Financial Engineering

Introduction
Need of a New System/ Instrument:

Q. Why do we need a new instrument/ system???

Example
1. In an informal financial system, there was a greater credit risk. To mitigate this risk, the need of a formal financial system was felt.

2. The basic forms of sources of funds (???) were not fulfilling the need of entrepreneurs and hence, there was need of development of new instruments to raise funds e.g: Hybrid instruments (FCCB, ECB etc.)

Definition
Financial engineering involves the design,

the development and the implementation

of innovative financial instruments and processes and the formulation of creative solutions to problems in finance.

Price Chart of NTPC

Q. You are a fund manager and have taken shares of NTPC in your portfolio. Share prices of NTPC are falling. What possible actions will you take ? (Before or/ and after the event )

Functions
Functions of financial engineers: Functions are not limited to the listed ones. Few of them are: 1. Investment and Money Management: Mutual Funds, Money Market Funds, Repo market etc. 2. Security and Derivative Products Trading: To take advantage of arbitrage, innovation of program trading (??).

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3. Corporate Finance: formulation of new instruments to raise funds, pay-off debts etc.

4. Investment Banks: IPO management, M & A ( Pricing methods of IPO, Innovative ideas to handle M&A like: issuance of junk bond, Leverage Buy-outs (LBO) etc.). 5. Risk Management: Development of derivative instruments (Future, option, SWAP etc.)

Case 1
You are a financial engineer and standing at a time when only Debt, Equity and F.D are the sources of investment. Mr. X is having Rs. 10 lakh to invest but his risk appetite is not high. At the same time, he would like to take exposure in both equity as well as debt and short-term F.Ds. What type of instrument can you design/ suggest him to invest in??

Risk
Define it ???

Price Risk
Risk is any deviation in expected value of a security/ portfolio/ asset class.

Ex: Share price of NTPC is Rs.130 per share today. But, What about tomorrows price??

Types of Financial Risk

The term "financial risk" covers the range of risks affecting financial outcomes, faced by a firm. Financial risk is essentially of two kinds: systematic and unsystematic.

Systematic Risk
Business risk is the risk of fluctuations in sales revenue. It arises from macroeconomic factors such as economic swings and deregulation, and demand factors such as seasonality of demand. This risk is not totally systematic, however, and some of it can be reduced by diversification of the firm's operations. Financing risk arises from leverage. It is possible to minimise it by restricting the amount of debt in the firm, even though there may be tax advantages to borrowing.

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Inflation risk arises from unanticipated inflation Marketability, or liquidity risk: When it is difficult to buy or sell a financial instrument at its market price. This risk is un-diversifiable and also completely systematic. Political risk can be both domestic and foreign; it is particularly high when operating in some politically unstable economy. This risk is highly systematic and undiversifiable

Unsystematic Risk
Interest rate risk arises both from fixed and floating rate debt. Unanticipated changes in floating interest rates can cause costs to rise. Floating-rate debt offers a long-run hedge against inflation risk.
At the same time, a fixed rate debt can cause financial difficulties in case interest rates drop. This is therefore a major risk faced by almost all companies. It can be hedged against in many ways.

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Currency (or foreign exchange) risk arises when cash inflows or outflows take place in foreign currency. This risk can be either diversified or hedged. Commodity price risk arises from unanticipated changes in commodity prices and can be hedged.

Calculation of Risk
Systematic Risk: Unsystematic Risk Total Risk Diversification What is beta ??

Future & Forward

Why do we need it??

Forward Market
A forward contract is a contract between two parties to exchange assets or services at a specified time in the future at a price agreed upon at the time of the contract. How do you the future price today ??? What is risk here ??

Forward contact is non-standardized. Traded on OTC (Over the Counter).

Future Market
A futures contract is a contract between two parties to exchange assets or services at a specified time in the future at a price agreed upon at the time of the contract.

It is standardized. It is traded on Exchanges.

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An exchange acts as an intermediary and guarantor, and also standardizes and regulates how the contract is created and traded

Pay-off Diagram of Future

Strike Price (K) Delivery Price

ST

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Pay-off from
Long position in future/ Forward = ST -K Where ST = Spot price of asset at maturity K = Strike Price (Delivery price)

- Short position in future/ Forward = K - ST

BANK Nifty Open 11,063.20 High 11,132.70 Low 10,972.40 Closing Price 10,989.45

BANK Nifty Future for Expiry on 30-Jan-2014 Date 3-Jan-14 4-Jan-14 5-Jan-14 6-Jan-14 7-Jan-14 8-Jan-14 9-Jan-14

Open
11,111.00 11,081.00 11,299.00 11,979.00 10,504.00 10,528.00 11,890.00

High
11,149.00 11,069.00 10,073.00 11,842.00 11,060.00 10,389.00 11,486.00

Low
10,970.10 11,729.00 10,331.00 11,393.00 10,495.00 10,392.00 10,110.00

Closing Price
10,998.00 11,315.00 10,934.00 11,109.00 10,260.00 11,246.00 10,439.00

10-Jan-14

10,359.00

10,832.00

11,902.00

11,718.00

Margin Calculation
Settlement is made on daily basis in future market while, In Forward market, it is done at the end of the contract period. ( Why ???) Task: Take an index future or stock future of your interest and calculate profit/loss in last 1 week.

