06/01/2023

BBA – B.Com ( Semester 8)

January, 2023
Rajesh Shah

We will cover…… Engineering

• Engineering, the application of science to the optimum conversion of the
• Meaning and scope of FE resources of nature to the uses of humankind
• Evolution • Engineering is the designing, testing and building of machines, structures and
processes using maths and science
• FE Vs Financial Analysis, • Engineering is the application of science and maths to solve problems. While
scientists and inventors come up with innovations, it is engineers who apply
• Knowledge base of FE – mathematical, statistical skills, product these discoveries to the real world
knowledge, relevant technology, tax and legal aspects • Art and science concerned with the practical application of scientific knowledge,
as in the design, construction, and operation of roads, bridges, buildings,
machines etc. The combination of art and science by which the materials and
power of nature are made useful to mankind.
• Application and advancement of skills based on mathematics, science and
3 technology, integrated with business and management. 4

Financial Engineering - evolution Financial Engineering

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Financial Engineering Financial Engineering

• FE encompasses a broad, multidisciplinary field of study and practice • It is also known as financial mathematics, mathematical finance, and
computational finance.
that, essentially, applies an engineering approach and methodology
• Investment banks, commercial banks, hedge funds, Fintech companies,
to the world of finance. insurance companies, corporate treasuries, and regulatory agencies
• FE integrates and utilizes information / knowledge from different employ financial engineers.
fields, such as economics, mathematics, computer science, and • These businesses apply the methods of FE to such problems as new
product development, derivative securities valuation, portfolio
financial theory - to address current financial issues as well as to structuring, risk management, and scenario simulation.
devise new and innovative financial products • Quantitative analysis has brought innovation, efficiency and rigor to
• FE consists of converting financial theories into practical applications financial markets and to the investment process.
• Financial Engineers, having built a very strong foundation of skills, are
in the financial world. 7 also able to succeed in Data Science, ML/AI and Developer roles. 8

Financial Engineering – major uses • The use of financial engineering was key to facilitating a sale by Amoco Corporation of its
• Corporate Finance subsidiary, MW Petroleum Corporation, to the Apache Corporation in the early 1990s. The
factor that became the ultimate sticking point for concluding a deal was the two companies’
• Arbitrage Trading divergent opinions on the likely future prices of oil and gas – Amoco was bullish, and Apache
was bearish.
• Technology and Algorithmic Finance
• A bit of financial engineering led to the creation of a financial product referred to as a capped
• Risk Management and Analytics price support warranty that was offered by Amoco to Apache. The warranty provided that in
the event of oil prices dipping below a designated level, Amoco would make supporting
• Pricing of Options and other Financial Derivatives payments to Apache to reduce its losses in revenue.
• Behavioral Finance • In return for receiving the warranty, Apache promised, in turn, to make additional payments
to Amoco in the event that, in the first few years following the sale of MW Petroleum, oil
• Creation of Structured Financial Products and Customized Financial prices rose above a designated level. Both the lower and upper designated price levels were
Instruments determined by financial engineers using financial models.
• In such a case, financial engineering provided a means for the two companies involved in the
• Quantitative Portfolio Management transaction to share the considerable risks in the uncertain environment of major commodity
• Credit Risk and Credit Management prices in a manner that was acceptable to both parties and that, thereby, made it possible for
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them to conclude the deal for Apache’s acquisition of MW Petroleum. 10

Financial Engineering vs Financial Analysis Managing Financial Risk

FINANCIAL ANALYSIS FINANCIAL ENGINEERING
• Instruments have been developed to hedge the following types of
• Doing analysis of any concept or work or • Creative application of maths / Stats /
instrument volatility
programs etc to solve financial problems or
Major Analysis like -
• Trend Analysis create financial opportunities - in order to
• Interest Rate
• Horizontal / Vertical Analysis maximize profits using different
• Common Size Statements combinations through theoretical finance • Exchange Rate
• Comparison to Budget
• Comparison to Industry Data and computer modeling skills to make
• Commodity Price
• Ratio Analysis pricing, hedging, trading and portfolio
• Liquidity Measures management decisions
• Profitability Measures
• Derivative – A financial asset that represents a claim to another asset.
• Market instruments like Equity, Debt,
• Asset Utilization Measures
• Solvency Measures futures, options, Derivatives, fixed income, It derives its value from that other asset
• Market Prospects Measures swaps, Commodities etc 11 12

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Interest Rate Volatility Exchange Rate Volatility

• Debt is a key component of a firm’s capital structure • Companies that do business internationally are exposed to exchange

• Interest rates can fluctuate dramatically in short periods of time rate risk

• Companies that hedge against changes in interest rates can stabilize • The more volatile the exchange rates, the more difficult it is to predict

borrowing costs the firm’s cash flows in its domestic currency

• Available tools: forwards, futures, swaps, futures options, and options • If a firm can manage its exchange rate risk, it can reduce the volatility
of its foreign earnings and do a better analysis of future projects

• Available tools: forwards, futures, swaps, futures options, and options

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Commodity Price Volatility Financial Engineering – major Products

• Securities like Equity , Debt, Bonds Preference Shares etc.
• Most firms face volatility in the costs of materials and in the price that • Balance sheet transactions
• Derivatives -derivative is a type of security whose value is derived from an individual or group
will be received when products are sold of individual securities. Derivatives represent a contract between the buyer and seller, and
the price of derivatives changes depending on price movements of the underlying asset
• Depending on the commodity, the company may be able to hedge • Futures - A future is a type of derivative that represents an agreement between two parties
to buy and sell an asset at a fixed price at a fixed date
price risk using a variety of tools • Options - Options are very similar to futures except that the holder of an option does not have
an obligation to exercise that agreement
• This allows companies to make better production decisions and reduce • Swaps - A swap is another kind of derivative that is used to turn one kind of cash flow into
another.
the volatility in cash flows • Interest-rate products
• Foreign exchange
• Available tools (depends on type of commodity): forwards, futures, • Commodities
• Structured products
swaps, futures options, and options 15 16

