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REV: DECEMBER 18, 2006
PETER TUFANO
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Introduction to Corporate Financial Engineering
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Over the past few decades, some of the most profound developments in finance have been the products of financial engineering. Financial engineering (FE), embodied in new securities, trading strategies, and risk management programs, is changing the practice of finance. Not only has the sheer volume of financially-engineered products exploded, but also financial-service firms have begun to use financial engineering as a basis of competition. Some have asserted that banks’ success will be increasingly determined by how they embrace these new financial technologies—and this attitude speaks to financial engineering’s prominent role in the financial-service sector.
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While there has been a great deal written about the tools and techniques of financial engineering and about their use by financial institutions, there has been less written about the application of this new technology by non-financial corporations. However, corporate financial managers also use financial engineering to advance shareholder value. Surveys from the 1990s suggest that two-thirds of large U.S. corporations use one type of financial engineering—derivatives—as part of their financial programs.1 While there might have been some retrenchment in the wake of the celebrated and criticized uses of financial engineering by firms, firms continue to use financial engineering widely. A 2005 survey of CFOs around the globe showed that:2 Those parts of the finance function where financial engineering plays the largest role (capital structure and risk management) were among the finance functions that contributed the greatest value to firms
In managing risks, 82% of firms use foreign exchange derivatives, 79% use interest rate derivatives, and 32% use commodity derivatives. Structured products, equity derivatives and credit derivatives are used , but less frequently (by 13%, 12% and 12% of firms, respectively.)
Through case studies, we study in detail how financial engineering is used in firms to reduce their costs of financing, to alter their fundamental risk exposures, and in a handful of cases, to provide them with new ways to compete. The premise behind the Corporate Financial Engineering (CFE)
1 See Charles W. Smithson, Managing Financial Risk 1996 Yearbook (Canadian Imperial Bank of Commerce, 1996), p. 45.
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2 See Henri Servaes and Peter Tufano, “Corporate Financial Policies and Practices: CFO Views on the Importance and
Execution of the Finance Function” (January 2006) and “Corporate Risk Management: The Theory and Practice of Corporate Risk Management Policy” (February 2006) Deutsche Bank Research Reports. ________________________________________________________________________________________________________________ Professor Peter Tufano prepared this note as the basis for class discussion.
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Introduction to Corporate Financial Engineering
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course is that financial engineering can be used by corporations to increase shareholder value. Therefore, the course seeks to help corporate managers understand how to use financial engineering to advance the goals and strategies of their firms. To accomplish this goal, the course (1) documents how financial engineering has been used by firms to accomplish various goals; (2) provides students with frameworks to determine when and how firms can apply financial engineering in managing their businesses; and (3) provides students with basic technical skills in financial engineering.
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What is financial engineering? One can liken financial engineers to civil engineers. Civil engineers are trained in materials science and mechanics, where financial engineers are trained in financial economics, and more specifically that sub-field that studies the economic principles that underlie securities markets. Both engineers work within physical and budgetary constraints, although in the financial engineer’s world, “physical” constraints might be a combination of transaction costs, taxes, and regulations. Where a civil engineer might construct a bridge, a financial engineer might fashion a financial contract (e.g., a structured equity product), a risk management strategy, or a trading strategy. One of the core concepts that underlies financial engineering is the notion of the “law of one price.” This seemingly simple law states that two portfolios with the same payoffs will have the same price. Using the law of one price forces us to consider how various portfolios or securities are alike or different, and to leverage this understanding to value complex securities.
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Goal 1: Documenting existing practice. A great deal of exciting innovation is going on by corporations using financial engineering, and the course seeks to allow students to examine these innovations carefully through case studies that take the corporate user’s perspective. To provide order to the vast array of uses of financial engineering, I categorize its applications into three categories: (1) lowering financing costs through speculation or arbitrage; (2) implementing riskmanagement strategies that allow firms to shed risks; and (3) using financial engineering to support new ways of carrying out business strategies, either by bearing risks from customers, suppliers, employees or others, or by substituting financial engineering for operating activities. From these specific examples, we can explore not only how and why financial engineering is used, but also the managerial challenges that arise from its application. Goal 2: Providing frameworks for deciding how to use financial engineering. At the broadest level, the CFE course shows that many uses of financial engineering result from firms coping with imperfections in markets. Therefore, the nature of the imperfection informs the appropriat+e response. For example, in the financing module, we see that tax and regulatory rules impose strict constraints on corporations and investors, and that financial engineering can be used to maximize firm value subject to these constraints. In the risk management module, we see that risk management is itself the response to a wide range of market imperfections, including deadweight costs of financial distress, costly external financing, non-linear tax schedules, imperfect shareholder knowledge of firm actions, and economies of scale in carrying out financially-engineered strategies. Finally, in the strategic applications module, we see that imperfections in non-financial markets (e.g., the product market for the firm’s goods, the factor markets for its inputs, the labor market for employees and executives) motivate the use of financial engineering. In these strategic applications, firms attempt to use financial markets and financial engineering to allow them to profit in these less-than-perfect nonfinancial markets.
