Finance

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Contents
Articles
Introduction 1 2 2 11 11 15 15 18 18 26 31 34 56 56 64 64 72 72 75 75 79 79 80 8
0 89 89
Main article
Finance
The main techniques and sectors of the financial industry
Financial services
Personal finance
Personal finance
Corporate finance
Corporate finance Financial capital Cornering the market Insurance
Risk Management
Derivative
Finance of states
Public finance
Financial economics
Financial economics
Financial mathematics
Financial mathematics
Experimental finance
Experimental finance
Behavioral finance
Behavioral finance
Intangible asset finance
Intangible asset finance
References
Article Sources and Contributors Image Sources, Licenses and Contributors 92 94
Article Licenses
License 95
Introduction
1
Introduction
Note. This book is based on the Wikipedia article, "Finance." The supporting art
icles 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 savi
ng money and often includes lending money. The field of finance deals with the c
oncepts of time, money, risk and how they are interrelated. It also deals with h
ow 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 m
oney out to other individuals or corporations for consumption or investment and
charges interest on the loans. Loans have become increasingly packaged for resal
e, 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 m
ain facilitators of funding through the provision of credit, although private eq
uity, mutual funds, hedge funds, and other organizations have become important a
s they invest in various forms of debt. Financial assets, known as investments,
are financially managed with careful attention to financial risk management to c
ontrol financial risk. Financial instruments allow many forms of securitized ass
ets 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 Engla
nd in the United Kingdom, are strong players in public finance, acting as lender
s of last resort as well as strong influences on monetary and credit conditions
in the economy.[4]
Overview of techniques and sectors of the financial industry
An entity whose income exceeds its expenditure can lend or invest the excess inc
ome. On the other hand, an entity whose income is less than its expenditure can
raise capital by borrowing or selling equity claims, decreasing its expenses, or
increasing its income. The lender can find a borrower, a financial intermediary
such as a bank, or buy notes or bonds in the bond market. The lender receives i
nterest, the borrower pays a higher interest than the lender receives, and the f
inancial intermediary earns the difference for arranging the loan. A bank aggreg
ates the activities of many borrowers and lenders. A bank accepts deposits from
lenders, on which it pays interest. The bank then lends these deposits to borrow
ers. Banks allow borrowers and lenders, of different sizes, to coordinate their
activity. Finance is used by individuals (personal finance), by governments (pub
lic finance), by businesses (corporate finance) and by a wide variety of other o
rganizations, including schools and non-profit organizations. In general, the go
als of each of the above activities are achieved through the use of appropriate
financial instruments and methodologies, with consideration to their institution
al setting. Finance is one of the most important aspects of business management
and includes decisions related to the use and acquisition of funds for the enter
prise. In corporate finance, a company's capital structure is the total mix of f
inancing methods it uses to raise funds. One method is debt financing, which inc
ludes bank loans and bond sales. Another method is equity financing - the sale o
f stock by a company to investors. Possession of stock gives the investor owners
hip in the company in proportion to the number of shares the investor owns. In r
eturn for the stock, the company receives cash, which it may use to
Finance expand its business or to reduce its debt.[5] Investors, in both bonds a
nd stock, may be institutional investors financial institutions such as investme
nt banks and pension funds - or private individuals, called private investors or
retail investors
3
Personal finance
Questions in personal finance revolve around • • • • • • How much money will be needed by a
individual (or by a family), and when? How can people protect themselves agains
t 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 deci
sions? How does credit affect an individual's financial standing? How can one pl
an 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 corpora
tion'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. Lo
ng term funds are provided by ownership equity and long-term credit, often in th
e 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 ext
ending a line of credit. Another business decision concerning finance is investm
ent, 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 co
mpany must: • Identify relevant objectives and constraints: institution or individ
ual goals, time horizon, risk aversion and tax considerations; • Identify the appr
opriate strategy: active v. passive – hedging strategy • Measure the portfolio perform
ance Financial management is duplicate with the financial function of the Accoun
ting profession. However, financial accounting is more concerned with the report
ing of historical financial information, while the financial decision is directe
d 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 se
rvice.
The desirability of budgeting
Budget is a document which documents the plan of the business. This may include
the objective of business, targets set, and results in financial terms, e.g., th
e target set for sale, resulting cost, growth, required investment to achieve th
e planned sales, and financing source for the investment. Also budget may be lon
g term or short term. Long term budgets have a time horizon of 5–10 years giving a v
ision to the company; short term is an annual budget which is drawn to control a
nd operate in that particular year.
Finance Capital budget This concerns proposed fixed asset requirements and how t
hese expenditures will be financed. Capital budgets are often adjusted annually
and should be part of a longer-term Capital Improvements Plan. Cash budget Worki
ng 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 Ba
lance - contains the last period's closing cash balance. 2. Cash collections - i
ncludes all expected cash receipts (all sources of cash for the period considere
d, mainly sales) 3. Cash disbursements - lists all planned cash outflows for the
period, excluding interest payments on short-term loans, which appear in the fi
nancing section. All expenses that do not affect cash flow are excluded from thi
s 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 polic
y. If total cash available is less than cash needs, a deficiency exists. 5. Fina
ncing - discloses the planned borrowings and repayments, including interest. 6.
Ending Cash balance - simply reveals the planned ending cash balance.
4
Management of current assets
Credit policy Credit gives the consumer the opportunity to buy, purchase or acqu
ire goods and services, and pay for them at a later date. This has its advantage
s and disadvantages as follows: Advantages of credit trade • • • • • • • • • • Usually resu
re customers than cash trade. Can charge more for goods to cover the risk of bad
debt. Gain goodwill and loyalty of customers. People can buy goods and pay for
them at a later date. Farmers can buy seeds and implements, and pay for them onl
y after the harvest. Stimulates agricultural and industrial production and comme
rce. Can be used as a promotional tool. Increase the sales. Modest rates to be f
illed. can be a marketing tool
Finance Disadvantages of credit trade • • • • • Risk of bad debt. High administration expe
nses. People can buy more than they can afford. More working capital needed. Ris
k of Bankruptcy.
5
Forms of credit • • • • • • • • • Suppliers credit: Credit on ordinary open account Install
les Bills of exchange Credit cards Contractor's credit Factoring of debtors Cash
credit Cpf credits
• Exchange of product Factors which influence credit conditions • • • • • • • • • Nature of
ness's activities Financial position Product durability Length of production pro
cess Competition and competitors' credit conditions Country's economic position
Conditions at financial institutions Discount for early payment Debtor's type of
business and financial position
Credit collection Overdue accounts • • • • Attach a notice of overdue account to stateme
nt. Send a letter asking for settlement of debt. Send a second or third letter i
f first is ineffectual. Threaten legal actions.
Effective credit control • • • • • • Increases sales Reduces bad debts Increases profits Bu
lds customer loyalty Builds confidence of financial industry Increase company ca
pitalisation
• Increase the customer relationship
Finance Sources of information on creditworthiness • • • • • • Business references Bank ref
rences Credit agencies Chambers of commerce Employers Credit application forms
6
Duties of the credit department • • • • • • • • Legal action Taking necessary steps to ensu
ttlement of account Knowing the credit policy and procedures for credit control
Setting credit limits Ensuring that statements of account are sent out Ensuring
that thorough checks are carried out on credit customers Keeping records of all
amounts owing Ensuring that debts are settled promptly
• Timely reporting to the upper level of management for better management. Stock P
urpose 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 stockpil
ing, the following are some of the examples: • • • • • Losses due to price fluctuations an
d stock loss kept to a minimum Ensures that goods reach customers timeously; bet
ter service Saves space and storage cost Investment of working capital kept to m
inimum No loss in production due to delays
There are several disadvantages to the stockpiling, the following are some of th
e examples: • • • • Obsolescence Danger of fire and theft Initial working capital invest
ment is very large Losses due to price fluctuation
Rate of stock turnover This refers to the number of times per year that the aver
age level of stock is sold. It may be worked out by dividing the cost price of g
oods sold by the cost price of the average stock level. Determining optimum stoc
k levels • Maximum stock level refers to the maximum stock level that may be maint
ained to ensure cost effectiveness. • Minimum stock level refers to the point belo
w which the stock level may not go. • Standard order refers to the amount of stock
generally ordered.
Finance • Order level refers to the stock level which calls for an order to be mad
e. Cash Reasons for keeping cash • • • • Cash is usually referred to as the "king" in fi
nance, as it is the most liquid asset. The transaction motive refers to the mone
y kept available to pay expenses. The precautionary motive refers to the money k
ept aside for unforeseen expenses. The speculative motive refers to the money ke
pt aside to take advantage of suddenly arising opportunities.
7
Advantages of sufficient cash • • • • • • • Current liabilities may be catered for meeting
current obligations of the company Cash discounts are given for cash payments.
Production is kept moving Surplus cash may be invested on a short-term basis. Th
e business is able to pay its accounts in a timely manner, allowing for easily o
btained credit. Liquidity Quick upfront pay.
Management of fixed assets
Depreciation Depreciation is the allocation of the cost of an asset over its use
ful life as determined at the time of purchase. It is calculated yearly to enfor
ce the matching principle Insurance Insurance is the undertaking of one party to
indemnify another, in exchange for a premium, against a certain eventuality. Un
insured risks • • • • • Bad debt Changes in fashion Time lapses between ordering and deliv
ery 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 a
bsolute honesty and must characterise the dealings of both the insurer and the i
nsured.
Finance
8
Shared Services
There is currently a move towards converging and consolidating Finance provision
s into shared services within an organization. Rather than an organization havin
g a number of separate Finance departments performing the same tasks from differ
ent locations a more centralized version can be created.
Finance of public entities
Public finance describes finance as related to sovereign states and sub-national
entities (states/provinces, counties, municipalities, etc.) and related public
entities (e.g. school districts) or agencies. It is concerned with: • • • • Identificati
on of required expenditure of a public sector entity Source(s) of that entity's
revenue The budgeting process Debt issuance (municipal bonds) for public works p
rojects
Financial economics
Financial economics is the branch of economics studying the interrelation of fin
ancial 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 studi
es: • Valuation - Determination of the fair value of an asset • • • • How risky is the ass
et? (identification of the asset-appropriate discount rate) What cash flows will
it produce? (discounting of relevant cash flows) How does the market price comp
are 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 -
opics Money market instruments- topics Derivatives - topics
• Financial institutions and regulation Financial Econometrics is the branch of Fi
nancial Economics that uses econometric techniques to parameterise the relations
hips.
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 th
e tools of mathematics, mainly statistics. Such data can be movements of securit
ies—stocks and bonds etc.—and their relations. Another large subfield is insurance m
athematics. This is also known as quantitative finance, practitioners as Quantit
ative analysts.
Experimental finance
Experimental finance aims to establish different market settings and environment
s to observe experimentally and provide a lens through which science can analyze
agents' behavior and the resulting characteristics of trading flows, informatio
n diffusion and aggregation, price setting mechanisms, and returns processes. Re
searchers in experimental finance can study to what extent existing financial ec
onomics theory makes valid predictions, and attempt to discover new principles o
n which such theory can be extended. Research may proceed by conducting trading
simulations or by establishing and studying the behaviour of people in artificia
l competitive market-like settings.
Behavioral finance
Behavioral Finance studies how the psychology of investors or managers affects f
inancial decisions and markets. Behavioral finance has grown over the last few d
ecades to become central to finance. Behavioral finance includes such topics as:
1. 2. 3. 4. Empirical studies that demonstrate significant deviations from clas
sical theories. Models of how psychology affects trading and prices Forecasting
based on these methods. 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 bia
ses in conjunction with valuation. Some of this endeavor has been led by Gunduz
Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance d
uring 2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate i
n Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran). Stud
ies by Jeff Madura, Ray Sturm and others have demonstrated significant behaviora
l effects in stocks and exchange traded funds. Among other topics, quantitative
behavioral finance studies behavioral effects together with the non-classical as
sumption of the finiteness of assets.
Intangible Asset Finance
Intangible asset finance is the area of finance that deals with intangible asset
s such as patents, trademarks, goodwill, reputation, etc.
Related professional qualifications
There are several related professional qualifications in finance, that can lead
to the field: • Accountancy: • Qualified accountant: Chartered Accountant (ACA - UK
certification / CA - certification in Commonwealth countries), Chartered Certifi
ed Accountant (ACCA, UK certification), Certified Public Accountant (CPA, US cer
tification),ACMA/FCMA ( Associate/Fellow Chartered Management Accountant) from C
hartered Institute of Management Accountant(CIMA) ,UK. • Non-statutory qualificati
ons: Chartered Cost Accountant CCA Designation from AAFM • Business qualifications
: Master of Business Administration (MBA), Bachelor of Business Management (BBM)
, Master of Commerce (M.Comm), Master of Science in Management (MSM), Doctor of
Business Administration
Finance (DBA) • Generalist Finance qualifications: • Degrees: Masters degree in Fina
nce (MSF), Master of Financial Economics, Master of Finance & Control (MFC), Mas
ter Financial Manager (MFM), Master of Financial Administration (MFA) • Certificat
ions: Chartered Financial Analyst (CFA), Certified International Investment Anal
yst (CIIA), Association of Corporate Treasurers (ACT), Certified Market Analyst
(CMA/FAD) Dual Designation, Corporate Finance Qualification (CF) • Quantitative Fi
nance 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).
