Financial Engineering and Innovation as Risk Management Tools: The Case of Indian Companies During Global Financial Crisis

Vivek Shah* and Padma Srinivasan** In laymans terms, financial engineering is an engineering discipline which deals with the creation of new and improved financial products through innovative design or repackaging of existing financial instruments. Financially, engineered products like American Depository Receipt (ADR) and Global Depository Receipt (GDR) have provided Indian companies access to international financial markets to raise funds. However, financial engineering is considered as being responsible for triggering the global financial crisis by increasing leverage and price risks. The regulatory framework is not the only solution to deal with the negative side of financial engineering, the informed market that responds sensibly to financial innovations (which is the current need) is also responsible. This paper looks into how fund raising by innovative financial instruments impacts the share price of the company using the cases of the Indian corporate houses.

Introduction
Financial engineering involves the design, the development and the implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in finance. John Finnerty Financial engineering is all pervasive. Its presence spans across areas like design of innovative financial instruments, financing Mergers & Acquisition (M&A) deals, corporate restructuring, derivative trading strategies, etc. Financial engineering and innovations are seen in bonds, equity, derivatives and in fields like mergers, acquisitions and corporate restructuring.1 Some of the innovations in the Indian financial market are debt-oriented schemes of mutual funds, interest rate futures, interest rate swaps, currency swaps, floating rate bonds, money market mutual funds, etc.
* Student, IBS, Bangalore, India. E-mail: vivekshah221@gmail.com ** Faculty, IBS, Bangalore, India. E-mail: bpadmasrinivasan@yahoo.co.in
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Some of the examples can give a glimpse of financial engineering and its application: Product Level (Financial instruments)

Launch of stock index futures to protect against rising volatility of equity; Launch of debt oriented schemes of mutual funds to get tax advantage; and Launch of Forward Rate Agreement (FRA) to hedge interest rate volatility.
Company Level (Corporate finance)

Mahindra-Satyam merger deal and Tata-Corus deal financed by Special Purpose

Vehicle (SPV);

Vijay Mallya securitized Kingfisher Airlines brand to raise Rs. 2,000 cr from State
Bank of India (SBI);

Tata-Tetley Leveraged Buyout; and Tatas Differential Voting Right (DVR) Issuethe first of its kind in India.
Financial Engineering is basically intended to split risk and return components of financial product/instruments and offering the combination which is best-suited to investors risk-return profile.

Objectives
The main objectives of this paper are:

To identify the process of financial engineering; To find out the development in engineering part of different asset classes like equity,
debt, mutual funds, etc.;

To find out the role played by investment banks and stock exchanges in financial
engineering;

To find out the rationale behind application of financial engineering; and To study the role of financial engineering in global financial crisis.
The scope of the study is limited to financial engineering in asset classes and developments in Indian Financial market (in terms of innovation).

Research Methodology
The methodology is based on the empirical research using BSE 200 companies for two years during 2007-09, where the Indian economy went through a multidimensional paradigm shift. Only secondary data based on Bombay Stock Exchange (BSE), National Stock Exchange (NSE) and company websites have been used here. The process included:

A classification of financially engineered products in terms of financially engineered

equity, debt, hybrid instruments and financially engineered mutual funds;

To study developments in Indian Financial market like launch of interest rate futures;
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 To apply latest corporate fund raising issues to its source (like ADR, GDR, etc.); To study patterns of corporate financing pre and post-liberalization; and To study the interrelations between securitization, credit default swaps and
collateralized mortgage obligations with global financial crisis. This study is based on secondary data and financial engineering field is related to innovation. Innovations like technology are vulnerable to obsolescence.

