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What Is Financial Engineering and Risk Management?

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  • Written By: Jim B.
  • Edited By: Shereen Skola
  • Last Modified Date: 02 September 2016
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Financial engineering and risk management are linked together in that one concept is used as a solution to the problem posed by the other. Investment firms employ financial engineers as a way to help the firms and their clients avoid financial market risks. This is generally achieved through the process of quantitative analysis, which takes various data gathered from market prices and company financial reports. Using complex mathematical formulas, the report provides a prediction for future market performance. Since this is such a crucial part of investment strategies in the modern world, universities and business schools have devoted much time to teaching financial engineering.

Technological advances have transformed investment markets around the world. Investment firms wishing to keep up with the changing times have adapted to the complexity of the market by using increasingly advanced techniques to improve profits for their clients. Part of this process also involves mitigating the risks attached to large investments. As a result, it is usually a must for financial engineering and risk management to be a part of an effective investment portfolio.

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Much of the driving force behind financial engineering comes from quantitative analysis. In essence, this type of analysis works like a mathematical formula. Information, such as stock prices, company income levels, and other pertinent numerical totals, is input into various equations. The output is a prediction of what will happen in the future. Quantitative analysis rests on the belief that all market action is based on former patterns, and, by employing it, investors can ideally remove risk from the process.

Part of the way that financial engineering removes risk is by employing complex investment techniques like derivatives, which base their value on the value of underlying instruments and can be used to hedge risk. In addition, financial engineering can be used to devise computer programs that can react to trading opportunities very quickly. The advantage gained from such split-second trading can also help to manage risk.

Since financial engineering and risk management are such a big part of the modern investment scene, the demand for financial engineers has grown immensely. As a result, many graduates from business schools have a strong background in mathematics and computer programming in response to this heavy demand. Most large firms are reliant on experts in quantitative analysis, and financial engineers are specially qualified to perform this task. Experts in the field with proven track records of risk management can often command large salaries and choose between competing firms.

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