OTHER FINANCIALLY ENGINEERED INSTRUMENTS

There are a myriad of other examples of new financial instruments or contracts. Many of these instruments are new and trade infrequently. They are often referred to as "exotics." For example, it is possible to use combinations of puts and calls on interest rate instruments to create caps, floors, and collars on interest payments. A cap represents the maximum rate that a floating interest rate position can obtain, a floor is the minimum rate, and a collar is the combination of a cap and a floor. Another unusual option feature is the lookback option. A call option with the lookback feature allows the holder to purchase the asset at the most favorable (lowest) price that prevailed over the life of the option. A put option with this feature allows the holder to sell the asset at the highest price over the option's life. These options set the exercise price at the end of the option's life rather than at the beginning. Closely related are Asian, or average-rate options. These options set the exercise price at expiration as the average asset price during the option's life span. Barrier options are options that are activated, canceled, or exercised if a particular price condition is met. For example, a "down and out" option is canceled if the asset price falls below the exercise price, while a "down and in" option is activated if the same price trigger is breached. Conversely, "up and out" and "up and in" options are canceled or activated when the exercise price is exceeded. Since these options are inert for large ranges of their underlying asset's price, they are less expensive than ordinary options and have generated interest among hedgers and speculators.

In summary, financial engineering is the design and construction of new financial contracts. These contracts are typically assembled from a modest number of basic financial instruments and indexes including stocks, bonds, options, forward contracts, and futures contracts. The need for properly engineered financial contracts is motivated by the client's interest in reducing risk, reducing costs associated with foreign exchange or other market transactions, and to provide the potential to enhance returns. Many financial intermediaries have developed specialized services in the area of financial engineering. As they have done so, the markets where elaborate and specialized contracts can trade efficiently have expanded and are likely to continue to do so.