Harsha Malhotra

Rohit Oberoi

Factors

Environmental Factors

Intrafirm Factors

Financial Engineering

Environmental Factors
Factors external to the firm and over which firm has no direct control but which are nevertheless of great concern to the firm because they impact the firms performance.
General globalization of industry & fin. markets

Increased price volatility

Tax assymetries

Technological advances

Advances in fin. theory

Regulatory Change
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Increased trans. cost and competition

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Intrafirm Factors
Factors internal to the firm and over which firm has at least some control.
Liquidity Needs Risk Aversion among managers and owners Agency Costs

Greater levels of Formal Training of quantitative Senior Level sophistication among personnel Financial Engineering investment managers

Interest Rate

Price Volatility
Equity Capitalization Rate

Exchange Rate

More Abstract

Price of Equity as Rupees per share

Rate of Return of Equity(CAPM) Consists of Dividend Rate and Capital Gain Rate
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Prices are determined by Market Forces

StablePrice Stability

Demand
Changes RapidlyPrice Volatility

Supply

Speed of Price Change

Frequency of Price Change

Magnitude of Price Change

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Financial Engineering

Other Factors

Change in Cost of Production

Change in price of other goods

Expectations about future demand and supply conditions

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Size of market

Inflationary Forces

Breakdown of Intl Agreement and Institutions like Bretton Woods Agreement

Globalization of Markets

Rapid Industrializ ation of many under developed countries

Greater Speed in acquiring , processing and acting upon info

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Cheap Labor

Overseas Subsidiaries for potential markets

Globalization

Better access to raw materials

Reduced Transportation Costs

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Globalization also leading to greater use of debt in capital structures causing increasing leverages and higher risks thereby paving way for devt. Of Financial Engg. instruments
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Tax Assymetry
A situation in which two parties to a transaction pay different tax rates. This may affect what one party or the other desires about the timing, price, or other factors regarding the transaction.
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Example of Tax Assymetry

Financial engineers that arbitrage tax assymetries helps firms to avoid taxes- a practice ruled by the courts to be a constitutionally guaranteed right.

Financial Engineers do not assist in aversion of TAXES

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Technological Advances

Devt in Communications

Advent of Spreadsheet programs

Leading to design and introduction of stock index futures(Program Trading)

Look down Satellites

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Financial Engineering

Advances in Financial Theory

Extensive theoretical contributions from academicians to financial theories formed the backbone of new financial instruments and their usage. Development of financial theory capable of explaining the valuation of stock Index futures contracts led to Order matching computer system on NYSE Known as Designated Order Turnaround (DOT) system. Elaborate research on mathematical relationship which exploit discrepancies in market price led to program trading or future-cash arbitrage causing short run volatility.

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Advances in Financial Theory

Valuation Theory
Portfolio Theory Hedging Theory
By Irving Fisher in 1896

By Harry Markovitz in 1952 By Leland Johnson and Jerome Stein in 1960

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Regulatory Change and Increased Competition

Increased competitive pressures, better risk management techniques, coupled with the 1980s atmosphere of deregulation led to efforts to repeal much of regulation heaped on the industry. Massive failures in the thrift industry acted as catalyst for deregulation.

Interstate banking broke down, commercial banks became increasingly involved in investment banking.
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Regulatory Change and Increased Competition

Competition among banks became so fierce, to keep existing clients investment bank would engineer unique instruments to fit the clients.
The complexity of these products was to the degree, that the client firm did not understand the products engineered on its behalf.

Many of the financial products innovated in the 1980s blew up in the faces of the clients firms soon it were issued.

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Transaction and Information cost

Enormous technological development decreased the cost of information, on which many transactions feed. Thus, the cost of transacting itself, declined significantly during the decade of 1980s. Unlike today under 1970s transaction cost, arbitrage opportunity does not exist. Ex. The per share cost of transacting a share of say $100 has declined from something on the order of $1.00 at the start of 1970s to under 2 cents by the start of 1990s.
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Intra- Firm factors

Liquidity needs Quantitative Sophistication

Agency cost

Risk Aversion

Formal Training of Senior-Level Personnel

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Liquidity Needs
Liquidity has many facets;
Ease of conversion of cash, or put cash to work, Degree to which market can absorb sale and purchase without imposing excessive cost, Size of bid-ask spread.
Financial innovations help corporation and individual to meet these needs
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Liquidity Needs (Example)

Money Mkt acct, Sweep Accts, Electronic fund transfer, Certificate of deposit(CD) market, Repo market were designed to provide access to cash or put unneeded cash to work.

Instruments such as floating rate notes, adjustable rate preferred stock are long term securities whose values do not deviate to nearly the same degree as traditional fixed coupons.

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Risk Aversion
Although corporate managers have become increasingly aware of their risk exposures,

These managers are also uncomfortable with the instruments of modern risk management.

They often fail to understand the intricacies of these modern instruments.

Hence Formal Training of Senior-Level Personnel has become a serious issue.

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Risk Aversion Instruments

Interest Rate Futures Stock Index Options Interest Rate Options Stock Index Futures

Currency Futures

Currency Options

Forward rate Agreements

Forward Exchange Agreements

Financial Engineering

Swaps
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Agency cost
An agency cost is an economic concept that relates to the cost incurred by an entity (such as organizations) associated with problems such as divergent management-shareholder objectives and information asymmetry. The costs consist of two main sources:

The costs inherently associated with using an agent (e.g., the risk that agents will use organizational resource for their own benefit)

The costs of techniques used to mitigate the problems associated with using an agent (e.g., the costs of producing financial statements or the use of stock options to align executive interests to shareholder interests).
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Agency cost (Example)

In a M&A activity by assuming ownership, management eliminates the agency relationship and presumably, most of the costs associated with that relationship entails.

This helps in increasing the share value, and justifying for the excess payment made.

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Quantitative Sophistication and management training

In very few areas is quantitative sophistication more important than in investment arena.

By deciphering complex situations through tedious mathematical techniques could enhance returns by a respectable number of basis points.

Hence firm expend huge sums on training of management in quantitative sophistication .

Example: Institutional Investors such as Mutual Funds, Insurance Companies, Pension Funds, Trust Managers, Security Dealers and Arbitragers uses these techniques.
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Financial Engineering

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