▲ Some derivatives are designed to hedge foreign exchange risks (photo from OTC Derivatives Law).

In 1998, Russia declared a financial moratorium, and the country’s bonds lost their value. Consequently, Long-Term Capital Management (LTCM), the biggest hedge fund of the time, collapsed with 1.25 trillion dollars vanishing into the air. This incident is recorded as one of the great financial accidents in history. Surprisingly, most of the members of LTCM were mathematicians with Ph.D.’s, and the two of them were among the most well-known financial engineers, Merton and Scholes.

What is financial engineering?

Financial engineering is a cutting-edge area of study which designs and evaluates financial assets and derivatives using computer science and mathematical methods. Though its name implies that it is some kind of ‘engineering,’ financial engineering does not belong to any type of the traditional concept of engineering. Financial engineering is not of a subject that can be defined in one or two sentences. Its area is wide: from risk management to actuary to algorithmic trading.

Beginning

The Black-Scholes-Merton formula is one of the first examples of financial engineering. They introduced stochastic calculus into finance to find a model which evaluates the rational option price.  In the past, prices for derivatives and bonds were traded with the traders’ own prices. The emergence of the concept of ‘theoretical price’ opened a new scene in the field of finance. Scholes and Merton’s LTCM actually used the theoretical price in arbitrage trading which catches the abnormal behaviors of markets to earn the difference between the actual price of abnormality and the theoretical price.

Derivatives

Derivatives are financial instruments whose values depend on the prices of other products such as stocks, corn, gold or even a market index. The well-known instrument from the financial crisis, CDS, is also a derivative which converts bonds to securities.

Accident

Long-Term Capital Management was a hedge fund consisting of 160 of the world’s most brilliant financial intellects. Among them, the legendary John Meriwether of Salomon Brothers took the key; Merton and Scholes were involved in playing with their equations to find the gap between ideal and actual prices. Instead of arbitrage trading previously on exchange, they traded government bonds, equity options and other assets and derivatives. With high leverage up to a multiple of 54 at maximum, the fund earned approximately 40% in price-earnings ratio each year. But its over-range trading in 1998 brought them down to the abyss. LTCM evaluated that the spread between the Russian bonds and the US bonds was too large. Expecting the spread to get smaller, it bought the Russian bonds and short-sold the US bonds. But what actually happened was that Russia declared a moratorium that it could not pay for its bonds and interest. Fearing the risky products, the prices for the US bonds rose and LTCM faded into history.

Future of Financial Engineering

There have been worries that the place for financial engineering would be reduced after the shock in the last financial crisis evoked by the subprime mortgage panic. As Prof. Jaewook Lee said during his lecture in Financial Supervisory Service, the sin is not of financial engineering but of the users. He said, “Just because nuclear weapons are developed and used, it does not mean that nuclear technology as a whole is vile. Nuclear technology can be utilized in positive means. What is malevolent is man.”

Options can be used to hedge the risks of investing in stocks. Global wholesalers buy financial instruments to hedge their risks from a volatile exchange rate.

Financial engineering will continuously be developed. It just needs revisions to count for the  variances of the market, which are assumed to be constant, and the actual irrationality of the human race. For this, the focuses are moving to data-based research from solely deductive-mathematical connections.