Introduction:

What is Investment and the need of investment in finance?

Investment means putting your savings in an asset created to help you

grow your money. In other words, Investment is the dedication of
money to purchase of an asset to attain an increase in value over a
period of time. Investment requires a sacrifice of some present asset,
such as time, money, or effort.

How an Investment Works?

The act of investing has the goal of generating income and increasing
value over time. An investment can refer to any mechanism used for
generating future income. This includes the purchase of bonds, stocks,
or real estate property, among other examples. Additionally,
purchasing a property that can be used to produce goods can be
considered an investment.
In general, any action that is taken in the hopes of raising future
revenue can also be considered an investment.
 For example: when choosing to pursue additional education, the goal
is often to increase knowledge and improve skills. The upfront
investment of time attending class and money to pay for tuition will
hopefully result in increased earnings over the student's career.
Because investing is oriented toward the potential for future growth or
income, there is always a certain level of risk associated with an
investment. An investment may not generate any income, or may
actually lose value over time. 
For example: A company you invest in may go bankrupt.
Alternatively, the degree you investing time and money to obtain may
not result in a strong job market in that field.
 
Return on Investment
The primary way to gauge the success of an investment is to calculate
the return on investment (ROI). ROI is measured as:
ROI = (Current Value of Investment - Original Value of
Investment) / Original Value of Investment
 
Investments and Risk
In its simplest form, investment return and risk should have a positive
correlation. If an investment carries high risk, it should be
accompanied by higher returns. If an investment is safer, it will often
have lower returns.
When making investment decisions, investors must gauge their risk
appetite. Every investor will be different, as some may be willing to
risk the loss of principle in exchange for the chance at greater profits.
Alternatively, extremely risk-averse investors seek only the safest
vehicles where their investment will only consistently (but slowly)
grow.
 
What are the Objectives of Investment?
1. To Keep Money Safe
Capital preservation is one of the primary objectives of investment for
people. Some investments help keep hard-earned money safe from
being eroded with time. By parking your funds in these instruments or
schemes, you can ensure that you do not outlive your savings. Fixed
deposits, government bonds, and even an ordinary savings account
can help keep your money safe. Although the return on investment
may be lower here, the objective of capital preservation is easily met. 

2. To Help Money Grow

Another one of the common objectives of investing money is to
ensure that it grows into a sizable corpus over time. Capital
appreciation is generally a long-term goal that helps people secure
their financial future. To make the money you earn grow into wealth,
you need to consider investment objectives and options that offer a
significant return on the initial amount invested. Some of the best
investments to achieve growth include real estate, mutual funds,
commodities, and equity. The risk associated with these options may
be high, but the return is also generally significant.
3. To Earn a Steady Stream of Income
Investments can also help you earn a steady source of secondary (or
primary) income. Examples of such investments include fixed
deposits that pay out regular interest or stocks of companies that pay
investors dividends consistently. Income-generating investments can
help you pay for your everyday expenses after you have retired.
Alternatively, they can also act as excellent sources of supplementary
income during your working years by providing you with additional
money to meet outlays like college expenses or EMIs.

4. To Minimize the Burden of Tax

Aside from capital growth or preservation, investors also have other
compelling objectives for investment. This motivation comes in the
form of tax benefits offered by the Income Tax Act, 1961. Investing
in options such as Unit Linked Insurance Plans (ULIPs), Public
Provident Fund (PPF), and Equity Linked Savings Schemes (ELSS)
can be deducted from your total income. This has the effect of
reducing your taxable income, thereby bringing down your tax
liability.

5. To Save up for Retirement

Saving up for retirement is a necessity. It is essential to have a
retirement fund you can fall back on in your golden years, because
you may not be able to continue working forever. By investing the
money you earn during your working years in the right investment
options, you can allow your funds to grow enough to sustain you after
you’ve retired.

6. To Meet your Financial Goals

Investing can also help you achieve your short-term and long-term
financial goals without too much stress or trouble. Some investment
options, for instance, come with short lock-in periods and high
liquidity. These investments are ideal instruments to park your funds
in if you wish to save up for short-term targets like funding home
improvements or creating an emergency fund. Other investment
options that come with a longer lock-in period are perfect for saving
up for long-term goals.

