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Contents
Articles
Introduction 1
Main article 2
Finance 2
Personal finance 15
Personal finance 15
Corporate finance 18
Corporate finance 18
Financial capital 26
Cornering the market 31
Insurance 34
Risk Management 56
Derivative 56
Finance of states 64
Public finance 64
Financial economics 72
Financial economics 72
Financial mathematics 75
Financial mathematics 75
Experimental finance 79
Experimental finance 79
Behavioral finance 80
Behavioral finance 80
Article Licenses
License 95
Introduction 1
Introduction
Note. This book is based on the Wikipedia article, "Finance." The supporting articles are those referenced as major
expansions of selected sections.
2
Main article
Finance
Finance is the science of funds management.[1] The general areas of finance are business finance, personal finance,
and public finance.[2] Finance includes saving money and often includes lending money. The field of finance deals
with the concepts of time, money, risk and how they are interrelated. It also deals with how money is spent and
budgeted.
One facet of finance is through individuals and business organizations, which deposit money in a bank. The bank
then lends the money out to other individuals or corporations for consumption or investment and charges interest on
the loans.
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.[3] 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.[4]
expand its business or to reduce its debt.[5] Investors, in 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
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 (Small and Medium Enterprises). It generally involves balancing risk and
profitability, while attempting to maximize an entity's wealth and the value of its stock.
Long term funds are provided by ownership equity and long-term credit, often in the form of bonds. The balance
between these elements forms the company's capital structure. Short-term funding or working capital is mostly
provided by banks extending a line of credit.
Another business decision concerning finance is investment, or fund management. An investment is an acquisition of
an asset in the hope that it will maintain or increase its value. In investment management – in choosing a portfolio –
one has to decide what, how much and when to invest. To do this, a company must:
• Identify relevant objectives and constraints: institution or individual goals, time horizon, risk aversion and tax
considerations;
• Identify the appropriate strategy: active v. passive – hedging strategy
• Measure the portfolio performance
Financial management is duplicate with the financial function of the Accounting profession. However, financial
accounting is more concerned with the reporting of historical financial information, while the financial decision is
directed toward the future of the firm.
Capital
Capital, in the financial sense, is the money that gives the business the power to buy goods to be used in the
production of other goods or the offering of a service.
Capital budget
This concerns proposed fixed asset requirements and how these expenditures will be financed. Capital budgets are
often adjusted annually and should be part of a longer-term Capital Improvements Plan.
Cash budget
Working capital requirements of a business should be monitored at all times to ensure that there are sufficient funds
available to meet short-term expenses.
The cash budget is basically a detailed plan that shows all expected sources and uses of cash. The cash budget has
the following six main sections:
1. Beginning Cash Balance - contains the last period's closing cash balance.
2. Cash collections - includes all expected cash receipts (all sources of cash for the period considered, mainly sales)
3. Cash disbursements - lists all planned cash outflows for the period, excluding interest payments on short-term
loans, which appear in the financing section. All expenses that do not affect cash flow are excluded from this list
(e.g. depreciation, amortization, etc.)
4. Cash excess or deficiency - a function of the cash needs and cash available. Cash needs are determined by the
total cash disbursements plus the minimum cash balance required by company policy. If total cash available is
less than cash needs, a deficiency exists.
5. Financing - discloses the planned borrowings and repayments, including interest.
6. Ending Cash balance - simply reveals the planned ending cash balance.
Credit policy
Credit gives the consumer the opportunity to buy, purchase or acquire goods and services, and pay for them at a later
date. This has its advantages and disadvantages as follows:
Forms of credit
• Suppliers credit:
• Credit on ordinary open account
• Installment sales
• Bills of exchange
• Credit cards
• Contractor's credit
• Factoring of debtors
• Cash credit
• Cpf credits
• Exchange of product
Credit collection
Overdue accounts
• Attach a notice of overdue account to statement.
• Send a letter asking for settlement of debt.
• Send a second or third letter if first is ineffectual.
• Threaten legal actions.
Stock
Purpose of stock control
• Ensures that enough stock is on hand to satisfy demand.
• Protects and monitors theft.
• Safeguards against having to stockpile.
• Allows for control over selling and cost price.
Stockpiling
This refers to the purchase of stock at the right time, at the right price and in the right quantities.
There are several advantages to the stockpiling, the following are some of the examples:
• Losses due to price fluctuations and stock loss kept to a minimum
• Ensures that goods reach customers timeously; better service
• Saves space and storage cost
• Investment of working capital kept to minimum
• No loss in production due to delays
There are several disadvantages to the stockpiling, the following are some of the examples:
• Obsolescence
• Danger of fire and theft
• Initial working capital investment is very large
• Losses due to price fluctuation
Rate of stock turnover
This refers to the number of times per year that the average level of stock is sold. It may be worked out by dividing
the cost price of goods sold by the cost price of the average stock level.
Determining optimum stock levels
• Maximum stock level refers to the maximum stock level that may be maintained to ensure cost effectiveness.
• Minimum stock level refers to the point below which the stock level may not go.
• Standard order refers to the amount of stock generally ordered.
Finance 7
• Order level refers to the stock level which calls for an order to be made.
Cash
Depreciation
Depreciation is the allocation of the cost of an asset over its useful life as determined at the time of purchase. It is
calculated yearly to enforce the matching principle
Insurance
Insurance is the undertaking of one party to indemnify another, in exchange for a premium, against a certain
eventuality.
Uninsured risks
• Bad debt
• Changes in fashion
• Time lapses between ordering and delivery
• New machinery or technology
• Different prices at different places
Requirements of an insurance contract
• Insurable interest
• The insured must derive a real financial gain from that which he is insuring, or stand to lose if it is destroyed or
lost.
• The item must belong to the insured.
• One person may take out insurance on the life of another if the second party owes the first money.
• Must be some person or item which can, legally, be insured.
• The insured must have a legal claim to that which he is insuring.
• Good faith
• Uberrimae fidei refers to absolute honesty and must characterise the dealings of both the insurer and the
insured.
Finance 8
Shared Services
There is currently a move towards converging and consolidating Finance provisions into shared services within an
organization. Rather than an organization having a number of separate Finance departments performing the same
tasks from different locations a more centralized version can be created.
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 studies:
• 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.
