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Finance
Contents
Articles
Main article
1
Finance 1
The main techniques and sectors of the financial industry
7
Financial services 7
Personal finance
11
Personal finance 11
Corporate finance
13
Corporate finance 13
Financial capital 21
Cornering the market 27
Insurance 31
Risk Management
53
Derivative 53
Finance of states
64
Public finance 64
Financial economics
72
Financial economics 72
Financial mathematics
75
Financial mathematics 75
Experimental finance
80
Experimental finance 80
Behavioral finance
81
Behavioral finance 81
Intangible asset finance
91
Intangible asset finance 91
References
Article Sources and Contributors 94
Image Sources, Licenses and Contributors 97
Article Licenses
License 98
1
Main article
Finance
Finance is often defined simply as the management of money or funds management.
[1]
Modern finance, however,
is a family of business activity that includes the origination, marketing, and management of cash and money
surrogates through a variety of capital accounts, instruments, and markets created for transacting and trading assets,
liabilities, and risks. Finance is conceptualized, structured, and regulated by a complex system of power relations
within political economies across state and global markets. Finance is both art (e.g. product development) and
science (e.g. measurement), although these activities increasingly converge through the intense technical and
institutional focus on measuring and hedging risk-return relationships that underlie shareholder value. Networks of
financial businesses exist to create, negotiate, market, and trade in evermore-complex financial products and services
for their own as well as their clients accounts. Financial performance measures assess the efficiency and profitability
of investments, the safety of debtors claims against assets, and the likelihood that derivative instruments will protect
investors against a variety of market risks.
[2]
The financial system consists of public and private interests and the markets that serve them. It provides capital from
individual and institutional investors who transfer money directly and through intermediaries (e.g. banks, insurance
companies, brokerage and fund management firms) to other individuals, firms, and governments that acquire
resources and transact business. With the expectation of reaping profits, investors fund credit in the forms of (1) debt
capital (e.g. corporate and government notes and bonds, mortgage securities and other credit instruments), (2) equity
capital (e.g. listed and unlisted company shares), and (3) the derivative products of a wide variety of capital
investments including debt and equity securities, property, commodities, and insurance products. Although closely
related, the disciplines of economics and finance are distinctive. The economy is a social institution that organizes
a societys production, distribution, and consumption of goods and services, all of which must be financed.
Economists make a number of abstract assumptions for purposes of their analyses and predictions. They generally
regard financial markets that function for the financial system as an efficient mechanism. In practice, however,
emerging research is demonstrating that such assumptions are unreliable. Instead, financial markets are subject to
human error and emotion.
[3]
New research discloses the mischaracterization of investment safety and measures of
financial products and markets so complex that their effects, especially under conditions of uncertainty, are
impossible to predict. The study of finance is subsumed under economics as finance economics, but the scope, speed,
power relations and practices of the financial system can uplift or cripple whole economies and the well-being of
households, businesses and governing bodies within themsometimes in a single day.
Three overarching divisions exist within the academic discipline of finance and its related practices: 1) personal
finance: the finances of individuals and families concerning household income and expenses, credit and debt
management, saving and investing, and income security in later life, 2) corporate finance: the finances of for-profit
organizations including corporations, trusts, partnerships and other entities, and 3) public finance: the financial
affairs of domestic and international governments and other public entities.
[4]

[5]
Areas of study within (and the
interactions among) these three levels affect all dimensions of social life: politics, taxes, art, religion, housing, health
care, poverty and wealth, consumption, sports, transportation, labor force participation, media, and education. While
each has a vast accumulated literature of its own, the effects of macro and micro level financing that mold and
impact these and other domains of human and societal life typically have been treated by researchers as policy,
welfare, work, stratification, and so forth, or have been largely unexplored. Recent research in "behavioral
finance" is promising, albeit a relative newcomer, to the existing body of financial research that focuses primarily on
measurement.
Finance
2
Loans have become increasingly packaged for resale, meaning that an investor buys the loan (debt) from a bank or
directly from a corporation. Bonds are debt instruments sold to investors for organizations such as companies,
governments or charities.
[6]
The investor can then hold the debt and collect the interest or sell the debt on a
secondary market. Banks are the main facilitators of funding through the provision of credit, although private equity,
mutual funds, hedge funds, and other organizations have become important as they invest in various forms of debt.
Financial assets, known as investments, are financially managed with careful attention to financial risk management
to control financial risk. Financial instruments allow many forms of securitized assets to be traded on securities
exchanges such as stock exchanges, including debt such as bonds as well as equity in publicly traded corporations.
Central banks, such as the Federal Reserve System banks in the United States and Bank of England in the United
Kingdom, are strong players in public finance, acting as lenders of last resort as well as strong influences on
monetary and credit conditions in the economy.
[7]
Overview of techniques and sectors of the financial industry
An entity whose income exceeds its expenditure can lend or invest the excess income. On the other hand, an entity
whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its
expenses, or increasing its income. The lender can find a borrower, a financial intermediary such as a bank, or buy
notes or bonds in the bond market. The lender receives interest, the borrower pays a higher interest than the lender
receives, and the financial intermediary earns the difference for arranging the loan.
A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it
pays interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders, of different sizes,
to coordinate their activity.
Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate
finance) and by a wide variety of other organizations, including schools and non-profit organizations. In general, the
goals of each of the above activities are achieved through the use of appropriate financial instruments and
methodologies, with consideration to their institutional setting.
Finance is one of the most important aspects of business management and includes decisions related to the use and
acquisition of funds for the enterprise.
In corporate finance, a company's capital structure is the total mix of financing methods it uses to raise funds. One
method is debt financing, which includes bank loans and bond sales. Another method is equity financing - the sale of
stock by a company to investors, the original shareholders of a share. Ownership of a share gives the shareholder
certain contractual rights and powers, which typically include the right to receive declared dividends and to vote the
proxy on important matters (e.g., board elections). The owners of both bonds and stock, may be institutional
investors - financial institutions such as investment banks and pension funds or private individuals, called private
investors or retail investors.
Finance
3
Areas of finance
Personal finance
Questions in personal finance revolve around
How much money will be needed by an individual (or by a family), and when?
How can people protect themselves against unforeseen personal events, as well as those in the external economy?
How can family assets best be transferred across generations (bequests and inheritance)?
How does tax policy (tax subsidies or penalties) affect personal financial decisions?
How does credit affect an individual's financial standing?
How can one plan for a secure financial future in an environment of economic instability?
Personal financial decisions may involve paying for education, financing durable goods such as real estate and cars,
buying insurance, e.g. health and property insurance, investing and saving for retirement.
Personal financial decisions may also involve paying for a loan, or debt obligations.
Corporate finance
Managerial or corporate finance is the task of providing the funds for a corporation's activities (for small business,
this is referred to as SME finance). Corporate finance generally involves balancing risk and profitability, while
attempting to maximize an entity's wealth and the value of its stock, and generically entails three interrelated
decisions. In the first, "the investment decision", management must decide which "projects" (if any) to undertake.
The discipline of capital budgeting is devoted to this question, and may employ standard business valuation
techniques or even extend to real options valuation; see Financial modeling. The second, "the financing decision"
relates to how these investments are to be funded: capital here is provided by shareholders, in the form of equity
(privately or via an initial public offering), creditors, often in the form of bonds, and the firm's operations (cash
flow). Short-term funding or working capital is mostly provided by banks extending a line of credit. The balance
between these elements forms the company's capital structure. The third, "the dividend decision", requires
management to determine whether any unappropriated profit is to be retained for future investment / operational
requirements, or instead to be distributed to shareholders, and if so in what form. Short term financial management is
often termed "working capital management", and relates to cash-, inventory- and debtors management. These areas
often overlap with the firm's accounting function, however, financial accounting is more concerned with the
reporting of historical financial information, while these financial decisions are directed toward the future of the
firm.
Finance of public entities
Public finance describes finance as related to sovereign states and sub-national entities (states/provinces, counties,
municipalities, etc.) and related public entities (e.g. school districts) or agencies. It is concerned with:
Identification of required expenditure of a public sector entity
Source(s) of that entity's revenue
The budgeting process
Debt issuance (municipal bonds) for public works projects
Finance
4
Financial risk management
Financial risk management is the practice of creating and protecting economic value in a firm by using financial
instruments to manage exposure to risk, particularly credit risk and market risk. (Other risk types include Foreign
exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc.) It focuses on when and how to hedge using
financial instruments; in this sense it overlaps with financial engineering. Similar to general risk management,
financial risk management requires identifying its sources, measuring it (see: Risk measure: Well known risk
measures), and formulating plans to address these, and can be qualitative and quantitative. In the banking sector
worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and
exposing operational, credit and market risks.
Finance theory
Financial economics
Financial economics is the branch of economics studying the interrelation of financial variables, such as prices,
interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on
influences of real economic variables on financial ones, in contrast to pure finance. It centres on decision making
under uncertainty in the context of the financial markets, and the resultant economic and financial models. It
essentially explores how rational investors would apply decision theory to the problem of investment. Here, the twin
assumptions of rationality and market efficiency lead to modern portfolio theory (the CAPM), and to the Black
Scholes theory for option valuation; it further studies phenomena and models where these assumptions do not hold,
or are extended. "Financial economics", at least formally, also considers investment under "certainty" (Fisher
separation theorem, "theory of investment value", Modigliani-Miller theorem) and hence also contributes to
corporate finance theory. Financial Econometrics is the branch of Financial Economics that uses econometric
techniques to parameterize the relationships suggested.
Financial mathematics
Financial mathematics is a field of applied mathematics, concerned with financial markets. The subject has a close
relationship with the discipline of financial economics, which is concerned with much of the underlying theory.
Generally, mathematical finance will derive, and extend, the mathematical or numerical models suggested by
financial economics. In terms of practice, mathematical finance also overlaps heavily with the field of computational
finance (also known as financial engineering). Arguably, these are largely synonymous, although the latter focuses
on application, while the former focuses on modeling and derivation (see: Quantitative analyst). The field is largely
focused on the modelling of derivatives, although other important subfields include insurance mathematics and
quantitative portfolio problems. See Outline of finance: Mathematical tools; Outline of finance: Derivatives pricing.
Experimental finance
Experimental finance aims to establish different market settings and environments to observe experimentally and
provide a lens through which science can analyze agents' behavior and the resulting characteristics of trading flows,
information diffusion and aggregation, price setting mechanisms, and returns processes. Researchers in experimental
finance can study to what extent existing financial economics theory makes valid predictions, and attempt to
discover new principles on which such theory can be extended. Research may proceed by conducting trading
simulations or by establishing and studying the behaviour of people in artificial competitive market-like settings.
Finance
5
Behavioral finance
Behavioral Finance studies how the psychology of investors or managers affects financial decisions and markets.
Behavioral finance has grown over the last few decades to become central to finance.
Behavioral finance includes such topics as:
1. 1. Empirical studies that demonstrate significant deviations from classical theories.
2. 2. Models of how psychology affects trading and prices
3. 3. Forecasting based on these methods.
4. 4. Studies of experimental asset markets and use of models to forecast experiments.
A strand of behavioral finance has been dubbed Quantitative Behavioral Finance, which uses mathematical and
statistical methodology to understand behavioral biases in conjunction with valuation. Some of this endeavor has
been led by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during
2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don
Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, Ray Sturm and others have demonstrated
significant behavioral effects in stocks and exchange traded funds. Among other topics, quantitative behavioral
finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.
Intangible asset finance
Intangible asset finance is the area of finance that deals with intangible assets such as patents, trademarks, goodwill,
reputation, etc.
Related professional qualifications
There are several related professional qualifications, that can lead to the field:
Generalist Finance qualifications:
Degrees: Masters degree in Finance (MSF), Master of Financial Economics, Master of Finance & Control
(MFC), Master Financial Manager (MFM), Master of Financial Administration (MFA)
Certifications: Chartered Financial Analyst (CFA), Certified Treasury Professional (CTP), Certified Valuation
Analyst (CVA), Certified International Investment Analyst (CIIA),, Association of Corporate Treasurers
(ACT), Certified Market Analyst (CMA/FAD) Dual Designation, Corporate Finance Qualification (CF),
Chartered Alternative Investment Analyst (CAIA)
Quantitative Finance qualifications: Master of Financial Engineering (MSFE), Master of Quantitative Finance
(MQF), Master of Computational Finance (MCF), Master of Financial Mathematics (MFM), Certificate in
Quantitative Finance (CQF).
Accountancy qualifications:
Qualified accountant: Chartered Accountant (ACA - UK certification / CA - certification in Commonwealth
countries), Chartered Certified Accountant (ACCA, UK certification), Certified Public Accountant (CPA, US
certification), ACMA/FCMA ( Associate/Fellow Chartered Management Accountant) from Chartered Institute
of Management Accountant(CIMA), UK.
Non-statutory qualifications: Chartered Cost Accountant CCA Designation from AAFM
Business qualifications: Master of Business Administration (MBA), Master of Management (MM), Master of
Commerce (M.Comm), Master of Science in Management (MSM), Doctor of Business Administration (DBA)
Finance
6
References
[1] Gove, P. et al. 1961. Finance. Webster's Third New International Dictionary of the English Language Unabridged. Springfield,
Massachusetts: G. & C. Merriam Company.
[2] "Vitt, L.A. 2011. "Financial Sociology." Ritzer, G. (ed.) T'he Blackwell Encyclopedia of Sociology.' Retrieved October 10, 2011 http:/ /
www.sociologyencyclopedia.com/ public/ search?query=Financial+ Sociology
[3] [3] Berezin, M. (2005). "Emotions and the Economy" in Smelser, N.J. and R. Swedberg (eds.) The Handbook of Economic Sociology, Second
Edition. Princeton University Press: Princeton, NJ
[4] The Blackwell Encyclopedia of Sociaology Online. Ritzer, G. (ed.) The Blackwell Encyclopedia of Sociology. Retrieved October 10, 2011
http:/ / www.sociologyencyclopedia.com/ public/ search?query=Financial+ Sociology
[5] Encyclopdia Britannica Online: britannica.com (http:/ / www. britannica. com/ EBchecked/ topic/ 207147/ finance)
[6] Charitytimes.com (http:/ / www. charitytimes.com/ pages/ ct_news/ news archive/ July_06_news/ 030706_wellcome_trust_charity_bond.
htm)
[7] Board of Governors of Federal Reserve System of the United States. Mission of the Federal Reserve System. Federalreserve.gov (http:/ /
www.federalreserve.gov/ aboutthefed/ mission.htm) Accessed: 2010-01-16. (Archived by WebCite at Webcitation.org (http:/ / www.
webcitation.org/ 5mpS52OAl))
External links
OECD work on financial markets (http:/ / www. oecd. org/ finance) Observation of UK Finance Market
Wharton Finance Knowledge Project (http:/ / knowledge. wharton. upenn. edu/ category. cfm?cid=1) - aimed to
offer free access to finance knowledge for students, teachers, and self-learners.
Professor Aswath Damodaran (http:/ / pages. stern. nyu. edu/ ~adamodar/ ) (New York University Stern School of
Business) - provides resources covering three areas in finance: corporate finance, valuation and investment
management and syndicate finance.
7
The main techniques and sectors of the
financial industry
Financial services
Financial services are the economic services provided by the finance industry, which encompasses a broad range of
organizations that manage money, including credit unions, banks, credit card companies, insurance companies,
consumer finance companies, stock brokerages, investment funds and some government sponsored enterprises. As of
2004, the financial services industry represented 20% of the market capitalization of the S&P 500 in the United
States.
[1]
History of financial services
The term "financial services" became more prevalent in the United States partly as a result of the
Gramm-Leach-Bliley Act of the late 1990s, which enabled different types of companies operating in the U.S.
financial services industry at that time to merge.
[2]
Companies usually have two distinct approaches to this new type
of business. One approach would be a bank which simply buys an insurance company or an investment bank, keeps
the original brands of the acquired firm, and adds the acquisition to its holding company simply to diversify its
earnings. Outside the U.S. (e.g., in Japan), non-financial services companies are permitted within the holding
company. In this scenario, each company still looks independent, and has its own customers, etc. In the other style, a
bank would simply create its own brokerage division or insurance division and attempt to sell those products to its
own existing customers, with incentives for combining all things with one company...
Banks
A "commercial bank" is what is commonly referred to as simply a "bank". The term "commercial" is used to
distinguish it from an "investment bank," a type of financial services entity which, instead of lending money directly
to a business, helps businesses raise money from other firms in the form of bonds (debt) or stock (equity).
Banking services
The primary operations of banks include:
Keeping money safe while also allowing withdrawals when needed
Issuance of checkbooks so that bills can be paid and other kinds of payments can be delivered by post
Provide personal loans, commercial loans, and mortgage loans (typically loans to purchase a home, property or
business)
Issuance of credit cards and processing of credit card transactions and billing
Issuance of debit cards for use as a substitute for checks
Allow financial transactions at branches or by using Automatic Teller Machines (ATMs)
Provide wire transfers of funds and Electronic fund transfers between banks
Facilitation of standing orders and direct debits, so payments for bills can be made automatically
Provide overdraft agreements for the temporary advancement of the Bank's own money to meet monthly spending
commitments of a customer in their current account.
Provide internet banking system to facilitate the customers to view and operate their respective accounts through
internet.
Financial services
8
Provide Charge card advances of the Bank's own money for customers wishing to settle credit advances monthly.
Provide a check guaranteed by the Bank itself and prepaid by the customer, such as a cashier's check or certified
check.
Notary service for financial and other documents
Accepting the deposits from customer and provide the credit facilities to them.
Other types of bank services
Private banking - Private banks provide banking services exclusively to high net worth individuals. Many
financial services firms require a person or family to have a certain minimum net worth to qualify for private
banking services.
[3]
Private banks often provide more personal services, such as wealth management and tax
planning, than normal retail banks.
[4]
Capital market bank - bank that underwrite debt and equity, assist company deals (advisory services, underwriting
and advisory fees), and restructure debt into structured finance products.
Bank cards - include both credit cards and debit cards. Bank Of America is the largest issuer of bank cards.
Credit card machine services and networks - Companies which provide credit card machine and payment
networks call themselves "merchant card providers".
Foreign exchange services
Foreign exchange services are provided by many banks around the world. Foreign exchange services include:
Currency exchange - where clients can purchase and sell foreign currency banknotes.
Foreign Currency Banking - banking transactions are done in foreign currency.
Wire transfer - where clients can send funds to international banks abroad.
Investment services
Asset management - the term usually given to describe companies which run collective investment funds. Also
refers to services provided by others, generally registered with the Securities and Exchange Commission as
Registered Investment Advisors.
Hedge fund management - Hedge funds often employ the services of "prime brokerage" divisions at major
investment banks to execute their trades.
Custody services - the safe-keeping and processing of the world's securities trades and servicing the associated
portfolios. Assets under custody in the world are approximately $100 trillion.
[5]
Insurance
Insurance brokerage - Insurance brokers shop for insurance (generally corporate property and casualty insurance)
on behalf of customers. Recently a number of websites have been created to give consumers basic price
comparisons for services such as insurance, causing controversy within the industry.
[6]
Insurance underwriting - Personal lines insurance underwriters actually underwrite insurance for individuals, a
service still offered primarily through agents, insurance brokers, and stock brokers. Underwriters may also offer
similar commercial lines of coverage for businesses. Activities include insurance and annuities, life insurance,
retirement insurance, health insurance, and property & casualty insurance.
Reinsurance - Reinsurance is insurance sold to insurers themselves, to protect them from catastrophic losses.
Financial services
9
Other financial services
Intermediation or advisory services - These services involve stock brokers (private client services) and discount
brokers. Stock brokers assist investors in buying or selling shares. Primarily internet-based companies are often
referred to as discount brokerages, although many now have branch offices to assist clients. These brokerages
primarily target individual investors. Full service and private client firms primarily assist and execute trades for
clients with large amounts of capital to invest, such as large companies, wealthy individuals, and investment
management funds.
Private equity - Private equity funds are typically closed-end funds, which usually take controlling equity stakes
in businesses that are either private, or taken private once acquired. Private equity funds often use leveraged
buyouts (LBOs) to acquire the firms in which they invest. The most successful private equity funds can generate
returns significantly higher than provided by the equity markets
Venture capital is a type of private equity capital typically provided by professional, outside investors to new,
high-potential-growth companies in the interest of taking the company to an IPO or trade sale of the business.
Angel investment - An angel investor or angel (known as a business angel or informal investor in Europe), is an
affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or
ownership equity. A small but increasing number of angel investors organize themselves into angel groups or
angel networks to share research and pool their investment capital.
Conglomerates - A financial services conglomerate is a financial services firm that is active in more than one
sector of the financial services market e.g. life insurance, general insurance, health insurance, asset management,
retail banking, wholesale banking, investment banking, etc. A key rationale for the existence of such businesses is
the existence of diversification benefits that are present when different types of businesses are aggregated i.e. bad
things don't always happen at the same time. As a consequence, economic capital for a conglomerate is usually
substantially less than economic capital is for the sum of its parts.
Debt resolution is a consumer service that assists individuals that have too much debt to pay off as requested, but
do not want to file bankruptcy and wish to payoff their debts owed. This debt can be accrued in various ways
including but not limited to personal loans, credit cards or in some cases merchant accounts. There are many
services/companies that can assist with this. These can include debt consolidation, debt settlement and
refinancing.
Financial crime
UK
Fraud within the financial industry costs the UK (regulated by the FSA) an estimated 14bn a year and it is believed
a further 25bn is laundered by British institutions.
[7]
Market share
The financial services industry constitutes the largest group of companies in the world in terms of earnings and
equity market capitalization. However it is not the largest category in terms of revenue or number of employees. It is
also a slow growing and extremely fragmented industry, with the largest company (Citigroup), only having a 3 % US
market share.
[8]
In contrast, the largest home improvement store in the US, Home Depot, has a 30 % market share,
and the largest coffee house Starbucks has a 32% market share.
Financial services
10
References
[1] "The Mistakes Of Our Grandparents?" (http:/ / www.contraryinvestor. com/ 2004archives/ mofeb04. htm). Contrary Investor.com. February
2004. . Retrieved 2009-02-06.
[2] "Bill Summary & Status 106th Congress (1999 - 2000) S.900 CRS Summary - Thomas (Library of Congress)" (http:/ / thomas. loc. gov/
cgi-bin/ bdquery/ z?d106:SN00900:@@@D& summ2=m& ). . Retrieved 2011-02-08.
[3] "Private Banking definition" (http:/ / www. investorwords. com/ 5946/ private_banking. html). Investor Words.com. . Retrieved 2009-02-06.
[4] "How Swiss Bank Accounts Work" (http:/ / money.howstuffworks. com/ personal-finance/ banking/ swiss-bank-account. htm). How Stuff
Works. . Retrieved 2009-02-06.
[5] Prudential: Securities Processing Primer (http:/ / www. cm1. prusec. com/ rschrpts. nsf/ $$rschidxw/
4A2ACD93260C58E785256FA3005F8D0E/ $FILE/ PROCESSINGPRIMER25-0076. PDF)
[6] "Price comparison sites face probe" (http:/ / news.bbc.co. uk/ 1/ hi/ business/ 7201345. stm). BBC News. 2008-01-22. . Retrieved
2009-02-06.
[7] "Watchdog warns of criminal gangs inside banks" (http:/ / money. guardian. co. uk/ news_/ story/ 0,1456,1643860,00. html). The Guardian
(London). 2005-11-16. . Retrieved 2007-11-30.
[8] The Opportunity: Small Global Market Share (http:/ / www. citigroup. com/ citigroup/ fin/ data/ p040602. pdf), Page 11, from the Sanford C.
Bernstein & Co. Strategic Decisions Conference 6/02/04
Further reading
Porteous, Bruce T.; Pradip Tapadar (December 2005). Economic Capital and Financial Risk Management for
Financial Services Firms and Conglomerates. Palgrave Macmillan. ISBN1-4039-3608-0.
External links
The role of the financial Services Sector in Expanding Economic Opportunity | A report by Christopher N. Sutton
and Beth Jenkins | John F. Kennedy School of Government | Harvard University (http:/ / www. hks. harvard.edu/
m-rcbg/ CSRI/ publications/ report_19_EO Finance Final. pdf)
What is Financial Consulting (http:/ / www. wisegeek. com/ what-is-financial-consulting. htm)
What Does a Financial Management Consultant Do? (http:/ / www. wisegeek. com/
what-does-a-financial-management-consultant-do. htm)
11
Personal finance
Personal finance
Personal finance is the application of the principles of finance to the monetary decisions of an individual or family
unit. It addresses the ways in which individuals or families obtain, budget, save, and spend monetary resources over
time, taking into account various financial risks and future life events. Components of personal finance might
include checking and savings accounts, credit cards and consumer loans, investments in the stock market, retirement
plans, social security benefits, insurance policies, and income tax management.
Personal financial planning
A key component of personal finance is financial planning, which is a dynamic process that requires regular
monitoring and reevaluation. In general, it has five steps:
1. Assessment: One's personal financial situation can be assessed by compiling simplified versions of financial
balance sheets and income statements. A personal balance sheet lists the values of personal assets (e.g., car,
house, clothes, stocks, bank account), along with personal liabilities (e.g., credit card debt, bank loan, mortgage).
A personal income statement lists personal income and expenses.
2. Setting goals: Two examples are "1. Retire at age 65 with a personal net worth of $1,000,000," and, "2. Buy a
house in 3 years while paying a monthly mortgage servicing cost that is no more than 25% of my gross income."
Having multiple goals is common, including a mix of short term and long term goals. Setting financial goals helps
to direct financial planning. Goal setting is done with an objective to meet certain financial requirements.
3. Creating a plan: The financial plan details how to accomplish your goals. It could include, for example,
reducing unnecessary expenses, increasing one's employment income, or investing in the stock market.
4. Execution: Execution of one's personal financial plan often requires discipline and perseverance. Many people
obtain assistance from professionals such as accountants, financial planners, investment advisers, and lawyers.
5. Monitoring and reassessment: As time passes, one's personal financial plan must be monitored for possible
adjustments or reassessments.
Typical goals most adults and young adults have are paying off credit card and/or student loan debt, investing for
retirement, investing for college costs for children, paying medical expenses, and planning for passing on their
property to their heirs (which is known as estate planning).
The six key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are
[1]
:
1. Financial position: this area is concerned with understanding the personal resources available by examining net
worth and household cash flow. Net worth is a person's balance sheet, calculated by adding up all assets under
that person's control, minus all liabilities of the household, at one point in time. Household cash flow totals up all
the expected sources of income within a year, minus all expected expenses within the same year. From this
analysis, the financial planner can determine to what degree and in what time the personal goals can be
accomplished.
2. Adequate protection: the analysis of how to protect a household from unforeseen risks. These risks can be
divided into liability, property, death, disability, health and long term care. Some of these risks may be
self-insurable, while most will require the purchase of an insurance contract. Determining how much insurance to
get, at the most cost effective terms requires knowledge of the market for personal insurance. Business owners,
professionals, athletes and entertainers require specialized insurance professionals to adequately protect
themselves. Since insurance also enjoys some tax benefits, utilizing insurance investment products may be a
Personal finance
12
critical piece of the overall investment planning.
3. Tax planning: typically the income tax is the single largest expense in a household. Managing taxes is not a
question of if you will pay taxes, but when and how much. Government gives many incentives in the form of tax
deductions and credits, which can be used to reduce the lifetime tax burden. Most modern governments use a
progressive tax. Typically, as your income grows, you pay a higher marginal rate of tax. Understanding how to
take advantage of the myriad tax breaks when planning your personal finances can make a significant impact
upon your success.
4. Investment and Accumulation Goals: planning how to accumulate enough money to acquire items with a high
price is what most people consider to be financial planning. The major reasons to accumulate assets is for the
following:
1. 1. purchasing a house
2. 2. purchasing a car
3. 3. starting a business
4. 4. paying for education expenses
5. 5. accumulating money for retirement, to generate a stream of income to cover lifestyle expenses.
Achieving these goals requires projecting what they will cost, and when you need to withdraw funds. A major
risk to the household in achieving their accumulation goal is the rate of price increases over time, or inflation.
Using net present value calculators, the financial planner will suggest a combination of asset earmarking and
regular savings to be invested in a variety of investments. In order to overcome the rate of inflation, the
investment portfolio has to get a higher rate of return, which typically will subject the portfolio to a number of
risks. Managing these portfolio risks is most often accomplished using asset allocation, which seeks to
diversify investment risk and opportunity. This asset allocation will prescribe a percentage allocation to be
invested in stocks, bonds, cash and alternative investments. The allocation should also take into consideration
the personal risk profile of every investor, since risk attitudes vary from person to person.
5. Retirement Planning: retirement planning is the process of understanding how much it costs to live at
retirement, and coming up with a plan to distribute assets to meet any income shortfall.
6. Estate Planning: involves planning for the disposition of your asset when you die. Typically, there is a tax due to
the state or federal government at your death. Avoiding these taxes means that more of your assets will be
distributed to your heirs. You can leave your assets to family, friends or charitable groups.
