Financial Engineering : Meaning, Types & Uses

What is Financial Engineering?

Financial engineering is an outcome of quantitative analysis developed by quantitative analysts. They design algorithmic or Artificial Intelligence (AI) trading programs for use in the financial markets and it is used by commercial banks, investment banks, hedge funds, and insurance agencies. A multidisciplinary and broad field of study, which practically implies engineering methodology and approach to the financial world, is termed Financial Engineering. In simple terms, Financial Engineering is the result of using mathematical/engineering tools and techniques to solve financial problems. This broad field of study uses tools and techniques from various areas, such as applied mathematics, economics, statistics, computer science, and finance solve and design innovative financial products.

Who is a Financial Engineer?

A Financial Engineer is called to someone who has the required skills and knowledge of financial engineering. Financial engineering’s main motive is to optimise the financial management of a business among a wide array of corporations. Often companies hire an expert financial engineer to either work as an investment manager or as a banker or a trader. Some of the key responsibilities of a financial engineer are listed below:

• Developing financial modules where technology, data, and mathematical calculations are integrated to predict the financial markets.
• Helping businesses to make financial decisions and mitigate risk by diversifying the portfolio.
• The volatility of the stock market is a matter of concern for financial engineers. Their recommendations and suggestions largely depend on how they have predicted and analyzed the stock market.
• Accessing technological upgrades is one of the key responsibilities of financial engineers as they deal with different financial tools and data. Using upgraded AI can also reap benefits in designing effective and efficient algorithms and tools in the finance domain.

How to become a Financial Engineer?

For choosing a Financial Engineer as the career path often requires various skillsets and expertise. Below listed are the steps which help one to build a career in financial engineering.

1. Grab a Degree: A degree in financial engineering or a related field would give an edge in the hiring process by an employer. For entry-level job positions, industry-specific skill sets should be focused on during graduation period. An internship in financial engineering where on-the-job skills are acquired may be a boon to earn the job.

2. Choose a Specialisation: Deciding the specialisation area as a financial engineer is important as one can take the necessary steps towards building a strong brand for yourself in that particular area.

3. Start Your Career with an Entry-Level Position: Once a degree is earned in this field, an entry-level position can be a good start to begin your career. Generally, a degree can be obtained within 2 years, and then you can pursue being a financial engineer. Depending on the nature of the role one has chosen, one can opt for various certification courses available online.

4. Advance in Your Career: One can take 2 years of entry-level position as a financial engineer after which he/she can be promoted to the next seniority level. Each advanced financial engineer position is applicable for at least 2 years of experience at each level to rise on the growth ladder of financial engineer. An additional education or degree, or a Master’s degree in a related field or special certifications courses would suffice for climbing the positional ladder.

5. Continuous Upgradation of Knowledge and Skills: All industries and corporations do not require continued learning but to advance in this financial engineering career path, one must keep learning and improve their skills and earn degrees to rise the career ladder quickly.

How Financial Engineering is Used?

The financial industry is consistently developing with new and innovative investment products and services for the various stakeholders. The products developed are mostly linked to the field of financial engineering. Financial engineers use different models of mathematics and computer science to test and release new tools and techniques in the market. A few of those tools and techniques are:

• New Methods of Investment Analysis
• Debt Offerings
• Trending Investments Opportunities
• Trading Strategies
• Latest Financial Models.

The job of financial engineers is to examine quantitative risk models which would forecast the performance of an investment tool, check the viability and feasibility of new products or services in the financial sector, and the risk associated with each of the offerings considering the uncertainty of the market. The financial engineers collaborate with insurance companies, banks, asset management firms and hedge fund corporations where they focus on the following:

• Proprietary Trading
• Portfolio Management
• Derivatives and Options Trading
• Risk Management
• Corporate Finance Departments
• Structured Products

Types of Financial Engineering

There are broadly two types of financial engineering that encompass several forms of trading and which require thorough market analysis and forecasting, Derivative Trading and Foreign Market Exchange Trading.

