Many financial engineers opine that financial engineering involves a lot of creativity because the field is pioneering and innovating, furthermore, the evolution of cheaper, faster computers has greatly expanded the financial engineering field. It is also controversial and some believe that it increases an economy’s systemic risk instead of decreasing it. For example, financial engineering was largely responsible for the development and use of derivatives like credit default swaps mortgaged backed securities that were blamed for the financial debacle in 2007-08.
According to Zvo Bodie, Professor of Management at Boston University, financial engineering is the application of science based mathematical models to decisions about saving, investing, borrowing, lending and managing risk. It refers to the strategies used by the company to maximize profits or other important performance metrics, for example: creating derivatives that address unusual risks faced by a party to a transaction, structuring a purchase or sale in a way that better addresses the interests of buyer and seller, and using new methods to compute the fair market value of new or existing financial instruments. Financial Engineering is a multidisciplinary field involving business knowledge, financial knowledge, statistics, mathematics and computation. There are a few analytic options that apply to the products and markets, so F.E’s must approximate all the time, and decide what complexities to ignore. Banks, Financial Institutions and Insurance companies hire financial engineers to design math models that lower financial risks and ensure better returns, financial engineers use modelling techniques such as simulations, convexity, duration, value at risk, linear programming and other quantitative techniques to determine future returns, loss scenarios etc. Financial engineers are well versed with topics such as calculus, statistics, along with finance, accounting and economics, they also have a strong background in risk management, modern portfolio theory, option theory along with their math and science backgrounds.
Differences between Mathematical Finance and Financial Engineering
Mathematical finance is a major part of computational finance and mainly uses arithmetic to find out solutions, however, financial engineering is concerned with solving financial problems using engineering principles, a financial engineer need to have a detailed awareness of financial economics and mathematical tools. Mathematical finance professionals mainly do the calculations on risk involved in a particular scenario; they measure risk using complex algorithms and data samples, they make use of engineering principles like mathematics, finance and computer models to make management decisions. A person who has detail knowledge on mathematical finance can work as mathematics modeller, financial statistician or quantitative analyst. Financial engineers are employed in Insurance companies, Banks, wealth management firms as analysts.
Actuarial Science Vs Financial Engineering
Both Actuaries and Financial Engineers work in financial services; Actuaries are the mathematical backbone of the insurance industry. Actuaries look at risk exposures, calculate probabilities, build and design insurance products and services. They are also tasked to hedge risk exposures using different types of financial instruments, there are different types of actuaries for example retirement benefits, enterprise risk, health, etc.
Financial engineers on the other hand work for hedge funds, banks or investment firms. They use their knowledge of finance to build different financial instruments For example: creating new types of option contracts. These instruments are then used by banks or hedge funds as risk management techniques or speculative devices, Financial Engineers apply concepts of typical engineering to the financial markets. Both actuaries and financial engineers require extensive talent in mathematics, especially on applied skills and both the fields require programming skills in C++ and C language.
Financial Engineering for Profitable Financial Instruments