PORTFOLIO INSURANCE.
One prominent example of financial engineering to meet the needs of clients is portfolio insurance. Portfolio insurance is essentially a strategy of hedging, stabilizing, or reducing the downside risk associated with the market value of a portfolio of financial assets such as stocks and bonds. There are a variety of techniques to protect the value of such a portfolio.
As an example, suppose a portfolio manager wants to build a floor under the current value of a well-diversified portfolio. Furthermore, suppose that this portfolio is currently valued at $1,594,000, and its changes in value closely correspond with changes in the Standard & Poor's 500 (S&P 500) index. Ideally, the manager would like to reap the benefits of further increases in portfolio value, but wants to assure investors that the value will not fall below a certain, specific level. One solution is to purchase put options on the S&P 500 index. These options are heavily traded at a variety of exercise prices. If the current level of the S&P 500 index is 1,225.50 and the manager wants to ensure that the value of his portfolio does not fall by more than 10 percent, put contracts with an exercise price of 1,110 (approximately 10 percent below the current level) can be purchased. The manager must purchase enough put option contracts so that the underlying value of the optioned asset is equal to the value of the portfolio. In this example, the portfolio value is approximately 1,300 times the current value of the S&P 500 index. Therefore, if the manager could buy puts on 1,300 "units" of the index, the position could be fully hedged. In reality, a single S&P 500 put contract represents 500 units of the index. So, the manager would purchase three put contracts. Subsequent to the purchase, if the S&P 500 index (and the portfolio) rises in value, the manager will not exercise the put. Gains to the portfolio will be reduced by the modest amount of the put premium that was paid. On the other hand, if the index and the portfolio dropped in value by 20 percent, the put could be exercised at a significant profit that would generate a combined net loss for the position of approximately 10 percent. If the index value fell even lower, the profit from the put would be even greater and always provide a net loss of 10 percent.
Other techniques of portfolio insurance use futures contracts on stock and other market indexes. In the previous example, the manager could "synthetically" sell some or all of the portfolio by selling futures contracts on the S&P 500 index. If the portfolio subsequently fell in value along with the S&P 500 index, the futures position would generate prohits that would partially or entirely offset the loss. If market prices rose, the portfolio would rise in value but the futures position would generate a loss that would tend to offset the gain. Note that this technique not only stabilizes the value of the stock portfolio, but also allows the manager to create a position with profits and losses that is equivalent to a smaller stock portfolio. This lower risk position is achieved without the significant expense of actually selling a portion of each individual stock position within the portfolio. Technically, this is an example of hedging, or maintaining a particular market value for a period rather than ensuring a minimum value while retaining the opportunity for upside gains. It is possible, however, to sell the proper number of S&P 500 index futures in order to mimic the overall profits of the put insured portfolio described above. This would require periodic adjustment to the hedge, or the number of futures contracts sold, as prices changed and the time to expiration of the contracts diminished.
SWAPS.
Another broad category of contracts that result from financial engineering are referred to as swaps. Swaps represent exchanges of cash flows generated by distinct sets of assets or tied to distinct measures of value. An early example of an engineered swap is the currency swap. In this example, consider two firms in different countries each having continuing financial obligations in the other's country. More specifically, consider a French firm with a U.S. subsidiary that requires dollars to operate and a U.S. firm with a French subsidiary that has need for French francs. One alternative is to borrow the funds in the home country and exchange them for the foreign currency needed by the subsidiary. Another alternative is for the subsidiary to borrow the needed funds in the local currency. This second alternative will provide needed funds for the subsidiary and avoid the costs associated with foreign exchange transactions. It is also likely, however, that the subsidiary is at a disadvantage when negotiating the rate on a loan in the local currency. For example, the U.S.-based subsidiary of a French corporation may not have the perceived creditworthiness of a U.S. corporation with foreign subsidiaries and as a result will be forced to pay a higher rate of interest on the dollar-denominated loan.