Finance 9
Financial mathematics
Financial mathematics is a main branch of applied mathematics concerned with the financial markets. Financial
mathematics is the study of financial data with the tools of mathematics, mainly statistics. Such data can be
movements of securities—stocks and bonds etc.—and their relations. Another large subfield is insurance
mathematics. This is also known as quantitative finance, practitioners as Quantitative analysts.
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.
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. Empirical studies that demonstrate significant deviations from classical theories.
2. Models of how psychology affects trading and prices
3. Forecasting based on these methods.
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.
(DBA)
• 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 International Investment Analyst (CIIA),
Association of Corporate Treasurers (ACT), Certified Market Analyst (CMA/FAD) Dual Designation,
Corporate Finance Qualification (CF)
• Quantitative Finance qualifications: Master of Science in Financial Engineering (MSFE), Master of
Quantitative Finance (MQF), Master of Computational Finance (MCF), Master of Financial Mathematics (MFM),
Certificate in Quantitative Finance (CQF).
See also
• Financial crisis of 2007–2010
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] finance. (2009). In Encyclopædia Britannica. Retrieved June 23, 2009, from Encyclopædia Britannica Online: Finance (http:/ / www.
britannica. com/ EBchecked/ topic/ 207147/ finance)
[3] Charitytimes.com (http:/ / www. charitytimes. com/ pages/ ct_news/ news archive/ July_06_news/ 030706_wellcome_trust_charity_bond.
htm)
[4] 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))
[5] Business.timesonline.co.uk (http:/ / business. timesonline. co. uk/ tol/ business/ industry_sectors/ natural_resources/ article5602963. ece)
External links
• OECD work on financial markets (http://www.oecd.org/finance)
• 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.
11
Financial services
Financial services refer to services provided by the finance industry. The finance industry encompasses a broad
range of organizations that deal with the management of money. Among these organizations are 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]
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.
Financial services 12
• 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
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.[4]
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.[5]
• 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 13
Financial crime
UK
Fraud within the financial industry costs the UK an estimated £14bn a year and it is believed a further £25bn is
laundered by British institutions.[6]
Market share
The financial services industry constitutes the largest group of companies in the world in terms of earnings and
equity market cap. 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.[7] 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 14
See also
• Accounting scandals
• Alternative financial services
• BFSI
• European Financial Services Roundtable
• Financial analyst
• Financial data vendors
• Financial markets
• Financialization
• Financial transaction tax
• Government sponsored enterprise
• Institutional customers
• International Monetary Fund
• Investment management
• List of banks
• List of investment banks
• Misleading financial analysis
• Thomson Financial League Tables
References
[1] "The Mistakes Of Our Grandparents?" (http:/ / www. contraryinvestor. com/ 2004archives/ mofeb04. htm). Contrary Investor.com. February
2004. . Retrieved 2009-02-06.
[2] "Private Banking definition" (http:/ / www. investorwords. com/ 5946/ private_banking. html). Investor Words.com. . Retrieved 2009-02-06.
[3] "How Swiss Bank Accounts Work" (http:/ / money. howstuffworks. com/ personal-finance/ banking/ swiss-bank-account. htm). How Stuff
Works. . Retrieved 2009-02-06.
[4] http:/ / www. globalcustody. net/ no_cookie/ custody_assets_worldwide/ GlobalCustody.net Asset Table
[5] "Price comparison sites face probe" (http:/ / news. bbc. co. uk/ 1/ hi/ business/ 7201345. stm). BBC News. 2008-01-22. . Retrieved
2009-02-06.
[6] "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.
[7] 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
• Porteous, Bruce T.; Pradip Tapadar (December 2005). Economic Capital and Financial Risk Management for
Financial Services Firms and Conglomerates. Palgrave Macmillan. ISBN 1-4039-3608-0.
• Schoppmann, Henning (Edit.); Julien Ernoult, Walburga Hemetsberger, Christoph Wengler (September 2008).
European Banking and Financial Services Law - Third Edition. Larcier. ISBN 2-8044-3180-0.
15
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.
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: a - purchasing a house b - purchasing a car c - starting a business d - paying for education expenses e -
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.
See also
• Accounting software
• Corporate finance
• Credit card debt
• Debt consolidation
• Equity investment
• Financial literacy
• Financial Literacy Month
• Family planning
• Insurance
• Investment
• List of personal finance related articles
• Mortgage loan
• Payday loan
• Pension
• Personal budget
• Personal financial management
• Separately managed account
• Settlement (finance)
• Wealth
• Wealth management
Personal finance 17
References
• 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 [1].
References
[1] http:/ / www. afcpe. org/ publications/ journal-articles. php
18
Corporate finance
Corporate finance
Corporate finance[1] is the field of
finance dealing with financial
decisions that business enterprises
make and the tools and analysis used to
make these decisions. The primary
goal of corporate finance is to
maximize corporate value [2] while
managing the firm's financial risks.
Although it is in principle different
from managerial finance which studies Domestic credit to private sector in 2005.
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.
Project valuation
In general [5] , 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.
The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate - often termed, the
project "hurdle rate" [6] - is critical to making an appropriate decision. The hurdle rate is the minimum acceptable
return on an investment—i.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 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) the paths of action to the company, but this
reality will not typically be captured in a strict NPV approach.[7] 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 “flexibile 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.
[8] [9] [10]
The two most common tools are Decision Tree Analysis (DTA) and Real options analysis (ROA); 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,
Corporate finance 20
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.)
Quantifying uncertainty
Given the uncertainty inherent in project forecasting and valuation,[11] [9] 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": ΔNPV / Δfactor. 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" (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, 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 or probabilistic financial models – as opposed to the traditional
static and deterministic models as above. For this purpose, the most common method is to use Monte Carlo
simulation to analyze the project’s NPV. This method was introduced to finance by David B. Hertz in 1964, although
has only recently become common: today analysts are even able to run simulations in spreadsheet based DCF
models, typically using an add-in, such as 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"; 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.
Corporate finance 21
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.)
• 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.
• Debtors management. 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.
• 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".
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 company’s 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.[16] 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
See: Financial engineering; Financial risk; Default (finance); Credit risk; Interest rate risk; Liquidity risk;
Market risk; Operational risk; Volatility risk; Settlement risk; Value at Risk;.