Need of investment 
(i) Financial security
 People want to be financially secure and this is why they need to
have extra money. They are able to protect themselves financially
against whatever financial hardship that might strike them. An
example could be a costly life event such as a major health crisis or
home destruction by a cyclone or fire. Having an investment ensures
that you are financially secured to meet such unforeseen events. 
(ii) Financial independence 
Your investment enables you to be independent and not rely on the
money of others in any event of financial hardship. It ensures that you
have enough money to pay for your needs and wants for the rest of
your life without having to rely on someone else or having to work in
your old age.
 (iii) Build your wealth 
People invest with the view to build their wealth. This means that they
save and then invest their savings over time. In this process, the
proceeds from the investments, whether they are dividends or interest
earned, can be reinvested into the same financial instrument or even
something else. This way you too can start investing and continue
building your wealth.
 (iv) Attain your goals
 Some people set specific goals in life and invest to achieve those
goals. For example, if it is your dream to buy a house or a new car or
take a trip around the world, the goal you set would be your
motivation to invest. It is important that you list down your goals and
how much money you need to achieve that goal. Your goals could be
short term, medium or long term in nature. Investing your money
according to your goals will enable you to grow your money and
achieve your goals quickly without you having to work all your life
 
 
 
Financial Instruments:
Financial Instruments are intangible assets, which are expected to
provide future benefits in the form of a claim to future cash. It is a
tradable asset representing a legal agreement or a contractual right to
evidence monetary value / ownership interest of an entity.
Under the subject of Finance Management, Financial Instruments can
be classified as cash instruments and derivative instruments. Financial
Instruments are typically traded in financial markets where price of a
security is arrived at based on market forces.

Derivative instruments can be defined as instruments whose

characteristics and value can be derived from its underlying entities
such as interest rates, indices or assets, among others. The value of
such instruments can be obtained from the performance of the
underlying component. Also, they can be linked to other securities
such as bonds and shares/stocks.

Cash instruments, on the other hand, are defined as instruments

which can be transferred and valued readily in the market. Some of
the most common examples of cash instruments are deposits and
loans where the lenders and borrowers are required to be agreed upon.

Other Classifications:
Financial instruments can also be classified based on the asset class,
i.e, equity-based and debt-based financial instruments.

Equity-based financial instruments include securities, such as

stocks/shares. Also, exchange-traded derivatives, such as equity
futures and stock options, fall under the same category.
Debt-based financial instruments, on the other hand, consist of
short-term securities, such as commercial paper (CP) and treasury
bills (T-bills) which have a maturity period of one year or less.
Cash instruments such as certificates of deposits (CDs) also fall
under this category. On the same lines, exchange-traded derivatives,
such as short-term interest rate futures fall under this category.
Since the maturity period on long-term debt-based financial
instruments exceeds a year, securities such as bonds fall under the
category. Exchange-traded derivatives include bond futures, and
options are the other examples.
Investing is an effective way to have your money work for you and
build wealth. Holding cash and bank savings accounts are considered
safe strategies, but investing your money allows it to grow in value
over time with the benefit of compounding and long-term growth.
One of the big- time examples of this is-
India's economy showed great signs of recovery in FY22 after the
COVID-19 pandemic. India's gross domestic product (GDP) at
current prices in the first quarter of 2022-23 is estimated to be Rs.
36.85 lakh crore (US$ 447.44 billion), as against Rs. 32.46 lakh crore
(US$ 394.13 billion) in 2021-22, showing a growth rate of 13.5%,
while nominal GDP is expected to stand at Rs. 64.95 lakh crore (US$
788.64 billion), a 26.7% growth. These figures make India the fastest-
growing major economy in the world, and this economic growth has
translated to the domestic investment market in India. Retail
investors, mutual funds and PE/VC firms have all stepped up their
domestic investments in the Indian market.
Financial instruments are used for:
1. Hedging purposes (that is, to change an existing risk
profile to which an entity is exposed). This includes:
o    The forward purchase or sale of currency to fix a future
exchange rate;
o    Converting future interest rates to fixed rates or floating
rates through the use of swaps; and
 o    The purchase of option contracts to provide an entity with
protection against a particular price movement, including
contracts which may contain embedded derivatives;
·            Trading purposes (for example, to enable an entity to take
a risk position to benefit from short term market movements);
and
·                    Investment purposes (for example, to enable an entity
to benefit from long term investment returns).

2. The use of financial instruments can reduce exposures to

certain business risks, for example changes in exchange
rates, interest rates and commodity prices, or a combination
of those risks. On the other hand, the inherent complexities
of some financial instruments also may result in increased
risk.

