Princeton Weekly Bulletin February 22, 1999

What is risky business?

Program in Financial Engineering provides students with tools for analysis

By Ken Howard


John Mulvey (l), Erik Vanmarcke, Erhan Cinlar, Mete Soner and Rene Carmona (photo: Denise Applewhite)


Life, from crossing the street to climbing Mt. Everest, is a gamble.

While we tackle daily risks using basic rules of thumb (look both ways and cross with the light, check weather patterns and stay on the established route), insurance allows us to minimize financial loss should things not go according to plan.

Life's uncertainties can also offer opportunities -- such as when the stock we bought at 100 rises to 150. A new program in the School of Engineering and Applied Science seeks to teach students throughout the University how to evaluate events beyond our control and decrease associated financial risk.

The Program in Financial Engineering "brings the tools of engineering analysis to bear upon the design and evaluation of financial instruments," explains Erhan Cinlar, Norman Sollenberger Professor in Engineering, who chairs the Department of Civil Engineering and Operations Research (CEOR). These instruments consist of contracts that help people and corporations make tradeoffs between risks and rewards. Examples include stocks, bonds and options. Since they make up a market of approximately $4 trillion a year, the stakes around financial instruments are high, and methods of pricing and evaluating them are highly valued.

Financial engineering brings together the economics and mathematics of finance with the recent capabilities in information technology and computer intensive methods, says Cinlar. "Its birth is due to a confluence of factors, including the growing complexity of the financial industry, the emergence of sophisticated tools and the relatively recent availability of powerful computers."

Twenty-five years ago mathematical and economic theories emerged to support complex financial risk analysis; 10 years ago computer power made the analysis of data practical; and financial institutions have recently begun recognizing the value of financial engineering, according to H. Mete Soner, Paul M. Wythes '55 Professor of Engineering and Finance, who joined the University this past fall. "The theories used to analyze financial instruments came around in 1973. They're maturing right now, giving financial people a common language," Soner says. "The market is also maturing, becoming more complex with more complex instruments; there's a need for people to understand it."

Collaborative effort

The Financial Engineering Program is part of a collaborative effort between the Economics Department and the Operations Research Group in CEOR. "The key players here are professors Rene Carmona, John Mulvey, Mete Soner and Erik Vanmarcke," explains Cinlar. "They bring to the enterprise years of expertise in stochastic modeling, stochastic optimization and large scale computations." Formally inaugurated as a one-year master's program this past fall, the Financial Engineering Program currently has six students, with a goal of enrolling 10 to 15 new students every year.

These graduate students are being trained in modern probability theory, statistics optimization under uncertainty, and Monte Carlo and other numerical methods of analysis as related to finance, while they satisfy core requirements in economics. An undergraduate certification program under the aegis of the new Bendheim Center for Finance is being designed. There is also a new financial engineering lab equipped with computers and financial data feeds, which is open to anyone in the University for finance-related research or teaching.

The program goal is to give students from any University discipline the option of studying financial engineering, itself a multidisciplinary approach.

The sophisticated level of math and engineering methods of problem-solving expose students to a way of thinking distinct from a purely math or economics-based approach. The training would also prepare students for a job on Wall Street.

180,000 financial products

Investment banks, brokerages and insurance companies offer approximately 180,000 financial products anything bought or sold in any financial market, according to Cinlar. These are essentially pieces of paper that spell out terms of exchange: stocks, bonds, options, currency exchange rates, or insurance at a specific price. Whatever the product, someone is betting that a stock will rise or fall, an exchange rate will be higher or lower in a specified amount of time, or a natural disaster will or will not occur.

To accomplish the goal of minimizing risk while maximizing gains, the financial engineer follows the example of the classic engineer and builds something -- in this case, intellectual property. The intellectual property, often a contract spelling out the terms of a financial deal, can take many forms.

One example is reinsurance. As Cinlar describes it, "A company that issues earthquake insurance is betting that an earthquake is unlikely to occur. The company must predict the chances of an earthquake occurring, the cost to the company should it have to pay out on its policies, and the policy price it must charge customers in order to make money.

"So the financial engineer obtains data from geologists to evaluate past earthquakes and then, through data analysis and extrapolation through analytic reasoning, decides the odds of a future earthquake occurring and the correspondingly appropriate price for insurance premiums."

That's the starting point. But the situation can get much more complex. Because the insurance company risks losing a significant amount of money, it may seek to reinsure itself, try to diversify or "securitize its risk," says Cinlar. "The recently emerging catastrophe bonds are examples of how to do the latter." Investors in such bonds will lose their money in case of an earthquake, but they also stand to make a return greater than interest rates or a government bond if the earth's mantle stays calm.

Options, derivatives

Other types of financial instruments are stock options and exchange rate derivatives. The earthquake insurance company, for instance, may not want

to put the profits from earthquake policies into the bank; instead, it may invest in stock or commodity options, says Soner. The option to buy or sell a stock or commodity at a certain date for a certain price is computed using formulas and a number of variables, such as volatility of the underlying stock, the time frame when the option will be exercised, and current and predicted rates for other financial instruments.

The company may also want to engage in exchange rate or interest rate swaps to reduce its exposure to fluctuating costs beyond its control. "These financial instruments allow a rate to be locked in with the payment of a premium, enabling a company to forecast future costs without worrying about changing rates," Soner explains.

The person to consider all the available financial instruments and determine the best mix of investments and the pricing structure to reduce overall risk for the company is the financial engineer. A solid schooling in advanced mathematical modeling and economics provides the fundamentals needed for advanced analyses. For, as Cinlar points out, "the future may be uncertain, but that doesn't mean we have to cower before it."