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ABSTRACT FINANCIAL ENGINEERING: A TOOL FOR RISK MANAGEMENT DURING GLOBAL DOWNTURN Financial engineering is a value addition process

to split the risk and return aspect of financial instruments and to develop an innovative solution to cater the need of users particularly investors of financial market. Such innovations are seen in bonds, equity, derivatives, and also in other fields like merger, acquisition and corporate restructuring. There are several financial engineering products in the financial market like- preference shares, convertible debentures, call and put options, futures, swaps, etc. In India, being capital market factors, interest rates, prices of the commodities, etc. highly volatile there is a continuous need to innovate a financial solution to minimize risk for investors. This paper will find the financial engineering solutions which are used by Indian Financial Institutions for managing risk arisen in the present global economic scenario. Keywords: Financial Engineering, risk, global meltdown, financial innovations

By:

Ms. Jyoti Assistant Professor, DoBA K. P. College of Management Navalpur, Agra Ph. No. 09897775590 Mail-Id : jyotidb18@rediffmail.com, jyotidb18@gmail.com

Introduction Risk is an inherent quality in the business of commercial banks and financial institutions. With the widened resource base, service range and client base, risk profile of these financial entities has further broadened. The most prominent financial risks to which these entities are exposed are classified into interest rate risk, liquidity risk; credit risk and forex risk (Figure 1). Since risk is embedded in the business of financial institutions, its efficient management holds key to their performance. Figure 1

There are three different but related ways of managing financial risks. The first is to purchase insurance. But this is viable only for certain type of risks such as credit risks, which arise if the party to a contract defaults. The second approach refers to asset liability management (ALM). This involves careful balancing of assets and liabilities. It is an exercise towards minimizing exposure to risks by holding the appropriate combination of assets and liabilities so as to meet earnings target of the firm. The third option, which can be used either in isolation or in conjunction with the first two options, is innovate. Such innovations are seen in bonds, equity, derivatives-the financially engineered solutions to manage risks.

Firms follow different processes for developing new value added product and services. Financial engineering is not different from that process. Identification or realization of a need is the starting point of the process. Such needs are to be identified in the context of market and to bring out new value added products or services or solutions which suits the users requirements. Financial engineering like any other engineering has brought several new products and solutions to the market. It has completely changed the financial market today. Its main contribution is to split the risk and return into several components and allow investors of financial markets to decide the combination that is most suitable to them. 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. Factors Contributing to Financial Engineering: There are several factors responsible for financial innovation. These factors are as follows: y y y y y y y y Tax Advantage Transaction Cost Agency Cost Risk Reallocation Increased Liquidity Regulatory or Legislative Factors Level and Volatility of Interest Rates Level and Volatility of Prices. Technological Development Academic Work
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y
y

Accounting Benefits

Risk management is uniquely important for financial institutions (FIs) because, in contrast to firms in other industries, their liabilities are a source of wealth creation for their shareholders. With the changing role in todays scenario, the Indian Financial Institutions are exposed directly and indirectly to various trade, management and market risks whenever they assume credit risks by granting loans to traders and industrialists. This has necessitated the creation of new instruments and solutions by financial institutions and regulatory authorities to protect and mitigate losses to FIs arising from such risks. FIs are working on the strategy of diversification through dividing the risks into various parts and evolving a solution for that type of risk. Interestingly, such financial innovations are growing which would be of great help to FIs to share and transfer their risks with other institutions operating in the market. Exhibit 1 summarizes various financial innovations with their principal motivating factors in India during last two decades. Typically, the risks faced by financial institutions have four major inter-related components: Credit risk Environmental and financial risk which arises from changes in the macroeconomic environment, interest rate fluctuations and market exposures.

y y

Exhibit 1: Financial Innovations in India


PRINCIPAL FACTOR Tax Advantage Pricing and Interest rate regulation under the Capital Issue Control Act Tax Benefi t Perceived Volatility of Interest rates Volatility of equity prices 4 Financially Engineered Solutions Debt-oriented schemes of Mutual Funds Partially Convertible Debentures and fully Convertible Debentures Deep Discount/Zero Coupon Bonds Puttable and Callable Bonds Stock Index Futures

Restriction under forward trading Havala Transactions RBI restrictions Volatility of interest rates Volatility of Interest rates Volatility of foreign exchange rates Volatility of Interest rates Technology Technology Volatility of Interest rates Technology Volatility of Interest rates Investor preference Volatility of stock prices Risk sharing

Badla Transactions Ready Forwards Restrictions under the portfolio management scheme Interest rate caps/fl oors/collars Interest rate Swaps Currency Swaps Forward rate Agreements Automated Teller Machines Screen-based Trading Floating rate bonds Electronic funds transfer Money market mutual funds Specialized mutual funds Exchange-traded options Project Finance

Interest Rate Derivatives

Recently, Indias financial system regulators have launched exchange traded interest rate futures again in the market to help financial institutions better manage risks arising from interest rate fluctuations. Interest rate futures are derivatives contract with an interest bearing security as an underlying instrument. This future contract is based on ten-year government- bond with a semiannual coupon of 7% introduced jointly by Reserve Bank of India and Securities and Exchange Board of India. Interest rate derivatives would help institutions such as banks, insurance companies and other financial sector players to hedge their interest rate risk.

Sharp fluctuations in the interest rates and the volatility in interest rates impact financial institutions and companies particularly banks who hold large stocks of government securities. By allowing banks to trade in these derivatives the government and regulators reckon that they would be able to better cope up with the interest rate differentials. This will also bring a more liquid and efficient debt market in India.

Mergers and Consolidations

Public sector banks are looking at consolidation as a serious option in order to reduce risk to financial stability and face competition. State Bank of India currently has six associate banks, and proposed a merger of these associates. This would really increase the size which means large balance sheets and good risk management. With the help of large size, FIs can fund large deals, achieve financial inclusion with more sharpness, invest higher in technology and survive better during downturn.

In October 2007, a string of companies, big and small, obscure and famous, reported huge losses in subprime related investments led by rising foreclosures and delinquencies on home loans as priced in the once-overheated housing market began crashing. Troubles in the mortgage market spread to the financial derivatives markets first, from there it went to hedge funds, then investment banks, then banks, insurers, pension funds, etc., and soon it became clear that the entire US financial sector, and Europe and other parts of the world as well, were in the grip of unpredicted credit crisis.

India's financial markets -equity market, money market, forex market and credit market - had all come under pressure from a number of directions. First, as a consequence of the global liquidity squeeze, Indian corporates found their overseas financing drying up, forcing corporates to shift their credit demand to the domestic banking sector. Also, in their search for substitute financing, corporate withdrew their investments in domestic money market mutual funds (MFs); consequently, non-banking financial companies (NBFCs) where the MFs had invested a significant portion of their funds came under redemption pressure. This substitution of overseas financing by domestic financing brought both money markets and credit markets under pressure.
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Second, the forex market came under pressure because of reversal of capital flows as part of the global deleveraging process. Simultaneously, corporates were converting the funds raised locally into foreign currency to meet their external obligations. Both these factors put downward pressure on the rupee. Third, the Reserve Bank's intervention in the forex market to manage the volatility in the rupee further added to liquidity tightening. The real channel was transmission of the global cues to the domestic economy has been quite straight forward through the slump in demand for exports.