See also
• Financial modeling
• Business organizations
• Financial planning
• Investment bank
• Managerial economics
• Private equity
• Real option
• Venture capital
• Right-financing
• Factoring (finance)
• Global Squeeze
Lists:
• List of accounting topics
Corporate finance 25
References
[1] See Corporate Finance (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/ CFin/ CF. htm#ch7), Aswath Damodaran, New York
University's Stern School of Business
[2] 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
[3] 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
[4] 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
[5] 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
[6] 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)
[7] See: Real Options Analysis and the Assumptions of the NPV Rule (http:/ / www. realoptions. org/ papers2002/ SchockleyOptionNPV. pdf. ),
Tom Arnold & Richard Shockley
[8] 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
[9] 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.
[10] 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
[11] See Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations (http:/ / www. stern. nyu. edu/ ~adamodar/ pdfiles/
papers/ probabilistic. pdf), Prof. Aswath Damodaran
[12] 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
[13] See Dividend Policy (http:/ / pages. stern. nyu. edu/ ~adamodar/ pdfiles/ ovhds/ divid. pdf), Prof. Aswath Damodaran
[14] 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
[15] 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
[16] Beaney, Shaun, "Defining corporate finance in the UK" (http:/ / www. icaew. co. uk/ index. cfm?route=122299), The Institute of Chartered
Accountants, April 2005
[17] See Professional Risk Managers' International Association (http:/ / www. prmia. org/ ) and Global Association of Risk Professionals (http:/ /
www. garp. com/ )
[18] Careers in Corporate Finance (http:/ / www. careers-in-finance. com/ cf. htm), careers-in-finance.com
Financial capital 26
Financial capital
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.
Financial capital generally refers to saved-up financial wealth, Capital imports in 2006
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.[4]
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
Financial capital 27
• 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
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
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.
Working capital
Working capital is money which is used to buy stock, pay expenses and finance credit.
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.
Borrowed capital
This is capital which the business borrows from institutions or people, and includes debentures:
• Redeemable debentures
• Irredeemable debentures
Financial capital 29
• Debentures to bearer
• Ordinary debentures
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.
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.[5] [6]
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"[7] conventions are three different
approaches to reconciling financial capital value units of account.
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.
See also
• banking
• capital
• capital market
• Capitalism
• finance
• financialization
• Financial commons
• Five Capitals
• funding
• money supply
• list of finance topics
• list of accounting topics
• spiritual capital
Financial capital 31
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] (http:/ / www. aasb. com. au/ admin/ file/ content105/ c9/ Framework_07-04nd. pdf) Framework for the Preparation and Presentation of
Financial Statements, Par 104
[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] The Risk Report, April 2009. Volume XXXI No. 8. IRMI (http:/ / www. irmi. com/ ).
[5] 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)
[6] 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]
[7] 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
Historical examples
“
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.
occurring on a single day now known as Silver Thursday, due to changes made to exchange rules regarding the
purchase of commodities on margin.[5]
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] Lefèvre, Edwin (1923), Reminiscences of a Stock Operator, chapter 19.
[2] Gwynne, S. C. (September 2001), "Bunker HUNT", Texas Monthly (Austin, Texas, United States: Emmis Communications Corporation) 29
(9): p78.
[3] 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.
[5] "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
[6] 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
[7] 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
[8] "Hedge funds make £18bn loss on VW" (http:/ / news. bbc. co. uk/ 1/ hi/ business/ 7697082. stm). BBC. 2008-10-29. .
[9] "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 VW’s 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
[10] "VW prepares to take over Porsche" (http:/ / news. bbc. co. uk/ 1/ hi/ business/ 8165524. stm). BBC. 2009-07-23. .
[11] http:/ / business. timesonline. co. uk/ tol/ business/ industry_sectors/ banking_and_finance/ article5460281. ece
Insurance 34
Insurance
In law and economics, 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; an insured, or policyholder, is the
person or entity buying the insurance policy. The insurance rate is a factor used to determine the amount to be
charged for a certain amount of insurance coverage, 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 loss. The
insured receives a contract, called the insurance policy, which details the conditions and circumstances under which
the insured will be 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. 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. 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
Insurance 35
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
U.S. Financial Accounting Standards Board standard number 113)
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 U.S., 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
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. 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
Insurance 36
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]
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 comparing 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 money policies would
therefore be charged twice as much. However, more complex multivariate analyses through generalized linear
modeling 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. An insurer's underwriting performance
is measured in its combined ratio[9] which is the ratio of losses and expenses to earned premiums. A combined ratio
of less than 100 percent indicates underwriting profitability, 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]
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.
Insurance 38
If a claims adjuster suspects underinsurance, 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. Commissions to agents represent a significant portion of an insurance cost and insurers such as GEICO
that sell policies directly via mass marketing campaigns can offer lower prices. The existence and success of
companies using insurance agents (with higher prices) 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: money economies (with markets, money, financial instruments and so
on) and non-money or natural economies (without money, markets, financial instruments and so on). The second
type is a more ancient form than the first. In such an economy and community, we can see insurance in the form of
people helping each other. For example, if a house burns down, the members of the community help build a new
one. Should the same thing happen to one's neighbour, the other neighbours must help. Otherwise, neighbours will
not receive help in the future. 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
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]
Insurance 39
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 Greeks and Romans introduced the origins of health and life insurance c. 600 AD when they organized guilds
called "benevolent societies" which cared for the families and paid funeral expenses of members upon death. 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.
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.[15]
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 Lloyd's of London, pictured in 1991, is one of the
world's leading and most famous insurance
devastating effects of the fire converted the development of insurance
markets
"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."[16] 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.[17]
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,
Insurance 40
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.
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 U.S. 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.[18]
Auto insurance
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. Property coverage, for damage to or theft of the car;
2. Liability coverage, for the legal responsibility to others for bodily
injury or property damage;
3. Medical coverage, for the cost of treating injuries, rehabilitation and
sometimes lost wages and funeral expenses. A wrecked vehicle in Copenhagen
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.
Insurance 41
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.[19] A home is destroyed by fire in Essex, England
Health insurance
Health insurance policies issued by publicly-funded health programs,
such as the UK's National Health Service will cover the cost of medical
treatments. Dental insurance, like medical insurance, is protects
policyholders for dental costs. In the U.S. and Canada, dental insurance
is often part of an employer's benefits package, along with health
Great Western Hospital, Swindon
insurance.
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 descendant'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.
In many countries, such as the U.S. 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 U.S., 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.
Property
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:
• 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.[21]
• 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.
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.
• Flood insurance protects against property loss due to flooding.
