Financial engineering

This paper is made to discuss some issues regarding financial engineering and its role in economy. Our discussion will also include role for commercial banks, credit rating agency etc. We will provide a wide idea about role of these factors in collapse in 2008. Our discussion include following-

• What is financial engineering?

Financial engineering is a process where combination of mathematical and financial theory is used to solve a problem. In short in this is a process where mathematical methods are used to solve financial problems. Financial engineering draws some help from applied mathematics, computer science, statistics and economic theory. In a broad view, any person who uses technical tools in finance could be called a financial engineer. For example, any computer programmer in a financial institution or any statistician in a government economic department works as a financial engineer. However, most of the time practitioners restrict themselves to someone educated in the full range of tools of modern finance and whose work is informed by financial theory. It is sometimes restricted to cover only for originating new financial products and strategies.

Computational finance as well as mathematical finance is considered as subfields of financial engineering. In this context it is also to be considering that computational finance is a field in computer science and it deals with the data that arise in financial modeling. Mathematical finance is the process where application of theoretical mathematics is widely done to finance. Very often businesses apply process of financial engineering to problems such as new product development, derivative securities valuation, portfolio structuring, risk management, and scenario simulation.

• What are credit default swaps and their role in the financial crisis/near collapse of 2008?

A credit default swap is an insurance contract between a protective buyer and a protective seller covering a corporation's, or sovereign’s specified bond or a particular loan. A protective buyer usually a pays an upfront payment and also pay yearly premiums to the protective seller to cover any loss on the face value of the referenced bond or loan.

So, actually credit default swaps are bilateral contracts i.e. they are private contracts between two parties. Credit default swaps are subject only to the collateral and margin agreed to by the contract. They are traded OTC usually by telephone or internet. They are always subject to re-selling to another party willing to enter into another this type of contract. So, most considerably, credit default swaps are subject to “counterparty risk.”

If the party providing the insurance protection does not able to pay have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan, the premium payments are gone as it is considered as insurance against default.

CDS are not standardized financial instruments. Actually, technically this is not true securities since they are not transparent and they do not traded on any exchange. Further, it does not cover under present securities laws and is not regulated. They

 This kind of derivative mostly used for hedging purpose.  They serve a real purpose as a hedging device. The actual holders of outstanding corporate or sovereign loans and bonds might seek for a guarantee that the debts they are owed are repaid.

However, this serves as tools for speculation for risk speculators who wanted exposure to certain asset classes, such as various bonds and loans or security pools such as residential and commercial mortgage-backed securities but didn't actually own the underlying credits.

Its role- In CDS if your house is washed away in the next hurricane I get paid its value because I am speculating on an event. So, I am making a bet over here.

The bad news over here is that there are even worse bets out there. There are CDS written on subprime mortgage securities. This are bad enough mortgage pools that banks and hedge funds were over-rated and ended up falling significantly in value as foreclosures mounted on the underlying mortgages in the pools. However, since this is a bet so it provides an exposure for buyer.

In order to explain this in a better way we will take an example of most famous insurance company of the world named AIG. The company was short of collateral at a time when it needs that most. This is because they are greedy and speculate much using CDS.

Picture illustrated bellow will show this better- 

 

Picture shown above shows the way crisis happens for AIG.  Make no mistake that there is nothing wrong with AIG's insurance subsidiaries. In fact, Fed made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate (LIBOR).

AIG got greedy. So as on June 30 AIG had written $441 billion value of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these securities fell, AIG had massive write-downs and additionally had to post more collateral. So, there ratings were downgraded. So, company had to post even more collateral. And they did not have this required collateral.

These securities are causing many of the massive write-downs at banks and other financial institutions like investment banks or insurance companies. Knowing this entire means for hedge funds the credit markets and the stock market is the key for understanding where this might end and how it should be end.