Review of Literature
Financial innovations play an important role in increasing cost-efficiency by reducing transaction costs. However, the by-products of financial engineering like securitization, Collateralized Debt Obligations (CDOs) and Collateralized Mortgage Obligations (CMOs), were blamed for the present economic turmoil and global financial crisis. But does it hold true? Financial engineering alone is not responsible for whatever has happened. There are some other reasons like ignorance among investors, counterparty credit risk, liquidity risk and regulatory failings. These factors also contributed to financial crisis. Cole et al. (2009) opine that financial engineering provides potential in reducing consumption fluctuations and lower adoption of risk management technology during select seasons. Mauri and Conti (2007) have found that corporate financial risk management has been practiced by banks and companies alike by using financial engineering products like that of derivatives and the accounting and regulatory framework are also being redone. Lo (2009) also feels that financial engineering may provide the appropriate expertise to handle all the regulatory reforms during the financial crisis of 2007-08.

Process of Financial Engineering and Creation of Innovative Financial Instruments

This is the general procedure followed by financial engineers while developing new financial instruments. Such financial engineers work at investment banks, which cater to the requirements of institutional clients. Identification of need involves the objective which the investor wants to achieve through financially engineered products. For example, individual investors wanted to reduce their tax liability. To help achieve this objective, mutual funds managers developed debtoriented mutual fund schemes by introducing variations in mutual fund schemes. Similarly, some investor might want to increase his exposure to a particular sector like the real estate sector. So, he can invest in infrastructure funds introduced by mutual fund managers. Among all these steps, pricing of the product has assumed more importance. For example, derivative product pricing is a very complex process. For this, Black, Scholes and Merton have formulated option pricing model for which they were awarded Nobel Prize. This kind of model helps to price the complex financial products (Figure 1). Besides, computer programs and mathematical algorithms are used to price some of the highly complex financial products.
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Figure 1: Financial Engineering and Innovation Processs

Identification of Need

Initial Sketch of Product

Complex Model Building Exercise

Pricing of the Product

Perfect Product on the Basis of Simulation Exercise

Testing of the Product

Restructuring of the Product

Test Marketing

Launching of the Product

Financial engineering is applied to asset classes like equity, debt, preferred stock. Basically, it is done by combining features of plain vanilla debt and equity. Besides, it is applied to trading mechanism like screen-based trading, electronic fund transfer, etc. Figure 2 indicates that debt involves lower risk but it also offers lower return compared to equity. Similarly, equity offers high return at high risk. To earn low risk, high return pay off profile, we need to combine features of equity and debt. That is exactly what is done by financially engineered products. Figure 2: Financially Engineered Products
Equity Financially Engineered Products

Debt

Pay-Off: Low Risk Low Return

Pay-Off: High Risk High Return

Financial Engineering in Equity

Non-Voting Shares
The holders of such shares do not have any voting right in the company, but are offered compensation in terms of issue of shares at discount or higher dividend on share. This kind of issue is not allowed to Indian public companies. However, if such kind of equity securities issued in future, it would have the following benefits:
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 It would enable management to retain their control; and It can be bought by retail investors who do not bother about voting rights, but are more concerned about dividends and returns. Example: (1) Even though it is prohibited in India, a similar kind of situation was created by corporate using treasury stock. For example, in October 2008, Reliance Industries reclassified Rs. 9.41 cr worth of shares and moved them from Promoters and Person Acting in Concert category to public category. These shares were pooled as treasury stock which was owned by eight corporate bodies, which was subsequently converted to subsidiaries of Reliance. As per statutory requirements, subsidiaries cannot own shares with voting rights in the parent company. So, shares held by these eight subsidiaries were non-voting right shares, which could protect company from hostile takeover; and (2) BNP Paribas issued non-voting shares worth 5.1 bn for the year ended March 31, 2009.

Differential Voting Rights (DVRs)

In shares with DVR, investors have disproportionate voting rights.2 The First set of investors have 1 voting right for 1 share, while another set of investors might have voting rights of 100 shares for 1 share. Those having less voting rights are paid higher dividends because of less control over the company. In the initial stage, all investors are offered same stock with same terms. Later on, they are allowed to exchange the same stock with less voting rights and high dividend provisions. Thus, it results into different voting rights for different set of investors. Example: Tata Motors was the first company in India to commence the issue of DVR which carried 1/10 of the value of ordinary shares and offered 5% point higher dividend to shareholders.