Many insurers in the U.S. 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,
Hurricane Katrina caused over $80bn of storm
as outlined above. and flood damage
• Volcano insurance is a specialized insurance protecting against The demand for terrorism insurance surged after
damage arising specifically from volcanic eruptions. 9/11
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.
• 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
The subprime mortgage crisis was the source of
dispersal, release or escape of pollutants. many liability insurance losses
• 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 practictioners against potential negligence claims made by their
Insurance 45
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.
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.[22] In car insurance, all-risk policy includes also the damages caused by the own driver.
• 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 High-value horses may be insured under a
vehicles) held as collateral for loans made by lending institutions. bloodstock policy
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
• 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.
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
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.
Insurance 49
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 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.
pace.[24]
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.[25] The National
Conference of Insurance Legislators (NCOIL) also works to harmonize the different state laws.[26]
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.[27]
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[28] 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.[29]
Controversies
Religious concerns
Muslim scholars have varying opinions about insurance. Insurance policies that earn interest are generally
considered to be a form of riba[30] (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.[31]
Jewish rabbinical scholars also have expressed reservations regarding insurance as an avoidance of God's will but
most find it acceptable in moderation.[32]
Some Christians believe insurance represents a lack of faith[33] 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.[34] [35] [36]
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,
such a consultant must still work through brokers and/or agents in order to secure coverage for their clients.
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.[37]
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.[38] The report was disputed by representatives of the Consumer
Insurance 52
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. [39]
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.[40]
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.
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
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 U.S. auto insurance company, Progressive Auto Insurance (U.S.
Patent 5797134 [41]) and a Spanish independent inventor, Salvador Minguijon Perez (EP 0700009 [42]).
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 U.S. 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.[43]
Inventors can now have their insurance U.S. patent applications reviewed by the public in the Peer to Patent
program.[44] The first insurance patent application to be posted was US2009005522 “Risk assessment company” [45].
It was posted on March 6, 2009. This patent application describes a method for increasing the ease of changing
insurance companies.[46]
Insurance 53
See also
• ACORD
• Agent of Record
• Earthquake loss
• Financial services (broader industry to which insurance belongs)
• Five for one
• Geneva Association (the International Association for the Study of Insurance Economics)
• Global assets under management
• Insurance fraud
• Insurance Hall of Fame
• Insurance law
• Insurance Premium Tax (UK)
• Intergovernmental Risk Pool
• The Invisible Bankers: Everything the Insurance Industry Never Wanted You to Know (book)
• List of finance topics
• List of insurance topics
• List of United States insurance companies
• Social security
• Uberrima fides
• Universal health care
• Welfare state
Country-specific articles:
• Insurance in Australia
• Insurance in India
• Insurance in the United States
• Insurance in the United Kingdom
Insurance 54
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] 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. ISBN 978-0470108758. . 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): 515–46. ( 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] "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
[16] Dickson (1960): 4
[17] Dickson (1960): 7
[18] Insurance Information Institute. "Business insurance information. What does a businessowners policy cover?" (http:/ / www. iii. org/
individuals/ business/ basics/ bop/ ). . Retrieved 2007-05-09.
[19] Insurance Information Institute. "What is homeowners insurance?" (http:/ / www. iii. org/ individuals/ homei/ hbasics/ whatis/ ). . Retrieved
2008-11-11.
[20] "Builder's Risk Insurance" (http:/ / www. adjustersinternational. com/ AdjustingToday/ ATfullinfo. cfm?start=1& page_no=1& pdfID=4).
Adjusters International. . Retrieved 2009-10-16.
[21] US application 20060287896 (http:/ / v3. espacenet. com/ textdoc?DB=EPODOC& IDX=US20060287896) “Method for providing crop
insurance for a crop associated with a defined attribute”
[22] http:/ / www. business. gov/ manage/ business-insurance/ insurance-types. html
[23] Margaret E. Lynch, Editor, "Health Insurance Terminology," Health Insurance Association of America, 1992, ISBN 1-879143-13-5
[24] http:/ / www. thecityuk. com/ media/ 2377/ Insurance_2009. pdfPDF (365 KB) page 2
[25] 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.
[26] 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
[27] 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.
[28] 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.
[29] 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.
[30] "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.
Insurance 55
[31] "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.
[32] "Jewish Association for Business Ethics - Insurance" (http:/ / www. jabe. org/ insurance. html). . Retrieved 2008-03-25.
[33] "CIC Insurance - Insurance and the Church" (http:/ / www. cic. co. ke/ template/ t02. php?menuId=72). . Retrieved 2010-01-18.
[34] 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.
[35] Donald B. Kraybill. The riddle of Amish culture. p. 277. ISBN 0801836824.
[36] "Global Anabaptist Mennonite Encyclopedia Online, Insurance" (http:/ / www. gameo. org/ encyclopedia/ contents/ I583ME. html). .
Retrieved 2010-01-18.
[37] 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
[38] Credit-Based Insurance Scores: Impacts on Consumers of Automobile Insurance (http:/ / ftc. gov/ opa/ 2007/ 07/ facta. shtm), Federal Trade
Commission (July 2007)
[39] Consumers Dispute FTC Report on Insurance Credit Scoring (http:/ / www. consumeraffairs. com/ news04/ 2007/ 07/ insurance_credit.
html) www.consumeraffairs.com (July 2007)
[40] Insurance Information Institute. "Issues Update: Regulation Modernization" (http:/ / www. iii. org/ media/ hottopics/ insurance/ ratereg/ ). .
Retrieved 2008-11-11.
[41] http:/ / www. google. com/ patents?vid=5797134
[42] http:/ / v3. espacenet. com/ textdoc?DB=EPODOC& IDX=EP0700009
[43] (Source: Insurance IP Bulletin, December 15, 2006) (http:/ / marketsandpatents. com/ IPB-12152006. mht)
[44] Mark Nowotarski "Patent Q/A: Peer to Patent", Insurance IP Bulletin, August 15, 2008 (http:/ / www. marketsandpatents. com/ bulletin/
IPB-08152008. html)
[45] http:/ / www. peertopatent. org/ patent/ 20090055227/ activity
[46] Bakos, Nowotarski, “An Experiment in Better Patent Examination”, Insurance IP Bulletin, December 15, 2008 (http:/ / www.
marketsandpatents. com/ bulletin/ IPB-12152008. html)
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 U.S. 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)
56
Risk Management
Derivative
In finance, a derivative is a financial instrument (or, more simply, an agreement between two parties) that has a
value, based on the expected future price movements of the asset to which it is linked—called the underlying
asset—[1] such as a share or a currency. There are many kinds of derivatives, with the most common being swaps,
futures, and options. Derivatives are a form of alternative investment.
