Understanding Financial Engineering For Investors

According to the Britannica Dictionary, an engineer is defined as:

“a person who has scientific training and who designs and builds complicated products, machines, systems, or structures: a person who specializes in a branch of engineering”

Engineering drives our modern world. From the buildings we live in to the cars we drive to the computing devices we all carry, engineers maintain and build the technologies of the 21st century.

What if I told you that engineering drives not only our physical world but also the financial one? Yes, I am talking about financial engineering, where individuals build new innovative products to drive progress (for better or worse) in financial markets and corporate finance.

a graphic showing different symbols for currencies

Financial engineers are not well known but have a huge impact on corporate balance sheets and investing over the last few decades. Therefore, it is important for beginning investors to understand the basic concepts of financial engineering and how it can be used to improve portfolio outcomes.

In this post, we will learn:

Let’s get right into it.

How financial engineering works for corporations

There are varying definitions of financial engineering and many ways it can be implemented. To sum up, financial engineering is when you invent and implement new products and contracts to drive some kind of financial outcome.

For corporations, there are many ways executives can use financial engineering. Essentially, it is a corporation working with a bank, customers, or suppliers to build a contract to improve business outcomes.

To understand further, it can be helpful to look at some common examples.

How Hershey uses financial engineering

Corporations have input costs that may swing wildly in price. For example, Hershey has to buy a lot of cocoa and sugar for its chocolate bars. However, sometimes the price of cocoa goes up. If Hershey could only buy cocoa at the daily price, it would see its profits swing wildly from quarter to quarter unless it wanted to sporadically change the price of its candy bars at retail locations. I don’t think customers would be happy if a Hershey bar was suddenly $10.

a stock candlestick chart going up

To smooth out these input costs, Hershey works with banks and commodity producers to sign fixed price contracts, hedging contracts, and futures contracts to reduce the impact of commodity price swings. This is a form of financial engineering used by many companies around the globe to preserve profits amidst pricing volatility.

Corporate financial engineering strategies

Global corporations that operate in many different countries can see profits impacted by wild swings in foreign currencies. For example, Argentina’s currency has depreciated by 99% vs. the U.S. dollar in the last few decades. Any company from the United States with much exposure to that country would see profits dry up if they just accepted these price swings at face value.

Like commodity prices, corporations will pay banks or other financial institutions to hedge their foreign currency risk. If a foreign currency falls in value compared to the company’s home market currency (such as the United States), profits could see a severe downturn despite no change in the underlying business operations. At their simplest, foreign currency contracts will hedge these risks for businesses, keeping profits intact.

Share repurchases are the most common form of financial engineering at corporations and perhaps the most important for individual investors to understand. A share repurchase is a simple form of financial engineering that reduces the shares outstanding for a stock.

A company will go to the open market—either on its own or through a bank—and buy back shares from investors. They then retire the shares, shrinking the total number of shares outstanding. This increases the ownership percentage for remaining shareholders, which means a higher percentage of the profits goes to each remaining share, which is good for investors.

Share buybacks can help juice stock returns. Most of the time, they are funded by cash flow, but sometimes companies will add even more fuel to buyback spending by taking on debt. This is what is known as a leverage buyback program. Using low-cost debt to repurchase a lot of stock on the cheap can be smart, but it also comes with risks if profits are not as stable as management thinks. Implementing financial engineering does not guarantee a good outcome.

Share issuance is on the opposite end of the financial engineering spectrum from share buybacks. Companies create new shares and sell them to the open market. This is a form of financial engineering that raises funds to invest in growth or stabilize a balance sheet. A company trading at a premium valuation may use this tactic to raise funds on the cheap. Conversely, a struggling company may be forced to issue stock to stave off bankruptcy.

Corporate finance is ruled by financial engineering. Understanding these methods can help investors better analyze a business’s prospects.

Options and derivative contracts for stock traders

Investors need to understand how financial engineering impacts the stocks they invest in. However, there are also direct ways investors can use financial engineering.

