The other day the new MSFE students showed up at Columbia for orientation and I had to welcome them. These are some notes from what I said.

Part 1

Background
Several years ago, my son, who did a PhD thesis on the reception history of Max Weber, the founding father of sociology, introduced me to two influential essays by Weber, entitled respectively Science as a Vocation and Politics as a Vocation. In them Weber discusses what problems you have to face, and what personality and character you have to own, if you decide to make these fields your calling, and he’s surprisingly thoughtful and yet practical about it.I thought it would be interesting to begin to think about the same questions with respect to entering the field of Quantitative Finance, particularly from a practitioner’s point of view.

Financial “Engineering“?!
According to Zvi Bodie, financial engineering is the application of science-based mathematical  models to decisions about saving, investing, borrowing, lending, and  managing risk. I think that’s a reasonable definition.

Science – mechanics, electrodynamics, molecular biology, etc., – seeks  to discover the fundamental principles that describe the world, and  is usually reductive and analytic. Engineering is about using those principles, constructively and synthetically, for a purpose.  Thus, mechanical engineering is concerned with building devices based on Newton’s laws, suitably combined  with heuristic or empirical rules about more complex forces (friction, for example) that are too difficult to derive from first principles. Electrical engineering is the study of how to create useful electrical devices based on Maxwell’s equations and solid-state physics, combined with similar heuristics. Similarly, bio-engineering is the art of building prosthetics and other biologically active devices based on the principles of biochemistry, physiology and molecular biology.

So what is financial engineering? In a logically consistent world, financial engineering should be layered above a solid base of financial science. Financial engineering would be the study of how to create functional financial devices – convertible bonds, warrants, synthetic CDOs, etc. – that perform in desired ways, not just at expiration, but throughout their lifetime. That’s what Black-Scholes does – it tells you, under certain assumptions, how to engineer a perfect option from stock and bonds.