Financial Engineering

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Unit I: Introduction to Financial Engineering- Scope- Tools- Financial Engineering Vs. Financial Analysis- Factors contributing to the growth of financial engineering.- Innovative Products of the Last twenty years- present changing scenario of securities industry. Unit I: Introduction to Financial Engineering

Unit I see the prescribed Text book. Unit II is OK
What is Finance?
• Finance is about the bottom line of business activities
• Every business is a process of acquiring and disposing assets – Real asset
– tangible and intangible
– Financial assets
• Objectives of business
– Valuation of assets
– Management of assets
• Valuation is the central issue of finance
Money vs. Finance
What is Financial Engineering?
• Financial Engineering refers to the bundling and unbundling of securities.
• This is done in order to maximize profits using different combinations of equity, futures, options, fixed income, and swaps.
• They apply theoretical finance and computer modeling skills to make pricing, hedging, trading and portfolio management decisions. Financial Engineers are prepared for careers in:
What is Financial Engineering?
• Generalizing: 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.
• Specializing: Financial Engineering is risk management via creative structural tools.
Type of Asset Exp. R of R Risk Level
1 Bank accounts
2.5-3% No risk of deposit loss. Inflation risk.
2 Money-market deposit
3.5-4% No risk of deposit loss. Rates geared to
3 Money-market funds
4.5-5% Very little. Rates vary with inflation.
4 Special 6-month
5% Early withdrawals subject to penalty. Rates
geared to expected inflation.
5 High-quality corporate
8-8.25% Very little if held to maturity. Rate geared to
expected long-run inflation rate.
6 Diversified portfolio of
blue-chip common stocks
(e.g., index fund)
9% Moderate to substantial. In any one year, the
actual return could be negative. Diversified
portfolios have at times lost 25% or more of
their actual value.
7 Diversified portfolios of
risky stocks such as
aggressive growth mutual
9-10% Substantial. Diversified portfolios have at
times lost 50% or more of their actual value.
8 Real estate similar to
Cannot be sold quickly. Hard to diversify.
Good inflation hedge if bought at reasonable
price levels. For long-term investors.
9 Gold unpredictable Substantial. Believed to be a hedge against hyperinflation. Can help to balance a
diversified portfolio.
Unifying Principles of Finance
• No arbitrage
• Preference
• Optimization
• Market in equilibrium
Principle of Financial
• No arbitrage
• Market in
• Principles of Financial
• Preference
• Optimization
• Principles of Finance
Unifying Equation of Valuation
• P=E(mx)
– Where m is state-dependent discount factor
– X is the state dependent payoff (cash flow)
• Consequence of no arbitrage equilibrium
– Conservation law of value of cash flow: the whole is equal to the sum of components
– Composition and de-composition of cash flow
What is a security?
A security is a fungible, negotiable instrument representing financial value.
Securities are broadly categorized into debt and equity securities such as bonds and common stocks, respectively.
What’s the purpose of securities?
For the Holder
• Investment: Debt securities generally offer a higher rate of interest than bank deposits, and equities may offer the prospect of capital growth.
• Collateral: Purchasing securities with borrowed money secured by other securities.
Equity and Debt
Traditionally, securities are divided into debt securities and equity. Debt
Debt securities may be called debentures, bonds, notes or commercial paper depending on their...
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