What is financial engineering?
Financial engineering is the use of mathematical techniques to solve financial problems. Financial engineering uses tools and knowledge in the fields of IT, statistics, economics and applied mathematics to solve current financial problems as well as to design new and innovative financial products.
Financial engineering is sometimes called quantitative analysis and is used by regular commercial banks, investment banks, insurance agencies and hedge funds.
Key points to remember
- Financial engineering is the use of mathematical techniques to solve financial problems.
- Financial engineers test and publish new investment tools and new methods of analysis.
- They work with insurance companies, asset management companies, hedge funds and banks.
- Financial engineering has caused an explosion in derivatives trading and speculation in the financial markets.
- It revolutionized the financial markets, but it also played a role in the 2008 financial crisis.
How financial engineering is used
The financial sector always offers new and innovative investment tools and products for investors and companies. Most of the products have been developed using techniques in the field of financial engineering. Using mathematical modeling and computer engineering, financial engineers are able to test and issue new tools such as new methods of investment analysis, new debt offers, new investments , new negotiation strategies, new financial models, etc.
Financial engineers run quantitative risk models to predict how an investment tool will work and whether a new offering in the financial sector would be viable and profitable in the long term, and what types of risks are presented in each product offering given market volatility. . Financial engineers work with insurance companies, asset management companies, hedge funds and banks. Within these companies, financial engineers work in proprietary trading, risk management, portfolio management, pricing of derivatives and options, structured products and corporate finance departments.
Types of financial engineering
While financial engineering uses stochastics, simulations, and analysis to design and implement new financial processes to solve financial problems, the field also creates new strategies that companies can leverage to maximize the benefits of companies. For example, financial engineering has led to the explosion of derivatives trading in the financial markets. Since the creation of the Chicago Board Options Exchange (CBOE) in 1973 and two of the earliest financial engineers, Fischer Black and Myron Scholes, have published their option pricing model, trading in options and other derivatives has increased significantly. Thanks to the regular options strategy where one can either buy a call or place it according to whether it is bullish or bearish, financial engineering has created new strategies in the options spectrum, offering more possibilities of hedging or to make a profit. Examples of option strategies arising from financial engineering efforts include the put put, the protective collar, the long straddle, the short throttles, the butterfly spreads, etc.
The field of financial engineering has also introduced speculative vehicles on the markets. For example, instruments such as the Credit Default Swap (CDS) were originally created in the late 1990s to provide insurance against default on bonds, such as municipal bonds. However, these derivatives have caught the attention of investment banks and speculators who have realized that they can make money with the monthly premiums associated with CDS by betting with them. Indeed, the seller or the issuer of a CDS, generally a bank, would receive monthly premiums from the buyers of the swap. The value of a CDS is based on the survival of a business – the buyers of swaps bet on the bankruptcy of the business and the sellers insure the buyers against any negative event. As long as the company remains in good financial health, the issuing bank will continue to be paid monthly. If the company goes bankrupt, CDS buyers will cash the credit event.
Financial engineering criticism
Although financial engineering revolutionized the financial markets, it played a role in the 2008 financial crisis. As the number of defaults on subprime mortgages increased, new credit events were triggered. The Credit Default Swap (CDS) issuers, i.e. the banks, were unable to make payments on these swaps because the defaults occurred almost at the same time. Many buyers of companies that had purchased CDSs on mortgage-backed securities (MBSs) in which they were heavily invested soon realized that the CDSs held were worthless. To reflect the loss in value, they reduced the value of assets on their balance sheets, which resulted in more corporate failures and a subsequent economic recession.
Due to the 2008 global recession caused by structured engineering products, financial engineering is considered a controversial area. However, it is evident that this quantitative study has considerably improved the financial markets and processes by introducing innovation, rigor and efficiency in the markets and industry.