10
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/ EBch
ecked/ 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. feder
alreserve. gov/ aboutthefed/ mission. htm) Accessed: 2010-01-16. (Archived by We
bCite at Webcitation.org (http:/ / www. webcitation. org/ 5mpS52OAl)) [5] Busine
ss.timesonline.co.uk (http:/ / business. timesonline. co. uk/ tol/ business/ ind
ustry_sectors/ natural_resources/ article5602963. ece)
External links
• OECD work on financial markets (http://www.oecd.org/finance) • Wharton Finance Kno
wledge Project (http://knowledge.wharton.upenn.edu/category.cfm?cid=1) - aimed t
o offer free access to finance knowledge for students, teachers, and self-learne
rs. • 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
The main techniques and sectors of the financial industry
Financial services
Financial services refer to services provided by the finance industry. The finan
ce industry encompasses a broad range of organizations that deal with the manage
ment of money. Among these organizations are banks, credit card companies, insur
ance companies, consumer finance companies, stock brokerages, investment funds a
nd some government sponsored enterprises. As of 2004, the financial services ind
ustry represented 20% of the market capitalization of the S&P 500 in the United
States.[1]
History of financial services
In the United States
The term "financial services" became more prevalent in the United States partly
as a result of the Gramm-Leach-Bliley Act of the late 1990s, which enabled diffe
rent types of companies operating in the U.S. financial services industry at tha
t time to merge. Companies usually have two distinct approaches to this new type
of business. One approach would be a bank which simply buys an insurance compan
y or an investment bank, keeps the original brands of the acquired firm, and add
s the acquisition to its holding company simply to diversify its earnings. Outsi
de the U.S. (e.g., in Japan), non-financial services companies are permitted wit
hin the holding company. In this scenario, each company still looks independent,
and has its own customers, etc. In the other style, a bank would simply create
its own brokerage division or insurance division and attempt to sell those produ
cts to its own existing customers, with incentives for combining all things with
one company.
Banks
A "commercial bank" is what is commonly referred to as simply a "bank". The term
"commercial" is used to distinguish it from an "investment bank," a type of fin
ancial services entity which, instead of lending money directly to a business, h
elps businesses raise money from other firms in the form of bonds (debt) or stoc
k (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 oth
er kinds of payments can be delivered by post • Provide personal loans, commercial
loans, and mortgage loans (typically loans to purchase a home, property or busi
ness) • Issuance of credit cards and processing of credit card transactions and bi
lling • Issuance of debit cards for use as a substitute for checks • Allow financial
transactions at branches or by using Automatic Teller Machines (ATMs) • Provide w
ire transfers of funds and Electronic fund transfers between banks • Facilitation
of standing orders and direct debits, so payments for bills can be made automati
cally • Provide overdraft agreements for the temporary advancement of the Bank's o
wn money to meet monthly spending commitments of a customer in their current acc
ount.
Financial services • Provide Charge card advances of the Bank's own money for cust
omers wishing to settle credit advances monthly. • Provide a check guaranteed by t
he Bank itself and prepaid by the customer, such as a cashier's check or certifi
ed check. • Notary service for financial and other documents
12
Other types of bank services
• Private banking - Private banks provide banking services exclusively to high net
worth individuals. Many financial services firms require a person or family to
have a certain minimum net worth to qualify for private banking services.[2] Pri
vate banks often provide more personal services, such as wealth management and t
ax planning, than normal retail banks.[3] • Capital market bank - bank that underw
rite debt and equity, assist company deals (advisory services, underwriting and
advisory fees), and restructure debt into structured finance products. • Bank card
s - include both credit cards and debit cards. Bank Of America is the largest is
suer of bank cards. • Credit card machine services and networks - Companies which
provide credit card machine and payment networks call themselves "merchant card
providers".
Foreign exchange services
Foreign exchange services are provided by many banks around the world. Foreign e
xchange services include: • Currency Exchange - where clients can purchase and sel
l foreign currency banknotes. • Wire transfer - where clients can send funds to in
ternational banks abroad. • Foreign Currency Banking - banking transactions are do
ne in foreign currency.
Investment services
• Asset management - the term usually given to describe companies which run collec
tive investment funds. Also refers to services provided by others, generally reg
istered with the Securities and Exchange Commission as Registered Investment Adv
isors. • Hedge fund management - Hedge funds often employ the services of "prime b
rokerage" divisions at major investment banks to execute their trades. • Custody s
ervices - the safe-keeping and processing of the world's securities trades and s
ervicing the associated portfolios. Assets under custody in the world are approx
imately $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 we
bsites have been created to give consumers basic price comparisons for services
such as insurance, causing controversy within the industry.[5] • Insurance underwr
iting - 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 cov
erage for businesses. Activities include insurance and annuities, life insurance
, retirement insurance, health insurance, and property & casualty insurance. • Rei
nsurance - Reinsurance is insurance sold to insurers themselves, to protect them
from catastrophic losses.
Financial services
13
Other financial services
• Intermediation or advisory services - These services involve stock brokers (priv
ate client services) and discount brokers. Stock brokers assist investors in buy
ing or selling shares. Primarily internet-based companies are often referred to
as discount brokerages, although many now have branch offices to assist clients.
These brokerages primarily target individual investors. Full service and privat
e client firms primarily assist and execute trades for clients with large amount
s of capital to invest, such as large companies, wealthy individuals, and invest
ment management funds. • Private equity - Private equity funds are typically close
d-end funds, which usually take controlling equity stakes in businesses that are
either private, or taken private once acquired. Private equity funds often use
leveraged buyouts (LBOs) to acquire the firms in which they invest. The most suc
cessful private equity funds can generate returns significantly higher than prov
ided by the equity markets • Venture capital is a type of private equity capital t
ypically provided by professional, outside investors to new, high-potential-grow
th companies in the interest of taking the company to an IPO or trade sale of th
e business. • Angel investment - An angel investor or angel (known as a business a
ngel or informal investor in Europe), is an affluent individual who provides cap
ital for a business start-up, usually in exchange for convertible debt or owners
hip equity. A small but increasing number of angel investors organize themselves
into angel groups or angel networks to share research and pool their investment
capital. • Conglomerates - A financial services conglomerate is a financial servi
ces firm that is active in more than one sector of the financial services market
e.g. life insurance, general insurance, health insurance, asset management, ret
ail banking, wholesale banking, investment banking, etc. A key rationale for the
existence of such businesses is the existence of diversification benefits that
are present when different types of businesses are aggregated i.e. bad things do
n't always happen at the same time. As a consequence, economic capital for a con
glomerate is usually substantially less than economic capital is for the sum of
its parts. • Debt resolution is a consumer service that assists individuals that h
ave too much debt to pay off as requested, but do not want to file bankruptcy an
d wish to payoff their debts owed. This debt can be accrued in various ways incl
uding but not limited to personal loans, credit cards or in some cases merchant
accounts. There are many services/companies that can assist with this. These can
include debt consolidation, debt settlement and refinancing.
Financial crime
UK
Fraud within the financial industry costs the UK 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 th
e world in terms of earnings and equity market cap. However it is not the larges
t 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 h
aving 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 Sta
rbucks has a 32 % market share.
Financial services
14
See also
• • • • • • • • • • • • • • • • Accounting scandals Alternative financial services BFSI Eur
ces Roundtable Financial analyst Financial data vendors Financial markets Financ
ialization Financial transaction tax Government sponsored enterprise Institution
al customers International Monetary Fund Investment management List of banks Lis
t of investment banks Misleading financial analysis
• Thomson Financial League Tables
References
[1] "The Mistakes Of Our Grandparents?" (http:/ / www. contraryinvestor. com/ 20
04archives/ mofeb04. htm). Contrary Investor.com. February 2004. . Retrieved 200
9-02-06. [2] "Private Banking definition" (http:/ / www. investorwords. com/ 594
6/ 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/ GlobalCu
stody.net Asset Table [5] "Price comparison sites face probe" (http:/ / news. bb
c. co. uk/ 1/ hi/ business/ 7201345. stm). BBC News. 2008-01-22. . Retrieved 200
9-02-06. [6] "Watchdog warns of criminal gangs inside banks" (http:/ / money. gu
ardian. co. uk/ news_/ story/ 0,1456,1643860,00. html). The Guardian (London). 2
005-11-16. . Retrieved 2007-11-30. [7] The Opportunity: Small Global Market Shar
e (http:/ / www. citigroup. com/ citigroup/ fin/ data/ p040602. pdf), Page 11, f
rom the Sanford C. Bernstein & Co. Strategic Decisions Conference - 6/02/04
• Porteous, Bruce T.; Pradip Tapadar (December 2005). Economic Capital and Financi
al Risk Management for Financial Services Firms and Conglomerates. Palgrave Macm
illan. ISBN 1-4039-3608-0. • Schoppmann, Henning (Edit.); Julien Ernoult, Walburga H
emetsberger, 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 indiv
iduals 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 an
d consumer loans, investments in the stock market, retirement plans, social secu
rity benefits, insurance policies, and income tax management.
Personal financial planning
A key component of personal finance is financial planning, a dynamic process tha
t requires regular monitoring and reevaluation. In general, it has five steps: 1
. Assessment: One's personal financial situation can be assessed by compiling si
mplified versions of financial balance sheets and income statements. A personal
balance sheet lists the values of personal assets (e.g., car, house, clothes, st
ocks, bank account), along with personal liabilities (e.g., credit card debt, ba
nk loan, mortgage). A personal income statement lists personal income and expens
es. 2. Setting goals: Two examples are "retire at age 65 with a personal net wor
th of $1,000,000" and "buy a house in 3 years paying a monthly mortgage servicin
g cost that is no more than 25% of my gross income". It is not uncommon to have
several goals, some short term and some long term. Setting financial goals helps
direct financial planning. 3. Creating a plan: The financial plan details how t
o accomplish your goals. It could include, for example, reducing unnecessary exp
enses, increasing one's employment income, or investing in the stock market. 4.
Execution: Execution of one's personal financial plan often requires discipline
and perseverance. Many people obtain assistance from professionals such as accou
ntants, financial planners, investment advisers, and lawyers. 5. Monitoring and
reassessment: As time passes, one's personal financial plan must be monitored fo
r possible adjustments or reassessments. Typical goals most adults have are payi
ng off credit card and or student loan debt, retirement, college costs for child
ren, medical expenses, and estate planning. The six key areas of personal financ
ial planning, as suggested by the Financial Planning Standards Board, are: 1 - F
inancial Position: this area is concerned with understanding the personal resour
ces available by examining net worth and household cash flow. Net worth is a per
son's balance sheet, calculated by adding up all assets under that person's cont
rol, minus all liabilities of the household, at one point in time. Household cas
h flow totals up all the expected sources of income within a year, minus all exp
ected expenses within the same year. From this analysis, the financial planner c
an determine to what degree and in what time the personal goals can be accomplis
hed. 2 - Adequate Protection: the analysis of how to protect a household from un
foreseen risks. These risks can be divided into liability, property, death, disa
bility, health and long term care. Some of these risks may be self-insurable, wh
ile most will require the purchase of an insurance contract. Determining how muc
h insurance to get, at the most cost effective terms requires knowledge of the m
arket for personal insurance. Business owners, professionals, athletes and enter
tainers require specialized insurance professionals to adequately protect themse
lves. Since insurance also enjoys some tax benefits, utilizing insurance investm
ent products may be a critical piece of the overall investment planning.
Personal finance 3 - Tax Planning: typically the income tax is the single larges
t expense in a household. Managing taxes is not a question of if you will pay ta
xes, 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. Mos
t 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 m
yriad tax breaks when planning your personal finances can make a significant imp
act upon your success. 4 - Investment and Accumulation Goals: planning how to ac
cumulate enough money to acquire items with a high price is what most people con
sider to be financial planning. The major reasons to accumulate assets is for th
e following: a - purchasing a house b - purchasing a car c - starting a business
d - paying for education expenses e accumulating money for retirement, to gener
ate a stream of income to cover lifestyle expenses. Achieving these goals requir
es 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 fina
ncial 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 in
flation, the investment portfolio has to get a higher rate of return, which typi
cally will subject the portfolio to a number of risks. Managing these portfolio
risks is most often accomplished using asset allocation, which seeks to diversif
y investment risk and opportunity. This asset allocation will prescribe a percen
tage allocation to be invested in stocks, bonds, cash and alternative investment
s. The allocation should also take into consideration the personal risk profile
of every investor, since risk attitudes vary from person to person. 5 - Retireme
nt Planning: retirement planning is the process of understanding how much it cos
ts 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 dispositio
n of your asset when you die. Typically, there is a tax due to the state or fede
ral government at your death. Avoiding these taxes means that more of your asset
s will be distributed to your heirs. You can leave your assets to family, friend
s or charitable groups.
