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Chapter 25 Financial Engineering

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Chapter 25 Financial Engineering. Financial Engineering Process. Innovative Financial Instruments Creation of Innovative Financial Processes Formulation of Creative Solutions To complex problems. Financial Engineering At Magma. Copper Interest - Indexed Bonds

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Chapter 25 Financial Engineering

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  1. Chapter 25Financial Engineering

  2. Financial Engineering Process • Innovative Financial Instruments • Creation of Innovative Financial Processes • Formulation of Creative Solutions • To complex problems

  3. Financial Engineering At Magma • Copper Interest - Indexed Bonds • What is the Financial Risk of Change? • Risk Profile • Stockholders Shifted Copper Price Risk to Bondholders

  4. Risk Profile Of Magma Change in Profitability Change in Copper Prices With CIB Without CIB

  5. Who Would Want To Purchase An Indexed Bond? • Pension Fund • Portfolio Manager • Reduce volatility

  6. Symmetric And Asymmetric Hedging Strategies • Symmetric • Used by Magma • Risk of loss eliminated at cost of potential gains • Linear relationship (straight line) • Asymmetric • Insures risk but allows for potential gain • Magma buys put options • Set a floor on losses • Gain is decreased by cost of put

  7. Which Method Is Better? • Evaluate Risk and Cost • Intolerable loss • Hedging strategy • Insignificant loss • Ignore risk • Significant loss • Asymmetric strategy • Symmetric hedging strategies • Bear the risk

  8. Why Pursue Financial Engineering Strategies? • Unique Situations • When Markets are Perceived to be Inefficient • When Markets are Perceived to be Efficient

  9. Why Pursue Financial Engineering Strategies? • Unique Situations • Underdiversified investor • Texas example • Unpredictable quantity to be hedged • Farming • Drought • Abundant rainfall • When Markets are Perceived to be Inefficient • When Markets are Perceived to be Efficient

  10. Why Pursue Financial Engineering Strategies? • Unique Situations • When Markets are Perceived to be Inefficient • Selective hedging • Hedging only during periods of high risk • Speculation • When Markets are Perceived to be Efficient

  11. Why Pursue Financial Engineering Strategies? • Unique Situations • When Markets are Perceived to be Inefficient • When Markets are Perceived to be Efficient • Hedging is useful in specific cases • No taxes • No transaction costs • Fixed investment policy

  12. Swaps • Interest Rate Swaps • Currency Swaps • Commodity Swaps

  13. Swaps • Interest Rate Swaps • Fixed for floating swap • Received fixed counterparty • Received floating counterparty • Currency Swaps • Commodity Swaps

  14. Swaps • Interest Rate Swaps • Currency Swaps • Future exchanges are different currencies • Currency risk management • Commodity Swaps

  15. Swaps • Interest Rate Swaps • Currency Swaps • Commodity Swaps • Exchange of cash based on specific • Commodity • Points in the future

  16. Recent Financial Engineering Innovations • Amortizing swaps • Step-up swaps • Cap • Floor • Collar

  17. The Value At Risk (VaR) • Risk Management • Banks • Insurance companies • Evaluates Risk • Hold a Sufficient Amount of Capital • Basel Rules

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