Financial Engineering - Arena Financial Engineering - Arena

Engineering
Actuarial Finance &
Statistics Economics Financial
Science
Engineering
Operational
Economics Financial Research
Engineering
Computer
Finance
Science Computer Maths &
Insurance & Mathematics Science Statistics
Risk Mgt
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Financial Engineering – Associates Financial Engineering – Career

Mathematical Financial Computer / Programming • Quantitative Research and Analysis
• Linear algebra and • Financial Modeling • C++ (it’s utilized for high- • Development of Quantitative Research and Analysis software
differential equations • Portfolio Theory frequency trading • Financial Product development
• Numerical linear algebra • Accounting applications) • Building Valuation Model
(NLA) • Financial Statement • Python • Derivatives Structuring and Pricing
• Game Theory Analysis • Data Mining
• Calculus (differential, • Knowledge of credit risk- • Java, .NET
• Risk Management
integral & stochastic) products • VBA Macros • Structured Products
• Probability & Statistics • Equity & Interest rate • Excel • Valuation of Options
derivatives • MatLab, SAS • Financial Regulation
• Fixed Income • Object-oriented • Corporate Finance
• Monte Carlo Techniques programming
• Portfolio Analysis and Management
• Big data modeling 19
• Trading – high frequency, algorithmic and derivatives
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Financial Engineering – Career skills required

Thank You

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We will cover……
• Design and testing of product,
• Preview of product and launch.
• Products like - Forwards, Forward Rate Arrangements, Structure of a
swap, Interest Rate Swap, Currency Swap, Commodity Swap, Options-
Single Period Options and Multi Period Options, Calls and Puts,
BBA – B.Com ( Semester 8) Hedging
January, 2022
Rajesh Shah 24

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Financial Engineering – Products Financial Engineering – Products

Forward • A contract is an agreement between two parties to trade a specific quantity of
• Forwards,
an asset for a pre-specified price at a specific date in the future.
• Forward Rate Arrangements, Forward • is an interest rate applicable to a financial transaction that will take place in
• Structure of a swap, rate future. Forward rates are calculated from the spot rate and are adjusted for cost
of carry to determine future interest rate that equates total return of a longer-
• Interest Rate Swap, term investment with a strategy of rolling over a shorter-term investment.
• Term may also refer to the rate fixed for a future financial obligation, such as the
• Currency Swap,
interest rate on a loan payment.
• Commodity Swap, Option • A derivative, a contract that gives buyer the right, but not the obligation, to buy
• Options- Single Period Options and Multi Period Options, or sell the underlying asset by a certain date (expiration date) at a specified
price (strike price). Two types of options: calls and puts
• Calls and Puts, Call options • Calls give the buyer the right, but not the obligation, to buy the
• Hedging underlying asset at the strike price specified in the option contract. Investors
buy calls when they believe the price of the underlying asset will increase and
25 sell calls if they believe it will decrease. 26

Financial Engineering – Products Financial Engineering – Product Development

Put Option • Puts give the buyer the right, but not the obligation, to sell the underlying asset • Financial Product Development deals with the initial concept development
at the strike price specified in the contract. The writer (seller) of the put option (sometimes called "ideation"), market analysis, product documentation
is obligated to buy the asset if the put buyer exercises their option.
development, internal approval and regulatory registration for new products
• Investors buy Puts when they believe the price of the underlying asset will
decrease and sell puts if they believe it will increase. launched by Financial Services companies (e.g., banks, insurers, investment
Hedging • Is a financial strategy used by investors because of the advantages it offers.
managers, etc.).
• As an investment, it protects an individual’s finances from being exposed to a • Product Development teams, conduct full-scale cost benefit and market
risky situation that may lead to loss of value. analysis to determine if the product is viable.
• Hedging doesn’t necessarily mean that the investments won’t lose value at all. • After internally approval documentation is compiled and submitted to
Rather, in the event that happens, the losses will be mitigated by gains in regulatory agencies for approval.
another investment.
• After approved by Regulatory bodies teams prepare for a full-scale market
Swap • Is a derivative contract between two parties that involves the exchange of pre- launch.
agreed cash flows of two financial instruments.
• Cash flows are usually determined using the notional principal amount (a
predetermined nominal value). 27 28

Financial Engineering – Product Development Financial Engineering – Product Development - challenges

• How can we translate customer needs into concrete attributes that are technical feasible?
Finance Approach Integration
Research methodology –Marketing-finance approach Attributes of financial product –
Technical Marketing approach conjoint approach –Finance approach , objective measuree.g.,hedging
Information effectiveness
• New tools are needed that can transform customers’ preferences in concrete attributes AND –
Financial Technical Economic Marketing are able to take the technical constraints into account simultaneously Hence operationalize the
Service Feasibility Feasibility issue MF approach toward product development

Marketing Approach • methodology –Marketing-finance approach (Mis)-match subjective vs. objective performance
Marketing – Finance
Current case study: –Dairy futures
Customer Specific Approach
Information
• Channel Relationships & Financial Derivatives Channel contract preferences differ –Driven by
risk attitudes, capital structure etc. Conflicts and unable to meet financial performance targets
Customer in terms of risk (volatility) – expected cash flow (return) trade offs.
Technical Finance
Customer needs and
Feasibility Issue
choice behavior 29 30