lecture 1: overview of nancial engineering financial...

Lecture 1: Overview of financial engineering

Financial Engineering for Undergraduates

Yang, Zhaojun

� [email protected] � http://zjyang.blog.hnu.cn

School of Finance and Statistics, Hunan University

September 5, 2013

c© Yang, Zhaojun (Hunan University) Overview of financial engineering September 5, 2013 1 / 29

http://zjyang.blog.hnu.cn

Overview of financial engineering

1 What is financial engineering?

2 Examples: the work of a financial engineer

3 Computational finance and mathematical finance

4 The father of financial engineering

5 The applications of financial engineering

6 Criticisms

7 References








6 Criticisms

7 References


Wikipedia: FE is a multidisciplinary field

Financial engineering (FE) is a multidisciplinary field involvingfinancial theory, the methods of engineering, the tools ofmathematics and the practice of programming.

It has also been defined as the application of technical methods,especially from mathematical finance and computational finance,in the practice of finance.

Despite its name, financial engineering does not belong to any ofthe fields in traditional engineering.

In the United States, financial engineering programs areaccredited by the International Association of FinancialEngineers.


FE and innovative financial technology

Financial engineering may be broadly defined as the developmentand creative application of innovative financial technology.Financial technology includes financial theory, quantitativetechniques, financial products, and financial processes.At a microeconomic level, the motivation behind financialengineering is to produce profits for the innovators by findingbetter ways to address society’s needs.At a macroeconomic level financial engineering helps improvethe allocation of scarce resources.Allocation of resources is the fundamental objective of anyeconomic system.Indeed, financial engineering epitomizes Joseph Schumpetersview of capitalism as “creative destruction.”New products replace old products, new theory improves on oldtheory, and new processes supplant old processes.


Who is a financial engineer?

Financial engineering draws on tools from applied mathematics,computer science, statistics and economic theory.

In broadest definition, anyone who uses technical tools in financecould be called a financial engineer, for example any computerprogrammer in a bank or any statistician in a governmenteconomic bureau.

However, most practitioners restrict the term to someoneeducated in the full range of tools of modern finance and whosework is informed by financial theory.

It is sometimes restricted even further, to cover only thoseoriginating new financial products and strategies.








6 Criticisms

7 References


Financial innovations

Financial engineering is a process that uses existing financialinstruments to create a new and enhanced product of some type.

Just about any combination of financial instruments andproducts can be used.

The process may involve a simple union between two products,or make use of several different products to create a newproduct that provides benefits that none of the otherinstruments could manage on their own.


First example: financial reinsurance

One excellent example of financial engineering is financialreinsurance.

Companies that offer reinsurance options essentially provide away for the ceding insurer to minimize a drain1 on availableresources when a major shift in premium growth or reduction istaking place.

In this scenario, the process helps to create a stable environmentthat will allow the insurer to remain solvent and stable evenwhen extreme conditions exist.

1The continuous loss or expenditure of a particular resource.c© Yang, Zhaojun (Hunan University) Overview of financial engineering September 5, 2013 9 / 29

A digression: what is reinsurance?

Reinsurance is insurance that is purchased by an insurancecompany (the “ceding company” or “cedant” or “cedent” or“ceding insurer” under the arrangement) from one or more otherinsurance companies (the “reinsurer”) as a means of riskmanagement, sometimes in practice including tax mitigation andother reasons described below.

The ceding company and the reinsurer enter into a reinsuranceagreement which details the conditions upon which the reinsurerwould pay a share of the claims incurred by the ceding company.

The reinsurer is paid a “reinsurance premium” by the cedingcompany, which issues insurance policies to its own policyholders.


Second example: working for consumers

For the consumer, the work of a financial engineer to create newproduct offerings can be a great advantage.

In some instances, the new and improved product is simply arepackage of several independent but complimentary productsmade available at a lower price (Tao Can!).

For example, the consumer may find that purchasing insurancecoverage2 that provides dental, hospital, and prescriptioncoverage may be significantly less expensive than purchasingindividual plans.

2The amount of protection given by an insurance policy.c© Yang, Zhaojun (Hunan University) Overview of financial engineering September 5, 2013 11 / 29

Last example: an application in thetelecommunications industry

Financial engineering works in other environments as well.

The financial theory of offering several existing products underone package has become very common in thetelecommunications industry, and many providers today offerbundled service packages that include local phone service,unlimited national long distance, Internet service, and cable ordigital satellite television.

The end result of this type of arrangement means one lowerprice to obtain three or more services at significant cost savingsto the consumer.








6 Criticisms

7 References


The relationship with computationalfinance and mathematical finance

Computational finance and mathematical finance are bothsubfields of financial engineering.

