Sunday, August 20, 2006

My other blog: walter's ecology blog

I don't think that market economy will destroy the planet but I think that people could well do so. That's why I created my other blog about ecology:

walter's ecology blog

Have a look if you are interested.

IRIS integrated risk management ag

I think it's fair to say a word about IRIS integrated risk management ag, the company which I'm working for directly or indirectly since 10 years now.

IRIS is a market leading provided of a Financial Analysis Infrastructure called riskpro(tm) (risk and profitability). I'm leading the development team building this product. In this sense I'm not a finance expert but more a specialist on how to apply financial theory in real life applications.

I hope this less formal knowledge of finance helps me vulgarize it.

Friday, August 18, 2006

Formal finance education

It is maybe interesting for someone to know that there are at least two organizations that provide training and certification in finance generally speaking and risk management specifically:

GARP Global Association of Risk Professionals

PRMIA


They provide courses, course material, networking and certifications.

Tuesday, August 15, 2006

Modeling complexity

Modeling precisely the macro-economic, micro-economic and contractual details related parameters influencing expected cash-flows of a given contract is a very complicated business.

Usually assumptions are taken and bundled into higher-order models. What does this buzzword of mine mean? Let's take an example:

Credit risk, i.e. the risk that a counterparty in a contract defaults, is driven by multiple factors that are very difficult to observe on one hand and model on the other hand. To solve this problem there are on one hand external rating agencies, like Moody’s, publishing "rating" of major counterparties (AAA means they have a very low probability of default and CCC a very high). To these ratings are associated standardized default probabilities and standardized credit spread curves, i.e. curves that, if added to the market expectation curves, used for discounting purpose give the price of the contract without applying difficult assumptions. I.e. we simply assume that if a contract is made with a more risky counterparty then the expected return of this contract should be higher by the amount defined by the spread curve.

Ok this post will need some refactoring, after second reading I don't even understand it myself.... sorry for that. :)

Saturday, August 12, 2006

Financial impact of global economy and politics

It's not always easy to understand how global events, like the war between Israel and Lebanon for instance or before that the war in Iraq, George Bush's global war against terror or more regional events can impact financial reality of everyday life.

What has to be understood is that financial markets, company's life and every area of finance are completely interlinked through on one side the investors and the people as consumers and on the other side the work forces that make companies life possible. When there is a crisis in middle-east, oil prices climb because of the fear of shortage of oil, oil prices climbing make everyday life more expensive and consumers consume less other goods impacting in this way financial health of companies and their stocks.

Many other examples will follow...

Finance and mathematics

Finance analysis is a big consumer of math

We can distinguish mostly two areas of maths that apply:

  • Analysis - In order to compute theoretical prices of instruments we take some assumptions, like the comparison to similar traded products described in another article, and turn these assumptions into formulas applied to compute the prices based on observed variables from the market and intrinsic characteristics of the instrument. Then we derive these formulas against the market variables to determine how risky they are, i.e. how strongly their value change when the market evolves.
  • Statistics - In order to predict future events, potential losses, expected gains and so on we usually assume that there is a higher probability for past events to reoccur in the future than any other different event. These past events are taken into account through statistical analysis based on past observations.

This is also what makes financial engineering very interesting: it is strongly connected to reality of everyday through investments, pension funds, company's lives and so on but also very theoretically challenging.

Thursday, August 10, 2006

Indexes

My article about stock pricing made me think that maybe some clarification about what an Index is could be a good idea.

An Index is an indicator of some category of instruments. This indicator is calculated by averaging the observed price of these given instruments. The choice of the instruments to be part of the index is very broad, you can have indices by industries (IT, Banking, Pharmaceutical, ...), by instrument type (Raw oil index, ...) or any other thing.

The interesting thing is that an index can be bought and sold. It is equivalent to buying a portfolio that will be always composed with the same logic like the index.

Evaluating the price of a stock (pricing a stock)

The price of a stock is driven by multiple factors ranging from the underlying company's financial statements which are rational measures to rumors, assumptions and other less rational factors.

There are various pricing strategies, i.e. strategies to estimate the value of a stock in case of market changes, the simplest one being the CAPM model (Capital Asset Pricing Model) which takes the historical variations of the stock into account with respect to the index of the market it's living in. (see CAPM)

Wednesday, August 09, 2006

IT and finance

It's obvious but Financial institutions are massive consumers of IT. Everything in their daily business is in some form inside a computer. You accounts, your portfolio, your insurance contracts, your profile for the insurance company, their accounting, their analytical infrastructure, their ... you see what I mean by now. :-)

It's also partially why I'm in this business: Financial institutions need IT development so my luck of having done finance all the time since I'm working in IT is a little bit forced because of the amount of IT these guys need.

