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February 14, 2006
Financial Engineering Defined
Have you ever heard me use the words "financial engineering" and wondered what the heck I was talking about? Are there really financial engineers? Indeed.
Financial engineering is also commonly referred to as "computational finance". Ugh! Sounds awful, doesn't it? That's why I prefer financial engineering. It just seems to be more descriptive for the lay-person.
Wikipedia defines financial engineering as "a cross-disciplinary field which relies on mathematical finance and computer simulations to make trading, hedging, and investment decisions, as well as facilitating the risk management of those decisions. Utilizing various methods, computational finance aims to precisely determine the financial risk that certain financial instruments create."
Financial engineering is a fairly young discipline made possible by advances in hardware and software. Much of the research of financial engineers challenges traditional economic theory. The primary goal of financial engineering is the reduction of risk. The secondary goal is the use of financial instruments to "restructure or rearrange cash flows in order to achieve particular financial goals."
Other explanations of financial engineering are as follows:
"The process of financial engineering can be ... viewed as the 'fine-tuning' of an existing financial product to improve its return or risk characteristics in light of changing market conditions. It can be considered as a process which allows existing financial products to be overhauled and restructured to take advantage of changed taxation, legal or general economic climate." Source: Eales, B., Financial Engineering, St. Martin's Press, 2000.
"Financial Engineering is the use of financial instruments to restructure an existing financial profile into one having more desirable properties." Source: Galitz, L., Financial Engineering: Tools and Techniques to Manage Financial Risk, Irwin Professional Publishers, 1995.
"Financial Engineering is the lifeblood of financial innovation - the process that seeks to adapt existing financial instruments and processes and the develop new ones so as to enable financial market participants to cope more effectively with the changing world in which we live." Source: Marshall, J.F, and V.K. Bansal, Financial Engineering, Kolb Publishing Company, 1993.
"Financial engineering is, in essence, the phenomenon of product and/or process innovation in the financial industries - the development of new financial instruments and processes that will enhance shareholders', issuers' or intermediaries' wealth. In the New Palgrave finance dictionary, John Finnerty lists countless recent financial innovations - from adjustable rate preferred stock to zero-coupon convertible debt - but these all can be classified into three principal types of activities: securities innovation; innovative financial processes; and creative solutions to corporate finance problems." Source: Dean LaBaron
You may be surprised to know that many of the top schools offer degree programs in financial engineering - typically at the graduate level. The most famous is the MIT program but there are many others including Princeton, Cal Berkeley, Carnegie Mellon, Columbia, Wharton, Cornell and countless others.
The offshoot of financial engineering, in my opinion, is that we will see more innovation in financial markets than at any time in our past. Unfortunately, much of that innovation will only benefit financial institutions and corporations. But a trickle down effect cannot be helped.
Financial engineers are working on products this very minute that will better manage the risks we now face as individual investors and that can only be a good thing. In fact, I will be in Boston for the second annual symposium on Managing Retirement Income, being held at MIT, where folks working on this very problem will convene. Like last year, I will blog my notes from each presentation in real time (and in plain English I might add) so that you can get a sense of what is in the pipeline.
SOURCES:
1. Wikipedia, "Computational Finance," http://en.wikipedia.org/wiki/Computational_finance, 14 February 2006.
2. David Enke, "Financial Engineering," http://web.umr.edu/~enke/main_financialeng.html, 14 February 2006.
3. Dean LaBaron, "Financial Engineering," http://www.deanlebaron.com/book/ultimate/chapters/fin_eng.html, 14 February 2006.
Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.
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Kim Snider is an author, speaker and host of Financial Success Coaching, Saturdays at noon, on KRLD Newsradio 1080, Dallas - Fort Worth. This blog is primarily devoted to empowering individual investors with information to help them be good stewards of their money. Above all, it is about achieving true financial success. Kim's book, How To Be the Family CFO: Four Simple Steps to Put Your Financial House in Order is in bookstores now. Order yours from Amazon or other fine booksellers today.
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