die skrywer voor dat die optimale ontwikkeling van
finansiele produkte in 'n toenemend mededingende omgewing 'n tweeledige
benadering vereis. Eerstens moet die finansiele diensorganisasie 'n produk
ontwikkel wat die medium- tot langtermyn strategiese doelstellings van die
organisasie die meeste sal bevorder. Dit is die konsep van strategiese passing.
Tweedens moet die finansiele diensorganisasie die vermod he om hierdie produk
doeltreffender en effektiewer as sy mededingers te ontwikkel.
As 'n implementeringsmeganisme ontwikkel die skrywer 'n Finansiele

Produkontwikkelingsmodel wat op stelselingenieurswesebeginsels, wat gekies is
vir hul toepaslikheid op finansiele produkontwikkeling, gebaseer is. Tegelykertyd
ontwikkel die skrywer 'n Mededingende Strategiese Raamwerk: 'n versameling
van vyf strategiese elemente wat ontwerp is om te verseker dat die finansiele
produkontwikkelingsbesluit 'n sekere mate van korrelasie met die strategiese
doelstellings van die organisasie vertoon. Die Mededingende Strategiese
Raamwerk word in die Finansiele Produkontwikkelingsmodel geImplementeer by
wyse van die gebruik van 'n Strategiese Stroombreker, wat deur die skrywer
ontwikkel is en op die konsep van handelstroombrekers gebaseer is, soos wat dit
op die wereld se hoofeffektebeurse gebruik word.
Die doel van die Finansiele Produkontwikkelingsmodel wat in hierdie dokument

voorgestel word, is om die proses van finansiele ingenieurswese te bevorder en
sodoende aan die finansiele diensorganisasies 'n instrument te gee om hul
strategiese mededingendheid binne die finansiele markte te verbeter.
Die voorgestelde Finansiele Produkontwikkelingsmodel word deur die praktiese

toepassing van die model geldig gemaak. Die resultate van hierdie
valideringsproses dui aan dat betekenisvolle voordele verkry kan word deur die
model korrek toe te pas. Ter verdere ondersteuning het die skrywer 'n beperkte
industriebestekopname gedoen wat ontwerp is om die menings van finansiele
diensberoepspersone oor die hoofkonsepte wat onderliggend aan die model is, te
bepaal. Die gunstige resultate van hierdie opname dui daarop dat (1) die
voorgestelde model prakties en toepaslik vir die finansiele diensindustrie is, en (2)
dat die finansiele diensindustrie oor die algemeen onbewus is van die
belangrikheid van die proses van produkontwikkeling en die wyse waarop
stelselingenieurswese gebruik kan word om hierdie proses to bevorder. Dit
impliseer dat die finansiele diensorganisasies wat hul finansiele
produkontwikkelingproses van hul mededingers kan onderskei, 'n betekenisvolle
mededingende voordeel daardeur kan bereik.
Acknowlledgements
The author would like to acknowledge the following persons for their valuable
assistance and encouragement throughout the period of study which
culminated in the preparation of this thesis:
The Statistical Consulting Service of the Rand Afrikaans University

for their input with regard to the survey design.
The numerous professionals within the financial services industry who

provided input on many of the practical issues contained within this
thesis,
Professor Alwyn Strauss, as co-promoter, for his advice and insightful

comments.
Professor Leon Pretorius, as lead promoter, for his tireless and

invaluable effort in guiding the author throughout the research process.
Thank you.
"You cannot discover new oceans unless you lose sight of the shore." —
Anonymous
Contents
PAGE
CONTENTS
i. INTRODUCTION
1.1 General Introduction 1
1.2 The Purpose of the Research 3
1.3 The Research Process 5
1.4 The Research Design and Methodology $
1.5 Defining Financial Products 9
1.6 Defining A Model Dl
1.7 An Overview of the Thesis Structure 10
1.8 Pedagogical Features 14
1.9 Conclusion 17
Part ne
FINANCIAL INNOVATION AND PRODUCT DEVELOPMENT
2.1 Introduction 19
2.2 The Importance of Product Innovation in the 21 St Century 20
2.3 The Drivers of Financial Product Innovation 25
2.4 The Current and Predicted Future State of Financial Product 26
Innovation
2.5 Conclusion 34
STRATEGIC CORPORATE FINANCIAL RISK MANAGEMENT

3.1 Introduction 36
3.2 Defining Corporate Financial Risk Management 38
3.3 Why Manage Risks? 40
3.4 The Various Types of Financial Risks 43
3.4.1 Market Risk 44
3.4.2 Interest Rate Risk 44
i
Contents
PAGE
CONTENTS CONTINUE 0 0 0
3.4.3 Liquidity Risk 45

3.4.4 Currency Risk 45
3.4.5 Credit Risk 46
3.5 Hedging As A Means Of Risk Management 46
3.6 Modern Day Failures In Risk Management 49
3.7 Conclusion 53
FINANCIAL ENGINEERING: CONCEPTS AND TECHNIQUES

4.1 Introduction 56
4.2 Financial Engineering Defined 58
4.3 Investigating The Need For Financial Engineering 61
4.4 The Applications of Financial Engineering 65
4.4.1 Hedging 66
4.4.2 Speculation 6$
4.4.3 Arbitrage 68
4.4.4 Structuring 69
4.5 Science and Financial Engineering: A Powerful Combination 70
4.6 The Use of Value-at-Risk Techniques in Corporate Risk 72
Management
4.7 Conclusion $4
FINANCIAL DERIVATIVES: A CORPORATE RISK MANAGEMENT

APPROACH
5.1 Introduction 87
5.2 Derivatives Defined 89
5.3 Forwards and Options: The Building Blocks of Derivatives 91
5.4 Forward Based Derivatives 92
5.4.1 Forward Contracts 92
5.4.2 Swap Transactions 96
ii
Contents
PAGE
CONTENTS CONTINUED...
5.4.3 Futures Contracts 99

5.5 Option Based Derivatives 100
5.5.1 Option Transactions 100
5.5.2 Caps, Floors and Collars 105
5.5.3 Swaptions 1106
5.6 Conclusion 107
rt Two
6. THE ROLE OF SYSTEM ENGINEERING IN COMPLEX SYSTEMS
6.1 Introduction 109
6.2 The Need For System Engineering 111
6.3 Defining System Engineering 1112
6.4 Systems Versus Products 115
6.5 The System Design Process 1116
6.5.1 Definition of the Problem 120
6.5.2 The Development of a Consumer Need 120
6.5.3 System Feasibility Analysis 122
6.5.4 System Operational Requirements 123
6.5.5 System Maintenance and Support 125
6.5.6 Technical Performance Measures (TPMs) 1126
6.5.7 The System Functional Analysis 130
6.5.8 The Requirements Allocation 131
6.5.9 System Synthesis, Analysis and Design Optimisation 133
6.5.10 Design Integration 134
6.5.11 Testing and Evaluation 134
6.5.12 Production and/or Construction of the System 135
iii
Contents
PAGE
C NTENTS CONTINUED.
6.5.13 Operational Use and Sustaining Support 135

6.6 Conclusion 135
THE FINANCIAL SERVICES COMPETITIVE STRATEGY

FRAMEWORK
7.2 Developing the Competitive Strategy Framework 140
7.3 Defining the Competitive Strategy Framework 141
7.4 Using the Competitive Strategy Framework 145
7.5 Change Leadership (Element 1) 1147
7.6 Knowledge Management in the Information Revolution 154
(Element 2)
7.7 Technology Integration (Element 3) 160
7.8 Product Innovation as a Competitive Advantage (Element 4) 1164
7.9 New Product Development as a Strategically Competitive 1171
Advantage (Element 5)
7.10 The Strategic Circuit Breaker 183
7.11 Integrating the Strategic Circuit Breaker and the Competitive 185
Strategy Framework Within the Financial Product
Development Model
7.12 Scientific Decision Making As An Aid to the Financial 1187
Product Development Process
7.13 Conclusion 197
THE FINANCIAL PRO P UCT DEVELOPMENT MODEL

8.2 The Purpose of the Financial Product Development Model 202
8.3 The Development of the Financial Product Development 205
Model
iv
Contents
C PCTENTS CONTINUED... PAGE
8.3.1 The Need to Accelerate the Development of 207

Innovative New Products
8.3.2 The Importance of Adequate Product Definition 208
8.3.3 Flexible Product Development in a Volatile 210
Environment
8.4 Introducing the Financial Product Development Model 212
8.5 Life-Cycle Cost Minimisation 217
8.6 Design Integration 2119
8.7 Strategic Analysis 222
8.8 Product Support and Maintainability 225
8.9 The Competitive Strategy Framework and Product Selection 226
8.10 Problem Definition 228
8.11 Product Feasibility Analysis 230
8.12 Product Operational Requirements 232
8.13 Product Functional Analysis 236
8.14 Technical Performance Measures 237
8.15 Environmental Volatility 239
8.16 Product Design and Construction 240
8.17 Product Testing and Evaluation 244
8.18 Product Development Process Analysis 245
8.19 Conclusion 247
9. THE FINANCIAL PRODUCT DEVELOPMENT MODEL: A

PRACTICAL IMPLEMENTATION
9.2 An Overview of the Practical Implementation of the Financial 250
Product Development Model
9.3 The Product to be Developed 251
9.4 Applying the Financial Product Development Model 252
Contents
PAGE
CONTEN'TS CONTINUED...
9.5 Market Scanning and Generic Product Definition 252

9.6 Implementing the Competitive Strategy Framework and 253
Strategic Circuit Breaker
9.7•Problem Definition 261
9.8 The Product Feasibility Analysis 264
9.9 Product Operational Requirements 270
9.10 Product Functional Analysis 276
9.11 Product Technical Performance Measures 279
9.12 Product Design and Construction 280
9.13 Product Testing and Evaluation 283
9.14 Product Development Process Analysis 284
9.15 Conclusion 286
AN INDUSTRY PERCEPTION OF THE FINANCIAL PRODUCT

DEVELOPMENT MODEL
10.2 Data Collection 289
10.3 The Target Population 290
10.4 The Choice of Sampling Method 291
10.5 Designing the Survey Form 292
10.6 The Survey Questions 296
10.7 Analysing the Survey Results 298
10.8 Practical Issues Arising From the Industry Survey 304
10.9 Conclusion 306
CONCLUSION
11.2 Further Research Opportunities 309
11.3 The Question Hierarchy Revisited 311
vi
Contents
PAGE
CONTENTS CONTINUED° 0 0
11.4 Concluding Summary 313
Glossary 321
Appendix A: Derivative Contracts and Derivative Securities 344
Appendix IL: Rocket Scientists Are Revolutionising Wall 345

Street
Appendix C: Creating a Synthetic Financial Security 350
Appendix D: The Future Financial Product Development

Environment
D.1 Introduction 360
D.2 Areas of Change 361
D.3 The Growing Importance of Financial Products 361
D.4 Risk Management Systems 362
D.5 New Product Trends 365
D.6 The Emergence of New Risk Types 367
Appendix E: The Survey Questionnaire 370
Appendix F: The Value-at-Risk System 372
Appendix G: On-Line Risk Management Service Providers 375
Appendix 1E: Option Pricing and the Delta-Gamma 376

Methodology
vii
Contents
PAGE
CONTENTS CONTINUED...
1:, ibIliography 382
Endex 393
viii
List Of Figures
PAGE
UST F FIGURES
1.11 The Question Hierarchy 5
1.2 The Thesis Structure 15
3.1 Total Financial Services Firm Risk 40
3.2 Publicly Disclosed Derivatives Losses as of Year-End 1995 53
4.1 Fluctuations In The USD/DEM Exchange Rate (1963-1992) 62
4.2 3-Month Dollar Interest Rate Volatility (1963-1992) 63
4.3 Derivatives Market Growth 64
4.4 A Perfect Hedge 67
4.5 A Typical Capped Exposure 67
4.6 Moving Average Volatility Estimates 75
4.7 A Comparison of Simple Moving Average and Exponential 76

Moving Average Volatility Estimates
4.8 Volatility Clustering in Financial Returns 78
4.9 An Illustration of Leptokurtosis in Financial Returns 79
4.10 Delta Versus Delta-Gamma Methodology $2
4.11 A Monte Carlo Analysis Generated PDF 83
5.1 A Simple Forward Contract 93
5.2 A Schematic Illustration of Interest Rate Parity 95
5.3 A Plain Vanilla Interest Rate Swap 97
5.4 A Plain Interest Rate Swap 98
5.5 A Currency Option 102
5.6 The Value of an Option Contract 103
5.7 Interest Rate Protection As A Result of A Cap 106
ix
List Of Figures
PAGE
LIST OF FIGURES CONTINUED...
6.1 The Current Environment 110
6.2 The Cost Of Downstream Changes in the Development Process 112
6.3 The System Development Process (With Integrated Logistic 118

Support)
6.4 An Alternative System Design and Development Process 119
6.5 The System Engineering Process in the System Life-Cycle 121
6.6 An Objectives Tree 12$
6.7 The House of Quality (HOQ) Matrix 129
6.8 The Development of System Functional Requirements 132
7.11 The Financial Product Development Competitive Strategy 142

Framework
7.2 The Evolutionary Cycle of Competitive Behaviour 150
7.3 The 10 Best Practice Companies In Knowledge Management 156
7.4 A Technology Integration Model 162
7.5 Buying Modes For Innovative New Offers 169
7.6 The Five Types of Development Projects 178
7.7 The Integration of the Competitive Strategy Framework and the 186
Financial Product Development Model
8.1 Most Difficult to Accomplish New Product Development 209

Activities
8.2 The Two Models of Effective Product Development 211
8.3 The Financial Product Development Model 213
_ 8.4 The Revised-DEC Requirements Management Process - 236
9.1 The Macro Product Feasibility Analysis 265
9.2 The Two-Level Product Functional Analysis Diagram 277

List Of Figures
PAGE
LIST OF FIGURES CONTINUED...
9.3 A Third Tier Functional Sub-Level 279
10.11 An Extreme Value Five-Point Ranking Scale 295
C.1 Synthetic Put Option Profile/Loss Profile 359
D.1 A MatLab Screenshot Illustrating the Use of Data Visualisation 364

Techniques to Show the Breakdown of Exposure to Market Risk
for a Complex Portfolio
D.2 The Decreasing Issuance of Government Debt 366
IF.! A Screenshot of the Value-at-Risk System 373
F.2 The Output of the Value-at-Risk System 3741
H.1 Delta Versus Delta-Gamma Methodology 379
xi
List Of Tables
PAGE
LIST (S F TA 1; LES
3.1 Corporate Losses Attributed to Derivatives: 1993-1995 54
4.1 Linear and Non-Linear Financial Instruments 80
6.1 The Quantitative Prioritisation of Technical Performance 130

Measures
7.1 The Reactions to Change Forces 149
7.2 The Role of Management in the Three-Part Learning Organisation 152
9.1 Comparing the Various Product Alternatives 267
9.2 Product Technical Performance Measures 280
10.1 The Survey Results 300
10.2 The Survey Questions Ranked By Average Response (Highest to 301

Lowest)
A.1 Derivative Contracts And Derivative Securities 344
C.1 Cash Flow Analysis 353
C.2 Redemption Analysis 358
G.1 On-Line Risk Management Service Providers 375
xi i
Introduction
Cha ter 1
Introduction
"If the other guy's getting better, then you'd better be getting
better faster than the other guy's getting better... or you're getting
worse." — Tom Peters, The Circle of Innovation
GENERAL 1INTRODUCTION
he strategic competitiveness of a financial services organisation is, to a

Ttlarge extent, dependent on the ability of the organisation to identify,
develop and market innovative financial products in an increasingly
competitive global environment. The financial products so produced must
satisfy specific requirements if they are to provide the organisation with the
ability to compete and, by definition, to be profitable in a market environment
characterised by intense competitive pressures and increasing complexity. The
most successful financial services organisations of the future will be those that
are best able to satisfy the diverse and complex requirements of the market via
the development of innovative financial products designed and manufactured
so as to ensure the optimal resolution of market needs.
Within the sphere of the financial services industry is a relatively new

discipline dedicated to the design and development of financial products. This
discipline is commonly known as financial engineering. The market needs that
financial engineering attempts to satisfy are typically the result of a desire on
the part of market participants to eliminate, transfer or manage financial or
business risk. Financial engineering is therefore concerned with the
development of innovative new financial products designed to facilitate this
transfer of risk.
1
- Introduction
New financial product development is becoming ever more important in the

modern globalised marketplace as both the diversity and prominence of
business and financial risks increase. Product innovation has become
imperative in providing organisations with the competitive edge needed to
survive in the modern marketplace. However, the ability to innovate per se is
not a guarantee of success since innovation is only one part (although an
admittedly large part) of corporate competitiveness. Complementary to
innovation is the ability to identify market opportunities and to understand how
such opportunities may best be met. Once such opportunities have been
identified, and an appropriate initial product definition has been specified, the
process of financial product development must be satisfactorily completed
before the product itself can be marketed. This process is critically important
since, as is evident in the typical conventional engineering fields, an
inadequate product development process can be disastrous for the financial
services organisation in terms of profitability, competitiveness and
marketability.
The 21 S ` century economy will be characterised by powerful surges in new

technology which will be accompanied by increasing volatility as people,
organisations and markets struggle to come to terms with the pace of change.
Consequently financial risks in the form of increased volatility in everything
from the ability of a counterparty to settle debts to the value of financial and
non-financial assets will increase. The science of financial engineering will
continue to increase in importance as a means of providing protection to
organisations from this increased volatility. Many opportunities will be created
in this field, opportunities which may be capitalised upon by those financial
services organisations that are best placed to not only identify such
opportunities but also to act upon the identified opportunities in a manner
which is both profitable (the very essence of a market economy) as well as
strategically optimal.
The increasing importance of financially engineered products is evident when

one considers the development of this industry since its inception in the early
2
Introduction
1970s. Starting from zero, the notional outstanding value of financial

derivatives, a product of financial engineering, has grown to an estimated $50
trillion as at 1995. Since 1995 the market for financial derivatives has been
further boosted by innovative new products such as credit derivatives which
have added an estimated $20 trillion to this total. In addition existing
instruments have experienced explosive growth over the past five years. The
market for interest rate and currency swaps, just one component of the total
derivatives market, has increased from $14 trillion in 1995 to $24 trillion in
1997 [173].
While the current importance of financial products in the global economy is

without question, such products are set to increase in importance in the 21 St
century. The discipline which is responsible for the creation of these products,
financial engineering, is set to undergo dramatic changes. Developing the best
strategic product at the lowest economic life-cycle cost will become critically
important for financial services organisations wishing to survive in an
increasingly competitive market. Consequently, the ability of the financial
services organisation to develop financial products will prove to be a major
component of their strategic market competitiveness.
1.2 THE PURPOSE OF THE RESEARCH
The issues surrounding the creation of financially engineered products lead to

the formulation of many interesting concepts. Most importantly, it is possible
to draw powerful parallels between the creation of financially engineered
products which are typically intangible and the creation of 'conventional'
engineering products which are typically, but not always, tangible. Irrespective
of whether the product to be created is an intangible financially engineered
product (such as a financial derivative) or a tangible 'conventionally'
engineered product (such as a concrete bridge or an air-conditioning system)
the process of identifying the need for the product, designing and developing a
solution to solve the perceived need, and manufacturing and implementing the
resultant solution or product remains the same.
3
Introduction
The reason for the author's emphasis on this similarity is the following: Given
that financial engineering is an extremely complex process, and given the
tremendous importance of the process of financially engineered product
development within the financial services industry, would it not be possible to
enhance the process of product development in the science of financial
engineering using established 'conventional' engineering techniques,
particularly given the apparent similarities between these two areas with regard
to product development? It is the contention of the author that within the broad
sphere of engineering the techniques associated with a particular subset,
namely system engineering, will prove to be effective in optimising the
financial product development process inherent within financial engineering. A
major part of this thesis is therefore devoted to research relating to the
application of system engineering techniques to the process of financial
engineering.
Successful product creation per se is not simply a function of process

optimisation though. A technically brilliant product is doomed to failure if it
does not satisfy the needs of the target market. Furthermore, the satisfaction of
target market requirements is a principle driver of organisational
competitiveness. For this reason this thesis goes one step further than simply
investigating how the concepts and techniques of system engineering may be
used in the process of financial engineering. The question of strategic
organisational competitiveness as a result of the financial product creation
process is also addressed. This concept, which is inextricably linked to that of
product optimisation, is extremely important because of the reasons underlying
the creation and use of financially engineered products. Such products are
created for one single reason, being that there is a need on the part of a market
participant to manage a particular identified risk and this need can be satisfied
by the development of a financial product with certain inherent characteristics.
There is therefore an underlying profit motive on the part of the producer.
Financially engineered products are created as a result of the inherent profit
opportunity that they present to the entrepreneur who is willing to take the risk.
4
Introduction
Organisational competitiveness and business success are therefore of prime

importance.
The primary purpose of the research presented within this thesis is the
enhancement of the financial product development process (financial
engineering) in terms of both operational and strategic components. The
outcome of the application of the research results should be the enhancement
of the strategic competitiveness of the financial services organisation as a
result of a strategically enhanced financial product development process. The
manner in which the author intends to achieve these aims is outlined in the
following section.
11.3 THE RESEARCH PROCESS
The research problem is approached in this thesis using a modified version of

the Question Hierarchy as proposed by Cooper and Emory [32]. This approach,
illustrated in Figure 1.1, assumes the research problem to be composed of a
hierarchy of questions with a descending level of specificity. The aim of the
Question Hierarchy is to achieve a focus on the research problem as a result of
increasingly descriptive questions.
Management Research Investigative

Question Question(s) Questions
The problem which The single Those questions
has prompted the objective or which must be
research hypothesis that answered to
best states the satisfactorily
objective of the respond to the
research study research question
Source: Adapted and modified by the author from Cooper, Donald R.; Emory, William C.;
Business Research Methods, Fifth Edition Irwin 1995 [32]
Figure 1.1 The Question Hierarchy
5
Introduction
In accordance with the data presented in Section 1.2, the author has defined the
following management, research and investigative questions in terms of the
Question Hierarchy:
Management Question
How may the corporate financial engineering function be enhanced
from a product development perspective in order to increase the
competitive position of the organisation within the financial
services industry?
Research Question
Can the risk induced corporate financial engineering function be
enhanced by the use of complex system engineering techniques and
principles in conjunction with applicable strategy enhancing
elements relating to the selection of product development projects
in order to enhance the financial product creation function?
Investigative Questions
How can the functions of system engintering, financial
engineering and strategic organisational competitiveness be
integrated froni a product selection and development point of
view so as to enhance the strategic competitiveness of the
financial services organisation?
Are there any differences in applying the concepts of system
engineering to the function of financial engineering as opposed
to 'conventional' engineering?
What additional factors (if any) need to be considered in this
integration (possibly factors particular to the financial
environment)?
Will it be possible to construct a generalised conceptual model
which may be used to guide the strategic financial engineering
product development process?
6
Introduction
Note that the term 'complex system engineering techniques' does not refer to
the complexity or otherwise of such techniques which may be employed.
Rather, for the remainder of this thesis, the term is taken to mean the use of
system engineering techniques in order to enhance the design and development
of complex products or systems.
The answers to the questions posed in the Question Hierarchy will be obtained
via a combination of descriptive and investigative research (see Section 1.4).
In line with the principles of system engineering (which form a substantial part
of the conceptual emphasis of this thesis) the author will use a structured
approach in the attainment of the research objectives.
Principally, it is the intention of the author to illustrate that the optimal

development of a financial product requires a two-pronged approach as
follows:
o The organisation must choose the 'correct' product to develop from a

strategic competitiveness perspective (the concept of strategic fit), and
o Once the financial product to develop is known, the organisation must

be able to develop that product faster and more efficiently than its
competitors and at a minimised total economic life-cycle cost if it
wishes to be successful in its target market.
Consequently, the author will develop a conceptualised Financial Product

Development Model based on the principles of system engineering and
incorporating a modification of the concept of strategic product fit as it applies
to the financial services organisation. The ultimate aim of this model is the
competitive enhancement of the financial product development process.
The issue of strategic product fit (competitiveness) will be introduced within

this thesis via the creation of a Competitive Strategy Framework. This
framework has as its function the collection and subsequent presentation of
7
Introduction
five strategic elements which the author will illustrate to be of critical

importance to the process of financial product development, both currently and
in the foreseeable future. The underlying concept inherent within the
Competitive Strategy Framework is that organisations involved in financial
product development should not lose sight of the fact that the products so
developed should contribute to the medium to long-term strategic aims of the
organisation. Developing a new product simply because 'everyone else is
doing it' will not maximise the value of the firm.
The use of the Competitive Strategy Framework is introduced within the

Financial Product Development Model through a process which the author has
termed the Strategic Circuit Breaker. The concept of the Strategic Circuit
Breaker has been adapted and modified by the author from that of a trading
circuit breaker as used on major stock exchanges around the world, and has as
its function the temporary suspension of the product development process for
such a period as is necessary for the organisation to ensure that the product
under development does adhere, and ultimately contribute, to the strategic aims
of the parent organisation.
The concepts so proposed will undergo a process of practical validation in

terms of the development of a financial product. This validation will be
followed by a limited scope industry survey which has as its purpose the
identification of industry perceptions with regard to the concepts proposed
within this thesis.
11.4 THE RESEARCH DESIGN AND METHODOLOGY
Cooper and Emory [32], while alluding to the problem based nature of research
describe the importance of descriptive research. It is pointed out that:
"...descriptive research is the stuff out of which the mind of man, the
theorist, develops the units that compose his theories. The very
essence of description is to name the properties of things: you may do
8
Introduction
more, but you cannot do less and still have description. The more
adequate the description, the greater is the likelihood that the units
derived from the description will be useful in subsequent theory
building." [32]
The author uses a combination of descriptive and investigative research in the

attainment of the stated objectives of the research. Specifically, the initial
chapters within this thesis rely primarily, but not exclusively, on descriptive
research as the mechanism via which the underlying fundamental concepts
inherent within this thesis are brought to the reader's attention. Four topics
receive such treatment, being the discipline of corporate risk management, the
principles of financial engineering, financial derivatives, and the role of system
engineering in the product development process.
This descriptive research is followed by the investigative research which is, in

effect, the heart of this thesis. The development of the Competitive Strategy
Framework and the Financial Product Development Model is illustrated here,
followed by the practical model validation and the limited scope industry
survey.
Further details on the thesis structure are provided in Section 1.6.
L5 DEFINING FINANCIAL PRODUCTS
Throughout this thesis the term 'financial product' will be used extensively.
This is a generic term used by the author to indicate the development of a
financial solution which is required to satisfy a specific need. Given this
definition the term 'financial product' may, for the purposes of this thesis, be
taken to mean either the creation of an intangible product (such as a derivative
instrument) which may be marketed as such or alternatively the creation of a
financial solution which has as its purpose the resolution of an identified need.
An example of such a financial solution may be the creation of a risk
management strategy for managing a particular financial risk or set of
9
Introduction
identified risks, or the design and development of an analytical risk analysis

algorithm. Such solutions are analogous to the provision of a service.
Note that the author makes a clear distinction between the terms 'financial
product' and 'financial instrument'. Within this thesis a financial product is
considered to consist of a collection of one or more financial instruments,
which serve to act as underlyings to the product concept.
It should therefore be apparent even at this early stage that the intangibility
associated with a financial product leads to the term being applicable in a wide
variety of circumstances. This emphasises the need for the results of the
research to be widely applicable with respect to the subject matter, a concept
inherent throughout the structure of this thesis.
1.6 REFINING A MODEL
The term 'model' is used extensively throughout this thesis. To this end the
author considers a model to be a representation of a system that is constructed
to study some aspect of the system, or the system as a whole. Models can be
used for both applied and highly theoretical purposes. The model developed
within this thesis was developed with a focus on the practical application
thereof.
Three types of models can be identified, being description, explication, and

simulation. The author has chosen to base the model developed within this
thesis on the explicative model format, being the use of models to extend the
application of well developed theories or improve our understanding of their
key concepts.
1.7 AN OVERVIEW OF THE THESIS STRUCTURE
This thesis has been structured in such a way as to ensure adherence to the
following concepts:
10
Introduction
o The concepts presented within the thesis must flow logically from one
point to the next in order to maximise reader comprehension of the
topics presented, and
o Given the diverse nature of the topics to be presented, the order of

presentation must be such that the reader has the requisite knowledge
of associated underlying fundamental theory at all stages within the
thesis.
The function of Part One of the thesis, which includes Chapters Two to Five,
is to provide the reader with all of the requisite information regarding the
nature of the research problem as well as the underlying fundamental theory
required for an in-depth understanding of the associated issues.
Part One begins with an illustration of both the importance and complexity of
financial innovation as described in Chapter Two: Financial Innovation and
Product Development. This sets the tone for the rest of the thesis since,
subsequent to this Chapter, the reader should appreciate the importance of
innovative financial product development in ensuring the strategic
competitiveness of the financial services organisation.
Chapter Three: Strategic Corporate Financial Risk Management is the

first in a series of four chapters designed to provide the reader with the
knowledge that will be required at a later stage within the thesis. Within this
Chapter the discipline of corporate financial risk management is illustrated. As
will be apparent upon completion of the Chapter, the need to manage financial
and business risk is a primary driver of the financial engineering process and
typically serves as the initiator of this process. It is therefore important that the
reader be familiar with not only the need to manage such risks, but also the
various methods with which this can be accomplished.
The concepts and techniques of financial engineering are covered in Chapter

Four: Financial Engineering: Concepts and Techniques. Financial
11
Introduction
engineering is a complex discipline, typically requiring the use of advanced

mathematics in conjunction with the ability to solve problems via the design
and development of financial products. This Chapter provides a brief overview
of the financial engineering function, concentrating on, amongst others, the
need for financial engineering, the financial engineering process, and some of
the techniques used in financial engineering. The complementary relationship
between the need to manage financial risks and the financial engineering
function is emphasised.
Chapter Four will also provide the reader with an overview of the concept of
value-at-risk, knowledge of which will be required for the practical model
validation as implemented in Chapter Nine.
Financial derivatives have historically been the most important products

created via the financial engineering process and as such an overview of their
types, properties and uses is included here in order to provide the reader with
an indication of the power and complexity of these instruments. This is
accomplished in Chapter Five: Financial Derivatives: A Corporate Risk
Management Approach. Upon completion of this Chapter the reader should
be left in no doubt as to the power of such products to control and manage risk
and, hence, the importance of the financial product development process both
in terms of creating the correct product for a given situation as well as having
the ability to create that product better and faster than competitors.
Part Two of the thesis has as its purpose the investigation of the research
topic, building on the theoretical foundations laid down in Part One. Here the
author suggests the use of the Competitive Strategy Framework with respect to
the product selection decision as well as a conceptualised system engineering
based model, the Financial Product Development Model, with respect to the
product design and development process. These two elements are integrated
through the use of the Strategic Circuit Breaker.
12
Introduction
Prior to the primary application of the research problem it is important that the
reader be familiar with the principles and techniques of system engineering in
as far as they may be applied to the product development process. Chapter
Six: The Role of System Engineering i Complex Syste s focuses on this
concept by detailing the need for system engineering, the importance of system
engineering, and the various ways in which system engineering may be used to
enhance the product development process.
With all of the fundamental groundwork complete the construction of the

Competitive Strategy Framework is illustrated in Chapter Seven: The
Financial Services Competitive Strategy Framework. Amongst others,
topics in this Chapter include the importance of selecting the 'correct' product
to develop, the importance of creating organisational competencies as a result
of the product development process, and the ways in which this process may
enhance organisational strategic competitiveness. In addition the author
describes the research process used in the construction of the Competitive
Strategy Framework as well as the importance of the application of this
framework in conjunction with the Strategic Circuit Breaker concept.
The development of the conceptualised system engineering based Financial

Product Development Model is detailed in Chapter Eight: The Financial
Product Development Model. This Chapter is the culmination of all of the
information presented up until this point. Included here is the methodology
used in the development of the model, the practical development of the model,
and the manner in which the model may be applied in the industry
environment.
Chapter Nine: The Financial Product Development Model: A Practical

plementation presents a detailed analysis of the practical implementation of
the system engineering based Financial Product Development Model
developed in the previous Chapter. The practical study involves the
development of a value—at-risk (VaR) system capable of determining value-at-
risk for a portfolio of financial securities which include non-linear securities.
13
Introduction
The purpose of this Chapter is to illustrate the results of the application of the
proposed model to a real world (practical) financial product development
project.
Research of the type presented here would not be complete without some
measure of input from the target environment. The author has elected to
conduct a limited scope industry survey, targeting product development
professionals within the financial services industry in order to gauge their
reaction to the concepts suggested here. The results of this survey can be found
in Chapter Ten: An Industry Perception of the Financial Product
Development Model. In addition to discussing the results of the survey this
Chapter will also illustrate the design and development of the survey
questionnaire in accordance with accepted survey design principles.
Part Two of the thesis terminates with Chapter 111: Conclusion. Schematically
the thesis structure is illustrated in Figure 1.2.
1.8 PEDAGOGIICAL FEATURES
Three pedagogical features are included within this thesis as follows:
o A Glossary of Terms is included towards the end of the thesis. The

function of this glossary is to illustrate and explain the meaning of
many of the technical financial concepts introduced within this thesis.
It is recommended that the reader make use of this glossary as and
when such terms may require further clarification.
o A list of Appendices is included toward the end of the thesis. These

appendices provide important information supplementary to the body
of the thesis.
14
Introduction
1. Introduction
2. Financial Innovation and Product

Development
3. Strategic Corporate Financial Risk

Management
♦
(
Part One
4. Financial Engineering: Concepts and
Techniques
5. Financial Derivatives: A Corporate Risk

Management Approach
6. The Role of System Engineering in

Complex Systems
The Financial Services Competitive

Strategy Framework
°
The Financial Product Development

Model
Part Two
The Financial Product Development
Model: A Practical Implementation
An Industry Perception of the Financial

Product Development Model
Conclusion
Appendices, Glossary of Terms,

Bibliography and Index
Source: Own Source
Figure 1.2 The Thesis Structure
15
Introduction
Appendix A: Derivative Contracts and Derivative Securities

provides a summary of the many types of financial derivative contracts
commonly used within the world's capital markets.
Appendix t: Rocket Scientists Are Revolutionising Wall Street,

extracted from the authoritative business and finance publication
BusinessWeek, details the increasingly important interaction between
the so called hard sciences (engineering, physics, mathematics) and
finance in the development of innovative financial products.
Appendix C: Creating A Synthetic Financial Security is a numerical

example of the concept of a synthetic financial security whereby a
standard put option is created using a call option, common stock and a
risk-free investment. The ability to create such synthetic securities
leads to the concept of no arbitrage, one of the most important in
modern day finance.
The world of financial product development is one subject to rapid

change and intense competitive pressures. The financial product
development landscape of the future is likely to exhibit significant
changes with respect to the current environment. As a result Appendix
D: The Future Financial Product Development Environment has as
its focus the identification and discussion of elements of change in as
far as their impact on financial product development is concerned. This
Appendix will prove useful to the financial services organisation in
that it will provide an indication of the future financial product
development landscape.
The survey form utilised in the limited scope industry survey is

illustrated to the reader in Appendix E: The Survey Questionnaire.
This form includes additional information not found within the body of
this thesis such as the biographical details requested from respondents.
16
Introduction
Appendix IF: The Value-at-Risk System is a brief description of the

value-at-risk system developed using the Financial Product
Development Model as detailed in this thesis. Its purpose is to provide
the reader with an appreciation of the end product since this is not
covered in the main text.
Appendix G: On-Line Risk Management Service Providers

provides details on a number of on-line risk management service
providers. The ability to provide such services over the internet has
been made possible by the innovative combination of technology and
financial expertise.
Finally, Appendix H: Option Pricing and the Delta-Gamma

Methodology covers the primary principles of the pricing of financial
options, knowledge of which leads to an understanding of the delta-
gamma value-at-risk methodology as discussed in this thesis. The
concepts discussed here are considered to be one of the most important
revolutions in financial theory over the past quarter century, leading to
the eventual award of the Nobel Prize in Economics to Myron Scholes
and Merton Miller.
o An index has been included at the end of the thesis. This index can be
used by the reader who wishes to find a specific topic covered within
this thesis.
1.9 CONCLUSION
The research contained within this thesis has as its function the strategic
optimisation of the process by which financially engineered products are
created. It is the intention of the author to illustrate how this process can be
enhanced via the use of applicable system engineering techniques. However
this is not enough. In order to be competitive in its target market the
organisation must ensure that its product selection process is able to integrate
17
Introduction
the need for the product development process to add to the strategic aims of the
organisation. Only by recognising the importance of selecting the 'best'
product to develop in conjunction with the ability to develop the selected
product optimally will the financial services organisation of the future be
competitive.
This thesis introduces three concepts developed by the author with a view to
the enhancement of the financial product development process. The
Competitive Strategy Framework is a collection of five key strategic elements
resulting from research by the author into the changing nature of strategic
product development. The Strategic Circuit Breaker is a concept developed by
the author to emphasise the need for the modern financial services organisation
to ensure that the product development projects undertaken are in fact able to
contribute to the strategic aims of the organisation. The need for this Strategic
Circuit Breaker is a function of the volatility inherent within the global capital
markets. Finally, both the Competitive Strategy Framework and the Strategic
Circuit Breaker are integrated within the Financial Product Development
Model which has as its purpose the exposition of a structured financial product
development process based on applicable system engineering techniques.
At the onset of the research process which led to the creation of this thesis the
author was of the opinion that the adoption of a structured product
development process would prove to be an extremely effective competitive
tool for the financial services organisation. This view has been reinforced
many times over. As should be clear upon completion of this thesis, the author
remains absolutely convinced that the key to the strategically successful
creation of financially engineered products in the 21 st century will be the
adoption of innovative, structured product development processes. It is the
intention of the author that this thesis will contribute to the body of knowledge
in this increasingly important field.
18
Financial Innovation and Product Development
Chapter 2
Tinancial innovation and Product Development
"You don't leap a chasm in two bounds." — Chinese proverb
"Incrementalism is innovation's worst enemy." — Nicholas

Negroponte, MIT Media Lab
"Wealth in the new regime flows directly from innovation, not

optimisation; that is, wealth is not gained by perfecting the known,
but by imperfectly seizing the unknown." — Kevin Kelly in 'New
Rules for the New Economy', Wired
2.11 NTRODUCTION
nnovation and successful competitive product development go hand-in-

hand. This has historically been the case in the manufacturing environment
and is without a doubt the case in the financial product development
environment. This is true for both product innovation (the development of new
products or the improvement of current ones) and process innovation (the
improvement of the processes that design, develop and sell the products).
Robert 11331 emphasises the importance of change in the innovation process.

Product innovation is seen to be the process of systematically anticipating,
recognising, and exploiting change. Change is seen as the raw material of new
product innovation.
While it is not the intention of the author to investigate the process of

innovation, an illustration of the rapid pace of change and hence the need for
product innovation within the financial services industry will serve as a useful
119
precursor to the main subject matter within this thesis. This is done in this
Chapter. Specifically:
The purpose of this Chapter is to illustrate to the reader both the critical
importance of product within the financial services industry as
well as the rapid pace of change inherent within this environment.
The data so presented will stand the reader in good stead in that it will allow
for a greater appreciation of the strategic potential of the Financial Product
Development Model to be developed at a later stage.
Amongst the topics covered in this Chapter will be the importance of product
innovation in the 2l st century, the primary drivers of financial product
innovation and the future state of financial product innovation.
2.2 THE ]IMPORTANCE OF PRODUCT INNOVATION IN THE 21 ST CENTURY
It should be clear even at this early stage that innovation and the resultant new
product development process within the financial services industry are
absolutely vital components of any financial services organisation's strategic
growth objectives. An excellent practical view on this issue is presented by
Brzeski and Martin [23]. In their view:
"The greatest risk associated with financial innovation is that of

failing to innovate." [23]
Stephen Friedman, a Senior Partner at Goldman, Sachs & Co., has observed
that many new companies are formed on the identification of a 'big idea' [23].
One need look no further than many of today's entrepreneurial companies to
find examples of this. Consider for example Netscape, whose founders realised
the need for internet users to have a powerful yet simple to use graphical
interface for accessing the internet. Or Jeff Bezos, the founder of
Amazon.com , the internet based online bookstore which provides access to in
20
excess of two million titles, who realised the potential of providing consumers
with a fast, efficient service to find and order books from the comfort of their
own home. Excellent examples of the power of product innovation indeed.
The importance of financial product innovation can be summed up with

reference to the following pertinent points [23]:
All too frequently organisations rely on past product successes as a

driver for organic growth. Such growth cannot last indefinitely and,
depending on the industry in which the organisation operates, can in
fact phase out over a relatively short time period.
Financial services firms are particularly susceptible to this danger

given that their products and services have shorter lives than those
found in the typical manufacturing industry. In order to be successful a
firm does not always have to be the first in the market with a new
product, but at the very least a 'fast second' is required in order to
avoid being shut out of the market. Innovation is therefore critical to
the continued profitable survival of the firm.
Innovation and new product development should not be seen in purely

defensive terms. The development of new financial products is in fact a
competitive weapon which can be used to attract new clients and gain
market share.
In recognition of the fact that innovation and technological change are

fundamental to economic growth, the South African Foundation for Research
and Development recently surveyed the use of innovation in the South African
manufacturing sector 1161. From the results of this survey it is clear that South
African businesses believe that -the ability to compete successfully in the
market depends more than ever before on the ability to develop and adapt new
21
innovative products and new production processes'. A sample of 244

innovative manufacturing firms indicated that they spent nearly 5 percent of
their turnover on the process of innovation and some 1.6 percent on research
and development. Most interesting was the indication that in undertaking
innovation most South African manufacturers are primarily concerned with the
ability of innovation to lead to increased market share. Four-fifths of the firms
surveyed indicated that market-related objectives such as increased market
share, reduced time to market and product quality were their main concern.
Seventy five percent of respondents indicated that they intended to use the
process of innovation within the following two years, with a similar proportion
indicating that they were more innovative than three years ago. It is thus clear
that in South Africa, as is the case world-wide, product innovation is playing
an ever increasing role in the strategic management of the organisation.
If the influence and importance of product innovation was considered

important in the past then the 21 st century is going to herald product innovation
as perhaps the most important competitive advantage that an organisation can
achieve. In a comprehensive study of this concept it was illustrated how the
growth of industrialised economies in the 1990s was no fluke [105]. More
importantly, it appears as if the so called 'New Economy' 2 which up until this
stage has been propelled mainly by advances in information technology may
turn out to be only the initial stages in a much broader era of creativity
(innovation) in technology, business and finance. Generically the information
revolution shows no signs of slowing down, and is in fact increasing in pace.
Biotechnology looks set to become a commercial reality with its associated
economic impacts, and scientists are currently working at the frontiers of
highly sophisticated technologies such as nanotechnology.
The profound effects of innovation are not limited to single organisational

entities operating within fixed markets. Entire economies are affected by the
I Note the emphasis on processes here. This is particularly interesting given that the underlying
theme of this thesis is the improvement of the financial product development process.
2 A term used by Business Week in reference to the knowledge based economy of the 1990s.
22
ability to innovate. The United States for example was described as a mature 3
market by economists in the 1980s as a result of the low growth rates which
the economy had experienced for some time. There is however growing
acceptance on the part of economists that the United States, with an average
3.5 percent growth per annum in the 1990s, is riding the crest of an innovation
wave. It is estimated that over the last year high-technology has taken half a
point off inflation and contributed almost a full point to growth [105]. And this
phenomenon is not unique to the United States but can be found in
industrialised countries all over the world. As is stated by Arnold B. Baker,
head economist at the Sandia National Laboratories:
"There's going to be a fundamental change in the global economy

unlike anything we've had since cavemen began bartering." [105]
Historically periods of innovation have proved to be an economic boom for the

world's population in general with profound increases in living standards.
From the invention of railroads in the 1890s to television and jet travel in the
1950s and 1960s the latest period of innovation has seen a quadrupling of real
per capita incomes along with rising productivity. Such a scenario means good
business for those organisations that are able to capitalise on such innovation.
However, only those that are able to identify the need for innovation within the
global economy will realise their true potential. Indeed, those organisations
that are not able to adapt to the need for innovation may find themselves
outgunned in critical areas by those that are. Increased globalisation will
simultaneously provide much larger markets with correspondingly tougher
competitors.
The increasing emphasis on innovation is in part driven by past developments

which are only now beginning to show their worth. The internet for example
was born out of a desire by the United States to ensure that they would have
uninterrupted lines of military communication in case of a nuclear attack by
3Economists define a mature economy as one which is no longer able to sustain the high growth
rates typically found in young economies undergoing significant economic expansion.
23
the then Soviet Union. Biotechnology, which according to Sunter [154] will
form the next Kondratieff Wave' s, has its roots in the first gene splicing
experiment conducted in 1973. Biological techniques now appear to be the
solution to the next wave of super-computers. In addition to past developments
innovation is also driven by the increasing globalisation of world markets.
Innovative ideas developed anywhere in the world are now apt to find their
way to those markets where the result can be most profitable for the creators.
This prospect of profitability has in turn led to a decrease in research and
development times as companies compete to be the first to market with a new
product.
Some economists argue that the future is unlikely to see economic growth rates
similar to those that have been experienced previously. This prediction is based
on the failure of certain technologies over the past two decades to live up to
their promise. Nuclear technology was supposed to provide the world with a
safe, clean, virtually unlimited source of energy. Space travel, which was
declared by John F. Kennedy as America's top scientific priority, has not
become a commercially viable prospect [105]. However, what such economists
ignore is the fact that the majority of the technological failures (from an
economic point of view) over the past two decades have been driven by
governments with set agendas and little if any regard for costs. Future
innovation will not follow such a route, but will be driven primarily by
commercial organisations who have the attainment of profit as their primary
objective. One can therefore expect areas of innovation to be much more
commercially viable than in the past, leading to greater opportunities for profit.
Business success in the 21 st century will to a large degree depend on the ability
of the organisation to innovate and to develop new products which will be the
first to satisfy the needs of the target market. This applies not only to
conventional manufacturing based firms, but to service based firms as well. It
certainly applies to those firms that create and market financial products. If
4 Kondratieff waves, so named after the Russian who first drew attention to these long-term cycles,
refer to the concept of economic upswings which follow significant technological enhancements.
24
anything this concept applies even more rigorously to financial services firms
than those in other sectors of the economy given the historic and projected
future growth of this industry.
In addition to the general need to be innovative, it is a known fact that in times

of extreme change volatility increases [166]. In the 21 st century technology
shocks will increase economic and financial volatility on a global scale. This is
an important point because, as will be seen in subsequent chapters, financial
engineering as a discipline is involved primarily in the creation of financial
products in order to manage, transfer and avoid both business (operational) and
financial risks. One can therefore expect financial engineering to play an ever
increasingly important role in the management of volatility. There is thus
tremendous opportunity for financial services organisations to take advantage
of this fact and in so doing to become market leaders.
2.3 THE DRIVERS OF FINANCIAL PRODUCT INNOVATION
Over the past number of years financial services companies have devoted
extensive resources to the development of new products to the point where
revenues generated from new products now make up a substantial percentage
of total profits. One need look no further than the creation of financial
derivatives to understand the extent of this phenomenon. From non-existence
in 1973 the market for financial derivatives has grown to one currently
measured in trillions of dollars [13].
This growth has not happened by accident. There are fundamental drivers
associated with the growing importance of financial product development [23].
The more important of these drivers are briefly described here:
o New financial product development has historically been driven by tax

and regulatory issues as well as fundamental economic and capital
market conditions. However, a new factor has emerged. Advances in
telecommunications and information technology as well as more
25
powerful computers are proving to be a substantial driver of new

product development. The ability to perform calculations faster means
that new opportunities can be identified in the financial markets for
which products may be delivered.
Financial product development is a self-reinforcing process. As one

product is developed so new risks are identified which in turn require
active management on the part of the organisation. For example, many
new product developments in the derivatives market are a result of the
need for firms to hedge their risks when trading in the futures and
options markets, the primary source of 'conventional' derivative
securities.
The need for firms to hedge against economic risks has increased over
the past decade. As economic and global conditions change so too
must these firms change their risk management strategies in order to
ensure that they are using the most appropriate strategy. This typically
requires new products in order to manage newly created risks.
The producer of a financial product may be able to take the opposing

side of a risk position should they so desire.
Note once again that the term 'financial product' as used here may refer to a
product in the conventional sense of the word (although the product is
intangible) or may refer to a service offered by the financial services
organisation.
2.4 THE CURRENT AND PREDICTED FUTURE STATE OF FINANCIAL PRODUCT

INNOVATION
Contrary to popular misconception, financial engineers do not wear white

coats. They do not spend their days in the lab slaving away at some
meaningless technology. Their raw material, money, isn't as exotic as those
26
used by physicists and geneticists, but the impact of their efforts on the
economy can be just as great as, and often exceed, those made by the more
conventional hard science fields 1341. It can certainly be argued that without
money all other scientific discoveries are simply a bunch of clever concepts.
Underpinning the entire science of financial engineering is the concept of
product innovation. Innovation in one form or another is the driver, the
irresistible force, which propels financial engineers to push the boundaries of
financial technology in the quest for products which may add economic value
to the firm. In the world within which financial engineers work it can truly be
said that the only constant is change. Products which worked two years ago
may not do so today for a wide variety of reasons: changes in taxation laws,
changes in the global and local capital markets, new risks which have been
created. Within this environment the term 'innovate or die' is no misnomer.
It is predicted that finance in the 21 St century will master money in the same
way that computers mastered data and biotechnology has begun to master
DNA 1341. This will be achieved by financial engineers who, with their new
theoretical tools, will be able to break down any security into its constituent
components and repackage such components so as to achieve a more optimal
configuration targeting a specific need. In the 21 St century the need for
innovation in finance will increase as a result of globalisation on an enormous
scale. As competition increases and margins get ever thinner the need for
businesses to become more creative will become devastatingly apparent.
Certainly, according to Henry Weil from the Massachusetts Institute of
Technology's Sloan School of Management:
"...financial services will be almost indistinguishable from any other

software business, with continual innovation and pre-emptive
cannibalisation." 1341
The 21 St century financial services landscape will be characterised by two

distinct types of financial services organisations. On the one side will be those
mega-corporates, global companies each with a full array of products and
27
services, where their sheer size will allow them to compete on the basis of cost
reduction. On the other extreme will be niche companies specialising in
particular aspects of the financial services industry. These specialist companies
will survive by doing things either extremely cheaply or exceptionally well.
Organisations between these two extremes (referred to as the 'barbell' effect)
will not survive.
Simplistically speaking, financial engineers view every investment opportunity

as a bundle of separate but identifiable risks. Using this knowledge investment
opportunities can be broken down into separate bundles, repackaged and sold
to investors who are willing to pay more for the newly created security. The
benefits of financial engineering are not only limited to companies operating
within the sphere of financial services though. Using financial engineering
Cargill Inc., the $51 billion commodities trader and processor, is able to
guarantee the price of airline omelettes to its customers for up to a year in
advance [158].
As an example of the broad sphere to which financial innovation can be

applied, and in particular the fact that such innovations do not necessarily have
to be associated with pure finance, consider the emergence of so called 'live
cat' (short for live catastrophe) coverage. As extreme weather conditions such
as a hurricane approach shore property insurers can reduce their risk exposure
by purchasing catastrophe-index call options on the Chicago Board of Trade
(CBOT). As the danger from the storm increases or decreases so the option
value changes in line with factors such as wind speed indicators. In a worst
case scenario profits from the purchased options help to offset losses from the
resulting insurance payments.
A recent survey of business editors and correspondents based in the United

States indicates that many of today's top positions relating to financial product
innovation are held by an increasingly younger, higher educated, workforce
[31]. Examples of such innovation include the practice of information age
marketing whereby highly sophisticated techniques are used to analyse existing
28
and potential customer preferences and probability as well as the use of

computerised credit scoring techniques in the allocation of credit in order to
reduce risk and enhance profitability. It is interesting to note that the issue of
financial management is regarded by many people as being one of the single
most important issues for the coming century 134 Increasing global volatility
has indicated in no uncertain terms the need for organisations to have a clear
and comprehensive risk management strategy. When it comes to understanding
the risks of open markets and economies there is little doubt that today's
generation will prove to be the best equipped to analyse and manage such
risks, if only because of past experiences.
Much innovation within the financial markets today comes from what is
commonly known as 'the new rocket science'. This term refers to the
increasing use of hard science techniques such as those found in physics and
mathematics in the analysis of financial elements such as trading, corporate
finance, investment banking and securities analysis. Such techniques have been
in use for at least a decade, but up until recently they have relied solely on the
ability to crunch numbers, to carry out existing methods of analysis at a faster
rate.
This is not the case any longer. Modern methods of analysis use increasingly
complex concepts such as neural networks, genetic algorithms, chaos theory,
fractals and expert systems to provide solutions to existing problems or to
increase the profitability of the firm. Techniques such as those found in neural
networks, expert systems and genetic algorithms attempt to solve complex
problems by simulating human thought processes. Chaos theory and fractals
help to explain the complexities of issues as diverse as weather patterns,
coastlines, and financial securities markets. While many of these concepts are
still in their infancy in terms of practical application within the financial
product development environment, there is no doubt that they will be playing
an increasingly important role in future product innovation 1139].
29
Neural networks in particular have captured the attention of market

participants. Such neural networks, combined with genetic algorithms, show
much promise both in terms of existing results and potential results for the
future [172]. The only drawback however is of course the fact that finding
people with the right skills in order to design and construct such products is
not a simple matter. However, increasingly institutions such as the United
States Department of Defence are losing highly skilled specialists to the
financial services markets where they can apply their skills and at the same
time earn huge salaries. Consider the case of Troy Nolen who, throughout the
1980s, helped create top-secret military software for the United States. Hired
as a defence contractor, Nolen helped create the software for guiding the flight
and battle plans for the YF-22 fighter. Today, working for Merrill Lynch &
Co., Nolen is developing a system to accurately set daily prices for more than
one million corporate bonds. In order to achieve this Nolen is building a neural
network running on a parallel-processing computer. Modelled after the human
nervous system the neural network continuously sifts through massive amounts
of data looking for patterns which can be used in the prediction of prices. This
in conjunction with the ability to combine the effect of economic indicators
into such predictions is a very powerful tool indeed [139].
Merrill Lynch is not the only company to adopt such high-tech innovation.
Shearson Lehman Brothers Inc. have been training their own neural network in
order to help their traders more accurately forecast market patterns. For the
past three years this program has been managing its own small portfolio. In the
first year it lost money, in the second it broke even, and the third year is on
course for a profit s [139].
Yet another innovation in the financial markets is the use of chaos theory as a
predictive mechanism. While the use of chaos theory is still in its infant stage,
and indeed many professionals remain_ sceptical of the practical use of such
theory, there is no doubt that great strides are being made in the practical
5Note that this is a typical characteristic of neural networks as their very function is to 'learn' from
past mistakes.
30
application of such theory to the investment function [162]. Chaos theory,

which along with most other innovations was brought to the financial markets
via academia, is the only revolutionary way of looking at the financial markets
since the 1960s when modern portfolio theory was first developed. The reason
for the scepticism on the part of many professionals is that chaos theory turns
one of the long held investment beliefs on its head — that investors act
rationally and that the financial markets are efficient. Contrary to its name, one
of the theoretical underpinnings of chaos theory is that natural systems and the
markets aren't chaotic in the conventional sense. Instead chaos theory
maintains that things which may seem random are in fact simply following
their own set of rules. The appearance of randomness is a function of the
inclusion of feedback loops whereby yesterday's events affect today's and
tomorrow's events will be affected by the combination of yesterday's events
and today's events.
Chaologists may yet have a substantial impact on portfolio management.

However, they adopt an approach to portfolio management which, in many
ways, contradicts the long held beliefs as specified by conventional portfolio
theory. In particular they believe that [1621:
Following and predicting market movements requires a new type of

mathematics — according to chaologists since markets may be
described as complex non-linear systems they must be analysed using
fractals (a mathematical tool which is used to describe complex
objects).
The financial markets are analogous to natural phenomena —

chaologists favour the use of statistical stratagems developed over the
years to study the social and natural sciences as a means of predicting
market movements.
The stock markets are not efficient — chaologists disagree with the
notion of an efficient market in which prices instantaneously reflect all
31
available information. According to them this can never be the case

since investors interpret information irrationally.
o Prices do not follow a random walk — chaologists believe that the

notion of prices following a 'random walk' is incorrect and that such
prices move in a more complex, but predictable, fashion.
Perhaps one of the fastest growing innovations in finance is that of

securitisation, whereby existing loans and receivables are broken down,
repackaged as securities (known as asset-backed securities) and sold to
investors who may then trade in such securities. Securitisation can take place
on receivables as diverse as housing loans, car loans, trade receivables,
hospital receivables, computer leases, loans on bankrupt companies and future
royalties earnings. Such asset-backed securities issued by non-governmental
agencies has mushroomed into a $50 billion market. The biggest securitised
market is the $1 trillion plus market for government backed home mortgages in
the United States [37].
If the growth in securitised assets has been phenomenal in the past, it has been
explosive in recent times. As far as Wall Street is concerned the sky is the limit
for securitisation. According to Andrew D. Stone, senior managing director in
charge of mortgage and asset-backed securities at Daiwa Securities America
Inc.:
"You can securitise virtually everything. The imagination is our only

constraint, and time, because you can't chase every deal." [37]
Securitised assets are popular with investors because they typically offer high
yields backed by investment grade ratings. By transforming illiquid risky loans
into less risky and liquid securities securitisation has attracted many followers.
This is in part achieved by the increased diversification of single loans as well
as the additional investor protection demanded by rating agencies.
32
Innovation within the financial services industry is dramatically changing the

role of top management, a trend which looks set to increase in the 21 st century.
New tools, often mathematically based, are making it imperative for top
management to not only be technology literate but also to understand the
impact of an increasingly diverse array of technologies on the businesses
which they run. For example, after Hurricane Andrew which ravaged South
Florida in 1992 and led to the bankruptcy of several small insurers and near
disastrous consequences for bigger insurers, researchers from IBM developed a
method of stochastic programming 6 to help insurers decide how much of their
investments to keep liquid for use in such emergencies 7 [36].
The use of such higher mathematics has typically been something that most top
executives have not had to worry about. This situation is however changing
rapidly. Management who fail to exploit the new tools either through
ignorance or fear are doing their organisations a terrible disservice, and may
even be failing in their fiduciary duties. There is still a need for human input
into decisions which may be based on the increasingly sophisticated techniques
in use today. One way in which this combination can be achieved is through
the use of data visualisation in which colour, form, motion and depth are used
to present masses of data in a more coherent, comprehensible way in order to
allow management to make the correct decisions. For example, in a program
developed by Andrew Lo, the head of financial engineering at the
Massachusetts Institute of Technology, a decision maker can use a computer
mouse to 'fly' over a three-dimensional landscape representing the risk, return
and liquidity of the company's assets. In this way, and with practice,
executives are able to easily identify areas where the trade-off between risk,
return and liquidity is the most crucial [36].
6Stochastic programming is used to analyse the impact of several variables in an attempt to derive
an optimum investment strategy.
The issue of investment liquidity is important for insurers because, as happened in the case of
Hurricane Andrew, a shortfall of liquid assets leads to the need to liquidate long-term assets such
as bonds at a significant cost.
33
2.5 CONCLUSION
This Chapter has illustrated the growing importance of product innovation as a

source of organisational competitive advantage, both in general and within the
financial services industry in particular. Organisations, financial or otherwise,
can no longer rely on past successes as a means of ensuring business success.
The economic environment of the 21 st century will be one of intense
competition where only those organisations that are able to both identify the
need for and subsequently develop superior innovative products will survive.
While the increasing importance of innovation is a general phenomenon

affecting all industries world-wide, the financial services industry, and in
particular the science of financial engineering, will be strongly affected by this
trend. This is due, in part, to increased volatility both within the world's
capital markets and within the internal organisation itself. Recognition of the
role which new products can play in counteracting such volatility will be a key
to business success for financial services firms in the 21 st century as there is a
tremendous opportunity inherent in the design and development of financial
products required by the market.
Note though that the move towards more innovative products introduces
increased levels of complexity in the development of the financial product.
Consider for example some of the cutting edge techniques used in financial
engineering as described in this Chapter. Concepts such as neural networks,
genetic algorithms, chaos theory and complexity theory, to name but a few, are
all being developed for application within the world's financial markets. As a
result the development of financial products, while never an easy task, is
simply becoming more complicated as competing organisations strive to gain a
vital competitive edge in an already intensely competitive market.
Given these intense competitive pressures, how can the financial services
organisation increase its competitive position within the market? Throughout
the remainder of this thesis the author will show that at least one of the keys to
34
increasing the strategic competitiveness of the financial services organisation

is a process of structured innovative product development. Conceptually the
solution is simple: (1) make sure that the best product from a strategic
organisational perspective is chosen for development, and (2) develop that
product more efficiently than your competitors. Practically however this is
somewhat easier said than done.
This Chapter has illustrated the growing strategic importance of product

development within the financial services industry. However, what is the
primary driver of the requirement for such financial products? After all, every
product, financial or otherwise, is developed in response to a perceived need
(whether real or not). The following Chapter has as its topic a concept which
has been responsible for the initiation of the vast majority of financial products
over the past twenty five years. This concept is that of the need for
corporations to manage their inherent risks, both financial or otherwise, in an
increasingly volatile business environment. No thesis concerned with the
development of financial products would be complete without investigating the
role of the corporate risk management function in the initiation of the need for
financial products. To this end Chapter Three will focus on the corporate risk
management function with specific attention given to the importance of
financial products in this function.
35
Strategic Corporate Financial Risk Management
Chapter 3
Strategic Corporate 7inancial Risk Management
"The greatest difficulty in the world is not for people to accept new
ideas, but to make them forget about old ideas" — John Maynard
Keynes, economist
"All of life is the management of risk, not its elimination." — Walter

Wriston, chairman of Citicorp
"Risk management —the theory of particle finance" — Charles

Sanford, chairman of Bankers Trust
IINTRODUCTIION
/i t is said that the true business of financial institutions is not so much to deal
2 in cash and securities as to manage risks. Accordingly, such institutions
face not only the potential default of counterparties, but also the price risks
associated with volatile assets and liabilities, while their day-to-day business is
fraught with a multitude of operational, legal, tax and regulatory
considerations - a business which grows continuously in volume and
complexity 121 . Increases in commercial risks as a result of volatility within
the global financial markets have led to the need for firms to adopt a much
more proactive approach to financial risk management than has been necessary
in the past. No longer is the concept and responsibilities of financial risk
management delegated to a middle manager within the firm. Events over the
past number of years (particularly those involving the destruction or near
collapse of major firms) have provided top management with the incentives
necessary to ensure that the management of the firm's financial risks enjoys a
high priority.
36
If the true business of financial institutions is indeed to manage financial risk,

then this business is not getting any easier. Revolutions in the economic
sciences combined with advances in computer and information technology
have led to the transformation of global financial markets on a scale that would
have been unimaginable merely twenty years ago. With such transformation
has come increased complexity, both in terms of identifying risks as well as
managing such risks. This increased complexity has served to highlight the
limitations of existing methods of financial risk management, resulting in the
creation of a new discipline, one which is able to marry the concepts and
techniques of financial theory, mathematics and computer technology. This
new profession has come to be known as financial engineering.
Business activity, by its very definition, involves financial risk. Commodity

prices may affect the cost of goods sold which in turn will affect sales. Interest
rates affect the interest expense related to debt and the interest income on spare
cash. If a company pursues business opportunities in another country it is
subjected to foreign currency exposure risk. Such risks are typical, some would
even say unavoidable, in the pursuit of business profits. However, while it may
not be possible to directly avoid financial risk, it certainly is possible to
minimise it, transfer it, or even exchange it for different risks which the
corporation may be happier to accept. This is the purpose of the financial risk
management function. As will be seen throughout this Chapter, a common
misconception regarding financial risk management is that the primary
function of this discipline is to eliminate risk. Nothing could be further from
the truth. In a free market economy the total elimination of risk results in the
elimination of business opportunities.
The discipline of corporate risk management is a primary driver of the use of

financial products and, consequently, the importance of the discipline of
financial engineering. As such the corporate risk management function can be
viewed as the starting point or the initiator of the financial engineering
process. This makes an understanding of the need for financial risk
management vital. Consequently:
37
The purpose of this Chapter is to present to the reader a brief overview of

the corporate financial risk management function in as far as its importance
as the initiator of the financial engineering process is concerned.
In order to accomplish this task the Chapter starts off with a definition of risk,
followed by an exposition on why it is necessary for the organisation to
actively manage both business and financial risks. This is followed by a
discussion of the various types of financial risks as well as the arguments both
for and against hedging as a means of risk management. Finally, the author
presents a number of brief examples of modern day failures in risk
management in order to illustrate the destructive effects of a failure to
recognise and manage risk within the corporate environment.
Following this Chapter the reader should begin to understand the causal
relationship between the need to manage financial risks and the financial
engineering function as a provider of appropriate products in order to achieve
this goal. This relationship will be emphasised further in Chapter Four and
Chapter Five.
3.2 DEFINING CORPORATE FINANCIAL RISK MANAGEMENT
It was Bertrand Russell who best summed up the discipline of risk

management as follows:
"A life without adventure is likely to be unsatisfying, but a life in

which adventure is allowed to take whatever form it will, is likely to
be short." [106]
This, in short, defines the very essence of risk management: the total avoidance
of risk is typically impractical and, in most cases, undesirable, but it is
nevertheless necessary to channel various risks into forms which may be better
controlled by the organisation or at the very least may provide the organisation
38
with an increased ability to control and manipulate such risks to the ultimate
advantage of shareholders.
However, before one can design ways in which to 'manage' risk, an

understanding of what is meant by the term is required. Galitz [59] provides us
with a simple yet powerful explanation of the concept of risk as follows:
Risk is any variation in outcome :
By definition not only is the possibility of an unexpected negative outcome

regarded as a risk, the possibility of an unexpected positive outcome is also
regarded as a risk.
Risk management may further be defined as a scientific approach to the

problem of dealing with the risks facing business and other organisations that
seeks to achieve identifiable objectives by avoiding, reducing and transferring
risk [160]. Essentially the science of risk analysis and management has its roots
in the field of corporate insurance buying where the concept first gained
prominence in the mid 1960s. Since then risk management has evolved to its
present state where, in the opinion of many authors [160],[163], it may be
considered to be both an art and a science. Thus while the field of risk
management is based primarily on quantifiable parameters which may be
measured and calculated it is something of an 'art' to be able to construct and
evaluate such quantifiable parameters in order to arrive at a best estimate of
what the future may hold.
It is possible to identify two elements of risk analysis and management which

are universal, irrespective of the environment in which the notion of risk may
be used. These two elements are (1) indeterminacy, and (2) loss. The notion
that an outcome_ may be indeterminate isimplicitin_all_definitions of risk. in
other words, there must always be doubt as to the eventual outcome. If there is
no doubt, there is no risk. If we know for certain that a loss will occur as a
result of a specific course of action then there is no risk implicit in the
39
decision. The loss will occur, and our subsequent probability of being correct
is one hundred percent.
The second element in the definition of risk is that at least two outcomes must
be possible (this follows as a natural consequence of the first element), one of
which is typically undesirable. This 'loss' may take the form of a physical loss
with which the term is most often associated, or it may take the form of an
opportunity loss as a result of a less than expected outcome.
Typically, total corporate risk can be thought of as a combination of a number

of different factors [8], as shown in Figure 3.1. Note the distinction between
business risk and financial risk.
Credit Interest Rate

Strategic Liquidity
Regulatory Currency
Operating Settlement
Commodity Rack
Human Resources
Legal
Product
Source: Beaver, William H.; Parker, George; Risk Management:

Problems and Solutions McGraw-Hill Inc. 1995 [8]
Figure 3.1 Total Financial Services Firm Risk
3.3 WHY MANAGE RISKS?
The question of whether an organisation should actively take steps in order to

manage its risks is one that has led to vigorous debate amongst academics and
40
businessmen alike. One of the first and best known results of academic
research is that as proposed by Modigliani and Miller [108]. They argued that in
a hypothetically perfect market setting a firm adds nothing to its share value by
actively managing its risks. The assertion is that investors would not pay a
company to do something which they could do themselves at a lower cost.
Theoretically the investor is in a better position to manage risks since his risk
preference may be satisfied by a combination of hedging, remaining unhedged,
and reversing any of the firm's risk positions.
However this hypothesis, as proposed by Modigliani and Miller, was for a

theoretically perfect market setting. Recognising that this was not likely to be a
realistic scenario Modigliani and Miller theorised that if risk management was
important, it must only be because of imperfect market conditions such as
taxes, bankruptcy, agency and other transaction costs. They reasoned that if
risk management is important it is because it is able to cut the tax bill, provide
better managerial incentives, or save the firm transaction costs. In each of
these cases the firm is able to do something that the investor cannot [111.
The question of risk management is one of when to increase or decrease risk.

