1. Explain how a financial engineer can use technology in the statistical analysis.

                                       
       [10]
2. Discuss the role and limitations of statistics in Business and Economics.                                                 
      [20]
3. Explain the Statistical Data Investigation Process.                                                                                 
              [10]

Statistical analysis is the collection and interpretation of data in order to uncover patterns and trends.
Technology in this field of study can be used by financial engineers in many ways. A financial engineer can
be defined as an individual that uses tools and knowledge in the field of computer science, statistics,
economics and applied mathematics to address current financial issues as well as to devise new and
innovative financial products. Financial engineers evaluate options, assess risks, manage portfolios and
contribute to the development of financial products. Therefore financial engineers can use these various
tasks in statistical analysis to create accurate statistical models to predict the behaviour of assets and other
financial products. Statistical analysis also plays a crucial role in areas of financial engineering such as
estimation and prediction together with numerical implementation of options and hedging evaluation
techniques.

Statistical analysis is used by financial engineers in the Black-Scholes model (BSM), The BSM model due
to Black, Scholes, and Merton (1974) makes assumptions on the probability distribution of the return of an
asset as it varies in time. Thus intervals for future prices are predicted and returns using current prices and
the interpretation of these intervals is the stock price or returns. The returns gives a bell-shaped or normal
distribution at every point in time and this is called a serial independence in statistics meaning that wild
variations in prices are unlikely to occur. For instance in the BSM model on a normal distribution there is
only a 3% probability that a future return will lie more than three standard deviations away from the mean
and for other distributions the probability can be much greater up to about 10 or 11%.

Financial engineers can use technology of statistical analysis in financial data modelling through statistical
models for option pricing. The model can be used for issues faced by traders daily on the stock market for
example given the current market value of one share you can purchase a call option on an asset and earn the
right to buy one share at a price above the market value (strike price) within the next two months or so
(maturity period). In that period if the price of the share stays below the strike price you will never exercise
the option and if the price goes above the strike price you may exercise the option. In this scenario
assessment of previous data to check if the assumptions hold is a necessity and can be achieved through the
use of statistical models for option pricing where we can assess whether the price of an asset and the option
are fair. The decision to buy the option or not can then be made through the technology in statistical analysis
to make predictions and approximations on the appropriateness of the data in hand.

Knowledge in statistical analysis can be used in portfolio management. According to Markowitz (1952) he
used a weighted sum of Normally distributed random variables to model the return of a portfolio and also
used the standard deviation as a measure of the risk of a portfolio (Pω), he also investigated the problem of
minimizing this risk for a given average return. In addition he considered the complementary problem of
maximizing the expectation Rω = E(Pω) for a given level of risk. The Markowitz model was able to solve
an optimization issue using elementary calculus where the variance can be modelled assuming that the
weights sum up to 1. Thus financial engineers can maximize a utility function representing the wealth of an
investor, or minimizing a risk measure such as the standard deviation.

Risk management is another key field of the use of technology in statistical analysis by financial engineers.
Risk management strains on the issue of measuring risks, beginning with Basel Accords (1991) he
introduced Value-at-Risk (VaR) to measure market risk. In relation to the Basel Accords (1991)) Artzner et
al. (1999) proposed axioms that should be satisfied by what they called coherent risk measures. One of the
issues in risk management is how to model individual risk factors and account for their interdependence.
Two areas of statistical analysis are relevant to this problem, copula modeling and extreme-value theory and
they are important for market and operational risks (Roncalli (2004).

In conclusion the use of technology in statistical analysis by financial engineers is significant in the
computational of financial methods and financial engineers can use this knowledge in creating statistical
methods that works in modelling finance.