INTRODUCTION TO INDUSTRIAL ENGINEERING APPLICATIONS IN FINANCIAL ASSET MANAGEMENT

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INTRODUCTION

Over the last decade, the challenges faced by asset managers have become significantly more com- plex. The array of investment choices has expanded tremendously in response to globalization and financial engineering. New products are now available such as collateralized debt, insurance-linked securities, and exotic structured products. At the same time, the need for investment planning has shifted more to individuals as companies and public entities relinquish responsibility for retirement programs.

Because of this incredible change in the investment world, institutions such as pension plan administrators, endowments, foundations, and asset managers are under greater pressure than ever to produce higher portfolio returns. This is the genesis for embracing new assets, which hopefully will generate superior investment performance than plain vanilla portfolios of stocks and bonds. Better returns reduce the need for future cash injections to fund obligations.

Unfortunately, market risks have increased as the array of available investment instruments has broadened. For example, the Mexican peso crisis in 1994, the Asian currency debacle and recession beginning in 1997, the Russian debt default and the unprecedented hedge fund bail-out coordinated by the Federal Reserve Bank in 1998, and a 30% drop in the price of technology shares early in 2000 all had major repercussions for financial markets. Where is an investor to find solace in such an unfriendly and disturbing environment?

The obvious answer to heightened complexity and uncertainty lies in utilizing financial engi- neering techniques to manage asset portfolios. This chapter reviews the current state of the art from a practitioner’s perspective. The prime focus is on mean-variance optimization techniques, which remain the principal application tool. The key message is that while the methods employed by today’s specialists are not especially onerous mathematically or computationally, there are major issues in problem formulation and structure. It is in this arena that imagination and inventiveness take center stage.

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