Financial Engineering-

Introduction
Financial Engineering
• Trading Perspective
– Create structured securities from basic assets to
catch specific market niches
• Modeling Perspective
– Develop/apply contingent claim valuation methods
to price exotic structured securities
• Management Perspective
– Assess the uncertainty of future payoff of portfolio
– Determine strategies to restructure the portfolio
risk-return to meet investor’s objectives
Modeling Perspective
• Cash flow allocation
• Discounted cash flows
– Discount expected cash flows by a Risk-Adjusted
Return
E (CFt )
P
t 1  kt
– Discount risk-adjusted cash flows by risk-free

E ' (CFt )
P
t 1  rt
Equilibrium (Risk-adjusted
Return) Approach
• CAPM
k  rf   ( rm  rf )

• APT/Multi-factor CAPM

k  rf  1 ( r1  rf )   2 ( r2  rf )  ....
Equilibrium Approach
• Stock value can up to $200 with 70%
probability and down to $50 with 30%
probability when risk-free rate is 10%
• Expected payoff = .7 (200) + .3 (50) = $155
– u = 200/100 = 2
– d = 50/100 = 0.5
– r = 1.10
• Risk-adjusted return = 155/100 - 1 = 55%
• Risk premium = 55% - 10% = 45%
Equilibrium Approach
• A call option with exercise price = $125
• Possible payoffs are $80 with 70% probability
and $0 with 30% probability
• Expected payoff of option = .7 (80) + .3 (0)
= $56
• Beta of the option = b(C) = 1.83
• Risk-adjusted return = k(C) = 10% + 1.83
(45%) = 92.5%
• Option Value = C = 56/(1.925) = $29.09
Risk-Neutral Probability
12%
10%
Risk-Neutral
Probability

8%
6%
Actuarial
4%
2%
0%

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25
1

10

13

16

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Payoff
Risk-Neutral Approach
• Risk-adjusted probability
• Pseudo probabilities
 pu  ur dd

p 
 d u d
ur

• Discount risk-adjusted expected cash

flows at risk-free rate
Risk-Neutral Approach
• Risk-neutral probability (u) = r  d = 0.4
ud
• Risk-neutral expected payoff of stock
= .4 (200) + .6 (50) = $110
• Stock price = 110/1.10 = $100

• Risk-neutral expected payoff of the call option

= .4 (80) + .6 (0) = $32
• Option value = $32/1.10 = $29.09
Model Solutions
• Closed form solutions
– Black-Scholes model, Vasicek model
• Finite Difference Methods
– Implicit
– Explicit (trinomial tree)
– Binomial tree
• Monte Carlo Simulation
– Risk-neutral process
– Actuarial based process
Examples
• Lattice Method (Binomial Tree)
– American Put Option
• Monte Carlo Simulation
– Bond pricing under the Hull-White term
structure model
drt   ( t  rt )dt  dz

– Value-at-Risk by Bootstrapping
Closed Form Solutions
• Pros
– Fast
– Easy to implement
• Cons
– Can only work under limited simplified
assumptions, which may not satisfy trading
needs
– May not exist for all derivative contracts
Finite Difference Methods
• Pros
– Intuitively simple
– Fast
– Capture forward looking behavior, best for
American style contracts
– Accuracy increases with density of time interval
• Cons
– Can not price path-dependent contracts
– Difficult to implement, especially with time and
state dependent processes
Monte Carlo Simulations
• Pros
– Intuitive
– Easy to implement
– Matches VaR concept
– Accuracy increases with number of simulations
• Cons
– Forwardly simulate cash flows, cannot handle
American style contracts
– Slow in convergence
Combined Approaches
• To handle both path-dependent and
American style cash flows
• Difficult to implement and time
consuming
• Alternative methods
– Simulation through tree
– Bundled simulation
Management Perspective
• Fundamental driving force of financial engineering
• Analyze the risk and return tradeoff for different cash
flow components of an asset/portfolio
• Determine the optimal risk-return profile for the
portfolio based on investor’s objectives and
constraints
– To hedge or not to hedge?
• Value-at-Risk applications
• Capital adequacy requirements for: regulator, rating
agency, stock holders
• Financial engineering is the
popular name for constructing
asset portfolios that have precise
technical characteristics
– Can construct a put by combining a
short position in the underlying asset
with a long call
– Synthetic puts were the first
widespread use of financial
engineering

17
Engineering an Option

• There are a variety of tactics by

which wealth can be protected
without disturbing the underlying
portfolio
– Shorting futures provides downside
protection but precludes gains from
price appreciation
– Writing a call provides only limited
downside protection
– Buying a put may be the best 18
Engineering an Option (cont’d)
Financial Engineering Example

Assume that T-bills yield 8% and market volatility is 15%.

Black’s options pricing model predicts the theoretical variables
for a 2-year XPS futures put option with a 325.00 striking price
as follows:
Striking price = 325.00
Index level = 326.00
Option premium = $23.15
Delta = -0.388
Theta = -0.011
Gamma = 0.016
Vega = 1.566

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Engineering an Option (cont’d)

Strategy Advantages Disadvantages

Short futures Low trading fees; Lose upside potential;

Easy to do Possible tracking error

Write calls Generate income Lose most upside potential;

Inconvenience if exercised;
Limited protection

Buy puts Reliable Premium must be paid;

protection Hedge may require periodic adjustment

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Engineering an Option (cont’d)
Financial Engineering Example

Linear programming models can be utilized to obtain

the desired theoretical values from existing call and put
options. The greater the range of striking prices and
expirations from which to choose, the easier the task.

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What is financial engineering?

Financial Engineering: Combining or carving up existing instruments

to create new financial products. (Campbell R. Harvey’s Hypertextual Financial
Glossary, http://www.duke.edu/~charvey/Classes/wpg/glossary.htm)

Another Definition: (from Neil D. Pearson, Assoc. Prof. UIUC)

Definition 1: Financial engineering is the application of
mathematical tools commonly used in physics and engineering to
financial problems, especially the pricing and hedging of derivative
instruments.

Definition 2: Financial engineering is the use of financial

instruments such as forwards, futures, swaps, options, and related
products to restructure or rearrange cash flows in order to achieve
particular financial goals, particularly the management of financial
risk.

Primbs, MS&E345 22