What is Financial Engineering?
Financial engineering as the name suggests is a marriage of two critical age-old concepts finance and engineering, which uses mathematical techniques, financial theories, engineering tools and advanced programming techniques to solve critical and complex financial problems like inconsistent cash flows generation, restructuring illiquid assets into liquid ones, creating perfect hedge on the derivatives, etc.
Example of Financial Engineering
It involves multiple fields like financial products, statistics, programming, etc to come up with innovative but structured products. One of such examples is securitization.
Securitization is the process of changing an illiquid asset or group of such assets and converting them into new structured products that can be attractive to investors and hence can be more liquid than the assets from which they have originated. A typical example is Mortgage-backed securities (MBS). Here the typical real estate projects which were lying vacant and were avoided by investors were restructured and sold as MBS. Once these individual units were packaged into a pool (MBS), they became liquid and were the darling of investors in the early 2000s.
How to use Financial Engineering?
- Need Identification: The first and foremost step is to do a primary analysis and come up with a hypothesis that there are a need and demand in the market.
- MVP Creation: Based on the research (both primary and secondary) conducted in step 1, a minimum viable product is created based on basic demands. This product will be refined further as per feedbacks received.
- Complex Model Designing Workshop: Based on the feedback and suggestions received from the users, designers, and developers, a workshop is conducted to brainstorm and a detailed discussion is carried out to include the complexities and design a new scope for the product
- Product Quality Assurance: The inculcated complexities need to be tested making sure that the crux of the product is much more useful and robust.
- Perfect Product: The product thus created can be called as a perfect one as it has undergone the transformation from MVP to a final product.
- Pricing: Now the sales team has to come up with the pricing of the product based on multiple factors like the ability to disrupt, need in the market if it caters to a niche market
- Marketing: The success of any product depends on how the product is marketed as the end-users have to be taught about its capabilities and usefulness. This becomes more important if the product caters to a niche market.
- Product Launching: How the product is launched and what distribution channels are utilized to implement go to market strategy is the final but one of the most important steps.
Types of Financial Engineering
#1 – Repackaging Structured Products
This makes use of mathematical techniques such as stochastics, simulations, and analytics to design and implement new approaches to explore solutions to problems in finance. In the procedure of finding new solutions, new strategies can also be developed for the benefit of the company to maximize corporate profits.
#2 – Options Trading
An interesting fact that dates back to 1973 is that two financial engineers Fischer Black and Myron Scholes came up with an option pricing model, which was popularly known as the Black Scholes model. To this day it is one of the best models and traders across the globe use it to price the option premiums and plan their hedging strategies, entry and exit strategies and to calculate implied volatility. In fact availability of some simple and yet useful has made trading in options so easy that there has been an unprecedented increase in the option trading volumes for both financial and commodity products.
- With the help of the techniques that comprise mathematical modeling and computer engineering, one can test, analyze, find new approaches and tools for investment analysis, debt structuring, investment options, trading strategies, financial models, etc.
- Any future date events such as contracts or investments have high risk involved due to uncertainty attached to it. In such cases, It helps corporates reduce risk in investments or contracts involving future delivery of services or commodity futures with its calculation techniques for future returns.
- This concept is to analyze the worth of each balance sheet and profit and loss account item for the future benefit of the business. This can help corporates to clean up adverse items and focus more on profitable items. These activities also result in better tax assessments for firms.
#1 – Speculation
It has also given rise to various speculative practices in the market. This is also given markets different viewpoints and outlooks.
#2 – New Products without Understanding the Risks Leading the 2008 Crisis
To provide insurance against defaults on bond payments credit default swap were developed to speculate the estimated losses if any. These newly designed complex products grew very popular among the front-end traders and investment bankers as they provided a technique to generate consistent cash flows with minimum leverage. Such was the marketing and distribution that there was no due diligence and many of the perils like high correlation, huge leverage, no collateralization and restructuring of junk bonds into high graded bonds were completely ignored.
This lead to an increased level of speculative trades as traders were able to generate a fixed income based on premiums and huge leverage. Everyone was happy as investors were getting good returns, traders were getting fat pay cheques and investment firms were growing exponentially leading to a bubble that burst in 2008 leading global economy into the biggest recession of all time. Such a sad end to a beautiful start
This can help individuals to assess and analyze the total risk and returns of their portfolio. With the help of this analysis, strategies can be formulated to reduce the total risk to the minimum possible level. Further, it can be used in various fields such as corporate finance, derivatives pricing, financial regulation, portfolio management, risk management, valuation of options, etc.
This has been a guide to What is Financial Engineering & its Definition. Here we discuss how to use financial engineering and types along with examples, advantages, and disadvantages. You can learn more about from the following articles-