Both scenarios have distinct advantages and disadvantages. Two dominant
points of view stand out, namely that of the debt holder who extends credit to
the firm on the presumption that it will be paid back with interest and that of
the equity holder who invests money in the firm in expectation of a positive net
return on investment [22]. Debt holders care about firm performance to- the
extent that the firm makes enough money to cover the cost of its operations
and to accommodate the repayment of financial debt, and for this reason most
arguments favouring risk reduction focus on the availability and cost of
capital. Equity holders tend to take a more balanced view between increased
and decreased risk, and generally find it in their interest to accommodate the
debt holders' desire for reduced risk, particularly if it means that capital can be
obtained at lower interest rates.
There are four main reasons for reducing the risks faced by a firm 1811:
411
The cost of financial distress - Many people would argue that if risk is
a zero-sum game r then the cost of managing that risk, no matter how
small, would outweigh the expected benefits. However, this only holds
true if the risk of gain or loss on shareholders is symmetrical. In other
words, only if the absolute value of a gain equals the absolute value of
a loss of the same magnitude. We know that this is not the case. A
corporation earning $500 million per annum would be much more
severely affected by a loss of $400 million than a gain of $400 million.
While the gain would be beneficial to the firm, the loss would have a
cascading effect in creating problems since access to credit or capital
may be restricted as a result of the inability of the firm to honour
outstanding debt.
Debt capacity/cost of debt - Corporate debt holders are well aware of

the risk of firms not being able to meet their obligations due to a
number of possible scenarios such as liquidation or insufficient cash
flow. Therefore, from a risk point of view, one should insure the ability
to pay if the cost of such insurance is more than offset by the cost of
issuing additional securities or increasing exposure to debt.
Investment capacity - External investment capital may be costly to

come by when it is required, particularly if the firm has difficulty
convincing potential investors of the viability of a proposed project. In
order to avoid this scenario firms may use risk management techniques
which will ensure the availability of capital in the future at the time
when it is most needed. For example, JCI, the South African mining
company, used a well known financial technique in order to sell
forward eight and a half years of output from its Western Areas gold
mine in order to fund investment in the project [114]. If the investment
A zero-sum game is one where any gain must be balanced by an equal and opposite loss. For
every one dollar that someone loses, someone must gain one dollar. A characteristic of many
derivative instruments is that they are zero-sum in terms of cash flows, though not in terms of
economic efficiency. Every profit made by the use of such an instrument is accompanied by an
equal and opposite loss [60].
42
is successful the firm will find available capital at much better terms
when such capital is required.
o Return on risk capital The return on risk capital argument essentially

-
specifies that the risk management technique which provides for the
greatest return on shareholder capital should be used. For example,
many firms use a strong equity base (shareholder capital) as a hedge
against the unexpected. The questions is could this capital be more
efficiently used elsewhere? If it could, then the firm is better off doing
exactly that. If the use of financial derivatives would allow the
company to hedge a particular risk which was previously covered by
shareholder capital then many people would argue that this should be
done, with the capital returned to the shareholders who may make
better use of it [22]. From an economic standpoint the question is who
or what can bear a particular risk most efficiently?
Having investigated the need to reduce risks there are nevertheless good
reasons why a firm should increase its risks. Risk management should
ultimately reflect the risk preferences of shareholders in the firm 1811. While
debt holders would obviously prefer to see a minimum risk approach,
shareholders require that optimum use is made of their share capital so as to
provide a maximum risk-adjusted rate of return. A firm that adopts a policy of
requiring no more than a 0.1 percent chance of default on debt while
shareholders would be willing to accept 1 percent may consider investing in
the additional opportunities that would be opened up [81],[102].
3.4 TIHIE VARIOUS TYPES OF FINANCIAL RISKS
Commercial risks can generally be divided into either business risks or

financial risks [8], as illustrated in Figure 3.1. Financial risks can further be
classified as one of the following general types of risk [1161:
43
Strategic Corporate FinancialRisk Management
Market risk
Interest rate risk
Liquidity risk
Currency risk
Credit risk
3.4.1 Market Risk
Market risk refers to the risks associated with investments within the financial
markets. A technique used to reduce the overall risk of a portfolio of financial
investments is diversification, where additional securities are included in a
portfolio with the intention of reducing the overall risk of the portfolio [22],[17].
However, portfolio diversification can only eliminate a certain amount of risk,
commonly known as unique risk, firm specific risk, nonsystematic risk, or
diversifiable risk [17]. The risk which cannot be eliminated by the use of
portfolio diversification techniques is known as market risk (also referred to as
systematic risk or nondiversifiable risk).
3.4.2 Ifffitterest Rate isk
Changes and fluctuations in interest rates can affect the liquidity of a firm as a
result of fluctuations in the price of financial assets. The 1970s and 1980s saw
the failure or near failure of many financial services firms in the United States
as a result of an inability to correctly recognise and price interest rate risk
which was assumed in the course of doing business [116]. Typically most firms
attempt to minimiseinterestrate risk by 'locking in' known interest rates for a
predetermined period. The term 'locking in' refers to the steps taken by the
organisation to structure its exposure, to interest rate risk in this case, in such a
44
manner so as to ensure that the real level of interest rates remains constant
irrespective of any movements in the underlying.
3.4.3 Liquidity Risk
Liquidity risk refers to the risk of a firm not being able to meet its financial
obligations. In the case of financial intermediaries liquidity risk usually takes
the form of an inability to pay withdrawals when requested to do so. In order to
keep liquidity risk in check a firm must ensure that the maturity profiles of its
liabilities closely matches that of its assets. A reasonable shift in interest rates
should not threaten this relationship and in so doing threaten the continued
existence and viability of the firm.
Liquidity risk has a further meaning in that it is often used to refer to the risk
of being unable to unwind a position in financial securities due to a lack of
trading activity in the security. In this case liquidity in the market for that
security is assumed to be low, leading to a significant risk of financial loss for
the organisation looking to sell the securities.
3.4.4 Currency Risk
Currency risk arises as a result of the volatility of exchange rates between two
different currencies. Any firm which receives or makes payments in a foreign
currency is subject to currency risk. As a result, currency risk is often a form
of hidden risk on the balance sheets of companies that derive a substantial
proportion of their earnings from overseas subsidiaries or that rely heavily on
imports and exports. The management of currency risk most often takes the
form of 'locking in' fixed rates of exchange for a predetermined time period so
as to reduce the possible consequences of a negative change in exchange rates.
The ability to do this has, however, only come about relatively recently as a
result of the creation and use of financially engineered products such as
financial derivatives.
45
3.4.5 Credit Risk
Credit risk is related to the degree of uncertainty of a counterparty's ability to

satisfy their legal obligations. This risk is assuming increasingly important
proportions as volatility within the world's capital markets increases. As such
the past number of years has seen tremendous growth in the use of financial
products developed to allow organisations to manage such credit risks, the best
example of which are credit derivatives (financial contracts designed to offset
the risk of loss as a result of a credit default by a counterparty) [82].
3.5 HEDGING AS A MEANS OF RISK MANAGEMENT
It is said that the concept of risk brings together two words: hope and fear.
When dealing with financial risk most organisations wish to retain the hope of
a favourable outcome while eliminating the fear of a negative outcome [62].
Consequently every risk management process starts with the identification of
risks to the organisation. Once these risks have been identified the manner in
which they are dealt with is dependent on a number of factors. In general five
such factors can be identified as follows [62]:
Competitive structures within the industry
Degree of tolerance for cash flow volatility
Access to financial resources
Sophistication/understanding of the financial alternatives available
Compensation strategies for the treasury/group finance function
In as far as the management of financial risk is concerned decision makers

have one fundamental decision which needs to be made: should the risk be
eliminated, ignored or hedged?
46
The elimination of the identified risk is typically not a viable option since it is
known that the total elimination of risk leads to the elimination of business
opportunities. The fundamental decision thus becomes one of whether to
simply ignore the risk and to build the possible cost of the risk into the
organisation's cost structure, or to take active steps in hedging the risk. Within
this context the term 'hedging' refers to the actions necessary to institute an
arrangement the effect of which is to counteract the potentially harmful effects
(typically financial) of the identified risk.
Much research has been conducted on the merits (or not) of active hedging and
proponents for and against such hedging can be found throughout industry
[62],[155]. Over the years opponents of the active hedging theory have produced
a number of theorems which are meant to prove the inappropriateness of active
hedging. Such theorems take the following form:
o The hope of favourable price or rate movements — Many

organisations do not hedge their risks because hedging would reduce
their ability to benefit from favourable price or rate movements.
However, in so doing such organisations must realise that by not
hedging they are making an implicit choice between protecting
potential profits and exposing the organisation to potentially
catastrophic risks. Such was the case with Laker Airlines which
brought British tourists to the United States in the 1970s. At that time
Laker bought five new aircraft when the British pound was strong,
contracting to pay for them in United States dollars. However, as the
dollar strengthened against the pound so the cost of paying for the
aircraft became more prohibitive. In addition, the strength of the dollar
reduced the number of British tourists to the United States. The
combination of these two factors led to the collapse of Laker Airlines
[1441.
o 'Hedging is not our business' — Many top managers are of the opinion
that they are not in business to hedge risks, but to create products or to
47
provide a service. Such assumptions can prove disastrous. By choosing

not to hedge such managers are in fact betting on a favourable outcome
with respect to any variables which would affect their organisational
cost structure. They are betting that interest rates will come down, they
are betting that exchange rates will move in their favour, and they are
betting that commodity prices will reduce. This misconception is
driven by the asymmetry of risk losses. An organisation which loses
money by implementing a derivatives based structure may incur the
wrath of shareholders. However, the same organisation which loses a
similar amount of money which could have been avoided had a proper
hedging program been in place will hardly raise an eyebrow.
o Shareholders are able to hedge more efficiently than the firm can —
It is often stated that shareholders are able to hedge their risks by
diversifying their portfolios much more efficiently than the
organisation could. In fact it could be argued that under such a
situation shareholders would not want the organisation to minimise
risks. In theory this makes sense. However, what this ignores is the fact
that shareholders typically do not, and cannot, have access to
organisational information which would enhance their portfolio
decisions. In addition shareholders do not have access to the same
hedging instruments available to management.
o The efficient market argument — Proponents of the efficient market

theory suggest that in an efficient market, on average and over time,
the results of organisations that do not hedge will be the same as those
that do. In fact, one may argue that since there are costs associated
with hedging those organisations that actively hedge will be worse off
than those that do not. Once again this may be fine in theory. However,
what this theorem neglects is the fact that increasingly organisations
are not measured 'over time' but are measured instantaneously. The
application of hedging techniques enables the organisation to smooth
out its cash flows which has positive business consequences. Smoothed
48
out cash flows imply reduced volatility of returns which leads to

investors requiring a lower risk-adjusted rate of return on an
investment in the organisation.
3.6 MODERN DAY FAILURES I[N RISK MANAGEMENT
Although the need for a well balanced risk management system is evident, and
one would think that the dangers of not being able to recognise and control risk
would be a major source of concern to most organisations, this is not always
the case. For this and other reasons the past ten years have seen a number of
highly publicised financial losses, particularly losses involving the incorrect
use of financial derivatives. The unfortunate thing is that in all cases these
losses could have been avoided or minimised had adequate risk management
procedures been in place. It is thus worthwhile to briefly examine some of the
more spectacular financial disasters in order to gain an appreciation of the need
for effective financial risk management. In so doing we will briefly consider
the cases of Metallgesellschaft, Orange County, Daiwa and Long Term Capital
Management (LTCM) 1871049105].
Metallgesellschaft, Germany's fourth largest industrial group with some

58,000 employees, faced near bankruptcy as a result of losses incurred by its
American subsidiary MG Refining and Marketing (MGRM). By 1993 MGRM
had entered into long-term fixed contracts to supply customers with 180
million barrels of oil products over a period of ten years at a price fixed in
advance. In order to hedge against the possibility of rising oil prices the
company should have entered into long-term forward contracts on oil.
However, due to the fact that no viable market for such long-term contracts
existed at the time the company decided to hedge this risk by implementing a
rolling hedge of short-term futures contracts (the concept of entering into and
subsequently renewing short-term futures contracts when they expire as a
proxy for a long-term futures contract). This exposed the company to basis
risk, being the risk that short-term oil prices temporarily deviate from long-
term prices. During 1993 the cash oil price fell from $20 to $15, leading to
49
billions of dollars in margin calls 2 on the company. The result was the
replacement of top management, with the new management liquidating the
remaining contracts at a reported loss of $1.3 billion.
Orange County in the United States entrusted their treasurer with a $7.5 billion
portfolio. The treasurer, in an effort to leverage potential returns, borrowed an
effective $12.5 billion for a total investment of $20 billion. This strategy
worked well in an environment where short-term rates were lower than long-
term yields. However, a series of interest rate hikes starting in February 1994
led to mounting paper losses on the portfolio. As the fund defaulted on its
margin payments Orange County declared bankruptcy. The remaining
securities in the fund were liquidated at a realised loss of $1.64 billion.
On the 26th of September 1995 Daiwa Bank announced that a 44 year old
trader in New York had accumulated losses valued at $1.1 billion. Although
Daiwa, the 12 th largest bank in Japan, managed to survive the loss one seventh
of its capital was wiped out. The $1.1 billion loss was the result of around
30,000 concealed trades in U.S. treasury bonds by the trader over an eleven
year period from 1984. Subsequent investigations illuminated the farcical risk
management procedures which allowed a single trader to conceal losses for
such a long period. As a result the bank was ordered to close its U.S.
operations by U.S. regulators, an unprecedented move at the time.
Long Term Capital Management (LTCM) was a firm based in Greenwich,

Connecticut. LTCM pioneered the art of computer-assisted bond trading made
possible by a highly intellectual combination of mathematics, finance theory
and market smarts. While most other firms would try to outguess the U.S.
Federal Reserve, LTCM used computer models to predict tiny but lucrative
discrepancies in bond prices. LTCM was led by John Meriwether the former
vice-chairmen of Salomon Brothers, and staffed by heavyweights such as
Lawrence Hilibrand, the reclusive trader whose market prowess earned him
2Margin calls relate to the daily profit or loss movements associated with positions in financial
futures.
50
$23 million at Salomon in 1990, Gregory Hawkins and William Krasker, both
former bond traders at Salomon Brothers and economics PhD's from MIT,
Myron Scholes from Stanford University and Robert Merton from Harvard
Business School, both of whom received the Nobel Peace Prize in Economics
for their work on the pricing of derivative instruments. This combination
resulted in LTCM making incredible returns for their shareholders as they
capitalised on inefficiencies in the market. In 1998 however this strategy was
to prove extremely costly as the models used by LTCM failed to predict the
impact that market turmoil would have on the company's open positions.
LTCM did not make money in the conventional way by searching out assets
whose value was not fully reflected in the market. Instead they bet on the
interior dynamics of the markets themselves, exploiting price differentials
between, for example, two bonds with different credit ratings or between
shares of merging companies. As a result, instead of using derivatives to hedge
risk (their conventional use) they used derivatives to amplify their exposure to
the market (a process known as leverage). LTCM's favourite strategy was to
bet on the difference between the yield (or the rate of return) of two debt
instruments (such as government or corporate bonds). Because the credit
ratings of different institutions vary (for example, a government bond is
generally considered to be free of default risk while a corporate bond would
contain a measure of credit risk, reflected in a lower price) there is typically a
difference in the yield of the two instruments. In essence LTCM would bet that
any change in the spread (difference) between these yields would eventually
move back into line.
As an example, 5 year junk-bonds usually yield about 2 percentage points

above 5 year U.S. treasury bonds because of their higher risk. One of LTCM's
strategies may have been that if the yield spread ever went higher than 2
_percentage points it would soon return to its original position. Ordinarily this
would be a smart bet. However, with the global market turmoil in 1998
investors became more risk averse and fled junk-bonds for the safety of U.S.
treasury securities. As a result the yield spread between these securities
51
increased from 2 percent to 2.8 percent. Thus instead of converging as LTCM

had hoped the yields diverged. While this situation implied a loss the matter
was compounded by the fact that LTCM's positions were highly leveraged.
Using a popular form of derivative known as a swap it is estimated that LTCM
was able to make bets on the market with notional amounts 3 of US$1 trillion
while its balance sheet showed assets of $100 billion on a capital base of $4
billion. The result was that LTCM needed to be bailed out by fourteen major
financial institutions with a capital injection of $3.6 billion which allowed it to
meet the margin calls on its positions.
The cases as discussed here illustrate how easy it is to lose large amounts of
money if one is not aware of the risks involved in a set of transactions. While
no risk management system is infallible, they go a long way toward ensuring
an understanding of the risks inherent in financial positions. Derivatives
related losses in particular have earned these instruments a reputation for being
`dangerous'. This is an unfortunate misconception on the part of the general
public.
While such publicly disclosed losses have increased over the past number of
years as a result of the increasing use of derivative instruments, as illustrated
in Figure 3.2 and Table 3.1, most people tend to forget two important
considerations:
o Derivative instruments are rather like aeroplanes. They have an

extremely good 'safety record' in relation to their use but an accident
typically makes headlines due to the nature with which it occurs, and
o All derivative instruments are what are known as zero-sum

instruments, meaning that for every one dollar lost by one party one
dollar is gained by another. The net loss to society is thus zero (in fact _
3The concept of a notional amount as used with respect to derivative instruments refers to the fact
that although the $1 trillion is outstanding this is not a true indication of the actual risk involved
since many of the positions offset one another.
52
the economic benefits to society are positive 1601). Nevertheless no

organisation likes to be on the receiving end of such huge losses and
for this reason financial risk management is assuming increasing
importance as the use of such leveraged instruments increases.
Billions
16.67
13.80
10
3.97
1.61 1.64 1.65 2.0 2 2.23

j§*„.0
0
1987 1988 1989 1990 1991 1992 1993 1994 1995
Cumulative Losses; Pretax Equivalents
Source: Jorion, Philippe; Value At Risk McGraw-Hill 1997 1871
Figure 3.2 Publicly Disclosed Derivative Losses as of Year-End 1995
3.7 CONCLUSION
This Chapter has served as a brief introduction to the major concepts of

corporate financial risk management. The concept of risk has received
attention, as has the arguments both for and against the active management of
risk on the part of the organisation. The reader will have noticed that
theoretically there are many compelling reasons for why the organisation
should not concern itself with the active management of financial risks.
Practically however this is seldom feasible.
53
Table 3.1 Corporate josses Attributed to Derivatives: 1993 1.99n -
Corporation linstrument Loss (S million)

Showa Shell Sekiyu, Currency forwards 1,580
Japan
Kashima Oil, Japan Currency forwards 1,450
Metallgesellschaft, Oil futures 1,340
Germany
Barings Bank, U.K. Stock index futures 1,330
Codelco, Chile Copper futures 200
Proctor & Gamble, Differential swaps 157
U.S.
Source: Jorion, Philippe; Value At Risk McGraw-Hill 1997 [87
Various types of financial risks were defined with a view to providing the
reader with an indication of the many disparate sources of risk. Market risk,
currency risk and interest rate risk have historically proven to be the most
volatile, and hence dangerous, of the various forms of financial risk. As a
result, and as will be demonstrated in the following chapters, many new
financial products have been developed to provide a means of managing such
risks.
The concept of hedging as well as the arguments for and against such practice
also received attention within this Chapter. Hedging often forms a major part
of the risk management procedures within most organisations and as such the
practical application of such techniques are naturally of concern to most
managers.
Finally, the author presented a number of examples of modern day failures in

financial risk management. This was done with the intention of highlighting
the need for accurate, well constructed risk management techniques. Such
techniques are only possible if the correct financial products are available.
Given the increasing importance of the corporate risk management function it
therefore follows that there should be a commensurate increase in the demand
54
for, and use of, innovative new financial products designed to satisfy the needs
of market participants. Predictably enough this is exactly what has happened.
In order to satisfy this need many organisations realised that there were
tremendous opportunities in the development of such products, both for
proprietary use as well as for sale to external customers. The result was the
creation of financial engineering as a separate, clearly identifiable discipline.
Now that the reader is aware of the importance of the financial risk
management function the following Chapter will discuss the process of
financial engineering in satisfying the requirements of the market for
appropriate products.
55
Financial Engineering: Concepts and Techniques
Chapter
Financial 3ngineering: Concepts and
Tecitniques
"I would suggest that one support all forms of radical applications
that show promise in changing the very nature of the business.
Experiment! " Gordon Bell, Microsoft Telepresence Research
—
Group
4.11 IINTRODUCTION
ver the past quarter of a decade the science of financial engineering has
risen from non-existence to one of the most exciting and powerful
disciplines today. The ability of financially engineered products to influence
the fortunes of not only single companies but indeed entire global financial
markets means that the process of financially engineered product creation is of
extreme importance, not only for those who create such products but also for
those who use and to some extent may be affected by such products.
Financial engineering has much in common with the more well known
`conventional' engineering disciplines. Financial engineering, as with any
other engineering discipline, involves the creation of products, the purpose of
which are to satisfy a stated need. Consider, for example, the following typical
engineering definition of the product design function:
Product design may be defined as the -proce-ss of seeking a match between a

set of customer-derived product requirements and a way of meeting those
requirements, or of finding an acceptable compromise [94].
56
The following definition of the engineering function is similarly appropriate:
Engineering is the profession in which a knowledge of the mathematical and

natural sciences gained by study, experience, and practice is applied with
judgement to develop ways to utilise, economically, the materials and forces
of nature for the benefit of mankind [55].
It is apparent that the function of engineering is to satisfy the needs of man in

an economical manner, and in so doing to ensure the progression of mankind
to an optimal state. This is true of financial engineering which, although
relatively young when compared to the more conventional engineering
disciplines, has nevertheless proved to be a powerful and innovative discipline.
Financial engineering is about managing financial risk, using whatever

techniques appropriate. This means altering the form of undesirable risk and,
where the alteration of such undesirable risk is not possible, reducing or
channelling such risk into areas where it may be controlled with greater
authority. This is done by either creating financial securities with the required
risk-return characteristics or, alternatively, modifying and combining existing
securities so as to achieve the desired result.
This Chapter will focus on the modern day corporate financial engineering
function. Issues to be covered in this Chapter include, amongst others, a
description of the financial engineering function, the techniques of financial
engineering and current product development related financial engineering
issues which are of concern to the modern day corporation. Furthermore, the
author will use this Chapter to illustrate to the reader the primary principles
inherent in the concept of value-at-risk (VaR). The VaR data so presented will
be used by the author in the practical validation of the Financial Product
Development Model which can be found-in Chapter Nine. The purpose of this
chapter will thus be threefold:
57
It will provide the reader with a brief analysis and investigation of the
financial engineering function within the corporate business
environment which will enhance the ability of the reader to appreciate
the importance of a structured product development process within the
financial services industry.
It will identify and 'analyse current issues related to financial

engineering in the corporate business environment, with particular
reference to the importance of the financial product development
process.
It will provide the reader with an understanding of the primary

concepts of value-at-risk in as far as knowledge of such concepts will
be required'at alater stage.
4.2 FINANCIAL ENGINEERING DEFINED
Many definitions of financial engineering exist. However, they all focus on

one key element:
o The creation of a new financial product required to satisfy a specific

stated need typically, but not necessarily, related to the need to manage
a particular financial risk or set of risks.
Wilson et al 11641 define financial engineering as follows:
Financial engineering describes the group of products, tools, services,

techniques and instruments developed to manage the risks inherent in
fluctuations in commodity, foreign exchange rates, and interest rate
changes.
58
Accordingly, Wilson illustrates the fact that many financially engineered

instruments are not necessarily entirely new creations, but are modified
instruments consisting of the amalgamation of so called underlying
instruments. In this respect financial engineering may in certain instances be
considered as an evolutionary process as opposed to a revolutionary one.
Galitz [59] adopts a more process specific approach to the financial engineering
function as follows:
Financial engineering is the use of financial instruments to restructure an

existing financial profile into one having more desirable properties.
Galitz stresses the point that financial engineering has many associations with
its 'mechanical cousin' (conventional engineering). For example, just as the
term engineering may suggest the honing of precision components which form
part of a complex system, or working with special tools or instruments in order
to achieve mechanical perfection, so the term financial engineering suggests
the use of precision tools in order to achieve a specific financial goal.
Similarly, as with conventional engineering, financial engineering can help to
achieve excellence, but not the impossible.
Tufano [158], in illustrating how financial engineering can advance corporate

strategy, adopts the following definition:
The financial engineer, using financial economics (the application of

economic principles to the dynamics of securities markets) as his knowledge
base, is concerned with the process of structuring, pricing, and managing
the risk of financial contracts.
Ross et al [134] introduce the concept of financial engineering - within a

management context, and illustrate how the process of financial engineering is
essentially one which is followed by the management of a firm in order to
hedge specific identified risks which may impact the firm.
59
All of these definitions of financial engineering are perfectly acceptable.

However, from an engineering perspective the elements which are apparent in
most if not all definitions are those related to the disciplines of systems
management and product creation. It is thus the intention of the author to adopt
a more engineering based definition of financial engineering for the purpose of
this investigation. The emphasis is, naturally enough, on the creation of a
product and the processes used in the creation of that product. For the purpose
of this thesis:
Financial engineering is the process of designing and manufacturing

financial products using applicable structured system processes so as to
satisfy a stated need relating principally, but not exclusively, to the
management of financial risks.
As is to be expected from an engineering based definition of the financial

engineering process, emphasis is placed on three elements, namely:
The design and manufacture of financial products (securities or

contracts),
the use of structured system based processes in order to accomplish

such design and manufacture, and
the need for this process to economically satisfy a stated need,

typically relating to the need to manage an organisation's financial
risks.
A financial product created as a result of the financial engineering process is

nothing more than a product produced as a result of a typical engineering
process of requirements definition, product design, and manufacture. Possibly
the only difference is the fact that a typical engineering product is tangible in
the sense that one can easily observe the result of this process. In general the
products of financial engineering are intangible. This does not negate the fact
60
that the creation of such a product should undergo a design and manufacture
process similar to that which would be used for the creation of any
conventional engineering product.
The use of system engineering principles in the design and manufacture

process is desirable because if the creation of financial products is essentially
an engineering process then applicable system engineering techniques may be
used in order to enhance the design and manufacture process. The fact that the
system in question is essentially one based on financial concepts and processes
is to a large degree irrelevant.
Finally, the result of the financial engineering process should be a product

which satisfies a stated need, typically in terms of the need to manage a
particular risk in a more efficient manner. Once again this is no different to the
output of a conventional engineering process. What is apparent is that, in both
disciplines, the resultant output needs to satisfy specific stated requirements,
and that should such requirements not be satisfied, the usefulness and worth of
the product and the attendant manufacturing process must be called into
question.
4.3 INVESTIGATING THE NEED FOR FINANCIAL ENGINEERING
Financial engineering is a relatively new discipline, having essentially been

born out of the need to manage currency risk as a result of the replacement of
the fixed parity exchange rate mechanism with a floating currency exchange
rate in the early 1970s' 1591. With the destruction of the fixed exchange rate
mechanism exchange rates were free to fluctuate in accordance with market
supply and demand principles. The result was periods of extreme volatility
within the currency markets, as illustrated by Figure 4.1 which plots the
I After the second world war most major countries were signatories to the Bretton Woods
agreement which established fixed rates of exchange between various currencies. This agreement
lasted until the early 1970s when it was finally abandoned as a result of the differential between
the economic growth .rates of the participating countries. The result was the formation of the
foreign exchange (FX) market in which the rates of exchange between different currencies was
determined by market forces (supply and demand).
61
USD/DEM exchange rate with respect to time. Note the increase in volatility
of this rate subsequent to the breakdown of the fixed exchange rate mechanism
in the early 1970s.
Source: Galitz, Lawrence; Financial Engineering: Tools and Techniques to Manage

Financial Risk Pitman Publishing 1994 [59]
Figure 4.11 Fluctuations in the USD/DEM Exchange Rate (1963 — 1992)
As a result of the increased volatility in exchange rates, interest rates became

the mechanism for central banks to influence the value of their currency. The
effect of this was increasing volatility in interest rates, as shown in Figure 4.2
which plots the 3-month eurodollar rate with respect to time. With increasing
volatility came increasing risk. The need for firms to manage this risk resulted
in the creation of the financial engineering function.
Martin [106] illustrates the important role that new financial products play in
the success of organisations. In particular, he illustrates why the greatest risk
associated with financial innovation is that of failing to innovate. The
increasing risks to which modern day organisations are subjected require the
creation and use of new products and methodologies within the sphere of risk
62
management. Financial engineering plays an important part in fulfilling this

requirement.

Financial Risk Pitman Publishing 1994 [591
Figure 4.2 3-Month Dollar Interest Rate Vollatillity (1963 — 1992)
Consider for example the use of financially engineered derivative 2 products.

As illustrated in Figure 4.3, the use of such products has shown exponential
growth over the past five years. Such new products have typically addressed
the stated needs of investors in terms of:
Yields in a low interest rate environment,
stability amid volatile interest rates and currency values, and
cross-border financial products and services - in the midst of the

globalisation of market opportunities.
2 See Chapter Five for a discussion on derivatives.
63
Source: Martin, Eff W.; 'Risk Management and New

Financial Products' from Beaver, William H.; Parker,
George; Risk Management: Problems and Solutions
McGraw-Hill 1995 [106]
Figure 4.3 Derivatives Market Growth
With such a myriad of risks facing an organisation executives have

increasingly sought to find ways to control risk in an appropriate" manner.
Financial engineering has historically provided, and continues to provide, the
tools required to manage the risks facing an organisation. Note though that the
use of financially engineered products is not necessarily limited to the
management of risk. There are many cases where financial engineering has
successfully been used to advance corporate strategy [158]. Companies making
use of such financial engineering techniques need not operate within the sphere
of financial services. Typical companies which have been successful in the use
of such techniques produce and market products as wide ranging as gas,
electricity, chemicals, cement and oi1 3 . It is therefore no wonder that "as
corporate executives overcome their long-standing wariness of futures and
options markets they are increasingly looking towards derivatives as a way of
improving turnover as well as hedging risk" [164].
3 Note that the products listed here are primarily commodities. Tufano [158] has shown how
financial engineering may successfully be used to enhance the sale of such commodities where
differences between competing products are practically indistinguishable.
64
The use of financially engineered products, some of which have been available
since 1975, has increasingly been recognised within the past number of years
as a tool that banks can use to adjust the amount of assumed interest rate risk
[91]. Typically banks are primarily concerned with the use of financial futures
contracts and interest rate swaps. In fact, the use by banks of such instruments
has grown to such levels that bank regulators are concerned that such a high
level of use will exceed the ability of the regulators to monitor and understand
the extent of the risks that banks assume [144].
The importance of financial engineering is thus clear. Corporations the world

over use financially engineered products as tools in their management of risks.
The growth in the use of financially engineered products such as derivatives is
also apparent. And just as important, this growth shows no signs of slowing
down. Consequently, the requirement for financially engineered products
which are able to satisfy the stated requirements of the market will continue to
increase in the future. It is therefore imperative that the designers and
`manufacturers' of such products (financial engineers) have the necessary
skills, tools and techniques in order to 'accomplish this task with the utmost
efficiency. One such tool is the use of an enhanced financial product
development process as a strategically competitive weapon. The development
of this process is the stated aim of this thesis.
4.4 THE APPLICATIONS OF FINANCIAL ENGINEERING
There are four primary applications for which financial engineering may be
used, namely:
Hedging,
speculation, -
arbitrage, and
65
o financial structuring.
Each application has a specific defined purpose and, as we shall see, financial
engineering is able to play an active and vital role in helping organisations to
attain their desired objectives.
4.4.11 Hedging
Hedging is one of the primary uses for financially engineered products and
involves the use of such instruments in order to adopt opposing positions on
financial exposures so as to minimise any potential loss. A simple example
may suffice. Consider the case of an investor who, upon retirement, wishes to
relocate to Cape Town. One of the risks that this investor faces is that property
prices in Cape Town may experience a boom prior to retirement, and as such
would become less affordable, placing the carefully constructed retirement
plans in jeopardy. In order to avoid, or at the very least minimise such risk the
investor may wish to hedge his exposure to the identified risk by investing in a
product whose return is linked to the price of property in Cape Town. The risk
of being unable to afford property upon retirement is therefore reduced or
eliminated to a large degree.
While this may be a somewhat simplistic example it clearly illustrates the

effect of the hedging concept. Typically, a perfect hedge is one that matches
the original exposure in exact detail. Consider Figure 4.4 which illustrates
graphically a perfect hedge. Using a perfect hedge as illustrated by Figure 4.4,
risk can be eliminated completely. As is to be expected, perfect hedges are not
common.
66

Financial Risk Pitman Publishing 1994 1591
Figure 4.4 A Perfect Hedge
While the perfect hedge may at first appear to be the ideal solution to the
management of risk, it does have its drawbacks. Primarily the perfect hedge
negates both positive and negative movements in the underlying exposure. It
would be preferable if a hedge could be developed which limits potential
downside loss but allows the desired upside movements to proceed unaffected.
This concept can and has been achieved through the use of financial
engineering. Figure 4.5 illustrates what is referred to as a 'capped exposure'.
With such a hedge adverse movements are compensated for by the hedge for
exposure past a certain level, while beneficial movements are allowed to
proceed untouched.

Financial Risk Pitman Publishing 1994 [59]
Figure 4.5 A Typicall Capped Exposure
67
4.4.2 Specuiation
Speculation can be described as the process of creating an exposure to the

market as a result of an anticipation of the change in price of a particular
element. Thus, a speculator is willing to create an exposure where none existed
previously in the hope of benefiting from a movement in market prices.
Speculation may, at its simplest, be nothing more than the purchase and sale of
financial instruments for a profit. It is a fact that a significant proportion of the
approximately $1 trillion traded in the currency markets each day is a direct
result of speculation on the part of investors [59]. Although financially
engineered products such as derivatives need not necessarily be used in the
process of speculation, they do offer significant advantages. Some of the more
important advantages of financial derivatives for the speculator are:
Gearing - A characteristic of most derivative instruments is that they

allow tremendous gearing (leverage) as a result of the fact that large
positions can be adopted in the financial markets with minimal capital
outlay. For example, it may be possible for a position on $1 million
worth of gilts to be achieved with a $20,000 capital outlay. Such
gearing ratios of 50 times or more are not uncommon.
The ability to assemble complex strategies - The use of derivatives as

building blocks allows the investor to create highly tailored specific
strategies purpose built to suit his needs.
The ability to create otherwise impossible exposures - Certain

strategies are impossible to carry out without the use of derivatives.
4.4.3 Arbitrage
In its simplest form arbitrage may be defined as the act of simultaneously

buying a financial security and selling it at a higher price [17]. Alternatively,
arbitrage may be thought of as the act of buying shares on one stock exchange
68
with the purpose of selling them on another exchange at a higher price, and in
so doing locking in a (relatively) risk-free return [46]. Arbitrage opportunities
exist as a result of temporary differences in the price of securities traded at
different locations. The reasons for such opportunities may be a delay in the
distribution of information, or simply a geographical separation between
markets (such as the Johannesburg Stock Exchange and the London Stock
Exchange). As a result of the profusion of interrelated financial products, and
the fact that it is possible to synthesise one product from a combination of
other products, the mathematical relationships between such products which
normally hold true may temporarily be out of balance, presenting the
arbitrageur with the opportunity for relatively risk-free gains if the opportunity
is identified promptly. The process of arbitrage acts to stabilise security prices
by driving up under-priced securities and driving down over-priced securities.
As a result, arbitrage opportunities need to be seized almost immediately since
they do not last long.
4.4.4 Structuring
The process of financial structuring is about meeting the needs of investors,

borrowers and other participants in the financial markets. The tools and
techniques of financial engineering may be used to restructure the
characteristics of transactions and exposures so as to suit the preferences of
different participants in the financial markets. Essentially this process involves
the identification of client requirements, the design of the (financial) product
which will best satisfy the client requirements, and the production and release
of such a product. Note the similarity between this process and a conventional
engineering design and construction process. Essentially there is no difference
in these two processes, save for the fact that the outcome of the engineering
process is typically tangible while that of the financial structuring process is
-not.- This-concept is important, and forms the foundation of the argument as
presented by the author throughout this thesis.
69
4.5 SCIENCE AND FINANCIAL ENGINEERING: A POWERFUL COMBINATION
Given that the discipline of financial engineering involves to a large degree the
use of a subset of economics known as financial economics, and that financial
engineering typically requires significant knowledge of financial principles
ranging from simple accounting to advanced financial analysis, one would
naturally expect that the vast majority of professionals in this field would be
educated in the field of finance and have worked in finance for the greater part
of their lives. However, the true state of affairs within the field of financial
engineering is anything but the situation previously described.
A large proportion of the professionals to be found in this field come from the
hard sciences: physics, engineering, and mathematics. In fact, so important is
the contribution of professionals trained outside of finance that they are being
attracted to the field of financial engineering at a rapid rate by financial
institutions who recognise the added value that their skills may bring (see
Appendix for an example of this). Typical backgrounds from which
financial engineers migrate include business, economics and finance, computer
science, engineering, mathematics, statistics, physical sciences, as well as any
other quantitative discipline.
An example of the input of `quants' as they are commonly known can be found
in the derivation of the now famous Black-Scholes option pricing equation (see
Chapter Five for an explanation of the significance of this equation). The
Black-Scholes equation's, derived by Fischer Black and Myron Scholes, is
relatively simple to use in its final form. However, the mathematics underlying
the derivation of the Black-Scholes equation is stochastic calculus, a
descendant of the work of Louis Bachelier and Albert Einstein s . As a result of
4 The Black-Scholes equation is further described in Chapter Five. However, for now it can simply
be described as the equation which allows for the calculation of the theoretical value of a financial
option.
5 Louis Bachelier was one of the first economists to attempt to speculate on the proper valuation of
options in the early 1900s, a question which had continuously perplexed economists. Interestingly,
one component of the formula that he constructed anticipated the model that Robert Brown later
used in his theory of Brownian Motion which predicts the manner in which molecules randomly
collide with one another as they move in space 111]
70
the interaction of science and financial engineering many universities have

opened so called `quant schools', programs that educate masters students in the
higher applied mathematics of finance. Alternatively, physicists and engineers
may be trained to appreciate the many nuances of finance, something which is
not always as obvious as it may appear. As is stated by Andrew Lo, head of the
financial engineering track at the Massachusetts Institute of Technology's
Sloan School of Management:
"Market pressures are directing physicists to get more education to

try to understand the motivation and intuition underlying financial
problems. "1150]
Consider for example Dr. Emanuel Derman (a native of Cape Town, South
Africa), head of the quantitative strategies group at Goldman Sachs. Derman,
whose job over the past thirteen years has been to analyse the imperfections of
the Black-Scholes model received his doctorate in 1973 for a thesis on the
weak interaction among sub-atomic particles. Similarly, James Tilley's PhD
thesis was on the effect of spin-orbit interactions in itinerant ferromagnets.
Tilley now works for Morgan Stanley & Co. helping insurance companies
match their cash flows to policyholder obligations 1171. Sometimes those
trained in the scientific fields are even able to synthesise their skills in a more
direct manner. For example, Kirill Ilinski of the University of Birmingham has
used Feynman's theory of quantum electrodynamics to model financial market
dynamics. In order to achieve this Ilinski replaces an electromagnetic field,
which controls the interaction of charged particles, with a so-called arbitrage
field that is able to describe changes in option and stock prices 1150].
The impact made by those trained in the hard science fields on the discipline of
financial engineering is often substantial, illustrating how effective the
combination of science and finance can be. This is one of the underlying
principles within this thesis: the integration of engineering (specifically system
engineering principles) within the field of financial engineering. However,
with the increasing complexity of financial engineering, it should come as no
711
surprise to find that remuneration within the industry is typically high. As a

result the entry qualifications into the field of financial engineering are rapidly
rising, with many new recruits possessing doctorates in mathematics and the
hard sciences [98].
4.6 THE USE OF VALUE-AT-RISK TECHNIQUES IN CORPORATE RISK

MANAGEMENT
Although the development of the Financial Product Development Model has

yet to receive attention in this thesis it is worth noting that this model, which is
developed in Chapter Eight, is the subject of a practical validation in Chapter
Nine. Specifically, the author illustrates the use of the model in the proprietary
development of a non-linear value-at-risk (VaR) methodology. In order for the
reader to appreciate the data presented in Chapter Nine it is necessary that a
functional level of knowledge with regard to the principles of VaR be attained.
This is the purpose of this section. Note though that the author will only
present the basic macro concepts applicable to VaR here. The actual
implementation and use of a VaR risk measurement system requires a more
thorough understanding of the principles of financial asset price returns, time
series analysis and, typically, stochastic calculus [2].
The concept of VaR is typically applied to the measurement of market risk,

being the measurement of the risk of financial loss as a result of movements in
the price of financial instruments, although organisations such as J. P. Morgan
have used VaR methodologies to model credit risk concepts [82]. VaR is a
single number which represents the total potential loss across a portfolio of
securities for a given statistical confidence level and a given holding period.
The fact that VaR can be encapsulated within a single number is what makes
the measure so extremely powerful and accounts for the increasing popularity
of VaR as the standard market risk measurement tool 6 . Essentially what VaR - -
6 The use of proprietary VaR models has been actively encouraged by financial regulators such as
the Bank for International Settlements (BIS) as a means of ensuring adherence to capital adequacy
requirements.
72
provides is a single number presented in currency terms which is the risk of

financial loss associated with a portfolio of financial securities. The important
principle is that VaR is able to take account of portfolio diversification effects
whereby the overall risk associated with a portfolio of financial instruments is
less than the sum of the individual instrument risks. This portfolio
diversification principle is made possible by the varying correlations between
the constituent portfolio securities.
A typical outcome of a VaR analysis would be the following statement:
"The VaR for this portfolio of securities is $3,500,000 at the 95

percent confidence level over a one day holding period."
This means that for this particular portfolio of financial securities there exists a
5 percent chance that the loss over the next day will be greater than or equal to
an amount of $3.5 million.
The usefulness of VaR is that it provides top management with a single

number by which to measure market risk. It also takes into account offsetting
correlations between various asset classes which have the effect of reducing
total portfolio risk, a much more accurate measurement than is available from
other systems.
The importance of correlations between various securities is highlighted by the

fact that such correlations can be used as a natural hedge against the risk of
excessive loss. For example, if the correlation between two stocks is equal to
minus 0.4 the effect of including both stocks in a single portfolio would be to
reduce the overall risk of loss of the portfolio since a downward movement in
one stock would (theoretically at least) imply an upward movement in the
other stock. The total risk of the two stocks combined is less than the sum of
their individual risks, a principle inherent in the calculation of VaR.
73
The derivation of a VaR system however is not as simple as it may seem at

first. This is due to a number of issues surrounding the measurement and
prediction of financial prices, a science known as financial econometrics [167].
A particularly complex area associated with VaR is the measurement and
prediction of volatility and correlation estimates. Both of these parameters are
absolutely crucial to the effectiveness of the VaR system because they both
have a substantial effect on the final VaR estimate. If the volatility of the
instruments on which the VaR calculation is being done increases then so too
will the VaR estimate increase. The predictability of financial volatilities has
important ramifications for financial theory in general.
There are a number of techniques that are used to estimate the future volatility
of a financial instrument (bearing in mind that this estimate will have a direct
effect on the VaR) [2],[167]. The simplest method is to use a simple moving
average of historical volatilities. Mathematically one can say that:
47,2 = m)E (4.1)

r=1
where 6i2 = the variance of returns r, over M days.
Using this method all weights on past returns are set equal to one. This method
has several drawbacks, the most important being that it ignores the dynamic
order of observations in assigning equal importance to old as well as new
observations (new observations should ideally have a greater impact). In
addition historical information is added and discarded suddenly, leading to
spikes in the data estimates. Furthermore the selection of M has a significant
impact on the estimates as illustrated in Figure 4.6 which illustrates two such
moving average estimates using 20 days (M=20) and 60 days (M=60) of
historical data respectively. Note that the 60 day moving average presents a
smoother profile.
74
.5 Volatility forecast (%)

1
1990 1991 1992 1993 1994

Source: Jorion, Philippe; Value At Risk McGraw-Hill 1997 1871
Figure 4.6 Moving Average Vollatillity Estimates
Many of the problems associated with the simple moving average estimate of
volatility can be overcome by using an exponential moving average forecast
whereby more recent data points are given a higher weighting. This method is
recommended by J. P. Morgan, the developers of the VaR concept, who detail
the development of a decay factor ( A.) to be applied to historical observations
in their RiskMetrics Technical Document 1831.
This method is relatively simple to use once one has obtained an optimal value
for A, . The differences in estimates which the simple moving average and the
exponential moving average methodologies can produce is illustrated in Figure
4.7 which shows the estimated volatilities for the DEM/British pound
exchange rate around the time that sterling was devalued and subsequently
removed from the European Monetary Union. Notice how the exponential
75
estimate more accurately tracks the actual implied volatility while the moving
average estimate exhibits significant lag.
Volatility forecast (%)

BP devalues
Option-implied
forecast
Exponential
0.5 MA(60)
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
1992
Source: Jorion, Philippe; Value At Risk McGraw-Hill 1997 187]
Figure 4.7 A Comparison of Simple Moving Average and Exponential

Moving Average Volatility Estimates
Yet another method which is gaining in popularity is the generalised

autoregressive conditional heteroskedastic (GARCH) model. Whereas the
other two methodologies assume that the variance (the square of volatility or
standard deviation) remains stationary with time, this model incorporates the
effect of non-stationary variances, a concept which has generated much
research in the field of financial econometrics [168] . Under GARCH
assumptions the variance of financial returns follows a predictable process
which depends on both the latest innovation as well as the previous conditional
variance. Inspection of real world data indicates that financial prices tend to
exhibit a characteristic known as volatility clustering, further confirming the
76
fact that the volatility of financial returns is not a constant but does in fact
change as a function of time as illustrated in Figure 4.8.
The correct calculation of VaR is important because apart from providing

management with a quick and easy measure of total portfolio risk exposure, it
can also be used in capital allocation within the organisation. Capital allocation
refers to the manner in which capital is used to finance various parts of the
business. A profit seeking business will always try to maximise its return on
capital by using scarce capital in those areas of the business where the return
on capital is greatest. However simply measuring return on capital as the net
profits divided by the net capital usage is highly misleading because this does
not take into account the risks inherent in that particular segment of business.
As a result various measures have been developed which take into account the
risk assumed in the pursuit of profit. For example Bankers Trust, a leading
U.S. financial institution, have developed a measure known as RAROC (Risk-
Adjusted Return on Capital) which they use to adjust trading profits for capital
at risk 11441. Capital at risk in this case is defined as the amount of capital
required to cover 99 percent of the maximum expected loss over one year.
Using this measure the firm can calculate a reward-to-risk ratio for each of its
traders (total trading profit divided by capital at risk). The higher the ratio the
better the trader's relative performance.
A further complication relating to the use of VaR estimates as a risk measure is

the fact that most VaR methodologies are based on the assumption that
financial returns follow a log-normal distribution. This however is not
technically a correct assumption. Such financial returns are in fact
leptokurtotic, meaning that the probability density distribution of financial .
returns tends to differ from a conventional normal distribution in that this
distribution has a thin waist and fatter tails. The concept of leptokurtosis is
illustrated in Figure 4.9 which illustrates actual USD/DEM log-returns versus a
log-normal distribution.
77
USD/DEM returns
0.04
high volatility
0.03
0.02 low volatility
0.01
-0.01
-0.02
-0.03
Jan-93 Jun-93 Dec-93 Jun-94 Dec-94 May-95 Nov-95
USINFRF retur
USD/FRF returns
0.03 high volatility
0.02 low volatility
0.01
-0.01
-0,02
-0.03
Jan-93 Jun-93 Dec-93 Jun-94 Dec-94 May-95 Nov-95
Source: J. P. Morgan; RiskMetrics Technical Document, 4th Edition 1831
Figure 4.8 Volatility Clustering in Financial Returns
78
Lellgokurtotic vs .normal distir bution
PDF
0.8
0.7 -
SD EM log returns
0.6
0.5
0.4 H.
0.3 Normal
0.2
0.1
0
-3.4 -2.3 013. 1.1 2.3 3.4
Returns (%)
Source: J. P. Morgan; RiskMetrics Technical Document, 4th Edition 1831
Figure 4.9 An illustration of Leptokurtosis in Financial Returns
The importance of leptokurtosis to the calculation of VaR is in the 'fat tails'

concept which financial prices tend to exhibit. The existence of fat tails affects
the VaR estimate since these so called fat tails occur in the extreme regions of
the normal distribution, which is exactly the region one is most interested in.
As a result VaR estimates based on the assumption of normality of financial

returns tend to be lower than the estimate from the actual distribution due to
79
the fact that in reality the tails of the distribution contain more extreme
movements than the normal distribution would predict.
The final issue of concern is the non-linearity of financial instruments.

Linearity is a measure of the relationship between the price of a financial
instrument and the underlying variable on which the price is based. A linear
instrument is one whose price changes linearly with a change in the underlying
variable. For example, a forward rate agreement (FRA) is a financial derivative
whose value is dependent on one or more interest rates. As the interest rates
change so too does the value of the FRA, in a linear fashion. A non-linear
instrument is one whose price does not move linearly with a change in the
underlying variable on which it is based. The best examples of non-linear
instruments are financial options. Examples of linear and non-linear financial
instruments are illustrated in Table 4.1.
.1 Linear inear thanciat in

Type Instrument Underlying Price/Rate
Linear FX forward FX rate/money market price
Forward rate agreement Money market price
Currency swap Swap price/FX rate
Non-linear Stock option Stock price

Bond option Bond price
FX option FX rate
Source: J. P. Morgan; RiskMetrics Technical Document, 4th Edition [831
There are two general methods to overcome the problems associated with the
non-linearity of option positions. The first method is to approximate the non-
linear relationship between the option and its underlying by means of an
analytical mathematical relationship. The second method is to use some form
of portfolio revaluation technique such as Monte Carlo analysis 11691.
80
One of the most popular analytical techniques is that of the Delta-Gamma VaR
methodology as recommended by J. P. Morgan in their RiskMetrics Technical
Document [83]. Under this methodology the non-linearity of the option is
accounted for by including an approximation of the rate of change of non-
linearity within the analytical approximation. This can be achieved because the
rate of change of the value of a financial option can be described in terms of a
number of parameters, the most important of which are the following:
Delta — the nominal change in value of an option for a change in value of the
underlying.
Vega (also known as Kappa) — the change in value of an option for a 1

percentage point change in implied underlying volatility.
Theta — the change in value of an option for a 1 day reduction in time to expiry
of the option.
Gamma — the rate of change of Delta.
Gamma is important in this context because it is this parameter that provides

the non-linear characteristic of options since the rate of change of option value
with respect to a change in the value of the underlying is not constant. The
Delta-Gamma methodology incorporates both the Delta term as well as the
Gamma term in estimating, mathematically, the potential change in option
price as a result of a movement in the underlying security, rate or index. The
accuracy of the simple Delta analytical approach versus the Delta-Gamma
methodology is illustrated in Figure 4.10. Note how the Delta-Gamma estimate
approximates the actual full revaluation method very closely while the
conventional Delta estimate becomes more inaccurate for extreme movements
in the price of the underlying.
7The J. P. Morgan RiskMetrics VaR methodology was one of the pioneers of the use of VaR for
market risk measurement.
81
strike = 0.65 USD/DEM, Value in USD/DEM
Option value
0.06 -
0.05 Full valuation
0.04
0.03
0,02
0.01
Delta + gamma
0
-0.01 c.
Delta
-0.02 ' ' , ' t
0.60 0.61 0.62 0.63 0.64 0.65 0.66 0.67 0.68 0.69 0.70
USD/DEM exchange rate
Source: J. P. Morgan; RiskMetrics Technical Document, 4th Edition [83]
Figure 4.110 Delta Versus Delta-Gamma Methodology
The second method by which the non-linearity of an option may be included in

a VaR analysis involves the use of Monte Carlo analysis. Monte Carlo analysis
is a sophisticated mathematical technique for generating a statistical
distribution of data (financial returns in this case) by using multiple scenarios
which conform to various statistical parameters. Under this approach the value
of the entire portfolio for which the VaR is required is recalculated for a
number of randomly generated scenarios. Under this revaluation approach the
non-linearity of the option is inherent in the recalculated portfolio value, hence
there is no need for an analytical approximation. It should therefore be
apparent that the application of a Monte Carlo analysis is typically more
accurate than the Delta-Gamma methodology. Further detail on the pricing of
financial options and the Delta-Gamma methodology can be found in
Appendix H.
82
In order to calculate the VaR associated with a particular portfolio Monte

Carlo analysis is used to construct a specified number of random scenarios
under which the portfolio is revalued. The results of the data so generated is
used to construct a probability density function (PDF) representing the
statistical probability of a particular value occurring. The most common
function is the classical normal distribution, although as has been illustrated
earlier, while financial prices are assumed to follow a log-normal distribution
this is not always the case. Once the probability density function has been
constructed the determination of VaR is simply a matter of finding the value
which corresponds to the required confidence level. This concept is illustrated
in Figure 4.11. Note though how an increase in the number of iterations used in
the analysis affects the resulting outcome.
Price distribution
130 J
3
1 3
0
120 0
110
.mom 4
netsamertairites.......-61
100
1
H
3 3
3
70
100 1000 10,000
Number of replications DP-
Source: Jorion, Philippe; Value At Risk McGraw-Hill 1997 [87]
Figure 4.111 A Monte Carlo A I I alysis Generated PDF

I
83
4.7 CONCLUSION
The purpose of this Chapter has been to provide the reader with an
understanding of both the historical development of financial engineering as
well as the continued importance of financial engineering in providing the
financial products necessary to manage financial risk within the organisation.
It was illustrated that financial engineering as a discipline first gained
prominence in the late 1970s and early 1980s as a result of dramatic increases
in financial volatility (particularly interest rate volatility and foreign exchange
volatility).
The author has provided a number of definitions of financial engineering and

illustrated the similarities of financial engineering to 'conventional
engineering'. This similarity in terms of the process by which the respective
products are developed is important in that it forms the foundation of many of
the arguments provided by the author in this thesis. Consequently the author
has illustrated that the major difference between the products produced via
these two disciplines respectively is the tangibility of the typical conventional
engineering products versus those created via the use of financial engineering.
It is interesting to note though that engineering in the information technology
age has produced many intangible products, most notably the software on
which most products today depend.
The application of financial engineering in practice as well as the four primary

applications of financial engineering received attention in as far as their ability
to provide the organisation with a tool to both manage financial risk and to
create speculative opportunities if desired is concerned. While financial
engineering has evolved as a result of the desire by corporations to manage
such risks, the tools of financial engineering can just as effectively be used to
create potential profit opportunities for the organisation.
The author has illustrated the powerful synergistic effects of combining

science and financial engineering. Given the author's initial engineering
84
background it is heartening to see that those professionals schooled in the hard

sciences (engineering, mathematics and science) are able to apply these skills
productively in other environments, thereby broadening the scope of influence
of these disciplines.
Finally, the concepts underlying value-at-risk have been illustrated in this

Chapter. It is required that the reader be aware of these details since the value-
at-risk concept will be used further by the author in Chapter Nine, the practical
validation of the Financial Product Development Model.
The following Chapter is the last one dealing with the financial concepts
necessary for this thesis. Up until now the author has illustrated the importance
of the financial risk management function. The historically increasing
importance of this function led to the creation of financial engineering as a
dedicated discipline, the purpose of which is the development of financial
products. These financial products are typically grouped together under a
common name — derivatives. Chapter Five provides a brief overview of some
of the more important types of derivatives.
85
Financial Derivatives: A Corporate Risk Management Approach
Chapter 5
-4inancia1 Derivatives: A Cor orate Risk
Management Approach
"The stock market will fluctuate." — J. P. Morgan, when asked what

the market was going to do.
"I want to do to the electron what Kellog's did to the corn flake." —
Richard C. Green, Jr., CEO and chairman, Utilicorp
5.11 RNTRODUCTION
p until this point the following has been accomplished within this thesis:
The increasing importance of innovation within the financial product

development process has been illustrated (Chapter Two),
The typical initiator of the need for a new financial product, the
financial risk management process, has been illustrated in terms of its
relationship to the financial product development process (Chapter
Three), and
The subsequent creation of the financial engineering function as well

as the characteristics of this discipline with respect to the development
of financial products has been investigated (Chapter Four).
In short we have investigated both the determinant of the need for new
financial products as well as the discipline which has emerged as the provider
87
of such products. There remains only one element which has not been covered,
namely the outcome of the financial engineering process.
The products developed as a result of the financial engineering process have

over the past two decades come to be known generically as financial
derivatives. As will be seen within this Chapter, the derivation of the term
`derivatives' is related to one of the primary characteristics of such financial
products, being that their value is primarily derived from that of an underlying
financial security or index. The use of financial derivatives has grown at such a
rate that their current value can be measured in the trillions of dollars.
The creation and use of financial derivatives over the past fifteen years has
dramatically changed the face of finance. Not only do corporations and
institutional investors now have more power, flexibility and investment choice
than ever before, but it appears as if this choice is set to grow with the
continued widespread use of derivatives. The creation and use of derivatives
has experienced explosive growth as a result of the need for firms to control
their financial risks in an increasingly volatile environment. As a result, the use
of derivatives has fostered a more precise way of quantifying and managing
financial risk [64].
Many of the concepts which underlie the creation and use of derivatives are
conceptually simple. However, when properly used, these concepts prove to be
extremely powerful in allowing firms to manage their risks. In essence the
primary concept which underpins all derivatives is that a party exposed to an
unwanted risk may pass such risk to another party and in return assume a
different risk or pay the opposing party for the transfer of risk. In so doing an
organisation is able to swap an unwanted risk for what it believes to be a more
manageable risk, or one which fits better into its risk management strategy.
As the financial markets (local and global) become more complex so

participants within these markets require methods of ensuring higher yields
while simultaneously keeping risks within acceptable limits. Users of
88
derivatives may be involved in activities as diverse as hedging current or

future risks, taking market risk positions, or exploiting inefficiencies within
and between the various markets.
As a result of the increasing importance of financial derivatives, and given

their inseparable relationship with the financial product development process,
the purpose of this Chapter can be stated as follows:
The author will use this Chapter to illustrate to the reader the increasing
complexity, importance and magnitude of the products developed via the
financial engineering process. Upon completion of this Chapter the reader
should understand the term 'financial derivative', have an understanding of ,
the major classes of financial derivatives, and have an appreciation of, the ,,
manner in which such derivatives can <be combined via a building block
approach in the creation of other derivatives.
5.2 DERIVATIVES DEFINED
The use of the word 'derivatives' often invokes fear on the part of those who
have heard of the many derivative related financial disasters in modern times
and confusion on the part of those who do not fully understand derivatives.
Perhaps more than any other concept derivatives appear to be the most
misunderstood term in modern day finance. Simplistically, a derivatives
contract may be defined as follows:
A derivative transaction is a bilateral contract or payments exchange

agreement whose value derives, as its name implies, from the value of an
underlying asset or underlying reference rate or index [64]
In other words, we may say that derivatives are financial arrangements

between two parties whose payments are based on, or derived from, the
performance of some agreed-upon benchmark [12]. Note the points of emphasis
in this description:
89
o There is a legal contract between two parties with specified parameters

such as expiry date, terms and conditions, payment intervals and
amounts, where applicable.
o The value of the contract is dependent on (is derived from) the value of
some underlying asset or quantifiable parameter. These so called
ùnderlyings' may take many forms, including securities which are
traded on the stock exchange, the price of physical commodities,
reference indices such as the various stock exchange indices (for
example the JSE All Share Index), interest rates and exchange rates.
It is important to remember that, in accounting terms, derivative contracts are

what are referred to as zero-sum contracts. With a zero-sum contract the net
cash benefits to various participants to the contract always sum to zero. In
other words, for every amount which is gained by a contract participant an
equal and opposite amount is lost by the opposing participant. As a result one
criticism often levelled at derivatives is that they do not create wealth but
merely distribute it. While this may be true conceptually this statement ignores
the vast benefits which may be derived as a result of the efficient and
controlled use of derivatives. Consequently while financial derivatives may be
zero-sum from a cash perspective, they most certainly are not zero-sum in
terms of their economic benefits [60].
Many people see derivatives as a complex arrangement of financial

transactions which, if prompted by the default (failure to pay) of a major
player, could result in a severe, some even say catastrophic, disruption of the
global financial system. Others such as Alan Greenspan, chairman of the
United States Federal Reserve, maintain that the risk of such a meltdown is
negligible [12]. Proponents of derivatives stress that the market hazards of such
contracts are more than outweighed by their ability to helpfirms to manage
their financial risks, to the benefit of many.
90
5.3 FoRwARDs AND OPTIONS: THE UILDING BLOCKS OF DERIVATIVES
There is at present a bewildering array of derivative contracts and securities

available, each of which has been financially engineered to satisfy a specific
requirement. However, irrespective of how complicated such instruments and
contracts may seem, all derivatives are essentially derived from two basic
building blocks, namely forwards and options. Using forwards and options as a
starting point it is possible to group together underlyings with certain
characteristics so as to 'derive' a new security or contract with the desired
properties.
In addition to breaking derivatives down into their constituent building blocks

it is also possible to distinguish different types of derivatives based on where
and how they are traded. Two distinctions may be made here. The first type is
derivative contracts that are privately negotiated between two parties who have
a mutually beneficial interest in entering into the contract. Such contracts are
known as OTC (over the counter) derivatives. The name 'over the counter'
derives from the fact that these contracts are entered into by two private
parties, and are not traded on an open exchange.
The second type of derivative is that traded on a controlled exchange, known

as exchange traded derivatives. Such derivative contracts are not privately
negotiated and entered into by two interested parties, but are openly traded on
a regulated exchange. Each type has specific advantages and disadvantages.
OTC derivative contracts have the advantage of flexibility since they can be
negotiated (customised) between two parties for a specific purpose. Their
disadvantage is credit risk, the risk of a default' on the part of the counterparty
on the expiry of the contract. Exchange traded derivative contracts have the
advantage of ease of trade and a reduced credit risk since the liabilities
between the different parties are monitored by the exchange on which the
instruments are traded. Their disadvantage is inflexibility since such contracts
The term default refers to the inability of a counterparty to a financial contract to pay the required
sum on the required date.
91
are traded in fixed units with regard to contract details, underlyings and expiry
dates. Credit risk is lower for exchange traded contracts than for OTC
contracts since the exchange monitors the total volume and positions of
contracts in order to maintain market integrity. Any participants to a
derivatives based contract which is running at a loss are required to make
margin payments 2 to the exchange, usually on a daily basis.
5.4 FORWARD BASED DERIVATIVES
Forward based derivatives consist of three types, namely: (1) forward

contracts, (2) swap contracts, and (3) futures contracts.
5.4.11 Forward Contracts
Forward contracts are the simplest form of derivative. Simplistically, a forward

contract is a contract between two parties for one to buy and the other to sell a
specific underlying asset at a specified amount and price at an agreed upon
date in the future. Forward contracts can be based on numerous underlyings,
the most popular being interest rates, foreign exchange rates, equities and
bonds. These contracts can be customised via negotiation between two parties
in order to provide both parties with the opportunity to transfer or to minimise
risk. For this reason forward contracts are not standardised but are a class of
OTC derivatives.
With all derivatives the pricing of the derivative as well as its performance is
of paramount importance to both parties. Forwards are relatively simple in that
the change in value of the forward contract is roughly proportional to the
change in value of the underlying on which the contract is based. The value of
the contract is conveyed at maturity with either delivery or payment being
made. As with all derivatives, a gain by one party equals a loss by the other
■.■
2Margin payments are a payment to the exchange calculated as a percentage of the total contract
value. These payments are usually updated on a daily basis. Thus, an initial margin is paid on
entering the contract, and a variable margin is paid on a daily basis in order to update the total
required margin which is based on the current market value of the contract.
92
party. Figure 5.1 illustrates the concept of forward contract values. In this
figure the vertical axis represents the change in value of an investment
portfolio for a change in value of a particular price parameter. Notice how the
payoff profile for the portfolio and the forward contract are perfectly
symmetrical, leading to a net exposure of zero across all possible changes in
the financial price variable (a perfect hedge).
AV
Payoff profile
for forward contract
AP
Resulting exposure
%%%%.%
Risk profile
Source: Smithson, Charles W.; Managing Financial Risk: A Guide to Derivative Products,
Financial Engineering, and Value Maximisation Irwin 1998 [144]
Figure 5.11 A Simple Forward Contract
Consider for example the need to manage currency risk. Corporations are
subject to currency exposure whenever any dealings involve the conversion of
cash flows from another currency into the local currency. For example, a South
African company which imports products from the United States is subject to
currency exposure at all stages. Should the rand depreciate against the US
dollar the South African company will have to pay more rands for the same
product. This translates directly into currency risk.
93
In the modern global marketplace currency risk is ever present. As a result

numerous methods of minimising such risk have been developed. The use of
financial instruments such as derivatives have helped corporations world-wide
to minimise their currency risks or to transfer such risks in favour of another
more acceptable risk.
Forward contracts create credit exposures since the profit and loss on the
contract is only settled at maturity. This, in combination with the fact that the
value of such contracts is typically large 3 , means that participants to forward
contracts are typically corporations, financial institutions, institutional
investors and government entities.
A typical example of a method to eliminate currency risk is the use of currency

forwards. Consider for example the case of a US based firm that expects to
receive DM15 million from a German client in one year. Should the
Deutschmark appreciate against the dollar, the firm stands to receive less
dollars than originally expected. Assume that the current exchange rate is 1.50
DM/USD, the current one-year German interest rate is 3.25 percent and the
current one-year US interest rate is 5.125 percent. The corporation may decide
to enter into a currency forward contract with a dealer to purchase forward
DM15 million in one year's time. Supposing that the dealer agrees to purchase
DM15 million in one year's time at an exchange rate of 1.47 DM/USD, the
resulting cash flows (in one year's time) are as follows:
The firm receives the DM15 million payment from its client,
The firm pays the dealer DM15 million as per the forward contract,
The dealer pays the firm $10.18 million as per the forward contract
_ DM15 million
(being equal to )
1.47 DM/USD
3Global daily turnover in the forward foreign exchange market is estimated to be in the region of
$420 billion 164].
94
The net result is that the firm has locked in a forward exchange rate of 1.47
DM/USD, thereby eliminating any possible currency risk. The firm is willing
to accept the loss of 0.03 DM/USD in exchange for the elimination of currency
risk. Note however that, as with all forward based transactions, the firm will
not be able to take advantage of an appreciating dollar against the
Deutschmark. In this case the firm has traded its currency exposure for a credit
exposure on the dealer.
Note that the difference between the current exchange rate and the forward
exchange rate compensates for the difference in interest rates between the two
countries. This consistency between interest rates and exchange rates is known
as interest rate parity, and forms an important part of modern finance. Any
disturbance of this interest rate parity opens up risk-free arbitrage opportunities
for anyone able to identify such a violation. This concept is shown
schematically in Figure 5.2.
USD10.18 million 1.4732 DM15 million
5.125% 3.250%
USD9.69 million 1.5000 DM14.53 million

Source: Own Source
Figure 5.2 A Schematic illustration of ][nterest Rate Parity
As is illustrated by Figure 5.2, there are multiple ways to achieve the final
result of DM15 million in one year's time. On could invest DM14.53 million at
3.25 percent for one year and in so doing receive DM15 million in one year's
95
time. Alternatively, one could also invest USD9.69 million at 5.125 percent
while locking in the forward exchange rate of 1.4732. The resulting USD10.18
million received in one year's time could be converted into DM15 million
using this forward exchange rate. Any divergence from this relationship would
lead to arbitrage opportunities being exercised by market participants until the
interest rate parity is restored.
5.41.2 Swap Transactions
A swap transaction obligates the two parties to the contract to exchange a

series of cash flows at specified intervals known as payment or settlement
dates [64]. The majority of swap transactions are based on interest rates,
currency exchange rates, commodities or equities as the underlyings. As with
forwards, swaps are bilateral agreements between two parties and thus fall
under the umbrella of OTC derivatives. As a result both parties are exposed to
credit risk. As at 1997 the notional outstanding principle of interest rate and
currency swaps was $23.7 trillion [93].
Conceptually the mechanics of a swap are quite simple. For example, in a plain
vanilla interest rate swap a contract is arranged between two parties with
specific matching requirements. One party may want to hedge its interest rate
exposure by receiving floating rate payments at periodic intervals on some
notional amount while the opposing party may be willing to accept the risk of
fluctuations in the level of interest rates. Correspondingly, in this simple form
of an interest rate swap both parties agree to the terms of a contract which
stipulates the fixed rate of interest to be paid by Party A to Party B and the
floating rate of interest to be paid by Party B to Party A at specified intervals
on a specified notional amount. The resulting cash flows are illustrated in
Figure 5.3.
96
UBOR0 x UBOR 1 x UBOR2 1.180R3 x U BOR4 x

$1,000,000 $1,000,000 $1,000,000 $1,000,000 $ 1 , 00 0, 000
.0875 x $1,000,000
$87,500
A,.
Year I
D 1 2 3 4
$90,000 $90,000 $90,000 $90,000 $90,000
Perspective of Party B (Receive-Fixed) Counterparty
$90,000 $90,000 $90,000 $90,000 $90,000

.........., .. 0.-
Year 1
D 1 2 3 4
F-1 't--1 X-
LIBOR° x [MOR I x UBOR2 x UBOR3 x UBOR4 x

$1,000,000 $1,000,000 $1,000,000 $ 1 ,00 0 ,00 0 $1,000,000
0875 x $1,000,000
$87,500
Source: Kolb, Robert W.; Futures, Options & Swaps Blackwell Publishers, 1997 1931
Figure 5.3 A Plain Vanilla l[nterest Rate Swap
In this example Party A is the fixed-rate payer, paying an interest rate of 9

percent on a notional amount of $1 million. Party B is the floating-rate payer,
paying Libor (a floating rate) on the notional amount of $1 million. Under such
a scenario Party A has effectively 'locked in' interest rates at 9 percent over a
period of five years.
Note that in this case the notional amount of $1 million is not exchanged
between the two parties. This amount is used purely to calculate the relevant
cash flows at the specified intervals. This eliminates credit risk to a great
degree.
Such swaps can similarly be implemented on currencies, the major difference

being that the principle amount is usually physically transferred, leading to the
need for credit risk management.
97
Consider a further example of the use of swaps in interest rate risk

management as shown in Figure 5.4.
Libor ± 80bp
ank
orp orattio n
loan
A
Swap Tate
Libor (6.70%)
Net funding cost = 7.5%
J.P. Mor an
Source: J. P. Morgan & Co. Incorporated; Arthur Andersen LLP; The J. P.

