Financial Engineering
The broad, multidisciplinary field of study and practice that applies an engineering methodology to the world of finance
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What is Financial Engineering?
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” – who develop things such as algorithmic or artificial intelligence trading programs that are used in the financial markets.
Financial engineering is not really related to traditional engineering jobs, other than it shares a methodological approach that incorporates principles and theories of mathematics. However, many people who later became 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’s grown rapidly enough that such programs of study are now accredited by official bodies, such as the International Association of Quantitative Finance and the International Association of Financial Engineers.
Summary
- Financial engineering refers to the broad, multidisciplinary field of study and practice that applies an engineering methodology to the world of finance.
- Financial engineering is used in a wide variety of areas in the financial services industry, including corporate finance, risk management, and the creation of financial derivative products.
- However, some have criticized over-reliance on financial engineering as contributing to financial problems and major financial crises, such as the 2008 Global Financial Crisis.
Uses of Financial Engineering
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 the following:
- 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
- Quantitative Portfolio Management
- Credit Risk and Credit Management
However, despite its widespread use and acceptance, the field of financial engineering is not without criticism. Scholars from the fields of both 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.
Example – Financial Engineering in Practical Business Applications
The use of financial engineering was key to facilitating a sale by Amoco Corporation of its subsidiary, MW Petroleum Corporation, to the Apache Corporation in the early 1990s. The factor that became the ultimate sticking point for concluding a deal was the two companies’ divergent opinions on the likely future prices of oil and gas – Amoco was bullish, and Apache was bearish.
A bit of financial engineering led to the creation of a financial product referred to as a capped price support warranty that was offered by Amoco to Apache. The warranty provided that in the event of oil prices dipping below a designated level, Amoco would make supporting payments to Apache to reduce its losses in revenue.
In return for receiving the warranty, Apache promised, in turn, to make additional payments to Amoco in the event that, in the first few years following the sale of MW Petroleum, oil prices rose above a designated level. Both the lower and upper designated price levels were determined by financial engineers using financial models.
In such a case, financial engineering provided a means for the two companies involved in the transaction to share the considerable risks in the uncertain environment of major commodity prices in a manner that was acceptable to both parties and that, thereby, made it possible for them to conclude the deal for Apache’s acquisition of MW Petroleum.
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