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For each application, the course provides students with tools that help them determine how to apply financial engineering. Consider the difficult corporate decision of whether a firm should attempt to moderate its exposures through a risk management program. Financial theory that ignores all market imperfections holds that risk management is irrelevant. At the other extreme is the viewpoint (held by some risk management vendors) that firms should hedge all risks that markets are willing to bear. Between these two extremes, academics, consultants, and financial advisors deluge
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managers with conflicting advice. In CFE, we acknowledge that there may be many valid reasons that firms engage in risk management. The only way to determine which of the theories is most relevant in a particular instance is for managers to test whether the theory’s hypotheses and logic apply to their own firm. For example, if a firm faces a linear tax schedule, then tax-motivated reasons for hedging are irrelevant. A firm with virtually no investment needs may not need to generate cash flow to avoid the need to access costly external financing. These firm-specific analyses can only be conducted with a great deal of information, which the cases were written to provide.
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Goal 3: Developing financial engineering skills. One cannot understand how firms are using, or should use, financial engineering without an appreciation of the tools and techniques of the field. Therefore, the CFE course also serves as an introduction to the technical content of financial engineering. Fortunately, there is a great deal written about the tools and techniques of the field. Journals, textbooks, and practitioner publications address the latest developments in the valuation and hedging of instruments.3 Unfortunately, much of this work is written by and for financial engineers, presumes Ph.D. math skills, and is not addressed to general managers interested in understanding these products from the perspective of end-users. My goal is to bring students to a level of basic literacy with FE so that they can understand the proposed application. Thus, in contrast to courses at other schools, the CFE course teaches this technical material in the context of corporate applications, interweaving traditional pedagogical materials (textbooks, problems, and quizzes) with case study materials.
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CFE’s link to research: Given the relative newness of the application of financial engineering by corporations, there is still much that we do not know. The firms we study in the course, and their experiments with financial engineering, raise a great number of interesting issues, many of which can be more formally studied through research. For example, the case study on the hedging activities of a major North American gold mining firm served as the stimulus for empirical research on the characteristics of firms that hedge more or less, and the implications of hedging for share price exposures of these firms. Underlying a few cases on risk management is the hypotheses that acquirers of assets might get “better deals” in some market environments rather than others; this has been the subject of another study. In general, I encourage students to become engaged in this research process by reviewing new research with them and encouraging them to suggest ways to test the ideas raised in the course.
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Why take the course? The central role that financial engineering has captured in finance theory and financial services practice, in conjunction with the unmistakable trends in the corporate use of financial engineering, suggests that an investment in learning about financial engineering will prove to be highly valuable. Given the newness of this field, almost surely there will be first-mover advantages to those who understand the opportunities (and limitations) of this new technology quicker than their rivals. To use a relevant metaphor, the option value of being able to apply FE to your business is likely to be very high.
3Dedicated journals and periodicals include the Journal of Financial Engineering, The Journal of Derivatives, The Journal of Derivatives Research, Derivatives Week, Risk, and Derivative Strategies. The Global Association of Risk Professionals (GARP) is one of the professional organizations which serves financial engineers. There are many MBA-level textbooks on the tools of financial engineering; At the current time, we use John Hull’s Introduction to Options and Futures Markets (Prentice Hall, 2005) in the course.
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Introduction to Corporate Financial Engineering
Three ways that corporations use financial engineering
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In the CFE course, we will see many different ways of using financial engineering. It is useful to categorize functionally-similar uses together, and we will tend to discuss corporations’ use of financial engineering as one of three related types of activities: financing, risk management, and strategic applications.
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Financing applications entail using financial engineering to obtain lower costs of financing through arbitrage or dominance, or active management of exposures. 4 “Arbitrage” refers to earning profits without taking on risk through the construction of riskless positions in mispriced securities; “dominance” refers to the substitution of one position that is in all ways superior to another; and “active management” refers to the risky speculation on the price of an asset. These uses tend to be predicated on the belief that the corporation has access to better information or a richer choice set than other players in the financial markets. The technical lessons in this portion of the course are well-known in academia and practice, and I use this relatively-straightforward material to develop and deepen students’ mastery of basic financial engineering skills. The managerial issues around active management revolve around the determination of investment management competence.