References
[1] http:/ / www. fpsb. org/ component/ docman/ doc_download/ 1008-financial-planning-curriculum-framework. html
Kwok, H., Milevsky, M., and Robinson, C. (1994) Asset Allocation, Life Expectancy, and Shortfall, Financial
Services Review, 1994, vol 3(2), pg. 109-126.
External links
Free Journal of Financial Counseling and Planning articles (http:/ / www. afcpe. org/ publications/
journal-articles. php).
Free Center for Financial Planning and Investment personal finance education resources for all ages (http:/ /
www. cfpionline. org/ education/ ) .
13
Corporate finance
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the
tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder
value.
[1]
Although it is in principle different from managerial finance which studies the financial decisions of all
firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the
financial problems of all kinds of firms.
The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions
are long-term choices about which projects receive investment, whether to finance that investment with equity or
debt, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the
short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and
short-term borrowing and lending (such as the terms on credit extended to customers).
The terms corporate finance and corporate financier are also associated with investment banking. The typical role
of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best
fits those needs. Thus, the terms corporate finance and corporate financier may be associated with transactions in
which capital is raised in order to create, develop, grow or acquire businesses.
Capital investment decisions
Capital investment decisions
[2]
are long-term corporate finance decisions relating to fixed assets and capital
structure. Decisions are based on several inter-related criteria. (1) Corporate management seeks to maximize the
value of the firm by investing in projects which yield a positive net present value when valued using an appropriate
discount rate in consideration of risk. (2) These projects must also be financed appropriately. (3) If no such
opportunities exist, maximizing shareholder value dictates that management must return excess cash to shareholders
(i.e., distribution via dividends). Capital investment decisions thus comprise an investment decision, a financing
decision, and a dividend decision.
The investment decision
Management must allocate limited resources between competing opportunities (projects) in a process known as
capital budgeting.
[3]
Making this investment, or capital allocation, decision requires estimating the value of each
opportunity or project, which is a function of the size, timing and predictability of future cash flows.
Project valuation
Further information: Business valuation,stock valuation,andfundamental analysis
In general,
[4]
each project's value will be estimated using a discounted cash flow (DCF) valuation, and the
opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (applied to
Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams#Theory). This
requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future
cash flows are then discounted to determine their present value (see Time value of money). These present values are
then summed, and this sum net of the initial investment outlay is the NPV. See Financial modeling.
Corporate finance
14
The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate often termed, the
project "hurdle rate"
[5]
is critical to making an appropriate decision. The hurdle rate is the minimum acceptable
return on an investmenti.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the
investment, typically measured by volatility of cash flows, and must take into account the project-relevant financing
mix. Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular
project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error
in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may
not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of
assets.)
In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance.
These are visible from the DCF and include discounted payback period, IRR, Modified IRR, equivalent annuity,
capital efficiency, and ROI. Alternatives (complements) to NPV include MVA / EVA (Joel Stern, Stern Stewart &
Co) and APV (Stewart Myers). See list of valuation topics.
Valuing flexibility
In many cases, for example R&D projects, a project may open (or close) various paths of action to the company, but
this reality will not (typically) be captured in a strict NPV approach.
[6]
Management will therefore (sometimes)
employ tools which place an explicit value on these options. So, whereas in a DCF valuation the most likely or
average or scenario specific cash flows are discounted, here the flexible and staged nature of the investment is
modelled, and hence "all" potential payoffs are considered. The difference between the two valuations is the "value
of flexibility" inherent in the project.
The two most common tools are Decision Tree Analysis (DTA)
[7][8]
and Real options analysis (ROA);
[9]
they may
often be used interchangeably:
DTA values flexibility by incorporating possible events (or states) and consequent management decisions. (For
example, a company would build a factory given that demand for its product exceeded a certain level during the
pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the
factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" each scenario must be
modelled separately.) In the decision tree, each management decision in response to an "event" generates a
"branch" or "path" which the company could follow; the probabilities of each event are determined or specified
by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to
management; (2) given this knowledge of the events that could follow, and assuming rational decision making,
management chooses the actions corresponding to the highest value path probability weighted; (3) this path is
then taken as representative of project value. See Decision theory#Choice under uncertainty.
ROA is usually used when the value of a project is contingent on the value of some other asset or underlying
variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low,
management will abandon the mining rights, if sufficiently high, management will develop the ore body. Again, a
DCF valuation would capture only one of these outcomes.) Here: (1) using financial option theory as a
framework, the decision to be taken is identified as corresponding to either a call option or a put option; (2) an
appropriate valuation technique is then employed usually a variant on the Binomial options model or a bespoke
simulation model, while Black Scholes type formulae are used less often; see Contingent claim valuation. (3) The
"true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in
corporate finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options
was originally per Timothy Luehrman, in the late 1990s.)
Corporate finance
15
Quantifying uncertainty
Further information: Sensitivity analysis,Scenario planning,andMonte Carlo methods in finance
Given the uncertainty inherent in project forecasting and valuation,
[8][10]
analysts will wish to assess the sensitivity
of project NPV to the various inputs (i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst
will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change
in that factor is then observed, and is calculated as a "slope": NPV / factor. For example, the analyst will
determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%,
0%, 5%....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and
their various combinations produce a "value-surface",
[11]
(or even a "value-space",) where NPV is then a function of
several variables. See also Stress testing.
Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular
outcome for economy-wide, "global" factors (demand for the product, exchange rates, commodity prices, etc...) as
well as for company-specific factors (unit costs, etc...). As an example, the analyst may specify various revenue
growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case"), where all key inputs
are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each. Note that for
scenario based analysis, the various combinations of inputs must be internally consistent (see discussion at Financial
modeling), whereas for the sensitivity approach these need not be so. An application of this methodology is to
determine an "unbiased" NPV, where management determines a (subjective) probability for each scenario the NPV
for the project is then the probability-weighted average of the various scenarios.
A further advancement is to construct stochastic
[12]
or probabilistic financial models as opposed to the traditional
static and deterministic models as above.
[10]
For this purpose, the most common method is to use Monte Carlo
simulation to analyze the projects NPV. This method was introduced to finance by David B. Hertz in 1964, although
it has only recently become common: today analysts are even able to run simulations in spreadsheet based DCF
models, typically using a risk-analysis add-in, such as @Risk or Crystal Ball. Here, the cash flow components that
are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". In
contrast to the scenario approach above, the simulation produces several thousand random but possible outcomes, or
trials, "covering all conceivable real world contingencies in proportion to their likelihood;"
[13]
see Monte Carlo
Simulation versus What If Scenarios. The output is then a histogram of project NPV, and the average NPV of the
potential investment as well as its volatility and other sensitivities is then observed. This histogram provides
information not visible from the static DCF: for example, it allows for an estimate of the probability that a project
has a net present value greater than zero (or any other value).
Continuing the above example: instead of assigning three discrete values to revenue growth, and to the other relevant
variables, the analyst would assign an appropriate probability distribution to each variable (commonly triangular or
beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions
would then be "sampled" repeatedly incorporating this correlation so as to generate several thousand random but
possible scenarios, with corresponding valuations, which are then used to generate the NPV histogram. The resultant
statistics (average NPV and standard deviation of NPV) will be a more accurate mirror of the project's "randomness"
than the variance observed under the scenario based approach. These are often used as estimates of the underlying
"spot price" and volatility for the real option valuation as above; see Real options valuation: Valuation inputs. A
more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a credit crunch) that drive
variations in one or more of the DCF model inputs.
Corporate finance
16
The financing decision
Domestic credit to private sector in 2005.
Achieving the goals of corporate
finance requires that any corporate
investment be financed
appropriately.
[14]
The sources of
financing are, generically, capital
self-generated by the firm and capital
from external funders, obtained by
issuing new debt and equity (and
hybrid- or convertible securities). As
above, since both hurdle rate and cash
flows (and hence the riskiness of the
firm) will be affected, the financing mix will impact the valuation of the firm (as well as the other long-term
financial management decisions). There are two interrelated decisions here:
Management must identify the "optimal mix" of financingthe capital structure that results in maximum
value.
[15]
(See Balance sheet, WACC, Fisher separation theorem; but, see also the Modigliani-Miller theorem.)
Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow
implications independent of the project's degree of success. Equity financing is less risky with respect to cash
flow commitments, but results in a dilution of share ownership, control and earnings. The cost of equity is also
typically higher than the cost of debt (see CAPM and WACC), and so equity financing may result in an increased
hurdle rate which may offset any reduction in cash flow risk.
[16]
Management must attempt to match the long-term financing mix to the assets being financed as closely as
possible, in terms of both timing and cash flows. Managing any potential asset liability mismatch or duration gap
entails matching the assets and liabilities according to maturity pattern ("Cashflow matching") or duration
("immunization"); managing this relationship in the short-term is a major function of working capital
management, as discussed below. Other techniques, such as securitization, or hedging using interest rate- or credit
derivatives, are also common. See Asset liability management; Treasury management; Credit risk; Interest rate
risk.
One of the main theories of how firms make their financing decisions is the Pecking Order Theory (Stewart Myers),
which suggests that firms avoid external financing while they have internal financing available and avoid new equity
financing while they can engage in new debt financing at reasonably low interest rates. Another major theory is the
Trade-Off Theory in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt
when making their decisions. Capital structure substitution theory hypothesizes that management manipulates the
capital structure such that earnings per share (EPS) are maximized. An emerging area in finance theory is
right-financing whereby investment banks and corporations can enhance investment return and company value over
time by determining the right investment objectives, policy framework, institutional structure, source of financing
(debt or equity) and expenditure framework within a given economy and under given market conditions. One last
theory about this decision is the Market timing hypothesis which states that firms look for the cheaper type of
financing regardless of their current levels of internal resources, debt and equity.
Corporate finance
17
The dividend decision
Whether to issue dividends,
[17]
and what amount, is calculated mainly on the basis of the company's unappropriated
profit and its earning prospects for the coming year. The amount is also often calculated based on expected free cash
flows i.e. cash remaining after all business expenses, and capital investment needs have been met.
If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then finance theory
suggests management must return excess cash to shareholders as dividends. This is the general case, however there
are exceptions. For example, shareholders of a "growth stock", expect that the company will, almost by definition,
retain earnings so as to fund growth internally. In other cases, even though an opportunity is currently NPV negative,
management may consider investment flexibility / potential payoffs and decide to retain cash flows; see above and
Real options.
Management must also decide on the form of the dividend distribution, generally as cash dividends or via a share
buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may
elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding.
Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action. Today, it is
generally accepted that dividend policy is value neutral i.e. the value of the firm would be the same, whether it
issued cash dividends or repurchased its stock (see Modigliani-Miller theorem).
Working capital management
Decisions relating to working capital and short term financing are referred to as working capital management.
[18]
These involve managing the relationship between a firm's short-term assets and its short-term liabilities. In general
this is as follows: As above, the goal of Corporate Finance is the maximization of firm value. In the context of long
term, capital investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive
investments. These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of
Working Capital (i.e. short term) management is therefore to ensure that the firm is able to operate, and that it has
sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational
expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See
Economic value added (EVA).
Decision criteria
Working capital is the amount of capital which is readily available to an organization. That is, working capital is the
difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements
(Current Liabilities). As a result, the decisions relating to working capital are always current, i.e. short term,
decisions. In addition to time horizon, working capital decisions differ from capital investment decisions in terms of
discounting and profitability considerations; they are also "reversible" to some extent. (Considerations as to Risk
appetite and return targets remain identical, although some constraints such as those imposed by loan covenants
may be more relevant here).
Working capital management decisions are therefore not taken on the same basis as long term decisions, and
working capital management applies different criteria in decision making: the main considerations are (1) cash flow /
liquidity and (2) profitability / return on capital (of which cash flow is probably the more important).
The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle. This represents
the time difference between cash payment for raw materials and cash collection for sales. The cash conversion
cycle indicates the firm's ability to convert its resources into cash. Because this number effectively corresponds to
the time that the firm's cash is tied up in operations and unavailable for other activities, management generally
aims at a low net count. (Another measure is gross operating cycle which is the same as net operating cycle
except that it does not take into account the creditors deferral period.)
Corporate finance
18
In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a
percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity
(ROE) shows this result for the firm's shareholders. As above, firm value is enhanced when, and if, the return on
capital, exceeds the cost of capital. ROC measures are therefore useful as a management tool, in that they link
short-term policy with long-term decision making.
Management of working capital
Guided by the above criteria, management will use a combination of policies and techniques for the management of
working capital.
[19]
These policies aim at managing the current assets (generally cash and cash equivalents,
inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.
Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but
reduces cash holding costs.
Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces
the investment in raw materials and minimizes reordering costs and hence increases cash flow; see Supply
chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity (EPQ).
Debtors management. There are two inter-related roles here: Identify the appropriate credit policy, i.e. credit
terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be
offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.
Implement appropriate Credit scoring policies and techniques such that the risk of default on any new business is
acceptable given these criteria.
Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the
inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan
(or overdraft), or to "convert debtors to cash" through "factoring".
Relationship with other areas in finance
Investment banking
Use of the term corporate finance varies considerably across the world. In the United States it is used, as above, to
describe activities, decisions and techniques that deal with many aspects of a companys finances and capital. In the
United Kingdom and Commonwealth countries, the terms corporate finance and corporate financier tend to be
associated with investment banking i.e. with transactions in which capital is raised for the corporation.
[20]
These
may include
Raising seed, start-up, development or expansion capital
Mergers, demergers, acquisitions or the sale of private companies
Mergers, demergers and takeovers of public companies, including public-to-private deals
Management buy-out, buy-in or similar of companies, divisions or subsidiaries typically backed by private
equity
Equity issues by companies, including the flotation of companies on a recognised stock exchange in order to raise
capital for development and/or to restructure ownership
Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and
restructuring of businesses
Financing joint ventures, project finance, infrastructure finance, public-private partnerships and privatisations
Secondary equity issues, whether by means of private placing or further issues on a stock market, especially
where linked to one of the transactions listed above.
Raising debt and restructuring debt, especially when linked to the types of transactions listed above
Corporate finance
19
Financial risk management
See also: Financial engineering; Financial risk; Default (finance); Credit risk; Interest rate risk; Liquidity
risk; Operational risk; Volatility risk; Settlement risk; Value at Risk.
Risk management
[21]
is the process of measuring risk and then developing and implementing strategies to manage
("hedge") that risk. Financial risk management, typically, is focused on the impact on corporate value due to adverse
changes in commodity prices, interest rates, foreign exchange rates and stock prices (market risk). It will also play an
important role in short term cash- and treasury management. It is common for large corporations to have risk
management teams; often these overlap with the internal audit function. While it is impractical for many small firms
to have formal risk management teams, many still apply risk management informally.
The discipline typically focuses on risks that can be hedged using traded financial instruments; see Cash flow hedge,
Foreign exchange hedge. Derivatives are often employed here. Because company specific, "over the counter" (OTC)
contracts tend to be costly to create and monitor, derivatives that trade on well-established financial markets or
exchanges are often preferred. These standard derivative instruments include options, futures contracts, forward
contracts, and swaps; the "second generation" exotic derivatives usually trade OTC. Note that hedging-related
transactions will attract their own accounting treatment: see Hedge accounting, Mark-to-market accounting, FASB
133, IAS 39.
This area is related to corporate finance in two ways. Firstly, firm exposure to business and market risk is a direct
result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of enhancing, or
preserving, firm value. There is a fundamental debate relating to "Risk Management" and shareholder value: in
question is the shareholder's desire to optimize risk versus taking exposure to pure risk (a risk event that only has a
negative side, such as loss of life or limb). The debate links the value of risk management in a market to the cost of
bankruptcy in that market. See Fisher separation theorem.
Personal and public finance
Corporate finance utilizes tools from almost all areas of finance. Some of the tools developed by and for corporations
have broad application to entities other than corporations, for example, to partnerships, sole proprietorships,
not-for-profit organizations, governments, mutual funds, and personal wealth management. But in other cases their
application is very limited outside of the corporate finance arena. Because corporations deal in quantities of money
much greater than individuals, the analysis has developed into a discipline of its own. It can be differentiated from
personal finance and public finance.
Alternate Approaches
A standard assumption in Corporate finance is that shareholders are the residual claimants and that the primary goal
of executives should be to maximize shareholder value. Recently, however, legal scholars (e.g. Lynn Stout
[22]
) have
questioned this assumption, implying that the assumed goal of maximizing shareholder value is inappropriate for a
public corporation. This criticism in turn brings into question the advice of corporate finance, particularly related to
stock buybacks made purportedly to "return value to shareholders," which is predicated on a legally erroneous
assumption.
Corporate finance
20
References
[1] See Corporate Finance: First Principles (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/ AppldCF/ other/ Image2. gif), Aswath
Damodaran, New York University's Stern School of Business
[2] The framework for this section is based on Notes (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/ AppldCF/ other/ Image2. gif)
by Aswath Damodaran at New York University's Stern School of Business
[3] See: Investment Decisions and Capital Budgeting (http:/ / www. duke. edu/ ~charvey/ Classes/ ba350_1997/ vcf2/ vcf2. htm), Prof. Campbell
R. Harvey; The Investment Decision of the Corporation (http:/ / www. bus. lsu. edu/ academics/ finance/ faculty/ dchance/ Instructional/
FinancialManagementDecisions. ppt#257,2,Slide), Prof. Don M. Chance
[4] See: Valuation (http:/ / pages. stern. nyu.edu/ ~adamodar/ New_Home_Page/ lectures/ val. html), Prof. Aswath Damodaran; Equity
Valuation (http:/ / www.duke.edu/ ~charvey/ Classes/ ba350_1997/ vcf1/ vcf1. htm), Prof. Campbell R. Harvey
[5] See for example Campbell R. Harvey's Hypertextual Finance Glossary (http:/ / biz. yahoo. com/ f/ g/ hh. html) or investopedia.com (http:/ /
www.investopedia.com/ terms/ h/ hurdlerate. asp)
[6] See: Real Options Analysis and the Assumptions of the NPV Rule (http:/ / www. realoptions. org/ papers2002/ SchockleyOptionNPV. pdf. ),
Tom Arnold & Richard Shockley
[7] See: Decision Tree Analysis (http:/ / www.mindtools. com/ pages/ article/ newTED_04. htm), mindtools.com; Decision Tree Primer (http:/ /
www.public.asu.edu/ ~kirkwood/ DAStuff/ decisiontrees/ index. html), Prof. Craig W. Kirkwood Arizona State University
[8] See: "Capital Budgeting Under Risk". Ch.9 in Schaum's outline of theory and problems of financial management (http:/ / books. google. com/
books?id=_lnmxnhoAUEC& printsec=frontcover& dq=related:ISBN0070580316#v=onepage& q& f=false), Jae K. Shim and Joel G. Siegel.
[9] See: Identifying real options (http:/ / faculty.fuqua.duke. edu/ ~charvey/ Teaching/ BA456_2002/ Identifying_real_options. htm), Prof.
Campbell R. Harvey; Applications of option pricing theory to equity valuation (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/
lectures/ opt.html), Prof. Aswath Damodaran; How Do You Assess The Value of A Company's "Real Options"? (http:/ / www.
expectationsinvesting. com/ tutorial11.shtml), Prof. Alfred Rappaport Columbia University & Michael Mauboussin
[10] See Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations (http:/ / www. stern. nyu. edu/ ~adamodar/ pdfiles/
papers/ probabilistic.pdf), Prof. Aswath Damodaran
[11] For example, mining companies sometimes employ the Hill of Value methodology in their planning; see, e.g., B. E. Hall, "How Mining
Companies Improve Share Price by Destroying Shareholder Value" (https:/ / www. u-cursos. cl/ ingenieria/ 2008/ 1/ MI75E/ 1/
material_docente/ bajar?id_material=167438)
[12] See: Quantifying Corporate Financial Risk (http:/ / www. qfinance. com/ financial-risk-management-best-practice/
quantifying-corporate-financial-risk?full), David Shimko.
[13] The Flaw of Averages (http:/ / www.analycorp.com/ uncertainty/ flawarticle. htm), Prof. Sam Savage, Stanford University.
[14] See: The Financing Decision of the Corporation (http:/ / www. bus. lsu. edu/ academics/ finance/ faculty/ dchance/ Instructional/
FinancialManagementDecisions. ppt#256,1,Slide), Prof. Don M. Chance; Capital Structure (http:/ / pages. stern. nyu. edu/ ~adamodar/ pdfiles/
ovhds/ capstr.pdf), Prof. Aswath Damodaran
[15] Capital Structure: Implications (http:/ / www.qfinance. com/ mergers-and-acquisitions-best-practice/ capital-structure-implications?full),
Prof. John C. Groth, Texas A&M University; A Generalised Procedure for Locating the Optimal Capital Structure (http:/ / rdcohen. 50megs.
com/ genOCS. pdf), Ruben D. Cohen, Citigroup
[16] See: Optimal Balance of Financial Instruments: Long-Term Management, Market Volatility & Proposed Changes (http:/ / www.
lawyersclubindia.com/ articles/
Optimal-Balance-of-Financial-Instruments-Long-Term-Management-Market-Volatility-Proposed-Changes-3765. asp), Nishant Choudhary,
LL.M. 2011 (Business & finance), George Washington University Law School
[17] See Dividend Policy (http:/ / pages.stern. nyu.edu/ ~adamodar/ pdfiles/ ovhds/ divid. pdf), Prof. Aswath Damodaran
[18] See Working Capital Management (http:/ / www.studyfinance. com/ lessons/ workcap/ index. mv), Studyfinance.com; Working Capital
Management (http:/ / www. treasury.govt.nz/ publicsector/ workingcapital/ chap2. asp), treasury.govt.nz
[19] See The 20 Principles of Financial Management (http:/ / www. bus. lsu. edu/ academics/ finance/ faculty/ dchance/ Instructional/
PrinciplesofFinancialManagement. htm), Prof. Don M. Chance, Louisiana State University
[20] Beaney, Shaun, "Defining corporate finance in the UK" (http:/ / www. icaew. com/ en/ technical/ corporate-finance/
corporate-finance-faculty/ what-is-corporate-finance-122299), Corporate Finance Faculty, ICAEW, April 2005 (revised January 2011)
[21] See: Global Association of Risk Professionals (GARP) (http:/ / www. garp. com/ ); Professional Risk Managers' International Association
(PRMIA) (http:/ / www. primia. org/ )
[22] Lynn A. Stout (2002). Bad and Not-So-Bad Arguments for Shareholder Primacy (http:/ / www. uclouvain. be/ cps/ ucl/ doc/ etes/
documents/ Stout_-SSRN-id331464.pdf), University of California, Los Angeles School of Law Research Paper No. 25; Lynn A. Stout (2007).
The Mythical Benefits of Shareholder Control (http:/ / www. lccge. bbk. ac. uk/ publications-and-resources/ docs/ Stout 2007. pdf),
REGULATION Spring 2007.
Financial capital
21
Financial capital
Capital exports in 2006
Capital imports in 2006
Financial capital can refer to money used by entrepreneurs and
businesses to buy what they need to make their products or provide
their services or to that sector of the economy based on its operation,
i.e. retail, corporate, investment banking, etc.
Three concepts of capital maintenance
authorized in IFRS
Financial capital or just capital in finance and accounting, refers to
the funds provided by lenders (and investors) to businesses to purchase
real capital equipment for producing goods/services. Real Capital or
Economic Capital comprises physical goods that assist in the
production of other goods and services, e.g. shovels for gravediggers,
sewing machines for tailors, or machinery and tooling for factories.
Financial capital generally refers to saved-up financial wealth, especially that used to start or maintain a business. A
financial concept of capital is adopted by most entities in preparing their financial reports. Under a financial concept
of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity
of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive
capacity of the entity based on, for example, units of output per day.
[1]
Financial capital maintenance can be
measured in either nominal monetary units or units of constant purchasing power.
[2][3]
There are thus three concepts
of capital maintenance in terms of International Financial Reporting Standards (IFRS): (1) Physical capital
maintenance (2) Financial capital maintenance in nominal monetary units (3) Financial capital maintenance in units
of constant purchasing power.
[4][5]
Financial capital is provided by lenders for a price: interest. Also see time value of money for a more detailed
description of how financial capital may be analyzed.
Furthermore, financial capital, is any liquid medium or mechanism that represents wealth, or other styles of capital.
It is, however, usually purchasing power in the form of money available for the production or purchasing of goods,
etcetera. Capital can also be obtained by producing more than what is immediately required and saving the surplus.
Financial capital has been subcategorized by some academics as economic or "productive capital" necessary for
operations, signaling capital which signals a company's financial strength to shareholders, and regulatory capital
which fulfills capital requirements.
[6]
Financial capital
22
Sources of capital
Long term - usually above 7 years
Share Capital
Mortgage loan
Retained Profit
Venture Capital
Debenture
Project Finance
Medium term - usually between 2 and 7 years
Term Loans
Leasing
Hire Purchase
Short term - usually under 2 years
Bank Overdraft
Trade Credit
Deferred Expenses
Factoring
Capital market
Long-term funds are bought and sold:
Shares
Debentures
Long-term loans, often with a mortgage bond as security
Reserve funds
Euro Bonds
Law Firms
Money market
Financial institutions can use short-term savings to lend out in the form of short-term loans:
Credit on open account
Bank overdraft
Short-term loans
Bills of exchange
Factoring of debtors
Financial capital
23
Differences between shares and debentures
Shareholders are effectively owners; debenture-holders are creditors.
Shareholders may vote at AGMs and be elected as directors; debenture-holders may not vote at AGMs or be
elected as directors.
Shareholders receive profit in the form of dividends; debenture-holders receive a fixed rate of interest.
If there is no profit, the shareholder does not receive a dividend; interest is paid to debenture-holders regardless of
whether or not a profit has been made.
In case of dissolution of firms debenture holders are paid first as compared to shareholder.
Fixed capital
This is money which is used to purchase assets that will remain permanently in the business and help it to make a
profit.
Factors determining fixed capital requirements
Nature of business
Size of business
Stage of development
Capital invested by the owners
location of that area
Working capital
Working capital is that part of capital invested which is used for running the business such like money which is used
to buy stock, pay expenses and finance credit.
Factors determining working capital requirements
Size of business
Stage of development
Time of production
Rate of stock turnover ratio
Buying and selling terms
Seasonal consumption
Seasonal product
profit level
growth and expansion
production cycle
general nature of business
business cycle
business policies
Financial capital
24
Instruments
A contract regarding any combination of capital assets is called a financial instrument, and may serve as a
medium of exchange,
standard of deferred payment,
unit of account, or
store of value.
Most indigenous forms of money (wampum, shells, tally sticks and such) and the modern fiat money is only a
"symbolic" storage of value and not a real storage of value like commodity money.
Own and borrowed capital
Capital contributed by the owner or entrepreneur of a business, and obtained, for example, by means of savings or
inheritance, is known as own capital or equity, whereas that which is granted by another person or institution is
called borrowed capital, and this must usually be paid back with interest. The ratio between debt and equity is named
leverage. It has to be optimized as a high leverage can bring a higher profit but create solvency risk.
Borrowed capital
This is capital which the business borrows from institutions or people, and includes debentures:
Redeemable debentures
Irredeemable debentures
Debentures to bearer
Ordinary debentures
bonds
deposits
loans
Own capital
This is capital that owners of a business (shareholders and partners, for example) provide:
Preference shares/hybrid source of finance
Ordinary preference shares
Cumulative preference shares
Participating preference shares
Ordinary shares
Bonus shares
Founders' shares
These have preference over the equity shares. This means the payments made to the shareholders are first paid to the
preference shareholder(s) and then to the equity shareholders.
Issuing and trading
Like money, financial instruments may be "backed" by state military fiat, credit (i.e. social capital held by banks and
their depositors), or commodity resources. Governments generally closely control the supply of it and usually require
some "reserve" be held by institutions granting credit. Trading between various national currency instruments is
conducted on a money market. Such trading reveals differences in probability of debt collection or store of value
function of that currency, as assigned by traders.
Financial capital
25
When in forms other than money, financial capital may be traded on bond markets or reinsurance markets with
varying degrees of trust in the social capital (not just credits) of bond-issuers, insurers, and others who issue and
trade in financial instruments. When payment is deferred on any such instrument, typically an interest rate is higher
than the standard interest rates paid by banks, or charged by the central bank on its money. Often such instruments
are called fixed-income instruments if they have reliable payment schedules associated with the uniform rate of
interest. A variable-rate instrument, such as many consumer mortgages, will reflect the standard rate for deferred
payment set by the central bank prime rate, increasing it by some fixed percentage. Other instruments, such as citizen
entitlements, e.g. "U.S. Social Security", or other pensions, may be indexed to the rate of inflation, to provide a
reliable value stream.
