Financial Engineering E-Book

Tanya S. Beder

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Robert W. Kolb Series
• Sprache: Englisch

Seitenzahl: 1165

Veröffentlichungsjahr: 2011

Beschreibung

FINANCIAL ENGINEERING Financial engineering is poised for a great shift in the years ahead. Everyone from investors and borrowers to regulators and legislators will need to determine what works, what doesn't, and where to go from here. Financial Engineering--part of the Robert W. Kolb Series in Finance--has been designed to help you do just this. Comprised of contributed chapters by distinguished experts from industry and academia, this reliable resource will help you focus on established activities in the field, developing trends and changes, as well as areas of opportunity. Divided into five comprehensive parts, Financial Engineering begins with an informative overview of the discipline, chronicling its complete history and profiling potential career paths. From here, Part II quickly moves on to discuss the evolution of financial engineering in major markets--fixed income, foreign exchange, equities, commodities and credit--and offers important commentary on what has worked and what will change. Part III then examines a number of recent innovative applications of financial engineering that have made news over the past decade--such as the advent of securitized and structured products and highly quantitative trading strategies for both equities and fixed income. Thoughts on how risk management might be retooled to reflect what has been learned as a result of the recent financial crisis are also included. Part IV of the book is devoted entirely to case studies that present valuable lessons for active practitioners and academics. Several of the cases explore the risk that has instigated losses across multiple markets, including the global credit crisis. You'll gain in-depth insights from cases such as Countrywide, Société Générale, Barings, Long-Term Capital Management, the Florida Local Government Investment Pool, AIG, Merrill Lynch, and many more. The demand for specific and enterprise risk managers who can think outside the box will be substantial during this decade. Much of Part V presents new ways to be successful in an era that demands innovation on both sides of the balance sheet. Chapters that touch upon this essential topic include Musings About Hedging; Operational Risk; and The No-Arbitrage Condition in Financial Engineering: Its Use and Mis-Use. This book is complemented by a companion website that includes details from the editors' survey of financial engineering programs around the globe, along with a glossary of key terms from the book. This practical guide puts financial engineering in perspective, and will give you a better idea of how it can be effectively utilized in real- world situations.

Leseprobe

Contents

Cover

Series

Title Page

Copyright

Dedication

Introduction

THEME 1: DERIVATIVES WILL CONTINUE TO PLAY A CRITICAL, VALUABLE, AND PERMANENT ROLE IN THE GLOBAL CAPITAL MARKETS

THEME 2: RISK MEASUREMENT AND MANAGEMENT WILL CHANGE SUBSTANTIALLY FOLLOWING LESSONS LEARNED FROM THE MELTDOWN THAT MANIFESTED IN 2007

THEME 3: FINANCIALLY-ENGINEERED SECURITIES AND STRATEGIES WILL EVOLVE TO INCLUDE MORE TRANSPARENCY AND BETTER WARNING LABELS

THEME 4: THE DEGREE TO WHICH INCREASED REGULATION WILL STYMIE FINANCIAL ENGINEERING AND INNOVATION IS UNCERTAIN

Part I: Overview

Chapter 1: The History of Financial Engineering from Inception to Today*

WHAT IS FINANCIAL ENGINEERING?

WHY DIDN'T FINANCIAL ENGINEERING START SOONER?

INCEPTION AND THE EARLY STAGES (1970 TO 1997)

THE MASSIVE GROWTH PERIOD (1998 TO 2006)

THE RATIONALIZATION PERIOD (2007 TO DATE, ONGOING)

HISTORICAL READINGS

ABOUT THE AUTHOR

Chapter 2: Careers in Financial Engineering

INTRODUCTION

A WORLD OF OPPORTUNITIES

FUNCTIONAL AREAS

SPECIFIC CAREER PATHS

USING THE TABLES

COMPUTER PROGRAMMING SKILLS

CONCLUSION

ABOUT THE AUTHOR

Chapter 3: A Profile of Programs and Curricula with a Financial Engineering Component