1. Derivative Trading

This trading was developed when financial engineers were targeting to maximise company profit by formulating new strategies. It is still now understood that financial engineering implements simulations, stochastics and analytics to formulate solutions to financial problems. But this trading is not a solution rather are agreement which has no monetary value. These financial agreements are related to assets, interest rates or indexes and the value of these derivatives depends on the performance of the underlying asset or commodity with time. In 1973, two financial engineers Fischer Black and Myron Scholes designed their option pricing model and at the same time, CBOE Option Exchange was formed. From then, trading in the derivative market grew exponentially. Traditionally option strategy comprises call and put options. But thanks to the financial engineers who have developed the latest strategies within the options range which would reap more chances to hedge or make profits.

2. Foreign Market Exchange Trading

This type of trading is beneficial in the global markets and the financial engineers utilise this market to maximise company profit. The forex market is dominated by currency exchange rates and thus, the companies hold on to different forms of foreign currencies from different regions. The engineers predict the foreign exchange rates whether they will rise or decline, and depending on this prediction, related brokers trade in the forex market to maximise profit and minimise loss.

Benefits of Financial Engineering

1. Reduced Risk: For a multinational company, currency or price fluctuations are a big issue or hurdle which they have to face. Use of financial engineering methodologies would cover those risks by offering products which would cushion the business from future market volatility.

2. Provide Compensation: Retention of key employees and engaging the high-performing management in the shares of the business is one of the primary focuses of an organisation. Providing stocks is a beneficial strategy as it has the capacity to enhance the performance of high-priced stocks. Financial engineering is a helpful technique to understand the repercussions of inserting stocks over cash in the company’s financial statements.

3. Contingent Payments: Companies use the tools and techniques of financial engineering to offer contingency payments to the contractual provisions. Also in the case of convertible loans or some other business agreements financial engineering can be put in place. Contingency payments can be further used to control risky business opportunities or ventures.

Limitations of Financial Engineering

1. Building Complexity: Apart from the benefits financial engineering incurs, limitations also persist in its tools and techniques. And one of the main limitations is its complex nature for solving various financial problems, financial engineering uses various complicated mathematical formulas and equations. Thus, the slightest mistake in the calculations could lead to huge complexities which ultimately would lead to the repetition of the entire process from the beginning.

2. A Hard Road for Investors: These techniques in solving financial problems cannot be used by investors or business themselves although it is used for their problems. Only a financial engineer is capable of using these techniques to solve the problems due to its complex nature as everyone won’t be able to understand or use it effectively.

3. Still a Controversial Area: During the 2008 financial crisis, financially engineered products were in the market which lent a hand in the crisis. The subprime mortgage was one of the major products during the crisis. Credit default swaps (CDS) were issued by the banks, but soon it was scraped as CDSs carried no value. The great 2008 financial crisis story says it all.

Frequently Asked Questions (FAQs)

1. Who was the first one to become a financial engineer?

Answer. The first person to become a financial engineer was Robert C. Merton who made it his profession. He is also known to be the father of financial engineering.

2. Which programming language is used to solve problems in financial engineering?

Answer. In financial engineering to solve financial problems Python, Ruby, SQL, C++, Java, C#, etc., are some of the commonly used programming languages.

3. What does a Financial Engineer do?

Answer. A financial engineer analyses and tests the recent investment tools and strategies. They also deal with insurance firms, asset management companies, banks and hedge funds along with thoroughly analyzing the stock market. In the US, the average remuneration of a financial engineer is around $106,377 per annum.

4. What are the important tools used by financial engineers?

Answer. Credit derivatives, money market instruments, cash instruments and a few more are some of the tools used by financial engineers. Options namely ‘Vanilla’ and ‘Exotics’ and interest rates associated with these options are also used by the financial engineers as important tools.

5. What is the financial engineering degree?

Answer. The financial engineering degree is a course on a multidisciplinary study of theoretical finance comprising the application of programming tools, mathematical models and engineering techniques. This degree would help graduates enter the banking industry, consulting and financial securities and financial management.