Trading in stock markets or commodity markets is actually trade in underlying assets which are not wholly financial
in themselves, although they often move up and down in value in direct response to the trading in more purely
financial derivatives. Typically commodity markets depend on politics that affect international trade, e.g. boycotts
and embargoes, or factors that influence natural capital, e.g. weather that affects food crops. Meanwhile, stock
markets are more influenced by trust in corporate leaders, i.e. individual capital, by consumers, i.e. social capital or
"brand capital" (in some analyses), and internal organizational efficiency, i.e. instructional capital and infrastructural
capital. Some enterprises issue instruments to specifically track one limited division or brand. "Financial futures",
"Short selling" and "financial options" apply to these markets, and are typically pure financial bets on outcomes,
rather than being a direct representation of any underlying asset.
Broadening the notion
The relationship between financial capital, money, and all other styles of capital, especially human capital or labor, is
assumed in central bank policy and regulations regarding instruments as above.
Such relationships and policies are characterized by a political economy - feudalist, socialist, capitalist, green,
anarchist or otherwise. In effect, the means of money supply and other regulations on financial capital represent the
economic sense of the value system of the society itself, as they determine the allocation of labor in that society.
So, for instance, rules for increasing or reducing the money supply based on perceived inflation, or on measuring
well-being, reflect some such values, reflect the importance of using (all forms of) financial capital as a stable store
of value. If this is very important, inflation control is key - any amount of money inflation reduces the value of
financial capital with respect to all other types.
If, however, the medium of exchange function is more critical, new money may be more freely issued regardless of
impact on either inflation or well-being.
Marxian perspectives
It is common in Marxist theory to refer to the role of "Finance Capital" as the determining and ruling class interest in
capitalist society, particularly in the latter stages.
[7][8]
Valuation
Normally, a financial instrument is priced accordingly to the perception by capital market players of its expected
return and risk.
Unit of account functions may come into question if valuations of complex financial instruments vary drastically
based on timing. The "book value", "mark-to-market" and "mark-to-future"
[9]
conventions are three different
approaches to reconciling financial capital value units of account.
Financial capital
26
Economic role
Socialism, capitalism, feudalism, anarchism, other civic theories take markedly different views of the role of
financial capital in social life, and propose various political restrictions to deal with that.
Finance capitalism is the production of profit from the manipulation of financial capital. It is held in contrast to
industrial capitalism, where profit is made from the manufacture of goods.
Notes
[1] (http:/ / www.aasb. com. au/ admin/ file/ content105/ c9/ Framework_07-04nd. pdf) Framework for the Preparation and Presentation of
Financial Statements, Par 102
[2] Constant item purchasing power accounting#CIPPA as per the IASB's Framework.5B14.5D .5B15.5D Constant item purchasing power
accounting
[3] (http:/ / www.aasb. com. au/ admin/ file/ content105/ c9/ Framework_07-04nd. pdf) Framework for the Preparation and Presentation of
Financial Statements, Par 104
[4] Constant item purchasing power accounting#CIPPA as per the IASB's Framework.5B14.5D .5B15.5D Constant item purchasing power
accounting
[5] (http:/ / www.aasb. com. au/ admin/ file/ content105/ c9/ Framework_07-04nd. pdf) Framework for the Preparation and Presentation of
Financial Statements, Par 104(a)
[6] The Risk Report, April 2009. Volume XXXI No. 8. IRMI (http:/ / www. irmi. com/ ).
[7] Imperialism, the Highest Stage of Capitalism ibid. Finance Capital and the Finance Oligarchy (http:/ / www. marxists. org/ archive/ lenin/
works/ 1916/ imp-hsc/ ch03. htm)
[8] Monopoly-Finance Capital and the Paradox of Accumulation John Bellamy Foster and Robert W. McChesney [[Monthly Review (http:/ /
www.monthlyreview.org/ 091001foster-mcchesney. php)] Sept-Oct 2009]
[9] The New Generation of Risk Management for Hedge Funds and Private Equity Investments (http:/ / books. google. com/
books?id=2w0bRIv7cygC& pg=PA349& lpg=PA349& dq="mark-to-future"& source=bl& ots=-wAo4Ibldg&
sig=a8u9-GRjc2ng_8ltgiKnus_cURk& hl=en& ei=l0YSSs_oEpLhtgea6oCSBA& sa=X& oi=book_result& ct=result& resnum=5#PPP1,M1),
edited by Lars Jaeger, p.349
References
F. Boldizzoni, Means and Ends: The Idea of Capital in the West, 1500-1970, New York: Palgrave Macmillan,
2008, chapters 7-8
Cornering the market
27
Cornering the market
In finance, to corner the market is to get sufficient control of a particular stock, commodity, or other asset to allow
the price to be manipulated. Another definition: "To have the greatest market share in a particular industry without
having a monopoly. Companies that have cornered their markets usually have greater leeway in their decisions; for
example, they may charge higher prices for their products without fear of losing too much business. Large
companies, such as Wal-Mart or Microsoft, are considered to have cornered their markets." [1] In either case, the
cornerer hopes to gain control of enough of the supply of the commodity to be able to set the price for it.
This can be done through several mechanisms. The most direct strategy is to simply buy up a large percentage of the
available commodity offered for sale in some spot market and hoard it. With the advent of futures trading, a cornerer
may buy a large number of futures contracts on a commodity and then sell them at a profit after inflating the price.
Although there have been many attempts to corner markets by massive purchases in everything from tin to cattle, to
date very few of these attempts have ever succeeded; instead, most of these attempted corners have tended to break
themselves spontaneously. Indeed, as long ago as 1923, Edwin Lefvre wrote, "very few of the great corners were
profitable to the engineers of them."
[2]
A cornerer can become vulnerable due to the size of the position, especially if
the attempt becomes widely known. If the rest of the market senses weakness, it may resist any attempt to artificially
drive the market any further by actively taking opposing positions. If the price starts to move against the cornerer,
any attempt by the cornerer to sell would likely cause the price to drop substantially. In such a situation, many other
parties could profit from the cornerer's need to unwind the position.
More success in cornering the market has come by gaining a near-monopoly share in industries such as computers
(like IBM) and software (like Microsoft).
Historical examples
ca 6th Century BCE: Thales of Miletus
According to Aristotle in The Politics (Book I Section 1259a),
[3]
Thales of Miletus once cornered the market in
olive-oil presses:
Thales, so the story goes, because of his poverty was taunted with the uselessness of philosophy; but
from his knowledge of astronomy he had observed while it was still winter that there was going to be a
large crop of olives, so he raised a small sum of money and paid round deposits for the whole of the
olive-presses in Miletus and Chios, which he hired at a low rent as nobody was running him up; and
when the season arrived, there was a sudden demand for a number of presses at the same time, and by
letting them out on what terms he liked he realized a large sum of money, so proving that it is easy for
philosophers to be rich if they choose.
19th century: Classic examples by Edwin Lefvre
Journalist Edwin Lefvre lists several examples of corners from the mid-19th century. He distinguishes corners as
the result of manipulations from corners as the result of competitive buying.
Cornelius Vanderbilt and the Harlem Railroad
One of the few cornerers whose rationale was published and justified, Cornelius Vanderbilt started accumulating
shares of the Harlem Railroad in 1862 because he anticipated its strategic value. He took control of the Harlem
Railroad and later explained that he wanted to show that he could take this railroad, which was generally considered
worthless, and make it valuable. The corner of June 25, 1863 can be seen as just an episode in a strategic investment
that served the public well.
Cornering the market
28
James Fisk, Jay Gould and the Black Friday (1869)
The 1869 Black Friday financial panic in the United States was caused by the efforts of Jay Gould and James Fisk to
corner the gold market on the New York Gold Exchange. It was one of several scandals that rocked the presidency of
Ulysses S. Grant. When the government gold hit the market, the premium plummeted within minutes and many
investors were ruined. Fisk and Gould escaped significant financial harm.
Lefvre thoughts on corners of the old days
In chapter 19 of his book, Edwin Lefvre tries to summarize the rationale for the corners of the 19th century.

A wise old broker told me that all the big operators of the 60s and 70s had one ambition, and that was to work a corner. In many cases this was
the offspring of vanity; in others, of the desire for revenge. [..] It was more than the prospective money profit that prompted the engineers of
corners to do their damnedest. It was the vanity complex asserting itself among cold-bloodest operators.
20th century: The Northern Pacific Railway
The corner of The Northern Pacific Railway on May 9, 1901, is a well documented case of competitive buying,
resulting in a panic. The 2009 Annotated Edition of Reminiscences of a Stock Operator contains Lefvre's original
account in chapter 3 as well as modern annotations explaining the actual locations and personalities on the page
margins.
1920s: The Stutz Motor Company
Called "a forerunner of the Livermore and Cutten operations of a few years later" by historian Robert Sobel, the
March 1920 corner of The Stutz Motor Company is an example of a manipulated corner ruining everyone involved,
especially its originator Thomas Fortune Ryan.
1950s: The onion market
In the late 1950s, United States onion farmers alleged that Sam Seigel and Vincent Kosuga, Chicago Mercantile
Exchange traders, were attempting to corner the market on onions. Their complaints resulted in the passage of the
Onion Futures Act, which banned trading in onion futures in the United States and remains in effect as of 2011.
1970s: The Hunt brothers and the silver market
Brothers Nelson Bunker Hunt and William Herbert Hunt attempted to corner the world silver markets in the late
1970s and early 1980s, at one stage holding the rights to more than half of the world's deliverable silver.
[4]
During
the Hunts' accumulation of the precious metal, silver prices rose from $11 an ounce in September 1979 to nearly $50
an ounce in January 1980.
[5]
Silver prices ultimately collapsed to below $11 an ounce two months later,
[5]
much of
the fall occurring on a single day now known as Silver Thursday, due to changes made to exchange rules regarding
the purchase of commodities on margin.
[6]
1990s: Hamanaka and the copper market
Rogue trader Yasuo Hamanaka, Sumitomo Corporation's chief copper trader, attempted to corner the international
copper market over a ten year period leading up to 1996.
[7]
At one point during this "Sumitomo copper affair,"
Hamanaka is believed to have controlled approximately 5% of the world copper market.
[7]
As his scheme collapsed,
Sumitomo was left with large positions in the copper market, ultimately losing US$2.6 billion.
[8]
In 1997 Hamanaka
pleaded guilty to criminal charges stemming from his trading activity and was sentenced to an eight year prison
sentence.
[8]
Cornering the market
29
2008: Porsche and shares in Volkswagen
During the financial crisis of 2007-2010 Porsche cornered the market in shares of Volkswagen, which briefly saw
Volkswagen become the world's most valuable company.
[9]
Porsche claimed that its actions were intended to gain
control of Volkswagen rather than to manipulate the market: in this case, while cornering the market in Volkswagen
shares, Porsche contracted with naked shortsenabling it to perform a short squeeze on them.
[10]
It was ultimately
unsuccessful, leading to the resignation of Porsche's chief executive and financial director and to the merger of
Porsche into Volkswagen.
[11]
One of the wealthiest men in Germany's industry committed suicide after shorting Volkswagen shares.
[12]
2010: Armajaro and the European cocoa market
On July 17, 2010, Armajaro purchased 240,100 tonnes of cocoa.
[13]
The buyout caused cocoa prices to rise to their
highest level since 1977. The purchase was valued at 658 million and accounted for 7 per cent of annual global
cocoa production.
[14]
The transaction, the largest single cocoa trade in 14 years, was carried out by Armajaro
Holdings, a hedge fund co-founded by Mr Anthony Ward. Ward, the manager of the hedge fund, has been dubbed
"Chocfinger" by fellow traders for his exploits. The nickname is a reference to both the Bond villain Goldfinger as
well as a British confection.
[15]
This example demonstrates that 7 per cent of a perishable good is enough to allow profit taking via cornering a
market.
2011: Oil and hedge funds
All of the above examples had effects that were limited to niche markets. This opens up the question about the
possibility of cornering one of the markets for strategic commodities that are fundamental to all economies around
the world. In Summer 2011 Jim Cramer drew the public's attention to a corner of the oil market
[16]
.
the cartel of nonconsumers who are using oil futures as part of an investing strategy that includes
endless attempts to corner the market for crudes in order to make fortunes for them. that's what they did
in 2008 when they cornered it and took it to $147. we know the futures markets are thin for oil. almost
all the execs on the show confirm to me these futures are unreliable and easily manipulated. the price
can be the benchmark for real commerce, meaning they can make a lot of money so long as no one seeks
to bust the cartel price.
While Cramer points out frankly that this is a corner (calling into question the proper working of the free market),
official sources avoid calling this situation a corner. For example, the U.S. Department of Energy explained it would
release million barrels of oil from the Strategic Petroleum Reserve and called this
a warning shot to speculators in the oil market
"Obama's SPR oil release confounds analysts"
[17]
. Yahoo. 2011-06-24..
Since this corner is not yet over, it has to be evaluated later if this is a global corner showing how a corner can harm
the public interest.
Cornering the market
30
Fictional examples
An attempt to corner the market on orange juice futures plays a key role in the 1983 movie Trading Places. The two
protagonists (played by Eddie Murphy and Dan Aykroyd) eventually foil their rivals' plan by short-selling the
futures, causing hundreds of millions of dollars in losses for the latter.
References
[1] http:/ / financial-dictionary. thefreedictionary.com/ Cornering+ the+ Market
[2] Lefvre, Edwin (1923), Reminiscences of a Stock Operator, chapter 19.
[3] Aristotle. Politics (http:/ / www.perseus.tufts.edu/ hopper/ text?doc=Aristot. + Pol. + 1. 1259a& redirect=true). Translated by H. Rackham. .
Retrieved 2011-01-11.
[4] Gwynne, S. C. (September 2001). "Bunker HUNT". Texas Monthly (Austin, Texas, United States: Emmis Communications Corporation) 29
(9): p78.
[5] Eichenwald, Kurt (1989-12-21). "2 Hunts Fined And Banned From Trades" (http:/ / query. nytimes. com/ gst/ fullpage.
html?res=950DE0DD103FF932A15751C1A96F948260). New York Times. . Retrieved 2008-06-29.
[6] "Bunker's Busted Silver Bubble" (http:/ / www. time. com/ time/ magazine/ article/ 0,9171,920875-2,00. html). Time Magazine (Time Inc.).
1980-05-12. . Retrieved 2008-06-29
[7] Gettler, Leon (2008-02-02). "Wake-up calls on rogue traders keep ringing, but who's answering the phone?" (http:/ / business. theage. com.
au/ wakeup-calls-on-rogue-traders-keep-ringing-but-whos-answering-the-phone-20080201-1plq. html). The Age (Melbourne). . Retrieved
2008-06-29
[8] Petersen, Melody (1999-05-21). "Merrill Charged With 2d Firm In Copper Case" (http:/ / query. nytimes. com/ gst/ fullpage.
html?res=9E00E0DC1F3EF932A15756C0A96F958260& sec=& spon=& pagewanted=all). New York Times. . Retrieved 2008-06-29
[9] "Hedge funds make 18bn loss on VW" (http:/ / news.bbc. co. uk/ 1/ hi/ business/ 7697082. stm). BBC. 2008-10-29. .
[10] "Squeezy money" (http:/ / www. economist.com/ finance/ displaystory. cfm?story_id=12523898). Economist. 2008-10-30. . Retrieved
2008-11-01; "A Clever Move by Porsche on VWs Stock" (http:/ / www. nytimes. com/ 2008/ 10/ 31/ business/ worldbusiness/ 31norris.
html), New York Times; "Porsche crashes into controversy in the ultimate 'short squeeze'" (http:/ / www. telegraph. co. uk/ finance/
globalbusiness/ 3362913/ Porsche-crashes-into-controversy-in-the-ultimate-short-squeeze. html), The Daily Telegraph
[11] "VW prepares to take over Porsche" (http:/ / news.bbc. co. uk/ 1/ hi/ business/ 8165524. stm). BBC. 2009-07-23. .
[12] Boyes, Roger (2009-01-07). "Adolf Merckle, German tycoon who lost millions on VW shares, commits suicide" (http:/ / business.
timesonline.co. uk/ tol/ business/ industry_sectors/ banking_and_finance/ article5460281. ece). London: The Sunday Times. .
[13] Farchy, Jack (16 July 2010). "Hedge fund develops taste for chocolate assets" (http:/ / www. ft. com/ cms/ s/ 0/
e50feefc-9120-11df-b297-00144feab49a.html). Financial Times. . Retrieved 27 July 2010.
[14] Sibun, Jonathan; Wallop, Harry (17 July 2010). "Mystery trader buys all Europe's cocoa" (http:/ / www. telegraph. co. uk/ finance/ markets/
7895242/ Mystery-trader-buys-all-Europes-cocoa. html). The Telegraph. . Retrieved 27 July 2010.
[15] Werdigier, Julia; Creswell, Julie (July 24, 2010). "Traders Cocoa Binge Wraps Up Chocolate Market" (http:/ / www. nytimes. com/ 2010/
07/ 25/ business/ global/ 25chocolate.html?_r=2). The New York Times. . Retrieved July 27, 2010.
[16] "No Huddle Offense: Oil 24 Jun 2011" (http:/ / video. cnbc. com/ gallery/ ?video=3000029661). CNBC. 24 June 2011. . Retrieved 25 June
2011.
[17] http:/ / finance. yahoo.com/ news/ Obamas-SPR-oil-release-cnnm-1977710904. html
Insurance
31
Insurance
Insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss.
Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for
payment. An insurer is a company selling the insurance; the insured, or policyholder, is the person or entity buying
the insurance policy. The amount to be charged for a certain amount of insurance coverage is called the premium.
Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and
practice.
The transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment
to the insurer in exchange for the insurer's promise to compensate (indemnify) the insured in the case of a financial
(personal) loss. The insured receives a contract, called the insurance policy, which details the conditions and
circumstances under which the insured will be financially compensated.
Principles
Insurance involves pooling funds from many insured entities (known as exposures) to pay for the losses that some
may incur. The insured entities are therefore protected from risk for a fee, with the fee being dependent upon the
frequency and severity of the event occurring. In order to be insurable, the risk insured against must meet certain
characteristics in order to be an insurable risk. Insurance is a commercial enterprise and a major part of the financial
services industry, but individual entities can also self-insure through saving money for possible future losses.
[1]
Insurability
Risk which can be insured by private companies typically share seven common characteristics:
[2]
1. Large number of similar exposure units: Since insurance operates through pooling resources, the majority of
insurance policies are provided for individual members of large classes, allowing insurers to benefit from the law
of large numbers in which predicted losses are similar to the actual losses. Exceptions include Lloyd's of London,
which is famous for insuring the life or health of actors, sports figures and other famous individuals. However, all
exposures will have particular differences, which may lead to different premium rates.
2. Definite loss: The loss takes place at a known time, in a known place, and from a known cause. The classic
example is death of an insured person on a life insurance policy. Fire, automobile accidents, and worker injuries
may all easily meet this criterion. Other types of losses may only be definite in theory. Occupational disease, for
instance, may involve prolonged exposure to injurious conditions where no specific time, place or cause is
identifiable. Ideally, the time, place and cause of a loss should be clear enough that a reasonable person, with
sufficient information, could objectively verify all three elements.
3. 3. Accidental loss: The event that constitutes the trigger of a claim should be fortuitous, or at least outside the
control of the beneficiary of the insurance. The loss should be pure, in the sense that it results from an event for
which there is only the opportunity for cost. Events that contain speculative elements, such as ordinary business
risks or even purchasing a lottery ticket, are generally not considered insurable.
4. 4. Large loss: The size of the loss must be meaningful from the perspective of the insured. Insurance premiums need
to cover both the expected cost of losses, plus the cost of issuing and administering the policy, adjusting losses,
and supplying the capital needed to reasonably assure that the insurer will be able to pay claims. For small losses
these latter costs may be several times the size of the expected cost of losses. There is hardly any point in paying
such costs unless the protection offered has real value to a buyer.
5. Affordable premium: If the likelihood of an insured event is so high, or the cost of the event so large, that the
resulting premium is large relative to the amount of protection offered, it is not likely that the insurance will be
purchased, even if on offer. Further, as the accounting profession formally recognizes in financial accounting
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32
standards, the premium cannot be so large that there is not a reasonable chance of a significant loss to the insurer.
If there is no such chance of loss, the transaction may have the form of insurance, but not the substance. (See the
US Financial Accounting Standards Board standard number 113)
6. 6. Calculable loss: There are two elements that must be at least estimable, if not formally calculable: the probability
of loss, and the attendant cost. Probability of loss is generally an empirical exercise, while cost has more to do
with the ability of a reasonable person in possession of a copy of the insurance policy and a proof of loss
associated with a claim presented under that policy to make a reasonably definite and objective evaluation of the
amount of the loss recoverable as a result of the claim.
7. Limited risk of catastrophically large losses: Insurable losses are ideally independent and non-catastrophic,
meaning that the losses do not happen all at once and individual losses are not severe enough to bankrupt the
insurer; insurers may prefer to limit their exposure to a loss from a single event to some small portion of their
capital base. Capital constrains insurers' ability to sell earthquake insurance as well as wind insurance in hurricane
zones. In the US, flood risk is insured by the federal government. In commercial fire insurance it is possible to
find single properties whose total exposed value is well in excess of any individual insurer's capital constraint.
Such properties are generally shared among several insurers, or are insured by a single insurer who syndicates the
risk into the reinsurance market.
Legal
When a company insures an individual entity, there are basic legal requirements. Several commonly cited legal
principles of insurance include:
[3]
1. Indemnity the insurance company indemnifies, or compensates, the insured in the case of certain losses only up
to the insured's interest.
2. Insurable interest the insured typically must directly suffer from the loss. Insurable interest must exist whether
property insurance or insurance on a person is involved. The concept requires that the insured have a "stake" in
the loss or damage to the life or property insured. What that "stake" is will be determined by the kind of insurance
involved and the nature of the property ownership or relationship between the persons.
3. Utmost good faith the insured and the insurer are bound by a good faith bond of honesty and fairness. Material
facts must be disclosed.
4. Contribution insurers which have similar obligations to the insured contribute in the indemnification, according
to some method.
5. Subrogation the insurance company acquires legal rights to pursue recoveries on behalf of the insured; for
example, the insurer may sue those liable for insured's loss.
6. Causa proxima, or proximate cause the cause of loss (the peril) must be covered under the insuring agreement
of the policy, and the dominant cause must not be excluded
7. 7. Mitigation - In case of any loss or casualty, the asset owner must attempt to keep the loss to a minimum, as if the
asset was not insured.
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Indemnification
To "indemnify" means to make whole again, or to be reinstated to the position that one was in, to the extent possible,
prior to the happening of a specified event or peril. Accordingly, life insurance is generally not considered to be
indemnity insurance, but rather "contingent" insurance (i.e., a claim arises on the occurrence of a specified event).
There are generally two types of insurance contracts that seek to indemnify an insured:
1. 1. an "indemnity" policy, and
2. a "pay on behalf" or "on behalf of"
[4]
policy.
The difference is significant on paper, but rarely material in practice.
An "indemnity" policy will never pay claims until the insured has paid out of pocket to some third party; for
example, a visitor to your home slips on a floor that you left wet and sues you for $10,000 and wins. Under an
"indemnity" policy the homeowner would have to come up with the $10,000 to pay for the visitor's fall and then
would be "indemnified" by the insurance carrier for the out of pocket costs (the $10,000).
[4][5]
Under the same situation, a "pay on behalf" policy, the insurance carrier would pay the claim and the insured (the
homeowner in the above example) would not be out of pocket for anything. Most modern liability insurance is
written on the basis of "pay on behalf" language.
[4]
An entity seeking to transfer risk (an individual, corporation, or association of any type, etc.) becomes the 'insured'
party once risk is assumed by an 'insurer', the insuring party, by means of a contract, called an insurance policy.
Generally, an insurance contract includes, at a minimum, the following elements: identification of participating
parties (the insurer, the insured, the beneficiaries), the premium, the period of coverage, the particular loss event
covered, the amount of coverage (i.e., the amount to be paid to the insured or beneficiary in the event of a loss), and
exclusions (events not covered). An insured is thus said to be "indemnified" against the loss covered in the policy.
When insured parties experience a loss for a specified peril, the coverage entitles the policyholder to make a claim
against the insurer for the covered amount of loss as specified by the policy. The fee paid by the insured to the
insurer for assuming the risk is called the premium. Insurance premiums from many insureds are used to fund
accounts reserved for later payment of claims in theory for a relatively few claimants and for overhead costs.
So long as an insurer maintains adequate funds set aside for anticipated losses (called reserves), the remaining
margin is an insurer's profit.
Effects
Insurance can have various effects on society through the way that it changes who bears the cost of losses and
damage. On one hand it can increase fraud, on the other it can help societies and individuals prepare for catastrophes
and mitigate the effects of catastrophes on both households and societies.
Insurance can influence the probability of losses through moral hazard, insurance fraud, and preventive steps by the
insurance company. Insurance scholars have typically used morale hazard to refer to the increased loss due to
unintentional carelessness and moral hazard to refer to increased risk due to intentional carelessness or
indifference.
[6]
Insurers attempt to address carelessness through inspections, policy provisions requiring certain types
of maintenance, and possible discounts for loss mitigation efforts. While in theory insurers could encourage
investment in loss reduction, some commentators have argued that in practice insurers had historically not
aggressively pursued loss control measures - particularly to prevent disaster losses such as hurricanes - because of
concerns over rate reductions and legal battles. However, since about 1996 insurers began to take a more active role
in loss mitigation, such as through building codes.
[7]
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Insurers' business model
Underwriting and investing
The business model is to collect more in premium and investment income than is paid out in losses, and to also offer
a competitive price which consumers will accept. Profit can be reduced to a simple equation: Profit = earned
premium + investment income - incurred loss - underwriting expenses.
Insurers make money in two ways:
1. Through underwriting, the process by which insurers select the risks to insure and decide how much in premiums
to charge for accepting those risks;
2. By investing the premiums they collect from insured parties.
The most complicated aspect of the insurance business is the actuarial science of ratemaking (price-setting) of
policies, which uses statistics and probability to approximate the rate of future claims based on a given risk. After
producing rates, the insurer will use discretion to reject or accept risks through the underwriting process.
At the most basic level, initial ratemaking involves looking at the frequency and severity of insured perils and the
expected average payout resulting from these perils. Thereafter an insurance company will collect historical loss
data, bring the loss data to present value, and compare these prior losses to the premium collected in order to assess
rate adequacy.
[8]
Loss ratios and expense loads are also used. Rating for different risk characteristics involves at the
most basic level comparing the losses with "loss relativities" - a policy with twice as many losses would therefore be
charged twice as much. More complex multivariate analyses are sometimes used when multiple characteristics are
involved and a univariate analysis could produce confounded results. Other statistical methods may be used in
assessing the probability of future losses.
Upon termination of a given policy, the amount of premium collected and the investment gains thereon, minus the
amount paid out in claims, is the insurer's underwriting profit on that policy. Underwriting performance is measured
by something called the "combined ratio"
[9]
which is the ratio of expenses/losses to premiums. A combined ratio of
less than 100 percent indicates an underwriting profit, while anything over 100 indicates an underwriting loss. A
company with a combined ratio over 100% may nevertheless remain profitable due to investment earnings.
Insurance companies earn investment profits on "float". Float, or available reserve, is the amount of money on hand
at any given moment that an insurer has collected in insurance premiums but has not paid out in claims. Insurers start
investing insurance premiums as soon as they are collected and continue to earn interest or other income on them
until claims are paid out. The Association of British Insurers (gathering 400 insurance companies and 94% of UK
insurance services) has almost 20% of the investments in the London Stock Exchange.
[10]
In the United States, the underwriting loss of property and casualty insurance companies was $142.3 billion in the
five years ending 2003. But overall profit for the same period was $68.4 billion, as the result of float. Some
insurance industry insiders, most notably Hank Greenberg, do not believe that it is forever possible to sustain a profit
from float without an underwriting profit as well, but this opinion is not universally held.
Naturally, the float method is difficult to carry out in an economically depressed period. Bear markets do cause
insurers to shift away from investments and to toughen up their underwriting standards, so a poor economy generally
means high insurance premiums. This tendency to swing between profitable and unprofitable periods over time is
commonly known as the underwriting, or insurance, cycle.
[11]
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Claims
Claims and loss handling is the materialized utility of insurance; it is the actual "product" paid for. Claims may be
filed by insureds directly with the insurer or through brokers or agents. The insurer may require that the claim be
filed on its own proprietary forms, or may accept claims on a standard industry form, such as those produced by
ACORD.
Insurance company claims departments employ a large number of claims adjusters supported by a staff of records
management and data entry clerks. Incoming claims are classified based on severity and are assigned to adjusters
whose settlement authority varies with their knowledge and experience. The adjuster undertakes an investigation of
each claim, usually in close cooperation with the insured, determines if coverage is available under the terms of the
insurance contract, and if so, the reasonable monetary value of the claim, and authorizes payment.
The policyholder may hire their own public adjuster to negotiate the settlement with the insurance company on their
behalf. For policies that are complicated, where claims may be complex, the insured may take out a separate
insurance policy add on, called loss recovery insurance, which covers the cost of a public adjuster in the case of a
claim.
Adjusting liability insurance claims is particularly difficult because there is a third party involved, the plaintiff, who
is under no contractual obligation to cooperate with the insurer and may in fact regard the insurer as a deep pocket.
