FINANCIAL ENGINEERING



Financial engineering is the design and construction of a new financial contract or the packaging of existing financial instruments to meet very specific risk and return requirements of the client. It is analogous to the engineering function in building construction. For example, the building construction contract may include specifications regarding size, number of rooms, adequate plumbing and heat, quality of materials to be used, and a completion date. The financially engineered contract may also include specifications of size (or dollar amount), the types of securities that will be used, the cash flows that they will generate, the risk associated with those cash flows, and the date upon which the contract will be renewed or expired.

This very general definition of financial engineering includes many contracts that are now considered commonplace. For example, banks sustained large losses in the early 1980s when their cost of funds rose sharply with interest rates. These banks had made large, long-term, fixed interest rate loans to families purchasing homes. The banks found, however, that the moderate fixed interest charges they received on these loans was not sufficient to cover the interest expense that was incurred to attract new funds to the bank. Hence, banks began to write adjustable-rate loans that would vary interest charges to borrowers commensurate with fluctuations in the cost of funds to the bank.

Another common example of financial engineering is the mutual fund. Individual investors realized that there were benefits in terms of risk reduction if they could invest in a broad array of securities. Most individuals, however, had limited resources and found it very expensive to purchase small amounts of many securities. A basic mutual fund is a portfolio of securities that can be as diverse and numerous as the client demands. The creation of these funds allowed individuals to purchase shares of an already diversified portfolio and establish an investment with lower risk, and at a more moderate cost than they could achieve otherwise.

The two previous examples illustrate the ubiquitous nature of financial engineering. Financial contracts that are now considered standard were designed and constructed to meet the needs of a particular set of clients. Financial engineering still responds to those needs but now frequently incorporates more complex combinations of securities, including foreign currencies and derivative securities. Before describing some of these more complex examples of financial engineering, a brief review of the fundamentals of the individual elements that are used in their construction is useful. This review begins with basic financial assets themselves: stocks, bonds, and various indexes. This will be followed by a description of various derivative securities. Derivative securities are so named because their value is derived from the value of another security. Options, forward contracts, and futures contracts are in this category.

BASIC FINANCIAL ASSETS

BONDS.

Shares of stock and bonds represent claims on current and future earnings of a corporation. Bonds represent a debt or liability on the corporation's (or government's) balance sheet and typically oblige the firm to make periodic interest payments to bondholders. Bonds eventually mature and at that time the principal amount of the loan that the bond represents must be returned to the holder. The holders of a bond may passively collect interest payments over the duration of the bond's life and then receive the principal at maturity. The holder may also elect to sell the bond at any time prior to maturity. Since the bond represents a claim on a series of future payments, the bond's value can be estimated at any time as the discounted present value of those remaining payments. Thus, when the bondholder offers the bond for sale, the interest rate used to discount the remaining payments will be the primary determinant of its value. This interest rate can also be interpreted as the potential buyer's required rate of return. This required rate will be determined by a variety of factors including expectations of inflation, the default risk associated with the corporation, and interest rates offered on similar securities. This description culminates in two observations regarding the value of bonds. First, the higher the required rate of return, the lower the discounted value of the bond's required payments and hence, its value. In other words, as interest rates go up, bond prices go down. Conversely, as interest rates fall, bond prices rise. Second, these interest rates are determined in a competitive market and they will fluctuate continuously. Therefore, the market value of the bond will change constantly.

STOCKS.

Stock represents a claim on residual earnings of the corporation. Since there may be no earnings available after all other claims have been satisfied and since those earnings may be retained by the firm rather than directly distributed to stockholders as dividends, the value of stock is inherently more volatile than the value of bonds. The value of stock is also related to the expected future cash flows: dividends and future selling price. These future cash flows, however, are much more difficult to forecast. Obviously, as the market's assessment of the level of these future cash flows improves or deteriorates, the stock's price will rise or fall.

MARKET INDEXES.

There are also a variety of market indexes that measure overall price movement of the U.S. stock market (e.g., Dow Jones Industrial Average, Standard & Poor's 500), interest rate sensitive instruments such as bonds (e.g., Salomon Brothers Bond Indexes), and the level of interest rates themselves (e.g., yields on various securities issued by the U.S. Treasury, the Federal Funds rate, and the London Interbank Offered Rate, or LIBOR). There are comparable indexes for every major financial market throughout the world (e.g., the Financial Times 100 in the U.K. and the Nikkei Index in Japan). These market indexes play an important role in financial engineering. Contracts can be tied to the value of a specific index and can thereby be used to initiate cash flows between contracting parties. In this way, a contract can simulate rates of return for an index without the obligation to buy and hold the securities actually included in the index.

