After the deal was closed, both sides were approached to sell off their positions and thus had the choice of monetizing the options and closing their risk exposures. All the case studies presented here show how financial engineering can offer solutions to intractable problems.
Although the cases differ in many respects, managers in each one recognized the need, for the sake of their own strategic goals, to help others bear risks. Financial engineers were then able to structure, value, and manage the transfer of those risks. Further similarities among the cases raise a number of questions that managers should consider when deciding whether it is appropriate to apply financial engineering techniques.
The use of financial engineering in these five cases contrasts with traditional forms of risk management, in which financial managers, seemingly divorced from the rest of the organization, inherit a set of exposures and manage their risk.
Business leaders in these five cases knowingly took on risks to satisfy their customers, employees, stockholders, or negotiation counterparties. The anticipated value of their transactions would come primarily from the strategic gains made possible by them. Although ECT, for example, sold fixed-price gas contracts, its primary goal was not to gain when gas prices rose or fell but rather to profit over the long term by differentiating its product.
Financial engineers are experts in transforming the risk-and-return characteristics of investments, and they are assisted by deep markets with low transaction costs.
The more closely they can correlate the risk they seek to modify to a traded market with established contract forms, the more likely they are to find a feasible solution. Some risks, such as a potential rise or fall in a broad stock index, are very common, and claims on these risks are actively traded in public and private markets.
Other risks are more idiosyncratic. But even a risk as personal as the potential property loss due to an auto accident can be mitigated—not in a market but through the risk sharing of property insurance.
Financial markets offer the opportunity to exchange risks at reasonably low transaction costs. Managers and academics should recognize that an efficient market, being essentially a zero-sum game, makes it difficult if not impossible to profit by taking on fairly priced risks.
And they should be skeptical about whether companies should assume those risks. But again, it should be remembered that the five companies used financial engineering, in large measure, to shed the risks they took on. In an important sense, the companies were arbitraging risks between efficient financial markets and less efficient nonfinancial markets. What is remarkable about these companies is their willingness to pursue financial engineering even though the relevant markets they faced were not very deep or well developed.
None of them could find a premade derivative contract at an exchange that would answer their needs. Yet the importance of their problems and the lack of traditional business solutions motivated them to construct tailor-made solutions. While these tailored solutions may have been expensive, they were less expensive and more effective than the alternatives. Financial engineering, of course, is not free, and transactions that transfer risk characteristically require cash payments or entail other contingent risks owing to the nature of the transactions.
Managers who use financial engineering must understand those costs or new risks. Managers obviously need to consider the cash costs of selling risks. For example, the owner of a stock portfolio might pay cash for a put option that gives him or her the right to sell the portfolio for a fixed price at some future time, thereby setting a floor value on the stock-and-option package.
Furthermore, when companies use financial engineering to obtain flexibility, they should understand and allow for the additional cash costs they may incur if they later change their plans. Often, the price of shedding risk is taking on another risk or giving up some of the upside potential of a future transaction or rate movement. In these forms of risk barter, the terms of trade were explicit and understood by all parties, but the allegations surrounding some recent cases of leveraged swaps underscore the need to make such understandings very clear.
In addition to these explicit costs or risks, managers using financial engineering should be mindful of other contingencies that are harder to quantify.
As in other corporate transactions, there is some degree of credit risk because financially engineered solutions generally involve fallible counterparties. Financial engineers have devised various ways to mitigate credit risk, from collateralization agreements to AAA-rated derivative subsidiaries. Nevertheless, when you buy a commodity contract from a financial institution, you often are trading price risk for counterparty risk.
A closely related problem arises from performance risk, or the risk that the counterparty in a commodity market will not be able to produce or deliver the product as specified in the contract. Another contingency is basis risk, which you encounter when you cannot find a market that trades precisely the kind of risk you want to shed, and you have to use a close substitute that behaves similarly. ECT, Apache, and Amoco wrote contracts tied to specific grades of gas or oil, delivered at particular locations; users of these types of contracts may have to contend with differences between their individual exposure and the benchmarks in the industry.
Other contracts might entail liquidity risks. For example, if a company uses short-term contracts to hedge long-term risks, the consequence may be sudden and unexpected cash-flow requirements. If so, a strategy intended to protect company value may turn out to be worse than no strategy at all. Perhaps the most troublesome risks that parties bear arise from legal, tax, and regulatory uncertainties.
Courts, commissions, legislatures, and politicians may suddenly change the rules or simply abrogate existing contracts. How much upside must I surrender to buy downside protection on a stock price?
But ultimately, the most significant returns on transactions can be understood and valued only by the general manager, who must answer such questions as, What is it worth for the company to have its employees own stock? Will divesting a large part of our business allow us to make significant gains elsewhere?
Each party has some of the relevant risk-and-return information. Working alone, neither the financial engineer nor the general manager has enough information to make a prudent decision. Working together, they may.