Sunday, August 06, 2006

Accronyms and definitions

I thought that a small glossary of terms would be a good idea before I move on:

Analysis and reporting:

  • NPV : Net Present Value sum of the present value of all in-flows and the present value of all outflows. The Present Value of a cash-flow happening in the future is the value that should be rationally paid today to obtain this given cash-flow in the future. This is typically obtained by looking on the market for a quoted instrument with the same or a comparable cash-flow.
  • Market Value : Value of a given instrument as observed on the market. The NPV is an estimator of this value.
  • Sensitivity : Importance of the change in NPV when the market changes.
  • VaR (Value At Risk) : value bellow which the NPV of an investment or group of investment won't statistically fall in a given % of confidence and a given time horizon.
  • Basel II : Latest set of banking supervisory rules, replaces the Basel Capital Accord of 1988. It basically gives the rules on how to calculate the capital required to cover the bank's risks.
  • Solvency II : Latest set of insurance supervisory rules (applicable from 2010 on) equivalent to Basel II but for insurances.
  • ... to be continued...

Financial instruments:

  • Bonds : Bonds are very close equivalents to loans. The major difference is that they are traded on the market and standardized. Typically a Bond is a loan emitted by a government or a company.
  • Stocks : Stocks are property rights (rights to vote, rights to take a share in the profit, ...) on a company. They can be traded or not.
  • Futures : Futures are the obligation for two counterparties to exchange a given underlying instrument or cash-flows for a pre-agreed price or other conditions. They can be traded or over the counter(signed between two counterparties without the mediation and standardization of a market place).
  • Options : Options are generally a combination of a right without obligation for one counterparty and an obligation for the other one. A typical option is the stock option giving the right to the buyer (which naturally pays something for that) to buy or sell a stock at a given pre-agreed price from the seller who has the obligation to provide the stock to the buyer if he requests it. Options are of very various nature from simple ones like the above described stock-option to very complex ones than the right of getting the value of some stocks in case the exchange rate between two currencies stays in a given corridor. Options can be traded or over the counter.

Options and futures can be used either for speculative reasons (bet on some future market movement of some instrument to make a gain) or for protection reasons (ensure that some needed instrument can be obtained or that some owned instrument can be soled for a guaranteed price)

Saturday, August 05, 2006

Financial contracts of everyday's life

What are the financial contracts we can find in our everyday life. There are basically two kinds:

Contracts to borrow money

  • Mortgages to buy a house. You borrow an important amount of money and repay it on a long period of time. You pay interest regularly. Your house being collateral of the mortgage, the interest rate is not far from the central bank guiding interest because there is not much risk for the bank or insurance lending you the money. If you cannot repay anymore, they sell your house.
  • Small Credits to finance quick money needs to buy a television or other consumer products. You usually don't provide guaranty or collateral for that and thus your interest rate is quite high since the business is risky and on a global base the bank has to collect money that covers some of its clients not being able to reimburse at all.
  • ...

Contracts to invest money

  • Your saving account which pays you interest
  • Any financial contract (stocks, bonds, options, ...) you could trade yourself and where you can gain on the value change of the contract or the income generated by it (interest payment of a bond, dividend payment of stocks, ...).
  • Investment funds that do the precise choosing of financial contract for you according to your investment profile.
  • ...

Financial analysis and reporting

Financial analysis is the activity measuring the financial reality of an institution from various perspectives like value, sensitivity of value to market movements, statistical losses, income, ...

It is the core activity to put the complex reality of a financial institution under control and give transparency to all levels of management and auditing.

Financial analysis and reporting requires usually intense computer processing power due to the huge number of contractual relationships the company has with other counterparties and the number of contractual and potential cash-flows that are exchanged.

Some typical figures for a commercial bank:

  • 5 million contracts
  • 500'000 cash-flows
  • sensitivity to thousands of correlated risk factors

Friday, August 04, 2006

What is regulatory reporting?

Regulatory reporting is one of the means through which the financial insitution controlling entities analyze the financial situation of the institution.

For the banking business, the international regulatory standards are defined by the so-called Basel Committee on Banking Supervision. This standardisation body edicts guidelines on reports the banks have to provide to their supervisory body. The latest set of guidelines is called Basel II and is currently enforced by the supervisory bodies. The general guidelines are adapted to each countries reality via Country Specific Adjustments.

For the insurrance business, the Solvency accord is giving similar guidelines.

Generally these guidelines are oriented around:
  • ensuring sound financial practices
  • ensuring the level of capital of the financial institutions covers the level of risk taken including correlation between various kinds of risk.
They tend to ensure that in case the risks faced by the institution realized themselves the institution has the required available funds to cover the losses.

Who controls financial institutions?

Here comes a very good question: knowing the very important role played by banks, insurrances, pension funds and other financial insitutions what guaranties that they operate in a sound way, i.e. can cover their current and future obligations ensuring this way stability and trust in the economy to everyone?

There are basically two levels of controle:
  • Internal supervision
  • Regulatory supervision
Internal supervision is done because the shareholders as represented by the board of the financial institution (a company like any other with owners) has naturally no interest at all in a company going bankrupt. There are for this internal risk and profitability management departments in each financial institution.

Regulatory supervision is done by some official state-driven supervisory institute expecting regular reporting from the financial institutions and doing regular auditing of their activities.

What is a financial market?

A financial market is a place where individuals or institutions can exchange standardized, well known financial instruments/contracts under standardized exchange rules.

There are financial markets for:

  • Stocks
  • Bonds
  • Commodities (raw material)
  • Derivatives (Options, Futures, ...)