Management’s failure to fully understand the risks inherent in a

financial instrument can have a direct effect on management’s ability
to manage these risks appropriately, and may ultimately threaten the
viability of the entity. The principal types of risk applicable to
financial instruments are listed below.
a.  Credit (or counterparty) risk is the risk that one party to a
financial instrument will cause a financial loss to another party by
failing to discharge an obligation and is often associated with
default. Credit risk includes settlement risk, which is the risk that
one side of a transaction will be settled without consideration
being received from the customer or counterparty.
b. Market risk is the risk that the fair value or future cash flows of
a financial instrument will fluctuate because of changes in market
prices. Examples of market risk include currency risk, interest
rate risk, commodity and equity price risk.
c.  Liquidity risk includes the risk of not being able to buy or sell a
financial instrument at an appropriate price in a timely manner
due to a lack of marketability for that financial instrument.
d. Operational risk relates to the specific processing required for
financial instruments. Operational risk may increase as the
 complexity of a financial instrument increases, and poor
management of operational risk may increase other types of risk.

TYPES OF FINANCIAL
INSTRUMENTS:
1. Equities:
Equities are the share in the ownership of the company and are one of
the most traded financial instruments on the exchange. But why do
investors and traders swarm towards equity? This is because it has the
ability to multiply your capital by generating higher returns as
compared to other financial instruments. Other features that make it
the most preferred avenue are:
● Buying shares/stocks give you the part-ownership in the
company
● Has better liquidity, which means you can easily sell your
shares in the market
● Its inherent volatility offers investors to book short term
profits based on stock price fluctuations
For example: A company called XYZ has a total capital of Rs. 6
lakhs. It has divided the capital into 6000 units of shares each
amounting to Rs. 100. Therefore, you can see that each unit or
share of the company costs Rs. 100. Individuals or corporations
can purchase the share at this price. Hence, holding a share in an
organization is often regarded as partial ownership as well. It is
for the same reason that anyone holding a share is termed as a
shareholder. 
2. Debt Securities:
Securities issued by companies or the government with an objective
to generate funds are known as Debt Instruments. Its features are:
●Interest on these instruments can be earned at specific
intervals
● The principal amount invested will be repaid at the end of the
contract period
● They can be both secured as well as unsecured
● Issued to raise funds for day-to-day operations, business
expansion, acquisitions, paying off debts, or more
● Yields lower returns as compared to most other instruments
like Equity, Gold, and Real Estate over the long run
Debt instruments traded on the exchange can be classified into
bonds and debentures.
(a)Bonds
These fixed-income debt instruments are issued by the central
and state government, and large corporations to raise funds.
They can either be secured by a physical asset or a guarantee.
There are various types of bonds such as floating bonds,
inflation-indexed bonds, sovereign gold bonds, and more.
(b)Debentures
Debentures are issued by the corporates to accumulate funds by
borrowing money from the public. Debentures are generally
unsecured and are issued to raise capital for a specific purpose.
For example: You run a retail store and want to borrow a large
sum of money from your bank to open a new shop. You plan to
use your current premises as security against the loan. You and
the lender sign a fixed charge debenture which details the
specifics of the loan, including the amount, interest rate, term
length and the fact that the loan is secured against the business’
 original premises. If you pay back the loan according to the
debenture terms, then no further action is taken. However, if
your business goes into liquidation because you’re unable to pay
your debts, the debenture would ensure that the lender is repaid
before any other creditors.

3. Mutual Funds:
A fund created by contribution from a number of investors is
known as a Mutual Fund. The money is then invested in
securities like equities, bonds, money market instruments, and
other securities available in the market. It offers investors an
opportunity to invest in diversified and professionally managed
securities at a relatively low cost. You can choose to get these
funds managed by expert and professional portfolio managers
who will do meticulous research before investing your money.
For those who want a way to invest that's more convenient,
with lower costs, less risk and more diversification, mutual
funds are a good option.

4. Cash Instruments:
Cash instruments are financial instruments with values directly
influenced by the condition of the markets. Within cash
instruments, there are two types; securities and deposits, and loans.

Cash instruments have their own market value. Common cash

instruments are stocks, bonds, loan agreements, and certificates of
deposit. Equity instruments represent ownership in a company.
Stocks are equity instruments. Debt instruments represent an
obligation to pay interest. Bonds, mortgages, and loan agreements
are debt instruments.
 
Securities: A security is a financial instrument that has monetary
value and is traded on the stock market. When purchased or traded,
 a security represents ownership of a part of a publicly-traded
company on the stock exchange.

Deposits and Loans: Both deposits and loans are considered cash
instruments because they represent monetary assets that have some
sort of contractual agreement between parties.

5. Foreign Exchange Instruments:

Foreign exchange instruments are financial instruments that are

represented on the foreign market and primarily consist of currency
agreements and derivatives.
In terms of currency agreements, they can be broken into three
categories:

Spot: A currency agreement in which the actual exchange of currency

is no later than the second working day after the original date of the
agreement. It is termed “spot” because the currency exchange is done
“on the spot” (limited timeframe).
 It is suitable for short-term arrangements.

