Financial Engineering and Risk Management

Financial Engineering was born in the city of Chicago. On May 16, 1972, the Chicago Mercantile Exchange launched the first financial futures products, currency futures. On April 26, 1973, less than a mile away, the Chicago Board Options Exchange launched the first exchange-traded options. These two events revolutionized financial management.

Futures Markets

Chicago, and particularly the Chicago Board of Trade, was (and is still) the center of agricultural risk management. Since the mid-19th century, the grain pits at the Chicago Board of Trade were the center of trade, and thus the place where world prices were set. The techniques developed to hedge against changes in the price of wheat [1] were found to work as well or better with financial risk, whether of currency price movements, interest rate shocks, or stock market volatility.

Financial futures allowed ordinary businesses to lay off the risk from financial price or rate shifts. By far the most widely traded products by any measure were those that hedged against interest rate movements. The Chicago Board of Trade’s T-Bond and T-Note contracts dominate the long end of the rate curve, while the Chicago Mercantile Exchange’s Eurodollar contract dominate the shorter end. Any firm which is borrowing, or lending, or planning to do either in the future will be affected by an interest rate shift, and that includes just about the entire economy.

In the 1980’s, stock index futures gave portfolio managers the ability to adjust their exposure to the market quickly. Though most futures investments are not long-term, the futures proved so useful to professional managers that the notional value of daily futures trading regularly exceeds that of the actual stock exchanges.

The OTC (Over-The-Counter) Market

Futures markets are designed to be liquid, so they are aimed at the “average” risk. Since the S&P500 index gives the average price of a representative group of stocks, the S&P500 index futures is the most heavily traded. However, in stocks, as in most other things, one size does not fit all. It is very likely that the futures contract will not match the risk of your portfolio in size, or timing, or composition.

For each type of risk served by the futures market, customized products were developed for individual customers. Interest rate products were particularly widely customized. Today, the interest rate swaps market is among the largest financial markets in the world. Derivatives dealers sell customized products to individual businesses, and then hedge their resulting exposure using futures.

The Options Market

Though options have always been available as an OTC product, the market took off in response to two almost simultaneous events. First, the opening of the Chicago Board Options Exchange meant that an options position could be taken in a competitive open market, and could be closed by trading out, rather than being held to expiration. Second, the development of the Black-Scholes model meant that options could be priced much more accurately.

The result was a very active market in options on individual stocks. Using a call, which locks in a buying price, or a put, which locks in a selling price, allows risk to be tailored to many more situations than by buying either the underlying stock or a futures contract.



Footnotes:
  1. If you own wheat, and would be hurt by a price drop, you can establish a short position on the futures market to protect yourself. If prices fall, though your wheat is worth less, you will show a profit on your future position to balance it out. On the other hand, if you are a flour miller, you are hurt when the price of wheat rises. Establishing a long futures position will protect you by giving you a profit if the price of wheat rises.

 

Courses at Illinois

What is financial engineering?

Definition 1

Financial engineering is the application of the mathematical tools commonly used in physics and engineering to financial problems, especially the pricing and hedging of derivative instruments.

Definition 2

Financial engineering is the use of financial instruments such as forwards, futures, swaps, options, and related products to restructure or rearrange cash flows in order to achieve particular financial goals, particularly the management of financial risk. If we define financial engineering this way, it is almost synonymous with financial risk management. "

Neil Pearson
Professor of Finance

Financial Engineering and Risk Management courses at Illinois cover both of Pearson’s definitions.

Financial Derivatives focuses on exchange-traded derivatives, though some aspects of the OTC market are dealt with. It covers basic pricing models of futures, options, and swaps, as well as the more commonly used strategies and applications.

Financial Engineering I focuses much more on the OTC market. It deals with swaps and related products, and also convertible bonds and structured notes. It also covers risk measurement, especially the application and pitfalls of the Value-at-risk measure. It can be taken without previous enrollment in Finance 512, and fits Definition 2 more closely than Definition 1.

Financial Engineering II is an introduction to modern option pricing. It makes heavier use of math, including coverage of stochastic differential equations and the Itô calculus, Black-Scholes-Merton analysis, and (parabolic) partial differential equations. It could usefully be characterized as a Definition 1 course.

In addition to these courses there are four specialized courses, two in Insurance/Risk Management, one in Real Estate, and one covering the Foreign Exchange market.

Enterprise Risk Management (ERM) is the application of the basic risk management principles to all risks facing an organization. ERM integrates hazard, financial, strategic and operational risks under a single framework. ERM is becoming an important issue partly as the result of the Sarbanes-Oxley Act of 2002 that puts greater responsibility on the Board of Directors for managing all an organization’s risks. Although the initial focus of ERM was as a method for avoiding the derivative disasters that occurred for many firms, ERM is now developing into a tool that can be used to optimize firm value. Risks are divided into core risks, which a firm should have a competitive advantage in coping with, and non-core risks, which can more effectively be transferred or hedged. This course will present the legal and regulatory environment that sets the stage for ERM, cover the technical tools used in risk analysis, examine data integration processes and show how risk measures relate to strategic and tactical business decisions.

Real Estate Financial Markets covers, among other things, the mortgage-backed securities market.

International Finance covers the foreign exchange market.

Managing Financial Risk for Insurers covers much of the material in Fin 512 and 513, but from the perspective of the insurance market.


Leo Melamed, recognized as the "Father of Financial Futures" with Professor David Ikenberry and Dean Avijit Ghosh during a University of Illinois Lecture in February.