INTRODUCTION

BACKGROUND INFORMATION ON FINANCIAL ENGINEERING PROGRAMS

CURRICULA

JOB PLACEMENT

CONCLUSION

APPENDIX: PROGRAMS CONTACTED

ABOUT THE AUTHOR

Part II: Financial Engineering and the Evolution of Major Markets

Chapter 4: The Fixed Income Market

INTRODUCTION

THE CASH MARKETS

DERIVATIVES MARKETS

PRICE–YIELD RELATIONSHIP

THE YIELD CURVE

INTEREST RATE MODELS

ABOUT THE AUTHOR

Chapter 5: The U.S. Mortgage Market

INTRODUCTION

A BRIEF HISTORY OF THE ORIGIN OF THE MARKET FOR MORTGAGE-BACKED SECURITIES

AGENCY MORTGAGE PASS-THROUGH SECURITIES

PRICING MORTGAGE-BACKED SECURITIES

BEYOND PASS-THROUGHS: COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS)

THE NON-AGENCY MARKET

FINANCIAL ENGINEERING AND THE FUTURE OF THE SECONDARY MORTGAGE MARKET

A NOTE ON THE GLOBAL GROWTH OF THE MORTGAGE MARKET

ABOUT THE AUTHOR

Chapter 6: The Equity Market

INTRODUCTION

CASH MARKET—ORIGINS

EQUITY DERIVATIVES

DECLINING TRADING COSTS INCREASE FINANCIAL ENGINEERING OPPORTUNITIES, AND FINANCIAL ENGINEERING OFTEN REDUCES TRADING COSTS

ARBITRAGE COMPLEXES

EQUITY STRUCTURED PRODUCTS AND EXCHANGE-TRADED FUNDS (ETFS)

PORTFOLIO TRADING AND STOCK INDEX FUTURES CONTRACTS

SHAREHOLDER PROTECTION

TAX EFFICIENCY

THOUGHTS ON IMPROVING ETFS

ABOUT THE AUTHORS

Chapter 7: The Foreign Exchange Market

INTRODUCTION

HOW FOREX IS TRADED: THE INSTITUTIONAL FRAMEWORK

HOW ARE EXCHANGE RATES DETERMINED?

