The world of finance is complex, and the use of financial engineering instruments has become increasingly popular in recent years. These instruments are designed to provide investors with greater flexibility and diversification in their investment portfolios, but they can also be very risky. Some examples of financial engineering instruments include derivatives, collateralized debt obligations (CDOs), and structured investment vehicles (SIVs). In this blog post, we will explain what these instruments are, their historical origin, and how they impact average workers.

What are Financial Engineering Instruments?

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Financial engineering instruments refer to a range of financial products that are designed to provide investors with greater flexibility and diversification in their investment portfolios. These products are created by financial engineers who use complex mathematical models and algorithms to structure financial instruments that meet the needs of investors.

Derivatives:

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Derivatives are financial instruments that derive their value from an underlying asset or benchmark. They can be used to hedge against risks or to speculate on the future value of an asset. The most common types of derivatives include futures contracts, options, and swaps.

Futures contracts are agreements to buy or sell an underlying asset at a future date and a predetermined price. Options give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price. Swaps are agreements between two parties to exchange cash flows based on different variables, such as interest rates or currency exchange rates.

The origin of derivatives can be traced back to the 19th century, when farmers in the United States began to use futures contracts to lock in prices for their crops. Today, derivatives are used by a wide range of investors, including hedge funds, pension funds, and individual investors.

Collateralized Debt Obligations (CDOs):

Collateralized debt obligations (CDOs) are complex financial instruments that pool together a group of debt securities, such as mortgage-backed securities, and then divide them into different tranches with different levels of risk and return. The highest tranche is usually the safest, while the lower tranches are riskier but offer higher returns.

CDOs became popular in the early 2000s as a way for banks and other financial institutions to securitize their loans and sell them to investors. However, the subprime mortgage crisis of 2008 highlighted the risks associated with CDOs, as many of these instruments were heavily invested in subprime mortgages that defaulted when the housing market collapsed.

Structured Investment Vehicles (SIVs):

Structured investment vehicles (SIVs) are another type of complex financial instrument that pools together a group of assets, such as loans or securities, and then issues short-term debt to investors. The SIV invests the proceeds in longer-term assets that offer higher returns.

SIVs were first introduced in the 1980s, but they became popular in the early 2000s as a way for banks and other financial institutions to raise funds without having to hold the assets on their balance sheets. However, the financial crisis of 2008 exposed the risks associated with SIVs, as many of these instruments invested heavily in subprime mortgages that defaulted when the housing market collapsed.

Impact on Average Workers:

The use of financial engineering instruments can have a significant impact on average workers. When these instruments are used responsibly, they can provide investors with greater flexibility and diversification in their investment portfolios, which can lead to higher returns and greater economic growth.

However, when these instruments are used irresponsibly or are not properly regulated, they can hurt the wider economy. The subprime mortgage crisis of 2008, for example, was largely caused by the use of complex financial instruments, such as CDOs and SIVs, that were heavily invested in subprime mortgages that defaulted. When these investments failed, it led to a collapse in the housing market and a wider economic recession that impacted many average workers who lost their homes, jobs, and savings.

Additionally, the use of financial engineering instruments can lead to increased inequality in society. The investors who have access to these instruments and can afford the risks associated with them are usually wealthy individuals, hedge funds, and other financial institutions. This means that they are the ones who benefit the most from the high returns these instruments offer, while average workers may not have the same opportunities to invest in these instruments or may not have the financial knowledge to understand the risks involved.

Furthermore, the complexity of these instruments can also make it difficult for regulators to effectively oversee the financial industry and ensure that investors are protected. This can lead to a situation where financial institutions take excessive risks or engage in unethical behavior, which can ultimately harm average workers and the wider economy.

Conclusion:

In conclusion, financial engineering instruments such as derivatives, CDOs, and SIVs have become increasingly popular in recent years as a way for investors to diversify their portfolios and potentially earn higher returns. However, these instruments can be very risky and have the potential to cause widespread economic harm if they are not properly regulated and managed.

Average workers can be impacted by the use of financial engineering instruments in a number of ways, including through increased inequality, economic downturns, and lack of regulatory oversight. As such, it is important for financial institutions, regulators, and policymakers to work together to ensure that these instruments are used responsibly and that investors are protected from the risks involved.