Introduction
The past three decades have been a remarkable period for innovation. This is no less true, and probably truer, for financial innovation. No prior period 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 fundamental 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 hazards, 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 securitization 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 homebuyers to secure the necessary financing for their purchase. How could making 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 (Chapters 1 through 3), provides a history of financial innovation and the commensurate 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 programs are discussed. Many of these programs carry a label other than financial engineering (e.g., quantitative finance, risk management, mathematical finance, and so forth), but they are nevertheless subsets within the broader field of financial engineering. A website, www.wiley.com/go/bedermarshall/ (password: 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 programs are being introduced regularly. We apologize to any university that feels they have a program that should have been included. We invite them to contact [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 derivatives 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 types of options, caps, floors, collars, and the more complex combinations thereof. After the introduction of these latter derivatives, innovation took off and continues 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 problems. 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 chapter. 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.
Part III (Chapters 10 through 16) examines a number of recent important innovative applications of financial engineering that have made news over the past decade and that will continue, in our opinion, to do so in the years ahead. Important among these are the advent of securitized products—both those that contributed to the financial crisis and those that did not; structured products, which have become an important new bank funding tool; the importance of obtaining independent valuation of financially-engineered products; and new, highly-quantitative trading strategies for both equities and fixed income. Also included in Part III are some thoughts on how risk management might be retooled to reflect what has been learned as a result of the financial crisis and how new financial products may make it possible to manage the risks associated with macroeconomic uncertainties.
THEME 3: FINANCIALLY-ENGINEERED SECURITIES AND STRATEGIES WILL EVOLVE TO INCLUDE MORE TRANSPARENCY AND BETTER WARNING LABELS
The successful financial engineer is always re-evaluating what has gone before and how it might be done better in the future. To fully appreciate what can go wrong, one has to be willing to examine failure. Indeed, one can often learn more from failure than from success.
Part IV (Chapters 17 through 22) deals with case studies in which some sort of operational failure led to a financial calamity. In all cases these were large failures, some of which led to the demise of the companies with which they were associated. In other cases, the companies were able to survive—often thanks to an acquisition or government bailout. We are grateful to Algorithmics for allowing us to draw on their extensive and proprietary data base of operational risk case studies. We are particularly grateful to Penny Cagan, formerly of Algorithmics, for assembling these case studies for incorporation in this book.
The cases that are included discuss risk themes that have led to losses across multiple market environments, including what we have experienced recently. These include the stories of Countrywide, Northern Rock, Société Général, Barings, Allied Irish/Allfirst, Allstate, Long-Term Capital Management, the state of Florida's Local Government Investment Fund, Orange County (California), American International Group (AIG), and Merrill Lynch.
THEME 4: THE DEGREE TO WHICH INCREASED REGULATION WILL STYMIE FINANCIAL ENGINEERING AND INNOVATION IS UNCERTAIN
Not all financially-engineered securities pose the same risks. Some are inherently riskier than others. Some anxiety-ridden legislators, regulators, academics, and supervisors have taken the extreme step of suggesting that all engineered securities should be purged from some firms’ activities. Other stakeholders have made the mistake of assuming that without engineered securities, risk going forward will be under control. Sadly, not only would many firms with purged activities have greater residual risk, but they are likely to be noncompetitive in the global arena.
We do not think it is advisable to put the securitization genie back into the bottle, and we agree with the stakeholders and overseers who have taken a more constructive approach. Greater transparency and disclosure regarding financially-engineered securities are at the center of how these firms plan to continue to use these products while learning from past losses.
In Part V (Chapters 23 through 29), we address special topics of interest to various segments of the financial engineering community and those who would employ the services of financial engineers. This is a rather eclectic mix. We begin by taking a look at compensation and performance fees. There is little doubt that risk-sensitive compensation frameworks will evolve as a direct result of the crisis as supervisors, government officials, company executives, and directors work to overcome the consequences of what many now view as too many short-term and one-sided incentives. We then continue with thoughts on hedging and the implications of hedge accounting for the volatility of corporate earnings; issues in operational risk and legal risk; the porting of alpha in the current market environment; and the essence of the no-arbitrage condition in valuation and its role in financial engineering.
Although the technological and transaction bridges across markets are well established, the social and political structures supporting cross-border and cross-institution transactions will take years to catch up. Through the meltdown, linkages in the global economy revealed that a shock in a key sector or country can reverberate rapidly through the world. The untoward results were increasingly accompanied by the question of whether government intervention became too lax, and whether supervisors did adequate jobs (including regulators, senior managers, boards of directors, and other overseers). Further, the question of whether protectionism and/or regionalism will overtake ongoing globalization has started to appear with increasing frequency in the debate. We close this book (Chapter ) with some thoughts on the role of the public sector in the management of systemic risk.
At this writing, the world continues its de-risking and de-leveraging. In April of 2010 the IMF revised downward to US$2.3 trillion its earlier estimate of global write-downs by banks. This number exceeds considerably the new capital raised by banks during the same period. The substantial losses by investors in certain types of financially engineered credit instruments and the incineration of trillions of dollars of value have resulted in the nationalization of numerous financial firms and global companies plus breathtaking bailouts by governments around the world. While some instruments are well into their write-down cycles (for example, residential mortgage-backed securities), other instruments are just beginning a likely write-down cycle (for example, commercial mortgage-backed securities and prime residential mortgage-backed securities). Given the huge injections of funds, we encourage you to think about whether governments and stakeholders (i.e., taxpayers) will demand higher levels of regulation and oversight in exchange for those bailout monies. There certainly seems a palpable probability that a reduction in the freedom of global banks is possible as countries and/or regions focus on limiting damage from future crises.
We have included several appendices at the end of this book (Part VI) that we believe can be useful to the beginning student looking forward to a career in financial engineering. These appendices include a brief look at some of the computational and information technology tools available to the financial engineer (Appendix A); and, as already noted, an overview of the survey of financial engineering programs and programs with a financial engineering component (Appendix B).
The authors wish to specially thank John F. Marshall for his insights, advice, and experience drawn from the publication of numerous past books and articles on many of these topics. His input was invaluable to the completion of this book. The authors also wish to thank the staff at SBCC Group Inc. for research and fact checking throughout numerous drafts. We also thank the entire team at John Wiley & Sons for their efforts and support. Finally, and perhaps foremost, we thank the innumerable executives, directors, regulators, risk managers, traders, investors, borrowers, academics and students who have shared their experiences and their challenges over the past three decades.