For example, the gold price on 01/04/20XX is ₹2,000. If the customer

has a desire to purchase the gold @ ₹2,000 he can enter into spot
contracts and take instant physical delivery of gold.
Characteristics of spot contracts
  Immediate physical delivery.
 Only cash involved transactions.
 Takes less time to finish the arrangement.
 
 Forwards: A currency agreement in which the actual exchange of
currency is done “forwardly” and before the actual date of the agreed
requirement. 
Forward contracts take place over the counter, two parties sit across
and negotiate the quantity, quality, cost, and date of the transaction.
Forward contracts should be used to fix specific rates on the date of
agreement to keep away from currency floating risks
It is beneficial in cases of fluctuating exchange rates that change
often.
For example, a buyer X and a seller Y agree to do trade in 10 tons of
gold on 31 December 2015 at ₹25,000 per ton. Here ₹25,000 per ton
is the forward price of 31 December 2015 gold. Once the contract has
been entered into, buyer X is obliged to pay ₹2,50,000 on 31
December 2015 and take delivery of 10 tons of gold. Same way seller
Y is obliged to accept the ₹2,50,000 on 31 December 2015 and give
10 tons of gold in exchange.
 
Swaps:
 Foreign Exchange Swaps is the agreement between two agencies to
exchange their revenue or cash flows from any assets or liabilities,
which is occurred during particular intervals. Swaps are an exchange
between two parties to trade currencies for a pre-determined period of
time
Most interest rates are getting swapped between two agencies. The
majority of swaps are categorized into the following groups:

 Interest rate swaps are derivative contracts which involves

exchange of interest rates between two agencies. It is a forward
contract which enable two parties to interchange their interest
rate from fixed to floating or floating to fixed to pay their debts.
It helps to reduce the movement in interest rates.
 Commodity swaps is derivative contract in which two parties
agreed to exchange their cash flows related to the fundamental
assets or commodity up to a defined period of time. Generally,
commodity swaps used to protect against the cost variance of
commodities in the market.
 Equity swaps is an arrangement in which total return on equity
or dividends and equity capital is exchanged with floating or
fixed rate of interest.
 Currency swap is a derivative, which allows two parties to
agree to transfer same amount of money but in various
currencies. Currency swap permits, organizations operated in
foreign can avail loans at lower interest rates from their home
country.
  

 Options
Options are exactly like forward contracts, parties can exercise
options on favourable terms. It is also a type of forex derivative used
to mitigate forex trading risks. It gives the purchaser the right, but not
a responsibility to transfer any underlying asset, currencies, security,
etc. at an agreed cost on a specified date. Parties involved in the
options are called: option holders, option writers. Options have two
key attributes.
Call option
It is a commitment that offers the purchaser the right, but not
responding to buy a particular number quantity of assets from the
seller of the option at a pre-determined price on the specified date.
Put option
It is a commitment that offers the purchaser the right, but not
responding to sell a particular number quantity of assets from the
seller of the option at a pre-agreed price on the specified date.

Futures

A futures contract is an arrangement between two agencies that make

one agent purchase an asset, financial instruments, securities,
currencies, and counterparty to sell an asset, financial instrument,
securities, and currencies at a fixed future date. Futures requisite both
the agencies in the arrangement have balance in their margin account.
Future contracts are a derivative instrument that is used by investors
to make huge profits on their investments. Because vast investments
are always associated with high risk.
CFD (Contract for Difference) permits players to invest in the future
market without the physical movement of underlying assets.

For example, buyer A and seller B enter into future contracts of 1,000
kilograms of corn at ₹10 per kg. The second-day price of corn is ₹11.
The price movement has led to a loss of ₹1,000 to seller B, while A
has gained the corresponding amount.
  
