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 as well as to devise new and innovative financial products. It is sometimes referred to as quantitative analysis and is used by regular commercial banks, investment banks, insurance agencies, and hedge funds.
Financial engineering encompasses a broad, multidisciplinary field of study and practice that, essentially, applies an engineering approach and methodology to the world of finance. It integrates and utilizes information obtained from different fields such as economics, mathematics, computer science and financial theory. Much of financial engineering consists of converting financial theories into practical applications in the financial world.
An example of financial engineering in practice is the work of quantitative analysts usually referred to as quants. They develop algorithmic or artificial intelligence trading programs that are used in the financial markets. Financial engineering is not related to traditional engineering jobs, other than it shares a methodological approach that incorporates principles and theories of mathematics. However, many people who later become financial engineers previously acquired a traditional degree in engineering.
Financial engineering is a relatively new field of study. The first recognized programs offering a degree in financial engineering were not established in the united states until the 1990s. However, the field grown rapidly enough that such programs are now accredited by official bodies such as the International Association of Quantitative Finance and the International Association of Financial Engineers.
Financial engineering is used across a broad range of tasks in the financial world. Some of the areas where it is most commonly applied are;
· Corporate Finance.
· Arbitrage Trading.
· Technology and Algorithmic Finance.
· Risk Management and Analytics.
· Pricing of Options and other Financial Derivatives.
· Behavioral Finance.
· Creation of Structured Financial Products and Customized Financial Instruments.
· Credit Risk and Management.
However, despite its widespread use and acceptance, the field of financial engineering is not without criticism. Scholars from the fields of economics and mathematics, and even scholars within the field itself, severely criticize certain applications of financial engineering. For example, some scholars believe that over reliance on financial models has, in some instances, created, rather than solved, financial problems. Following the 2008 Global Financial Crisis, some economists blamed the banks’ widespread use of the Black-Scholes formula – a popular mathematical model used for investing in financial derivative instruments – for precipitating, or at least contributing to, the severity of the worldwide economic crash.
Financial engineers test and issue new investment tools and methods of analysis. They work with insurance companies, asset management firms, hedge funds, and banks. Financial engineering led to an explosion in derivatives trading and speculation in the financial markets.
There are many environmental and intra-firm factors driving the growth of financial engineering such as price volatility, tax asymmetry and risk aversion by managers. It has resulted in many innovative and customized financial products for individuals and corporates to achieve their specific objectives.
It is a field of study that helps in the reduction of risk in investments by assessing the total risk of the portfolio. The course also assists in making financial markets more active and efficient by simple means of matching the needs and wants.
It is often assumed to be limited to innovation of financial products or services but its application goes much beyond in making core processes of financial institutions and financial markets more accurate, efficient and profitable; and distribution of financial products and services more cost effective to provide broader access of funds to issuers and opportunities to investors while mitigating risk and creating a robust financial system.
According to Merton (1992), typically there are six core functions performed by the financial system: (i) Facilitating the exchange of goods and services with a payment system,(ii) Providing a structure for pooling of funds (iii) Providing mechanism for transferring of economic resources through time and across geographic regions and industries, (iv) Devising processes to manage uncertainty and control risk, (v) Making coordination of decentralized decision-making in various economic sectors more natural by providing price information, (vi) Providing means to handle asymmetric-information and incentive problems.
Financial engineering has penetrated all six core functions to provide innovative ways to perform numerous tasks in each function more efficiently. The proliferation of the financial engineering in financial systems stems majorly from the emphasis on risk management by corporates and retail investors looking for significantly reducing uncertainty of their profitability and sustainability. Marshall (1992:20) has classified the growth drivers of financial engineering into two categories: (i) Environmental, and (ii) Intra-firm.
Some of the building blocks of financial engineering are;
Special process and instruments that are used by Financial Engineers in combination to gain a specific task or purpose are called as physical tools. The examples include variants, securities, futures, swaps, options, and equities. At a very broad level, the basic instruments are cash market instruments and derivatives.
Cash and cash equivalents.
Money market instruments and bonds.
Forwards and Swaps.
Vanilla and exotics Interest rate options.
Financial engineers often work with companies, trading firms, IT departments at banks, and even with mobile banking businesses. A financial profession, on the other hand, works directly with individual clients or companies to help them build or consolidate their worth.
Financial engineering has revolutionized the financial markets by introducing innovative and customized financial products for individuals and corporates to achieve their specific objectives. Financial engineering has also aided to the innovation of processes and distribution in the financial services industry.
Technology has been both source and enabler in this innovation journey. From the development of complex financial models, predictive analytics, design, and distribution of financial products, trading of instruments to providing ultimate customer experience, technology is the key to every aspect of financial engineering. The information technology companies have a major role to play in the sustainable growth of the financial services industry.
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Some topics covered under Financial Engineering include:-
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