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What Is Financial Engineering?
 
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29-Feb-2012  
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Since the beginning of the government’s payment to Mr Alfred Agbesi Woyome issue came into the media, a lot of social commentators, media analysts, politicians have been trying to sinuate, imply or explain that the financial arrangement Mr Woyome tried to put together for Waterville to undertake the various development projects for the government of Ghana was financial engineering arrangement.

I am not here to pass a value judgment on the case but to offer an explanation of what financial engineering is all about. I am not very sure that what Mr Woyome attempted to do to raise funds for the projects will be classified as financial engineering.

It has no semblance to financial engineering.

So what is financial engineering? Financial engineering is a process that utilises existing financial instruments (bonds and other financial instruments) to create a synthetic, new and enhanced product of some type.

Just about any combination of financial instruments and products can be used in financial engineering.

The process may involve a simple union between two products or make use of several different products to create a new product that provides benefits that none of the other individual instruments could offer on their own.

Market risks
In reality, financial engineering can be applied to many different types of currencies and pricing options. These include equity, fixed income such as bonds, commodities such as oil or gold, as well as derivatives, swaps, futures, forwards, options, and embedded options. With financial engineering come many risks.

Basically, risks are divided into two: market risk and credit risk. Market risks can be managed using risk identification, risk measurements and risk management. Credit risks can be managed using credit modeling and credit pricing.

Credit risks modeling has to do with aspects of financial risk management, which include measuring the risk of a financial transaction (transaction risk) or of a large investment portfolio (portfolio risk), an entire financial institution (enterprise risk), or a network of financial institutions (systemic risk), exploring ways to reduce risk, and determining an adequate capital reserve against potential losses.

Portfolio optimisation finds an investment strategy that best fits a decision-maker's objectives and preferences. Derivative securities, such as stock options and commodities futures, have payoffs that are related to the value of an underlying asset, such as a stock or a commodity. Financial engineering helps to find the relationship between the derivative security's price and that of the underlying asset.

Technically, financial engineering relies heavily on mathematically calculating the outcome if various combinations of financial instruments are offered under one umbrella as a package deal.

Usually, the calculations indicate that the providers stand to do very well with the new hybrid financial product as the product holds the potential to attract new consumers who would have foregone use of one or more of the instruments if the only option was to purchase them individually.

Examples
One excellent example of financial engineering is financial reinsurance.

Companies that offer reinsurance options essentially provide a way for the ceding insurer to minimise a drain on available resources when a major shift in premium growth or reduction is taking place. Under this scenario, the process of financial engineering helps to create a stable environment that will allow the insurer to remain solvent and stable even when extreme conditions arises.

For the consumer, the work of a financial engineer to create new finance product offerings can be a great advantage. In some instances, the new and improved product created by the financial engineer is simply a repackage of several independent but complimentary products made available at a lower price.

For example, the consumer may find that purchasing insurance coverage that provides dental, hospital and prescription coverage may be significantly less expensive than purchasing individual insurance coverages.

Basically, what Mr Woyome sought to do was raising funds from the international financial markets leveraging on the resources and guarantees from certain institutions so as to mitigate the associated or corresponding risks of loaning to the Government of Ghana.

It is well known that financing for infrastructure is available from several traditional sources: government funding (consisting of grants, loans and credit enhancement) and direct investment, suppliers (with respect to construction financing), multi- and bi-lateral agency funding, credit facilities provided by commercial banks or other financial institutions (provided in reliance upon the credit of the corporate promoter of the particular infrastructure project- whether contractor, owner or operator- or sovereign promoter of the infrastructure project), capital markets financing based on such credit (in the form of U.S. public offerings, municipal bond offerings, Eurobond offerings and private placements), project financing (dependent solely or principally on the assets and cash flow of the project in question) and securitisation (consisting of the transfer of the right to receive the revenue from the project, often under a government-granted concession, to a special purpose vehicle, and the contemporaneous issuance of securities that are payable from revenues generated by the project).

Sovereign Project Promoter
Financing which is based upon the credit of a private sector or sovereign project promoter is limited in availability and is also subject to changes in the perception of the creditworthiness of the promoter, local market considerations and developments unrelated to any particular project that may adversely influence the financial condition or business of the promoter.

What I believe Mr Woyome sought to do was to raise special finance for the identified projects. This is a long-term financing of infrastructure that specifically meets IMF and World bank conditions, usually with grant-in aid of about 35 per cent giving it a repayment period of about 20 years with a grace period of five years and an interest rate of about two per cent.

However, normal project finance depends upon the projected cash flows of the project rather than the balance sheets of the project sponsors. Usually, a project financing structure involves a number of equity investors, known as sponsors, as well as a syndicate of banks or other lending institutions that provide loans to the operation.

These loans are most commonly non-recourse loans, which are secured by the project assets and paid entirely from project cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part supported by financial modeling. The financing is typically secured by all of the project assets, including the revenue-producing contracts.

Project lenders are given a lien on all of these assets and are able to assume control of a project if the project company has difficulties complying with the loan terms.

A point to note is that where the project is a public sector sponsored and sovereign guaranteed, the issuing sovereign nation replaces the supposed-to-be projected cash flow required to determine the project’s viability. The repayment of the loan is the responsibility of the nation-state.

In summary, financial engineering is a sophisticated and mathematically based modern finance, which seeks to provide synthetic products designed to mimick an underlying financial instrument so as to eliminate a credit risk associated with the original financial instrument.

Once the credit risk is known, then the financial engineer will design the corresponding synthetic product (credit derivative) to eliminate the associated credit risk.
 
 
 
Source: The writer is an economic consultant and former Assistant Professor of Finance and Economics at Alabama State University. Montgomery, Alabama. [email protected]
 
 

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