1. INTRODUCTION TO
FINANCIAL ENGINEERING
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2. Introduction
• What is Finance?
• What is Financial Engineering?
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3. What is Finance
• Finance is about the bottom line of business
activities
• Every business is a process of acquiring and
disposing assets
– Real asset –tangible and intangible
– Financial assets
• Objectives of business
– Valuation of assets
– Management of assets
• Valuation is the central issue of finance
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4. Money vs. Finance
Monetary Economics vs. Financial Economics
Money / Credit Return / Risk
Creation Allocation
Money & International Corporate Investments
Banking Finance Finance (Capital
Markets)
Central Commercial Non-Bank
Bank Banking Financial
Money
Control Liquidity Sector
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5. What is Financial Engineering?
• Financial Engineering refers to the bundling
and unbundling of securities.
This is done in order to maximize
profits using different combinations of
equity, futures, options, fixed income,
swaps.
• They apply theoretical finance and computer
modeling skills to make pricing, hedging,
trading and portfolio management decisions.
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6. Financial Engineers are prepared for
careers in:
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7. What is Finance?
• Money & Banking —
Monetary Economics
• International Finance —
International Economics
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8. Multinational International
Corporate
Financial Financial
Finance Engineering Market
Corporate Capital Market
Finance (Investments)
Financial
Economics 8

9. What is Financial Engineering?
• Generalizing: Financial Engineering involves
the design, the development, and the
implementation of innovative financial
instruments and processes, and the
formulation of creative solutions to problems
in finance.
• Specializing: Financial Engineering is risk
management via creative structural tools.
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10. Type of Asset Exp. R of R Risk Level
1 Bank accounts 2.5-3% No risk of deposit loss. Inflation risk.
2 Money-market deposit 3.5-4% No risk of deposit loss. Rates geared to
accounts inflation
3 Money-market funds 4.5-5% Very little. Rates vary with inflation.
4 Special 6-month 5% Early withdrawals subject to penalty. Rates
certificates geared to expected inflation.
5 High-quality corporate 8-8.25% Very little if held to maturity. Rate geared to
bonds expected long-run inflation rate.
6 Diversified portfolio of 9% Moderate to substantial. In any one year, the
blue-chip common stocks actual return could be negative. Diversified
(e.g., index fund) portfolios have at times lost 25% or more of
their actual value.
7 Diversified portfolios of 9-10% Substantial. Diversified portfolios have at
risky stocks such as times lost 50% or more of their actual value.
aggressive growth mutual
funds
8 Real estate similar to Cannot be sold quickly. Hard to diversify.
common Good inflation hedge if bought at reasonable
stocks price levels. For long-term investors.
9 Gold unpredictable Substantial. Believed to be a hedge against
hyperinflation. Can help to balance a
diversified portfolio. 10

11. Unifying Principles of Finance
• No arbitrage
• Preference
• Optimization
• Market in equilibrium
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12. Principle of Financial
Engineering
• No arbitrage • Principles of Financial
• Market in Engineering
equilibrium
• Preference • Principles of Finance
• Optimization
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13. Unifying Equation of Valuation
• P=E(mx)
– Where m is state-dependent discount factor
– X is the state dependent payoff (cash flow)
• Consequence of no arbitrage equilibrium
– Conservation law of value of cash flow: the
whole is equal to the sum of components
– Composition and de-composition of cash flow
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14. FINANCE
F.E
I.T. . ENGINEERING
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15. Financial Engineers are prepared for
careers in:
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16. Suggested Background
Generally, Financial Engineers are strong on
the following fields:
• Statistics/Probability
• C++ Programming
• Basic Business Finance Theory
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17. What is a security?
A security is a fungible, negotiable
instrument representing financial value.
Securities are broadly categorized into
debt and equity securities
such as bonds and
common stocks,
respectively.
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18. What’s the purpose of securities?
For the Issuer
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19. What’s the purpose of securities?
For the Holder
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20. Equity and Debt
Traditionally, securities are divided
into debt securities and equity.
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21. Debt
Debt securities may be called debentures, bonds,
notes or commercial paper depending on their
maturity and certain other characteristics.
The holder of a debt security is typically entitled to
the payment of principal and interest, together with
other contractual rights under the terms of the issue,
such as the right to receive certain information.
Debt securities are generally issued for a fixed term
and redeemable by the issuer at the end of that term.
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22. Equity
An equity security is a share in the capital stock of a
company (typically common stock, although preferred
equity is also a form of capital stock).
The holder of an equity is a shareholder, owning a
share, or fractional part of the issuer. Unlike debt
securities, which typically require regular payments
(interest) to the holder, equity securities are not entitled
to any payment.
Equity also enjoys the right to profits and capital gain.
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23. Weighted average cost of capital
The Weighted Average Cost of Capital
(WACC) is used in finance to measure a
firm's cost of capital.
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24. Formula
The cost of capital is then given as:
Kc = (1-δ) Ke + δ Kd
Where:
Kc The weighted cost of capital for the firm
δ The debt to capital ratio, D / (D + E)
Ke The cost of equity
Kd The after tax cost of debt
D The market value of the firm's debt, including bank loans and leases
E The market value of all equity (including warrants, options, and the equity
portion of convertible securities)
In writing:
WACC = (1 - debt to capital ratio) * cost of equity + debt to capital ratio * cost
of debt
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25. The Modigliani-Miller Theorem
The basic theorem states that, in the absence of
taxes, bankruptcy costs, and asymmetric
information, and in an efficient market, the value
of a firm is unaffected by how that firm is
financed. It does not matter if the firm's capital is
raised by issuing stock or selling debt. It does
not matter what the firm's dividend policy is.
Therefore, the Modigliani-Miller theorem is also
often called the capital structure irrelevance
principle.
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26. Proposition
y = C0 + D/E (C0 – b)
* y is the required rate of return on equity, or
cost of equity.
* C0 is the cost of capital for an all equity firm.
* b is the required rate of return on
borrowings, or cost of debt.
* D / E is the debt-to-equity ratio.
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