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FINANCIAL

ENGINEERING

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The Robert W. Kolb Series in Finance provides a comprehensive view of the field

of finance in all of its variety and complexity. The series is projected to include

approximately 65 volumes covering all major topics and specializations in finance,

ranging from investments to corporate finance and financial institutions. Each

volume in the Kolb Series in Finance consists of new articles written especially for

the volume.

Each Kolb Series volume is edited by a specialist in a particular area of finance, who

develops the volume outline and commissions articles by the world’s experts in

that particular field of finance. Each volume includes an editor’s introduction and

approximately 30 articles to fully describe the current state of financial research

and practice in a particular area of finance.

The essays in each volume are intended for practicing finance professionals, grad￾uate students, and advanced undergraduate students. The goal of each volume is

to encapsulate the current state of knowledge in a particular area of finance so that

the reader can quickly achieve a mastery of that special area.

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FINANCIAL

ENGINEERING

The Evolution of

a Profession

Tanya Beder

Cara M. Marshall

The Robert W. Kolb Series in Finance

John Wiley & Sons, Inc.

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Copyright c 2011 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or

transmitted in any form or by any means, electronic, mechanical, photocopying,

recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the

1976 United States Copyright Act, without either the prior written permission of the

Publisher, or authorization through payment of the appropriate per-copy fee to the

Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978)

750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the

Publisher for permission should be addressed to the Permissions Department, John

Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201)

748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used

their best efforts in preparing this book, they make no representations or warranties with

respect to the accuracy or completeness of the contents of this book and specifically

disclaim any implied warranties of merchantability or fitness for a particular purpose. No

warranty may be created or extended by sales representatives or written sales materials.

The advice and strategies contained herein may not be suitable for your situation. You

should consult with a professional where appropriate. Neither the publisher nor author

shall be liable for any loss of profit or any other commercial damages, including but not

limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support,

please contact our Customer Care Department within the United States at (800) 762-2974,

outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that

appears in print may not be available in electronic formats. For more information about

Wiley products, visit our Web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Financial engineering : the evolution of a profession / Tanya S. Beder and Cara M.

Marshall, editors.

p. cm. – (Robert W. Kolb series ; 2)

Includes index.

ISBN 978-0-470-45581-4 (hardback); ISBN 978-0-470-88981-7 (ebk);

ISBN 978-0-470-88982-4 (ebk); ISBN 978-0-470-88983-1 (ebk)

1. Financial engineering. I. Beder, Tanya S. II. Marshall, Cara M.

HG176.7.F558 2011

332–dc22

2010049290

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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To my mother, Margaret, and in memory of my father, Clarence,

with gratitude for your inspiration, love, and support.

—Tanya Beder

To my father and mother, Jack and Joanne, and to my in-laws Jim

and Marie. Thank you for all that you do.

—Cara M. Marshall

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Contents

Introduction xi

Tanya Beder and Cara M. Marshall

PART I Overview 1

1 The History of Financial Engineering from Inception

to Today 3

Tanya Beder

2 Careers in Financial Engineering 29

Spencer Jones

3 A Profile of Programs and Curricula with a Financial

Engineering Component 51

John Cornish

PART II Financial Engineering and the Evolution of

Major Markets 71

4 The Fixed Income Market 73

Peruvemba Satish

5 The U.S. Mortgage Market 111

Bruce McNevin

6 The Equity Market 131

Gary L. Gastineau and John F. Marshall

7 The Foreign Exchange Market 159

Laurent L. Jacque

8 The Commodity Market 191

Helen Lu and Cara M. Marshall

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viii Contents

9 The Credit Market 215

Frank Iacono

PART III Key Applications of Financial Engineering 241

10 Securitized Products 243

Konstantin Braun

11 Structured Products 259

Timothy A. Day

12 Thoughts on Retooling Risk Management 273

Tanya Beder and Spencer Jones

13 Financial Engineering and Macroeconomic Innovation 289

Cara Marshall and John O’Connell

14 Independent Valuation for Financially-Engineered

Products 305

Cindy W. Ma and Andrew MacNamara

15 Quantitative Trading in Equities 323

Kun Gao

16 Systematic Trading in Foreign Exchange 337

Chris Attfield and Mel Mayne

PART IV Case Studies in Financial Engineering:

The Good, the Bad, and the Ugly 367

17 Case Studies Introduction 369

Penny Cagan

18 Mortgage Case Studies: Countrywide and Northern Rock 373

Algorithmics Software LLC

19 Derivatives Case Studies: SocGen, Barings, and Allied

Irish/Allfirst 385

Algorithmics Software LLC

20 Fixed Income Case Study, Swap Market: The Allstate

Corporation 405

Algorithmics Software LLC

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CONTENTS ix

21 Lessons from Funds: LTCM, Florida, and

Orange County 409

Algorithmics Software LLC

22 Credit Derivatives Case Studies: AIG and

Merrill Lynch 421

Algorithmics Software LLC

PART V Special Topics in Financial Engineering 431

23 Performance Fees 433

Mark P. Kritzman

24 Musings About Hedging 445

Ira Kawaller

25 Operational Risk 455

Monique Miller

26 Legal Risk 465

Jordana Krohley

27 Portable Alpha 487

Tanya Beder and Giovanni Beliossi

28 The No-Arbitrage Condition in Financial Engineering:

Its Use and Misuse 497

Andrew Aziz

29 Influencing Financial Innovation: The Management

of Systemic Risks and the Role of the Public Sector 521

Todd Groome, John Kiff, and Paul Mills

PART VI Appendices 547

A IT Tools for Financial Asset Management

and Engineering 549

B About the Companion Website 569

About the Editors 575

Index 577

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Introduction

TANYA BEDER

Chairman, SBCC and SBCC Group Inc.

CARA M. MARSHALL

Queens College of the City University of New York

The past three decades have been a remarkable period for innovation. This

is no less true, and probably truer, for financial innovation. No prior pe￾riod of equal length has ever witnessed anything that even comes close.

This innovation has included amazing advances in financial theory, computational

capability, new product design, new trading processes, new markets, and new

applications. In fact, each of these innovations has supported and reinforced the

others. In the early 1990s, practitioners and academics alike began to recognize

that this spate of innovation was not just a passing fad. Rather, something funda￾mental had changed. Indeed, something had, and the new profession known as

financial engineering emerged. These think-out-of-the box, often technologically

and/or quantitatively sophisticated, individuals are the drivers behind the new

finance.

All periods of innovation are traumatic. The old, only grudgingly, makes way

for the new. Adapting to a new environment takes effort, and not all will survive.

For example, many floor traders on stock, futures, and options exchanges fought

tooth and nail to prevent the introduction of electronic trading platforms. But,

in the end, the new platforms won out. Why? Because they are better—they are

faster, less error prone, and they lead to tighter bid-ask spreads, which means lower

transaction costs for investors.

Innovation is not without its problems. Good ideas often have unintended

consequences. Cell phones, for example, have made it possible for anyone to reach

almost anyone else at any time in real time. How can that be bad? But cell phones

and their associated capabilities, such as text messaging, have increased road haz￾ards, become an annoyance to anyone dining out, attending a theater, or just trying

to read in peace on the commute home. Similarly, financial innovation has often

had unintended consequences. The financial crisis that began in 2007 and, some

would say, continues as of this writing, has been blamed in part on the secu￾ritization of subprime mortgages and other financial innovations. Securitization

dramatically changed the way mortgage lending worked. It brought huge amounts

of capital to the mortgage market, making it faster and easier for would-be home￾buyers to secure the necessary financing for their purchase. How could making

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xii Introduction

it easier to achieve the American Dream possibly be bad? But securitization has

had unintended consequences. Many mortgage originators changed their focus

from managing their credit risk to originating as much volume as possible with

little regard to credit quality. Securitization had made credit risk “someone else’s

problem.”

The years ahead will be a period of great change for financial engineering.

Investors, borrowers, regulators, supervisors, boards of directors, legislators, and

individuals alike will need to determine what to keep—and what to throw out.

This book is designed to help readers do precisely that. Whether experienced or

new to financial engineering, this book will help you focus on not only established

activities but also the areas of greatest opportunity and need.

