Figure 1

Bundling creates a complex security

Source: The Wall Street Journal, December 19, 2001.

Often, creating a security that appears to be attractive requires the unbundling of an asset. An example is given in Figure 1.4. There, a mortgage pass-through certificate is unbundled into classes. Class 1 receives only principal payments from the mortgage pool, whereas Class 2 receives only interest payments.

The process of bundling and unbundling is called financial engineering, which refers to the creation and design of securities with custom-tailored characteristics, often regarding exposures to various sources of risk. Financial engineers view securities as bundles of (possible risky) cash flows that may be carved up and rearranged according to the needs or desires of traders in the security markets.

Computer Networks

The Internet and other advances in computer networking are transforming many sectors of the economy, and few more so than the financial sector. These advances will be treated in greater detail in Chapter 3, but for now we can mention a few important innovations: online trading, online information dissemination, and automated trade crossing.

Online trading connects a customer directly to a brokerage firm. Online brokerage firms can process trades more cheaply and therefore can charge lower commissions. The average commission for an online trade is now below $20, compared to perhaps $100-$300 at fullservice brokers.

financial engineering

The process of creating and designing securities with custom-tailored characteristics.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

Get My Free Ebook

Post a comment