Introduction to Financial Engineering
What is Financial Engineering (FE)?
● The discipline of financial engineering includes applications of
mathematical, statistical modeling and computational technology to problems
in the financial industry and financial management of non-financial
organizations.
● FE involves design and development of financial products, strategies, and
systems to meet the needs of financial institutions, corporations,
governments, and households.
Financial Engineering Application Areas
● Financial risk management for financial institutions, corporations, and public
institutions (from hedging risks of individual transactions to enterprise-wide
risk management systems)
● Derivative securities (contract design, pricing, market making, and
investment, trading, and hedging applications)
● Modeling stochastic dynamics of stock prices, interest rates, foreign exchange
rates, commodity and energy prices
● Asset/liability management technology for corporations, banks, pension funds
● Credit risk modeling and management and credit derivatives
● Energy industry and energy derivatives
● Real options: valuing businesses and strategic managerial decisions by
applying option pricing technology
Some Factors that Drive the Growth of Financial Engineering
● Increasing Volatility of Global Financial Markets and the Need for Risk
Management
○ Volatility of equity prices, foreign exchange rates, commodity and energy
prices, and interest rates increased dramatically over the past three
decades
○ Higher volatility increases risk (as well as more opportunities)
○ Risk Management is crucial to the survival and competitiveness of
organizations
● Global Nature of Financial Markets
○ Multinational firms produce, market, and obtain financing globally
○ Every multinational firm has significant risk exposures to foreign
currencies, domestic and foreign interest rates, energy and commodity
prices, and global equity prices
● Information Technology
○ Advances in information technology drive the growth of financial
engineering. Real-time worldwide information and data collection, analysis,
decision-making, and trading are made possible.
○ Securities trading goes electronic and moves from exchange floors into
cyberspace.
○ Banks are the biggest users of information technology!
● Goals of this Course
○ Provide an introduction to the field of financial engineering
○ Develop theoretical foundations of financial engineering
○ Study some of the most important products and applications of financial
engineering
○ Develop practical modeling skills
INTRODUCTION TO DERIVATIVES
What is a Derivative?
○ A derivative is a financial contract between two parties that specifies
conditions – in particular, dates and the resulting values of underlying
variables – under which payments or payoffs are to be made between the
parties (payments can be either in the form of cash or delivery of some
specified asset).
Examples
○ A Forward contract is a contract to buy some pre-specified underlying
asset at a predetermined price (delivery price) on a specified date in the
future.
○ Call and Put Options
■ A call option is a contract that gives its holder the right but not the
obligation to buy some specified quantity of an underlying asset (e.g.
fixed number of shares of stock of a particular company) at a
predetermined price (strike price) on or before a specified date in the
future (option expiration).
■ A put option is a contract that gives its holder the right but not the
obligation to sell some specified quantity of an underlying asset (e.g.
fixed number of shares of stock of a particular company) at a
predetermined price on or before a specified date in the future.
Underlying assets or variables in derivatives
■ Stocks and stock market indexes
■ Commodities (e.g., oil, gas, coal, gold, silver, aluminum, copper, corn,
wheat, soybeans, paper)
■ Bonds
■ Interest rates
■ Exchange rates
■ Credit events (defaults)
■ Economic variables (e.g., inflation)
There are two types of derivatives:
○ Exchange-traded:
■ Futures
■ Options
○ Over-the-Counter (OTC):
■ Forward contracts
■ Swaps
■ CDS
The size of the global derivatives market
The derivative market is huge: the notional outstanding value of derivatives is
equal to several hundreds trillions US dollars and it is still growing!
The notional outstanding value of
○ OTC contracts (4Q 2009): $615 trillions
■ FX contracts: $50 trillions
■ Interest rate contracts: $450 trillions
■ CDS contracts: $33 trillions
■ Equity-linked: $6.5 trillions
■ Commodity-linked: $3 trillions
○ Exchange-traded (1Q 2010):
■ Futures: $346 trillions
■ Options: $168 trillions
(Source: [Link])
Types of Derivatives Traders
○ Hedgers
■ Objective: reduce risks they already face in the course of their business.
○ Investors/Speculators
■ Objective: profit from taking directional/speculative positions on the
future market direction.
○ Arbitrageurs
■ Objective: find arbitrage opportunities to realize “riskless” profits.