16
See also
• • • • • • • • • • • • • • • • • Accounting software Corporate finance Credit card debt De
investment Financial literacy Financial Literacy Month Family planning Insuranc
e Investment List of personal finance related articles Mortgage loan Payday loan
Pension Personal budget Personal financial management Separately managed accoun
t
• Settlement (finance) • Wealth • Wealth management
Personal finance
17
References
• Kwok, H., Milevsky, M., and Robinson, C. (1994) Asset Allocation, Life Expectanc
y, 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 th
at business enterprises make and the tools and analysis used to make these decis
ions. The primary goal of corporate finance is to maximize corporate value [2] w
hile 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 probl
ems of all kinds of firms. The discipline can be divided into long-term and shor
t-term decisions and techniques. Capital investment decisions are long-term choi
ces about which projects receive investment, whether to finance that investment
with equity or debt, and when or whether to pay dividends to shareholders. On th
e other hand, short term decisions deal with the short-term balance of current a
ssets 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 cu
stomers). The terms corporate finance and corporate financier are also associate
d 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 be
st fits those needs. Thus, the terms “corporate finance” and “corporate financier” may b
e associated with transactions in which capital is raised in order to create, de
velop, grow or acquire businesses.
Capital investment decisions
Capital investment decisions [3] are long-term corporate finance decisions relat
ing to fixed assets and capital structure. Decisions are based on several inter-
related criteria. (1) Corporate management seeks to maximize the value of the fi
rm by investing in projects which yield a positive net present value when valued
using an appropriate discount rate. (2) These projects must also be financed ap
propriately. (3) If no such opportunities exist, maximizing shareholder value di
ctates that management must return excess cash to shareholders (i.e., distributi
on via dividends). Capital investment decisions thus comprise an investment deci
sion, a financing decision, and a dividend decision.
Corporate finance
19
The investment decision
Management must allocate limited resources between competing opportunities (proj
ects) in a process known as capital budgeting. [4] Making this investment, or ca
pital allocation, decision requires estimating the value of each opportunity or
project, which is a function of the size, timing and predictability of future ca
sh flows. Project valuation In general [5] , each project's value will be estima
ted using a discounted cash flow (DCF) valuation, and the opportunity with the h
ighest value, as measured by the resultant net present value (NPV) will be selec
ted (applied to Corporate Finance by Joel Dean in 1951; see also Fisher separati
on theorem, John Burr Williams: theory). This requires estimating the size and t
iming of all of the incremental cash flows resulting from the project. Such futu
re cash flows are then discounted to determine their present value (see Time val
ue of money). These present values are then summed, and this sum net of the init
ial investment outlay is the NPV. See Financial modeling. The NPV is greatly aff
ected by the discount rate. Thus, identifying the proper discount rate - often t
ermed, the project "hurdle rate" [6] - is critical to making an appropriate deci
sion. The hurdle rate is the minimum acceptable return on an investment—i.e. the p
roject appropriate discount rate. The hurdle rate should reflect the riskiness o
f 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 we
ighted 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 a
pplies to the entire firm. Such an approach may not be appropriate where the ris
k of a particular project differs markedly from that of the firm's existing port
folio 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 ann
uity, capital efficiency, and ROI. Alternatives (complements) to NPV include MVA
/ EVA (Joel Stern, Stern Stewart & Co) and APV (Stewart Myers). See list of val
uation topics. Valuing flexibility In many cases, for example R&D projects, a pr
oject may open (or close) the paths of action to the company, but this reality w
ill not typically be captured in a strict NPV approach.[7] Management will there
fore (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 cas
h flows are discounted, here the “flexibile and staged nature” of the investment is
modelled, and hence "all" potential payoffs are considered. The difference betwe
en the two valuations is the "value of flexibility" inherent in the project. The
two most common tools are Decision Tree Analysis (DTA) [8] [9] and Real options
analysis (ROA); [10] they may often be used interchangeably: • DTA values flexibi
lity by incorporating possible events (or states) and consequent management deci
sions. (For example, a company would build a factory given that demand for its p
roduct 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 manag
ement decision in response to an "event" generates a "branch" or "path" which th
e company could follow; the probabilities of each event are determined or specif
ied by management. Once the tree is constructed: (1) "all" possible events and t
heir resultant paths are visible to management; (2) given this “knowledge” of the ev
ents that could follow, and assuming rational decision making, management choose
s 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 co
ntingent 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 pri
ce is too low,
Corporate finance management will abandon the mining rights, if sufficiently hig
h, management will develop the ore body. Again, a DCF valuation would capture on
ly one of these outcomes.) Here: (1) using financial option theory as a framewor
k, the decision to be taken is identified as corresponding to either a call opti
on or a put option; (2) an appropriate valuation technique is then employed - us
ually a variant on the Binomial options model or a bespoke simulation model, whi
le Black Scholes type formulae are used less often; see Contingent claim valuati
on. (3) The "true" value of the project is then the NPV of the "most likely" sce
nario plus the option value. (Real options in corporate finance were first discu
ssed by Stewart Myers in 1977; viewing corporate strategy as a series of options
was originally per Timothy Luehrman, in the late 1990s.) Quantifying uncertaint
y Given the uncertainty inherent in project forecasting and valuation,[11] [9] a
nalysts 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 anal
yst will vary one key factor while holding all other inputs constant, ceteris pa
ribus. The sensitivity of NPV to a change in that factor is then observed, and i
s calculated as a "slope": ΔNPV / Δfactor. For example, the analyst will determine N
PV at various growth rates in annual revenue as specified (usually at set increm
ents, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using this
formula. Often, several variables may be of interest, and their various combina
tions produce a "value-surface" (or even a "value-space"), where NPV is then a f
unction 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 facto
rs (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 "B
est Case"), where all key inputs are adjusted so as to be consistent with the gr
owth assumptions, and calculate the NPV for each. Note that for scenario based a
nalysis, the various combinations of inputs must be internally consistent, where
as for the sensitivity approach these need not be so. An application of this met
hodology is to determine an "unbiased" NPV, where management determines a (subje
ctive) probability for each scenario – the NPV for the project is then the probabi
lity-weighted average of the various scenarios. A further advancement is to cons
truct stochastic or probabilistic financial models – as opposed to the traditional
static and deterministic models as above. For this purpose, the most common met
hod 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 bec
ome 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 flo
w components that are (heavily) impacted by uncertainty are simulated, mathemati
cally reflecting their "random characteristics". In contrast to the scenario app
roach above, the simulation produces several thousand random but possible outcom
es, or "trials"; see Monte Carlo Simulation versus “What If” Scenarios. The output i
s then a histogram of project NPV, and the average NPV of the potential investme
nt – as well as its volatility and other sensitivities – is then observed. This hist
ogram provides information not visible from the static DCF: for example, it allo
ws for an estimate of the probability that a project has a net present value gre
ater than zero (or any other value). Continuing the above example: instead of as
signing three discrete values to revenue growth, and to the other relevant varia
bles, the analyst would assign an appropriate probability distribution to each v
ariable (commonly triangular or beta), and, where possible, specify the observed
or supposed correlation between the variables. These distributions would then b
e "sampled" repeatedly - incorporating this correlation - so as to generate seve
ral 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. Th
ese are often used as estimates of the underlying "spot price" and volatility fo
r the real option valuation as above; see Real options valuation: Valuation inpu
ts.
20
Corporate finance
21
The financing decision
Achieving the goals of corporate finance requires that any corporate investment
be financed appropriately. [12] As above, since both hurdle rate and cash flows
(and hence the riskiness of the firm) will be affected, the financing mix can im
pact the valuation. Management must therefore identify the "optimal mix" of fina
ncing—the capital structure that results in maximum value. (See Balance sheet, WAC
C, Fisher separation theorem; but, see also the Modigliani-Miller theorem.) The
sources of financing will, generically, comprise some combination of debt and eq
uity financing. Financing a project through debt results in a liability or oblig
ation that must be serviced, thus entailing cash flow implications independent o
f the project s degree of success. Equity financing is less risky with respect t
o cash flow commitments, but results in a dilution of ownership, control and ear
nings. The cost of equity is also typically higher than the cost of debt (see CA
PM and WACC), and so equity financing may result in an increased hurdle rate whi
ch may offset any reduction in cash flow risk. Management must also attempt to m
atch the financing mix to the asset being financed as closely as possible, in te
rms of both timing and cash flows. One of the main theories of how firms make th
eir financing decisions is the Pecking Order Theory, which suggests that firms a
void external financing while they have internal financing available and avoid n
ew equity financing while they can engage in new debt financing at reasonably lo
w interest rates. Another major theory is the Trade-Off Theory in which firms ar
e assumed to trade-off the tax benefits of debt with the bankruptcy costs of deb
t when making their decisions. An emerging area in finance theory is right-finan
cing whereby investment banks and corporations can enhance investment return and
company value over time by determining the right investment objectives, policy
framework, institutional structure, source of financing (debt or equity) and exp
enditure framework within a given economy and under given market conditions. One
last theory about this decision is the Market timing hypothesis which states th
at firms look for the cheaper type of financing regardless of their current leve
ls of internal resources, debt and equity.
The dividend decision
Whether to issue dividends,[13] and what amount, is calculated mainly on the bas
is of the company s unappropriated profit and its earning prospects for the comi
ng year. If there are no NPV positive opportunities, i.e. projects where returns
exceed the hurdle rate, then management must return excess cash to investors. T
hese free cash flows comprise cash remaining after all business expenses have be
en met. This is the general case, however there are exceptions. For example, inv
estors in a "Growth stock", expect that the company will, almost by definition,
retain earnings so as to fund growth internally. In other cases, even though an
opportunity is currently NPV negative, management may consider “investment flexibi
lity” / potential payoffs and decide to retain cash flows; see above and Real opti
ons. Management must also decide on the form of the dividend distribution, gener
ally as cash dividends or via a share buyback. Various factors may be taken into
consideration: where shareholders must pay tax on dividends, firms may elect to
retain earnings or to perform a stock buyback, in both cases increasing the val
ue of shares outstanding. Alternatively, some companies will pay "dividends" fro
m stock rather than in cash; see Corporate action. Today, it is generally accept
ed that dividend policy is value neutral (see Modigliani-Miller theorem).
Corporate finance
22
Working capital management
Decisions relating to working capital and short term financing are referred to a
s working capital management[14] . These involve managing the relationship betwe
en a firm s short-term assets and its short-term liabilities. As above, the goal
of Corporate Finance is the maximization of firm value. In the context of long
term, capital investment decisions, firm value is enhanced through appropriately
selecting and funding NPV positive investments. These investments, in turn, hav
e implications in terms of cash flow and cost of capital. The goal of Working ca
pital management is therefore to ensure that the firm is able to operate, and th
at it has sufficient cash flow to service long term debt, and to satisfy both ma
turing short-term debt and upcoming operational expenses. In so doing, firm valu
e is enhanced when, and if, the return on capital exceeds the cost of capital; S
ee Economic value added (EVA).
Decision criteria
Working capital is the amount of capital which is readily available to an organi
zation. That is, working capital is the difference between resources in cash or
readily convertible into cash (Current Assets), and cash requirements (Current L
iabilities). As a result, the decisions relating to working capital are always c
urrent, 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. (Consid
erations 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 criter
ia 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 pay
ment 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 nu
mber effectively corresponds to the time that the firm s cash is tied up in oper
ations 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 op
erating cycle except that it does not take into account the creditors deferral p
eriod.) • In this context, the most useful measure of profitability is Return on c
apital (ROC). The result is shown as a percentage, determined by dividing releva
nt income for the 12 months by capital employed; Return on equity (ROE) shows th
is result for the firm s shareholders. As above, firm value is enhanced when, an
d if, the return on capital, exceeds the cost of capital. ROC measures are there
fore useful as a management tool, in that they link short-term policy with long-
term decision making.
Management of working capital
Guided by the above criteria, management will use a combination of policies and
techniques for the management of working capital [15] . These policies aim at ma
naging the current assets (generally cash and cash equivalents, inventories and
debtors) and the short term financing, such that cash flows and returns are acce
ptable. • Cash management. Identify the cash balance which allows for the business
to meet day to day expenses, but reduces cash holding costs. • Inventory manageme
nt. Identify the level of inventory which allows for uninterrupted production bu
t reduces the investment in raw materials - and minimizes reordering costs - and
hence increases cash flow; see Supply chain management; Just In Time (JIT); Eco
nomic order quantity (EOQ); Economic production quantity (EPQ).
Corporate finance • 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 Ret
urn on Capital (or vice versa); see Discounts and allowances. • Short term financi
ng. Identify the appropriate source of financing, given the cash conversion cycl
e: 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 debto
rs to cash" through "factoring".
