Notes on financial engineering by D.Messerschmitt

(based in part on the lecture by Jerry Block)

Jerry Block described the field of financial engineering, which is essentially controlling risk in financial transactions. Financial engineering uses four fundamental building blocks, and packages them in different ways, to shift risk from one party to another:

• Cash (fixed short-term rate of return)
• Assets (entities with a value that varies with time due to market forces, but has some expected return)
• Forwards (contracts for sale of assets at some future time at a price set today)
• Options (option to buy an asset at some time in the future at a price set today)

Risk is an important factor in the decision to develop new technologies or products. The technology or product may pay off in profits, or it may be a failure. The ability to understand and quantify that risk is an important element of decision making. What financial engineering offers is an opportunity to shift that risk to another party. Of course, the expected return would be diminished in the process.

Another interesting aspect of this lecture was the underlying information technology which is an enabler of financial engineering. Financial institutions in this field must keep track of a large number of contracts on their books (a typical number 60,000 was mentioned), with a great deal of variation in details. There is the need to quantify the risk in each contract, and also the aggregate risk, each day, or possibly even more often. This is a massive database and computational problem that stretches the limits of today's technology.

In talking to Jerry after his lecture, it emerged that there are two serious problems related to technology and information technology professionals in this industry:

• The nature of the computational problem is such that performance and efficiency are at a great premium. However, software professionals are often focused on complexity management and structure to the extent that they don't succeed in achieving the necessary performance. In particular, Jerry argued against object-oriented programming, at least at a low level of object granularity, in this industry.
• There is often a disconnect between the business problem and the technology. The business managers often don't have the technology knowledge to guide technology decisions, and technology professionals don't have sufficient understanding of the business problems.

Surely this second issue is not limited to financial engineering!

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