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Great Accomplishments in Financial Engineering

It’s still challenging for most people to talk about the great accomplishments of financial engineers. So this time, we’re looking to the future.

The rebirth of financial engineering that has occurred over the past few years has been every bit as striking as the returns once promised by some of the discipline’s most daring adherents.

Not that long ago, it looked like it was game over for the field of study that produced the mortgage backed security, the credit default swap and all manner of other exotic derivatives that exploded spectacularly in the crisis of 2008.

Now, financial engineering theory is being touted by several academics as the key to curing cancer faster, reducing the impact of climate change and imposing better risk discipline on the same banks that were once almost crushed by the discipline’s creations.

Graduates are flocking to specialist courses in record numbers. Columbia received more than 1,200 applications for a course that has fewer than 90 places; Cornell attracted more than 1,000 applications for a course with just 55 spots.

“It was Warren Buffett who said derivatives are financial markets’ weapons of mass destruction,” says Andrew Lo, the MIT Sloan finance professor and hedge fund manager behind the pioneering work on how financial theory can help cure cancer.

“Uncontrolled use of these kinds of weapons can be extremely devastating and create nuclear fallout for decades. If we use these powerful tools responsibly and in a controlled way, the power they can provide is virtually unlimited.”

Lo has literally spent years looking at how the principles of financial theory can be applied to fighting cancer. “Because the risks of failure are so high in cancer drug development that the probability of success goes up quite dramatically if you create a portfolio,” says Lo.

He adds that the historical probability of success for developing a single anti-cancer treatment is around 5%, but the probability of success shoots up to 99.59 per cent in a portfolio of 150 cancer drugs with statistically uncorrelated successes. That 99.59% is not just the probability of one drug succeeding, it is the probability that two or more end up approved by the US’s Food and Drug Administration.

With financial pay-offs for each success potentially yielding billions of dollars, Lo believes investing in cancer drugs on a large scale is safer than focusing on one long shot.

Lo bases his research on binomial distribution—a probability theory that looks at the distribution of outcomes from a repeated test—and basic portfolio theory, which advocates the benefits of holding a group of complementary assets. Lo cites UBS’s recently launched $470m oncology fund as a real-life example of this theory.

Another good example of financial engineering put to broader use is Bob Litterman’s work on climate change. Mr Litterman, Goldman Sachs’s former head of risk now works at hedge fund Kepos Capital. He has studied how asset pricing theory can be applied to the true price of carbon, and has concluded that carbon is massively underpriced, and that we are on course for a sharp, painful correction. He also believes more work between climate scientists and financial modelers is needed to understand how carbon should be priced very soon.

“Economists haven’t taken the science very seriously in projecting damages and in particular in projecting the full possible distribution of damages from climate change,” Mr Litterman says. “The bottom line is that these economic models can give us the social cost of carbon from $2 a tonne to several hundred dollars a tonne,” he adds, citing a report from an Intergovernmental Panel on Climate Change.

Certain investors are already positioning for the correction, including the World Wildlife Fund, of which Mr Litterman is a director. The fund has bought forward a derivative that swaps the total return on an index of carbon-heavy assets like coal, tar and expensive sources of oil for the total return on an index of the S&P 500. The value of the swap has risen by 73% since it was created in 2014 by the WWF’s advisers, Cambridge Associates.

Peter Carr, chair of New York University’s finance and risk department, says that financial engineering can be applied to anything systemic or pervasive. He cites the examples of predicting weather patterns and human responses to drugs.

Carr’s students are using financial engineering to look at the systemic risk of banks. “Financial engineers are already trained to understand what values are going to be in the future,” he says. “That’s valuable for banks that need to staff up to deal with additional demands from regulators.”

Victoria Averbukh, director and senior lecturer at Cornell’s financial engineering department in Manhattan, says more of her students are considering working in risk management now than before.

“The financial industry comes back for financial engineers when they need to solve risk management problems and analyze the data,” she says. “There was a backlash against engineering—but now it’s moving on.”

Interesting in joining the engineers with a positive mindset and the good of humanity within their vision? Let us know how we can help you.

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