23
Relationship with other areas in finance
Investment banking
Use of the term “corporate finance” varies considerably across the world. In the Uni
ted States it is used, as above, to describe activities, decisions and technique
s that deal with many aspects of a company’s finances and capital. In the United K
ingdom and Commonwealth countries, the terms “corporate finance” and “corporate financ
ier” tend to be associated with investment banking - i.e. with transactions in whi
ch capital is raised for the corporation.[16] These may include • Raising seed, st
art-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 comp
anies, divisions or subsidiaries - typically backed by private equity • Equity iss
ues by companies, including the flotation of companies on a recognised stock exc
hange 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 securit
ies for the refinancing and restructuring of businesses • Financing joint ventures
, project finance, infrastructure finance, public-private partnerships and priva
tisations • Secondary equity issues, whether by means of private placing or furthe
r issues on a stock market, especially where linked to one of the transactions l
isted above. • Raising debt and restructuring debt, especially when linked to the
types of transactions listed above
Financial risk management
Risk management [17] is the process of measuring risk and then developing and im
plementing strategies to manage that risk. Financial risk management focuses on
risks that can be managed ("hedged") using traded financial instruments (typical
ly changes in commodity prices, interest rates, foreign exchange rates and stock
prices). Financial risk management will also play an important role in cash man
agement. This area is related to corporate finance in two ways. Firstly, firm ex
posure to business and market risk is a direct result of previous Investment and
Financing decisions. Secondly, both disciplines share the goal of enhancing, or
preserving, firm value. All large corporations have risk management teams, and
small firms practice informal, if not formal, risk management. There is a fundam
ental debate on the value of "Risk Management" and shareholder value that questi
ons a shareholder s desire to optimize risk versus taking exposure to pure risk.
The debate links value of risk management in a market to the cost of bankruptcy
in that market. Derivatives are the instruments most commonly used in financial
risk management. Because unique derivative contracts tend to be costly to creat
e and monitor, the most cost-effective financial risk management methods usually
involve derivatives that trade on well-established financial markets or exchang
es. These standard derivative instruments include options, futures contracts, fo
rward contracts, and swaps. More customized and second generation derivatives kn
own as exotics trade over the counter aka OTC.
Corporate finance 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;.
24
Personal and public finance
Corporate finance utilizes tools from almost all areas of finance. Some of the t
ools developed by and for corporations have broad application to entities other
than corporations, for example, to partnerships, sole proprietorships, not-for-p
rofit organizations, governments, mutual funds, and personal wealth management.
But in other cases their application is very limited outside of the corporate fi
nance arena. Because corporations deal in quantities of money much greater than
individuals, the analysis has developed into a discipline of its own. It can be
differentiated from personal finance and public finance.
Related professional qualifications
Qualifications related to the field include:[18] • Finance qualifications: • Degrees
: Masters degree in Finance (MSF), Master of Financial Economics • Certifications:
Chartered Financial Analyst (CFA), Corporate Finance Qualification (CF), Certif
ied International Investment Analyst (CIIA), Association of Corporate Treasurers
(ACT), Certified Market Analyst (CMA/FAD) Dual Designation, Master Financial Ma
nager (MFM), Master of Finance & Control (MFC), Certified Treasury Professional
(CTP), Association for Financial Professionals, Certified Merger & Acquisition A
dvisor (CM&AA) • Business qualifications: • Degrees: Master of Business Administrati
on (MBA), Master of Management (MM), Master of Science in Management (MSM), Mast
er of Commerce (M Comm), Doctor of Business Administration (DBA) • Certification:
Certified Business Manager (CBM), Certified MBA (CMBA) • Accountancy qualification
s: • Qualified accountant: Chartered Accountant (ACA, CA), Certified Public Accoun
tant (CPA), Chartered Certified Accountant(ACCA), Chartered Management Accountan
t (CIMA) • Non-statutory qualifications: Chartered Cost Accountant (CCA Designatio
n from AAFM), Certified Management Accountant (CMA)
See also
• • • • • • • • • • • Financial modeling Business organizations Financial planning Investme
agerial economics Private equity Real option Venture capital Right-financing Fac
toring (finance) Global Squeeze
Lists: • List of accounting topics
Corporate finance • List of finance topics • List of corporate finance topics • List o
f valuation topics
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 o
f Business [2] See Corporate Finance: First Principles (http:/ / pages. stern. n
yu. edu/ ~adamodar/ New_Home_Page/ AppldCF/ other/ Image2. gif), Aswath Damodara
n, New York University s Stern School of Business [3] The framework for this sec
tion is based on Notes (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Pag
e/ AppldCF/ other/ Image2. gif) by Aswath Damodaran at New York University s Ste
rn School of Business [4] See: Investment Decisions and Capital Budgeting (http:
/ / www. duke. edu/ ~charvey/ Classes/ ba350_1997/ vcf2/ vcf2. htm), Prof. Campb
ell R. Harvey; The Investment Decision of the Corporation (http:/ / www. bus. ls
u. edu/ academics/ finance/ faculty/ dchance/ Instructional/ FinancialManagement
Decisions. ppt#257,2,Slide), Prof. Don M. Chance [5] See: Valuation (http:/ / pa
ges. stern. nyu. edu/ ~adamodar/ New_Home_Page/ lectures/ val. html), Prof. Aswa
th Damodaran; Equity Valuation (http:/ / www. duke. edu/ ~charvey/ Classes/ ba35
0_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. h
tml) 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 & R
ichard Shockley [8] See: Decision Tree Analysis (http:/ / www. mindtools. com/ p
ages/ article/ newTED_04. htm), mindtools.com; Decision Tree Primer (http:/ / ww
w. public. asu. edu/ ~kirkwood/ DAStuff/ decisiontrees/ index. html), Prof. Crai
g 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:ISB
N0070580316#v=onepage& q& f=false), Jae K. Shim and Joel G. Siegel. [10] See: Id
entifying real options (http:/ / faculty. fuqua. duke. edu/ ~charvey/ Teaching/
BA456_2002/ Identifying_real_options. htm), Prof. Campbell R. Harvey; Applicatio
ns 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. expectations
investing. com/ tutorial11. shtml), Prof. Alfred Rappaport Columbia University &
Michael Mauboussin [11] See Probabilistic Approaches: Scenario Analysis, Decisi
on Trees and Simulations (http:/ / www. stern. nyu. edu/ ~adamodar/ pdfiles/ pap
ers/ probabilistic. pdf), Prof. Aswath Damodaran [12] See: The Financing Decisio
n of the Corporation (http:/ / www. bus. lsu. edu/ academics/ finance/ faculty/
dchance/ Instructional/ FinancialManagementDecisions. ppt#256,1,Slide), Prof. Do
n M. Chance; Capital Structure (http:/ / pages. stern. nyu. edu/ ~adamodar/ pdfi
les/ 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 (htt
p:/ / www. treasury. govt. nz/ publicsector/ workingcapital/ chap2. asp), treasu
ry.govt.nz [15] See The 20 Principles of Financial Management (http:/ / www. bus
. lsu. edu/ academics/ finance/ faculty/ dchance/ Instructional/ PrinciplesofFin
ancialManagement. htm), Prof. Don M. Chance, Louisiana State University [16] Bea
ney, Shaun, "Defining corporate finance in the UK" (http:/ / www. icaew. co. uk/
index. cfm?route=122299), The Institute of Chartered Accountants, April 2005 [1
7] See Professional Risk Managers International Association (http:/ / www. prmi
a. 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 sect
or of the economy based on its operation, i.e. retail, corporate, investment ban
king, etc.
Financial capital vs. real capital
Financial capital or just capital in finance and accounting, refers to the funds
provided by lenders (and investors) to businesses to purchase real capital equi
pment for producing goods/services. Real Capital or Economic Capital comprises p
hysical goods that assist in the production of other goods and services, e.g. sh
ovels for gravediggers, sewing machines for tailors, or machinery and tooling fo
r factories.
Capital exports in 2006
Capital imports in 2006 Financial capital generally refers to saved-up financial
wealth, especially that used to start or maintain a business. A financial conce
pt of capital is adopted by most entities in preparing their financial reports.
Under a financial concept of capital, such as invested money or invested purchas
ing power, capital is synonymous with the net assets or equity of the entity. Un
der a physical concept of capital, such as operating capability, capital is rega
rded as the productive capacity of the entity based on, for example, units of ou
tput per day.[1] Financial capital maintenance can be measured in either nominal
monetary units or units of constant purchasing power. [2] There are thus three
concepts of capital maintenance in terms of International Financial Reporting St
andards (IFRS): (1) Physical capital maintenance (2) Financial capital maintenan
ce in nominal monetary units (3) Financial capital maintenance in units of const
ant purchasing power.[3]
Financial capital is provided by lenders for a price: interest. Also see time va
lue of money for a more detailed description of how financial capital may be ana
lyzed. Furthermore, financial capital, is any liquid medium or mechanism that re
presents 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 immediatel
y required and saving the surplus. Financial capital has been subcategorized by
some academics as economic or productive capital necessary for operations, signa
ling capital which signals a company s financial strength to shareholders, and r
egulatory capital which fulfills capital requirements.[4]
Sources of capital
• Long term - usually above 7 years • • • • • • Share Capital Mortgage loan Retained Profit
nture Capital Debenture Project Finance
• Medium term - usually between 2 and 7 years • Term Loans
Financial capital • Leasing • Hire Purchase • Short term - usually under 2 years • • • • Ba
Overdraft Trade Credit Deferred Expenses Factoring
27
Capital market
• Long-term funds are bought and sold: • • • • • Shares Debentures Long-term loans, often w
th 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 sho
rt-term loans: • • • • • Credit on open account Bank overdraft Short-term loans Bills of e
xchange Factoring of debtors
Differences between shares and debentures
• Shareholders are effectively owners; debenture-holders are creditors. • Shareholde
rs may vote at AGMs and be elected as directors; debenture-holders may not vote
at AGMs or be elected as directors. • Shareholders receive profit in the form of d
ividends; debenture-holders receive a fixed rate of interest. • If there is no pro
fit, the shareholder does not receive a dividend; interest is paid to debenture-
holders regardless of whether or not a profit has been made. • In case of dissolut
ion of firms debenture holders are paid first as compared to shareholder.
Fixed capital
This is money which is used to purchase assets that will remain permanently in t
he business and help it to make a profit.
Factors determining fixed capital requirements
• • • • Nature of business Size of business Stage of development Capital invested by the
owners
• location of that area
Financial capital
28
Working capital
Working capital is money which is used to buy stock, pay expenses and finance cr
edit.
Factors determining working capital requirements
• • • • • • • • • • • • Size of business Stage of development Time of production Rate of st
ratio Buying and selling terms Seasonal consumption Seasonal product profit leve
l growth and expansion production cycle general nature of business business cycl
e
Instruments
A contract regarding any combination of capital assets is called a financial ins
trument, and may serve as a • • • • medium of exchange, standard of deferred payment, un
it of account, or store of value.
Most indigenous forms of money (wampum, shells, tally sticks and such) and the m
odern fiat money is only a "symbolic" storage of value and not a real storage of
value like commodity money.
Capital vs. money
Liquidity requirements of these vary significantly – leading to a diversity of con
tracts and financial markets to trade them on. When all four functions are serve
d by one instrument, this is called money, which does not need to be traded on f
inancial markets since the risk of loss of value of money is uniform across the
whole society. Where no one form of money is agreed to have reliable value, and
barter is undesirable, less liquid or more diverse instruments have served the f
our functions. This article focuses mostly on financial instruments which are no
t uniformly affected by native currency inflation and which are not guaranteed b
y a state.
Own and borrowed capital
Capital contributed by the owner or entrepreneur of a business, and obtained, fo
r example, by means of savings or inheritance, is known as own capital or equity
, whereas that which is granted by another person or institution is called borro
wed capital, and this must usually be paid back with interest. The ratio between
debt and equity is named leverage. It has to be optimized as a high leverage ca
n bring a higher profit but create solvency risk.
Borrowed capital
This is capital which the business borrows from institutions or people, and incl
udes debentures: • Redeemable debentures • Irredeemable debentures
Financial capital • Debentures to bearer • Ordinary debentures
29
Own capital
This is capital that owners of a business (shareholders and partners, for exampl
e) provide: • Preference shares/hybrid source of finance • Ordinary preference share
s • Cumulative preference shares • Participating preference shares • Ordinary shares • B
onus shares • Founders shares These have preference over the equity shares. This
means the payments made to the shareholders are first paid to the preference sha
reholder(s) and then to the equity shareholders.
