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Enhancing the Market Value of the Companies through Financial Engineering

S.S.Prasada Rao* & G.V.S.Sekhar** Financial engineering involves the design, development of innovative financial instruments and processes, and the formulation of creative solutions problems of financial management. By the late 1980s it had become clear that finance was changing in a truly fundamental way. This change was driven in large part by the development of extraordinary new financial products, mostly derivatives of various sorts, and remarkable advances in financial theory. These new products, coupled with the advancing theory, made it possible to structure better solutions to long standing financial problems. Financial engineering involves the development and creative application of financial theory and financial instruments to structure solutions to complex financial problems and to exploit financial opportunities. Financial engineering is not a tool by itself, but, it is a profession that uses multiple (or various) tools, of which derivatives are one.

*Dr.S.S.Prasada Rao, Professor, Department of Finance, GITAM Institute of Mangement, GITAM Unviersity, Visakhapatnam 45. **Mr.G.V.S.Sekhar, Assistant Professor, Department of Finance, GITAM Institute of Mangement, GITAM Unviersity, Visakhapatnam 45.

Introduction: Financial engineering is the application of mathematical models to decisions about saving, investing, borrowing, lending, and managing risk. The term financial engineering came into use after the innovation of the BlackScholes-Merton option pricing model in the early 1970s. This major scientific breakthrough led to a new way to solve practical financial problems by designing custom contracts and replicating them dynamically using instruments traded in markets. In recent years the rise of many new organized markets for futures and swaps and innovations in telecommunications and computer technology have dramatically reduced the cost of trading standardized financial instruments. This has vastly increased the scope of financial engineering. As a result it has become possible to produce at a reasonable cost to a customized financial contracts, which address a broad range of investment and risk management needs faced by firms, governments, and households around the world. Engineering is the practical application of mathematical or scientific principles to solve problems design useful products and services. Engineers of all sorts get similar formal training in mathematics, and move on to their respective specializations. Civil engineers use their understanding of materials science and mechanics to design bridges; chemical engineers use their knowledge of chemical properties and interactions to design new compounds or make chemical processing plants more efficient. The financial engineers knowledge base is financial economics, or the application of

economic principles to the dynamics of securities markets, especially for the purpose of structuring, pricing, and managing the risk of financial contracts. In designing a security or a risk-management strategy, the financial engineer works within physical and budgetary constraints: Will this structure deliver the desired result even if the market moves suddenly and severely? How will it withstand a financial earthquake, such as counterpartys default? How will it perform under current and future tax and accounting rules? How much will it cost? To succeed, the financial engineers must find optimal solutions within many different and often conflicting constraints. These varied constraints lead to different solutions. Just as civil engineers can design various kinds of bridges, so financial engineers can design different kinds of financial instruments or strategies to produce a payoff. Robert C. Merton has presented a concrete example of the financial engineers ability to design alternative routes to the same end, all fundamentally similar yet each with its own advantages and disadvantages (Journal of Banking and Finance, Volume 19, June 1995.) Suppose that a professional investor wants to take a leveraged position in the Standard & Poors 500 basket of U.S. stocks; Merton enumerates eleven ways of achieving that goal. There are traditional do-it-yourself solutions in which the investor borrows to buy stock: buying each stock individually on the margin, borrowing to purchase shares in a Standard & Poors 500 index mutual fund, or borrowing to buy a basket of stocks such as the American Stock Exchanges SPDR product. There are products in which traditional financial intermediaries act as principals and offer payoffs that closely mimic the leveraged stock position; the actual products are structured as

