Monthly Archives: April 2017

Financial risk management

Financial risk management is the practice of economic value in a firm by using financial instruments to manage exposure to risk: Operational risk, credit risk and market risk, Foreign exchange risk, Shape risk, Volatility risk, Liquidity risk, Inflation risk, Business risk, Legal risk, Reputational risk, Sector risk etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them. Financial risk management can be qualitative and quantitative. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk. 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 (i.e., financial economics) prescribes that a firm should take on a project if it increases shareholder value. Finance theory also shows that firm managers cannot create value for shareholders, also called its investors, by taking on projects that shareholders could do for themselves at the same cost.

When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. This notion was captured by the so-called “hedging irrelevance proposition”: In a perfect market, the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm. In practice, financial markets are not likely to be perfect markets.

This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management, wherein they have to determine which risks are cheaper for the firm to manage than the shareholders. Market risks that result in unique risks for the firm are commonly the best candidates for financial risk management.

The concepts of financial risk management change dramatically in the international realm. Multinational Corporations are faced with many different obstacles in overcoming these challenges. There has been some research on the risks firms must consider when operating in many countries, such as the three kinds of foreign exchange exposure for various future time horizons: transactions exposure, accounting exposure, and economic exposure. Financial management overlaps with the financial function of the accounting profession. However, financial accounting is the reporting of historical financial information, while financial management is concerned with the allocation of capital resources to increase a firm’s value to the shareholders and increase their rate of return on the investments.

Government Debt

Government debt is the debt owed by a government. By contrast, the annual “government deficit” refers to the difference between government receipts and spending in a single year. A central government with its own currency can pay for its spending by creating money ex novo. In this instance, a government issues securities not to raise funds, but instead to remove excess bank reserves (caused by government spending that is higher than tax receipts) and ‘…create a shortage of reserves in the market so that the system as a whole must come to the Bank for liquidity.’  Governments create debt by issuing securities, government bonds and bills. Less creditworthy countries sometimes borrow directly from a supranational organization (e.g. the World Bank) or international financial institutions.

In countries which are Monetarily Sovereign (like the US, the UK and most other countries), government debt held in the home currency are merely savings accounts held at the central bank. In this way this “debt” has a very different meaning to the debt acquired by households who are restricted by their income. Monetarily Sovereign Governments issue their own currencies and do not need this income to finance spending. In these self-financing nations, government debt is effectively an account of all the money that has been spent but not yet taxed back. Their ability to issue currency means they can always service the interest repayments on these savings accounts. This is why bonds and gilts are considered the safest form of investment. Government debt can be categorized as internal debt (owed to lenders within the country) and external debt (owed to foreign lenders). Another common division of government debt is by duration until repayment is due. Short term debt is generally considered to be for one year or less, long term is for more than ten years. Medium term debt falls between these two boundaries. A broader definition of government debt may consider all government liabilities, including future pension payments and payments for goods and services the government has contracted but not yet paid.

A government bond is a bond issued by a national government. Such bonds are most often denominated in the country’s domestic currency. Sovereigns can also issue debt in foreign currencies: almost 70% of all debt in 2000 was denominated in US dollars. Government bonds are sometimes regarded as risk-free bonds, because national governments can if necessary create money de novo to redeem the bond in their own currency at maturity. Although many governments are prohibited by law from creating money directly (that function having been delegated to their central banks), central banks may provide finance by buying government bonds, sometimes referred to as monetizing the debt.

Government debt, synonymous to sovereign debt, can be issued either in domestic or foreign currencies. Investors in sovereign bonds denominated in foreign currency have exchange rate risk: the foreign currency might depreciate against the investor’s local currency. Sovereigns issuing debt denominated in a foreign currency may furthermore be unable to obtain that foreign currency to service debt. In the 2010 Greek debt crisis, for example, the debt is held by Greece in Euros, and one proposed solution (advanced notably by World Pensions Council (WPC) financial economists) is for Greece to go back to issuing its own drachma. This proposal would only address future debt issuance, leaving substantial existing debts denominated in what would then be a foreign currency, potentially doubling their cost.

Public Finance

Public finance is the study of the role of the government in the economy. It is the branch of economics which assesses the government revenue and government expenditure of the public authorities and the adjustment of one or the other to achieve desirable effects and avoid undesirable ones.

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.

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.  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 policytool. 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.

Financial Modeling

Financial modeling is the task of building an abstract representation (a model) of a real world financial situation. This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or portfolio of a business, project, or any other investment. Financial modeling is a general term that means different things to different users; the reference usually relates either to accounting and corporate finance applications, or to quantitative finance applications. While there has been some debate in the industry as to the nature of financial modeling—whether it is a tradecraft, such as welding, or a science—the task of financial modeling has been gaining acceptance and rigor over the years. Typically, financial modeling is understood to mean an exercise in either asset pricing or corporate finance, of a quantitative nature.

In corporate finance and the accounting profession, financial modeling typically entails financial statement forecasting; usually the preparation of detailed company-specific models used for decision making purposes and financial analysis.

Applications include:

  • Business valuation, especially discounted cash flow, but including other valuation problems
  • Scenario planning and management decision making
  • Capital budgeting
  • Cost of capital calculations
  • Financial statement analysis
  • Project finance

Modelers are sometimes referred to (tongue in cheek) as “number crunchers”, and are often designated “financial analyst”. Typically, the modeler will have completed an MBA orMSF with (optional) coursework in “financial modeling”. Accounting qualifications and finance certifications such as the CIIA and CFA generally do not provide direct or explicit training in modeling. At the same time, numerous commercial training courses are offered, both through universities and privately.

In quantitative finance, financial modeling entails the development of a sophisticated mathematical model. Models here deal with asset prices, market movements, portfolio returns and the like. A general distinction is between: “quantitative financial management”, models of the financial situation of a large, complex firm; “quantitative asset pricing”, models of the returns of different stocks; “financial engineering”, models of the price or returns of derivative securities; “quantitative corporate finance”, models of the firm’s financial decisions.

Relatedly, applications include:

  • Option pricing and calculation of their “Greeks”
  • Other derivatives, especially interest rate derivatives, credit derivatives and exotic derivatives
  • Modeling the term structure of interest rates (Bootstrapping, short rate modelling) and credit spreads
  • Credit scoring and provisioning
  • Corporate financing activity prediction problems
  • Portfolio optimization.[17]
  • Real options
  • Risk modeling (Financial risk modeling) and value at risk[18]
  • Dynamic financial analysis (DFA)
  • Pairs trading
  • Credit valuation adjustment, CVA, as well as the various XVA

These problems are generally stochastic and continuous in nature, and models here thus require complex algorithms, entailing computer simulation, advanced numerical methods(such as numerical differential equations, numerical linear algebra, dynamic programming) and/or the development of optimization models. The general nature of these problems is discussed under Mathematical finance, while specific techniques are listed under Outline of finance# Mathematical tools. For further discussion here see also: Financial models with long-tailed distributions and volatility clustering; Brownian model of financial markets; Martingale pricing; Extreme value theory; Historical simulation (finance). Modellers are generally referred to as “quants” (quantitative analysts), and typically have advanced (Ph.D. level) backgrounds in quantitative disciplines such as physics,engineering, computer science, mathematics or operations research. Alternatively, or in addition to their quantitative background, they complete a finance masters with a quantitative orientation, such as the Master of Quantitative Finance, or the more specialized Master of Computational Finance or Master of Financial Engineering; the CQF is increasingly common.