 

 Financial Engineering & Need for

transition:
 

Financial engineering is the use of mathematical techniques to solve

financial problems and knowledge from the fields of computer
science, statistics, economics that is applied mathematics to address
current financial issues as well as to devise new and innovative
financial products.
Financial engineering is sometimes referred to as quantitative analysis
and is used by regular commercial banks, investment banks, insurance
agencies, and hedge funds. Financial engineers run quantitative risk
models to predict how an investment tool will perform and whether a
new offering in the financial sector would be viable and profitable in
the long run, and what types of risks are presented in each product
offering given the volatility of the markets. The field focuses on
developing models and techniques to develop and test investment
strategies, to envision and create new financial products, to manage
risk, and to produce scenarios and forecasts for both short- and long-
term perspectives on the markets. The importance of financial
engineering in the modern world can hardly be overestimated. It is
used by investors and major international financial institutions such as
banks, insurance companies and engineering giants. The right choice
of a financing model for a new project today can decide the fate of a
multi-billion dollar investment. As the pace of financial innovation
accelerates, the need for highly qualified people with specific training
in financial engineering continues to grow in all market environments.
Financial engineers may explore patterns and trends in financial
markets and seek to understand the behaviour of market participants,
potentially leading to insights on investment and/or hedging strategies
or hedging. Alternatively, a financial engineer might delve deeply into
areas of machine learning like natural language processing or analysis
of alternative data sets to develop ideas for further research and
testing.  Some financial engineers are focused on market
microstructure and may explore technical areas such as algorithmic or
high frequency trading and their impact on financial market dynamics.
Finally, financial engineers may work on developing approaches for
evaluating and managing risk for specific asset classes or financial
products, or for the so-called “systemic risk” that is inherent in the
financial system as a whole.

Factors:
 The factors can be classified into external and internal. Business
cannot control external factors, although these factors significantly
affect the performance of companies and the success of their
investment projects. Internal factors can be controlled to some
extent. External factors include changes in interest rates,
globalization of markets, technological progress, tax policy, and so
on. Internal factors of the company include liquidity needs, risk
management methods, administrative costs, etc. 

Need of Transition:
The main reasons for the transition to financial engineering:  
 Introduction of a complex high technology production.
 Globalization and development of the international capital
market.
 Possibility of international diversification of investment
portfolios.
 The need to attract the cheapest financing possible.
 Development of computing technologies and new financial
instruments.
In today's reality, successful companies build long-term relationships
with consumers, suppliers, employees and shareholders. They are
forced to maintain and develop their competencies in order to obtain
long-term benefits. They act quickly so that short-term barriers do not
interfere with the long-term strategy of increasing the market value of
the business. Today, when shaping and implementing corporate
strategies, top managers must have the qualifications of many
specialists, from analysts, production experts to stock traders, dealers,
risk managers, and the like.
Financial engineering teaches a business to use financial instruments
correctly to reduce or avoid risk altogether. Financial engineers apply
modern management techniques to financial markets of any nature.
Professional bodies such as the International Association for
Quantitative Finance (IAQF) are expanding the opportunities for
these professionals to exchange experiences and enhance their skills.
Modern financial engineering tools bring success in financially
sustainable and market-oriented projects in a variety of areas,
including power generation, fuel and energy sector, urban planning,
infrastructure and more.
The financing mechanisms for these projects include loans, venture
capital, and the issuance of securities on various scales, most often as
part of the project finance concept. Typical applications for financial
engineering include the construction of power plants, water treatment
plants and waste treatment plants, transport infrastructure, sports
facilities, and so on. 

ESFC Investment Group is a credit institution based in Girona,

Spain. The firm practice area includes project financing, loans, and
refinancing services. ESFC caters to business products and services,
energy, financial services, infrastructure, oil, gas, material, and
resources sectors. sectors.
ESFC is an international company offering advanced financial
engineering tools for large projects in Europe and beyond. We and
our partners have been involved in financing the construction of
power plants, waste treatment plants, LNG plants, mines and ore
processing plants, gas pipelines and seaports, offering optimal
solutions for customers.
ESFC offers a full range of professional services in financial
engineering, including arranging financing for large investment
projects. The activity of a financial engineer is multifaceted, and
therefore requires an appropriate knowledge base. Leading financial
engineers emphasize the fact that they work in a team. The amount of
specialized knowledge required to understand the complex
interweaving of financial, legal, accounting and tax issues is always
beyond the capabilities of one single specialist.
The areas of activity of their finance team includes:
1. Development of a strategy for entering the securities market.
2.Formation, forecasting and evaluation of financial models.
3. Consulting on any issues related to the issue of shares and bonds.
4. Increasing the value of the company using innovative tools.
5. Development of an optimal strategy for working with financial
intermediaries.
6. IPO technology for the initial placement of the issuer’s securities.
7. Reorganisation of the share capital (merger or acquisition)
8. Control over the company’s activities in the financial market.
9. Optimization of business taxation.
10. Financial innovations etc.
Price and operational risks increase when implementing large
projects, therefore, the importance of skill-full risk management in
lending and investing arises. Our clients also need services to
efficiently and securely manage their cash flows within the global
market. Most of ESFC's innovations have come from solving specific
customer problems. Together with their Spanish partners, they have
participated in dozens of projects in Europe, North America, Latin
America, Africa, the Middle East and East Asia, always
demonstrating a commitment to financial innovation. 