The adjuster must obtain legal counsel for the insured (either inside "house" counsel or outside "panel" counsel),
monitor litigation that may take years to complete, and appear in person or over the telephone with settlement
authority at a mandatory settlement conference when requested by the judge.
If a claims adjuster suspects under-insurance, the condition of average may come into play to limit the insurance
company's exposure.
In managing the claims handling function, insurers seek to balance the elements of customer satisfaction,
administrative handling expenses, and claims overpayment leakages. As part of this balancing act, fraudulent
insurance practices are a major business risk that must be managed and overcome. Disputes between insurers and
insureds over the validity of claims or claims handling practices occasionally escalate into litigation (see insurance
bad faith).
Marketing
Insurers will often use insurance agents to initially market or underwrite their customers. Agents can be captive,
meaning they write only for one company, or independent, meaning that they can issue policies from several
companies. The existence and success of companies using insurance agents is likely due to improved and
personalized service.
[12]
History of insurance
In some sense we can say that insurance appears simultaneously with the appearance of human society. We know of
two types of economies in human societies: natural or non-monetary economies (using barter and trade with no
centralized nor standardized set of financial instruments) and more modern monetary economies (with markets,
currency, financial instruments and so on). The former is more primitive and the insurance in such economies entails
agreements of mutual aid. If one family's house is destroyed the neighbours are committed to help rebuild. Granaries
housed another primitive form of insurance to indemnify against famines. Often informal or formally intrinsic to
local religious customs, this type of insurance has survived to the present day in some countries where modern
money economy with its financial instruments is not widespread.
Turning to insurance in the modern sense (i.e., insurance in a modern money economy, in which insurance is part of
the financial sphere), early methods of transferring or distributing risk were practised by Chinese and Babylonian
traders as long ago as the 3rd and 2nd millennia BC, respectively.
[13]
Chinese merchants travelling treacherous river
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rapids would redistribute their wares across many vessels to limit the loss due to any single vessel's capsizing. The
Babylonians developed a system which was recorded in the famous Code of Hammurabi, c. 1750 BC, and practised
by early Mediterranean sailing merchants. If a merchant received a loan to fund his shipment, he would pay the
lender an additional sum in exchange for the lender's guarantee to cancel the loan should the shipment be stolen or
lost at sea.
Achaemenian monarchs of Ancient Persia were the first to insure their people and made it official by registering the
insuring process in governmental notary offices. The insurance tradition was performed each year in Norouz
(beginning of the Iranian New Year); the heads of different ethnic groups as well as others willing to take part,
presented gifts to the monarch. The most important gift was presented during a special ceremony. When a gift was
worth more than 10,000 Derrik (Achaemenian gold coin) the issue was registered in a special office. This was
advantageous to those who presented such special gifts. For others, the presents were fairly assessed by the
confidants of the court. Then the assessment was registered in special offices.
The purpose of registering was that whenever the person who presented the gift registered by the court was in
trouble, the monarch and the court would help him. Jahez, a historian and writer, writes in one of his books on
ancient Iran: "[W]henever the owner of the present is in trouble or wants to construct a building, set up a feast, have
his children married, etc. the one in charge of this in the court would check the registration. If the registered amount
exceeded 10,000 Derrik, he or she would receive an amount of twice as much."
[14]
A thousand years later, the inhabitants of Rhodes invented the concept of the general average. Merchants whose
goods were being shipped together would pay a proportionally divided premium which would be used to reimburse
any merchant whose goods were deliberately jettisoned in order to lighten the ship and save it from total loss.
The ancient Athenian "maritime loan" advanced money for voyages with repayment being cancelled if the ship was
lost. In the 4th century BC, rates for the loans differed according to safe or dangerous times of year, implying an
intuitive pricing of risk with an effect similar to insurance.
[15]
The Greeks and Romans introduced the origins of
health and life insurance c. 600 BCE when they created guilds called "benevolent societies" which cared for the
families of deceased members, as well as paying funeral expenses of members. Guilds in the Middle Ages served a
similar purpose. The Talmud deals with several aspects of insuring goods. Before insurance was established in the
late 17th century, "friendly societies" existed in England, in which people donated amounts of money to a general
sum that could be used for emergencies.
Separate insurance contracts (i.e., insurance policies not bundled with loans or other kinds of contracts) were
invented in Genoa in the 14th century, as were insurance pools backed by pledges of landed estates. These new
insurance contracts allowed insurance to be separated from investment, a separation of roles that first proved useful
in marine insurance. Insurance became far more sophisticated in post-Renaissance Europe, and specialized varieties
developed.
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Lloyd's of London, pictured in 1991, is one of the
world's leading and most famous insurance
markets
Some forms of insurance had developed in London by the early
decades of the 17th century. For example, the will of the English
colonist Robert Hayman mentions two "policies of insurance" taken
out with the diocesan Chancellor of London, Arthur Duck. Of the value
of 100 each, one relates to the safe arrival of Hayman's ship in
Guyana and the other is in regard to "one hundred pounds assured by
the said Doctor Arthur Ducke on my life". Hayman's will was signed
and sealed on 17 November 1628 but not proved until 1633.
[16]
Toward the end of the seventeenth century, London's growing
importance as a centre for trade increased demand for marine
insurance. In the late 1680s, Edward Lloyd opened a coffee house that
became a popular haunt of ship owners, merchants, and ships' captains,
and thereby a reliable source of the latest shipping news. It became the
meeting place for parties wishing to insure cargoes and ships, and
those willing to underwrite such ventures. Today, Lloyd's of London
remains the leading market (note that it is an insurance market rather
than a company) for marine and other specialist types of insurance, but
it operates rather differently than the more familiar kinds of insurance.
Insurance as we know it today can be traced to the Great Fire of
London, which in 1666 devoured more than 13,000 houses. The
devastating effects of the fire converted the development of insurance
"from a matter of convenience into one of urgency, a change of opinion
reflected in Sir Christopher Wren's inclusion of a site for 'the Insurance
Office' in his new plan for London in 1667."
[17]
A number of attempted fire insurance schemes came to nothing, but
in 1681 Nicholas Barbon, and eleven associates, established England's first fire insurance company, the 'Insurance
Office for Houses', at the back of the Royal Exchange. Initially, 5,000 homes were insured by Barbon's Insurance
Office.
[18]
The first insurance company in the United States underwrote fire insurance and was formed in Charles Town
(modern-day Charleston), South Carolina, in 1732. Benjamin Franklin helped to popularize and make standard the
practice of insurance, particularly against fire in the form of perpetual insurance. In 1752, he founded the
Philadelphia Contributionship for the Insurance of Houses from Loss by Fire. Franklin's company was the first to
make contributions toward fire prevention. Not only did his company warn against certain fire hazards, it refused to
insure certain buildings where the risk of fire was too great, such as all wooden houses. In the United States,
regulation of the insurance industry is highly Balkanized, with primary responsibility assumed by individual state
insurance departments. Whereas insurance markets have become centralized nationally and internationally, state
insurance commissioners operate individually, though at times in concert through a national insurance
commissioners' organization. In recent years, some have called for a dual state and federal regulatory system
(commonly referred to as the Optional federal charter (OFC)) for insurance similar to that which oversees state banks
and national banks.
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Types of insurance
Any risk that can be quantified can potentially be insured. Specific kinds of risk that may give rise to claims are
known as perils. An insurance policy will set out in detail which perils are covered by the policy and which are not.
Below are non-exhaustive lists of the many different types of insurance that exist. A single policy may cover risks in
one or more of the categories set out below. For example, vehicle insurance would typically cover both the property
risk (theft or damage to the vehicle) and the liability risk (legal claims arising from an accident). A home insurance
policy in the US typically includes coverage for damage to the home and the owner's belongings, certain legal claims
against the owner, and even a small amount of coverage for medical expenses of guests who are injured on the
owner's property.
Business insurance can take a number of different forms, such as the various kinds of professional liability insurance,
also called professional indemnity (PI), which are discussed below under that name; and the business owner's policy
(BOP), which packages into one policy many of the kinds of coverage that a business owner needs, in a way
analogous to how homeowners' insurance packages the coverages that a homeowner needs.
[19]
Auto insurance
A wrecked vehicle in Copenhagen
Auto insurance protects the policyholder against financial loss in the
event of an incident involving a vehicle they own, such as in a traffic
collision.
Coverage typically includes:
1. 1. Property coverage, for damage to or theft of the car;
2. 2. Liability coverage, for the legal responsibility to others for bodily
injury or property damage;
3. 3. Medical coverage, for the cost of treating injuries, rehabilitation and
sometimes lost wages and funeral expenses.
Most countries, such as the United Kingdom, require drivers to buy
some, but not all, of these coverages. When a car is used as collateral for a loan the lender usually requires specific
coverage.
Home insurance
Home insurance provides coverage for damage or destruction of the policyholder's home. In some geographical
areas, the policy may exclude certain types of risks, such as flood or earthquake, that require additional coverage.
Maintenance-related issues are typically the homeowner's responsibility. The policy may include inventory, or this
can be bought as a separate policy, especially for people who rent housing. In some countries, insurers offer a
package which may include liability and legal responsibility for injuries and property damage caused by members of
the household, including pets.
[20]
Health insurance
Great Western Hospital, Swindon
Health insurance policies cover the cost of medical treatments. Dental
insurance, like medical insurance protects policyholders for dental
costs. In the US and Canada, dental insurance is often part of an
employer's benefits package, along with health insurance.
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Accident, sickness and unemployment insurance
Workers' compensation, or employers' liability
insurance, is compulsory in some countries
Disability insurance policies provide financial support in the event
of the policyholder becoming unable to work because of disabling
illness or injury. It provides monthly support to help pay such
obligations as mortgage loans and credit cards. Short-term and
long-term disability policies are available to individuals, but
considering the expense, long-term policies are generally obtained
only by those with at least six-figure incomes, such as doctors,
lawyers, etc. Short-term disability insurance covers a person for a
period typically up to six months, paying a stipend each month to
cover medical bills and other necessities.
Long-term disability insurance covers an individual's expenses for
the long term, up until such time as they are considered permanently
disabled and thereafter. Insurance companies will often try to encourage the person back into employment in
preference to and before declaring them unable to work at all and therefore totally disabled.
Disability overhead insurance allows business owners to cover the overhead expenses of their business while they
are unable to work.
Total permanent disability insurance provides benefits when a person is permanently disabled and can no longer
work in their profession, often taken as an adjunct to life insurance.
Workers' compensation insurance replaces all or part of a worker's wages lost and accompanying medical
expenses incurred because of a job-related injury.
Casualty
Casualty insurance insures against accidents, not necessarily tied to any specific property. It is a broad spectrum of
insurance that a number of other types of insurance could be classified, such as auto, workers compensation, and
some liability insurances.
Crime insurance is a form of casualty insurance that covers the policyholder against losses arising from the
criminal acts of third parties. For example, a company can obtain crime insurance to cover losses arising from
theft or embezzlement.
Political risk insurance is a form of casualty insurance that can be taken out by businesses with operations in
countries in which there is a risk that revolution or other political conditions could result in a loss.
Life
Life insurance provides a monetary benefit to a decedent's family or other designated beneficiary, and may
specifically provide for income to an insured person's family, burial, funeral and other final expenses. Life insurance
policies often allow the option of having the proceeds paid to the beneficiary either in a lump sum cash payment or
an annuity.
Annuities provide a stream of payments and are generally classified as insurance because they are issued by
insurance companies, are regulated as insurance, and require the same kinds of actuarial and investment management
expertise that life insurance requires. Annuities and pensions that pay a benefit for life are sometimes regarded as
insurance against the possibility that a retiree will outlive his or her financial resources. In that sense, they are the
complement of life insurance and, from an underwriting perspective, are the mirror image of life insurance.
Certain life insurance contracts accumulate cash values, which may be taken by the insured if the policy is
surrendered or which may be borrowed against. Some policies, such as annuities and endowment policies, are
financial instruments to accumulate or liquidate wealth when it is needed.
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40
In many countries, such as the US and the UK, the tax law provides that the interest on this cash value is not taxable
under certain circumstances. This leads to widespread use of life insurance as a tax-efficient method of saving as
well as protection in the event of early death.
In the US, the tax on interest income on life insurance policies and annuities is generally deferred. However, in some
cases the benefit derived from tax deferral may be offset by a low return. This depends upon the insuring company,
the type of policy and other variables (mortality, market return, etc.). Moreover, other income tax saving vehicles
(e.g., IRAs, 401(k) plans, Roth IRAs) may be better alternatives for value accumulation.
Burial insurance
Burial insurance is a very old type of life insurance which is paid out upon death to cover final expenses, such as the
cost of a funeral. The Greeks and Romans introduced burial insurance circa 600 AD when they organized guilds
called "benevolent societies" which cared for the surviving families and paid funeral expenses of members upon
death. Guilds in the Middle Ages served a similar purpose, as did friendly societies during Victorian times.
Property
This tornado damage to an Illinois home would
be considered an "Act of God" for insurance
purposes
Property insurance provides protection against risks to property, such
as fire, theft or weather damage. This may include specialized forms of
insurance such as fire insurance, flood insurance, earthquake insurance,
home insurance, inland marine insurance or boiler insurance. The term
property insurance may, like casualty insurance, be used as a broad
category of various subtypes of insurance, some of which are listed
below:
US Airways Flight 1549 was written off after
ditching into the Hudson River
Aviation insurance protects aircraft hulls and spares, and associated
liability risks, such as passenger and third-party liability. Airports
may also appear under this subcategory, including air traffic control
and refuelling operations for international airports through to
smaller domestic exposures.
Boiler insurance (also known as boiler and machinery insurance, or
equipment breakdown insurance) insures against accidental physical
damage to boilers, equipment or machinery.
Builder's risk insurance insures against the risk of physical loss or
damage to property during construction. Builder's risk insurance is typically written on an "all risk" basis covering
damage arising from any cause (including the negligence of the insured) not otherwise expressly excluded.
Builder's risk insurance is coverage that protects a person's or organization's insurable interest in materials,
fixtures and/or equipment being used in the construction or renovation of a building or structure should those
items sustain physical loss or damage from an insured peril.
[21]
Crop insurance may be purchased by farmers to reduce or manage various risks associated with growing crops.
Such risks include crop loss or damage caused by weather, hail, drought, frost damage, insects, or disease.
[22]
Earthquake insurance is a form of property insurance that pays the policyholder in the event of an earthquake that
causes damage to the property. Most ordinary home insurance policies do not cover earthquake damage.
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Earthquake insurance policies generally feature a high deductible. Rates depend on location and hence the
likelihood of an earthquake, as well as the construction of the home.
Fidelity bond is a form of casualty insurance that covers policyholders for losses incurred as a result of fraudulent
acts by specified individuals. It usually insures a business for losses caused by the dishonest acts of its employees.
Hurricane Katrina caused over $80 billion of
storm and flood damage
Flood insurance protects against property loss due to flooding.
Many insurers in the US do not provide flood insurance in some
parts of the country. In response to this, the federal government
created the National Flood Insurance Program which serves as the
insurer of last resort.
Home insurance, also commonly called hazard insurance, or
homeowners insurance (often abbreviated in the real estate industry
as HOI), is the type of property insurance that covers private homes,
as outlined above.
Landlord insurance covers residential and commercial properties
which are rented to others. Most homeowners' insurance covers only owner-occupied homes.
Fire aboard MV Hyundai Fortune
Marine insurance and marine cargo insurance cover the loss or
damage of vessels at sea or on inland waterways, and of cargo in
transit, regardless of the method of transit. When the owner of the
cargo and the carrier are separate corporations, marine cargo
insurance typically compensates the owner of cargo for losses
sustained from fire, shipwreck, etc., but excludes losses that can be
recovered from the carrier or the carrier's insurance. Many marine
insurance underwriters will include "time element" coverage in such
policies, which extends the indemnity to cover loss of profit and
other business expenses attributable to the delay caused by a
covered loss.
Supplemental natural disaster insurance covers specified expenses after a natural disaster renders the
policyholder's home uninhabitable. Periodic payments are made directly to the insured until the home is rebuilt or
a specified time period has elapsed.
Surety bond insurance is a three-party insurance guaranteeing the performance of the principal.
The demand for terrorism insurance surged after
9/11
Terrorism insurance provides protection against any loss or damage
caused by terrorist activities. In the US in the wake of 9/11, the
Terrorism Risk Insurance Act 2002 (TRIA) set up a federal Program
providing a transparent system of shared public and private
compensation for insured losses resulting from acts of terrorism.
The program was extended until the end of 2014 by the Terrorism
Risk Insurance Program Reauthorization Act 2007 (TRIPRA).
Volcano insurance is a specialized insurance protecting against
damage arising specifically from volcanic eruptions.
Windstorm insurance is an insurance covering the damage that can
be caused by wind events such as hurricanes.
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Liability
Liability insurance is a very broad superset that covers legal claims against the insured. Many types of insurance
include an aspect of liability coverage. For example, a homeowner's insurance policy will normally include liability
coverage which protects the insured in the event of a claim brought by someone who slips and falls on the property;
automobile insurance also includes an aspect of liability insurance that indemnifies against the harm that a crashing
car can cause to others' lives, health, or property. The protection offered by a liability insurance policy is twofold: a
legal defense in the event of a lawsuit commenced against the policyholder and indemnification (payment on behalf
of the insured) with respect to a settlement or court verdict. Liability policies typically cover only the negligence of
the insured, and will not apply to results of wilful or intentional acts by the insured.
The subprime mortgage crisis was the source of
many liability insurance losses
Public liability insurance covers a business or organization against
claims should its operations injure a member of the public or
damage their property in some way.
Directors and officers liability insurance (D&O) protects an
organization (usually a corporation) from costs associated with
litigation resulting from errors made by directors and officers for
which they are liable.
Environmental liability insurance protects the insured from bodily
injury, property damage and cleanup costs as a result of the
dispersal, release or escape of pollutants.
Errors and omissions insurance is business liability insurance for
professionals such as insurance agents, real estate agents and brokers, architects, third-party administrators
(TPAs) and other business professionals.
Prize indemnity insurance protects the insured from giving away a large prize at a specific event. Examples would
include offering prizes to contestants who can make a half-court shot at a basketball game, or a hole-in-one at a
golf tournament.
Professional liability insurance, also called professional indemnity insurance (PI), protects insured professionals
such as architectural corporations and medical practitioners against potential negligence claims made by their
patients/clients. Professional liability insurance may take on different names depending on the profession. For
example, professional liability insurance in reference to the medical profession may be called medical malpractice
insurance.
Credit
Credit insurance repays some or all of a loan when certain circumstances arise to the borrower such as
unemployment, disability, or death.
Mortgage insurance insures the lender against default by the borrower. Mortgage insurance is a form of credit
insurance, although the name "credit insurance" more often is used to refer to policies that cover other kinds of
debt.
Many credit cards offer payment protection plans which are a form of credit insurance.
Accounts Receivable insurance also known as Credit or Trade Credit insurance is business insurance over the
accounts receivables of the insured. The policy pays the policy holder for covered accounts receivable if the
debtor defaults on payment.
Insurance
43
Other types
All-risk insurance is an insurance that covers a wide-range of incidents and perils, except those noted in the
policy. All-risk insurance is different from peril-specific insurance that cover losses from only those perils listed
in the policy.
[23]
In car insurance, all-risk policy includes also the damages caused by the own driver.
High-value horses may be insured under a
bloodstock policy
Bloodstock insurance covers individual horses or a number of
horses under common ownership. Coverage is typically for
mortality as a result of accident, illness or disease but may extend to
include infertility, in-transit loss, veterinary fees, and prospective
foal.
Business interruption insurance covers the loss of income, and the
expenses incurred, after a covered peril interrupts normal business
operations.
Collateral protection insurance (CPI) insures property (primarily
vehicles) held as collateral for loans made by lending institutions.
Defense Base Act (DBA) insurance provides coverage for civilian
workers hired by the government to perform contracts outside the US and Canada. DBA is required for all US
citizens, US residents, US Green Card holders, and all employees or subcontractors hired on overseas government
contracts. Depending on the country, foreign nationals must also be covered under DBA. This coverage typically
includes expenses related to medical treatment and loss of wages, as well as disability and death benefits.
Expatriate insurance provides individuals and organizations operating outside of their home country with
protection for automobiles, property, health, liability and business pursuits.
Kidnap and ransom insurance is designed to protect individuals and corporations operating in high-risk areas
around the world against the perils of kidnap, extortion, wrongful detention and hijacking.
Legal expenses insurance covers policyholders for the potential costs of legal action against an institution or an
individual. When something happens which triggers the need for legal action, it is known as "the event". There
are two main types of legal expenses insurance: before the event insurance and after the event insurance.
Locked funds insurance is a little-known hybrid insurance policy jointly issued by governments and banks. It is
used to protect public funds from tamper by unauthorized parties. In special cases, a government may authorize
its use in protecting semi-private funds which are liable to tamper. The terms of this type of insurance are usually
very strict. Therefore it is used only in extreme cases where maximum security of funds is required.
Livestock insurance is a specialist policy provided to, for example, commercial or hobby farms, aquariums, fish
farms or any other animal holding. Cover is available for mortality or economic slaughter as a result of accident,
illness or disease but can extend to include destruction by government order.
Media liability insurance is designed to cover professionals that engage in film and television production and
print, against risks such as defamation.
Nuclear incident insurance covers damages resulting from an incident involving radioactive materials and is
generally arranged at the national level. (See the nuclear exclusion clause and for the US the Price-Anderson
Nuclear Industries Indemnity Act.)
Pet insurance insures pets against accidents and illnesses; some companies cover routine/wellness care and burial,
as well.
Pollution insurance usually takes the form of first-party coverage for contamination of insured property either by
external or on-site sources. Coverage is also afforded for liability to third parties arising from contamination of
air, water, or land due to the sudden and accidental release of hazardous materials from the insured site. The
policy usually covers the costs of cleanup and may include coverage for releases from underground storage tanks.
Intentional acts are specifically excluded.
Insurance
44
Purchase insurance is aimed at providing protection on the products people purchase. Purchase insurance can
cover individual purchase protection, warranties, guarantees, care plans and even mobile phone insurance. Such
insurance is normally very limited in the scope of problems that are covered by the policy.
Title insurance provides a guarantee that title to real property is vested in the purchaser and/or mortgagee, free
and clear of liens or encumbrances. It is usually issued in conjunction with a search of the public records
performed at the time of a real estate transaction.
Travel insurance is an insurance cover taken by those who travel abroad, which covers certain losses such as
medical expenses, loss of personal belongings, travel delay, and personal liabilities.
Tuition insurance insures students against involuntary withdrawal from cost-intensive educational institutions
Interest rate insurance protects the holder from adverse changes in interest rates, for instance for those with a
variable rate loan or mortgage
Insurance financing vehicles
Fraternal insurance is provided on a cooperative basis by fraternal benefit societies or other social
organizations.
[24]
No-fault insurance is a type of insurance policy (typically automobile insurance) where insureds are indemnified
by their own insurer regardless of fault in the incident.
Protected self-insurance is an alternative risk financing mechanism in which an organization retains the
mathematically calculated cost of risk within the organization and transfers the catastrophic risk with specific and
aggregate limits to an insurer so the maximum total cost of the program is known. A properly designed and
underwritten Protected Self-Insurance Program reduces and stabilizes the cost of insurance and provides valuable
risk management information.
Retrospectively rated insurance is a method of establishing a premium on large commercial accounts. The final
premium is based on the insured's actual loss experience during the policy term, sometimes subject to a minimum
and maximum premium, with the final premium determined by a formula. Under this plan, the current year's
premium is based partially (or wholly) on the current year's losses, although the premium adjustments may take
months or years beyond the current year's expiration date. The rating formula is guaranteed in the insurance
contract. Formula: retrospective premium = converted loss + basic premium tax multiplier. Numerous
variations of this formula have been developed and are in use.
Formal self insurance is the deliberate decision to pay for otherwise insurable losses out of one's own money. This
can be done on a formal basis by establishing a separate fund into which funds are deposited on a periodic basis,
or by simply forgoing the purchase of available insurance and paying out-of-pocket. Self insurance is usually used
to pay for high-frequency, low-severity losses. Such losses, if covered by conventional insurance, mean having to
pay a premium that includes loadings for the company's general expenses, cost of putting the policy on the books,
acquisition expenses, premium taxes, and contingencies. While this is true for all insurance, for small, frequent
losses the transaction costs may exceed the benefit of volatility reduction that insurance otherwise affords.
Reinsurance is a type of insurance purchased by insurance companies or self-insured employers to protect against
unexpected losses. Financial reinsurance is a form of reinsurance that is primarily used for capital management
rather than to transfer insurance risk.
Social insurance can be many things to many people in many countries. But a summary of its essence is that it is a
collection of insurance coverages (including components of life insurance, disability income insurance,
unemployment insurance, health insurance, and others), plus retirement savings, that requires participation by all
citizens. By forcing everyone in society to be a policyholder and pay premiums, it ensures that everyone can
become a claimant when or if he/she needs to. Along the way this inevitably becomes related to other concepts
such as the justice system and the welfare state. This is a large, complicated topic that engenders tremendous
debate, which can be further studied in the following articles (and others):
National Insurance
Insurance
45
Social safety net
Social security
Social Security debate (United States)
Social Security (United States)
Social welfare provision
Stop-loss insurance provides protection against catastrophic or unpredictable losses. It is purchased by
organizations who do not want to assume 100% of the liability for losses arising from the plans. Under a stop-loss
policy, the insurance company becomes liable for losses that exceed certain limits called deductibles.
Closed community self-insurance
Some communities prefer to create virtual insurance amongst themselves by other means than contractual risk
transfer, which assigns explicit numerical values to risk. A number of religious groups, including the Amish and
some Muslim groups, depend on support provided by their communities when disasters strike. The risk presented by
any given person is assumed collectively by the community who all bear the cost of rebuilding lost property and
supporting people whose needs are suddenly greater after a loss of some kind. In supportive communities where
others can be trusted to follow community leaders, this tacit form of insurance can work. In this manner the
community can even out the extreme differences in insurability that exist among its members. Some further
justification is also provided by invoking the moral hazard of explicit insurance contracts.
In the United Kingdom, The Crown (which, for practical purposes, meant the civil service) did not insure property
such as government buildings. If a government building was damaged, the cost of repair would be met from public
funds because, in the long run, this was cheaper than paying insurance premiums. Since many UK government
buildings have been sold to property companies, and rented back, this arrangement is now less common and may
have disappeared altogether.
Insurance companies
Insurance companies may be classified into two groups:
Life insurance companies, which sell life insurance, annuities and pensions products.
Non-life, general, or property/casualty insurance companies, which sell other types of insurance.
General insurance companies can be further divided into these sub categories.
Standard lines
Excess lines
In most countries, life and non-life insurers are subject to different regulatory regimes and different tax and
accounting rules. The main reason for the distinction between the two types of company is that life, annuity, and
pension business is very long-term in nature coverage for life assurance or a pension can cover risks over many
decades. By contrast, non-life insurance cover usually covers a shorter period, such as one year.
In the United States, standard line insurance companies are "mainstream" insurers. These are the companies that
typically insure autos, homes or businesses. They use pattern or "cookie-cutter" policies without variation from one
person to the next. They usually have lower premiums than excess lines and can sell directly to individuals. They are
regulated by state laws that can restrict the amount they can charge for insurance policies.
Excess line insurance companies (also known as Excess and Surplus) typically insure risks not covered by the
standard lines market. They are broadly referred as being all insurance placed with non-admitted insurers.
Non-admitted insurers are not licensed in the states where the risks are located. These companies have more
flexibility and can react faster than standard insurance companies because they are not required to file rates and
forms as the "admitted" carriers do. However, they still have substantial regulatory requirements placed upon them.
State laws generally require insurance placed with surplus line agents and brokers not to be available through
Insurance
46
standard licensed insurers.
Insurance companies are generally classified as either mutual or stock companies. Mutual companies are owned by
the policyholders, while stockholders (who may or may not own policies) own stock insurance companies.
Demutualization of mutual insurers to form stock companies, as well as the formation of a hybrid known as a mutual
holding company, became common in some countries, such as the United States, in the late 20th century.
Other possible forms for an insurance company include reciprocals, in which policyholders reciprocate in sharing
risks, and Lloyd's organizations.
Insurance companies are rated by various agencies such as A. M. Best. The ratings include the company's financial
strength, which measures its ability to pay claims. It also rates financial instruments issued by the insurance
company, such as bonds, notes, and securitization products.
Reinsurance companies are insurance companies that sell policies to other insurance companies, allowing them to
reduce their risks and protect themselves from very large losses. The reinsurance market is dominated by a few very
large companies, with huge reserves. A reinsurer may also be a direct writer of insurance risks as well.
Captive insurance companies may be defined as limited-purpose insurance companies established with the specific
objective of financing risks emanating from their parent group or groups. This definition can sometimes be extended
to include some of the risks of the parent company's customers. In short, it is an in-house self-insurance vehicle.
