Financial Engineering for Individuals and Small Companies

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:

Exchange Traded Funds - ETFs

Unit Trusts, Investment Trusts, OEICs and Mutual Funds

Mortgages or loans

Property

Covered Warrants, Options, Futures

Spread Betting (See related article)

Gold, Silver (See related article)

structured products, absolute return funds

Zero Dividend Preference Shares (See related article)

Other Split Capital Investment Trusts

Government Bonds

Corporate Bonds

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.

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.

Some future events can be predicted, both in terms of when they will happen, but also approximately how much they might cost. e.g.

school fees

retirement

mortgage repayments

weddings

Some events will not be so predictable:

redundancy

illness/injury

death

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.