Computational finance
Encyclopedia
Computational finance, also called financial engineering, is a cross-disciplinary field which relies on computational intelligence
, mathematical finance
, numerical methods
and computer simulation
s to make trading
, hedging
and investment
decisions, as well as facilitating the risk management
of those decisions. Utilising various methods, practitioners of computational finance aim to precisely determine the financial risk
that certain financial instruments create.
”, referring to the quantitative skills necessary to perform the job. Specifically, knowledge of the C++ programming language
, as well as of the mathematical subfields of stochastic calculus
, multivariate calculus, linear algebra
, differential equations, probability theory
and statistical inference
are often entry level requisites for such a position. C++ has become the dominant language for two main reasons: the computationally intensive nature of many algorithms, and the focus on libraries rather than applications.
Computational finance was traditionally populated by Ph.Ds in finance, physics and mathematics who moved into the field from more pure, academic backgrounds (either directly from graduate school, or after teaching or research). To work in computational finance, one must have a strong understanding of financial economics, mathematical tools such as probability and statistics and differential equations, as well as engineering methodologies. However, as the actual use of computers has become essential to rapidly carrying out computational finance decisions, a background in computer programming has become useful, and hence many computer programmers enter the field either from Ph.D. programs or from other fields of software engineering
. Specially with the advent of more complex computational machines, a knowledge of computer software and hardware has become a necessity. In recent years, advanced computational methods, such as neural network
and evolutionary computation
have opened new doors in computational finance. Practitioners of computational finance have come from the fields of signal processing
and computational fluid dynamics
and artificial intelligence
. Masters level degree holders are also increasingly making their presence felt as more terminal programs
become available at the leading schools; see Master of Computational Finance.
Today, all full service institutional finance firms employ computational finance professionals in their banking and finance operations (as opposed to being ancillary information technology
specialists), while there are many other boutique firms ranging from 20 or fewer employees to several thousand that specialize in quantitative trading alone. JPMorgan Chase & Co.
was one of the first firms to create a large derivatives business and employ computational finance (including through the formation of RiskMetrics
), while Renaissance Technologies
, founded in 1982, is probably the oldest and most notable quant fund (along with D.E. Shaw & Co.).
s and specialized interest rate derivative
s. The field applies engineering methodologies to problems in finance, and employs financial theory
and applied mathematics
, as well as computation and the practice of programming.
Computational finance is also used in the process of creating new securities or processes, and designing new financial instruments, especially derivative securities. More importantly, computational finance is used in the process of employing mathematical, finance and computer modeling skills to make pricing, hedging, trading and portfolio management decisions. Utilizing various derivative securities and other methods, computational finance aims to precisely control the financial risk that an entity takes on. Methods can be employed to take on unlimited risks under certain events,or completely eliminate other risks by utilizing combinations of derivative and other securities.
Computational finance can be applied to many different types of currencies and pricing options. These include equity, fixed income such as bonds, commodities such as oil or gold, as well as derivatives, swaps, futures, forwards, options, and embedded options. With computational finance comes many risks. Risks are divided into market risk and credit risk. Market risks can be managed using risk identification, risk measurements, and risk management. Credit risks can be managed using credit modeling and credit pricing.
Computational finance is normally employed in the securities and banking industries. It is also used by quantitative analyst
s in consulting firms or in general manufacturing and service firms, in corporate treasury, corporate finance
and risk management
roles. Financial engineers will often hold doctorates in computer science
or mathematics
, although, increasingly, have instead completed a specialized (terminal
) masters degree - usually the Master of Financial Engineering, or the more general Master of Quantitative Finance
.
Areas where computational finance techniques are employed include:
Some major contributors to computational finance include:
Computational intelligence
Computational intelligence is a set of Nature-inspired computational methodologies and approaches to address complex problems of the real world applications to which traditional methodologies and approaches are ineffective or infeasible. It primarily includes Fuzzy logic systems, Neural Networks...
, mathematical finance
Mathematical finance
Mathematical finance is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory. Generally, mathematical finance will derive and extend the mathematical...
, numerical methods
Numerical analysis
Numerical analysis is the study of algorithms that use numerical approximation for the problems of mathematical analysis ....
and computer simulation
Computer simulation
A computer simulation, a computer model, or a computational model is a computer program, or network of computers, that attempts to simulate an abstract model of a particular system...
s to make trading
Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
, hedging
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
and investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
decisions, as well as facilitating the risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
of those decisions. Utilising various methods, practitioners of computational finance aim to precisely determine the financial risk
Financial risk
Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...
that certain financial instruments create.
History
Generally, individuals who fill positions in computational finance are known as “quantsQuantitative analyst
A quantitative analyst is a person who works in finance using numerical or quantitative techniques. Similar work is done in most other modern industries, but the work is not always called quantitative analysis...