Issuing and trading
Like money, financial instruments may be "backed" by state military fiat, credit
(i.e. social capital held by banks and their depositors), or commodity resource
s. Governments generally closely control the supply of it and usually require so
me "reserve" be held by institutions granting credit. Trading between various na
tional currency instruments is conducted on a money market. Such trading reveals
differences in probability of debt collection or store of value function of tha
t currency, as assigned by traders. When in forms other than money, financial ca
pital may be traded on bond markets or reinsurance markets with varying degrees
of trust in the social capital (not just credits) of bond-issuers, insurers, and
others who issue and trade in financial instruments. When payment is deferred o
n any such instrument, typically an interest rate is higher than the standard in
terest rates paid by banks, or charged by the central bank on its money. Often s
uch instruments are called fixed-income instruments if they have reliable paymen
t schedules associated with the uniform rate of interest. A variable-rate instru
ment, such as many consumer mortgages, will reflect the standard rate for deferr
ed payment set by the central bank prime rate, increasing it by some fixed perce
ntage. Other instruments, such as citizen entitlements, e.g. "U.S. Social Securi
ty", or other pensions, may be indexed to the rate of inflation, to provide a re
liable value stream. Trading in stock markets or commodity markets is actually t
rade in underlying assets which are not wholly financial in themselves, although
they often move up and down in value in direct response to the trading in more
purely financial derivatives. Typically commodity markets depend on politics tha
t affect international trade, e.g. boycotts and embargoes, or factors that influ
ence natural capital, e.g. weather that affects food crops. Meanwhile, stock mar
kets are more influenced by trust in corporate leaders, i.e. individual capital,
by consumers, i.e. social capital or "brand capital" (in some analyses), and in
ternal organizational efficiency, i.e. instructional capital and infrastructural
capital. Some enterprises issue instruments to specifically track one limited d
ivision or brand. "Financial futures", "Short selling" and "financial options" a
pply to these markets, and are typically pure financial bets on outcomes, rather
than being a direct representation of any underlying asset.
Financial capital
30
Broadening the notion
The relationship between financial capital, money, and all other styles of capit
al, especially human capital or labor, is assumed in central bank policy and reg
ulations regarding instruments as above. Such relationships and policies are cha
racterized by a political economy - feudalist, socialist, capitalist, green, ana
rchist or otherwise. In effect, the means of money supply and other regulations
on financial capital represent the economic sense of the value system of the soc
iety itself, as they determine the allocation of labor in that society. So, for
instance, rules for increasing or reducing the money supply based on perceived i
nflation, or on measuring well-being, reflect some such values, reflect the impo
rtance of using (all forms of) financial capital as a stable store of value. If
this is very important, inflation control is key - any amount of money inflation
reduces the value of financial capital with respect to all other types. If, how
ever, the medium of exchange function is more critical, new money may be more fr
eely issued regardless of impact on either inflation or well-being.
Marxian perspectives
It is common in Marxist theory to refer to the role of "Finance Capital" as the
determining and ruling class interest in capitalist society, particularly in the
latter stages.[5] [6]
Valuation
Normally, a financial instrument is priced accordingly to the perception by capi
tal market players of its expected return and risk. Unit of account functions ma
y come into question if valuations of complex financial instruments vary drastic
ally based on timing. The "book value", "mark-to-market" and "mark-to-future"[7]
conventions are three different approaches to reconciling financial capital val
ue 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 var
ious political restrictions to deal with that. Finance capitalism is the product
ion 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 Fina
mons 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, P
ar 102 [2] (http:/ / www. aasb. com. au/ admin/ file/ content105/ c9/ Framework_
07-04nd. pdf) Framework for the Preparation and Presentation of Financial Statem
ents, Par 104 [3] (http:/ / www. aasb. com. au/ admin/ file/ content105/ c9/ Fra
mework_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 (h
ttp:/ / www. irmi. com/ ). [5] Imperialism, the Highest Stage of Capitalism ibid
. Finance Capital and the Finance Oligarchy (http:/ / www. marxists. org/ archiv
e/ lenin/ works/ 1916/ imp-hsc/ ch03. htm) [6] Monopoly-Finance Capital and the
Paradox of Accumulation John Bellamy Foster and Robert W. McChesney [[Monthly Re
view (http:/ / www. monthlyreview. org/ 091001foster-mcchesney. php)] Sept-Oct 2
009] [7] The New Generation of Risk Management for Hedge Funds and Private Equit
y Investments (http:/ / books. google. com/ books?id=2w0bRIv7cygC& pg=PA349& lpg
=PA349& dq="mark-to-future"& source=bl& ots=-wAo4Ibldg& sig=a8u9-GRjc2ng_8ltgiKn
us_cURk& hl=en& ei=l0YSSs_oEpLhtgea6oCSBA& sa=X& oi=book_result& ct=result& resn
um=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 Y
ork: Palgrave Macmillan, 2008, chapters 7-8
Cornering the market
In finance, to corner the market is to purchase enough of a particular stock, co
mmodity, or other asset to allow the price to be manipulated, by analogy to the
general business jargon where a company described as having "cornered the market
" has a very high market share. The cornerer hopes to gain control of enough of
the supply of the commodity to be able to set the price for it. This can be done
through several mechanisms. The most direct strategy is to simply buy up a larg
e percentage of the available commodity offered for sale in some spot market and
hoard it. With the advent of futures trading, a cornerer may buy a large number
of futures contracts on a commodity and then sell them at a profit after inflat
ing the price. Although there have been many attempts to corner markets in every
thing from tin to cattle, to date very few of these attempts have ever succeeded
; instead, most of these attempted corners have tended to break themselves spont
aneously. Indeed, as long ago as 1923, Edwin Lefèvre wrote, "very few of the great
corners were profitable to the engineers of them."[1] A cornerer can become vul
nerable due to the size of the position, especially if the attempt becomes widel
y known. If the rest of the market senses weakness, it may resist any attempt to
artificially drive the market any further by actively taking opposing positions
. If the price starts to move against the cornerer, any attempt by the cornerer
to sell would likely cause the price to drop substantially. In such a situation,
many other parties could profit from the cornerer's need to unwind the position
.
Cornering the market
32
Historical examples
1800s: Classic examples by Edwin Lefèvre
Journalist Edwin Lefèvre lists several examples of corners from the mid-1800s. He
distinguishes corners as the result of manipulations from corners as the result
of competitive buying. Cornelius Vanderbilt and the Harlem Railroad One of the f
ew cornerers whose rationale was published and justified, Vanderbilt started acc
umulating shares of the Harlem Railroad in 1862 because he anticipated its strat
egic value. He took control of the Harlem Railroad and later explained that he w
anted to show that he could take this railroad, which was generally considered w
orthless, and make it valuable. The corner of June 25 1863 can be seen as just a
n episode in a strategic investment that served the public well. James Fisk, Jay
Gould and the Black Friday (1869) A financial panic in the United States caused
by two speculators’ efforts to corner the gold market on the New York Gold Exchan
ge. It was one of several scandals that rocked the presidency of Ulysses S. Gran
t. When the government gold hit the market, the premium plummeted within minutes
and many Investors were ruined. Fisk and Gould escaped significant financial ha
rm. Lefèvre thoughts on corners of the old days In chapter 19 of his book, Edwin L
efèvre tries to summarize the rationale for the corners of the 19th century.
“
A wise old broker told me that all the big operators of the 60s and 70s had one
ambition, and that was to work a corner. In many cases this was the offspring of
vanity; in others, of the desire for revenge. [..] It was more than the prospec
tive money profit that prompted the engineers of corners to do their damnedest.
It was the vanity complex asserting itself among cold-bloodest operators.
”
1900s: The Northern Pacific Railway
This corner on May 9, 1901, is a well documented case of competitive buying, res
ulting in a panic. The 2009 Annotated Edition of Reminiscences of a Stock Operat
or contains Lefèvre s original account in chapter 3 as well as modern annotations
explaining the actual locations and personalities on the page margins.
1920s: The Stutz Motor Company
Called a forerunner of the Livermore and Cutten operations of a few years later
by historian Robert Sobel, this corner of March 1920 is an example of a manipula
ted corner ruining everyone involved, especially its originator Thomas Fortune R
yan.
1950s: The onion market
In the late 1950s, United States onion farmers alleged that Chicago Mercantile E
xchange traders were attempting to corner the market on onions. Their complaints
resulted in the passage of the Onion Futures Act, which banned trading in onion
futures in the United States and remains in effect as of 2010.
1970s: The Hunt brothers and the silver market
Brothers Nelson Bunker Hunt and Herbert Hunt attempted to corner the world silve
r markets in the late 1970s and early 1980s, at one stage holding the rights to
more than half of the world s deliverable silver.[2] During the Hunts accumulat
ion of the precious metal, silver prices rose from $11 an ounce in September 197
9 to nearly $50 an ounce in January 1980.[3] Silver prices ultimately collapsed
to below $11 an ounce two months later,[4] much of the fall
Cornering the market occurring on a single day now known as Silver Thursday, due
to changes made to exchange rules regarding the purchase of commodities on marg
in.[5]
33
1990s: Hamanaka and the copper market
Rogue trader Yasuo Hamanaka, Sumitomo Corporation s chief copper trader, attempt
ed to corner the international copper market over a ten year period leading up t
o 1996.[6] At one point during this "Sumitomo copper affair," Hamanaka is believ
ed to have controlled approximately 5% of the world copper market.[6] As his sch
eme collapsed, Sumitomo was left with large positions in the copper market, ulti
mately losing US$2.6 billion.[7] In 1997 Hamanaka pleaded guilty to criminal cha
rges stemming from his trading activity and was sentenced to an eight year priso
n sentence.[7]
2008: Porsche and shares in Volkswagen
During the financial crisis of 2007-2010 Porsche cornered the market in shares o
f Volkswagen, which briefly saw Volkswagen become the world s most valuable comp
any.[8] Porsche claimed that its actions were intended to gain control of Volksw
agen rather than to manipulate the market: in this case, while cornering the mar
ket in Volkswagen shares, Porsche contracted with naked shorts—enabling it to perf
orm a short squeeze on them.[9] It was ultimately unsuccessful, leading to the r
esignation of Porsche s chief executive and financial director and to the merger
of Porsche into Volkswagen.[10] As a tragic consequence of this unprecedented c
orner, one of the wealthiest men in Germany s industry committed suicide after s
horting Volkswagen shares. Boyes, Roger (2009-01-07). "Adolf Merckle, German tyc
oon who lost millions on VW shares, commits suicide" [11]. London: The Sunday Ti
mes.
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, causin
g hundreds of millions of dollars in losses for the latter.
References
[1] Lefèvre, Edwin (1923), Reminiscences of a Stock Operator, chapter 19. [2] Gwyn
ne, S. C. (September 2001), "Bunker HUNT", Texas Monthly (Austin, Texas, United
States: Emmis Communications Corporation) 29 (9): p78. [3] Eichenwald, Kurt (198
9-12-21). "2 Hunts Fined And Banned From Trades" (http:/ / query. nytimes. com/
gst/ fullpage. html?res=950DE0DD103FF932A15751C1A96F948260). New York Times. . R
etrieved 2008-06-29. [5] "Bunker s Busted Silver Bubble" (http:/ / www. time. co
m/ 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 ca
lls on rogue traders keep ringing, but who s answering the phone?" (http:/ / bus
iness. theage. com. au/ wakeup-calls-on-rogue-traders-keep-ringing-but-whos-answ
ering-the-phone-20080201-1plq. html), The Age (Melbourne), , retrieved 2008-06-2
9 [7] Petersen, Melody (1999-05-21), "Merrill Charged With 2d Firm In Copper Cas
e" (http:/ / query. nytimes. com/ gst/ fullpage. html?res=9E00E0DC1F3EF932A15756
C0A96F958260& 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/ bus
iness/ 7697082. stm). BBC. 2008-10-29. . [9] "Squeezy money" (http:/ / www. econ
omist. 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 T
imes; "Porsche crashes into controversy in the ultimate short squeeze " (http:/
/ www. telegraph. co. uk/ finance/ globalbusiness/ 3362913/ Porsche-crashes-int
o-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/ 81
65524. 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 h
edge against the risk of a contingent, uncertain loss. Insurance is defined as t
he equitable transfer of the risk of a loss, from one entity to another, in exch
ange 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 amoun
t of insurance coverage, called the premium. Risk management, the practice of ap
praising and controlling risk, has evolved as a discrete field of study and prac
tice. The transaction involves the insured assuming a guaranteed and known relat
ively small loss in the form of payment to the insurer in exchange for the insur
er s promise to compensate (indemnify) the insured in the case of a loss. The in
sured receives a contract, called the insurance policy, which details the condit
ions 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 p
rotected from risk for a fee, with the fee being dependent upon the frequency an
d severity of the event occurring. In order to be insurable, the risk insured ag
ainst must meet certain characteristics in order to be an insurable risk. Insura
nce is a commercial enterprise and a major part of the financial services indust
ry, but individual entities can also self-insure through saving money for possib
le future losses.[1]
Insurability
Risk which can be insured by private companies typically share seven common char
acteristics:[2] 1. Large number of similar exposure units. Since insurance opera
tes through pooling resources, the majority of insurance policies are provided f
or individual members of large classes, allowing insurers to benefit from the la
w of large numbers in which predicted losses are similar to the actual losses. E
xceptions include Lloyd s of London, which is famous for insuring the life or he
alth of actors, sports figures and other famous individuals. However, all exposu
res 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 f
rom a known cause. The classic example is death of an insured person on a life i
nsurance policy. Fire, automobile accidents, and worker injuries may all easily
meet this criterion. Other types of losses may only be definite in theory. Occup
ational disease, for instance, may involve prolonged exposure to injurious condi
tions 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. Acciden
tal 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 on
ly the opportunity for cost. Events that contain speculative elements, such as o
rdinary business risks or even purchasing a lottery ticket, are generally not co
nsidered 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 expect
ed cost of losses, plus the cost of issuing and administering the policy, adjust
ing losses, and supplying the capital needed to reasonably assure that the insur
er will be able to pay claims. For small losses these latter costs may be severa
l times the size of the expected cost of losses. There is hardly any point in pa
ying such costs unless the protection offered has real value to a buyer. 5. Affo
rdable 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, ev
en if on offer. Further, as the accounting profession formally recognizes in fin
ancial accounting
Insurance standards, the premium cannot be so large that there is not a reasonab
le chance of a significant loss to the insurer. If there is no such chance of lo
ss, 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 c
alculable: 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 o
f a reasonable person in possession of a copy of the insurance policy and a proo
f of loss associated with a claim presented under that policy to make a reasonab
ly 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 zon
es. 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 valu
e is well in excess of any individual insurer s capital constraint. Such propert
ies are generally shared among several insurers, or are insured by a single insu
rer who syndicates the risk into the reinsurance market.