DERIVATIVE SECURITIES

Stocks, bonds, and market indexes represent the fundamental set of building blocks that can be used to engineer a financial contract. Such derivative securities as options, forward contracts, and futures contracts comprise the next level.

OPTIONS.

An option is a contract that provides the holder with the right to purchase or sell a security at a predetermined price regardless of the prevailing market price. To obtain such a contract, the potential holder must buy it from a seller who has assessed the risk associated with the potential gains and losses on the contract. The option to buy is referred to as a call and the option to sell is a put. For example, suppose an individual paid $5 to purchase a call option on XYZ stock with an exercise price of $60 and the stock subsequently rose to $72. This individual could exercise the option to buy at $60 and, ignoring brokerage fees and taxes, resell the stock for $72 for a gross profit of $12. When the initial cost of the option is factored in, the net profit to the call buyer is $7. If XYZ's price had gone higher the profit would have been even greater. On the other hand, if XYZ's price had fallen to $57, the call buyer would not elect to exercise the right to buy at $60. The maximum loss at any price below $60 would be limited to the initial cost of the option, $5 in this case. So, the call option buyer has unlimited potential for gains while losses are limited to the price, or premium, initially paid. Conversely, the seller of the option has limited gains, but the potential for significant losses.

Contrast the position of the call buyer with that of the put buyer. Suppose an individual buys a put option on XYZ's stock for $4 with an exercise price of $60. This individual now has the right but not the obligation to sell XYZ for $60. If the price falls to $55, the put holder can buy the stock in the market and sell it for $60 by exercising the put option. This produces a gross profit of $5 and a net profit of $1 when the original put premium is factored in. The gains to the put buyer will increase as the value of XYZ continues to fall, but will diminish if the price rises. If the price is above the exercise price of $60, the put buyer will not exercise the option and will incur a net loss of $4, the amount of the put premium. Therefore, the put buyer has significant potential for gains if XYZ's stock price falls significantly, but losses are limited to the amount of the put premium. Again, the converse is true for the put seller. The seller incurs significant losses if XYZ's value falls materially, but gains are limited to the amount of the premium.

Since there must be a buyer for every seller, both must agree to the initial price or premium. This premium will be influenced by the difference between the current price for the stock (or other asset) and the exercise price on the contract. Options are essentially a "zero-sum" game. This means that what the buyer gains, the seller loses. Only one party to the contract will have made the proper assessment. Both parties, however, will agree that stocks with greater potential for large price movements are worthy of higher option premiums than those with more stable prices. Also, options have an expiration date and buyers are willing to pay more for an option that has longer to live.

While these examples have centered on stock options, there are also many actively traded contracts on various government bonds, market indexes, commodities (e.g., corn, oil, gold), and foreign currencies.

FORWARD CONTRACTS AND FUTURE CONTRACTS.

Forward and futures contracts are typically derived from price levels for various market indexes, interest rate sensitive securities such as bonds, commodities, and foreign currencies. These contracts are designed to transfer the risk associated with the price level of the underlying asset from one party to the other. Forward contracts represent an agreement to make or take delivery of a specific asset at a specific future date for a price that is also predetermined. For example, suppose A, a U.S. businessperson, has an obligation denominated in French francs (Fr) that is due in six months. A's major concern is that the dollar will weaken with respect to the franc. If the current rate of exchange is $0.20 per Fr, then a weaker dollar will produce an exchange rate of, say $0.22 per Fr in six months. This means that A will have to pay more dollars for the same number of francs. Conversely, if the dollar strengthens and the exchange rate moves to $0.18 per Fr, then A can meet the franc denominated obligation with fewer dollars. A's concern is exchange rate risk. One way to avoid this risk is to buy French francs on the forward market. Suppose that A can enter into an agreement to take delivery of the necessary francs in six months for a price of $0.21 per Fr. That forward price is fixed, eliminating exposure to subsequent fluctuations in the exchange rate, favorable or unfavorable. This practice is referred to as hedging.