Employee Stock Option Plan

It is offered to employees and directors of the company to give them a sense of ownership of the company and to encourage them to participate actively in the management of the company. This plan is voluntary and employees opting for such plan gets an option to subscribe to the companys shares at discounted price in future date. This option is exercised by swapping the salary of the employee with equity. Example: Companies like Infosys, Jain Irrigation, Dish TV, Bajaj Electricals offers ESOP to their employees. It is widely practiced in software companies. In recent economic downturn, ESOPs could be one way of motivating the employees (when pay cut measures are taken) and to increase their productivity.

Sweat Equity Shares

In this case, the entrepreneur invests his capital and the manager brings his knowledge. Over time, the manager is offered shares in lieu of salary and it is called sweat equity. Example: Mukesh Ambani had 12% sweat equity stake in Reliance Infocomm which became cause of dispute between the Ambani Brothers.
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Puttable Common Stock

Companies in the USA issue this kind of stock where investors are offered put option, that is they can sell shares at predetermined date at agreed price. This is one kind of buy-back offer by the company. The company, which has good reputation in the market, charges higher premium for puttable common stock. There is no loss to the company because shareholders will not exercise option once the company performs well. For example, Intel had issued puttable common stock.

Master Limited Partnership

A business is given the legal form of a partnership but otherwise it is traded like public company on stock exchange. It does not exist in India.

Financial Engineering in Debt

Zero Coupon Bonds
These bonds are issued at discount and redeemed at par. These bonds do not carry interest. The difference between face value and issue price is implied interest. For example, in October 2009, Essar Group raised Rs. 4,500 cr by zero coupon bond and it was backed by put option with Vodafone Group.

Secured Promissory Notes (SPNs)

SPNs is a secured debenture and it is redeemable at premium over face value. The redemption is made in installments. During lock-in period, no interest is paid on SPN and redemption is also not allowed. SPN is tradable in market. An example of it could be issue of SPN by TISCO.

Dual Currency Bonds

In these kinds of bonds, principal is denominated in dollars while interest is denominated in Indian Rupees.3 This kind of bond can be issued to Non-Resident Indians (NRIs). They could designate beneficiary in India and the amount is remitted to designated beneficiary in India. Because of this, NRIs are free from the hassle of remitting money to relatives in India through banking channels. For example, in April 2008, Adani Power issued dual currency bond amounting $1.113 bn to finance Mundra Power Project.

Floating Rate Bonds

In floating rate bonds, interest is not fixed but is linked to some reference rate like London Interbank Offer Rate (LIBOR) or Mumbai Interbank Offer Rate (MIBOR). The floating interest rate provides protection against inflation risk. The rate could be quoted as LIBOR + 200 Basis Points. For example, in November 2009, Power Finance Corporation raised Rs. 11 bn via floating rate bonds. The company sold 3-year bond paying 135 basis points over one year government security and 10-year bond paying 179 basis points over one year government security.
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www.financialexpress.com/printer/news/82561

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Dual Rate Loans

In dual rate loans, fixed interest rate is charged to the borrower up to prefixed period and thereafter loan is linked to benchmark rate. For example, HDFC recently announced dual rate loan. In a 20-year loan of Rs. 30 lakh, a borrower will be required to pay 8.25% up to March 2012 and then a floating rate thats 500 points below the Prime Lending Rate (PLR).4 Currently, PLR is 13.75%.

Non-Convertible Debentures (NCDs)

NCDs are straight debentures on which interest is paid on regular basis. Recently, Tata Capital and Shriram Transport Finance has issued NCDs.

Financial Engineering in Hybrid Instruments

Convertible Debentures (CDs)
CDs are converted into equity share on predetermined date at predetermined rate. Convertible debentures best suit companies which have long gestation period and are not able to raise fund through equity. In 2002, Reliance Industries issued triple option convertible debentures which can be converted into three equity shares.