35
Legal
When a company insures an individual entity, there are basic legal requirements.
Several commonly cited legal principles of insurance include:[3] 1. Indemnity – t
he insurance company indemnifies, or compensates, the insured in the case of cer
tain losses only up to the insured s interest. 2. Insurable interest – the insured
typically must directly suffer from the loss. Insurable interest must exist whe
ther property insurance or insurance on a person is involved. The concept requir
es 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 invol
ved 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 bon
d of honesty and fairness. Material facts must be disclosed. 4. Contribution – ins
urers which have similar obligations to the insured contribute in the indemnific
ation, according to some method. 5. Subrogation – the insurance company acquires l
egal rights to pursue recoveries on behalf of the insured; for example, the insu
rer may sue those liable for insured s loss. 6. Causa proxima, or proximate caus
e – 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 th
at one was in, to the extent possible, prior to the happening of a specified eve
nt or peril. Accordingly, life insurance is generally not considered to be indem
nity insurance, but rather "contingent" insurance (i.e., a claim arises on the o
ccurrence of a specified event). There are generally two types of insurance cont
racts 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 un
til the insured has paid out of pocket to some third party; for example, a visit
or 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 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 in
surance is written on the basis of "pay on behalf" language.[4] An entity seekin
g 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 insura
nce contract includes, at a minimum, the following elements: identification of p
articipating parties (the insurer, the insured, the beneficiaries), the premium,
the period of coverage, the particular loss event covered, the amount of covera
ge (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 "indem
nified" 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 c
laim against the insurer for the covered amount of loss as specified by the poli
cy. The fee paid by the insured to the insurer for assuming the risk is called t
he premium. Insurance premiums from many insureds are used to fund accounts rese
rved for later payment of claims — in theory for a relatively few claimants — and fo
r overhead costs. So long as an insurer maintains adequate funds set aside for a
nticipated losses (called reserves), the remaining margin is an insurer s profit
.
36
Effects
Insurance can have various effects on society through the way that it changes wh
o 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 mitiga
te the effects of catastrophes on both households and societies. Insurance can i
nfluence the probability of losses through moral hazard, insurance fraud, and pr
eventive steps by the insurance company. Insurance scholars have typically used
morale hazard to refer to the increased loss due to unintentional carelessness a
nd moral hazard to refer to increased risk due to intentional carelessness or in
difference.[6] Insurers attempt to address carelessness through inspections, pol
icy provisions requiring certain types of maintenance, and possible discounts fo
r loss mitigation efforts. While in theory insurers could encourage investment i
n loss reduction, some commentators have argued that in practice insurers had hi
storically not aggressively pursued loss control measures - particularly to prev
ent disaster losses such as hurricanes - because of concerns over rate reduction
s and legal battles. However, since about 1996 insurers began to take a more act
ive role in loss mitigation, such as through building codes.[7]
Insurers business model
Underwriting and investing
The business model is to collect more in premium and investment income than is p
aid out in losses, and to also offer a competitive price which consumers will ac
cept. Profit can be reduced to a simple equation: Profit = earned premium + inve
stment income - incurred loss - underwriting expenses. Insurers make money in tw
o ways: 1. Through underwriting, the process by which insurers select the risks
to insure and decide how much in premiums to charge for accepting those risks; 2
. By investing the premiums they collect from insured parties. The most complica
ted aspect of the insurance business is the actuarial science of ratemaking (pri
ce-setting) of policies, which uses statistics and probability to approximate th
e rate of future claims based on a given risk. After producing rates, the insure
r will use discretion to reject or accept risks through the underwriting process
.
Insurance At the most basic level, initial ratemaking involves looking at the fr
equency 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 expe
nse loads are also used. Rating for different risk characteristics involves at t
he most basic level comparing the losses with "loss relativities" - a policy wit
h twice as money policies would therefore be charged twice as much. However, mor
e complex multivariate analyses through generalized linear modeling are sometime
s used when multiple characteristics are involved and a univariate analysis coul
d produce confounded results. Other statistical methods may be used in assessing
the probability of future losses. Upon termination of a given policy, the amoun
t of premium collected and the investment gains thereon, minus the amount paid o
ut 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 pe
rcent indicates underwriting profitability, while anything over 100 indicates an
underwriting loss. A company with a combined ratio over 100% may nevertheless r
emain 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 c
laims are paid out. The Association of British Insurers (gathering 400 insurance
companies and 94% of UK insurance services) has almost 20% of the investments i
n 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 e
nding 2003. But overall profit for the same period was $68.4 billion, as the res
ult 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 a
n underwriting profit as well, but this opinion is not universally held. Natural
ly, the float method is difficult to carry out in an economically-depressed peri
od. Bear markets do cause insurers to shift away from investments and to toughen
up their underwriting standards, so a poor economy generally means high insuran
ce premiums. This tendency to swing between profitable and unprofitable periods
over time is commonly known as the underwriting, or insurance, cycle.[11]
37
Claims
Claims and loss handling is the materialized utility of insurance; it is the act
ual "product" paid for. Claims may be filed by insureds directly with the insure
r 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 l
arge number of claims adjusters supported by a staff of records management and d
ata entry clerks. Incoming claims are classified based on severity and are assig
ned to adjusters whose settlement authority varies with their knowledge and expe
rience. The adjuster undertakes an investigation of each claim, usually in close
cooperation with the insured, determines if coverage is available under the ter
ms of the insurance contract, and if so, the reasonable monetary value of the cl
aim, and authorizes payment. The policyholder may hire their own public adjuster
to negotiate the settlement with the insurance company on their behalf. For pol
icies that are complicated, where claims may be complex, the insured may take ou
t a separate insurance policy add on, called loss recovery insurance, which cove
rs the cost of a public adjuster in the case of a claim. Adjusting liability ins
urance claims is particularly difficult because there is a third party involved,
the plaintiff, who is under no contractual obligation to cooperate with the ins
urer and may in fact regard the insurer as a deep pocket. The adjuster must obta
in legal counsel for the insured (either inside "house" counsel or outside "pane
l" counsel), monitor litigation that may take years to complete, and appear in p
erson or over the telephone with settlement authority at a mandatory settlement
conference when requested by the judge.
Insurance If a claims adjuster suspects underinsurance, the condition of average
may come into play to limit the insurance company s exposure. In managing the c
laims handling function, insurers seek to balance the elements of customer satis
faction, administrative handling expenses, and claims overpayment leakages. As p
art of this balancing act, fraudulent insurance practices are a major business r
isk that must be managed and overcome. Disputes between insurers and insureds ov
er the validity of claims or claims handling practices occasionally escalate int
o litigation (see insurance bad faith).
38
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 i
ndependent, meaning that they can issue policies from several companies. Commiss
ions to agents represent a significant portion of an insurance cost and insurers
such as GEICO that sell policies directly via mass marketing campaigns can offe
r lower prices. The existence and success of companies using insurance agents (w
ith 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 appearan
ce 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 co
mmunity, we can see insurance in the form of people helping each other. For exam
ple, if a house burns down, the members of the community help build a new one. S
hould 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 insuranc
e has survived to the present day in some countries where modern money economy w
ith its financial instruments is not widespread. Turning to insurance in the mod
ern 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 we
re practised by Chinese and Babylonian traders as long ago as the 3rd and 2nd mi
llennia BC, respectively.[13] Chinese merchants travelling treacherous river rap
ids 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 reco
rded in the famous Code of Hammurabi, c. 1750 BC, and practised by early Mediter
ranean 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 t
o cancel the loan should the shipment be stolen or lost at sea. Achaemenian mona
rchs of Ancient Persia were the first to insure their people and made it officia
l by registering the insuring process in governmental notary offices. The insura
nce tradition was performed each year in Norouz (beginning of the Iranian New Ye
ar); 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 go
ld 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 ass
essed by the confidants of the court. Then the assessment was registered in spec
ial offices. The purpose of registering was that whenever the person who present
ed the gift registered by the court was in trouble, the monarch and the court wo
uld help him. Jahez, a historian and writer, writes in one of his books on ancie
nt Iran: "[W]henever the owner of the present is in trouble or wants to construc
t 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 exce
eded 10,000 Derrik, he or she would receive an amount of twice as much."[14]
Insurance 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 merch
ant whose goods were deliberately jettisoned in order to lighten the ship and sa
ve it from total loss. The Greeks and Romans introduced the origins of health an
d life insurance c. 600 AD when they organized guilds called "benevolent societi
es" 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 seve
ral aspects of insuring goods. Before insurance was established in the late 17th
century, "friendly societies" existed in England, in which people donated amoun
ts of money to a general sum that could be used for emergencies. Separate insura
nce 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 insur
ance to be separated from investment, a separation of roles that first proved us
eful in marine insurance. Insurance became far more sophisticated in post-Renais
sance Europe, and specialized varieties developed. Some forms of insurance had d
eveloped in London by the early decades of the 17th century. For example, the wi
ll of the English colonist Robert Hayman mentions two "policies of insurance" ta
ken 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 i
s 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 u
ntil 1633.[15] Toward the end of the seventeenth century, London s growing impor
tance as a centre for trade increased demand for marine insurance. In the late 1
680s, Edward Lloyd opened a coffee house that became a popular haunt of ship own
ers, merchants, and ships captains, and thereby a reliable source of the latest
shipping news. It became the meeting place for parties wishing to insure cargoe
s and ships, and those willing to underwrite such ventures. Today, Lloyd s of Lo
ndon 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 kn
ow it today can be traced to the Great Fire of Lloyd s of London, pictured in 19
91, is one of the London, which in 1666 devoured more than 13,000 houses. The wo
rld s leading and most famous insurance devastating effects of the fire converte
d 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 numb
er of attempted fire insurance schemes came to nothing, but in 1681 Nicholas Bar
bon, 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 C
ontributionship for the Insurance of Houses from Loss by Fire. Franklin s compan
y was the first to make contributions toward fire prevention. Not only did his c
ompany 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,
39
Insurance regulation of the insurance industry is highly Balkanized, with primar
y responsibility assumed by individual state insurance departments. Whereas insu
rance markets have become centralized nationally and internationally, state insu
rance commissioners operate individually, though at times in concert through a n
ational insurance commissioners organization. In recent years, some have called
for a dual state and federal regulatory system (commonly referred to as the Opt
ional federal charter (OFC)) for insurance similar to that which oversees state
banks and national banks.
40
Types of insurance
Any risk that can be quantified can potentially be insured. Specific kinds of ri
sk that may give rise to claims are known as perils. An insurance policy will se
t 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. Fo
r 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 d
amage to the home and the owner s belongings, certain legal claims against the o
wner, 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 differ
ent forms, such as the various kinds of professional liability insurance, also c
alled professional indemnity (PI), which are discussed below under that name; an
d 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 homeown
ers 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. Covera
ge 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, reha
bilitation 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-rel
ated issues are typically the homeowner s responsibility. The policy may include
inventory, or this can be bought as a separate policy, especially for people wh
o rent housing. In some countries, insurers offer a package which may include li
ability and legal responsibility for injuries and property damage caused by memb
ers 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. I
n the U.S. and Canada, dental insurance is often part of an employer s benefits
package, along with health insurance.
Great Western Hospital, Swindon
Accident, sickness and unemployment insurance
• Disability insurance policies provide financial support in the event of the poli
cyholder becoming unable to work because of disabling illness or injury. It prov
ides monthly support to help pay such obligations as mortgage loans and credit c
ards. Short-term and long-term disability policies are available to individuals,
but considering the expense, long-term policies are generally obtained only by
those with at least six-figure incomes, such as doctors, lawyers, etc. Short-ter
m disability insurance covers a person for a period typically up to six months,
paying a stipend each month to cover medical bills and other necessities.
• Long-term disability insurance covers an individual s expenses for the long term
, up until such time as they are considered permanently disabled and thereafter.
