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Chapter 25 Financial Engineering. Financial Engineering Process. Innovative Financial Instruments Creation of Innovative Financial Processes Formulation of Creative Solutions To complex problems. Financial Engineering At Magma. Copper Interest - Indexed Bonds
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Financial Engineering Process • Innovative Financial Instruments • Creation of Innovative Financial Processes • Formulation of Creative Solutions • To complex problems
Financial Engineering At Magma • Copper Interest - Indexed Bonds • What is the Financial Risk of Change? • Risk Profile • Stockholders Shifted Copper Price Risk to Bondholders
Risk Profile Of Magma Change in Profitability Change in Copper Prices With CIB Without CIB
Who Would Want To Purchase An Indexed Bond? • Pension Fund • Portfolio Manager • Reduce volatility
Symmetric And Asymmetric Hedging Strategies • Symmetric • Used by Magma • Risk of loss eliminated at cost of potential gains • Linear relationship (straight line) • Asymmetric • Insures risk but allows for potential gain • Magma buys put options • Set a floor on losses • Gain is decreased by cost of put
Which Method Is Better? • Evaluate Risk and Cost • Intolerable loss • Hedging strategy • Insignificant loss • Ignore risk • Significant loss • Asymmetric strategy • Symmetric hedging strategies • Bear the risk
Why Pursue Financial Engineering Strategies? • Unique Situations • When Markets are Perceived to be Inefficient • When Markets are Perceived to be Efficient
Why Pursue Financial Engineering Strategies? • Unique Situations • Underdiversified investor • Texas example • Unpredictable quantity to be hedged • Farming • Drought • Abundant rainfall • When Markets are Perceived to be Inefficient • When Markets are Perceived to be Efficient
Why Pursue Financial Engineering Strategies? • Unique Situations • When Markets are Perceived to be Inefficient • Selective hedging • Hedging only during periods of high risk • Speculation • When Markets are Perceived to be Efficient
Why Pursue Financial Engineering Strategies? • Unique Situations • When Markets are Perceived to be Inefficient • When Markets are Perceived to be Efficient • Hedging is useful in specific cases • No taxes • No transaction costs • Fixed investment policy
Swaps • Interest Rate Swaps • Currency Swaps • Commodity Swaps
Swaps • Interest Rate Swaps • Fixed for floating swap • Received fixed counterparty • Received floating counterparty • Currency Swaps • Commodity Swaps
Swaps • Interest Rate Swaps • Currency Swaps • Future exchanges are different currencies • Currency risk management • Commodity Swaps
Swaps • Interest Rate Swaps • Currency Swaps • Commodity Swaps • Exchange of cash based on specific • Commodity • Points in the future
Recent Financial Engineering Innovations • Amortizing swaps • Step-up swaps • Cap • Floor • Collar
The Value At Risk (VaR) • Risk Management • Banks • Insurance companies • Evaluates Risk • Hold a Sufficient Amount of Capital • Basel Rules