DERIVATIVES AND THE PRIVATIZATION OF FOREX RISK MANAGEMENT

ABOUT THE AUTHOR

Chapter 8: The Commodity Market

HISTORICAL PERSPECTIVE

EXCHANGE-TRADED VERSUS OTC COMMODITY PRODUCTS

FUTURES CONTRACTS

RISK MANAGEMENT WITH COMMODITY FUTURES/OPTIONS

COMMODITY SWAPS

COMMODITY OPTIONS

FINANCIAL ENGINEERING IN COMMODITIES MARKETS

COMMODITY ETFS

REGULATION OF COMMODITY MARKETS

A FINANCIAL ENGINEERING EXERCISE: SYNTHESIZING BARTER

ABOUT THE AUTHORS

Chapter 9: Credit Markets

INTRODUCTION

PREDECESSOR PRODUCTS

APPLICATIONS

FIRST-GENERATION PRODUCTS: 1992–2000

SECOND-GENERATION PRODUCTS: 2001–2007

GOING FORWARD

ABOUT THE AUTHOR

Part III: Key Applications of Financial Engineering

Chapter 10: Securitized Products

INTRODUCTION

ORIGINS OF SECURITIZATION

MARKET SIZE AND SEGMENTS

TRANSACTION PROCESS

CREDIT RATINGS

ABOUT THE AUTHOR

Chapter 11: Structured Products

INTRODUCTION

A HISTORY

EQUITIES

CREDIT

CONCLUSION

ABOUT THE AUTHOR

Chapter 12: Thoughts on Retooling Risk Management

INTRODUCTION

REVISITING THE TONE AT THE TOP OF THE ORGANIZATION

CONDUCT A BOARD-LEVEL REVIEW OF VAR AND STRESS TESTING

ADDING WARNING LABELS TO RISK REPORTS

CONCLUSION AND AN ENDNOTE

ABOUT THE AUTHORS

Chapter 13: Financial Engineering and Macroeconomic Innovation

INTRODUCTION

A REFRESHER ON MONETARY POLICY

POLICY TOOLS OF CENTRAL BANKS

THE FEDERAL RESERVE AND THE LIQUIDITY CRISIS

EXPRESSING A VIEW: INVESTING WITH PRICE INSTABILITY

MACROECONOMIC DERIVATIVES

ABOUT THE AUTHORS

Chapter 14: Independent Valuation for Financially-Engineered Products

INTRODUCTION

THE UNIVERSE OF FINANCIALLY ENGINEERED PRODUCTS

THE FAIR VALUE HIERARCHY

MODELING ALTERNATIVES: CDOS

INCORPORATING THE EFFECTS OF ILLIQUIDITY IN VALUATION

THE ROLE OF THIRD-PARTY VALUATION PROVIDERS

CONCLUSION

ABOUT THE AUTHORS

Chapter 15: Quantitative Trading in Equities

INTRODUCTION

STRUCTURE OF QUANTITATIVE EQUITY MODELS

OUTLOOK

ABOUT THE AUTHOR

Chapter 16: Systematic Trading in Foreign Exchange

INTRODUCTION

IS SYSTEMATIC TRADING JUST FOR GEEKS AND QUANTS?

WHAT CAN SYSTEMATIC TRADING ANALYSIS DO FOR ME?

ADVANTAGES AND LIMITATIONS OF SYSTEMATIC TRADING

WHAT IS NECESSARY FOR A SYSTEM TO WORK?

WHAT CAN I REASONABLY EXPECT?

