Financial Engineering

Financial Engineering
It is a multi disciplinary field in which various mathematical tools are applied to develop new and improved financial products. New innovative strategies developed to maximize the return from potential investment opportunities.

Applications
Investment banking Corporate Strategic planning Risk management Primary and derivative securities valuation Swaps & derivatives trading or dealing Portfolio management Securities trading

Speculators
A person who trades derivatives, commodities, bonds, equities or currencies with a higher-than-average risk in return for a higher-than-average profit potential. Speculators take large risks, especially with respect to anticipating future price movements, in the hope of making quick, large gains.

Arbitrageurs
A type of investor who attempts to profit from price inefficiencies in the market by making simultaneous trades that offset each other and capturing risk-free profits. Arbitrageurs are typically very experienced investors since arbitrage opportunities are difficult to find and require relatively fast trading.

Hedgers
Hedgers are those who protect themselves from the risk associated with the price of an asset by using derivatives. A person keeps a close watch upon the prices discovered in trading and when the comfortable price is reflected according to his wants, he sells futures contracts. In this way he gets an assured fixed price of his produce.

Types of Derivatives
Forward contracts Futures Commodity Financial (Stock index, interest rate & currency ) Options Put Call Swaps. Interest Rate Currency

Forwards
A one to one bipartite contract, which is to be performed in future at the terms decided today. Note: Product ,Price ,Quantity & Time have been determined in advance by both the parties. Delivery and payments will take place as per the terms of this contract on the designated date and place. This is a simple example of forward contract.

Futures
Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges. These markets are very liquid In these markets, clearing corporation/house becomes the counter-party to all the trades or provides the unconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by the exchange through the clearing corporation/house.

Positions in Future contract

Long - This is when a person buys a futures contract, and agrees to receive delivery at a future date. The long makes money when the underlying assets price rises above the futures price Short - This is when a person sells a futures contract, and agrees to make delivery. The short makes money when the underlying assets price falls below the futures price.

Options
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties.

Options
Strike Price or Exercise Price :Price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day. Expiration date: The date on which the option expires is known as Expiration Date Exercise: An action by an option holder taking advantage of a favourable market situation .Trade in the option for stock. Exercise Date: It is the date on which the option is actually exercised.

Options
European style of options: The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that. American style of options: An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry. Intrinsic Value: The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.

Types of Options
Call option: An option contract giving the owner the right to buy a specified amount of an underlying security at a specified price within a specified time. For a call option: Intrinsic Value = Spot Price (Todays market price or selling price) - Strike Price Put Option: An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time For a put option: Intrinsic Value = Strike Price - Spot Price (Todays market price or selling price)

In-the-money: For a call option, in-the-money is when the option's strike price is below the market price of the underlying stock. For a put option, in the money is when the strike price is above the market price of the underlying stock. Out the money: For a call option, in-the-money is when the option's strike price is above the market price of the underlying stock. For a put option, in the money is when the strike price is below the market price of the underlying stock..

Swaps
An agreement between two parties to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time.

The most popular are interest rate swaps and currency swaps

Interest rate swaps

An Interest Rate Swap is a financial instrument in which one party swaps a stream of floating Interest payments for another party's fixed interest payments. For example, Borrowers with a financing arrangement that is subject to variable interest rates can enter into an Interest Rate Swap to fix their interest liabilities so they are no longer exposed to changes in interest rates. Investors can enter into an Interest Rate Swap to modify their floating or fixed interest exposure in line with their investment view.

Types of interest rate swap

Fixed-for-floating rate swap, same currency Fixed-for-floating rate swap, different currencies Floating-for-floating rate swap, same currency Floating-for-floating rate swap, different currencies Fixed-for-fixed rate swap, different currencies

Swaptions
How does it work? At each Payment Date: if the Floating Rate is greater than the Fixed Rate, the Payer will receive a cash payment from the Receiver; or if the Floating Rate is less than the Fixed Rate, the Receiver will receive a cash payment from the Payer. In each case, the cash payment will be determined by the difference between the Floating Rate and the Fixed Rate. If the Floating Rate and the Fixed Rate are the same, no cash payment is made. The Floating Rate will have been set on the preceding Reset Date, or the Commencement D

Swaptions
An option in which the buyer of the option has the right to enter into to an interest rate swap. The terms of the swaption specify whether the buyer will be the payer of the floating rate or the payer of the fixed rate. It is called a swaption because it is an option on a swap. A swaption is useful if an interest rate swap may be useful for the buyer's investment strategy If the buyer believes that interest rates will rise, he can enter into a swaption agreement, which he can later convert into an interest rate swap if interest rates do indeed go up.