”, referring to the quantitative skills necessary to perform the job. Specifically, knowledge of the C++ programming language
C++
C++ is a statically typed, free-form, multi-paradigm, compiled, general-purpose programming language. It is regarded as an intermediate-level language, as it comprises a combination of both high-level and low-level language features. It was developed by Bjarne Stroustrup starting in 1979 at Bell...
, as well as of the mathematical subfields of stochastic calculus
Stochastic calculus
Stochastic calculus is a branch of mathematics that operates on stochastic processes. It allows a consistent theory of integration to be defined for integrals of stochastic processes with respect to stochastic processes...
, multivariate calculus, linear algebra
Linear algebra
Linear algebra is a branch of mathematics that studies vector spaces, also called linear spaces, along with linear functions that input one vector and output another. Such functions are called linear maps and can be represented by matrices if a basis is given. Thus matrix theory is often...
, differential equations, probability theory
Probability theory
Probability theory is the branch of mathematics concerned with analysis of random phenomena. The central objects of probability theory are random variables, stochastic processes, and events: mathematical abstractions of non-deterministic events or measured quantities that may either be single...
and statistical inference
Statistical inference
In statistics, statistical inference is the process of drawing conclusions from data that are subject to random variation, for example, observational errors or sampling variation...
are often entry level requisites for such a position. C++ has become the dominant language for two main reasons: the computationally intensive nature of many algorithms, and the focus on libraries rather than applications.
Computational finance was traditionally populated by Ph.Ds in finance, physics and mathematics who moved into the field from more pure, academic backgrounds (either directly from graduate school, or after teaching or research). To work in computational finance, one must have a strong understanding of financial economics, mathematical tools such as probability and statistics and differential equations, as well as engineering methodologies. However, as the actual use of computers has become essential to rapidly carrying out computational finance decisions, a background in computer programming has become useful, and hence many computer programmers enter the field either from Ph.D. programs or from other fields of software engineering
Software engineering
Software Engineering is the application of a systematic, disciplined, quantifiable approach to the development, operation, and maintenance of software, and the study of these approaches; that is, the application of engineering to software...
. Specially with the advent of more complex computational machines, a knowledge of computer software and hardware has become a necessity. In recent years, advanced computational methods, such as neural network
Neural network
The term neural network was traditionally used to refer to a network or circuit of biological neurons. The modern usage of the term often refers to artificial neural networks, which are composed of artificial neurons or nodes...
and evolutionary computation
Evolutionary computation
In computer science, evolutionary computation is a subfield of artificial intelligence that involves combinatorial optimization problems....
have opened new doors in computational finance. Practitioners of computational finance have come from the fields of signal processing
Signal processing
Signal processing is an area of systems engineering, electrical engineering and applied mathematics that deals with operations on or analysis of signals, in either discrete or continuous time...
and computational fluid dynamics
Computational fluid dynamics
Computational fluid dynamics, usually abbreviated as CFD, is a branch of fluid mechanics that uses numerical methods and algorithms to solve and analyze problems that involve fluid flows. Computers are used to perform the calculations required to simulate the interaction of liquids and gases with...
and artificial intelligence
Artificial intelligence
Artificial intelligence is the intelligence of machines and the branch of computer science that aims to create it. AI textbooks define the field as "the study and design of intelligent agents" where an intelligent agent is a system that perceives its environment and takes actions that maximize its...
. Masters level degree holders are also increasingly making their presence felt as more terminal programs
Terminal degree
A terminal degree is, in some countries, the highest academic degree in a given field of study. This phrase is in common use in the United States, but is not universal in an international context: the concept is not in general use in the United Kingdom, for example, and the exact definition varies...
become available at the leading schools; see Master of Computational Finance.
Today, all full service institutional finance firms employ computational finance professionals in their banking and finance operations (as opposed to being ancillary information technology
Information technology
Information technology is the acquisition, processing, storage and dissemination of vocal, pictorial, textual and numerical information by a microelectronics-based combination of computing and telecommunications...
specialists), while there are many other boutique firms ranging from 20 or fewer employees to several thousand that specialize in quantitative trading alone. JPMorgan Chase & Co.
JPMorgan Chase & Co.
JPMorgan Chase & Co. is an American multinational banking corporation of securities, investments and retail. It is the largest bank in the United States by assets and market capitalization.It is a major provider of financial services, with assets of $2 trillion and according to Forbes magazine is...
was one of the first firms to create a large derivatives business and employ computational finance (including through the formation of RiskMetrics
RiskMetrics
The RiskMetrics variance model was first established in 1989, when Sir Dennis Weatherstone, the new chairman of J.P. Morgan, asked for a daily report measuring and explaining the risks of his firm. Nearly four years later in 1992, J.P...
