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Lecture 1

What is Financial Engineering

Giampaolo Gabbi

Financial Engineering MSc in Finance 2011 - 2012

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Outline • • • • • • What is Financial Engineering Financial Derivatives Pricing Risk management Financial Crisis Regulation 2 .

Utilizing various derivative securities and other methods. 3 . Methods can be employed to take on unlimited risks under certain events or completely eliminate other risks by utilizing combinations of derivative and other securities. • Financial engineering is the process of employing mathematical finance and computer modeling skills to make pricing. especially derivative securities. trading and portfolio management decisions.What is Financial Engineering • The process of researching and developing new financial products and services that would meet customer needs and prove profitable – The process of creating new securities or processes – The process of designing new financial instruments. hedging. financial engineering aims to precisely control the financial risk that an entity takes on.

stochastic process. physics. computational mathematics – Quantitative finance 4 . etc. • Engineering principles – Software engineering • Different names: – Financial engineering – Financial mathematics. time series analysis.What is Financial Engineering • Financial Engineering Requirements • Financial Economics • Mathematical tools – Probability and Statistics. differential equations.

Milestone in FE 5 .

Milestone in FE 6 .

soybean.Financial derivatives • Different kinds of derivatives: from plain vanilla to exotic derivatives • Underlying – Equity – Fixed Income. – Weather 7 . coffee. electricity. such as bonds. – Commodity. cotton. copper. gas. etc. such as oil.

Pricing • Closed-form formulas • Simulations • Portfolio Optimization 8 .

Risk Management • Market risk: – Risk identification – Risk measurements • Credit risk and credit derivatives – Credit modeling – Credit pricing • Counterparty risk – Wrong-way risk – New regulation on OTC markets and clearing 9 .

1994.6 billion • Metallgesellschaft: commodity. energy trading • LTCM –Sept 1998. WorldCom. 10 .5 billion rescue package • 2001 –2002. Feds orchestrated a $3. in a matter of few day. etc. 1995. loss $1. Britain’s oldest merchant bank • Orange County –bankrupt in Dec.Financial crisis • Baring’s bank –bankrupt. Feb. Enron.

Financial crisis • • • • Investors’ perspective Market’s perspective The risk from the regulators’ point of view … and for financial institutions 11 .

An experience on 1929 market crash • Eddie Cantor was an American comic actor • He was acting before and after the Market crash (1929) • Same period of the Marx Brothers 12 .

Within a week I was an old man” (Eddie Cantor) 13 .His experience during the 1929 market crash • “They told me to buy this stock for my old age. It worked wonderfully.

Purposes • Discuss how different risk factors generated collapses in financial systems • Examine the impact for insurance companies • Review how regulation should model agents’ behaviour • Exchange experiences in mixed teams 14 .

Clinic cases to find out SUB PRIME THE DOT.COM CRASH TULIP MANIA LONG-TERM CAPITAL MANAGEMENT BARINGS THE EQUITABLE LIFE ASSURANCE S OCIETY 15 .

Format to discuss the clinic case • • • • • • • • • • Period …………………………………………………………………………………… Country / Area …………………………………………………………………………………… Brief description of the case …………………………………………………………………………………… Risk factors explaining the case ……………………………………………………………………………………… Lessons to be learnt (strategy / control / regulation) …………………………………………………………………………………… 16 .