Financial Engineering
Financial Engineering was born in the city of Chicago. On May 16th, 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.
- 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.
Financial Engineering and Risk Management courses at Illinois cover both definitions.
Finance
412, 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.
Finance
413, 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.
Finance
441 and Finance
451, International Finance, cover the foreign exchange market.
Finance
432, Managing Financial Risk for Insurers, covers much of the material in
Fin 512 and 513, but from the perspective of the insurance
market.
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