Morgan/Arthur Andersen Guide to Corporate Risk Management Risk Publications
1997 181]
Figure 5.4 A Plain Interest Rate Swap
A corporation would enter into an interest rate swap agreement with a financial
services company such as J. P. Morgan. In terms of the swap contract the
corporation promises to pay J. P. Morgan a fixed rate of interest (6.7 percent in
this case) on a notional principle amount at predetermined intervals for the
duration of the contract. In turn J. P. Morgan promises to pay the corporation a
floating rate of interest (equal to Libor 4 in this case) on the principle amount at
predetermined intervals for the duration of the contract. The corporation is thus
the fixed rate payer and J. P. Morgan is the floating rate payer.
4 Libor, being the London Interbank Offered Rate, is the rate at which large banks in London are
willing to lend money amongst themselves. This rate has become the premier short-term interest
rate quoted in the European market and serves as a reference rate for a number of transactions.
98
Simultaneously, the corporation arranges a loan from a bank (or similar

commercial lending organisation) at a floating rate (Libor + 80bp 5 in this case).
Since the corporation is paying out a fixed rate to J. P. Morgan, receiving a
floating rate (Libor) from J. P. Morgan, and paying out a floating rate to the
bank (Libor + 80bp), the net effect is effective long-term funding at a fixed
rate of 6.7 percent (the swap rate) plus 80bp (the borrowing spread over
Libor). The corporation has thus secured capital at a fixed rate of 7.5 percent.
This means that interest rate risk has been eliminated since, irrespective of the
change in interest rates, the corporation only pays the fixed rate which has
been locked in.
5.4.3 Futures Contracts
Futures contracts are similar to forward contracts in that they obligate two
parties to buy and sell an underlying in specified quantities at a specified price
on a specified date (the contract maturity date). The major economic
differences between futures and forwards and swaps is that the futures
contracts are traded on regulated exchanges and as such take the form of
standardised contracts with regard to the possible variables. Futures contracts
are traded in fixed sizes with fixed contract maturity dates. The only variable
which is left to determine is the price paid for the contract. As illustrated
previously, credit risk (the risk of a counterparty default) is greatly reduced
when trading in futures because the exchange requires that the value of the
contract be marked-to-market 6 daily and that any changes in contract value be
offset by the payment of a margin to the exchange. These margin payments by
buyers and sellers alike act as collateral for the settlement of the contract on
the maturity date. In addition to these differences, the anonymous nature of
futures trading (all trading is done through an exchange) as well as the fact that
1
5 80bp refers to 80 basis points. One basis point is equal to — . 80bp is thus equal to 0.8
100
percentage points.
6
To mark-to-market is to re-value an existing contract, typically on a daily basis, in order to take
into account changes in the value of the underlyings on which the contract is based.
99
futures contracts are traded in smaller standardised forms makes it possible for
members of the general public to trade and invest in such derivatives.
5.5 OPTION ASED DERIVATIVES
There are many forms of option based derivatives, each with a specific
characteristic designed to satisfy a particular financial requirement. Three
general types will be covered here, namely: (1) option transactions, (2) caps,
floors and collars, and (3) swaptions.
5.5.11 Option Transactions
An option contract gives the holder the right, but not the obligation, to buy or
sell the underlying at a specified price (the strike price) during a specified
period or on a specified date [64]. Since the price at which the underlying can
be bought or sold is fixed it stands to reason that the holder of an option will
only exercise the option if it is financially worthwhile. Since the option holder
does not necessarily have to take up the option he has very little risk in terms
of financial loss. Under such an arrangement the seller of the option is subject
to risk since, should the holder choose to exercise the option at any stage (take
the option up), the seller has no choice but to sell the underlying to the buyer at
the specified price. For this reason the seller of the option charges the buyer a
premium in order to compensate for the asymmetrical risk profile of the
option. It follows that the maximum amount the buyer could expect to lose is
limited to the total premium paid for the option. Note that the exercise of an
option does not mean that the underlying must physically be delivered to the
holder of the option. Often the difference between the strike price and the
actual price of the underlying is simply exchanged (referred to as a cash
settlement).
Two types of options are possible. A call option gives the holder the right, but
not the obligation, to purchase the underlying at a specified price. This option
is thus exercised if the actual price of the underlying is higher than the strike
100
price of the option. A put option gives the holder the right, but not the
obligation, to sell the underlying at a specified price. This option will be
exercised if the actual price of the underlying is lower than the strike price of
the option. In either case the price differential multiplied by the number of
options may simply be paid out to the option holder by the issuer should the
option be exercised.
Options may be further subdivided with respect to when they may be

exercised. So called European options may only be exercised at the maturity
date of the option contract, and not before. At the maturity date the option
holder compares the current price of the underlying with the strike price and
makes a decision as to whether to exercise the option. In contrast so called
American options allow the holder to exercise the option at any stage up to and
including the option expiry date. Should the option go 'in the money' at any
stage prior to the expiry date the holder may elect to exercise the option at that
point. Privately negotiated OTC options can exist on a multitude of
underlyings such as bonds, equities, currencies, commodities and even swaps.
As illustrated in Section 5.4.1, the use of a currency forward (or any forward)
does not allow the firm the opportunity to profit should the rate of exchange
move in their favour. This situation can be avoided by the use of a currency
option. Once again, the use of an example will illustrate this simple yet
powerful concept.
Consider the case of a Canadian company that expects a payment one year
from now of 800 million Japanese yen. At the current exchange rate of 80 yen
to the Canadian dollar this translates into C$10 million. As the Canadian dollar
appreciates against the yen so the cash receivable becomes less when
converted to Canadian dollars. To insure against this possibility the firm would
buy a Canadian dollar call. option. Assuming that the cost of this call is
When the exercise of an option would result in a financial gain for the holder, the option is
referred to as being 'in the money'. Similarly, when the exercise of an option is not feasible due to
a negative differential between the actual price of the underlying and the strike price of the option,
it is said to be 'out of the money'.
101
C$340,000, and the call option is exercised by the company in one year's time,
the dealer will compensate the firm for any appreciation of the Canadian dollar
to a level above 80 yen/CS. Alternatively put, the hedged value of the future
income receivable will not drop below C$9.66 million. However, should the
yen appreciate against the Canadian dollar the firm will be able to benefit from
the higher exchange ratio. This concept is shown in Figure 5.5.
C$.mil ion
11.43 Underlying
11,08 exposure
Fledged
10. 00
exposure
9.66
8.89
70 80 90
Source: J. P. Morgan & Co. Incorporated; Arthur Andersen LLP; The J. P.

Morgan/Arthur Andersen Guide to Corporate Risk Management Risk Publications
1997 1811
Figure 5.5 A Currency Option
The pricing of options has been a major area of research since they were
introduced. Whenever a seller sells an option, the question is what the selling
price should be? In fact, the principle of option pricing is considered to be so
important that work on this topic by Fischer Black and Myron Scholes in 1973
is often described as one of the most important financial developments of the
20th century. The value of an option contract can be considered to be made up
of two elements, as shown in Figure 5.6 which plots the value of the option
(vertical axis) against the price of the underlying (horizontal axis).
102
Led cell
Source: Ross, Stephen A.; Westerfield, Randolph W.; Jordan, Bradford D.; Fundamentals of
Corporate Finance, Second Edition Irwin 1993 [1341
Figaire 5.6 The Value of an Option Contract
The total value of an option is composed of its intrinsic value and time value.
The intrinsic value of the option is the profit which would be made if the
option were to be exercised immediately. The time value of an option refers to
the fact that the intrinsic value of the option will change over time, and as such
is a measure of the risk which the seller is accepting. The greater the time to
expiry of the option the greater the possibility that the option will expire 'in
the money'. Given the asymmetrical risk distribution 8 of an option it follows
that the seller would expect to be compensated for the additional risk. In
addition, the volatility of the underlying on which the option is based is an
important factor to consider, given the asymmetrical nature of options. The
more volatile the price of the underlying the greater the risk to the seller that
the buyer will exercise the option.
8 Options have an asymmetrical risk distribution since the risk to the buyer is limited to the
premium paid for the option while the risk to the seller is essentially unlimited.
103
The Black-Scholes formula, which describes the value of a call option, has
been used by options market participants since its derivation in 1973. The most
common version of the Black-Scholes formula is the following:
Co = SoN(di)— Xe - rr N(d2) (5.1)
where
= ln(So / X) + (r + a 2 /2)T
(5.2)
d2= — cr,./T (5.3)
and where
Co = Current call option value

So = Current stock price
N(d) = The probability that a random draw from a standard normal
distribution will be less than d .
X = The exercise price of the option
2.71828, the base of the natural logarithm function
Risk-free interest rate (the annualised continuously compounded
rate on a safe asset with the same maturity as the expiration of
the option)
Time to maturity of the option (in years)
In = The natural logarithm function
Standard deviation of the annualised continuously compounded
rate of return on the stock
Further details on the derivation of the Black-Scholes option pricing model can
be found in Appendix H.
104
5.5.2 Caps, Floors and Collars
Caps, floors and collars, while sounding exotic, are really very logical
combinations of options which afford the investor a particular type of
protection. They are the result of options which have been bundled together for
a specific purpose. A cap is used to protect a floating interest rate borrower
against fluctuations in the rate and is essentially an option which pays out if
interest rates rise above a predetermined level while still allowing the holder to
profit from a fall in interest rates. The cost of the cap to the organisation is a
premium which adds to the effective interest rate below the cap. The benefit to
the corporation is that the maximum interest rate payable on a loan is known in
advance.
The concept behind a cap is illustrated by Figure 5.7. The cap level in this
example is set at 5 percent. Thus at predetermined dates the actual prevailing
interest rate is compared with the capped rate. Should the actual rate be lower
than the capped rate the holder of the cap (the borrower) may take advantage
of these lower rates by borrowing at the prevailing interest rate. If the actual
interest rate is higher than the cap rate the payoff from the cap will offset the
higher interest rates, effectively limiting the borrowing rate to that of the cap
level.
While the benefits of a cap are obvious it may be that the corporation is not
willing to pay the required premium. In such cases the cap premium may be
offset (partially or completely) by selling an interest rate floor. The use of an
interest rate floor to offset the premium (cost) of an interest rate cap is known
as a collar (so called because the effective interest rate payable by the
corporation is constrained within the cap and floor limits). A corporation may
thus purchase an interest rate cap at 8.5 percent. The cost of this cap can be
offset by the sale of an interest rate floor at 5.5 percent (say). The borrower is
thus willing to forgo the benefits of a fall in interest rates in order to pay for
protection against a rise in interest rates. This is an effective hedge because the
105
corporation is happy with the range within which the effective interest rates
could move.
6.0
5.5
Cap
5.0
G) level
U)
4.5
4.0
1 1 I i 1 i
3.5
0 0.5 1 1.5 2 2.5 3
Time (years)
Source: Galitz, Lawrence; Financial Engineering: Tools and Techniques to

Manage Financial Risk Pitman Publishing 1994 [591
Figure 5.7 'Interest Rate Protection As A Result of A Cap
5.5.3 Swaptions
A swaption (swap option) is an option on a swap. The holder of a swaption has

the right, but not the obligation, to enter into a swap contract on a specified
date should such an arrangement prove to be economically sound. As an
example it is possible for a buyer to purchase protection against a rise in the
level of interest rates by purchasing a swaption which provides the option to
enter into a swap contract at a specified date. Swaptions, in combination with
caps, floors and collars, have proved to be very useful tools in the management
of corporate debt.
106
The types of derivatives covered here are indeed only the tip of the iceberg. By
using combinations of the two primary types, namely forwards and options, it
is possible to structure securities and contracts so as to satisfy a specific need.
The number and types of 'products' which can be created is limited only by the
ingenuity and imagination of those involved in the design and creation of such
products.
It is worthwhile to remember than in relative terms the discipline of financial

engineering has not been in existence for very long (of the order of 25 years).
There are thus many exiting times ahead. As an example of just some of the
types of financial derivatives which have been created over the years, consider
those presented in Appendix A. This should make clear to the reader the vast
possibilities that the field of financial engineering has to offer.
5.6 CONCLUSION
This Chapter has illustrated the primary types and uses of financial derivatives
— the products of financial engineering. Although the examples as illustrated in
this Chapter are conceptually the simplest types of derivatives available the
reader should appreciate that these base derivatives can be packaged together
in many varied ways in order to create extremely complex products. It is this
complexity which makes the product development process so important. The
financial services organisation can no longer survive by simply offering
existing products to the market. Volatility within the global economy
necessitates the continuous development and introduction of new and
innovative financial products.
The reader should also appreciate the power of financial derivatives in

influencing the fortunes of organisations, capital markets, and indeed the
global economy. From a base of zero in the mid-1980s most derivative
instruments today trade in markets with notional values outstanding measured
in the trillions of dollars.
107
This Chapter concludes Part One of the thesis. Up until now the author has
illustrated the importance of product innovation in general, and in particular in
the financial services industry. This was followed by a brief introduction to the
principles of corporate financial risk management. The increasing importance
of such risk management has led to the emergence of financial engineering as a
discipline, as was illustrated in Chapter Four. Financial engineering has as its
function the development of financial products designed to satisfy the needs of
the organisation with regard to the management of risk. These products are
known as derivatives, the importance and characteristics of which were
introduced in this Chapter.
Part Two of this thesis will concentrate on the development of the Strategic
Circuit Breaker concept, the Competitive Strategy Matrix, and the Financial
Product Development Model, each of which are designed to provide the
organisation with an enhanced, competitive, financial product development
strategy. The underlying emphasis will be on the use of system engineering
principles in the development of the Financial Product Development Model.
Before developing these concepts however it is worthwhile to familiarise
oneself with the underlying principles and concepts of system engineering, in
particular the manner in which system engineering may help to enhance the
product development process. This is done in the following Chapter.
108
The Role of System Engineering in Complex Systems
Chapter
The Role of System Engineering in Complex
Systems
"Fifteen years ago, companies competed on price. Today it's

quality. Tomorrow it's design." — Robert Hayes, professor, Harvard
Business School
"At Sony, we assume all products of our competitors will have

basically the same technology, price, performance, and features.
Design is the only thing that differentiates one product from
another in the marketplace"' — Norio Ohga, chairman and CEO,
Sony
6J IINTRODUCTION
e live in a society which is constantly producing more people, more

materials, more things and more information than ever before. And not
only is the rate of output increasing, but the inter-relationships between these
elements is becoming ever more complex. The current environment is thus one
characterised by change, as is illustrated in Figure 6.1. The result is that new
products are continuously being developed which do not optimally conform to
the specified user requirements. The discipline of system engineering is
indispensable in meeting the challenge of this complexity.
Complexity within the modern day environment has become a necessary evil.
Consumers demand better products with more functions at a lower price.
Manufacturers, eager to gain market share where such an opportunity exists,
will do everything in their power to satisfy these consumer requirements if a
profit opportunity exists. And while there is absolutely nothing wrong with this
109
in principle, indeed such actions are a basic requirement of a free market

system, the optimal manner in which such objectives may be achieved is
debatable. System engineering adopts an integrated approach which
encourages the design of a firm framework for accomplishing a set goal.
System engineering is employed in the sense that adaptive devices must be
designed and employed to tie the individual bits and pieces together in order
that they may function as an integrated whole.
CONSTANTLY CHANGING REQUIREMENTS INCREASING SYSTEM COMPLEXITIES
L LANINDUNG RESOURCES ERODING INDUSTRIAL BASE
[...CHANGING TECHNOLOGY HIGHER OVERALL COSTS
LONGER ACQUISITION TIMES EXTENDED SYSTEM LIFE CYCLES.
GREATER INTERNATIONAL COMPETITION MULTIPLE PRIME/SUPPLIER TEAMS
Source: Blanchard, Benjamin S.; System Engineering Management, Second Edition

John Wiley & Sons 1998 [15]
Figure 6.1 The Current Environment
The field of system engineering is extremely diverse. Admittedly this diversity

is a function of the role which system engineering attempts to accomplish,
namely the optimisation of (complex) products in order to achieve identifiable
objectives within a particular situation. As such the purpose of this Chapter can
be defined as follows:
1110
The purpose of this Chapter is to provide the reader with an understanding

of the primary concepts underlying the discipline of system engineering
with a view to integrating such concepts, where applicable, in the Financial
Product Development Model to be developed at a later stage. The concepts
presented in this Chapter are extremely important in that they form the
foundation of the Financial Product Development Model.
6.2 THE NEED FOR SYSTEM ENGIINEERIING
Historically, conventional system development has been characterised by a

lack of good early planning, inadequate system definition and allocation of
system requirements, and a short-term focus [15]. The impact of downstream
changes and modifications as a result of inadequate initial planning was to a
large extent ignored. However, as Figure 6.2 illustrates, the cost of such
downstream amendments can become prohibitively expensive. With consumers
demanding high quality products at the lowest possible cost any firm which
ignores such costs cannot be competitive in the long-term.
The result of this historical state of affairs was an unhealthy and unsustainable
imbalance between system life-cycle cost (LCC) (which was high) and system
effectiveness (which was low). System engineering recognises the cost of
decisions made early on in the system life-cycle and subsequently emphasises
the need for attention to be paid to the early life-cycle development of the •
system, as shall be seen later.
In addition to the lack of attention historically paid to the initial part of the
system development life-cycle, further downstream functions such as
maintenance and supportability have not received the attention which they
deserve. This results in the 'iceberg effect', whereby the overall system cost is
analogous to an iceberg. While the total system cost is initially perceived to be
that which is visible above the water (the tip of the iceberg), it soon becomes
evident that there are many other downstream costs which have not been
adequately controlled, either through ignorance or a lack of proper planning.
111
The total system cost thus equals the total 'iceberg' (visible and below water),
to the detriment of the organisation.
Current practices
Cost ofdesign c ha nges
Desired practices
Conceptual Preliminary Detail design Production and/or

design design and development construction
Major program phases
Source: Blanchard, Benjamin S.; System Engineering Management, Second Edition John
Wiley & Sons 1998 [15]
Figure 6.2 The Cost of Downstream Changes in the Development Process
The challenge is thus to ensure that the system development process is able to
provide the user with a high quality, cost effective system (product). This can
only be achieved with the more efficient and effective selection, development
and operation of new and existing systems. The means by which this may best
be achieved is inherent in the system engineering process.
It is interesting to note that many of the concepts found within system

engineering are not new, but have been around since as far back as 1960. What
system engineering provides is the integration of such elements, to the benefit
of the organisation.
6.3 DEFINING SYSTEM ENGINEERING
The concept of system engineering has many definitions, but one of the most
accepted is that as proposed by Blanchard [14 According to Blanchard:
112
System engineering is the'effective application of scientific and engineering

efforts to transform an operational need into a defined system configuration
through the top-down iterative process of requirements definition,
functional analysis, allocation, synthesis, design optimisation, test and
evaluation [14].
System engineering is thus the orderly process of bringing a system into being.
In order to achieve this system engineering promotes the following values:
A top-down approach is emphasised, whereby the system as a whole is

visualised,
Emphasis is placed on a life-cycle orientation to include all phases of

the system,
Strong emphasis is placed on the initial identification of system

requirements as a precursor to successful system design and
implementation, and
An interdisciplinary or team effort is required throughout the

development, implementation and processing of the system.
The need for a clear and concise approach to the establishment and creation of
systems and products has occurred as a result of the increased complexity of
these elements.
But what exactly is a system? Yet again Blanchard [14] provides us with a
commonly accepted definition:
A system is a nucleus of elements structured in such a manner so as to

, accomplish a•.unction to satisfy a stated or identified need [14].
113
A system may thus be described as a set of interrelated components working

together with the objective of fulfilling a desired need. In general, systems
have the following attributes [151:
They are a complex combination of resources,
They typically form part of a hierarchy, and for this reason systems
must be evaluated with this hierarchical structure,
They may be broken down into subsystems, necessitating the overall

view of the system as a result of the interaction between the various
subsystems, and
They must have a purpose and this purpose must be satisfied as

effectively as possible.
However, as Chase 1281 points out, it is virtually impossible for any two
individuals to achieve a common understanding of a given system. According
to Chase, that which constitutes a system is a state of mind, an "abstract,
devised, synthetic entity." As a result a system is only a system because
someone views it from a given point of reference, typically involving an
organisation or an integration of forces or events for which a set of boundaries
can be defined. Man should thus be able to explain to his own satisfaction what
the energy transformations are which must occur in order to attain a
predictable or desired outcome under specific controlled conditions.
Systems may also be classified under each of the following characteristics:
Natural or man-made systems
Physical or conceptual systems
Static or dynamic systems
114
o Closed or open loop systems
The ultimate objective of system engineering is to design a system which can

fulfil its mission at the lowest overall life-cycle cost (LCC). As a result the
system should allow man to design, develop and produce a product which will
fully satisfy a set of stated customer requirements. In order to achieve this the
system engineering approach is to focus not only on the mission orientated part
of the production system but also on the production processes and support
capabilities that are required. Historically system engineering elements such as
logistic support have been considered as downstream processes, issues which
required resolution once the design and development work was done . This has.
proved to be a terminally flawed approach to system design and product

creation, resulting in the realisation that such an approach would not be
sustainable in the future as consumers became more aware (technically) and
started demanding better service and product support. System engineering
eliminates this problem by emphasising the role of overall decisions at an early
stage in the product design and manufacture process.
In short, system engineering provides an improved procedure for optimising

the design and creation of a system, the purpose of which is to allow the profit
seeking organisation to satisfy stated requirements and needs on the part of
consumers. Adherence to and implementation of applicable system engineering
procedures can be a significant advantage to a firm in the modern globalised
market place. The realisation of this fact has prompted significant research
interest in system engineering the world over, adding to an already impressive
armoury of engineering knowledge.
6.4 SYSTEMS VERSUS PRODUCTS
The manner in which the concepts of systems and products are interchangeable --
is often the source of confusion. As a result it is worthwhile defining clearly
how these terms are understood by the author (and consequently how they will
be used throughout this thesis).
115
Systems may be defined in terms of 'how' and 'what' type definitions. Both
definitions are valid and neither makes any statement about system complexity.
The 'how' definition illustrates the essentially algorithmic nature of systems
while the 'what' definition is an indication of how the algorithm may be
partitioned as a prelude to detailed design. It is therefore clear that all products
are essentially systems. What varies however is the relative complexity of
products and systems, a distinction which is typically used in industry. To this
end, relatively simple high-volume systems are generally referred to as
products while low-volume complex products are typically referred to as
systems. Conceptually however there is very little difference between a
product and a system, save for the relative complexity and sales volume [94
For the purpose of this thesis it is the intention of the author to use the term
`system' throughout the rest of this Chapter and the term 'product' throughout
the remainder of the thesis. In particular the author will often refer to a
financial product as opposed to a financial system. The author is of the opinion
that, although financial products exhibit many of the characteristics of a
system, the use of the term 'product' will find greater acceptance within the
financial services industry.
6.5 THE SYSTEM DESIGN PROCESS
The process of system design is inherently scientific although many systems

can be considered to be anthropocentric'. In other words, most systems tend to
reflect human qualities in their design characteristics even when the inclusion
of such qualities may lead to a less than optimum output 1281. Nevertheless
system engineering attempts to adopt a systematic approach to the techniques
required to derive a coherent system which is able to satisfy stated
requirements. While there are numerous examples of system design
methodologies 1141,1281,1151, each customised methodology contains similar, if
not identical, principles for the design, development and implementation of a
To regard the human race as being the centre of, or central to, the universe.
1116
system. Two such examples are illustrated here using Figures 6.3 and 6.4 .
Notice how the process as shown in Figure 6.3 integrates the logistic support
process.
An emphasis. of system engineering is the integration of supporting functions

such as logistic support or maintainability. In identifying the components of
each methodology, notice how the underlying principles remain the same.
While there are differences between the two methods shown here they are
really more author specific than methodology specific. In other words,
irrespective of which method is used, the final outcome should be the same.
This is an important principle because while we can use system engineering
techniques to design optimal systems, such techniques provide the foundation
on which the organisation specific requirements can be customised. There is
thus no such thing as a single 'correct' methodology, merely certain principles
which may be used in order to facilitate the system design process.
While it may seem premature to jump straight into the system design process at
this point such a move allows for the rapid identification of the general sub-
components which make up the system design methodology. Each component
can be enhanced at a later stage once the overall systems process is understood.
System engineering is a life-cycle orientated top-down process and involves

the integration of functions, activities and organisations. Key system
engineering activities are the requirements analysis and allocation, design
synthesis and verification and system analysis and control. The components of
system engineering can be found throughout the system life-cycle.
It is worthwhile to give a brief overview of each of the major components of

the system engineering process within the system life-cycle. Note however that
each system is unique and may include additional components to those
discussed here, or may have fewer components. The important concept is that
117
•
Need 1 Basic Logistic Support

L J
Requirements
Mission Requirements System Maintenance

Analysis Concept
Operational Requirements Maintenance Requirements
System Analysis Allocation of Qualitative and

Quantitative Criteria For
Functional Analysis and Support Elements
Allocation (Prime Equipment)
Preliminary Logistic
System Optimization Support Analysis
Alt CM/ iVCS ••■.•
Evaluation of Alternatives Logistics Factors
Evaluation of Alternatives
System Synthesis Preliminary

Updated Logistic
Preliminary Design and Analysis Design Data
Support Analysis
of a Chosen Configuration
o--Corrective Action—.
(Prime Equipment) Identification of Preliminary
Logistics Resource Requirements
41,
si 9
System Definition/Documentation
Prime Equipment and Support

Element Specification(s).
10
Detailed System/Equipment Updated Logistic
Firm Design Data
Design Support Analysis
Design Data. Design Review, Corrective Identification of Specific

Engineering Mockups and Prototype — Action Logistics Resource Requirements
Models. Test and Evaluation,
Assessment. Modification,
Manufacturing Data 12
Initial Provisioning of
13 Logistic Support Elements
Production/Construction and
Coordination Design and Development of
Integrated Test of
New Support Items
Operational System for Compatibility
(Prime Equipment)
4
15 Acquisition of
System Deployed and Logistic Support
in Operational Use Material
(Prime Equipment and Support)
6
I 7
System Phase-Out
L ... System Operational Evaluation
(Prime Equipment and Support)
LCorrective Action
Reprovisioning of Logistic
Support Elements as
Required
- Source: Blanchard, Benjamin S.; Logistics Engineering and Management, Fourth Edition
Prentice-Hall 1992 [14]
Figure 6.3 The System Development Process (With Entegrated Logistic
Support)
118
Conceptual phase
- operations research
- feasibility studies
U
System Requirements
operational mission objectives

concept of operations and support
operational performance requirements
system effectiveness criteria
cost limitations
U
System Engineering
System Functional Requirements Process
total system mission and functional requirements Application of the
performance requirements and sub-system reliability necessary scientific
functional design characteristics for an integrated system and technical
evaluation of system performance knowledge to the
interrelation of system and functional requirements study and planning
of the overall
U system, whereby the
interrelationships of
System Trade-Off Studies various parts of the
system and the
developing a descriptive system model utilisation of the
evaluate alternatives and variations in design various subsystems
selecting 'best fit' synthesis of solutions for management are fully analysed
considerations in relation to performance, cost and time and designed in
requirements terms of their
contribution to the
U achievement of the
specified mission
System Design and performance
requirements within
derive a coherent system design to produce a defined set of outputs the given cost and
from given inputs with respect to time, cost and performance delivery limitations
measures of system effectiveness
U
System Definition
system and end item performance design requirements covering,

amongst others, prime mission equipment; support equipment ;
facilities; procedures; personnel training; logistic support;
production, testing and deployment
Source: Adapted and modified by the author from Chase, Wilton P.; Management of System
Engineering John Wiley & Sons 1974 [28]
Figure 6.4 An Alternative System Design and Development Process
119
each unique system may undergo a process of integrated development using a •

combination of the processes presented here.
The life-cycle system engineering process is illustrated in Figure 6.5. Using

this Figure as a template each process will be briefly described.
6.5.11 Definition of the Problem
The first step in the system engineering process is the identification and
quantification of a need. This need is the result of a real or perceived
deficiency which may take the form of a product which does not exist, current
functionality which requires upgrading, inadequate system performance, and so
on. While it may seem self evident that this step should precede the system
engineering process, requests for the creation of a system or product are not
always the result of rational decision making. The number of 'false starts'
which accompany such rationality can prove to be extremely costly.
In order to ensure that the requirement is clearly understood a 'statement of the

problem' should be produced which describes the need in quantitative and
qualitative terms. Issues such as delivery schedules, resource requirements and
so forth should be considered. Yet again this may seem simplistic, but it cannot
be over emphasised how important this step is in ensuring that the system
development process gets off to a good start. Even though an engineer may
genuinely believe that he or she clearly understands the customer's needs, it is
still worthwhile to ensure that the statement of the problem or a statement of
need is produced and thoroughly studied prior to the commencement of
development.
6.5.2 The Development of a Consumer Need
Subsequent to the identification of a need, a 'needs analysis' must be

accomplished. The purpose of the needs analysis is to describe, in specific
functional terms, what the exact requirements of the system are. Typical questions
120
Development of
problem (identification
.61 of need)
System feasibility
analysis
System operational
reauirements
Maintenance and
support concept
Identification of
technical performance
measures (TPMs)
Functional analysis
F Requirements analysis
E
E System synthesis,
analysis, and design
optimisation
B
A
Design integration
C
K
System test and
evaluation
Construction and/or
production
System operation and

life-cycle support
System retirement and

material disposal
Source: Adapted and modified by the author from Blanchard, Benjamin S.; System Engineering
Management, Second Edition John Wiley & Sons 1998 [151
Figure 6.5 The Syste ,Il E i gineering Process in the System Life-Cycle
121
may include: What functions must the system perform? What are the primary and
secondary functions? What must be accomplished to alleviate the stated
deficiency and when must this be accomplished? Where and how many times
must this be accomplished? The general pattern of questions is to investigate
the system requirements in functional terms as opposed to solution specific
terms. In other words, the focus is on what problems need to be solved, and not
how they are to be solved. The use of a functional approach has the benefit of
not precluding any possible solution and not constraining the system developer
in terms of the solution to the identified need.
The needs analysis can only be properly accomplished as a team effort and as
such it is not surprising to find that all parties which may have input into the
system development must be involved at this stage. It is important that the
`voice of the customer' be heard. The customer, the ultimate consumer (if
different from the customer), the contractor or producer and major suppliers
should all be involved in the needs analysis. It is imperative that proper
communication exists between all of the parties involved.
6.5.3 System Feasibility Analysis
The role of the system feasibility analysis is to identify at an early stage the
possible (feasible) solutions to the stated requirement. Different technological
and design approaches are evaluated as part of the feasibility analysis. The
output of the feasibility analysis must satisfy three key areas:
The various possible design approaches which may lead to a solution

must be identified,
The most likely candidates in terms of satisfying required performance

characteristics, effectiveness characteristics and cost characteristics
must be identified and evaluated, and
A preferred approach must be recommended.
122
The decisions made at this early stage in the life-cycle will have a substantial
impact on the system in terms of total life-cycle cost, performance, satisfaction
of the stated need(s) and maintainability aspects of the system. It therefore
follows that, given the criticality of the feasibility analysis, particular attention
should be paid to this process. This requirement becomes all the more
important when the complications which arise when different specialists are
required to provide input into the system design and development are
considered. It is often the case that such specialists are not orientated to the
overall system, but are concerned (logically) with only their part of the overall
process. This must be avoided at all costs.
6.5.4 System Operational 1 11

equirements
The system operational requirements process is an attempt to reflect the needs

of the consumer relative to system utilisation. Such information is required in
order to ensure that the system operational requirements are clearly understood
prior to design commencement.
In order to satisfy the operational requirements concept the following

information is required:
Operational distribution or deployment - factors such as the

geographical distribution of the system and the number of sites where
the system will be used must be considered.
Mission profile or scenario - a full description of the primary and

secondary missions of the system. Factors for consideration include
what the system must accomplish in satisfying the stated need and how
this will be accomplished:
Performance and related parameters - a description of the basic

operating characteristics and functions of the system. All system
parameters must be quantitatively described. Critical performance
123
parameters must be highlighted in order that they are given the

required attention during the design process.
Utilisation requirements - the manner in which it is anticipated that

the system will be used in satisfying the stated consumer requirements.
The stresses imposed on the system within its operational environment
must be estimated.
Effectiveness requirements - the requirements, pertaining to the

measurement of system effectiveness, specified quantitatively.
Amongst the issues to be considered are cost versus system
effectiveness, operational availability, dependability and reliability.
Operational life-cycle horizon - the length of time that the system

will be in operational use, inventory requirements of the system and
the anticipated system life-cycle need to be defined.
Environment - the environment in which the system is required to

operate must be defined. What environmental factors will impact upon
system performance throughout its life-cycle? Transportation and
storage requirements (where applicable) may have a severe impact on
system design and as such must be concisely defined up front.
Given that the system operational requirements form the base for subsequent
design it is imperative that the following four questions be satisfactorily
answered prior to proceeding to the next stage :
What function(s) will the system be required to perform?
o- When will the system be required to perform its intended function(s)?
Where will the system physically be utilised and for what period of
time (or multiple time periods) will this utilisation take place?
t24
o How will the system accomplish its objective(s)?
Historically the definition of operational requirements has proved to be a

classic weak point in the system development process 1151. Such requirements
are prepared and then filed away pending a decision on the go-ahead for the
system. Once authorisation is received the lack of operational requirements
induces a free-for-all amongst various specialists and designers who set about
re-inventing the wheel. The resultant lack of communication leads to an ill-
conceived system design which requires costly modifications at a later stage
(consider Figure 6.2).
6.5.5 System Maintenance and Support
Traditionally the design of systems has meant that only the 'operational' part
of the system received attention during the design phase. This led to problems
further on in the system development process. It is therefore required that all
aspects of the proposed system be considered on an integrated basis. This is
best achieved by developing an integrated system maintenance concept up-
front in the conceptual design process. System support and maintenance
capability must be considered from the start of the design and development
process (refer to Figure 6.3 for an illustration of this concept).
The maintenance concept requires the following information:
o Levels of maintenance - Maintenance may be carried out on the

system as well as on system sub-components on site, at some
intermediate site, or at the supplier depot: The levels of maintenance
refer to the specifications of those functions and tasks to be performed
at each location where maintenance is performed. Typical
classifications of maintenance levels are at the organisational level, the
intermediate level and the supplier/depot level.
125
Repair policy - This refers to the specific conditions under which an

item is to be either repaired or replaced.
Organisational responsibilities - Such responsibilities define when

and under what conditions the maintenance of the system becomes the
responsibility of the consumer, the producer/supplier, a third party or
some combination thereof.
Maintenance support elements - Various elements of maintenance

support can be established, such as supply support, test and support
equipment, personnel and training, and so forth. These elements
provide input to the system design criteria.
Effectiveness requirements - All support capability effectiveness

factors must be specified in quantitative terms (for example, personnel
levels of skill, experience, and time to availability). These
effectiveness requirements should compliment the overall system
requirements.
Environment - This is the environment as it affects the system

maintenance concept.
The system maintenance concept provides the base for system supportability
requirements during the design phase.
6.5.6 Technical Performance Measures (TPMs)
All of the processes described up to this point have in some way established
general system level requirements which must be satisfied. It is apparent that
the number of requirements so generated can be numerous, -with often
conflicting resource requirements. In the system design it is most likely that
trade-offs will have to be made since it will not be possible to simultaneously
satisfy conflicting requirements (for example a high quality system at a low
126
price). Decisions thus need to be made in terms of these identified trade-offs

and clearly communicated to all parties involved. The system engineering
process cannot proceed until this has been done.
What is required is some form of measurable goals which accurately reflect the
customer requirements. Given that there will be conflicting requirements it is
necessary that these requirements be prioritised. Such prioritisation may be
achieved with the use of an objectives tree such as that illustrated in Figure
6.6. Such prioritised objectives are however typically qualitative. It is required
that quantitative objectives for each block be achieved through a team effort.
With good communication the system designers become aware of where the
relative emphasis must be in the design process.
Communication between the design team and the customer may best be
achieved by the use of the Quality Function Deployment 2 (QFD) technique.
The QFD technique emphasises the use of a team approach in system or
product development to ensure that 'the voice of the customer' is heard in the
development process and is, by definition, inherent within the final product.
Customer requirements, which are defined as attributes, are translated into
technical solutions through an importance weighting process whereby the
requirements are ranked. The benefits of this approach are:
The design team understands the customer desires,
The customer is forced to prioritise such desires, and
Comparisons of different design approaches are made possible.
2 The Quality Function Deployment method was first developed at the Kobe Shipyard of
Mitsubishi Heavy Industries Limited, Japan, in the late 1960s.
127
To develop a total integrated system capable of satisfying all

specified customer requirements
I
To minimise the cost of To maximise the
the proposed system availability and reliability
of the proposed system
I I I
Minimise total Maximise cost Minimise Maximum The use of
life-cycle cost effectiveness of system system highly skilled
of the system the system by downtime as a reliability as a operators in
means of result of result of using order to ensure
standardisation breakdowns high quality maximum
and components system
maintenance nerformance
V V
Implement a The use of

comprehensive information
maintenance systems and data
program feedback in order
(preventative and to optimise
corrective) maintainability
functions
V V
Source: Own Source
Figure 6.6 An Objectives Tree
QFD is achieved through the construction of various matrices, the first of

which is commonly termed the 'House of Quality' (HOQ) 3 . A modified
version of the HOQ matrix is shown in Figure 6.7.
The left hand side of the HOQ matrix refers to the identification and ranking of
customer needs in quantitative terms. Prioritisation of these needs is achieved
through customer and design team iteration. The top part of the HOQ matrix is
the developer's response in technical terms to the prioritised needs. In addition,
the interrelationships amongst these needs are defined. The centre of the HOQ
3
Readers interested in further information regarding this concept may refer to Hauser, J. R.;
Clausing, D.; 'The House of Quality', Harvard Business Review, May-June 1988 [72]
128
matrix provides an indication of the impact of the proposed technical solutions

on the stated requirements. The bottom part provides a comparison between
different alternatives while the right hand side is used for planning purposes.
Interrelationships
among attributes
(technical correlations)
Design attributes
I I 1-10Ws'
(technical response)
Will.. ■ ■MIll
— Customer Relationships III Planning matrix,
IMO between _
(comsu merr 111111 EMI market evaluation, _
customer needs um
-J
nee ds
'WHATs" A
1111
and
design attributes
Una
Mill
customer perceptions.
and strategic planning _
IN al
Technical response
measures and priorities,
competitive benchmarking,
and technical targets

John Wiley & Sons 1998 [15]
Figure 6.7 The House of Quality (JHIOQ) Matrix
Quality Function Deployment translates a prioritised set of subjective customer

requirements into a set of system level requirements during conceptual design.
This may take place at many levels, and the ability to trace requirements from
the top down should be assured.
Finally, system specifications should always include prioritised technical

performance measures (TPMs) in order to ensure that designers have a
measure of the relative importance (in quantitative terms) of customer
requirements. A sample technical performance measure is illustrated in Table
6.1.
t29
Table 6.1 The Quantitative Prioritisation of Technical Performance

Measures
Technical Quantitative Current Relative %

Performance Requirement Benchmark of lImportance
Measure (TIFM) Competing Terms of
S stems Customer Desires
Construction 7 days 9 days 20
time
Power output 150 kilowatts 135 kilowatts 25
minimum
Maximum weight 1200 1350 kilograms 10
kilo rams kilo rams
Number of 4 adults 4 adults 10
passengers
minimum
Service interval 2 years 1 year 5
minimum
Percentage of 30 percent 45 — 60 percent 30
imported
material
maximum
Source: Own Source
6.5.7 The System Functional Analysis
A function is any action or set of actions necessary to accomplish a given

objective. With this in mind we can define the functional analysis as the
specification of required functions in order to satisfy the system objectives.
The emphasis is on what needs to be done as opposed to how it is to be done.
Functional analysis is achieved through the iterative process of breaking the
system down into sub-systems and still further sub-systems as far as necessary.
This helps with the identification of input design criteria and constraints on the
system.
Functional analysis is best achieved through the creation of a functional block

flow diagram which splits the system into conceptual functions which are
broken down still further as required, providing a top-down hierarchy. The
benefits of the functional analysis approach are:
130
All significant system life-cycle design activities (design, production,

operation, support and retirement) are covered,
All system elements are fully recognised and defined,
System support requirements are related to system functions, resulting

in a good functional design, and
The proper sequence of activity and design relationships are

established as well as the identification of critical design interfaces.
A partial functional analysis block flow diagram is illustrated in Figure 6.8. An

initial need (that of developing a specified transportation capability) is
identified. Subsequent to a feasibility analysis it is determined that a new
airborne transportation capability is the most feasible approach. From the
mission profile it is possible to design a primary system level functional flow
indicating the primary functions to be accomplished. Each of these functions
may then be further subdivided into sub-functions as required in order to arrive
at the final system function hierarchy. This structure allows one to drive down
from the system level in order to identify the resources needed to perform
specific functions. In addition, given a specific sub-system requirement, it is
possible to drive upwards in order to determine the justification for that
requirement. It is thus clear that the functional analysis provides the capability
for a downwards/upwards traceability.
6.5.8 The Requirements Allocation
The specification of resources to each function identified in the functional analysis

can be costly. Often multiple functions can be accomplished by a common set of
resources. Requirements analysis involves the grouping together of common
131
Need
To develop a transportation capability

To
between City À* and City 13'
Feasibility Analysis
Ground Airborne Waterway

transportation transportation transportation
Results of Analysis
(Select airborne transportation capability) .
ry
Mission wale
Start mission
I
C> Complete mission
City 'A" City`'Er
Functional Analysis
System lop , ievel

functional flow
Second-level functional flow

4 . 43
_o
9 9A 9
atuvate ...ten own atocee0 tom CC a at eoly
0 Z
Opeeto
i ancran 194
;sort Ctty 'A' -A- le Cry 8
sister, ■r∎
user
jzotronnterj_ Poziro
aectaft for
scanooy
Second-level tunctionat flow a-
Precoee nom CO3,0 Centem cont419. COrtlettl c-Iceret

City 'A'te --a ciontnninscat ,nonin C41 •mmo. C4,1 13'
— Ca! '8' leinVilten1
- -t. Maintenance !Mee

John Wiley & Sons 1998 1151
Figure 6.8 The Development of System Functional Requirements
132
system functions in order to enhance the design. The objective is to break the
system into elements such that only critical elements may affect the system
architecture. Once these elements have been identified we need to allocate the
system level requirements down to the desired level. These sub-level requirements
serve as an input into the element's design. In other words, what should be
specified for the unit level in order to meet the specified system level technical
performance measures? The requirements analysis can thus be thought of as the
top-down specification of design requirements at the unit level (to whatever
hierarchical depth is necessary) in order to provide input for the design of the
various system elements such that the overall system requirements are
achieved.
6.5.9 System Synthesis, Analysis and Design Optimisation
System synthesis is the combining of components to achieve a feasible system

configuration. Preliminary concepts plus basic relationships amongst
components are identified. An initial system configuration is selected which
represents what may be the final form. This configuration, which is subject to
changes, typically results in several possible design alternatives. These
alternatives are subjected to further evaluation, refinement and optimisation.
Blanchard [15] suggests the following procedure:
Definition of analysis goals
Selection and weighting of evaluation parameters
Identification of data needs
Identification of evaluation techniques
Selection and/or development of a model
133
Generation of data and model application
Evaluation of design alternatives
Sensitivity analysis
Identification of risk and uncertainty
Recommendation of a preferred approach
6.5.110 Design Entegration
Design integration commences early on in the system conceptual design phase

and continues throughout the system life-cycle. System level design functions
are performed by an initial design team made up of professionals who are able
to see the 'big picture'. As the system develops so the appropriate specialists
are integrated. The aim is to ensure that the right skills are available as
required. System engineering continues through the system life-cycle in the
form of the evaluation and validation of subsequent design changes.
6.5.1111 Testing and Evaluation
There is a need to continuously evaluate and test the system during the design
and production phases in order to avoid problems being identified further down
the line (which, as has already been demonstrated, may prove costly to fix).
Early detection of problems, where possible, is therefore highly desirable. The
role of system evaluation is to verify, as soon as possible, that the system will
perform as intended. The use of computers in modern day testing (for example,
the use of computers as simulation tools) has meant that many of the costs
traditionally associated with testing have been eliminate
134
Once the system requirements and technical performance measures are known
the methods that may be used in testing and evaluating such elements must be
identified. The result should be a comprehensive test and evaluation program.
6.5.12 Production and/or Construction of the System
System engineering continues throughout follow-on production or construction

in order to ensure that the standards initiated in the design and development
phase is maintained throughout the entire process. This ensures that system
effectiveness is not subject to degradation.
Operationall Use and Sustaining Support
A major part of system engineering is ensuring that the system is initially

produced with the desired characteristics. However, system engineering does
not end here. These effectiveness characteristics must be maintained
throughout the system life-cycle in order to prevent system degradation and in
so doing to satisfy the stated customer needs. This is achieved by:
0 Producing the system to be supportable, and
o Ensuring that the system maintenance and support capabilities are

designed up-front with the use of, for example, concurrent
engineering.
6.6 CONCLUSION
This Chapter has provided a brief introduction to the principles and concepts
inherent within the discipline of system engineering. Its purpose was to
4 Concurrent engineering is the process of simultaneously designing the system as well as its
maintenance and support capabilities (hence the term concurrent). The advantage is that such
activities are not merely designed downstream or as afterthoughts, but are designed concurrently
up-front where they may provide input into the system design function. The resulting savings in
life-cycle cost can be significant.
135
illustrate to the reader why the product development process often results in
failure and how system engineering can help in the elimination of weak points
within the product development process.
The reader will have noticed a number of important principles running

throughout the Chapter. First of all, system engineering recommends the use of
a structured product development process. Successful product development is
not the result of random actions, but rather the outcome of a purposeful
development process structured in such a way as to enhance the final product
outcome. Secondly, system engineering emphasises the need for a greater
emphasis on the up-front product definition process. Adherence to this concept
minimises the number of downstream amendments, leading to a reduced
product development time and lower product life-cycle cost. The minimisation
of economic life-cycle cost (as opposed to accounting life-cycle cost) can only
be achieved using the principles inherent within system engineering. Thirdly,
system engineering emphasises the need for the parallel development of both
the product as well as its downstream support processes, a concept commonly
known as concurrent engineering.
The use of system engineering in modern day product development is

absolutely imperative given both the importance of the new product
development function as well as the volatility often associated with this
function. To this end system engineering has the ability to provide the
organisation with a strategically competitive advantage within its target market
as a result of an enhanced product development process.
This concept of strategic competitiveness is critical since it is a major

determinant of the ability of the organisation to survive and prosper, both at
present and in the future. The combination of the structured system
engineering based product development process and a method for analysing the
strategic consequences of the product development decision will prove to be a
critical determinant of the future competitiveness of the financial services
organisation. The author would suggest that the concepts of strategic product
136
development decisions and the structured system engineering based product

development process are not separable. Both go hand in hand, and the outcome
of one affects the other.
With this concept in mind the author has developed a method to integrate the
analysis of the strategic financial product development decision within the
system engineering based Financial Product Development Model. The vehicle
by which this is achieved is the Competitive Strategy Framework, the
development of which is illustrated in the following Chapter.
137
The Financial Services Competitive Strategy Framework
Chipter
The Financial Services Competitive Strategy
7 ramework
"Whatever made you successful in the past won't in the future." —

Lew Platt, chairman and CEO of Hewlett-Packard
7.11 INTRODUCTIION
p until now this thesis has accomplished two major goals. In the first
instance the importance of product innovation within the financial
services sector has been illustrated — firstly from a macro perspective where
the general global trend towards product innovation as a source of
competitiveness was illustrated and secondly from the micro perspective of the
financial services industry. In the second instance the four functional areas of
corporate risk management, financial engineering, financial derivatives, and
the use and practical implementation of system engineering have been covered
in sufficient detail so as to provide the reader with an appreciation of these
elements and the manner in which they relate to the financial product
development process. These chapters have, in essence, laid the groundwork for
the concepts to be presented from this point forward.
The stated aim of this thesis is the development of a financial product

development model based on applicable system engineering principles. As
Chapter Six has illustrated, the application of system engineering within the
design, development and manufacture of engineering based products is well
advanced, and has over the years been refined as a result of significant
research into the optimisation of this process. It is therefore the intention of the
138
author to illustrate, via the development of the Financial Product Development

Model, how such techniques can be successfully applied to the financial .
engineering process.
Conceptually, the author considers the successful development of a financial

product (and indeed any product) to be the culmination of a two-step process.
In the first instance:
o The financial services organisation must choose to develop the

`correct' product, with the correct product being defined as that
product which optimally adheres to the concept of strategic fit, being
the manner in which the product advances the strategic (medium to
long-term) aims of the organisation.
As the author will illustrate, the manner in which the product advances the
strategic aims of the organisation is critical to the continued competitive
success of the organisation in the market.
In the second instance:
o The financial services organisation must have the ability to develop the
chosen product more efficiently than its competitors. In this case 'more
efficiently' is considered by the author to be analogous to the
minimisation of the economic life-cycle cost of the product.
It is therefore not enough for the organisation to have a superior product idea.
The organisation must be capable of developing that product optimally in
terms of its economic life-cycle cost.
The author has developed the Financial Product Development Model with
these principles in mind. As such this model is comprised of two major
components, being the strategic analysis of the financial product development
decision (choose the best product to develop) and the optimal development of
139
the chosen product. The strategic product analysis is introduced into the
Financial Product Development Model via the Competitive Strategy
Framework as developed by the author. In addition the use of the Competitive
Strategy Framework is initiated by the concept of a Strategic Circuit Breaker.
The Competitive Strategy Framework and the Strategic Circuit Breaker are the
focus of this Chapter, with the development of the conceptualised Financial
Product Development Model taking place in the following Chapter. In
summary then:
The primary aim of this Chapter is to illustrate both the reasons for and the
development of the Strategic Circuit Breaker concept and the Competitive
Strategy Framework. The emphasis within this Chapter is therefore on the
identification and analysis of the strategic relevance of the financial product
development decision In terms of its ability to advance the strategic aims of
the, financial services. organisation.,
7.2 DEVELOPING THE COMPETITIVE STRATEGY FRAMEWORK
The Competitive Strategy Framework was developed by the author following

extensive research into the latest engineering based competitive product
selection techniques and strategies. The resulting investigative output was a set
of strategies, concepts and techniques (ways of thinking) which, when properly
applied, would prove to be compatible with the proposed system engineering
based Financial Product Development Model and, subsequently, would
enhance the market competitiveness of the financial services organisation.
Most importantly, the Competitive Strategy Framework is based on strategic
concepts which, as will be illustrated throughout this Chapter, have been
proven to be beneficial to the product development process within an
engineering environment.
The challenge in the creation of the Competitive Strategy Framework was not
the identification of concepts and techniques per se, but the identification of
140
relevant engineering based concepts which could be directly applied and/or

adapted to the financial product development process.
The Competitive Strategy Framework was developed with the importance of

concept integration in mind. Because the author proposes the use of a system
engineering based product development process encompassing the Competitive
Strategy Framework which, in turn, is a function of the application of the
Strategic Circuit Breaker, it is vital that these elements exhibit the integrative
concepts required of most modern day processes. As will be seen at a later
stage organisational competitiveness within a rapidly changing market is
dependent on the integration of various elements of the organisation, the
ultimate goal of which is to provide the customer with a superior product
which satisfies their stated needs before competitors can.
7.3 DEFINING THE COMPETITIVE STRATEGY FRAMEWORK
For the purpose of this thesis the term Competitive Strategy Framework may
be accepted as having the following definition:
The Competitive Strategy Framework is that collection of organisational

product selection processes, elements and managerial techniques which,
when applied as a collective whole within the ambit of applicable system
engineering principles, have as their primary function the enhancement of
organisational — competitiveness from a product development perspective
within the financial services industry.
It is important to emphasise at this stage that the Competitive Strategy

Framework is not a stand alone product for the purposes of this thesis and its
resulting recommendations. The framework forms an integral part of the
proposed model- in that it has as its role the establishment of the competitive
frameworks within which the financial product development process takes
place.
141
Research by the author into appropriate engineering based product selection

strategies identified five areas which (1) are appropriate to the financial
product development process (in other words, the underlying concepts can be
directly adapted), and (2) will be a necessary part of the product selection
decision by the financial services organisation in the future as this decision
takes on increased importance. The five elements which make up the
Competitive Strategy Framework are illustrated in Figure 7.1.
-\\
Change Knowledge
Leadership Management
in the
Information
Revolution
Financial Product Development

Process
Technological Product New Product

Integration Innovation as Development
a Competitive Strategy
Advantage
Source: Own Source
Figure 7.11 The Financial Product Development Competitive Strategy

Framework
142
The aim of the Competitive Strategy Framework is not to replace existing

financial product selection techniques, but merely to supplement such
techniques with strategic considerations which may not traditionally have been
associated with development work done within the financial services sector.
Traditional product development theory as well as research relating to the use
of competitive strategy has tended to focus primarily on the more conventional
product creation industries. Companies such as General Electric, IBM, Intel
and Ford have been the subject of much research with regard to product
development, process theory and competitive management. In comparison the
amount of research on organisations who derive their income from the
generation of financial products is minimal.
This is not to say that such conventional research is in any way inapplicable to
the financial services industry. Quite the opposite in fact. However, cognisance
must be taken of the fact that, in relative terms, the financial services industry
is in its infancy when compared with many other industries. It therefore comes
as no surprise to the author to find this research disparity. However, this is
changing. As the world's financial markets play an ever increasingly important
role in everyday business and as the relative profits which can be made or lost
within these markets increase and become more volatile so the attention of
researchers and practitioners alike will increasingly be focused on the financial
product development process.
The Competitive Strategy Framework as proposed by the author is based on

research aimed at identifying competitive strategies which have been found to
achieve consistently superior results when properly applied within an
environment of tangible product development and manufacture (typically
engineering based). Each of the Competitive Strategy Framework elements
have been successfully used by progressive organisations who have achieved
excellent and, in many cases, phenomenal, results. All of the Competitive
Strategy Framework elements have one common thread: when properly applied
they have the ability to provide the organisation with a strategic competitive
advantage in as far as the product selection decision is concerned. However,
143
the Competitive Strategy Framework elements have been applied primarily,

although not exclusively, to more conventional production processes. It is
therefore the intention of the author to illustrate how these elements may be
used in the financial product development process.
Finally, the importance of the two-pronged approach to financial product

development is such that it bears repeating here. Throughout the remainder of
this thesis the reader should keep in mind that the author has suggested that the
optimal development of financial products is a two-pronged process. First, the
financial services organisation must select the correct product to develop. To
this end this thesis adopts the following definition of the 'correct' financial
product:
The 'correct' financial product to be developed by the financial services

organisation is that ',product which is best able to satisfy the concept of
strategic fit and in so doing to optimally satisfy the need for the product
development process to advance the strategic aims of the financial services
organisation.
The Competitive Strategy Framework elements have been chosen such that the
process of product selection adheres to this concept. This Framework is
explored further in this Chapter.
In the second instance, once the financial product to develop has been chosen,
it is necessary that the process via which the product is developed is optimal in
terms of the minimisation of the economic life-cycle cost of the product. This
is done via the use of system engineering techniques integrated with the
Competitive Strategy Framework in order to form the Financial Product
Development Model, the development of which is illustrated in the following
Chapter.
144
7.4 USING THE COMPETITIVE STRATEGY FRAMEWORK
The Competitive Strategy Framework has been developed by the author to be

integrated within the Financial Product Development Model, using the
Strategic Circuit Breaker as an activation mechanism. Its purpose is to ensure
that the financial services organisation, and in particular executive
management, apply adequate consideration to the strategic consequences of the
product development decision. The fundamental concept on which the
Competitive Strategy Framework is based is that the product development
decision cannot be separated from the strategic objectives of the organisation.
By ensuring that applicable strategic considerations are adequately analysed
within the product development decision the organisation is able to not only
develop a great product, but to use the very process of product development as
a mechanism for enhancing the strategic market competitiveness of the
organisation.
The Competitive Strategy Framework consists of five elements which, when

applied to the financial product selection decision, provide the organisation
with a measure of the strategic fit of the product. The concept of strategic fit is
introduced by Robert 11331 who illustrates the importance of this concept in the
selection of product development projects.
Conceptually strategic fit is a measure of the degree to which a new product or

market opportunity fits the strategy of the business. Robert illustrates both the
importance of and inseparability of this function with respect to the
organisational product development decision. The concept of strategic fit is the
fundamental conceptual foundation upon which the Competitive Strategy
Framework is built.
Robert 11331 further emphasises the importance of the concept of strategic fit
by illustrating that organisations that try to be innovative outside the strategic
framework of their business usually do not succeed. For example, a number of
years ago Exxon, the international oil producer, made the decision to expand
145
into the office information business. However, despite the infusion of massive
amounts of money and highly qualified staff this project was a dismal failure.
The office product market was simply not part of Exxon's strategic direction.
Top management were comfortable with the nuances of producing oil, not
office products. The development of such products did not fit Exxon's business
objectives. There was no strategic fit.
Each of the five Competitive Strategy Framework elements have been selected
to focus on one particular strategic aspect of future financial services
organisational competitiveness. The product development decision should
therefore be analysed in terms of each of these five elements. The key question
however is at which point does the organisation make the decision to proceed
or suspend the product development process? The simple answer is that there
is no simple answer. Given the diverse nature of organisations within the
financial services industry it becomes hard, if not impossible, to develop
generic guidelines. For this reason the Competitive Strategy Framework makes
no attempt to specify pass or fail criteria for the continuation of the financial
product development process. Such a decision must be made by management
based on the overall outcome of the Competitive Strategy Framework analysis.
A product which is deemed to satisfy two of the Competitive Strategy
Framework elements need not necessarily be abandoned. Similarly a product
which satisfies four or five of the elements may not necessarily be allowed to
proceed. The purpose of the Competitive Strategy Framework is purely to draw
the attention of management to the strategic consequences of the product
development decision with a view to enhancing the organisation's market
competitiveness as a result of the product development process.
With this in mind the author will now focus on each of the five Competitive
Strategy Framework elements, both by describing the element in greater detail
and by illustrating how the element relates the product development decision
to the organisation's competitive strategy. The author has purposefully chosen
to include many practical examples of the application of the concepts as
detailed within the Competitive Strategy Framework. It will however be
146
noticed by the reader that the vast majority of these samples are taken from
industries as diverse as pharmaceuticals, the airline industry, the motor vehicle
industry and the information technology industry. This is desirable because the
reader will appreciate both the importance of such concepts as well as their
general applicability to any industry, including the financial services industry.
7.5 CHANGE LEADERSHIP (ELEMENT 11)
Change leadership, or change management as it is often referred to, has

become a critical element in the armoury of the modern day organisation as
volatility within the world's global markets reaches levels unimaginable a few
decades ago. Competitive pressures are such that, quite literally, only the 'best-
of-the-best' survive. Within such an environment only those organisations that
understand the concept of change leadership and are able to apply this concept
in practical terms will survive. As a result:
The purpose of this section is to illustrate that the capability to be a leader

of change (as opposed to a manager of change) will in the future prove to be
a significant element within the strategic success of the financial services
organisation. The selection of the financial product to develop should as far
as possible be based on its ability to add to the proactive change leadership
process within the organisation and in so doing to ultimately advance the
organisation's strategic aims.
The importance of change in the modern day business environment is best

summed up by Lew Platt, chairman and CEO of Hewlett-Packard when he
says:
"Whatever made you successful in the past won't in the future." [124]
Similarly, Peter Georgescu, chairman of Young & Rubicam has declared:
"It's the end of the world as we know it." [124]
147
Sam Walton, the legendary founder of Wal-Mart, used the phrase:
"Swim upstream." 11001
However you look at it, all of the world's greatest companies have one thing in
common: they are all leaders of change.
There has been much research dedicated to the concept of change management.
However, it is the opinion of the author, and indeed many others 11531,1691,1701,
that the term change management is a misnomer in modern business. Instead of
talking about change management businesses should be talking about change
leadership. The term change management implies a reactionary approach to
change which can often prove fatal for business. Far preferable is the concept
of change leadership which one more easily associates with a proactive
approach to creating change rather than simply conforming to change. This
small but nevertheless significant conceptual hurdle is vital for sustained
competitive advantage in the marketplace. While this is applicable to all
businesses it is especially so for the financial services industry. In the financial
services market one attains a competitive advantage (becomes a market leader)
by being at the cutting edge of change, and this can only be achieved as a
result of a sustained program of change leadership. Reacting to the changes
brought about by competitors is not good enough.
The author's emphasis on change leadership as opposed to change

management is supported by the change path model as proposed by Strebel
11521. According to Strebel three change forces are possible:
o Weak change forces,
o Moderate change forces, and
0 Strong change forces.
148
Each change force has a predictable reaction, as illustrated in Table 7.1.
---- -
Table 7.1 The Reactions to Change Forces
Change Force ' eaction
Weak Proactive change occurs while the change force is
still weak and can be identified early
Moderate Reactive change results when the force of change is
moderate and has begun to affect organisational
performance, but not so severely that survival is
threatened
Strong Rapid crises change is the result of a strong change
force which threatens the survivability of the
business.
Source: Adapted and modified by the author from Strebel, Paul; 'Choosing the Right Change
Path' The Complete MBA Companion Pitman Publishing 1997 [152]
The speed with which new products can be introduced and new markets
created within the financial services industry means that the adoption of
reactive change and rapid crises change methods will not lead to a competitive
advantage. No firm can afford to adopt reactive change measures for any
sustained period of time.
Strebel [151] also introduces the concept of the evolutionary cycle of

competitive behaviour with regards to breakpoint dynamics, a concept
applicable within the financial services industry. A breakpoint is a new product
offering to the market which is so superior in terms of delivered value and
delivered cost that it redefines the rules of the competitive game. For example,
the arrival of IBM in the early 1980s created a breakpoint in the computer
industry. Subsequently, Apple's Macintosh created another industry breakpoint
with its new level of ease of use and user friendliness. The importance of
industry breakpoints cannot be over-emphasised, and it therefore becomes
imperative that the firm is able to identify new breakpoints in order to remain
competitive. This requires an understanding of breakpoint dynamics.
149
In illustrating breakpoint dynamics Strebel [151] introduces the concept of the

evolutionary cycle of competitive behaviour. This evolutionary cycle is
illustrated in Figure 7.2.
Two types of breakpoints may be identified as follows:
o Divergent breakpoints where one finds an increased variety in

competitive offerings resulting in more customer value, and
o Convergent breakpoints where improvements in systems and processes

are used to create and deliver products which have an ultimately lower
cost.
Efficiency:
Survival of the
Convergence of
ittest
offerings
Divergence of
offerings
}Innovation:
Variety creation
Source: Strebel, Paul; 'Breakpoint: How To Stay In The Game' The Complete MBA
- Companion Pitman Publishing 1997 [151]
Figure 7.2 The Evolutionary Cycle of Competitive ehaviour
150
When a divergent breakpoint occurs competitors rush to explore the

possibilities created. The result is a surge in innovative new offerings. This
trend continues until further innovation is no longer possible and imitation of
competitors best product features has run its course. Consequently the value of
innovation in terms of providing a competitive advantage diminishes until
someone identifies the possibility of gaining a competitive advantage by means
of cost reduction mechanisms. Techniques such as Total Quality Management
(TQM) and business process reengineering (BPR) come to the fore in an effort
to reduce the final product delivered cost. This convergence leads to a shake-
out of the less efficient industry participants until eventually the ability to
reduce costs reaches its limit. At this stage someone identifies the opportunity
to gain a competitive advantage by means of introducing an innovative new
product, and so the whole evolutionary process starts again.
Most companies find themselves continually reacting to industry breakpoints.

