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Understanding Financial Engineering

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Finance
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Understanding Financial
Engineering
Financial engineering studies train the individual in the application of
engineering methodologies and quantitative methods to finance. It is
designed for students who wish to obtain positions in the securities,
banking, and financial management and consulting industries, or as
quantitative analysts in corporate treasury and finance departments of
general manufacturing and service firms.
T
he field of finance refers to the concepts of
time, money and risk and how they are
interrelated. Banks are the main facilitators
of funding through the provision of credit,
although private equity, mutual funds, hedge
funds and other organizations have become
important. Financial assets known as investments
are managed with careful attention to financial risk
management in order to control financial risk.
Financial instruments allow many forms of
securitized assets to be traded on securities
exchanges such as stock exchanges, including
debt such as bonds as well as equity in publicly-
traded corporations.
Financial engineering is a cross-disciplinary
field which relies on mathematical finance,
numerical methods and computer simulations to
make trading, hedging and investment decisions as
well as facilitating the risk management of those
decisions. Utilizing various methods, practitioners
of financial engineering aim at precisely
determining the financial risks that certain financial
instruments create.
Generally individuals who fill positions in
financial engineering are known as ‘quants’,
* Accredited Management Teacher (AIMA), PhD-Guide, Faculty of Management, University of Pune. The author can be reached at neetajb@rediffmail.com
© 2009 IUP. All Rights Reserved.
MBA Review 41
FINANCE
Neeta Baporikar*
referring to the quantitative skills necessary to
perform the job. Specifically knowledge of the
C++ programming language as well as of the
mathematical subfields of: stochastic calculus,
multivariate calculus, linear algebra, differential
equations, probability theory and statistical
inference are often entry level requisites for such a
position. C++ has become the dominant language
against the intensive nature of many algorithms.
Financial engineering was traditionally populated
by PhDs in finance, physics and mathematics that
moved into the field from purer academic
backgrounds (either directly from graduate school,
or after teaching or research). However as the
actual use of computers has become essential to
rapidly carrying out computational finance
decisions, a background in computer programming
has become useful; hence many computer
programmers enter the field either from PhD
programs or from other fields of software
engineering. Practitioners of financial engineering
have also come from the fields of signal processing
and computational fluid dynamics. Master level
degree holders are also increasingly making their
presence felt as more terminal programs become
available at the leading schools.
March-09
 FINANCE
Today all full service institutional finance firms
employ financial engineering professionals in their
banking and finance operations (as opposed to
being ancillary information technology
specialists), while there are many other boutique
firms ranging from 20 or fewer employees to
several thousands that specialize in quantitative
trading alone. JP Morgan Chase & Co. was one of
the first firms to create a large derivatives business
and employ computational finance specialists,
while DE Shaw & Co. is probably the oldest and
largest quant fund.
Definition of Financial Engineering
Financial engineering is the application of
mathematical methods to the solution of problems
in finance. It is also known as financial
mathematics, mathematical finance and
computational finance. Financial engineering
draws on tools from applied mathematics,
computer science, statistics and economic theory.
Investment banks, commercial banks, hedge
funds, insurance companies, corporate treasuries
and regulatory agencies need financial
engineering. These businesses apply the methods
of financial engineering to such problems as new
product development, derivative securities
valuation, portfolio structuring, risk management
and scenario simulation.
Financial engineering is a multidisciplinary
field involving financial theory, the methods of
engineering, the tools of mathematics and the
practice of programming. It is also devoted to the
tools of the trade and their use in modeling
financial markets and instruments.
Students need to take courses in stochastic
processes, optimization, numerical techniques,
Monte Carlo simulation (a class of computational
algorithms that rely on repeated random sampling
to compute their results) and data analysis. They
also have to understand portfolio theory,
derivatives valuation and financial risk analysis,
making use of the methods they have learned.
Students can take the opportunity and do more
advanced courses and study specialized topics on
current subjects of interest ranging from models of
MBA Review 42
the term structure of interest rates, implied
volatility smile, applications programming for
financial engineering on particular markets and
their models; for example, mortgage-backed
securities or credit-risk modeling.
Meaning of Financial Engineering?
