To what extent does financial engineering have an important role - Free Essay Example

As we are in modern world today, everything around us has been changing continuously. The world that we see today is different from the world in 40 years ago. Technologies are one example, which has been improving dramatically. Letter had been a popular way to communicate and then land line telephone came to help communication more easily and the following is mobile phones, which have more and more convenient until today. The most important technologies are computer and internet. These technologies have improved from local communication to instant global communications. People from Africa can talk with his friend in Thailand within a few second of connecting. Furthermore, money can be transferred from country to another country within one day. Undoubtedly, people around the world have equal chance to take a great number of news, information of stock market and financial figures from all over the world. Hence, financial markets will respond without delay. It is clear that globalization has made information in financial market spread fast and developed in term of size and complication. Implication of globalization in financial markets is that there are more speculators, which increase volatility of financi al markets. The meaning of volatility of financial markets is amount ofÂÂ  uncertainty or riskÂÂ  about the size of changes inÂÂ  aÂÂ  securitys value. Due to the volatility of markets, they created an increasing demand for intelligent financial product to manage financial risk. This foundation contributes to establishment of financial engineering (Galitz 1994). This essay will provide background information of financial markets and financial engineering and then examine the role of financial engineering in financial market. The reader of this essay might have basic background in finance. Hence, technical terms are defined clearly and avoided to discuss in deep knowledge. Background knowledge of Financial Market Financial market is a market where financial asset are exchanged (Fabozzi, Modigliani, Jones, Ferri 2002). Financial asset can be classified as tangible asset (such as, money, building, land or machinery) or intangible asset (future benefit, patents). Participants in financial market are household, corporations or government. There are various ways that financial market can be classified. It can be classify by financial claim, such as debt market and equity market. Another type of classification, which is generally used, is classified by financial assets that are traded in. Firstly, it is capital market, where is divided into two submarket; stock market and bond market. Secondly, money market, it is a source of short-term borrowing and lending. Thirdly, derivative market, this market is necessary for financial engineering because it is where financial instruments are used to manage financial risk. Financial market can be found in almost countries in the world because of three main functions of financial markets. First, interaction of buyers and sellers in the market determine the price of the traded asset. The price depends on demand(buyer) and supply(seller) (Fabozzi 2002). Second, the market provides liquidity, which is offer investor to sell financial asset (Fabozzi 2002). Third, it reduces cost of transactions, which is search costs and information costs (advertisement) (Fabozzi 2002). Background knowledge of Financial Engineering The term financial engineering is defined in numerous definitions, but most definitions are about managing and reducing risk. It is generally defined that is application of various mathematical, statistical and computational techniques to solve practical problems in finance. Similarly, a few of definitions in books are explained in the same way. First, it is referred to adjustment or tuning existing financial product to increase profits or reduce risk in financial market that changing continuously (Eales 2000). Another definition that totally clarifies the concept of financial engineering is Financial engineering is the use of financial instruments to restructure an existing financial profile into one having more desirable properties (Galitz 1994). It seems that this term has wide range of definition due to a vast of utilization and knowledge in this field. Goal of financial engineering is different in each position in financial markets. There are two sides in financial market, which are buyer and seller. For buyer side, such as investor, an achievement is to take high profits from investment in financial markets. For seller side, such as the company treasurer, it may be diminished influences of currency on a project that is in initial stage (Galitz 1994). Hence, achievements of financial engineering depend on position in financial market. Instruments of financial engineering Mechanical engineer has knowledge about materials and machineries system such as, theories of solid and gear system. This knowledge seems to be tools of mechanical engineer that are applied to create new machinery. Similarly, financial engineering has knowledge about financial market, mathematics and computer programming, which are tools for managing risk in financial market. Many of instruments were invented or developed to do a particular job, whereas they were found to have an extensive variety of other uses as well. Therefore, each type of situation in financial market needs to be supplied by suitable instruments. Financial instruments can be divided into six sectors, which are fixed income instruments, equities, currencies and commodities, derivatives, credit instruments and structured products (Neftci 2008). In this essay will explain only financial instrument in derivatives market, which has futures contracts and options. However, swaps is another financial instrument in derivative market, I would not describe it in the essay due to complication of its structure. There are distinct characteristics of each financial instrument in derivatives market. First, a futures contract is a contract that is an agreement between two parties to buy or sell an asset at a certain time in future for a certain price (Hull 2006). For example, in July 2010, company A sign a future contract between company B that company B will sell live cattle 50 units to company A with unit price of 100 pounds in Dec 5, 2010. This means that at Dec 5, 2010 company A have to pay 5000 pounds to company B and company B have to transfer 50 live cattle to company A. The contracts can be any asset, such as pork, sugar, wool, stock indices and currencies. The benefits of futures in term of managing risk will be explained in later. The second instrument in derivative market is options. There are two basic types of options. A call option offers the holder the right to buy the underlying ass et by a certain date and a certain price. On the other hand, a put option gives the holder right to sell the underlying asset by a certain date and a certain price (Hull 2006). The price of the contract is called exercise price or strike price. The distinction between futures and options is that options allow the holder does not have to exercise, which mean holder have choices to sell or buy at favorite price, but the holder of future contract must buy or sell at certain price. Consequently, both futures contracts and options have similar condition, but they are use in different situation, which will be explained in next paragraph. Role of financial engineering in financial market (450) As I mentioned, roles of financial engineering are divided into sell side and buy side. Financial engineering is useful for those buy side and sell side. To begin with buy side, they can be person or company who want to buy futures contracts or options and used the contracts as a tool to hedge the risk. For example, suppose that it is Sep 5, 2009 , Import Co., based in United States , know that it will have to pay 10,000 pounds on Dec 5, 2009, for goods it has purchased from a British supplier. The USD-GBP is important factor that affect to the exact money (USD) that have to pay to British supplier on Dec 5, 2009. Hence, Import Co. can use futures contracts to hedge its foreign exchange risk by buying pounds (GBP) from financial institution in the 3-month forward. This would have the effect of fixing price to be paid to British supplier because whatever exchange rate in the next three months is Import Co can pay the same amount of money by using exchange rate in future contracts. F inancial engineering has responsibility to calculate exchange rate of future contracts that should buy. Hence, Risk in foreign exchange rate can be managed by financial engineering. Moreover, the buy side can be investors, who use financial engineering to maximize the income with utilizing the idle money. Financial engineering have mathematics and computer programming skill, which can create a model of any financial indices with a certain uncertainty. This is some examples of using financial engineering from buy side in financial market. For sell side, can be financial institution that set the price of futures and options in each contract. Price of options and futures for each contract have profound implication because they have to set in appropriate position. It seems setting price of goods. If the price is too low, company might lose money, whereas if the price is too high, consumers might not interest in this product. Another important role is that creating new financial instr uments. Financial market is developing everyday with an increasing of complicated structure. Thus, new financial instruments need to be created to manage new type of risk and There are wide ranges of financial instruments and they have numerous roles in financial markets. Development of financial market needs to support by new instruments. Hence, the role of financial engineering will be increased. Financial crisis and financial engineering (400) Conclusion (200) Financial engineering has crucial role in financial market today and it is increasing continuously. Due to globalization, financial market has been improving. Volatility of financial market also increases as well. This is the reason that financial engineering was established. Financial engineering has major role is that managing risk in financial market. There are many type of instruments that be applied into the market, such as futures contract and options. For example, future contracts can be used for hedge foreign exchange rate. There are also other types of instruments for dealing with financial problem. Consequently, in the next century, financial engineering might be interested more and more.