USES OF SYSTEMATIC TRADING METHODS

EVALUATION OF SYSTEMATIC TRADING IDEAS AND PRODUCTS

ABOUT THE AUTHORS

Part IV: Case Studies in Financial Engineering: The Good, the Bad, and the Ugly

Chapter 17: Case Studies Introduction

INTRODUCTION

ABOUT THE AUTHOR

Chapter 18: Mortgage Case Studies: Countrywide and Northern Rock

CASE STUDY ONE: COUNTRYWIDE FINANCIAL1

CASE STUDY TWO: NORTHERN ROCK2

ABOUT THE AUTHOR

Chapter 19: Derivatives Case Studies: SocGen, Barings, and Allied Irish/Allfirst

CASE STUDY ONE: SOCIéTé GéNéRALE1

CASE STUDY TWO: BARINGS2

CASE STUDY THREE: ALLIED IRISH/ALLFIRST3

ABOUT THE AUTHOR

Chapter 20: Fixed Income Case Study, Swap Market: The Allstate Corporation

THE ALLSTATE CORPORATION1

ABOUT THE AUTHOR

Chapter 21: Lessons from Funds: LTCM, Florida, and Orange County

CASE STUDY ONE: LONG-TERM CAPITAL MANAGEMENT1

CASE STUDY TWO: FLORIDA STATE BOARD OF ADMINISTRATION2

CASE STUDY THREE: ORANGE COUNTY MARKET RISK EVENT3

ABOUT THE AUTHOR

Chapter 22: Credit Derivatives Case Studies: AIG and Merrill Lynch

CASE STUDY ONE: AMERICAN INTERNATIONAL GROUP (AIG)1

CASE STUDY TWO: MERRILL LYNCH2

ABOUT THE AUTHOR

Part V: Special Topics in Financial Engineering

Chapter 23: Performance Fees

INTRODUCTION

PERFORMANCE FEES

HEDGE FUND VERSUS MUTUAL FUND FEES

ABOUT THE AUTHOR

Chapter 24: Musings About Hedging

THE HEDGING ORIENTATION

THE TRADING ORIENTATION

THE ACCOUNTING ORIENTATION

CONCLUSION

ABOUT THE AUTHOR

Chapter 25: Operational Risk

INTRODUCTION AND CURRENT STATE OF KNOWLEDGE

A BRIEF HISTORY OF THE BUSINESS OF OPERATIONAL RISK

OVERVIEW OF SUBJECT

MORE ON HEDGE FUNDS AND OPERATIONAL RISK

MITIGATING OPERATIONAL RISK

ABOUT THE AUTHOR

Chapter 26: Legal Risk

INTRODUCTION

KEY LEGAL RISKS

MITIGATING LEGAL RISK

THE REGULATORY LANDSCAPE

REGULATORY EVOLUTION

ABOUT THE AUTHOR

Chapter 27: Portable Alpha

INTRODUCTION

WHAT IS PORTABLE ALPHA?

THE APPEAL OF PORTABLE ALPHA

ABOUT THE AUTHORS

Chapter 28: The No-Arbitrage Condition in Financial Engineering: Its Use and Misuse

INTRODUCTION

THE OPTIMIZATION FORMULATION

POSSIBLE SOLUTIONS

MARKET EQUILIBRIUM

THE DUAL PROBLEM

PRICING RELATIONSHIPS

PERFECT CAPITAL MARKETS

A TWO-STATE, SINGLE-PERIOD EXAMPLE

INCORPORATING THE EVENT OF DEFAULT

A MULTIPERIOD FRAMEWORK

INCORPORATING DEFAULT

CONCLUSION

ABOUT THE AUTHOR

Chapter 29: Influencing Financial Innovation: The Management of Systemic Risks and the Role of the Public Sector

INTRODUCTION

FINANCIAL MARKET INNOVATION

INCOMPLETE MARKETS FOR INSURANCE RISK

PUBLIC POLICY CONSIDERATIONS

CONCLUSION

ABOUT THE AUTHORS

Part VI: Appendices

Appendix A: IT Tools for Financial Asset Management and Engineering

INTRODUCTION

BASIC MS-EXCEL® TOOLS

MATHEMATICA®, GAUSS™, MAPLE®, AND MATLAB®2

BLOOMBERG®3, INFORMATION, AND THE API

MORE COMPLEX MS-EXCEL COMPUTATIONS

MONTE CARLO SIMULATION

CONCLUSION

READER RESOURCES

ABOUT THE AUTHOR

Appendix B: About the Companion Website

MORE ABOUT THE SURVEY

About the Editors

Index

The Robert W. Kolb Series in Finance provides a comprehensive view of the field of finance in all of its variety and complexity. The series is projected to include approximately 65 volumes covering all major topics and specializations in finance, ranging from investments to corporate finance and financial institutions. Each volume in the Kolb Series in Finance consists of new articles written especially for the volume.

Each Kolb Series volume is edited by a specialist in a particular area of finance, who develops the volume outline and commissions articles by the world's experts in that particular field of finance. Each volume includes an editor's introduction and approximately 30 articles to fully describe the current state of financial research and practice in a particular area of finance.

The essays in each volume are intended for practicing finance professionals, graduate students, and advanced undergraduate students. The goal of each volume is to encapsulate the current state of knowledge in a particular area of finance so that the reader can quickly achieve a mastery of that special area.

Copyright © 2011 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at http://www.wiley.com/go/permissions.

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Library of Congress Cataloging-in-Publication Data:

Financial engineering : the evolution of a profession / Tanya S. Beder and Cara M. Marshall, editors. p. cm. – (Robert W. Kolb series ; 2) Includes index. ISBN 978-0-470-45581-4 (hardback); ISBN 978-0-470-88981-7 (ebk); ISBN 978-0-470-88982-4 (ebk); ISBN 978-0-470-88983-1 (ebk) 1. Financial engineering. I. Beder, Tanya S. II. Marshall, Cara M. HG176.7.F558 2011 332–dc22 2010049290

To my mother, Margaret, and in memory of my father, Clarence, with gratitude for your inspiration, love, and support.

