Friday, September 30, 2005

Engineering + Finance = Financial Engineering

The above equation is true, however, what the equation does'nt impress upon is the fact that you are combining two age old disciplines (okay, maybe modern finance is not that old) to produce innovation in a whole new field.

Someone at the panel said the other day that engineering makes a detailed analysis of a physical system and then adds on it a huge factor of safety. This is not so in finance, where values to the last digit could (and are) very significant.

In a way, this exact-ness is what appeals to me about quant finance. There is no room for hand waving - a security is priced according to a model and its underlying assumptions. Period. No BS. On the other hand, engineering seems to be moving into the hand-waving domain (with safety factors and other such CYA strategies). Finance is moving to from the other end of the spectrum (from obscure valuation models, M&A) to the "exact" side (pricing, securitization).

Ironic? Well, maybe so.. but it is refreshing.

3 Comments:

Blogger aloke said...

not sure if i agree...just starting out in mathfin myself (and keeping a blog) but my impression is that there is a lot of intuition that goes into pricing... certainly you can plug in parameters and get an exact answer but does it make sense?

also, the assumptions are sometimes pretty heavy (e.g. gaussian...) and yet the answers are still good enough.

10:05 PM, October 03, 2005  
Blogger Quantjock said...

I agree about the intuition part. You have to know the model's assumptions and its limitations, inside out. And have a good feel for the factors driving the model.

Hey, what do I know.. I am just starting out :)

Nice blog btw.. its good to see some more finengineers out there blogging.

9:09 AM, October 04, 2005  
Blogger derivativesgeek said...

my last post kinda like disappeared, so i'll retyle.

the two terms on the left hand side of your equation are inextricably linked.

financial engineering depends on the constructs: the financial instruments, their behaviroual characteristics, and the economical-mathematical laws & principles upon which these instruments are contrived.

on the other hand;

innovation and the success of new financial products, and existing ones, as well as the exchanges on which they trade, is dependant on the application of financial engineering, the tools that make these "things" work.

with respect to your comment about exactness of financial engineering and quantitative engineering.. i must add there are limitations and violations of some of the most "seemingly" obvious theorums.

For instance most people forget that Black, Scholes, and Merton's Model under went significant criticism BEFORE Long Term Management Capital. In the 1970s-1980s researchers, at that time many statisticians, and physicists working in economics realised that the NUMBER ONE assumption was not concrete-solid. That is, securities prices are not exactly log normally distributed, and flat tailed. What was actually observed is that kurtosis and skewness is observed. And thus, we have made advancements on advancements in Financial Engineering to fine tune the various Option Pricing models which are widely used today.

- derivatives geek aka phdquant

7:00 PM, October 25, 2005  

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