Uses of Financial Engineering:

The financial industry is always coming up with new and innovative
investment tools and products for investors and companies. Most of
the products have been developed through techniques in the field of
financial engineering. Using mathematical modelling and computer
science, financial engineers are able to test and issue new tools such
as new methods of investment analysis, new debt offerings, new
investments, new trading strategies, new financial models, etc.
Financial engineers run quantitative risk models to predict how an
investment tool will perform and whether a new offering in the
financial sector would be viable and profitable in the long run, and
what types of risks are presented in each product offering given the
volatility of the markets. Financial engineers work with insurance
companies, asset management firms, hedge funds, and banks. Within
these companies, financial engineers work in proprietary trading, risk
management, portfolio management, derivatives and options pricing,
structured products, and corporate finance departments.
Financial engineering provides many unique challenges and benefits
to those who pursue this career path, including high-earning
compensation for most jobs and integration with many potential
industries. Financial engineering is sometimes referred to as
quantitative analysis and is used by regular commercial banks,
investment banks, insurance agencies, and hedge funds. The engineers
manage quantitative risk models to predict investment tools’
performance and test the future new product’s applicability and
profitability. They can handle the unpredictable market and know the
kinds of risks to be faced in each product offering.
Also the engineers employ options trading as the proven model to
price option premiums, plan hedging tactics, and compute the implied
volatility. 
Financial engineering is used across a broad range of tasks in the
financial world. Some of the areas where it is most commonly
applied are the following:
 Corporate Finance
 Arbitrage Trading
 Technology and Algorithmic Finance
 Risk Management and Analytics
 Pricing of options and other financial derivatives
 Behavioural finance
 Creation of structured financial products and Customized
financial instruments 
 Quantitative portfolio management 
 Credit Risk and Credit Management.

Example: The US Federal (Fed) has used the expertise of individuals

with the financial engineering degree to back equity markets without
commencing or directly buying the stocks.
To clarify, it used three techniques to boost the price of shares.
1.Direct backing of corporate bonds
The Fed bought billions of dollars of exchange-traded funds (ETFs) to
leverage the connection between corporate equities and corporate
bonds. Thus, it helped raise the companies’ equity rates without a
single share purchase.
2.Suppression of irregularity
The Federal has decreased the Volatility index (VIX) to move up the
equity markets and further escalate the credit spreads.

3.Controlling the discount rate

Regarding interest rates, the US Fed has three conventional and two
more novel levers. First, it slashed short rates to zero, and then the
Fed began the latest quantitative easing (QE) for long-term assets
purchase. Afterward, it utilizes expectations management or forward
guidance to avoid the surge in long-term yields.