The most common financial engineering product for traders is options contracts. These are contracts that a brokerage/bank sells to you that allow you to bet not only on the direction of a stock but also at a specific price and on a specific date.

When someone buys a call option contract, they are given the right to buy a stock at a certain price (the option price) before a certain date. If the stock is below that price after the date passes, the contract expires worthless. If it is above the option price, the trader pockets the difference between the actual stock price and the option price they bought.

a piece of paper with options trading written on it next to a keyboard

Put options are exactly like call options except betting in the opposite direction. If a stock falls below a certain price on a certain date, the trader pockets the spread vs. the option price in the contract they bought. If it is above that price, the options contract expires worthless.

The financial engineering isn’t limited to these two options contracts. There are call spreads, strangles, straddles, long puts, and plenty of other types of options that investors can buy and sell.

For bigger traders, banks will work with them to financially engineer new options and derivatives contracts. There is the famous Credit Default Swap (CDS) from the Big Short that allowed investment funds to bet against shaky mortgage-backed securities.

Confused about how all this works? Don’t worry, options and derivatives typically cause more harm than good for individual investors. 90% of options traders lose money. Do you really think you can be the 10% that actually makes money?

Options give investors more freedom in portfolio allocation. But that doesn’t make it a good thing if most lose money trading options. Smart investors will buck this trend and avoid options in their portfolio, no matter how enticing the potential returns are.

Quantitative and algorithmic investing

The last major type of financial engineering that can impact investors is quantitative and algorithmic investing. Quantitative funds (quant funds, for short) use predetermined rules and automated trading to allocate a fund into a specific group of stocks based on quantitative factors.

This is also called factor investing and is made most famous by the value and momentum factors. Quantitative value funds buy the cheapest set of stocks from a group regardless of any personal feelings about the companies. This is typically based on a metric such as price-to-earnings ratio (P/E) or price-to-book ratio (P/B), but there are many types of value funds out there.

Quantitative momentum investing means buying stocks that have recently gone up, hence the term momentum. It will take the top-performing stocks of the last 50 or any set of days and buy them for the portfolio. This tactic is strange and counterintuitive, but one that has worked over the long term.

a person using a futuristic touch screen with different charts and maps

Both value and momentum investing are based on academic studies showing that these stocks historically outperform the broader market indices. This is why so many funds are focused on building portfolios to take advantage of these quantitative factors. Essentially, investment funds are looking to financially engineer an outcome for their investors based on prior market patterns.

Algorithmic trading is similar to quantitative investing, but instead of using quantitative factors, it uses trained artificial intelligence (AI) to make trades for a fund based on the ingestion of prior market data. Renaissance Technologies’ most famous algorithmic fund is the Medallion Fund. It has returned 62% per year before fees (uncompounded), beating the market by a wide margin.

Quantitative factor investing can be replicated by an individual investor, but algorithmic trading is much more complicated and likely something everyone should avoid. Save it for the geniuses at Renaissance Technologies.

Takeaways for beginning investors

The financial markets are awash with financial engineering. Thanks to modern computers’ speed, companies can ingest and analyze more data than they could a few decades ago.

For better or worse, almost every publicly traded stock relies on financial engineering to help boost or stabilize its business operations. These methods are not necessarily good or bad in a vacuum; they just need to be implemented intelligently to boost intrinsic value for shareholders.

On the other hand, options, derivatives, and other financial instruments invented by the financial engineers at big banks and other institutions should be avoided by individual investors. The sad thing is, that these products are only getting more popular. Especially the rise of zero-date options, which is an options contract that expires on the same date you buy it.

This is not investing, not even trading. It is pure speculation that only leads to ruin.

Financial engineering has a place in this world. Hedging helps the world’s corporations balance costs to stabilize operations. However, it is probably best to minimize the use of financial engineering in your personal investment portfolio.

Brett Schafer

Brett Schafer is an investor, host of the Chit Chat Stocks Podcast, and writer at the Motley Fool.

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