Financial Engineering for Individuals and Small Companies
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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
Principles of Financial Engineering, Second Edition (Academic Press Advanced Finance)
Amazon Price: $59.83 (as of 12/19/2009) 
Mathematics for Finance: An Introduction to Financial Engineering (Springer Undergraduate Mathematics Series)
Amazon Price: $32.54 (as of 12/19/2009)
Financial Engineering: Derivatives and Risk Management
Amazon Price: $75.27 (as of 12/19/2009)
Financial Engineering
Amazon Price: (as of 12/19/2009)
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:
Finance and Financial Engineering with Microsoft Excel
Amazon Price: (as of 12/18/2009)
Excel for Dummies
Amazon Price: $14.95 (as of 12/18/2009)
Statistical Analysis with Excel For Dummies (For Dummies (Computer/Tech))
Amazon Price: $19.79 (as of 12/18/2009)
Principles of Finance with Excel: Includes CD
Amazon Price: $67.38 (as of 12/18/2009)
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.
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Bond and Stock Investment Books
See also Government and Corporate Bond Article
Bonds: The Unbeaten Path to Secure Investment Growth
Amazon Price: $16.47 (as of 12/19/2009)
The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More
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All About Bonds, Bond Mutual Funds, and Bond ETFs, 3rd Edition
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Bond Investing For Dummies (For Dummies (Business & Personal Finance))
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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):
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Please Tell Me What You Think
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Reply
- ElizabethJeanAllen ElizabethJeanAllen Sep 13, 2009 @ 5:46 am
- Thanks for stopping by my lenses.
lizzy
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- ElizabethJeanAllen ElizabethJeanAllen Aug 6, 2009 @ 5:51 am
- Great information!
Thanks for sharing.
Lizzy
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- 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!
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- Confidenttrader Confidenttrader May 26, 2009 @ 10:01 pm
- You have put together a very comprehensive lens for the serious investor. Thank you!
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- nightbear nightbear Mar 7, 2009 @ 2:04 am
- very intensely detailed information. I have to admit a bit ovr my head. enjoyed your lens.
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- mulberry mulberry Mar 6, 2009 @ 7:35 pm
- Great information, I need to save this!
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- sandyspider sandyspider Mar 4, 2009 @ 7:23 pm
- Good lens on Financial security. Very timely piece.
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- 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 :)
by AndyPo
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