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What is Financial Engineering?
There are numerous definitions of financial engineering, but most
revolve around managing and reducing financial risk. A few definitions from
popular books and web sites include the following:
"Financial engineering refers to the application of various
mathematical, statistical and computational techniques to solve practical
problems in finance. Such problems include the valuation of derivatives
instruments such as options, futures and swaps, the trading of securities,
risk management and regulation of financial markets. No single set of
mathematical tools, computational techniques or financial theory describes
financial engineering. Rather, it is the synthesis of a variety of these
elements. Financial engineering is a practical field and a practitioners’
field by its nature. It is driven in large part by practical problems that
arise in the course of daily business; the nature of the problems demand
that practitioners draw from as broad a palate of tools as possible to find
the best solutions to their problems. A second, related definition is that
financial engineering is the use of financial instruments such as forwards,
futures, swaps, options, and related products to restructure or rearrange
cash flows in order to achieve particular financial goals, particularly the
management of financial risk." Source: International
Association of Financial Engineers - FAQ
"The process of financial engineering can be ... viewed as the
'fine-tuning' of an existing financial product to improve its return or
risk characteristics in light of changing market conditions. It can be
considered as a process which allows existing financial products to be
overhauled and restructured to take advantage of changed taxation, legal or
general economic climate." Source: Eales, B., Financial
Engineering, St. Martin's Press, 2000.
"Financial Engineering is the use of financial instruments to
restructure an existing financial profile into one having more desirable
properties." Source: Galitz, L., Financial Engineering:
Tools and Techniques to Manage Financial Risk, Irwin Professional
Publishers, 1995.
"Financial Engineering is the lifeblood of financial innovation - the
process that seeks to adapt existing financial instruments and processes
and the develop new ones so as to enable financial market participants to
cope more effectively with the changing world in which we live." Source:
Marshall, J.F, and V.K. Bansal, Financial Engineering, Kolb
Publishing Company, 1993.
What are the goals of Financial Engineering?
Usually the primary goal of Financial Engineering is to reduce financial
risk. A secondary goal is to restructure cash flows for better financial
management, such as using a swap to change a variable rate loan to a fixed
rate loan for tax purposes and/or better cash flow predictability.
What type of background is necessary to be a Financial
Engineer? What types of securities and tools are used in Financial
Engineering?
Financial Engineering often uses financial derivative products, such as
options, futures, forwards, and swaps, among others. Bonds and various
fixed-income securities are also used for hedging purposes.
Financial Engineers need a good understanding of investment models,
security valuation techniques, market efficiency, and portfolio theory.
Value-at-Risk (VaR) techniques are also used for understanding market and
portfolio risk.
A firm understanding of statistics, statistical distributions, and Monte
Carlo simulation is necessary. Forecasting techniques, such as regression,
exponential smoothing, moving averages, ARIMA, and GARCH are popular for
time series analysis. Understanding Ito processes, stochastic processes,
geometric Brownian motion, the random walk model, Fourier transforms,
partial differential equations, and game theory is also important.
Computer skills (C / C++, Java, Spreadsheets, Databases) are necessary.
Finally, tools in computational intelligence, such as neural networks,
fuzzy logic, genetic algorithms, chaos, artificial life, and intelligent
agents are being used by some financial engineers for optimization,
forecasting, and understanding market dynamics.
What types of jobs can I pursue as a Financial Engineer?
Since Financial Engineering is quantitative and computational in nature,
Financial Engineers are often called "Quants." Initial jobs for
Quants often involve number crunching, simulation, and analysis. With
experience, Quants begin to trade, structure portfolios, and engineer custom
securities and financial products. Financial Engineers are Quants who are
typically more focused on financial risk reduction. Careers are dynamic and
compensation is often excellent.
Do I have to have a degree in finance or economics to be
a Financial Engineer?
While eventually gaining experience in finance and investment is
necessary, students are often not required to have an undergraduate degree
in finance or economics to pursue a graduate degree with an emphasis in
Financial Engineering. What are necessary are computer skills and a solid
background in mathematics. As such, many students that pursue a graduate
degree in Financial Engineering have an undergraduate degree in Engineering,
Mathematics, Computer Science, or a physical science, such as Physics.
Links to related information
International Association of Financial Engineers
IAFE -
Academic Programs
IAFE - Core
Body of Knowledge
IAFE - Frequently Asked Questions
IAFE -
Industry Links
Financial Engineering and
Risk Management Information
Laboratory for Financial
Engineering at MIT
Real Options Resource
All About
Value-at-Risk (VaR)
Risk Glossary
Futures
and Options Resource on the Web
Firms using
Financial Engineering
Contingency
Analysis (Risk Links)
Game Theory Resource
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