Insurance companies will often try to encourage the person back into employment
in preference to and before declaring them unable to work at all and therefore
totally disabled. • Disability overhead insurance allows business owners to cover
the overhead expenses of their business while they are unable to work. • Total per
manent disability insurance provides benefits when a person is permanently disab
led and can no longer work in their profession, often taken as an adjunct to lif
e insurance. • Workers compensation insurance replaces all or part of a worker s
wages lost and accompanying medical expenses incurred because of a job-related i
njury.
Workers compensation, or employers liability insurance, is compulsory in some
countries
Insurance
42
Casualty
Casualty insurance insures against accidents, not necessarily tied to any specif
ic 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 lia
bility insurances. • Crime insurance is a form of casualty insurance that covers t
he policyholder against losses arising from the criminal acts of third parties.
For example, a company can obtain crime insurance to cover losses arising from t
heft or embezzlement. • Political risk insurance is a form of casualty insurance t
hat can be taken out by businesses with operations in countries in which there i
s 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 des
ignated beneficiary, and may specifically provide for income to an insured perso
n s family, burial, funeral and other final expenses. Life insurance policies of
ten 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 compa
nies, are regulated as insurance, and require the same kinds of actuarial and in
vestment management expertise that life insurance requires. Annuities and pensio
ns that pay a benefit for life are sometimes regarded as insurance against the p
ossibility that a retiree will outlive his or her financial resources. In that s
ense, they are the complement of life insurance and, from an underwriting perspe
ctive, 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 surre
ndered or which may be borrowed against. Some policies, such as annuities and en
dowment policies, are financial instruments to accumulate or liquidate wealth wh
en it is needed. In many countries, such as the U.S. and the UK, the tax law pro
vides that the interest on this cash value is not taxable under certain circumst
ances. 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 ta
x on interest income on life insurance policies and annuities is generally defer
red. 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 sav
ing vehicles (e.g., IRAs, 401(k) plans, Roth IRAs) may be better alternatives fo
r 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 m
arine insurance or boiler insurance. The term property insurance may, like casua
lty insurance, be used as a broad category of various subtypes of insurance, som
e of which are listed below:
This tornado damage to an Illinois home would be considered an "Act of God" for
insurance purposes
Insurance
43
• Aviation insurance protects aircraft hulls and spares, and associated liability
risks, such as passenger and third-party liability. Airports may also appear und
er this subcategory, including air traffic control and refuelling operations for
international airports through to smaller domestic exposures. • Boiler insurance
(also known as boiler and machinery insurance, or equipment breakdown insurance)
insures against accidental physical damage to boilers, equipment or machinery.
US Airways Flight 1549 was written off after ditching into the Hudson River
• Builder s risk insurance insures against the risk of physical loss or damage to
property during construction. Builder s risk insurance is typically written on a
n "all risk" basis covering damage arising from any cause (including the neglige
nce of the insured) not otherwise expressly excluded. Builder s risk insurance i
s coverage that protects a person s or organization s insurable interest in mate
rials, fixtures and/or equipment being used in the construction or renovation of
a building or structure should those items sustain physical loss or damage from
an insured peril.[20] • Crop insurance may be purchased by farmers to reduce or m
anage various risks associated with growing crops. Such risks include crop loss
or damage caused by weather, hail, drought, frost damage, insects, or disease.[2
1] • Earthquake insurance is a form of property insurance that pays the policyhold
er in the event of an earthquake that causes damage to the property. Most ordina
ry 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. • Fidel
ity bond is a form of casualty insurance that covers policyholders for losses in
curred as a result of fraudulent acts by specified individuals. It usually insur
es a business for losses caused by the dishonest acts of its employees. • Flood in
surance 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 th
is, the federal government created the National Flood Insurance Program which se
rves as the insurer of last resort. • Home insurance, also commonly called hazard
insurance, or homeowners insurance (often abbreviated in the real estate industr
y as HOI), is the type of property insurance that covers private homes, as outli
ned above.
Hurricane Katrina caused over $80bn of storm and flood damage
• Landlord insurance covers residential and commercial properties which are rented
to others. Most homeowners insurance covers only owner-occupied homes. • Marine
insurance and marine cargo insurance cover the loss or damage of vessels at sea
or on inland waterways, and of cargo in transit, regardless of the method of tra
nsit. When the owner of the cargo and the carrier are separate corporations, mar
ine cargo insurance typically compensates the owner of cargo for losses sustaine
d from fire, shipwreck, etc., but excludes losses that can be recovered from the
carrier or the carrier s insurance. Many marine insurance underwriters will inc
lude "time element" coverage in such policies, which extends the indemnity to co
ver loss of profit and
Fire aboard MV Hyundai Fortune
Insurance other business expenses attributable to the delay caused by a covered
loss. • Supplemental natural disaster insurance covers specified expenses after a
natural disaster renders the policyholder s home uninhabitable. Periodic payment
s are made directly to the insured until the home is rebuilt or a specified time
period has elapsed. • Surety bond insurance is a three-party insurance guaranteei
ng the performance of the principal. • Terrorism insurance provides protection aga
inst any loss or damage caused by terrorist activities. In the U.S. in the wake
of 9/11, the Terrorism Risk Insurance Act 2002 (TRIA) set up a federal Program p
roviding a transparent system of shared public and private compensation for insu
red losses resulting from acts of terrorism. The program was extended until the
end of 2014 by the Terrorism Risk Insurance Program Reauthorization Act 2007 (TR
IPRA). • Volcano insurance is a specialized insurance protecting against damage ar
ising specifically from volcanic eruptions. • Windstorm insurance is an insurance
covering the damage that can be caused by wind events such as hurricanes.
The demand for terrorism insurance surged after 9/11
44
Liability
Liability insurance is a very broad superset that covers legal claims against th
e 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 liab
ility insurance that indemnifies against the harm that a crashing car can cause
to others lives, health, or property. The protection offered by a liability ins
urance policy is twofold: a legal defense in the event of a lawsuit commenced ag
ainst the policyholder and indemnification (payment on behalf of the insured) wi
th 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 i
ntentional 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 wi
th litigation resulting from errors made by directors and officers for which the
y are liable. • Environmental liability insurance protects the insured from bodily
injury, property damage and cleanup costs as a result of the dispersal, release
or escape of pollutants.
The subprime mortgage crisis was the source of 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-par
ty administrators (TPAs) and other business professionals. • Prize indemnity insur
ance protects the insured from giving away a large prize at a specific event. Ex
amples would include offering prizes to contestants who can make a half-court sh
ot at a basketball game, or a hole-in-one at a golf tournament. • Professional lia
bility insurance, also called professional indemnity insurance (PI), protects in
sured professionals such as architectural corporations and medical practictioner
s against potential negligence claims made by their
Insurance patients/clients. Professional liability insurance may take on differe
nt names depending on the profession. For example, professional liability insura
nce in reference to the medical profession may be called medical malpractice ins
urance.
45
Credit
Credit insurance repays some or all of a loan when certain circumstances arise t
o the borrower such as unemployment, disability, or death. • Mortgage insurance in
sures the lender against default by the borrower. Mortgage insurance is a form o
f credit insurance, although the name "credit insurance" more often is used to r
efer 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 per
ils, except those noted in the policy. All-risk insurance is different from peri
l-specific insurance that cover losses from only those perils listed in the poli
cy.[22] In car insurance, all-risk policy includes also the damages caused by th
e own driver. • Bloodstock insurance covers individual horses or a number of horse
s under common ownership. Coverage is typically for mortality as a result of acc
ident, 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 proper
ty (primarily vehicles) held as collateral for loans made by lending institution
s.
High-value horses may be insured under a bloodstock policy
• Defense Base Act (DBA) insurance provides coverage for civilian workers hired by
the government to perform contracts outside the U.S. and Canada. DBA is require
d for all U.S. citizens, U.S. residents, U.S. Green Card holders, and all employ
ees or subcontractors hired on overseas government contracts. Depending on the c
ountry, foreign nationals must also be covered under DBA. This coverage typicall
y includes expenses related to medical treatment and loss of wages, as well as d
isability and death benefits. • Expatriate insurance provides individuals and orga
nizations operating outside of their home country with protection for automobile
s, property, health, liability and business pursuits. • Kidnap and ransom insuranc
e is designed to protect individuals and corporations operating in high-risk are
as around the world against the perils of kidnap, extortion, wrongful detention
and hijacking. • Legal expenses insurance covers policyholders for the potential c
osts of legal action against an institution or an individual. When something hap
pens which triggers the need for legal action, it is known as "the event". There
are two main types of legal expenses insurance: before the event insurance and
after the event insurance. • Locked funds insurance is a little-known hybrid insur
ance policy jointly issued by governments and banks. It is used to protect publi
c funds from tamper by unauthorized parties. In special cases, a government may
authorize its use in protecting semi-private funds which are liable to tamper. T
he terms of this type of insurance are usually very strict. Therefore it is used
only in extreme cases where maximum security of funds is required. • Livestock in
surance is a specialist policy provided to, for example, commercial or hobby far
ms, aquariums, fish farms or any other animal holding. Cover is available for mo
rtality or economic slaughter as a result of accident, illness or disease but ca
n extend to include destruction by government order.
Insurance
46
• Media liability insurance is designed to cover professionals that engage in film
and television production and print, against risks such as defamation. • Nuclear
incident insurance covers damages resulting from an incident involving radioacti
ve materials and is generally arranged at the national level. (See the nuclear e
xclusion clause and for the U.S. the Price-Anderson Nuclear Industries Indemnity
Act.) • Pet insurance insures pets against accidents and illnesses; some companie
s cover routine/wellness care and burial, as well.
• Pollution insurance usually takes the form of first-party coverage libel claims
for contamination of insured property either by external or on-site sources. Cov
erage is also afforded for liability to third parties arising from contamination
of air, water, or land due to the sudden and accidental release of hazardous ma
terials from the insured site. The policy usually covers the costs of cleanup an
d may include coverage for releases from underground storage tanks. Intentional
acts are specifically excluded.
Media insurances can protect newspapers against
• Purchase insurance is aimed at providing protection on the products people purch
ase. Purchase insurance can cover individual purchase protection, warranties, gu
arantees, care plans and even mobile phone insurance. Such insurance is normally
very limited in the scope of problems that are covered by the policy. • Title ins
urance provides a guarantee that title to real property is vested in the purchas
er and/or mortgagee, free and clear of liens or encumbrances. It is usually issu
ed in conjunction with a search of the public records performed at the time of a
real estate transaction. • Travel insurance is an insurance cover taken by those
who travel abroad, which covers certain losses such as medical expenses, loss of
personal belongings, travel delay, and personal liabilities.
Insurance financing vehicles
• Fraternal insurance is provided on a cooperative basis by fraternal benefit soci
eties or other social organizations.[23] • No-fault insurance is a type of insuran
ce policy (typically automobile insurance) where insureds are indemnified by the
ir own insurer regardless of fault in the incident. • Protected self-insurance is
an alternative risk financing mechanism in which an organization retains the mat
hematically calculated cost of risk within the organization and transfers the ca
tastrophic risk with specific and aggregate limits to an insurer so the maximum
total cost of the program is known. A properly designed and underwritten Protect
ed Self-Insurance Program reduces and stabilizes the cost of insurance and provi
des valuable risk management information. • Retrospectively-rated insurance is a m
ethod of establishing a premium on large commercial accounts. The final premium
is based on the insured s actual loss experience during the policy term, sometim
es subject to a minimum and maximum premium, with the final premium determined b
y a formula. Under this plan, the current year s premium is based partially (or
wholly) on the current year s losses, although the premium adjustments may take
months or years beyond the current year s expiration date. The rating formula is
guaranteed in the insurance contract. Formula: retrospective premium = converte
d loss + basic premium × tax multiplier. Numerous variations of this formula have
been developed and are in use. • Formal self insurance is the deliberate decision
to pay for otherwise insurable losses out of one s own money. This can be done o
n a formal basis by establishing a separate fund into which funds are deposited
on a periodic basis, or by simply forgoing the purchase of available insurance a
nd paying out-of-pocket. Self insurance is usually used to pay for high-frequenc
y, low-severity losses. Such losses, if covered by conventional insurance, mean
having to pay a premium that includes loadings for the company s general expense
s, cost of putting the policy on the books,
Insurance acquisition expenses, premium taxes, and contingencies. While this is
true for all insurance, for small, frequent losses the transaction costs may exc
eed the benefit of volatility reduction that insurance otherwise affords. • Reinsu
rance is a type of insurance purchased by insurance companies or self-insured em
ployers to protect against unexpected losses. Financial reinsurance is a form of
reinsurance that is primarily used for capital management rather than to transf
er insurance risk. • Social insurance can be many things to many people in many co
untries. But a summary of its essence is that it is a collection of insurance co
verages (including components of life insurance, disability income insurance, un
employment insurance, health insurance, and others), plus retirement savings, th
at 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 oth
er concepts such as the justice system and the welfare state. This is a large, c
omplicated topic that engenders tremendous debate, which can be further studied
in the following articles (and others): • • • • • National Insurance Social safety net Soc
ial security Social Security debate (United States) Social Security (United Stat
es)
47
• Social welfare provision • Stop-loss insurance provides protection against catastr
ophic or unpredictable losses. It is purchased by organizations who do not want
to assume 100% of the liability for losses arising from the plans. Under a stop-
loss policy, the insurance company becomes liable for losses that exceed certain
limits called deductibles.