Types of Financial Engineering

Instruments:
1. Derivatives: A derivative is a financial agreement that carries a
value derived from an inherent asset. While derivatives have no
specific value on their own, their value comes from the expected
future price fluctuations implicit in the asset. Derivative holders
use these instruments to protect themselves against risk, such as
changes in commodity prices, movements in foreign currency
exchange rates and fluctuations in interest rates. Derivatives
include:
a) Futures contracts: Futures contracts are financial
engineering instruments based on the anticipated future
prices of stocks, bonds and commodities. A futures
contract is an agreement to buy or sell an item at a
specified price on a specified date. These futures are
traded on futures exchange, which is a marketplace where
a diverse range of commodity contracts are bought and
sold.
For example: Oil producers often use futures contracts to
sell the commodity. This allows them to lock in a price to
 sell it and complete delivery once the expiration date hits.
But let's assume that Company A is afraid that demand
will slow down and affect the price of oil on the market,
which will impact its bottom line. The company enters into
a futures contract to lock in the oil price at $75 a barrel,
believing it will drop in six months. If demand drops and
the price drops to $65 per barrel, Company A can still
settle the contract on the original promised price of $75
per barrel and make a profit of $10 per barrel. But if
demand increases and the price rises to $85 a barrel,
Company A stands to lose out on the potential for an
additional $10 per barrel profit from the contract.
b) Forwards : A forward contract is a customizable
derivative contract between two parties to buy or sell an
asset at a specified price on a future date. Forward
contracts can be tailored to a specific commodity, amount,
and delivery date. Both forward and futures contracts
involve the agreement to buy or sell a commodity at a set
price in the future. But the slight difference between the
two is that, while a forward contract does not trade on an
exchange, a futures contract does. This means that the
forward contracts are not regulated whereas futures are
overseen by a central government body. Example: Let's
assume that a producer has an abundant supply of
soybeans and is concerned that the price of the commodity
will drop in the near future. In order to hedge the risk, the
producer negotiates a contract with a financial institution
that involves the sale of three million bushels of soybeans
at a price of $6.50 per bushel in six months. Both parties
agree to settle the contract in cash. Soybean prices have a
few ways to move by the time the contract is ready for
settlement: If the price is exactly as contracted, the
contract is settled as per the agreement and neither party
owes the other any additional money. If the price is lower
than the negotiated price, let's say the price drops to $5 per
bushel, the settlement still goes through at the agreed-
upon price. This means the producer's bet to hedge the risk
 of a price drop works. If the price is higher than the
agreed-upon price, then the contract is settled at the
negotiated price, even though the producer may have
profited from a higher price per barrel.
c) Options: Options are financial derivatives that give
buyers the right, but not the obligation, to buy or sell an
underlying asset at an agreed-upon price and date. Call
options allow the holder to buy the asset at a stated price
within a specific timeframe. Put options, on the other
hand, allow the holder to sell the asset at a stated price
within a specific timeframe. 
d) Swaps: A swap is a derivative contract through which
two parties exchange the cash flows or liabilities from two
different financial instruments. Swaps offer great
flexibility in designing and structuring contracts based on
mutual agreement. This flexibility generates many swap
variations, with each serving a specific purpose. A credit
default swap allows the buyer to make payments to the
seller up until the due date of a contract. In exchange, the
seller pays off debt from a third party if that party fails to
pay off the loan. The credit default swap protects the
lender against default from the borrower. Critics blame the
rise of credit default swaps on high-risk mortgages -- at
least in part -- for the economic collapse of 2008. A debt
equity swap involves the exchange of debt for equity—in
the case of a publicly-traded company, this would mean
bonds for stocks. It is a way for companies to refinance
their debt or reallocate their capital structure. Interest rate
swaps whereby the parties agree to swap a floating stream
of interest payments for a fixed stream of interest
payments and vice versa. In a currency swap, the parties
exchange interest and principal payments on debt
denominated in different currencies. Currency swaps can
take place between countries. For example, China has
used swaps with Argentina, helping the latter stabilize its
foreign reserves. 
 e) Interest rate caps and floors: An interest rate cap
establishes ceiling on interest payments (useful for
borrowers). An interest rate floor is where an option is
used to set a minimum rate thereby it reduces the risk to
the party receiving the interest payments ,i.e, investors.

2. Forex funds: The foreign exchange market, also called "Forex"

for short, is the worldwide market for trading currencies. The
principles of financial engineering allow brokers and traders to
take advantage of fluctuations in exchange rates between
currencies to make a profit. A Forex fund can hold several types
of currencies, including U.S. dollars, British pounds, Japanese
yen and European euros. Companies doing business in foreign
countries are at risk due to fluctuations in currency values when
they buy or sell goods and services outside of their domestic
market. Foreign exchange markets provide a way to hedge
currency risk by fixing a rate at which the transaction will be
completed. The fund makes trades on the exchange rates by
anticipating when one currency will gain or lose value against
the others.
For example: a trader who expects interest rates to rise in the
United States compared to Australia while the exchange rate is
0.71 USD = 1 AUD. The trader believes higher U.S. interest
rates will increase demand for USD, and the AUD/USD
exchange rate therefore will fall. Assume that the trader is
correct and interest rates rise, which decreases the AUD/USD
exchange rate. Now, if the investor had shorted the AUD and
went long on the USD, then they would have profited from the
change in value.
 3. Participating debentures: The investors are given a part of the
excess profits that the company has earned after giving a
dividend to the equity shareholders.

4. Deep discount bonds: Such bonds have a long -term maturity

period between 20 to 25 years. They carry the feature of ‘call’
which means that the company can call back the bond after 5 or
10 years. It is sold at a discount but has no interest.

For example: a 25- year bond is issued at Rs.10,000 but is

redeemed at Rs.1,00,000. The discount makes up for not
receiving any interest during the waiting period.