Equity-Linked Debentures (ELDs)

ELDs are introduced by asset management companies to meet retail investors requirements. The interest on ELDs depends on the performance of underlying stock or index, and hence, it is not fixed. ELDs can be linked to stocks and indices by participation ratio. If it is linked to Sensex at participation ratio of 100%, then, if Sensex rises by 10%, interest on ELDs rise by 10%. In case, Sensex falls below, then investors will get back principal amount without return. ELDs are of two types: 1. Principal protected where principal is protected while interest is linked to market; and 2. Principal is linked to market. In October 2008, JP Morgan Chase issued its first ELD which was referenced to Nifty Index.

Gold-Linked Debentures
Gold-linked debenture is a structured product with underlying being gold and is linked to gold price. In case the price of gold falls, then investors get their principal back without return. If the price of gold rises, the investor gets principal plus extent to which there has been rise in gold prices. It is a recent development in financial market. It is targeted to High Networth Individuals (HNIs) and the minimum investment requirement is 5 lakhs. It is offered by Edelweiss Capital, Kotak and Citi Group.
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Foreign Currency Convertible Bonds (FCCBs)

FCCBs are convertible bonds issued in foreign currency. The interest on FCCBs is lower by 30-40% and it could translate into 2-3% cost saving of issue. Therefore, it seems an attractive option for the corporates to raise money from abroad at cheaper rate. Another differentiating feature of FCCB is that one can detach equity portion and sell debt portion. In November 2009, Tata Power launched and allotted FCCBs convertible at the 10% premium over closing price on NSE on November 5, 2009.5 The yield to maturity on semiannual basis is 3.5% and has also been listed in Singapore Stock Exchange.

Non Convertible Debentures + Warrants (NCD + Warrants)

NCD + Warrants are the new financial instruments proposed by SEBI which has two parts containing a debt portion (NCD) and an equity portion (Warrant). Exercise of warrant by the shareholder leads to dilution of control and issue of more equity. While in case of options, transfer of shares take place among existing shareholders. NCD + Warrants allow detaching both and trading them as separate units. The issue corporation might issue it combined in order to reduce cost of issue. In August 2009, HDFC closed corporate Indias first Qualified Institutional Placement (QIP) issue of this instrument. HDFC raised Rs. 4,301 cr via QIP issue of NCD + Warrants.

Stripped Mortgage Backed Securities

Mortgage payment stream is divided into two classes: (1) One with below market coupon and another with above market coupon, and (2) One receiving interest and the other receiving principal from mortgage pool. These securities have unique option characteristics and hence are useful for hedging purpose. It is issued by Government National Mortgage Association of USA.

Stripped Treasury or Municipal Securities

This is also known as STRIPS. Here, coupons are separated from principal to create a series of zero coupon bonds that can be sold separately.

Indexed Currency Options

Issuer pays reduced principal at maturity if specified foreign currency appreciates relative to the US dollar. This means that it is risky proposition for investors who assume foreign currency risk by selling call option denominated in foreign currency.

Interest Rate Caps, Floors and Collars

Investors who write interest rate caps, floors and collars agrees to make payment to the purchaser of contract when specified interest rate exceeds the specified cap or falls below the floor.6
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Medium-Term Notes
A corporate note is issued by the corporate to the investors for medium-term or maturity period ranging from 1 year to 10 year. Through medium-term notes, the corporate has constant cash flow coming from debt issue. In October 2009, SBI raised $750 mn via medium-term notes.

Mortgage Pass Through Certificates

It is an undivided interest in mortgage pool which is insured by Government National Mortgage Association of USA. In this, homeowners payments pass from original bank through investment bank to investors in mortgage pool.

Financial Engineering in Derivatives (Risk Management Tools)

Forwards
Forward is a customized contract between two parties where one party agrees to sell/buy predetermined quantity of underlying on future date. However, as it is customized, it is too expensive and issues arise in settling the transactions. An example of it could be currency forward contracts.