The role of these markets is to ensure liquidity of the financial instruments, i.e. guaranty the possibility to always be able to buy or sell a financial contract at some price even if not at the expected price.

There are two kinds of markets:

  • Primary markets : theses are markets of professionals where huge amounts of money are collected to make initial investments in some market segments and produce the initial financial contracts.
  • Secondary markets : these are markets of professionals and individuals where the financial contracts are further exchanged on.

Both kinds of market are complementary. Without a secondary market no-one would take the risk to bring the money on the primary market. Without a primary market, the companies wouldn't be able to collect the amount of money needed by initial investments.

Finally the economic goal of markets is to make investments of any size possible by putting together people having complementary financial needs.

Role of Financial institutions

The basic role of financial institutions is to change the shape of money. What I mean by that is for instance:

  • Size change : Collect small amounts of money from some people and lend big amounts of money to others.
  • Term change : Collect money from some people for a long period and lend it to other people for very short periods of time.
  • Payment schedule change : Collect money from some people regularly in order to give it to other people when rare events occur. (Insurances)

This role is very important and cannot be taken by individuals entering bilateral deals because two people never have the same constraints in terms of “shape” of the exchange.

Risks

All financial contracts bare some risk for at least one side of the contract.

A risk is a potential event that can lead to losses. There are a multiple kinds of risk, here are some:

  • Risk of price fluctuations. The contract we entered is not worth anymore the money we invested in it.
  • Risk of default of the other counterparty. The counterparty goes bankrupt and cannot pay us anymore.
  • Risk of ensured event realizing itself. We have to pay for the risk we ensure.

Risks can be transferred, i.e. sold. This is what happens when we enter into an insurance contract or an option. Some risks are transferred between the counterparties sharing the contractual relationship. This also means that a risk has a price and we have to have ways to compute this price in order to properly transfer risks.

Transferring parts of a risk to someone else is also called hedging the risk.

Thursday, August 03, 2006

Financial Contracts

The basis of finance is to bind contractual relationships between people. These contractual relationships can be as example:

  • "renting" money (loans, bonds)
  • buying a property share of a company's profits and voting rights (stocks)
  • paying someone to protect us against some risk (options, insurances, credit derivatives)
  • pre-arranging availability of money for a given rate (Interest Rate Futures)
  • ...

These financial contracts (or instruments) share some common properties, they have:

  • a price
  • an owner
  • a counterparty on the other hand of the contract
  • a date of origination

A convenient way to see financial contracts or instruments is to see them as streams of cash-flows, i.e. a certain number of certain or contingent money exchanges between the counterparties. These cash-flows always happen on pre-arranged terms which are the contractual conditions.

What is Finance?

Yes indeed, I didn't define yet what we call finance.

Let's give it a free-style try: Finance is about finding, investing, securing, transfering money between people or organisations.

The companies specialized in activities of these kind are called Financial Institutions. Banks, Insurrances, Trading companies, ... are all Financial Insitutions.

Some examples:

A set of individuals started a new business of selling oranges on the internet, they financed the first steps by themselves but want now to go global, i.e. sell world-wide. They budget estimate is that they need 1 million USD to achieve that. One way to get that money would be to borrow it from a bank but in this case it is very unlikely that they will find a bank ready to finance such a risky business and only get interest payements from it but maybe they could be interested in taking ownership of part of the company in exchange of the needed capital. We described here to financial activities: commercial banking and investment banking.

There are various others like:

  • Insurance
  • Pension funds
  • Trading
  • ...
And all our naturally completely interlinked. An Insurance invests the premiums received from the insurance contracts into stocks, bonds or other financial instruments.

Some more from wikipedia

Why Finance?

You could wonder why I give so much importance to finance... let's try to define that.

Finance is what backs capitalism and capitalism was the major driver in wealth increase in the world in the past century. Ironically capitalism was the major contributor to what humanists looked for with socialism which never worked. Without entering into details here: I'm not a neo-liberal in the sense that I believe that efficient capitalism is only possible with a frame ensuring equality of chances between people but I'm definitively believing that socialism is just impossible with human nature.

Finance is a continuously evolving complicated and very human field. In fact it shows the creative and twisted mind of humanity.

Finance is a field which can be very well modeled, requires some mathematics, and requires a lot of logic and a good dose of empiric knowledge. In fewer words: it’s challenging and intellectually fun!

My Experience in Finance

I started working in finance a little bit by chance... like most of the things in life.

In 1992 I started my IT engineering studies in the EPFL - the swiss federal institute of technologies in Lausanne and, after having already done an IT degree, I was awfully bored by the courses' content so I desperatly needed to do something else.

One of my friends was working for a small company called Sibelius Informatique in Geneva who did portfolio management software. I started there as a trainee and so got in touch with finance.

In 1996, after having completed my studies at the EPFL I was hired by a consulting company called Linkvest in order to be body shoped but, while waiting on an assignement, they assigned me on the development of the ALM (Asset and Liability Management) dynamic simulation modules of a risk and profitability management system.... and I'm still working on the very same software 10 years later! :)







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