Examples of Financial Engineering

by Gerald Hanks Google

Financial engineering uses mathematical formulas to resolve financial problems. It employs methods and skills from areas as diverse as computer programming, statistical analysis, macroeconomics and advanced mathematics. Experts in financial analysis use these methods to deal with the latest financial events and to formulate original financial products, some of which have become established parts of the financial world, such as futures and options. Other products of financial engineering have shown both innovation and volatility, such as derivatives and mortgage-backed securities.


A derivative is a financial agreement that carries a value derived from an inherent asset. While derivatives have no specific value on their own, their value comes from the expected future price fluctuations implicit in the asset. Derivative holders use these instruments to protect themselves against risk, such as changes in commodity prices, movements in foreign currency exchange rates and fluctuations in interest rates. Derivative buyers can also purchase them to gain additional rewards in exchange for exposure to higher risks.

Credit Default Swaps

A credit default swap, also called a "credit derivative contract," allows the buyer to make payments to the seller up until the due date of a contract. In exchange, the seller pays off debt from a third party if that party fails to pay off the loan. The credit default swap protects the lender against default from the borrower and allows the buyer to "bet" that the original loan will go into default. Critics blame the rise of credit default swaps on high-risk mortgages -- at least in part -- for the economic collapse of 2008.

Forex Funds

The foreign exchange market, also called "Forex" for short, is the worldwide market for trading currencies. The principles of financial engineering allow brokers and traders to take advantage of fluctuations in exchange rates between currencies to make a profit. A Forex fund can hold several types of currencies, including U.S. dollars, British pounds, Japanese yen and European euros. The fund makes trades on the exchange rates by anticipating when one currency will gain or lose value against the others.

Futures Contracts

Futures contracts are financial engineering instruments based on the anticipated future prices of stocks, bonds and commodities. A futures contract is an agreement to buy or sell an item at a specified price on a specified date. Futures buyers take a "long" position, anticipating that the item's price will be higher on that future date. Sellers take the "short" position, guessing that the item's price will fall. Futures traders can set contracts based on individual items or on the values of entire markets, such as the New York Stock Exchange.

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