9. Financial Engineering.......................................
This chapter shows some applications of derivative securities to managing the
risk exposure in various situations. The presentation will be by means of exam-
ples and mini case studies. Even though these are concerned with very particu-
lar circumstances, the methods are applicable to a wide range of tasks handled
by financial managers.
First, we shall present methods for eliminating or reducing the risk involved
in writing options. This is a problem faced by financial institutions who issue
and sell derivative securities, but may not wish to bear the accompanying risk.
Such institutions are typically satisfied by the commission charged for their
services, without taking an active position in the market.
Next, we shall analyse methods of reducing undesirable risk stemming from
certain business activities. Our case studies will be concerned with foreign ex-
change risk. It is possible to deal in a similar way with the risk resulting from un-
expected future changes of various market variables such as commodity prices,
interest rates or stock prices. We shall introduce a measure of risk called Value
at Risk (VaR), which has recently become very popular. Derivative securities
will be used to design portfolios with a view to reducing this kind of risk.
Finally, we shall consider an application of options to manufacturing a lev-
ered investment, for which increased risk will be accompanied by high expected
return.
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