Definition of Financial Engineering

Wall Street has developed numerous innovative financial instru-ments in recent years. These new financial instruments are classified according to the following traditional categories:

Debt instruments,

Equity, and

Hedging instruments.

Debt Instruments

Commercial Paper

Unsecured short-term (up to 270 days) obligations issued through brokers or directly. The interest is usually discounted. Universal commercial paper is foreign currency denominated commercial paper that trades and settles in the United States.

Convertible Bonds

Debt securities those are convertible into stock of the issuer at a specified price at the option of the holder.

Carrot and Stick Bonds

Carrots have a low conversion premium to encourage early conversion, and sticks allow the issuer to call the bond at a specified premium if the common stock is trading at a specified percentage above the strike price.

Convertible Bonds with a Premium Put

Convertible bonds issued at face value with a put option entitling the bondholder to redeem the bonds for more than their face value.

Debt with Equity Warrants

It means bonds issued with warrants for the purchase of shares.

The warrants are separately tradable.

Dual-Currency Bonds

Bonds denominated in one currency, for which interest is paid in the same currency but are redeemable in another currency is known as dual-currency bonds. It allows interest rate arbitrage between two markets.

COPS (Covered Option Securities)

‘Covered option securities’ is a short-term debt that gives the issuer an option to repay the principal and interest in U.S. dollars or a mutually acceptable foreign currency.

ECU Bonds (European Currency Unit Bonds)

A Eurobond denominated in a basket of currencies of the 10 countries that constitute the European Community is called ECU bonds. The bonds pay interest and principal in ECUs or in any of the 10 currencies at the option of the holder.

ICONs (Indexed Currency Option Notes)

A bond denominated and paying interest and principal in dollars but with principal payments linked to the exchange rate of another currency is known as ICONs.

PERLS (Principal Exchange-Rate-Linked Securities)

Securities paying interest and principal in dollars but with principal payments linked to the exchange rate between the dollar and a second currency is called as PERLS.

Flip-Flop Notes

It is an instrument that allows investors to switch between two types of securities – for example, to switch from a long-term bond to a short-term fixed-rate note.

FRNs (Floating Rate Notes)

It is a Debt instrument. Its feature is periodic interest rate adjustments.

Capped Floater

It is an FRN with an interest rate ceiling.

Convertible FRNs

The feature of Convertible FRNs is that the issuer can convert the FRNs into long-term fixed rate bonds.

Drop-Lock FRNs

In this type of the instrument, FRNs automatically are converted to fixed-rate bonds when short-term interest rates fall below a specified level.

Minimax FRNs

Minimax FRNs are those FRNs which have upper and lower interest limits.

Indexed debt instruments: Instruments with guaranteed andcontingent payments, the latter being linked to an index or prices of certain commodities (oil or gold, for example) are called Indexed debt instruments.

Bull and Bear Bonds

Bonds linked to upward and downward movements in a designated index are called Vull and bear bonds. Bulls yield more in a rising market; bears yield more in a falling market.

SPINs (Standard and Poor’s Indexed Notes)

A debt instrument interest payment of which is linked to the performance of the Standard and Poor›s stock indexes is called SPINs.

Put Bonds

Bonds that the investor can put (or tender) back to issuer after a specified period are known as put bonds.

Stripped Government Securities

It is a type of zero coupon bonds. These securities represent long-term Treasury bonds “stripped” of semiannual interest coupons by an investment banker who resells these coupons and an interest in the principal payments. Investment banks market these stripped securities under such registered acronyms such as

Certificates of Accrual on Treasury certificates(CATs)

Certificates of Government Receipts (COUGRs)

Sterling Transferrable Accruing Government Securities (STAGs)

Separate Trading of Registered Interest and Principal of Securities (STRIPs)

Treasury Investment Growth Registered certificates (TIGRs)

Zero Coupon Euro sterling Bearer or Registered Accruing Certificates (ZEBRAs)

Zero-coupon bonds - A bond that’s sold at a deep discount from its face value is known as Zero coupon bond. It carries no interest coupon, but investors receive the gradual appreciation to the face value.

LYONs - Liquid Yield Option Notes

Liquid Yield Option Notes are Zero-coupon bonds which are convertible into the issuer›s common stock.

Asset-Backed Securities

CMOS: (Collateralized Mortgage Obligations)

It is debt obligations that are backed by a pool of whole mortgages or mortgage-backed securities. They are of two types

Mortgage-backed securities (A participation in an organized pool of residential mortgages)

Securitized receivables (Debt securities collateralized by a pool of receivables)

Equity Instruments

MMP – ‘Money Market Preferred Stock’ or ‘Dutch Auction Preferred Stock’

‘Dutch Auction Preferred stock’ is an action in which the securitiesare sold at the lowest yield necessary to sell the entire issue. Several investment banks have issued these instruments under such registered names as CAMPS- Cumulative Auction Market Preferred Stock.

CMPS - Capital Market Preferred Stock

It is a convertible Money Market Preferred stock that can be converted into common stock. Examples:

DARTS - Dutch-Auction Rate Transferable Securities

FRAPS - Fixed Rate Auction Preferred Stock

MAPS - Market Auction Preferred Stock

STARS - Short-Term Auction Rate Cumulative Preferred Stock

STRAPS - Stated Rate Auction Preferred Stock

PIK (pay in kind) preferred stock - Dividends are paid in additional shares of preferred stock

Exchangeable PIK preferred stock - The issuer can convert the PIK stock into debt.

Hedging Instruments

A strategy employed in the futures, options and warrants markets to reduce risk by making a transaction in one market to protect against a loss in another. Traditionally a commodity producer (say, a cocoa grower) would agree to sell his goods at a stated price at a stated time in the future, and the user of the commodity (say, a chocolate manufacturer) would agree to buy them. By agreeing on a price, quantity and delivery date, they introduce certainty into their operations and reduce risk. For the producer, the risk would be that prices drop, and for the processor that they would rise. In the financial markets, options and warrants can be used to hedge a portfolio position. In the case where shares have been sold, for example, the purchase of equivalent call options (the option to buy shares) means that if the shares rise in price, a corresponding rise in the value of the option will offset the notional loss expected on the underlying shares.

The following are some of the hedging instruments:

Butterfly spread - Options strategy involving two calls and two puts in the same or different markets, with several maturity dates

Calendar spread - Options strategy that involves buying and selling options on the same security with different maturities.

Cancelable forward exchange contracts - The holder has the unilateral right to cancel the contract at maturity.

CIRCUS - Combined currency and interest rate swap.

Convertible Option Contracts - A foreign currency option that converts to a forward contract if the forward exchange rate falls below a trigger price.

Cross-hedging- Hedging one exposure with an instrument pegged to another market or index.

Cylinder options - A combined call option and put option on currency.

Range Forwards - A forward exchange contract specifying a range of exchange rates within which currencies will be exchanged at maturity.

ZCRO (zero cost ratio option) - A cylinder option with a put written in an amount offsetting the call premiums.

OPOSSMS- Options to purchase or sell specified mortgage-backed securities.

Perpendicular spread - Options strategy using options with the same maturities but different strike prices.

Swaption - An option to enter or be forced to enter a swap.

Synthetic instruments - Two or more transactions that have the effect of a financial instrument. For example, a fixed-rate bond combined with an interest rate swap can result in a synthetic floating rate instrument.

Zero-coupon swap - A swap of zero-coupon debt into floating rate debt.