Futures
Futures are just an extension of forward contracts. It is a standardized contract between two parties wherein one party agrees to buy/sell predetermined quantity at predetermined future price on future date. As it is standardized contract, it is exchange traded. It is marked-to-market to avoid loss to clearing corporation as it acts as counterparty in futures transactions. Both parties to contract have to pay upfront margin. At the same time, there are three contracts trading near month, 2-month, 3-month (on stock exchange). The example of futures could be stock futures, index futures, currency futures which are traded on National Stock Exchange.

Options
Options give its holder right but not an obligation to buy/sell contract. There are two types of options: Call options and Put options. Call options give its holder right but not an obligation to buy underlying at future date at predetermined price. The holder of call option gains when stock price goes above strike price. Put option entitles its holder with right but not an obligation to sell underlying at predetermined price on future date. In option contract, there are two parties: One taking positive side and another taking negative side. Those having bullish outlook about the market buy call option while those having bearish outlook go long on put option. An example of it could be stock options and index options.

Swaps
Swaps are similar to futures but there is a small difference. Swap is a series of futures. The most popular are currency swaps. This is used when a company has taken loan in one currency and its cash inflows come from some other country. For example, an Indian manufacturer has taken
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loan in US$ but his major revenues are denominated in Euro. So, he should enter into swap transaction wherein he can swap dollar currency loan with euro denominated loan.

Financial Engineering in Mutual Funds

There are various types of mutual funds offered to investors depending on their risk appetite and time horizon for investment. The classification of mutual funds is as follows:

Classification According to Maturity

Open-ended funds: The holder of unit of these funds can redeem them at any time to issuing company. There is no fixed maturity for these funds. Such mutual fund companies invest in secondary market, for example, ICICI Prudential Very Cautious Plan. Close-ended funds: Close-Ended Fund Asset Management Company has a definite target amount for the funds and cannot sell more shares after its initial offering. Its shares are issued like any other companys new issues and are quoted at the stock exchange, for example, Kotak Dynamic Asset Allocation Scheme.

Classification According to Portfolio

Bond funds: Bond funds provide fixed returns to investors and it is for risk averse investors. The savings of retail investors are invested in conservative instruments with modest capital gains. Stock funds: The retail investors funds are invested in diversified portfolio of common stock. This best suits the investor who is willing to take high risk for high return. Income funds: Income funds invest in equity and debt to maximize the income of the investors with modest risk, for example, ICICI Prudential Income Mutual Fund. Money market funds: The corpus is invested in short-term liquid assets like commercial papers and certificate of deposits. It best suits risk averse investors. Specialized funds: Specialized mutual funds invest in specialized securities or specialized industry, for example, Principal Emerging Blue chip Fund. Leveraged funds: In this fund, borrowed amount is used to increase the size of the value of the portfolio. This is speculative in nature and it involves trading strategies like short sale to take advantage of declining market. Balanced funds: These funds invest 25% to 40% of the funds in conservative assets and the rest in the equity. It best suits the investor who wants reasonable rate of return with modest risk, for example, HDFC Prudence fund. Growth funds: The fund is invested in growth stock which has above average growth potential. This generates high capital gain component of return, for example, HDFC MIP. Performance funds: It invests in stock with high price-earnings ratio and high price volatility.
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Dual purpose funds: Income and growth are the two objectives of investment in mutual funds. It is achieved by offering half of the amount of funds to those investors who wish regular income and half to those who wish growth. Tax saving funds: It offers tax benefits to investors, for example, Bajaj Capital Tax Saving Fund. Real estate funds: These funds invest in real estate ventures, for example, Reliance Infrastructure Fund.