However, in order to be one of the best (and indeed, some would say the best)
it is necessary to create industry breakpoints. Creating industry breakpoints as
opposed to merely reacting to them requires a three-part learning organisation
11531. Such an organisation is based conceptually on a functional division
between frontline managers, middle management, and top management, with
each level of management having an important, identifiable role to play in the
creation of an industry breakpoint. These roles are outlined in Table 7.2.
Note how the emphasis clearly shifts from the identification of opportunities at
the frontline management level to the recognition and selection amongst
different possibilities at the middle management level. Encompassing all of
this is top management whose role it is to create the right environment in
which the frontline and middle managers may be encouraged to explore
possible opportunities.
151
Table 7.2 The Role of Management in the Three-Part LeiNiiiii

Organisation
Frontline Managers Middle Managers Top Management
o Experimentation Manage opportunity o Provide the right
o Problem solving portfolio in order to climate for frontline
provide: and middle managers
o Commit the company
o Learning from to exploit industry
own experience breakpoints from time
o Learning from to time
others
o Transfer of
knowledge
Discover new Select and develop Time full-scale exploitation
opportunities new opportunities of opportunities
Source: Strebel, Paul; 'Creating Industry Breakpoints' The Complete MBA Companion
Pitman Publishing 1997 [153]
An excellent example of an organisation which has identified the benefits of

creating rather than reacting to industry breakpoints is Yamaha [153]. Yamaha
started out in wood carpentry before moving into pianos in 1941. The onset of
the second world war produced an unexpected opportunity in the form of
wooden aircraft propellers which were required for the war effort. Yamaha
soon realised that wooden propellers, while usable, did not do the job
efficiently, and thus work was done on creating steel propellers. After the war
ended with a subsequent drop in demand for steel propellers Yamaha used its
knowledge in steel casting to develop motorcycle engines for which there was
an upsurge in demand. In the 1960s competition between motorcycle
manufacturers was so intense that a major shake-out occurred, leaving just four
major players (Yamaha, Honda, Kawasaki and Suzuki). As a result of price
pressure Honda moved into cars while Yamaha identified motor boat motors as
a potentially lucrative opportunity. This move was to prove correct, with
Yamaha subsequently capturing roughly 50 percent of the market.
152
The need to be a change leader rather than change reactor is emphasised

emphatically by Harari [69]. According to Harari change should be embraced as
a business opportunity and managed in such a way that it can be capitalised
on. Many organisations fall into the trap of adopting the approach of 'how can
we best counteract this change?' This is totally wrong and can only lead to
business failure, particularly as competition increases. The organisational
approach should rather be 'how can we capitalise on this change and in so
doing enhance our competitiveness?' This is well summed up by a vice
president of Nypro (a leading US plastics moulder) who made the following
statement [69]:
"I went to business school, and they teach you fundamentals of

management — direct, control, plan, cut costs. It's the wrong thing to
teach. They should be teaching people what their job is, which is to
reinvent the systems within which people work." [69]
The financial services industry has been dramatically affected by change over
the past decade. A typical example is the growth of investment banking which
now dwarfs commercial banking which for many years was the mainstay of the
financial services sector [129]. Major improvements in technology have
allowed many new financial innovations. A classic example is the growth of
derivatives which is recognised as being the single most important
development in finance over the past decade. The same innovation is currently
being applied to the science of financial risk management. Techniques such as
value-at-risk (VaR) are being adopted as the preferred method for establishing
bank capital adequacy requirements' [87].
I Capital adequacy is a measure of the capital- which banks should -have underpinning their
operations. Capital adequacy directives specify the minimum amount of stockholder equity and the
maximum amount of debt that banks can use to finance their assets [91]. In order to avoid a
recurrence of the banking failures of the 1980s central bankers from the Group of Ten (G10)
countries, under the auspices of the Bank for International Settlements (BIS) announced the 1988
Basle Accord which had as its purpose the international convergence of supervisory regulations
governing the capital adequacy of international banks [87].
153
The pace of change within financial services is so fast that many regulators
have begun to issue warnings regarding their capability to monitor and regulate
such changes. Alan Greenspan, chairman of the US Federal Reserve Board has
stated that in the 21 st century evaluation of financial soundness will
increasingly focus on process and not on historical records. An example of the
magnitude of such changes is that of credit risk carried by banks. This risk can
often make up as much as 90 percent of total bank risk; and for this reason
most major banks have started to quantify their credit risks for internal
management purposes. The increasing importance of credit risk has created a
new divergent industry breakpoint, namely that of credit derivatives. The use
of credit derivatives, which have evolved as a means to manage and control
credit risk, is increasing at an exponential pace. At the end of 1996 the notional
outstanding amount of credit derivatives was $21 trillion. It is estimated that
the notional amount outstanding in the year 2006 will be $510 trillion 11291.
This section has illustrated clearly that in an environment of volatility a

proactive approach to change is required. Reacting to change within the
financial services industry will not allow the organisation the chance to
increase its competitive position. The early identification of industry
breakpoints is vital to the organisation involved in the development of
financially engineered products since the maximum opportunity for profit is
associated with the ability to identify and capitalise on the changing
requirements of participants within the financial markets.
Consequently, the ability of the financial product to positively enhance the

organisation's status as a change leader should form part of the product
development decision.
7.6 KNOWLEDGE MANAGEMENT IN THE 'INFORMATION REVOLUTION

(ELEMENT 2)
We live in an age where access to information is critical. The management of

knowledge and intellectual capital is a primary determinant of business success
154
in industries which rely on these intangible elements. The financial services

industry is one such industry, and the development of financial products is
without a doubt dependent on the availability of appropriate knowledge and
skills. Therefore:
The aim of this section is to illustrate the importance of knowledge

management as a separate and identifiable organisational function and to
relate this function to the financial product development decision in as far
as the development of the product will further the development and spread
of knowledge throughout the organisation.
Most if not all people are aware that we are currently in the age of information.
Information has become central to everything we do. Decisions are made on
the basis of information. Terms such as 'the information age' and 'the
information revolution' are liberally used in business. While it is good that
many more people are becoming aware of the benefits of information
management many do not understand the true worth of information. The true
worth of information is not in the information itself, but in the ability to use
such information in the enhancement of knowledge on an individual or
organisational basis.
Most experts make a clear differentiation between information and knowledge.

Information on its own is not particularly useful. Information needs to be
converted into knowledge if it is to be of any value. As is illustrated by
Pascarella [117]:
"Too much information can be negative for a company. The mind-set

has to shift from a focus on stockpiling information to gaining
knowledge. Only knowledge can bring true value to a company." [117]
Not only must information be converted into knowledge in order to be useful,

the flow of such knowledge must be controlled. The flow of knowledge, if
properly controlled, leads to innovation which is vital for maintaining a
155
competitive edge. For example Dow Chemical, the US chemical giant, has put
its 25,000 patents into a central database in order to allow all of its divisions to
develop new ways to create additional revenue from existing assets 11171.
In addition to emphasising the difference between information and knowledge

Pascarella 11171 also illustrates how knowledge, which leads to innovation, is
one of the keys to future competitiveness. Various concepts such as concurrent
engineering, agile manufacturing and business re-engineering are all
converging on a single theme: transformation of the business through
knowledge management. The underlying concept is that the total collection of
all individual intelligence is not equal to group intelligence.
The points raised thus far are not merely theoretical concepts which have yet to
be tested in practice. The importance of knowledge management (as opposed
to information management) is well illustrated by the fact that the ten best-
practice companies in knowledge management are all leaders in their field (see
Figure 7.3).
Arthur Anderson
Buckman Laboratories
Canadian Imperial Bank of
Commerce
Chevron Corporation
Dow Chemical
Ernst & Young
Hewlett-Packard
Hughes Space &
Communications
McKinsey & Company
Skandia Group Insurance
Source: Pascarella, Perry; 'Harnessing Knowledge'

American Management Review (October 1997) [1117]
Figure 7.3 The Ten Best Practice Companies 1ln Knowledge Management
156
The importance of knowledge management in modern organisations is well

illustrated by Kenichi Ohmae, the well known Japanese consultant [70]. A
decade ago Ohmae predicted that the emerging economy would be brain based.
He has subsequently been proven to be correct. World-wide profits continue to
be depressed on anything which is not unique and can be easily copied by
competitors. Intangible assets such as expertise and intellectual capital will
become more important than conventional balance sheet items such as fixed
assets [26]. Any business wishing to survive and be competitive must therefore
focus on the intangibles. Winning organisations spread the flow of knowledge
and in so doing enhance their competitiveness in the market.
Business success no longer relies exclusively on mass and physical presence.

While these are still important, their importance is diminishing. Almost 50
percent of the 1980 Fortune 500 companies in the United States no longer
exist. And those that do, such as McDonalds, are finding business conditions
increasingly tough [70].
Harari [70] recommends two requirements for a competitive organisation in a

knowledge based economy, namely:
o Spread information everywhere — In the emerging brain based

economy the organisations that will eventually emerge as winners will
be those that are committed to spreading the flow of knowledge. The
requirement is to be able to gather knowledge quickly and then to be
able to convert such attained knowledge into something useful before
competitors can. Note the emphasis on doing something with the
information gained. Information is not simply accumulated for no
purpose.
o Use knowledge to_ challenge sacred cows in pursuit of revolutionary

goals (as opposed to evolutionary goals) — The knowledge within the
organisation should be used to continuously challenge organisational
beliefs in the pursuit of innovation and 'mind blowing' products.
157
The issue of knowledge management, or more specifically, knowledge creation

in an organisational environment focused on product development is a complex
one since these two elements would appear to be contradictory to one another.
However contrary to popular belief it is possible to achieve these goals
simultaneously provided certain principles are adhered to. In an excellent
paper on the subject Duru Ahanotu [50] develops a conceptual model for
modelling the conflict between product creation and knowledge development.
While the focus of this paper is specifically on production workers within a
manufacturing environment the principles so developed are equally applicable
to the development of products within the financial services industry, a
primarily service based environment.
In this conceptualised framework Duru Ahanotu 1501 illustrates how most

theories of manufacturing model knowledge as flowing into and defining
production but rarely model such knowledge flowing out of the product
development process. In order for an organisation to be competitively
successful this cannot be the case. Under the framework so proposed
production knowledge can effectively support evolving manufacturing core
competencies while simultaneously ensuring the creation and maintenance of
knowledge in conjunction with the realisation of products.
In order to increase the ability of the organisation to develop the knowledge of

those involved in the product development process while balancing the need
for productive output the 'production portfolio of tasks' should contain at least
three activities, namely:
o Production/operations, being all of those activities that directly

manipulate the product,
o Experimentation, being the purposeful discovery of knowledge

separate from the production/operations functions, and
158
Absorption, being the acquisition of knowledge external from one's

direct actions.
Duru Ahanotu [50] refers to these three activities as the TPT — tripartite
production tasks. This co-operation between the respective functions of
operations and design is known as expansive systems development and has
found favour with a number of organisations, notably Advanced Micro Devices
(the producer of computer chips) who have had success with similar initiatives.
Finally the author would suggest that, in as far as the conflict between product
development and simultaneous knowledge creation is concerned, the following
three principles as suggested by Duru Ahanotu [50] are perfectly applicable to
the financial services industry:
Sustained growth in targeted knowledge assets enhances an

organisation's ability to provide competitive products. The need for
simultaneous product development and knowledge creation is not
simply a nice to have, but will prove to be a significant source of
competitive advantage for the organisation. Simply put, the
product/knowledge conflict is manageable and can be used to the
advantage of the organisation.
The organisation is designable to support and encourage the required

growth in knowledge. Underlying this point is the concept that as
knowledge is created and spread throughout the organisation so new
structures will emerge which will evolve the organisation into a new
range of competencies and capabilities and in so doing enhance the
ability of the organisation to successfully compete with competitors in
the market.
In order for the system to function properly an integrated product

development cycle is required. The tasks critical to creating, spreading
159
and sustaining knowledge are often found within this product

development cycle.
It is thus apparent that not only is the conflict between operational product
development and simultaneous knowledge creation manageable, such conflict
can in fact be used by the organisation as a source of competitive advantage.
This section has emphasised the importance of seeing the financial product
development process as more than just the simple development of an end
product. This development process itself can be used in the creation of
organisational knowledge which will allow for the creation of key
organisational competencies. As has been illustrated, true core competencies
are typically intangible and cannot easily be copied by competitors. The
successful financial services organisation of the future will need to use the
financial product development process as a means of creating core
organisational knowledge in order to provide the organisation with the ability
to implement a sustainable competitive strategy.
7.7 TECHNOLOGY INTEGRATION (ELEMENT 3)
Technology integration, or the inclusion of both proprietary and external

technologies in the successful development of a product, is an engineering
based concept. It has strong applicability to the financial services industry
however. To this end:
The aim of this section is to illustrate the concept of technological

integration and to describe how this concept may be applied in the financial
product development process.. At the end of this section the reader should
have an appreciation for the appropriateness of this concept to the financial
product development process and,, hence, _ the important- strategic
- -
ramifications this concept may have for the financial services organisation.
160
Technology integration is one of the most effective methods of enhancing

organisational competitiveness in a competitive environment, and is credited
with being one of the breakthroughs that led to the resurgence of the US
electronics sector in the nineties [79]. Technology integration is concerned with
the process of turning good research into great products. Often this link is not
present, with the result being that the organisation effectively loses money on
research leading to a situation where market share is lost to more aggressive
competitors.
It is obvious that an organisation's ability to translate good research into great

products is vitally important. Achieving this utopia is not easy though.
Technology integration helps in the achievement of this goal by ensuring that
the organisation carefully and intelligently chooses and refines the
technologies employed in a new product, process or service. In order to
achieve this technology integration defines the interaction between the world
of research and the worlds of manufacturing and product application.
The fundamental principle of technology integration is the following:
The most competitive and successful companies are those that are able to
choose from the vast range of available technological options and integrate
such options in their product design, not necessarily those that :create them.
This is an immensely powerful statement since the implication is that pure

research capability is not necessarily a primary indicator of performance. This
assertion is borne out by studies which indicate that technology integration is a
key to competitive performance [79].
Figure 7.4 illustrates a general technology integration model. Three distinct

stages can be identified. First,_ both internal and external organisations conduct
research which leads to a variety of technological options. The organisation is
able to choose from amongst these options and the identification and selection
of appropriate options takes place in the second step. Thereafter the chosen
161
options are used in the product development process with the result being a
new (revolutionary) product. Note that the new product typically generates a
whole generation of so called derivative products. It is thus apparent that
revolutionary product design is not simply the process of converting in-house
research into product development ideas.
The integration team The team works with

investigates, selects, and developers to deliver a
refines the options complete generation of a
product or processes
New
Technology Product
COI Integration
Derivative
Products
Internal and
external
research
organisations
generate a
variety of
technological
options
Source: Adapted and modified by the author from Iansiti, Marco; West, Jonathan; 'Technology
Integration: Turning Great Research Into Great Products' Harvard Business Review (May-
June 1997) 179]
Figure 7.4 A Technology tegration Model
It is important to understand that while the general concept of technology

integration is applicable to all organisations in all sectors of the economy this
does not in any way imply a standard 'one fits all' approach. The importance
162
of a proprietary approach to technological integration cannot be over

emphasised. The model as illustrated in Figure 7.4 has been proven to work
well for organisations operating in the United States for a number of reasons.
This model takes advantage of employee churn which has become a way of life
in many US industries as well as taking advantage of the strong culture of
academic research which exists in the US. Such an approach would not
necessarily work well in Japan, for example. Japan has a much weaker
tradition of academic research and, as a result of the traditionally long terms of
employment that Japanese employees enjoy, most companies cannot gain much
advantage by luring away employees from a rival company. In addition US
companies tend to favour a more revolutionary approach to new product
development while Japanese companies in general prefer incremental
technology improvements [79].
Irrespective of the differences in the manner that technology integration may

be employed one thing which is applicable to all economies is that the
successful organisations are those that are most adept at choosing technologies
that can work together in an increasingly complex productive system.
Organisational proficiency in technology integration is most critical in an
environment which involves a novel base of technology and an increasingly
complex context in which such technology must be applied. This is an
excellent description of the financial services sector given its increasing
complexity which, to a large degree, relies on increasingly novel and
innovative ways to solve identified deficiencies.
The complexity of product development within the financial services industry

in combination with the rapid pace of discovery makes the use of the
technology integration concept vital to the competitiveness of the organisation.
No organisation has the capability to conduct research in all areas of financial
theory. However, with the concept of technology integration this is not -
necessarily a disadvantage. What is required though is that the financial
services organisation be aware of this concept as well as the manner in which
its implementation can benefit the organisation.
1163
7.8 PRODUCT INNOVATION As A COMPETITIVE ADVANTAGE (ELEMENT 4)
Chapter Two illustrated some of the many innovations in the financial markets
over the past number of years as well as focusing on the process of innovation
as a means of achieving increased market competitiveness. Given the
tremendous importance of the process of innovation, not only within the
financial services industry but indeed within any industry, it follows that this
concept must make up one of the elements of the Competitive Strategy
Framework. As such:
The purpose of this section is to illustrate how the concept of product

innovation can enhance the strategic aims of the financial services
organisation and, consequently, to suggest that the relative measure of
innovation associated,with the proposed financial product .,be considered as
an integral part of the overall product selection decision.
In the future the competitiveness of a firm will, to a large degree, be

determined by its ability to produce innovative new product ranges. Those
firms that can bring successful new products to the market first will emerge as
competitive leaders. Note however the emphasis on product ranges. Companies
must think in terms of product ranges since this is where true innovation can
take place. The development and marketing of derivative products currently
plays a great part in product development strategy and will continue to do so to
a greater extent in the future.
Lawlor 1971 illustrates how corporate financiers will have to look for
increasingly innovative ways to service their clients in the future. Conventional
corporate finance techniques will no longer provide a distinguishing
competitive advantage. In the future corporate financiers will increasingly have
to work with their firm's dealing and structuring departments in order to - ensure
a steady flow of innovative products. The unique skills to be found in these
areas will prove vital to attaining a sustainable competitive advantage. As an
example financial derivatives in the form of options could be used as a means
164
of effecting a corporate take-over. While the legalities of such a structure

would have to be explored one can rest assured that this will not stop
companies from creating such structures for possible use in the market.
The new product development environment of the future is essentially one of

high-tech entrepreneurship [101. As a result many companies will need to turn
to internally generate ventures, commonly known as intraventures. The
purpose of such intraventures is to create innovative new products and services
which deliver new levels of value to the customer (remembering of course that
the term 'customer' may have many connotations): However, successful
intraventures are not simply the outcome of a natural business process, but
require dedication and commitment on the part of management in order to be
successful. It is possible to identify eight elements of a successful corporate
intraventure [10]:
Senior executive alignment and commitment — an understanding of how

intraventures fit into the organisation's future as well as the core
competencies which may be capitalised on are required on the part of
senior management.
The ability to pick the best shots — in the future successful

organisations will be those that have the ability to scan the markets for
changes (particularly in technology) in order to identify unfulfilled
customer needs.
Developing corporate interoperability — interoperability in the field of

information technology refers to the ease with which two seemingly
disparate information systems work together. Intraventures will require
seamless interoperability between the different parts of the
organisation in order to satisfy fast moving market requirements (for
example, interoperability between derivative structuring and corporate
finance within a financial services organisation). The speed with which
165
decisions can be made will prove to be a significant advantage in the

product development process.
Clearly defined stages and metrics — the ability to measure the

progress of the intraventure via its five generic stages (concept, seed,
intraventure development, market realisation and intraventure
maturity) is of paramount importance. Senior executives must know
when to add additional resources in order to move to the next stage and
when to remove existing resources from a completed stage.
The 'best' team — given the importance of product innovation it

follows that the company should assign the best leaders to the
intraventure team. Traditional project management concerns such as
career path opportunities and scope for personal expansion should be
addressed.
Management of the venture portfolio — active management of the

venture portfolio is necessary for success. In particular the
effectiveness of corporate interoperability must be closely monitored.
Using a platform for the launch of multiple products — traditional

product development often concentrates solely on a single product.
However, using the innovation based intraventure approach the product
should rather be seen as a platform from which the primary and
secondary (derivative) products can be launched.
Ensuring the correct operating state — a key characteristic of an

intraventure is the entrepreneurial approach which is required.
Members of the team should know how to get things done in the
organisation but should maintain the spirit and attitude of a small start-
up company.
166
Much research has been conducted with regard to the elements of successful
innovation [74 More often than not good management is found as being one
of the keys to ensuring successful innovation within the firm. In particular it is
suggested that one of the keys to building an innovative capacity in the future
will be the ability to manage innovation in an information intensive
environment (recall the difference between information and knowledge).
Financial innovation within the financial services sector can be used as a

means of producing a competitive advantage. Research by Johne and Muller-
Teut 1861 shows how, in the UK, fierce competition in the financial services
market has presented many opportunities for product and service innovation.
The recent proliferation of credit cards issued by retailers is just one such
example. Most importantly, they show how companies which do not rise to the
challenge of innovation risk being left behind in the competitive race. Johne
and Muller-Teut identify distinct conceptual types of financial innovation
which can be used to strengthen market leadership. These categories of
innovation are:
Market innovation
Process innovation
Product innovation
Product augmentation
Market innovation is concerned primarily with improving the mix of target

markets. As such market innovation is important if the business opportunities
resulting from innovation are to be developed to their full potential. Using this
_ approach present and future market opportunities must be identified by
marketing specialists.
167
Product innovation in combination with process innovation is perhaps one of

the best known forms of innovation (in addition to being one of the easiest
forms to understand conceptually). Product innovation may take many forms
including, but not limited to, new products, new product lines, additions to
existing product lines, improvements to existing products, cost reductions, and
repositionings within the market. Process innovation may typically take the
form of equivalent product quality at a reduced cost brought about by what is
commonly termed 'business re-engineering'. Continued process improvement
will, over time, lead to the ability to provide a product with similar features
and quality to that of a competitor's, but at a lower cost. Examples of process
innovation are the increasing number of banks and insurance companies that
are willing to conduct business via a phone call.
Product augmentation innovation is a new concept which prescribes that

competitive innovation may be achieved as a result of a repositioning in the
way a core product may be offered to customers. In the service orientated
marketplace which is common in most developed countries a product consists
not only of a core product but also of back-up service and support. Product
augmentation innovation refers to the ability to present the same core product
to different customers at different prices as a result of differences in the level
of support offered with the product. This is an extremely powerful concept
because this means that the same product can be optimised for different market
segments, leading to an optimal return. As a result of the combination of
product innovation and product augmentation innovation many managers
prefer to use the term 'offer innovation'. The author recommends the use of
product augmentation innovation in the development of financial products.
Johne and Muller-Teut 1861 present a modified buying mode model for new
offers which illustrates the principle components of any offer. This model,
which is illustrated in Figure 7.5, emphasises the possible _buying modes from
the point of view of the customer. The four buying modes that are illustrated in
Figure 7.5 correspond to identified customer preferences and can be explained
as follows:
168
Support Provided
Seen as: Differentiated Seen as: Undifferentiated
Core Seen as: System I: uy Product uy

Differentiated
Product
Seen as: Consulting I: uy Commodity uy
Features Undifferentiated
Source: Johne, F. Axel; Muller-Teut Godo; 'Maintaining Competitive Edge In Fast Moving
Markets' Journal of Financial Services Marketing (Volume 2 Number 1) 1861
Figure 7.5 uying Modes For linnovative New Offers
Commodity Buy Mode
In this mode, prospective customers know the core product and its features
well. In this case the customer is not interested in superior product features or
product augmentation. The overriding consideration is price, and the product
which is available at the most competitive price will most likely be chosen.
Product Buy Mode
Under the product buy mode superior core product features are of primary
concern to the buyer. Potential buyers are prepared to pay a premium for
superior core product features.
System Buy Mode
In the system buy mode buyers are prepared to pay a premium for what they
perceive to be superior core product features as well as superior product
augmentation.
1169
Consulting Buy Mode
Predictably enough, in this mode buyers are primarily interested in the product
augmentation features, and are essentially buying support and advice rather
than a core product.
An example of the application of these various buying modes can be found in

the financial services derivatives markets 1861. As has already been illustrated
in Part One of this thesis, derivatives are extremely sophisticated financial
instruments which can be used, amongst other things, to control risk.
Depending on the buyers, derivatives are subject to the four buying modes as
illustrated here. Experienced professionals such as corporate treasurers
typically buy derivatives in the commodity buy mode. Such professionals are
fully familiar with the features and capabilities of the core product and as such
will purchase the product which is attainable at the lowest overall cost. Less
knowledgeable professionals may prefer to buy such derivatives in the system
buy mode where a premium is paid for perceived superior product features as
well as product support.
As a result of the tremendous speed with which financial professionals are

becoming familiar with derivative products, banks and other such
organisations must work hard to introduce products which clearly have
superior features. These derivatives are introduced on a product buy basis.
Finally, financial professionals in small and medium companies who are often
not fully familiar with the use of financial derivatives as risk management
mechanisms will often purchase such products under the consulting buy mode.
Such buyers are interested primarily in the support and advice that comes with
the product and not so much in the actual core product features.
Within any market, but especially so in- the -financial services market, it is
usually possible to identify both incumbent leaders in the market as well as the
challengers who aim to end the reign of the incumbent leaders. Research has
indicated that these two elements are driven by fundamentally different forces
170
1861. Incumbent leaders typically emphasise a process innovation approach,

while challengers use product innovation as a competitive weapon.
This section has briefly illustrated the use and importance of innovation in the
product development process. Of particular interest to participants in the
financial services industry is the concept of product augmentation whereby the
product can be considered to consist of both a core set of features as well as a
certain level of support. This concept is highly applicable to the development
of financially engineered products since such products can range from a pure
`conventional' product to a pure service.
It is therefore recommended by the author that the financial services

organisation clearly investigate the level of innovation associated with a
proposed new financial product. In addition an up-front identification of the
buy-mode(s) for which the product is being developed will help to focus the
attention of the developers on the (relative) importance of the various elements
of the product. This is of particular relevance to the financial product
development process where the support provided with the product can often be
of more importance than the final product itself.
7.9 NEW PRODUCT DEVELOPMENT As A STRATEGICALLY COMPETITIVE

ADVANTAGE (ELEMENT 5)
It has for some time now been acknowledged that within the engineering
industry the process via which the product is developed can be just as
important, and in many cases more important, than the final end product itself
1151041. This is because in developing the product the organisation is exposed
to forces which, as a cumulative whole, strengthen the organisation's ability to
compete competitively in its chosen market. Consequently:
171
The purpose of this section is to illustrate the manner in which the product
development process may be able to, contribute positively to the financial
services organisation's strategic competitive advantage in its target market
Conceptually the important point to understand is that the final product
itself is not simply a means to an end, but is the result of a structured
process which, if properly managed, can be leveraged such that the
organisation is provided with medium to long-term core organisational
competencies which cannot easily be copied by competitors.
If properly managed, the development and marketing of new products can act
as a substantial source of competitive leverage in the marketplace. Much of the
latest research in this field illustrates how the new product development
process can be thought of as a competitive weapon in the armoury of the
organisation. This topic will receive substantial attention in this section.
New product development and the development projects which result may be
thought of as a competitive weapon because the resulting capability of such
projects is often of more importance than the product itself 1191. In particular,
the learning environment in which the development takes place plays an
absolutely crucial role in not only the success of the end product and its
derivatives but also in the skills and capabilities which the project brings to the
organisation. The important issue to remember is that development projects
can be designed and managed so that they continually generate powerful,
distinctive organisational capabilities as well as winning products and
processes. An excellent example of just how this may be achieved is that of
Digital Equipment Corporation (DEC) 1191.
At the end of the 1970s DEC, then the world's second largest computer
manufacturer, found itself in serious trouble as a result of technological
deficiencies. DEC was about ten years -behind in the state of the art of
magnetic storage systems which were becoming an increasingly critical
component within the computer industry. As a result of the increasing
importance of magnetic storage media senior management decided that DEC
172
should embark on a program to develop a viable product based on what they

saw as two important new technologies: thin-film magnetic storage media and
thin-film heads for reading and writing on such media. The success of the
project was dependent on significant technological breakthroughs in four key
areas: (1) the thin-film media as well as the process by which it would be
manufactured, (2) the thin-film head as well as its manufacturing process, (3) a
new electromechanical drive system, and (4) a new process for assembling
these components into the final system.
Based on future industry projections extremely ambitious cost and

performance specifications were set for the project. Initial specifications called
for a 9-inch drive with a storage density of 30 million bits per square inch.
However, after DEC discovered that Fujitsu of Japan planned to develop a
similar drive with a storage density of 45 million bits per square inch DEC
increased their specifications to the same level.
The outcome of this project taught DEC a few harsh lessons. The final product
was shipped two years late, at a cost of $5,000 per unit versus the $2,500 that
had been planned. In addition DEC had not achieved the 45 million bits per
square inch specification, although Fujitsu had not achieved this either and the
state of art at that point was 30 million bits per square inch. Most disheartening
however was the fact that by the time the drive was delivered the computer
industry was already moving toward smaller physical drive sizes, and as such
the just released 9-inch drive would soon be obsolete. One could therefore
surely call this project an unqualified failure.
Although they had failed to meet the ambitious specifications (some would
later say too ambitious), the project had given DEC what they needed to
become a leader in disk drives, namely state of the art capabilities for making
thin-film media as well as the corresponding thin-film heads which had been
correctly identified by senior management as being the way of the future. DEC
was thus able to use the development project as an agent of change in order to
build new capabilities which gave them a competitive edge in the marketplace.
173
Six key elements can be identified which have the unique ability to foster such
a 'learning' culture in the organisation, namely 1191:
Core capabilities — those attributes and skills of the organisation that

enable it to satisfy customer requirements in a way that is unique
within the marketplace and which cannot be easily copied by
competitors 2 .
A guiding vision — the organisation must have a clear vision of the

future, a guiding light so to speak. The purpose of this vision is not to
provide a specific goal, but rather to illustrate the general direction in
which the organisation is heading. It is important that individuals are
allowed to decide how best the end goal is to be achieved within the
guiding vision.
Organisation and leadership — leadership should be recognised and

rewarded within the organisation. Each project may require a distinct
or somewhat modified approach but, at the end of the day, everyone
within the organisation should clearly understand their roles in the
organisation in relation to specified goals and long-term objectives.
The ability to 'push the envelope' — pushing the envelop is the practice
of continually making productive modifications and enhancements to
existing projects, products and organisational capabilities with the aim
of reaching an optimal level of performance.
The use of prototypes — modern modelling and simulation tools make

the use of prototypes easier and more justifiable in cost terms than ever
before. Judicious use of such techniques can help the organisation to
learn more about not only the product itself but also about the
2
The issue of core capabilities is an interesting one because many organisations often mistake the
true meaning of a core capability. A core capability is one that cannot easily be copied by a
competitor. Such capabilities are therefore often intangible. The ability to work together as a tight
organisational unit cannot easily be copied. State of the art information systems can.
174
surrounding processes which will influence the product, the

organisation and its surrounding environment.
Integration — joint decision making amongst all functional units

involved in the project is required in order to enhance the probability
of success. Individual work is optimised in order to enhance the ability
of the project team to attain its stated objective(s).
The idea of an organisational 'learning culture' is inherent in the concept of

product development as a driver for organisational competitiveness. This
learning culture needs to be reinforced with a comprehensive project selection
strategy which ties in with the organisation's strategy. It is important that
projects are selected on the basis of their ability to not only produce a viable
product, but also to increase organisational competencies. As a result
organisations should always keep the following key project related issues in
mind:
All development projects should enhance the capabilities of the

company. It is important to note that the emphasis is not solely on
creating a great product but also on the enhancement of organisational
core capabilities.
The range and selection of projects which may be undertaken must be

carefully considered and planned in the required detail so as to match
the overall organisational strategy.
A post project analysis should always be performed, even on projects

which were seemingly flawless.
The use of product development capabilities as an organisational competitive

advantage is not merely a short-term phenomenon. Indeed, improving
organisational competitiveness is not in any way a short-term phenomenon.
The theory of competitive product development is therefore based on a
175
medium to longer term outlook. It therefore follows that in order to be

successful an organisation must emphasise the use of an aggregate project plan
as opposed to a modular approach 1291. Instead of viewing development
projects on a modular basis organisations need to devote more time to
analysing and managing the mix of projects which are undertaken. It is
therefore the role of management to create a set of projects that are consistent
with the organisation's development strategies.
It is important for management to understand that projects come in many forms

and may have significantly different goals. At least five project types can
generally be distinguished 1291:
Derivative projects — which range from cost-reduced versions of

existing products to additional 'add-on' products which are designed to
fill the void created by the core product.
Breakthrough projects — which produce significant changes to existing

products and/or processes. The outcome of successful breakthrough
projects is typically a core product or process which is a marked
departure from anything previously developed. Typical examples are
compact discs and fibre-optic cables. which created entirely new
markets once they were released.
Platform projects — which are somewhere between derivative projects

and breakthrough projects in that while they do not merely introduce
enhanced or somewhat modified products or processes, they do not
introduce significantly different products based on untried technology.
Research and development projects — the creation of know-how and

know-why of new materials and technologies which, eventually, leads
to commercial development in the form of a marketable product.
176
Alliances and partnerships — which may be formed in order to pursue

any of the previously mentioned project types.
These five project types are schematically illustrated in Figure 7.6.
The integration of product development expertise within the organisation is an

important part of any strategy. To this end four elements have been identified
which may help organisations correct imbalances and build core capabilities,
namely 1201:
An incremental approach to improving and expanding capabilities,
A focus on processes as well as the resulting products,
The use of innovative methods to challenge conventional thinking, and
Coherent vision and leadership within the organisation.
Research on the 'new' manufacturing strategy of the future (within a world

class environment) illustrates the importance of building critical capabilities in
order to achieve competitive strategy 1731. Manufacturing itself can prove to be
a significant competitive advantage. However, it is a fallacy that the simple
improvement of manufacturing processes will lead to a sustainable competitive
advantage. The key to achieving such an advantage is to be able to do certain
things better than competitors can. It is important to understand the need for
uniqueness in terms of core capabilities. For example, the implementation of a
Total Quality Management (TQM) system cannot be considered as a core
capability because such a system can be relatively easily copied by
competitors. The organisational understanding of the benefits of such a system
as- well as the ability -to optimise the benefit to cost ratio is a much more
intangible element (although under no circumstances of less importance) which
cannot easily be copied.
177
Research and
advanced
development
projects
Product Change
New core Next Addition to Derivatives

product generation product and
roduct family enhancements
Breakthrough
New core projects
processes
Next
generation
processes
Platform projects
Single
development
upgrade
Derivative
Incremental projects
change
R&D
Alliances Breakthrough
and
partnership
projects
Platform
Derivative
Source: Clark, Kim B.; Wheelwright, Steven C.; 'Creating Project Plans to Focus Product
Development' Harvard Business Review (March — April 1992) [29]
Figure 7.6 The Five Types of Deveflopment Projects
178
Note however that strategy is a dynamic concept and as such organisational

strategy may have different goals depending on the environment in which the
organisation finds itself. For example, in a stable environment a typical goal of
organisational strategy is to stake out a position in the market with
manufacturing strategy focused on ensuring that the organisation is able to get
better at those things which are necessary to defend that position. In contrast,
in a turbulent environment the focus of strategy becomes one of strategic
flexibility which allows the organisation to switch gears from, for example,
rapid prototyping and product development to low cost development with
minimal resources 1731.
The author is of the opinion that the manufacturing framework as proposed by

Skinner 1731 is adaptable to modern financial services business conditions and
to those which may be expected in the future. In essence Skinner suggests that
the notion of an organisation's manufacturing strategy should be based on the
concept of strategic fit. The adopted framework should reflect the
organisation's competitive position and strategy. This is because
manufacturing strategy is not simply about aligning operations to current
competitive priorities, but also about selecting and creating the operating
capabilities the organisation will need in the future. This situation is brought
about by the fact that success is, to a large degree, dependent on the ability of
the organisation to continually seek new ways to differentiate itself from its
competitors.
Those organisations that are able to transform their manufacturing operations

into sources of competitive advantage are the ones that can harness various
improvement programs to the broader goal of selecting and developing unique
operating capabilities with the goal of enhancing corporate competitiveness.
Great manufacturing capabilities are built on unique skills and capabilities, not
on investments in buildings, equipment or specific individuals. In both the
current and the future business environment organisations should think of
themselves as a collection of evolving capabilities, not just a collection of
products and businesses.
179
In the future the management of technology in terms of its selection and use is
going to play an ever increasing role in the product development capabilities of
the organisation (this phenomenon can already be witnessed, but looks set to
increase in importance in the future). However, organisations must not make
the mistake of seeing the combined process of new product development and
technology management in tactical rather than strategic terms. Research which
has been conducted illustrates how companies faced with new product
development and technological challenges can be described in terms of their
approach to five key elements, ranging from a tactical and compartmentalised
approach to that of strategic integration Hi. The five key elements which show
why financial services organisations must adopt a strategic approach to the
product development process are as follows:
o The assignment of management responsibilities — Under the

conventional, tactical, segmented approach responsibility for
technological management is assigned almost exclusively to technical
specialists. However, under the more strategic approach it is
recognised that technology is both a driver and is driven by all other
elements of the business strategy. Those with managerial responsibility
should therefore ensure that they are aware of both the technical as
well as the business aspects of any new product development project.
For example, Honda Motor Company, although smaller than most of
its Japanese rivals, has managed to gain significant market share
through the use of a strategic perspective on the integration of
technology and product development. Technology has therefore been
integrated with all other elements of their competitive strategy. This
entails that their R&D specialists are aware of the marketplace,
customers and competition, an awareness achieved as a result of
spending up to two months a year in the field with customers and
suppliers. Similarly Honda business specialists are trained to consider
their effects on the R&D function
180
The role of functional departments — The most powerful and

sustainable competitive advantages are derived from integrating
product, process and supporting technologies. Downstream functions
are involved in the upstream product development process (the
principle of concurrent engineering). Strategically the role of
technology is not simply to support the R&D process, as it has been
viewed in the past, but is to refine and possibly even re-direct the R&D
process along with the associated business strategies.
The nature of planning — Conventionally the view has been that an

organisation's technological plan should be identified and completed
up-front with subsequent changes to be avoided at all cost. This is a
static view. The strategic view, whilst not abandoning technological
planning, does alter it significantly. It is preferable to define a general
sense of direction for technological evolution rather than attempting to
pre-define the future technological path of the organisation (a task
which many would say cannot be done in any case). The analogy is
thus that strategic planning is used to provide the organisation with a
compass and a general heading.
The means of protecting competitive advantage — Protecting an

organisation's hard earned competitive advantage is an important point
to consider since this may have a substantial impact on future business
prospects. How this is best achieved is a matter for debate. The tactical
view has typically been that organisations should resort to legal means
of protecting such advantages: patents and trade secrets. While such
methods may be important in certain industries (such as the
pharmaceuticals industry) they more often than not fail to achieve the
desired results in others. When tested in court roughly half of all
patents are found to be invalid. This view is contrasted by the strategic
approach whereby the source of competitive advantage is derived from
a continuous improvement in organisational know-how and capabilities
which allows the organisation to increase the gap between itself and
181
competitors. This is an immensely powerful concept: the means to

secure a technological advantage is not through the restriction of
competitor knowledge with regards to such technology, but rather
through having the underlying capabilities to implement and make use
of such technology. The key is therefore enhancing and extending
these capabilities faster than your competitors.
o The link between technology management and new product

development — Using the tactical approach technology is considered to
be separate from the organisation's new product development
processes. Such an approach cannot work in the modern business
environment and is certain to fail in the future environment. Rather,
technology management should be seen as a learning process which
requires close collaboration with both the product development as well
as the manufacturing processes.
This section has illustrated how the process of development of new products
can lead to a competitive advantage for the organisation. Yet again this
concept is highly applicable to the financial services industry. Given the
importance of new product development and the rate with which it occurs
within this industry it naturally follows that the process of financial
engineering should be structured so as to take maximum advantage of the
principles inherent within this concept.
It is critically important that financial services organisations realise the

inherent potential that the process via which they develop financial products
has in advancing the organisation's strategic competitiveness. This process is
not simply a means to an end, but should form part of the organisation's
approach to increasing its competitiveness in the target market, a management
function which will assume increasing importance in- the future as competition
within the world's financial markets increases at an exponential rate.
182
7.110 THE STRATEGIC CIRCUIT BREAKER
The emphasis on organisational competitiveness related to the development of

financial products is without a doubt of utmost importance. However
inadequate application of this concept can lead to the competitive downfall of
the organisation. In their haste.to be part of the 'latest thing' organisations, and
particularly those involved in the development of financial products, are
naturally keen to stake their claim in what may at first seem to be a lucrative
opportunity. Products may therefore be developed and marketed by the
organisation simply because it appears as if there is a short-term gain inherent
in their development. Just as the discovery of gold enticed miners to stake their
claim (often at a heavy cost) without adequate knowledge of the probability of
actually being able to successfully mine such gold so too may the modern
financial product development environment entice organisations to stake their
claim to the apparent riches available, again at a significant cost, without
considering all the consequences. Such an approach is short sighted in the
extreme. In particular it ignores the strategic consequences of the decision to
proceed with the development of the financial product.
The use of the Competitive Strategy Framework is dependent on the

organisation taking the time to analyse the product development decision in
terms of five competitive elements. In order to facilitate this analysis the
author would like to suggest the concept of a Strategic Circuit Breaker, the
effect of which will be to force the organisation to temporarily halt the
financial product development process in order to analyse the effects of the
product from a strategic perspective.
The Strategic Circuit Breaker as defined here is based on the concept of a

trading circuit breaker as used on major stock exchanges around the world. The
purpose of such trading circuit breakers is to slow or stop trading on the
exchange during periods of extreme volatility [17]. Conceptually the trading
circuit breaker is a response to the herd mentality of traders during periods of
extreme volatility. Such circuit breakers were implemented on many of the
183
world's financial stock exchanges subsequent to the market crash of 1987 in an

effort to reduce the negative effects of a rapid fall in the value of financial
securities [135].
In periods of extreme volatility traders tend to make psychologically driven

uninformed decisions. They follow the herd instinct. Since everyone else is
selling stocks those traders who would not normally sell stocks based on their
current underlying fundamentals do so nevertheless. The function of the
trading circuit breaker is to temporarily suspend trading in order to facilitate
the return to normality of trading decisions. The temporary period of inactivity
allows traders and investors time to reassess the situation and to determine
whether their actions are in fact correct and in the best interests of the
organisation.
The application of the Strategic Circuit Breaker concept as proposed here by

the author is exactly analogous to the trading circuit breaker. Product
development within the world's financial markets is at best an extremely
volatile activity. The result is that financial services organisations are at times
prone to proceed with the development of a particular financial product simply
because it appears to be what everyone else is doing. Under such a situation
the organisation is ignoring the strategic fundamentals of the product
development decision and substituting such fundamentals with a short-term,
often ill-informed, decision. While this may result in a short-term profit for the
organisation (at best), the long-term strategic consequences are of much
greater importance in that such consequences are the primary forces which
shape the ability of the organisation to compete effectively in its target market.
Short-term product development decisions based on an inadequate analysis of
the strategic effects of such a decision will have a negative impact on the
medium to long-term competitiveness of the organisation [133].
For this reason the author proposes the use of the Strategic Circuit Breaker
concept within the financial product development environment as a means of
ensuring compatibility between the financial product development decision and
184
the strategic aims of the organisation. This will be achieved by placing the
Strategic Circuit Breaker at an appropriate location within the Financial
Product Development Model, the development of which is illustrated in the
following Chapter.
7.11 IINTEGRATIING THE STRATEGIC CIRCUIT IREAKER AND THE

COMPETITIVE STRATEGY FRAMEWORK WITHIN THE FINANCIAL PRODUCT
DEVELOPMENT MODEL
The fundamental conceptual approach adopted by the author in this thesis is

that the Competitive Strategy Framework elements should act as primary
drivers for the financial product development process from an organisational
competitiveness perspective. In other words the Competitive Strategy
Framework should act in a manner similar to the 'invisible hand' proposed by
the seventeenth century economist Adam Smith 3 [1091. The Competitive
Strategy Framework should guide the actions of decision makers (possibly
with differing agendas) in the attainment of an optimal solution.
The requirement for the use of the Competitive Strategy Framework is

generated by the Strategic Circuit Breaker which forces the organisation to
temporarily suspend the product development process in order to apply the
Competitive Strategy Framework. The ultimate aim is to ensure that the
organisation bases the final go-ahead for the product development decision on
the results of an analysis of the strategic consequences of the development of
the product.
Conceptually the Competitive Strategy Framework and the Financial Product

Development Model have different though integrated roles to play.
3
Adam Smith, in The Wealth of Nations (1776), describes the actions of the market mechanism as
an 'invisible hand' which coordinates the (selfish) actions of individuals to ensure that decisions
are made on such a basis so as to enhance the optimality of the final outcome.
1185
FFDM (R) Sc
Identification of product Temporarily suspend the
requirements and related financial product
parameters. development process in
order for the CSF to be
applied.
1 2
CSF FP M (2)
What are the strategic How can the new product
consequences of the new best be developed so as to
product development optimally satisfy the
decision? organisation's strategic
aims?
Satisfy Strategic Financial

Organisational (Intangible)
Competitive Objectives Product
(Strategic Fit)
.1
Source: Own Source
Figure 7.7 The 'Integration of the Competitive Strategy Framework and

the Financial Product Development Model
The primary role of the Competitive Strategy Framework is to provide the

strategic reasons for the development of the financial product. However, the
correct identification and subsequent completion of any process is of no
consequence if the process is not carried out in a manner consistent with the
achievement of specific objectives, and it is here where the Financial Product
Development Model plays a role. The purpose of the Financial Product
Development Model is to provide the methods used to carry out the product
development process which satisfies the Competitive Strategy Framework.
186
Simplistically, the purpose of the Competitive Strategy Framework is to

provide the what? In particular, we are interested in determining what the
strategic effects of the new product development decision will be. The primary
purpose of the Financial Product Development Model is to answer the how?
Once again, we are primarily interested in determining how the proposed
product can best be developed once the final decision to proceed has been
made? This relationship is illustrated conceptually in Figure 7.7.
7.12 SCIENTIFIC DECISION MAKING AS AN AID TO THE FINANCIAL PRODUCT

DEVELOPMENT PROCESS
The author has thus far used this Chapter to illustrate the concepts underlying
the Competitive Strategy Framework as well as the Strategic Circuit Breaker.
Although not explicitly associated with the Competitive Strategy Framework,
the author would like to briefly investigate a concept which appears to be
gaining prominence in the product development process (financial or
otherwise) — the use of scientific techniques in the product or project selection
phase of the overall development process.
This section has its roots in the indirect results of the research conducted by
the author in the preparation of this thesis. During this process the increasing
usage, and hence the perceived importance, of modern scientific techniques in
the product development process (primarily in the selection of the product or
project to be undertaken by the organisation) became obvious to the author.
Being a man of science, and one who is a strong believer in the ability of
science to add to the competitive management of a commercial business, the
author felt it appropriate to illustrate to the reader the type of role which such
techniques can play, and indeed are playing, in the modern product
development process. Consequently:
187
The purpose of this section is to illustrate both the importance and benefits
of the use of scientific techniques in the financial product development
decision as the frequency and complexity of such decisions increase, and to
suggest that the successful financial services organisation of the future will
increasingly rely on such techniques as an aid to the product development
decision. Although the qualitative aspects of the product development
decision continue to play an important role the skill and expertise of
competitors within a competitive market environment makes the use of
additional quantitative techniques critical to the continued success of the
financial services firm.
Modern day business revolves to a great extent around decisions — how are
they made, why are they necessary and how can the risk of an incorrect
decision be minimised? At every turn decisions must be made, from the C.E.O.
to the shop floor worker. Much theory already exists for the science of decision
making (although some would argue that it is an art). This theory is commonly
referred to as decision analysis, and has as its aim the enhancement of
decisions in an environment of uncertainty [110]. Decision analysis therefore
provides the user with a technique to make good decisions 4 by helping decision
makers to think systematically about complex problems and in so doing to
improve the quality of the resulting decision [30].
It is not the intention of the author to illustrate or expand on the scope of the
science of decision analysis here. However, it is the intention of the author to
suggest that the strategic financial services product development decision may
be further enhanced by the use of a multi-disciplinary, quantitative approach to
decision making. In essence greater use should be made of the many
innovative techniques which are available.
4 An understanding of the distinction between a good decision and a lucky outcome is important in
this context. A good decision may have a bad outcome while a lucky outcome may be the result of
a bad decision. Decision analysis does not focus on lucky or unlucky outcomes, but emphasises an
approach to good decision making which, all other thing being equal, should lead to an optimum
outcome [30].
188
Many innovative companies world-wide have adopted and then modified

scientific techniques which help in the analysis of complex problems,
particularly with regards to strategic issues such as which products to develop,
which markets to target and whether to invest in a certain opportunity or not.
An excellent example of such innovation is the use of scientific management
techniques at Merck & Co., the United States pharmaceutical giant. Merck
have developed an innovative approach to the use of scientific techniques to
aid in financial investment and product development decisions, borrowing
from such disciplines as scientific management and investment theory
(particularly derivatives and financial engineering) 11121. The importance of
such techniques are clear when one considers the characteristics of the industry
in which Merck operates.
It costs on average US$359 million and 10 years to bring a new drug to the
market. Significant time, money and effort by anyone's standards. Such
numbers become even more significant when one considers that 7 out of every
10 drugs which are brought to the market do not return the firm's cost of
capital. Merck is thus faced with a major risk in terms of research and
development decisions. Moreover, the risks which Merck face do not simply
stop at R&D expenditure. Currency risk is a major part of the overall risk at
Merck, given that Merck has operations in more than 40 countries world-wide.
Merck typically spends $1 billion per annum on research and development.

Should a product be successful it is generally 10 to 15 years before any profit
is received. Merck is therefore clearly faced with many diverse and potentially
disastrous risks. This fact is compounded by the fact that such risks are
increasing in complexity and uncertainty, particularly currency risks (foreign
exchange risk) and core business risks (research and development). Choosing
to develop the right product and to make the correct investment decisions is
consequently of enormous importance.
There are many existing tools and techniques for making product development
decisions. For example, traditional finance theory would suggest techniques
189
such as the calculation of net present value (NPV) or internal rate of return
(IRR) as a means of making investment decisions. Merck has however realised
that such techniques, while still important under certain conditions, have
limited applicability in the pharmaceutical industry. As a result Merck has
adopted an innovative approach to modifying techniques from other disciplines
for use in their own industry. Consider the following examples:
The use of options analysis - Merck has discovered that the use of
financial options analysis 5 provides a more flexible approach to valuing
investments. They have correctly identified the similarity between the
concept of an option and the valuation of a research project. An initial
investment in a research project provides the firm with the right, but not
the obligation, to continue this research at a later stage. Merck uses a
proprietary database of information to value the risk inherent in key
projects (volatility in option terminology) 6 . Merck therefore views all
business decisions as an option. For example, Merck uses the Black-
Scholes option pricing model in order to price the 'option value' of a
project. The five factors which are used to determine the option price in
the Black-Scholes model were adopted and redefined by Merck as
follows [1401:
The exercise price is the capital investment to be made at some point

in the future provided the project proves viable.
The stock price or value of the underlying asset is equivalent to the

present value of the cash flows from the project.
The time to expiration is the time within which the option to continue
with the project must either be accepted or declined. Factors which may
5Options analysis refers to the concepts and techniques as used in the analysis of financial options.
6The key to the analysis of financial options is the determination of the volatility of returns of the
underlying security. This volatility is the only variable which cannot be determined with ease, and
as such is the key to accurate option valuation.
1190
affect the time to expiration include, for example, marketing factors

related to the possible competitiveness of the planned product.
The standard deviation (volatility) is obtained from experience with

past projects and products. For example, Merck used the annual
standard deviation of returns for typical biotechnology stocks as an
approximate measure for volatility on a particular project.
The risk-free irate of interest is typically set equal to the rate on a risk-
free security such as government bonds.
Monte Carlo Analysis - Monte Carlo Analysis is a sophisticated source

of mathematical analysis that helps to determine the range of possible
outcomes as a result of simultaneous changes in multiple input
variables. Merck is faced with the problem that historically only 1 in
10,000 explored chemicals results in a prescription drug. Given the high
costs of research and development it is therefore vital that Merck is able
to accurately assess the probability of success for research projects. In
order to counter this problem Merck developed the Research Planning
Model which marries science and finance via the use of Monte Carlo
Analysis. The results achieved have been so impressive that this model
now forms an integral part of Merck's strategic decision making
process 1112].
Financial Engineering At Merck - In 1993 Merck spent well over $2

billion in R&D and capital expenditures. Much of this was spent on
risky, long-term projects which are notoriously difficult to evaluate.
However, Merck has defied the critics of modern finance who argue
that such risky projects should not be subject to financial analysis since
such analysis does not necessarily capture the true value of the project.
Merck has become a leader in building highly quantitative scientific
and financial models of commercial processes in order to improve the
business decisions taken with regard to those processes [1011. Two of
191
Merck's most prominent models, the Research Planning Model and the
Revenue Hedging Model, integrate economics, finance, statistics and
computer science in order to model specific elements of Merck's
business. Merck is acknowledged as a clear leader in the use of
financial engineering to structure, analyse and solve complex business
problems. However, it is interesting to note that the problems faced by
Merck are in no way unique and are typical of the problems faced by
most companies.
Merck is not the only company to have realised the potential of an options
approach to capital investment. Dixit and Pindyck 1451 advocate such an
approach to making capital investment decisions and illustrate the advantages
of this approach over traditional net present value (NPV) or internal rate of
return (IRR) methods which they describe as being applicable under limited
conditions. Business opportunities may be thought of as options and evaluated
using option theory which is relatively advanced. The advantage of the options
approach is that a greater emphasis is placed on the role of risk in the decision
and as such management is forced to ensure that a thorough understanding of
the risks involved in the project have been attained before a decision is made.
As with options analysis the use of game theory has attracted the attention of
many of today's most innovative firms. As a result, game theory has become a
valuable tool in business situation analysis. In fact, game theory has become
the focus of much attention at many business schools. For example, Donald
Jacobs, Dean of Northwestern University's J. L. Kellogg Graduate School of
Management illustrates how game theory is infused in many of the courses
taught at this institution 11031.
Game theory provides managers and decision makers with a way to determine
the impact of opponent strategies on their own strategies. In this context a
game is a contest involving two or more decision makers. Game theory can
Interestingly enough, when asked about what is 'hot' in business, Jacobs lists new kinds of
innovation in the financial markets as one of the most exiting developments.
192
thus be described as the study of how optimal strategies are formulated in

conflict 11311.
Game theory originated in 1944 when the mathematics genius John von
Neumann and economist Oskar Morgenstern published their groundbreaking
book Theory of Games and Economic Behaviour. Since this point game theory
has been used in the planning of war strategies s , collective bargaining
strategies and by businesses to construct the best strategies for a given business
environment. Since 1944 the importance of game theory in competitive
strategy has steadily increased, leading to the award of the Nobel Prize in
Economics in 1994 to John Harsanui, John Nash and Reinhard Selten for their
work on non-cooperative game theory [131].
Brandenburger [21] illustrates effectively the use of game theory in corporate

strategy with particular emphasis on how game theory requires a shift in
perspective on the part of the user. Instead of adopting an egocentric approach
to game theory where the user views the game from his own perspective it is
required that the user adopt an allocentric approach where the game is viewed
from the point of view of the competitor. It is particularly important to realise
that the rewards which may be attained by changing the game rather than
merely playing it can be significant. When this approach is adopted there are
many examples of how game theory has been successfully used as a tool to
enhance corporate competitiveness [75]. Consider the following:
The Case of Nintendo — In the late 1980s the home video game
industry was becoming increasingly competitive, with major players
such as Nintendo, Sega and Sony all competing furiously for market
share. However it was Nintendo who came out the winner thanks in no
small part to their adoption of one of the underlying concepts of game
theory which is that competitiveness revolves not only around the
8Allen [3] provides an excellent account of the use of war game theory by the world's
superpowers. Interestingly enough, in the most realistic war games conducted during the 1980s,
NATO always loses to the Soviet bloc in a nuclear confrontation.
193
ability of the players to add to their own value, but also to reduce the
added value of the other players. Playing the game successfully
(succeeding in business) thus requires the manipulation of added values
— increasing your own and reducing your opponent's. Realising this
Nintendo devised a strategy to consolidate their dominance of the video
game industry by changing the added values of the players.
Nintendo sold its games to a highly customised market, typically mega-

retailers such as Toys R Us and Wal-Mart. The buying power of such
retailers was a threat and in 1988 Nintendo changed this by not
completely filling retailers orders. At that stage the market could have
absorbed 45 million cartridges, but Nintendo sold only 33 million,
leading to queues of people clambering for cartridges. With this short
supply the buying power of the big retailers was effectively reduced.
The next target was the development of the games. Nintendo first
developed the software in-house and later licensed the development of
the games to a limited number of developers. Because there were many
would be developers and because Nintendo could develop the games in-
house should they so desire the added value of the game developers was
effectively minimised.
Suppliers to Nintendo too had little added value since Nintendo used
older electronic chips which were at that stage a commodity. Finally,
the only other threat to Nintendo was in the form of competitors
products since there were no effective substitutes for video games.
Since Nintendo had the largest installed base of machines software
developers were obviously most keen to develop games for their
system. This coupled with exclusivity agreements which Nintendo had
with the developers meant that it became very difficult to port Nintendo
games over to other systems. The result? A positive feedback loop. As
more games were developed for the Nintendo system so more units
were sold, and as more units were sold so more games were developed.
194
How much was this strategy worth? For a start more than Sony or
Nissan. Between July 1990 and June 1991 Nintendo's average market
value was 2.4 trillion yen, compared with Sony's 2.2 trillion yen and
Nissan's 2 trillion yen. A profitable strategy indeed [211.
The case of Trans World Airlines (TWA) - TWA realised that the use
of game theory provided the solution to a problem that had plagued the
airline industry for years — that of price competition amongst rival
airlines which drove prices down dramatically. The underlying concept
in this case is that optimum results are not always achieved by playing
to destroy your opponent 9 . TWA introduced a new Comfort Class in
1993, removing 5 to 40 seats per plane to provide passengers with
additional legroom. This move raised TWA's added value which
resulted in the company gaining first place for customer satisfaction in
long-haul flights. The result was that with fuller planes TWA was not
about to start a price war. And if other competitors copied this strategy
excess capacity would be eliminated from an industry plagued with
overcapacity. The net result? Aircraft throughout the airline industry
with higher occupancy ratios filled with customers who were prepared
to pay a small premium for the additional comfort.
Brandenburger [21] illustrates four important concepts related to game theory

which are highly relevant in today's modern globalised business environment:
o Make sure you are playing the right game. Winning the game is
meaningless if it is not the right one in relation to your corporate
strategy
o One can get paid to simply participate in the game or to change the
rules of the game. It is therefore not always necessary to play to win.
9 Note the interesting contrast here with traditional war game theory. Most people are of the
opinion that in order to win, one must destroy one's opponent, as is advocated in war games. This
is not the case with game theory. There are many situations where a mutually beneficial outcome
can be reached, if the game is played properly.
195
o Raising your own added value is not the only way to enhance
organisational competitiveness. This can be achieved just as effectively
by lowering the added value of competitors.
o Game theory is often likened to war games, but this analogy is in fact
incorrect. Game theory does not require the destruction of other
players in order to win. A win-win situation is possible.
The purpose of this section has been to illustrate how a competitive advantage
can be achieved by the use of scientific concepts from many external
disciplines. The emphasis here is on the innovative recognition and adoption of
such concepts in order to enhance organisational competitiveness. Note that
the use of quantitative methods, when properly applied in combination with
other techniques, is an extremely powerful tool. Progressive organisations are
those whose management are not intimidated by such techniques and are aware
of the advantages. Merck & Co. are perhaps one of the best examples of this
attitude, and it therefore comes as no surprise to learn that Merck is a leader in
what is traditionally an extremely difficult industry to operate in. This is
perhaps best summed up by Judy Lewent, Merck's Chief Financial Officer
(CFO):
"In general there is a healthy respect for learning, technology, and

quantitative models at Merck, and there is no question that helps us in
finance. Quantitative approaches, the use of models, the use of
advanced math do not daunt our CEO, Roy Vagelos, or other senior
managers here. They don't view our models as some black box that
completely ignores the great wisdom of management and tries to
mechanise the decision making of business. They understand both the
potential and limitations." [112]
At this point the reader should appreciate the importance of scientific product
decision techniques. This section has illustrated many cases where the use of
such techniques led to increased market competitiveness for the organisation in
196
question. From the pharmaceutical industry to the airline industry to the video
game industry, such techniques, when properly applied, have contributed
positively to not only the short-term profitability of the organisation, but to the
longer term strategic aims of the organisation.
The power of such concepts can be leveraged within the financial services
industry in the financial product development decision. This is particularly
important given the increasing complexity of financial products which must be
produced and marketed in an extremely competitive environment. Under such
a scenario the financial services organisation must use every tool at their
disposal to gain a competitive edge on competitors. Certainly, the use of
scientific techniques cannot do any harm. They can however do much good.
7.13 CONCLUSION
This Chapter has developed two important concepts which, when integrated
within the Financial Product Development Model, will provide the
organisation with a strategically competitive financial product development
process. These two concepts are the Competitive Strategy Framework and the
Strategic Circuit Breaker. The author has illustrated that the fundamental
foundation upon which the Competitive Strategy Framework is based is the
concept of strategic fit as proposed by Robert [133]. As a result the
development of the Competitive Strategy Framework is a direct representation
of the fact that the product development decision in the modern globalised
economy cannot be divorced from the strategic intentions of the organisation.
It is important that the reader understand the key aspects of the Competitive
Strategy Framework as proposed here. These are:
The Competitive Strategy. Framework contains five elements, each of

which were selected by the author for their ability to contribute to the
strategic competitiveness of the financial services organisation in the
future. This emphasis on the future is important because strategy is not
1197
a static concept. Its very nature is dynamic, as many organisations have

discovered, to their detriment.
The Competitive Strategy Framework should not be considered to be

the single solution to what is an inherently complex concept. The
author would not be so presumptuous as to suggest that this be the
case. However, what the Competitive Strategy Framework does do is
draw the attention of management to the need for a strategic analysis of
the financial product development decision. Once again, the product
should satisfy the concept of strategic fit. The five elements included
in the Competitive Strategy Framework have been purposely selected
by the author for the development of financial products within the
financial services industry, although they could just as well apply to
any other industry.
The Competitive Strategy Framework does not suggest any form of

quantitative pass or fail criteria relating to the product development
decision since this is hard, if not impossible, to quantify given the
enormous differences in style, strategy and intent within various
financial services organisations. The final product go-ahead decision
must still be made by management. What the Competitive Strategy
Framework does do is provide a structured methodology for the
consistent analysis of financial product development decisions from a
strategic perspective.
The Competitive Strategy Framework, based on the concept of

strategic fit, has been designed to work in conjunction with the
Financial Product Development Model and the Strategic Circuit
Breaker. While it could be used as a stand alone concept this was never
the intention -of the author in the development of this concept. The
Competitive Strategy Framework is most effective when integrated
within a structured product development process, as suggested by the
Financial Product Development Model (see the next Chapter).
198
In the analysis of the five Competitive Strategy Framework elements the

author has attempted to highlight the practical applicability inherent within
each of these elements. This was done via the inclusion of numerous real world
applications. This is important because the Competitive Strategy Framework is
of no use if it cannot be practically applied to the targeted product
development environment. The practical application of the concepts suggested
throughout this thesis always was, and still is, an important consideration on
the part of the author.
The author has illustrated the development of the Strategic Circuit Breaker
concept as well as its application with respect to the Competitive Strategy
Framework. This concept, based on that of the trading circuit breaker, is
designed for a volatile environment in which common sense does not always
take precedence to the need to market and develop products in an intensely
competitive market. Just as the trading circuit breaker is designed to
temporarily suspend trading in periods of extreme volatility in order to allow
market participants time to gather more information and to make more
informed decisions, so the Strategic Circuit Breaker is designed to temporarily
suspend the financial product development process to allow the organisation
time to analyse the strategic consequences of the product development decision
within the Competitive Strategy Framework. The Strategic Circuit Breaker is
thus the vehicle on which the activation of the Competitive Strategy
Framework is based.
Finally, the increasing use of scientific decision techniques by many of the

world's most innovative organisations received brief attention within this
Chapter. There is scope for such techniques to be integrated within the
financial product development process in order to add an element of
quantitative analysis to the process.
Throughout this Chapter, and indeed throughout all of the preceding chapters,
the author has made numerous references to the Financial Product
Development Model. All of the work presented up until this point has in fact
199
been done with a view to the ultimate objective of this thesis — the
development of the Financial Product Development Model. By now the reader
is familiar with the importance of product innovation, as well as the concepts
and principles of the various elements of corporate risk management, financial
engineering, and system engineering. In addition the Competitive Strategy
Framework, Strategic Circuit Breaker and strategic fit concept have been
developed and illustrated. It is now time to proceed to the following Chapter
which integrates all of this knowledge in the development and analysis of the
Financial Product Development Model.
200
The Financial Product Development Model
Chapter
The Financial product Development Model
"We didn't want to get into the transportation industry. We're still
in the entertainment industry — at 25,000 feet." — Richard Branson,
chairman and CEO, Virgin Group
8.1 IINTRODUCTION
hus far the author has illustrated the importance of product innovation,
and hence product development, within the financial services industry. In
addition the three fields of financial risk management, financial engineering
and financial derivatives received attention in as far as knowledge of the tools
and techniques used in these disciplines allow the reader to appreciate both the
importance and the complexity of the financial product development process.
The author then illustrated the concepts inherent in system engineering as they
may be applied to the financial product development process. Finally, the
creation, use and importance of the Competitive Strategy Framework in
conjunction with the Strategic Circuit Breaker concept was detailed in the
previous Chapter.
Having illustrated the need for a structured product development process,

detailed the concepts and techniques associated with financial engineering,
financial risk management and system engineering, and developed the
Competitive Strategy Framework which is designed to enhance the product
selection function of the financial services organisation, it is now time to
integrate all of this knowledge into the primary focus of this thesis: the
Financial Product Development Model.
201
There is much evidence to suggest that the process of product development

does not receive enough attention within the financial services industry
11571,1481. As a result many of the product development issues which were
historically prevalent within the manufacturing industry have to a large extent
appeared within the financial services industry. Issues such as inordinately
long product development times, high project life-cycle costs (particularly
once unrealised costs have been discovered and accounted for) and inadequate
product performance have begun to appear just as they did within the typical
manufacturing environment. This does not have to be the case. As has been
illustrated, the correct application of system engineering based techniques can
avoid many of these issues. Existing inefficiencies in the financial product
development process can be eliminated and even those processes that are
running smoothly can be enhanced. This translates into increased profitability
for the financial services organisation in terms of reduced product development
costs as well as increased market competitiveness. Consequently:
The purpose of this Chapter is to illustrate the developitient of the Financial