Financial engineering means the creation of new
and improved financial products through
innovative design or repackaging of existing
financial instruments. Financial engineers use
various mathematical tools in order to create new
investment strategies. The new products created
by financial engineers can serve as solutions to
problems or as ways to maximize returns from
potential investment opportunities.
Globalization and technical change increase the
intensity of competition within and between
financial centers already subject to competitive
pressures from an apparently high mobile
financial capital. However financial production is
shaped by its complex, socially constructed
cultural geography through which the variety of its
markets takes place and its profits are defined and
made. The production of mortgage-backed
securities within the City of London illustrates the
argument. Management of risk is necessary in
today’s highly leveraged, highly competitive global
economy. Using advanced quantitative methods
and path-breaking concepts of strategic planning
and responsible risk management, the financial
engineering program combines the most relevant
aspects of mathematics and financial management.
Thus financial engineering studies prepare
individuals for careers in a broad range of
specialties which include: risk management,
valuations, fixed income, financial analysts, asset
management, hedging analysts and mortgage-
backed securities.
In trying to understand what financial
engineering is all about some questions which are
frequently asked are given in the Box next page.
Areas of Application
The broad areas of application where the financial
engineering techniques are employed include:
March-09

Box: Frequently Asked Questions (FAQs)
1. Is there a standard financial engineering curriculum?
Presently, there are no national or international standards for what
topics should appear in a financial engineering program.
2. What programs are available?
There are dozens of financial mathematics programs around the
world. The majority of these programs are in the US, but there are
programs in Canada, the UK and Continental Europe as well.
Masters programs usually run from one to two years in length with
the major differences between programs being the curriculum’s
distribution between mathematical, statistical and computational
techniques, and financial theory and its applications. This is further
reflected in the choice of faculty and, in particular, the balance
between academicians and practitioners. Though we do not know
of any official PhD in financial mathematics, there is increasing
number of students who receive PhDs from mathematics
departments in which the topics studied and the problems solved
are derived from financial engineering. There are number of
institutions offering mathematical finance and financial engineering
programs.
3. Are specific programs ranked? How do we know which program is
the best?
There are no recommended rankings and there are no officially
published ranking of mathematical finance programs presently
available. While the factors one should use to evaluate a
mathematical finance program will naturally depend on the
background and future plans in the financial engineering world, here
are a few things to consider:
• Curriculum: Does the curriculum offer a broad selection of topics in
mathematics, computing and finance that will form a solid
foundation for career in financial engineering?
• Practical Versus Theoretical Training: Does the curriculum offer
the right blend of exposure to theoretical concepts and practitioner-
based ‘real-world’ ideas?
• Faculty: What is the quality of the faculty and what is the level of
contact between the faculty and the community of practitioners of
financial mathematics/financial engineering?
• Resources and Facilities: What sort of resources does the
program have (e.g., financial data, software, computer labs,
trading labs, etc.)?
• Placement: What is the placement record of the program and, more
specifically, what sort of jobs do graduates of the program get upon
graduation and what sort of jobs do former graduates hold today?
The best recommendation to students who are serious about
investigating their options in financial engineering is to “take the time
to talk to faculty at various programs and request to be put in touch
with alumni of the programs to get their perspectives as well”.
4. What sort of careers do financial engineers pursue?
Financial engineers use the skills they acquire during their degree
programs towards a broad selection of careers in finance, including
the trading of securities, financial modeling, sales, risk
management and portfolio management. We believe that the skill
sets acquired in a financial mathematics masters program are
sufficiently broad to prepare students for many interesting fields.
Moreover, as it is increasingly recognized in financial firms that
computational and mathematical skills are critical to the success of
Source: IAFE Education Committee
MBA Review 43
FINANCE
all organizations, the market for students with financial
mathematics degree continues to broaden. In a 2002 survey, 38%
of students stated that they wanted a career in some sort of job
related to derivatives pricing, while 21% said risk management and
18% said trading derivative instruments (14% of students did not
respond).
5. What sort of majors do undergraduates who pursue the financial
mathematics masters program have?