Who will sell the French francs to A using the forward contract? There are two possibilities. B is a French businessperson who has an upcoming obligation denominated in U.S. dollars. B is also subject to exchange rate fluctuations and may be willing to sell francs at $0.21 per Fr in six months. B's willingness to sell francs can also be interpreted as an interest in buying dollars in the forward market. In this example, both A and B are hedging to eliminate exchange rate risk. If B is not interested or available to accept the other side of this contract, there is another possibility. C is a speculator in exchange rate movements. C believes that the current rate of $0.20 per Fr will be stable for the next six months and is therefore willing to agree to sell to A at $0.21 per Fr in six months. Again, A has eliminated concern with exchange rate fluctuation. C expects to be able to buy francs for $0.20 and sell them to A for $0.21 earning $0.01 per franc. If the rate rises to $0.22 per Fr, C will lose $0.01 per franc. If the dollar strengthens, however, and the rate falls to $0.18 per Fr, C will earn $0.03 per franc. C is willing to speculate on the future exchange rate of dollars for francs. Exchange rate risk has not been eliminated, only transferred from A, the hedger, to C, the speculator.

While forward contracts can be customized to meet the very specific needs of the parties involved, they also create counterparty risk. Counterparty risk is an important underlying concept in all financially engineered contracts. It represents the potential that one of the parties to the contract will not follow through on its obligation. For example, if A entered into a forward contract to purchase five million French francs from C six months from now and C failed to deliver, A would be obliged to purchase the necessary francs at the prevailing market price. Conversely, after six months, A may find that the market price for French francs is favorable to the price specified in the forward contract and renege on the promise to purchase from C. Though the contract itself can (and does) penalize each party for deviations in promised performance, it may be inconvenient and costly to enforce these provisions.

Futures contracts are similar to forward contracts in that they represent an agreement to engage in a transaction at some future date. Futures contracts, however, are standardized with respect to size, expiration date, and many other relevant features. This means that hedgers may not be able to obtain the exact contract parameters to completely eliminate risks associated with price movements. It also means, however, that buyers (who agree to take delivery of an asset) and sellers (who agree to make delivery) of futures contracts are pricing identical contracts. This allows all trades to be funneled through a clearinghouse that can assume all counterparty risk. It also means that traders can quickly purchase or sell additional contracts to perfect a hedged position or to amplify a speculative one. Likewise, positions in the futures market can be "unwound" by selling contracts to offset previous purchases or by buying contracts to offset previous sales.

Another important distinction between forward and futures contracts regards the timing of the cash exchange between the parties. In a forward contact, the cash flow from the buyer to the seller of the asset occurs at the end of the contract period. With a futures contract, the buyer and seller agree on a price for future delivery at a particular time, but that future price is changed continuously. If the price for future delivery rises in a given day, the buyer is now holding a claim that is more valuable than it was previously. The seller now finds it more costly to fulfill the contract. To adjust for this change, an amount equivalent to the aggregate change in value is transferred from the seller's account to the buyer's account. Likewise, if the price for future delivery falls during the day, funds are transferred from the buyer's account to the seller's account. This process is repeated daily for the life of the contract and is called "marking to market." As a result, at the contract's expiration, all favorable or unfavorable movements in the market price of the asset to be delivered have already been accounted for. If the buyer of the contract opts to take delivery of the asset at this point, the transaction occurs at the prevailing market price.

The derivative securities discussed previously can correctly be considered as products of financial engineering. These contracts were invented and in some cases standardized in order to provide clients with a more effective vehicle for avoiding particular types of risk or of speculating on specific price movements. In the next section, these securities will be included as some of the primary building blocks for more complex financially engineered contracts.

COMPLEX FINANCIAL ENGINEERING
CONTRACTS

PORTFOLIO INSURANCE.

One prominent example of financial engineering to meet the needs of clients is portfolio insurance. Portfolio insurance is essentially a strategy of hedging, stabilizing, or reducing the downside risk associated with the market value of a portfolio of financial assets such as stocks and bonds. There are a variety of techniques to protect the value of such a portfolio.

As an example, suppose a portfolio manager wants to build a floor under the current value of a well-diversified portfolio. Furthermore, suppose that this portfolio is currently valued at $1,594,000, and its changes in value closely correspond with changes in the Standard & Poor's 500 (S&P 500) index. Ideally, the manager would like to reap the benefits of further increases in portfolio value, but wants to assure investors that the value will not fall below a certain, specific level. One solution is to purchase put options on the S&P 500 index. These options are heavily traded at a variety of exercise prices. If the current level of the S&P 500 index is 1,225.50 and the manager wants to ensure that the value of his portfolio does not fall by more than 10 percent, put contracts with an exercise price of 1,110 (approximately 10 percent below the current level) can be purchased. The manager must purchase enough put option contracts so that the underlying value of the optioned asset is equal to the value of the portfolio. In this example, the portfolio value is approximately 1,300 times the current value of the S&P 500 index. Therefore, if the manager could buy puts on 1,300 "units" of the index, the position could be fully hedged. In reality, a single S&P 500 put contract represents 500 units of the index. So, the manager would purchase three put contracts. Subsequent to the purchase, if the S&P 500 index (and the portfolio) rises in value, the manager will not exercise the put. Gains to the portfolio will be reduced by the modest amount of the put premium that was paid. On the other hand, if the index and the portfolio dropped in value by 20 percent, the put could be exercised at a significant profit that would generate a combined net loss for the position of approximately 10 percent. If the index value fell even lower, the profit from the put would be even greater and always provide a net loss of 10 percent.

