Financial Engineering for Individuals and Small Companies
Ranked #2,313 in Business, #66,556 overall
What is Financial Engineering?
Financial Engineering is a complex process used by large companies to ensure that they can fulfill their financial obligations at certain times in the future. It is however just as relevant for individuals and small companies.
We cannot accurately predict the level of stock markets, bond yield or house-prices on any given date, but we do know when we are likely to need money (retirement, school fees) and we know that there will be times when we unexpectedly need money (illness, redundancy). How can we engineer our finances to guarantee providing us with what we need when we need it?
Large companies employ teams of financial engineers to use highly mathematical, statistical analysis to model possible scenarios and construst synthetic financial products or fine-tune existing products to meet the needs of the company's financial requirements. Individuals generally have fewer resources and options, but we can at least use similar techniques and ideas to help guarantee a secure future.
Recoomeded Investment and Finance Books
Table of Contents: Financial Engineering
- Financial Engineering Books
- Financial Engineering Tools readily available to us
- The Simplest Form Of Financial Engineering
- CafePress
- Income Stream
- Spreadsheets
- Planning for Future Events
- Related Articles
- Bond and Stock Investment Books
- Finance Articles
- More Related Articles
- About Me
- Please Tell Me What You Think
Financial Engineering Books
Financial Engineering Tools readily available to us
Financial Engineering uses stock-market investments, bonds, property etc. then modifies or insures their capital values and yields using derivatives, options, futures and various other complex instruments to fulfill their requirements at a later date. e.g. futures can be used to guarantee the delivery of commodities required for a construction job at a predefined price on a certain date to remove the uncertainty in price and possible reduction of profit.As an individual or small company we now also have access to complex derivatives, but there are also simpler devices we can use to engineer our future finances:
The Simplest Form Of Financial Engineering
The Balanced Portfolio
The simplest kind of financial engineering is to build a balanced portfolio (See related article). This reduces risk by mixing uncorrelated assets, but does not guarantee a defined amount of money on a certain date. An extension to this would be to use a carefully selected choice of government bonds with a range of maturities, which would naturally be a part of a balanced portfolio anyway, to provide a defined amount on various dates in the future as required. Once your obligations have been met the rest of the portfolio can be invested in higher risk investments for potentially higher returns.Financial engineering, as practiced by professional organisations, may involve the use of stock options and other derivatives to ensure certain outcomes are achieved on certain dates and complex mathematics such as the Black Scholes option pricing equation used to determine the value of the derivatives (effectively using Physics - Brownian Motion - to model the random movements of asset prices) but, although this is very useful, it is also possible to model your porfolio with a spreadsheet and estimate some best and worst case assumptions.
CafePress
Income Stream
Income from employment must also be factored into the equation, with the possibilty of that revenue stream being terminated being taken into consideration. Early in a carreer some risk has to be taken and the assumption that many years of employment are ahead is reasonable, but as time goes by this assumption becomes a dangerous one and a safety-net of cash needs to be kept for emergencies.If you are employed and have a sufficient income stream to live on, your investment portfolio does not need to create any income until you retire, but should grow with time. Income is generally taxed more heavily than capital gains, but if your other income streams stop you need to be able to convert the portfolio to provide sufficient income or have a reserve to keep you going until new employment is found.
Spreadsheets
An essential tool for modeling and testing your portfolio
If you are familiar with spreadsheets it is simple to create a table of all of your assets and debts using the SUM(...) function. Then predicting future values of each asset can be achieved by making assumptions about inflation, bank base-rates, stock-market returns and income requirements. Maximum and minimum values for each should be plugged into the spreadsheet to model future possible returns and see if you are on the right track. Spreadsheets are also useful for technical analysis or charting.
For more on the subject here are some recommended books:
Planning for Future Events
Government bonds, corporate bonds and Preference Shares
Some future events can be predicted, both in terms of when they will happen, but also approximately how much they might cost. e.g.Some events will not be so predictable:
Planning for the predictable events, as mentioned earlier, can be planned for using government bonds. These pay out a defined sum every year or half year (The "coupon") and a final sum on maturity. It the maturity coincides approximately with when you need the money this makes an ideal financial planning tool. The income and final payment is predictable and governments of stable countries rarely default on their payments.
An alternative to government bonds is corporate bonds, issued by companies rather than governments, which in general pay a higher yield depending on the perceived quality of the company. Alternatively Zero Dividend Preference Shares (See related article) provide the same function, but producing no income (zero dividend) producing their return entirely from capital gain - i.e. paying a predefined amount on a certain day in the future. These are ideal for financial planning and tax planning.
