Back to: ECONOMICS, FINANCE, & ACCOUNTING
Financial engineering (or quantitative analysis) is the application of various technical fields, particularly applied mathematics and computer science, to the development of financial products – such as derivative assets.
Financial engineering is generally carried out by banks, managed funds, and insurance agencies.
A Little More on What is Financial Engineering
Financial engineers or quantitative analysts employ mathematics and computer systems to develop approaches to analyzing and creating new investment vehicles, investment models, trading strategies, and other forms of financial instruments.
The objectives of these approaches are to develop new methods of investing money and determining how these investments will perform. Many derivative assets (investments that derive their value from other assets) were developed using financial engineering. High-powered computers applying sophisticated mathematical formulas are able to project how certain assets will perform with respect to other assets.
Academic Research on Financial Engineering
Implementing Derivative Models (Wiley Series in Financial Engineering), Clewlow, L., & Strickland, C. (1996). Implementing Derivative Models (Wiley Series in Financial Engineering). This paper examines the increased global implementation of the Derivatives Models Les Clewlow and Chris Strickland Derivatives markets, particularly in the over-the-counter market in complex or exotic options. The paper further analyses the limited availability of information regarding the theory and applications of the numerical techniques required to succeed in these markets and the problems it could pose.
Financial engineering in corporate finance: An overview, Finnerty, J. D. (1988). Financial engineering in corporate finance: An overview. Financial management, 14-33. This introduction to the special issue provides an overview of financial engineering in corporate finance. It characterizes the process of financial innovation, describes the factors that stimulate financial innovation, and evaluates a variety of financial innovations within this framework in order to assess the sources of the value added by each.
Longevity bonds: financial engineering, valuation, and hedging, Blake, D., Cairns, A., Dowd, K., & MacMinn, R. (2006). Longevity bonds: financial engineering, valuation, and hedging. Journal of Risk and Insurance, 73(4), 647-672. This article examines the main characteristics of longevity bonds (LBs) and shows that they can take a large variety of forms which can vary enormously in their sensitivities to longevity shocks. The authors examine different ways of financially engineering LBs and consider problems arising from the dearth of ultra‐long government bonds and the choice of the reference population index. The article also looks at valuation issues in an incomplete markets context and finishes with an examination of how LBs can be used as a risk management tool for hedging longevity risks.
The determinants of stock price exposure: Financial engineering and the gold mining industry, Tufano, P. (1998). The determinants of stock price exposure: Financial engineering and the gold mining industry. The Journal of Finance, 53(3), 1015-1052. This paper studies the exposure of North American gold mining firms to changes in the price of gold.
How financial engineering can advance corporate strategy, Tufano, P. (1996). How financial engineering can advance corporate strategy. Harvard Business Review, 74(1), 136-146. In this paper, the author looks at how financial engineering can help senior managers achieve their companies’ objectives. He presents five case studies that illustrate innovative applications of financial engineering and helps managers determine when such techniques are appropriate. The cases highlight five companies that faced different challenges: Enron Capital & Trade Resources, Tennessee Valley Authority, Rhone-Poulenc, Cemex, and MW Petroleum Corporation. The cases show that collaboration between managers and financial engineers can help create a competitive edge in a corporation.
Retail banking and behavioral financial engineering: The case of structured products, Breuer, W., & Perst, A. (2007). Retail banking and behavioral financial engineering: The case of structured products. Journal of Banking & Finance, 31(3), 827-844. In this paper, the authors apply cumulative prospect theory and hedonic framing to evaluate discount reverse convertibles (DRCs) and reverse convertible bonds (RCBs) as important examples of structured products from a boundedly rational investor’s point of view. Conclusions are documented withing the text.
Incoherence of contract-based Islamic financial jurisprudence in the age of financial engineering, El-Gamal, M. A. (2007). Incoherence of contract-based Islamic financial jurisprudence in the age of financial engineering. Wis. Int’l LJ, 25, 605. This paper analyses the Islamic financial jurisprudence and its impact on financial practices. It also analyses modernb day use of financial engineering in this jurisprudence. The paper shows that in today’s age of low-cost financial engineering, the regulatory substance of prohibitions, contract conditions, and other contract-based juristic rulings has been diluted to the point of rendering the contract-based jurisprudence incoherent.
Jump-diffusion models for asset pricing in financial engineering, Kou, S. G. (2007). Jump-diffusion models for asset pricing in financial engineering. Handbooks in operations research and management science, 15, 73-116. This survey focuses on the following issues related to jump-diffusion models for asset pricing in financial engineering. (1) The controversy over tailweight of distributions. (2) Identifying a risk-neutral pricing measure by using the rational expectations equilibrium. (3) Using Laplace transforms to pricing options, including European call/put options, path-dependent options, such as barrier and lookback options. (4) Difficulties associated with the partial integro-differential equations related to barrier-crossing problems. (5) Analytical approximations for finite-horizon American options with jump risk. (6) Multivariate jump-diffusion models.
Financial engineering in Islamic finance, Iqbal, Z. (1999). Financial engineering in Islamic finance. Thunderbird International Business Review, 41(4‐5), 541-559. The objective of this article is to examine the scope of financial innovation and engineering within an Islamic financial system. The article concludes that, contrary to common belief, Islamic finance provides the basic building blocks that can be used to construct more complex instruments that will enhance liquidity and offer risk management tools.
Financial engineering with Islamic options, Obaidullah, M. (1998). Financial engineering with Islamic options. In view of the central role which options play in mainstream financial engineering – in design of innovative financial products and management of risk, this paper undertakes an Islamic evaluation of options and its role in the Islamic system of financial contracting. It also proposes a comparison of istijrar to enable Islamic financial engineers to design contracts in a more efficient manner.
Financial engineering, consumer credit, and the stability of effective demand, Brown, C. (2007). Financial engineering, consumer credit, and the stability of effective demand. Journal of Post Keynesian Economics, 29(3), 427-450. This paper examines the macroeconomic implications of recent developments in financial engineering, with particular emphasis on the post-1987 growth of markets for securities backed by credit card, installment, student loan, and home equity receivables.
Financial engineering, corporate governance, and the collapse of Enron, Gillan, S., & Martin, J. D. (2002). Financial engineering, corporate governance, and the collapse of Enron. This paper presents an insight into the failure of Enron in less than one year after being named 7th largest US firm and six-time winner of Fortune’s most innovative firm. This paper aims to solve the cause of the company’s bankcrupty. Findings show that management used financial engineering and related-party transactions to disguise Enron’s financial condition for over three years. The authors document the existence of potential conflicts of interest throughout Enron’s governance structure, and conflicts that contributed to the firm’s bankruptcy.