Product Development Model and the manner in which this model may be
used to enhance the,financial product development process. The author will
start with a conceptualised framework before narrowing the focus down into
the constituent model components. Each component will be discussed in
depth with respect to its role within the Financial Product Development
Model as well as its importance with regard to the specific functionality it is
designed- to achieve.
8.2 THE PURPOSE OF THE FINANCIAL PRODUCT DEVELOPMENT MODEL
The purpose of the Financial Product Development Model can very simply be
described as follows:
202
The Financial Product Development Model has as its primary function the
enhancement of the financial product development process with a view to
reducing product economic life-cycle costs, reducing product development
times and ensuring compatibility between customer requirements and the
final delivered product specifications. The application of the model should
'increase the strategic organisational competitiveness of the financial
services organisation as a result of superior product development techniques
and superior satisfaction of stated requirements, leading to enhanced
organisational profitability.
The Financial Product Development Model is thus a tool designed to increase

the strategic competitiveness of the financial services organisation in an
increasingly competitive, innovation driven, global business environment.
The development of the Financial Product Development Model is based on the

underlying concept that insufficient attention is given to the process by which
products are developed within the financial services industry. As a result,
many of the product development inefficiencies which have historically been
prevalent within a conventional manufacturing environment can be found
within the financial services environment. The result is, predictably enough,
decreased organisational competitiveness in a highly competitive market as a
result of extended product development times, unsustainable product life-cycle
costs and the development of products which do not conform to market needs.
This is where the Financial Product Development Model serves its primary
purpose.
The Financial Product Development Model is a structured product

development process based on applicable system engineering principles and
techniques which have been proven to enhance the efficiency of the product
development process. The concept of 'efficiency' is, of course, relative to the
requirements of the organisation. Typically organisations will strive to
minimise the costs associated with the development of the product, the time
taken to develop and subsequently 'manufacture' the product, and the
203
possibility of producing a product that is either not required by the target

market or does not conform to the requirements (whether stated or not) of the
customer. These may at first appear to be conflicting requirements. However
the correct application of system engineering is not only able to satisfy all of
these requirements, but may do so in an optimal manner which is entirely
beneficial to the organisation.
The aim of the Financial Product Development Model is very simply to

provide the financial services organisation with the methodological tools
necessary to improve strategic competitiveness as a result of an enhanced
product development process. The ability to identify, develop and produce
financial products better than one's competitors is not simply a 'nice to have',
but is an essential competitive factor within the financial services industry.
The need for the Financial Product Development Model is based on two
principles which are highly indicative of the present and future importance of
product development within the financial services sector (although this
importance will of course apply to product development in any sector). Firstly,
it is acknowledged that the ability to develop innovative products and to be the
first organisation to develop and market such products will be a major source
of competitive advantage in the future. To emphasise this point many experts
are calling new product development "the economic battleground of the next
decade" 161. The ability to commercialise new technology and to move the
product from concept to market in the shortest possible time will be key factors
influencing the strategic market competitiveness of the financial services
organisation. Secondly, the process by which products are developed is just as
important as the final product itself. It is no coincidence that Japan,
acknowledged as the clear world leader in new product development, spends
approximately 70 percent of its product development funds on improving the
design process with the remaining 30 percent being spent on new products.
The corresponding ratio in Germany is about 50/50 while in the United States
some 70 percent of available funds are spent on the product itself with the
remaining 30 percent being spent on process improvements 161.
204
In designing the Financial Product Development Model the author has placed
great emphasis on these two important principles. As a result, the Financial
Product Development Model emphasises not only the importance of
competitive product development within the financial services sector, but also
the importance of a structured approach to new product development. The
importance of such a structured approach cannot be over-emphasised. As is
noted by Karl Ulrich, mechanical engineer and assistant professor of
management at the Massachusetts Institute of Technology's Sloan School of
Management:
"American managers still have a somewhat romantic view of product

development, that its being done by creative individuals in
unstructured environments. In the best firms, 90 percent of product
development is a highly disciplined, organised activity. Most
companies don't have a well-lubricated product development
process." 161
8.3 THE DEVELOPMENT OF THE FINANCIAL PRODUCT DEVELOPMENT MODEL
As has been emphasised repeatedly throughout this thesis, the process by

which a product is developed plays a critical role in the future success of that
product. This concept can be applied to the development of the Financial
Product Development Model. It is thus worthwhile for the reader to gain an
appreciation of the conceptual methodology used by the author in the
development of the Financial Product Development Model. The aim here is not
to provide a step by step description of the process, but rather to illustrate the
macro approach selected by the author in the identification of suitable
components for inclusion in the model as well as the relative position of those
components.
In essence the author adopted a macro top-down approach in the initial stages
of the development of the Financial Product Development Model which was
subsequently followed by a more detailed component analysis. The model
205
development was initiated by the creation of a financial product development

framework which had as its purpose the identification and subsequent
schematical representation of the macro conceptual components of the
Financial Product Development Model. The theory behind this is simple. One
cannot successfully develop a model, and in particular a conceptual model,
without first understanding the framework within which the modular
components must operate. The modular framework selected by the author is
based on four principle drivers embedded within the system engineering
process, namely:
The need for the product development process to be structured in such

a way as to ensure the minimisation of the product life-cycle cost
whilst ensuring the achievement of all specified product requirements.
The need for the integration of various components of the functional

design and development process (product definition) to permeate
throughout this process, henceforth referred to as design integration.
The need for an element of strategic analysis embedded within the

product selection process in order to ensure that the development of the
product supports the organisation's strategic objectives (achieved via
the Strategic Circuit Breaker and the Competitive Strategy
Framework).
The need for an emphasis on downstream product support and

maintainability functions to be imbedded within the subsequent
product design and development stage (product creation).
These four elements were fused in such a way so as to maximise the potential
impact of the use of system engineering.
In addition to the development of the macro components of the Financial

Product Development Model it was necessary for the author to focus attention
206
on the integration of the micro product development components within the

macro framework. The selection and sequential placement of the individual
micro Financial Product Development Model elements was done on the basis
of research by the author into common modern day product development issues
typically found within a manufacturing based environment in conjunction with
the appropriate system engineering based principles which, when applied
within the macro framework, would lead to the enhanced resolution of such
issues. In essence the author developed the Financial Product Development
Model by identifying the product development lessons learnt within a
manufacturing environment and coupling such concepts with the appropriate
solution as specified by system engineering. Three major concepts may be
identified as (1) the need to accelerate the development of innovative new
financial products, (2) the importance of adequate product definition in the
financial product development process, and (3) the need for a flexible approach
to financial product development within a volatile environment.
8.3.1 The Need to Accelerate the Development of innovative New Products
There is no doubt that the speed with which new products can be produced by
the organisation plays a major role in the competitiveness of that organisation.
In recognition of this fact, Gupta and Wilemon [661 have conducted significant
research into the issues surrounding the acceleration of the development of
technology based new products. Their findings produce startling results.
Using a model developed by the international consultancy McKinsey & Co.

they illustrate how high-tech products which come to the market six months
late earn 33 percent less profit over 5 years while those products which are
delivered on time but 50 percent over budget lose only 4 percent of potential
profits. Organisations too are aware of the need for reduced product
development times. In a survey of 12 large technology-based companies Gupta
and Wilemon [66] find that some 88 percent of respondents indicated that they
had experienced a need for reduced product development times since the
207
1980s. Correspondingly, 87 percent of respondents indicated that they were

also under increased pressure to develop more new products.
Given the obvious need for a reduced product development cycle what are the
major problems encountered in achieving this goal? Respondents to the Gupta
and Wilemon survey indicated the overwhelming influence of two major
factors:
o Poor definition of product requirements (71 percent), and
o Technological uncertainty (58 percent).
Fortunately system engineering is able to provide the solution to these

identified problems.
It is interesting to note that the most difficult to accomplish new product

development activities as identified by respondents tended to focus on (1)
determining the suitability of the product for the target market, and (2)
ensuring that the product is optimally designed and that the crossover between
design and manufacturing was a smooth one, as illustrated in Figure 8.1.
8.3.2 The 'Importance of Adequate Product Definition
Much research has been conducted which illustrates how the management of
the product definition process in the early stages of product development has a
critical effect on the success or failure of the product in the market place.
Gupta and Wilemon 1661 illustrate how a robust and well understood product
definition is associated with a shorter product development cycle. Eisenhardt
152] and Gomory 1631 argue that shorter product development times contribute
to greater competitive product success by facilitating the insertion of new
component technologies into products while accelerating the integration of
improvements brought about by the process of learning.
208
assessing market potential
market testing
finalizing the product design
making the transition from R&D to manufacturing
managing manufacturing/marketing interface
managing marketing/R&D interface
developing the business plan
getting the to-ahead" from senior management

defining product performance specifications
launching the product
0 20 40 80
Percentage of Respondents (N=80) Citing
These Activities as Very Difficult to Accomplish
Source: Gupta, Ashok K.; Wilemon, David L.; 'Accelerating the Development of Technology-
Based New Products' California Management Review, Winter 1990 [66]
Figure 8.11 Most Difficult to Accomplish New Product Development

Activities
Bacon et al [7] illustrate the importance of successful product definition in a

pilot study of twelve product development projects (six successful and six
unsuccessful) conducted within six large United States corporations engaged in
the development and production of electronic systems products. In
summarising their findings they reach the following conclusions:
Strategic alignment — It was found that the alignment of product

development efforts with the overall business strategy of the organisation
was critical to product success (the strategic fit concept). Most of the
successful projects in the study took advantage in some way of the
organisation's core competencies while exploiting the core competencies
of others.
The management of information collection for the product definition -

Successful product development teams not only understood their
209
business unit's strategic direction, customer and user needs, competitive

product offerings (current as well as prospective), and applicable
regulatory standards for their product, but also knew how to
communicate this information to team members and incorporate such
information in the decision making process.
The use of multifunctional teams — All of the successful projects in the

sample were undertaken by multifunctional teams, typically combining
resources from marketing, engineering, and where applicable,
manufacturing.
Managing change in the product definition — The successful product

development teams did not significantly change their product definition
during development. They 'froze' some or all of the product definition.
Such teams responded to a change in the environment by adjusting their
strategy for future products. In several projects hastily made or poorly
managed changes in the product definition led to inadequacies in the
product development process. Successful products that allowed change in
their product definition did so on a selective basis, changing the fewest
possible elements of the definition.
8.3.3 Flexible Product Development in a Volatile Environment
Iansiti [781, in analysing the management of product development in turbulent

environments, illustrates how the needs of the nascent customer base, the
number of competitors, and the range of technological possibilities are all
characterised by frequent and substantial change. These concepts, originally
developed as a result of a study of the differences in research and development
performance of competitors involved in the design and development of
advanced processor modules, have much applicability in the financial services
industry.
210
Iansiti differentiates between 'traditional' and 'flexible' models of product

development. Subsequently, it is illustrated how traditional models are based
on observations in relatively mature environments such as the automobile or
appliance industries. Such models tend to avoid change within the product
development process as far as possible. Flexible models however embrace
change as a means of competitive advantage, with the development process
characterised by extreme flexibility and responsiveness. Concept development
can overlap with the design and development of the product, provided this
takes place within a structured product development environment. This
concept is illustrated in Figure 8.2.
Traditional Model
project concept market

start freeze introduction
0 0
concep. t d
5mpiernentat:on
1:›
concept lead time development lead time
Flexible Model
project concept market

start freeze introduction
0 0 0
co; pment
rriplementation
concept lead time development lead time
Source: Iansiti, Marco; 'Shooting the Rapids: Managing Product Development in Turbulent
Environments' California Management Review, Fall 1995 [78]
Figure 8.2 The Two Models of Effective Product Development
Traditional product development is characterised by a clear separation between

concept development and implementation. Using this approach the product
211
definition and applicable parameters are defined and then 'frozen' for the
duration of the product development. Good projects are characterised by
minimal changes in this definition which are inherently expensive to introduce
at a late stage in the product development cycle.
While this concept may work fine within a stable environment it is not
necessarily feasible within a turbulent product development environment. The
cost to the organisation of freezing the product definition in the face of obvious
changes in market requirements may exceed the cost of late implementation of
changes. The flexible product development environment thus demands an
overlap between the concept definition and concept implementation. Within
this environment the focus of the product development team should shift from
the capability for focused and rapid project execution to the capability to react
to newly discovered information during the project itself.
8A INTRODUCING THE FINANCIAL PRODUCT DEVELOPMENT MODEL
With all of the previously illustrated concepts in mind, the author has
developed the Financial Product Development Model as illustrated in Figure
8.3. This model is the result of the integration of both macro and micro system
engineering based product development concepts. These relevant concepts
have been drawn from the lessons learnt in manufacturing based industries,
analysed for their adequacy in terms of application to the development of
financial products, and integrated so as to provide a single model, the Financial
Product Development Model, for use in the development of financial products
Before progressing to the analysis of the various individual components of the

Financial Product Development Model it will be worthwhile to analyse the
general workings of the model. In particular an understanding of the macro
components as well as the functional flow described by the micro components
will be useful.
212
( Market Scanning or Customer Requirement ) Strate2,i61

Ci -cult
13Te-aka-1
Generic Product Identification
Strategic Analysis
k
[Phase 1: Product Definition Functional)
Problem Definition
1_
Product Feasibility
Analysis
Product Operational Design Integration

Requirements
Product Functional
Analysis
Technical
Performance
Measures
LCC Minimisation
> Flexible Manufacturing
Phase 2: Product Creation (Oper atioal

n
Product Design &

Construction
Testing & Evaluation Product Support &

Maintainability
Product Development
Process Analysis
Source: Own Source

Da taba se
Figure 8.3 The Financial Product Development Model
213
From a macro perspective the model suggests four elements which are the
fundamental drivers of the system engineering based Financial Product
Development Model. The first, and perhaps most fundamental, macro concept
is that of life-cycle cost (LCC) minimisation. This concept is inherent
throughout the entire product development process and is emphasised
throughout the discipline of system engineering as being fundamental to
ensuring that the product is developed in such a way as to ensure adherence to
required principles. The minimisation of the product life-cycle cost implies a
number of things, not the least of which is that the product has been properly
developed (in other words, it satisfies the stated requirements) within the
specified time period whilst making optimum use of the (limited) resources
available. If we include costs such as loss of revenue due to bad product
design, loss of intangible revenue such as goodwill and market position, and
the opportunity cost of investing in the product development process, then it
becomes clear that the minimisation of the product life-cycle cost must by
definition imply a successful product development process.
The second macro concept, design integration, emphasises the potential impact
of the initial stages of the product development process (the product definition
stage) on the latter stages of this process (the product creation stage). Design
integration, under the auspices of the life-cycle cost minimisation concept,
ensures that the initial product definition and analysis stages of the product
development process are approached in such a manner so as to make the latter
product creation stage of the process something akin to a mere formality. In
other words, under the design integration concept the micro concepts listed in
Phase One of the Financial Product Development Model must be approached
in such a manner as to enhance the Phase Two processes. The impact of the
Phase One micro concepts must thus be integrated with those of Phase Two.
Strategic analysis forms the third macro concept in the Financial -Product
Development Model and has as its function the analysis of product options
with a view to enhancing the strategic competitiveness of the organisation.
Under this concept the selection of the product to be developed is not simply a
214
function of the desired end-product characteristics, but is also influenced by

the ability of the product development process to add to or create
organisational skills which may enhance the competitiveness of the
organisation. This is achieved primarily via the use of the Competitive Strategy
Framework which has been designed with this function in mind. The
Competitive Strategy Framework is initiated via the Strategic Circuit Breaker
at an appropriate point in the product development process.
The fourth and last macro concept presented as part of the Financial Product
Development Model is that of product support and maintainability. Under this
concept, also known as concurrent engineering, the design and development of
the product once the preliminary stages of the system engineering process have
been completed coincides with the design and development of the support and
maintainability processes. This ensures the recognition of the importance of
these downstream processes in complimenting the original product'. This
concept is particularly important in the financial services industry where one
can typically clearly distinguish between the operational component of the
`product' and its support component. Given the high level of specialist skills
that can be required in the use of financial products the issue of support takes
on an increasingly important role.
The first micro elements in the Financial Product Development Model are
those of market scanning and generic product identification. Here the
organisation is continuously scanning the market for new product ideas or
requirements on the part of market participants. Once such an idea is identified
the product is generically identified in terms of the requirements which it must
satisfy.
I The term 'product' has come to mean both the tangible or intangible product as well as its
support processes. For example, as has been illustrated in earlier chapters, many products can be
considered to consist of both the original product as well as the associated support. A fmancial
derivative is an excellent example of such a product, where the support in terms of specialist
knowledge can be just as important, if not more so, than the actual 'product' itself.
215
At this point the organisation would typically initiate the product development
process if it was believed that the potential return on the product was
worthwhile. The Financial Product Development Model however implements
the Competitive Strategy Framework as a result of the initiation of the
Strategic Circuit Breaker concept.
Two distinct phases of the product development process are identified in the
Financial Product Development Model. In Phase One the emphasis is on the
functional definition of the product. In other words we are interested in
determining what it is that the product must do. In Phase Two the emphasis
moves from determining what the product must do to determining how the
product will meet the specified requirements. There is thus a definite shift from
a functional approach to product development to an operational approach
inherent within the Financial Product Development Model. As a result Phase
One consists of five micro concepts each of which has a specific identifiable
role to play in the product definition process. In hierarchical order these
concepts are: (1) the product definition, (2) the product feasibility analysis, (3)
the identification of product operational requirements, (4) the product
functional analysis, and (5) the determination of applicable technical
performance measures (TPM's).
Phase One and Phase Two are separated by a decision variable relating to the
concept of environmental volatility as described in Section 8.3.3. This decision
variable has as its function the selection of either a traditional or flexible
approach to the manufacture of the financial product.
Phase Two, the operational part of the product development process, consists
of three micro elements which have as their purpose the design, development
and testing of the product based on input received from the Phase One
functional elements. In hierarchical order they are: (1) the design and
construction of the selected product, (2) the testing and evaluation of the
product, and (3) an analysis of the lessons learnt during the product
216
development project which serves as a feedback loop into the organisational

database of product development knowledge.
The last component of the Financial Product Development Model is the

database component which is used to record the relevant experience gained
throughout the product development process.
Having briefly described the components of the Financial Product

Development Model it is now time to analyse each of these components, macro
and micro, in detail. This task is accomplished in the following sections.
8.5 LIIFE-CYCLE COST MINIIMIESATION
Within the Financial Product Development Model the all-encompassing macro

concept is that of product life-cycle cost (LCC) minimisation. The Financial
Product Development Model in general and all macro and micro components
are structured in such a way so as to ensure the minimisation of total product
related costs. This is in fact the very essence of system engineering. Note
though that the author prefers to adopt a more substantial definition of costs
than is typically the norm. More often than not the term 'costs' or 'total
product costs' is associated with accounting costs, being those explicit costs
that are associated with the use of a resource. Such an approach is no longer
feasible in a competitive business environment 1671. Rather, the emphasis
should be on the minimisation of economic costs, being those implicit and
explicit costs associated with the product. Implicit costs are those costs
typically not accounted for under conventional accounting standards and
include costs such as opportunity costs.
Under the auspices of system engineering the minimisation of product life-

cycle costs implies an acceptable (enhanced) product development _process in
that the attainment of such minimised costs is only possible if the concepts of
system engineering are adhered to. For this reason the choice of LCC
minimisation as the primary Financial Product Development Model macro
217
component is justified in that the attainment of this component implies a

successful product development process.
The benefits in terms of LCC minimisation of a structured process approach

such as that suggested by system engineering are evident. For example,
research has shown that most work processes can be subdivided into four
processes as follows [681:
Clear articulation of the goals of the process,
Designing the work in a manner such that the attainment of the stated
goals is not simply left to chance but is a dependable outcome,
Continual measurement of process performance, and
Assigning end-to-end responsibility for the process to key people.
It has subsequently been shown that business processes so managed perform

reliably, with the result being a low system or product LCC. There is thus no
doubt that the process of product development benefits from the LCC
minimisation approach.
The author would suggest that there is a strong positive correlation between the
minimisation of life-cycle costs and the reduction of cycle time, defined as the
interval from the start of product definition until the product is made available
to the customer. In other words, a reduction in cycle time will lead to a
corresponding reduction in product LCC. The benefits of this approach are
twofold. Firstly, a reduction in product LCC will enable the organisation to
make a greater profit out of the product. Secondly, a shorter development time
enhances the organisation's ability to obtain maximum advantage from the
timely release of innovative products prior to those released by competitors.
218
This view is justified by the experience of AT&T in improving their time to

market with respect to new products. AT&T view time to market as a measure
associated with their Product Realisation Process (PRP), defined as "the way in
which AT&T moves from technology in the laboratories to products in the
hands of customers." 11361 The emphasis on time is important on two fronts:
(1) speed is often regarded as a competitive element, particularly in any
industry where success is often a measure of the organisation's ability to
continuously develop innovative new products, and (2) the real value of any
time minimisation process such as the just-in-time (JIT) methodology is not so
much in the tangible benefits which it may bring but in the fact that such
methodologies often uncover process problems.
8.6 DESIGN INTEGRATION
Within the Financial Product Development Model design integration forms the
vital link between the initial product definition stages and the subsequent
product development stages. Coherence between these two stages of the
Financial Product Development Model is achieved via the implementation of
design integration (as a macro concept) as a means of ensuring adequate data
flow. In other words, the design integration concept has as its goal the
successful transfer of product development data between Phase One (Product
Definition) and Phase Two (Product Creation) of the Financial Product
Development Model. This is in accordance with the principles of system
engineering which illustrate in unequivocal terms the importance of active
communication between the initial functional definition of the product and the
subsequent operational development of the product so defined.
Design integration within the Financial Product Development Model is not a

specific identifiable process but rather an integrated process methodology
which is all encompassing and should pervade all elements of the Financial
Product Development Model. Any actions taken within the product
development process should be guided by the need to ensure compatibility
with either prior or subsequent requirements. In the initial stages of the product
219
development process the emphasis is on how the decisions made and actions
taken at present will influence subsequent elements of the process.
Correspondingly, decisions and actions taken at a later stage in the
development process should be understood in terms of their impact on prior
Financial Product Development Model elements. In accordance with the
principles of system engineering no element of the product development
process should be practised in isolation.
The concept of design integration in the Financial Product Development Model

is not however simply limited to the integration of the macro and micro
elements of the model. While this is undoubtedly important, it is the aim of the
author to ensure that design integration within this context is able to achieve its
full potential. To this end design integration also includes the integration of the
product or system design process within other parts of the organisation.
Product development is not an isolated occurrence which can be separated
from other entities within the organisation. As competitive forces increase on a
global scale so organisations are beginning to realise the importance of not
only the product development process but also the integration of this process
within the organisation (and indeed, within the organisational culture).
This trend is demonstrated in the annual BusinessWeek industrial design

excellence awards. In particular, these awards illustrate how "the fast-evolving
world of product design is pervading all the nooks and crannies of the business
world in the United States, Europe and Asia." 11131 Most importantly, it is
illustrated how the leading edge of design is being transformed into one that
focuses on both the process as well as the product. From the perspective of
corporate profitability the design process is proving that it can deliver
innovative new products that carry high profit margins. The implications of
this are, of course, obvious to say the least. Little wonder then that many of the
world's top management consultancy firms such- as McKinsey & Co. and
Boston Consulting Group increasingly offer design as a solution to corporate
growth problems 11131.
220
As has been illustrated previously in this thesis the Financial Product

Development Model has been constructed so as to integrate elements of the
corporate strategy process into the product development process via the use of
the Competitive Strategy Framework. The reason for this is because in the
modern environment the strategic selection of a product and the subsequent
development of that product cannot be considered as separate entities. It is
therefore interesting to note that many of the world's leading innovative
companies are arriving at the same conclusion. For example the 1997
BusinessWeek annual industrial design awards illustrated without a doubt the
manner in which design emphasis has been shifting from form-giving to
competitive strategy [113]. Lou Lenzi, jury chair and vice-president for
multimedia products and services at Thomson Consumer Electronics, provides
an accurate description of the changing emphasis of design when he says that:
"This year's awards entries signal the beginning of yet another new
era — applying design's problem-solving skills to address overall
strategic business issues." [113]
The concept of design integration is not limited to internal organisational

elements. External elements also have an important role to play in this process,
most notably the customer. For this reason many manufacturers the world over
are crafting new product development strategies designed to give the customer
more of a voice in the product development process 144]. The challenge
inherent in this concept is to create a product design process which supports
customisation while simultaneously minimising the overall design cycle — a
requirement for competitiveness in modern markets.
Design integration is not simply about integrating the various elements of the
product development process, but also about integrating the various entities
involved in the design and development of the product. This is because it is
accepted in the modern business environment that product development is
typically a team sport. It is relatively rare that a product, particularly a
complex one, is developed by a single person. And while the concept of a team
221
conjures up images of large numbers of people providing input into the

development process this need not necessarily be the case. Two people make a
team. A small team perhaps, but a team nevertheless.
Product development is therefore without doubt an interdisciplinary process.

This is a requirement for designing a successful product, keeping in mind that
a 'successful' product is generally considered to be one that (1) is technically
superior to competing products, (2) meets the customers' needs, (3) is cost
effective to manufacture and maintain, (4) is launched on time and within
budget, and (5) is brought to the attention of all potential market segments
11411. As a result, the development of a successful product means calling on the
skills of numerous people and functions within the organisation. The
development of a structured financial product will, for example, typically
require input from specialists in fields such as structured derivatives, corporate
finance, corporate law and corporate taxation. It is highly unlikely that any
single person will have sufficient skills in all of these areas.
8.7 STRATEGIC ANALYSIS
The concept of strategic analysis forms one of the macro components of the
Financial Product Development Model given the importance with which the
author regards this function in as far as its ability to compliment the financial
product development process is concerned. To this end the ability of the
product selection and development process to contribute to the strategic
competitiveness of the organisation is irrefutable. Since the product
development process forms an integral part of the strategic direction of the
organisation it stands to reason that this process, and in particular the selection
of the product to be developed, should be subjected to an appropriate strategic
analysis. This concept is introduced in the Financial Product Development
Model via the strategic analysis macro component. As will be seen at a later
stage, the practical implementation of this strategic review takes place via the
use of the Competitive Strategy Framework.
222
The concept which provides for the initiation of the Competitive Strategy
Framework is the Strategic Circuit Breaker which has as its function the
temporary suspension of the product development process in order to allow for
the strategic analysis of the product development decision in terms of the five
Competitive Strategy Framework elements. The positioning of the Competitive
Strategy Framework element in the Financial Product Development Model is
therefore between the market scanning process and Phase One (Functional
Product Definition) of the Financial Product Development Model. In this way
the organisation is able to assess the strategic appropriateness of the product
prior to embarking on a full scale product development process as outlined in
the Financial Product Development Model.
In terms of the Financial Product Development Model, the strategic review of

product selection and development decisions is an ongoing process. Strategy is
not static. By its very nature the concept of strategy suggests a continuous
process. This is emphasised in the Financial Product Development Model.
Such strategic reviews can however be self defeating if not approached
correctly. To combat this Hammer and Stanton 1681 suggest an appreciation of
the power of reflection, a term they use to emphasise the need for management
to stop every now and then and re-assess where their companies are headed
(note the similarity of this concept to the Strategic Circuit Breaker).
The author would suggest that within the sphere of financial services this
concept becomes an absolute necessity given the speed with which the
requirements of the industry change. For example, within the field of
structured finance, a discipline which has traditionally focused on the creation
of tax structured financial products designed to minimise an organisation's tax
liability, it is now accepted that the importance of taxation issues is reducing.
Rather, the development of such financial products is being characterised by
increasing innovation in terms of the ability to add value to the client through
the provision of an appropriate product [125]. Any organisation involved in the
development of structured finance products would thus be required to alter
223
their strategy if they wished to remain competitive within the market. This can
only be achieved if management are aware of the pending changes.
It is important to realise that the Financial Product Development Model does

not suggest any single product selection strategy as the only way to achieve
success. Such an approach would be naïve in the extreme. Rather, it should be
appreciated that different organisations will have different routes to successful
product selection. While one could certainly argue that the subsequent
development of the product could •be standardised up to a certain point this
argument does not hold for the product selection process. This is reinforced by
Dwyer and Mellor [511 who, on conducting a study of the product selection
strategies of 108 Australian firms, find that while one strategy appears to be
somewhat more successful than the others there appears to be multiple
strategies associated with success. In summarising their findings the following
five product strategies are identified:
The corporate fit, defensive strategy (34 percent of firms),
The unfocused, differentiated strategy (27 percent of firms),
The technical offensive strategy (23 percent of firms),
The high budget, high risk strategy (5 percent of firms), and
The conservative strategy (11 percent of firms).
While this study identified the technical offensive strategy as the most
successful strategy (with a 77 percent success rate), there was no statistical
evidence to suggest that this finding may be generalised. This conforms to the
multiple-strategy principle inherent in the Financial Product Development
Model.
224
8.8 PRODUCT SUPPORT AND MAINTAINABILITY
The emphasis within the product development and support macro element of
the Financial Product Development Model is on the use of concurrent
engineering in the simultaneous design and development of both the product as
well as its downstream support and maintenance requirements. Used in
conjunction with the other system engineering principles as discussed in this
thesis, concurrent engineering has the capability to not only reduce product
development times but also to ensure compatibility between the product and its
support requirements, a concept which is often overlooked in the financial
product development process. While the need for product support requirements
to be identified early has been accepted as being important in the development
of typical manufactured products, the author believes that, within the sphere of
financial product development within the financial services industry, the
importance of this concept will continue to increase as such products become
ever more complex with a corresponding increase in product support
requirements on the part of the users. The use of intellectual capital as a
support tool is already prevalent within the financial services industry, and
there is no doubt that this will increase in the future.
Consider for example the case of Toyota, long considered to be one of the
world's best organisations with respect to the introduction of innovative
product development techniques. Toyota, recognising the value of concurrent
engineering, have taken this concept one step further. Typically, a vehicle
manufacturer would produce a new vehicle in a sequential process. For
example, one would design a Camry sedan, then a Camry coupe. In so doing
the engineering workload is lightened and problems on the one model are
solved before the next model is developed. Toyota however has begun
developing similar models simultaneously so that the associated engineering
tasks overlap. The suspension team, for example, may thus be working on
several versions at the same time. It is estimated that by using this technique
Toyota can save 15 percent in lead time and 50 percent in engineering hours by
overlapping such projects 11571.
225
Such product support and maintainability concepts are important within a

financial services environment given the inherent difference between the end-
user and manufacturer of a financial product. The end-user of such a product is
typically primarily interested in its potential terminal value while the
manufacturer would typically be concerned with the need to hedge the risks
associated with the product. If such risks require dynamic hedging (the concept
of constantly re-adjusting the hedge for a particular risk or set of risks) then
the organisation must be confident that it possesses the skills and resources
required to support the product in such a manner. The cost to the organisation
of discovering an inability to support a financial product throughout its entire
life-cycle can potentially be extremely costly [1551. Such issues must therefore
receive adequate attention in the initial stages of the financial product
development process.
8.9 THE COMPETITIVE STRATEGY FRAMEWORK AND PRODUCT SELECTION
The emphasis of this element of the Financial Product Development Model is

on competitive strategy and how the organisation can use the product selection,
design and development process to enhance organisational competitiveness in
the market. Product selection should be made in conjunction with the
application of the Competitive Strategy Framework.
Examples of the importance of having a clear strategic product development

vision are abundant in everyday business. In the eighties Japanese banks
literally ruled the world. They occupied the first six positions in international
league tables, accounting for approximately 50 percent of the business in the
international capital and lending markets. Today not a single Japanese bank
appears in the top ten. Many people believe that the primary reason for this
loss of dominance by Japanese banks is the fact that they are strong followers,
not innovators. Their growth in the eighties can be attributed to their appetite
for plain vanilla business such as syndicated loans and Eurobonds. However,
since then it has been proven that a big balance sheet is not enough to ensure
226
dominance. Creativity in product offerings must be present — new ideas and an

ability to adapt to change [96].
A further indication of the importance of product strategy can be found by

analysing the way in which many of the world's best businessmen run their
organisations. Microsoft's Bill Gates, Intel's Andy Grove, Compaq's Eckhard
Pfeiffer, Enron's Ken Lay and SAP's Hasso Plattner. All of these businessmen,
along with many other companies such as Proctor & Gamble, Motorola,
Samsung and Johnson & Johnson have one thing in common: they see market
creation and recreation as their central strategic challenge [90]. The reason for
this approach is quite clear. From 1975 to 1995 some 60 percent of the Fortune
500 companies disappeared from the list, overtaken by innovative companies
which were rewriting the rules of the game. The reasons for this were
confirmed by Kim and Mauborgne [90] when, in a study of 100 new business
launches, they found that although 86 percent were me-too launches or
incremental improvements they generated only 62 percent of launch revenues
and 39 percent of profits. By contrast the remaining 14 percent of business
launches — those that created markets or recreated existing ones — generated 38
percent of revenues and 61 percent of the profits.
It is thus clear that the organisation must focus on creating landmark products
instead of simple 'me too' products. This concept should not be obscured by
the need to emphasise the positive outputs of the product development process
such as reduced cycle times. Studies have illustrated the negative effect of
sacrificing innovation in order to achieve pure process parameters such as
reduced cycle times [76].
The problem with modern product development is that the organisation rarely
has the chance to correct a mistake the second time around. There is therefore
limited scope for 'doing it over'. Customers demand the right product the first
time. Those organisations that cannot satisfy this requirement will simply be
out of business 1711.
227
8.110 PROBLEM DEFINITION
The first micro element of Phase One of the Financial Product Development
Model is that of problem definition. The reason for this is quite simple one
cannot solve a problem until one has defined exactly what the problem is. An
inadequate problem definition has historically been the cause of a number of
product disasters as products were developed for totally the wrong reasons, as
is illustrated in section 8.3.2.
The importance of an adequate up-front problem definition is increasing as

modern day products become increasingly sophisticated with associated
increases in the levels of complexity 1761. For example, recent technological
enhancements have changed the rules of the game for many commercial banks
in terms of the products demanded by their clients and those supplied by the
banks. This phenomenon is particularly prevalent in the area of electronic
banking. In South Africa, for example, many elements of the banking fraternity
believe that their existing corporate electronic banking products may no longer
meet the changing demands of the business sector 1251. Such clients are
increasingly demanding a customised, solutions driven, approach such as that
provided by e-commerce. Internationally e-commerce has allowed banks to
combine low-cost delivery with a customised set of products such as
automated receipt management, micro-payments and smart procurement cards
integrated with a customers' enterprise system, such as SAP or Baan. It is
estimated that e-commerce transactions in the United States alone will amount
to $48.5 billion by the year end 2000 125].
Such knowledge, while useful, provides a measure of just some of the

complexities inherent in product development, and why a clear cut problem
definition is so important at the start of the product development process. In
the case of e-commerce there is no doubt that the traditional form of electronic
banking is under threat. There is also no doubt that those organisations that do
not realise the potential threat and take the appropriate steps may soon find
228
themselves out of business. What is less clear however is how this threat
should be combated.
Under such a scenario it seems obvious that the development of innovative

new products is the only viable solution to the problem at hand. Existing
products cannot compete with the new generation of e-commerce products
being introduced by leading banks. However, the dangers of simply developing
new products in an attempt to retain a competitive advantage without clearly
understanding the underlying problem are often not understood by market
participants. As is illustrate by a partner at Deloitte & Touche Consulting
Group, most banks do not understand the value of e-commerce to their
customers and have not effectively understood the potential of this new
technology. Accordingly, banks are seen to be "throwing money at a product
without a strategy." [25]
As yet another example, consider the recent move to incorporate complexity

theory into modern day decision enhancing products designed to allow
organisations to test the effect of strategic decisions in a simulated world prior
to physically implementing such decisions. Complexity theory, the notion that
complicated behaviour emerges from the interactions of many components, is
being tested by PricewaterhouseCoopers as a radical new consulting tool. The
potential of this concept comes from the fact that, as opposed to operations
research and linear programming which are difficult to grasp, the results of the
simulations are visible on-screen using the concept of visualisation (which is
described as the marriage of mathematics and marketing). Companies as
diverse as Citicorp, Coca-Cola, Shell International Petroleum and Texas
Instruments have been sponsoring research into the field of complexity at the
Santa Fe Institute in New Mexico, regarded by many as the foremost think
tank on nascent science [24].
Such developments, while potentially a brilliant innovation, must be tempered

with the need for a clear understanding of the underlying problem.
229
Sill PRODUCT FEASIBILITY ANALYSIS
As specified in Chapter Six the role of the product feasibility analysis is to

identify at an early stage the possible (feasible) solutions to the stated
requirements as derived from the problem definition. Different technological
and design approaches must be evaluated as part of the feasibility analysis. The
output of the feasibility analysis should be expressed in terms of the following
three key areas:
The various possible design approaches which may lead to a solution

must be identified,
The most likely candidates in terms of satisfying required performance

characteristics, effectiveness characteristics and cost characteristics
must be identified and evaluated, and
A preferred approach must be recommended.
Properly conducted, the feasibility analysis will ensure that no single product
solution is ignored. The benefits are obvious: the developer(s) of the financial
product is(are) presented with a range of options from which to make an
optimal selection in terms of satisfying the market requirements.
The importance of this concept is easily illustrated in the financial services

industry. Associated with the increasing complexity of financial products is an
increasing number of alternatives by which a desired product can be
constructed. For example, in the world of financial engineering a class of
financial product known as synthetic products or synthetic securities (see
Appendix C for an example of the development of a synthetic security)
provide the developer with the ability to replicate the characteristics of almost
any other product using a combination of alternative products or securities.
Derivative securities such as options, swaps and futures can be combined in a
multitude of ways in order to replicate just about any characteristic desirable.
230
This means that when faced with a particular product specification the
financial engineer is often able to meet that specification in a number of ways,
each of which will have different consequences for the product development
process.
Note that the mere identification of feasible solutions to the problem at hand is
not enough to satisfy the output of the product feasibility analysis. It is further
required that the solution which would be most feasible be identified in
conjunction with the preferred approach to meeting the stated requirements.
The many ways in which a particular financial problem may be solved is made
inherently clear in the area of financial treasury systems development. The
problem is that not all of the applicable or possible solutions will be optimal in
terms of ensuring a competitive advantage in the market for the organisation.
This is due primarily to the pace of change within the treasury systems
industry. For example, it is a well known fact that modern day (in this context
extremely modern day) treasury systems are almost unrecognisable from the
systems in place a mere three years ago [95]. Such modern day treasury
systems have interfaces to main multi-autency accounting systems and to one
or more enterprise wide systems stuck` as SAP. Exchange of data between
various systems is, of course, automata. , The emphasis is thus clearly on the
integration of such corporate treastitY::$Ystems, which provide a vital risk
management function for the organiSati!Oii.;With other business systems.
There are at least two major identifiabl approaches to the development of the
functionality associated with such • a stem. In the first instance an
organisation can follow the approkh ''of developing stand alone highly
specialised units which may be added.On to existing business or enterprise
systems. This approach provides th-e customer with a high level of
specialisation in particular areas but does not allow for standardisation or easy
integration of the multiple units so developed. The alternative approach is to
develop an integrated enterprise wide system incorporating functions such as
treasury management. This is a far co§tlier approach and requires greater
231
resources on the part of the organisation. Which approach is preferable? At

present many organisations use semi-integrated stand alone treasury
management units. However, the suppliers of enterprise wide systems such as
SAP argue that their products offer far greater integration than such stand-
alone products. This clearly appears to be the case, and once such systems
incorporate the functionality of specialist treasury management products they
will present a threat to suppliers of stand-alone products.
The important point to note here is not the fact that integrated enterprise
systems appear to be gaining the upper hand on stand-alone products, but that
the feasibility analysis would identify both approaches as being able to satisfy
the requirement for such a system. This is not to say that both approaches are
practical or indeed optimal for the organisation, but the important outcome of
the feasibility analysis is that the organisation is aware that multiple solutions
do exist.
Part of the product feasibility analysis should be devoted to the

manufacturability of the product. The reason for this is quite simple. The
ultimate aim of the product development process is to provide a product that
can be manufactured and sold for a profit. For this reason manufacturability
should be a prime consideration and should receive attention in the early
phases of the development process 1138].
8.12 PRODUCT OPERATIONAL REQUIREMENTS
The purpose of the product operational requirements element of the Financial

Product Development Model is to ensure that the product operational
requirements are clearly understood prior to design commencement. The
absolutely clear and unambiguous understanding of the product operational
requirements is a historical weakness of the product development process in a
typical manufacturing environment 11261477]. There is no reason why this will
not be the case in the financial product development environment unless active
steps are taken to ensure that such development weakness are eliminated. This
232
becomes all the more important when one considers the nature of financial
product development within the financial services environment. This
environment is characterised by rapid rates of change with exponentially
increasing product complexity. In fact, so rapid is the change inherent within
this environment that industry regulators have begun to issue warnings about
their ability to regulate technologies and products which they do not fully
understand. Small wonder then that a clear understanding of client product
requirements may be difficult to achieve at the best of times.
In order to avoid an inadequate understanding of the product operational

requirements it is recommended that the following four questions (at a
minimum) be satisfactorily answered prior to preceding to the next stage of the
Financial Product Development Model:
What functions will the product be required to perform?
When will the product be required to perform its intended function(s)?
Where will the product physically be utilised (if applicable) and for
what period of time (or multiple time periods) will this utilisation take
place?
How will the product accomplish its objective(s)?
The answers to these questions will provide the product developer(s) with a
macro view of the operational requirements of the product which will prove to
be invaluable in ensuring that the design and development process stays on
track.
While an understanding of the product operational requirements has been

important in the past, there is no doubt that such importance is increasing in
the modern economy. Nowhere is this more evident than in the concept of
mass customisation which has certain applicability within financial services.
233
Mass customisation, in simple terms, is about organisations with millions of

customers designing products for each individual customer. Companies as
diverse as BMW, Dell Computer, Levi Strauss, Mattel, McGraw-Hill and
Wells Fargo are increasingly turning to mass customisation as a means of
maintaining or obtaining a competitive edge [138]. However, mass
customisation is more than simply a manufacturing process, logistics system or
marketing strategy. At its core it is an in-depth understanding of what the
customer wants from a product. Simply put, an understanding of the product's
operational requirements. How should the product look? What should it do?
Under what circumstances should it perform? These are all issues with which
companies must grapple if they are to be competitive — companies such as Dell
Computers which recently passed IBM to become the number two computer
manufacturer in the world (behind Compaq) as a result of huge increases in
internet based sales of customisable PC's, or Mattel which allows children to
order customised Barbie Dolls in up to 6000 permutations over the internet, or
one of the many Ritz-Carlton hotels each of which are linked to a database
filled with the quirks and preferences of over half a million guests so that the
desk clerk can find out whether you are allergic to feathers, what your
favourite newspaper is, or how many extra towels you like [138]. All of this, in
one form or another, relies on an understanding of the product operational
requirements.
The critical strategic importance of the product requirements definition is ably

illustrated by the case of Digital Equipment Corporation (DEC) who re-
engineered their product requirements definition process in order to ensure the
competitiveness of DEC's products in terms of meeting customer
requirements. One of the outcomes of this process was the concept of what
DEC refer to as 'whole products' which had the effect of broadening the scope
of the requirements definition process to include parameters such as marketing
messages, pricing and packaging, as well as deployment and service scenarios.
The power inherent within this concept is that instead of the product being
conceived as a set of capabilities delivered to the customer it is defined so as to
include the additional elements of a customer's experience with the
234
organisation such as marketing messages, the sales engagement, and the

distribution channel. In addition DEC moved away from defining the concept
of a process as a series of sequential procedures which when satisfied yield a
desired result to a view of process as a map of the product development terrain
which serves as a guide through the peaks and valleys towards the final
destination [771.
The author is in favour of the use of this 'whole product' approach in the
financial services sector since this concept captures the very essence of such
services, being that a product can often be considered to be a collection of
tangible and intangible entities packaged in such a way as to yield a desired
result. An inability to view the 'whole product' will in most cases be fatal
since the notion of a conventional product does not belong in this industry.
DEC's Achieving Excellence (AEC) program as it was known had the

responsibility of reducing the product development cycle by 50 percent.
Subsequent methods of analysis such as benchmarking indicated that a
substantial amount of time was lost in the development process due to
`requirements churn' — a concept describing the fact that some 40 percent of
the requirements specified in the feasibility and requirements phase of the life-
cycle were re-defined in subsequent life-cycle phases. Three major causes were
identified:
Requirements for the product were loosely defined,
As a technology driven organisation there was a general mistrust on

the part of technical specialists to the technical feasibility of
requirements handed to them by business groups staffed with
marketing and sales representatives, and
Technology development generally took place without a contextualised

sense of the problem to be solved.
235
The result of this analysis was the definition of the whole product concept as
well as a revised requirements management process, illustrated here in Figure
8.4.
Requirements Management, Revision 13. June 24th, 1994
Digital
Cus tom s Mark Product Engineering System Test Pieta
Equipment Management Integration ErtgineenegIGA
Manufacturing Purchasing
Support
Corporation
Understand System Business Needs
Gather Customer Information
Translate Needs into internally consistent ist of Requirements
Dovemp and Prove key enabliItg Concepts
Compare cnosen solutions against composition
Derma {diagram} too-level subsystem Commitm oma
PriiduCt, iicqufidirint;
etermine 'impactIst of proposed change
4
Update product requirements definition
Source: Hutchings, Anthony F.; Knox, Steve T.; 'Creating Products Customers
Demand' Communications of the AMC, Vol 38 No 5 (May 1995) 177]
Figure 8.4 The Revised DEC Requirements Management Process
While the DEC requirements management process is illustrated here this

process will in all likelihood be different for different organisations selling
different products in different markets. In other words there is no single
`correct' process. What is however clear is that the adequate and acceptable
definition of product requirements (between both the external customer and
internal elements of the organisation) is a prerequisite for successful product
development.
8.13 PRODUCT FUNCTIONAL ANALYSIS
The development of a product functional analysis is included in the Financial

Product Development Model because not only does this ensure that the
development team are left with a clear, in-depth, understanding of what the
236
product should do, but they are also exposed to the system functional
hierarchy. The benefit of this exposure is that one is able to drive down from
the macro product level in order to identify the resources necessary in order to
perform specific functions. Similarly, one is also able to drive upwards in
order to determine the justification for that specific requirement.
The product functional analysis is a hierarchical diagram indicating the

primary product level functional flow which indicates the primary functions
which the product must accomplish. The final functional hierarchy is arrived at
by dividing and sub-dividing each of these primary functions until such time as
the product functionality has been fully described to the satisfaction of the
development team.
The manner in which the system functional analysis is accomplished will be

demonstrated in Chapter Nine.
8.14 TECHNICAL PERFORMANCE MEASURES
The ultimate aim of the Technical Performance Measures component of the

Financial Product Development Model is to develop a quantitative description
of the applicable measures of product performance ordered in terms of
importance to the customer. This ensures that the product development team
have a certain measure of quantifiable parameters with which to work as
opposed to pure qualitative parameters which are often subject to varying
levels of interpretation.
Within the context of financial product development however the author would
suggest a slight revision to the conventional application of technical
performance measures as typically applied within a manufacturing
environment. The fast changing nature of financial services combined with the
intangibility of many financial products makes the exact quantification of
technical parameters somewhat harder than in a conventional engineering
environment. For example in civil engineering one can specify a minimum
237
concrete compressive strength of 30 MPa. This is a directly and widely

understood measure of strength, and can be measured accurately, a feature
which is not typically found in financial services.
As a result the author suggests the use of technical performance comparatives

as opposed to pure technical performance measures where appropriate. As the
name would suggest technical performance comparatives are quantitative
measures of relative value, possibly linked to measures associated with
external product parameters.
Consider for example a recent trend in structured products which make use of
financial options in order to achieve their stated goals. During 1997 and 1998
volatility within equity markets world-wide increased substantially as equity
prices were subjected to large swings as a result of economic conditions at the
time. This posed a problem for any financial services organisation using
financial options in the creation of a structured product. The reason for this is
the manner in which such options are priced [121],[56]. According to the Black-
Scholes theorem the price of an option is related to the implied volatility of the
underlying. In other words, as the volatility (in terms of returns) of the
underlying increases so too does the price of the option (both call options and
put options). The result was that as the price of these options increased so too
did the overall cost of the structured product, making it much harder to sell
[48].
In this case the development of a new product which could bypass these issues
was driven largely by the need to reduce the cost of the financial options. Note
though that one cannot associate a pure quantitative technical performance
measure to this problem. We cannot, for example, say that the price of the
option should be less than 97 cents. It thus becomes impossible for the
development team to define a single quantitative number. What is required is a
238
technical performance comparative. In this case the cost of the new option
must be less than the cost of a 'plain vanilla' option 2 .
The solution to this particular problem was the creation of an outperformance

option whose value is determined by the difference between the return of a
particular underlying and that of an index or basket of stocks. This solution
was effective because of the inherent inclusion of correlation between the
single underlying and the basket or index of stocks. Any measure of positive
correlation between these two entities leads to reduced underlying volatility
which in turn leads to a lower option price since the price of an option is
strongly dependent on the implied volatility of the underlying(s).
8.15 ENVIRONMENTAL VOLATILITY
As has been ably demonstrated in Section 8.3.3 the modern day product
development environment can be characterised by either relative stability in
terms of the requirements of the market or relative volatility in terms of
constantly changing market requirements and technological enhancements.
Each characterisation demands a different product development style with
regards to the overlap of the product concept development and product
implementation. Development in a stable environment is best achieved by
developing the product definition and freezing such definition prior to the
implementation phase. Subsequent changes to the product definition are only
made in extreme circumstances. Development in a volatile environment means
that the concept of a static product definition is not suitable since the cost to
the organisation of developing a product which does not satisfy the (changing)
market requirements is higher than the cost of implementing downstream
changes. Under this scenario the product definition is subject to change
provided that such change can be justified.
2 The term 'plain vanilla' is used in the financial derivatives industry to describe a product which
is assumed to be straightforward or comparatively simple.
239
The environmental volatility micro component brings the issue of volatility

during the product development process to the attention of management.
Consequently management must make a decision as to whether the traditional
approach or the flexible approach will be optimal for the development of the
required product. This decision will be a function of past volatility and
predicted volatility within the market that the organisation is targeting. As such
there are no hard and fast rules relating to this decision.
The important consideration here is that there must be a clear selection of one
of the two alternatives. There is no room for middle ground here. Either the
traditional approach is adopted or the flexible approach is selected. Both
approaches are mutually exclusive.
8.116 PRODUCT IDESIIGN AND CONSTRUCTION
Up until this point the Financial Product Development Model has focused on
the functional definition of various product elements with macro strategies
concerning the minimisation of the total product life-cycle cost and the concept
of design integration. The purpose of these elements was to identify and
develop those functional components associated with the required product. The
design and development of the product which satisfies the parameters specified
in Phase One takes place in Phase Two of the Financial Product Development
Model.
Throughout this thesis it has been illustrated that the product development
process consists of three sequential elements as follows:
o Select the product to be developed using the Competitive Strategy

Framework as a guide. The Competitive Strategy Framework, the use
of which is initiated via the Strategic Circuit Breaker, has been -
developed in response to the fact that modern day financial product
development is not simply about developing that product that appears
to have the highest cash benefit for the organisation. There are many
240
other strategic factors which must be considered in the product

selection process if the organisation is to attain and maintain a
competitive advantage. The emphasis here is thus on economic benefits
as opposed to simple accounting benefits.
o Identify and analyse all of the functional elements of the product

development process such as why the product is required, what
functions the product must be able to perform, and what parameters,
both quantitative and qualitative, the product must satisfy. The
emphasis has thus been on the what as opposed to the how.
o Design and develop the final selected product which conforms to the
functional requirements as specified above and which has been
`filtered' through the Competitive Strategy Framework. At this stage
there should be no doubt that the product being developed is the best
one on aggregate, taking into account all of the previous elements. The
emphasis is thus on the efficient production of the product, being the
ability to produce the product faster and more efficiently (and hence at
a lower life-cycle cost) than competitors. The final development of the
product takes place under either the traditional manufacturing approach
or the flexible manufacturing approach
Once all of the attributes of the product have been defined in absolutely clear
and concise terms, and the product to be developed has been selected, the next
phase is the design and subsequent construction of the product. Up until this
point all of the preliminary work carried out as part of the macro product
development process has emphasised the need to answer the what as opposed
to the how. At this point the development team has a clear understanding of
what it is that the product should accomplish, and why the particular product
has been chosen (as part of the organisation's Competitive Strategy
Framework). These concepts must now •e -.donverted into reality in the form of
a created product (typically intangible in tbe-financial services industry).
241
The creation of the product is accomplished by a serial process of product

design, in accordance with the requirements and specifications previously
generated, and subsequent product manufacture in accordance with the design
parameters. The emphasis is thus on determining how the product is to satisfy
the requirements. It is worth mentioning that although the product design and
construction phase is shown as a single micro component in the Financial
Product Development Model, it is likely that this process will be the most time
consuming, and possibly the most complex, of the entire product development
process. It goes without saying that this process forms a vital component of the
Financial Product Development Model in that all of the previous elements have
no meaning if the organisation is not able to act on the information so gained.
This thesis has on numerous previous occasions highlighted the similarities

between the development of tangible and intangible products. However, the
importance of this concept is such that it bears repeating again. One of the
major foundation elements of this thesis is that the development of an
engineering based physically manufactured product is conceptually identical to
the development of a financially engineered intangible financial product. Civil
engineers work with concrete and structural steel and financial engineers with
money and financial securities. The materials and tools may differ, but the
process of product development remains the same.
The need for integration of the various Phase One micro elements into the
product design and development element has been illustrated previously. The
Financial Product Development Model uses the concept of design integration
to achieve this all important goal. An excellent example of just how design
integration can be used and the effect of this concept on the product design and
development phase can be found in the details of the new product development
strategy announced by Boeing early in 1998. The reason for the new strategy
was that top management at Boeing realised that "without a drastic overhaul of
its transport creation process the company may not find it feasible to introduce
future models or major derivatives." [1261 The result of this recognition was the
242
development of what Boeing refers to as the Aircraft Creation Process Strategy

(ACPS).
To put the need for the ACPS into perspective, the time to market for new
products and major derivatives at Boeing increased from 3 years to almost 4.5
years during the period from the 1960s. Financially non-recurring expenses on
the 777-200 transport program included more than 40 percent attributed to
engineering and 45 percent for operations. Clearly a new approach to product
development was required. Although the ACPS contains many unique
principles, the most interesting in the opinion of the author is the fact that pro
forma schedules in terms of the ACPS indicate a 12-month aircraft
development period (down from 4.5 years). This schedule consists of the
following:
2 months of configuration planning.
4-6 months of near simultaneous structural and systems definition

including tool design and fabrication. Concurrent parts assembly would
take place, beginning with common components shared with other
Boeing products.
The 9th and 10th months would be used for final assembly with
certification work beginning in the 10 th and ending in the 12 th month.
Note the strong parallels between this ACPS and the Financial Product
Development Model as suggested by the author. In both models configuration
planning is the first requirement (Phase One in the Financial Product
Development Model), followed by the design and construction of the product
in accordance with the principles of concurrent engineering. Finally, in
accordance with the ACPS the product is certified (a function which is
obviously required in the aircraft industry). The direct comparison to this
certification in the ACPS would be the testing, evaluation and post-
development analysis in the Financial Product Development Model.
243
8.117 PRODUCT TESTING AND EVALUATION
Product testing and evaluation forms an important part of any engineering

based manufacturing process. To this end tools such as Total Quality
Management (TQM) and Statistical Process Control (SPC) have proved very
popular in many organisations as a method of ensuring the required level of
product quality 1921. Herein lies the crux of the matter though. Within the
sphere of financial services how do we define product quality? The typical
financial product has no physical attributes. One cannot easily measure or
identify imperfections in the product. If such problems are present they are
often only identified when it is too late (usually once financial devastation has
resulted). Therefore a typical engineering based definition of product quality
will not suffice.
For the purposes of the Financial Product Development Model the author
would like to define the 'quality' of a financial product as follows:
The quality of a financial product is a measure of the effectiveness with

which the product ,satisfies the stated requirements of either an external
party or an internal organisational element froth a technical product,
specification perspective.
This definition circumvents the problems associated with the lack of tangibility
of product elements associated with financial products.
Note though the important emphasis in this definition. The product is

considered to be appropriate (a quality product) if it satisfies the stated
technical requirements presented to the development team, whether such
requirements are presented by an external party (such as a customer who
initiated the product development process) or an internal organisational party
(for example the marketing department who identified a need for the product).
Product quality is thus not a function of the correctness of these technical
specifications. In other words the product is considered to be a quality product
244
if it satisfies the technical requirements so specified irrespective of whether

these requirements themselves are correct.
The emphasis on this concept is appropriate within the financial services sector
because the need for the product is not always as obvious as it may at first
appear to be. An organisation looking to implement a particular risk
management strategy will not necessarily be interested in explaining the
strategy for the benefit of the product development team. What they will
require is a product which will satisfy specific stated requirements. The
Financial Product Development Model does of course emphasise the need for
the development team to ensure that the product requirements and technical
specifications so obtained are a true indication of the parameters which the
product must satisfy, but once such parameters have been obtained the
development team will find it hard if not impossible to make any judgements
about the applicability or correctness of such requirements.
This emphasis on product quality as a measure of adherence to design

specifications is to some extent influenced by the practical experience of the
author within an information technology system development, analysis and
implementation environment. In this environment it was noticeable to the
author how often the system (the product in this case) was blamed for being
inadequate or poorly designed for not satisfying the requirements of the
operators. In other words the system was considered to be a poor quality
system. The fact of the matter however was that the system had been designed
in accordance with specifications which had been provided a number of years
earlier. From this perspective the system could justifiably be considered to be a
high quality system.
8J1 PRODUCT DEVELOPMENT PROCESS ANALYSIS
The need for a post product development process analysis of the lessons learnt
is best summed up by James Mateyka, the veteran A. T. Kearney consultant.
245
Commenting on the ability of Toyota to consistently develop better products

than their competitors his view is that:
"A lot of people view product development as an artistic achievement,

but they are losing the race. It is not superior people; it is a superior
system — a factory really — and a culture that learns from mistakes.
Toyota's strength is awesome. They can develop a car in 18 months or
less, and they don't make the same mistake twice." 11571
Duru Ahanotu [50] illustrates how an optimal learning cycle contains a positive
feedback loop where new knowledge leads to new products and vice versa. In
addition it is apparent that although a significant amount of learning occurs
during the product development cycle, time to reflect, experiment, and
collaborate are critical determinants of the organisation's ability to validate the
lessons so learnt and to create new ones.
It is important to realise that the post product development analysis is not

purely intended to generate meaningless piles of information which are simply
stored away in some remote location. The clear objective of this concept is to
allow the organisation to develop new products more rapidly as the lessons
learnt previously are incorporated into current development processes. The
method in which this information is captured and stored is dependent on the
organisation, although modern technology would no doubt dictate that storage
would be in one of the many electronic formats available. The ability of the
post product development analysis to influence corporate competitiveness is
illustrated by Spencer 11481 who refers to the concept of a 'corporate memory'.
For example, Xerox Corporation has had the ability to generate and store such
information in an electronic format since the mid-1970s, and has now
expanded the use of such tools throughout the entire corporation. The resulting
`corporate memory' so established allows for the rapid development of new
products, providing Xerox with the vital edge required in the modern
marketplace.
246
8.19 CONCLUSIION
This Chapter has detailed the development of the Financial Product

Development Model, the culmination of all of the concepts presented up until
this point. This model has been developed for use within the financial services
industry in order to enhance the financial engineering process of product
development. This was done by analysing many product development concepts
inherent within the typical manufacturing industry, determining the feasibility
of the concepts to the development of financial products, and integrating all
such applicable concepts within a structured, system engineering based,
product development framework.
In analysing each of the components of the Financial Product Development

Model the author has once again included many practical examples of the
application of particular concepts. As with the previous Chapter such examples
were drawn from both the manufacturing environment as well as the financial
services environment.
The Financial Product Development Model is composed of both macro as well

as micro concepts. In developing the model the author first developed the
macro Financial Product Development Model framework which is based on
important system engineering principles. Thereafter the inclusion of the micro
Financial Product Development Model components was based on an analysis
of certain underlying product development principles as illustrated by the
author.
In this Chapter the author has also introduced the concept of the traditional
versus the flexible product development model as proposed by Iansiti [78]. The
appropriateness of either model is a function of the volatility of the product
development environment in _which the organisation finds itself. Because this
environment is subject to change the selection of only one of these methods
would limit the general applicability of the Financial Product Development
Model. In order to avoid this the author has included a decision step within the
247
Financial Product Development Model in which management is forced to

select one of the approaches for the further design and development of the
financial product. This provides the model with maximum flexibility while
simultaneously drawing management's attention to these important concepts.
Now that the reader is familiar with the Financial Product Development Model
as proposed by the author the mechanics of the practical implementation of this
model can be explored. This is done in the form of a practical validation of the
Financial Product Development Model by the author. This validation is the
subject of the following Chapter.
248
The Financial Product Development Model: A Practical Implementation
Chapter 9
le Financial Product Development Model: A
Practical Implementation
"We should do something when people say its crazy. If people say
something is "good," it means someone else is already doing it." —
Hajime Mitarai, president, Canon
"The old weapons for achieving real differentiation have become

inadequate. No longer can comparative advantage be sustained for
long through lower costs, or higher technologies ...The design
dimension is no longer an optional part of marketing and corporate
strategy, but should be at their very core." — Christopher Lorenz,
The Design Dimension
NTRODUCTION
he previous two chapters were, in essence, the heart of this thesis in that
they illustrated two extremely important concepts which the author
suggests will lead to improved organisational competitiveness within the
financial services industry, namely:
o The selection of the product to develop is not simply a case of 'lowest

cost wins' but involves a number of strategic elements which will
affect the ability of the organisation to be successful in its target
market. These elements combined form the Competitive Strategy
Framework as detailed in Chapter Eight.
o The process by which financial products are developed (throughout

their entire life-cycle) can be improved by the application of system
249
engineering principles which have been proven to be successful within

a typical manufacturing environment. This is possible because the
development of financial products is different only in terms of
tangibility from that of a conventional manufactured product.
Given these concepts as proposed by the author one would ideally like to
validate such concepts in order to determine their appropriateness within a
practical application. This is important since, as has been stated by the author
previously, the outcome of the research detailed in this thesis must have
practical applicability to the financial services environment if it is to be of any
use.
With this in mind the author has implemented the concepts as detailed in this
thesis in as far as the development of a financial product within a practical
situation is concerned. The manner in which the Financial Product
Development Model can be applied as well as the results of the practical
application of this model to the financial product development process are
detailed in this Chapter. As such:
The primary purpose of this Chapter is to illustrate to the reader the manner
in which the Financial Product Development Model, incorporating the
Competitive Strategy ;Framework and the Strategic ,Eircuit Breaker, can be ,
practically implemented and to report the results of such an implementation.
9.2 AN OVERVIEW OF THE PRACTICAL IIMPLEMENTATION OF THE FINANCIAL

PRODUCT DEVELOPMENT MODEL
In order to practically validate the Financial Product Development Model it is

necessary for one to be in an environment similar to that as described
throughout this thesis. Throughout the greater part -of the research period the
author was part of the Equity and Derivative Structuring team at a leading
South African financial services organisation. This allowed the author the
opportunity to practically apply the principles inherent in this thesis.
250
The main focus of the Equity and Derivative Structuring team was to provide
financial solutions to proprietary and external clients. Such solutions were
extremely varied, ranging from trading solutions to structured products to
advisory services. This team worked in close collaboration with the other
teams within the organisation including areas such as investment banking,
corporate finance, and equities and derivatives trading.
The Financial Product Development Model was applied by the author to a

product development project within the author's work environment. The
purpose of this application was twofold, namely:
o To enable the author to test the practical applicability of the proposed

model, and
o To be able to illustrate to the reader both the method of application and

the results of the application of the Financial Product Development
Model. This is achieved throughout the remainder of this Chapter.
9.3 THE PRODUCT TO BE DEVELOPED
The product in question was a proprietary value-at-risk (VaR) risk

management system which would have certain enhanced capabilities over and
above the system in use at the time (the concepts on which VaR is based have
been covered in Chapter Four). It can be appreciated that with any organisation
involved in the trading of financial securities, an effective risk management
system becomes paramount to the successful control of financial risk.
Although an existing VaR system was in use at the time it had a number of
issues associated with it which were not entirely satisfactory. Principally the
legacy system was-unable to account for the-VaR of non-linear securities such
as financial options on equities and futures. This meant that in calculating the
VaR of portfolios containing such securities one was forced to make extremely
conservative assumptions regarding the potential risk. The result was a sub-
251
optimal use of available capital since most financial institutions are governed
by minimum capital adequacy requirements in terms of the risk borne by
themselves. A new VaR system was thus required which would overcome
these problems.
9.4 APPLYING THE FINANCIAL PRODUCT DEVELOPMENT MODEL
On the assumption that the reader is familiar with the basic principles of VaR
the application of the Financial Product Development Model within a practical
environment can be illustrated. The layout of this section will follow that of
the micro elements of the Financial Product Development Model. Each
element will be described in detail in conjunction with an illustration of how
one would apply the principles inherent within the Financial Product .
Development Model in a practical environment. One of the primary purposes
of this section is to bridge the gap between theory and reality in as far as the
Financial Product Development Model is concerned.
Note that for the purposes of this Chapter the environment in which the
Financial Product Development Model implementation was conducted will be
referred to as the Target Environment.
9.5 MARKET SCANNING AND GENERIC PRODUCtDEFIINITION
As a result of changes to the structure of the Target Environment the

proprietary financial risk management systeh in place at the time were
subject to a review in terms of their adequacy and capability to provide the
Target Environment with the ability to manage its financial risk effectively.
One of the results of this analysis was the identification of a weakness in the
proprietary value-at-risk (VaR) system in use at the time. This weakness-was
the inability of this system to accurately incorporate the inclusion of non-linear
financial securities in the VaR calculation. As such the need for a revision to
the existing proprietary risk management systems within the Target
252
Environment was realised. This was to take the form of an improved VaR
system capable of calculating the VaR for portfolios of financial securities,
both linear and non-linear.
The new VaR system should, at a minimum, provide all of the functionality of
the existing system while improving on the identified weaknesses of the
existing system.
The Target Environment was thus faced with the need to develop a new
financial product (remember that the author has defined a financial product
broadly so as to include the provision of a financial solution such as that
required here).
9.6 IIMPLEMENTING THE COMPETITIVE STRATEGY FRAMEWORK AND