What is most interesting about these five cases is not their technical virtuosity; to the contrary, the financial engineering employed was quite simple. Rather, the cases are exciting because they demonstrate that collaboration between financial engineers and general strategists can produce concepts and insights capable of meeting complex challenges. The potential for this kind of collaboration will vary from company to company and from situation to situation.
But the cases presented here should suggest that the possibilities are broader than might at first be imagined. The use of derivatives in an acquisition can be beneficial if the contract is structured around the subsequent accounting or stock market performance of the unit being sold. The use of futures markets and indices in commodity settings can also be applied much more broadly—for example, there are new real estate indices, as well as new derivative contracts on the indices.
By using these contracts, a real estate brokerage could differentiate its services from those of its rivals by protecting a home seller or buyer against marketwide moves in prices between the time of listing and the time of sale or purchase.
Surely not all experiments in financial engineering will be successful. Some returns may be smaller than anticipated, some risks larger than expected. New technologies like computing or financial engineering usually produce winners and losers. In the case of computing, we remember the survivors—companies made richer by capitalizing on low-cost technology. Yet if we think back a decade or two, we also will remember companies whose experiments failed. Similarly, there are companies whose experiments with financial technology have been uninspiring.
What they seem to have in common is a degree of myopia on the part of senior management. We often learn that the specifications, design, execution, and oversight of these programs were all performed by the same technicians, without strategic direction and review.
Facing a new specialty, senior managers sometimes throw their hands up and abdicate responsibility. The results are not surprising: An advanced financial program designed without reference to the business and its strategy, like a computer system built without input from end users, runs the risk of missing the mark. The companies studied here adopted financial solutions as integral parts of their core business processes.
The financial engineering used in these cases was remarkably simple, but it was able to solve complex managerial problems. Furthermore, these experiments with financial wizardry promise to accomplish the objectives that management established: capturing market share and profit with minimal risk, developing new production capacity, persuading employees and shareholders to buy stock, and bringing an important acquisition to completion. Although such success stories produce blander headlines than do dramatic tales of derivatives disasters, they should be more suggestive and inspiring to forward-thinking leaders.
You have 1 free article s left this month. You are reading your last free article for this month. Subscribe for unlimited access. Create an account to read 2 more. Financial markets. How can a producer of a commodity like natural gas differentiate its product? Concepts drawn from financial markets will help TVA manage the risk of an options portfolio.
The financial engineering used in these cases was simple, but it solved complex problems. Read more on Financial markets or related topics Finance and investing , Risk management and Strategy execution. Free Investment Banking Course.
Login details for this Free course will be emailed to you. Forgot Password? Article by Madhuri Thakur. What is Financial Engineering?
Example of Financial Engineering It involves multiple fields like financial products, statistics, programming, etc to come up with innovative but structured products. Follow below steps for financial engineering. Need Identification The first and foremost step is to do a primary analysis and come up with a hypothesis that there are a need and demand in the market.
MVP Creation Based on the research both primary and secondary conducted in step 1, a minimum viable product A Minimum Viable Product A minimum viable product MVP is a particular product version representing sufficient features for early customer satisfaction to collect exclusive customer feedback for proper product development as per customer requirement and remove unwanted attributes, reducing the risk of failure following wrong assumptions.
Complex Model Designing Workshop Based on the feedback and suggestions received from the users, designers, and developers, a workshop is conducted to brainstorm and a detailed discussion is carried out to include the complexities and design a new scope for the product.
Product Quality Assurance The inculcated complexities need to be tested making sure that the crux of the product is much more useful and robust. Perfect Product The product thus created can be called as a perfect one as it has undergone the transformation from MVP to a final product. Pricing Now the sales team has to come up with the pricing of the product based on multiple factors like the ability to disrupt, need in the market if it caters to a niche market. Marketing The success of any product depends on how the product is marketed as the end-users have to be taught about its capabilities and usefulness.
Product Launching How the product is launched and what distribution channels are utilized to implement go to market strategy is the final but one of the most important steps. Leave a Reply Cancel reply Your email address will not be published. Please select the batch.
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Develop and improve products. List of Partners vendors. Your Money. Personal Finance. Your Practice. Popular Courses. What Is Financial Engineering? Key Takeaways Financial engineering is the use of mathematical techniques to solve financial problems. Financial engineers test and issue new investment tools and methods of analysis. They work with insurance companies, asset management firms, hedge funds, and banks. Financial engineering led to an explosion in derivatives trading and speculation in the financial markets.
It has revolutionized financial markets, but it also played a role in the financial crisis. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Hedge A hedge is a type of investment that is intended to reduce the risk of adverse price movements in an asset.
What Is Fixed-Income Arbitrage? Fixed-income arbitrage is an investment strategy that realizes small but highly leveraged profits from the mispricing of similar debt securities.
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