If each firm becomes aware of the other's needs, they can do the following. First, each parent corporation should borrow an equivalent amount in their home currencies. These amounts will be equal based on the current exchange rate between dollars and francs. Second, they will simultaneously transfer the proceeds of the loan to the other firm's subsidiary (i.e., the French parent will transfer the borrowed francs to the U.S. firm's French subsidiary, and the U.S. parent will transfer the borrowed dollars to the French firm's U.S. subsidiary). As interest payments become due, the French-based subsidiary pays the French parent and the U.S.-based subsidiary pays the U.S. parent. Finally, when the term of the loans expires, each subsidiary will repay the other's parent. Note that this financially engineered contract has (I) effectively exploited each firm's ability to borrow at more favorable rates in its home country and (2) avoided all need for foreign currency exchange.
Obviously, the crucial factor in the formation of such a mutually advantageous contract is the identification of two parties with offsetting needs. In recent years, many financial intermediaries have developed services to fill this need. Swap dealers and brokers have developed the expertise to serve a broad variety of needs by matching the interests of counterparties and by engineering contracts that are mutually advantageous to the contracting parties and profitable for the intermediary.
A second common swap agreement is the interest rate swap. This typically takes the form of an exchange of a fixed-rate interest payment for a floating-rate interest payment. Suppose a bank has made a large number of loans at a fixed rate, but most of its liabilities are floating-rate obligations. If interests rise materially, its expenses will rise but its revenues are fixed. Profitability will suffer. If the bank can swap its 9-percent fixed-rate loans for a comparable amount of floating-rate obligations that generate the yield on 30-year U.S. Treasury bonds plus 4 percent, it has materially reduced the influence of interest rate fluctuations on its profitability. In this example, once the bank has found a willing swap partner, the parties will agree to a notional principal amount. That is, the counterparties will agree on the amount of interest-generating capital that will be used to design the agreement. Typically, the parties will not exchange these notional amounts because they are identical. As time elapses, the bank will swap interest payments with its counterparty. For example, if the Treasury bond rate is 6 percent during a particular period, the agreement mandates that the bank receive 10 percent while it pays 9 percent. The swap agreement will require only that the net difference be exchanged, I percent paid to the bank in this case. If the Treasury bond rate drops to 4.5 percent, then the bank is obligated to pay the net difference between 8.5 percent (or 4.5 percent + 4 percent) and 9 percent, or 0.5 percent to the counterparty. If the Treasury bond rate remains at 5 percent, the fixed and floating rates are equivalent and no cash exchange would be necessary. Since there was no need for an actual exchange of the identical principal amounts at the beginning of the swap, none is required to close the positions at expiration of the agreement.
More complex swaps could involve trades of fixed- and floating-rate payments denominated in different currencies. Others could involve swaps of the income from debt instruments for the income generated by an equity investment in a specific portfolio such as the S&P 500. Swaps can also provide the basis for engineering a more efficient method of diversifying risk or allocating assets across asset classes. Consider this well-documented example. A chief executive officer (CEO) of a major corporation has accumulated a significant equity stake in his firm. While the CEO has other investments, he is not effectively diversified since he has an enormous amount of his own firm's stock. The CEO can contact a swap dealer who will arrange to swap the cash flows generated from the CEO's stock (capital gains and/or dividends) for a cash flow generated by an identically valued investment in a broadly diversified portfolio or market index. In this example, the CEO has (1) avoided the cost of selling his stock and any capital gains taxes that may result from the sale; (2) retained the voting rights of his stock; and (3) created a "synthetic" portfolio that is much less sensitive to the fluctuations in value of any particular company.
The swap can be engineered to provide immediate international diversification. Suppose two portfolio managers, one in the United States and another in Japan, manage purely domestic portfolios. They may agree to swap notional values that would generate returns on their own managed portfolios or generate cash flows commensurate with an investment in a market index. For example, the U.S. manager may agree to provide the cash flow generated by a $100 million investment in the S&P 500 in exchange for returns generated from a similar-sized investment in the Nikkei 225 index. This would provide instant international diversification without the sizable cost of purchasing a large number of individual foreign securities. In addition, many countries impose fees or taxes on returns to foreign owners. A properly engineered swap agreement can avoid most or all of these expenses.
