Financial Engineering (2/2)

In this lesson, you’re expected to learn about:
– bundling assets and unbundling securities
– exotic finances
– portfolio engineering
– computational finance

Bundling

Not all combinations of investments are hybrids. Grouping together several of a single type of asset, or sometimes several different types of assets, and selling them collectively as a single security is called bundling.

The act of bundling involves taking several different assets and lumping them together in something called an asset pool with a nominal value equivalent to the sum of the values of the individual assets included.

The issuer takes the total value of the assets or their future cash flows and sells equity backed by this value, whereby ownership in the asset itself or its cash flows generates returns. The source of derived value is similar to that of a share or a bond, respectively.

The aspect that makes bundling significantly different from standard securitization is the matter of risk – the risk-adjusted value is higher than the sum of the individual assets. By its very nature, bundling creates a certain amount of inherent diversification with the security and so the risk of the bundle has to be measured as a unique set in itself.

This assessment is done by classifying each individual asset by its risk level and then taking the weighted average of the different classifications present within the bundle.

Multi-Asset Bundles 

One form of bundling includes grouping together multiple different types of assets. Mutual funds are a common example of this type of bundling because they frequently group together different types of equities, bonds and other forms of assets into a single pool. Investors then purchase shares of ownership in the mutual fund itself.

As opposed to a hedge fund, where people give their money to someone who then manages their cash as a pool, mutual funds are pools of assets in which people invest.

The risk of these multi-asset bundles is measured a bit differently compared to single-asset bundling, because the risk of each individual asset isn’t measured in the same way and each asset often doesn’t have the same type of risk.

These bundles are similar to investment portfolios; in a way they’re investment portfolios that have been securitized. As a result, the most effective method to assess the risk of these bundles is to measure them in the same way you would an investment portfolio.

Unbundling Securities 

Another innovation related to bundling comes into play when a single security is broken into several different securities, in a process called unbundling.

This term usually refers to the process by which the cash flows from a single security, such as a bond, are broken apart and each is sold as a different security.

This form of unbundling is not as popular compared to bundling, although it holds just as much potential for being applied to any sort of investment that generates cash flows over time. The cash flows from a single mortgage can be unbundled, not only by the types of cash flows, as with unbundled bonds, but also with regard to their repayment periods.

This process makes several new types of investments from a single mortgage, each with a differing level of risk not only from credit risk, but also from interest-rate risk: the longer the repayment period on the security, the higher the interest-rate risk.

[Optional] Bundling
Exotic financial
Exotic financial products aren’t new – they’re just new and/or rare variations of existing products. The word exotic is used in finance to mean that something is attractive simply because it’s out of the ordinary.

Ordinary products are popular because they appeal to a larger market. The exotic products being developed through financial engineering are rare and extraordinary in large part because they only appeal to a small market of people who have much more experience in financial management and unique needs.

However, exotic doesn’t necessarily imply useful. Just because an asset or investment is available doesn’t mean that you need it. Still, these great products fulfill a number of roles in the financial world.
Owning Options 

The derivatives market, which is based almost entirely on contracts that can be customized as long as a legal document is in place between the issuer and the holder, has been rife with the development of exotic financial tools.

A number of unusual options (the right to buy or sell equities, bonds, foreign exchange contracts etc. at a future date but at a price that is agreed now) have been developed.

Options are available that are dependent on some milestone occurring before the option expires but after it’s issued.

Some options become valid only if the price of the underlying asset drops below a certain level, whereas others become invalid if they drop below that level. The same can be said for some options that become valid or invalid when they rise above a certain level.

The value of some options depends not on the final stock or share price on the expiry date, but on the maximum or minimum price achieved while the option was in play.

The value of some options varies depending on different macroeconomic indicators, such as unemployment levels, the balance of trade or any of a number of indicators, such as GDP.

[Optional] Top Strategies For Trading Exotic Options
Swaps Contracts 

Swaps contracts are derivatives whose value varies not with the value of the underlying asset or even in response to variations in some indicator, but in response to the level of variation itself.

Here are three examples:

– Variance swaps: Derive their value form the amount of volatility experience, called a variance strike.

– Forward contracts: customized by their very nature (in contrast to futures which are standardized). Thus, they’re unique such that you may only see a particular variation once, depending on what the two parties to the contract agree upon.

– Indexed-principal swaps: have their principal value vary with some index, usually inflation or interest rates.

Exotic Loans 

The development of exotic financial products isn’t limited only to derivatives. A number of loans have become exotic as well.

Some lenders promote interest-only loans, which have extremely low initial repayment rates because borrowers are only paying back the interest without affecting the principal balance. Repayment of the principal comes after a certain period of time, at which point payments increase dramatically.

Although these types of loans are attractive, because they attract lower payments, don’t be tempted. You still need to produce the cash to repay the principal at the end of the term.

Another type of loan, called a negative amortization loan, requires borrowers to pay less than their interest payments at first, deferring those payments back into the principal loan and thereby increasing the amount they must pay back in the long run when repayment costs jump.

