In its modern sense, financial engineering is the design (or engineering) of contracts and portfolios of contracts that result in predetermined cash flows contingent to different events. Broadly speaking, financial engineering is used to manage investments and risk. The objective is the transfer of risk from one entity to another via appropriate contracts.
Though the aggregate risk is a quantity that cannot be altered, risk can be transferred if there is a willing counterparty. Just why and how risk transfer is possible will be discussed in Chapter 23 on risk management. Financial engineering came to the forefront of finance in the 1980s, with the broad diffusion of derivative instruments. However the concept and practice of financial engineering are quite old.
Evidence of the use of sophisticated cross-border instruments of credit and payment dating from the time of the First Crusade (1095–1099) has come down to us from the letters of Jewish merchants in Cairo. The notion of the diversification of risk (central to modern risk management) and the quantification of insurance risk (a requisite for pricing insurance policies) were already understood, at least in practical terms, in the 14th century.
The rich epistolary of Francesco Dating, a 14th century merchant, banker and insurer from Prato (Tuscany, Italy), contains detailed instructions to his agents on how to diversify risk and insure cargo.5 It also gives us an idea of insurance costs: Dating charged 3.5% to insure a cargo of wool from Malaga to Pisa and 8% to insure a cargo of malmsey (sweet wine) from Genoa to Southampton, England.
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These, according to one of Dating’s agents, were low rates: He considered 12–15% a fair insurance premium for similar cargo. What is specific to modern financial engineering is the quantitative management of uncertainty.
Both the pricing of contracts and the optimization of investments require some basic capabilities of statistical modeling of financial contingencies. It is the size, diversity, and efficiency of modern competitive markets that makes the use of modeling imperative.