FINANCIAL engineering is the use of mathematical techniques to solve financial problems. It uses tools and knowledge from the fields of computer science, statistics, economics, and applied mathematics to address current financial issues. The tools are meant to come up with new methods of investment analysis, new debt offerings, new investments, new trading strategies and new financial models.
Financial engineers create derivative financial products aimed at enhancing a business’s performance while reducing or managing risk. They 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. Basically financial engineering is knowledge and imagination.
Financial engineering instruments
Derivative — a financial security with a value that is reliant upon or derived from an underlying asset or group of assets. A contract between two or more parties based upon the assets. Examples include ‘Options’, which are financial derivatives sold by an option writer and bought by an option buyer.
The contract offers the buyer the right nut not obligation to buy or sell the underlying asset at an agreed upon price during a certain period of time or a specified date.
There are ‘Futures’, which are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset such as a physical commodity or financial instrument at a pre-determined future date and price. ‘Swaps’ are a contract between two parties agreeing to trade loan terms.
Opportunities for financial engineering
Current difficult business environments in Zimbabwe call for financial innovation, which allows companies not only to survive but to grow and expand using underutilised assets that they may have such as real estate and other infrastructure. The public sector can collaborate with institutions such as insurance companies, pension funds, financial institutions, venture capitalists, et al to create new financial products and transactions that create mutually beneficial outcomes like sale and lease back of buildings using derivatives such as options
The bond market is a good platform for the public sector to raise capital because it is cheaper. Local municipalities/government can issue out bonds. The Zimbabwean money market in general is illiquid, not tight and lacks immediacy and depth, it is failing to fully attract foreign investment and this makes it slow. The central bank not being able to be the lender of last resort due to lack of a local currency has negatively affected the performance of the financial markets in general. This has led to the banking sector being the main market participant — range of securities is narrow because mainly it is bankers acceptance’s and Treasury Bills.
Current public sector performance
State owned enterprises and parastatals drive investment and job creation in key sectors, they provide vital public services and implement public policies.
Most of them are operating at a loss and require public subsidies to remain solvent.
The money is borrowed from domestic and foreign markets, which increases national public debt. Some have significant tax arrears, net drain on public finances, weak accountability and monitoring (Problematic transparency and financial reporting), poor corporate governance, poor oversight/insufficient oversight of the entities, inadequate, expensive and poor service delivery, salary services ratio not ideal and misplaced priorities on budget allocations.
Corporate governance of public sector
Corporate governance — system of rules, practices and processes by which a firm is directed and controlled. Poor and weak corporate governance has been playing a major role in the underperformance of the public sector.
The appointment process of some of the boards of the organisations did not adhere to basic corporate governance requirements. Some board members having been appointed based on their relationship with the appointers and not based on their skills and competencies hence resulting in weak boards.
This also covers managerial interference by ministries, lack of board charters and code of ethics for some and poor corporate governance affects their contribution to GDP and employment creation.
Balance sheet and profit and loss accounts
Balance sheets of most of the entities are weak. Current assets and non-current assets are not being tracked and accounted for which makes the true financial position and performance of the entities unknown, full cost of government services is unknown. Net current position of most entities is precarious, failure to produce audited/unaudited financial statements, current cash basis of accounting only based on inputs and outputs against the budget; liabilities, accrued interest, pension obligations etc remain unaccounted for. New government accounting system to be implemented- International Public Sector Accounting Standard (IPSAS) will make it possible to have full disclosure of liabilities and will improve overall management and planning as a result of more precise estimates of income and expenditure.
Country risk, debt
Country risk comes in political and economic form. Government debt is currently in excess by approximately $400 million. Government serves as a guarantee for some of the entities and this can expose it to the risk of unpredictable obligations in order to make up for the inability of these entities to pay their debts. Debt is from domestic and foreign markets, which increases national public debt. Most entities in the public sector have the wrong culture.
Research and development is, thus, crucial in order to remain relevant, effective and efficient.
Consequences of underperformance
Underperformance of the public sector results in various consequences such as burden on the fiscus, antiquated infrastructure, inadequate working capital, under capitalisation, skills deficit- human capital flight and lack of, looting, vandalism, mismanagement and corruption.
Improvements are required in the following areas: corporate governance issues, transparency and accountability of entities, extinguishing of debts, service delivery-adherence to service delivery and wage bill ratios, performance of the bond markets, which is dependent on the overall economic performance.
Commercialisation and privatisation of some state owned enterprises and parastatals, monetisation of debt- debt re-engineering/ debt factoring, pricing accordingly, public sector being entrepreneurial in approach and tax innovativeness. Some of these are captured in the TSP.
Financial engineering instruments are meant to attract investors. However, if the underlying challenges within the public sector are not addressed first the innovation will be of no use. Their successful creation and implementation lies in the improvement of overall performance and clean balance sheets of the entities in the public sector. Local and foreign investors will be attracted to invest in some of these entities if there is a decrease in political and economic risk so the government has a role to play.