Students in financial mathematics masters program have degrees in
a variety of different majors, but a majority have degrees in pure and
applied mathematics and engineering. Other majors with significant
representation include computer sciences, physics, engineering,
economics and a variety of liberal arts majors. Despite the
concentration in mathematics and engineering, the important
common factor among students is a foundational level of training in
mathematics and computer programming and a strong interest in
finance and financial markets. In the 2002 survey, students were
asked what best described their undergraduate major; 34% of the
students responded with engineering and 24% with mathematics or
applied mathematics. Nine percent responded with humanities.
6. If I do not have a math or engineering degree what are my
chances of being accepted into a financial mathematics
program?
Your chances will mainly be determined by your overall
background, not your major. A strong history major with appropriate
course work (see question below) in mathematics and an
appropriate level of computer skills can be admitted to a financial
mathematics program. While a majority of students in financial
mathematics programs do have math and engineering degrees,
students from all majors with the appropriate mathematical and
computer science background are encouraged to apply. The main
factor for success is the level of mathematical background and
talent, the experience in computing, and an interest in finance.
7. What coursework is appropriate to be accepted to a
mathematical finance program?
Standards vary from program to program. However there seems to
be a broad consensus that without course work in calculus,
advanced calculus (including Taylor series), linear algebra and
probability theory a student will find most financial mathematics
programs difficult. Similarly students with no experience
programming computers in languages like C, C++, PERL or Java
will also find such programs difficult. We do encourage students to
take this as a general guideline and to contact specific programs
for more details.
8. Should I take time off and work before going to a financial
mathematics program or should I go straight from college?
So much of a job search comes down to individual factors that it is
hard to generalize. Our experience is that students going straight
from undergraduate to masters programs usually compete with
other masters students as well as undergraduates for jobs.
However some employers prefer students with a four-year degree
plus specific training in financial mathematics. Others will simply
seek out the strongest students from the increased pool. We have
found that masters students with no job experience compete
favorably with undergraduates, and also that students who
returned to a masters program after work experience of one to five
years do quite well in their job searches too.
March-09
 FINANCE
• Investment banking.
• Risk management software.
• Corporate strategic planning.
• Securities trading and financial risk management.
• Derivatives trading and risk management.
• Investment management.
• Pension scheme.
• Insurance policy.
• Mortgage agreement.
• Lottery design.
• Islamic banking.
• Currency peg.
• Gold and commodity valuation.
• Collateralized debt obligation.
• Credit default swap.
Views Regarding Financial Engineering
It is a plain fact that the field of quantitative finance
has not made a single fundamental step forward
over the past 20 years. The Black-Scholes equation
was first formulated and solved by Casey Sprenkle
some ten years before Black’s famous 1973 paper
in the Journal of Political Economy. Statistics and
numerical analysis have nothing to do with
finance per se but are merely tools of financial
analysis, just like accounting statements and legal
opinions. Finance is quantitative by definition;
there is, thus, no need to add an adolescent
adjective to the word. This is like saying aerial
flight or wet swimming. Although people
employed as aerospace engineers use computers
on a daily basis, none would describe himself/
herself as a computer programmer.
But if this were about mere semantics, it would
not be worth mentioning. Unfortunately financial
engineering programs are also drifting farther and
farther away from their purported subject matter.
In effect quantitative finance has entered the
scholastic stage whereby numerical techniques are
taught completely out of context as if a deal were
somehow a differential equation that could be
solved for the right solution. In fact, there is no
solution to a deal as there is to a differential
equation. A deal only happens when various
constituencies (lawyers, investors, bankers, rating
MBA Review 44
agencies and sometimes, regulators, accountants,
etc.) are able to come together under a unified
framework. This is not the time to deliberate or
lecture on cross-correlation and conditional
variable. On the contrary, any such talk is
completely counterproductive.
Students who consider themselves to be financial
experts simply because they can solve the Black-
Scholes equation in a few minutes are probably
misled into the naïve belief that this amounts to
finance. Too often, students who would otherwise
have something valuable to contribute are being led
down the primrose path. The promise of high-flying
jobs is all that has made financial engineering so
prominent, since—once on the job—graduates of
financial engineering programs quickly become
aware that it is MBA graduates, and not themselves,
who are destined to breathe the rarefied air of
boardroom deal-making. In fact, the label quant has
now become quasi-pejorative, the practical
equivalent of geek or inconsequential number
cruncher. Given the current state of affairs, one could
not agree more.