Fund Raising and Innovative Instruments: Hypothesis Testing

During the period of post-liberalization, use of innovative financial instruments to lower the cost of financing huge expansion plans increased. But what was the reaction of company shareholders, who are the ultimate owners of the company, to the fund raising drive by Indian corporates using financially engineered products? So the following hypotheses were set and tested using a few Indian company cases. H0: Fund raising by innovative financial instruments impact the share price of the company. H1: Fund raising by innovative financial instruments does not impact the share price of the company. There are many factors which should be taken into consideration while studying the reaction of shareholders:

What is the type of instrument used to raise fund? Is it Equity focused, Debt focused
or Hybrid?

What is the impact of it on capital structure? Will it increase leverage and financial risk? What is the cost of financing associated with the instrument? What is the gestation period of the project for which raised fund will be allocated? How will the cost of financing impact shareholders return in the long-term? Do financially engineered products or traditional method of financing serve the
purpose better?

Will the innovative financial instrument dilute their voting rights?

These are some questions which come to investors mind while reacting to the news of fund-raising drives by corporates. This is part of behavioral finance. Based on perception about the situation, the investor reacts by creating buying or selling pressure which subsequently impacts the stock price. When investors react negatively, they dump the shares and stock price subsequently drops. When investors react positively, they buy shares and stock price subsequently rises.
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Cases of Indian Corporates to Test the Hypotheses

Tata Group (2008-10)
DVR Issue (November 2008) Tata Motors DVR issue backfires on promoters.7 This headline hit the newspaper on the next day of DVR issue by Tata Motors. JM Financial, underwriter to the DVR issue, renegotiated deal with Tata Motors due to poor response from minority shareholders. Promoters ended up subscribing 84.3% of DVR shares. The reason for poor response from shareholders was that they feared losing voting rights. DVR shares had one voting right for every 10 shares held. On November 5, Tata Motors closed at 182.20. On November 6, stock price fell to 157.5, approximately 16% fall. So, it clearly shows negative reaction of shareholders to DVR issue. FCCB Issue (November 2009) Tata Power raised $300 mn on November 20. On the next trading day, November 23, 2009, stock price of Tata Power went up by Rs. 3 and by Rs. 17 on November 24, 2009. Before FCCB issue, Tata Power was trading at Rs. 1,319. After FCCB issue, Tata Power went up to touch Rs. 1,339. So, FCCB issue of Tata Power received positive response from shareholders. Tata Steels GDR Issue (July 2009) Tata Steel raised $500 mn via GDR route to finance overseas mining and Jamshedpur plant expansion. On July 21, GDR instrument was used to raise fund. On July 21, stock was trading at Rs. 391.20. On July 23, stock price increased by Rs. 21 to Rs. 412.15. So, the issue got positive response from shareholders.

Suzlon (2009-10)
GDR Issue (July 2009) Suzlon raised $200 mn on July 21, 2009, $100 mn through GDR issue and $90 mn through zero coupon convertible debentures issue. Suzlon gave negative return of 15% in July 2009. Suzlons debt post acquisition of German Wind Power Company, REPower, had interest coverage ratio of 1.68 and it was facing pressure to service debt. So, capital structure coupled with fund raising drive impacted stock price negatively as $90 mn was raised through zero coupon convertible debentures. Treasury Stock Sale (September 2009) Suzlon offloaded 7 crores treasury stocks to raise Rs. 689 cr which was 4.5% stake of promoters. Suzlon shares went down by 3.9% post treasury stock sale. So, treasury stock sale got negative response from shareholders.
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Reliance Industries Limited (RIL)

Treasury Stock Sale (September 2009) RIL sold 15 million treasury stock at an average price of Rs. 2,125. The fund raised is intended to be utilized for overseas acquisition and expansion of organized retail, exploration and production business. Stock of RIL went down by 4.5% to Rs. 2,086.4 post treasury stock sale.