Investing in individual corporate bonds is fairly risky in that the company could default or go bust, so a portfolio of bonds would help to reduce the risk or better still a managed bond fund (e.g. an exchange traded fund or ETF, mutal-fund, unit trust or OEIC) Unfortunately these do no have a defined end date, but they will have a average "duration" value published, just like any bond, which defines the weighted-average amount of time for the bond or fund's cash-flows to be received by the investor (i.e. how long before half of the total payout - coupons and redemption value - is received) Choosing an ETF with a similar duration to your ideal individual bond would give a similar effect. The lower the duration the less risky the bond or fund and the lower the sensitivity to the bank base rate - as bank base-rate goes up generally the bond-price goes down and vice versa:
Change in Bond-Price = -(Duration) x (Bond Price) x (Change in Bond Yield)
or more formally: dP = -(ModD)(P0)(dr)
Zero Dividend Preference Shares behave like a zero coupon bond which makes them far easier to use: no complicated duration calculations to worry about because all of the payout is at the end on the predefined end-date.
Related Articles
-
Invest in a tax-free ISA
-
In the UK Individual Savings Accounts or ISAs are little more than an official tax-wrapper into which other investments may be hidden from the tax-man, but they are a useful way to reduce tax. This article is about the advantages and disadvantages o...
-
Investing in Investment Trusts
-
What are Investment Trusts and why should you invest in them? This article is all about the advantages (and disadvantages) of these relatively unpopular equity investments. They are generally only purchased by experienced investors because they are...
-
Investing in Exchange Traded Funds - ETFs
-
Exchange Traded Funds or ETFs are an alternative to other kinds of collective investment funds, such as Mutual Funds, Unit Trusts or Investment Trusts ETFs are a relatively new invention, especially in the UK, but in the USA there are many hundreds t...
-
Personal Pensions (and SIPPs)
-
Pensions are extremely important, but very boring and tend to be neglected until it is too late. Personal Pensions, SIPPs (Self Invested Personal Pensions) and Stakeholder Pensions are not the only way to financially prepare for life after work, but...
-
Spread Trading with Stocks and Shares
-
How to make lots of money from financial spread trading. Or how not to lose all of your money... Financial spread trading is a very risky way of playing the stock-market, but does have the advantage of allowing you to make money no matter which way...
Bond and Stock Investment Books
See also Government and Corporate Bond Article
Finance Articles
-
Technical Analysis (Charting)
-
Technical analysis is the art/science of using charts to predict the direction of financial markets (i.e. using the past to predict the future). Various different types of chart may be created and patterns within those charts, intersections of lines...
-
Investment and Finance Book Reviews
-
If you are an active stock market trader an investor or just have an interest in economics and the markets there are several books that you should read to help understand the markets or just for a enlightening read. Here are a few of my favourite i...
-
Investment and Money Making Ideas for the UK
-
Confused by the complexities of the UK savings and investment schemes and tax laws: PEPs; Pensions; ISAs; SIPPs etc.? This article is all about some good investments available in the U.K. the ways to reduce your tax bill and improve your return: fro...
-
Make Money In Any Market: Balance Your Portfolio
-
What is a "balanced" portfolio? Why should mixing different asset classes make your investment portfolio much less risky? Here is an explanation (and some of the maths) behind this useful risk reduction method. Most portfolios are highly...
-
Great Investment and Money Making Ideas
-
Have you ever been stuck for investment ideas? What should I invest in at the moment? Which stocks are good value? Which markets or investment vehicles should you invest in?This article attempts to cut through some of the jargon and provide some safe...
More Related Articles
-
Safe Investments For Uncertain Times
-
How to invest money in these difficult times? If you have a lump-sum to invest, or even if you just want to preserve what money you have accumulated, in these tough times, how would you invest for a comfortable life? The "Credit Crunch"...
-
Lensography Retire Young and Travel The World...
-
I am a semi-professional travel photographer (i.e. I once sold a few photos) and semi-retired consultant physicist (i.e. unemployed boffin) but with a keen interest in finance (i.e. how to get rich quick) I live in Richmond-upon-Thames in West Lond...
-
Investing in Gold and Silver
-
Many advisors recommend having 5% to 10% of gold, silver and other precious metals in your investment portfolio. This can be in the form of mining shares, ETFs (Exchange Traded Funds), mutual funds or investment trusts, although at least some of it s...
