Dear Team,
Innovation is the corner stone of any successful business; Innovation simply means fresh thinking and approaches, that add value to consistently create wealth and social welfare.
Innovation is nothing new for the financial world as there has been constant innovation in the way we do our business, starting from the barter system to where we are now, using electronic transfer through credit cards and net banking for all our purchases. The way we invest has also changed with numerous options available to suit any investor today when compared to the options which existed a few years back.
While the term financial engineering is new to most of us, we have been practicing parts of it while handling each of our personal finances.
Financial engineering broadly is classified into three major activities: securities innovation; innovative financial processes; and creative solutions to corporate finance problems.
Financial engineering has taken the center stage. In Andrew Lo’s words, “Despite the recent turmoil in financial markets or perhaps because of it, quantitative methods have become indispensable to even the most hardened fundamental investment manager.”
Indeed, the distinctions between fundamental, technical and quantitative have become blurred - all three approaches to financial decision-making are now subsumed by the term financial engineering'.
Charmaine Suares from our Mumbai office gives you a wonderful insight of financial engineering, its application, and its future in the following article.
Happy reading
Cheers !
Anil S Kumar
Head – Corporate Relations; CAS
Finance is the life and blood of business organizations.
The study of finance is not just limited to theoretical description and analysis of financial statements but has now reached the engineering stage.
Regards,
Charmaine.
Financial Engineering is the development and creative application of financial technology for solving financial problems, exploiting financial opportunities, and for otherwise adding value.
It is normally used in the securities, banking, financial management and consulting industries, or as quantitative analysts in corporate treasury and finance departments of general manufacturing and service firms.
The new products created by financial engineers can serve as solutions to problems or as ways to maximize returns from potential investment opportunities.
Some of the forces stimulating Financial Engineering are, risk management, tax advantages, agency and issuance, cost reduction, regulation compliance or evasion, interest and exchange rate changes, technological advances, accounting gimmicks and academic research.
Popularity of financial engineering
The enormous Popularity of financial engineering can be attributed to three factors.
1. The complex nature of the finance system overtime due to economic growth and development.
2. The set of breakthroughs in the quantitative modelling of financial markets, for example, financial technology.
3. An almost parallel set of breakthroughs in computer technology, including hardware, software, and data collection and organization.
Without these breakthroughs, much of the financial technology developed over the past thirty years would be irrelevant.
Emergence of Financial Engineering
JPMorgan Chase & Co. was the pioneer in introducing FE and also started a large derivatives business. Their Risk Metrics Technical Document changed the course of risk management greatly and in addition had a major impact on financial theory and quantitative methods.
The emergence of financial engineering has also been influenced by the realization on Wall Street in the early to mid-1990s that there was a need for a new kind of graduate training. The financial institutions wanted people with heavy mathematics skills and some finance training. Universities began to respond to the demand by setting up masters programs in financial engineering.
Andrew Lo - Professor of Finance at the MIT Sloan School of Management (also known as the Guru of Financial Engineering) comments, ‘The recent turmoil in financial markets, or perhaps because of it, quantitative methods have become indispensable to even the most hardened fundamental investment manager. Indeed, the distinctions between fundamental, technical and quantitative have become blurred - all three approaches to financial decision-making are now subsumed by the term financial engineering'.
Applications and Practices of FE
Mutual funds (MFs) are the most common example of practical applications of financial engineering wherein diverse individual securities are packaged in different proportions in order to meet different objectives such as growth, high return or stable income of the investors.
Financial reinsurance is designed to minimize the outflow of resources of an insurer when there is reduction in the premium growth or heavy insurance payments due to unforeseen events. FE helps in creating an insurer to remain solvent and stable when faced with unwarranted circumstances.
JP Morgan pioneered Value-at-Risk (VaR) to quantify the risk of a bank’s asset portfolios. VaR was extended to industrial firms in the form of currency risk management and enterprise-wide risk management.
Various forms of “asset-backed” bonds were created, most notably mortgage-backed bonds.
Catastrophe, or CAT, bonds were developed covering weather, earthquake, and other naturally occurring catastrophes.
Credit derivatives allow one to manage default risk valuing the Impact of Financial
Engineering.
All these innovations are implemented using a few basic techniques, such as increasing or reducing risk.
Areas where financial engineering techniques are employed
· Investment banking and Insurance
· Corporate Strategic planning
· Risk management
· Primary and derivative securities valuation / Commodity Valuation
· Swaps & derivatives trading or dealing
· Financial information systems management
· Portfolio management
· Securities trading
· Consulting Industries
· Corporate Treasury departments
· Forecasting
· Mortgage agreements
· Design of market mechanism
· Manufacturing and service firms
The engineering aspect of this field involves design and development of new financial securities or breaking and combining existing securities for trading, investment and hedging purposes.
Financial Engineering innovations in the Indian banking sector
The recent Financial Engineering innovations in the Indian banking sector amongst many others include Electronic Fund Transfer, Prefunded Cheque, and Cheque Truncation System (CTS), Biometric ATMs for National Rural Employment Guarantee Act (NREGA), Fixed Deposit (FD) Products, Gold Deposit, Reverse Mortgage Product, innovations in the insurance sector, Market Linked Pension Product, Insurance Linked Education Loan, Customized Insurance Policies, Insurance Policies with Terrorism Cover, Insurance Cover on Lost Credit Cards, Micro Insurance Products, Micro Insurance for Women, and financial innovations in mutual fund sector.
Impact of Financial Engineering
· Financial Engineering has an impact on banking, contributing in the areas of sourcing of capital, allocation of capital and risk management.
· It has made distinct contributions in analyzing and affecting sustainable competitive advantage.
· Large companies employ teams of financial engineers to use highly mathematical, statistical analysis to model possible scenarios and construct synthetic financial products or fine-tune existing products to meet the needs of the company's financial requirements.
· Approximately 150 universities worldwide offer a degree in Financial Engineering or one of three closely related fields: Mathematical Finance, Quantitative Finance, and Computational Finance.
· India has witnessed phenomenal growth in innovations in financial markets in the last three decades.
Recruitment in Financial Engineering
There is a growing demand for professionals with analytical expertise in the design of innovative financial products and also having knowledge of structured products, pricing of securities and market mechanism.
With the aid of tools, techniques and technology, financial engineers create improved and innovative financial products, find solutions to problems and also maximize the returns of potential investment opportunities. They study the financial reports in detail and also measure and quantify risks.
The need for trained financial engineers has increased tremendously. People are needed to thoroughly understand the financial products and underlying mathematics even to sell them to prospective buyers.
Financial Engineers :
Financial engineers hold one of the most enviable positions.
Investment banks, commercial banks, hedge funds, insurance companies, corporate treasuries, and regulatory agencies employ financial engineers.
Firms looking for financial engineers include banks, the securities industry, the financial management and consulting industries, as well as hedge funds and government agencies.
More and more industries are realizing the value of mathematics in making sound business decisions, and this is truer than ever in the world of finance where valuing financial products requires an ever increasing amount of technical expertise.
Connection to Computer Science
This is a field of knowledge that is drawing the attention of computer science graduates with a good mathematical background.
Computer programming plays a major part in financial engineering. Computational finance is a closely related field to financial engineering. Financial engineers working on computational finance use programming languages such as C++ to create programs that determine risk.
Financial engineers working in computational finance are often called quants, short for quantitative analysts.
To Conclude: Financial engineering will grow in global importance due to, the globalization of production and distribution, the drive for increased economic efficiency and the universality of money
Research in FE would help in responding to the growing complexity of international financial markets.
