Financial Engineering

WHAT IS FINANCIAL ENGINEERING?

Financial engineering is a multidisciplinary field involving a financial theory, the methods of engineering, the tools of mathematics and the practice of programming. It has also been defined as the application of technical methods, especially from mathematical finance and computational finance, in the practice of finance.

Financial engineering draws on tools from applied mathematics, computer science, statistics and economic theory. In the broadest definition, anyone who uses technical tools under a Financial theory could be called a financial engineer.

WHAT IS FINANCIAL ENGINEERING?

In plain terms, Financial Engineering is the art to combine Quantitative, Technical and Fundamental Analysis in a scientific way and apply the results quantified in Financial markets.

What is the difference between Quantitative and Technical analysis?

Technical analysis is a methodology of studying historical price action of financial markets in an attempt to forecast future price movements. It uses price charts, charting tools and indicators all derived simply from the price points of open, high, low, close and volume. It stands in contrast to Fundamental analysis which looks at economic factors about the company being analyzed, its markets and competitors etc.and works under a Financial Theory.

Technical analysis makes three basic assumptions:

  1. Price discounts everything. In other words, all known information about a security is factored into its current price.
  2. Markets move in trends.
  3. Human nature is constant. Meaning, given a certain price pattern, the probabilities of investors reaction to it can be determined.

Technical analysis is popular amongst discretionary traders – traders who will use these techniques, amongst perhaps other inputs, to decide when to enter and exit their trades.

Quantitative analysis, on the other hand, is a non-discretionary rules-based approach to analyzing financial markets – which use elements of technical analysis – but ultimately allows any particular method of entering and exiting trades in a market to be quantified. This is normally achieved by codifying the rules and using a computer to back-test and forward test the rules against a historic price series.

Quantitative analysis has three basic assumptions:

  1. There are inefficiencies in financial markets that can be profitably exploited
  2. These inefficiencies can be discovered
  3. The inefficiencies will persist long enough to produce profits in the future.

Quantifying a trading idea allows a number of advantages over a purely discretionary approach to the markets:

  • It produces metrics giving profiles for return, draw-down, win rate, Sharpe ratio, amongst many other, which can be assessed for trade-ability before any capital is risked.
  • It allows competing ideas to be compared like for like.
  • It allows ideas to be refined to meet a stated objective

Fundamental analysis

Fundamental analysis looks at economic factors about the company being analyzed through balance sheets and income statements, its markets, and competitors etc.

The basic assumption of fundamental analysis is that by studying underlying information of a company you can define the well being of that company and the “intrinsic value”, something that can produce estimated profits in the future.

Whilst there is some crossover, you will tend to find a quantitative and fundamental based approach being employed by investing professionals, whilst lay or beginner investors will tend to rely more on a discretionary approach using technical analysis.

Through Techninvestor, students learn how to combine a modern finance theory and technical methods with a practical knowledge of the forums in which they can employ these skills.

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