Computational finance is a branch of applied

computer science Computer science is the study of computation, information, and automation. Computer science spans Theoretical computer science, theoretical disciplines (such as algorithms, theory of computation, and information theory) to Applied science, ...

that deals with problems of practical interest in

finance Finance refers to monetary resources and to the study and Academic discipline, discipline of money, currency, assets and Liability (financial accounting), liabilities. As a subject of study, is a field of Business administration, Business Admin ...

.Rüdiger U. Seydel, ''Tools for Computational Finance'', Springer; 3rd edition (May 11, 2006) 978-3540279235 Some slightly different definitions are the study of

data Data ( , ) are a collection of discrete or continuous values that convey information, describing the quantity, quality, fact, statistics, other basic units of meaning, or simply sequences of symbols that may be further interpreted for ...

and

algorithm In mathematics and computer science, an algorithm () is a finite sequence of Rigour#Mathematics, mathematically rigorous instructions, typically used to solve a class of specific Computational problem, problems or to perform a computation. Algo ...

s currently used in finance and the

mathematics Mathematics is a field of study that discovers and organizes methods, Mathematical theory, theories and theorems that are developed and Mathematical proof, proved for the needs of empirical sciences and mathematics itself. There are many ar ...

computer program A computer program is a sequence or set of instructions in a programming language for a computer to Execution (computing), execute. It is one component of software, which also includes software documentation, documentation and other intangibl ...

s that realize financial

models A model is an informative representation of an object, person, or system. The term originally denoted the plans of a building in late 16th-century English, and derived via French and Italian ultimately from Latin , . Models can be divided int ...

system A system is a group of interacting or interrelated elements that act according to a set of rules to form a unified whole. A system, surrounded and influenced by its open system (systems theory), environment, is described by its boundaries, str ...

s.Cornelis A. Los, ''Computational Finance'' World Scientific Pub Co Inc (December 2000) Computational finance emphasizes practical

numerical methods Numerical analysis is the study of algorithms that use numerical approximation (as opposed to symbolic manipulations) for the problems of mathematical analysis (as distinguished from discrete mathematics). It is the study of numerical methods t ...

rather than

mathematical proof A mathematical proof is a deductive reasoning, deductive Argument-deduction-proof distinctions, argument for a Proposition, mathematical statement, showing that the stated assumptions logically guarantee the conclusion. The argument may use othe ...

s and focuses on techniques that apply directly to economic analyses.Mario J. Miranda and Paul L. Fackler, ''Applied Computational Economics and Finance'', The MIT Press (September 16, 2002) It is an interdisciplinary field between

mathematical finance Mathematical finance, also known as quantitative finance and financial mathematics, is a field of applied mathematics, concerned with mathematical modeling in the financial field. In general, there exist two separate branches of finance that req ...

and

.Omur Ugur, ''Introduction to Computational Finance'', Imperial College Press (December 22, 2008) Two major areas are efficient and accurate computation of

fair value In accounting, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. The derivation takes into account such objective factors as the costs associated with production or replacement, market c ...

s of financial securities and the modeling of

stochastic Stochastic (; ) is the property of being well-described by a random probability distribution. ''Stochasticity'' and ''randomness'' are technically distinct concepts: the former refers to a modeling approach, while the latter describes phenomena; i ...

time series In mathematics, a time series is a series of data points indexed (or listed or graphed) in time order. Most commonly, a time series is a sequence taken at successive equally spaced points in time. Thus it is a sequence of discrete-time data. ...

.Jin-Chuan Duan, Wolfgang Karl Härdle and James E. Gentle (editors), ''Handbook of Computational Finance'', Springer (October 25, 2011)

History

The birth of computational finance as a discipline can be traced to

Harry Markowitz Harry Max Markowitz (August 24, 1927 – June 22, 2023) was an American economist who received the 1989 John von Neumann Theory Prize and the 1990 Nobel Memorial Prize in Economic Sciences. Markowitz was a professor of finance at the Rady Scho ...

in the early 1950s. Markowitz conceived of the portfolio selection problem as an exercise in mean-variance optimization. This required more computer power than was available at the time, so he worked on useful algorithms for approximate solutions.Harry M. Markowitz, ''Portfolio Selection: Efficient Diversification of Investments'', Wiley, second edition (September 3, 1991) 978-1557861085 Mathematical finance began with the same insight, but diverged by making simplifying assumptions to express relations in simple closed forms that did not require sophisticated computer science to evaluate.Justin Fox, ''The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street'', HarperBusiness (June 9, 2009) In the 1960s, hedge fund managers such as

Ed Thorp Edward Oakley Thorp (born August 14, 1932) is an American mathematics professor, author, hedge fund manager, and blackjack researcher. He pioneered the modern applications of probability theory, including the harnessing of very small correlatio ...

William Poundstone, ''Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street'', Hill and Wang (September 19, 2006) and

Michael Goodkin Michael Goodkin (August 12, 1942 - June 6, 2022) was a quantitative finance entrepreneur and author. Biography Goodkin was born in Chicago. He holds a BA from the University of Illinois, a JD from Northwestern University and an MBA from Columbia ...

(working with Harry Markowitz,

Paul Samuelson Paul Anthony Samuelson (May 15, 1915 – December 13, 2009) was an American economist who was the first American to win the Nobel Memorial Prize in Economic Sciences. When awarding the prize in 1970, the Swedish Royal Academies stated that he "h ...

and

Robert C. Merton Robert Cox Merton (born July 31, 1944) is an American economist, Nobel Memorial Prize in Economic Sciences laureate, and professor at the MIT Sloan School of Management, known for his pioneering contributions to continuous-time finance, especia ...

