What is the core of financial engineering? It is financial innovation. Without innovation, there will be no financial engineering. Financial engineering emerges and develops with the innovation of financial theory and financial market. Therefore, financial engineering is very young which has developed rapidly in the last two to three decades. It is the development of modern financial theory, the improvement of financial markets, and the development of science and technology, especially information technology, that lay the foundation of this subject.
There are three pillars in modern financial theory, namely the time value of capital, asset pricing, and risk management. Financial engineering also has three pillars: asset pricing, risk management, and innovation of financial instruments. Among them, the last one is the core, and the discipline of financial engineering came out with the pace of financial innovation in the past half a century.
The two most notable achievements in innovation of financial instruments so far are financial derivatives and asset securitization. Financial derivatives appeared earlier and can be said to be the basis of asset securitization.
The development of derivatives is a milestone not only in the financial market, but also in the development of financial engineering. It can be said that the emergence and development of derivatives is the most prominent achievement of current financial engineering. Derivatives are wonderful in that they do not create a new underlying asset but initiatea new financial instrument through the precise stipulation of the contract based on the existing basic financial assets, with the risk and return characteristics stemming but different from the underlying assets.
In principle, these derivative products can be replicated with a combination of underlying assets to be priced. However, the emergence of these derivatives has provided us with powerful tools, allowing market participants to manipulate the financial market more flexibly, greatly expanding market participation, enhancing liquidity, and promoting a more effective and complete market.
The branches of modern financial theory generally have four aspects, namely, efficient market hypothesis, risk-benefit assessment theory, asset pricing theory, and corporate finance theory. Among them, asset pricing theory is the core of modern financial theory as well as an important research object of financial engineering. Transactions in the financial market are zero net present value transactions.
Besides, the overall value of the company comes from the organic combination of parts, rather than simple addition, and the way of combination is the key. Continuous operating value is generated during the operation, and only the liquidation value is left when the operation stops.
