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The relationship between Financial Innovation, Financial Engineering, and Risk Management
Definition of Financial Engineering Financial engineering is the use of financial instruments to restructure an exiting financial profile into having more desirable properties. (Galitz) Financial engineering is the process of tailoring financial instruments and organizational structure to improve the profitability of intermediaries customers. (Mason etc.)
Definition of Financial Engineering Financial engineering involves the design, the development, and the implementation of innovative financial instruments and processes, and the formation of creative solutions to problems in finance. (John Finnerty) From the above definitions, it is clear that financial innovations are the crucial part of financial engineering.
Definition of Risk Management Risk management is to manage the risks faced by firms using various tools, including financial products. Business risk (generally difficult to hedge and manage by using financial instruments) Financial risk One main purpose of financial innovations (or financial engineering) is to help firms to do the risk management.
Receipt or expense = P Q Transaction exposures focus on only the direct effect of a price change the impact of price changes on quantity is ignored. A parallel exposure one that also focuses only on the direct effects of a price change that would be reflected in the firms balance sheet is referred to as a translation exposure. A translation exposure reflects the change in the value of the firm as foreign assets are converted to home currency.
Moving beyond the strict accounting-based exposures, some firms have begun to consider their economic exposures also referred to as competitive exposures. It measures the indirect effect of a price change.
Caterpillars FX Whammy
The strong dollar is a prime factor in Caterpillars reduced sales and earnings This is a typical example of economic exposure. The reversed story appears in A Summer of
Discontent for Japanese Manufactures
Futures contract can be traced back to 1600s in Japan. Forward contract can be found in the 12th century. Options were traded in the 17th century in Amsterdam.
Concluding Remarks
Financial innovation is a demand-driven phenomenon. Its better to manage risk actively rather than to try to predict price movements.