STRATEGIC CIRCUIT BREAKER
Let us recap the reasons for the inclusion of the Competitive Strategy
Framework within the Financial Product Development Model. The author has
developed the Financial Product Development Model based on system
engineering principles because the use of this model will enhance the financial
product development process used in the identification, design, construction
and support of financial products. The emphasis here is on the process by
which such products are created. However, as has been stressed on many
occasions throughout this thesis, an efficient product development process is
only one part of successful product creation. In addition to having an effective
product development process the financial services organisation must be sure
that they are developing a product which is optimal in terms of the strategic
aims of the organisation. In other words the organisation should not sacrifice
long-term gains for short-term benefits.
The Competitive Strategy Framework has been developed by the author for
inclusion within the Financial Product Development Model as a strategic filter.
The initially identified financial product development opportunity is in effect
253
filtered through the Competitive Strategy Framework in order to provide the

organisation with confirmation that the product is broadly in line with medium
to long-term strategic aims. Note though that the author has not made any
attempt to prescribe a methodology for determining whether or not to proceed
with the product development based on the outcome of the Competitive
Strategy Framework analysis. There is a good reason for this. The development
of such a methodology would be difficult, if not impossible, given the
complexities associated with such a decision. Every organisation is different.
Every product development project is different. Different managers think in
different ways and have different approaches to business. It should therefore be
clear that the Competitive Strategy Framework does not in any way attempt to
prescribe any type of quantitative pass or fail parameters in as far as the
strategic appropriateness of the product under consideration is concerned.
Successfully satisfying four of the five Competitive Strategy Framework

elements does not necessarily constitute a 'pass'. Nor does satisfying only one
of the five elements constitute a 'fail'. What the Competitive Strategy
Framework does achieve, and what it was designed to achieve, is that top
management are alerted to the fact that there are certain strategic
considerations inherent in the selection of a financial product to develop and
that product development within the modern day financial services industry is
no longer simply a case of developing a product because it may provide a
short-term gain or because 'every one else is doing it'. Those financial services
organisations that wish to prosper must recognise that there is another element
that needs to be considered. The strategic appropriateness of the product must
be determined prior to final development.
The vehicle used to implement the Competitive Strategy Framework is the

Strategic Circuit Breaker. The Strategic Circuit Breaker, analogous to a
conventional trading circuit breaker, is used to temporarily halt the application
of the Financial Product Development Model in order to allow for the
application of the Competitive Strategy Framework in the strategic analysis of
the pending product development decision.
254
The Competitive Strategy Framework in conjunction with the Strategic Circuit

Breaker concept was implemented within the Target Environment in the
development of the revised VaR methodology. The application of the
Competitive Strategy Framework was used to determine the strategic
appropriateness of this product development project:
This section will illustrate the manner in which the Competitive Strategy
Framework was applied within the Target Environment..It will also emphasise
the author's statement that the Competitive Strategy Framework is designed to
be flexible and to draw certain issues to the attention of top management as
opposed to being a strictly quantitative pass/fail mechanism.
The first Competitive Strategy Framework element to be applied was that of

change leadership within a volatile product development environment. The
essential question here was whether the development of the revised VaR
system would allow the Target Environment to not merely react to change, but
to proactively use such change and in so doing to improve its competitive
position.
In order to appreciate the ability of the adoption of a more sophisticated VaR

methodology to enhance the competitive position of the Target Environment it
was worthwhile investigating world-wide trends with regard to VaR. Such an
investigation revealed that VaR was establishing a dominant position globally
as the pre-eminent market risk management system. For example, the Basle
Committee on Banking Supervision had, in April 1995, recommended that
banks use their own proprietary VaR models with approved input parameters
as a means of monitoring and ensuring adherence to international capital
adequacy requirements. In a similar manner the European Union Capital
Adequacy Directive recognises VaR as a valid method of calculating capital
requirements for foreign exchange transactions and, recently ; market risk
management. The United States Federal Reserve had recommended the use of
VaR models in their 'pre-commitment' approach to capital adequacy, whereby
banks essentially determine their own capital adequacy requirements with
255
penalties for those banks who adopt an insufficient capital adequacy

requirement 1146].
VaR is however more than a simple market risk management methodology. It

was seen to be increasingly useful in the concept of integrated risk
management [145], while the use of VaR methodologies in other areas of the
commercial business enterprise such as investment management was on the
increase [61].
It was apparent to those within the Target Environment that both the
importance and complexity of VaR as a means of market risk measurement
was on the increase and that VaR was increasingly being adopted as the
òfficial' market risk management methodology in highly developed countries
the world over 11651,[130],[119],1541,1181. Subsequently, the adoption of a revised
VaR system was seen to be a key factor in allowing the Target Environment to
adopt risk management methodologies which were equal to those used by some
of the world's best financial services organisations. Within the South African
environment this was seen as being able to provide an undoubted competitive
advantage.
The proposed product was considered to adequately satisfy the change

leadership criteria as specified by the Competitive Strategy Framework.
The ability of the preferred product alternative to contribute to the concept of

knowledge management within the organisation was considered to be high. In
particular it was recognised that the development of the product would provide
the Target Environment with a critical knowledge base in terms of not only the
various VaR methodologies available as well as their strengths and
weaknesses, but also many of the practical issues related to the implementation
of the product. This was considered to be of critical importance given the
growing acceptance of VaR as the preferred approach to capital adequacy
regulation within the global financial markets. The ability of the selected
alternative to add to the organisational knowledge base as opposed to the
256
information base was thus considered to be acceptable. In particular the design

and construction of the product would provide the Target Environment with a
pool of knowledge of not only the product in question but also the various
alternative approaches including an understanding of the situations in which
each approach would prove to be superior to the others (remember the
important difference between knowledge and information).
The flow of knowledge in this particular case was also considered to be

beneficial to the Target Environment given the restructuring of the risk
management function from that of one practised primarily on a functional
entity basis to that of a centralised core risk management function responsible
for the management of macro organisational risks. The application of the
knowledge gained during the product development process could be spread
from this core risk management function to the intermediary functions within
the Target Environment so as to allow for the systematic spread of knowledge
within this environment. To this end it was recognised that one of the three
knowledge creation principles as suggested by Duru Ahanotu [50] would prove
to be particularly relevant within the Target Environment, namely that of the
ability of continual growth in targeted knowledge assets within the
organisation to enhance the organisation's ability to develop and provide
competitive products to the market. While the product in question was being
developed as a result of the identification of a particular need within the Target
Environment the very fact that such a need had been identified meant that there
was a good possibility of other organisations having exactly the same need.
The pre-emptive development of the product could therefore conceivably
provide the Target Environment with a competitive advantage in the future
development of similar products for external parties.
As with the concept of knowledge management the concept of product

innovation as a competitive advantage was considered to be adequately
covered in the development of the product. In particular the concept of product
augmentation as a means of competitive advantage as proposed by Johne and
Muller-Teut [86] was considered to be extremely applicable within the Target
257
Environment. As described previously, product augmentation innovation is a

new concept which prescribes that competitive innovation may be achieved as
a result of a repositioning in the way a core product is offered to customers. In
this case the fact that the 'customer' as such was the Target Environment made
no difference to the ability of the product to add to the concept of competitive
innovation. This was made possible by the concept of product augmentation
innovation in which the product is considered to be composed of two elements:
the core product and the associated professional services and support. It was
realised that under this scenario the development of the revised VaR
methodology could indeed prove to be a source of competitive innovation.
The concept of product augmentation worked particularly well in this case

given that the 'product' could easily be subdivided into the two elements of
core product features and associated professional support. The professional
support in terms of the application of the knowledge gained within the product
development process as well as the competitive use of the core product would
prove to be invaluable in ensuring that the fundamental principles of not only
financial risk management but also VaR were understood by those persons who
were responsible for the implementation of the risk management strategy
(including back office personal). This was extremely important because the
implementation of such risk management procedures are only as effective as
the ability of the people using them to understand clearly the consequences of
certain actions. For example, setting a VaR limit is of no use if the need to
adhere to this limit and to investigate any violations of the limit is not
understood by those people involved in the preparation of applicable data.
The ability of the process of new product development to lead to a competitive

advantage for the Target Environment was considered to be one of the major
strengths of the development of the revised VaR methodology. This was
because in the process of developing the product the development team, and by
definition the Target Environment, was exposed to many issues surrounding
the selection, development and implementation of a VaR methodology. In
particular the need for and effect of the ability to measure VaR for non-linear
258
securities was aptly demonstrated during the development process. As a result

of the many issues which would have to be considered in the development of
the product the outcome of this development process would be an enhanced
understanding of many of the finer intricacies of financial risk measurement
and the role that VaR plays in such measurement.
This conformed to the principle that the resulting capability of any

development project is often as important, if not more so, than the final
product. In this case the revised VaR methodology was the final product, but
the knowledge gained in the development of this product could prove to be
absolutely invaluable in providing the Target Environment with a core
capability. In other words, even if the product itself proved to be less than
successful the competencies created as a result of the product development
process would prove to be valuable in providing the Target Environment with
capabilities which could be utilised in other ways.
Consider once again the previously illustrated example of Digital Equipment

Corporation who gained a competitively advantageous capability with regards
to thin film media as a result of a failed product development project. As a
result the concept of organisational learning was considered to be present. In
addition the definition of a core capability was emphasised. To this end the
process led development of appropriate risk management knowledge was
considered to be a core capability while the final delivered product was not. In
other words the knowledge gained as a result of the product development
process would add more to the competitive standing of the Target Environment
than the use of the final product. For example, this product could just as easily
have been purchased from an external supplier. However simply using the
product is not as effective as having an in-depth understanding of the product.
This was considered to be extremely important. The development of the
product could thus provide the Target Environment with a core capability
which could not easily be copied by competitors.
259
The final Competitive Strategy Framework element, technology integration,

was considered to be perfectly applicable to the product under consideration.
In fact, although this concept has its roots in the electronics industry in the
United States, it is the opinion of the author that it could just as well have been
purposely designed for the financial services environment. To recap,
technology integration refers to the concept that the organisation does not
necessarily have to develop all of the technology inherent within a product
internally. The use of external technologies structured correctly in conjunction
with internal development work can prove extremely effective. This is
certainly applicable within the financial services environment where the pace
of change is such that no single organisation can develop all the technology
required to develop financial products. The development of the revised VaR
methodology illustrated this concept perfectly.
Much of the technology used in the VaR methodology was based on

development done by external organisations and academics all over the world.
For example the valuation of financial options (non-linear instruments) could
be processed using one of the many versions of the famous Black-Scholes
option pricing model. Certain of the techniques used in the VaR analysis, such
as the calculation of historical volatilities, could be adapted from published
material provided by organisations such as J. P. Morgan who provide the
RiskMetrics VaR methodology 1831. In certain instances required data such as
implied volatilities could be obtained from external sources. The concept of
technology integration was thus prevalent within the proposed product
development project. It was therefore determined that this concept could easily
be applied to the development of the product.
Viewing the analysis of the Competitive Strategy Framework elements as a

whole, it was clear that the development of the revised VaR methodology was
in-line with the strategic aspirations of the Target Environment. This analysis
revealed nothing which could be considered to be at odds with the stated aims
of the Target Environment and as such the decision was made to proceed with
the development of the revised VaR methodology.
260
9.7 PROBLEM DEFINITION
By now it should be readily apparent that a major cause of new product

failures is a fundamental failure by the organisation to understand the true
nature of the problem for which the product is being developed. Simplistically
one cannot hope to develop a successful product for a problem which is ill
understood. This lack of understanding has historically proved to be a
weakness in the development of many manufactured products, and will
manifest itself just as easily in the financial services environment where the
developers of a product do not typically have any tangible elements to guide
them in the product development process [170]. This concept takes on increased
importance when one considers the rapidly increasing complexity of modern
financial products.
As a result of significant structural changes taking place in the Target

Environment the need for a revision of current risk management practices was
identified. The nature of the structural changes was a re-organisation of a
number of functions within the Target Environment so as to ensure better
integration between units that had previously operated on a somewhat isolated
basis. In addition the restructuring would provide the Target Environment with
an opportunity to become a more powerful force in the South African financial
services industry as a result of being able to offer a broader array of services
including financial product structuring, investment banking, corporate finance,
derivative trading and related activities.
Prior to the restructuring within the Target Environment each function had
essentially conducted their own risk management. This was set to change.
Under the new environment the risk management function would be applied
throughout the entire Target Environment. Each element within the Target
Environment would oversee_ certain micro risk management functions but the
implementation of the macro risk management functions would be done as part
of a group risk management function.
261
As part of the revised risk management strategy the development of a value-at-

risk (VaR) methodology which could be applied within the securities trading
environment was required. The existing system in use within the Target
Environment, while functional, had one major weak point in that it had not
been designed to cater for non-linear instruments. As a result the VaR for
portfolios containing such instruments was calculated using specifications
from the South African Futures Exchange (SAFEX). The problem with this
arrangement was the different emphasis placed on risk management by SAFEX
and the Target Environment. SAFEX, in their role as the financial derivatives
authority in South Africa, use a statistical confidence interval of 99.95 percent
in specifying the margin required by trading participants. The reason for this is
that a default on the part of a SAFEX trading member is potentially a very
serious occurrence, and as such SAFEX uses statistical risk measures designed
to ensure that the chance of such a default is practically zero [147].
For the purpose of SAFEX a 99.95 percent confidence level was appropriate.
However a commercial profit seeking organisation could not structure its
operations in order to satisfy such a high level of risk avoidance. The simple
reason is that there is a relationship between risk and return inherent in every
business. By seeking to eliminate the majority of risk inherent within a
business one is by default eliminating profit opportunities. A profit seeking
business requires risk measures to be constructed such that they are in fact
`bumped into' occasionally. For example the use of a 95 percentile VaR
estimate implies that the total VaR should in fact be exceeded five days out of
every one hundred on average. For this reason the SAFEX risk calculations,
while in use, were not optimal for the Target Environment.
With an in-depth understanding of the various reasons underlying the

requirement for the product the following problem definition was adopted:
262
The need for a revised VaR methodology to be implemented within the

Target Environment is driven by a recognition of the inadequacy of the ,
present methodology to accurately account for the inclusion of non-linear
derivative securities in various trading portfolios. The impact on the Target
Environment is a possibly over conservative VaR estimate on such
portfolios which has several consequences, the most important of which
being an inefficient use of capital and an inaccurate risk-adjusted return on
capital calculation. It is therefore required that a revised VaR methodology
be developed (the new finanCial product) which will eliminate these issues
by increasing the accuracy of the VaR estimate (market risk) for the Target
Environment's trading portfolios and, consequently, ensuring a better'
understanding of the ri§ks inherent within this >environment which will
result in the more accurate'allocation of capital.
This problem definition followed the principles of good system engineering by

adhering to the following:
o The underlying reason for the requirement of the new product was
clearly stated. In this case it was clear that the existing VaR
methodology was inadequate in a number of areas, hence the need for a
revised methodology.
o The impact of the existing problem was clearly specified. Within the
Target Environment it was apparent that the existing VaR methodology
was not able to provide accurate (as opposed to conservative) estimates
for any portfolio containing non-linear securities. This had numerous
impacts of varying magnitude, with the most important being a
possible inaccurate risk profile which in turn had implications for
capital management in the Target Environment (and as any
businessman knows, capital management is vital to the successful
continuation of a business).
263
o The required impact or outcome of the new product was stated. In this
case the required impact was simply the contra of the existing
deficiencies. In other words, at a macro level, it was required that the
new product (the revised VaR methodology) be able to provide the
Target Environment with VaR estimates of increased accuracy with
respect to the legacy methodology. This in turn would allow for better
capital management which would lead to the Target Environment
becoming more competitive within its target market.
9.8 THE PRODUCT FEASIBILITY ANALYSIS
As indicated previously the product feasibility analysis has as its function the
identification of alternative solutions to the problem definition with a
subsequent recommendation of a preferred approach. The aim is not to make a
final selection in terms of the approach to be followed, but rather to ensure that
all possible alternatives have been explored. Once all the cards are on the table,
so to speak, then a preferred selection can be made.
In accordance with the problem definition as specified previously an

application of the product feasibility analysis yielded • the alternatives as
illustrated in Figure 9.1.
Figure 9.1 indicates all of the product alternatives available to the Target
Environment (excluding the do nothing alternative however). At this stage no
attempt had been made to determine the feasibility or otherwise of the
alternatives.
Two macro alternatives were identified, as shown in Figure 9.1. Firstly, the
development of a solution could take place either in an external environment
(solution provided by another organisation) or in the internal environment
(development of solution takes place within the Target Environment). If
developed within the external environment two further alternatives presented
themselves. Either an existing product could be chosen, or a new (proprietary)
264
solution could be developed for the Target Environment by the external

organisation. If the solution was to be developed internally two alternatives
were similarly present.
Problem Definition
External Organisation Internal Development
Existing Proprietary Analytical Structured

Solution (New) Solution (Mathematical) Monte Carlo
(Product) (Product) Approximation Analysis
(1) (2) (6)
Simple Delta Delta-Gamma Extended Delta-

Methodology Methodology Gamma
(3) (4) (5)
Source: Own Source
Figure 9.1 The Macro Product Feasibility Analysis
265
The revised VaR methodology could be developed using the analytical

(mathematical) approximation or it could be developed using a structured
Monte Carlo simulation approach as a base. Should the decision be made to
proceed with the analytical approximation three further alternatives presented
themselves. The analytical approximation could be based on either the simple
Delta methodology, the modified Delta-Gamma methodology, or the extended
Delta-Gamma' methodology.
Having identified the possible alternative solutions to the problem as defined

in the problem definition it was worthwhile summarising the positive and
negative aspects of each alternative as a step towards the selection of a
preferred method. The results of this analysis are illustrated in Table 9.1.
As is illustrated in Table 9.1, each alternative had both positive and negative
aspects associated with it. In this specific case the indicators of suitability
focused primarily on the issues of cost, development time, and suitability for
the specified purpose.
The first stage of the product feasibility analysis had been accomplished,
namely the identification of all product development alternatives. In order to
complete the feasibility analysis it was required that a preferred
approach/alternative be selected prior to moving on to the development of the
product operational requirements.
The selection of a preferred approach is a function of the weighted importance

of the various macro product requirements. In this case three were identified,
namely:
The cost associated with the development of the product,
The development time associated with the product, and
I The Delta-Gamma methodology can be extended further to include third and fourth order
differentials of the option pricing formula which would improve the accuracy of the estimate.
266
o The ability of the product to optimally satisfy the operational

requirements.
linpartrtg the Vanoug - c'na.tives
Alternative Positive Aspects Negative Aspects

External existing Minimised time to Standardised
solution delivery solution
Lower cost due to Limited flexibility
standardisation
External Flexibility Time to delivery

proprietary Cost
solution
Internal Delta Simplicity, ease of Accuracy

methodology use
Low development
time
Internal Delta- Simplicity, ease of Flexibility when

Gamma use compared to Monte
methodology Low development Carlo analysis
time
Increased accuracy
over Delta analysis
Internal Delta- Increased accuracy Increased complexity

Gamma-... over Delta-Gamma Decreasing marginal
methodology analysis accuracy as a
function of
complexity
(6) Internal Structured o Most accurate o Complexity

Monte Carlo methodology due to 0 Computing power
methodology full revaluation required
0 Highly flexible 0 Time to process
analysis
Source: Own Source
267
While any organisation obviously wishes to minimise total product

development costs one has to weigh this factor up against the cost of choosing
a sub-optimal alternative purely to save on such initial costs. Bear in mind that
the focus of system engineering, and hence the focus of the Financial Product
Development Model, is to minimise the total economic product life-cycle
costs. Hence one must weigh up the impact on total product life-cycle cost of a
decision to choose the product with the lowest initial (observable) cost
(remember the iceberg effect as described in Chapter Six). Within the Target
Environment the possibility of financial losses due to an inadequate financial
risk management system was high, hence the need to ensure that the alternative
chosen was able to satisfy the stated requirements optimally. Given the relative
similarity in apparent development costs for each of the alternatives listed here
it was apparent that, in this particular instance, the cost of each alternative had
a minor effect on the selection of a preferred approach.
The product development time was certainly a concern within the Target
Environment given the need to meet specific deadlines associated with the
restructured Target Environment. Ideally the selected alternative should be
able to deliver a developed VaR methodology within a reasonable period of
time. While one is always keen to ensure a minimum development time
associated with a particular product the situation within the Target
Environment was compounded by the need to ensure system integration with
other elements of the business.
The final element, suitability of the preferred alternative as a means of solving

the problem as defined previously, was perhaps the most important
consideration. The focus here was on the optimal resolution of the problem.
The focus on optimality was particularly pertinent within the Target
Environment given the nature of financial econometrics (the analysis and
forecasting of price movements in financial markets). There are many varying
methodologies which one may adopt, of which four were identified as being
appropriate in this situation. Each methodology had both positive and negative
aspects associated with it which would affect the optimality of the application
268
of the methodology to any particular problem. For example in this case the
Monte Carlo analysis was without a doubt the most powerful and flexible
alternative available. However its complexity combined with the processing
power required to process such an analysis (and hence the time taken for the
results to be achieved, remembering that the accuracy of a Monte Carlo
analysis is to a great degree determined by the number of iterations used in the
analysis) meant that the increased flexibility of this method had to be weighed
up against the issues just described.
Similarly the use of the extended Delta-Gamma methodology, while displaying

marginally increased accuracy as a result of the inclusion of additional option
pricing parameters such as the option's Theta and Vega, could be questioned in
terms of its ability to satisfy the stated problem optimally. While this
methodology may be slightly more accurate than a conventional Delta-Gamma
methodology the increased complexity that such an approach would require
meant that it was unlikely to be the optimal solution in as far as the accuracy
versus computational intensity trade-off was concerned.
The outcome of the product feasibility analysis must be the selection of a

preferred approach based on the data obtained during the analysis. In this case
the conventional Delta-Gamma alternative was selected based on a
consideration of all of the relevant factors. An internal development was
selected since this would allow for maximum flexibility in the development of
the product. Within the internal development the use of a Monte Carlo analysis
was given much thought. However, at the end of the day this would have
proven costly in terms of complexity and processing time as a function of the
ability to optimally satisfy the problem. Of the three analytical alternatives the
simple Delta method was discounted as being inaccurate when compared to the
enhanced Delta-Gamma approach. This observation was further strengthened
by the limited marginal complexity of the Delta-Gamma - approach when
compared to the simple Delta approach. The extended Delta-Gamma approach
was similarly discounted as being less than optimal in that the increase in
269
complexity and computational intensity required to produce a VaR estimate

was associated with a very limited increase in accuracy.
9.9 PRODUCT OPERATIONAL REQUIREMENTS
The development of macro product operational requirements is the first step in

the Financial Product Development Model which begins to identify the what
associated with a particular product. The emphasis here is on what is required
from the product from an operational perspective. The term 'operational' is a
measure of the environment and conditions under which the product is
expected to perform as well as the level of utilisation and effectiveness
requirements which the product must be able to satisfy.
The development of such product operational requirements may prove to be

one of the more difficult areas in which to apply the principles of system
engineering given that, within this context, such principles are inherently
designed to focus on the tangible aspects of a product. This makes the
development of such operational requirements conceptually difficult within the
financial services industry given the intangibility of most products. For
example, a typical product operational requirement is that related to the
environment in which the product is expected to perform. The South African
Rooivalk attack helicopter was in all likelihood designed to operate in hot, dry
conditions. Many coastal structures are designed to operate in extremely
corrosive conditions (with respect to concrete and steel reinforcing). A
Formula One or Indycar racing engine is designed to operate under extreme
conditions, typically in the region of 13,000 to 16,000 revolutions per minute.
However, what can we say about the environment in which a financial
derivative must operate? We know that the environment is likely to be one of
the global capital markets. Attaching identifiable (possibly physical?)
characteristics to this market is difficult though.
Although the author has pointed out the conceptual difficulty which may arise
in the application of some of the concepts inherent in the product operational
270
requirements process to a financial product this in no way nullifies or reduces

the benefits to be gained from an identification of such issues at this early
stage in the product development process. This issue can be solved by
recognising the basic principle underlying the development of product
operational requirements — such requirements must provide the designers and
developers of the product with accurate, relevant guidelines for the subsequent
development of the product. Inappropriate elements as defined in conventional
system engineering principles should therefore only be viewed as inappropriate
as a result of the uniqueness of the financial product under development. Such
elements can, at the discretion of the development team, be replaced with more
effective measures of operational product characteristics such that they adhere
to the principles inherent within the development of such requirements.
With this in mind, the operational requirements for the revised VaR
methodology were developed as illustrated throughout the remainder of this
section.
Operational deployment
Operational deployment factors include factors such as the geographical
distribution of the product including an estimate of the number of sites where
the product will be used. In a conventional sense this is an important
consideration since it may have a substantial impact on the development of the
product. For a typical financial product this need not necessarily be the case,
although it will often be an important consideration. With respect to the Target
Environment the revised VaR methodology would be utilised at a maximum of
two sites within South Africa as at the time of development. The required
operation of the methodology would not in any way be influenced by any
particular site since the methodology should be designed to ensure total
flexibility in terms of the types of portfolios to which it may be applied.
The number of users of the product (the VaR methodology) would in all
likelihood not exceed five at each location. Given the centralised nature of the
risk management function it was expected that the users of the product would
271
have a certain minimum level of knowledge regarding the need for the product
and the manner in which it could be used within the risk management function.
Mission profile
In describing the mission profile for the product it is important to indicate (1)
what the primary mission of the product is, and (2) what the secondary
mission(s) of the product is(are).
The primary mission of the revised VaR methodology was to provide the
Target Environment with the ability to quickly and efficiently determine the
degree of financial risk inherent in any one or a combination of portfolios of
financial securities by calculating a VaR estimate of reasonable accuracy,
taking into account the non-linear characteristics of certain securities (such as
financial options). It is worthwhile reiterating the importance of such data to
any financial services organisation involved in the creation and trading of
financial products and financial securities. As many high profile financial
failures in the past have illustrated, an inadequate knowledge of the level of
risk associated with a single position or a combination of positions can prove
to be fatal 1171]. In addition to the need to understand the level of risk inherent
within any position of financial securities at any one stage the knowledge of
such risk also has important implications for the operation of the organisation.
The allocation of scarce organisational capital is best done on a risk-adjusted
basis. This requires accurate measurements of financial risk.
The secondary mission of the revised methodology was to make the calculation
of VaR a relatively simple exercise for those involved. In other words both the
methodology and, perhaps most importantly, the user interface should be
developed in such a manner so as to ensure that the user is at no stage in doubt
as to what is required and why it is required. This is once again a function of
the complexities involved in the calculation of VaR estimates of market risk. -
Such calculations are (1) mathematically somewhat complex, and (2) highly
dependent on the underlying assumptions made in the development of the
methodology. For example, while the Delta-Gamma methodology typically
272
assumes that the financial returns of the underlying instruments follow a log-
normal statistical distribution (geometric Brownian motion), this is not always
the case. It can (and often does) happen that such prices deviate from the
standard log-normal distribution by exhibiting high degrees of skewness or
kurtosis. A VaR estimate in such a case based on the assumption of normality
of returns can be highly misleading (remember the 'fat tails' concept detailed
in Chapter Four).
A further secondary mission requirement of the proposed product was that the
interface with the user should be 'bullet proof'. In other words the interface
should adhere to good principles of software engineering in that it should have
the ability to filter user input for both mistakes and inconsistencies, thereby
eliminating the possibility of incorrect output (based on the well known
information technology saying of GIGO, garbage in...garbage out).
Performance parameters
The specification of product performance parameters is important in that the
identification of such parameters in conjunction with the development of
technical performance measures will provide the product developers with both
qualitative (this section) and quantitative (see the section on technical
performance measures further on) measures with which to validate the product
design. Obviously the final product should satisfy all the measures so
specified.
Within the Target Environment the following product performance measures

were considered to be applicable to the product under consideration:
o The processing time associated with the calculation of VaR, either on a

single portfolio basis or on a total diversified portfolio basis. As
mentioned earlier the -calculation of a VaR estimate is a
computationally intensive exercise, particularly as the number of
securities included in the portfolio increase. Indeed as the number of
securities increase so the time to calculate increases dramatically. This
273
is a function of the manner in which VaR is typically calculated. For

each security a volatility (standard deviation) must be constructed
based on either historical information or implied volatilities 2 .
Thereafter appropriate correlations must be determined between each
security in the portfolio (typically calculated using a n-by-n correlation
matrix with n equal to the number of securities). Only once this data is
available can one begin to construct the VaR estimate.
While modern computing power has increased tremendously over the

past number of years it nevertheless may take some time to calculate
such an estimate. In addition further considerations in terms of the
source of the raw financial data must by borne in mind. This data must
be obtained from somewhere, typically a source which specialises in
the provision of price data such as Reuters or Bloomberg. This leads to
network considerations, particularly the speed with which such data
can be downloaded.
The processing time associated with a VaR estimate was thought of as

a critical factor in the development of the revised VaR methodology.
o The number of securities which can be accommodated in the VaR

calculation. While this was unlikely to prove much of a problem (apart
from increasing calculation time) it was worthwhile considering a
rough estimate of the maximum number of securities which may be
present in any single portfolio. Such an estimate could be obtained
from the known number of financial instruments available in the
markets in which the Target Environment is active. A reasonable
estimate could be achieved based on knowledge of the type of trading
2The use of historical volatilities versus implied volatilities is a source of great debate in financial
econometrics. Both have their own advantages and disadvantages. Principally the evidence is
mixed as to whether historical volatilities provide a good measure of future volatilities, while the
use of implied volatilities is hampered by the fact that many securities do not have financial
options available on them (financial options are the source of implied volatility estimates since
their price is dependent on market perceptions about the future volatility of the underlying
instrument).
274
strategies undertaken within the Target Environment as well as

historical considerations.
Utilisation requirements
Product utilisation would take place in the form of user interaction with a
software interface designed to accept input with regard to the required
parameters from the user prior to VaR calculation. The mathematical VaR
methodology underlying this interface would then be used to process the
appropriate calculations and to present the output of such calculations in an
appropriate format. The calculation of VaR would typically be done once a day
every business day.
Product effectiveness requirements

In a case such as this product effectiveness can be measured in a number of
ways. However, the most important considerations related to product
effectiveness were considered to be the following:
The speed with which the required calculations could be processed.

This has been discussed previously.
The operational availability of the product. Naturally, as with most

products, it was required that the product be able to process the
necessary calculations with as little potential down-time as possible.
The trade-off between product cost and effectiveness. There is of

course a level at which the increasing cost of the product can no longer
be justified in terms of marginally increasing effectiveness.
Ease of use of the product. It was important that the product be

developed so as to make it easy to use for administrative personnel. It
was important to cater for the possibility that the person using the
product would not necessarily be totally familiar with the concepts and
methodologies of VaR calculations.
275
Operational life-eyele horizon

The selection of an operational life-cycle is important because, in conjunction
with many of the parameters previously identified, it provides the developers
of the product with a guide as to the type of resources and expenditures which
should be associated with the development of the product. Within the Target
Environment, given the rapidly changing nature of risk management within the
financial services industry, an initial operational life-cycle of two years was
identified as being optimal given all other information. This time period was
considered optimal in that it would allow for the recovery of the product
development costs while simultaneously allowing for the possibility of a
change or 'upgrade' after the initial two year period.
9.10 PRODUCT FUNCTIONAL ANALYSIS
As part of the preliminary design and development phase the product

functional analysis serves as a basis for the identification of the resources
necessary for the product to satisfy the stated objectives. This is achieved via
the construction of a functional flow diagram which describes in purely
functional terms what sequence of actions need to take place for the product to
accomplish its objectives. Once again the emphasis at this stage is on what the
product needs to do to accomplish these objectives as opposed to how it needs
to do it.
The functional flow diagram is basically a block flow diagram depicting the
sequence of events pertaining to a particular function or sequence of functions.
It is hierarchical in that each function is broken down into smaller sub-
functions until the required level of detail has been achieved. This ensures an
accurate transition from macro system or product level requirements down to
the detailed design requirements. The functional analysis provides the
mechanism -for vertical traceability, and is particularly useful in providing -
justification for sub-level requirements by means of tracing a vertical upwards
path to determine the originating requirement.
276
1.0 2.0 3.0 4.0

C– \ c \ C --\ c
Request User Obtain Raw Calculate Display
Data Price Data VaR D Results
Estimate
L
1.3
1.1 i> Request
Request number portfolio
of observations identification
1 data
1.2
Activate error 1.4
trapping Activate error
trapping
\
2.1 2.2 2.3 2.4 2.5
-4> ID security Select data Initialise Send —› Store data
type source data request for received
channel info.
r
."\ C. \ C .\
3.1 3.2 3.3
ID linear vs _t> Select — I> Calculate —I.>
non-linear appropriate historical
security method volatility
_.)
3.4 3.5
Calculate Calculate
correlations diversified
portfolio VaR
4.1 4.2 4.3 4.4

Display Update Display firm- Highlight
calculated VaR diversified wide violations of set
summary VaR diversified VaR VaR limits
Source: Own source
Figure 9.2 The Two-Level Product Functional Analysis Diagram
277
The appropriate functional flow diagram developed for the revised VaR
methodology within the Target Environment is illustrated in Figure 9.2. This
diagram, which is a two-level block flow diagram, illustrated that at a macro
level there were four functions which the product should accomplish in order
to achieve its objectives. Each of these macro functions was broken down
further into sub-functions which illustrated the flow of actions required to
ensure that the particular macro function achieves its objectives. Under the
functional analysis concept this continues until such time as the required level
of detail is reached, being that level such that the system or product has been
broken down into its most basic components in terms of both resources and
actions. A third tier analysis is shown for function 3.1 (as illustrated in Figure
9.2) in Figure 9.3.
Consider the function labelled 'Obtain Raw Price Data' in Figure 9.2. At the
first level the functional analysis indicates that five sub-functions are required
in order to process this macro function. First the security type is identified
(sub-function 2.1), being either a stock, a futures contract, or an option
contract. Next the data source for the historical prices of the security is
selected (sub-function 2.2). Examples of such data sources are Reuters and
Bloomberg. Thereafter the data channel to the external data source is
initialised programmatically, typically being the initialisation of a dynamic
data exchange (DDE) link between the host and the data provider (sub-function
2.3). A request for data is passed to the host subsequent to the initialisation of
the data channel (sub-function 2.4), with the price data so received stored
within the system for use in the value-at-risk calculations to be performed
(sub-function2.5). Finally the system initiates a go versus no-go loop which
repeats function 2.0 for each security in the database until such time as no
more securities are present.
- It is apparent that the product functional analysis provides the developers with
a great deal of data regarding what must be done in order for the product to
achieve its goals. In addition the resources necessary for the development and
operation of the product can be determined much more accurately using this
278
analysis. This is possible because by proceeding with the functional analysis

until the most basic resource element is reached the exact resource
requirements can be determined by aggregating across this lowest level.
3.1 3.2
ID linear vs Select
non-linear appropriate
security method
1
3.1.3
3.1.1 Is it a financial Security is
ID security option? non-linear
type
3.1.2
Security is
linear
Source: Own Source
Figure 9.3 A Third Tier Functional Sub-Level
9.111 PRODUCT TECHNICAL PERFORMANCE MEASURES
The final element within Phase One of the Financial Product Development
Model is the identification and quantification of technical performance
measures (TPM's). These quantitative parameters in conjunction with the
qualitative parameters which have been specified in previous elements will
provide the developers of the product with the information necessary to
proceed with the selection of how the specified requirements and constraints
can be satisfied.
279
The requirements for the revised VaR methodology for the Target
Environment were described in terms of the technical (quantitative)
requirements as illustrated in Table 9.2.
le 9.2 Product P,ten

wf/1"
Lor m. r os
TPM Requirement Relative Importance
Calculation time < 20 minutes 17
Capacity for financial > 100 5

instruments
Platform parameters Networked PC running 18

(user interface) Windows 95/98,
Windows NT
External interfaces INET, Reuters, 10

(data feed) Bloomberg
Historical data point 1 — 1,000 5

capacity
Calculation accuracy Conventional Delta 20

mathematical
approximation
Confidence intervals 90% - 99.9% 5
Multiple portfolios 1 — 50 10
Operational availability 95% 10 .
100%
Source: Own Source
9.112 PRODUCT DESIGN AND CONSTRUCTION
With all of the preliminary work completed the process of product design and
development can now be completed with the knowledge that the increased
effort in the initial stages of the product development process has produced an
accurate, quantifiable set of product parameters which may be used as an input
to the actual product design and construction process. One has thus achieved
exactly what system engineering promises to deliver: a set of usable product
280
design parameters developed so as to ensure the enhancement of the product

development process and in so doing to reduce the economic product life-cycle
cost.
At this point, in as far as the need for a new product within the Target
Environment was concerned, the product development team had:
Identified and accurately described the underlying problem,
Identified the primary applicable qualitative parameters, giving due

concern to the importance of the 'voice of the customer',
Described the product requirement quantitatively in the form of

technical requirement parameters,
Selected an initial preferred approach based on applicable data, and
Validated the proposed product by applying the Competitive Strategy

Framework in the consideration of the strategic impact of the said
product on the organisation.
To summarise then, the Delta-Gamma VaR methodology was chosen for

development since it was considered to be the optimal solution to the stated
product requirements, particularly with respect to the accuracy versus
computational intensity trade-off. Further, this 'product' had satisfied the
Competitive Strategy Framework in that it had been demonstrated to provide a
sufficient strategic advantage to the Target Environment. This product was
therefore not being developed simply because 'it should be' or because it was
required in a hurry. It was able to satisfy a specific stated requirement in terms
of the original problem definition while simultaneously enhancing the strategic
competitiveness of the Target Environment in as far as the process of product
development could be used in the development of core competitive
281
competencies. The final step then, and the one described in this section, was
the design and construction (for want of a better word) of the product.
The design and development of this product consisted of the following

sequential steps:
Determine the mathematical algorithm to be used in each of the two

possible cases (linear security versus non-linear security),
Determine the optimal user interface for the input and output of data,
Verify the required data sources, including the technical details of

accessing and downloading the required data,
Develop (construct) a system based on the detailed VaR calculation

methodologies as discussed previously incorporating all of the
parameters, both qualitative and quantitative, as identified in Phase
One of the Financial Product Development Model.
The product itself was constructed using a version of Visual Basic for
Applications (VBA). This software programming language (an offshoot of the
well known Visual Basic) was chosen for its ease of use and, most importantly,
its tight integration with Microsoft Excel. This meant that the revised VaR
methodology could be applied in an environment which was familiar to the
Target Environment (Microsoft Excel) and that the requisite mathematical
functionality could be achieved with relative ease by leveraging the use of
Excel's mathematical capabilities.
It is not the intention of the author to detail the actual operational development
■•■
of the product here since this is not the aim of this thesis. Rather, as should be
clear by now, the author wishes to impress upon the reader the manner in
which the use of the Financial Product Development Model has led to the
enhanced development of all of the required product parameters prior to the
282
design and construction of the product taking place. The emphasis on the
expenditure of additional initial up-front resources in the product development
process is therefore justifiable in terms of the overall saving on total life-cycle
cost, as is predicted by system engineering.
An example of the typical output from the final VaR system is illustrated in
Appendix F which provides further details as appropriate.
9.13 PRODUCT TESTING AND EVALUATION
The aim of the product testing and evaluation element of the Financial Product
Development Model is, predictable enough, to ensure that the product satisfies
the parameters developed in Phase One of the Financial Product Development
Model. Under the principles of system engineering the testing and evaluation
of the final developed product should not lead to any major surprises. The
discovery of a major problem at this point would be indicative of a flaw in the
processes used to develop the product.
Testing of the final product took the form of a two stage process as follows:
o Testing for the technical accuracy of the revised VaR methodology. In

other words, does the new product provide the results that we expect?
o Testing for the functionality of the user interface. Within the field of
information technology this is known as user acceptance testing (UAT)
and has as its objective the determination of the acceptability of the
product functionality to the end users.
The technical accuracy of the product was determined by comparing the

- outputs of various scenarios with those known to be 'correct' in as far as they
were an accurate reflection of the VaR for a particular portfolio of securities
under given parameters (holding periods, confidence intervals and historical
data points). An analysis of the results obtained by means of such comparisons
283
indicated that the product was within acceptable limits in terms of

conformance to existing VaR estimates. It is worth pointing out however that
the presence of existing estimates were used as a simple guide to the technical
accuracy of the product. This was due to the inherent complexity of the
calculation of VaR combined with the multitude of competing methodologies
available for such calculation. No single methodology could be considered to
be 'correct' since if this were the case there would only be one methodology in
use. The best that could be done was to ensure that the results of the new
methodology provided what appeared to be a reasonable analysis given
historical data which could be used in the validation process.
A number of issues were discovered in the user acceptance testing of the

product. These issues were however minor in nature and involved principally
cosmetic issues related to the user interface (such as the layout of the interface
and sequence of data input). This is to be expected in any user acceptance test.
9.114 PRODUCT DEVELOPMENT PROCESS ANALYSIS
The final element in the Financial Product Development Model, namely the
post development analysis of the product development process, has as its
function the identification of pertinent issues related to the completed product
development with a view to using such data to enhance future development
projects. As was illustrated previously this concept has found much favour
with Toyota, an acknowledged leader in the development of new products. The
post development analysis will enable the organisation to build a knowledge
base of product development which will prove extremely useful in avoiding
past mistakes. This is important since no organisation can afford to
continuously repeat past mistakes in the product development process. Any
organisation that does will soon be out of business. This is particularly relevant
in the development of financial products given the high rate at which such new
products are generated. The intangibility of the product under development
means that past mistakes are inherently harder to identify.
284
A subsequent analysis of the development of the revised VaR methodology

revealed the following elements which, it was felt, would provide valuable
input into future product development projects:
o The identification of all feasible solutions to the identified problem in

the product feasibility analysis element was considered to be extremely
beneficial. Prior to this analysis it had been assumed that the options
available were limited to one or two possibilities. And even though the
final alternative chosen was one that would have been included in the
provisional alternatives it nevertheless proved to be strategically
beneficial to the developers of the product to develop a knowledge of
the various alternatives available and to understand why one
alternative was chosen above another in this particular situation. The
author uses the term strategically competitive here because the product
feasibility analysis illustrated that there was more to selecting an
alternative solution to the identified problem than simply the cheapest
option or the one which was technically the most feasible.
o It was felt that not enough emphasis had been placed on the 'soft' user
interface issues once the technical parameters for the product had been
identified. Although the revisions to the user interface as a result of the
user acceptance testing phase were minor, it was felt that additional
effort should have been expended in interacting with the end users of
the product in order to ensure the acceptability of the interface at an
earlier stage. In this case there were no major problems but this may
certainly be a cause for concern in the future.
285
9.115 CONCLUSION
Within this Chapter the author has accomplished the following goals:
o The manner in which the Financial Product Development Model can be

applied to the financial product development process has been
illustrated by means of a practical product development project, and
o The results of the practical application of the Financial Product

Development Model have been illustrated.
The results obtained via the implementation of the model lead the author to
believe that this model, which is based primarily on the system engineering
concept, is not only viable, but is indeed a requirement within the financial
product development process which is found within many financial services
organisations.
Throughout the practical validation as detailed in this Chapter it was clear that
the benefits resulting from the application of system engineering principles
were both tangible and valuable. Furthermore, the application of the Strategic
Circuit Breaker and the Competitive Strategy Framework had the effect for
which they were designed: those involved in the development of the revised
VaR system were forced to consider the effects of the product development
process in broad strategic terms. This eliminated the narrow focused approach
so often found within the financial product development process, providing the
Target Environment with benefits which would not normally be associated
with the product development process, such as the spread of core knowledge
throughout the Target Environment and a greater understanding of not only the
technical aspects of market risk management, but also the manner in which the
effective management of financial risk could be used as a competitive weapon
286
The important conclusion which can be drawn from the results of the practical
validation as described in this Chapter is that the Financial Product
Development Model appears to be feasible in as far as it adequately satisfies
the requirement for which it was designed, namely the competitive
enhancement of the financial product development process. Furthermore there
does not appear to be any elements within the model, either micro or macro,
which are either ineffective or ill-conceived.
The practical validation of the Financial Product Development Model, while

extremely useful, has one flaw. It views the model from the perspective of a
single entity. In order to overcome this potential weakness, and to ensure that
the proposed model has maximum practical applicability, the author has
conducted a limited scale survey of professionals within the financial services
market in South Africa in order to determine their attitude towards the major
concepts imbedded within the Financial Product Development Model as
presented within this thesis. The development of this survey as well as the
results so obtained is detailed in the following Chapter.
287
An Industry Perception of the Financial Product Development Model
Chapter 0
An Industry Perception of the F financial Product
evelopment Model
"Expose yourself to the best things humans have done and then try to bring
those things into what you are doing." — Steve Jobs, Apple/NeXT/Pixar, on
developing 'insanely great' new products.
"Cannibalising existing products is the way to remain the leader. " — Lew
Platt, chairman and CEO, Hewlett-Packard
"You miss 100 percent of the shots you don't take." — Wayne Gretzky, hockey
great.
10.11 INTRODUCTION
rr
T1 he practical validation of the Financial Product Development Model
indicates the advantages inherent in the use of this model with respect to
the development of financially engineered products. This validation has
focused on the practical development of a financial product and has illustrated
in detail the manner in which the Financial Product Development Model can be
applied to the process of financial product development. Such practical
validation is extremely useful. However, such validation was, by necessity,
undertaken within a confined environment given the obvious issues related to
the proprietary product so developed. As such it is the intention of the author
to provide the reader with a wider perspective on the benefits of the Financial
Product Development Model.
This will be accomplished by the application of a limited survey conducted by

the author within the financial services environment. The purpose of this
288
survey will be to ascertain the opinions of professionals involved in the

development of financial products with regard to the proposals made by the
author within this thesis. It is not the intention of the author to conduct a full
scale survey subject to the methods of statistical analysis typically associated
with such surveys. The main aim of the limited survey undertaken here will be
to provide the reader with an appreciation of the general applicability of the
Financial Product Development Model as perceived by experienced
professionals within this field and in so doing to reinforce both the uniqueness
of this approach as well as the potential commercial benefits to be obtained.
Although the author will use a limited scope survey in this Chapter such a
survey must nevertheless adhere to the standard levels of acceptable survey
design. The design and implementation of the survey in addition to a
discussion of the results so obtained will thus receive attention within this
Chapter. Consequently:
The aim of this Chapter is to describe the development of the liniited scope
industry survey and to discuss the results of the survey as appropriate. The
results so obtained will be used to make inferences about the
appropriateness of the Financial Product Development Model as proposed
by the author.
10.2 DATA COLLECTION
As with most research studies the collection of research data forms an

important part of this study. The choice of data collection method as well as
the attendant issues therefore require clarification. For the purposes of this
study the required information with regards to the choice of survey
methodology, and in this case survey questionnaire design, has been obtained
primarily from the following authoritative sources: Cooper and Emory [32],
Slife and Williams [143], Reaves 11271, van der Ven 11591, Walizer and Wiener
[161], and Oppenheim [115]
289
Three primary types of data collection (survey) methods may be distinguished,

namely 1321:
Personal interviewing,
Telephone interviewing, and
Self-administered questionnaires/surveys.
The data collection method used in this study is the self-administered survey
questionnaire in conjunction with the personal interview.
The reasons for the selection of the survey questionnaire as a data collection
instrument are varied, but the following important elements can be identified:
The ease with which the survey questionnaire lends itself to data
collection,
The issue of time constraints within the target environment, and
The ease with which input from diversified sources (particularly

geographically) can be obtained using modern information technology.
The use of personal interviews as an additional element to the data collection

process is considered by the author to be important since this allows the
identification of issues within the target environment which may not be readily
identifiable using a pure survey questionnaire.
10.3 THE TARGET POPULATION
With any survey of the type used here it is necessary to clearly define the
target population. The target population is that group which constitutes the
290
defined population from a statistical viewpoint. For the purposes of this study
the author has identified the following target population:
The target population shall consist of professionals involved in the

development of financial products within the author's organisation or within
any South African based financial services organisation so chosen by the
author for their level of expertise and applicability to the study.
Given the intention of the author to conduct a limited scope survey the target
population has, in essence, been defined as that collection of financial
professionals recognised by the author and fellow professionals as being able
to provide meaningful input into the study in terms of the applicability of the
Financial Product Development Model. This definition of the target population
as well as the limited number of respondents means that the concept of bias
cannot be statistically eliminated. However, it is worth repeating that the
intention of the author with respect to the limited scope survey is to determine
the general attitude of respondents to the introduction of the Financial Product
Development Model within the financial services environment, not to perform
a statistical analysis in terms of validating a hypothesis as is often done with
full scale surveys. The target population was specifically chosen in order to
allow the author to validate the practicality of the concepts as presented here.
10.4 THE CHOICE OF SAMPLING METHOD
Cooper and Emory [32] define two methods of survey sampling. Firstly, there
is the conventional sample whereby a limited number of elements smaller than
the chosen population are chosen (typically randomly) in such a manner as to
accurately represent (without bias) the total population. This method may be
used in the case where the total population is sufficiently large to make a
survey of all the constituent elements impractical.
Secondly, there is the census approach where an attempt is made to survey

every element within the population. The census approach works best when the
291
total number of population elements are sufficiently small and there is a strong
measure of diversity amongst the population elements.
The method to be adopted in this study is that of the census method. There are
two reasons for this:
o The identified target population as proposed in this study will be

sufficiently small in order to make the use of a census survey practical.
In addition, the variety of specialist services offered by the various
elements within the target population is such that there is no doubt
about the diversity present within this population. The target
population therefore conforms well to the requirements for a census
survey.
o By using a census survey many of the issues with regards to population

sampling are avoided. In particular there is no need to derive a
reasonable and fair population sample since the census approach
samples the entire population.
10.5 DESIGNING THE SURVEY FORM
A survey questionnaire can be likened to a scientific instrument for the

collection and measurement of data. As such much planning is required in the
design of this instrument. Good survey design covers topics such as what will
be measured, what kind of sample will be drawn, whether control groups are
required, who will be questioned and how often, and what types of scales are
to be used. It is important to remember that a survey usually will not be able to
show a causal connection [115]. At best it could indicate associates or
correlates.
One can further make a distinction between two types of surveys as follows:
292
The analytical survey has as its purpose the exploration of the

relationships between different variables or groups of variables. This
type of survey typically uses 'why' questions and then proceeds to an
examination of group differences from which relationships between
variables can be inferred.
The descriptive survey has as its purpose the counting of a

representative sample which allows inferences to be made about the
population as a whole. Descriptive surveys indicate how many
members of a population have a certain characteristic.
The survey to be used in this thesis is that of the descriptive survey. It is not
the aim of the author to investigate relationships amongst the sample
population, but rather to attempt to make general inferences about the attitudes
of the survey participants since this has greater applicability to the validation
of the Financial Product Development Model.
Within the process of survey design the author has identified the following
variables as being pertinent to this investigation:
Dependent variables — these are the results of the survey, the so-called
èffects variables'.
Controlled variables — those variables which may be eliminated as a

source of variation in the study in order to fulfil the condition of 'other
things being equal'. Such variables may be controlled by means of
exclusion, holding them constant or by randomisation. For this survey
the organisational entity within which respondents are situated has
been selected as the control variable, with the concept of exclusion
applied in order to eliminate this variable as a source of variation. The
only organisations targeted by the author in the survey are those that
are extensively involved in the process of financial product
development.
293
Uncontrolled variables — those 'free floating' variables which are

assumed to have a negative effect on the results of the survey. Two
such variables can be distinguished, namely: (1) confounded variables,
often referred to as correlated biases which have an influence of
unknown size on the results, and (2) errors. Confounded variables are
typically extremely difficult to identify and quantify. Error variables
are assumed to be randomly distributed, or at the very least distributed
in such a way so as not to have a significant effect on the results [115],
[127].
The design and selection of survey questions forms a major part of any survey.
The author has selected a combination of statements and questions as the basis
for the design of the survey. The statements and questions within the survey
have been designed with the following principles in mind:
Double-barrelled questions — great care has been taken in the

avoidance of the three types of double-barrelled questions, being the
situation where multiple questions are asked in one, the situation
whereby a statement of fact is made (which the respondent may not
agree with) with the subsequent question using the supposed fact as a
premise, and the use of hidden premises.
Double-negative questions — the use of such questions has been

avoided with great care given the historic difficulty that their inclusion
in a survey may cause.
Prestige bias — it is the opinion of the author that the concept of

prestige bias (or socially acceptable responses) will not play a role in
this survey given the characteristics of the target population.
Leading questions — such questions, as a result of the way that they are
structured, let the respondent know (whether consciously or sub-
consciously) that a certain answer is expected. The author has taken
294
great care in structuring the survey statements in such a way that any
potential leading bias is eliminated.
o The assumption of prior knowledge — the assumption of prior

knowledge is dangerous in a survey of this type, particularly given that
the study subject entails the response of professionals within the
financial services environment to concepts which are typically found in
the engineering environment. This element will be eliminated both by
the structure of the survey question as well as the manner of interview
presentation adopted by the author.
The survey form to be used in the proposed survey will consist of a pattern of
questions designed in such a way so as to accurately ascertain the reaction of
professionals within the financial services field to the primary concepts
underlying the development of the Financial Product Development Model. In
the next section the survey questions will be developed by the author.
The author has elected to use a conventional 5-point extreme value ranked
scale on the survey, as illustrated in Figure 10.1. The benefit of such a ranking
scale is that by simply placing two extreme responses at either end and not
indicating an appropriate response per block the respondent is able to answer
on a relative scale. The use of a 5-point ranking scale such as the one
illustrated here also has the advantage of allowing the respondent to indicate a
neutral opinion.
Strongly agree Strongly disagree
Source: Own Source

Figure 10.1 An Extreme Value Five-Point anking Scale
The length of the survey questionnaire is an important consideration for the

purposes of this study given the environment which the author intends to
target. Professionals within this environment are typically highly skilled with
an extremely high work rate. As such it is imperative that the survey
295
questionnaire be short, concise and to the point. For this reason the author has
elected to include a maximum of ten questions on the questionnaire. These ten
questions will be structured so as to cover the primary concepts inherent within
the development of the Financial Product Development Model, as explained
within this thesis.
10.6 THE SURVEY QUESTIONS
The author has developed ten survey questions designed to determine the
opinions of survey respondents to various concepts as introduced throughout
this thesis. These questions are illustrated in this section. Note that a copy of
the actual survey form can be found in Appendix E.
(1) Innovation within the financial product development process will play an
increasingly important role in the market competitiveness of the financial
services organisation in the future.
(2) The development of financially engineered products is increasing in

complexity.
(3) The process by which financial products are developed can be used as a
source of competitive advantage for the financial services organisation.
(4) System engineering overcomes typical manufacturing based product

development problems such as a lack of good early planning, an inadequate
problem definition, and a short-term product focus by placing great emphasis
296
on the initial stages of the product development process. Do you believe this
concept to be applicable to the financial product development process?
Applicable Not applicable
(5) System engineering recognises the proportionally higher economic costs of

downstream amendments or changes to the product design and as such
emphasises the need for comprehensive, coherent and structured planning in
the initial stages of the product development process. Do you believe this
(6) System engineering makes use of the concept of concurrent engineering

whereby the development of both the operational and support functionality of
the product takes place simultaneously, leading to reduced product
development cycles, lower economic life-cycle costs and increased product
efficiency. Do you believe this concept to be applicable to the financial
product development process?
(7) System engineering ensures that the functional definition of the product is
adequately completed prior to the operational design and development.
Conceptually, it is important that the organisation clearly understands what the
product must do (functional) before deciding how these requirements may best
be achieved (operational). Do you believe this concept to be applicable to the
financial product development process?
(8) The Financial Product Development Model as proposed by the author

considers the successful development of financial products to be dependent
297
on: (1) the strategic fit (appropriateness) of the product with respect to the
organisation's strategic aims, and (2) the ability of the organisation to develop
the product more efficiently (minimised economic life-cycle cost) than
competitors. Do you believe this concept to be applicable to the financial
product development industry?
(9) Do you believe that the concept of strategic product fit (a measure of the
manner in which the product supports and enhances the organisation's
strategic aims) forms an important part of the product development decision
within a financial services organisation?
Absolutely Not at all
(10) Do you believe that the application of the concepts introduced within this
questionnaire, which are inherent within the Financial Product Development
Model, will be able to provide the financial services organisation with a
competitive advantage relative to competitors who may not be aware of such
concepts?
10.7 ANALYSING THE SURVEY I' ESULTS
A simple analysis of the survey results as returned by the sixteen respondents

to the limited scope survey is illustrated in Table 10.1. For the purposes of
comparison a five rating corresponds to a positive extreme scale response to
the survey question while a one rating corresponds to a negative extreme scale
response. Accordingly, Table 10.1 indicates the responses of the respondents
to each of the questions posed in terms of the industry survey. These responses
are averaged across both the question number as well as the respondent.
Similarly, the standard deviation of responses is indicated on a per question
298
and per respondent basis. Finally, Table 10.1 includes some basic biographical
information on the respondents in terms of their work experience and
education.
As illustrated by Table 10.1, the average experience and education of the

respondent population is high. The average number of years of working
experience in their current profession across the sixteen respondents is 9.78
years, with a range from 0.5 years to 25 years. Four of the sixteen respondents
have in excess of 15 years experience in their current profession. Education
levels are correspondingly impressive with the respondent population having
academic qualifications of a diploma, a bachelors degree and fourteen masters
degrees, typically in business related fields.
An analysis of the survey results in terms of ranked average responses per

question leads to a number of interesting observations. A ranking of the
questions on an average response basis is illustrated in Table 10.2. Note that
the author has chosen to concentrate on ranked-responses here as opposed to
nominal averages. This decision was taken as a result of the small size of the
survey as well as a desire to avoid the statistical issues associated with
averaging across extreme value scales.
The results of the survey as measured by average response per question are
extremely encouraging. It is apparent that the general concepts underlying the
Financial Product Development Model are considered by the respondents to be
applicable to the financial product development industry and of benefit to the
financial services organisation involved in the development of financial
products. This is evident when one considers that the worst average response
received lies toward the top-end of neutrality in terms of the ranked scales used
in the survey questionnaire.
299
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An Indust?), Perception of the Financial Product Development Model
Talire_10.2_12he-Survey- uestioliS=RTifirtrti gy ATirraTeResponse (Ma egt

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Rank Question Average

Response
The Financial Product Development Model as proposed by the author considers the 4.625
1
successful development of financial products to be dependent on: (1) the strategic fit
(appropriateness) of the product with respect to the organisation's strategic aims, and
(2) the ability of the organisation to develop the product more efficiently (minimised
economic life-cycle cost) than competitors. Do you believe this concept to be
applicable to the financial product development industry?
2 Innovation within the financial product development process will play an increasingly 4.4375
important role in the market competitiveness of the financial services organisation in
the future.
3 The development of financially engineered products is increasing in complexity. 4.3125

3 Do you believe that the concept of strategic product fit (a measure of the manner in 4.3125
which the product supports and enhances the organisation's strategic aims) forms an
important part of the product development decision within a financial services
organisation?
3 Do you believe that the application of the concepts introduced within this 4.3125
questionnaire, which are inherent within the Financial Product Development Model,
will be able to provide the financial services organisation with a competitive
advantage relative to competitors who may not be aware of such concepts?
System engineering ensures that the functional definition of the product is adequately 4.25
6 completed prior to the operational design and development. Conceptually, it is
important that the organisation clearly understands what the product must do
(functional) before deciding how these requirements may best be achieved
(operational). Do you believe this concept to be applicable to the financial product
development process?
7 System engineering overcomes typical manufacturing based product development 4.125

problems such as a lack of good early planning, an inadequate problem definition, and
a short-term product focus by placing great emphasis on the initial stages of the
product development process. Do you believe this concept to be applicable to the
System engineering makes use of the concept of concurrent engineering whereby the 4.125
development of both the operational and support functionality of the product takes
place simultaneously, leading to reduced product development cycles, lower
economic life-cycle costs and increased product efficiency. Do you believe this
System engineering overcomes typical manufacturing based product development 4

9 problems such as a lack of good early planning, an inadequate problem definition, and
a short-term product focus by placing great emphasis on the initial stages of the
product development process. Do you believe this concept to be applicable to the
10 The process by which financial products are developed can be used as a source of 3.875
competitive advantage for the financial services organisation. _
Source: Own Source
301
It is extremely interesting to note that those questions which relate to concepts

that financial professionals would most readily associate with, such as
innovation, financial engineering and strategic product fit, feature prominently
at the top of the ranked questions. Those questions related to the concepts of
system engineering and the product development process occupy the bottom
half of the ranked list. This is not totally unexpected. However, the immediate
question which comes to mind is whether this is an indication of the
inapplicability of system engineering concepts as proposed by the author or
simply a natural response on the part of the survey respondents to concepts
which they would not be familiar with. It is the opinion of the author that the
answer lies within the latter case.
Although the questions related to system engineering occupy the lower half of
the ranked list, note that no question has been rated negatively on average by
the respondents. In fact, only one of the system engineering related questions
received a ranking under 4, implying a high degree of acceptance of the
concepts by the respondents. It was also apparent to the author during the
interview process that respondents were, in general, unaware of the concepts of
system engineering as suggested here. In particular they displayed a certain
lack of awareness of the importance of the process of product development,
and hence did not appear to fully appreciate the positive impact which the
application of the system engineering concepts as detailed here may have on
this process. This is illustrated further by the ranking (10) of the question
regarding the process of financial product development as a source of
competitive advantage for the financial services organisation.
These results are extremely encouraging in the context of this thesis because
by indicating an acceptance of the principles of system engineering and the
importance of the process of product development, and systematically ranking
these concepts lower than those with which they would typically be more
comfortable, the respondents have illustrated exactly what the author most
hoped to achieve via the research presented here, namely that:
302
The concepts of system engineering, where applicable, can be applied

to the financial product development process in order to enhance this
process,
An enhanced product development process can provide the financial

services organisation with a strategically competitive advantage within
its target market, a requirement for success within the modern
globalised economy, and, perhaps most importantly,
The financial services industry, as represented by this population,

appears to be unaware of the vast benefits which system engineering
may have on the financial product development process.
The top half of the ranked responses provide further confirmation of the
concepts introduced by the author throughout this thesis. Note that the question
which received the highest response rating details the importance of
considering two primary issues with regard to the development of any product,
namely the measure of strategic fit that the proposed product exhibits and the
ability of the organisation to develop that product more efficiently than
competitors. Remember that it is this principle upon which the entire Financial
Product Development Model is founded. First the organisation determines
whether the product is strategically acceptable (in other words, the emphasis is
not purely on short-term gain) and then, provided the proposed product is
acceptable, the product is developed using a structured process which provides
the organisation with the ability to develop the product more effectively
(shorter development time, minimised economic life-cycle cost) than
competitors.
Chapter Two illustrated briefly the growing importance of innovation within

the financial -product development industry and the predicted impact of
innovation, or the lack thereof, on the success of the financial services
organisation in the 21 St century. This is confirmed by the respondents with the
303
second position ranking of the statement dealing with the importance of

innovation in the development of financial products.
The increasing complexity of the financial engineering process, the concept of

strategic product fit, and the ability of the Financial Product Development
Model to provide the financial services organisation with a competitive
advantage all receive equal rankings by the respondents, indicating the general
applicability of the concepts as illustrated by the author.
Of the system engineering related questions the highest ranked question is that
relating to the functional definition of the product during the development
process. The high ranking awarded to this question most likely indicates a
growing awareness on the part of financial services professionals of the extent
of the problems caused by an inadequate initial product definition. This
problem is further exacerbated by the intangibility of the financial product,
making the initial functional definition all the more important. This provides
further credence to the concept of the Financial Product Development Model
as suggested by the author.
J10.8 PRACTICAL ISSUES ARISING FROM THE INDUSTRY SURVEY
In addition to the survey responses received by the author, as detailed in