One more Observation

NSE - National Stock Exchange of India Ltd..htm Normal Market: When the future prices of the underlying increases as the time to maturity increases. Inverted Market: If the future price of the underlying decreases as the time to maturity increases.

Purpose of Future Markets

To Hedge
Minimize or manage risks Have position in spot market with the goal to offset risk

To Speculate
Take a position with the goal of profiting from expected changes in the contracts price No position in underlying asset

Marking to Market
One of the unique features of futures contracts is that the positions of both buyers and sellers of the contracts are adjusted every day for the change in the market price that day. In other words, the profits or losses associated with price movements are credited or debited from an investors account even if he or she does not trade. This process is called marking to market.

VaR (Value at Risk)

My Financial advisor made a portfolio of Rs. 10 lakh for me by investing in different asset class in 2006 when market was in boom. Now, My heart-beat started increasing looking at the market condition.

What is the most I can lose on this investment?

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Value at Risk measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. Ex: VaR on an asset is $ 100 million at a one-week, 95% confidence level. i.e There is a only a 5% chance that the value of the asset will drop more than $ 100 million over any given week

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The VaR can be specified for an individual asset, a portfolio of assets or for an entire firm. Task: Take a security (Share of any company). Collect data of last one week-trading price and calculate VaR assuming that you knew this can be the lowest price of share in one-week.

Basis Risk
Basis is the difference between the spot price of an asset and its future price. Basis = Spot price of hedged asset - Futures price of contract Where is risk ?? Hint: What should be basis at Maturity ?

Hedge Ratio
The ratio of the size of the position taken in future contract to the size of the position taken in spot is known as Hedge Ratio. Hedge Ratio =
Number of future contract/ Number of spot position.

Number of future required = (Beta of portfolio * Value of portfolio)/value of one index future contract
Mr. X buys three future contracts of company ABC ltd. To hedge the risk of 6 number of shares bought of ABC ltd. What is hedge ratio? ( Is there anything wrong in this strategy??).

Stop and Think for a moment !!

Why Mr. X is taking position in future market ? Which type of risk does he want to mitigate? How does it work?

Calculation of number of futures

Mr. X is having a portfolio of Rs. 660 lakhs and he wants to hedge his portfolio using NIFTY Index Future. The strike price of future contract is Rs. 6600 and beta of his portfolio is 0.8. NIFTY index future trade in multiples of 100. Find number of future contract that he should buy or sell to hedge his portfolio.

Rolling Hedge

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If Mr. X wants to buy future of Month April in India on 1-Jan. (Can he buy??) The possible strategy he could have:
Buy future of march month At the expiration of march month contract buy contract of next1 month

Task
Buy 50 shares of SBI at todays price. Find beta of SBI. Hedge this asset using NIFTY Index future. Buy 50 shares of MARUTI and 50 shares of SBI. Find beta of SBI and MARUTI. Calculate beta of the portfolio and hedge this portfolio using NIFTY index futures.

Interest Rate Future

interest rate futures suggests that the underlying is interest rate. It is actually bonds that form the underlying instruments. An important point to note is that the underlying bond in India is a notional government bond which may not exist in reality. In India, the RBI and the SEBI have defined the characteristics of this bond: maturity period of 10 years and coupon rate of 7% p.a

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One other salient feature of the interest rate futures is that they have to be physically settled Unlike the equity derivatives which are cash settled in India. Physical settlement entails actual delivery of a bond by the seller to the buyer

Trading Strategy
If an investor is of the view that interest rates will go up, he would sell the IRF. This is so, because interest rates are inversely related to prices of bonds, which form the underlying of IRF. So, expecting a rise in interest rates is same as expecting a fall in bond prices. Similarly, if an investor expects a decline in interest rates (equivalently, a rise in bond prices), he would buy interest rate futures.

Lot Size in IRF

Lot size: The minimum amount that can be traded on the exchange is called the lot size. All trades have to be a multiple of the lot size. The interest rate futures contract can be entered for a minimum lot size of 2000 bonds at the rate of Rs. 100 per bond (Face Value) leading to a contract value of Rs. 200,000.

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At any given time, a maximum of four contracts can be allowed for trading on the exchange (Viz., March, June, September and December contracts).

Currently, at NSE only three contracts are allowed to be traded

Settlement
Mark-To-Market Settlement and Physical settlement:

For IRF, settlement is done at two levels: 1. Mark-to-market (MTM) settlement which is done on a daily basis and 2. Physical delivery which happens on any day in the expiry month

Application of IRF
Asset-liability management
Banks typically have lots of government bonds and other long term assets (loans given to corporate) in their portfolio.
while their liabilities are predominantly short-term (deposits made by individuals range from 1 to 5 years). To address this risk (Where is the risk???)