—Tanya Beder

To my father and mother, Jack and Joanne, and to my in-laws Jim and Marie. Thank you for all that you do.

—Cara M. Marshall

Introduction

Tanya Beder

Chairman, SBCC and SBCC Group Inc.

Cara M. Marshall

Queens College of the City University of New York

The past three decades have been a remarkable period for innovation. This is no less true, and probably truer, for financial innovation. No prior period of equal length has ever witnessed anything that even comes close. This innovation has included amazing advances in financial theory, computational capability, new product design, new trading processes, new markets, and new applications. In fact, each of these innovations has supported and reinforced the others. In the early 1990s, practitioners and academics alike began to recognize that this spate of innovation was not just a passing fad. Rather, something fundamental had changed. Indeed, something had, and the new profession known as financial engineering emerged. These think-out-of-the box, often technologically and/or quantitatively sophisticated, individuals are the drivers behind the new finance.

All periods of innovation are traumatic. The old, only grudgingly, makes way for the new. Adapting to a new environment takes effort, and not all will survive. For example, many floor traders on stock, futures, and options exchanges fought tooth and nail to prevent the introduction of electronic trading platforms. But, in the end, the new platforms won out. Why? Because they are better—they are faster, less error prone, and they lead to tighter bid-ask spreads, which means lower transaction costs for investors.

Innovation is not without its problems. Good ideas often have unintended consequences. Cell phones, for example, have made it possible for anyone to reach almost anyone else at any time in real time. How can that be bad? But cell phones and their associated capabilities, such as text messaging, have increased road hazards, become an annoyance to anyone dining out, attending a theater, or just trying to read in peace on the commute home. Similarly, financial innovation has often had unintended consequences. The financial crisis that began in 2007 and, some would say, continues as of this writing, has been blamed in part on the securitization of subprime mortgages and other financial innovations. Securitization dramatically changed the way mortgage lending worked. It brought huge amounts of capital to the mortgage market, making it faster and easier for would-be homebuyers to secure the necessary financing for their purchase. How could making it easier to achieve the American Dream possibly be bad? But securitization has had unintended consequences. Many mortgage originators changed their focus from managing their credit risk to originating as much volume as possible with little regard to credit quality. Securitization had made credit risk “someone else's problem.”

The years ahead will be a period of great change for financial engineering. Investors, borrowers, regulators, supervisors, boards of directors, legislators, and individuals alike will need to determine what to keep—and what to throw out. This book is designed to help readers do precisely that. Whether experienced or new to financial engineering, this book will help you focus on not only established activities but also the areas of greatest opportunity and need.

For those who are new to financial engineering, Part I of this book (Chapters 1 through 3), provides a history of financial innovation and the commensurate growth of financial engineering as a profession. In this same section, various types of financial engineering occupations are discussed, but not to the point of being exhaustive. Also in this section, financial engineering curricula and programs are discussed. Many of these programs carry a label other than financial engineering (e.g., quantitative finance, risk management, mathematical finance, and so forth), but they are nevertheless subsets within the broader field of financial engineering. A website, www.wiley.com/go/bedermarshall/ (password: kolb) has been provided to allow the prospective student to get a good sense of which universities offer financial engineering-related programs and what these programs contain. The data is not exhaustive because our survey did not reach all universities with financial engineering-related programs, some of the schools we sent our survey to did not respond in a timely fashion, and new programs are being introduced regularly. We apologize to any university that feels they have a program that should have been included. We invite them to contact [email protected] to have their institution's programs added to our data base.

The chapters included in this book are organized around several key themes.

