financial engineering part 2 lecture 1 2012 2

8/13/2019 Financial Engineering Part 2 Lecture 1 2012 2

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Lecture 1

What is Financial Engineering

Giampaolo Gabbi

Financial Engineering

MSc in Finance2011 - 2012


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Outline


Financial Derivatives

Pricing

Risk management

Financial Crisis

Regulation


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The process of researching and developing new financial products andservices that would meet customer needs and prove profitable The process of creating new securities or processes

The process of designing new financial instruments, especially derivativesecurities.

Financial engineering is the process of employing mathematicalfinance and computer modeling skills to make pricing, hedging,trading and portfolio management decisions. Utilizing variousderivative securities and other methods, financial engineering aims toprecisely control the financial risk that an entity takes on. Methods

can be employed to take on unlimited risks under certain events orcompletely eliminate other risks by utilizing combinations ofderivative and other securities.


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What is Financial Engineering Financial Engineering Requirements

Financial Economics

Mathematical tools Probability and Statistics, stochastic process, time series analysis,

differential equations, physics, etc.

Engineering principles Software engineering

Different names: Financial engineering

Financial mathematics, computational mathematics

Quantitative finance


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Milestone in FE


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Milestone in FE


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Financial derivatives

Different kinds of derivatives: from plain vanillato exotic derivatives

Underlying

Equity

Fixed Income, such as bonds,

Commodity, such as oil, gas, electricity, copper,

soybean, coffee, cotton, etc.

Weather


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Pricing

Closed-form formulas

Simulations

Portfolio Optimization


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Risk Management Market risk:

Risk identification Risk measurements

Credit risk and credit derivatives

Credit modeling

Credit pricing

Counterparty risk

Wrong-way risk

New regulation on OTC markets and clearing


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Financial crisis Barings bank bankrupt, Feb. 1995, in a matter

of few day, Britains oldest merchant bank Orange County bankrupt in Dec. 1994, loss $1.6

billion

Metallgesellschaft: commodity, energy trading

LTCM Sept 1998, Feds orchestrated a $3.5

billion rescue package

2001 2002. Enron, WorldCom, etc.


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Financial crisis

Investors perspective

Markets perspective

The risk from the regulators point of view and for financial institutions


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An experience on 1929 market

crash

Eddie Cantor was an American comic actor

He was acting before and after the Market

crash (1929) Same period of the Marx Brothers


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His experience during the 1929

market crash

They told me to buy this stock for my

old age. It worked wonderfully. Within

a week I was an old man (EddieCantor)


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Purposes Discuss how different risk factors generated collapses in

financial systems

Examine the impact for insurance companies

Review how regulation should model agents behaviour

Exchange experiences in mixed teams


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Clinic cases to find out

SUB PRIME

THE DOT.COM CRASH

TULIP MANIA

LONG-TERM CAPITAL MANAGEMENT

BARINGS

THE EQUITABLE LIFE ASSURANCE SOCIETY


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Format to discuss the clinic case Period

Country / Area

Brief description of the case

Risk factors explaining the case

Lessons to be learnt (strategy / control / regulation)

financial engineering part 2 lecture 1 2012 2

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