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The risk resulting from the asset-liability mismatch, they generally sell IRF and thereby, hedge the interest rate risk. On the other hand, for the insurance companies and several big corporates, the tenure of their liabilities is longer than that of their assets. So, they buy IRF to hedge the interest rate risk.

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2. Investment portfolio management:

Mutual funds and similar asset classes having a portfolio of bonds can use IR futures to manage their interest rate exposure in turbulent times.

Questions for Practice

What do you mean by derivative? What are differences between Future and Forward contracts? What is Index future? What is stock future? What is IRF ? What is Forward Agreement? What is future agreement? Why the underlying bond in IRF is a notional bond?

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A hypothetical banks is having more short term asset and more long-term liabilities. Using the concept of IRF explain, which type of hedging strategy the bank should use? A company has taken loan from a bank of 20 years term and have fixed deposits in banks of tenure 5 years. The interest rates on both ( loan as well as F.D.) are floating. Suggest which type of strategy the company should follow to hedge Interest rate risk. Also explain how interest rate fluctuation can bring risk in its portfolio if not hedged?

Foreign Currency Future

What is foreign exchange rate?
Value of a foreign currency relative to domestic currency. The participants in this markets are: banks, exporters, importers etc. Foreign exchange deal is always done in currency pairs. Ex: US-INR : US dollar & Rs. GBP-INR : British pound & INR JPY-CHF: Japanese Yen and Swiss-Franc.

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In a currency pair, first currency is called base currency and second currency is called Counter/ term/Quote currency. Ex: USD-INR = 62.45 The price fluctuation in currency market is expressed as appreciation/ depreciation or strengthening/ weakening of a currency with respect to other. Ex: a change of US-INR from 35 to 36 indicates that US dollar has ????

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USD is the most widely traded currency and is referred as Vehicle currency. Why Vehicle currency ?? A vehicle currency helps a market in reducing the number of quotes at any point of time. Any quote not against the USD is termed as Cross. Ex: Cross Quote for GBP-CHF can be arrived through GBP-USD USD-CHF Quote. Therefore the availability of USD quote helps in finding cross quote for any other currency.

Task
From NSE collect last days data of exchange rate of following:
USD-INR EUR-INR GBP-INR & JPY-INR And calculate the following: 1. USD-EUR exchange rate. 2. EUR-GBP exchange rate 3. GBP-JPY exchange rate Verify your answer with real data of these exchange rates from other sources and find reason of deviation, if any.

Pricing Currency Futures

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Long-Short Concept clarity

Q1. If I would like to own an asset in future, I should take ..position? Q2. If I would like to sell an asset in future, I should take ..position? Q3. If I have taken a liability and I want to hedge it, I will take .position? Q4. If I have an asset and I want to hedge it, I will take .position?

Options
Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something, but the holder does not have to exercise this right. By contrast, in a forward or futures contract, the two parties have committed themselves to some action.

Types of Options
Call Option: gives the holder of the option the right to buy an asset by a certain date for a certain price. Put Option: gives the holder the right to sell an asset by a certain date for a certain price. The date specified in the contract is known as the expiration date or the maturity date. The price specified in the contract is known as the exercise price or the strike price.

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Options can be either American or European, a distinction that has nothing to do with geographical location. American options can be exercised at any time up to the expiration date, whereas European options can be exercised only on the expiration date itself.

Profit Diagram of ??

1. 2. 3. 4.

Option price =?? Strike Price = ?? Call / Put ? European/ American ??

Task
From NSE site identify the periods for which options are available? Note strike price corresponding to each period. Do analysis by taking volume also into consideration. Which option is most active option?

Test 1
Q1. In forward market credit risk is not present ? (True/ False) Q2. In a forward market daily settlement is done? (True/ False) Q3. In mark-to-market concept, the profit/loss for the day is settled on the same day. (True/ False) Q4. If I have a share, which type of hedging strategy should I use? (Long Future/ Short Future) Q5. If I hedge a share using NIFTY Future, which risk am I hedging. (Systematic/ Unsystematic)

Q6. Total risk of the portfolio cant be mitigated. (True/ False). Q7. beta measures unsystematic risk of the portfolio. (True/ False) Q8. Forward and futures are obligatory contracts. (True/ False). Q9. We take opposite position in future market than spot market. (True/ False). Q10. VaR measures the minimum loss that my portfolio will make. (True/ False). Q11. beta of market is always 1.5? (True/ False)

Q12. VaR on an asset is $ 100 million at a one-week, 95% confidence level. Meaning of this is my portfolio will lose a value of $100 million with 95% confidence? (True/ False). Q13. An American option can be excised only at the expiration. (True/ False) Q14. If I want to buy share of NTPC in March, I will take position in Option Market today. ( Long Call/ Long Put) Q15. Higher the beta lower is the risk. (true/ False)

Q16. I

dont understand this subject at all.

(True/ False).