), while Renaissance Technologies
Renaissance Technologies
Renaissance Technologies is a hedge fund management company of about 275 employees and more than $ billion in assets under management in three funds...
, founded in 1982, is probably the oldest and most notable quant fund (along with D.E. Shaw & Co.).
Applications
Computational finance is used in the creation of new financial instruments and strategies, typically exotic optionExotic option
In finance, an exotic option is a derivative which has features making it more complex than commonly traded products . These products are usually traded over-the-counter , or are embedded in structured notes....
s and specialized interest rate derivative
Interest rate derivative
An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate...
s. The field applies engineering methodologies to problems in finance, and employs financial theory
Financial economics
Financial Economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment"....
and applied mathematics
Applied mathematics
Applied mathematics is a branch of mathematics that concerns itself with mathematical methods that are typically used in science, engineering, business, and industry. Thus, "applied mathematics" is a mathematical science with specialized knowledge...
, as well as computation and the practice of programming.
Computational finance is also used in the process of creating new securities or processes, and designing new financial instruments, especially derivative securities. More importantly, computational finance is used in the process of employing mathematical, finance and computer modeling skills to make pricing, hedging, trading and portfolio management decisions. Utilizing various derivative securities and other methods, computational finance aims to precisely control the financial risk that an entity takes on. Methods can be employed to take on unlimited risks under certain events,or completely eliminate other risks by utilizing combinations of derivative and other securities.
Computational finance can be applied to many different types of currencies and pricing options. These include equity, fixed income such as bonds, commodities such as oil or gold, as well as derivatives, swaps, futures, forwards, options, and embedded options. With computational finance comes many risks. Risks are divided into market risk and credit risk. Market risks can be managed using risk identification, risk measurements, and risk management. Credit risks can be managed using credit modeling and credit pricing.
Computational finance is normally employed in the securities and banking industries. It is also used by quantitative analyst
Quantitative analyst
A quantitative analyst is a person who works in finance using numerical or quantitative techniques. Similar work is done in most other modern industries, but the work is not always called quantitative analysis...
s in consulting firms or in general manufacturing and service firms, in corporate treasury, corporate finance
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
and risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
roles. Financial engineers will often hold doctorates in computer science
Computer science
Computer science or computing science is the study of the theoretical foundations of information and computation and of practical techniques for their implementation and application in computer systems...
or mathematics
Mathematics
Mathematics is the study of quantity, space, structure, and change. Mathematicians seek out patterns and formulate new conjectures. Mathematicians resolve the truth or falsity of conjectures by mathematical proofs, which are arguments sufficient to convince other mathematicians of their validity...
, although, increasingly, have instead completed a specialized (terminal
Terminal degree
A terminal degree is, in some countries, the highest academic degree in a given field of study. This phrase is in common use in the United States, but is not universal in an international context: the concept is not in general use in the United Kingdom, for example, and the exact definition varies...
) masters degree - usually the Master of Financial Engineering, or the more general Master of Quantitative Finance
Master of Quantitative Finance
A masters degree in quantitative finance concerns the application of mathematical methods to the solution of problems in financial economics. There are several like-titled degrees which may further focus on financial engineering, financial risk management, computational finance and/or mathematical...
.
Areas where computational finance techniques are employed include:
- Investment banking
- ForecastingForecastingForecasting is the process of making statements about events whose actual outcomes have not yet been observed. A commonplace example might be estimation for some variable of interest at some specified future date. Prediction is a similar, but more general term...
- Risk ManagementFinancial risk managementFinancial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc...
software - Corporate strategic planningStrategic planningStrategic planning is an organization's process of defining its strategy, or direction, and making decisions on allocating its resources to pursue this strategy. In order to determine the direction of the organization, it is necessary to understand its current position and the possible avenues...
- SecuritiesSecurity (finance)A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
tradingTrader (finance)A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
and financial risk managementFinancial risk managementFinancial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc... - DerivativesDerivative (finance)A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
trading and risk management - Investment managementInvestment managementInvestment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...
- PensionPensionIn general, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.The terms retirement...
- Insurance policy
- MortgageMortgage loanA mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
agreement - LotteryLotteryA lottery is a form of gambling which involves the drawing of lots for a prize.Lottery is outlawed by some governments, while others endorse it to the extent of organizing a national or state lottery. It is common to find some degree of regulation of lottery by governments...
design - Islamic bankingIslamic bankingIslamic banking is banking or banking activity that is consistent with the principles of Islamic law and its practical application through the development of Islamic economics. Sharia prohibits the fixed or floating payment or acceptance of specific interest or fees for loans of money...