For those who are new to financial engineering, Part I of this book (Chap￾ters 1 through 3), provides a history of financial innovation and the commensu￾rate growth of financial engineering as a profession. In this same section, various

types of financial engineering occupations are discussed, but not to the point of

being exhaustive. Also in this section, financial engineering curricula and pro￾grams are discussed. Many of these programs carry a label other than finan￾cial engineering (e.g., quantitative finance, risk management, mathematical fi￾nance, and so forth), but they are nevertheless subsets within the broader field

of financial engineering. A website, www.wiley.com/go/bedermarshall/ (pass￾word: kolb) has been provided to allow the prospective student to get a good

sense of which universities offer financial engineering-related programs and what

these programs contain. The data is not exhaustive because our survey did not

reach all universities with financial engineering-related programs, some of the

schools we sent our survey to did not respond in a timely fashion, and new pro￾grams are being introduced regularly. We apologize to any university that feels

they have a program that should have been included. We invite them to con￾tact [email protected] to have their institution’s programs added to our

data base.

The chapters included in this book are organized around several key themes.

THEME 1: DERIVATIVES WILL CONTINUE TO PLAY

A CRITICAL, VALUABLE, AND PERMANENT ROLE

IN THE GLOBAL CAPITAL MARKETS

According to the Bank for International Settlements, notional principal for deriva￾tives outstanding peaked in 2007 at US$ 1,444 trillion (all types combined). This

number declined significantly during the global financial crisis, but by the latter

part of 2009 it was again rising rapidly. Because this figure is notionals outstanding,

it can be misleading. Many prefer to measure the size of the market in terms of

gross market value, which is the cost of replacing existing contracts. Gross market

value is typically a small fraction of the notionals outstanding. Nevertheless, by

any measure, the derivatives markets are massive in size and, by all accounts, are

once again growing rapidly.

Although some derivatives, most notably futures, have a very long history, as

chronicled in the financial engineering history chapter, many of the more important

derivatives have been around for less than 35 years. These include swaps, most

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INTRODUCTION xiii

types of options, caps, floors, collars, and the more complex combinations thereof.

After the introduction of these latter derivatives, innovation took off and contin￾ues at breakneck speed. Today financial derivatives are a core part of the global

capital markets. They continue to assist borrowers to achieve lower-cost funding,

investors to achieve greater rates of return and/or more desirable risk/reward

tradeoffs, and financial and nonfinancial firms to better manage risks linked to

interest rates, currencies, commodities, equities, credit, weather, and greenhouse

gases, among others. With such rapid growth it is not surprising that the drivers of

some derivatives strategies and financially-engineered products had some prob￾lems. Despite these, and the fact that some pioneers of financial engineering feel

they unwittingly helped to make an atom bomb in the financial markets with

the advent of certain types of securitized products, we believe that derivatives

will continue to play a critical, valuable, and permanent role in the global capital

markets.

Part II (Chapters 4 through 9) examines each of the major markets, one per chap￾ter. Not surprisingly, derivatives play an important role in each of these markets.

Specifically Part II addresses, sequentially, financial innovation and engineering

associated with the fixed-income markets, the mortgage market more narrowly,

the equity markets, the foreign exchange markets, the commodity markets, and

the credit markets.

THEME 2: RISK MEASUREMENT AND

MANAGEMENT WILL CHANGE SUBSTANTIALLY

FOLLOWING LESSONS LEARNED FROM THE

MELTDOWN THAT MANIFESTED IN 2007

Since the onset of the financial meltdown, losses have been realized by almost every

type of firm on every continent. Trillions in taxpayers’ funds have been deployed

by countries around the world to try to stabilize firms and markets. Disclosed

losses involved not only exotic or highly leveraged securities, but simple products

as well. As we continue to work our way through these losses, it is clear that risk

measurement and risk management failed to identify some exposures. Further,

many supervisors, boards of directors, senior managers, and other overseers were

seduced by a dangerous sense of calm, placing too much faith in data derived

during a relatively benign period in the history of the capital markets.

Revising risk measurement methodologies and risk management techniques

will be an important focus of the financial engineering community over the next

decade. So-called once-in-100-year events have occurred all too frequently, thereby

exposing serious flaws in current techniques for identifying and managing risks.

Further, the risk that a model’s value may be different from that ultimately obtained

in the market reared its head globally and without prejudice as to continent or type

of firm, costing trillions. Those who assumed that engaging in multiple activities in

multiple geographic markets would provide so-called natural diversification lost

breathtaking sums; and different financial markets and different types of financial

services were found to be much more interconnected during times of stress than

their risk measurement systems predicted.