Section 10.7, the survey process led to discussions between the author and
certain respondents with regard to the practical implementation of the proposed
Financial Product Development Model. As a result of these discussions the
author was able to identify a number of issues, not covered on the survey form,
which may to a greater or lesser extent have an impact on the implementation
of the model as proposed here. These issues can be summarised as follows:
While the-complexity of financial products was seen to be on the increase,

many respondents pointed out the relationship between product complexity and
marketability. In general it is harder to market a financial product which has a
level of complexity higher than that which the client would typically feel
304
comfortable with. Even though the product may be technically superior many
clients tend to be hesitant to use a product which they themselves do not fully
understand, particularly given many of the high profile financial losses arising
as a result of the use of such products by organisations who did not fully
understand the risks associated with their use.
This is an understandable issue, and one which the author fully agrees with.
However, this does not in any way nullify the effectiveness of the proposed
model. Although complex products may be harder to sell there is no doubt that
there will always be an increasing complexity associated with such products
because only by producing new and innovative products can the financial
services organisation satisfy the increasingly complex requirements of the
market. This makes the process of financial product development imperative as
a differentiating factor between competing organisations. Furthermore, even if
financial products were to become simpler overnight they would still have to
be designed in such a way that the organisation could provide a unique service
to the target market.
The increased emphasis on initial product functional definition may be more

complicated within the financial services industry than in a conventional
engineering industry because of costs which may be incurred such as lawyer
fees and tax opinion fees.
This may be a valid point. However, in emphasising increased attention to the

initial functional definition of the product system engineering theory predicts
an increase in initial costs since it would be impossible to achieve this
increased emphasis without increased costs (refer to Figure 6.2 in Chapter Six
which illustrates this concept perfectly). According to the theory of system
engineering these additional initial costs will be more than compensated for by
an overall saving in the life-cycle cost of the product. Such increased initial
costs should therefore not be seen as unnecessary expenditure, but should
rather be identified as a measure of the correlation of the product development
305
process to the idealised project life-cycle cost as described by system

engineering.
The use of structured financial products is set to increase within the financial
services industry.
The author is in complete agreement with this element. This relates directly to
the increasing importance of financial engineering in providing the tools
necessary for the creation of these products. See Appendix D for further
discussions related to this topic.
The development of a complex financial product does not necessarily take

place in a single location given the different skills which are often required to
structure such a product.
This issue makes the implementation of system engineering concepts

embedded within the Financial Product Development Model all the more
important since this is one of the crucial areas which system engineering
emphasises. Remember that the initial functional definition of the product and
subsequent operational design is structured within the system engineering
process in order to maximise the flow of information between the various
participants to the product development process. Concurrent engineering, for
example, has as its function the optimisation of the communication flow
between the initial designers of a product and the downstream operational
development and manufacture personnel.
10.9 CONCLUSION
This Chapter has accomplished two major goals in that: (1) the author has
illustrated the development of the survey questionnaire, touching on the
application of accepted survey design principles, and (2) the results of the
industry survey were presented and discussed by the author.
306
The stated intention of this Chapter was to provide the reader with an
appreciation of the general attitude of professionals within the financial
product development industry to the Financial Product Development Model as
proposed by the author, with specific reference to the major concepts
underlying the model. An analysis of the survey results indicated that all of the
respondents to the survey were in favour of the major concepts presented
within this thesis and incorporated within the proposed model. No single
survey question received a negative rating on average, with all but one rated
four or higher.
An analysis of the results of the survey revealed a distinct pattern in that

respondents systematically rated the system engineering related questions
under those relating to the concepts of financial engineering, strategic fit, and
innovation, concepts which the typical financial services professional would be
far more comfortable with. This would appear to indicate a lack of awareness
on the part of the respondents of the benefits of system engineering with
respect to the process of product development as well as the importance of this
process in providing the organisation with a competitive advantage. This
confirms the opinion of the author that the financial services industry is, as
represented by the survey population, unaware of the benefits of system
engineering as they may be applied to the financial product development
process. The implication of this is that those financial services organisations
that are able to best introduce such concepts within their product development
processes may enjoy a substantial competitive advantage over their rivals, an
advantage which will prove to be crucial as an already competitive industry
reaches new levels of competitiveness in the 2l St century. The successful
implementation of the Financial Product Development Model as proposed by
the author will enhance the ability of the organisation to use the process of
product development as a strategic lever.
Finally, the author presented and briefly discussed a number of issues which
were identified during discussions with respondents to the industry survey. In
general the issues raised corresponded to the predicted effects of the
307
application of system engineering principles as seen by someone unaware of

such concepts. The issues listed here and other issues discussed by the author
and respondents during the industry survey do not in any way nullify or reduce
the potential benefits of the application of the Financial Product Development
Model. The identification of such issues have served to highlight the apparent
inefficiencies within the typical financial product development process,
making the implementation of the proposed model a significant source of
potential competitive advantage for the financial services organisation.
308
Conclusion
Chapter 1 1
Conclusion
"You've heard of the 'global village. ' I say a village is too big. Try
`global block. ' Better yet, try 'global mall. ' " — Tom Peters, The
Circle of Innovation
H.1 'INTRODUCTION
ow that the author has conveyed the principles underlying the Financial
Product Development Model, illustrated the model, discussed the
practical implementation of the model, and presented the results of an industry
survey, there remains only a few elements which must be completed. As a
result, the purpose of this Chapter is as follows:
The purpose of this Chapter is to summarise all of the data and concepts
presented within this thesis and to highlight those concepts which the author
believes to be of most value. Furthermore the author will use this Chapter to
recommend further research opportunities related to the subject at_hand.
111.2 FURTHER RESEARCH OPPORTUNITIES
As with any research of the type presented here it is not possible to cover all
research possibilities. Inevitably there are further research opportunities
available. The purpose of this Section is to highlight such possibilities as
identified by the author.
It is the opinion of the author that three valid and practical further research
opportunities exist as follows:
309
Conclusion
The use of scientific decision techniques in financial product

development. As illustrated in Chapter Seven the use of such scientific
decision techniques has found much favour with many of the world's
most progressive organisations. It may be feasible to conduct research
into the application of such techniques within the financial product
development process. In particular the inclusion of such techniques
within the Financial Product Development Model may be desirable in
order to add a more detailed quantitative element to the concept of
strategic fit.
The use of financial products as a means of enhancing corporate

strategy. It is the sincere belief of the author that financial products
such as derivatives have a tremendous role to play in the enhancement
of corporate strategy. In an article on this subject Tufano 11581 alludes
to the various ways in which derivatives, and in particular financial
engineering, can advance corporate strategy. Further research along
these lines may prove extremely beneficial providing the results are
practically sound.
The quantification of pass or fail criteria within the Competitive

Strategy Framework. As illustrated by the author throughout this
thesis the Competitive Strategy Framework makes no attempt to
specify any type of pass or fail criteria with regards to the strategic fit
of the proposed financial product. In its current form the Competitive
Strategy Framework is designed to ensure that management are aware
of and fully consider the strategic impact of the financial product
development decision on the market competitiveness of the
organisation. There may be merit in developing a set of quantitative
pass or fail criteria which would formalise the use of this framework.
The further research opportunities listed here are by no means exhaustive. The
discipline of financial engineering is full of research opportunities, particularly
with respect to the enhancement of this process and, by definition, the ability
310
Conclusion
of the financial services organisation to develop optimal products for

distribution to prospective clients.
111.3 THE QUESTION HIERARCHY REVISITED
Chapter One of this thesis detailed the Question Hierarchy which listed, in a
descending level of specificity, the questions which needed to be answered in
order to propose a solution to the research problem which is the focus of this
thesis. At this stage it will be useful to return to this Question Hierarchy in
order to survey the answers provided by this thesis. Starting with the
investigative questions:
How can the functions of system engineering, financial engineering and

strategic organisational competitiveness be integrated from a product
selection and development point of view so as to enhance the strategic
competitiveness of the financial services organisation?
The author has shown how the modern financial services organisation is
dependent on each of these distinct yet inseparable elements as a means of
competitive success within the market. Financial engineering is the scientific
discipline responsible for the development of innovative new financial
products, the lifeblood of many financial services organisations. The selection
of the product development projects to be undertaken impacts on the issue of
strategic organisational competitiveness, as was clearly demonstrated in
Chapter Seven. Linking financial engineering and organisational
competitiveness is the concept of system engineering as proposed by the
author. The author has illustrated the importance of a holistic view of these
concepts, leading to the development of the Financial Product Development
Model.
Are there any differences in applying the concepts of system engineering

to the function of financial engineering as opposed to 'conventional'
engineering?
311
Conclusion
In general system engineering can be successfully applied to the financial

product development process with little, if any, modification of the underlying
concepts and techniques. This is because even though the typical financial
product is intangible, the process used in the development of such products
must be the same as for any other product development project. Financial
products, as with any product, must be designed in order to optimally satisfy a
need on the part of market participants, and for as long as this is the case the
science of system engineering will be beneficial in the optimisation of the
financial product development process.
What additional factors (if any) need to be considered in this integration

(possibly factors particular to the financial environment)?
As illustrated, the intangibility of the typical financial product may complicate

the application of system engineering marginally. This is especially prevalent
in system engineering concepts such as the operating mission profile and the
development of technical performance measurements. However, other system
engineering elements such as the functional analysis concept and concurrent
engineering are perfectly applicable. What is important to remember is that the
benefit of system engineering to the development of financial products lies not
so much in the micro detail of the application of such concepts, but rather in
the macro concepts which system engineering is able to bring to any such
product development project. Concepts such as the minimisation of economic
life-cycle costs and the emphasis on initial up-front design considerations are
important because of their macro-level impact on the total product
development process. This is where the true value of system engineering lies
and it is precisely at this point where the manufacturing and financial product
development processes are most similar.
Will it be possible to construct a generalised conceptual model which may

be used to guide the strategic financial engineering product development
process?
312
Conclusion
Based on all of the preceding information the answer to this question is an

unreserved yes. The author has identified and illustrated the importance of the
links between the various concepts presented within this thesis and, most
importantly, has suggested a conceptual model in order to enhance the
resultant financial product development process. The application of this model
makes simple business sense. Every profit seeking organisation has as its
ultimate goal the maximisation of shareholder wealth through the enhancement
of the organisation's relative competitive standing within its target market.
Increasing competition means that the modern financial services organisation
is forced to continually seek ways to gain a vital competitive edge over
competitors. The conceptual model proposed by the author emphasises one
such element — the process via which the financial product is selected,
designed and developed.
Having answered the micro level investigative questions the answers to the
research and management questions respectively become obvious. Simply put,
the corporate financial engineering function can be enhanced in as far as the
financial product development process is concerned, and the primary method
of optimisation is the inclusion of system engineering in the process in
combination with strategic product selection principles which view the process
of product design as more than simply a means to an end. Recognition and
implementation of this principle will prove to be a significant competitive
advantage for the financial services organisation of the 21 st century.
11.4 CONCLUDING SUMMARY
The aim of this thesis, and the research presented herein, has been the
optimisation of the financial product development (financial engineering)
process via the application of applicable system engineering concepts in
conjunction with measures designed to enhance the strategic potential of the
financial product development process as a source of competitive advantage
for the modern financial services organisation operating within a competitive
market environment. The output of the structured combination of such
313
Conclusion
concepts and measures, applied within a conceptual framework, was the

primary element of concern within this thesis: the Financial Product
Development Model.
This model, designed by the author to be practically applicable within the

financial services organisation, is the result of the structured integration of
relevant system engineering concepts drawn from a conventional engineering
environment and the concept of strategic product fit in as far as the potential
financial product to be developed must satisfactorily contribute to the strategic
aims of the parent organisation. Inherent within the application of the model is
the fact that the process via which any product (in this case a financially
engineered product) is developed can act as a source of competitive advantage
to the profit seeking organisation operating within a competitive, typically
globalised, market.
The Financial Product Development Model is based on two simple, yet

conceptually powerful, principles. The structure of this model is such that the
successful development of a financial product is assumed to consist of the
following two steps:
o The potential product to develop must to a certain degree satisfactorily

satisfy the concept of strategic fit. It must contribute in some way to
the strategic aims of the parent organisation because, as has been
shown throughout this thesis, one of the keys to organisational success
in the 2l st century will be the creation of strategic competencies. The
process via which the financial product is developed is just as
important as the end product itself.
o Once the financial product to develop has been selected, the

organisation must have the ability to develop that product quicker and
more effectively than competitors if it wishes to be successful in a
market characterised by increasing complexity and competitiveness.
The Financial Product Development Model considers the effective
314
Conclusion
development of a financial product to be one in which the economic

life-cycle cost of the product is minimised.
The concept of strategic fit is introduced into the model via the Competitive
Strategy Framework, a conceptual framework developed by the author. The
Competitive Strategy Framework consists of five key strategic elements
selected by the author for their applicability to the financial product
development process. Each of these elements, being (1) change leadership, (2)
knowledge management, (3) technology integration, (4) product innovation,
and (5) the product development process as a source of competitive advantage
have been illustrated by the author to be applicable to the financial product
development process and to provide a measure of the strategic fit of the
product with respect to the strategic aims of the parent organisation. The
product to be developed is 'filtered' through this framework in order to allow
management to appreciate the impact that the development of the product may
have on the strategic positioning of the organisation within its target market.
In short, the selection of a financial product to develop should not be based

purely on short-term profitability, but should rather be a function of the ability
of the product, and by definition the process used to develop that product, to
enhance the competitive position of the financial services organisation in the
medium to long-term. The application of this framework is not to provide any
form of quantitative pass or fail criteria, but rather to draw the attention of
management to the need to conduct an adequate strategic analysis on the
proposed product prior to initiating the product development process.
The Competitive Strategy Framework is introduced into the Financial Product

Development Model via the Strategic Circuit Breaker, a concept developed by
the author to ensure the correct application of the Competitive Strategy
Framework. The Strategic Circuit Breaker is modelled on the concept of a
trading circuit breaker as used on major stock exchanges world-wide. The
purpose of the Strategic Circuit Breaker is to temporarily halt the financial
product development process in order to allow for the activation of the
315
Conclusion
Competitive Strategy Framework. This allows management time to analyse the

product in terms of its strategic impact on the organisation instead of making
product development decisions based purely on perceived short-term benefits.
The Strategic Circuit Breaker is thus designed to enhance the informational
efficiency of the financial product development process, a concept similar to
that of the trading circuit breaker which has as its function the temporary
suspension of trading activity in order to allow market participants time to
process information more efficiently and hence to make more informed,
rational, decisions.
The efficient development of the financial product, in terms of the minimised

economic life-cycle concept, is achieved via the inclusion of applicable system
engineering concepts within the Financial Product Development Model. Such
concepts have been drawn by the author from the typical engineering based
product development environment and modified, where required, for
application to the financial product development process. Typical concepts
which are emphasised within the discipline of system engineering include an
emphasis on the initial functional definition of the product, the adequate
determination of both qualitative and quantitative product parameters well in
advance of the operational design of the product, the need for a concurrent
relationship between the design of the product and its downstream support
functions, and the optimisation of the flow of information between various
participants to the product development process.
In developing the Financial Product Development Model, the Competitive

Strategy Framework, and the Strategic Circuit Breaker, the author followed a
structured process designed to maximise comprehension of the topics
presented. This was required due to the diverse nature of the topics covered in
this thesis.
In Chapter Two the author covered the concept of financial product innovation
and illustrated how this concept was set to increase in importance in the 21 St
century as competition within the financial services industry increases and as
316
Conclusion
the relative complexity of new financial products increases. Brief attention was
given to current innovative techniques in the design and development of
financial products such as neural networks, chaos theory, expert systems and
genetic algorithms. It was further illustrated how many professionals, schooled
in the hard science fields such as engineering, physics, mathematics and
statistics, are actively contributing to the development of complex, innovative,
financial products.
Chapter Three introduced the reader to the discipline of financial risk

management and illustrated why the management of financial risk is such a
crucial part of the modern day organisation. It was shown how risk, while
unavoidable in the pursuit of profits, can be effectively broken down and
repackaged in other forms for distribution to market participants who are
willing to accept such risk. The financial risk management function is therefore
a measure of the efficient diversification of risk from those parties who are
looking to eliminate unwanted or undesirable risk to those who are willing to
accept such risk. It was further shown that while the commercial profit seeking
organisation would theoretically be better of by not eliminating risk the reality
of the situation is that such theory is based on assumptions which are not
tenable within a commercial business environment.
The increasing importance of the financial risk management function led to the
development of a separate and identifiable discipline the objective of which
was to satisfy this function via the development of appropriate financial
products. This discipline, financial engineering, was introduced to the reader in
Chapter Four. The increasing importance of financial engineering as well as a
description of the manner in which financial engineering is able to provide the
products required within the financial risk management process was illustrated
by the author. In addition, the concepts and techniques of value-at-risk, a
market risk management model, was introduced by the author in as far as
knowledge of this concept would be required by the reader at a later stage.
319
Conclusion
The results of the financial engineering process, financial derivatives, were

discussed by the author in Chapter Five. The basic building blocks of financial
engineering, namely forwards, options and swaps were explained to the reader
along with practical examples of how these financial instruments could be used
to manage the financial risk (typically market risk, currency risk or interest
rate risk) of the organisation, financial or otherwise.
Chapter Six had as its subject the principles and concepts underlying system
engineering and the manner in which the discipline of system engineering
could be used in the optimisation of the product development process.
Concepts such as life-cycle cost minimisation and the manner in which system
engineering could help to achieve this were explored. Chapter Six provided the
knowledge base of system engineering principles required for an appreciation
of the Financial Product Development Model.
The development of the Competitive Strategy Framework and the Strategic

Circuit Breaker concept was the focus of Chapter Seven. In this Chapter the
author illustrated how the optimal development of the financial product was a
function of the strategic appropriateness (strategic fit) of the product. The five
elements of the Competitive Strategy Framework were illustrated in terms of
their applicability to the financial product development process. Finally, the
author recommended the use of scientific decision techniques in the financial
product development process given the apparent increase in application and
effectiveness of such techniques with respect to the optimisation of corporate
strategy.
Chapter Eight was the culmination of all of the concepts presented up until that
point and detailed the conceptual development of the Financial Product
Development Model. The structure of the model was discussed along with the
various macro and micro elements inherent within the model. The practical
application of each of the micro elements of the model was further developed
by the author with specific reference to the application of each element within
the financial product development process. Furthermore the integration of the
318
Conclusion
Competitive Strategy Framework and the Strategic Circuit Breaker within this
model was detailed by the author.
With the development of any form of conceptualised model it is ideally

required that the model be validated in some manner. The author achieved this
within this thesis in two ways. The first form of validation was detailed in
Chapter Nine and took the form of a practical implementation study of the
application of the Financial Product Development Model. The use of the model
within a practical financial product development situation was detailed and
analysed. Issues related to the application of the model were brought to the
reader's attention and discussed as appropriate. The results of this application
showed that the Financial Product Development Model was indeed practically
applicable and that the model did exhibit the product development process
enhancement characteristics for which it was designed.
The second form of validation, a limited scope industry survey, was introduced
in Chapter Ten. The development of the survey form in accordance with
accepted design techniques as well as issues such as the target population and
aims of the survey were illustrated to the reader. An analysis of the results of
the survey showed that the Financial Product Development Model was well
received by the target population of sixteen financial services professionals. Of
the ten questions presented in terms of the survey no question was rated
negatively on average. Distinctive trends were observed in the ranked question
data, indicating that while the use of system engineering techniques as
suggested by the Financial Product Development Model are applicable within
the financial services industry, such techniques are largely unknown and
misunderstood by the financial services community in general. The
implications of this are significant. In particular it becomes apparent that the
financial services organisation which is able to successfully implement such
techniques within the financial product development process will enjoy a
process based competitive advantage over other competitors within the market.
Chapter Ten ended with a discussion of various issues which were identified
by respondents during the survey process. These issues further reinforced the
319
Conclusion
applicability of the Financial Product Development Model as a source of

competitive advantage for the financial services organisation.
Having read through all of the Chapters and Appendices presented within this
thesis the reader should be left with an appreciation of the increasing
importance and complexity of the financial product development function and
the immense benefits to be gained from the strategic optimisation of this
process within the financial services sector. The financial services organisation
operating within a competitive market is no longer able to make product
development decisions based on purely short-term objectives. The key to
modern day success is core competencies, and core competencies are created
as a result of maximising the strategic effectiveness of the product selection
and subsequent product development functions within the financial services
industry.
In developing the Financial Product Development Model the author proposes

the simultaneous integration of applicable strategic product selection elements
as well as subsequent product development process enhancement techniques as
suggested by the discipline of system engineering. The use of such techniques,
and in particular the inclusion of system engineering principles, presents a
novel approach to a very real problem. It has been shown that the research
presented here contributes positively to the recognition of the value that
engineering, and in particular system engineering, as a discipline may add to
the process of financial product development. The potential of discipline
integration is enormous. If the development of financial products via the
process of financial engineering is indeed to be the economic battleground of
the next decade then those organisations involved in the development of such
products had better be prepared for a competitive war. The concepts inherent
in the Financial Product Development Model as detailed here will be one of the
keys to the strategic success of the financial services organisation of the future.
320
Glossary
Note: Unless otherwise indicated the data in this Glossary has been excerpted
and modified by the author from The Chase Manhattan Bank Guide to
Financial Risk Management as published in Managing Risk in Asia, Risk
Publications, 1998 [27].
Active Versus Passive Management

Two forms of investment management may be identified, namely active
management and passive management.
Active management is a combination of market timing and security selection.

The concepts of passive management, market timing and security selection
may be defined as follows [17]454
Passive management is the strategy of holding a well: diversified portfolio

of generic security types without attempting to outperform other investors
through superior market forecasting techniques or superior ability to find
mispriced securities.
Market timing involves the application of techniques in attempting to time

the stock market by increasing one's commitment to stocks when 'one is
`bullish' and decreasing one's commitment to stocks when one is `bearish' 1 .
Security selection is the attempt to find mispriced securities and to improve

one's risk-return trade-off by concentrating on such securities.
Which of the management techniques is preferable? This depends on whether

one is a follower of the efficient market hypothesis. Essentially, the efficient
market hypothesis states that in the modern market environment the
dissemination of information is of such a nature that the market 'efficiently'
Investors are typically referred to as either a 'bull' or 'bear'. A 'bull' is an investor who believes
that the price of stocks is going to increase and so takes measures to increase the holdings of stock.
On the other extreme, a 'bear' is an investor who believes that the price of stocks is going to
decrease, and thus reduces the total stock holding.
321
Glossary
rates a security at the 'correct price' virtually instantaneously. Thus the ability
of an investor to find mispriced 2 securities is severely limited since such
`bargains' typically only exist for very brief periods, and with so many highly
skilled investment analysts constantly scouring the markets for such mispriced
securities the chances of any one person being able to practice successful
active management principles over an extended period of time becomes
minimal. The efficient market hypothesis therefore suggests that active
investment management techniques will not enable the investor to earn a
superior return, and that any investor who has achieved a superior return may
have enjoyed a degree of luck as opposed to having achieved such a return via
skill.
Nevertheless, while the efficient market hypothesis makes a strong case, there
are many examples of investors who have been able to consistently earn
superior returns. For this and other reasons many authors contend that markets
are nearly efficient and in this environment opportunities for highly skilled and
diligent investors are plentiful [17],[107],[156].
American - Style Option

A financial option in which the holder has the right to exercise the option at
any time during the life of the option, up to and including the expiry date.
Amortising
A description, applicable to a variety of instruments, denoting that the notional
principle decreases successively over the life of the instrument. If the decrease
takes place in increments the instrument may be known as a step-down.
Mortgage-style amortisation refers to an amortising swap such that the
principle amortisation plus interest is the same amount in each interest period.
2 A mispriced security may be defined as a security whose price does not reflect the true
underlying value of the company. If one assumes that the price will eventually be re-rated by the
market and rise to the appropriate level then buying such a mispriced security may present a
unique investment opportunity.
322
Glossary
Asset-1 ached Security

A financial instrument which is collateralised by bundled assets such as
mortgages, real estate or other receivables. This class of securities includes
collateralised mortgage obligations and mortgage-backed securities, which are
debt instruments collateralised with pooled real-estate mortgages.
Asset Swap
A swap that involves altering the payment basis on assets rather than
liabilities. The pricing is the same as for ordinary interest rate or cross-
currency swaps. Usually fixed-rate assets are converted into floating rate
assets. The fixed-rate assets are purchased by the investor who simultaneously
enters into a swap and receives floating-rate payments plus or minus a spread.
The more efficient the market the fewer opportunities there are for this type of
business since it relies on the original bonds being underpriced.
Such opportunities may arise as borrowers are downgraded and investors with
certain credit criteria are forced to dump bonds into the market, causing them
to trade cheaply. This has enabled floating-rate investors such as banks and
relative value players to access a broad supply of attractively priced fixed-rate
assets.
At-The-Money
o At-the-money spot: An option whose strike is set the same as the
prevailing market price of the underlying. Because forwards commonly
trade at a premium or discount to the spot, the Delta may not be close
to 50 percent.
o At-the-money forward: An option whose strike is set at the same level
as the prevailing market price of the underlying forward contract. With
a Black-Scholes model the Delta of a European style at-the-money
forward option will be close to 50 percent.
323
Glossary
artier Risk
The value and sensitivities (Greeks) of barrier options can be subject to large
swings when the spot rate is at or near the trigger level. This is particularly
true for reverse barrier options and geared barrier options where the option has
a positive intrinsic value at the barrier. The specific nature of these swings can
make the management of such products riskier, hence the term barrier risk.
asis
o The difference between the price of a futures contract and the
underlying.
o The convention for calculating interest rates. A bond can be 30/360 or
actual/365 in the US or 360/360 in Europe. Money market instruments
can be actual/360 in the US or actual/365 in the UK and Japan.
asis Risk
In the futures market the basis risk is the risk that the value of the futures
contract does not move in line with the underlying exposure. Because a futures
contract is a forward agreement many factors can affect the basis. These
include shifts in the yield curve, which affect the cost of carry, a change in the
cheapest-to-deliver bond, and changing expectations in the futures market
about the market's direction.
Generally, basis risk is the risk of a hedge's price not moving in line with the
hedged position. For example, hedging swap positions with bonds incurs basis
risk because changes in the swap spread would result in the hedge being
imperfectly correlated. Basis risk increases the more the instrument to be
hedged and the underlying are not perfect substitutes.
asis Swap
An interest rate -basis swap or - cross-currency basis swap is one in which two
streams of floating-rate payments are exchanged. Examples of interest rate
basis swaps include swapping US dollar Libor payments for floating
commercial paper, Prime, Treasury bills, or Constant Maturity treasury rates.
324
Glossary
A typical cross-currency swap exchanges a set of Libor payments in one

currency for a set of Libor payments in another currency.
asket Option
An option that enables a purchaser to buy or sell a basket of currencies,
equities or bonds.
ilaterall Netting
Agreement between two counterparties whereby the value of all in-the-money
contracts is offset by the value of all out-of-the-money contracts, resulting in a
single net exposure amount owed by one counterparty to another.
Bilateral netting can be multi-product and encompass portfolios of swaps,

interest rate options and forward foreign exchange.
Binary Option
Unlike simple options which have continuous payout profiles, that of a binary
option is discontinuous and pays out a fixed amount if the underlying satisfies
a pre-determined trigger condition but nothing otherwise. Binary options are
also known as digital or all-or-nothing options.
lack-Scholles Modell
The original closed-form solution to option pricing developed by Fischer Black
and Myron Scholes in 1973. In its simplest form it offers a solution to pricing
European-style options on assets with interim cash payouts over the life of the
option. The model calculates the theoretical or fair value for the option by
constructing an instantaneous riskless hedge whose performance is the mirror
image of the option payoff. The portfolio of option and hedge can then be
assumed to earn the risk-free rate of return.
Central to the model is the assumption that the markets' returns are normally
distributed (have log-normal prices), that there are no transaction costs, that
325
Glossary
volatilities and interest rates remain constant throughout the life of the option,
and that the market follows a diffusion process.
The model has five major inputs: the risk-free interest rate, the option's strike
price, the price of the underlying, the time to maturity, and the assumed
volatility of the underlying. Since the first four are usually determined by the
market option traders tend to trade on the implied volatility of the option.
Bond Markets
The bond market is similar to the money market with the exception that the
securities traded in this market have maturities much longer than those found
in the money market. The majority of instruments in the bond market have
maturities of two to ten years, although maturities of up to thirty years are not
uncommon. The biggest issuers of bonds are government and large
corporations. Such bonds are typically issued with a face value (the amount
repayable upon maturity) and a coupon rate (the interest rate payable at fixed
periods). Because of the ability of governments to collect taxes, bonds issued
by governments are typically referred to as risk-free (no risk of a default on the
payment), although technically this is not entirely correct. Because of the fact
that most bonds have known maturities and coupon rates they are often
referred to as fixed income securities.
Bonds are often issued at a discount to their face value (the face value being
the amount which is returned to the investor on the maturity date). The
difference between the issue price of the bond and the face value of the bond
adjusted to take the time value of money into account is referred to as the
yield, usually quoted on an annual basis. Since bonds are issued with differing
maturities (the time from the issue of the bond to the repayment of the bond) it
is not surprising to find that the yields do vary. This is due to a number of
_ reasons, but one fundamental reason is that the longer the maturity period of
the bond, the greater the risk to the investor. Investors must thus be
compensated for this increased risk. This compensation takes the form of an
326
Glossary
increased yield. It is therefore possible to construct a yield curve which

illustrates the yields on bonds with increasing maturity periods.
Break Forward
A strategy that involves buying a synthetic off-market currency forward
(buying a call and selling a put at the same price) and the simultaneous
purchase of another option, allowing a purchaser to benefit from favourable
exchange rate movements. The transaction is usually constructed for zero cost
because the premium from the off-market forward pays for the option.
Call Spread
A strategy that reduces the cost of buying a call option by selling another call
at a higher level. This limits the potential gain if the underlying goes up, but
the premium received from the sale of the out-of-the-money call partly
finances the at the money call. A call spread may be advantageous if the
purchaser thinks there is only limited upside in the underlying.
Callable Swap
An interest rate swap in which the fixed-rate payer has the right to terminate
the swap after a certain time if the rates fall. Often done in conjunction with
debt issues where an issuer is more concerned with the cost of debt than the
maturity.
The imbedded option is in effect a swaption sold by the fixed-rate receiver

which enables the fixed-rate payer to receive the same high fixed-rate for the
remaining years of the swap in the event that interest rates fall.
The fixed-rate received under the swaption offsets the fixed-rate paid under the
original swap, effectively cancelling the swap.
Cap
A contract whereby the seller agrees to pay to the purchaser, in return for an
upfront premium or a set of annuity payments, the difference between a
327
Glossary
reference rate and an agreed strike rate when the reference exceeds the strike.
Commonly the reference rate is three- or six-month Libor.
A cap is therefore a strip of interest rate guarantees that allows the purchaser to
take advantage of a reduction in interest rates and to be protected if they rise.
They are priced as the sum of the cost of the individual options or caplets.
Cash ]instruments Versus Derivatives

With many financial instruments it is required that cash actually changes
hands. This introduces additional risks. For example, consider a $100 million
loan between two parties. Upon the repayment date if the counterparty defaults
on the loan the lender stands to lose $100 million. One of the parties thus
always bears the risk of a potential loss.
However, in many cases the flow of funds in a deal is not required, and can
even be undesirable. This is particularly true when one considers the issues of
hedging and speculation. This is where derivative securities come into their
own. Since the 1970s derivatives markets have been developed which are able
to bypass such risk. Since derivatives are linked to underlying primary
securities the use of such derivatives exposes one to the fluctuations in prices
and rates associated with the underlying principles but does not place the
initial capital at risk. Consider for example the purchase of an option to buy $1
million against sterling. The option holder will be subject to fluctuations in
currency rates, but the risk of a counterparty default on the $1 million is
eliminated since this money does not actually change hands. Someone who
executed such a deal in the foreign exchange market could conceivably lose
the $1 million.
The use of derivatives has implications for capital adequacy requirements for
banks, who are required to set aside a portion- of their capital to cover possible
losses. The smaller risk (in terms of nominal value) of derivatives means that
banks are required to hold less capital for risk purposes which has implications
for the cost structure of banks.
328
Glossary
Cliquet Option
Also known as a ratchet or reset option. A path-dependent option that allows
buyers to lock in gains on the underlying security during chosen intervals over
the lifetime of the option. Cliquet options were developed in France with the
Cac 40 stock index as the underlying, although they are used in structured
retail products elsewhere in Europe. The option's strike price is effectively
reset on predetermined dates. Gains, if any, are locked in. So, if an index rises
from 100 to 110 in year one the buyer locks in 10 points. If it falls to 97 in the
next year the strike price is reset at that lower level, but no further profits are
locked in.
Collar
The simultaneous purchase of an out-of-the-money call and sale of an out-of-
the-money put. The premium from selling the put reduces the cost of
purchasing the call. The amount saved depends on the strike rate of the two
options. If the premium raised by the sale of the put exactly matches the cost
of the call the strategy is known as a zero-cost collar. When used to hedge an
outright position in the underlying this locks the hedger into a range of values.
This hedging strategy is known as a cylinder.
Convertible Bond
A bond issued by a company that must be exchanged for a set number of that
company's shares at a predetermined price. Because the bond embeds a call
option on the company's equity convertibles tend to carry much lower rates of
interest than conventional debt and are therefore a cheap way for companies to
raise money. The problem for existing shareholders is that conversion has the
effect of diluting the company's outstanding shares.
Covered Call
To sell a call option while owning the underlying security on which the option
is written. The technique is used by fund managers to increase income by
receiving option premium. It would be used for securities they are willing to
sell, only if the underlying went up sufficiently for the option to be exercised.
329
Glossary
Covered Put
To sell a put option while holding cash. This technique is used to increase
income by receiving option premium. If the market goes down and the option
is exercised the cash can be used to buy the underlying to cover.
Credit Derivative
A financial instrument of the derivative class whose payout depends in some
way upon the creditworthiness of an organisation as gauged by objective
financial criteria or a third-party evaluation from a recognised credit rating
agency such as Moody's Investors Service or Standard & Poor's.
Cross-Currency Swap
Involves the exchange of cash flows in one currency for those of another.
Unlike single-currency swaps, cross-currency swaps often require an exchange
of principle. Typically the notional principle is exchanged at inception at the
prevailing exchange rate. Interest rate payments are then passed back on a
fixed, floating or zero basis. The principle is then re-exchanged at maturity at
the original spot rate.
Delta
The Delta of an option describes the premium's sensitivity to changes in the
price of the underlying. The option's Delta will be the amount of the
underlying necessary to hedge changes in the option price for small
movements in the underlying.
The Delta of an option changes with changes to the price of the underlying. An
at-the-money option will have a delta of close to 50 percent. Delta falls for out-
of-the-money options and increases for in-the-money options, but the change is
non-linear. Delta changes much faster when the option is close to at-the-
money. The rate of change of an option's Delta is known as Gamma.
330
Glossary
Efficient Market Hypothesis

The question of efficient markets is one of the most influential issues
underlying modern corporate finance. An understanding of the theory of
efficient markets is fundamental to determining where analysts, fund managers
and corporate treasurers can add value. Although the term 'efficient market'
has been used to denote different phenomena at different times, in modern day
finance it has come to mean that security prices fully reflect all available
information [53]. However, it is apparent that a necessary condition for
investors to trade until all price information is inherent in a security is that the
costs of trading and information gathering be zero. Since this is clearly not the
case it is more realistic to say that security prices will reflect all information
until the marginal costs of trading and information gathering exceed the
marginal benefit.
Historically the efficient markets hypothesis has been subdivided into three
categories, each dealing with a different type of information. These categories
are [107]:
Weak-form efficient markets A market is weak-form efficient if current

prices reflect all information contained in
past prices. This form of market efficiency
is weak because only a small amount of
information need be incorporated in
current security prices. The implications of
weak-form efficient markets are substantial
because, by definition, if a market is weak-
form efficient then past prices cannot
predict future price movements, effectively
ruling out any predictable patterns of price
movements such as trends and cycles. This
rules out the use of investment tools which
331
Glossary
fall under the scope of technical analysis 3

since such technical trading rules attempt
to predict future price movements based on
information that is already reflected in
market prices.
Semi-strong-form efficient markets A market is said to be semi-strong-form

efficient if all publicly available
information is reflected in prices. The
implication is thus that no investor can
improve his or her ability to forecast future
price movements by studying and
analysing macro-economic news, company
earnings statements, annual reports and
any other publicly available information.
In other words, fundamental analysis
cannot lead to profitable stock picking on
the part of the investor. Numerous studies
have been conducted to test stock price
reactions to the release of public
information which, in general, prove that
the market incorporates such public
information quickly and efficiently.
Strong-form efficient markets A market may be considered to be strong-

form efficient if all applicable information,
public and private, is incorporated in stock
prices. The implication here is that nobody
can ever profit from any information,
3Investment analysts typically use either one or a combination of the two main forms of analysis
available, namely technical analysis and fundamental analysis. Fundamental analysis includes the
use of basic economic concepts and information available from publicly available statistics such as
economic cyclical indicators, export and import activity, inflation and interest rates. Technical
analysis, on the other hand, does not concern itself with the reason for price movements but is
more concerned with the history of price movements [142],[104].
332
Glossary
whether it be public information or insider

information. In such a market prices adjust
instantaneously to trades based on insider
information. However, given that studies
have shown that analysts and fund
managers cannot consistently beat the
market while trades by corporate insiders
are usually very profitable, it can be
concluded that markets are generally not
strong-form efficient.
It is possible to use another method of classification for market efficiency,

from a financial transaction point of view. If we consider for example the net
present value (NPV) of a share purchase as the present value of the share (the
present value of all future dividends) minus its price, then the market may be
considered efficient if the NPV of this transaction is zero.
In the early 1950s many business cycle theorists felt that by tracing the
evolution of economic variables over time it would provide a means of
predicting the progress of the economy through boom and bust cycles. On the
assumption that stock prices reflect the fortunes of the firm the movement in
these prices through such periods ought to be a realistic indicator of economic
trends. Kendall [89] examined this hypothesis in 1953 and found that he could
not identify any predictable movements in stock prices. Prices were as likely to
go up as they were to go down on any particular day, regardless of past
performance. The results of this observation form the basis for the random
walk hypothesis [17]. The random walk hypothesis states that the best predictor
of tomorrow's stock price is today's price. Mathematically, tomorrow's price
Pt+i can be expressed in terms of today's price P t plus a random expectation
error, E, +1 which has an expected value of zero. In summary:
Pt+i =Pt+ Et+IE(Ei+1)= 0 (G1)
333
Glossary
Randomly changing security prices are a consequence of intelligent investors

striving to ascertain additional information before other investors are able to
take advantage of such knowledge.
Equilibrium Pricing Relationships

One of the most interesting aspects of the investment function is that the price
of securities must often have a specific relationship with one another. Should
this relationship be disturbed market forces will come into play in order to
restore the pricing relationship. This phenomenon is termed an equilibrium
pricing relationship by financial economists. What makes this phenomenon
particularly interesting for investment professionals is the fact that anyone who
identifies such an imbalance early enough stands to make a profit from the
subsequent market correction with little or no risk. The most important of these
equilibrium pricing relationships are the following [17]:
The security market line (expected return — beta) relationship
The put-call parity relationship
The Black-Scholes option pricing model
The spot-futures parity relationship
The international interest rate parity relationship
Equities Market
Equities are instruments which indicate ownership of a company, both in terms
of company assets as well as participation in future profits. The important
distinction between equities and bonds is that, unlike bonds, equity instruments
do not guarantee future returns. Companies are under no -obligation to pay out
profits in the form of dividends if it is felt that the money could be better used
internally. For this reason equities are generally associated with increased risk.
One would therefore expect the return on investment for equities to be superior
334
Glossary
to that of bonds in order to compensate for the increased risk. This has
historically been the case. Much work has been done in the field of finance in
order to investigate the relationship between risk and return for securities. An
example of such a theory is the Capital Asset Pricing Model (CAPM).
European-Style Option
An option which may only be exercised on the expiry date, and not before.
Exotic Option
An option with a more complicated payout structure than a plain vanilla put or
call option whose payout is simply the difference between the strike price of
the option and the spot price of the underlying at the time of the exercise.
]Financial Intermediation
In order for economic development to take place those who have resources
which they wish to invest must effectively make contact with those who wish
to borrow such resources in order to increase their wealth by making
productive use of such resources. The means by which such contact is made
would be difficult without the help of financial intermediaries. Essentially,
financial intermediaries facilitate the transferral of spare resources from those
who wish to invest such resources to those who wish to borrow such resources.
Typical examples of financial intermediaries include banks, investment
companies and insurance companies. Financial intermediaries thus sell their
own liabilities to raise funds that are used to purchase the liabilities of other
corporations.
For example, banks raise funds by borrowing (taking in deposits) and lending
the money so raised (purchasing the loans of ) to other borrowers. The bank's
profit is derived from the spread between the interest rates paid to depositors
and the rates charged to borrowers. As is apparent, profit considerations alone -
dictate that banks will emerge in a modern market economy.
335
Glossary
Floor
A contract whereby the seller agrees to pay the purchaser, in return for an
upfront premium, the difference between an agreed upon strike rate and a
reference rate should the strike rate exceed the reference rate.
Foreign' Exchange Market

The foreign exchange market is the international forum for the exchange of
currencies. This market did not always exist. In 1944 the signing of the Bretton
Woods agreement meant that most major currencies were linked to one another
with a fixed rate of exchange, subject only to revisions when required. This
arrangement worked well up until the late 1960s when the differences in
growth between major countries began to make the fixed exchange rate system
impractical. In the early 1970s this fixed-rate system was scrapped and
replaced with a floating exchange rate system where the relative rate of
exchange between two currencies was subject to daily fluctuation determined
by market forces. The result of this was the creation of the foreign exchange
(FX) market.
The result of the creation of a foreign exchange market was twofold: (1) banks
and other commercial companies now had to manage their currency exposure
risk given that currencies were subject to fluctuation, and (2) the opportunity
was created for speculators who could bet on the depreciation or appreciation
of currencies.
In today's FX market there are three dominant trading centres, namely New
York, London and Tokyo. It is estimated that the daily dollar equivalent
volume of transactions passing through these three centres is in the region of
$1 trillion.
Gamma
The rate of change in the Delta of an option for a small change in the
underlying. The rate of change is greatest when an option is at the money and
336
Glossary
decreases as the price of the underlying moves further away from the strike
price in either direction.
A long Gamma position is one in which the trader is long options. For a
position that is short Gamma the opposite holds.
Gamma can be hedged by mirroring the opposite position. Alternatively a

trader may choose to alter the position in the underlying constantly in order to
maintain Delta neutrality.
Hedge
To hedge is to reduce risk by making transactions that reduce exposure to
market fluctuations. For example, an investor with a long equity position might
compensate by buying put options to protect against a fall in equity prices.
l[mpllied Volatility
The value of volatility embedded in an option price. All things being equal,
higher implied volatility will lead to higher option prices and vice versa. The
effect of changes in volatility on an option's price is known as Vega.
If the option premium is known its implied volatility can be calculated by

inputting all the known factors into an option pricing model. The implied
volatility is the market's estimate of the future volatility of the underlying.
En-The-Money
Describes an option whose strike price is advantageous compared with the
current market price of the underlying. The more the option is in-the-money
the higher its intrinsic value and the more expensive it becomes. As an option
becomes more in the money its Delta increases and it behaves more like the
underlying in profit and loss terms. Deep in-the-money options will have a
Delta of close to 100 percent. ,
337
Glossary
hitrinsic Value
The amount by which an option is in-the-money. Option premiums are
comprised of intrinsic value and time value.
Marking-To-Market
To mark-to-market is to calculate the value of a financial instrument or
portfolio based on the current market rates of the underlying(s). Most risk
management guidelines recommend marking-to-market on a daily basis.
Money Market
The money market is the market for the trading of short-term debt securities. In
general, short-term refers to any security with a maturity of up to one year.
Typical deals in this market range from $250,000 to $50 million. A secondary
market4 exists for most of the securities traded in this market.
Out-Of-The-Money
Describes an option whose underlying is below the strike price in the case of a
call, or above it in the case of a put. The more the option is out-of-the-money
the cheaper it is since the chances of exercise are reduced. The option's Delta
declines and becomes less sensitive to movements in the underlying.
Path-Dependent Option
A path-dependent option has a payout directly related to movements in the
price of the underlying during the option's life. By contrast the payout of a
standard European-style option is determined solely by the price of the
underlying at expiry.
Put-Call Parity
The relationship between a European-style put option and a European-style
call option on- the same underlying with the same exercise price and -time to -
4Markets are typically divided into a number of levels, the most important of which are the
primary and secondary markets. The primary market is the market in which securities are issued
while the secondary market is the market in which securities are traded.
338
Glossary
maturity. Put-call parity states that the payout profile of a portfolio containing
an asset plus a put option is identical to that of a portfolio containing a call
option of the same strike on that same asset (with the rest of the money earning
the risk-free rate of return).
Real Assets Versus Financial Assets

The real assets of an economy are the productive assets which determine the
productive capacity of the economy. Real assets are thus income generating
assets, used by firms to earn a return for their shareholders. Examples of real
assets include land, machinery, buildings and knowledge used in the
production of goods as well as the workers whose skills are required to
optimally use such assets. In contrast financial assets such as stocks and bonds
do not represent real assets, but represent financial claims on the income
derived from the operational use of real assets. Financial assets thus define the
allocation of income or wealth among investors.
The money a firm receives when it issues financial securities is used to

purchase real assets which are used to create wealth and to provide a return to
the shareholders of the firm. The financial assets held can thus be seen as a
proportional claim to the real assets of the firm as well as any income derived
from the use of those real assets.
In addition to the distinguishing features already mentioned, it is worth noting

that financial assets are created and destroyed during the course of business
while real assets are only destroyed by accident or by wear and tear over time.
Risk- eturn Trade-Off

Just as in life, in the investment process a prospective investor is faced with
choices regarding risk, or the allocation thereof. One may choose to keep all
spare cash in a bank account where a guaranteed return on investment is
offered, or the decision may be made to use the money in order to invest in a
riskier prospect which offers the possibility of a return greater than that offered
by the bank. The notion that an investor may be willing to choose a riskier
339
Glossary
investment over a less risky one in the hope of obtaining an increased return is
inherent in the risk-return trade-off. For this reason a considerable part of the
investment analysis function is devoted to the study of the risk-return trade-off
and its effect on rational investment decision making.
One of the most widely used techniques for analysing the risk-return trade-off
is that of modern portfolio theory (MPT) [17]. This theory is based on the
principle of efficient diversification which states that any risk averse investor s
will be better of by reorganising their investment portfolio so as to increase its
expected rate of return without increasing the total risk. The contention is thus
that by constructing an efficiently diversified investment portfolio 6 increased
returns may be achieved with a reduction in risk or at the very least no increase
in risk.
Role of Financial Markets in the Modern Day Economy

Although many people do not realise it, modern day financial markets play a
vital role in the economy. Most financial markets consist of three types of
institutions, namely:
Stock markets (equities, bonds and other securities),
Banks (or similar financial intermediaries), and
Futures and options exchanges.
In general, well constructed financial markets provide the following benefits

[111]:
5
The notion of the risk averse investor is central to investment theory. A risk averse investor is
one who requires a higher expected rate of return on an investment before the additional risk
inherent in that investment will be considered acceptable.
6 An investment portfolio may, in simple terms, be considered as a collection of financial securities
chosen in such a manner so as to provide a required or expected rate of return with minimal
associated risk 11341
340
Glossary
They enable individuals to achieve a better balance between current

and future consumption. Financial markets have the function of
bringing borrowers into contact with lenders, and in the process
making both better off.
They allow greater efficiency in risk sharing amongst investors.

Financial markets allow the elimination or reduction of diversifiable
risks as a result of holding securities with returns that are not perfectly
correlated.
They allow for the separation of ownership and management of a

business, a concept which is necessary for successful business
management. Most corporations have shareholders who have different
levels of wealth, risk profiles and expectations, but they all agree on
one thing: as long as investment in real assets continues to provide a
real marginal return, shareholders will have no objection to such
investment. With this being the case the management of a company can
be left to specialists who have as their sole objective the investment in
assets which will provide a net return greater than that offered in the
capital markets. Managers are thus able to maximise net present value
(NPV). As a result, a well functioning financial market ensures that
individual maximisation leads to a socially optimal outcome.
They allow for the efficient allocation of resources through the use of
the market price mechanism.
They allow for the analysis and control of managerial performance

through the signals contained in market prices.
As a whole, financial markets improve the quality of investment decisions as

well as the welfare of market participants.
341
Glossary
Straddle
The sale or purchase of a put option and a call option with the same strike
price, on the same underlying and with the same expiry. The strike is normally
set at-the-money. The purchaser benefits, in return for paying two premiums, if
the underlying moves enough either way. It is a way of taking advantage of an
expected upturn in volatility. Sellers of straddles assume unlimited risk but
benefit if the straddle does not move.
Structured Note
Structured notes are over-the-counter (OTC) products which bundle several
disparate elements to create a single product, generally by embedding options
in a debt instrument such as a medium-term note.
Time Value
The value of an option, other than its intrinsic value. The time value therefore
includes cost of carry and the probability that the option will be exercised
which in turn depends on the volatility of the underlying.
Volatility
A measure of the variability (but not the direction) of the price of the
underlying instrument. It is defined as the annualised standard deviation of the
natural logarithm of the ratio of two successive prices.
Historical volatility is a measure of the standard deviation of the underlying

instrument over some past period. Implied volatility is a volatility implied in
the price of the option and is a measure of the market's estimate of the future
volatility of the underlying instrument.
In traditional Black-Scholes models volatility is assumed to be constant over

the life of the option. This- may be a somewhat unrealistic assumption. As a
result new techniques have been developed to cope with the variability of
volatility. The best known are stochastic volatility, ARCH (Autoregressive
342
Glossary
Conditional Heteroskedasticity) and GARCH (Generalised Autoregressive

Conditional Heteroskedasticity).
Voiatillity Trading
A strategy based on a view that future volatility in the underlying will be more
or less than the implied volatility in the option price. The most common way to
buy/sell volatility is to buy/sell options, hedging the directional risk with the
underlying. Volatility buyers make money if the underlying is more volatile
than the implied volatility predicted. Sellers of volatility benefit if the opposite
holds.
Other strategies take advantage of the difference between implied volatilities

of differing maturity options, not between implied volatility and actual
volatility. For example, if implied volatility in short-term options is high and in
longer options low, a trader can sell short-term options and buy longer ones.
343
Appendix A: Derivative Contracts and Derivative Securities
APPENDIX A: DERIVATIVE CONTRACTS AND DERIVATIVE

SECURITIES
Tfflli1V—AT1—Derivative Contracts and Derivative Securities

-
Derivative Contracts
Privately Privately Negotiated Exchange Traded Exchange

Negotiated (OTC) (OTC) Options Futures Traded Options
Forwards
Forward Commodity options Eurodollar (CME) S&P futures
commodity options (Merc)
contracts
Forward foreign Currency options US treasury bond Bond futures

exchange contracts (CBT) options
(LIFFE)
Forward rate Equity options 9% British gilt Corn futures
agreements (FRAs) (LIFFE) options (CBT)
Currency swaps FRA options CAC-40 (MATIF) Yen/$ futures

options (IMM)
Interest rate swaps Caps, floors, collars DM/$ (IMM)
Commodity swaps Swap options German Bund

(DTB)
Equity swaps Bond options Gold (COMEX)
Derivative Securities
Structured Securities & Stripped Securities Securities With Option

Deposits Characteristics
Dual currency bonds Treasury strips Callable bonds
Commodity-linked bonds IO's and PO's Putable bonds
Yield curve notes Convertible securities

■•■
Equity-linked bank Warrants

deposits
Source: Group of Thirty, Washington DC Derivatives: Practices and Principles 1993 [64]
344
Appendix B: Rocket Scientists Are Revolutionising Wall Street
111
APPENDIX OCKET SCIENTISTS ARE REVOLUTIONISING WALL
STREET
Before coming to Wall Street in 1980, Henry Nicholas Hanson was a physicist
at Brown University, where he researched the properties of helium at low
temperatures. Now Hanson, a Salomon Brothers vice president, is one of Wall
Street's leading authorities on stock-index futures.
Stanley Diller is a former economics professor. In the mid-1970s, at the age of

40, he started a bond research department at Goldman, Sachs & Co. Now at
Bear Sterns & Co., Diller is said to earn at least $500,000 a year and tells his
colleagues: "Never call me doctor. It would cut my salary by 75 percent."
Fischer Black, one of the nations leading finance academics, left a full tenured
professorship at the Massachusetts Institute of Technology in early 1984 to
become a vice president at Goldman Sachs. Black is internationally known for
developing an option-pricing model that traders use to value stock options.
The three men represent Wall Street's new breed, known as the 'rocket
scientists' or `quants'. These former academics, trained in mathematics, and
the whiz kids, most from physical sciences, who have come after them, are
revolutionising the stock and bond markets. They are the brains behind
program trading - the controversial use of stock-index futures to lock in high
risk-free yield. They have introduced a plethora of new financial products,
including interest rate swaps, zero-coupon bonds, and new types of mortgage
backed securities. In the process, they've made hundreds of millions of dollars
for the brokerage houses that employ them and for the firm's clients.
Today the top firms employ more than 1,000 rocket scientists and usually pay
them well over six figures. _Indeed, the Wall Street whiz kids - just like top
traders and salesmen - can become millionaires in only a few years. "There is
no way a technical guy is going to make that kind of money," says Diller.
345
The first rocket scientists on Wall Street were cut from a different mould. In
the early .1970s they and their computer programs were used for back office
functions such as data processing to handle the increased trading volumes.
Although they vastly increased the efficiency of the brokerage industry, they
were pigeonholed by top management.
By the end of that decade, as interest rates began fluctuating wildly and the
deregulation of the financial markets was picking up steam, Wall Street houses
turned to the quants in increasing numbers. The firms desperately needed ways
to protect against the calamitous movements in bond prices that could wipe out
their capital. To their horror, they found that the old way of hedging one bond
against another of different maturity was often producing big losses. Rocket
scientists solved the problem using 'convexity', a tool from calculus that
describes the behaviour of bond prices when interest rates move violently.
They also designed new hedges using options and futures contracts.
Now the quants are the mainstream of virtually all activity in the markets.
They helped develop the hottest game on Wall Street: program trading. To
play, a brokerage house or institutional client usually buys stocks that make up
an index, such as the Standard & Poor's 500-stock index, and simultaneously
sells short a matching futures contract that generally commands a premium
over the underlying stocks. Risk-free profits come because on expiration the
value of the futures contract must equal the value of the stock index.
The trick is to buy as few stocks as possible, both to minimise transaction costs
and to make sure that both sides of the trade are done at the same time. Yet the
basket of securities must still track the entire index. For example, the rocket
scientists showed the program traders how they can approximate the S&P 500
index with 95 percent accuracy by buying only about half the stocks in the
index.
The quants are also involved in other types of buy programs that have nothing
to do with risk-free arbitrage. They are using their computers to decide when to
346
buy as many as 2,000 different stocks at a time worth hundreds of millions of

dollars. Doing such trades all at once saves transaction fees and reduces the
risk that the market will change before the trade can be accomplished. "Clients
call us, and we will commit to buy or sell an entire portfolio at a given price,"
says Arthur S. Estey, a vice president at Shearson Lehman Brothers and former
finance professor. Indeed, a good part of the 34 point rise in the Dow
industrials on 8 April 1988 resulted from a $300 million buy program that was
unrelated to arbitrage.
The whiz kids have also developed a kind of insurance that is being sold to
portfolio managers. As the stock market has soared, nervous clients have
sought to guard their gains. By selling short futures, big investors can protect
themselves against general market declines and still stay invested in individual
stocks. Such 'insurance' has helped keep the stock market at high levels while
reducing the level of risk to investors. "People don't have to use their capital to
make major moves just to play the direction of the market," says Hugh A.
Johnson, chief investment strategist with First Albany Corp.
The rocket scientists continue to streamline the bond market. Even during
periods of relative interest rate stability, bond managers incur risks if they
don't protect themselves against an upturn in rate. But if they're not careful,
the hedge they use can kill them. Since October, interest rate have fallen 3
percentage points. The typical hedge - usually the short sale of futures -
created a big loss. The offsetting gain should have been in the bond itself, but
companies have the right to call bonds if interest rates fall steeply. Thus a bond
holder who sells futures contracts short could find himself losing a fortune on
the short sale without making anything on the bonds themselves. The quants
were summoned and they devised hedge program that overcame the call
problem. The quants' solution "is the talk of the town right now," says Dexter
E. Senft, a managing director of Boston First Corp.
Senft, 33, has become a role model for the new Wall Street whiz kid. In 1983
he invented the collateralised mortgage obligation (CMO), a type of mortgage-
347
backed security. Rather than keep him in the corner, First Boston rewarded
him with the title and money of managing director. But no one argues that he is
overpaid. The CMO market, starting from nothing 3 years ago, is approaching
$35 billion.
Other phenomenally successful products of the quants include zero-coupon

bonds, which are issued at a huge discount but pay no interest. Currently there
are over $200 billion worth of outstanding Treasury zeros alone. Interest rate
swaps, which permit two companies to exchange fixed-rate debt for the
floating-rate variety is also a $200 billion business. Neither interest rate swaps
nor zero-coupon bonds existed before 1981.
The rise of the older rocket scientists on Wall Street has inspired a whole new
generation, many of whom have abandoned other careers. James Kennedy,
head of Merril Lynch and Co.'s Debt Strategy Group, went to medical school
in New Zealand. A member of his team, John H. Carlson, is a meteorologist
who, before coming to Merril, sold long-range weather forecasts to commodity
brokers.
James A. Tilley's Ph.D. thesis was titled The Effects of Spin—Orbit Interactions
in Itinerant Ferromagnets. Now at Morgan Stanley & Co., Tilley helps
insurance companies meet their policyholder obligations by matching those
cash needs with the flows generated from investments. He exhibits the polish
of the typical investment banker - not the dishevelment of the stereotyped
technician.
More and more rocket scientists, like Tilley, are getting directly involved with
corporate clients. Kennedy of Merril Lynch recalls a client that had a series of
payments totalling $45 million to make over 5 years and owned bonds whose
cash flows precisely matched those obligations. Merril's rocket scientists were
asked whether there might be a less expensive way to do it. They constructed a
new portfolio that would save the client $1 million. They also developed a
348
solution that could save the company even more money for a short period. The
company did, and saved $3 million.
Some analytical problems, such as matching the cash flows of assets and
liabilities, "if run to completion would occupy the largest computer
mainframes for weeks," says First Boston's Senft. "Rocket scientists get the
computer to give answers that are close enough in a short time - like 15
minutes - to reduce the risk of a change in market prices during the analysis."
The message that Wall Street wants rocket scientists is being heard on
university campuses. From MIT to the University of California at Berkeley,
big firms are actively courting students with advanced degrees in all scientific
fields. Meanwhile, investment managers around the country are struggling to
keep up with the latest techniques of the quants. "We make sure we make a
quarterly pilgrimage to the esoteric pillars of money management," says Bruce
P. Bedford, chairman of Flagship Financial Inc. in Dayton, Ohio. "Some of it
is above our heads, yeah." But "that's where the action is."
Source: Bodie, Zvi; Kane, Alex; Marcus Alan J.; Investments, Third Edition Irwin 1996 1171
349
Appendix C: Creating A Synthetic Financial Security
APPENDIX C: CREATING A SYNTHETIC FINANCIAL SECURITY
By now the reader should be aware that all financial derivatives can be
constructed via a combination of the elemental financial building blocks of
forwards, futures, options and swaps. The only difference among instruments
so created is the complexity inherent in the piecing together of these 'building
blocks'. This building block approach, a function of the put-call parity
theorem, makes possible the construction of so called synthetic securities via a
combination of one or more of the fundamental securities. Two such relations
can be readily identified [1441:
e Options can be replicated by combining a forward, futures or swap

contract with a position in risk-free securities.
o Call options and put options can be combined to produce a forward

contract.
This Appendix will illustrate the creation of a synthetic security using an

analysis of real world data.
The cash flow analysis presented in Table C.1 details the cash flows associated
with a sequence of transactions involving a convertible bond listed on the
London Stock Exchange. The bond, denominated is US dollars, pays an annual
coupon (interest rate) of 6.5 percent on a bi-annual basis. At the redemption
date (September 2004) the holder of the bond has the option of either electing
to receive the nominal face value or to convert the cash so received into
ordinary shares in the parent company (listed on the LSE and the JSE) at a
fixed consideration of US$23.04. The selection of this conversion option is
dependent on the rand price of the parent company's shares as at the
redemption date, which in turn is dependent on the exchange rate between the
South African rand and the United States dollar. The cash flow analysis
detailed in Table C.1 is the result of the following sequence of transactions:
350
Appendix C. Creating A Synthetic Financial Security
Borrow $1 million at an interest rate of Libor plus a certain premium

(possibly as much as 150 basis points).
Use this $1 million to purchase a notional amount of bonds equivalent

to $1.1 million (at an approximate yield of 8.5 — 9 percent).
Sell short' the appropriate number of ordinary shares (into which the
bond may be converted on redemption), equal to approximately 47,700
shares in this case.
Hedge the forward foreign exchange risk for the redemption date in
September 2004. In this case a forward rand/$ exchange rate of 11.69
has been used.
As a result of these transactions the cash flows from inception of the structure
to termination are:
Pay interest on the $1 million loan at Libor plus some premium

(assumed to be 100 basis points in this case)
Receive the bi-annual coupon payments on the $1.1 million notional

amount
Pay scrip lending fees
Receive interest on the cash due to the short sale of the ordinary shares
At redemption (of the bond) the investor is faced with two possibilities. If the
rand value of the parent company's ordinary shares is less than the dollar
equivalent of $23.04 (the fixed conversion price) then the cash is accepted and
used to purchase the ordinary shares in the open market which are then
I To sell 'short' is to sell shares which one does not own in the hope of purchasing them back later
at a reduced price.
351
returned to the lender. If the equivalent rand value is higher than $23.04 the
bond is converted directly into ordinary shares at a fixed cost of $23.04.
The cash considerations associated with a number of scenarios for the ordinary
share price is shown in Table C.2. By extending this table to a price of 300
rand and totalling all the relevant cash flows the profit/loss profile as a
function of the parent company's ordinary share price at redemption is
obtained, as illustrated in Figure C.1.
Note that this profit/loss profile is similar to that which would be obtained by
purchasing a put option on the ordinary shares. By using a combination of
bonds, short selling of shares, and hedging the forward foreign exchange
exposure we have created a synthetic put option with a strike price in the
region of 170 rand.
352
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Ord(R) Ord($) Profit(Loss) on redemption Net total profit(loss)

40 3.42 3053150 6,608,897
41 3.51 3005450 6,561,197
42 3.59 2957750 6,513,497
43 3.68 2910050 6,465,797
44 3.76 2862350 6,418,097
45 3.85 2814650 6,370,397
46 3.93 2766950 6,322,697
47 4.02 2719250 6,274,997
48 4.11 2671550 6,227,297
49 4.19 2623850 6,179,597
50 4.28 2576150 6,131,897
51 4.36 2528450 6,084,197
52 4.45 2480750 6,036,497
53 4.53 2433050 5,988,797
54 4.62 2385350 5,941,097
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56 4.79 2289950 5,845,697
57 4.88 2242250 5,797,997
58 4.96 2194550 5,750,297
59 5.05 2146850 5,702,597
60 5.13 2099150 5,654,897
61 5.22 2051450 5,607,197
62 5.30 2003750 5,559,497
63 5.39 1956050 5,511,797
64 5.47 1908350 5,464,097
65 5.56 1860650 5,416,397
66 5.65 1812950 5,368,697
67 5.73 1765250 5,320,997
68 5.82 1717550 5,273,297
69 5.90 1669850 5,225,597
70 5.99 1622150 5,177,897
71 6.07 1574450 5,130,197
72 6.16 1526750 5,082,497
73 6.24 1479050 5,034,797
74 6.33 1431350 4,987,097
75 6.42 1383650 4,939,397
76 6.50 1335950 4,891,697
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78 6.67 1240550 4,796,297
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85 7.27 906650 4,462,397
86 7.36 858950 4,414,697
87 7.44 811250 4,366,997
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89 7.61 715850 4,271,597
90 7.70 668150 4,223,897
358
App endix C: Creating A Synthetic FinancialSecurity
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Appendix D: The Future Financial Product Development Environment
APPENDIX ID: TEHE FUTURE FINANCIAL PRODUCT DEVELOPMENT
ENVIRONMENT
D.I INTRODUCTION
T
r. 1
he discipline of risk based financial engineering has undergone dramatic
--
_i_ changes over the past twenty years and will continue to undergo dramatic
changes in the future. Such changes have historically manifested themselves in
terms of the process of product development, the need for financial products,
the knowledge base of the financial engineer (which has undergone significant
changes, particularly in terms of complexity), and the importance of the
corporate financial engineering function.
Given the historical rate of change within this industry it follows that the
future financial engineering environment will exhibit characteristics different
to that found within today's environment. This has important implications for
organisations active within this environment because the strategy of the
organisation should be such that maximum advantage may be taken of
knowledge with regard to the future state of this environment. In other words
the organisation that is best able to foresee future trends within the financial
engineering industry, and take appropriate steps to ensure strategic alignment,
will attain a significant competitive advantage over competitors within the
industry.
In line with this concept, this Appendix has one primary function:
At the end of this Appendix the reader will have a clear understanding and
appreciation of the future financial product development 'landscape' in as
far as the risk based financial engineering process is concerned. It should
also be abundantly-clear that the financial product development process has
a great role to play in the strategic competitiveness of the financial services
organisation of the future.
360
D.2 AREAS OF CHANGE
Research conducted by the author indicates four areas of change within the
financial services industry which will have an impact on the financial services
organisation of the future. These broad based trends will affect the fortunes of
the organisation in that the rapid identification and realisation of the profit
opportunities inherent therein will provide the organisation with a distinct
advantage in an industry prone to extremely rapid rates of change (remember
the concept of industry breakpoints as described in the Competitive Strategy
Framework). In no particular order of importance, the four trends are as
follows:
The growth in the use of financial products as a means of combating

increasing volatility within the world's capital markets,
The increasing importance of risk management systems,
New product trends, and
The emergence of new risk types.
D.3 THE GROWING I[MPORTANCE OF FINANCIAL PRODUCTS
As a result of the increasing- volatility within the world's global capital and
financial markets (driven by a number of factors, not the least of which are
globalisation and technological advancement) the use and development of
volatility instruments seems set for dramatic growth. The growing use of
optionality in the world of mergers and acquisitions and development of a two-
way market in volatility swaps are just two examples of the important role
which option based instruments are set to play in the future PO].
Associated with the increasing use of volatility products will be the increasing
use of correlation products as a mechanism to reduce the cost of the volatility
361
products. For example, correlation can be used to reduce the cost of options in
a volatile environment by means of products such as basket options whose
payouts depend on the correlations between the various constituent
instruments. However, before this can be achieved more accurate correlation
pricing models will have to be developed [122].
The net effect of increasing volatility will be further growth in the use and
development of financially engineered products. It is predicted that derivatives
will move from a stand alone business to a virtual business, with an extension
of derivatives techniques beyond sales and trading into traditional corporate
finance or investment banking activities such as mergers and acquisitions,
valuing real investment decisions and the manipulation of the organisation's
capital structure. The emergence of correlation and volatility products will
allow participants within the financial markets to access these dimensions of
risk directly [5].
The future will be characterised by a deeper understanding of risk, exponential

growth in computing power and cheaper costs of information. Credit risk
products in particular, being a relatively new addition to the scope of risk
management products, will see further growth in the form of actuarial, life
assurance and behavioural risk.
D.4 RISK MANAGEMENT SYSTEMS
The use of integrated risk management systems has assumed an important role
in the active and effective management of the organisation's risk and by all
indications will assume an even greater role in the future. This increasing
importance is simply a function of the increasing complexity within the field of
corporate risk management. Software technology is increasingly used by asset
managers to manage multiple risks and enhance returns. The use of new
instruments such as asset-backed securities and increased regulatory scrutiny is
forcing organisations to turn to software based risk management solutions. As
362
investors demand more complex products with enhanced yields so valuation of

these products becomes more difficult [42].
The future will see much greater integration of risk management and trading
technology, leading to enhanced integration of the front and back office.
Enterprise-wide risk management will lead to the consolidation of risk
management data. There will be a greater integration of functions within the
financial services industry with risk and pricing models previously used for
derivatives now used for fixed-income, equity and foreign exchange products
[43].
The integration of risk management systems will not take place within a single
dimension however. Derivatives trading and risk management systems will be
required to integrate horizontally with existing applications, vertically from the
front to back office, as well as with extra third-party and in-house components
1381, 1411.
There is no doubt that the emergence of the internet as a viable medium for the
commercial transfer of information and services will have a substantial impact
on the role and use of risk management systems. Technology has historically
been a barrier for the transfer and implementation of sophisticated risk
management products to the end user. This is changing rapidly. The internet is
increasingly proving to be an efficient method of providing end users with both
the data and products required to manage risks. This is ably illustrated in
Appendix G which illustrates the lead which United States financial
institutions have taken in the use of the internet as a medium for the provision
of financial products to the end user [128].
It is further predicted that there will be an increasing convergence of the

products provided by both derivative software providers and data providers.
Software providers are increasingly realising the advantages of providing both
the software and the requisite data while data providers, not wanting to be
363
pushed out of the market, have begun to provide software solutions in

conjunction with the provided data [39].
The use of sophisticated information technologies in risk management, such as

data mining, will lead to the identification of new risks and the emergence of
new business ideas. In particular the use of data mining techniques in
conjunction with the technique of data visualisation will prove to be effective
products. This is because data visualisation 2 is able to take advantage of the
ability of the human eye to identify structures and patterns quickly and easily.
Figure D.1 illustrates a typical output of the application of data visualisation
[40].
-4t4(411..k
'cv-A1)-
Source: Davidson,
Davidson, Clive; 'Deeper Underground' Risk, September 1998 [40]
Figure D.1 A MatLab Screenshot illustrating the Use of Data

