What Is Financial Engineering?

Financial engineering is the use of mathematical techniques to solve financial problems. Financial engineering 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. Financial engineering is sometimes referred to as quantitative analysis and is used by regular commercial banks, investment banks, insurance agencies, and hedge funds.

How Financial Engineering Is Used

The financial industry is always coming up with new and innovative investment tools and products for investors and companies. Most of the products have been developed through techniques in the field of financial engineering. Using mathematical modeling and computer science, financial engineers are able to test and issue new tools such as new methods of investment analysis, new debt offerings, new investments, new trading strategies, new financial models, etc.

Financial engineers run quantitative risk models to predict how an investment tool will perform and whether a new offering in the financial sector would be viable and profitable in the long run, and what types of risks are presented in each product offering given the volatility of the markets. Financial engineers work with insurance companies, asset management firms, hedge funds, and banks. Within these companies, financial engineers work in 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 analytics to design and implement new financial processes to solve problems in finance, the field also creates new strategies that companies can take advantage of to maximize corporate profits. For example, financial engineering has led to the explosion of derivative trading in the financial markets.

Since the Cboe Options Exchange was formed in 1973 and two of the first financial engineers, Fischer Black and Myron Scholes, published their option pricing model, trading in options and other derivatives has grown dramatically. 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 within the options spectrum, providing more possibilities to hedge or make profits.

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 in the markets. For example, instruments such as the Credit Default Swap (CDS) were initially created in the late 90s to provide insurance against defaults on bond payments, such as municipal bonds. However, these derivative products drew the attention of investment banks and speculators who realized they could make money from the monthly premium payments associated with CDS by betting with them.

In effect, the seller or issuer of a CDS, usually a bank, would receive monthly premium payments from the buyers of the swap. The value of a CDS is based on the survival of a company—the swap buyers are betting on the company going bankrupt and the sellers are insuring the buyers against any negative event. As long as the company remains in good financial standing, the issuing bank will keep getting paid monthly. If the company goes under, the CDS buyers will cash in on the credit event.

Criticism of Financial Engineering

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

Many corporate buyers that had taken out CDSs on mortgage-backed securities (MBS) that they were heavily invested in, soon realized that the CDSs held were worthless. To reflect the loss of value, they reduced the value of assets on their balance sheets, which led to more failures on a corporate level, and a subsequent economic recession.

Due to the 2008 global recession brought on by engineered structured products, financial engineering is considered to be a controversial field. However, it is apparent that this quantitative study has greatly improved the financial markets and processes by introducing innovation, rigor, and efficiency to the markets and industry.