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Financial Engineering

How Financial Engineering Can Advance Corporate Strategy

Leaders of successful businesses build long-term relationships with customers, suppliers, employees, and shareholders. They make farsighted investments to support and develop their core competencies. They act quickly to ensure that short-term obstacles do not disrupt their long-term strategies. In conceiving and implementing corporate strategies, managers have always drawn on the skills of many specialists, from marketers to production experts. Now a small but growing number of senior managers have found that practitioners of a new technical specialty—financial engineering—can help them achieve their companies’ strategic objectives. They have found that, like other technological breakthroughs such as cheap computing power, financial engineering has the potential not only to reduce the cost of existing activities but also to make possible the development of new products, services, and markets. The notion that financial engineering—the use of derivatives to manage risk and create customized financial instruments—can advance a company’s strategic goals might contradict the impression one gets from recent stories in the press. In many of these tales, traders within the finance staff use derivatives to speculate on the steepness of the yield curve or on movements of exchange rates. It appears that these bets have not been driven by the company’s business strategy and that senior managers have been unaware of choices made deep within their finance organizations. When misguided wagers backfire, companies lose millions and executives lose their jobs. Managers who seek to avoid disasters certainly must pay careful attention to these cautionary tales. Nevertheless, these accounts could easily give the impression that financial engineering is not used, and indeed should not be used, by nonfinancial companies to advance core business goals. That impression would be wrong. It is well to recognize the pitfalls of new technologies, but failure to appreciate their true competitive value can be shortsighted and ultimately hazardous. Forward-looking managers need to keep abreast of their rivals’ successful uses of promising breakthroughs like financial engineering. Unfortunately, those are the stories that remain untold. Were they to be told, managers would learn of leading organizations that have used financial engineering to solve classic and vexing business problems. These are not narrow finance problems that involve shaving a few basis points off financing costs or shedding transaction exposures arising from sales abroad. Rather, they are broad strategic problems—in marketing, production, human resources, investor relations, and strategic restructuring—for which advanced financial techniques have offered new solutions. This article presents five case studies that illustrate innovative applications of financial engineering and offers managers guidance for determining when such techniques are appropriate.

Managers need to keep abreast of their rivals’ successful uses of financial engineering.

The cases highlight five corporations—three headquartered in the United States, one in France, and one in Mexico—that produce and market gas, electricity, chemicals, cement, or oil. Although the companies faced different management challenges, their goals were clear and their opportunities well defined. Traditional approaches toward achieving their objectives, however, seemed inadequate—either the costs or the risks appeared to be too high. The outline of a new, nontraditional solution was not hard to discern. But the innovative approach required that the companies commit themselves to bearing risks that their customers, employees, or counterparties sought to shed. Without a means of structuring, valuing, and mitigating those risks, the strategic initiatives that management pursued seemed doomed to failure. In the end, the innovative approach was made possible by the concepts, tools, and markets of financial engineers. The cases demonstrate that close collaboration between general managers and financial engineers can help create a competitive edge in a variety of ways: by differentiating products through enhanced price and delivery options, by increasing production capacity with flexible alternatives to capital investment, by changing the risk characteristics of holding stock, or by keeping strategic mergers on track through the creation of win-win situations. The underlying aim of the cases is to follow the eye of the financial engineer who thinks like a strategist (or the strategist who thinks like a financial engineer). That means “following the risk” through the process of identifying the sources of risk, evaluating the strategic advantage of bearing risk, creating financial instruments to transfer risk, and using financial markets to value and shed risk.

Controlling Volatility: Enron Capital & Trade Resources

Producers and distributors of regulated commodity products, such as natural gas or electricity, have not generally been known for their sophisticated marketing programs. Before deregulation, there was little need or incentive to differentiate their products. But price decontrols, open distribution systems, and market economics have changed all that. How, then, can a commodity producer succeed in a competitive environment? Elementary strategy suggests that the company must either be the lowest-cost provider or distinguish its product from the competition. And yet it would seem almost senseless for a company to establish a brand name for a product like methane, which can be fully described as one molecule of carbon attached to four molecules of hydrogen.


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