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INTRODUCTION TO FINANCIAL ENGINEERING

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Introduction

• What is Finance?

• What is Financial Engineering?

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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

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Money vs. Finance

Monetary Economics

Financial Economics

vs.

Money / Credit Creation

Return / Risk Allocation

International Finance

Money & Banking

Corporate Finance

Investments (Capital Markets)

Central Bank

Commercial Banking

Non-Bank Financial SectorLiquidity

Money Control

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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, swaps.• They apply theoretical finance and computer

modeling skills to make pricing, hedging, trading and portfolio management decisions.

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Financial Engineers are prepared for careers in:

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What is Finance?

• Money & Banking — Monetary Economics

• International Finance — International Economics

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Corporate Finance

Capital Market

(Investments)

Financial Economics

Multinational Corporate

Finance

International Financial Market

Financial

Engineering

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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.

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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 accounts

3.5-4% No risk of deposit loss. Rates geared to inflation

3 Money-market funds

4.5-5% Very little. Rates vary with inflation.

4 Special 6-month certificates

5% Early withdrawals subject to penalty. Rates geared to expected inflation.

5 High-quality corporate bonds

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 funds

9-10% Substantial. Diversified portfolios have at times lost 50% or more of their actual value.

8 Real estate similar to common stocks

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.

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Unifying Principles of Finance

• No arbitrage

• Preference

• Optimization

• Market in equilibrium

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Principle of Financial Engineering

• No arbitrage

• Market in equilibrium

• Principles of Financial Engineering

• Preference

• Optimization

• Principles of Finance

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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

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FINANCE

I.T. ENGINEERING

F.E.

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Financial Engineers are prepared for careers in:

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Suggested Background

Generally, Financial Engineers are strong on the following fields:

• Statistics/Probability

• C++ Programming

• Basic Business Finance Theory

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What is a security?

A security is a fungible, negotiable instrument representing financial value.

Securities are broadly categorized into debt and equity securitiessuch as bonds and common stocks, respectively.

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What’s the purpose of securities?

For the Issuer

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What’s the purpose of securities?

For the Holder

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Equity and Debt

Traditionally, securities are divided into debt securities and equity.

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Debt

Debt securities may be called debentures, bonds, notes or commercial paper depending on their maturity and certain other characteristics.

The holder of a debt security is typically entitled to the payment of principal and interest, together with other contractual rights under the terms of the issue, such as the right to receive certain information.

Debt securities are generally issued for a fixed term and redeemable by the issuer at the end of that term.

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Equity

An equity security is a share in the capital stock of a company (typically common stock, although preferred equity is also a form of capital stock).

The holder of an equity is a shareholder, owning a share, or fractional part of the issuer. Unlike debt securities, which typically require regular payments (interest) to the holder, equity securities are not entitled to any payment.

Equity also enjoys the right to profits and capital gain.

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Weighted average cost of capital

The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital.

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The cost of capital is then given as:Kc = (1-δ) Ke + δ Kd

Where:Kc The weighted cost of capital for the firmδ The debt to capital ratio, D / (D + E)Ke The cost of equityKd The after tax cost of debtD The market value of the firm's debt, including bank loans and leasesE The market value of all equity (including warrants, options, and the equity portion of convertible securities)In writing: WACC = (1 - debt to capital ratio) * cost of equity + debt to capital ratio * cost of debt

Formula

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The Modigliani-Miller Theorem

The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle.

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Proposition

y = C0 + D/E (C0 – b)

* y is the required rate of return on equity, or cost of equity. * C0 is the cost of capital for an all equity firm. * b is the required rate of return on borrowings, or cost of debt. * D / E is the debt-to-equity ratio.