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Defining financial engineering

I heard a talk entitled “Financial Engineering: An Oxymoron” by Jim Grant tonight at our NYQF seminar. It reminded me of something I once wrote about defining the field.


I first heard the words “financial engineering” in 1992, and I thought they were a poor descriptor of the field I knew. I had been on Wall Street for seven years, and the contents of the few available textbooks we practitioners typically owned – Cox & Rubinstein’s Options Markets and Jarrow & Rudd’s Option Pricing – looked more like science than engineering to me. But inappropriate though I thought the name was, it’s become accepted, and, I now think, more or less rightfully so.

Mechanical engineering is concerned with building devices based on the principles of mechanics, i.e. Newton’s laws, suitably combined with empirical rules about more complex forces (friction, for example) that are too difficult to derive from first principles. Electrical engineering is the study of how to create useful electrical devices based on Maxwell’s equations. Bio-engineering is the art of building prosthetics and other biologically active devices based on the principles of biochemistry, physiology and molecular biology.

Science – mechanics, electrodynamics, molecular biology, etc., – seeks to discover the fundamental principles that describe the world, and is usually reductive. Engineering is about using those principles, constructively, for a purpose.

What about financial engineering? In a logically consistent world, financial engineering, layered above a solid base of financial science, would be the study of how to create functional financial devices – convertible bonds, warrants, default swaps, etc. – that perform in desired ways, not just at expiration, but throughout their lifetime. Which brings us to financial science, the putative study of the fundamental laws of financial objects, be they stocks, interest rates, or whatever else your theory uses as atomic constituents. Here, unfortunately, be dragons.

Canonical financial engineering rests upon the science of Brownian motion and other idealizations that, while they capture some of the essential features of uncertainty, are not very accurate descriptions of the characteristic behavior of financial objects. Markets are filled with anomalies that disagree with standard theories. Stock evolution, to take just one of many examples, isn’t Brownian (see Mandelbrot, or Stanley and his econolaborators). So, while we in financial engineering are rich in techniques (stochastic calculus, optimization, the Hamilton-Jacobi-Bellman equation, and so on), we don’t (yet? ever?) have the right laws of science to exploit.


Now I think that maybe “financial engineering” suggests too much precision, like using too many decimal places in specifying your height as 6′ 1.2345″. Maybe FE is a politically correct word for something more fuzzy.

Computer scientists should be called computer engineers. Nutritional scientists should be called nutritionists, without the science. Maybe people shouldn’t be allowed to self-describe and name their occupation.

What is the most accurate job name to describe what financial engineers do?

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