bank certificates of deposit, indexed notes, or variable-rate annuities. In five more alternatives, investors buy futures, forwards, swaps, or one of two different options on the Standard & Poors 500 index, all of which are derivative contracts in that their payoffs are a function of (or are derived from) the value of an underlying index. Each of the 11 products or trading strategies can give the investor exposure to the stock market, and each produces functionally similar payoffs. The multitudes of solutions exist because of the differing constraints facing the financial engineer. Derivatives have been traded for centuries, stretching back to the option contracts traded in Amsterdam in the seventeenth century, the modern field of financial engineering leaped forward in 1973, when Fisher Black, Myron Scholes, and Merton developed an approach to creating and valuing option contracts. In the same year, the Chicago Board of Exchange began the first modern market for options by trading calls on a dozen companies shares. Following these pioneering steps in theory and practice, the past two decades have witnessed an explosion in research and in the understanding of how to structure, price, and manage the risks of derivative instruments. Bridges occasionally collapse, sometimes because of poor engineering and other times because of bad luck. Except in extreme cases, it is often hard to distinguish between the two. Suppose that a bridge designed to withstand an earthquake of a certain magnitude crumples after suffering a slightly larger shock. Is this calamity the result of improbable event occurred? the poor engineering because the specifications should have been tighter, or of bad luck because an extremely

Financially engineered products also sometimes fail, and examining their wreckage to determine culpability is equally difficult. Some would contend that in 1987, portfolio insurance- a trading strategy designed to provide institutional investors with downside protection- failed because it provided less than absolute protection. Yet if one looked closely at the specifications of the product as written by financial engineers before October 1987, it was clear that the strategy was not designed to cover all scenarios. In the aftermath of the crash, financial engineers have searched for alternative ways to deliver insurance. More recently, the failure of Metallgesellschafts financially engineered hedging strategy has prompted much finger-pointing, litigation, and vigorous debate among practitioners and academics alike. The debate may never be resolved, but one can safely wager that clever financial engineers are working on ways to create alternative hedging strategies to avoid the problems that this incident exposed. When designing a bridge, the civil engineer works within physical and budgetary constraints: Will the bridge support 50 trucks at once? Will it withstand extreme lateral forces of wind?4 Will it survive a once-a-century earthquake? How much will it cost? In designing a security or a riskmanagement strategy, the financial engineer also works within physical and budgetary constraints: Will this structure deliver the desired result even if the market moves suddenly and severely? How will it withstand a financial earthquake, such as counterpartys default? How will it perform under current and future tax and accounting rules? How much will it cost? To succeed, both types of engineers must find optimal solutions within many different and often conflicting constraints.

The smart ones expand when the chips are down and the sector is going through a rough patch. Thats when valuations are down, investor expectations are low, cash flows are poor and acquisition of assets is cheap. Thats why the market gives a premium to larger and/or more diversified companies that have the cash flows even during bad times. Take a look also at private equity companies worldwide. They do so out of savvy financial engineering The point is that most companies focus on running their businesses or operations. So, the natural tendency is to think of growth, or value creation, through the organic route. However, organic expansions, which can take several years to complete, cannot be responsive to swiftly changing markets. With markets becoming more fickle and India becoming more open to fast changing global developments, the conditions on whose basis a project was originally conceived may have changed dramatically by the time the project comes on stream. Organizations should chart their strategies to ensure a balance of both forms of value creation with timing and market conditions determining the actual growth strategy. Derivatives, such as options or futures, are financial contracts which derive their value of a spot price time-series, which is called the underlying. For examples: wheat farmers may wish to contract to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction would take place through a forward or futures market. This market is the derivative market and the prices on this market would be driven by the spot market price of wheat which is the underlying. The terms

contracts or products are often applied to denote the specific traded instrument. The world over, derivatives are a key part of the financial system. The most important contract- types are futures and options, and the most important underlying markets are equity, treasury bills, commodities, foreign exchange and real estate. In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed. Forward contracting is very valuable in hedging and speculation. The classic hedging application would be that of a wheat farmer forwardselling his harvest at a known price in order to eliminate price risk. Conversely, a bread factory may want to buy bread forward in order to assist production planning without the risk of price fluctuations. If a speculator has information or analysis which forecasts an upturn in a price, then she can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to raise, and then take a reversing transaction. The use of forward markets here supplies leverage to the speculator. Futures markets were designed to solve all the three problems (a) lack of centralization of trading, (b) illiquidity, and (c) counterparty risk. Futures markets are exactly like forward markets in terms of basic economics. However, contracts are standardized and trading is centralized, so that futures markets are highly liquid. In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counterparty risk

