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.

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.