Financial engineering covers a broad, multidisciplinary field of study that involves the practice and application of engineering and mathematical approaches to solving financial problems. It combines and uses information acquired from different fields like computer science, statistics, economics, applied mathematics, and financial theory.
This financial engineering field involves the conversation of financial theories to practical applications in the world of finance.
The practical applications deal with the current financial issues and introduce new and innovative financial products.
Financial engineering is a quantitative analysis used by regular commercial banks, investment banks, and insurance agencies.
A financial engineer works as a quantitative analyst sometimes referred to as “quants”, who develops algorithms or AI (artificial intelligence) trading applications used in the financial markets.
Many see financial engineering as a subset of traditional engineering jobs, but it only shares a technical approach that contains the principles and theories of mathematics.
In other news, most people who end up as financial engineers have already acquired a degree in traditional engineering.
Financial engineering is a new field of study in the educational system. It was first established and recognized as a degree program in the United States in the 1990s.
It has expanded so well that it can be accredited by official bodies, such as the International Association of Quantitative Finance and the International Association of Financial Engineers.
Financial Engineering Usages
Financial engineering is popular across a wide range of tasks in finance. Financial engineers across the globe work with insurance companies, asset management firms, hedge funds, and banks.
These are some of the areas where their skills and expertise are mostly used:
- Risk Management and Analytics
- Credit Risk and Credit Management
- Technology and Algorithmic Finance
- Arbitrage Trading
- Corporate Finance Department
- Structured Products
- Quantitative Portfolio Management
- Pricing of Options and other Financial Derivatives
The financial industry is in the habit of developing new investment tools and products for companies and investors. This product was developed through the techniques of the financial engineering field.
Financial engineers use mathematical modeling and computer science to test and issue new tools, such as new methods of investment analysis, new debt offerings, new financial models, new trading strategies, etc.
These engineers run quantitative risk models to foresee how the investment tool will perform, and if the new offering in the financial sector will be profitable and applicable in the long run.
They also know the types of risk they face in each product offering, due to how unpredictable the market is.
Despite this widespread use and acceptance, the financial engineering field still faces criticism from experts within its field and those from economics and mathematics.
They have issues with certain applications of financial engineering.
This is because they feel that, relying too much on financial models will create more financial problems rather than solve them.
According to the 2008 Global Financial crisis, banks used the popular mathematical model called the Black-Scholes formula, which is used to invest in imitative financial instruments.
The economists blamed them for their contribution to the severe crash of the worldwide economy.
How It Works (Its applications to business)
In the early 1990s, financial engineering was key to facilitating sales by the Amoco Corporation of its subsidiary, the MW Petroleum Corporation, to the Apache Corporation.
Both companies’ diverse opinions on the likely future prices of oil and gas became the ultimate point for concluding a deal.
Amoco Corporation used a little financial engineering skill to create a financial product, referred to as a capped price support warranty, and offered it to Apache Corporation.
The warranty on the product was for any occurrence in the future of oil prices going down below their appointed level.
A supporting payment to reduce the losses in revenue will be made by Amoco to Apache. (Amoco is bullish while Apache is bearish).
In the wake of receiving such a generous warranty, Apache, in turn, promised Amoco an additional payment for the first few years in rising oil prices above their appointed level.
This is in line with the MW petroleum sales. In the end, the financial engineers who used the financial models controlled both the lower and upper appointed price levels.
In cases such as this one, financial engineering made provisions for both companies involved in the business transaction to share considerable risks.
This they did, making sure that in case of an uncertain environment of major commodity prices, it will be acceptable by both parties involved.
They helped in concluding the deal of Apache’s acquisition of MW Petroleum. Financial engineering uses stochastics, simulations, and analytic designs to implement new finance processes in solving financial issues.
This field of study creates ways that companies can use to take advantage of maximizing corporate profits.
An example is the explosion of derivative trading in the financial markets led by financial engineering.
Also, in 1973 when the Chicago Board Options Exchange was created, the first financial engineers by the name of Fischer Black and Myron Scholes published an option pricing model.
Which were a trade-in option and other derivatives that grew unexpectedly. It is through the regular options strategy that one can either buy a call or put, depending on whether he is bullish or bearish.
They created ways within the options range to provide more possibilities to hedge or make profits. Examples of the options strategies borne out of financial engineering efforts are Married Put, Protective Collar, Long Straddle, Short Strangles, Butterfly Spreads, etc.
Financial engineering is broad and can be found in multidisciplinary fields of study and practice. It applies mainly to technical engineering concerning the financial world.
It is also used in a wide area of the financial services industry, including creating financial derivative products, risk management, and corporate finance.
It is the use of mathematical techniques to solve financial-related problems. These engineers test and issue new investment tools and various methods of analysis.
They also work with insurance companies, asset management firms, hedge funds, and banks. Financial engineering is responsible for the outbreak in derivatives trading and prediction in the financial markets.
Although the finance field is wide, the finance consultant’s demand for it is steady. This is a competitive profession with experts recommending it to people who want to become one by taking mathematics, computer science, and financial courses as their career foundation.