Captives may take the form of a "pure" entity (which is a 100% subsidiary of the self-insured parent company); of a
"mutual" captive (which insures the collective risks of members of an industry); and of an "association" captive
(which self-insures individual risks of the members of a professional, commercial or industrial association). Captives
represent commercial, economic and tax advantages to their sponsors because of the reductions in costs they help
create and for the ease of insurance risk management and the flexibility for cash flows they generate. Additionally,
they may provide coverage of risks which is neither available nor offered in the traditional insurance market at
reasonable prices.
The types of risk that a captive can underwrite for their parents include property damage, public and product
liability, professional indemnity, employee benefits, employers' liability, motor and medical aid expenses. The
captive's exposure to such risks may be limited by the use of reinsurance.
Captives are becoming an increasingly important component of the risk management and risk financing strategy of
their parent. This can be understood against the following background:
heavy and increasing premium costs in almost every line of coverage;
difficulties in insuring certain types of fortuitous risk;
differential coverage standards in various parts of the world;
rating structures which reflect market trends rather than individual loss experience;
insufficient credit for deductibles and/or loss control efforts.
There are also companies known as 'insurance consultants'. Like a mortgage broker, these companies are paid a fee
by the customer to shop around for the best insurance policy amongst many companies. Similar to an insurance
consultant, an 'insurance broker' also shops around for the best insurance policy amongst many companies. However,
with insurance brokers, the fee is usually paid in the form of commission from the insurer that is selected rather than
directly from the client.
Neither insurance consultants nor insurance brokers are insurance companies and no risks are transferred to them in
insurance transactions. Third party administrators are companies that perform underwriting and sometimes claims
handling services for insurance companies. These companies often have special expertise that the insurance
companies do not have.
The financial stability and strength of an insurance company should be a major consideration when buying an
insurance contract. An insurance premium paid currently provides coverage for losses that might arise many years in
the future. For that reason, the viability of the insurance carrier is very important. In recent years, a number of
Insurance
47
insurance companies have become insolvent, leaving their policyholders with no coverage (or coverage only from a
government-backed insurance pool or other arrangement with less attractive payouts for losses). A number of
independent rating agencies provide information and rate the financial viability of insurance companies.
Across the world
Life insurance premiums written in 2005
Non-life insurance premiums written in 2005
Global insurance premiums grew by 2.7% in inflation-adjusted terms
in 2010 to $4.3 trillion, climbing abovepre-crisis levels. The return to
growth and record premiums generated during the year followed two
years of decline in real terms. Life insurance premiums increased by
3.2% in 2010 and non-life premiums by 2.1%. While industrialised
countries saw an increase in premiums of around 1.4%, insurance
markets in emerging economies saw rapid expansion with 11% growth
in premium income. The global insurance industry was sufficiently
capitalised to withstand the financial crisis of 2008 and 2009 and most
insurance companies restored their capital to pre-crisis levels by the
end of 2010. With the continuation of the gradual recovery of the
global economy, it is likely the insurance industry will continue to see
growth in premium income both in industrialised countries and
emerging markets in 2011.
Advanced economies account for the bulk of global insurance. With
premium income of $1,620bn, Europe was the most important region in 2010, followed by North America $1,409bn
and Asia $1,161bn. Europe has however seen a decline in premium income during the year in contrast to the growth
seen in North America and Asia. The top four countries generated more than a half of premiums. The US and Japan
alone accounted for 40% of world insurance, much higher than their 7% share of the global population. Emerging
economies accounted forover 85% of the worlds population but only around 15% of premiums. Their markets are
however growing at a quicker pace.
[25]
Regulatory differences
In the United States, insurance is regulated by the states under the McCarran-Ferguson Act, with "periodic proposals
for federal intervention", and a nonprofit coalition of state insurance agencies called the National Association of
Insurance Commissioners works to harmonize the country's different laws and regulations.
[26]
The National
Conference of Insurance Legislators (NCOIL) also works to harmonize the different state laws.
[27]
In the European Union, the Third Non-Life Directive and the Third Life Directive, both passed in 1992 and effective
1994, created a single insurance market in Europe and allowed insurance companies to offer insurance anywhere in
the EU (subject to permission from authority in the head office) and allowed insurance consumers to purchase
insurance from any insurer in the EU.
[28]
The insurance industry in China was nationalized in 1949 and thereafter offered by only a single state-owned
company, the People's Insurance Company of China, which was eventually suspended as demand declined in a
communist environment. In 1978, market reforms led to an increase in the market and by 1995 a comprehensive
Insurance Law of the People's Republic of China
[29]
was passed, followed in 1998 by the formation of China
Insurance Regulatory Commission (CIRC), which has broad regulatory authority over the insurance market of
China.
[30]
In India, IRDA is insurance regulatory authority. As per the section 4 of IRDA Act' 1999, Insurance Regulatory and
Development Authority (IRDA), which was constituted by an act of parliament. National Insurance Academy, Pune
is apex insurance capacity builder institute promoted with support from Ministry of Finance and by LIC, Life &
Insurance
48
General Insurance compnies.
Controversies
Insurance insulates too much
In United States, an insurance company may inadvertently find that its insureds may not be as risk-averse as they
might otherwise be (since, by definition, the insured has transferred the risk to the insurer), a concept known as
moral hazard. To reduce their own financial exposure, insurance companies have contractual clauses that mitigate
their obligation to provide coverage if the insured engages in behavior that grossly magnifies their risk of loss or
liability.
For example, life insurance companies may require higher premiums or deny coverage altogether to people who
work in hazardous occupations or engage in dangerous sports. Liability insurance providers do not provide coverage
for liability arising from intentional torts committed by or at the direction of the insured. Even if a provider were so
irrational as to want to provide such coverage, it is against the public policy of most countries to allow such
insurance to exist, and thus it is usually illegal.
Complexity of insurance policy contracts
9/11 was a major insurance loss, but there were
disputes over the World Trade Center's insurance
policy
Insurance policies can be complex and some policyholders may not
understand all the fees and coverages included in a policy. As a result,
people may buy policies on unfavorable terms. In response to these
issues, many countries have enacted detailed statutory and regulatory
regimes governing every aspect of the insurance business, including
minimum standards for policies and the ways in which they may be
advertised and sold.
For example, most insurance policies in the English language today
have been carefully drafted in plain English; the industry learned the
hard way that many courts will not enforce policies against insureds
when the judges themselves cannot understand what the policies are
saying. Typically, courts construe ambiguities in insurance policies
against the insurance company and in favor of coverage under the
policy.
Many institutional insurance purchasers buy insurance through an insurance broker. While on the surface it appears
the broker represents the buyer (not the insurance company), and typically counsels the buyer on appropriate
coverage and policy limitations, it should be noted that in the vast majority of cases a broker's compensation comes
in the form of a commission as a percentage of the insurance premium, creating a conflict of interest in that the
broker's financial interest is tilted towards encouraging an insured to purchase more insurance than might be
necessary at a higher price. A broker generally holds contracts with many insurers, thereby allowing the broker to
"shop" the market for the best rates and coverage possible.
Insurance may also be purchased through an agent. Unlike a broker, who represents the policyholder, an agent
represents the insurance company from whom the policyholder buys. Just as there is a potential conflict of interest
with a broker, an agent has a different type of conflict. Because agents work directly for the insurance company, if
there is a claim the agent may advise the client to the benefit of the insurance company. It should also be noted that
agents generally can not offer as broad a range of selection compared to an insurance broker.
An independent insurance consultant advises insureds on a fee-for-service retainer, similar to an attorney, and thus
offers completely independent advice, free of the financial conflict of interest of brokers and/or agents. However,
Insurance
49
such a consultant must still work through brokers and/or agents in order to secure coverage for their clients.
Limited consumer benefits
In United States, economists and consumer advocates generally consider insurance to be worthwhile for
low-probability, catastrophic losses, but not for high-probability, small losses. Because of this, consumers are
advised to select high deductibles and to not insure losses which would not cause a disruption in their life. However,
consumers have shown a tendency to prefer low deductibles and to prefer to insure relatively high-probability, small
losses over low-probability, perhaps due to not understanding or ignoring the low-probability risk.
[31]
This is
associated with reduced purchasing of insurance against low-probability losses, and may result in increased
inefficiencies from moral hazard.
[31]
Redlining
Redlining is the practice of denying insurance coverage in specific geographic areas, supposedly because of a high
likelihood of loss, while the alleged motivation is unlawful discrimination. Racial profiling or redlining has a long
history in the property insurance industry in the United States. From a review of industry underwriting and
marketing materials, court documents, and research by government agencies, industry and community groups, and
academics, it is clear that race has long affected and continues to affect the policies and practices of the insurance
industry.
[32]
In July, 2007, The Federal Trade Commission (FTC) released a report presenting the results of a study concerning
credit-based insurance scores in automobile insurance. The study found that these scores are effective predictors of
risk. It also showed that African-Americans and Hispanics are substantially overrepresented in the lowest credit
scores, and substantially underrepresented in the highest, while Caucasians and Asians are more evenly spread across
the scores. The credit scores were also found to predict risk within each of the ethnic groups, leading the FTC to
conclude that the scoring models are not solely proxies for redlining. The FTC indicated little data was available to
evaluate benefit of insurance scores to consumers.
[33]
The report was disputed by representatives of the Consumer
Federation of America, the National Fair Housing Alliance, the National Consumer Law Center, and the Center for
Economic Justice, for relying on data provided by the insurance industry.
[34]
All states have provisions in their rate regulation laws or in their fair trade practice acts that prohibit unfair
discrimination, often called redlining, in setting rates and making insurance available.
[35]
In determining premiums and premium rate structures, insurers consider quantifiable factors, including location,
credit scores, gender, occupation, marital status, and education level. However, the use of such factors is often
considered to be unfair or unlawfully discriminatory, and the reaction against this practice has in some instances led
to political disputes about the ways in which insurers determine premiums and regulatory intervention to limit the
factors used.
An insurance underwriter's job is to evaluate a given risk as to the likelihood that a loss will occur. Any factor that
causes a greater likelihood of loss should theoretically be charged a higher rate. This basic principle of insurance
must be followed if insurance companies are to remain solvent. Thus, "discrimination" against (i.e., negative
differential treatment of) potential insureds in the risk evaluation and premium-setting process is a necessary
by-product of the fundamentals of insurance underwriting. For instance, insurers charge older people significantly
higher premiums than they charge younger people for term life insurance. Older people are thus treated differently
than younger people (i.e., a distinction is made, discrimination occurs). The rationale for the differential treatment
goes to the heart of the risk a life insurer takes: Old people are likely to die sooner than young people, so the risk of
loss (the insured's death) is greater in any given period of time and therefore the risk premium must be higher to
cover the greater risk. However, treating insureds differently when there is no actuarially sound reason for doing so
is unlawful discrimination.
Insurance
50
What is often missing from the debate is that prohibiting the use of legitimate, actuarially sound factors means that
an insufficient amount is being charged for a given risk, and there is thus a deficit in the system. The failure to
address the deficit may mean insolvency and hardship for all of a company's insureds. The options for addressing the
deficit seem to be the following: Charge the deficit to the other policyholders or charge it to the government (i.e.,
externalize outside of the company to society at large).
Insurance patents
Further information: Insurance patent
New assurance products can now be protected from copying with a business method patent in the United States.
A recent example of a new insurance product that is patented is Usage Based auto insurance. Early versions were
independently invented and patented by a major US auto insurance company, Progressive Auto Insurance (U.S.
Patent 5797134
[36]
) and a Spanish independent inventor, Salvador Minguijon Perez (EP 0700009
[37]
).
Many independent inventors are in favor of patenting new insurance products since it gives them protection from big
companies when they bring their new insurance products to market. Independent inventors account for 70% of the
new US patent applications in this area.
Many insurance executives are opposed to patenting insurance products because it creates a new risk for them. The
Hartford insurance company, for example, recently had to pay $80 million to an independent inventor, Bancorp
Services, in order to settle a patent infringement and theft of trade secret lawsuit for a type of corporate owned life
insurance product invented and patented by Bancorp.
There are currently about 150 new patent applications on insurance inventions filed per year in the United States.
The rate at which patents have issued has steadily risen from 15 in 2002 to 44 in 2006.
[38]
Inventors can now have their insurance US patent applications reviewed by the public in the Peer to Patent
program.
[39]
The first insurance patent application to be posted was US2009005522 Risk assessment company
[40]
.
It was posted on March 6, 2009. This patent application describes a method for increasing the ease of changing
insurance companies.
[41]
The insurance industry and rent-seeking
Certain insurance products and practices have been described as rent-seeking by critics. That is, some insurance
products or practices are useful primarily because of legal benefits, such as reducing taxes, as opposed to providing
protection against risks of adverse events. Under United States tax law, for example, most owners of variable
annuities and variable life insurance can invest their premium payments in the stock market and defer or eliminate
paying any taxes on their investments until withdrawals are made. Sometimes this tax deferral is the only reason
people use these products. Another example is the legal infrastructure which allows life insurance to be held in an
irrevocable trust which is used to pay an estate tax while the proceeds themselves are immune from the estate tax.
Religious concerns
Muslim scholars have varying opinions about insurance. Insurance policies that earn interest are generally
considered to be a form of riba
[42]
(usury) and some consider even policies that do not earn interest to be a form of
gharar (speculation). Some argue that gharar is not present due to the actuarial science behind the underwriting.
[43]
Jewish rabbinical scholars also have expressed reservations regarding insurance as an avoidance of God's will but
most find it acceptable in moderation.
[44]
Some Christians believe insurance represents a lack of faith
[45]
and there is a long history of resistance to
commercial insurance in Anabaptist communities (Mennonites, Amish, Hutterites, Brethren in Christ) but many
participate in community-based self-insurance programs that spread risk within their communities.
[46][47][48]
Insurance
51
Notes
[1] Gollier C. (2003). To Insure or Not to Insure?: An Insurance Puzzle (http:/ / dhenriet. perso. egim-mrs. fr/ gollier. pdf). The Geneva Papers
on Risk and Insurance Theory;).
[2] This discussion is adapted from Mehr and Camack Principles of Insurance, 6th edition, 1976, pp 34 37.
[3] Irish Brokers Association. Insurance Principles (https:/ / www. iba. ie/ development2009/ index. php?option=com_content& view=article&
id=76& Itemid=167).
[4] C. Kulp & J. Hall, Casualty Insurance, Fourth Edition, 1968, page 35
[5] [5] However, bankruptcy of the insured does not relieve the insurer. Certain types of insurance, e.g., workers' compensation and personal
automobile liability, are subject to statutory requirements that injured parties have direct access to coverage.
[6] Dembe AE, Boden LI. (2000). Moral hazard: A question of morality? (http:/ / baywood. metapress. com/ index/ 1GU8EQN802J62RXK. pdf).
New Solutions.
[7] Kunreuther H. (1996). Mitigating Disaster Losses Through Insurance (http:/ / opim. wharton. upenn. edu/ risk/ downloads/ archive/ arch167.
pdf). Journal of Risk and Uncertainty.
[8] Brown RL. (1993). Introduction to Ratemaking and Loss Reserving for Property and Casualty Insurance (http:/ / books. google. com/
books?id=1j4O50JENE4C). ACTEX Publications.
[9] Feldstein, Sylvan G.; Fabozzi, Frank J. (2008). The Handbook of Municipal Bonds (http:/ / books. google. com/ ?id=Juc4fb1Fx1cC&
lpg=PA614& pg=PA614#v=onepage& f=false). Wiley. p.614. ISBN978-0470108758. . Retrieved February 8, 2010.
[10] http:/ / www.abi. org.uk/ About_The_ABI/ role.aspx
[11] Fitzpatrick, Sean, Fear is the Key: A Behavioral Guide to Underwriting Cycles, (http:/ / ssrn. com/ abstract=690316) 10 Conn. Ins. L.J. 255
(2004).
[12] Berger, Allen N.; Cummins, J. David; Weiss, Mary A. (October 1997). "The Coexistence of Multiple Distribution Systems for Financial
Services: The Case of Property-Liability Insurance.". Journal of Business 70 (4): 51546. doi:10.1086/209730. ( online draft (http:/ / fic.
wharton. upenn. edu/ fic/ papers/ 95/ 9513.pdf))
[13] See, e.g., Vaughan, E. J., 1997, Risk Management, New York: Wiley.
[14] http:/ / www.iran-law. com/ article.php3?id_article=61
[15] Franklin, J., 2001, The Science of Conjecture: Evidence and Probability Before Pascal, Baltimore:Johns Hopkins University Press, 259.
[16] [16] "And whereas I have left in the hands of Doctor Ducke Channcellor of London two pollicies of insurance the one of one hundred pounds for
the safe arivall of our Shipp in Guiana which is in mine owne name, if we miscarry by the waie (which God forbid) I bequeath the advantage
thereof to my said Cosin Thomas Muchell...whereas there is an other insurance of one hundred pounds assured by the said Doctor Arthur
Ducke on my life for one yeare if I chance to die within that tyme I entreat the said doctor Ducke to make it over to the said Thomas Muchell
his kinsman..." Will of Robert Hayman, 1628:Records of the Prerogative Court of Canterbury, Catalogue Reference PROB 11/163
[17] [17] Dickson (1960): 4
[18] [18] Dickson (1960): 7
[19] Insurance Information Institute. "Business insurance information. What does a businessowners policy cover?" (http:/ / www. iii. org/
individuals/ business/ basics/ bop/ ). . Retrieved 2007-05-09.
[20] Insurance Information Institute. "What is homeowners insurance?" (http:/ / www. iii. org/ individuals/ homei/ hbasics/ whatis/ ). . Retrieved
2008-11-11.
[21] "Builder's Risk Insurance" (http:/ / www.adjustersinternational. com/ AdjustingToday/ ATfullinfo. cfm?start=1& page_no=1& pdfID=4).
Adjusters International. . Retrieved 2009-10-16.
[22] US application 20060287896 (http:/ / worldwide. espacenet. com/ textdoc?DB=EPODOC& IDX=US20060287896) Method for providing
crop insurance for a crop associated with a defined attribute
[23] http:/ / www.business.gov/ manage/ business-insurance/ insurance-types. html
[24] [24] Margaret E. Lynch, Editor, "Health Insurance Terminology," Health Insurance Association of America, 1992, ISBN 1-879143-13-5
[25] http:/ / www.thecityuk.com/ assets/ Uploads/ Insurance-2011-F2. pdfPDF(365KB) page 2
[26] Randall S. (1998). Insurance Regulation in the United States: Regulatory Federalism and the National Association of Insurance
Commissioners (http:/ / www.law.fsu.edu/ Journals/ lawreview/ downloads/ 263/ rand. pdf). FLORIDA STATE UNIVERSITY LAW
REVIEW.
[27] J Schacht, B Foudree. (2007). A Study on State Authority: Making a Case for Proper Insurance Oversight (http:/ / www. ncoil. org/ policy/
Docs/ 2007/ ILFStudy. pdf). NCOIL
[28] CJ Campbell, L Goldberg, A Rai. (2003). The Impact of the European Union Insurance Directives on Insurance Company Stocks (http:/ /
people. hofstra. edu/ Anoop_Rai/ research/ JORI70-1Campbell. pdf). The Journal of Risk and Insurance.
[29] Insurance Law of the People's Republic of China - 1995 (http:/ / www. lehmanlaw. com/ resource-centre/ laws-and-regulations/ insurance/
insurance-law-of-the-peoples-republic-of-china-1995.html). Lehman, Lee & Xu.
[30] Thomas JE. (2002). The role and powers of the Chinese insurance regulatory commission in the administration of insurance law in China
(http:/ / www. genevaassociation. org/ PDF/ Geneva_papers_on_Risk_and_Insurance/ GA2002_GP27(3)_Thomas. pdf). Geneva Papers on
Risk and Insurance.
[31] Schindler RM. (1994). Consumer Motivation for Purchasing Low-Deductible Insurance (http:/ / www. business. camden. rutgers. edu/
FacultyStaff/ research/ schindler/ Schindler (1994). pdf). In Marketing and Public Policy Conference Proceedings, Vol. 4, D.J. Ringold (ed.),
Insurance
52
Chicago, IL: American Marketing Association, 147-155.
[32] Gregory D. Squires (2003) Racial Profiling, Insurance Style: Insurance Redlining and the Uneven Development of Metropolitan Areas
Journal of Urban Affairs Volume 25 Issue 4 Page 391-410, November 2003
[33] Credit-Based Insurance Scores: Impacts on Consumers of Automobile Insurance (http:/ / ftc. gov/ opa/ 2007/ 07/ facta. shtm), Federal Trade
Commission (July 2007)
[34] Consumers Dispute FTC Report on Insurance Credit Scoring (http:/ / www. consumeraffairs. com/ news04/ 2007/ 07/ insurance_credit.
html) www.consumeraffairs.com (July 2007)
[35] Insurance Information Institute. "Issues Update: Regulation Modernization" (http:/ / www. iii. org/ media/ hottopics/ insurance/ ratereg/ ). .
Retrieved 2008-11-11.
[36] http:/ / www.google.com/ patents?vid=5797134
[37] http:/ / worldwide. espacenet. com/ textdoc?DB=EPODOC& IDX=EP0700009
[38] (Source: Insurance IP Bulletin, December 15, 2006) (http:/ / marketsandpatents. com/ IPB-12152006. mht)
[39] Mark Nowotarski "Patent Q/A: Peer to Patent", Insurance IP Bulletin, August 15, 2008 (http:/ / www. marketsandpatents. com/ bulletin/
IPB-08152008. html)
[40] http:/ / www.peertopatent.org/ patent/ 20090055227/ activity
[41] Bakos, Nowotarski, An Experiment in Better Patent Examination, Insurance IP Bulletin, December 15, 2008 (http:/ / www.
marketsandpatents.com/ bulletin/ IPB-12152008.html)
[42] "Islam Question and Answer - The true nature of insurance and the rulings concerning it" (http:/ / islamqa. com/ en/ ref/ 8889/ insurance). .
Retrieved 2010-01-18.
[43] "Life Insurance from an Islamic Perspective" (http:/ / www. islamonline. net/ servlet/
Satellite?pagename=IslamOnline-English-Ask_Scholar/ FatwaE/ FatwaE& cid=1119503543412). . Retrieved 2010-01-18.
[44] "Jewish Association for Business Ethics - Insurance" (http:/ / www. jabe. org/ insurance. html). . Retrieved 2008-03-25.
[45] "CIC Insurance - Insurance and the Church" (http:/ / www. cic. co. ke/ template/ t02. php?menuId=72). . Retrieved 2010-01-18.
[46] Rubinkam, Michael (October 5, 2006). "Amish Reluctantly Accept Donations" (http:/ / www. washingtonpost. com/ wp-dyn/ content/
article/ 2006/ 10/ 05/ AR2006100501360.html). The Washington Post. . Retrieved 2008-03-25.
[47] Donald B. Kraybill. The riddle of Amish culture. p.277. ISBN0801836824.
[48] "Global Anabaptist Mennonite Encyclopedia Online, Insurance" (http:/ / www. gameo. org/ encyclopedia/ contents/ I583ME. html). .
Retrieved 2010-01-18.
Bibliography
Dickson, P.G.M. (1960). The Sun Insurance Office 1710-1960: The History of Two and a half Centuries of British
Insurance. London: Oxford University Press. pp.324.
External links
Congressional Research Service (CRS) Reports regarding the US Insurance industry (http:/ / digital. library. unt.
edu/ govdocs/ crs/ search. tkl?type=subject& q=Insurance companies & q2=LIV)
Federation of European Risk Management Associations (http:/ / www. ferma. eu/ )
Insurance (http:/ / www. dmoz. org/ Home/ Personal_Finance/ Insurance/ ) at the Open Directory Project
Insurance Bureau of Canada (http:/ / www. ibc. ca/ )
Insurance Information Institute (http:/ / www. iii. org/ )
Museum of Insurance (http:/ / www. immediateannuities. com/ museumofinsurance/ ) - displays thousands of
antique insurance policies and ephemera
National Association of Insurance Commissioners (http:/ / www. naic. org/ )
The British Library (http:/ / www. bl. uk/ collections/ business/ insurind. html) - finding information on the
insurance industry (UK bias)
53
Risk Management
Derivative
A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting
values of the underlying variables, and notional amounts) under which payments, or payoffs, are to be made between
the parties.
[1][2]
Under US law and the laws of most other developed countries, derivatives have special legal exemptions that make
them a particularly attractive legal form through which to extend credit.
[3]
However, the strong creditor protections
afforded to derivatives counterparties, in combination with their complexity and lack of transparency, can cause
capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks.
[3]
Indeed,
the use of derivatives to mask credit risk from third parties while protecting derivative counterparties contributed to
both the financial crisis of 2008 in the United States and the European sovereign debt crises in Greece and Italy.
[3][4]
Financial reforms within the US since the financial crisis have served only to reinforce special protections for
derivatives, including greater access to government guarantees, while minimizing disclosure to broader financial
markets.
[5]
One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the
eighteenth century.
[6]
Derivatives are broadly categorized by the relationship between the underlying asset and the
derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign exchange
derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade
(such as exchange-traded or over-the-counter); and their pay-off profile.
Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example, a speculator may
sell deep in-the-money naked calls on a stock, expecting the stock price to plummet, but exposing himself to
potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to
fluctuations in the exchange rate of two currencies.
Third parties can use publicly available derivatives prices as educated predictions of uncertain future outcomes, for
example, the likelihood that a corporation will default on its debts.
[7]
Usage
Derivatives are used by investors for the following:
provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in
the value of the derivative;
[8]
speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given
direction, stays in or out of a specified range, reaches a certain level);
hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite
direction to their underlying position and cancels part or all of it out;
[9]
obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);
[10]
create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying
reaching a specific price level).
Derivative
54
Hedging
Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For
example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a
specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty
of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be
available because of events unspecified by the contract, such as the weather, or that one party will renege on the
contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured
against counter-party risk.
From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures
contract: the farmer reduces the risk that the price of wheat will fall below the price specified in the contract and
acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional
income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall
below the price specified in the contract (thereby paying more in the future than he otherwise would have) and
reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is
the insurer (risk taker) for one type of risk, and the counter-party is the insurer (risk taker) for another type of risk.
Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon
payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution
has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according
to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while
reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the
future value of the asset.
Derivatives traders at the Chicago Board of Trade
Derivatives can serve legitimate business purposes. For
example, a corporation borrows a large sum of money
at a specific interest rate.
[11]
The rate of interest on the
loan resets every six months. The corporation is
concerned that the rate of interest may be much higher
in six months. The corporation could buy a forward rate
agreement (FRA), which is a contract to pay a fixed
rate of interest six months after purchases on a notional
amount of money.
[12]
If the interest rate after six
months is above the contract rate, the seller will pay the
difference to the corporation, or FRA buyer. If the rate
is lower, the corporation will pay the difference to the
seller. The purchase of the FRA serves to reduce the
uncertainty concerning the rate increase and stabilize
earnings.
Speculation and arbitrage
Derivatives can be used to acquire risk, rather than to hedge against risk. Thus, some individuals and institutions will
enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking
insurance will be wrong about the future value of the underlying asset. Speculators look to buy an asset in the future
at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future
at a high price according to a derivative contract when the future market price is low.
Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset
falls below the price specified in a futures contract to sell the asset.
Derivative
55
Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings
Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack
of oversight by the bank's management and regulators, and unfortunate events like the Kobe earthquake, Leeson
incurred a US$1.3 billion loss that bankrupted the centuries-old institution.
[13]
Types
OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in
the market:
Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between
two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate
agreements, exotic options - and other exotic derivatives - are almost always traded in this way. The OTC
derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of
information between the parties, since the OTC market is made up of banks and other highly sophisticated parties,
such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity
being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional
amount is US$708 trillion (as of June 2011).
[14]
Of this total notional amount, 67% are interest rate contracts, 8%
are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity
contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central
counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party
relies on the other to perform.
Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized
derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange.
[15]
A derivatives exchange acts as an intermediary
to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee. The world's
largest
[16]
derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index
Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products),
and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of
Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover
in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of derivative
instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds
and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed
on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a
complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other
derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics
that, while related to an underlying commodity, nonetheless are distinctive.
Derivative
56
Common derivative contract types
Some of the common variants of derivative contracts are as follows:
1. Forwards:A tailored contract between two parties, where payment takes place at a specific time in the future at
today's pre-determined price.
2. Futures: are contracts to buy or sell an asset on or before a future date at a price specified today. A futures
contract differs from a forward contract in that, while the former is a standardized contract written by a clearing
house that operates an exchange where the contract can be bought and sold, the latter is a non-standardized
contract written by the parties themselves.
3. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or
sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and
is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the
case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity
date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity
date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the
transaction. Options are of two types: call option and put option. The buyer of a Call option although has a right
to buy a certain quantity of the underlying asset, at a specified price on or before a given date in the future, he
however has no obligation whatsoever to carry out this right. Similarly, the buyer of a Put option although has the
right to sell a certain quantity of an underlying asset, at a specified price on or before a given date in the future, he
however has no obligation whatsoever to carry out this right.
