financial engineering.docx
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FinancialEngineering
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What is Finance
Finance is about the bottom line of business activities Every business is a process of acquiring and disposing assets
Real assettangible and intangible Financial assets
Objectives of business Valuation of assets Management of assets
Valuation is the central issue of finance
What is Financial Engineering
Generalizing: Financial Engineering involves the design, the development, and theimplementation 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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Definition
Principles and strategies for developing innovative financial solutions
Characteristics
Principles: Goals and rules for economic transactions Strategies: methods and techniques Innovative: New and novel Solutions: Satisfy real needs and create added value
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Financial Engineers are prepared for careers in:
Investment Banking
Corporate Strategic
Planning
Risk Management
Primary and Derivatives
Securities Valuation
Financial Information
Systems Management
Portfolio Management
Security Trading
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Suggested Background
Generally, Financial Engineers are strong on the following fields:
Statistics/Probability and PDEs Stochastic Processes
C++ Programming Basic Business Finance Theor
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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Whats the purpose of securities?
For the Issuer
Rise New Capital: Depending on the pricing and market demand, securities might be anattractive option.
Repackaging: Achieve regulatory capital efficiencies.
Equity and Debt
Traditionally, securities are divided into debt securities and equity.
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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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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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Formula
The cost of capital is then given as:
Kc = (1-) Ke + Kd
Where:
Kc The weighted cost of capital for the firm
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
Proposition
y = C0 + D/E (C0b)
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* 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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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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FINANCE
I.T. ENGINEERING
F.E.