Romancing financial engineering

By Michael Ogembo Kachieng’a

Financial engineering, sometimes called financial calculus, can be notoriously intimidating and precise.

For those with mathematical engineering brains, the calculations can be comprehensibly sexy. Both preciseness and comprehensibility are needed in risk markets, such as insurance, stock and derivatives. For most market practitioners, what is mathematically precise is rarely comprehensible, and what is comprehensible is rarely precise. On the academic side, effort is too often expanded on finding precise solutions to the wrong questions. Markets need practical answers. Most market players have neither time nor brains for precision mathematics. Much of market practice is based on soft understanding of the market processes, rather than on mathematical calculations.

The majority of stock market practitioners base their activities on semi-correct information from financial newspapers. Some fund managers take chances in market actions and, more often than not, get burnt because newspapers rarely analyse long-term economic fundamentals of individual stocks. Also, the majority of brokers have no professional motivation to go through financial calculus, because their incomes are based by the quantity and velocity of transactions, rather than precise mathematical calculations of transient risks.

Unfortunately, the market needs precision, because the ‘stakes are too high’. For example, the derivatives market has grown into a business of more than $20 trillion (Sh160 trillion). Precision is needed to tame the madness and greed associated with modern capitalism. Stock market instruments can be divided into two distinct species: there are the so-called ‘underlying stocks’, which include shares, bonds, commodities, foreign currencies, and their ‘derivatives’, claims that promise some payments or delivery in the future, contingent on underlying stock’s behaviour. Derivatives can reduce risk by enabling a player to fix a price for a future transaction now. A costless contract agreeing to pay the difference between a stock price and some agreed future price lets both sides ride the risk inherent in owning stock, without needing the capital to buy it outright.

economic fundamentals

In the stock market, the problem is not how to make money, but how to spot the misalignment of prices in relation to economic fundamentals. For many years, applied mathematics has lubricated the stock market operations in search of the intrinsic value of stocks. The price of stock depends on its presumed or estimated intrinsic value. Financial engineering approaches the determination of stock prices through the evaluation of transient risks associated with a particular stock or portfolio of stocks. The beauty of financial engineering is that it marries the precision of mathematical calculations with the engineering logic of market transactions.

That is why engineers have become essential players in the stock markets and financial institutions. Spotting risks and evaluating them requires engineering process logic and mathematical excellence. The purpose of financial calculus is to provide mathematical tools for spotting transient risks and to develop compensating mechanisms for cancelling or minimising risks. Investment banks and brokerage houses employ many engineering graduates just to do that. But one of capitalism’s powerful economic strengths is its appetite for risk. Regulating risk implies regulating capitalism.

In the last three decades, financial calculus has progressively gained a foothold in the evaluation of transient risks in stock transactions. It originates from the fundamental policy conflict of modern capitalism —stability versus growth.

The world is in a financial mess because stock markets and financial institutions took risks that they should not have taken. Financial engineering facilitates the quantification of risks, which, therefore, provides the basis of management and regulation of risk markets — insurance, derivatives, credit default swaps or restricted risks that financial institutions can take. The role of financial engineering is to inject mathematical common sense into the behaviour of risk markets.

Same mistakes

The greatest unknown in the stock market is its emotional side. Understanding the emotional side of the market means appreciating human motivation in all activities. All the technical charts and trend indicators are statistical attempts to describe the emotional state of the market. For market addicted stockbrokers, there is no safer investment in the world than in the stock exchange. Fund managers are basically slaves of the quarterly and annual financial reports. If they have a bad quarter, they lose clients, and if they have a bad year, they lose lots of clients.

What we learn from the history of the stock market is that market participants do not learn from history. People make the same mistakes over and over again in the stock market – they overpay for a business in the hope of making a profit on the short-term price movements of the company’s shares. This mistake drives the entire market and is perpetuated by fund managers focusing on short-term marginal profits. The history lesson that people never seem to learn is that, when companies are priced far in excess of their long-term economic value, as often happens during a bull-market, any sudden change in the wind of expectation can cause stock prices to drop dramatically, thus wiping out those investors who paid the high bull-market prices.

Genius investors like Warren Buffet treat stock price fluctuations as an indicator to do the opposite – they profit from the market folly rather than participate in it. Uncertainty in the stock market creates fear, and fear creates panic selling, which forces prices downward – regardless of a business’ long-term economic prospects.

This chain reaction creates a buying opportunity if the long-term economic value of the business is in excess of its selling price. It is the long-term economics of the business that will eventually pull the stock price back up in line with the realities of the business.

The stock market is merely a platform where shares of companies are valued on their short-term economic prospects, which creates lots of price gyrations over the short-term, which means prices often get out of line with the long-term economic realities of the business.

The power of financial engineering resides in making business sense of short-term stock prices in relation to the long-term business economics of the company. The mathematical logic of stock prices is pretty simple: At the beginning, prices are driven by the economic fundamentals, and at some point, speculation drives them.

—The writer is a Biomedical Engineering Scientist, Consulting Entrepreneur and Professor of Technological Entrepreneurship at the Graduate School of Technology Management, University of Pretoria, South Africa.