-
Investing in Bonds
-
How to invest in bonds: Corporate bonds; Government Bonds (or "Gilts" in the U.K. "Treasuries" in the US) and what are bonds? While stock markets have suffered during recent economic turmoil, bond markets have been more secure. They have not been im...
About Me
Lensmaster AndyPo has been a member since July 7 2008, has rated 1,996 lenses, favorited 1,919, and has created 205 lenses from scratch. This member's top-ranked page is "The Rocky Mountaineer Train, Canada". See all my lenses
My Bio
Hi, I am Andy. I live in the U.K. but have worked and travelled all over the world. I am a semi-professional wildlife and travel photographer (i.e. I sold a couple of photos once), semi-retired consultant physicist (i.e. unemployed boffin) with a keen interest in finance (i.e. get rich quick..ly):
My Home Page, More About Me!, My Blog and My other publications
My Newest Lenses:
Apple Mac Computers, Software etc.
Volterra in Italy
Etosha National Park
Turtle Island, Borneo
Chianti Road, Tuscany, Italy
Chobe National Park, Africa
Danum Valley, Jungles in Malaysia
Lens Of The Day (Twice) and a purple star: "Rain Forests of Borneo" - 20th AND 30th November 2008



Please also check out my Zazzle Gallery
And a few other publications:
Safari in Botswana
Understanding ETFs (Exchange Traded Funds)
Rio de Janeiro: A Travel Diary
Waterfalls in Brazil and Argentina
Bangkok, Thailand (during a military coup)
Tiger Safari in India
Marrakech, Morocco
Vacation in Cuba
African Safari: Namibia
Classic Car Review: Ferrari 308 GTS
Car Review: Jaguar XJ12, Daimler Double Six
Car Review: Jaguar XKR
Investing in National Savings Premium Bonds
How to Reduce Risk of Your Investment Portfolio
Investing in Corporate Bonds
Check out these great lenses...
-
- Wildlife & Travel Photo Gallery
After many years of traveling the world and taking photos, mostly of wildlife and nature and I have published some of them in a Zazzle Gallery. Here is a selection of some of these photographs and links to the associated Zazzle productions; cards and... view lens -
- Make Money From Home
There are many ways to make money from home and there is a lot of money out there on the internet to be had, but there are also a lot of people chasing the money. This article is about my research: The methods I have tried and the results I have achi... view lens -
- Safari and Wildlife Viewing
Here is a selection of articles and reviews of safari holidays and wildlife viewing vacations in various parts of the world: Africa (Namibia and Botswana), Borneo, Canada, USA and Asia... Lots of photographs, travel tips, advice and recommendations,... view lens -
- European Travel Highlights
A quick photographic tour of Europe to some of my favourite bits and links to a few more of my more detailed european travel articles, including: Tuscany in Italy Loire Valley and Brittany, France Gibraltar, U.K. (Near Spain) Richmond, London, Engla... view lens -
- Great Investment and Money Making Ideas
Have you ever been stuck for investment ideas? What should I invest in at the moment? Which stocks are good value? Which markets or investment vehicles should you invest in?This article attempts to cut through some of the jargon and provide some safe... view lens
Please Tell Me What You Think
-
Reply
- ElizabethJeanAllen ElizabethJeanAllen Sep 13, 2009 @ 5:46 am
- Thanks for stopping by my lenses.
lizzy
-
Reply
- ElizabethJeanAllen ElizabethJeanAllen Aug 6, 2009 @ 5:51 am
- Great information!
Thanks for sharing.
Lizzy
-
Reply
- JaguarJulie JaguarJulie Jun 30, 2009 @ 8:15 am
- Gosh, after our two tenants lost their jobs and weren't able to pay rent, it made us serious candidates for financial engineering!
-
Reply
- Confidenttrader Confidenttrader May 26, 2009 @ 10:01 pm
- You have put together a very comprehensive lens for the serious investor. Thank you!
-
Reply
- nightbear nightbear Mar 7, 2009 @ 2:04 am
- very intensely detailed information. I have to admit a bit ovr my head. enjoyed your lens.
-
Reply
- mulberry mulberry Mar 6, 2009 @ 7:35 pm
- Great information, I need to save this!
-
Reply
- sandyspider sandyspider Mar 4, 2009 @ 7:23 pm
- Good lens on Financial security. Very timely piece.
-
Reply
- jadebydesign jadebydesign Mar 4, 2009 @ 10:31 am
- Hi Andy,
This is a really great lens and very in-depth for those looking to financially secure their future retirement with the right investment portfolio. I however could use a financial engineer just to be able to make sense of my financial portfolio lol :)






