Understanding Financial Engineering

Financial engineering is, in essence, the phenomenon of product and/or process innovation in the financial industries the development of new financial instruments and processes that will enhance shareholders', issuers' or intermediaries' wealth. In the New Palgrave finance dictionary, John Finnerty lists countless recent financial innovations from adjustable rate preferred stock to zero-coupon convertible debt but these all can be classified into three principal types of activities: securities innovation; innovative financial processes; and creative solutions to corporate finance problems.

All these innovations are implemented using a few basic techniques, such as increasing or reducing risk (options, futures and other more exotic derivatives see Risk Management), pooling risk (see Mutual Funds), swapping income streams (interest-rate swaps), splitting income streams (stripped bonds), and converting long-term obligations into shorter-term ones or vice versa (maturity transformation). But to be truly innovative, a new security or process must enable issuers or investors to accomplish something they could not do previously, in a sense making markets more efficient or complete.

Finnerty describes ten forces that stimulate financial engineering. These include risk management, tax advantages, agency and issuance cost reduction, regulation compliance or evasion, interest and exchange rate changes, technological advances, accounting gimmicks and academic research.

The emergence of financial engineering has also been influenced by the realization on Wall Street in the early to mid-1990s that there was a need for a new kind of graduate training. The financial institutions wanted people with heavy mathematics skills and some finance training, but had previously been fed from a haphazard network of different programs. Universities began to re spond to the demand by setting up masters programs in financial engineering and they were helped by the fact that the physics job market was at an all-time low due to the end of the Cold War.