Table of Contents
- What Is Financial Engineering?
- Key Takeaways
- Understanding Financial Engineering
- Types of Financial Engineering
- Derivatives Trading
- Speculation
- Criticism of Financial Engineering
- Do Financial Engineers Make a Lot of Money?
- Does Financial Engineering Require Coding?
- Is Financial Engineering a Major?
- The Bottom Line
What Is Financial Engineering?
Let me tell you directly: financial engineering is that part of the financial sector where we use computer science, statistics, economics, and applied mathematics to tackle quantitative financial problems. It's all about analyzing financial markets, fixing current issues, and coming up with new financial products.
You might hear it called quantitative analysis, and it's something regular commercial banks, investment banks, insurance agencies, and hedge funds rely on.
Key Takeaways
Financial engineering boils down to using mathematical techniques to solve financial problems. Financial engineers test and roll out new investment tools and analysis methods. They work in places like insurance companies, asset management firms, hedge funds, and banks. This field sparked a huge increase in derivatives trading and speculation in the markets. It has transformed financial markets, but it also had a hand in the 2008 financial crisis.
Understanding Financial Engineering
The financial industry keeps inventing new investment tools and products for investors and companies, and most of them come from financial engineering techniques.
By applying mathematical modeling and computer science, financial engineers test and launch new tools—like new ways to analyze investments, new debt offerings, new investments, trading strategies, and financial models.
They run quantitative risk models to forecast how an investment tool will perform, if a new financial offering will be viable and profitable over time, and what risks come with each product given market volatility.
Financial engineers are found in insurance companies, asset management firms, hedge funds, and banks. In these roles, they handle proprietary trading, risk management, portfolio management, pricing derivatives and options, structured products, and corporate finance.
Types of Financial Engineering
Financial engineering uses stochastics, simulations, and analytics to design and implement new financial processes that solve problems and create strategies for maximizing corporate profits. For instance, it led to the boom in derivative trading.
Derivatives Trading
Since the Cboe Options Exchange started in 1973, and with the option pricing model from Fischer Black and Myron Scholes, trading in options and derivatives has exploded.
Beyond basic options strategies where you buy calls or puts based on being bullish or bearish, financial engineering has introduced more options like married puts, protective collars, long straddles, short strangles, and butterfly spreads, giving you more ways to hedge or profit.
Speculation
Financial engineering has also brought speculative instruments into the markets. Take credit default swaps (CDS), created in the late 90s to insure against defaults on bonds like municipal ones.
Investment banks and speculators saw they could profit from the monthly premiums by betting with CDS. The seller, often a bank, gets monthly payments from buyers. The CDS value depends on a company's survival—buyers bet on bankruptcy, sellers insure against it.
If the company stays solvent, the bank keeps getting paid. If it fails, buyers collect on the credit event.
Criticism of Financial Engineering
Financial engineering has revolutionized markets, but it contributed to the 2008 crisis. As subprime mortgage defaults rose, more credit events hit, and CDS issuers couldn't pay out since defaults happened simultaneously.
Corporate buyers with CDS on mortgage-backed securities found them worthless, leading to asset devaluations on balance sheets, more corporate failures, and the recession.
Because of the 2008 recession from these engineered products, financial engineering is controversial. Still, it's clear this quantitative field has improved markets with innovation, rigor, and efficiency.
Do Financial Engineers Make a Lot of Money?
Yes, they do. The average total pay is $140,000, ranging from $105,000 to $193,000, depending on company, location, and experience.
Does Financial Engineering Require Coding?
Generally, yes—you'll need knowledge of at least one programming language. Jobs vary, but to compete, you should be able to code.
Is Financial Engineering a Major?
Some colleges offer it as a major, but not all. You can still study related courses in mathematics, computer science, statistics, and finance.
The Bottom Line
Financial engineering is essential in the financial world. It uses mathematics, statistics, computer science, and more to innovate with new products, better modeling, investments, and improving financial institutions' profits. It has mostly bettered the field, though it has caused economic issues at times.
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