4. Warrants: Apart from the commonly used short-dated options which have a maximum maturity period of 1 year,
there exists certain long-dated options as well, known as Warrant (finance). These are generally traded
over-the-counter.
5. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value
of currencies exchange rates, bonds/interest rates, commodities exchange, stocks or other assets. Another term
which is commonly associated to Swap is Swaption which is basically an option on the forward Swap. Similar to
a Call and Put option, a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on one hand,
in case of a receiver Swaption there is an option wherein you can receive fixed and pay floating, a payer swaption
on the other hand is an option to pay fixed and receive floating.
Swaps can basically be categorized into two types:
Interest Rate Swap: These basically necessitate swapping only interest associated cash flows in the same
currency, between two parties.
Currency swap: In this kind of swapping, the cash flow between the two parties includes both principal and
interest. Also, the money which is being swapped is in different currency for both parties.
[17]
Examples
The overall derivatives market has five major classes of underlying asset:
interest rate derivatives (the largest)
foreign exchange derivatives
credit derivatives
equity derivatives
commodity derivatives
Some common examples of these derivatives are the following:
Derivative
57
UNDERLYING CONTRACT TYPES
Exchange-traded
futures
Exchange-traded options OTC swap OTC forward OTC option
Equity DJIA Index future
Single-stock future
Option on DJIA Index
future
Single-share option
Equity swap Back-to-back
Repurchase agreement
Stock option
Warrant
Turbo warrant
Interest rate Eurodollar future
Euribor future
Option on Eurodollar
future
Option on Euribor future
Interest rate swap Forward rate agreement Interest rate cap and
floor
Swaption
Basis swap
Bond option
Credit Bond future Option on Bond future Credit default
swap
Total return swap
Repurchase agreement Credit default option
Foreign
exchange
Currency future Option on currency future Currency swap Currency forward Currency option
Commodity WTI crude oil futures Weather derivatives Commodity swap Iron ore forward
contract
Gold option
Other examples of underlying exchangeables are:
Property (mortgage) derivatives
Economic derivatives that pay off according to economic reports
[18]
as measured and reported by national
statistical agencies
Freight derivatives
Inflation derivatives
Weather derivatives
Insurance derivatives
[19]
Emissions derivatives
[20]
Economic function of the derivative market
Some of the salient economic functions of the derivative market include:
1. Prices in a structured derivative market not only replicate the discernment of the market participants about the
future but also lead the prices of underlying to the professed future level. On the expiration of the derivative
contract, the prices of derivatives congregate with the prices of the underlying. Therefore, derivatives are essential
tools to determine both current and future prices.
2. The derivatives market relocates risk from the people who prefer risk aversion to the people who have an appetite
for risk.
3. The intrinsic nature of derivatives market associates them to the underlying Spot market. Due to derivatives there
is a considerable increase in trade volumes of the underlying Spot market. The dominant factor behind such an
escalation is increased participation by additional players who would not have otherwise participated due to
absence of any procedure to transfer risk.
4. As supervision, reconnaissance of the activities of various participants becomes tremendously difficult in assorted
markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the
presence of an organized derivatives market, speculation can be controlled, resulting in a more meticulous
environment.
5. A significant accompanying benefit which is a consequence of derivatives trading is that it acts as a facilitator for
new Entrepreneurs. The derivatives market has a history of alluring many optimistic, imaginative and well
Derivative
58
educated people with an entrepreneurial outlook, the benefits of which are colossal.
In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by
derivative Market participant.
[21]
Valuation
Total world derivatives from 19982007
[22]
compared to total world wealth in the year
2000
[23]
Market and arbitrage-free
prices
Two common measures of value are:
Market price, i.e., the price at which
traders are willing to buy or sell the
contract;
Arbitrage-free price, meaning that
no risk-free profits can be made by
trading in these contracts; see
rational pricing.
Determining the market price
For exchange-traded derivatives,
market price is usually transparent,
making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to
collate and disseminate prices.
Determining the arbitrage-free price
See List of finance topics# Derivatives pricing.
The arbitrage-free price for a derivatives contract can be complex, and there are many different variables to consider.
Arbitrage-free pricing is a central topic of financial mathematics. For futures/forwards the arbitrage free price is
relatively straightforward, involving the price of the underlying together with the cost of carry (income received less
interest costs), although there can be complexities.
However, for options and more complex derivatives, pricing involves developing a complex pricing model:
understanding the stochastic process of the price of the underlying asset is often crucial. A key equation for the
theoretical valuation of options is the BlackScholes formula, which is based on the assumption that the cash flows
from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A
simplified version of this valuation technique is the binomial options model.
OTC represents the biggest challenge in using models to price derivatives. Since these contracts are not publicly
traded, no market price is available to validate the theoretical valuation. Most of the model's results are
input-dependant (meaning the final price depends heavily on how we derive the pricing inputs).
[24]
Therefore it is
common that OTC derivatives are priced by Independent Agents that both counterparties involved in the deal
designate upfront (when signing the contract).
Derivative
59
Criticism
Derivatives are often subject to the following criticisms:
Erroneous Analysis of Benefits
Economists and bankers claimed derivatives made markets safer. But instead, they made them [the markets]
unstable.
[25]
Hidden Tail Risk
According to Raghuram Rajan, a former chief economist of the International Monetary Fund (IMF), "... it may well
be that the managers of these firms [investment funds] have figured out the correlations between the various
instruments they hold and believe they are hedged. Yet as Chan and others (2005) point out, the lessons of summer
1998 following the default on Russian government debt is that correlations that are zero or negative in normal times
can turn overnight to one a phenomenon they term phase lock-in. A hedged position can become unhedged at
the worst times, inflicting substantial losses on those who mistakenly believe they are protected."
[26]
Risk
The use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives allow
investors to earn large returns from small movements in the underlying asset's price. However, investors could lose
large amounts if the price of the underlying moves against them significantly. There have been several instances of
massive losses in derivative markets, such as the following:
American International Group (AIG) lost more than US$18 billion through a subsidiary over the preceding
three quarters on Credit Default Swaps (CDS).
[27]
The US federal government then gave the company US$85
billion in an attempt to stabilize the economy before an imminent stock market crash. It was reported that the
gifting of money was necessary because over the next few quarters, the company was likely to lose more
money.
The loss of US$7.2 Billion by Socit Gnrale in January 2008 through mis-use of futures contracts.
The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September
2006 when the price plummeted.
The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.
The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft AG.
[28]
The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.
[29]
UBS AG, Switzerlands biggest bank, suffered a $2 billion loss through unauthorized trading discovered in
September, 2011.
[30]
Counter party risk
Some derivatives (especially swaps) expose investors to counter party risk. Different types of derivatives have
different levels of counter party risk. For example, standardized stock options by law require the party at risk to have
a certain amount deposited with the exchange, showing that they can pay for any losses; banks that help businesses
swap variable for fixed rates on loans may do credit checks on both parties. However, in private agreements between
two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.
Derivative
60
Large notional value
Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses for
which the investor would be unable to compensate. The possibility that this could lead to a chain reaction ensuing in
an economic crisis was pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report.
Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an
increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets.
Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was
originally meant to be a market to transfer risk now becomes a leading indicator.(See Berkshire Hathaway Annual
Report for 2002)
[31]
Leverage of an economy's debt
Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real
economy to service its debt obligations, thereby curtailing real economic activity, which can cause a recession or
even depression. In the view of Marriner S. Eccles, US Federal Reserve Chairman from November, 1934 to
February, 1948, too high a level of debt was one of the primary causes of the Great Depression. (See Berkshire
Hathaway Annual Report for 2002)
Benefits
The use of derivatives also has its benefits:
Derivatives facilitate the buying and selling of risk, and many financial professionals consider this to have a
positive impact on the economic system. Although someone loses money while someone else gains money with a
derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system
because it is not zero-sum in utility.
Government regulation
In the context of a 2010 examination of the ICE Trust, an industry self-regulatory body, Gary Gensler, the chairman
of the Commodity Futures Trading Commission which regulates most derivatives, was quoted saying that the
derivatives marketplace as it functions now "adds up to higher costs to all Americans." More oversight of the banks
in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice is looking into
derivatives, too. The departments antitrust unit is actively investigating 'the possibility of anticompetitive practices
in the credit derivatives clearing, trading and information services industries,' according to a department
spokeswoman."
[32]
Over-the-counter dealing will be less common as the 2010 Dodd-Frank Wall Street Reform Act comes into effect.
The law mandated the clearing of certain swaps at registered exchanges and imposed various restrictions on
derivatives. To implement Dodd-Frank, the CFTC developed new rules in at least 30 areas
[33]
. The Commission
determines which swaps are subject to mandatory clearing and whether a derivatives exchange is eligible to clear a
certain type of swap contract.
Derivative
61
Glossary
Bilateral netting: A legally enforceable arrangement between a bank and a counter-party that creates a single legal
obligation covering all included individual contracts. This means that a banks obligation, in the event of the
default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of
contracts included in the bilateral netting arrangement.
Credit derivative: A contract that transfers credit risk from a protection buyer to a credit protection seller. Credit
derivative products can take many forms, such as credit default swaps, credit linked notes and total return swaps.
Derivative: A financial contract whose value is derived from the performance of assets, interest rates, currency
exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including
structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various
combinations thereof.
Exchange-traded derivative contracts: Standardized derivative contracts (e.g., futures contracts and options) that
are transacted on an organized futures exchange.
Gross negative fair value: The sum of the fair values of contracts where the bank owes money to its
counter-parties, without taking into account netting. This represents the maximum losses the banks
counter-parties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was
held by the counter-parties.
Gross positive fair value: The sum total of the fair values of contracts where the bank is owed money by its
counter-parties, without taking into account netting. This represents the maximum losses a bank could incur if all
its counter-parties default and there is no netting of contracts, and the bank holds no counter-party collateral.
High-risk mortgage securities: Securities where the price or expected average life is highly sensitive to interest
rate changes, as determined by the U.S. Federal Financial Institutions Examination Council policy statement on
high-risk mortgage securities.
Notional amount: The nominal or face amount that is used to calculate payments made on swaps and other risk
management products. This amount generally does not change hands and is thus referred to as notional.
Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are transacted off
organized futures exchanges.
Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or more
indices and / or have embedded forwards or options.
Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common shareholders
equity, perpetual preferred shareholders equity with non-cumulative dividends, retained earnings, and minority
interests in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt,
intermediate-term preferred stock, cumulative and long-term preferred stock, and a portion of a banks allowance
for loan and lease losses.
References
[1] Rubinstein, Mark (1999). Rubinstein on derivatives. Risk Books. ISBN1899332537.
[2] Hull, John C. (2006). Options, Futures and Other Derivatives, Sixth Edition. Prentice Hall. pp.1.
[3] Michael Simkovic, Secret Liens and the Financial Crisis of 2008, American Bankruptcy Law Journal, Vol. 83, p. 253, 2009 (http:/ / ssrn.
com/ abstract=1323190)
[4] Michael Simkovic, Bankruptcy Immunities, Transparency, and Capital Structure, Presentation at the World Bank, January 11, 2011 (http:/ /
ssrn.com/ abstract=1738539)
[5] Michael Simkovic, Paving the Way for the Next Financial Crisis, Banking & Financial Services Policy Report, Vol. 29, No. 3, 2010 (http:/ /
ssrn.com/ abstract=1585955)
[6] Kaori Suzuki and David Turner (December 10, 2005). "Sensitive politics over Japan's staple crop delays rice futures plan" (http:/ / www. ft.
com/ cms/ s/ 0/ d9f45d80-6922-11da-bd30-0000779e2340. html). The Financial Times. . Retrieved October 23, 2010.
[7] Michael Simkovic and Benjamin Kaminetzky, Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap
Solution (August 29, 2010). Columbia Business Law Review, Vol. 2011, No. 1, p. 118, 2011 (http:/ / ssrn. com/ abstract=1632084)
Derivative
62
[8] Shirreff, David (2004). "Derivatives and leverage" (http:/ / books. google. com/ books?id=mwirEO_f1DkC). Dealing With Financial Risk.
USA: The Economist. p.23. ISBN1-57660-162-5. . Retrieved 14 September 2011.
[9] Khullar, Sanjeev (2009). "Using Derivatives to Create Alpha" (http:/ / books. google. com/ books?id=uv73DVVSgAsC). In John M. Longo.
Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance. Singapore: World Scientific. p.105.
ISBN978-981-283-465-2. . Retrieved 14 September 2011.
[10] Don M. Chance; Robert Brooks (2010). "Advanced Derivatives and Strategies" (http:/ / books. google. com/ books?id=DT0nnLDMYTgC).
Introduction to Derivatives and Risk Management (8th ed.). Mason, Ohio: Cengage Learning. pp.483515. ISBN978-0-324-60120-6. .
Retrieved 14 September 2011.
[11] [11] Chisolm, Derivatives Demystified (Wiley 2004)
[12] [12] Chisolm, Derivatives Demystified (Wiley 2004) Notional sum means there is no actual principal.
[13] News.BBC.co.uk (http:/ / news. bbc.co.uk/ 2/ hi/ business/ 375259. stm), "How Leeson broke the bank BBC Economy"
[14] BIS survey: The Bank for International Settlements (BIS) semi-annual OTC [derivatives market (http:/ / www. bis. org/ publ/ otc_hy1111.
pdf) report, for end of June 2008, shows US$683.7 trillion total notional amounts outstanding of OTC derivatives with a gross market value of
US$20 trillion. See also Prior Period Regular OTC Derivatives Market Statistics (http:/ / www. bis. org/ publ/ otc_hy1111. htm).
[15] [15] Hull, J.C. (2009). Options, futures, and other derivatives . Upper Saddle River, NJ : Pearson/Prentice Hall, c2009
[16] Futures and Options Week: According to figures published in F&O Week 10 October 2005. See also FOW Website (http:/ / www. fow.
com).
[17] "Financial Markets: A Beginner's Module" (http:/ / www. nseindia. com/ education/ content/ module_ncfm. htm). .
[18] "Biz.Yahoo.com" (http:/ / biz.yahoo. com/ c/ e. html). Biz.Yahoo.com. 2010-08-23. . Retrieved 2010-08-29.
[19] Canter, Michael S.; Cole, Joseph B.; Sandor, Richard L. (1996). "Insurance Derivatives A New Asset Class for the Capital Markets and a
New Hedging Tool for the Insurance Industry". Journal of Derivatives 4 (2): 89104. doi:10.3905/jod.1996.407966.
[20] FOW.com (http:/ / www. fow. com/ Article/ 1385702/ Issue/ 26557/ Emissions-derivatives-1. html), Emissions derivatives, 1 December
2005
[21] "Currency Derivatives: A Beginner's Module" (http:/ / www. nseindia. com/ education/ content/ module_ncfm. htm). .
[22] "Bis.org" (http:/ / www. bis. org/ statistics/ derstats.htm). Bis.org. 2010-05-07. . Retrieved 2010-08-29.
[23] "Launch of the WIDER study on The World Distribution of Household Wealth: 5 December 2006" (http:/ / www. wider. unu. edu/ events/
past-events/ 2006-events/ en_GB/ 05-12-2006/ ). . Retrieved 9 June 2009.
[24] Boumlouka, Makrem (2009),"Alternatives in OTC Pricing", Hedge Funds Review, 10-30-2009. http:/ / www. hedgefundsreview. com/
hedge-funds-review/ news/ 1560286/ otc-pricing-deal-struck-fitch-solutions-pricing-partners
[25] Ferguson, Charles (Director) (May 16, 2010). [[Inside Job (film)|Inside Job (http:/ / www. imdb. com/ title/ tt1645089/ )]] (Television
Documentary (DVD)). Sony Pictures Classics. Event occurs at 22:58. .
[26] Raghuram G. Rajan (September 2006). "Has Financial Development Made the World Riskier?" (http:/ / ssrn. com/ abstract=923683).
EUROPEAN FINANCIAL MANAGEMENT (EUROPEAN FINANCIAL MANAGEMENT) 12 (4): 499-533.
doi:10.1111/j.1468-036X.2006.00330.x. . Retrieved January 17, 2012.
[27] Kelleher, James B. (2008-09-18). ""Buffett's Time Bomb Goes Off on Wall Street" by James B. Kelleher of Reuters" (http:/ / www. reuters.
com/ article/ newsOne/ idUSN1837154020080918). Reuters.com. . Retrieved 2010-08-29.
[28] Edwards, Franklin (1995), "Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft" (http:/ / www0. gsb. columbia.
edu/ faculty/ fedwards/ papers/ DerivativesCanBeHazardous. pdf), Derivatives Quarterly (Spring 1995): 817,
[29] Whaley, Robert (2006). Derivatives: markets, valuation, and risk management (http:/ / books. google. com/ books?id=Hb7xXy-wqiYC&
printsec=frontcover& cad=0#v=onepage& q& f=false). John Wiley and Sons. p.506. ISBN0471786322. .
[30] http:/ / www.businessweek.com/ news/ 2011-09-15/ ubs-loss-shows-banks-fail-to-learn-from-kerviel-leeson. html
[31] http:/ / www.berkshirehathaway. com/ 2002ar/ 2002ar. pdf
[32] Story, Louise, "A Secretive Banking Elite Rules Trading in Derivatives" (http:/ / www. nytimes. com/ 2010/ 12/ 12/ business/ 12advantage.
html?hp), The New York Times, December 11, 2010 (December 12, 2010 p. A1 NY ed.). Retrieved 2010-12-12.
[33] http:/ / www.cftc. gov/ LawRegulation/ DoddFrankAct/ index. htm
1. http:/ / www. sebi. gov. in/ faq/ derivativesfaq. html
Derivative
63
Further reading
Hull, John C. (2011). Options, Futures and Other Derivatives (8th ed.). Harlow: Pearson Education.
ISBN9780132604604.
Durbin, Michael (2011). All About Derivatives (2nd ed.). New York: McGraw-Hill. ISBN9780071743518.
Mattoo, Mehraj (1997). Structured Derivatives: New Tools for Investment Management: A Handbook of
Structuring, Pricing & Investor Applications. London: Financial Times. ISBN0273611208.
External links
BBC News Derivatives simple guide (http:/ / news. bbc. co. uk/ 1/ hi/ business/ 2190776. stm)
European Union proposals on derivatives regulation 2008 onwards (http:/ / ec. europa. eu/ internal_market/
financial-markets/ derivatives/ index_en. htm)
Derivatives in Africa (http:/ / www. mfw4a. org/ capital-markets/ derivatives-derivatives-exchanges-commodities.
html)
Derivatives Litigation (http:/ / derivatives-litigation. blogspot. com/ )
64
Finance of states
Public finance
Public finance is the study of the role of the government in the economy.
[1]
The purview of public finance is considered to be threefold: governmental effects on (1) efficient allocation of
resources, (2) distribution of income, and (3) macroeconomic stabilization.
Overview
The proper role of government provides a starting point for the analysis of public finance. In theory, under certain
circumstances, private markets will allocate goods and services among individuals efficiently (in the sense that no
waste occurs and that individual tastes are matching with the economy's productive abilities). If private markets were
able to provide efficient outcomes and if the distribution of income were socially acceptable, then there would be
little or no scope for government. In many cases, however, conditions for private market efficiency are violated. For
example, if many people can enjoy the same good at the same time (non-rival, non-excludable consumption), then
private markets may supply too little of that good. National defense is one example of non-rival consumption, or of a
public good.
"Market failure" occurs when private markets do not allocate goods or services efficiently. The existence of market
failure provides an efficiency-based rationale for collective or governmental provision of goods and services.
Externalities, public goods, informational advantages, strong economies of scale, and network effects can cause
market failures. Public provision via a government or a voluntary association, however, is subject to other
inefficiencies, termed "government failure."
Under broad assumptions, government decisions about the efficient scope and level of activities can be efficiently
separated from decisions about the design of taxation systems (Diamond-Mirlees separation). In this view, public
sector programs should be designed to maximize social benefits minus costs (cost-benefit analysis), and then
revenues needed to pay for those expenditures should be raised through a taxation system that creates the fewest
efficiency losses caused by distortion of economic activity as possible. In practice, government budgeting or public
budgeting is substantially more complicated and often results in inefficient practices.
Government can pay for spending by borrowing (for example, with government bonds), although borrowing is a
method of distributing tax burdens through time rather than a replacement for taxes. A deficit is the difference
between government spending and revenues. The accumulation of deficits over time is the total public debt. Deficit
finance allows governments to smooth tax burdens over time, and gives governments an important fiscal policy tool.
Deficits can also narrow the options of successor governments.
Public finance is closely connected to issues of income distribution and social equity. Governments can reallocate
income through transfer payments or by designing tax systems that treat high-income and low-income households
differently.
The Public Choice approach to public finance seeks to explain how self-interested voters, politicians, and
bureaucrats actually operate, rather than how they should operate.
Public finance
65
Public finance management
Collection of sufficient resources from the economy in an appropriate manner along with allocating and use of these
resources efficiently and effectively constitute good financial management. Resource generation, resource allocation
and expenditure management (resource utilization) are the essential components of a public financial management
system.
Public Finance Management (PFM) basically deals with all aspects of resource mobilization and expenditure
management in government. Just as managing finances is a critical function of management in any organization,
similarly public finance management is an essential part of the governance process. Public finance management
includes resource mobilization, prioritization of programmes, the budgetary process, efficient management of
resources and exercising controls. Rising aspirations of people are placing more demands on financial resources. At
the same time, the emphasis of the citizenry is on value for money, thus making public finance management
increasingly vital.
Government expenditures
Economists classify government expenditures into three main types. Government purchases of goods and services
for current use are classed as government consumption. Government purchases of goods and services intended to
create future benefits--- such as infrastructure investment or research spending--- are classed as government
investment. Government expenditures that are not purchases of goods and services, and instead just represent
transfers of money--- such as social security payments--- are called transfer payments.
[2]
Government operations
Government operations are those activities involved in the running of a state or a functional equivalent of a state (for
example, tribes, secessionist movements or revolutionary movements) for the purpose of producing value for the
citizens. Government operations have the power to make, and the authority to enforce rules and laws within a civil,
corporate, religious, academic, or other organization or group.
[3]
In its broadest sense, "to govern" means to rule over
or supervise, whether over a state, a set group of people, or a collection of people.
[4]
Income distribution
Income distribution - Some forms of government expenditure are specifically intended to transfer income from
some groups to others. For example, governments sometimes transfer income to people that have suffered a loss
due to natural disaster. Likewise, public pension programs transfer wealth from the young to the old. Other forms
of government expenditure which represent purchases of goods and services also have the effect of changing the
income distribution. For example, engaging in a war may transfer wealth to certain sectors of society. Public
education transfers wealth to families with children in these schools. Public road construction transfers wealth
from people that do not use the roads to those people that do (and to those that build the roads).
Income Security
Employment insurance
Health Care
Public financing of campaigns
Public finance
66
Financing of government expenditures
Budgeted revenues of governments in 2006.
Government expenditures are financed
in two ways:
Government revenue
Taxes
Non-tax revenue (revenue from
government-owned corporations,
sovereign wealth funds, sales of
assets, or Seigniorage)
Government borrowing
Privatization
How a government chooses to finance its activities can have important effects on the distribution of income and
wealth (income redistribution) and on the efficiency of markets (effect of taxes on market prices and efficiency). The
issue of how taxes affect income distribution is closely related to tax incidence, which examines the distribution of
tax burdens after market adjustments are taken into account. Public finance research also analyzes effects of the
various types of taxes and types of borrowing as well as administrative concerns, such as tax enforcement.
Taxes
Taxation is the central part of modern public finance. Its significance arises not only from the fact that it is by far the
most important of all revenues but also because of the gravity of the problems created by the present day heavy tax
burden. The main objective of taxation is raising revenue. A high level of taxation is necessary in a welfare State to
fulfill its obligations. Taxation is used as an instrument of attaining certain social objectives i.e. as a means of
redistribution of wealth and thereby reducing inequalities. Taxation in a modern Government is thus needed not
merely to raise the revenue required to meet its ever-growing expenditure on administration and social services but
also to reduce the inequalities of income and wealth. Taxation is also needed to draw away money that would
otherwise go into consumption and cause inflation to rise.
[5]
A tax is a financial charge or other levy imposed on an individual or a legal entity by a state or a functional
equivalent of a state (for example, tribes, secessionist movements or revolutionary movements). Taxes could also be
imposed by a subnational entity. Taxes consist of direct tax or indirect tax, and may be paid in money or as corve
labor. A tax may be defined as a "pecuniary burden laid upon individuals or property to support the government
[...] a payment exacted by legislative authority."
[6]
A tax "is not a voluntary payment or donation, but an enforced
contribution, exacted pursuant to legislative authority" and is "any contribution imposed by government [...]
whether under the name of toll, tribute, tallage, gabel, impost, duty, custom, excise, subsidy, aid, supply, or other
name."
[7]
There are various types of taxes, broadly divided into two heads - direct (which is proportional) and indirect tax
(which is differential in nature):
Stamp duty, levied on documents
Excise tax (tax levied on production for sale, or sale, of a certain good)
Sales tax (tax on business transactions, especially the sale of goods and services)
Value added tax (VAT) is a type of sales tax
Services taxes on specific services
Road tax; Vehicle excise duty (UK), Registration Fee (USA), Regco (Australia), Vehicle Licensing Fee (Brazil)
etc.
Gift tax
Public finance
67
Duties (taxes on importation, levied at customs)
Corporate income tax on corporations (incorporated entities)
Wealth tax
Personal income tax (may be levied on individuals, families such as the Hindu joint family in India,
unincorporated associations, etc.)
Debt
Foreign currency reserves and gold minus external debt based on 2010 data from CIA
Factbook.
Governments, like any other legal
entity, can take out loans, issue bonds
and make financial investments.
Government debt (also known as
public debt or national debt) is money
(or credit) owed by any level of
government; either central or federal
government, municipal government or
local government. Some local
governments issue bonds based on
their taxing authority, such as tax
increment bonds or revenue bonds.
As the government represents the people, government debt can be seen as an indirect debt of the taxpayers.
Government debt can be categorized as internal debt, owed to lenders within the country, and external debt, owed to
foreign lenders. Governments usually borrow by issuing securities such as government bonds and bills. Less
creditworthy countries sometimes borrow directly from commercial banks or international institutions such as the
International Monetary Fund or the World Bank.
Most government budgets are calculated on a cash basis, meaning that revenues are recognized when collected and
outlays are recognized when paid. Some consider all government liabilities, including future pension payments and
payments for goods and services the government has contracted for but not yet paid, as government debt. This
approach is called accrual accounting, meaning that obligations are recognized when they are acquired, or accrued,
rather than when they are paid.
Seigniorage
Seigniorage is the net revenue derived from the issuing of currency. It arises from the difference between the face
value of a coin or bank note and the cost of producing, distributing and eventually retiring it from circulation.
Seigniorage is an important source of revenue for some national banks, although it provides a very small proportion
of revenue for advanced industrial countries.
Public finance through state enterprise
Further information: State-owned enterprise
Public finance in centrally planned economies has differed in fundamental ways from that in market economies.
Some state-owned enterprises generated profits that helped finance government activities. The government entities
that operate for profit are usually manufacturing and financial institutions, services such as nationalized healthcare
do not operate for a profit to keep costs low for consumers. The Soviet Union relied heavily on turnover taxes on
retail sales. Sales of natural resources, and especially petroleum products, were an important source of revenue for
the Soviet Union.
Public finance
68
In market-oriented economies with substantial state enterprise, such as in Venezuela, the state-run oil company
PSDVA provides revenue for the government to fund its operations and programs that would otherwise be profit for
private owners. In various mixed economies, the revenue generated by state-run or state-owned enterprises are used
for various state endeavors; typically the revenue generated by state and government agencies goes into a sovereign
wealth fund. An example of this is the Alaska Permanent Fund and Singapore's Temasek Holdings.
Various market socialist systems or proposals utilize revenue generated by state-run enterprises to fund social
dividends, eliminating the need for taxation altogether.
Government Finance Statistics and Methodology
Macroeconomic data to support public finance economics are generally referred to as fiscal or government finance
statistics (GFS). The Government Finance Statistics Manual 2001 (GFSM 2001)
[8]
is the internationally accepted
methodology for compiling fiscal data. It is consistent with regionally accepted methodologies such as the European
System of Accounts 1995
[9]
and consistent with the methodology of the System of National Accounts (SNA1993)
[10]
and broadly in line with its most recent update, the SNA2008
[11]
.
Challenges in measuring government
The size of governments, their institutional composition and complexity, their ability to carry out large and
sophisticated operations, and their impact on the other sectors of the economy warrant a well-articulated system to
measure government economic operations.
The GFSM 2001 addresses the institutional complexity of government by defining various levels of government. The
main focus of the GFSM 2001 is the general government sector defined as the group of entities capable of
implementing public policy through the provision of primarily nonmarket goods and services and the redistribution
of income and wealth, with both activities supported mainly by compulsory levies on other sectors. The GFSM 2001
disaggregates the general government into subsectors: central government, state government, and local government
(See Figure 1). The concept of general government does not include public corporations. The general government
plus the public corporations comprise the public sector (See Figure 2).