A derivative is not a stand-alone asset, since it has no value of its own. However, more common types of derivatives
have been traded on markets before their expiration date as if they were assets. Among the oldest of these are
rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[2]
Derivatives are usually broadly categorized by:
• the relationship between the underlying asset and the derivative (e.g., forward, option, swap);
• the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives,
commodity derivatives or credit derivatives);
• the market in which they trade (e.g., exchange-traded or over-the-counter);
• their pay-off profile.
Another arbitrary distinction is between:[3]
• vanilla derivatives (simple and more common); and
• exotic derivatives (more complicated and specialized).
Uses
Derivatives are used by investors to:
• provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in
the value of the derivative;
• 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;
• obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);
• 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).
Hedging
Derivatives can be considered as providing a form of insurance in hedging, which is itself a technique that attempts
to reduce risk.
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
Derivative 57
Types of derivatives
3. 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, stocks or other assets.
More complex derivatives can be created by combining the elements of these basic types. For example, the holder of
a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date.
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:
Equity DJIA Index future Option on DJIA Index Equity swap Back-to-back Stock option
Single-stock future future Repurchase agreement Warrant
Single-share option Turbo warrant
Interest rate Eurodollar future Option on Eurodollar Interest rate swap Forward rate agreement Interest rate cap and
Euribor future future floor
Option on Euribor future Swaption
Basis swap
Bond option
Credit Bond future Option on Bond future Credit default Repurchase agreement Credit default option
swap
Total return swap
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 Gold option
contract
Valuation
Criticism
Derivatives are often subject to the following criticisms:
necessary because further losses were foreseeable over the next few quarters.
• The loss of US$7.2 Billion by Société Générale 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.[17]
• The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[18]
Members of President Clinton's Working Group on Financial Markets: Larry Summers, Alan Greenspan, Arthur
Levitt, and Robert Rubin, have been criticized for torpedoing an effort to regulate the derivatives' markets, and
thereby helping to bring down the financial markets in Fall 2008. President George W. Bush has also been criticized
because he was President for 8 years preceding the 2008 meltdown and did nothing to regulate derivative trading.
Bush has stated that deregulation was one of the core tenets of his political philosophy.
Counter-party risk
Some derivatives (especially swaps) expose investors to counter-party risk.
For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer
variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate
for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business
will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the
first business may be adversely affected, because it may not be prepared to pay the higher variable rate.
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.
Benefits
The use of derivatives also has its benefits:
• Derivatives facilitate the buying and selling of risk, and many people 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.
• Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of
derivatives has softened the impact of the economic downturn at the beginning of the 21st century.
Definitions
• 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 bank’s 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 bank’s
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 FFIEC 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 bank’s allowance
for loan and lease losses.
Derivative 63
See also
• Dual currency deposit
• Forward contract
• FX Option
References
[1] McDonald, R.L. (2006) Derivatives markets. Boston: Addison-Wesley
[2] 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.
[3] Taylor, Francesca. (2007). Mastering Derivatives Markets. Prentice Hall
[4] Chisolm, Derivatives Demystified (Wiley 2004)
[5] Chisolm, Derivatives Demystified (Wiley 2004) Notional sum means there is no actual principal.
[6] News.BBC.co.uk (http:/ / news. bbc. co. uk/ 2/ hi/ business/ 375259. stm), "How Leeson broke the bank - BBC Economy"
[7] BIS survey: The Bank for International Settlements (BIS) semi-annual OTC derivatives statistics (http:/ / www. bis. org/ statistics/ derstats.
htm) report, for end of June 2008, shows US$683.7 billion 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_hy0805. htm).
[8] Hull, J.C. (2009). Options, futures, and other derivatives . Upper Saddle River, NJ : Pearson/Prentice Hall, c2009
[9] Futures and Options Week: According to figures published in F&O Week 10 October 2005. See also FOW Website (http:/ / www. fow. com).
[10] "Biz.Yahoo.com" (http:/ / biz. yahoo. com/ c/ e. html). Biz.Yahoo.com. 2010-08-23. . Retrieved 2010-08-29.
[11] FOW.com (http:/ / www. fow. com/ Article/ 1385702/ Issue/ 26557/ Emissions-derivatives-1. html), Emissions derivatives, 1 December
2005
[12] "Bis.org" (http:/ / www. bis. org/ statistics/ derstats. htm). Bis.org. 2010-05-07. . Retrieved 2010-08-29.
[13] "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.
[14] 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
[15] Derivatives Counter-party Risk: Lessons from AIG and the Credit Crisis (http:/ / www. compoundinghappens. com/ opinion/
DerivativesCounterPartyRisk. htm)
[16] 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.
[17] 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): 8–17,
[18] Whaley, Robert (2006). Derivatives: markets, valuation, and risk management (http:/ / books. google. com/ books?id=Hb7xXy-wqiYC&
printsec=frontcover& source=gbs_ge_summary_r& cad=0#v=onepage& q& f=false). John Wiley and Sons. p. 506. ISBN 0471786322. .
[19] http:/ / www. berkshirehathaway. com/ 2002ar/ 2002ar. pdf
Further Reading
• Mehraj Mattoo (1997), Structured Derivatives: New Tools for Investment Management A Handbook of
Structuring, Pricing & Investor Applications (Financial Times) Amazon listing (http://www.amazon.com/
Structured-Derivatives-Investment-Structuring-Applications/dp/0273611208)
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)
64
Finance of states
Public finance
Public finance is a field of economics concerned with paying for collective or governmental activities, and with the
administration and design of those activities. The field is often divided into questions of what the government or
collective organizations should do or are doing, and questions of how to pay for those activities. The broader term,
public economics, and the narrower term, government finance, are also often used.
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
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.[1]
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.[2] 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.[3]
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 finance 66
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.[4]
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 corvée
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."[5] 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."[6]
• 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
Debt
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
Map of countries by foreign currency reserves and gold minus external debt based on
their taxing authority, such as tax 2009 data from CIA Factbook.
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.
revenue generated by state-run enterprises to fund social dividends, eliminating the need for taxation altogether. 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.