An option is the right, but not the obligation, to buy or sell something at a stated date and a stated price. A call option gives one the right to buy, a put option gives one the right to sell. Options come in two varieties. In a European option, the holder of the option can only exercise his right on the expiration date. In an American option, he can exercise this right anytime between purchase date and the expiration date. The key motivation for such instruments is that they are useful in reallocating risk either across time or among individuals with different riskbearing preferences. One kind of passing-on of risk is mutual insurance between two parties who face the opposite kinds of risk. For example, in the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This sort of thing also takes place in speculative position taking - the person who thinks the price will go up is called as long term futures and the person who thinks the price will go down is called as short-term futures. Another style of functioning can be considered like: a risk averse person ( who buys insurance), and a risk-tolerant person ( who sells insurance). For instance, an investor who tries to protect himself against a drop in the index buys put options and a risk-taker sells these options. Obviously, people would be very suspicious about entering into such trades without the institution of the clearing-house which is a legal counterparty to both sides of the trade. In these ways, derivatives supply a method for people to do hedging and reduce their risks. As compared with an economy lacking these facilities, it is a considerable gain. The ultimate importance of a derivatives

market hence hinges upon the extent to which it helps investors to reduce the risks that they face. Some of the largest derivatives markets in the world are on treasury bills, to help control interest rate risk, and the market index, to help control risk that is associated with fluctuations in the stock market and on exchange rates, to cope with currency risk. Derivatives are also very convenient in terms of international investment. For example, Japanese insurance companies fund housing loans in the US by buying into derivatives on real estate in the US. Such funding patterns would be harder without derivatives. Conclusion The rapidity with which corporate finance, bank finance, and investment finance have changed in recent years has given birth to a new discipline that has come to be known as financial engineering. As with most disciplines in their early stages of development, the field of financial engineering has attracted people with an assortment of backgrounds and perspectives. Examples include the use of existing products to reduce firms financial risks, to reduce the cost of a firms financing, to gain some accounting or tax benefit or to exploit market inefficiency. It is often difficult to distinguish between those innovations which truly represent quantum leaps and those which involve novel twit on old ideas. Organisations with a good mix of both capabilities will do better in the long run. But it is equally important to have the ability of determining which strategy is more suitable at a given point of time. At different points in time, even within a sector, different value creation strategies work better. Organic

growth may be better in certain industries and at certain times. At other times, financial engineering based value creation may be more relevant. By not having the skills to create value through both forms, depending on the need, organisations may be hobbling themselves. Every organisation needs to focus on all means of value creation. Skills in financial engineering can be as, and often more, important as organizational capability in running operations. References: 1. Marshal John.F, Finanancial Engineering: A Complete Guide to Financial Innovation, Prentice Hall of India, New Delhi, 1996. 2. T.V.Somanathan, Derivatives, Tata McGraw-Hill Publishing Company Limited, New Delhi 3. Prasanna Chandra, Financial Management, Tata McGraw-Hill Publishing Company Limited, New Delhi 4. Dr. S. Gurusamy, Financial Markets & Institutions, Vijay Nicole Imprints Ltd., Chennai 5. Redhead, Keith, Financial Derivatives: Introduction to Futures, Forwards, Options and Swaps, Prentice Hall of India, New Delhi, 1998. 6. Strong, Robert A, Derivatives: An Introduction, Thomson Asia Private Limited, New Delhi, 2003.

7. Sunil K. Parameswaran, Futures Markets: Theory and Problems, Tata McGraw-Hill Publishing Company Limited, New Delhi, 2003. 8. Satyanarayana Chary T, Financial Engineering & Risk Management Indian Management, June 2002, New Delhi. 9. Vijay Bhaskar P, Derivatives Simplified: An Introduction to Risk Management, Response Books, New Delhi, 2003. 10. www.expressindia.com 11. www.financialexpress.com