Roles of investment banks in crisis-

Investment banking is a specified banking system that allows customers to invest their money directly and indirectly. Further this also helps companies, government and individual raise fund by selling bonds, security and by issuing an IPO. Investment banking gives both experienced as well as the novice of investment sector an opportunity to maximize better dividend of their business. However, reason for crisis exists over here as investors believes on investment banks but in greediness of profit they choose some wrong investment destination and insists investor to engage in this type of investment. An example of this could be involvement heavily on subprime mortgage 

They also help to boost financial security of a country from possible financial crisis. Every economy that wants to be a growing economy must require the services of investment banking. Investment banking is all about money.  Its main goal is to turning the paper works into real money. They also help investor by advising on the most suitable investment for a particular investor. In short investment banks works as a professional adviser in this respect. However, as we speak earlier in crisis major investment banks in US found clueless. They don’t even back their given advice. This creates panic which in turn leads to more crises.

Unlike the commercial banks that helps investors to invest their money directly where they want to deposit. Investment banks indirectly help investors to invest their money in a chosen market, though this is not a direct investment but most of the time it gives a higher return than normal. Recently investment banks in US have more power to enter into the market. This is one great aspect of open economy. However, this expose to high risk also, high return without risk is impossible. So, as the investment destination does not hold good investors suffers a heavy loss.

Another duty of investment banker is to sale of securities and bond in order to raise funds and capital for government and others. This is to aid the corporation to raise enough capital funds for the executions of projects and acquire more property for business.

Investment banking helps to manage portfolio. A company or an individual need service of an investment bank to manage assets in a better way. In a growing economy in which finance comes from either the public or banks, there is a higher need of an investment banks to do the proper management of both the assets and finance.

   

Picture above shows the leverage growth of investment banks in US. A higher ratio shown in the illustration reflects more risks. It is calculated as total debt divided by shareholders equity. So, this shows a comparative analysis of debt and equity also. This shows financial stability of an investment bank i.e. its ability to bear risks. This will give a clear idea about risk tolerance ability of an investment banks.

    

Role of commercial banks in crisis-

Banks play a major role in financing a developed and developing countries economy. Commercial banks main actions are:

• Accepting deposits from clients
• Lend money to borrowers
• Process domestic and foreign payments
• Issue drafts and checks
• Offer safety deposit boxes such as locker for valuable items and documents.

Of course there are some more actions. Commercial banks offers services such as financial brokering, giving investment advice etc. They also provide a wide variety of loans to business and industry in order to help them growing up. I also provide loan to individual and offer credit vehicles like cards and overdrafts. However, the common sense among these activities is that commercial banks are aimed at providing financial services to an individual or business.

Now there is the inherent reason for crisis. If you notice properly point of origin for great financial crisis of 2007-09 is the sub-prime mortgage. Commercial bank is one of the main culprit for issuing this low quality mortgage which destroy the whole system altogether.

A commercial bank is actually a collection of capital held for investment in search of a good return. The bank and its entire process, people and services is works as a mechanism for drawing in more investment capital. The main aim is to allocate this investment capital in a way that will offer the best return. By allocating capital efficiently, the bank will be more profitable and the share price will increase.

So, overall a commercial bank provides a service to the consumer. But it also provides a service to investors and borrowers by acting as a filter. Banks that do both types of jobs successfully will go on to growth at a high rate and this will also help economy to grow up. In the changing scenario, Banks that do not do one or either of these jobs may eventually fail.

But if a bank does these activities aggressively without any proper planning then there is a chance of collapse always exists. In such situation it is the duty of the government to step into the system. Later in our discussion we will look into these matters.

Role of bond rating agencies in crisis-

Bonds rating agencies work as a trusted gatekeeper. They work to provide assurance about a particular company or its securities. In the markets for structured products role of the rating agencies goes far beyond eliminating information asymmetry. Markets for structured products could not have developed without the quality assurance provided by CRAs to unsophisticated investors about inherently complex financial products.  In 2007 crisis CRAs play a pivotal role as investors believes in their rating as they should be but due underestimation of risks they trends to provide a higher rating than the mortgage securities deserves. This leads to crisis.

CRAs' substantial underestimation of the risk is due to methodological shortcomings. And when their ratings are found under scrutiny and criticism then this agencies main logic is that we have inadequate historical data, which significantly increased model risk. This is partly true but the fact that CRAs had not taken care for deteriorating lending standards.

