Lecture 1 What is Financial Engineering Giampaolo Gabbi Financial Engineering MSc in Finance 2015-2016 1
Outline What is Financial Engineering Financial Derivatives Pricing Risk management Financial Crisis Regulation 2
What is Financial Engineering The process of researching and developing new financial products and services that would meet customer needs and prove profitable The process of creating new securities or processes The process of designing new financial instruments, especially derivative securities. Financial engineering is the process of employing mathematical finance and computer modeling skills to make pricing, hedging, trading and portfolio management decisions. Utilizing various derivative securities and other methods, financial engineering aims to precisely control the financial risk that an entity takes on. Methods can be employed to take on unlimited risks under certain events or completely eliminate other risks by utilizing combinations of derivative and other securities. 3
What is Financial Engineering Financial Engineering Requirements Financial Economics Mathematical tools Probability and Statistics, stochastic process, time series analysis, differential equations, physics, etc. Engineering principles Software engineering Different names: Financial engineering Financial mathematics, computational mathematics Quantitative finance 4
Milestone in FE 5
Milestone in FE 6
Financial Engineering Topics The traditional financial engineering area covers the following topics: Asset pricing models; volatility modeling and volatility derivatives; credit risk and credit derivatives; fixed income markets; commodities; pathdependent options; risk measures and risk management; asset allocation; empirical asset pricing models; model calibration; corporate finance; and the theoretical foundations of mathematical finance. Some recent research projects address topics related to the financial crisis, such as hedge fund management; systemic risk and contingent capital; behavioral finance; real estate finance; and longevity risk. With advances in information technology, high frequency trading and algorithmic trading have also gained increasing research attention. 7
Financial Innovations and Financialization Different kinds of derivatives: from plain vanilla to exotic derivatives Underlying Equity Fixed Income, such as bonds, Commodity, such as oil, gas, electricity, copper, soybean, coffee, cotton, etc. Weather 8
Financial Innovations and Financialization Financialization refers to the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operation of the economy and its governing institutions, both at the national and international levels (Epstein, 2001) Financialization may be defined as: "the increasing dominance of the finance industry in the sum total of economic activity, of financial controllers in the management of corporations, of financial assets among total assets, of marketised securities and particularly equities among financial assets, of the stock market as a market for corporate control in determining corporate strategies, and of fluctuations in the stock market as a determinant of business cycles" (Dore 2002) 9
Pricing Closed-form formulas Simulations Portfolio Optimization 10
Risk Management Market risk: Risk identification Risk measurements Credit risk and credit derivatives Credit modeling Credit pricing Counterparty risk Wrong-way risk New regulation on OTC markets and clearing 11
Financial Innovations, Financialization and Crisis Cases of financialization Futures markets The evolution of leverage Securitization Foreign exchange trading FIRE economy Shadow banking system 12
Topics Lesson 1 (7/4) Introduction to FE and Engineering Derivative Contracts (I) Lesson 2 (8/4) Engineering Derivative Contracts (II) Lesson 3 (14/4) Securitization [Case study] Lesson 4 (21/4) Credit Derivatives [Case study] Lesson 5 (22/4) Real Estate and Financialization [Case Study] Lesson 6 (28/4) Energy, Oil and Water Finance [Case study] Lesson 7 (29/4) High Frequency Trading [Case study] Lesson 8 (5/5) Hedge Funds and ETF [Case study] Lesson 9 (6/5) Shadow Banking [Case study] Lesson 10 (12/5) Systemic Risk and Contingent Capital [Case study] 13
Financial Engineering Project In this course, students work with faculty on research projects. Generally, students work under faculty supervision. However, the course is intended to be largely self-directed within the guidelines established by the supervising faculty member. A significant written research component is required. Theoretical Background Description of the events The Market s perspective The risk from the regulators point of view and for financial institutions Policy implications 14
Purposes Discuss how different financialization events generated collapses in financial systems Examine the impact for financial companies Review how regulation should model agents behaviour Exchange experiences in mixed teams 15
Teaching Methods The course is based on a mix of lectures and case studies. The mix enables students to apply concepts to real-life financial investments situations and risk management applications. The teacher will provide other compulsory readings Course Evaluation: Cases discussion 50% Final written exam 50% 16