THEME 1: DERIVATIVES WILL CONTINUE TO PLAY A CRITICAL, VALUABLE, AND PERMANENT ROLE IN THE GLOBAL CAPITAL MARKETS

According to the Bank for International Settlements, notional principal for derivatives outstanding peaked in 2007 at US$ 1,444 trillion (all types combined). This number declined significantly during the global financial crisis, but by the latter part of 2009 it was again rising rapidly. Because this figure is notionals outstanding, it can be misleading. Many prefer to measure the size of the market in terms of gross market value, which is the cost of replacing existing contracts. Gross market value is typically a small fraction of the notionals outstanding. Nevertheless, by any measure, the derivatives markets are massive in size and, by all accounts, are once again growing rapidly.

Although some derivatives, most notably futures, have a very long history, as chronicled in the financial engineering history chapter, many of the more important derivatives have been around for less than 35 years. These include swaps, most types of options, caps, floors, collars, and the more complex combinations thereof. After the introduction of these latter derivatives, innovation took off and continues at breakneck speed. Today financial derivatives are a core part of the global capital markets. They continue to assist borrowers to achieve lower-cost funding, investors to achieve greater rates of return and/or more desirable risk/reward tradeoffs, and financial and nonfinancial firms to better manage risks linked to interest rates, currencies, commodities, equities, credit, weather, and greenhouse gases, among others. With such rapid growth it is not surprising that the drivers of some derivatives strategies and financially-engineered products had some problems. Despite these, and the fact that some pioneers of financial engineering feel they unwittingly helped to make an atom bomb in the financial markets with the advent of certain types of securitized products, we believe that derivatives will continue to play a critical, valuable, and permanent role in the global capital markets.

Part II (Chapters 4 through 9) examines each of the major markets, one per chapter. Not surprisingly, derivatives play an important role in each of these markets. Specifically Part II addresses, sequentially, financial innovation and engineering associated with the fixed-income markets, the mortgage market more narrowly, the equity markets, the foreign exchange markets, the commodity markets, and the credit markets.

THEME 2: RISK MEASUREMENT AND MANAGEMENT WILL CHANGE SUBSTANTIALLY FOLLOWING LESSONS LEARNED FROM THE MELTDOWN THAT MANIFESTED IN 2007

Since the onset of the financial meltdown, losses have been realized by almost every type of firm on every continent. Trillions in taxpayers’ funds have been deployed by countries around the world to try to stabilize firms and markets. Disclosed losses involved not only exotic or highly leveraged securities, but simple products as well. As we continue to work our way through these losses, it is clear that risk measurement and risk management failed to identify some exposures. Further, many supervisors, boards of directors, senior managers, and other overseers were seduced by a dangerous sense of calm, placing too much faith in data derived during a relatively benign period in the history of the capital markets.

Revising risk measurement methodologies and risk management techniques will be an important focus of the financial engineering community over the next decade. So-called once-in-100-year events have occurred all too frequently, thereby exposing serious flaws in current techniques for identifying and managing risks. Further, the risk that a model's value may be different from that ultimately obtained in the market reared its head globally and without prejudice as to continent or type of firm, costing trillions. Those who assumed that engaging in multiple activities in multiple geographic markets would provide so-called natural diversification lost breathtaking sums; and different financial markets and different types of financial services were found to be much more interconnected during times of stress than their risk measurement systems predicted.

Part III (Chapters 10 through 16) examines a number of recent important innovative applications of financial engineering that have made news over the past decade and that will continue, in our opinion, to do so in the years ahead. Important among these are the advent of securitized products—both those that contributed to the financial crisis and those that did not; structured products, which have become an important new bank funding tool; the importance of obtaining independent valuation of financially-engineered products; and new, highly-quantitative trading strategies for both equities and fixed income. Also included in Part III are some thoughts on how risk management might be retooled to reflect what has been learned as a result of the financial crisis and how new financial products may make it possible to manage the risks associated with macroeconomic uncertainties.

THEME 3: FINANCIALLY-ENGINEERED SECURITIES AND STRATEGIES WILL EVOLVE TO INCLUDE MORE TRANSPARENCY AND BETTER WARNING LABELS

The successful financial engineer is always re-evaluating what has gone before and how it might be done better in the future. To fully appreciate what can go wrong, one has to be willing to examine failure. Indeed, one can often learn more from failure than from success.