In short CRAs does following things which are not prudent in practice-

·         CRAs provides low ratings for finance products as same as they give for government securities. They have a wrong perception based on which they provide AAA ratings to the senior tranches of structured finance products like collateralized debt obligations (CDOs).

·         Methodologies used for providing ratings are insufficient to judge risks. This is the prime reason for underestimating the credit default risks of instruments collateralized by subprime mortgages. Following has contributed to the poor rating performances of structured products:

ü  the lack of historical data related to the US subprime mortgage market,

ü  the underestimation of correlations in market

ü  An inability to judge weakness involved in securities.

Role of Congressional Legislation in the crisis-

Government housing policies plays a pivotal role for sub-prime mortgage crisis. Over-regulation and deregulation have played a vital role for the crisis, along with many others. Government policy is to promote for home ownership for people of US. For this purpose government got aggressive for mortgage loans. However it shall be done based on the credit quality of the borrower. Government policy does not allow financial institutions to take care of this situation.

Failure to regulate the non-depository banking system is another failure of government. The non-depository system grow significantly to exceed the size of the regulated depository  system but the investment banks, insurers, hedge funds, and money market funds were not subject to the same regulations. Many of this entity suffered the equivalent of a bank run, with the notable collapses of Lehman Brothers and AIG during September 2008 precipitating a financial crisis and subsequent recession.   

The impact on this entire scenario of the Community Reinvestment Act of 1977-

The Community Reinvestment Act, 1977 requires banks to lend in the low-income neighborhoods where they take deposits. There is a strong ideology that crisis of 2007 has a significant part of this rule also. This act backs certain community to meet their credit needs.

 Depending on perspective, this simple directive plays a part to charge that it imposes unfair burdens on financial institutions and helped to fuel the subprime mortgage crisis of 2007.

Financial leverage and its role in collapse-

Financial leverage is the degree to which a company uses its fixed income securities, such as debt and preferred equity. A high degree of financial leverage means higher interest payments. This will negatively impact profitability of the company.

As we know financial risk is the risk of stock holders caused by an increased debt capital in the capital structure. So, financial leverage means how much liberty do shareholders have in terms of safeness of their investment.

Recent financial crisis is a result of poor risk management. So, it is in ability to control financial leverage. The magnitude of the current financial crisis was the amount of leverage used in the housing market and mortgage backed securities derived from it. Leverage is a sensitive factor that works as a powerful ally during boom times, but at the same time can quickly become your worst enemy during the ensuing bust. 

A company with high leverage is more vulnerable at down times in the business cycle because the company must continue to pay its debt regardless of how bad sales are. A greater proportion of equity provides some financial strength.

Financial engineering method for new product development-

For developing a new product, financial engineering method can be applied to judge overall prospect of a future product. As we discuss earlier it is process of combining mathematical and financial theory in order to solve problems. So, for a new product financial engineering is used to-

1.      Decide life cycle of a product.

2.      Determine profitability level at different lifecycle period of that product.

3.      To judge prospect of the new product.

Financial engineering method for derivative securities valuation -

Finance is a sub-field of economics. So, it concerns about the valuation of assets and financial instruments as well as the allocation of resources. Centuries of history and experience have produced fundamental theories about the way economies function and the way we value assets. Derivatives security is a security whose price is derived from particular assets. So, in order to value this security there lots of mathematical logic involves financial engineering plays it part over here. There are so many methods for valuing this security but every method involves some kind of financial engineering.

Financial engineering method for portfolio structuring -

Portfolio structuring is a process of allocating investment between all possible investment options in order to optimize return. So, there are lots of calculation involves for optimizing a portfolio. Financial engineering is used for measuring risk and possible return of a portfolio as this is done in a combination of mathematics and future forecast.

Financial engineering method for risk management -

Risk management is one of the very key issues in this day’s business. Managing risk refers to mitigating risk as much as possible. In order to mitigate risk, the first job is to measure risk. The next process is to find out all possible way of mitigating such risks. The whole process of measuring and mitigating risks involves lots mathematics and   financial strategy. Financial engineering plays its part over here.

In short most of the factors stated above are calculated using a formula which is a result of pure mathematical equation but there are lots of financial theory goes behind it make it as prudent as possible.