Definition of financial engineering

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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 computer science, 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 mainstream 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 deliver new investment tools and new methods of analysis.
  • They work with insurance companies, asset management firms, hedge funds, and banks.
  • Financial engineering has led to an explosion in derivatives trading and speculation in 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 industry is always coming up with new and innovative investment tools and products for investors and businesses. Most of the products have been developed using techniques in the field of financial engineering. Thanks to mathematical modeling and computer science, financial engineers are able to test and publish new tools such as new investment analysis methods, new debt offers, new investments, new trading strategies , new financial models, etc.

Financial engineers run quantitative risk models to predict the performance of an investment tool and whether a new offering in the financial industry would be viable and profitable in the long run, and what types of risks are presented in each product offering. due to market volatility. . Financial engineers work with insurance companies, asset management firms, hedge funds, and banks. Within these firms, financial engineers work in the proprietary trading, risk management, portfolio management, derivatives and options pricing, structured products, and corporate finance departments.

Types of financial engineering

Derivatives trading

While financial engineering uses stochastics, simulations, and analysis to design and implement new financial processes to solve problems in finance, the field also creates new strategies that businesses can leverage to maximize profits. business profits. For example, financial engineering has led to the explosion of derivatives trading in financial markets.

Since the Chicago Board Options Exchange (CBOE) was established in 1973 and two of the first financial engineers, Fischer Black and Myron Scholes, published their options pricing model, trading in options and other derivatives has significantly increased. Through the regular options strategy where one can either buy a call or put depending on whether they are bullish or bearish, financial engineering has created new strategies in the options spectrum, providing more opportunities to hedge or make a profit.

Examples of options strategies born out of financial engineering efforts include Married Put, Protective Collar, Long Straddle, Short Strangles, Butterfly Spreads, etc.

Speculation

The field of financial engineering has also introduced speculative vehicles to the markets. For example, instruments such as the Credit Default Swap (CDS) were originally created in the late 1990s to provide insurance against defaults in payments of bonds, such as municipal bonds. However, these derivatives caught the attention of investment banks and speculators who realized they could make money from the monthly premiums associated with CDSs by betting with them.

In effect, the seller or issuer of a CDS, usually a bank, would receive monthly premiums from the buyers of the swap. The value of a CDS is based on the survival of a company – swap buyers bet on the failure of the company and sellers insure 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 profit from the credit event.

Critique of financial engineering

Although financial engineering revolutionized financial markets, it played a role in the 2008 financial crisis. As the number of defaults on subprime mortgages increased, more credit events were triggered . Credit Default Swap (CDS) issuers, i.e. banks, could not make payments on these swaps since the defaults occurred almost at the same time.

Many corporate buyers who had purchased CDS on mortgage-backed securities (MBS) in which they were heavily invested soon realized that the CDS held had no value. To reflect the loss in value, they wrote down the value of assets on their balance sheets, leading to more corporate-level bankruptcies and a subsequent economic recession.

Due to the 2008 global recession caused by engineered structured products, financial engineering is considered a controversial area. However, it is evident that this quantitative study has significantly improved markets and financial processes by introducing innovation, rigor and efficiency to markets and industry.

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