What is obvious and regrettable is that no effort
is ever made to teach numerical analysis as a
proper and rigorous discipline. Instead, students
literally learn numerical recipes and are no more
equipped to handle reality than someone with a
driver’s license when the car breaks down. It is
simply not possible to claim expertise in
numerical analysis if one does not have at least a
passing acquaintance with the above foundational
elements. However, learning these things takes
time. On the other hand, if the goal is not to
become knowledgeable in numerical analysis but
simply to learn a sundry assortment of basic
methods, there are much cheaper ways to do
those; for instance, in the mathematics or
computer science department of the same school.
Numerical analysis is a well-formed discipline that
does not need finance to give it credibility.
The consequence of all this is that today and
through no fault of their own, students who take
up financial engineering may be ill-equipped to
face the rapidly changing face of finance. Once
ensconced in their jobs, they are quickly
March-09

marginalized and relegated to the role of a glorified
programmer until being eliminated in the next
headcount reduction because (with unfortunate
justification) they are not considered producers.
Financial engineering never grew up within
finance; it was taken over by physics. Unless the
field reinvents itself pronto and starts becoming
relevant to what people actually do out there,
graduates with newly minted financial engineering
degrees hoping to see a decent return on their own or
their parents’ sizable investment will continue to be
sorely disappointed by their actual career prospects,
and will keep wondering where in God’s name they
went wrong. Regrettably, the answer is: Nowhere.
This argument seems to have given some
people the opportunity to take financial
engineering bashing as an excuse to do some
general mathematics hating. Of course using math
isn’t appropriate in all fields, but it can—when
used properly—help make arguments much more
precise and clear. The problem always arises from
the fact that the math must be applied on some
kind of model and the model itself might be
unrealistic.
The problems that operational research tends
to be used on are very specific; how can we lay out
this fibre optic network to minimize the cost, how
should we schedule this sports tournament to
avoid conflicts? How can this major international
shipping company best route its airplanes? Some
feel one could just use ‘good judgment’—but many
problems like this become very big. You have a
large number of sports teams; you have a large
number of houses that need to be connected; or a
large fleet of aircraft. One simply can’t use ‘good
judgment’ to come up with good solutions to very
big problems with lots of inputs. You need a
methodology—you need math. Since many of
these operational research type problems are very
specific, not subject to much outside/hard-to-
quantify influence, you can probably come up
with an acceptable model that the optimization
algorithms can go to work on. So, then, the
problem is: “Can a good model be developed?”
The same thing is even truer for a field like
physics, where the phenomenon trying to be
MBA Review 45
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FINANCE
modeled is very specific, so good models can be
developed. On a final note it seems that financial
engineering people are mostly ex-physicists,
engineers, or mathy-type economists. Perhaps, the
banks would have done better to hire actual
mathematicians who spend a lot more time
working with theorems and, hence, know the
conditions under which the various techniques
work.
Clearly, there’s a problem with trying to learn
all in a two-year masters program. To learn the
enormous amount of math well, plus the finance,
one should take a 5+ year PhD program and years
of learning afterwards as a professor or working in
an investment firm. If one tries to learn all of that
in just two years, one is not going to learn the
math well nor going to learn the finance well; and
it will show on the job.
I know something about finance, so it seems
reasonable to say many financial decisions like
pricing assets are subject to a large amount of hard-
to-quantify influence: Psychology, greed,
irrationality. This means the financial engineering
stuff is not the beginning and the end of financial
expertise.
Conclusion
But at the academic level because of training and work
in this area for years, the financial engineering material
is, in general, as Paul Krugman said, “really useful
stuff”. It has led to important insights and valuable
tools, and will lead to more. It just takes a while to
understand and apply quantitative finance well, given
how advanced it is and certainly, as expected,
mistakes have been made along the way. One can
make most great advances without it, but one can
make additional ones with it.
Quantitative analysis has no doubt, brought
innovation, efficiency and rigor to financial
markets and to the investment process. As the
pace of financial innovation accelerates, the need
for highly qualified people with specific training
in financial engineering would surely continue to
grow in all market environments.
Reference # 16M-2009-03-10-01
March-09