Abstract
Financial engineering employs finance science to create risk-management-based solutions to improve the efficiency and effectiveness of achieving strategic sovereign policy objectives. These tailored solutions frequently employ derivatives – intangible financial contracts – as more precise alternatives to generic securities, tangible physical investments, and regulatory restrictions and thereby to reduce cost and improve performance. Analogous to “precision medicine”, this “precision finance” approach seeks to eliminate dysfunctional, unintended, and undesirable “side effects” from more generic solutions.
Derivative contracts are a powerful and versatile tool for efficient, scalable risk transfer, transforming risk exposures quickly at low cost, in a non-invasive fashion. They provide easy, fast, and low-cost strategy implementation as well as reversal should the adopted solution need to be changed.
The presentation will offer two illustrative demonstrations of policy improvement:
1. Improving the trade-off between two fundamental strategic investment dictums: Pursue comparative advantage versus employ efficient diversification to maximize expected return for whatever amount of risk taken.
Countries face an inherent policy conflict in the trade-off between these economic dictums. Comparative advantage calls for concentration in a relatively small number of activities, often highly correlated, while efficient diversification calls for a large number of diverse activities, preferably with low correlations among them.
2. Improving other sovereign policy objectives such as financial stabilization using capital controls, maintaining domestic governance and control of industry, and political constraints that can impede efficient across geopolitical border diversification.
