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Modern Finance and Financial Theory: Financial Engineering

Updated on June 5, 2014
Engineering: but not as we know it. Source NASA/JPL
Engineering: but not as we know it. Source NASA/JPL

Financial Engineering: Definition

Financial Engineering is a multidisciplinary field involving computer science, financial theory, the tools of mathematics and the methods of engineering used extensively by banks, hedge funds and insurance companies.

It has also been defined in the practice of finance as the application of technical methods, especially from mathematical finance and computational finance.

The term is normally used for someone knowledgeable in the full range of tools of modern finance and whose work is informed by financial theory. This is sometimes restricted to mean only those involved in developing new financial strategies and products.

Financial Engineering: Fields

Financial Engineering uses tools and knowledge from the fields of applied mathematics, statistics, economic theory and computer science.

Sub fields of Financial Engineering are Computational Finance and Mathematical Finance.

Computational Finance is a discipline in Computer Science that deals with data and algorithms that arise in financial modelling.

Mathematical Finance is the application of theoretical mathematics to finance.

THE MAIN APPLICATIONS OF FINANCIAL ENGINEERING

► Portfolio Management

Financial Engineering is applied in the form of portfolio insurance to stabilise or reduce the risk associated with the market value of a portfolio of financial assets such as stocks and bonds over a period of time. This is a complex task involving a large number of parameters which have to be estimated in a statistically meaningful way including various other requirements expressed in a mathematical framework.

► Risk Management

Past high profile failures of banks and hedge funds have led to calls for a more consistent, quantitative company wide approach to risk monitoring and control. Risk management requires the defining, developing, implementing and maintenance of a companies risk management policies.

As an example, by combining elements of forwards, futures, swaps and options companies can create a financial model that should meet their risk exposure needs.

► Derivatives Pricing

The aim of Derivatives Pricing is to determine the fair price of a given security in terms of the law of supply and demand. It is a complex exercise to determine the current market value of a security. There are a number of different models and processes that can be used such as logarithmic changes in stock prices.

► Corporate Finance

This involves creating specific tools for a business that takes into account their company lifecycles, technical shifts, valuations, pricing, market screening and regulatory stock.

► Structured Products

Also known as a Market Linked Investment. Structured Products are investment strategies based on derivatives such as options, currencies, indices, commodities or securities. The wide range of this subject means there is no single uniformed definition of a Structured Product. They can be used as part of the asset process to reduce exposure of risk to a portfolio.

► Execution

This involves the area of market microstructure which studies how the markets work and how prices are decided on. It uses algorithms to measure market components such as the previous day’s closing prices against the current opening prices.

Financial Engineering: Advantages

The advantages of Financial Engineering are considered to be; the design and construction of a financial model which meets specific risk and return requirements by quantifying the “known unknowns”. This can be a complex combination involving one, or a combination, of stocks, bonds, securities, foreign currencies and derivatives.

Financial Engineering: Disadvantages

There are critics of Financial Engineering as there is still the unknown risk of future systemic changes leading to the failure of the model. One critic having said; “it replaces common sense and leads to disaster”. Others have identified specific areas that have caused financial disasters such as quantitative traders and over reliance on the models in certain other fields.

Financial Engineering: Qualifications

In the United States and the United Kingdom various Universities and other Institutions offer a post graduate MSc degree in Financial Engineering lasting between one and two years. The degree is called a Masters in Financial Engineering (MFE).

Competition is fierce and, at present, to be considered for the programme requires all students to, as a minimum, be proficient in calculus, matrix algebra, probability and real analysis and have a knowledge of programming languages.

Entry requirements and qualifications do vary from country to country and institution to institution so anyone considering this discipline as a career should first check that they have the necessary qualifications.

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@ 2013 Brian McKechnie (aka WorldEarth)

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