Opto Circuits Limited

Qualified Institutional Placement (QIP) (September 2009) Opto Circuits hit upper circuit on news of its fund-raising of Rs. 400 cr by QIP. On September 9, 2009, stock closed at Rs. 188. On September 10, 2009, stock went up to Rs. 206, approximately 10% increase. The fund raised was intended to pay back loans and to finance expansion. These were the few samples to study the reaction of shareholders which can be measured by direction of change: positive or negative. Out of seven instances, shareholders reacted positively to three instances and reacted negatively to four instances. It depends on condition and purpose for which funds raised are to be utilized. So, we can conclude that situation and other factors matter a lot when triggering shareholders response. Tata Motors DVR=> Dilution of Voting Right => Negative Price Change Tata Powers FCCB Issue => Financing Expansion => Positive Price Change Tata Steels GDR Issue => Overseas Expansion => Positive Price Change Suzlon GDR Issue => Existing Debt Burden => Negative Price Change Suzlons Treasury Stock Sale => Negative Price Change RIL Treasury Stock Sale => Negative Price Change Opto Circuits Limited => Financing Expansion => Positive Price Change So, H0 and H1 are relevant depending on the situation. Findings Based on the Above Case Analysis As discussed earlier, many innovative financial instruments have stormed into the Indian financial market. For instance, DVRs can be cited, and here, the share carries different voting rights for different class of shareholders. For example, Class A of investors might have one voting right for one share while Class B of shareholders has 10 voting rights for one share. Tata Motors came out in 2008 with this DVR and the utility of DVRs share is as follows: Shares with DVRs act as a boon for management when another company is trying to takeover it (hostile). Tata Motors right issue combined shares with full voting rights and less voting rights. Normal shares were offered at Rs. 340 while shares with less voting rights were offered at Rs. 305, i.e., discount of Rs. 35. The right issue was proposed to repay bridge loans taken to acquire Jaguar Land Rover.
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The other findings based on the hypotheses are: As interest rates were low during the second half of 2009, corporates adopted cheaper route of debentures and FCCBs. As liquidity in market dried up due to recession, corporate went for treasury stock sale to repay due debt and finance expansion plans. Tata Group has been the most active during the year 2009 in fund-raising activities. Signaling hypothesis becomes relevant as information about fund-raising plans even impacted stock price as they are fed into market by speculators. Treasury Stock Sale led to negative price change. QIPs led to positive price change. Companys debt burden leads to lower valuation of company.

Financial Engineering and Innovations as Risk Diversion Tools: Strategies in Indian Financial Market
Till the 1980s, the Indian Financial Market did not see enough development. It was only after the 1991 economic reforms, Indian Financial Market started developing and new financial instruments were designed to cater to the varied requirements of clients and investors. Some of the financial innovations in Indian Financial Market and the motivating factors are summarized in Table 1. Table 1: Financial Innovations in Indian Financial Market and the Motivating Factors
Innovations Debt-Oriented Scheme of Mutual Fund Partially Convertible Debentures and Fully Convertible Debentures Zero Coupon Bonds Puttable and Callable Bonds Stock Index Futures Badla Transactions Ready Forwards Havala Transactions Interest Rate Floors/Caps/Collars Interest Rate Swaps Currency Swaps Forward Rate Agreements Automated Teller Machines Motivating Factor Tax Advantage Pricing and Interest Rate Regulation Under Capital Control Act Tax Benefit Volatility of Interest Rates Volatility of Equity Prices Restrictions Under Forward Trading Restrictions Under Portfolio Management Scheme RBI Restrictions Volatility of Interest Rates Volatility of Interest Rates Volatility of Exchange Rates Volatility of Interest Rates Technology 63

Financial Engineering and Innovation as Risk Management Tools: The Case of Indian Companies During Global Financial Crisis

Table 1 (Cont.)
Innovations Screen Based Trading Floating Rate Bonds Electronic Funds Transfer Money Market Mutual Funds Specialized Mutual Funds Exchange Traded Options Project Finance Motivating Factor Technology Volatility of Interest Rates Technology Volatility of Interest Rates Investor Preference Volatility of Stock Prices Risk Sharing

