Financial Engineering (1/2)

In this lesson, you’re expected to learn about:
– the basics of financial engineering
– securities
– hybrid finances

Financial engineering is the practice of continuously assessing current investment methods and finding new ones in order to gain an advantage, increase returns and customize products.

It has become increasingly prevalent in corporate and personal finance, allowing you to improve your financial understanding and ability to manage finances and increasing the number of financial tools available.

In the next two lessons, we’ll talk about the propensity for changing everything into a security investment, for merging financial products to make hybrids, for combining and splitting investments and cash flows for different purposes, and for developing new and specialized investment tools.

Creating New Tools Through Financial Engineering

Financial engineering is nothing more than the creation of new and interesting financial tools, often accomplished through the use of mathematical modeling and computer engineering.

Financial engineering is where the majority of innovation is occurring in the field of finance. These innovations include new ways of interpreting information, investments, debt, transaction methods, strategies and accounts, and new ways for organizations to improve their financial efficiency and overall financial wellbeing – assuming that they know how to make effective use of the tools available to them.

Note: As a financial manager, you need to be careful with unique and exotic financial tools and products. If you’re not certain about what you’re doing, ask an expert.
Securities
When talking about securities, usually we’re referring to equity securities, also known as shares. Equity securities aren’t the only type of security though.

Securities include any financial investment that derives its value from an underlying asset. So although shares are a type of security whose value is derived from the ownership in a company that’s also changing in value, bonds derive their value from underlying assets, as do mutual funds and derivatives. With that mind, people can make securities out of almost anything.

Securitization

Securitization is the creation of new forms of securities or new classifications of an existing security, based on some asset that currently has value or future value but in which no one is yet investing.

The goal is to raise funds and distribute risk to a group of people seeking risk. You can do securitization with just about anything that has a value and it’s a common trend in financial engineering.

Commodities Trading 

Although it isn’t a form of financial engineering, commodities trading helps illustrate the nature of securitization. In commodities trading, brokers act as intermediaries between producers and processors or retailers, usually for agricultural goods, natural resources, gold, diamonds, industrial metals etc.

People don’t just securitize items; they securitize everything. For example, car loans and credit card debts. One of the trends in financial engineering is to find assets that have values and securitize them, developing securities that derive their value from that asset.
Mortgage-Backed Securities 

Probably the most successful development in securitization, as measured by the popularity of its use, is the mortgage-backed security (MBS).

An MBS starts out with the banks; they issue mortgagees just like any normal bank. The future cash flows on these mortgage loans are considered an asset now, because the bank receives repayments from the borrower for the principal balance as well as the interest payments. The banks then sell securities that use those future cash flows as the underlying asset. They sell the securities for cash to investors, and then repay the investors using the future cash flows on the mortgages.

The investors generate a return on investment, and the banks use the capital raised from selling the securities to reinvest and increase the current value of future cash flows from the increased number of mortgages issued.

MBSs are also a way for banks to limit their exposure to risk by issuing loans. A mortgage that goes into default doesn’t continue to generate cash flows, and so the holder of the MBS is the one who loses value on the investment if a mortgage defaults, not the bank.

By selling mortgage loans to the investment market in the form of MBSs and thereby distributing the risk among a larger group of people, banks can reduce their own risk exposure on these loans.

[Optional] Mortgage-Backed Securities
Tranches 

Financial engineering has taken securitization even further, allowing individual securities to be divided into classes, called tranches, of investments that have varying repayment periods.

This strategy varies the amount of interest-rate risk associated with each tranche and attracts a wider range of investors to a single security.

With MBSs, for example, this division is a special class called collateralized mortgage obligations, and the tranches are classified by class: A, B and C.

Investors in each class receive their portion of the interest payments for as long as their portion of the principal isn’t yet paid off. Regarding the principal, Class A shares receive their repayment first, followed by B and finally C. So although Class C shareholders receive more interest payment in the long run, they’re also accepting a higher degree of risk that interest rates will exceed the payments they’re currently receiving.

The Class A tranche has the lowest risk but receives repayment over a shorter period of time. The class that investors choose depends greatly on their level of risk avoidance as well as their current portfolio strategy needs.

Credit rating agencies (agencies that decide how much of a credit risk a company or an individual is) are also involved in this whole process too, which demonstrates how attractive these products are to investors.
Hybrid Finances
A hybrid is anything made by combining two or more things. For example, hybrid cars are cars that run some of the time on an electric engine and some of the time on a standard combustion engine.

In finance, hybrids are created by taking two financial products and combining them together into a single product.

Some work more effectively together than others; sometimes the traits of each component of the hybrid function separately, creating no benefit other than having two financial products rather than one.

The more successful hybrids are those where the traits of each component complement each other in some way.

Let’s now look at some examples of hybrid financial products.
1) Mixed-interest class of hybrids

Whether you’re talking about investments (such as bonds, money markets, annuities) or loans (such as mortgages, business loans, credit cards), mixed-interest hybrids combine aspects of fixed-rate and variable-rate financial products.

A mixed-rate bond, for example, guarantees a minimum rate of return that also matches interest rates if they go over a certain level, giving you the best of a variable- and fixed-rate bond.

For example, a typical mixed-rate bond may include a minimum guaranteed fixed 3% interest rate with the potential to increase above 3% if interest rates rise above that level. This sort of hybrid interest rate is partially pegged to some other indicator, such as interest rates or some index.

Mixed-rate products can also be time-dependent. Many mixed-rate mortgages include teaser rates where the interest on a mortgage remains fixed for a period of time before switching to a variable rate.

These types of mortgages have come under scrutiny recently as a form of bait-and-switch arrangement. Customers are ‘baited’ by low rates only to find out that they’re not available and are then sold another mortgage with higher rates of interest.

Mixed-rate loans can be quite beneficial in the right circumstances but the reality is that these circumstances can be extremely difficult for even professionals to predict.

2) Single asset class hybrids

Some hybrids combine different types of a single asset class. Convertible debt, for example, is a loan that has the option to be converted into a fixed number or value of shares.

Convertible preference shares also have the option to be converted into a fixed number or value of ordinary shares. This form of hybrid doesn’t provide the same sort of simultaneous benefits of each component as other forms of hybrid do, but the option to choose which traits you have available to you in your investing is still a valuable benefit for strategic and portfolio investing.

2) Single asset class hybrids

Some hybrids combine different types of a single asset class. Convertible debt, for example, is a loan that has the option to be converted into a fixed number or value of shares.

Convertible preference shares also have the option to be converted into a fixed number or value of ordinary shares. This form of hybrid doesn’t provide the same sort of simultaneous benefits of each component as other forms of hybrid do, but the option to choose which traits you have available to you in your investing is still a valuable benefit for strategic and portfolio investing.

Furthermore, a number of hybrids combine completely different types of asset classes. Packaging different types of investments together with call or put options is a particularly popular option.

In cases of equity, debt and even money-market investments, hybrid investments are now available that include, by default, put options that allow you to sell your investment at a given rate or price.

3) Index-backed CDs

One hybrid investment uses several of the hybrids we just mentioned to create a sort of chimera; something that has been combined with so many different things that it barely resembles its original form anymore. This investment is the index-backed CD with a put-option hybrid.

To create this, you start with a standard certificate of deposit (CD), which is a timed deposit that works like a savings account, except that it includes an obligation to maintain the principal balance for a minimum period of time.

You combine that with a variable-rate security that’s pegged to an equity index, so that the interest rate floats with the index. Now, you tack on a put option that allows the investor to sell his stake in the CD for a set return that’s usually based on the present value.

[Optional] Hybrid Financing
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