What is Financial Engineering?
Financial Engineering is a complex process used by large companies to ensure that they can fulfill their financial obligations at certain times in the future. It is however just as relevant for individuals and small companies.
We cannot accurately predict the level of stock markets, bond yield or house-prices on any given date, but we do know when we are likely to need money (retirement, school fees) and we know that there will be times when we unexpectedly need money (illness, redundancy). How can we engineer our finances to guarantee providing us with what we need when we need it?
Large companies employ teams of financial engineers to use highly mathematical, statistical analysis to model possible scenarios and construst synthetic financial products or fine-tune existing products to meet the needs of the company’s financial requirements. Individuals generally have fewer resources and options, but we can at least use similar techniques and ideas to help guarantee a secure future.
Disclaimer: Information in this and other linked articles is unregulated and for general information only and is not intended to be relied upon in making specific investment decisions. Appropriate independent advice should be obtained before making any such decision.
Financial Engineering Tools readily available to us:
Financial Engineering uses stock-market investments, bonds, property etc. then modifies or insures their capital values and yields using derivatives, options, futures and various other complex instruments to fulfill their requirements at a later date. e.g. futures can be used to guarantee the delivery of commodities required for a construction job at a predefined price on a certain date to remove the uncertainty in price and possible reduction of profit.
The Simplest Form Of Financial Engineering – The Balanced Portfolio:
The simplest kind of financial engineering is to build a balanced portfolio (See related article). This reduces risk by mixing uncorrelated assets, but does not guarantee a defined amount of money on a certain date. An extension to this would be to use a carefully selected choice of government bonds with a range of maturities, which would naturally be a part of a balanced portfolio anyway, to provide a defined amount on various dates in the future as required. Once your obligations have been met the rest of the portfolio can be invested in higher risk investments for potentially higher returns.
Financial engineering, as practiced by professional organisations, may involve the use of stock options and other derivatives to ensure certain outcomes are achieved on certain dates and complex mathematics such as the Black Scholes option pricing equation used to determine the value of the derivatives (effectively using Physics – Brownian Motion – to model the random movements of asset prices) but, although this is very useful, it is also possible to model your porfolio with a spreadsheet and estimate some best and worst case assumptions.
Income from employment must also be factored into the equation, with the possibilty of that revenue stream being terminated being taken into consideration. Early in a carreer some risk has to be taken and the assumption that many years of employment are ahead is reasonable, but as time goes by this assumption becomes a dangerous one and a safety-net of cash needs to be kept for emergencies.
If you are employed and have a sufficient income stream to live on, your investment portfolio does not need to create any income until you retire, but should grow with time. Income is generally taxed more heavily than capital gains, but if your other income streams stop you need to be able to convert the portfolio to provide sufficient income or have a reserve to keep you going until new employment is found.
A spreadsheet should be used to model your portfolio; both the current totals of each investment, minus the loans, mortgages etc. but also the future expected value and possible range of values of each entity at various points in the future. i.e. “What-if?” analysis can be performed (What if I lose my job? what if inflation increases or stock-markets crash etc.)
If you are familiar with spreadsheets it is simple to create a table of all of your assets and debts using the SUM(…) function. Then predicting future values of each asset can be achieved by making assumptions about inflation, bank base-rates, stock-market returns and income requirements. Maximum and minimum values for each should be plugged into the spreadsheet to model future possible returns and see if you are on the right track.
Planning for the predictable events, as mentioned earlier, can be planned for using government bonds. These pay out a defined sum every year or half year (The “coupon”) and a final sum on maturity. It the maturity coincides approximately with when you need the money this makes an ideal financial planning tool. The income and final payment is predictable and governments of stable countries rarely default on their payments.
An alternative to government bonds is corporate bonds, issued by companies rather than governments, which in general pay a higher yield depending on the perceived quality of the company. Alternatively Zero Dividend Preference Shares (See related article) provide the same function, but producing no income (zero dividend) producing their return entirely from capital gain – i.e. paying a predefined amount on a certain day in the future. These are ideal for financial planning and tax planning.
Investing in individual corporate bonds is fairly risky in that the company could default or go bust, so a portfolio of bonds would help to reduce the risk or better still a managed bond fund (e.g. an exchange traded fund or ETF, mutal-fund, unit trust or OEIC) Unfortunately these do no have a defined end date, but they will have a average “duration” value published, just like any bond, which defines the weighted-average amount of time for the bond or fund’s cash-flows to be received by the investor (i.e. how long before half of the total payout – coupons and redemption value – is received) Choosing an ETF with a similar duration to your ideal individual bond would give a similar effect. The lower the duration the less risky the bond or fund and the lower the sensitivity to the bank base rate – as bank base-rate goes up generally the bond-price goes down and vice versa:
Change in Bond-Price = -(Duration) x (Bond Price) x (Change in Bond Yield)
or more formally: dP = -(ModD)(P0)(dr)