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How is financial engineering used within risk management?

In this article, we’ll provide a brief outline of the basics of financial engineering and risk management and how the two work together.

What is financial engineering?

Financial engineering is a field in which mathematical techniques are employed to solve financial problems. It combines tools and knowledge from the fields of economics, statistics, computer science and applied mathematics. The job of a financial engineer is to solve financial problems by creating and implementing new financial models and processes. Doing this involves extensive research and testing, with in-depth analysis such as risk analysis.

Financial engineers are the source of many of the new and innovative products that arise in the financial industry, such as new trading strategies, new investment analysis, new financial models and much more. They are often employed by businesses that are involved in investment banking, consulting and financial management sectors.

What is risk management?

In finance, risk management is the process of identifying and analysing investment decisions to discover how such risks can be addressed and mitigated. It is done to protect the economic value of the company and to calculate the potential for losses in an investment. The investor can then take the appropriate action (or inaction) in line with their fund’s investment objectives and risk tolerance.

Risk management is extremely important to get right, as huge losses and hits to the economy can occur if it’s done wrong. For example, the Great Recession between 2007 to 2009 was partly down to bad risk management that triggered a subprime mortgage meltdown.

There will always be a degree of risk when you’re looking for a return, so you need to be prepared by gaining a solid understanding of the different forms of risk to discover new opportunities, as well as the trade-offs and costs involved. A financial engineer can help you with this.

How is financial engineering applied to risk management?

When creating new product offerings such as investment models, a financial or quantitative engineer will run complex risk models to predict how the tool will perform and whether the tool will be profitable in the long run, as well as the risks associated with the new product offering given the current volatility of the markets.

In the customer-driven derivatives business, financial engineers play a key role. They use quantitative modelling and programming as well as trading and risk managing derivative products that are developed in compliance with regulations and in line with the Basel Accords. For example, a financial engineer that works on a derivative trading desk will design products that will help customers reach their investment or risk management objectives. In the corporate world, financial engineers will conduct risk analysis to help senior management make strategic decisions in where to invest.

To sum up, financial engineers can therefore be utilised to both reduce the costs associated with a company’s existing investment activities as well as develop new products, services and markets. They are there to ensure that their employers or clients are making the best financial decisions that will result in minimal loss and maximum return.

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