Visualisation Techniques to Show the reakdown of Exposure to Market
Risk for a Complex Portfolio
Data mining aims at finding patterns and correlations in market prices and business information
that are not immediately apparent to managers because the volume of data is too large and is
generated too quickly for the human brain to process.
Data visualisation is the process whereby complex data is converted into a graphical format
which is easier visualised by the human brain.
364
D.5 NEW PRODUCT TRENDS
The future financial services environment will of course be characterised by

new and changing product trends. Organisations that are not able to identify
and act upon such trends risk becoming strategically obsolete in a market
which demands increasingly complex products as a result of the increase in
both business, financial and operational risk which organisations have
historically experienced and will continue to experience in the future.
For example, the use of guaranteed products has grown sharply over the past
number of years due to falling interest rates, stock market volatility, and a
general shift to equity products. Such products are designed to capture business
from the traditional risk averse bond investor, and can be considered to offer a
`stepping stone' into the more volatile equities market. The market for such
guaranteed products in Europe as at the end of 1997 stood at $40 billion 11231.
An excellent example of such a guaranteed product is the guaranteed

investment savings account introduced by Barclays in the United Kingdom.
This product, which allows savers access to the stock market, uses 14 percent
of the principle amount to purchase options to protect the downside risk of
investment with the remaining amount being invested in the FTSE 100.
Interestingly enough in developing this product Barclays purposely attempted
to develop a product which the average layman could understand, clearly
bucking the trend to develop increasingly complex products [118].
The increasing shortage of government bonds (particularly United States

government bonds) may lead to a liquidity squeeze in treasuries. Given the
general reduction in government debt issues over the past number of years (see
Figure D.2) it is predicted that the use of so called high-yield 3 bonds (also
known as junk bonds) will increase 1991.
3A high-yield bond is typically a sub-investment grade corporate bond paying a higher yield than
a similar government bond given the higher credit risk associated with the corporation.
365
This increase in the use of high-yield bonds has already manifested itself in
Europe where such bonds have traditionally been treated with suspicion (as
opposed to the United States where they are far more popular). It is estimated
that European currency high-yield issues will reach $5 billion in 1998, up from
around $1.8 billion in 1997 and $0.2 billion in 1996 [991.
-77 -e.-744"--` -- 7- 1. ' W` t--

Orrty) s 444 4
Source: Locke, Jane; 'Surplus to Requirements' Risk, March 1998 [991
Figure D.2 The Decreasing T[ssuance of Government Debt
It is predicted that the future financial services environment could see an

increase in the trend towards financial disintermediation. This trend was
highlighted in the global financial services industry with the creation of a $60
million equity swap between the Ontario Teachers Pension Plan Board
(Canada) and Stichting Pensionfonds ABP (Holland) without the use of a
broker. An estimated 25 basis points was saved via the elimination of the
`middle man' in this transaction. And although there will most likely always be
a need for brokers given the difficulties in matching counterparty requirements
it is interesting to note that many of the largest pension fund schemes in the
United States have expressed keen interest in the idea of financial
arrangements conducted directly between two counterparties [581.
Finally, it is worthwhile to point out the increasing dominance of global giants

in the financial services industry with respect to derivatives products given that
this has serious implications for smaller organisations within this industry. In
the United States only eight holding companies, led by Chase Manhattan and
366
J.P. Morgan account for some 95 percent of the $28.2 trillion notional amount
of derivatives in the commercial banking system. The reason for this may be
the increased flexibility of larger organisations since the larger their
derivatives book the more natural hedges or offsets they can generate. This
does not necessarily mean the end of smaller financial product development
organisations. However, such organisations will need to adopt a clearly defined
corporate strategy in order to be competitive (remember the barbell effect as
described earlier) [137].
D.6 THE EMERGENCE OF NEW IISIK TYPES
Over the past 25 years many new risks have been created and identified both
within the financial services industry as well as the traditional business
environment. Such new risks produce many opportunities for those financial
services organisations that are able to identify the risk and develop and market
appropriate financial products. It therefore makes sense to briefly examine
some of the new risks which, by all accounts, will manifest themselves in the
21 st century.
The rapidly evolving global industry, linked by technology and non-stop

innovation, is constantly creating new risks which demand new ways of
thinking. For example, new technology which provides greater information
provides greater reason to trade, leading to increased trade volumes which in
turn has implications for liquidity dependence. Such risks are the result of the
law of unintended consequences which applies to the financial markets and the
global information economy. As markets evolve they generate unforeseen
dependencies that must be uncovered and dealt with, leading to many
commercial opportunities 1651.
One of the high growth areas in risk management in the future will
undoubtedly be that of operational risk. The definition of operational risk is
often open to much debate, but it is generally considered to be all forms of risk
not encompassed by the definitions of financial risk and credit risk. Such
367
operational risk can manifest itself in many ways, particularly large

organisational mergers where system integration is often an exceedingly
complex task. Interestingly enough, Jeffrey Skilling, CEO of Enron
Corporation, believes that financial services organisations such as banks can
learn much about operational risk from manufacturing organisations [33].
The question of increasing operational risk is so important that organisations

such as the Basle Committee on Banking Supervision are taking active steps to
ensure that banking organisations are made aware of the imperative need to
adequately manage operational risk [85]. The problem is that operational risk is
extremely difficult to define, and even harder to measure [84]. There is much
scope for organisations to solve the complex issues surrounding the
identification, analysis and subsequent management of operational risk [49].
Yet another form of risk which is set to grow in importance is that of single-
point failure. Single-point failure risk, which increases as our dependence on
technology increases, is the risk associated with the failure of a single critical
element within any system. Examples of single-point failure risk is the Year
2000 bug as well as the much publicised technical failure of the Galaxy IV
satellite in May 1998 which seriously disrupted Yahoo's financial services
website and caused 40 million pagers in the United States to stop beeping [132].
Finally, perhaps one of the most complex and difficult to identify new risk
types is that of model risk. It has always been known that mathematical models
are only as good as the assumptions on which they are based, but the past
number of years has illustrated clearly just how dangerous model risk can be.
Capital Market Risk Advisors, the well known risk consultancy, estimates that
some 40 percent of derivatives losses for 1997 ($2.7 billion) were attributable
to model risk, being the risk that model data inputs, assumptions or mispricing
errors leads to financial loss. Insufficient oversight of model - inputs and
assumptions caused Union Bank of Switzerland to book losses at around $240
million 1571.
368
A major cause of model risk is the breakdown in historical market

relationships. For example the historical volatility of the Thai baht went from 3
percent to 50 percent and its correlation with the yen moved from 0.98 to 0.04
and back to 0.82 in late 1997. Such extreme cases and their resulting financial
consequences have led to the increasing bank regulation of models by
organisations such as Britain's Financial Services Authority (FSA) and the
United States Office of the Comptroller of the Currency (OCC) [471.
In conclusion, the data presented here has shown that:
o The use of financial products, both generic and customised, looks set
to increase in the 21 St century as organisations, both financial and non-
financial, struggle to cope with an increasingly volatile business
environment, and
o Many new risk types will emerge in the future, just as the past twenty
five years has seen the emergence of concepts such as foreign
exchange risk and interest rate risk as a result of changes in the global
capital markets. This will result in an increase in the use of risk
management systems which themselves will be a function of the
financial products available to manage such risk.
It should therefore be obvious that the 21 st century will be one in which the use
of financial products will come to the fore on an as yet unprecedented scale.
Those financial services organisations that recognise this and are best equipped
to satisfy the pending demand for innovative new financial products will be
able to attain significant competitive positions within their target markets.
369
Appendix E: The Survey Questionnaire
APPENINIX E: THE S1URVEY Q1UESTIONNAIRE
The following questionnaire has been designed to measure the attitude of professionals within the
financial services industry to proposals regarding the competitive development of (strategic)
financial products. The proposals relate principally, but not exclusively, to the use of system
engineering techniques in the process of financial product development within the financial
services industry. The purpose of these proposals and/or concepts is to improve the strategic
competitiveness of the fmancial services organisation by (1) using the process of financial product
development as a strategically competitive tool, and (2) ensuring that the organisation is able to
identify, design and develop financial products at a lower economic life-cycle cost than that of its
competitors.
Your valuable input is appreciated.
Innovation within the financial product development process will play an increasingly
important role in the market competitiveness of the financial services organisation in the
future.
The development of financially engineered products is increasing in complexity.
The process by which financial products are developed can be used as a source of competitive
advantage for the financial services organisation.
System engineering overcomes typical manufacturing based product development problems

such as a lack of good early planning, an inadequate problem definition, and a short-term
product focus by placing great emphasis on the initial stages of the product development
process. Do you believe this concept to be applicable to the fmancial product development
process?
System engineering recognises the proportionally higher economic costs of downstream

amendments or changes to the product design and as such emphasises the need for
comprehensive, coherent and structured planning in the initial stages of the product
development process. Do you believe this concept to be applicable to the financial product
development process?
System engineering makes use of the concept of concurrent engineering whereby the
development
- - of
- simultaneously, both the operational and support functionality of the product takes place
- leading to reduced product development cycles, lower economic life-cycle
costs and increased product efficiency. Do you believe this concept to be applicable to the
370
Appendix E: The Survey Questionnaire
System engineering ensures that the functional definition of the product is adequately
completed prior to the operational design and development. Conceptually, it is important that
the organisation clearly understands what the product must do (functional) before deciding
how these requirements may best be achieved (operational). Do you believe this concept to be
applicable to the financial product development process?
The Financial Product Development Model as proposed by the author considers the successful
development of financial products to be dependent on: (1) the strategic fit (appropriateness) of
the product with respect to the organisation's strategic aims, and (2) the ability of the
organisation to develop the product more efficiently (minimised economic life-cycle cost)
than competitors. Do you believe this concept to be applicable to the fmancial product
development industry?
Do you believe that the concept of strategic product fit (a measure of the manner in which the
product supports and enhances the organisation's strategic aims) forms an important part of
the product development decision within a financial services organisation?
Do you believe that the application of the concepts introduced within this questionnaire, which
are inherent within the Financial Product Development Model, will be able to provide the
financial services organisation with a competitive advantage relative to competitors who may
not be aware of such concepts?
Biographical Details
ORGANISATION
JOB TITLE
HIGHEST EDUCATION
Matric Diploma Bachelors degree Masters Degree Doctorate
Other (Please specify)
EXPERIENCE IN CURRENT PROFESSION (Years)
Do you wish to receive feedback on the results of the survey? Yes No
371
Appendix F: The Value-at-Risk System
APPENDIX IF: THE VALUE-AT-RISK SYSTEM
A sample output from the value-at-risk system as detailed in Chapter Nine is

illustrated in Figure F.1 and Figure F.2 on the following pages. The purpose of
this sample output is to illustrate to the reader the type of information provided by
the calculation of VaR for a portfolio of financial securities. It should be noted
that the securities as shown here have been randomly selected by the author for
illustrative purposes and should not be considered to be any indication of the
positions taken within the Target Environment.
The data presented in cells A9:A24 is the exchange codes for the listed securities.
This input is provided by the user. Cells B9:B24 indicate the position taken in
each security, with a negative sign indicating a short position in the security. The
user is able to update the latest closing price of each security, the result of which
is shown in cells C9:C24. Cells D9:D24 use the volume held and the price data in
order to calculate a current market value for the position in each security. The user
selects the VaR confidence interval required in cell C3 which calculates the
equivalent number of standard deviations in cell C4. All other data presented is
calculated as a result of the processing of the VaR analysis, the technicalities of
which are in the embedded code underlying this system.
Column E indicates the relative liquidity of the current holding in the security.
Such liquidity is used as a measure of the risk that the organisation will not be
able to unwind the position in that security when required. The higher this
number, the more illiquid the security. Column F displays the calculated standard
deviation of returns for each security, based on a time period as specified by the
user. Column G displays the calculated daily earnings-at-risk for each security,
defined as the expected maximum loss over one day for the stated holding in the
security. Column H calculates the value-at-risk per security as the daily earnings-
at-risk multiplied by the square root of the liquidity factor. The nominal
percentage of total portfolio value and total market capitalisation for each security
is shown in columns I and J. Finally, the results of the calculation of diversified
value-at-risk are shown along the top of the worksheet
372
App endix F: The Value-at-Ris k Sy stem
."?
.e;
•- • 3 r
4:
cp
;c:Aco.i.o :
t,
Kr:06:6 ittil
Figure F. 1: A Sereeinshot of the Value-at-Risk System (Source: Own Source)

•
(471 trt %T. . op,
F‘-- CNA f:11;. 0:1:15);
: crt
1711-r,
, ; • 4:4 1
! (Li CTs — Lc) .;

co LEV CA
. , ..1 -4tIr244;
I
1
cc
• ,
;se. zA, ;se gz., g;,, <

App endix F: The Value-at-Ris k Sy stem
0 0 0 0-
0 0 CO yr '- N N- O 0) CY) 01 NNZZ
0 0 0 N
(..) 0 0T- T- N- 0 CD CO 0 LO C) CD
O ci 0 0 0 0 0 0 0 0 0 Y- 0 0 0 0
0 0 0 C5 C5 C5 C5 C5 C5 C5 C5 C5 C5 C5 C5 C5 C5
2
111 0
._o
.u)
E ig 8 8 g g ig g Oe Oe 8 g g g g 8 8g
CO (I) CO N r-- CO LO CD CO Yr CO M Yr V' N-
O 't C) CO N- CD T1- O Ce) CO VI ce) Nr CO N CO
C 0 VAR %of Portfo lio CD 6 6 ci ci ci CO ai O c1
0 -c N
-J
35
CD
CC 3 3
.c; LB Ts
> >
CO O LO LC) •-• Ln LO CO NI' st N 0) CO N-
LO cm LO N N 0) CO 0) 0 CD T4- N-
C141 03 U) CO r Tr .4r T CD LO N co in CO
03 CO N N- CT; f■ Ns M 03 LO 0) CO
N 0 1-- N N C
CO 'Cr ' C11
Figuire F.2: The Output of the Vallue-at-Risk System

O CO CO 0 11) y- LO LO N- CO CO N 0) CO ' 1.*•
a) (- LO CV 0 CV CV CO 0') CO CO 0 0 •Cr 'Cr CO
co N- Ln0;) ••1- oj e- CO LO N CO LO 0) CO
UJ 05 co
C*1 CO 05. L6 N.- t6 CO CO e- L11 r C7) CO
z 1-- "q" N NC
ID O O O O LO 0 N- CD CO 0 CO 0 x- CO N
O O N- NI- 0) 0) 0) CD CO 0) 01 01 CD CO N- 01 LC)
0) N 3 1:21 0) CO CO N- N N N 14 V LO 03 CO
Q)
Ir•Z C.6 CD CO CO N 03 CO Yr CO CO N 0 C) 14- N CO
N O CO "c) Tr co cm co Tr N Tr 00 N N 01 01 01 T T
CO P 0 C., 0 0 0 0 0 0 0 0 0 0 0 0
Ti* CO (/)
Car (xi 6 6 O ci O ci ci O ci 6 6 ci O ci ci ci
oe O co 001%- NN-
.c O
0 O
0
U)
2
U) 6 O
O
U CD CO CO LO LO0 0 CD LO 0 0 0 0 0 0 0
Marke tValue
0 0 CO Nr r-- O) 0') LO 0 r••• CO CO C) LC) CO C:) C)

0 1:1- N N N CO CD N CO CO 0 CD f■ 01 CO CD
O 01 N N LO N f■ C6 CO 06 1- C1 'TJ N- LO 1- C6
N- 03 •,- 0) •,- N- N CO CO CO N x- LO N- 0)
..- .4. , Tr I .-- Tr T- LO U..) 14- C
0 •-- CO
.
...E.) Tr O ca, c) co in in co c) O LO 0 0 0 0 0 LO
O CO C.) CO CO co v.) O cn to c) LO N O 0 CO N 0) It)
t: N O O N co x— Lc) r•-. In co Ln
N) N CO v- LO
cp 0000 0000000CD00OO (0
9
0 0 0 0 CD 0 0 0 Co CD LO
0 CO 00 LO CD LC) 14•-• Ll) 0) CO 0 co
0. r- coLn co in cm co co oo
Eq u iv No. ofStd Dev's
VAR Confidence Level
co ' CO CO .1- CD ID N
Source: Own Source
N
StockCode
cr,
2 2
a) Lu F- () CC 2E
0 2 0 __I LIL
Ca U. cz 2E -I 0) W F- 0) LU CI co n: 0
0 g( d co c) LL 0 2 2E CL 0) 3: 2E
App endix G: On-Line Ris k Management Service Providers
• i■t
-
..
*
i..
,,3
;;.— -- ..i
CZ)
•—.
. 0..
'--.4
CC
U
....
z...
C ,
4,...
E•••.4
k.
C:)
c)
4.
.4E,--,
Pricing Forecasting
k, r
4)
6r4
c)
Z
Goldman Sachs Yes Yes No * Yes Yes Yes Yes Yes
c)
Z
0
cu
cn
cn
C)
ci)
En
cn
cn
eu
Morgan Stanley Yes (equity Yes (equity

only) only)
›-'
V
V)
JP Mo rgan Yes No * Yes No * Yes Yes Yes
*
*
›-'
a)
Z
0
U,
›-4
cU
0
Z
Z
0
CI)
CI)
cu
cn
Bank of Amer ica Yes (forex

only)
*Under development
Source: Reed, Nick; 'One for All'Risk, March 1 998 [1 28]
tr
Appendix H: Option Pricing and the Delta-Gamma Methodology
APPENDIX IE: OPTION PRICING AND THE DELTA-GAMMA
METHODOLOGY
The Delta-Gamma methodology for the calculation of value-at-risk for non-

linear securities relies, to a large extent, on the theory of option pricing which
has been developed since the early 1970s. The pricing of financial options is
inherently complex given the non-linear nature of these financial securities as
well as the stochastic nature of the underlying financial price returns. In 1973
Fischer Black and Myron Scholes solved the problem by constructing a special
portfolio of financial securities. This portfolio consisted of a long (positive)
position in a call option, a short (negative) position in the underlying security,
and a risk-free investment.
Mathematically let II denote the value of a portfolio of one long position of the
option and a short position of some quantity delta ( A ) of the underlying:
= V(S, t) - (11.1)
where S is the underlying security and V(S,t) is the value of the option on
underlying S with time to expiry T — t where T is the expiry date of the
option and t is the current time. On the assumption that the underlying follows
a log-normal random walk the change in the value of the underlying over small
time periods can be represented by:
dS = pSdt + o-SdX (H.2)
where dS is the change in value of the underlying, p is the drift rate (mean)
of the underlying, dt is the change in time, a is the standard deviation of
returns of the underlying and dX is equivalent to a random variable, drawn
from a normal distribution, with mean zero and variance dt . Equation (H.2) is
the classical definition of the random walk model of asset price returns.
376
The change in value of this portfolio from time t to t + dt is then:
dfI = dV — AdS (H.3)
This stochastic differential equation cannot be solved via conventional

calculus, but requires a special subset of calculus, namely stochastic calculus.
Using a mathematical concept known as Ito's lemma (a method of solving
stochastic differential equations) the solution to (H.3) can be expressed as:
av av 1 2 2
dt + — dS + — a S
a 2v
dV =
at as 2 as'
dt (H.4)
The total portfolio thus changes by:
dri a v dt + a v dS + —1 a' S2 a2v dtAdS

=
at as 2 as 2 .(H.5)
The randomness in this portfolio is introduced via the dS and AdS terms.
as
as
av
This risk can be eliminated completely by choosing A such that A = — . This
as
reduction in randomness exploits the correlation between two instruments in
order to eliminate risk from a portfolio of such financial instruments, a concept
commonly known as delta hedging.
By choosing A as has been done one now holds a portfolio whose value
changes according to:
d11 =
( av 1 2 2 a 2 v jdt
at+2— c as 2
(H.6)
377
Appendix H. Option Pricing and the Delta-Gamma Methodology
This change is completely riskless. According to the theory of no arbitrage one

cannot earn excess returns by holding a riskless portfolio. Hence this portfolio
must earn the risk-free rate of return given by:
dri = rIl dt . (H.7)
where r is the risk-free interest rate.
Substituting into (H.7) one can see that:
av
at 2 2 2 av
+ 2 0- s as 2 +rsav r V = 0
- (H.8)
as
This is the Black-Scholes equation, which in this form represents a linear

parabolic partial differential equation. The most common closed-form solution
to this differential equation can be represented by:
Co = SoN(di)— Xe -rT N(d z) (H.9)
where
= ln(So/X)+ (r + o-2 / 2)T

(H.10)
d2 = — al,ff (H.11)
and where
Co = Current call option value

So = Current stock price
N(d) = The probability that a random draw from a standard normal
distribution will be less than d .
378
X = The exercise price of the option

2.71828, the base of the natural logarithm function
Risk-free interest rate (the annualised continuously compounded
rate on a safe asset with the same maturity as the expiration of
the option)
Time to maturity of the option (in years)
In = The natural logarithm function
o- = Standard deviation of the annualised continuously compounded
rate of return on the stock
strike = 0.65 USD/DEM. Value in SD/DEM
Option value
0.06
005 Full valuation
0.04
0.03
0,02
0.01
Delta + g amma
0
0.01 Delta
-0,02 ii i ' I i I
0.60 0.61 0,62 0,63 064 0,65 0.66 0.67 0.68 0.69 0.70
USD/DEM exchange rate
Source: J. P. Morgan; RiskMetrics Technical Document, 4th Edition [83]
Figure H.1 Delta Versus Delta-Gamma Methodology
As should be apparent, delta as described previously represents the rate of

change of the option value with respect to the underlying. This knowledge is
useful because this enables one to determine the approximate rate of change of
an option portfolio with respect to movements in the underlying securities,
379
knowledge of which is important in the calculation of value-at-risk. However,

as illustrated by Figure 11.1, delta is only useful with respect to small changes
in the value of the underlying. As the underlying moves further away from its
current level so the delta estimate of the change of value of the portfolio
becomes less accurate.
This inaccuracy can be compensated for by including gamma, the rate of

change of delta, in the estimation of the change in option value with respect to
a change in the value of the underlying. Conceptually gamma is the first
derivative of delta and the second derivative of the Black-Scholes equation
with respect to the underlying.
On the assumption that a portfolio consists of an option on stock the

relationship between the change in the underlying &S and the change in value
of the option ST/ is:
av a2 v av
by — efss + a)) ...(H.12)
as 2 as
(
According to the random walk theory:
= pSgt + oSgt 2 0 (H.13)
where 0 is drawn from the standardised normal distribution. It can therefore

be written that:
av av 1 a2 v av
= — crS gt 2 0 + 64 pS + (7252 0 2 + )+ (H.14)
as as 2 as 2 at
which can be rewritten as
380
1 1 , , 2 av
SV = AoSgt 2 0 + gt(ApS+ -ircr- S - 0 - ± — )+ .(H.15)
at
av
where A = — , the partial derivative of the change in value of the option with
a
32 17
respect to the change in value of the underlying, and F = , the partial
as 2
second derivative of the change in value of the option with respect to the
change in value of the underlying.
To the leading order the change in value of the option is proportional to that of
the underlying. In the next order there is a deterministic shift 67/ due to the
shift in S and the theta (time decay) of the option. The effect of gamma is to
introduce a term that is non-linear in the random component of SS .
381
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[15$] Tufano, Peter; 'How Financial Engineering Can Advance Corporate

Strategy' Harvard Business Review (January — February) 1996
van der Ven, A. H. G. S.; Introduction to Scaling John Wiley & Sons
1980
Vaughan, Emmett J.; Risk Management John Wiley & Sons Inc. 1997
Walizer, Michael H.; Wienir, Paul L.; Research Methods and Analysis:
Searching for ' ellationships Harper & Row 1978
Weiss, Gary; 'Chaos Hits Wall Street — The Theory That Is'
BusinessWeek 2 November 1992
Williams Jr., Arthur; Smith, Michael L.; Young, Peter C.;"ask

Management and Insurance, Seventh Edition McGraw-Hill Inc. 1995
Wilson, David R.; Wunnicke, Brooke; Wunnicke, Diane B.; Corporate

Financial Risk Management: Practical Techniques of Financial
Engineering John Wiley & Sons 1992
Yeager, Gordon; 'The est Method For Accurate Risk Measurement'

Corporate Finance, November 1996
Wheatley, Kathleen K.; Wilemon, David; 'Global Innovation Teams: A

Requirement for The New Millennium' Portland International
Conference on Management of Engineering and Technology, 1999
391
Bibliography
Campbell, John Y.; Lo, Andrew W.; Mackinlay, A. Craig; The

Econometrics of Financial Markets Princeton university Press, 1997
Wilmott, Paul; Derivatives: The Theory and Practice of Financial

Engineering John Wiley & Sons, 1998
Wilson, Thomas C.; 'Value at 'sk" Risk Management and Analysis:

Measuring and Modelling Financial Risk (Edited by Carol Alexander) John
Wiley & Sons, 1999
Black, Ian; Ritchie, James; 'Product Design and Manufacturing

Methods — Learning the Historical Lesson' Portland International
Conference on Management of Engineering and Technology
[171] Ross, Stephen; 'Lessons From Two 1) ) evades in the Risk Management
Morgue' Risk, May 1999
Herman, H.; enchmarking A Neural Network Forecaster Against

Statistical Measures M.Eng Thesis, Rand Afrikaans University, 1998
The JP Morgan Guide to Credit Derivatives, 1999
392
Index
index
A C
Active versus passive management 321 Call option 100
Advanced Micro Devices 159 Callable swap 327
Aggregate project plan. 176 Cap 327
Agile manufacturing 156 Capital adequacy 153, 328
Alliances and partnerships 177 Capital allocation 77
Amazon.com 20 Capital Asset Pricing Model 335
American options 101 CAPM See Capital Asset Pricing Model
American-style option 322 Caps 105
Amortisation 322 Cargill Inc. 28
ARCH See Autoregressive Conditional Cash instruments versus derivatives 328
Heteroskedasticity Cash settlement 100
Asset backed securities 32 CBoT See Chicago Board of Trade
Asset swap 323 Change forces 148
Asset-backed security 323 Change leader versus change reactor 153
Asymmetrical risk distribution 103 Change leadership 147
AT&T 219 versus change management 148
At-the-money 323 Chaos theory 30
Autoregressive Conditional Heteroskedasticity Chicago Board of Trade 28
343 Citicorp 229
Cliquet option 329
Coca-Cola 229
Collar 329
Baan 228 Collars 105
Bank for International Settlements 72 Commodity buying mode 169
Bankers Trust 77 Compaq 227
Barbell Effect, The 28 Compartmentalised strategic integration .... 180
Barrier risk 324 Competitive Strategy Framework
Basis 324 definition of 141
Basis risk 324 development of 140
Basis swap 324 identification of competitive strategies... 143
Basket option 325 integration of 185
Bear 321 integration within document 141
Bilateral netting 325 purpose of 187
Binary option 325 Complexity theory 229
Biotechnology 22 Concurrent engineering 156, 225
BIS See Bank for International Settlements Confidence interval 83
Black, Fischer 376 Consulting buy mode 170
Black-Scholes option pricing equation 70 Convergent breakpoints 150
Black-Scholes option pricing formula 104 Convertible bond 329
Black-Scholes option pricing model 190, 260, Core capability 259
325 definition of 177
BMW 234 Core product 168
Boeing 242 Corporate financial risk management
Aircraft Creation Process Strategy 243 definition of 38
Bond markets 326 Corporate memory 246
Bond yield 326 Correlation 239
Bond yields Correlation matrix 274
convergence and divergence of 52 Correlations 73
Boston Consulting Group 220 Covered call 329
Brain based economy 157 Covered put 330
Break-forward 327 Creativity in product offerings 227
Breakpoint dynamics 149 Credit derivative 330
Breakthrough projects 176 Credit derivatives 3
Bretton Woods agreement 61, 336 Credit risk 46, 91
Brownian Motion 70 Cross-currency -swap 330
Bull 321 CSF See Competitive Strategy Framework
Business risk 40 Currency forwards 94
Buying mode model (modified) 168 Currency option 101
Currency risk 45, 105
393
Index
B Financial innovation
as a competitive advantage 167
Daiwa Bank 50 the importance of 20
Data visualisation 33 Financial intermediation 335
DDE See Dynamic data exchange Financial leverage 52
Decision analysis 188 the effect of derivatives on 51
Deep in-the-money 337 Financial management
Dell Computer 234 the importance of 29
Deloitte & Touche Consulting Group 229 Financial markets
Delta 81, 330 the role of 340
Delta hedging 377 Financial product
Delta-Gamma methodology 269, 376 definition of 9, 26
Delta-Gamma VaR methodology 81 Financial Product Development Model
Derivative projects 176 an overview of 212
Descriptive research 8 as a structured product development process
Digital Equipment Corporation 172, 234 203
Divergent breakpoints 150 design integration 219
DNA 27 integration of phases 214
Dow Chemical 156 life-cycle cost minimisation 217
Downwards/upwards traceability 131 problem definition 228
Dynamic data exchange 278 product design and construction 241
product development process analysis 245
product feasibility analysis 230
product functional analysis 236
E-commerce 228 product operational requirements 232
Efficient market hypothesis 331 product support and maintainability 225
Electronic banking 228 product testing and evaluation 244
Engineering purpose of 186, 202
definition of 57 strategic analysis 222
Enron 227 technical performance measures 237
Equilibrium pricing relationships 334 the development of 205
Equities market 334 the need for 204
European Monetary Union 75 Financial product innovation
European options 101 drivers of 25
European-style option 335 future state of 26
Evolutionary cycle of competitive behaviour the self reinforcing process of 26
150 Financial risk
Exchange traded derivatives 91 the elimination of 37
Exotic option 335 Floor 336
Expansive systems development 159 Floors 105
Extended Delta-Gamma methodology 266 Ford 143
Foreing exchange market 336
Forward contracts 92
F Forward rate agreement 80
Fat tails 79 Forwards 91
Feynman's theory of quantum electrodynamics Foundation for Research and Development
71 (FRD) 21
Financial derivatives Fujitsu 173
definition of 89 Functional analysis 276
Financial econometrics 74 emphasis of 130
Financial engineering hierarchical nature 131
advancement of corporate strategy 64 Functional block flow diagram 130
and science 70 Functional flow diagram 276
at Merck & Co. 191 Futures contracts 99
author's definition of 60
background of professionals 70
compared to conventional engineering 59
definition of 58, 59 Game theory 192
increasing importance of 25 analogy to war games. 196
the need for - 61 and corporate strategy 193
Financial engineering applications as used by Nintendo 193
arbitrage 68 as used by Trans World Airlines 195
financial structuring 69 decreasing your opponent's added value 194
hedging 66 increasing your own added value 194
speculation 68 Gamma 81, 330, 336, 380
394
Index
GARCH See Generalised Auto-Regressive J

Conditional Heteroskedasticity
Gearing 68 J. P. Morgan 75, 81, 260
General Electric 143 Johannesburg Stock Exchange 69
Generalised Autoregressive Conditional Johnson & Johnson 227
Heteroskedasticity 343
Generalised Auto-Regressive Conditional
Heteroskedasticity 76
K
GIGO 273 Knowledge management 155
Globalisation best practice companies 156
the effect of 27 Kondratieff Waves 24
Goldman Sachs 71 Kurtosis 273
Good decision 188
LCC See life-cycle cost

Hedging 46, 337 Learning culture in the organisation
arguments for and against 47 six key elements 174
Herd mentality 183 Leptokurtosis 77
Hewlett-Packard 147 Levels of maintenance 125
High-tech entrepreneurship 165 Levi Strauss 234
Historical volatilities 274 Libor See London Interbank Offered Rate
Historical volatility 342 Life-cycle cost 111, 115
HOQ See House of Quality Matrix Life-cycle cost minimisation 214
House of Quality Matrix 128 Liquidity risk 45
Live catastrophe coverage 28
II Log-normal distribution
and financial returns 77
IBM 33, 143, 149 London Interbank Offered Rate 98
Iceberg effect 111 London Stock Exchange 69
Imbedded option 327 Long Term Capital Management 50
Implied volatilities 274
Implied volatility 238, 337
In the money 101
Incumbent leaders versus challengers 171 Maintenance support elements 126
Industry breakpoints 149 Margin payments 92
example of the identification of 152 Market creation 227
Information revolution 22 Market innovation 167
Information versus knowledge 155 Market price mechanism 341
Initial margin 92 Market risk 44,72
Innovation Market timing 321
and increased market share 22 Mass customisation 234
commercial viability of 24 Massachusetts Institute of Technology 33
importance of in the 21st century 22 Mattel 234
in the South African manufacturing sector2l McGraw-Hill 234
Innovative products McKinsey & Co. 220
as a competitive advantage 204 Merck & Co 189
Intel 143, 227 Merrill Lynch & Co. 30
Intellectual capital 225 Metallgesellschaft 49
importance of 157 Microsoft 227
Interest rate collar 105 Mission profile 123,272
Interest rate floor 105 Mitsubishi Heavy Industries Limited 127
Interest rate parity 95 Modern Portfolio Theory 340
Interest rate risk 44 Modigliani and Miller
Internal rate of return 190, 192 active risk management hypothesis 41
International interest rate parity 334 Money market 338
Internet, The 23 Monte Carlo analysis 80, 82, 269
In-the-money 337 Monte Carlo Analysis 191
Intraventures 165 Moody's Investors Services - 330
Intrinsic value 338 Morgan Stanley & Co. 71
Intrinsic value of an option 103 Motorola 227
Invisible hand, The 185 MPT See Modern Portfolio Theory
IRR See Internal rate of return
Ito's lemma 377
395
Index
N Product buy mode 169

Product design
Nanotechnology 22 definition of 56
Natural hedge 73 Product development
Net present value 190, 192 as a sequential process 240
Netscape 20 Product development process
Neural networks 30 importance of 204
New Economy, The 22 Product effectiveness requirements 275
New product development Product innovation 168
as a strategic advantage 172 as a competitive advantage 164
as an economic battleground 204 Product performance parameters 273
New York Stock Exchange 8 Product ranges 164
Nintendo 193 Product utilisation 275
Nissan 195 Profit seeking business
No arbitrage characteristic of 77
the theory of 378 Put option 101
Non-linearity of financial instruments 80 Put-call parity 334, 338
Normality
of financial returns 79
NPV See Net present value Q
NYSE See New York Stock Exchange QFD See Quality Function Deployment
Quality Function Deployment 127
Quality of financial product
author's definition 244
Objectives tree 127 Question Hierarchy 5
Offensive innovation 21
Offer innovation 168
Operational deployment 123
Operational deployment factors 271 Random walk hypothesis 333
Operational life-cycle 276 Random walk model 376
Operational life-cycle horizon 124 Random walk of financial prices 32
Optimal learning cycle 246 RAROC...See Risk Adjusted Return on Capital
Option contracts 100 Real assets versus financial assets 339
Option premium 100 Repair policy 126
Options 91 Requirements churn 235
Options analysis approach to decisions 190 Research and development projects 176
Options approach to capital investment 192 Return on capital 77
Orange County 50 Reward-to-risk ratio 77
Organic growth 21 Risk
OTC See Over-the-counter derivatives definition of 39
Out-of-the-money 338 elements of 39
Outperformance option 239 reasons for the increase of 43
Over-the-counter derivatives 91 reasons for the reduction of 41
Risk Adjusted Return on Capital 77
Risk management
modern day failures of 49
Path-dependent option 338 RiskMetrics 81
Pattern recognition 30 Risk-return trade-off 339
PDF See Probability Density Function Ritz-Carlton hotels 234
Pedagogical features 14 Rolling hedge 49
Per capita income
effect of innovation on 23
Plain vanilla option 239
S
Platform projects 176 SAFEX.... See South African Futures Exchange
Portfolio diversification 73 Salomon Brothers 50
Portfolio revaluation (versus analytical Samsung 227
approximation) 82 SAP 227, 228, 231
Portfolio risk 73 Scholes, Myron 376
Power of reflection 223 Scientific product decisions 188
PricewaterhouseCoOpers 229 Securitisation 32
Probability Density Function 83 Security market line 334
Process innovation 168 Sega 193
Proctor & Gamble 227 Semi-strong form efficient markets 332
Product augmentation 257 Shearson Lehman Brothers Inc. 30
Product augmentation innovation 168 Shell International Petroleum 229
396
Index
Simple Delta methodology 266 Time value of an option 103, 342

Skewness 273 Total Quality Management 151, 177, 244
Skinner's manufacturing framework 179 Toyota 225, 284
Sony 193, 195 Toys R Us 194
South African Futures Exchange 262 TPM See Technical Performance Measures
SPC See Statistical Process Control TQM See Total Quality Management
Spot-futures parity 334 Trading circuit breaker 183
Standard & Poor's 330 Treasury systems 231
Statistical . Process Control 244
Stochastic calculus 70
Straddle 342
Strategic Circuit Breaker 183, 215, 223, 254 UAT See User acceptance testing
Strategic fit 179 Underlyings 90
Strong form efficient markets 332 United States Department of Defence 30
Structured notes 342 United States Federal Reserve 90
Successful product User acceptance testing 283
definition of 222
Swap 96
Swaption 106 V
Synthetic securities 230 Value at Risk 153
System V aR See Value at Risk
classifications of 114 Variance margin 92
definition of 113 Vega 337
System buy mode 169 Vega (Kappa) 81
System effectiveness requirements 124 Vertical traceability 276
System engineering Visual Basic for Applications 282
the definition of 113 Voice of the customer 122
the need for 111 Volatility 74, 342
System engineering process Volatility clustering 76
design integration 134 Volatility measurement techniques
development of consumer need See exponential moving average 75
feasibility analysis 122 Generalised Auto-Regressive Conditional
four principle drivers 206 Heteroskedasticity 76
functional analysis 130 simple moving average 74
maintenance and support 125 Volatility trading 343
operational requirements 123
operational use and sustaining support 135
problem definition 120 w
production 135
Wal-Mart 148, 194
requirements allocation 131
Weak form efficient markets 331
system synthesis 133
Wells Fargo 234
Technical Performance Measures 126
134
Whole product approach 235
testing and evaluation
System functional hierarchy 237
System integration 125 x
System utilisation requirements 124
Systems versus products 115 Xerox Corporation 246
T Y
Tactical strategic integration 180 Yamaha 152
Target Environment 252 Yield curve 327
Technical performance comparatives 238 Young & Rubicam 147
Technical Performance Measures 273, 279 See
Technology integration
Texas Instruments
161, 260
229
z
The Competitive Strategy Framework 215 Zero-sum contracts 90
Theta 81, 381 Zero-sum instruments 52
Thomson Consumer Electronics 221
Three-part-learning organisation - 151
397
Courses will be structured in a modular IMEIEPIROSIE SOLMORIS
fashion over a period of four months dur-
ing which time progress will be monitored
by mentors, who will be allocated to each
student upon acceptance into the
GAG MGM
Academy. 0
Nevhutalu confirms that selected can-
didates will be required to sign an em-
ployment contract prior to commence-
Becoming a trusted partner
ment of training, that will tie them to the
company for a period. t he IT midrange sector has become a standards because of the value-added fo-
This is understandable considering the _ difficult area in which to operate. It's cus of our business. We sell end to end
investment CCH will place in these young highly competitive with all major vendors solutions that are hardware-centric.
people. vying for a cut of the business. Enterprise platforms are utilised in cor-
Nevhutalu says that an important aspect As the technology develops, these porate mission critical applications. Any
of the scheme is that the 40 candidates servers or enterprise platforms have be- one installation is a lengthy process
become full employees of the group, from come commodity items with no real mar- inclusive of pre-sales consultation with
day one, with all of the benefits that gin to be made on the hardware. Profit regard to configuration for customers, per-
accrue to CCH staff, with the exception of goals now centre on the value-added conformance tuning, capacity planning, sys-
share options. sulting services and implementation of the tems architecture, network design and
The commitment from senior manage- systems. data management.
ment is intense, in that selected can- CCH Enterprise Systems MD Andrew Redundant arrays of inexpensive disks,
didates will be interviewed by each mem- Sims says as enterprise platforms are the capability, redundancy, security and back-
ber of the executive, prior to being offered company's core business, the real trick is up solutions are also crucial "added val-
permanent employment. to stay ahead of the commodity curve. ues" in the tailoring of a solution for
Nevhutalu says the proposed scheme is This is achieved, he says, in various ways, clients, he says.
a costly exercise but it forms part of CCH's including developing firm relationships CCH Enterprise Systems is a solutions
commitment to delivering meaningful em- with vendors and becoming a trusted part- reseller of Sun and Hewlett-Packard hard-
powerment to the previously disadvan- ner with its corporate clients. ware platforms, that Sims says are equally
taged. ❑ "We protect our margins above industry weighted with regard to software and
CORHICDKI 4MMHOGDCX24
Ni- ERNATKDVAL. FREIG -IT FORWARDERS
Congratulates Computer Configurations --Eoldings
on their Phenomenal Success
WE DELIVE COMPETITIVE ADVANTAGE

TO OUR CUSTOMER'S SUPPLY CHAIN
www.za.0 rftntrans.com
FSUT 0 11
Telephone : 45 24'01
10 FINANCIAL MAIL NOVEMBER 26 1999

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CECIL
ntranet. Staff are expected to log their Thought, says collaboration is not enough. Several other initiatives and pro-
ales leads and feedback on the intranet, Specific knowledge-sharing projects that grammes have also been implemented to
o that colleagues have instant access to span the entire organisation must be an develop intellectual capital.
his when they approach the same cus- integral part of the work. This is "not an To ensure new sales recruits understand
omer. add-on frill that can safely be ignored", the CCH culture, they do a tour of the
"I have been accused of being bureau- warns Gates. group, and work in various divisions and
ratic," says Pinheiro, "but it is such sys- "Knowledge management is vital to the subsidiaries.
ematic processes that allow us to pursue success of our business," says Shuter. "We invest time and effort in motivating,
cur cross-pollination strategy between op- "Though the investor community is not educating and rewarding people, bringing
rations. We have been able to extract there yet, IT companies will be rated ac- out the best in them and getting them to
remendous value through this approach cording to their intellectual capital in fu- work as entrepreneurs," says Pinheiro.
o doing business." ture." CCH is also investing heavily in black
Pinheiro and senior executives are not He should know. As the former head of empowerment through the Yashu Trust
lone in their quest to record and structure investment banking at Standard Corporate and through the soon-to-be-listed data
vork processes. Microsoft chairman Bill & Merchant Bank, Shuter was instrumen- storage manufacturing initiative, Orca
sates, in his book, Business @ the Speed of tal in CCH's listing in September 1997. Technologies. ❑
VASFIU ACADEMY those selected will be black. He says that we will look more favourably on com-
white graduates are not the target. panies implementing meaningful empow-
"We have interviewed 500 students from erment programmes."
EH0,1110
„
various universities, including Fort Hare, He says the group will also provide
Rhodes and Wits, but specifically from the training on business issues in the form of
UDIT University of the North where we hope to
source the bulk of our
customer relationship skills development.
ielp for those who missed out graduates". Nevhutalu

says the candidate's
attitude, aptitude and
ue to political oppression and rejection academic record will
F3 of the government-controlled educa- be scrutinised and
on system, young black people missed graded. Candidates are
le opportunities that arose with the IT short-listed, re-inter-
evolution in this country in the early viewed and again
,ighties. short-listed, until the
As a consequence, no scope was pro- final selection is made.
ided for black people to gain a foothold in He continues: "We
le IT industry says Lufuno Nevhutalu, will judge the areas of
xecutive director of Computer Config- interest of each stu-
rations Holdings (CCH), says that because dent.
f this no scope was provided for black "Upon final selection
eople to gain a foothold in IT. candidates will be
He confirms that CCH plans is address- trained in designated
ig this problem, as part of the group's IT domains, including
verall empowerment strategy, by setting software development
p Yashu Academy for industry training of through CCH Software
lack IT graduates. Futures and IT consult-
"We decided that the best way to attract ing services through
lack graduates was by providing them CCH Consulting. More
nth much needed experience in terms of technical areas like
ractical industry training. We intend to Unix support or NT op-
ecruit 40 graduates for the current fi- erating systems will be
ancial year, which ends in June 2000," handled by CCH Enter-
ays Nevhutalu. prise Systems.
He says the company will only take "Most of the training
that he describes as the cream of the crop will take place at CCH
ut that the selected black graduates will Software Futures, but
nly start early next year, to give them some will be subcon-
me to sit repeat examinations, where tracted to training
ecessary. houses. This initiative
Nevhutalu confirms that university com- is expected to produce
uter science departments were furnished spin-off business for
nth selection criteria aimed at black, In- outside companies. In Lufuno Nevhutalu . . practical training attracting blacks
ian and coloured graduates, but 80% of awarding contracts,
FINANCIAL MAIL • NOVEMBER 26 • 1999

CULTIONE
INTEL. ECTUAL PROPERTY GOES

HEAD TO HEAD IN BUSINESS
Disseminating information creates a rich store of knowledge
Gandeneral Electric chairman Jack Welsh

said: "An organisation's ability to learn,
to translate that learning into action
people — and make it available to all
employees, CCH has implemented a com-
prehensive knowledge management pro-
rapidly, is the ultimate competitive ad- gramme, says group COO Rob Shuter.
vantage." Software programs and the corporate
During the past two years CCH staff has intranet are used by staff in different di-
increased more than tenfold but such visions around the country to share best
growth represents a challenge. An inability working practices and insights about cus-
to maintain a common culture and retain tomers and business partners.
scarce skills has been the downfall of "People take a simplistic view of in-
many promising IT firms. tellectual property. They see this as the
CCH executives echo Welsh's advice as proprietary hardware and software tech-
they strive to capture the skills and knowl- nologies in a company. But people are a
edge of their staff and share it with the rest large part of this," says Shuter.
of the organisation. He adds that CCH is recording work
"CCH is valued highly by investors be- processes, staff skills and project infor-
cause of its intellectual capital," says chair- mation. A benefit of this, for example, is
man Mario Pinheiro. "We have a unique that project managers are able to locate
formula, integral to our success, that glues key skills even if staff have moved to
the business together and is key to mo- different jobs within the group.
Rob Shuter . . we're valued highly by tivating and empowering our people." Cut-and-paste templates have been
investors because of our intellectual capital To capture this culture — including the drawn up for sales presentations and
tacit knowledge in the heads of skilled scripted corporate documents are on the
"What do a surpn lag

nn um oer of infloygiv
companies
in common? The Very Idea is not an advertising agency in the
conventional sense. We prefer the term "marketing".
That's because we specialise in providing marketing
solutions for IT. Our deep understanding of the IT
industry, and our unmatched creativity is what, we
believe, sets us apart. We're proud of the company we
keep, which is why we're delighted to be associated with
an IT organisation as innovative as CCH.
• -______
Why not give us a shout to see what we can do for your

IT company, by calling Deon on (011) 803-2827 or
email: deon@theveryidea.co.za
Creative Marketing for IT

, trazicarN• .
FINANCIAL MAIL • NOVEMBER 26 1999 7

CCH
'he CCH Compute Utility runs and man- ment on the go. CCH's competencies. It looks at the needs
[ges data-centre facilities, call-centres, Staying ahead in fast-moving IT is cru- of the client and devises a solution that
ransaction switching, application hosting cial. CCH Software Futures is focused on taps into CCH's broad range of products.
,nd disaster recovery services. CCH In- new wave technologies and application Customer relationship management
racom is a project management company development for delivery over the Inter- (CRM), for instance, requires a strong in-
pecialising in the construction and fit- net. frastructure foundation but also needs
nent of "intelligent buildings", facilities The proliferation of new ways to access strong knowledge management pro-
imilar to those managed by The CCH the Internet — from the familiar PC, to cesses.
:ompute Utility. mobile devices to set-top boxes for the TV But Ling is adamant that each of CCH's
"Companies are realising that infras- — is a strong force driving development. businesses is market facing and ready to
ructure is a bottleneck to getting new The next generation of cellular phones, for respond to client needs.
entures out of the starting blocks," says instance, will have software that allows Beyond the five business units, CCH also
ing. The CCH Compute Utility and CCH financial transactions to be conducted operates CCH Future School, an IT ed-
*acorn are a response to a worldwide from the phone. ucation and training facility. It's a lucrative
'end towards infrastructure outsourcing On the technology side, CCH Enterprise sideline that offers highly focused training
- why own it when you can rent it? Systems offers hardware and software so- courses in CCH's areas of core compe-
In the US, chipmaker Intel is investing lutions plus professional services. tency, such as object orientated devel-
[5$1 bn on Webhosting data centres. Busi- The rationale behind CCH Enterprise opment. "It's a good business to be in,"
esses now also rent rather than buy soft- Systems is that it's impossible to deploy says Ling, "but we must create IT capacity
/are, accessing the system through the any new business without technology — in this country." Training is also tied back
iternet. both hardware and software. to Yashu Academy, CCH's empowerment
Bundling a number of services under "The key to success here is continuously vehicle, to increase black IT skills.
ne roof gives The CCH Compute Utility a _ ensuring that the technology we have is The market responded well to the re-
lore marketable product. Mid-sized com- relevant to the market," says Ling. IT is structuring, sending the group's share
anies with IT sections often cannot afford particularly susceptible to the product life- price on the day of the announcement up
le elaborate security measures needed to cycle. to R27,25 from P26,30 the day before.
rotect against disaster. The break-neck pace at which "hot" Ling's appointment to the post of CEO
"There is a cost advantage to what The products become obsolete forces CCH En- was motivated by her success at building
ompute Utility offers," says Ling, "but the terprise Systems to assiduously monitor up the Software Futures Group and her
:al advantage is dramatically reducing new trends. But by keeping itself ahead of strategic grip on the future of e-com-
me-to-market on new ventures." competitors, CCH Enterprise Systems also merce.
Setting up infrastructure in-house is both ensures that clients remain ahead of the CCH also announced the appointment of
)stly and time consuming. SA companies technology curve. Rob Shuter as the Group COO to assist in
aye traditionally opted to go it alone but The fifth pillar of the new CCH structure the day-to-day running of CCH which now
rge corporates are now running out of is CCH Consulting Services, specialising in employs 1 300 people. Shuter was pre-
opacity and a dearth of IT skills is forcing systems integration and consulting. It's viously director of Corporate Development
)mpanies to look to new options. here where complete IT solutions are and Strategy..
Ling sees IT as a pyramid. At the top is born. The resignation of former group MD
[novation and knowledge while at the In many ways CCH Consulting Services Mike Rolfe prompted rumours of person-
Atom is infrastructure. "Infrastructure is is the overarching business unit, speaking ality clashes and boardroom upheaval.
ther an enabler or a blocker to the high to clients with a voice representing all of Ling says there was nothing of the sort.
clued added processes at "We are constantly
Le top," says Ling. . "It 1., refreshing ourselves.
could be reliable, certain ' „ J. j.f D The market is moving
id at digital speed." Public Sector CoMMEMICall0138 I I FIMIC101 &Olen I GeneratiCerarnaralal so quickly that, with-
In the middle of the @.2 D.@ :JD lei-, ;0 out constant reinven-
rramid are enabling ap- ; I tion, we will become
ications — the capability G
. SALEi SI:IV-SALES
irrelevant. "To con-
turn innovation and CCM CCU tinue the spectacular
iowledge into some- OUTSOURCE/ CONSULTING SOFTWARE growth of CCH we
ing practically useable. ASP SERUMS FUTURES WODD 07, needed a new man-
its is the other side of agement model.
Risk Management 0 Management Cons 0 RR kkituv Camp Cerf:iis
:H's business: software Mug MAE "The restructuring
BRS Industry Comp
;velopment and technol- was a strategic move
e-Centrle o Programmes- -CFACCAI
w application. to grow our depth of
Data Centres e-Bus Mi■ • SFF3 P-ioduas
CCH Software Futures " management and
N5113s031
)erates five software Customerild 0 SI/Engagement keep us on the
:lodes writing applica- g@ME9
FinSourco Pro]. Management
Gauteng
ClgrilE growth path.
ms for the Microsoft, Parl of SC KIN o DIkka
"We want to be
va and Oracle environ- strategically geared
nits. With 400 develop-
s, the company has a 1}2211111111 SEMI SALES and we have now
moved to achieve
de range of develop- cl-Am vnom:z2::a
SOURCE: CCH that," says Ling. ❑
FINANCIAL MAIL • NOVEMBER 26. 1999
CCH
Free your
Eta,
Aletha Ling . . . you have to be part of e-business
111A9M0119NOTORI
GETTING CONFIGURED FOR EVEN Already installed at a number

of blue chip clients nationally,
MORE GROWTH Orca Technologies enjoys an
enviable reputation for
The Internet is changing everything in business providing high capacity
storage solutions designed for
Every company will be doing business itself from an ungainly- web of 17 sub- consistent reliability and
over the Internet in five years or they sidiaries into a simpler structure of five unrivalled cost performance.
won't be doing business at all, says Intel complementary business units: infrastruc-
chairman Andy Grove. ture provider CCH Infracom, outsourcing
Forecasts vary but market researchers and hosting provider the CCH Compute
agree that doing business electronically Utility, software developer CCH Software
will boom. Forrester, for instance, predicts Futures, hardware and software provider
that global e-business transactions will CCH Enterprise Systems and consulting
reach US$3,2 trillion by 2003. and systems integration unit CCH Con-
"You'll either be part of it or out of sulting Services.
business," says CCH group CEO Aletha As before, CCH still offers clients an
Ling. She adds that selling over the Web is integrated IT solution, but now with a
a small side to e-business because most of clearer message or offering.
_the_growth will be in business to business. "There were obvious natural clusters TECHNOLOGIES
The battle=for-digital_dominance, ac- within the 17 companies," says Ling, "so it
cording to research firm IntematioifirMta - was-logicalio simplify what was a con- HIGH CAPACITY
Corp, will be won in the back office by fusing picture to cliefitS7 -The o DATA STORAGE
firms that make their technology a door together the delivery capability and critical -1-2711-8043772—__
through which customers and suppliers mass of the separate companies and is www.orca.co.za
can enter whenever it pleases them. expected to create operational and man-
But for many traditional organisations,
the jump to doing business electronically
agement efficiencies built on the natural
linkages.
Sia A CCH COMPANY
is fraught with difficulties. CCH Infracom and the CCH Compute
With this in mind, CCH has restructured Utility provide infrastructure backbone.
FINANCIAL MAIL --NOVEMBER 26 1999

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nology firms have left gaps in the market.
"CCH has won significant sales from rivals
like Comparex, which has been pre-oc-
BIG DEAL
cupied with its European operations."
Pinheiro does not rule out selective
moves offshore, however, as alliances or
acquisitions are essential to gain leading
technology. Negotiations in the US, for
example, may see CCH acquire a company
that complements Orca Technologies' lo-
cally developed data storage equipment
from a technological point of view.
R113m, while turnover jumped 327% from with the share price, we have a lotto to be Pinheiro says he may split CCH into
R110m to R470m. The figures were thankful for. Our technology has never separate listed entities, keeping the group
boosted by a leap in operating margins looked better and both IT and e-commerce manageable while unlocking shareholder
from 23% to 29%, significantly above the spend is increasing. And the sales look value. First will be a separate listing for
sector average of 10%. "We are firing on all vibrant," says Pinheiro, adding that the Orca, which will debut on the develop-
cylinders," grins Pinheiro, adding that financial market's perception of IT stocks ment capital sector in the first half of next
these were CCH's best results. is likely to improve in the new year. year. Orca's locally made data storage
The only disappointment was the Middle The downrating has affected CCH's abil- products are targeted at the SA govern-
East joint venture, which missed its targets ity to raise capital, but the group has ment and parastatals, as well as Asian
as a result of the downturn in that region's R108m in cash to fund acquisitions and - Pacific, UIC and European markets. The
economy. "With CCH's businesses in SA moves offshore. Pinheiro has until now new Orca factory, under construction in
having grown substantially, the boom or bucked the industry trend of aggressive Midrand, is due for completion in March
bust trend of the oil-dependent Middle foreign expansion. "There is a huge mar- 2000. The new premises will have a ca-
Eastern economy is unlikely to have as ket here, why should I go overseas?" he pacity 25 times the output of Orca's pre-
dramatic an impact in future," says Pin- asks, pointing out that CCH has grown sent plant. "The listing and new facility
heiro. rapidly because some of the larger tech- will help us attract serious interest from
Though the acquisition of In- local and international distribu-
fracom helped CCH's revenues tors who will see Orca as an
and profits, analysts agree that hiLlattl' 12111111 faffil i?2, allfSAJilthillis/ independent, credible manufac-
the group's overall results are im- Sigmoid turer of cost-effective, reliable,
pressive considering that rivals mass storage solutions. Software
have seen a drop in business or NIATURITY
Futures will also help exports.
have had to issue profit warnings. ,-------- Software applications developed
Though the verdict is still out on en
a cost effectively in SA will be ex-
whether CCH can sustain growth r0 ported and deals with offshore
in the long term, IT analysts are 0 HIGH -
distributors are likely," says Pin-
GROWTH
positive about the group. E ,----'
RENEWAL FOR heiro.
"We are backing the jockey. So MVAINABLE Pinheiro says: "As for the future,
START UP GROWTH
far management has shown an people often ask me if we will be
ability to perform well," says Johan the next Dimension Data or Com-
Augustyn of BOE Securities. parex. We will continue to evolve
CCH has proved profitable since our strategies around high-growth
DEAT3HVALLEY
its inception, but only came to the and value-added areas. There's al-
r
public's attention after listing. "We Time ways room for improvement." The
are no flash in the pan company. aim, he says, is to continue out-
Sigmoid Curve
We've done well in both bad and selling the competition. "I tell my
good times," says Pinheiro. "We WO diversification staff and colleagues that if they do
efflicg§Talb0
will continue to exceed expec- the right thing then business will
tations and will continue to build LTiroli happen. We realise that informa-
capability internally rather than
m Lam tion is vital for intelligent decision
ODSillek/HPS
Stateof Maturity
__buy companies. It's costly and dis- 1990 i making and therefore a chief in-
riifithre- to-re-engineer_anctinte- formation officer will be appointed
P
grate outside companies to fit our Broad based shortly. The left hand needs to
culture." CCH shares were R2 at Eftagifflow
, _know what the right hand is do-
-
glidalflEOCErkl? technology
listing and hit a high of R47,05 in rli 1991
company ing," h-Cs-ays:--
August 1998, prior to the market 11 ,....— 1999 Pinheiro will soon take a less
crash. With the continuing de- operational role. "A strong exec-
rating of IT stocks, the shares 1991 utive management team headed by
have been trading at about half Corollary distributorM technology Aletha Ling is now in place and
this over the past few months. Time everyone is singing from the same
"Though we are disappointed SOURCE: CM hymn sheet."
FINANCIAL MAIL NOVEMBER 26 • 1999 3

CSC
ince founding Computer Configura- CORPODATE W1131101A
tions 14 years ago, Mario Pinheiro
has remained quick to identify new
opportunities. He has consistently pre-
dicted when to shift the group's focus to
new high-growth technologies.
"For continued and sustainable growth
we must constantly refresh our business,"
says Pinheiro, who left Hewlett-Packard
(HP) in 1986 and started Computer Con- It's all about trading and trading some more
figurations with just R9 000. He initially sold
second-hand HP equipment and attributes a
great deal of his success to service. "It's all
about relationships. If you offer good ser-
vice, people want to buy from you," he
says.
Today, CCH has evolved into one of SA's
largest broadbased IT solutions compa-
nies. It has 1 300 staff locally, and op-
erations in the Middle East. "We've grown
from a one man show into a R3bn busi-
ness," says Pinheiro, whose mantra re-
mains one of trade, trade and trade some
more! He says CCH has been able to
identify new ' technology growth curves
and exit before the technology matures
and enters its sunset stage.
Having acquired half of the HP mission
critical server market by 1990, Pinheiro
sold this business to HP's official dis-
tributor HiPerformance Systems (HPS),
seeing long-term opportunities arising out
of a new distribution agreement with US-
based Corollary. Corollary had developed
"symmetric multiprocessing technology'
using industry standard Intel micropro-
cessors that successfully competed against
traditional high-end mini-computers such
as provided by IBM and Data General.
By September 1997, when it made its
debut on the Johannesburg Stock Ex-
change, CCH had expanded its offering to
encompass midrange servers, data stor-
age, outsourcing services and disaster re-
covery solutions.
The acquisition of software developer
Software Futures in 1998 helped its entry
into the big league. The other major deal Mario Pinheiro . . offer good service and people want to buy from you
came with this year's controversial ac-
quisition of SA's leading telecommuni-
cations rollout and project management "All are heavy spenders on IT and viding holistic solutions to key clients. "It's
firm, Infracom. telecommunications. Increasingly the em- vital staff are motivated and allowed to
"We have done a number of smaller 'tuck phasis is on enabling businesses to op- work as entrepreneurs across the group,"
ins' where we needed the technology. But erate electronically. All our businesses are says Pinheiro.
at least two thirds of our business has been involved in electronic business in one way The recent R105m five-year business
grown organically from white board ideas," or another. This is the way business will continuity deal with Standard Corporate
says Pinheiro. be transacted," he said. and Merchant Bank is the result if such
CCH's major focus is now on providing a CCH's strategy is to empower and de- cross-selling.
holistic offering, whether specially develop staff. Sales staff represent almost "Strong organic growth and a strategy of
signed for customers or outsourced. "The 10% of the total staff complement. New cross-pollination lie behind this financial
focus is on the financial services, telecom- sales people are introduced to all divisions year's outstanding results," says Pinheiro.
munications, public sector and retail mar- and virtual group sales teams, located in For the year ended June 1999, attributable
kets," said Pinheiro. different divisions, work together on pro- earnings shot up 553% from R17m to
2 FINANCIAL MAIL • NOVEMBER 26 1999

Conte=
Marto Pinheiro Aletha Ling Morris Kotzen Lufuno Nevhutalu
NOW IT IS A BIG DEAL

2 It's all about trading and trading some more
GETTING CONFIGURED FOR EVEN MORE GROWTH

5 The Internet is changing everything in business
INTELLECTUAL PROPERTY GOES HEAD TO HEAD IN BUSINESS

7 Disseminating information creates a rich store of knowledge
CCH TRAINS IT GRADUATES

8 Help for those who missed out
STAYING AHEAD OF THE COMMODITY CURVE Anne Tissiman

10 Becoming a trusted partner
PLANNING FOR A DISASTER

13 Taking contingency route
A UNITED FACE FOR CLIENTS

14 From top technology and top people
ONE-STOP SHOP FOR CLIENT SATISFACTION

18 All kinds of information co-ordinated in data warehouse
KEEPING THE SKILLS IS THE PROBLEM

19 Not enough skilled people to go around
A LITTLE KNOWLEDGE CAN GO A LONG WAY

21 In fact, it's a company's biggest asset
PREPARING FOR AN IT SHAKE-UP Andrew Sims

24 Something is on the go
KEEP CLOSE TO YOUR CLIENTS Associate editor : Mick Collins

26° Get-to know the customer Senior editor : Bill Cain
Production editor : Donald Henderson
A COMPLETE SOLUTION THE Editorial assistant : Debi Kreiger
29 Packages are constantly being reviewed —Writers: Marina Bidoli, Greg Gordon,
James
IT'S THE NEW BUZZWORD AND THERE'S A RUSH TO JOIN Photographers : Jeremy Glyn, Arnold
32 And it's growing quicker than most people think Pronto, Russell Roberts
Design & layout : Heather Botha
Cover : Star Art: Corrie Maritz
Advertising executive : Wendy Calvert
CYPWeB PRINTERS 11-113 974-6976

FINANCIAL MAIL NOVEMBER 26 1999 1
an Tans Cousness?
We'we god a re0a .UoneMp manager ftr you.
No matter how specialised your field, at financial solutions and advice, you can network
Standard Bank Commercial Suites you'll find with someone who speaks your language.
someone who understands it. We assign to your For more information contact:
company a dedicated team of financial advisors 0860 123 000
who know your line of business, headed by a
relationship manager who will call on you to

COMMERCIAL SUITES
keep you personally updated. So when you need With us you can go so much further.
www.standardbank.co.za
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agiTN[E0 2Em roned Pag
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ovem
Cv

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FINANCIAL PRODUCT DEVELOPMENT: A STRATEGICALLY

COMPETITIVE SYSTEM ENGINEERING APPROACH TO

Nicholas Paul Piquito

submitted in partial fulfilment of the requirements for the degree of

RAND AFRIKAANS UNIVERSITY

Promoter: Professor L. Pretorius

The ultimate aim of financial engineering, as with any product development

The science of engineering has within it a special subset devoted to the

As an implementation mechanism the author develops a Financial Product

Die hoofdoel van finansiele ingenieurswese, soos met enige

As 'n implementeringsmeganisme ontwikkel die skrywer 'n Finansiele

Die doel van die Finansiele Produkontwikkelingsmodel wat in hierdie dokument

Die voorgestelde Finansiele Produkontwikkelingsmodel word deur die praktiese

The Statistical Consulting Service of the Rand Afrikaans University

The numerous professionals within the financial services industry who

Professor Alwyn Strauss, as co-promoter, for his advice and insightful

Professor Leon Pretorius, as lead promoter, for his tireless and

STRATEGIC CORPORATE FINANCIAL RISK MANAGEMENT

3.4.3 Liquidity Risk 45

FINANCIAL ENGINEERING: CONCEPTS AND TECHNIQUES

FINANCIAL DERIVATIVES: A CORPORATE RISK MANAGEMENT

5.4.3 Futures Contracts 99

6.5.13 Operational Use and Sustaining Support 135

THE FINANCIAL SERVICES COMPETITIVE STRATEGY

THE FINANCIAL PRO P UCT DEVELOPMENT MODEL

C PCTENTS CONTINUED... PAGE

8.3.1 The Need to Accelerate the Development of 207

9. THE FINANCIAL PRODUCT DEVELOPMENT MODEL: A

9.5 Market Scanning and Generic Product Definition 252

AN INDUSTRY PERCEPTION OF THE FINANCIAL PRODUCT

11.4 Concluding Summary 313

Appendix A: Derivative Contracts and Derivative Securities 344

Appendix IL: Rocket Scientists Are Revolutionising Wall 345

Appendix C: Creating a Synthetic Financial Security 350

Appendix D: The Future Financial Product Development

Appendix E: The Survey Questionnaire 370

Appendix F: The Value-at-Risk System 372

Appendix G: On-Line Risk Management Service Providers 375

Appendix 1E: Option Pricing and the Delta-Gamma 376

1:, ibIliography 382

1.11 The Question Hierarchy 5

1.2 The Thesis Structure 15

3.1 Total Financial Services Firm Risk 40

3.2 Publicly Disclosed Derivatives Losses as of Year-End 1995 53

4.1 Fluctuations In The USD/DEM Exchange Rate (1963-1992) 62

4.2 3-Month Dollar Interest Rate Volatility (1963-1992) 63

4.3 Derivatives Market Growth 64

4.4 A Perfect Hedge 67

4.5 A Typical Capped Exposure 67

4.6 Moving Average Volatility Estimates 75

4.7 A Comparison of Simple Moving Average and Exponential 76

4.8 Volatility Clustering in Financial Returns 78

4.9 An Illustration of Leptokurtosis in Financial Returns 79

4.10 Delta Versus Delta-Gamma Methodology $2

4.11 A Monte Carlo Analysis Generated PDF 83

5.1 A Simple Forward Contract 93

5.2 A Schematic Illustration of Interest Rate Parity 95

5.3 A Plain Vanilla Interest Rate Swap 97

5.4 A Plain Interest Rate Swap 98

5.5 A Currency Option 102

5.6 The Value of an Option Contract 103

5.7 Interest Rate Protection As A Result of A Cap 106

6.1 The Current Environment 110