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 government’s 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 government’s financial statements contain the
relevant information for this analysis.
The government’s balance sheet presents the level of the debt; that is the government’s 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.
See also
• Constitutional economics
• Corporate finance
• Fiscal incidence
• Functional finance
• Government budget
• Personal finance
• Public economics
• Public choice
• Rule according to higher law
• Harris School of Public Policy Studies
Notes
[1] Robert Barro and Vittorio Grilli (1994), European Macroeconomics, Ch. 15-16. Macmillan, ISBN 0-333-57764-7.
[2] Columbia Encyclopedia, Government, Columbia University Press
[3] See for example, The American Heritage Dictionary of the English Language, entry "Govern"
[4] http:/ / budget. ap. gov. in/ es2k_pf. htm
[5] Black's Law Dictionary, p. 1307 (5th ed. 1979).
[6] Id.
[7] http:/ / www. imf. org/ external/ pubs/ ft/ gfs/ manual/ index. htm
[8] http:/ / circa. europa. eu/ irc/ dsis/ nfaccount/ info/ data/ esa95/ esa95-new. htm
[9] http:/ / unstats. un. org/ unsd/ sna1993/ toctop. asp?L1=4
[10] 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=&
Public finance 71
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.
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)
• US Debt Clock.org (http://www.usdebtclock.org/) - Real Time U.S. Debt Clock
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:
• 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
See also
• List of economics topics
• List of economists
• List of finance topics
• List of master's degrees in financial economics
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)
Financial economics 74
Financial mathematics
Financial mathematics
Mathematical finance is 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). 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
The history of mathematical finance starts with The Theory of Speculation (published 1900) by Louis Bachelier,
which discussed the use of Brownian motion to evaluate stock options. However, it hardly caught any attention
outside academia.
The first influential work of mathematical finance is the theory of portfolio optimization by Harry Markowitz on
using mean-variance estimates of portfolios to judge investment strategies, causing 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 and bonds, an optimization
strategy was used to choose a portfolio with largest mean return subject to acceptable levels of variance in the return.
Simultaneously, William Sharpe developed the mathematics of determining the correlation between each stock and
the market. 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 mean–variance optimization was replaced by more general increasing, concave utility functions
[1]
.
The next major revolution in mathematical finance came with the work of Fischer Black and Myron Scholes along
with fundamental contributions by Robert C. Merton, by modeling financial markets with stochastic models. 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.
More sophisticated mathematical models and derivative pricing strategies were then developed but their credibility
was damaged by the financial crisis of 2007–2010. Bodies such as the Institute for New Economic Thinking are now
attempting to establish more effective theories and methods.[2]
Financial mathematics 76
Mathematical tools
• Asymptotic analysis
• Calculus
• Copulas
• Differential equations
• Expected value
• Ergodic theory
• Feynman–Kac formula
• Fourier transform
• Gaussian copulas
• Girsanov's theorem
• Itô's lemma
• Martingale representation theorem
• Mathematical models
• Monte Carlo method
• Numerical analysis
• Real analysis
• Partial differential equations
• Probability
• Probability distributions
• Binomial distribution
• Log-normal distribution
• Quantile functions
• Heat equation
• Radon–Nikodym derivative
• Risk-neutral measure
• Stochastic calculus
• Brownian motion
• Lévy process
• Stochastic differential equations
• Stochastic volatility
• Numerical partial differential equations
• Crank–Nicolson method
• Finite difference method
• Value at risk
• Volatility
• ARCH model
• GARCH model
Financial mathematics 77
Derivatives pricing
• The Brownian Motion Model of Financial Markets
• Rational pricing assumptions
• Risk neutral valuation
• Arbitrage-free pricing
• Futures contract pricing
• Options
• Put–call parity (Arbitrage relationships for options)
• Intrinsic value, Time value
• Moneyness
• Pricing models
• Black–Scholes 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
• Trinomial tree
• Optimal stopping (Pricing of American options)
• Interest rate derivatives
• Short rate model
• Hull–White model
• Cox–Ingersoll–Ross model
• Chen model
• LIBOR Market Model
• Heath–Jarrow–Morton framework
See also
• Computational finance
• Quantitative Behavioral Finance
• Derivative (finance), list of derivatives topics
• Modeling and analysis of financial markets
• International Swaps and Derivatives Association
• Fundamental financial concepts - topics
• Model (economics)
• List of finance topics
• List of economics topics, List of economists
• List of accounting topics
• Statistical Finance
• Brownian model of financial markets
• Master of Mathematical Finance
Financial mathematics 78
Notes
[1] Karatzas, I., Methods of Mathematical Finance, Secaucus, NJ, USA: Springer-Verlag New York, Incorporated, 1998
[2] 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. 77–91
• William Sharpe, Investments, Prentice-Hall, 1985
79
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.
See also
• Experimental economics
• Game theory
80
Behavioral finance
Behavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors
in understanding the economic decisions of individuals and institutions performing economic functions, including
consumers, borrowers and investors, and their effects on market prices, returns and the resource allocation. The
fields are primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents.
Behavioral models typically integrate insights from psychology with neo-classical economic theory.
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, economics was closely linked to psychology. For example, Adam Smith wrote The
Theory of Moral Sentiments, which proposed psychological explanations of individual behavior 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, Irving Fisher and John Maynard Keynes. Economic psychology
emerged in the 20th century in the works of Gabriel Tarde[1] , George Katona[2] and Laszlo Garai.[3] 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.
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,[4] 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).[5]
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 neo-classical
theory.[6] 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
Behavioral finance 81
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 though 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.
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 finance 82
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
(such as game theory) probe psychological aspects of decision making, other experiments explore institutional
features or serve as "beta testing" for new market mechanisms. And not all behavioral economics uses experiments;
behavioral economists rely heavily on theory and on observational studies "in the field."
Key observations
Three themes predominate in behavioral finance and economics:[13]
• 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[14] and Daniel, Hirshleifer, and Subrahmanyam (1998)[15] 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
• Status quo bias
• Gambler's fallacy
• Self-serving bias
• Money illusion
Behavioral finance 83
Framing
• Cognitive framing
• Mental accounting
• Anchoring
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.[18]
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.[19] 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.[20] 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
for many anomalies.[21]
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.[22] In reply, others contend that most personal
Behavioral finance 85
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.
