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Computational Finance

Computational Finance

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Published by: zeshan khaliq on Jul 25, 2009
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Computational finance
Computational finance
Computational finance or financial engineering is a cross-disciplinary field whichrelies onmathematical finance,numerical methods,computational intelligence  andcomputer simulationsto maketrading,hedgingandinvestment decisions, as well as facilitating therisk managementof those decisions. Utilizing variousmethods, practitioners of computational finance aim to precisely determine thefinancial risk that certainfinancial instrumentscreate. 1)Mathematical finance2) Numerical methods3)Computer simulations4)Computational intelligence5)Financial risk 
History
Generally, individuals who fill positions in computational finance are known asquants”, referring to the quantitative skills necessary to perform the job.Specifically, knowledge of theC++ programming language, as well as of themathematical subfields of:stochastic calculus,multivariate calculus,linear   algebra, differential equations, probability theoryandstatistical inferenceare often entry level requisites for such a position. C++ has become the dominantlanguage for two main reasons: the computationally intensive nature of manyalgorithms, and the focus on libraries rather than applications.Computational finance was traditionally populated byPh.Dsin finance, physicsand mathematics who moved into the field from more pure, academic backgrounds (either directly from graduate school, or after teaching or research).However, as the actual use of computers has become essential to rapidly carryingout computational finance decisions, a background in computer programming has become useful, and hence many computer programmers enter the field either fromPh.D. programs or from other fields of  software engineering. In recent years, advanced computational methods, such asneural networ andevolutionary  computationhave opened new doors in computational finance. Practitioners of computational finance have come from the fields of signal processingandcomputational fluid dynamics andartificial intelligence. Today, all full service institutional finance firms employ computational finance professionals in their banking and finance operations (as opposed to beingancillaryinformation technologyspecialists), while there are many other boutiquefirms ranging from 20 or fewer employees to several thousand that specialize inquantitative trading alone.JPMorgan Chase & Co.was one of the first firms tocreate a large derivatives business and employ computational finance (including
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Computational finance
through the formation of RiskMetrics), while D. E. Shaw & Co. is probably the oldest and largest quant fund (Citadel Investment Groupis a major rival).
Introduction
One of the most common applications of computational finance is within thearena of  investment banking.Because of the sheer amount of funds involved in this type of situation, computational finance comes to the fore as one of the toolsused to evaluate every potential investment, whether it be something as simple asa new start-up company or a well established fund. Computational finance canhelp prevent the investment of large amounts of funding in something that simplydoes not appear to have much of a future.Another area where computational finance comes into play is the world of financial risk management. Stockbrokers, stockholders, and anyone who choosesto invest in any type of investment can benefit from using the basic principles of computational finance as a way of managing an individual portfolio. Running thenumbers for individual investors, just alike for larger concerns, can often make itclear what risks are associated with any given investment opportunity. The resultcan often be an individual who is able to sidestep a bad opportunity, and live toinvest another day in something that will be worthwhile in the long run.In the business world, the use of computational finance can often come into playwhen the time to engage in some form of corporate strategic planning arrives. For instance, reorganizing the operating structure of a company in order to maximize profits may look very good at first glance, but running the data through a processof computational finance may in fact uncover some drawbacks to the current planthat were not readily visible before.Being aware of the complete and true expenses associated with the restructuremay prove to be more costly than anticipated, and in the long run not as productive as was originally hoped. Computational finance can help get past thehype and provide some realistic views of what could happen, before any corporatestrategy is implemented.
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Computational finance
Quantitative analys is
A
quantitative analysis
is working in finance using numerical or quantitativetechniques. Similar work is done in most other modern industries, the work iscalled quantitative analysis. In the investment industry, people who performquantitative analysis are frequently called
quants.
Although the original quants were concerned with risk management andderivatives pricing, the meaning of the term has expanded over time to includethose individuals involved in almost any application of mathematics in finance.An example isstatistical arbitrage.
History
Quantitative financestarted in the U.S. in the 1930s as some astute investors began using mathematical formulae to price stocks and bonds.
,a pioneer of quantitative analysis, introducedstochastic  calculus into the study of finance.Harry Markowitz's 1952 Ph.D thesis "Portfolio Selection" was one of the first papers to formally adapt mathematical concepts to finance. Markowitz formalizeda notion of mean return and covariances for common stocks which allowed him toquantify the concept of "diversification" in a market. He showed how to computethe mean return and variance for a given portfolio and argued that investorsshould hold only those portfolios whose variance is minimal among all portfolioswith a given mean return. Although the language of finance now involvesItō calculus,minimization of risk in a quantifiable manner underlies much of themodern theory.In 1969Robert Merton introducedstochastic calculus into the study of finance. Merton was motivated by the desire to understand how prices are set in financialmarkets, which is the classical economics question of "equilibrium," and in later  papers he used the machinery of stochastic calculus to begin investigation of thisissue.At the same time as Merton's work and with Merton's assistance,Fischer Black  andMyron Scholeswere developing their option pricing formula, which led towinning the 1997 Nobel Prize in Economics. It provided a solution for a practical problem, that of finding a fair price for a European call option, i.e., the right to buy one share of a given stock at a specified price and time. Such options arefrequently purchased by investors as a risk-hedging device. In 1981, Harrison andPliska used the general theory of continuous-time stochastic processes to put theBlack-Scholes option pricing formula on a solid theoretical basis, and as a result,showed how to price numerous other "derivative" securities.
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