Part IV (Chapters 17 through 22) deals with case studies in which some sort of operational failure led to a financial calamity. In all cases these were large failures, some of which led to the demise of the companies with which they were associated. In other cases, the companies were able to survive—often thanks to an acquisition or government bailout. We are grateful to Algorithmics for allowing us to draw on their extensive and proprietary data base of operational risk case studies. We are particularly grateful to Penny Cagan, formerly of Algorithmics, for assembling these case studies for incorporation in this book.

The cases that are included discuss risk themes that have led to losses across multiple market environments, including what we have experienced recently. These include the stories of Countrywide, Northern Rock, Société Général, Barings, Allied Irish/Allfirst, Allstate, Long-Term Capital Management, the state of Florida's Local Government Investment Fund, Orange County (California), American International Group (AIG), and Merrill Lynch.

THEME 4: THE DEGREE TO WHICH INCREASED REGULATION WILL STYMIE FINANCIAL ENGINEERING AND INNOVATION IS UNCERTAIN

Not all financially-engineered securities pose the same risks. Some are inherently riskier than others. Some anxiety-ridden legislators, regulators, academics, and supervisors have taken the extreme step of suggesting that all engineered securities should be purged from some firms’ activities. Other stakeholders have made the mistake of assuming that without engineered securities, risk going forward will be under control. Sadly, not only would many firms with purged activities have greater residual risk, but they are likely to be noncompetitive in the global arena.

We do not think it is advisable to put the securitization genie back into the bottle, and we agree with the stakeholders and overseers who have taken a more constructive approach. Greater transparency and disclosure regarding financially-engineered securities are at the center of how these firms plan to continue to use these products while learning from past losses.

In Part V (Chapters 23 through 29), we address special topics of interest to various segments of the financial engineering community and those who would employ the services of financial engineers. This is a rather eclectic mix. We begin by taking a look at compensation and performance fees. There is little doubt that risk-sensitive compensation frameworks will evolve as a direct result of the crisis as supervisors, government officials, company executives, and directors work to overcome the consequences of what many now view as too many short-term and one-sided incentives. We then continue with thoughts on hedging and the implications of hedge accounting for the volatility of corporate earnings; issues in operational risk and legal risk; the porting of alpha in the current market environment; and the essence of the no-arbitrage condition in valuation and its role in financial engineering.

Although the technological and transaction bridges across markets are well established, the social and political structures supporting cross-border and cross-institution transactions will take years to catch up. Through the meltdown, linkages in the global economy revealed that a shock in a key sector or country can reverberate rapidly through the world. The untoward results were increasingly accompanied by the question of whether government intervention became too lax, and whether supervisors did adequate jobs (including regulators, senior managers, boards of directors, and other overseers). Further, the question of whether protectionism and/or regionalism will overtake ongoing globalization has started to appear with increasing frequency in the debate. We close this book (Chapter ) with some thoughts on the role of the public sector in the management of systemic risk.

At this writing, the world continues its de-risking and de-leveraging. In April of 2010 the IMF revised downward to US$2.3 trillion its earlier estimate of global write-downs by banks. This number exceeds considerably the new capital raised by banks during the same period. The substantial losses by investors in certain types of financially engineered credit instruments and the incineration of trillions of dollars of value have resulted in the nationalization of numerous financial firms and global companies plus breathtaking bailouts by governments around the world. While some instruments are well into their write-down cycles (for example, residential mortgage-backed securities), other instruments are just beginning a likely write-down cycle (for example, commercial mortgage-backed securities and prime residential mortgage-backed securities). Given the huge injections of funds, we encourage you to think about whether governments and stakeholders (i.e., taxpayers) will demand higher levels of regulation and oversight in exchange for those bailout monies. There certainly seems a palpable probability that a reduction in the freedom of global banks is possible as countries and/or regions focus on limiting damage from future crises.

