Finance and engineering (Financial Engineering) in the same term! Now that sounds out of place and intimidating at the same time.
How do these two disciplines collab to form this term – financial engineering.
Financial engineering uses mathematical tools and concepts to provide solutions to complex financial problems.
What else does it help in?
Financial engineering is used to come up with various financial tools and models. These tools and models would then help to predict the behavior of a financial asset (e.g., derivatives, bonds, shares, etc.). Financial engineers also create financial instruments(assets). They build complex financial models to test their created investing options. E.g., How these financial instruments would function in the financial markets over a long period?
Myron Scholes and Fischer Black are known as the first financial engineers who started their careers in financial engineering in 1973.
The idea behind financial engineering is to automate the investing ecosystem.
Just like machines, this field of study works to automate the investing process through computerized systems.
Investors can put down their investing data like the principal amount they want to invest, the financial instrument in which they wish to invest, investment duration, and their earning objective. The financial models would give them the answer, as to which investment option is suitable for them.
Fixing the pricing models of options
Financial engineering is used to set the prices of options(derivatives). To make things clearer, derivatives are investing options that derive their value from an underlying financial asset. If the underlying asset does well, the derivative shall also do well. But if the waves are in the wrong direction, derivatives will not fare well.
Options are contracts between a buyer and a seller that gives a right to the buyer they can purchase the underlying asset at a later date and a specified rate. There is a certain price assigned to this contract. Financial engineering is used to determine the price of such options(contracts).
Disciplines like advanced mathematics, statistics, computer programming, economics, and finance are used to determine such prices. In the absence of such a field of study, people would just start pricing based on their gut feelings.
Financial engineering exists to elevate the financial maturity of an individual or a company. It helps to increase resource effectiveness. What does that mean?
Well, it simply means that a person who has better knowledge of finance would be able to earn more money. A person who exercises budgeting will be able to save(earn) more when compared to a person who spends randomly.
Individuals can invest their limited resources in the most lucrative investment option. Likewise, companies that know better can do better. A robust example would be that financial engineers can restructure a company to enhance its visibility of the company in the capital markets. As more suitable investors would find the company, the demand for the company shall rise to cause a hike in share prices, and therefore the value of the company spikes.