- Currency peg
- GoldGoldGold is a chemical element with the symbol Au and an atomic number of 79. Gold is a dense, soft, shiny, malleable and ductile metal. Pure gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. Chemically, gold is a...
and commodity valuation - Collateralised debt obligation
- Credit default swapCredit default swapA credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
- BargainingBargainingBargaining or haggling is a type of negotiation in which the buyer and seller of a good or service dispute the price which will be paid and the exact nature of the transaction that will take place, and eventually come to an agreement. Bargaining is an alternative pricing strategy to fixed prices...
- Market mechanism designMechanism designMechanism design is a field in game theory studying solution concepts for a class of private information games...
Major contributors
Notable people in computational finance include F. Black and M. Scholes for the pricing of options and corporate liabilities, Robert C. Merton for his theory of rational option pricing and the introduction of stochastic calculus in the study of finance. Robert F. Engle is also notable for the work in analyzing economic time-series with time-varying volatility. Clive W. J. Granger analyzed the economic time series with common trend.Some major contributors to computational finance include:
- Fischer BlackFischer BlackFischer Sheffey Black was an American economist, best known as one of the authors of the famous Black–Scholes equation.-Background:...
- Phelim BoylePhelim BoylePhelim Boyle , a distinguished professor and actuary, is a professor of finance in the Laurier School of Business & Economics at Wilfrid Laurier University in Canada and is a pioneer of quantitative finance. He is best known for initiating the use of Monte Carlo methods in option pricing...
- Emanuel DermanEmanuel DermanEmanuel Derman is a South African-born academic, businessman and writer. He is best known as a quantitative analyst, and author of the book My Life as A Quant: Reflections on Physics and Finance....
- Robert Jarrow
- Harry MarkowitzHarry MarkowitzHarry Max Markowitz is an American economist and a recipient of the John von Neumann Theory Prize and the Nobel Memorial Prize in Economic Sciences....
- Robert C. MertonRobert C. MertonRobert Carhart Merton is an American economist, Nobel laureate in Economics, and professor at the MIT Sloan School of Management.-Biography:...
- Stephen RossStephen RossStephen Ross may refer to:* Stephen Jay Ross , U.S. communications businessman* Stephen Ross, Baron Ross of Newport , former Liberal Member of Parliament* Stephen Ross , financial economist and textbook author...
- Myron ScholesMyron ScholesMyron Samuel Scholes is a Canadian-born American financial economist who is best known as one of the authors of the Black–Scholes equation. In 1997 he was awarded the Nobel Memorial Prize in Economic Sciences for a method to determine the value of derivatives...
- Paul WilmottPaul WilmottPaul Wilmott is a researcher, consultant and lecturer in quantitative finance. He is best known as the author of various academic and practitioner texts on risk and derivatives, and for Wilmott magazine and Wilmott.com , a quantitative finance portal....
- Blake LeBaron
- Darrell DuffieDarrell DuffieJames Darrell Duffie is a Canadian economist. He is the Dean Witter Distinguished Professor of Finance at Stanford Graduate School of Business, and has been on the finance faculty at Stanford since receiving his Ph.D. from Stanford in 1984...
- Edward TsangEdward TsangEdward Tsang is a Computer Science professor at the University of Essex. He holds a first degree in Business Administration from the Chinese University of Hong Kong , and an MSc and PhD in Computer Science from the University of Essex...
- Dietmar Maringer
See also
- List of finance topics
- Quantitative analystQuantitative analystA quantitative analyst is a person who works in finance using numerical or quantitative techniques. Similar work is done in most other modern industries, but the work is not always called quantitative analysis...
- Mathematical financeMathematical financeMathematical finance is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory. Generally, mathematical finance will derive and extend the mathematical...
- QuantLibQuantLibQuantLib is an open-source software library which provides tools for software developers interested in financial instrument valuation and related subjects. QuantLib is written in C++.-History:...
- Master of Computational Finance
- Financial reinsuranceFinancial reinsuranceFinancial Reinsurance , is a form of reinsurance which is focused more on capital management than on risk transfer. In the non-life segment of the insurance industry this class of transactions is often referred to as finite reinsurance....
- Financial modelingFinancial modelingFinancial modeling is the task of building an abstract representation of a financial decision making situation. This is a mathematical model designed to represent the performance of a financial asset or a portfolio, of a business, a project, or any other investment...
External links
- IEEE Computational Finance and Economics Technical Committee
- An Introduction to Computational Finance without Agonizing Pain
- Introduction to Computational Finance, IEEE Computational Intelligence Society Newsletter, August 2004
- Numerical Techniques for Options
- Monte Carlo Simulation of Stochastic Processes
- Centre for Computational Finance and Economic Agents (CCFEA)