Written by Shohorat Mahapara Purnata
Financial Engineering: The term means using mathematical techniques to solve financial problems. Financial engineering uses tools and knowledge from computer science, statistics, economics, and applied mathematics to address economic issues and develops innovative financial products.
I will teach you about financial engineering in the old school but believe me. The term may be a familiar one to you, but let's get into a deep dive into this topic today. Today's blog will give you an insight into engineering and finance and is just the tip of the world of business, finance, investment, and the stock market.
Financial Engineering is creating new financial instruments or modifying existing ones to meet specific needs. Financial engineers are responsible for creating complex financial products that satisfy the demands of investors, companies, and governments. Financial engineering combines financial theory, quantitative methods, and computer technology to develop and implement solutions for complex financial problems.
The roots of financial engineering began in the 1970s when options trading first started on the Chicago Board of Options Exchange. It gained popularity in the 1980s by developing new financial instruments such as interest rate swaps, futures, and options. Since then, financial engineering has evolved to encompass various financial tools and techniques, including structured products, derivatives, and securitization.
Numerous financial instruments are present, and STRUCTURED PROJECTS are among them. They are created by combining one or more traditional securities such as stocks, bonds, or derivatives. These products are designed to provide a customized investment solution that meets the needs of investors. Structured products offer investors a combination of risk and return tailored to their investment objectives.
One of the most popular structured products is the equity-linked note. Equity-linked notes are debt securities that offer a return linked to the performance of an underlying equity index, such as the S&P 500. The return on the note is typically calculated as a percentage of the index return, and the note may have a maturity date or be callable by the issuer. Equity-linked notes are famous with investors who want exposure to the stock market but are concerned about the risk of investing directly in equities.
Another one is DERIVATIVES, driving their value from an underlying asset, such as a stock, commodity, or currency. Derivatives include options, futures, and swaps. Options give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date. Futures contracts are agreements to buy or sell an underlying asset at a predetermined price on a selected date in the future. Swaps are agreements between two parties to exchange cash flows based on the performance of an underlying asset.
Derivatives are popular because they offer investors a way to manage risk. An investor who owns a stock can use a put option to protect against a decline in the stock price. If the stock price falls, the put option eases value, offsetting the decline. Derivatives are also used by speculators who want to bet on the market's direction or a particular asset.
Lastly, there is SECURITIZATION, the process of creating a new financial instrument by pooling assets such as mortgages, auto loans, or credit card receivables and then selling shares in the pool to investors. The securities created through securitization are known as asset-backed securities (ABS).
ABS offers investors a way to invest in a diversified pool of assets with a higher yield than traditional fixed-income securities. The risk associated with ABS varies depending on the quality of the underlying assets. For example, a pool of prime mortgages will have a lower chance than a pool of subprime mortgages.
Are you feeling bored? Wait, let's learn why financial engineering is crucial for us. Financial engineering can help manage risk by creating financial products that allow investors to hedge their exposure to different types of risk. For example, an investor concerned about interest rate risk can use an interest rate swap to protect against changes in interest rates. Financial engineering can also create products that transfer risk from one party to another. For example, insurance companies use financial engineering to create insurance policies that transmit the risk of loss from the policyholder to the insurance company.
However, financial engineering can also create new risks. For example, the financial crisis of 2008 was partly caused by the creation of complex financial products such as mortgage-backed securities.
Nonetheless, financial engineering has become an integral part of the financial industry, as it allows financial institutions to create innovative products that meet the diverse needs of their clients. Financial engineering has enabled financial institutions to expand their product offerings, increase revenue, and manage risk more effectively.
Financial engineering has also played a significant role in the growth of global financial markets. The development of new financial instruments has allowed investors to access new sources of capital and diversify their portfolios. Financial engineering has also facilitated money flow across borders, enabling companies and governments to raise capital from a global investor base.
However, financial engineering has also been criticized for its complexity, opacity, and potential to create systemic risk. The complexity of some financial products can make it difficult for investors to understand the risks they are taking on. The opacity of some financial products can also make it difficult for regulators to monitor the market and detect potential threats. Finally, the interconnectedness of financial institutions and the complexity of some financial products can create systemic risks that can significantly impact the broader economy.
In response to these concerns, regulators have increased their oversight of financial engineering and introduced new regulations to manage risk. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in response to the 2008 financial crisis, introduced new rules on derivatives trading, securitization, and credit rating agencies.
Despite the challenges and risks associated with financial engineering, it remains a critical discipline in the financial industry. Financial engineering allows financial institutions to develop products that meet the needs of their clients and manage risk more effectively. Financial engineering will be critical in developing new financial instruments and solutions as financial markets evolve.
Sources:
Wikipedia
Investopedia
Business Insights
Harvard Business Review
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