5. Retirement bonds: These bonds are useful for investors who

are in the retirement stage. They are issued at a discount with
the option of monthly income and for a specified fixed time
period. On the exit time of the bond the investor gets a lump
sum amount

ADVANTAGES & DISADVANTAGES

-FINANCIAL INSTRUMENTS:
Advantages:
 Liquid assets like cash in hand and cash equivalents are of great
use for companies since these can be easily used for quick
payments or for dealing with financial contingencies.
 Stakeholders often feel more secure in an organization that has
employed more capital in its liquid assets
 Financial instruments provide major support in funding tangible
assets. It is possible through fund transfer from tangible assets
that are running in surplus values to those lying in deficit.
 Financial instruments allocate the risk concerning the risk-
bearing capacities of the counterparties participating in investing
intangible assets
 Companies that invest in real assets yield higher revenues since
they get a diversified portfolio of hedged inflation. They can
also hedge against uncertainties caused as a result of political
reasons.
 Financial instruments like equity act as a permanent source of
funds for an organization. Equity shares also allow an
organization to have an open chance of borrowing and enjoy
retained earnings. With equity shares, payment of dividends to
equity holders is purely optional.

Disadvantages:

 Liquid assets such as savings accounts balances and other bank

deposits are limited for ROI or investment return. It is high
because there are zero restrictions for the withdrawal of deposits
in savings accounts and other bank balances.
 Liquid assets like cash deposits, money market accounts, etc.,
might disallow organizations from making a withdrawal for
months or years, too, or whatever is specified in the agreement.
 If an organization wishes to withdraw the money before
completing the tenure mentioned in the agreement, then the
same might get penalized or receive lower returns.
 High transactional costs are also a matter of concern for
organizations dealing with or wishing to deal with financial
instruments.
 An organization must not over-rely on debts like principal and
interest since these are supposed to be paid on a consequent
basis.
 Financial instruments like bonds payout return much less than
stocks. Companies can even default on bonds.
 Some financial instruments like equity capital are a Life-long
burden for the company. Equity capital acts as a permanent
burden in an organization. Equity capital cannot be refunded
 even if the organization has sufficient funds. However, as per
the latest amendments, companies can buy back their shares for
cancellation, but the same is subjected to certain terms and
conditions.

-FINANCIAL ENGINEERING INSTRUMENTS:

Advantages:

 Currency and Commodity Fluctuations

Financial engineering can reduce risk. If you operate a company
that does business in another country, sells commodities or
commodity-based products and services, then your business is
subject to significant fluctuations in currency or commodity
prices. Although these swings in value can generate unexpected
profits, they can also adversely impact your business. However,
if you are not in the trading business, your business typically
benefits from minimizing these fluctuations, despite the upside.
Financial engineering structures or provide products that reduce
these risks, making your business more predictable and
facilitating better planning.

 Compensation
Financial engineering allows you to offer equity-like
compensation to attract or keep executives and key employees.
You can create restricted stock or options that have minimal
impact on your company’s balance sheet or income statement
when compared to traditional stock and options. Due to their
complexity and the need to understand the impact on your
 company’s financial statements, it may be best to engage a
compensation firm or other entity well-versed in this area.

 Agreements and Ventures

Your company can use financial engineering products and
strategies to provide contingent payments tied to contractual
provisions. You can do the same for convertible loan or other
agreements. You can use financial engineering to leverage risky
business opportunities or ventures. By creating a solution that
provides a minimum loss scenario for your company, you can
participate in the upside, but limit your company’s downside.

Disadvantages:
Although financial engineering has revolutionized the financial
markets, it played a role in the 2008 financial crisis. As the number of
defaults on subprime mortgage payments increased, more credit
events were triggered. Credit Default Swap (CDS) issuers, that is
banks, could not make the payments on these swaps since the defaults
were happening almost at the same time.

Many corporate buyers that had taken out CDSs on mortgage-backed

securities (MBS) that they were heavily invested in, soon realized that
the CDSs held were worthless. To reflect the loss of value, they
reduced the value of assets on their balance sheets, which led to more
failures on a corporate level, and a subsequent economic recession.

Conclusion
Financial instruments are nothing but a piece of document that acts as
financial assets to one organization and as a liability for another
organization. These can either be in the form of debentures, bonds,
cash, and cash equivalents, bank deposits, equity shares, preference
shares, swaps, forwards and futures, call or notice money, letters of
credit, caps and collars, financial guarantees, receivables and
payables, loans and borrowings, etc. Each type of financial instrument
has its advantages and disadvantages.

Financial instruments must be appropriately taken into use to derive

the most benefits. These can be of huge significance for companies
looking to minimize their costs and maximize their revenue model.
Thus, organizations must make sure that they are properly using
financial instruments to reap greater benefits from it and eliminate the
chances of them getting backfired.

Financial engineering is the use of mathematical techniques to solve

financial problems.
Financial engineers test and issue new investment tools and methods
of analysis.
They work with insurance companies, asset management firms, hedge
funds, and banks.
Financial engineering led to an explosion in derivatives trading and
speculation in the financial markets.