We have included several appendices at the end of this book (Part VI) that we believe can be useful to the beginning student looking forward to a career in financial engineering. These appendices include a brief look at some of the computational and information technology tools available to the financial engineer (Appendix A); and, as already noted, an overview of the survey of financial engineering programs and programs with a financial engineering component (Appendix B).

The authors wish to specially thank John F. Marshall for his insights, advice, and experience drawn from the publication of numerous past books and articles on many of these topics. His input was invaluable to the completion of this book. The authors also wish to thank the staff at SBCC Group Inc. for research and fact checking throughout numerous drafts. We also thank the entire team at John Wiley & Sons for their efforts and support. Finally, and perhaps foremost, we thank the innumerable executives, directors, regulators, risk managers, traders, investors, borrowers, academics and students who have shared their experiences and their challenges over the past three decades.

Part I

Overview

Chapter 1. The History of Financial Engineering from Inception to Today

Chapter 2. Careers in Financial Engineering

Chapter 3. A Profile of Programs and Curricula with a Financial Engineering Component

Chapter 1

The History of Financial Engineering from Inception to Today*

Tanya Beder

SBCC Group Inc.

WHAT IS FINANCIAL ENGINEERING?

Financial engineering may be broadly defined as the development and creative application of innovative financial technology. Financial technology includes financial theory, quantitative techniques, financial products, and financial processes. At a microeconomic level, the motivation behind financial engineering is to produce profits for the innovators by finding better ways to address society's needs. At a macroeconomic level financial engineering helps improve the allocation of scarce resources. Allocation of resources is the fundamental objective of any economic system. Indeed, financial engineering epitomizes Joseph Schumpeter's view of capitalism as “creative destruction.” New products replace old products, new theory improves on old theory, and new processes supplant old processes.

Financial engineering borrows heavily and liberally from other disciplines, which helps explain why the field has attracted people from across the scientific spectrum. The key to understanding financial engineering is understanding innovation in all of its dimensions and turning this innovation into practical solutions. While, in some sense, financial engineering has been with us since the innovation of money, financial engineering has not, until quite recently, been recognized as a profession. What has changed, more than anything else, is the pace of innovation.

The history of financial engineering is presented in the segments illustrated in Exhibit 1.1.

Exhibit 1.1 Financial Engineering Time Line

Source: SBCC Group Inc.

WHY DIDN'T FINANCIAL ENGINEERING START SOONER?

Markets and some financial functions have been around for thousands of years. There is evidence, for example, that the Romans may have invented checking as early as 352 B.C. By the year 1750 the basic financial firms were established to take deposits; make loans; write insurance; provide investments (savings and pension products); intermediate (checking, crossing trades, brokering); underwrite; distribute; and facilitate trade. From the 1700s until about 1970 (more than 200 years), the development of financial firms was continuous and done at a manageable pace. But the period was also one of frequent violent upheaval, as wars repeatedly ravaged nations and populations. New firms were born and others went out of business, but the basic functions of banks, insurance companies, asset managers, company pension funds, central banks, brokers, and dealers did not change radically. Most firms had monoline business models, and the primary business was the intermediation of capital.

As summarized in Exhibit 1.1, the pace of innovation was slow, but there were notable developments in the four decades leading up to the inception of financial engineering. Harry Markowitz published his seminal work on portfolio theory in the 1950s; the first Eurobonds were issued in the early 1960s, and certificates of deposit were introduced in the late 1960s. There were advancements in technology, but most were not broad-based consumer products: Chester Carlson invented xerography (photocopying) in 1938; the first computer (the ENIAC) was unveiled in the 1940s; Bell Systems revealed the transistor that would revolutionize telecommunications in 1947; the first modem enabling communication between machines was developed in the late 1950s; and the National Aeronautics and Space Administration (NASA) launched the first communications satellite in 1962. As the 1960s ended, Texas Instruments developed the first handheld calculator, which retailed for $2,000.