Thursday, July 21, 2011

Beder and Marshall, Financial Engineering

Financial Engineering: The Evolution of a Profession, edited by Tanya S. Beder and Cara M. Marshall (Wiley, 2011), is part of the Kolb Series in Finance and, like its predecessors, is a big book—some 600 pages long. It is a fascinating collection of 29 original papers written by both academics and practitioners.

Two articles outline career opportunities and educational programs for aspiring financial engineers. The rest of us can home school ourselves from the comfort of our own favorite reading nook. The curriculum? In addition to a brief history of financial engineering, the volume deals with such major themes as financial engineering and the evolution of major markets (fixed income, U.S. mortgage, equity, foreign exchange, commodity, and credit); key applications of financial engineering; case studies in financial engineering—the good, the bad, and the ugly (mostly ugly); and special topics in financial engineering.

Financial engineering may be the stomping ground for quants, but you wouldn’t know it from this book—at least not until the first appendix that describes some IT tools for financial asset management and engineering. The book has virtually no math in it; aside from a few figures, charts, and graphs, the authors rely on good old-fashioned prose, most of it quite lucid, to explain the many facets of financial engineering.

I tried to decide what to share in this review. I contemplated the piece on portable alpha because I was thinking just the other day about what ever happened to this once hot concept. (Apparently it may see a rebirth in a more robust and dynamic form.) I ruled out the chapters on quantitative trading in equities and systematic trading in foreign exchange because we’ve touched on these topics, at least in their general form, often enough on this blog. I finally decided to wade into new waters—financial engineering and macroeconomic innovation, a paper by Cara M. Marshall and John H. O’Connell.

We know that some U.S. municipalities are in severe financial straits, even if the situation is not as dire as Meredith Whitney would have us believe. Take the case of Harrisburg, which faced default on its incinerator bonds and had to be bailed out by the state of Pennsylvania. Given the cyclicality of the economy, why didn’t Harrisburg simply have a rainy day fund? The authors concede that “surpluses are hard to justify as they lead to pressure to either “(1) increase spending, (2) cut taxes, or (3) some combination of the two.” But, they suggest, “macroeconomic derivatives could easily represent a powerful, albeit partial, solution to this problem. Using historic data, a city like Harrisburg should be able to determine how changes in national or regional GDP growth impact its cash flows. Alternatively, it might do the analysis using the national or a regional growth rate in non-farm payrolls. The city could then enter into a GDP or non-farm payroll swap.” The goal would be to “keep the city’s budget balanced in all economic climates.”

Let’s say that the budget is balanced when real GDP grows at 2.7% and that a 1% change in GDP translates into $20 million of net cash flow (in or out) for the city. The city could enter into a 10-year GDP-swap with a macroeconomic swap dealer. In its simplest form, disregarding any spread, the deal could be structured in such a way that “the city pays the swap dealer the actual annual growth rate in GDP on notionals of $2 billion and the swap dealer pays the city an annual fixed rate of 2.7 percent on the same $2 billion of notionals.” Suppose the GDP increases to 3.7%. Then “the municipality would pay the dealer $74 million (i.e., 3.7 percent x $2 billion), and the swap dealer would pay the city $54 million (i.e., 2.7 percent x $2 billion). In a swap, only the net is exchanged with the higher paying party paying the lower paying party the difference. So, in this case, the city pays the swap dealer $20 million—which is precisely the size of its surplus for the year. On the other hand, suppose that the following year the economy sinks into a recession and GDP growth becomes negative, say -1.3 percent. Then, the swap dealer will pay the city $26 million on the GDP leg. (This is because the payment on the GDP leg is negative, so it goes in the opposite direction.) And the swap dealer also pays the city $54 million on the fixed leg. Thus, the city receives an infusion of $80 million from the swap dealer thereby offsetting its cash flow shortfall caused by the decline in GDP (i.e., the recession).” (pp. 301-302) Another solution would be to structure municipal debt offerings along the lines of inflation-indexed bonds with a floating coupon that would be tied inversely to the growth rate of the GDP.

There’s always room for financial innovation, and Financial Engineering offers its share of ideas. It also provides ample documentation of the unintended consequences of innovation gone awry. All in all, a thought-provoking read.

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