)Michael Goodkin, ''The Wrong Answer Faster: The Inside Story of Making the Machine that Trades Trillions'', Wiley, (February 21, 2012) pioneered the use of computers in

arbitrage Arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more marketsstriking a combination of matching deals to capitalize on the difference, the profit being the difference between the market prices at which th ...

trading. In academics, sophisticated computer processing was needed by researchers such as Eugene Fama in order to analyze large amounts of financial data in support of the

efficient-market hypothesis The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis ...

. During the 1970s, the main focus of computational finance shifted to

options pricing In finance, a price (premium) is paid or received for purchasing or selling options. The calculation of this premium will require sophisticated mathematics. Premium components This price can be split into two components: intrinsic value, and ...

and analyzing

mortgage A mortgage loan or simply mortgage (), in civil law (legal system), civil law jurisdictions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners t ...

securitization Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans, or credit card debt obligations (or other non-debt assets which generate receivables) and sellin ...

s.Aaron Brown, ''Red-Blooded Risk: The Secret History of Wall Street'', Wiley (October 11, 2011) In the late 1970s and early 1980s, a group of young quantitative practitioners who became known as "rocket scientists" arrived on

Wall Street Wall Street is a street in the Financial District, Manhattan, Financial District of Lower Manhattan in New York City. It runs eight city blocks between Broadway (Manhattan), Broadway in the west and South Street (Manhattan), South Str ...

and brought along

personal computer A personal computer, commonly referred to as PC or computer, is a computer designed for individual use. It is typically used for tasks such as Word processor, word processing, web browser, internet browsing, email, multimedia playback, and PC ...

s. This led to an explosion of both the amount and variety of computational finance applications.John F. Ehlers, ''Rocket Science for Traders'', Wiley (July 20, 2001) Many of the new techniques came from

signal processing Signal processing is an electrical engineering subfield that focuses on analyzing, modifying and synthesizing ''signals'', such as audio signal processing, sound, image processing, images, Scalar potential, potential fields, Seismic tomograph ...

and

speech recognition Speech recognition is an interdisciplinary subfield of computer science and computational linguistics that develops methodologies and technologies that enable the recognition and translation of spoken language into text by computers. It is also ...

rather than traditional fields of

computational economics Computational economics is an interdisciplinary research discipline that combines methods in computational science and economics to solve complex economic problems.''Computational Economics''."About This Journal"an"Aims and Scope" This subject e ...

optimization Mathematical optimization (alternatively spelled ''optimisation'') or mathematical programming is the selection of a best element, with regard to some criteria, from some set of available alternatives. It is generally divided into two subfiel ...

and

analysis. By the end of the 1980s, the winding down of the

Cold War The Cold War was a period of global Geopolitics, geopolitical rivalry between the United States (US) and the Soviet Union (USSR) and their respective allies, the capitalist Western Bloc and communist Eastern Bloc, which lasted from 1947 unt ...

brought a large group of displaced

physicist A physicist is a scientist who specializes in the field of physics, which encompasses the interactions of matter and energy at all length and time scales in the physical universe. Physicists generally are interested in the root or ultimate cau ...

s and applied mathematicians, many from behind the

Iron Curtain The Iron Curtain was the political and physical boundary dividing Europe into two separate areas from the end of World War II in 1945 until the end of the Cold War in 1991. On the east side of the Iron Curtain were countries connected to the So ...

, into finance. These people become known as " financial engineers" ("quant" is a term that includes both rocket scientists and financial engineers, as well as quantitative portfolio managers).Aaron Brown, ''The Poker Face of Wall Street'', Wiley (March 31, 2006) 978-0470127315 This led to a second major extension of the range of computational methods used in finance, also a move away from personal computers to mainframes and

supercomputer A supercomputer is a type of computer with a high level of performance as compared to a general-purpose computer. The performance of a supercomputer is commonly measured in floating-point operations per second (FLOPS) instead of million instruc ...

s. Around this time computational finance became recognized as a distinct academic subfield. The first degree program in computational finance was offered by

Carnegie Mellon University Carnegie Mellon University (CMU) is a private research university in Pittsburgh, Pennsylvania, United States. The institution was established in 1900 by Andrew Carnegie as the Carnegie Technical Schools. In 1912, it became the Carnegie Institu ...

in 1994. Over the last 20 years, the field of computational finance has expanded into virtually every area of finance, and the demand for practitioners has grown dramatically. Moreover, many specialized companies have grown up to supply computational finance software and services.

Applications of Computational Finance

Insurance Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to protect ...

Quantitative investing Quantitative analysis is the use of mathematical and statistical methods in finance and investment management. Those working in the field are quantitative analysts (quants). Quants tend to specialize in specific areas which may include derivative ...

References

External links

IEEE Computational Finance and Economics Technical Committee

An Introduction to Computational Finance without Agonizing PainIntroduction to Computational Finance, IEEE Computational Intelligence Society Newsletter, August 2004Centre for Computational Finance and Economic Agents (CCFEA)

The Journal of Computational Finance
{{Finance Mathematical finance Actuarial science Computational fields of study

History

Applications of Computational Finance

See also

References

External links