Other techniques of portfolio insurance use futures contracts on stock and other market indexes. In the previous example, the manager could "synthetically" sell some or all of the portfolio by selling futures contracts on the S&P 500 index. If the portfolio subsequently fell in value along with the S&P 500 index, the futures position would generate prohits that would partially or entirely offset the loss. If market prices rose, the portfolio would rise in value but the futures position would generate a loss that would tend to offset the gain. Note that this technique not only stabilizes the value of the stock portfolio, but also allows the manager to create a position with profits and losses that is equivalent to a smaller stock portfolio. This lower risk position is achieved without the significant expense of actually selling a portion of each individual stock position within the portfolio. Technically, this is an example of hedging, or maintaining a particular market value for a period rather than ensuring a minimum value while retaining the opportunity for upside gains. It is possible, however, to sell the proper number of S&P 500 index futures in order to mimic the overall profits of the put insured portfolio described above. This would require periodic adjustment to the hedge, or the number of futures contracts sold, as prices changed and the time to expiration of the contracts diminished.

SWAPS.

Another broad category of contracts that result from financial engineering are referred to as swaps. Swaps represent exchanges of cash flows generated by distinct sets of assets or tied to distinct measures of value. An early example of an engineered swap is the currency swap. In this example, consider two firms in different countries each having continuing financial obligations in the other's country. More specifically, consider a French firm with a U.S. subsidiary that requires dollars to operate and a U.S. firm with a French subsidiary that has need for French francs. One alternative is to borrow the funds in the home country and exchange them for the foreign currency needed by the subsidiary. Another alternative is for the subsidiary to borrow the needed funds in the local currency. This second alternative will provide needed funds for the subsidiary and avoid the costs associated with foreign exchange transactions. It is also likely, however, that the subsidiary is at a disadvantage when negotiating the rate on a loan in the local currency. For example, the U.S.-based subsidiary of a French corporation may not have the perceived creditworthiness of a U.S. corporation with foreign subsidiaries and as a result will be forced to pay a higher rate of interest on the dollar-denominated loan.

If each firm becomes aware of the other's needs, they can do the following. First, each parent corporation should borrow an equivalent amount in their home currencies. These amounts will be equal based on the current exchange rate between dollars and francs. Second, they will simultaneously transfer the proceeds of the loan to the other firm's subsidiary (i.e., the French parent will transfer the borrowed francs to the U.S. firm's French subsidiary, and the U.S. parent will transfer the borrowed dollars to the French firm's U.S. subsidiary). As interest payments become due, the French-based subsidiary pays the French parent and the U.S.-based subsidiary pays the U.S. parent. Finally, when the term of the loans expires, each subsidiary will repay the other's parent. Note that this financially engineered contract has (I) effectively exploited each firm's ability to borrow at more favorable rates in its home country and (2) avoided all need for foreign currency exchange.

Obviously, the crucial factor in the formation of such a mutually advantageous contract is the identification of two parties with offsetting needs. In recent years, many financial intermediaries have developed services to fill this need. Swap dealers and brokers have developed the expertise to serve a broad variety of needs by matching the interests of counterparties and by engineering contracts that are mutually advantageous to the contracting parties and profitable for the intermediary.

A second common swap agreement is the interest rate swap. This typically takes the form of an exchange of a fixed-rate interest payment for a floating-rate interest payment. Suppose a bank has made a large number of loans at a fixed rate, but most of its liabilities are floating-rate obligations. If interests rise materially, its expenses will rise but its revenues are fixed. Profitability will suffer. If the bank can swap its 9-percent fixed-rate loans for a comparable amount of floating-rate obligations that generate the yield on 30-year U.S. Treasury bonds plus 4 percent, it has materially reduced the influence of interest rate fluctuations on its profitability. In this example, once the bank has found a willing swap partner, the parties will agree to a notional principal amount. That is, the counterparties will agree on the amount of interest-generating capital that will be used to design the agreement. Typically, the parties will not exchange these notional amounts because they are identical. As time elapses, the bank will swap interest payments with its counterparty. For example, if the Treasury bond rate is 6 percent during a particular period, the agreement mandates that the bank receive 10 percent while it pays 9 percent. The swap agreement will require only that the net difference be exchanged, I percent paid to the bank in this case. If the Treasury bond rate drops to 4.5 percent, then the bank is obligated to pay the net difference between 8.5 percent (or 4.5 percent + 4 percent) and 9 percent, or 0.5 percent to the counterparty. If the Treasury bond rate remains at 5 percent, the fixed and floating rates are equivalent and no cash exchange would be necessary. Since there was no need for an actual exchange of the identical principal amounts at the beginning of the swap, none is required to close the positions at expiration of the agreement.