Portfolio engineering
Portfolio engineering and investing strategy go hand in hand and is easily the most mathematically complicated subject in financial engineering. Financial engineering often involves highly advanced probability and calculus.

Portfolio engineering is all about developing models and strategies that use combinations of assets to maintain a certain percentage return on investment.

A wide variety of investments are typically used, including equities and debt, bundled and hybrid investments, but they’re almost always derivatives of some sort. The intention is to ensure a certain amount of return on investment.

Some of the early portfolio strategies include options with complicated names such as covered call, protective put, straddle, iron condor, collar etc. Many futures strategies focus greatly on generating revenue off the spread, which is the difference between the ask price and the bid price.

However, more and more companies are beginning to move away from these simple strategies and towards the use of algorithms (step-by-step procedures used for calculations, data processing automated reasoning) to determine financial transactions and strategies for the development of portfolios.

These algorithms are often based in stochastic calculus, which, when applied to mathematical finance, sets out to estimate and predict time intervals of asset prices by treating them as a random variable.

Flash Crashes 

Modern portfolio management is done, in large part, automatically – managers preset computer algorithms that are designed to take specific actions if specific milestones are reached.

For example, they may automatically buy or sell a certain amount of shares that change in value to meet specific criteria, depending on the current value of other assets already in the portfolio at that moment in time. This strategy is determined using mathematical models.

In May 2010, the stock market experienced something called a flash crash, where the Dow Jones Industrial Average stock index lost nearly 10% of its entire value almost instantly and then regained that value in just minutes.

It was caused by the use of automated algorithms as a form of portfolio management. When one algorithm triggered a sell-off of a particular quantity and type of asset, the action triggered other algorithms also to sell certain things, and the entire thing became a chain reaction.

As prices dropped so low, those managers aware of what was occurring took the opportunity to buy up the undervalued assets and at some point the algorithms eventually triggered a repurchase, driving up the price again.

This example illustrates two trends in financial engineering: 

i) The flash crash was primarily caused by the use of automated mathematical modeling, making it an issue of concern for portfolio engineering.

ii) The crash couldn’t have happened without the use of advanced computer engineering, which allows high-frequency trading and automated responses to occur.

Computational finance
The most significant trend in the manner in which financial transactions take place and the financial implications of this change comes from an overlap between financial engineering and computer engineering, called computational finance.

Portfolio engineering and computerization have become intrinsically interconnected. As the calculations related to financial decision-making become more complex, doing them manually is no longer efficient (or even possible in some cases). Instead, the process is automated. The financial management is more related to computer programming and pre-setting action triggers is more connected to the portfolio strategy than to actual trading.

In addition to portfolio management, computerization has also significantly changed the dynamics of trading as a whole, altering how transactions take place. With this change in the manner of transactions comes a change in the methods used to gain an advantage.

Thus, the success of financial managers is increasingly intrinsically linked to their computer skills. Every company needs to link its finance and IT departments, regardless of the range and scope of its financial functions. This aspect of financial engineering has completely reshaped the world of finance and this trend is sure to continue to have implications for all companies around the world.

[Optional] What is Computational Finance?
The changing face of trading 

With regard to corporate investments, nearly every aspect except capital investments and the setting of strategies, is done by computers now. The stereotypical image of the trading floor of a stock exchange is no longer existent, because those floors are now set up with rows of computers where all exchanges take place.

This shift to e-trading has provided just about anyone the opportunity to become nearly as effective as professionals. Not only do they have access to fast transactions using some of the same networks, or at least similar ones, but also these transactions are extremely cheap. Discount brokers often charge less per transaction and people no longer have to go through a professional for these transactions to take place.

Computerization has hugely changed what makes one trader competitive compared to others. Traders and portfolio managers are becoming more competitive based on the effectiveness of their automated algorithms and the speed of their computer network.

The speed of orders and trades is measured in milliseconds as traders attempt to ensure that they’re the first to get their orders through, before other automated systems have a chance to drive up or down the price of a particular asset.

The fastest can take advantage of this ability by instantaneously reselling at the higher or lower price, making extremely high volume trades within seconds of each other and generating revenue by repeating this process countless times throughout each day.

All computer programming is based on logic to some extent. Over time, programs have become far more mathematical and can be used for things such as tax management and even executive management.

Automated systems that directly track a company’s financial activities, or interact with other financial computer systems, make decisions based on tax legislation or other more advanced algorithms related to business-decision management.

As with most jobs, computerization and computer engineering is being applied to corporate finance at the functional level as well. Computers are supplementing or replacing multiple financial roles within organizations.

Some common financial software packages are:

· ERP Financials: comprehensive financial management
· Hyperion: financial management
· SAS: modeling and analysis
· SPSS: statistical analytics
· STATA: modeling and analysis

Computerization is the most dynamic, comprehensive and fast-changing aspect of financial engineering, and so these software packages are prone to becoming outdated at any point.

Still, most of them are well integrated into the financial community and have been around for quite a while. This particular area of financial innovation changes at a fast pace and companies must review it continuously in order to remain competitive.

Jim Rohn Sứ mệnh khởi nghiệp