Figure 1: General Government (IMF Government Finance Statistics Manual 2001(Washington,
2001) pp.13
Public finance
69
Figure 2: Public Sector(IMF Government Finance Statistics Manual 2001(Washington, 2001)
pp.15
The GFSM 2001 framework is similar to the financial accounting of businesses. For example, it recommends that
governments produce a full set of financial statements including the statement of government operations (akin to the
income statement), the balance sheet, and a cash flow statement. Two other similarities between the GFSM 2001 and
business financial accounting are the recommended use of accrual accounting as the basis of recording and the
presentations of stocks of assets and liabilities at market value. It is an improvement on the prior methodology -
Government Finance Statistics Manual 1986 based on cash flows and without a balance sheet statement.
Users of GFS
The GFSM 2001 recommends standard tables including standard fiscal indicators that meet a broad group of users
including policy makers, researchers, and investors in sovereign debt. Government finance statistics should offer
data for topics such as the fiscal architecture, the measurement of the efficiency and effectiveness of government
expenditures, the economics of taxation, and the structure of public financing. The GFSM 2001 provides a blueprint
for the compilation, recording, and presentation of revenues, expenditures, stocks of assets, and stocks of liabilities.
The GFSM 2001 also defines some indicators of effectiveness in governments expenditures, for example the
compensation of employees as a percentage of expense. The GFSM 2001 includes a functional classification of
expense as defined by the Classification of Functions of Government (COFOG) .
This functional classification allows policy makers to analyze expenditures on categories such as health, education,
social protection, and environmental protection. The financial statements can provide investors with the necessary
information to assess the capacity of a government to service and repay its debt, a key element determining
sovereign risk, and risk premia. Like the risk of default of a private corporation, sovereign risk is a function of the
level of debt, its ratio to liquid assets, revenues and expenditures, the expected growth and volatility of these
revenues and expenditures, and the cost of servicing the debt. The governments financial statements contain the
relevant information for this analysis.
The governments balance sheet presents the level of the debt; that is the governments liabilities. The memorandum
items of the balance sheet provide additional information on the debt including its maturity and whether it is owed to
domestic or external residents. The balance sheet also presents a disaggregated classification of financial and
non-financial assets.
Public finance
70
These data help estimate the resources a government can potentially access to repay its debt. The statement of
operations (income statement) contains the revenue and expense accounts of the government. The revenue accounts
are divided into subaccounts, including the different types of taxes, social contributions, dividends from the public
sector, and royalties from natural resources. Finally, the interest expense account is one of the necessary inputs to
estimate the cost of servicing the debt.
Fiscal Data Using the GFSM 2001 Methodology
GFS can be accessible through several sources. The International Monetary Fund publishes GFS in two publications:
International Financial Statistics and the Government Finance Statistics Yearbook. The World Bank gathers
information on external debt. On a regional level, the Organization for Economic Co-operation and Development
(OECD) compiles general government account data for its members, and Eurostat, following a methodology
compatible with the GFSM 2001, compiles GFS for the members of the European Union.
Notes
[1] Gruber, Jonathan (2005). Public Finance and Public Policy. New York: Worth Publications. pp.2. ISBN0-7167-8655-9.
[2] Robert Barro and Vittorio Grilli (1994), European Macroeconomics, Ch. 15-16. Macmillan, ISBN 0-333-57764-7.
[3] Columbia Encyclopedia, Government, Columbia University Press
[4] [4] See for example, The American Heritage Dictionary of the English Language, entry "Govern"
[5] http:/ / budget.ap. gov.in/ es2k_pf.htm
[6] Black's Law Dictionary, p. 1307 (5th ed. 1979).
[7] [7] Id.
[8] http:/ / www. imf.org/ external/ pubs/ ft/ gfs/ manual/ index. htm
[9] http:/ / circa. europa. eu/ irc/ dsis/ nfaccount/ info/ data/ esa95/ esa95-new. htm
[10] http:/ / unstats. un.org/ unsd/ sna1993/ toctop. asp?L1=4
[11] http:/ / unstats. un.org/ unsd/ nationalaccount/ sna2008.asp
References
Anthony B. Atkinson and Joseph E. Stiglitz (1980). Lectures in Public Economics, McGraw-Hill Economics
Handbook Series
James M. Buchanan and Richard A. Musgrave (1989). Public Finance and Public Choice: Two Contrasting
Visions of the State. MIT Press. Scroll down to chapter-preview links. (http:/ / books. google. com/
books?id=jEnjN7dKrzcC& printsec=frontcover& source=gbs_atb#v=onepage& q& f=false)
Richard A. Musgrave (1959). The Theory of Public Finance: A Study in Public Economy. J.M. Buchanan review,
1st page. (http:/ / www. jstor. org/ pss/ 1054956)
R.A. Musgrave (2008). "public finance," The New Palgrave Dictionary of Economics Abstract. (http:/ / www.
dictionaryofeconomics. com/ article?id=pde2008_P000244& edition=current& q=public finance& topicid=&
result_number=1)
Richard A. Musgrave and Peggy B. Musgrave (1973). Public Finance in Theory and Practice
Joseph E. Stiglitz (2000). Economics of the Public Sector, 3rd ed. Norton.
Public finance
71
External links
Taxation and Public Finance course at the Harris School of Public Policy Studies (http:/ / harrisschool. uchicago.
edu/ Programs/ courses/ description. html?course=32900)
State and Local Public Finance course at the Harris School of Public Policy Studies (http:/ / harrisschool.
uchicago. edu/ Programs/ courses/ description. html?course=32100)
IMF--Dissemination Standards Bulletin Board-- Subscribing ... (http:/ / dsbb. imf. org/ Applications/ web/
sddsnsdppage/ ) (see "fiscal sector")
The IMF's Public Financial Management Blog (http:/ / blog-pfm. imf. org)
Other Public Financing Resource (http:/ / dpfg. com/ services/ public. php)
US Debt Clock.org (http:/ / www. usdebtclock. org/ ) - Real Time U.S. Debt Clock
Canadian Governments Compared (http:/ / etatscanadiens-canadiangovernments. enap. ca/ fr/ index. aspx)
72
Financial economics
Financial economics
Financial economics is the branch of economics concerned with "the allocation and deployment of economic
resources, both spatially and across time, in an uncertain environment".
[1]
It is additionally characterised by its
"concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a
trade".
[2]
The questions within financial economics are typically framed in terms of "time, uncertainty, options, and
information".
[2]
Time: money now is traded for money in the future.
Uncertainty (or risk): The amount of money to be transferred in the future is uncertain.
Options: one party to the transaction can make a decision at a later time that will affect subsequent transfers of
money.
Information: knowledge of the future can reduce, or possibly eliminate, the uncertainty associated with future
monetary value (FMV).
The subject is usually taught at a postgraduate level; see Master of Financial Economics.
Subject matter
Financial economics is the branch of economics studying the interrelation of financial variables, such as prices,
interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on
influences of real economic variables on financial ones, in contrast to pure finance.
It studies the following:
Valuation - Determination of the fair value of an asset
How risky is the asset? (identification of the asset appropriate discount rate)
What cash flows will it produce? (discounting of relevant cash flows)
How does the market price compare to similar assets? (relative valuation)
Are the cash flows dependent on some other asset or event? (derivatives, contingent claim valuation)
Financial markets and instruments
Commodities - topics
Stocks - topics
Bonds - topics
Money market instruments- topics
Derivatives - topics
Financial institutions and regulation
Financial Econometrics is the branch of Financial Economics that uses econometric techniques to parameterise the
relationships.
Financial economics
73
Models in financial economics
Financial economics is primarily concerned with building models to derive testable or policy implications from
acceptable assumptions. Some fundamental ideas in financial economics are portfolio theory, the Capital Asset
Pricing Model. Portfolio theory studies how investors should balance risk and return when investing in many assets
or securities. The Capital Asset Pricing Model describes how markets should set the prices of assets in relation to
how risky they are. The Modigliani-Miller Theorem describes conditions under which corporate financing decisions
are irrelevant for value, and acts as a benchmark for evaluating the effects of factors outside the model that do affect
value.
A common assumption is that financial decision makers act rationally (see Homo economicus; efficient market
hypothesis). However, recently, researchers in experimental economics and experimental finance have challenged
this assumption empirically. They are also challenged, theoretically, by behavioral finance, a discipline primarily
concerned with the limits to rationality of economic agents.
Other common assumptions include market prices following a random walk or asset returns being normally
distributed. Empirical evidence suggests that these assumptions may not hold and that in practice, traders, analysts
and particularly risk managers frequently modify the "standard models".
References
[1] "Robert C. Merton - Nobel Lecture" (http:/ / nobelprize. org/ nobel_prizes/ economics/ laureates/ 1997/ merton-lecture. pdf) (PDF). .
Retrieved 2009-08-06.
[2] "Financial Economics" (http:/ / www. stanford.edu/ ~wfsharpe/ mia/ int/ mia_int2. htm). Stanford.edu. . Retrieved 2009-08-06.
External links
Theory
Foundations of Finance (http:/ / faculty. chicagogsb. edu/ eugene. fama/ research/ index. htm), Theory of Finance
(http:/ / faculty. chicagogsb. edu/ eugene. fama/ research/ index. htm), Eugene Fama, University of Chicago
Graduate School of Business
Macro-Investment Analysis (http:/ / www. stanford. edu/ ~wfsharpe/ mia/ int/ mia_int2. htm), Professor William
Sharpe, Stanford Graduate School of Business
Lecture Notes in Financial Economics (http:/ / personal. lse. ac. uk/ mele/ files/ fin_eco. pdf), Antonio Mele,
London School of Economics
Great Moments in Financial Economics I (http:/ / web. archive. org/ web/ 20070927123033/ http:/ / www.
in-the-money. com/ artandpap/ I+ Present+ Value. doc), II (http:/ / web. archive. org/ web/ 20070927123027/
http:/ / www. in-the-money. com/ artandpap/ II+ Modigliani-Miller+ Theorem. doc), "III" (http:/ / web. archive.
org/ web/ 20070927123024/ http:/ / www. in-the-money. com/ artandpap/ III+ Short-Sales+ and+ Stock+ Prices.
doc). Archived from the original (http:/ / www. in-the-money. com/ artandpap/ III Short-Sales and Stock Prices.
doc) on 2007-09-27.; IVa (http:/ / web. archive. org/ web/ 20070927123029/ http:/ / www. in-the-money. com/
artandpap/ IV+ Fundamental+ Theorem+ -+ Part+ I. doc); "IVb" (http:/ / web. archive. org/ web/
20070927123021/ http:/ / www. in-the-money. com/ artandpap/ IV+ Fundamental+ Theorem+ -+ Part+ II. doc).
Archived from the original (http:/ / www. in-the-money. com/ artandpap/ IV Fundamental Theorem - Part II. doc)
on 2007-09-27.. Prof. Mark Rubinstein, Haas School of Business
Microfoundations of Financial Economics (http:/ / www. ulb. ac. be/ cours/ solvay/ farber/ PhD. htm) Prof. Andr
Farber Solvay Business School
Handbook of the Economics of Finance (http:/ / ideas. repec. org/ b/ eee/ finhes/ 2. html#related), G.M.
Constantinides, M. Harris, R. M. Stulz
Financial economics
74
Financial economics (http:/ / www. sciencedirect. com/ science?_ob=RefWorkIndexURL& _idxType=SC&
_cdi=23486& _refWorkId=21& _explode=151000131,151000133& _alpha=& _acct=C000050221&
_version=1& _userid=10& md5=f2c773b745753022e1cccc9a38d83508& refID=151000133#151000133),
International Encyclopedia of the Social & Behavioral Sciences, Oxford: Elsevier, 2001.
Financial economics topics (http:/ / www. dictionaryofeconomics. com/ articles_by_topic?topicid=G) with
Abstracts, The New Palgrave Dictionary of Economics, 2008.
An introduction to investment theory (http:/ / viking. som. yale. edu/ will/ web_pages/ will/ finman540/
classnotes/ notes. html), Prof. William Goetzmann, Yale School of Management
Notes on General Equilibrium Asset Pricing (http:/ / pascal. iseg. utl. pt/ ~pbrito/ cursos/ mestrado/ fef/ fef2009.
pdf), Prof. Paulo Brito, ISEG, Technical University of Lisbon
Context and history
Finance Theory (http:/ / cepa. newschool. edu/ het/ schools/ finance. htm), The History of Economic Thought
Website, The New School
The Scientific Evolution of Finance (http:/ / www. finance-and-physics. org/ Library/ Articles3/
scienceandfinance/ science. htm) Prof. Don Chance, Prof. Pamela Peterson
50 Years of Finance (http:/ / www. ulb. ac. be/ cours/ solvay/ farber/ VUB/ 01 Inaugurale rede. pdf) Prof. Andr
Farber, Universit Libre de Bruxelles
"A Short History of Investment Forecasting" (http:/ / web. archive. org/ web/ 20071012112134/ http:/ /
roundtable. informs. org/ public-access/ min061a. htm). Archived from the original (http:/ / roundtable. informs.
org/ public-access/ min061a. htm) on 2007-10-12., Professor Michael Phillips, California State University,
Northridge
Pioneers of Finance (http:/ / campus. murraystate. edu/ academic/ faculty/ larry. guin/ FinancialHistory. htm),
Prof. Larry Guin, Murray State University
Links and portals
Financial Economics Links on WebEc (http:/ / www. helsinki. fi/ WebEc/ webecg. html)
JEL Classification Codes Guide (http:/ / www. aeaweb. org/ jel/ guide/ jel. php?class=G)
Financial Economics Links on RFE (http:/ / rfe. org/ showCat. php?cat_id=56)
SSRN Financial Economics Network (http:/ / www. ssrn. com/ fen/ index. html)
"Books on Financial Economics": list on economicsnetwork.ac.uk (http:/ / www. economicsnetwork. ac. uk/
books/ FinancialEconomics. htm)
75
Financial mathematics
Financial mathematics
Mathematical finance is a field of applied mathematics, concerned with financial markets. The subject has a close
relationship with the discipline of financial economics, which is concerned with much of the underlying theory.
Generally, mathematical finance will derive and extend the mathematical or numerical models suggested by financial
economics. Thus, for example, while a financial economist might study the structural reasons why a company may
have a certain share price, a financial mathematician may take the share price as a given, and attempt to use
stochastic calculus to obtain the fair value of derivatives of the stock (see: Valuation of options).
In terms of practice, mathematical finance also overlaps heavily with the field of computational finance (also known
as financial engineering). Arguably, these are largely synonymous, although the latter focuses on application, while
the former focuses on modeling and derivation (see: Quantitative analyst), often by help of stochastic asset models.
The fundamental theorem of arbitrage-free pricing is one of the key theorems in mathematical finance. Many
universities around the world now offer degree and research programs in mathematical finance; see Master of
Mathematical Finance.
History: Q versus P
There exist two separate branches of finance that require advanced quantitative techniques: derivatives pricing on the
one hand, and risk and portfolio management on the other hand. One of the main differences is that they use different
probabilities, namely the risk-neutral probability, denoted by "Q", and the actual probability, denoted by "P".
Derivatives pricing: the Q world
The goal of derivatives pricing is to determine the fair price of a given security in terms of more liquid securities
whose price is determined by the law of supply and demand. Examples of securities being priced are plain vanilla
and exotic options, convertible bonds, etc.
Once a fair price has been determined, the sell-side trader can make a market on the security. Therefore, derivatives
pricing is a complex "extrapolation" exercise to define the current market value of a security, which is then used by
the sell-side community.
Derivatives pricing: the Q world
Goal "extrapolate the present"
Environment risk-neutral probability
Processes continuous-time martingales
Dimension low
Tools Ito calculus, PDEs
Challenges calibration
Business sell-side
Quantitative derivatives pricing was initiated by Louis Bachelier in The Theory of Speculation (published 1900),
with the introduction of the most basic and most influential of processes, the Brownian motion, and its applications
Financial mathematics
76
to the pricing of options. However, Bachelier's work hardly caught any attention outside academia.
The theory remained dormant until Fischer Black and Myron Scholes, along with fundamental contributions by
Robert C. Merton, applied the second most influential process, the geometric Brownian motion, to option pricing.
For this M. Scholes and R. Merton were awarded the 1997 Nobel Memorial Prize in Economic Sciences. Black was
ineligible for the prize because of his death in 1995.
The next important step was the fundamental theorem of asset pricing by Harrison and Pliska (1981), according to
which the suitably normalized current price P0 of a security is arbitrage-free, and thus truly fair, only if there exists a
stochastic process Pt with constant expected value which describes its future evolution:
(1 )
A process satisfying (1) is called a "martingale". A martingale does not reward risk. Thus the probability of the
normalized security price process is called "risk-neutral" and is typically denoted by the blackboard font letter "
".
The relationship (1) must hold for all times t: therefore the processes used for derivatives pricing are naturally set in
continuous time.
The quants who operate in the Q world of derivatives pricing are specialists with deep knowledge of the specific
products they model.
Securities are priced individually, and thus the problems in the Q world are low-dimensional in nature. Calibration is
one of the main challenges of the Q world: once a continuous-time parametric process has been calibrated to a set of
traded securities through a relationship such as (1), a similar relationship is used to define the price of new
derivatives.
The main quantitative tools necessary to handle continuous-time Q-processes are Itos stochastic calculus and partial
differential equations (PDEs).
Risk and portfolio management: the P world
Risk and portfolio management aims at modelling the probability distribution of the market prices of all the
securities at a given future investment horizon.
This "real" probability distribution of the market prices is typically denoted by the blackboard font letter " ", as
opposed to the "risk-neutral" probability " " used in derivatives pricing.
Based on the P distribution, the buy-side community takes decisions on which securities to purchase in order to
improve the prospective profit-and-loss profile of their positions considered as a portfolio.
Risk and portfolio management: the P world
Goal "model the future"
Environment real probability
Processes discrete-time series
Dimension large
Tools multivariate statistics
Challenges estimation
Business buy-side
The quantitative theory of risk and portfolio management started with the mean-variance framework of Harry
Markowitz (1952), who caused a shift away from the concept of trying to identify the best individual stock for
investment. Using a linear regression strategy to understand and quantify the risk (i.e. variance) and return (i.e.
mean) of an entire portfolio of stocks, bonds, and other securities, an optimization strategy was used to choose a
Financial mathematics
77
portfolio with largest mean return subject to acceptable levels of variance in the return. Next, breakthrough advances
were made with the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) developed by
Treynor (1962), Mossin (1966), William Sharpe (1964), Lintner (1965) and Ross (1976).
For their pioneering work, Markowitz and Sharpe, along with Merton Miller, shared the 1990 Nobel Memorial Prize
in Economic Sciences, for the first time ever awarded for a work in finance.
The portfolio-selection work of Markowitz and Sharpe introduced mathematics to the "black art" of investment
management. With time, the mathematics has become more sophisticated. Thanks to Robert Merton and Paul
Samuelson, one-period models were replaced by continuous time, Brownian-motion models, and the quadratic utility
function implicit in meanvariance optimization was replaced by more general increasing, concave utility
functions.
[1]
Furthermore, in more recent years the focus shifted toward estimation risk, i.e., the dangers of incorrectly assuming
that advanced time series analysis alone can provide completely accurate estimates of the market parameters
[2]
Criticism
More sophisticated mathematical models and derivative pricing strategies were then developed but their credibility
was damaged by the financial crisis of 20072010.
Contemporary practice of mathematical finance has been subjected to criticism from figures within the field notably
by Nassim Nicholas Taleb in his book The Black Swan
[3]
and Paul Wilmott. Taleb claims that the prices of financial
assets cannot be characterized by the simple models currently in use, rendering much of current practice at best
irrelevant, and, at worst, dangerously misleading. Wilmott and Emanuel Derman published the Financial Modelers'
Manifesto in January 2008
[4]
which addresses some of the most serious concerns.
Bodies such as the Institute for New Economic Thinking are now attempting to establish more effective theories and
methods.
[5]
Mathematical finance articles
Mathematical tools
Asymptotic analysis
Calculus
Copulas
Differential equations
Expected value
Ergodic theory
FeynmanKac formula
Fourier transform
Gaussian copulas
Girsanov's theorem
It's lemma
Martingale representation theorem
Mathematical models
Monte Carlo method
Numerical analysis
Real analysis
Partial differential equations
Probability
Probability distributions
Financial mathematics
78
Binomial distribution
Log-normal distribution
Quantile functions
Heat equation
RadonNikodym derivative
Risk-neutral measure
Stochastic calculus
Brownian motion
Lvy process
Stochastic differential equations
Stochastic volatility
Numerical partial differential equations
CrankNicolson method
Finite difference method
Value at risk
Volatility
ARCH model
GARCH model
Derivatives pricing
The Brownian Motion Model of Financial Markets
Rational pricing assumptions
Risk neutral valuation
Arbitrage-free pricing
Futures contract pricing
Options
Putcall parity (Arbitrage relationships for options)
Intrinsic value, Time value
Moneyness
Pricing models
BlackScholes model
Black model
Binomial options model
Monte Carlo option model
Implied volatility, Volatility smile
SABR Volatility Model
Markov Switching Multifractal
The Greeks
Finite difference methods for option pricing
Vanna Volga method
Trinomial tree
Optimal stopping (Pricing of American options)
Interest rate derivatives
Short rate model
HullWhite model
Financial mathematics
79
CoxIngersollRoss model
Chen model
LIBOR Market Model
HeathJarrowMorton framework
Notes
[1] Karatzas, I., Methods of Mathematical Finance, Secaucus, NJ, USA: Springer-Verlag New York, Incorporated, 1998
[2] Meucci, A., Risk and Asset Allocation, Springer, 2005
[3] Taleb, N. N. (2007) The Black Swan: The Impact of the Highly Improbable, Random House Trade, ISBN 978-1400063512
[4] http:/ / www. wilmott. com/ blogs/ paul/ index.cfm/ 2009/ 1/ 8/ Financial-Modelers-Manifesto
[5] Gillian Tett (April 15, 2010), Mathematicians must get out of their ivory towers (http:/ / www. ft. com/ cms/ s/ 0/
cfb9c43a-48b7-11df-8af4-00144feab49a.html), Financial Times,
References
Harold Markowitz, Portfolio Selection, Journal of Finance, 7, 1952, pp.7791
William Sharpe, Investments, Prentice-Hall, 1985
Attilio Meucci, versus Q: Differences and Commonalities between the Two Areas of Quantitative Finance (http:/ /
ssrn. com/ abstract=1717163''P), GARP Risk Professional, February 2011, pp.41-44
80
Experimental finance
Experimental finance
The goals of experimental finance are to establish different market settings and environments to observe
experimentally and analyze agents' behavior and the resulting characteristics of trading flows, information diffusion
and aggregation, price setting mechanism and returns processes. This can happen for instance by conducting trading
simulations or establishing and studying the behaviour of people in artificial competitive market-like settings.
Researchers in experimental finance can study to what extent existing financial economics theory makes valid
predictions and attempt to discover new principles on which theory can be extended.
The methodology of experimental finance is closely related to that of Experimental economics.
81
Behavioral finance
Behavioral finance
Behavioral economics and the related field, behavioral finance, study the effects of social, cognitive and emotional
factors on the economic decisions of individuals and institutions and the consequences for market prices, returns and
the resource allocation. The fields are primarily concerned with the bounds of rationality of economic agents.
Behavioral models typically integrate insights from psychology with neo-classical economic theory. In so doing they
cover a range of concepts, methods, and fields.
[1]
Behavioral analysts are not only concerned with the effects of market decisions but also with public choice, which
describes another source of economic decisions with related biases towards promoting self-interest.
History
During the classical period, microeconomics was closely linked to psychology. For example, Adam Smith wrote The
Theory of Moral Sentiments, which proposed psychological explanations of individual behavior, including concerns
about fairness and justice,
[2]
and Jeremy Bentham wrote extensively on the psychological underpinnings of utility.
However, during the development of neo-classical economics economists sought to reshape the discipline as a
natural science, deducing economic behavior from assumptions about the nature of economic agents. They
developed the concept of homo economicus, whose psychology was fundamentally rational. This led to unintended
and unforeseen errors.
However, many important neo-classical economists employed more sophisticated psychological explanations,
including Francis Edgeworth, Vilfredo Pareto and Irving Fisher. Economic psychology emerged in the 20th century
in the works of Gabriel Tarde,
[3]
George Katona
[4]
and Laszlo Garai.
[5]
Expected utility and discounted utility
models began to gain acceptance, generating testable hypotheses about decision making given uncertainty and
intertemporal consumption respectively. Observed and repeatable anomalies eventually challenged those hypotheses,
and further steps were taken by the Nobel prizewinner Maurice Allais, for example in setting out the Allais paradox,
a decision problem he first presented in 1953 which contradicts the expected utility hypothesis.
Daniel Kahneman
In the 1960s cognitive psychology began to shed more light on the brain as
an information processing device (in contrast to behaviorist models).
Psychologists in this field, such as Ward Edwards,
[6]
Amos Tversky and
Daniel Kahneman began to compare their cognitive models of
decision-making under risk and uncertainty to economic models of rational
behavior. In mathematical psychology, there is a longstanding interest in
the transitivity of preference and what kind of measurement scale utility
constitutes (Luce, 2000).
[7]
Prospect theory
In 1979, Kahneman and Tversky wrote Prospect theory: An Analysis of
Decision Under Risk, an important paper that used cognitive psychology to
explain various divergences of economic decision making from
Behavioral finance
82
neo-classical theory.
[8]
Prospect theory is an example of generalized expected utility theory. Although not a
conventional part of behavioral economics, generalized expected utility theory is similarly motivated by concerns
about the descriptive inaccuracy of expected utility theory.
In 1968 Nobel Laureate Gary Becker published Crime and Punishment: An Economic Approach, a seminal work that
factored psychological elements into economic decision making. Becker, however, maintained strict consistency of
preferences. Nobelist Herbert Simon developed the theory of Bounded Rationality to explain how people irrationally
seek satisfaction, instead of maximizing utility, as conventional economics presumed. Maurice Allais produced
"Allais Paradox", a crucial challenge to expected utility.
Psychological traits such as overconfidence, projection bias, and the effects of limited attention are now part of the
theory. Other developments include a conference at the University of Chicago,
[9]
a special behavioral economics
edition of the Quarterly Journal of Economics ('In Memory of Amos Tversky') and Kahneman's 2002 Nobel for
having "integrated insights from psychological research into economic science, especially concerning human
judgment and decision-making under uncertainty".
[10]
Intertemporal choice
Behavioral economics has also been applied to intertemporal choice. Intertemporal choice behavior is largely
inconsistent, as exemplified by George Ainslie's hyperbolic discounting (1975) which is one of the prominently
studied observations, further developed by David Laibson, Ted O'Donoghue, and Matthew Rabin. Hyperbolic
discounting describes the tendency to discount outcomes in near future more than for outcomes in the far future. This
pattern of discounting is dynamically inconsistent (or time-inconsistent), and therefore inconsistent with basic
models of rational choice, since the rate of discount between time t and t+1 will be low at time t-1, when t is the near
future, but high at time t when t is the present and time t+1 the near future.
The pattern can actually be explained through models of subadditive discounting which distinguishes the delay and
interval of discounting: people are less patient (per-time-unit) over shorter intervals regardless of when they occur.
Much of the recent work on intertemporal choice indicates that discounting is a constructed preference. Discounting
is influenced greatly by expectations, framing, focus, thought listings, mood, sign, glucose levels, and the scales used
to describe what is discounted. Some prominent researchers question whether discounting, the major parameter of
intertemporal choice, actually describes what people do when they make choices with future consequences.
Considering the variability of discount rates, this may be the case.
Other areas of research
Other branches of behavioral economics enrich the model of the utility function without implying inconsistency in
preferences. Ernst Fehr, Armin Falk, and Matthew Rabin studied "fairness", "inequity aversion", and "reciprocal
altruism", weakening the neoclassical assumption of "perfect selfishness." This work is particularly applicable to
wage setting. Work on "intrinsic motivation" by Gneezy and Rustichini and on "identity" by Akerlof and Kranton
assumes agents derive utility from adopting personal and social norms in addition to conditional expected utility.
"Conditional expected utility" is a form of reasoning where the individual has an illusion of control, and calculates
the probabilities of external events and hence utility as a function of their own action, even when they have no causal
ability to affect those external events.
[11][12]
Behavioral economics caught on among the general public, with the success of books like Dan Ariely's Predictably
Irrational. Practitioners of the discipline have studied quasi-public policy topics such as broadband mapping.
[13][14]
Behavioral finance
83
Methodology
Behavioral economics and finance theories developed almost exclusively from experimental observations and survey
responses, although in more recent times real world data have taken a more prominent position. Functional magnetic
resonance imaging (fMRI) allows determination of which brain areas are active during economic decision making.
Experiments simulating markets such as stock trading and auctions can isolate the effect of a particular bias upon
behavior. Such experiments can help narrow the range of plausible explanations. Good experiments are
incentive-compatible, normally involving binding transactions and real money.
