Financial technology is not just for economic objectives--it can be used for broader strategic and business management goals, too. For example, the emerging notion of real options applies option theory concepts to analyze business situations. As financial technology develops, its use in business will only increase. This article examines various ways this will happen.
APPLICATION OF PROCESS KNOWLEDGE
TO BUSINESS MANAGEMENT
Business managers often find themselves in situations where they would prefer to have quantitative and objective evaluations of a situation, but with no proper means of numerical analysis, have to contend with qualitative assessments.
The financial industry continually analyzes various forms of risks and processes to facilitate capital allocation, product structuring, and so forth. It attempts to develop quantitative assessments of risks by identifying risk factors, inter-dependencies between various processes, and so forth. In the last several years, substantial progress has been made toward analyzing market and credit risk. Efforts are underway to comprehend other forms of risks such as operational risk, liquidity risk, strategic risk, reputational risk, and so forth.
In certain situations business managers could draw upon the work of financial researchers. For instance, as part of understanding operational risk in a particular process, financial researchers might identify the probability distribution of losses due to manual errors. Business management may utilize this research in order to establish a forecast of losses. This forecast may then be used in business decisions such as those involving automation of the process.
Currently much analytical effort focuses on predicting magnitude of losses due to explicit unfavorable events, such as adverse interest rate movements or manual errors. Over time, as areas apart from risk management and financial engineering take interest in process research, analytical procedures will be extended to include other effects such as opportunity costs and gains. Knock-on effects, where one type of risk leads to another, will also be recognized.
STRATEGIC RISK SHARING
An organization, business or government is sometimes hesitant to take a step--such as making a strategic investment--because of the potential risks involved.
Financial products provide a powerful capability to allocate risks among different parties. We can now re-assign varying forms of risks--those associated with interest rate and exchange rate movements, with credit events or with natural events. Also different forms of risk may be segregated among different parties or the same form of risk may be allocated in different amounts.
Consider a situation where a country's government is hesitant to take major policy initiatives because it needs to keep cash on hand for relief payouts to farmers in the event of drought or excessive rainfall. Through catastrophe bonds, the government may create partners to share the risks and push forward its policy initiatives.
A CATALYST FOR STRATEGIC INITIATIVES
Advances in financial engineering allow mangers to custom design products for target investor bases or for specific purposes. These products can in turn provide incentives for specific behavior. For example, the U.S. Government has long used asset securitization to accomplish a strategic objective of promoting home-ownership. Three special purpose entities in the U.S. purchase mortgages from mortgage lenders and then securitize them, creating liquidity to purchase additional mortgages. Thus, through securitization the government created a mechanism to channel funds in the desired directionfrom the investors to the home buyers.
Asset securitization and credit derivatives are often used to manage the degree of involvement in a business. For example, banks frequently make loans with sub-par profitability for relationship purposes but then offload them from their balance sheet through asset securitization or credit derivatives.
MARKETS AS INFORMATION SOURCE
Prices in the financial markets reflect the aggregate expectations of the market participants on how the future is likely to evolve. As products develop around various processes and events, markets are becoming a rich source of information for a wide range of parameters. Products now exist concerning consumer payment patterns, credit events, weather events and interest rate or exchange rate volatilities. A business executive may examine the information tactically.
In situations where executives need to foresee the future, they may use expectations of the financial markets to guide strategic decisions. For example, many old economy firms recently moved into Internet-related businesses. High Internet stock prices reflected the market's expectations of phenomenal growth in the area, prompting many firms to expand into the Internet.
This week's Learning Curve was written by Udayan Srivastava, v.p.-risk analysis & audit at Chase Manhattan in New York. The views expressed are his own and do not necessarily reflect the bank's.