More complex swaps could involve trades of fixed- and floating-rate payments denominated in different currencies. Others could involve swaps of the income from debt instruments for the income generated by an equity investment in a specific portfolio such as the S&P 500. Swaps can also provide the basis for engineering a more efficient method of diversifying risk or allocating assets across asset classes. Consider this well-documented example. A chief executive officer (CEO) of a major corporation has accumulated a significant equity stake in his firm. While the CEO has other investments, he is not effectively diversified since he has an enormous amount of his own firm's stock. The CEO can contact a swap dealer who will arrange to swap the cash flows generated from the CEO's stock (capital gains and/or dividends) for a cash flow generated by an identically valued investment in a broadly diversified portfolio or market index. In this example, the CEO has (1) avoided the cost of selling his stock and any capital gains taxes that may result from the sale; (2) retained the voting rights of his stock; and (3) created a "synthetic" portfolio that is much less sensitive to the fluctuations in value of any particular company.

The swap can be engineered to provide immediate international diversification. Suppose two portfolio managers, one in the United States and another in Japan, manage purely domestic portfolios. They may agree to swap notional values that would generate returns on their own managed portfolios or generate cash flows commensurate with an investment in a market index. For example, the U.S. manager may agree to provide the cash flow generated by a $100 million investment in the S&P 500 in exchange for returns generated from a similar-sized investment in the Nikkei 225 index. This would provide instant international diversification without the sizable cost of purchasing a large number of individual foreign securities. In addition, many countries impose fees or taxes on returns to foreign owners. A properly engineered swap agreement can avoid most or all of these expenses.

OTHER FINANCIALLY ENGINEERED
INSTRUMENTS

There are a myriad of other examples of new financial instruments or contracts. Many of these instruments are new and trade infrequently. They are often referred to as "exotics." For example, it is possible to use combinations of puts and calls on interest rate instruments to create caps, floors, and collars on interest payments. A cap represents the maximum rate that a floating interest rate position can obtain, a floor is the minimum rate, and a collar is the combination of a cap and a floor. Another unusual option feature is the lookback option. A call option with the lookback feature allows the holder to purchase the asset at the most favorable (lowest) price that prevailed over the life of the option. A put option with this feature allows the holder to sell the asset at the highest price over the option's life. These options set the exercise price at the end of the option's life rather than at the beginning. Closely related are Asian, or average-rate options. These options set the exercise price at expiration as the average asset price during the option's life span. Barrier options are options that are activated, canceled, or exercised if a particular price condition is met. For example, a "down and out" option is canceled if the asset price falls below the exercise price, while a "down and in" option is activated if the same price trigger is breached. Conversely, "up and out" and "up and in" options are canceled or activated when the exercise price is exceeded. Since these options are inert for large ranges of their underlying asset's price, they are less expensive than ordinary options and have generated interest among hedgers and speculators.

In summary, financial engineering is the design and construction of new financial contracts. These contracts are typically assembled from a modest number of basic financial instruments and indexes including stocks, bonds, options, forward contracts, and futures contracts. The need for properly engineered financial contracts is motivated by the client's interest in reducing risk, reducing costs associated with foreign exchange or other market transactions, and to provide the potential to enhance returns. Many financial intermediaries have developed specialized services in the area of financial engineering. As they have done so, the markets where elaborate and specialized contracts can trade efficiently have expanded and are likely to continue to do so.

SEE ALSO : Call and Put Options

[ Paul Bolster ]

FURTHER READING:

Jarrow, Robert, and Stuart Turnbull. Derivative Securities. Cincinnati: SouthWestern, 1996.

Smithson, Charles W., and Clifford W. Smith. Managing Financial Risk: A Guide to Derivative Products, Financial Engineering, and Value Maximization. 3rd ed. Burr Ridge, IL: Irwin McGraw-Hill, 1998.



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