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Risk Management involves modifying corporate exposures that are an outgrowth of a firm’s existing business strategy. For example, in a transaction-hedging currency hedging program, new sales in foreign currencies give rise to foreign-currency-denominated receivables, which can be hedged using futures or options. In this static form of risk management, fixed business strategies inform the risk management strategy, but are not informed by it. While there has been much theory written about corporate risk management, there has been less written on either (a) how risk management is carried out by firms; and (b) how it should be carried out in actual business settings. The course seeks to describe existing practice (which does not always conform to theory), and to provide students with a framework to make risk management choices that jointly considers general theory and firm-specific information. Strategic Applications entail using financial engineering to advance new business models and strategies. These applications of financial engineering are the newest and are distinguished from the first two phases by the integral role financial engineering plays in facilitating new ways of doing business. In particular, we study how FE is used to support new marketing programs, offer alternatives to production strategies, structure incentives and signal information in new fashions, value assets, and facilitate strategic mergers and acquisitions. What differentiates these uses of financial engineering from simple risk management is that executives are finding new ways of conducting their business, not just modifying the risks of their businesses. Often these new ways of doing business call for firms to assume new risks from customers, suppliers, shareholders or counterparties, which financial engineering then allows firms to value, structure, and lay off. These uses of financial engineering in corporate applications constitute a new area. The cases in the course (and the associated research) allow students to examine new developments as they unfold, and develop an appreciation of the potential for and limitations of financially-engineered business strategies.
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A graphical illustration of the differences between the three types of uses. Suppose that you were to array different markets (e.g., financial markets, product markets, labor markets, merger and 4The use of financial engineering to lower financing costs was one of the earliest uses of the technology. Researchers of innovation have found that diffusion of new ideas, products, and technologies tends to follow certain recognizable patterns, with adoption determined by a group’s prior training, experiences, and attitudes. It is not surprising that early activity took place among the most technically-aware potential users (finance professionals), who were carrying out “technical” activities delegated to them by general managers.
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acquisition markets) along a single axis that is defined by the level of “imperfections” in the markets which might permit firms to earn abnormal profits. Of the various markets, financial markets probably have fewer imperfections than the other markets. It is probably easier to transfer ownership and attempt to exploit pricing differentials in these markets than in labor markets, product markets, or the corporate control market. The top panel of Exhibit 1 represents purely “financial applications,” those uses of FE in which firms attempt to earn profits by transacting strictly in financial markets. These activities could entail the sale of a firm’s own securities (financing), the purchase of securities, or the sale of liquid assets, such as another firm’s securities. In each of these, all of the relevant activity takes place only in the financial markets, which are arguably the hardest place to make money, especially for non-financial firms. These activities are predicated on the firm’s superior knowledge or access to financial markets.
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In risk-management applications, firms use financial engineering to support their ability to profit in other, more profitable non-financial markets. The firm’s strategy creates exposures, which are transmitted to the finance area to manage, as shown by the one-way arrow in the second panel in Exhibit 1. This traditional risk management clearly results from an interaction between financial and non-financial markets, but a one-way flow of information and direction from the firm’s business to its risk managers.
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In strategic applications, firms change their activities in non-financial markets due to the availability of the new technology of financial engineering, hence the two-way arrow in the final panel of Exhibit 1. For example, financial engineering enables a firm to construct a “better” incentive plan for employees, hopefully creating values through more highly motivated workers. By using financial contracts, a firm seeks to find a viable alternative to constructing new costly power plants. By sharing risks with the buyer of corporate assets, a firm hopes to capture some of the value attributable to a change in control of oil fields. In each case, firms seek means to leverage efficient financial markets to capture value in less perfect non-financial markets. Rather than arbitraging within the financial markets, they are seeking to arbitrage between financial and non-financial markets.
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Risk management and strategic applications are closely related. They differ with respect to the ways in which financial engineering is used to help extract profits from non-financial markets. In risk management, financial engineers receive information about the firm’s business strategy and act to reduce the firm’s exposures. In strategic applications, financial engineers also transmit information back to general managers, allowing them to either carry out new business strategies or to conduct old ones in new ways. These distinctions are subtle, but consider an analogy: how the technology of computing has changed business. Early on, it was used to make existing processes more efficient. For example, early word processing was a faster and easier form of typing (a substitute for correction fluids), and early e-mail was an improved way to distribute memos. However, computing has also supported new businesses as well. For example, computing technology makes possible businesses like Intuit’s Quicken or Federal Express’ delivery system. These firms are not merely more efficient versions of earlier business models, but new businesses made possible by technology. In a similar way, the technology of financial engineering may also be able to support new types of businesses and new means of carrying out existing businesses.
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Introduction to Corporate Financial Engineering
Exhibit 1
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Three Uses of Financial Engineering by Corporations
Product Markets
Financial Markets
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More Imperfections
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Risk Management
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Financial Applications
Fewer Imperfections
Strategic Applications
Product Markets
M& A Market
Financial Markets
Fewer Imperfections
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More Imperfections
Labor Markets
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