Behavioral economics vs experimental economics
Note that behavioral economics is distinct from experimental economics, which uses experimental methods to study
economic questions. Not all economics experiments are psychological. While many experimental economics studies
probe psychological aspects of decision making, other experiments explore institutional features or serve as "beta
testing" for new market mechanisms. Not all behavioral economics uses experiments, either; behavioral economists
rely heavily on theory and on observational studies "in the field."
Key observations
Three themes predominate in behavioral finance and economics:
[15]
Heuristics: People often make decisions based on approximate rules of thumb, not strict logic. See also cognitive
biases and bounded rationality.
Framing: The collection of anecdotes and stereotypes that make up the mental emotional filters individuals rely
on to understand and respond to events.
Market inefficiencies: These include mis-pricings, non-rational decision making, and return anomalies. Richard
Thaler, in particular, has described specific market anomalies from a behavioral perspective.
Barberis, Shleifer, and Vishny
[16]
and Daniel, Hirshleifer, and Subrahmanyam (1998)
[17]
built models based on
extrapolation (seeing patterns in random sequences) and overconfidence to explain security market under- and
overreactions, though their source continues to be debated. These models assume that errors or biases are positively
correlated across agents so that they do not cancel out in aggregate. This would be the case if a large fraction of
agents look at the same signal (such as the advice of an analyst) or have a common bias.
More generally, cognitive biases may also have strong anomalous effects in the aggregate if there is social contagion
of ideas and emotions (causing collective euphoria or fear) leading to phenomena such as herding and groupthink.
Behavioral finance and economics rests as much on social psychology within large groups as on individual
psychology. In some behavioral models, a small deviant group can have substantial market-wide effects (e.g. Fehr
and Schmidt, 1999).
Topics
Models in behavioral economics typically address a particular market anomaly and modify standard neo-classical
models by describing decision makers as using heuristics and subject to framing effects. In general, economics
continues to sit within the neoclassical framework, though the standard assumption of rational behavior is often
challenged.
Heuristics
Prospect theory
Loss aversion
Disappointment
Status quo bias
Behavioral finance
84
Gambler's fallacy
Self-serving bias
Money illusion
Framing
Cognitive framing
Mental accounting
Anchoring
Anomalies (economic behavior)
Disposition effect
Endowment effect
Inequity aversion
Reciprocity
Intertemporal consumption
Present-biased preferences
Momentum investing
Greed and fear
Herd behavior
Sunk-cost fallacy
Anomalies (market prices and returns)
Equity premium puzzle
Efficiency wage hypothesis
Price stickiness
Limits to arbitrage
Dividend puzzle
Fat tails
Calendar effect
[17]
Criticisms
Critics of behavioral economics typically stress the rationality of economic agents.
[18]
They contend that
experimentally observed behavior has limited application to market situations, as learning opportunities and
competition ensure at least a close approximation of rational behavior.
Others note that cognitive theories, such as prospect theory, are models of decision making, not generalized
economic behavior, and are only applicable to the sort of once-off decision problems presented to experiment
participants or survey respondents.
Traditional economists are also skeptical of the experimental and survey-based techniques which behavioral
economics uses extensively. Economists typically stress revealed preferences over stated preferences (from surveys)
in the determination of economic value. Experiments and surveys are at risk of systemic biases, strategic behavior
and lack of incentive compatibility.
Rabin (1998)
[19]
dismisses these criticisms, claiming that consistent results are typically obtained in multiple
situations and geographies and can produce good theoretical insight. Behavioral economists have also responded to
these criticisms by focusing on field studies rather than lab experiments. Some economists see a fundamental schism
between experimental economics and behavioral economics, but prominent behavioral and experimental economists
Behavioral finance
85
tend to share techniques and approaches in answering common questions. For example, behavioral economists are
actively investigating neuroeconomics, which is entirely experimental and cannot be verified in the field.
Other proponents of behavioral economics note that neoclassical models often fail to predict outcomes in real world
contexts. Behavioral insights can influence neoclassical models. Behavioral economists note that these revised
models not only reach the same correct predictions as the traditional models, but also correctly predict some
outcomes where the traditional models failed.
Behavioral finance
Topics
The central issue in behavioral finance is explaining why market participants make systematic errors. Such errors
affect prices and returns, creating market inefficiencies. It also investigates how other participants arbitrage such
market inefficiencies.
Behavioral finance highlights inefficiencies such as under- or over-reactions to information as causes of market
trends (and in extreme cases of bubbles and crashes). Such reactions have been attributed to limited investor
attention, overconfidence, overoptimism, mimicry (herding instinct) and noise trading. Technical analysts consider
behavioral economics' academic cousin, behavioral finance, to be the theoretical basis for technical analysis.
[20]
Other key observations include the asymmetry between decisions to acquire or keep resources, known as the "bird in
the bush" paradox, and loss aversion, the unwillingness to let go of a valued possession. Loss aversion appears to
manifest itself in investor behavior as a reluctance to sell shares or other equity, if doing so would result in a nominal
loss.
[21]
It may also help explain why housing prices rarely/slowly decline to market clearing levels during periods of
low demand.
Benartzi and Thaler (1995), applying a version of prospect theory, claim to have solved the equity premium puzzle,
something conventional finance models have been unable to do so far.
[22]
Experimental finance applies the
experimental method, e.g. creating an artificial market by some kind of simulation software to study people's
decision-making process and behavior in financial markets.
Models
Some financial models used in money management and asset valuation incorporate behavioral finance parameters,
for example:
Thaler's model of price reactions to information, with two phases, underreaction-adjustment-overreaction,
creating a price trend
One characteristic of overreaction is that average returns following announcements of good news is lower than
following bad news. In other words, overreaction occurs if the market reacts too strongly or for too long to
news, thus requiring adjustment in the opposite direction. As a result, outperforming assets in one period are
likely to underperform in the following period.
The stock image coefficient
Criticisms
Critics such as Eugene Fama typically support the efficient-market hypothesis. They contend that behavioral finance
is more a collection of anomalies than a true branch of finance and that these anomalies are either quickly priced out
of the market or explained by appealing to market microstructure arguments. However, individual cognitive biases
are distinct from social biases; the former can be averaged out by the market, while the other can create positive
feedback loops that drive the market further and further from a "fair price" equilibrium. Similarly, for an anomaly to
violate market efficiency, an investor must be able to trade against it and earn abnormal profits; this is not the case
Behavioral finance
86
for many anomalies.
[23]
A specific example of this criticism appears in some explanations of the equity premium puzzle. It is argued that the
cause is entry barriers (both practical and psychological) and that returns between stocks and bonds should equalize
as electronic resources open up the stock market to more traders.
[24]
In reply, others contend that most personal
investment funds are managed through superannuation funds, minimizing the effect of these putative entry barriers.
In addition, professional investors and fund managers seem to hold more bonds than one would expect given return
differentials.
Quantitative
Quantitative behavioral finance uses mathematical and statistical methodology to understand behavioral biases. In
marketing research, a study shows little evidence that escalating biases impact marketing decisions.
[25]
Leading
contributors include Gunduz Caginalp (Editor of the Journal of Behavioral Finance from 20012004) and
collaborators including 2002 Nobelist Vernon Smith, David Porter, Don Balenovich,
[26]
Vladimira Ilieva and Ahmet
Duran
[27]
and Ray Sturm.
[28]
The research can be grouped into the following areas:
1. 1. Empirical studies that demonstrate significant deviations from classical theories
2. 2. Modeling using the concepts of behavioral effects together with the non-classical assumption of the finiteness of
assets
3. 3. Forecasting based on these methods
4. 4. Testing models against experimental asset markets
Behavioral game theory
Behavioral game theory is a subject that analyzes interactive strategic decisions and behavior using the methods of
game theory,
[29]
experimental economics, and experimental psychology. Experiments include testing deviations
from typical simplifications of economic theory such as the independence axiom
[30]
and neglect of altruism,
[31]
fairness,
[32]
and framing effects.
[33]
On the positive side, the method has been applied to interactive learning
[34]
and
social preferences.
[35][36]
As a research program, the subject is a development of the last three decades.
[37]
Key figures
Economics
Dan Ariely
[38]
Colin Camerer
Ernst Fehr
Daniel Kahneman
David Laibson
George Loewenstein
Sendhil Mullainathan
[39]
Drazen Prelec
Matthew Rabin
Herbert Simon
Paul Slovic
Vernon L. Smith
Larry Summers
[40]
Richard Thaler
Behavioral finance
87
Amos Tversky
Finance
Malcolm Baker
Nicholas Barberis
Gunduz Caginalp
David Hirshleifer
Andrew Lo
Michael Mauboussin
Terrance Odean
Charles Plott
Hersh Shefrin
Robert Shiller
Andrei Shleifer
Richard Thaler
Notes
[1] Search of behavioural economics at (2008-) The New Palgrave Dictionary of Economics Online. (http:/ / www. dictionaryofeconomics. com/
search_results?q=behavioural+ economics+ & edition=current& button_search=GO)
[2] Nava Ashraf, Colin F. Camerer, and George Loewenstein (2005). "Adam Smith, Behavioral Economist," Journal of Economic Perspectives,
19(3), p. 142. [pp. 131-145 (http:/ / webserver1.pugetsound. edu/ facultypages/ gmilam/ courses/ econ291/ readings/ ASmithBenEcon. pdf)].
[3] Tarde, G. Psychologie conomique (http:/ / classiques.uqac. ca/ classiques/ tarde_gabriel/ psycho_economique_t1/ psycho_eco_t1. html)
(1902),
[4] [4] The Powerful Consumer: Psychological Studies of the American Economy. 1960.
[5] Garai,L. Identity Economics An Alternative Economic Psychology. (http:/ / www. staff. u-szeged. hu/ ~garai/ Identity_Economics. htm)
19902006.
[6] "Ward Edward Papers" (http:/ / www. usc. edu/ libraries/ archives/ arc/ libraries/ collections/ records/ 427home. html). Archival Collections. .
Retrieved 2008-04-25.
[7] [7] Luce 2000
[8] [8] Kahneman 2003
[9] [9] Hogarth 1987
[10] "Nobel Laureates 2002" (http:/ / nobelprize.org/ nobel_prizes/ lists/ 2002. html). Nobelprize.org. . Retrieved 2008-04-25.
[11] Grafstein R (1995). "Rationality as Conditional Expected Utility Maximization". Political Psychology 16 (1): 6380. doi:10.2307/3791450.
JSTOR3791450.
[12] Shafir E, Tversky A (1992). "Thinking through uncertainty: nonconsequential reasoning and choice". Cognitive Psychology 24 (4):
449474. doi:10.1016/0010-0285(92)90015-T. PMID1473331.
[13] "US National Broadband Plan: good in theory" (http:/ / www. telco2. net/ blog/ 2010/ 03/ us_national_broadband_plan_qui. html). Telco
2.0. March 17, 2010. . Retrieved 2010-09-23. "... Sara Wedemans awful experience with this is instructive...."
[14] Gordon Cook, Sara Wedeman (July 1, 2009). "Connectivity, the Five Freedoms, and Prosperity" (http:/ / www. muninetworks. org/ reports/
cook-report-broadband-mapping-connectivity-five-freedoms-and-prosperity). Community Broadband Networks. . Retrieved 2010-09-23. "In
this report, Gordon Cook interviews Sara Wedeman, a mapping expert who also works in behavioral economics"
[15] [15] Shefrin 2002
[16] Barberis, Shleifer & Vishny 1998
[17] Daniel, Hirshleifer & Subrahmanyam 1998
[18] [18] see Myagkov and Plott (1997) amongst others
[19] Rabin & 1998 1146
[20] [20] Kirkpatrick 2007, p.49
[21] Genesove & Mayer, 2001
[22] [22] Benartzi 1995
[23] http:/ / www.dimensional.com/ famafrench/ 2009/ 08/ fama-on-market-efficiency-in-a-volatile-market. html Fama on Market Efficiency in
a Volatile Market
[24] [24] See Freeman, 2004 for a review
[25] J. Scott Armstrong, Nicole Coviello and Barbara Safranek (1993). "Escalation Bias: Does It Extend to Marketing?" (http:/ / www.
forecastingprinciples. com/ paperpdf/ Escalation Bias.pdf). pp. 247-352. .
Behavioral finance
88
[26] "Dr. Donald A. Balenovich" (http:/ / www.ma. iup.edu/ people/ dabalen. html). Indiana University of Pennsylvania, Mathematics
Department. .
[27] "Ahmet Duran" (http:/ / www. umich. edu/ ~durana). Department of Mathematics, University of Michigan-Ann Arbor. .
[28] "Dr Ray R. Sturm, CPA" (http:/ / www.bus.ucf. edu/ rsturm). College of Business Administration. .
[29] R. J. Aumann (2008). "game theory," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ / www.
dictionaryofeconomics. com/ article?id=pde2008_G000007& q=game theory& topicid=& result_number=3).
[30] Colin F. Camerer and Teck-Hua Ho (1994). "Violations of the Betweenness Axiom and Nonlinearity in Probability," Journal of Risk and
Uncertainty, 8(2), pp. 167 (http:/ / www.springerlink.com/ content/ u7w803138w478655/ )-196.
[31] James Andreoni et al. (2008). "altruism in experiments," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ / www.
dictionaryofeconomics. com/ article?id=pde008_A000240& edition=current& q=altruism game& topicid=& result_number=2).
[32] H. Peyton Young (2008). "social norms," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ / www.
dictionaryofeconomics. com/ article?id=pde2008_S000466& edition=current& q=fairness game & topicid=& result_number=1).
[33] Colin F. Camerer (1997). "Progress in Behavioral Game Theory," Journal of Economic Perspectives, 11(4), p. 172 [pp. 167-188 (http:/ /
authors.library. caltech. edu/ 22122/ 1/ 2138470[1]. pdf)].
[34] William H. Sandholm (2008). "learning and evolution in games: an overview," The New Palgrave Dictionary of Economics, 2nd Edition.
Abstract (http:/ / www. dictionaryofeconomics. com/ article?id=pde2008_E000241& edition=current& q=learning game& topicid=&
result_number=1).
Teck H. Ho (2008). "Individual learning in games," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ / www.
dictionaryofeconomics. com/ article?id=pde2008_L000055).
[35] Martin Dufwenberg and Georg Kirchsteiger (2004). "A Theory of Sequential reciprocity," Games and Economic Behavior, 47(2), pp.
268-298. Abstract (http:/ / www. sciencedirect. com/ science/ article/ pii/ S0899825603001908).
[36] Faruk Gul (2008). "behavioural economics and game theory," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ /
www.dictionaryofeconomics. com/ article?id=pde2008_G000210& edition=current& q=behavioural economics & topicid=&
result_number=2).
Colin F. Camerer (2008). "behavioral game theory," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ / www.
dictionaryofeconomics. com/ article?id=pde2008_B000302& q=Behavioral economics & topicid=& result_number=13).
[37] Colin F. Camerer (2003). Behavioral Game Theory, Princeton. Description (http:/ / press. princeton. edu/ chapters/ i7517. html), preview
(http:/ / books. google. com/ books?id=cr_Xg7cRvdcC& printsec=find& pg=PR7=#v=onepage& q& f=false) ([ctrl]+), and ch. 1 link (http:/ /
press. princeton. edu/ chapters/ i7517. pdf).
_____, George Loewenstein, and Matthew Rabin, ed. (2003). Advances in Behavioral Economics, Princeton. 1986-2003 papers.
Description (http:/ / press. princeton. edu/ titles/ 8437.html), contents (http:/ / books. google. com/ books?id=sA4jJOjwCW4C&
printsec=find& pg=PR7=#v=onepage& q& f=false), and .
Drew Fudenberg (2006). "Advancing Beyond Advances in Behavioral Economics," Journal of Economic Literature, 44(3), pp. 694 (http:/ /
www.jstor. org/ pss/ 30032349)-711.
Vincent P. Crawford (1997). "Theory and Experiment in the Analysis of Strategic Interaction," in Advances in Economics and
Econometrics: Theory and Applications, pp. 206-242 (http:/ / weber. ucsd. edu/ ~vcrawfor/ CrawfordThExp97. pdf). Cambridge. Reprinted in
Camerer et al. (2003), Advances in Behavioral Economics, Princeton, ch. 12.
Martin Shubik (2002). "Game Theory and Experimental Gaming," in R. Aumann and S. Hart, ed., Handbook of Game Theory with
Economic Applications, Elsevier, v. 3, pp. 2327-2351. Abstract (http:/ / www.sciencedirect. com/ science/ article/ pii/ S1574000502030254).
Charles R. Plott and Vernon L. Smith, ed. (2008). Handbook of Experimental Economics Results, v. 1, Elsevier, Part 4, Games preview
(http:/ / www. sciencedirect.com/ science/ article/ pii/ S1574072207001217) and ch. 45-66 preview links (http:/ / www. sciencedirect. com/
science?_ob=PublicationURL& _hubEid=1-s2.0-S1574072207X00015& _cid=277334& _pubType=HS& _auth=y& _acct=C000228598&
_version=1& _urlVersion=0& _userid=10& md5=49f8b6d5e3024eac39ed5fad351fe568).
Games and Economic Behavior, Elsevier. Aims and scope (http:/ / www. journals. elsevier. com/ games-and-economic-behavior/ ) and,
article-preview links (http:/ / www.sciencedirect.com/ science/ journal/ 08998256) by year and issue.
[38] "Predictably Irrational" (http:/ / www.predictablyirrational. com/ ?page_id=5). Dan Ariely. . Retrieved 2008-04-25.
[39] Sendhil Mullainathan: Solving social problems with a nudge (http:/ / www. ted. com/ talks/ sendhil_mullainathan. html)
[40] How Obama Is Using the Science of Change (http:/ / www. time. com/ time/ magazine/ article/ 0,9171,1889153,00. html). Michael
Grunwald, TIME, April 2, 2009.
Behavioral finance
89
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Quarterly Journal of Economics (The MIT Press) 110 (1): 7392. doi:10.2307/2118511. JSTOR2118511.
Cunningham, Lawrence A. (2002). "Behavioral Finance and Investor Governance". Washington & Lee Law
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Diamond, Peter A., and Hannu Vartiainen, ed. (2007). Behavioral Economics and its Applications. Description
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Behavioral Finance Initiative (http:/ / icf. som. yale. edu/ research/ behav_finance. shtml) of the International
Center for Finance at the Yale School of Management
Overview of Behavioral Finance (http:/ / papers. ssrn. com/ sol3/ papers. cfm?abstract_id=1488110)
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91
Intangible asset finance
Intangible asset finance
Intangible Asset Finance is the branch of finance that deals with intangible assets such as patents (legal intangible)
and reputation (competitive intangible). Like other areas of finance, intangible asset finance is concerned with the
interdependence of value, risk, and time.
Basic principles
In 2003, one estimate put the economic equilibrium of intangible assets in the U.S. economy at $5 trillion, which
represented over one-third or more of the value of U.S. domestic corporations in the first quarter of 2001.
[1]
One of the goals of people working in this field is to unlock the "hidden value" found in intangible assets through the
techniques of finance. Another goal is to measure how firm performance correlates with intangible asset
management.
Intangible assets include business processes, Intellectual Property (IP) such as patents, trademarks, reputations for
ethics and integrity, quality, safety, sustainability, security, and resilience. Today, these intangibles drive cash flow
and are the primary sources of risk. Intangible asset information, management, risk forecasting and risk transfer are
growing services as the economic base divests itself of physical assets.
Business models
A number of intangible asset business models have evolved over the years.
Patent Licensing & Enforcement Companies ("P-LECs"): These are firms that acquire patents for the sole
purpose of securing licenses and/or damages awards from infringing parties. Perhaps the most famous P-LEC is
NTP, Inc., which has successfully asserted patents related to email push technology. Another name for a P-LEC is
"patent troll," although this is viewed as a pejorative reference. Recently, hedge funds have raised capital for the
specific purpose of investing in patent litigation. One such hedge fund is Altitude Capital Partners, which is based
in New York.
Royalty stream securitizers: These are firms that are engaged in the buying and selling of what are essentially
specialized asset-backed securities. The assets that are securitized are typically intellectual properties, such as
patents, that have been bearing royalties for a period of time. Royalty Pharma is a well known firm that uses this
business model, and which has done by far the largest and most high-profile deals in this space.
[2]
Royalty
Pharma handled what many consider to be the first pharmaceutical patent-backed securitization to be rated by
Standard and Poors, which involved a patent on the HIV drug Zerit.
[3]
The other parties involved in the Zerit
transaction were Yale (the owner of the patent) and Bristol Myers Squibb.
Reinsurers: These are firms that use the techniques of reinsurance to mitigate intangible asset risks. In the same
way that some firms issue Cat bonds to mitigate the risks associated with extreme weather, earthquakes, or other
natural disasters, firms exposed to substantial intangible risk can issue "intangible asset risk-linked securities" that
transfer intangible risk to hedge funds and other players in the capital markets with a sufficient appetite for risk.
Steel City Re, which is based in Pittsburgh, is a thought leader regarding the use of risk transfer techniques to
protect and recover intangible asset value.
[4]
Market makers: Firms that are working to provide more liquidity to the market for intellectual property. Early
market makers offered on-line intellectual property exchanges where buyers and sellers could exchange rights in
Intangible asset finance
92
licensed intellectual property, usually patents. On April 22, 2008, Ocean Tomo reported
[5]
that it had transacted
approximately $70 million in its IP auctions across Europe and the United States. In 2009, The Intellectual
Property Exchange International (IPXI), headquartered in Chicago, will begin operations as the worlds first stock
exchange with an intellectual property focus.
Investment Research Firms: Companies that provide specific advice to investors on intellectual property issues.
Recently, hedge fund managers have been hiring patent attorneys to follow and handicap outcomes in high stakes
patent cases. IPD Analytics, which is based in Miami, is known for is research reports on patent litigation pending
in the United States district court as well at the United States Court of Appeals for the Federal Circuit.
Significant transactions
1997: David Bowie securitizes the future royalty revenues earned from his pre-1990 music catalogue by issuing
Bowie Bonds.
2000: BioPharma Royalty Trust completes the $115 million securitization of a single Yale patent with claims
covering Stavudine, which is a reverse transcriptase inhibitor and the active ingredient in the drug Zerit. This was
the first publicly rated patent securitization in the U.S. At the time of the deal, Bristol Myers Squibb had the
exclusive rights to distribute Zerit in the U.S. Not long after closing slow sales of Zerit along with an accounting
scandal at Bristol Myers Squibb triggered the accelerated and premature amortization of the transaction. Many
observers believe that this deal was ultimately unsuccessful because of a lack of diversification as it involved a
single patent and a single licensee.
2005: UCC Capital Corporation securitization of BCBG Max Azria's royalty receivables generated from
worldwide intellectual property rights worth $53 million. This transaction is recognized as the first "whole
company securitization" involving primarily intangible assets. UCC Capital Corporation has since been acquired
by NexCen Brands, Inc., which is currently helmed by Robert W. D'Loren. NexCen is a vertically integrated
global brand management company focused on assembling a diversified portfolio of intellectual property-centric
companies operating in the consumer branded products and franchise industries. On May 19, 2008, NexCen
issued a press release in which it stated that there was substantial doubt about its ability to continue as a going
concern.
[6]
2005: Ocean Tomo holds its first live IP auction. Although proceeds from the first auction were unremarkable, the
relative success of the Ocean Tomo auctions that followed showed that the live auction is a reasonably viable
business model for monetizing intellectual property.
2006: Marvel Entertainment's film rights securitization in conjunction with Ambac Financial Group to provide a
triple-A financial guarantee on a credit facility for Marvel backed by a slate of 10 films to be produced by Marvel
Studios and intellectual property related to some of Marvels most popular comic book characters.
[7]
Government, societies, think tanks, and other non-profits
On June 23, 2008, the United States National Academies hosted a one-day conference in Washington, D.C. entitled
"Intangible Assets: Measuring and Enhancing Their Contribution to Corporate Value and Economic Growth."
The Intangible Asset Finance Society provides a forum for finance, innovation, legal and management professionals
to discover better ways to create, capture and preserve the value of intangible assets.
The Athena Alliance is a non-profit organization dedicated to public education and research on the emerging global
information economy. On April 16, 2008 it published
[8]
a widely-circulated working paper on the topic of intangible
asset finance.
Intangible asset finance
93
References
[1] "A Trillion Dollars A Year In Intangible Investment," Leonard Nakamura in Intangible Assets: Values, Measures and Risks at 28, Hand &
Lev, Oxford University Press (2003). (http:/ / books. google. com/ books?id=RmFLUk7NydQC& printsec=frontcover& dq=Intangible+
Assets:+ Values,+ Measures+ and+ Risks,& sig=W2d87NPMzvfWlTDrmUNijOziu-8#PPA28,M1)
[2] "A seller's market," The Deal, September 5, 2008 (http:/ / www. thedeal. com/ newsweekly/ features/ a-seller's-market. php#bottom)
[3] "Avoiding Transaction Peril," Heller et al., in From Ideas to Assets: Investing Wisely in Intellectual Property at 487, Bruce Berman, John
Wiley & Sons, 2002 (http:/ / books. google. com/ books?id=rESRFPqSKzQC& pg=PA487& lpg=PA487& dq=zerit+ patent+ securitization&
source=web& ots=sN9S5ZWcrM& sig=LhlE-nYfxXddjCKeoGql6ap5KxM& hl=en#PPA487,M1)
[4] Steel City Re (http:/ / www. steelcityre. com/ accelerating_innovation. shtml)
[5] Ocean Tomo Press Release April 22, 2008 (http:/ / www. oceantomo. com/ press/ Europe_Auction_Catalogue_Release_4. 22. 08. pdf)
[6] NexCen Press Release, May 19, 2008 (http:/ / www.nexcenbrands. com/ press_release93. html)
[7] Ambac's press release, 2006 (http:/ / www.ambac.com/ pdfs\Deals\marvel. pdf)
[8] "Intangible Asset Monetization: The Promise and the Reality" (http:/ / www. athenaalliance. org/ pdf/ IntangibleAssetMonetization. pdf)
Further reading
Rembrandts In the Attic: Unlocking the Hidden Value of Patents (http:/ / books. google. com/
books?id=jCLqq80CpwwC& dq=rembrandts+ in+ the+ attic& pg=PP1& ots=XpvuUlYAtv&
sig=UkrpK3Dt_bFbI8Hcix46iZIQGhU& hl=en& prev=http:/ / www. google. com/ search?hl=en&
q=rembrandts+ in+ the+ attic& btnG=Search& sa=X& oi=print& ct=title&
cad=one-book-with-thumbnail#PPR7,M1)
"When Balance Sheets Collide With the New Economy," New York Times, September 9, 2007 (http:/ / www.
nytimes. com/ 2007/ 09/ 09/ business/ 09frame. html?ei=5124& en=f04ad9659c3221fa& ex=1346990400&
adxnnl=1& partner=permalink& exprod=permalink)
"IP-Focused Hedge Funds Launch Amid Market Volatility", Dow Jones, April 29, 2008 (http:/ / news.
morningstar. com/ newsnet/ ViewNews. aspx?article=/ DJ/ 200804291343DOWJONESDJONLINE000826_univ.
xml)
"Hedge Fund Spies in the Courtroom, IP Law & Business, May 10, 2007 (http:/ / www. law. com/ jsp/ article.
jsp?id=1178701483131)
Intellectual Asset Management Magazine Blog (http:/ / www. iam-magazine. com/ blog/ default. aspx)
Article Sources and Contributors
94
Article Sources and Contributors
Finance Source: http://en.wikipedia.org/w/index.php?oldid=477191819 Contributors: .derf, 11B, 16@r, 28421u2232nfenfcenc, A. B., A3RO, ABF, APH, Aaronchall, Abdullais4u,
Abhilash2abhi, Addihockey10, Afaber012, Afb525, Agemoi, Ahd2007, Alansohn, Albertod4, Alphachimp, Altenmann, Amorymeltzer, Andman8, Andorin Kato, AndreaFox2, Andres,
AndrewHowse, Andy Marchbanks, Andycjp, Andyjsmith, Apb123, Apparition11, ArglebargleIV, Argon233, Ariaconditzione, Artman772000, Avoided, Ayonbd2000, BD2412, Balochdude,
Barek, BarrelRollZRTwice, Bart133, Bcostel7, Beagel, Bearian, Beetstra, Ben Ben, Bentogoa, Berek, Betacommand, Bhallukchana, BiT, Blanchardb, Blathnaid, Bluerasberry, Bob Burkhardt,
Bobo192, Boleeva, Bongwarrior, Brahui, Brandon, Brillig20, Bryan Derksen, BunBun002, Burntsauce, C.Fred, COMPFUNK2, CRGreathouse, CaMpixx, Cabe6403, Calabe1992, Calcuscribe,
Caltas, CambridgeBayWeather, Can't sleep, clown will eat me, Canterbury Tail, Capricorn42, CarlAndersOlsson, Carnildo, Catgut, Cflm001, Cfseo, Chasingsol, Chennaiseo, Chester Markel,
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