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A Brief History of FE

What is FE?
Computational Finance (quantitative finance, financial engineering, or mathematical finance):
A cross-disciplinary field which uses quantitative methods developed in math or engineering to solve financial problems.

Time and Risk


A typical financial problem concerns how to allocate and deploy economic resources, both spatially and across time, in an uncertain environment. Example: Investment for retirement Time and risk

Diversify Your Portfolio, But How?


Diversification to reduce risks: Do not put all the eggs in one basket. But we need a more quantitative answer. First attempt: Harry Markowitz (1952) and William Sharpe (1962)

Efficient Market Hypothesis: From Random Walk to Stochastic Calculus


Economics statisticians tried very hard to predict financial markets, but failed. In the mid of 1960s, Paul Samuelson had begun to circulate Bachelier's work among economists. Inspired by this new idea, Eugene Fama published his dissertation in 1965 arguing for the efficient market hypothesis:
prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.

Efficient Market Hypothesis: From Random Walk to Stochastic Calculus


EMH is a starting point where more advanced mathematics steps in:
Robert Merton in 1969 introduced stochastic calculus to understand how prices are set in financial markets through equilibriums.

Building More Complex Financial Instruments: Black and Scholes


In 1973, Black and Scholes developed their celebrated option pricing formula. In the period of 1979-1983, Harrison, Kreps, and Pliska used a general theory of continuous-time martingales to extend the Black-Scholes work to price numerous other derivative securities. The theory of Black-Scholes and Harrison-KrepsPliska laid a solid theoretical foundation for the prosperity of derivative markets.

Political Impetus: Regan and Thatcher


A serious stagflation fatigued the whole capitalism world during the period of 1970s and early 1980s. That stimulated several major western countries, led by Regan in US and Thatcher in UK, to switch away from the Keynesian economics to the New Classical Doctrine. The new classical economics emphasizes less government intervention and free market principle.

The Rise and Decline of FE


A friendly political environment and the corresponding academic preparation prompted a rapid growth in the derivative markets and in turn the demand for more sophisticated mathematical tools. However, the credit crisis in 2007-2009 casts doubt on the philosophy behind financial engineering. What is the next step?

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