Computational finance is a field in computer science and dealswith the data and algorithms that arise in financial modeling.

Mathematical finance is the application of theoreticalmathematics to finance.


Another eye

FE is sometimes known as computational finance since it reliesheavily on mathematically calculating the outcome if variouscombinations of financial instruments are offered under oneumbrella as a package deal.

Usually, the calculations indicate that the providers stand to dovery well with the new hybrid financial product, as the productholds the potential to attract new consumers who would haveforegone use of one or more of the instruments if the only optionwas to purchase them individually.








6 Criticisms

7 References


Paul A. Samuelson

The following is abstracted from The Father of FinancialEngineering, Bloomberg Markets April 2008, authored by PeterCarr, the winner of Financial Engineer of the Year award in 2010awarded by International Association of Financial Engineers.

In 1965, Samuelson published two papers in the same issue of anMIT journal called Industrial Management Review.

The first one, Proof That Properly Anticipated Prices FluctuateRandomly, proved that in an informationally efficient andfrictionless market, futures prices would follow a martingale,once the effects of the markets aversion to risk have beenaccounted for · · ·


Paul A. Samuelson, ctd

The other paper by Samuelson in the spring 1965 issue of thejournal is called Rational Theory of Warrant Pricing.

The paper includes an appendix written by Henry McKean, nowof New York University, whom Samuelson refers to in theDecember interview as a hotshot mathematical probabilist.


Louis Bacheliar

Louis Bachelier pioneered the study of financial engineering wellbefore it became central to financial practice.

His doctoral thesis, The Theory of Speculation (1900), helpedoriginate the mathematics and modeling of finance, and thetheory of Brownian motion.

Public acknowledgement of his work, richly deserved for theinnovations he brought to financial theory, did not really arriveuntil after his death, when he was rediscovered by those (saySamuelson) founding modern financial theory in the 1950s.








6 Criticisms

7 References


The applications include · · ·

Securities Pricing

Risk management

Portfolio Optimization

Corporate finance

Financial regulation

Structured products

· · ·


Securities Pricing

We can typically identify two classes of securities: primitivesecurities and derivative securities.Examples of primitive securities are stocks and bonds whereasoptions, futures and swaps are examples of derivative securities.It is probably fair to say that financial economics is moreconcerned with pricing primitive securities, usually usingequilibrium arguments (e.g. supply = demand) to do so.Financial engineering is typically more concerned with pricingderivative securities and uses arbitrage arguments to do so.This distinction is not hard, however, and sometimes it isnecessary to use equilibrium arguments when pricing derivativesecurities.Moreover, some models such as the Capital Asset Pricing Model(CAPM), are equilibrium-based models that are of fundamentalimportance to both financial economists and financial engineers.


Risk management

Risk management is concerned with understanding the risks thatare inherent to your portfolio of securities.

For example, you might be interested in determiningP(WT/W0 ≤ 0.8), i.e., the probability that you will have lostmore than 20% of your wealth by time T .

If this probability is unacceptably high then you need to adjustyour portfolio to reduce this probability.

There are a number of interesting and challenging questions thatare related to risk management.


Portfolio Optimization

At the most basic level, portfolio optimization is the problem ofchoosing a trading strategy with the goal of optimizing someobjective function that measures the performance of theportfolio.

For example, you may wish to solve

maxθ

E[u(WT (θ))], subject to various constraints

where θ is the (possibly dynamic) trading strategy, WT (θ) isterminal wealth and E[u(WT (θ))] is the objective function.

The problems of security pricing and portfolio optimization areintimately related.








6 Criticisms

7 References


Comments of Paul A. Samuelson

Samuelson writes that financial engineering is like the sciencethat can help mankind or create atomic bombs.

Under proper regulation and with optimal transparency, it canspread risk efficiently and in that sense reduce intrinsic riskiness.

But sans (without) transparency and lacking understanding ofthe arithmetic of cancerous leveraging, maybe it introduces intomodern finance new fragility (the quality of being easily brokenor damaged).








6 Criticisms

7 References


References

Higham D. An Introduction to Financial Option Valuation,Cambridge 2004

Shreve S E. Stochastic Calculus for Finance I: The BinomialAsset Pricing Model. Springer, 2004

Shreve S E. Stochastic Calculus for Finance II: Continuous-TimeModels. Springer, 2004

Cochrane J. Asset Pricing, Princeton University Press, Princeton2001

Duffie D. Dynamic Asset Pricing Theory, Third Edition,Pricnceton University Press 2001

Yang Z J. The foundation of Financial Engineering, in progress,http://blog.hnu.cn/resserver.php?blogId=71&resource=FEbook.pdf


Thank You !

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