Leading contributors include Gunduz Caginalp (Editor of the Journal of Behavioral Finance from 2001–2004) and
collaborators including 2002 Nobelist Vernon Smith, David Porter, Don Balenovich,[23] Vladimira Ilieva and Ahmet
Duran[24] and Ray Sturm.[25]
The research can be grouped into the following areas:
1. Empirical studies that demonstrate significant deviations from classical theories
2. Modeling using the concepts of behavioral effects together with the non-classical assumption of the finiteness of
assets
3. Forecasting based on these methods
4. Testing models against experimental asset markets
Key figures
Economics
• Dan Ariely[26]
• Colin Camerer
• Ernst Fehr
• Daniel Kahneman
• David Laibson
• George Loewenstein
• Sendhil Mullainathan[27]
• Drazen Prelec
• Matthew Rabin
• Herbert Simon
• Paul Slovic
• Vernon L. Smith
• Larry Summers[28]
• Richard Thaler
• Amos Tversky
Finance
• Malcolm Baker
• Nicholas Barberis
• Gunduz Caginalp
• David Hirshleifer
• Andrew Lo
• Terrance Odean
• Charles Plott
• Hersh Shefrin
• Robert Shiller
• Andrei Shleifer
Behavioral finance 86
• Richard Thaler
See also
• Adaptive market hypothesis
• Behavioral Operations Research
• Cognitive bias
• Cognitive psychology
• Confirmation bias
• Cultural economics
• Culture change
• Culture speculation
• Economic sociology
• Emotional bias
• Experimental economics
• Experimental finance
• Habit (psychology)
• Hindsight bias
• Important publications in behavioral finance(economics)
• Journal of Behavioral Finance
• List of cognitive biases
• Neuroeconomics
• Observational Techniques
• Rationality
• Repugnancy costs
• Socioeconomics
• Socionomics
Notes
[1] Tarde, G. Psychologie économique (http:/ / classiques. uqac. ca/ classiques/ tarde_gabriel/ psycho_economique_t1/ psycho_eco_t1. html)
(1902),
[2] The Powerful Consumer: Psychological Studies of the American Economy. 1960.
[3] Garai,L. Identity Economics - An Alternative Economic Psychology. (http:/ / www. staff. u-szeged. hu/ ~garai/ Identity_Economics. htm)
1990-2006.
[4] "Ward Edward Papers" (http:/ / www. usc. edu/ libraries/ archives/ arc/ libraries/ collections/ records/ 427home. html). Archival Collections. .
Retrieved 2008-04-25.
[5] Luce 2000
[6] Kahneman 2003
[7] Hogarth 1987
[8] "Nobel Laureates 2002" (http:/ / nobelprize. org/ nobel_prizes/ lists/ 2002. html). Nobelprize.org. . Retrieved 2008-04-25.
[9] Grafstein R (1995). "Rationality as Conditional Expected Utility Maximization" (http:/ / jstor. org/ stable/ 3791450). Political Psychology 16
(1): 63–80. doi:10.2307/3791450. .
[10] Shafir E, Tversky A (1992). "Thinking through uncertainty: nonconsequential reasoning and choice". Cognitive Psychology 24 (4):
449–474. doi:10.1016/0010-0285(92)90015-T. PMID 1473331.
[11] "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 Wedeman’s awful experience with this is instructive...."
[12] 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"
[13] Shefrin 2002
[14] Barberis, Shleifer & Vishny 1998
[15] Daniel, Hirshleifer & Subrahmanyam 1998
Behavioral finance 87
References
• Ainslie, G. (1975). "Specious Reward: A Behavioral /Theory of Impulsiveness and Impulse Control".
Psychological Bulletin 82 (4): 463–496. doi:10.1037/h0076860. PMID 1099599.
• Barberis, N.; Shleifer, A.;; Vishny, R. (1998). "A Model of Investor Sentiment" (http://jfe.rochester.edu/).
Journal of Financial Economics 49 (3): 307–343. doi:10.1016/S0304-405X(98)00027-0. Retrieved 2008-04-25.
• Gary Becker (1968). "Crime and Punishment: An Economic Approach". The Journal of Political Economy 76, pp.
169–217.
• Benartzi, Shlomo; Thaler, Richard H. (1995). "Myopic Loss Aversion and the Equity Premium Puzzle" (http://
jstor.org/stable/2118511). The Quarterly Journal of Economics (The MIT Press) 110 (1): 73–92.
doi:10.2307/2118511.
• Camerer, Colin, George Loewenstein, and Matthew Rabin (2003). Advances in Behavioral Economics.
Description (http://books.google.com/books?id=sA4jJOjwCW4C&dq=) and scroll to chapter-preview links.
(http://books.google.com/books?id=sA4jJOjwCW4C&printsec=frontcover&source=gbs_v2_summary_r&
cad=0#v=onepage&q&f=false)
• Cunningham, Lawrence A. (2002). "Behavioral Finance and Investor Governance". Washington & Lee Law
Review 59: 767. doi:10.2139/ssrn.255778. ISSN 19426658.
• Diamond, Peter A. and Hannu Vartiainen, ed. (2007). Behavioral Economics and its Applications. Description
(http://books.google.com/books?id=1-SVhlC9mVoC&dq=&source=gbs_navlinks_s) and scroll to chapter
-preview links. (http://books.google.com/books?id=1-SVhlC9mVoC&printsec=frontcover&
source=gbs_v2_summary_r&cad=0#v=onepage&q&f=false)
• Daniel, K.; Hirshleifer, D.; Subrahmanyam, A. (1998). "Investor Psychology and Security Market Under- and
Overreactions". Journal of Finance 53 (6): 1839–1885. doi:10.1111/0022-1082.00077.
• Garai Laszlo (1990-2006). Identity Economics - An Alternative Economic Psychology.
• Hens, Thorsten; Bachmann, Kremena (2008). Behavioural Finance for Private Banking (http://www.bfpb.ch).
Wiley Finance Series. ISBN 0-470-77999-3.
• Hogarth, R. M.; Reder, M. W. (1987). Rational Choice: The Contrast between Economics and Psychology.
Chicago: University of Chicago Press. ISBN 0226348571.
• Kahneman, Daniel; Tversky, Amos (1979). "Prospect Theory: An Analysis of Decision under Risk" (http://jstor.
org/stable/1914185). Econometrica (The Econometric Society) 47 (2): 263–291. doi:10.2307/1914185.