Economic Cycle, Financial Instruments and Corporate Financing Pattern

The pattern of corporate financing in India since Independence has been as follows: 1960-1990: During this period, the stress was more on public finance and the economy was highly regulated. Post 1980s, the performance of capital market improved and economic scenario changed. It was during this time debt financing was started. 1990 onwards: Post liberalization, there was healthy development in capital markets. Equity was increasingly used as a source of financing. The corporate started tapping offshore market for fund raising and innovations in trading mechanism, financial instruments took place during this period. Corporates use different kind of financial instruments to raise funds depending on the stage of economic cycle. Economic boom: Most of the companies go for IPO, as investors have confidence in the market and the market sentiment is overall good. Besides, there is less use of derivatives because market is stable and there is less volatility. Companies try to find innovative ways to finance like ADR, GDR, etc. Economic recession: During recession, investors outlook is pessimistic and IPO markets dry up. So, QIPs, bank loans and debentures are used to raise funds. Derivative contracts are widely used to hedge interest rate volatility and price volatility because market turns out to be more volatile. During recession, inflation rises, and hence, interest rate rises. So bond price falls and as a result interest rate risk arises. So, interest rate futures come as rescue instrument in such scenario. Thus, depending on the stage of economic cycle, different kinds of financial instruments are used. To conclude, financial innovations have played an important role in expanding source of finance and meeting investor and issuer requirements.

Conclusion
The field of financial engineering needs much more development to ensure that investors have wider choice of investing and corporates have wider choice of financing. The new instruments should be created to ensure financial efficiency and solve the problem of financing the corporations. This can be done by two ways: (1) By unbundling existing products, and (2) By
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creating new products. The financial engineering field has emerged by creating new instruments from plain vanilla equity and debt. So, different mix of debt and equity, i.e., hybrid instruments can best serve investors needs to avoid the extremes of high risk and low return. These are some innovations where awareness should be created among investors and more innovations and engineering should be encouraged by the regulatory authority.

Bibliography
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1. http://economictimes.indiatimes.com/Markets/Bullion/Wealth-managers-offering-Gold-linkeddebenture-on-underlying-price/articleshow/5118003.cms 2. http://economictimes.indiatimes.com/Markets/Stocks/Market-News/Companies-raise-over-Rs14k-cr-in-upbeat-market/articleshow/5064916.cms 3. http://groups.yahoo.com/phrase/statistical-terms 4. http://in.reuters.com/article/companyNews/idINBOM38418420091118 5. http://sify.com/finance/ncds-yielding-good-listing-gains-to-retail-investors-news-editorspicks-jj1j7hcifcg.html 6. http://www.business-standard.com/india/news/is-dual-listingsharesgood-idea/21/49/370943/ 7. http://www.business-standard.com/india/news/sbi-raises-750-mn-via-medium-term-notes/ 373871/ 8. http://www.businessworld.in/bw/2009_09_23_Firms_Raise_530_Mn_In_Share_Sales.html 9. http://www.docstoc.com/docs/9421517/Corporate-fund-raising-using-hybrid-instruments 10. http://www.indianexpress.com/news/adrs-lose-favour-with-indian-companies/490479/ 11. http://www.moneycontrol.com/news/the-firm/ncds-+-warrants-how -will-theywork_370663.html 12. http://www.thehindubusinessline.com/2009/07/23/stories/2009072351001200.htm 13. www.deal4loans.com/loans/...loan/8-25-fixed-rate-for-new-home-loans-hdfc/ 14. www.financialexpress.com/printer/news/82561 15. www.icwai.org/.../ICWAI%20Magazine%20Page%2036%20To%2040.pdf 16. www.livemint.com/.../Tata-Motors8217-DVR-issue-b.html 17. www.springerlink.com/index/G2217845282846J8.pdf 18. www.thehindubusinessline.com/.../2009090350210900.htm

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The IUP Journal of Risk & Insurance, Vol. VII, Nos. 1 & 2, 2010

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