• Kahneman, Daniel; Ed Diener (2003). Well-being: the foundations of hedonic psychology. Russell Sage
Foundation.
• Kirkpatrick, Charles D.; Dahlquist, Julie R. (2007). Technical Analysis: The Complete Resource for Financial
Market Technicians. Upper Saddle River, NJ: Financial Times Press. ISBN 0131531131.
Behavioral finance 88
• Kuran, Timur (1995). Private Truths, Public Lies: The Social Consequences of Preference Falsification, Harvard
University Press. Description (http://www.hup.harvard.edu/catalog.php?isbn=9780674707580) and scroll to
chapter-preview links. (http://books.google.com/books?id=HlKBaiCpSxYC&printsec=frontcover&
dq=private+truths+public+lies&source=bl&ots=zbKWjEqViP&sig=PwbkqOp05ErR3QeJ5p93B-u66yE&
hl=en&ei=GmMJTPafC4GBlAemw7mdDg&sa=X&oi=book_result&ct=result&resnum=4&
ved=0CCYQ6AEwAw#v=onepage&q&f=false)
• Luce, R Duncan (2000). Utility of Gains and Losses: Measurement-theoretical and Experimental Approaches.
Mahwah, New Jersey: Lawrence Erlbaum Publishers.
• Mullainathan, S.; Thaler, R. H. (2001). "Behavioral Economics". International Encyclopedia of the Social &
Behavioral Sciences. pp. 1094–1100.. Abstract. (http://www.sciencedirect.com/science?_ob=ArticleURL&
_udi=B7MRM-4MT09VJ-41P&_rdoc=2&_hierId=151000134&_refWorkId=21&
_explode=151000131,151000134&_fmt=high&_orig=na&_docanchor=&_idxType=SC&view=c&_ct=28&
_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=691f9ca74480a55183807ed9dcf1933e)
• Rabin, Matthew (1998). "Psychology and Economics". Journal of Economic Literature 36 (1): 11–46 (http://
pages.towson.edu/jpomy/behavioralecon/PsychologyandEconomicsRabin98JEL.pdf). Press +.
• Shefrin, Hersh (2002). Beyond Greed and Fear: Understanding behavioral finance and the psychology of
investing. New York: Oxford University Press. ISBN 0195161211.
• Shleifer, Andrei (1999). Inefficient Markets: An Introduction to Behavioral Finance. New York: Oxford
University Press. ISBN 0198292287.
• Simon, Herbert (1987). "Behavioral Economics". The New Palgrave: A Dictionary of Economics,. 1. pp. 221–24.
• Richard H. Thaler and Sendhil Mullainathan (2008). "Behavioral Economics," (http://www.econlib.org/library/
Enc/BehavioralEconomics.html) The Concise Encyclopedia of Economics, 2nd Edition. Liberty Fund.
• Abstracts from The New Palgrave Dictionary of Economics (2008), 2nd Edition:
Augier, Mie. "Simon, Herbert A. (1916–2001)." (http:/ / www. dictionaryofeconomics. com/
article?id=pde2008_S000455&q=behavioural&topicid=&result_number=8)
Bernheim, B. Douglas; Rangel, Antonio. "Behavioral public economics." (http:/ / www.
dictionaryofeconomics.com/article?id=pde2008_B000331&q=public &topicid=&result_number=3)
Bloomfield, Robert. "Behavioral finance." (http:/ / www. dictionaryofeconomics. com/
article?id=pde2008_B000339&q=Behavioral economics &topicid=&result_number=5)
Camerer, Colin F. "Behavioral game theory." (http:/ / www. dictionaryofeconomics. com/
article?id=pde2008_B000302&q=Behavioral economics &topicid=&result_number=13)
Gul, Faruk. "Behavioural economics and game theory." (http:/ / www. dictionaryofeconomics. com/
article?id=pde2008_G000210&q=Behavioral economics &topicid=&result_number=2)
Simon, Herbert. "Rationality, bounded.' (http:/ / www. dictionaryofeconomics. com/
article?id=pde2008_B000176&q=behavioural economics&topicid=&result_number=4)
External links
• 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)
• Geary Behavioural Economics Blog (http://gearybehaviourcenter.blogspot.com/), of the Geary Institute at
University College Dublin
• Society for the Advancement of Behavioural Economics
89
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 90
licensed intellectual property, usually patents. In 2008, Ocean Tomo launched,[5] which it styled as "the only
public marketplace that allows buyers and sellers to place and receive offers for their intellectual property in a
completely transparent fashion." Patent Bid Ask now complements Ocean Tomo's experience in providing
multi-lot, live auctions for intellectual property. On April 22, 2008, Ocean Tomo reported[6] 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 world’s 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.[7]
• 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 Marvel’s most popular comic book characters.[8]
Intangible asset finance 91
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] Patent Bid Ask (http:/ / www. patentbidask. com/ )
[6] Ocean Tomo Press Release April 22, 2008 (http:/ / www. oceantomo. com/ press/ Europe_Auction_Catalogue_Release_4. 22. 08. pdf)
[7] NexCen Press Release, May 19, 2008 (http:/ / www. nexcenbrands. com/ press_release93. html)
[8] Ambac's press release, 2006 (http:/ / www. ambac. com/ pdfs\Deals\marvel. pdf)
[9] "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 92
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Ahd2007, Alansohn, Albertod4, Alphachimp, Altenmann, Amorymeltzer, Andman8, AndreaFox2, Andres, AndrewHowse, Andy Marchbanks, Andycjp, Andyjsmith, Apb123, Apparition11,
ArglebargleIV, Argon233, Ariaconditzione, Artman772000, Ayonbd2000, Balochdude, Barek, BarrelRollZRTwice, Bart133, Bcostel7, Beagel, Bearian, Beetstra, Berek, Betacommand,
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Edward321, Eglim, Ej463, El C, ElTyrant, Elemesh, Epbr123, Eric-Wester, Everyking, Excirial, Expertricky, FactsAndFigures, Falcon8765, Fawcett5, Feco, FelixKaiser, Fieldday-sunday,
Financeman11, Finbar Canavan, Fintor, Flowanda, Fluent aphasia, Fplay, Freddy S., Funandtrvl, GB fan, Galoubet, Garyjeppesen, Gatesbuffett, Gazimoff, Giftlite, Gilliam, Girolamo Savonarola,
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