Closed community self-insurance
Some communities prefer to create virtual insurance amongst themselves by other
means than contractual risk transfer, which assigns explicit numerical values to
risk. A number of religious groups, including the Amish and some Muslim groups,
depend on support provided by their communities when disasters strike. The risk
presented by any given person is assumed collectively by the community who all
bear the cost of rebuilding lost property and supporting people whose needs are
suddenly greater after a loss of some kind. In supportive communities where othe
rs can be trusted to follow community leaders, this tacit form of insurance can
work. In this manner the community can even out the extreme differences in insur
ability that exist among its members. Some further justification is also provide
d by invoking the moral hazard of explicit insurance contracts. In the United Ki
ngdom, The Crown (which, for practical purposes, meant the civil service) did no
t insure property such as government buildings. If a government building was dam
aged, the cost of repair would be met from public funds because, in the long run
, this was cheaper than paying insurance premiums. Since many UK government buil
dings have been sold to property companies, and rented back, this arrangement is
now less common and may have disappeared altogether.
Insurance
48
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. G
eneral insurance companies can be further divided into these sub categories. • Sta
ndard lines • Excess lines In most countries, life and non-life insurers are subje
ct to different regulatory regimes and different tax and accounting rules. The m
ain reason for the distinction between the two types of company is that life, an
nuity, and pension business is very long-term in nature — coverage for life assura
nce or a pension can cover risks over many decades. By contrast, non-life insura
nce cover usually covers a shorter period, such as one year. In the United State
s, standard line insurance companies are "mainstream" insurers. These are the co
mpanies that typically insure autos, homes or businesses. They use pattern or "c
ookie-cutter" policies without variation from one person to the next. They usual
ly have lower premiums than excess lines and can sell directly to individuals. T
hey 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 S
urplus) typically insure risks not covered by the standard lines market. They ar
e 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. T
hese companies have more flexibility and can react faster than standard insuranc
e companies because they are not required to file rates and forms as the "admitt
ed" carriers do. However, they still have substantial regulatory requirements pl
aced upon them. State laws generally require insurance placed with surplus line
agents and brokers not to be available through standard licensed insurers. Insur
ance companies are generally classified as either mutual or stock companies. Mut
ual companies are owned by the policyholders, while stockholders (who may or may
not own policies) own stock insurance companies. Demutualization of mutual insu
rers to form stock companies, as well as the formation of a hybrid known as a mu
tual holding company, became common in some countries, such as the United States
, in the late 20th century. Other possible forms for an insurance company includ
e reciprocals, in which policyholders reciprocate in sharing risks, and Lloyd s
organizations. Insurance companies are rated by various agencies such as A. M. B
est. The ratings include the company s financial strength, which measures its ab
ility to pay claims. It also rates financial instruments issued by the insurance
company, such as bonds, notes, and securitization products. Reinsurance compani
es are insurance companies that sell policies to other insurance companies, allo
wing them to reduce their risks and protect themselves from very large losses. T
he reinsurance market is dominated by a few very large companies, with huge rese
rves. A reinsurer may also be a direct writer of insurance risks as well. Captiv
e insurance companies may be defined as limited-purpose insurance companies esta
blished with the specific objective of financing risks emanating from their pare
nt 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-i
nsurance 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 in
sures the collective risks of members of an industry); and of an "association" c
aptive (which self-insures individual risks of the members of a professional, co
mmercial or industrial association). Captives represent commercial, economic and
tax advantages to their sponsors because of the reductions in costs they help c
reate 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 The types of risk that a captive can underwrite for their parents incl
ude property damage, public and product liability, professional indemnity, emplo
yee 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 fin
ancing strategy of their parent. This can be understood against the following ba
ckground: • • • • • heavy and increasing premium costs in almost every line of coverage; d
ifficulties 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 deductibl
es and/or loss control efforts.
49
There are also companies known as insurance consultants . Like a mortgage broke
r, these companies are paid a fee by the customer to shop around for the best in
surance policy amongst many companies. Similar to an insurance consultant, an i
nsurance broker also shops around for the best insurance policy amongst many co
mpanies. 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 clie
nt. Neither insurance consultants nor insurance brokers are insurance companies
and no risks are transferred to them in insurance transactions. Third party admi
nistrators 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 o
f 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 insu
rance carrier is very important. In recent years, a number of insurance companie
s have become insolvent, leaving their policyholders with no coverage (or covera
ge only from a government-backed insurance pool or other arrangement with less a
ttractive payouts for losses). A number of independent rating agencies provide i
nformation and rate the financial viability of insurance companies.
Across the world
Global insurance premiums grew by 3.4% in 2008 to reach $4.3 trillion. For the f
irst time in the past three decades, premium income declined in inflation-adjust
ed terms, with non-life premiums falling by 0.8% and life premiums falling by 3.
5%. The insurance industry is exposed to the global economic downturn on the ass
ets side by the decline in returns on investments and on the liabilities side by
a rise in claims. So far the extent of losses on both sides has been limited al
though investment returns fell sharply following the bankruptcy of Lehman Brothe
rs and bailout of AIG in September 2008. The financial crisis has shown that the
insurance sector is sufficiently capitalised. The vast majority of insurance co
mpanies had enough capital to absorb losses and only a small number turned to go
vernment for support.
Life insurance premiums written in 2005
Advanced economies account for the bulk of global insurance. With Non-life insur
ance premiums written in 2005 premium income of $1,753bn, Europe was the most im
portant region in 2008, followed by North America $1,346bn and Asia $933bn. The
top four countries generated more than a half of premiums. The US and Japan alon
e accounted for 40% of world insurance, much higher than their 7% share of the g
lobal population. Emerging markets accounted for over 85% of the world’s populatio
n but generated only around 10% of premiums. Their markets are however growing a
t a quicker
Insurance pace.[24]
50
Regulatory differences
In the United States, insurance is regulated by the states under the McCarran-Fe
rguson Act, with "periodic proposals for federal intervention", and a nonprofit
coalition of state insurance agencies called the National Association of Insuran
ce Commissioners works to harmonize the country s different laws and regulations
.[25] The National Conference of Insurance Legislators (NCOIL) also works to har
monize the different state laws.[26] In the European Union, the Third Non-Life D
irective and the Third Life Directive, both passed in 1992 and effective 1994, c
reated a single insurance market in Europe and allowed insurance companies to of
fer insurance anywhere in the EU (subject to permission from authority in the he
ad office) and allowed insurance consumers to purchase insurance from any insure
r in the EU.[27] The insurance industry in China was nationalized in 1949 and th
ereafter offered by only a single state-owned company, the People s Insurance Co
mpany 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 19
95 a comprehensive Insurance Law of the People s Republic of China[28] was passe
d, followed in 1998 by the formation of China Insurance Regulatory Commission (C
IRC), which has broad regulatory authority over the insurance market of China.[2
9]
Controversies
Religious concerns
Muslim scholars have varying opinions about insurance. Insurance policies that e
arn 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 (specula
tion). Some argue that gharar is not present due to the actuarial science behind
the underwriting.[31] Jewish rabbinical scholars also have expressed reservatio
ns 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 Anabap
tist communities (Mennonites, Amish, Hutterites, Brethren in Christ) but many pa
rticipate in community-based self-insurance programs that spread risk within the
ir communities.[34] [35] [36]
Insurance insulates too much
By creating a "security blanket" for its insureds, an insurance company may inad
vertently find that its insureds may not be as risk-averse as they might otherwi
se be (since, by definition, the insured has transferred the risk to the insurer
), a concept known as moral hazard. To reduce their own financial exposure, insu
rance companies have contractual clauses that mitigate their obligation to provi
de coverage if the insured engages in behavior that grossly magnifies their risk
of loss or liability. For example, life insurance companies may require higher
premiums or deny coverage altogether to people who work in hazardous occupations
or engage in dangerous sports. Liability insurance providers do not provide cov
erage for liability arising from intentional torts committed by or at the direct
ion of the insured. Even if a provider were so irrational as to want to provide
such coverage, it is against the public policy of most countries to allow such i
nsurance to exist, and thus it is usually illegal.
Insurance
51
Complexity of insurance policy contracts
Insurance policies can be complex and some policyholders may not understand all
the fees and coverages included in a policy. As a result, people may buy policie
s on unfavorable terms. In response to these issues, many countries have enacted
detailed statutory and regulatory regimes governing every aspect of the insuran
ce business, including minimum standards for policies and the ways in which they
may be advertised and sold. For example, most insurance policies in the English
language today have been carefully drafted in plain English; the industry learn
ed the hard way that many courts will not enforce policies against insureds when
the judges themselves cannot understand what the policies are saying. Typically
, courts construe ambiguities in insurance policies against the insurance compan
y and in favor of coverage under the policy.
9/11 was a major insurance loss, but there were disputes over the World Trade Ce
nter s insurance policy
Many institutional insurance purchasers buy insurance through an insurance broke
r. While on the surface it appears the broker represents the buyer (not the insu
rance company), and typically counsels the buyer on appropriate coverage and pol
icy 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 insuranc
e premium, creating a conflict of interest in that the broker s financial intere
st is tilted towards encouraging an insured to purchase more insurance than migh
t be necessary at a higher price. A broker generally holds contracts with many i
nsurers, 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 b
roker, who represents the policyholder, an agent represents the insurance compan
y from whom the policyholder buys. Just as there is a potential conflict of inte
rest with a broker, an agent has a different type of conflict. Because agents wo
rk 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 ins
urance broker. An independent insurance consultant advises insureds on a fee-for
-service retainer, similar to an attorney, and thus offers completely independen
t advice, free of the financial conflict of interest of brokers and/or agents. H
owever, 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 a
reas, supposedly because of a high likelihood of loss, while the alleged motivat
ion is unlawful discrimination. Racial profiling or redlining has a long history
in the property insurance industry in the United States. From a review of indus
try underwriting and marketing materials, court documents, and research by gover
nment agencies, industry and community groups, and academics, it is clear that r
ace has long affected and continues to affect the policies and practices of the
insurance industry.[37] In July, 2007, The Federal Trade Commission (FTC) releas
ed 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 subs
tantially overrepresented in the lowest credit scores, and substantially underre
presented in the highest, while Caucasians and Asians are more evenly spread acr
oss 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 eva
luate benefit of insurance scores to consumers.[38] The report was disputed by r
epresentatives of the Consumer
Insurance Federation of America, the National Fair Housing Alliance, the Nationa
l 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 rat
e regulation laws or in their fair trade practice acts that prohibit unfair disc
rimination, often called redlining, in setting rates and making insurance availa
ble.[40] In determining premiums and premium rate structures, insurers consider
quantifiable factors, including location, credit scores, gender, occupation, mar
ital status, and education level. However, the use of such factors is often cons
idered 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 us
ed. An insurance underwriter s job is to evaluate a given risk as to the likelih
ood 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, "discrimin
ation" 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 peo
ple 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 differentia
l treatment goes to the heart of the risk a life insurer takes: Old people are l
ikely 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 h
igher to cover the greater risk. However, treating insureds differently when the
re 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, actu
arially sound factors means that an insufficient amount is being charged for a g
iven 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 o
ptions for addressing the deficit seem to be the following: Charge the deficit t
o the other policyholders or charge it to the government (i.e., externalize outs
ide of the company to society at large).
52
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 inven
ted and patented by a major U.S. auto insurance company, Progressive Auto Insura
nce (U.S. Patent 5797134 [41]) and a Spanish independent inventor, Salvador Ming
uijon Perez (EP 0700009 [42]). Many independent inventors are in favor of patent
ing new insurance products since it gives them protection from big companies whe
n they bring their new insurance products to market. Independent inventors accou
nt for 70% of the new U.S. patent applications in this area. Many insurance exec
utives 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 paten
t infringement and theft of trade secret lawsuit for a type of corporate owned l
ife insurance product invented and patented by Bancorp. There are currently abou
t 150 new patent applications on insurance inventions filed per year in the Unit
ed States. The rate at which patents have issued has steadily risen from 15 in 2
002 to 44 in 2006.[43] Inventors can now have their insurance U.S. patent applic
ations reviewed by the public in the Peer to Patent program.[44] The first insur
ance 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
The insurance industry and rent seeking
Certain insurance products and practices have been described as rent seeking by
critics. That is, some insurance products or practices are useful primarily beca
use of legal benefits, such as reducing taxes, as opposed to providing protectio
n against risks of adverse events. Under United States tax law, for example, mos
t owners of variable annuities and variable life insurance can invest their prem
ium payments in the stock market and defer or eliminate paying any taxes on thei
r investments until withdrawals are made. Sometimes this tax deferral is the onl
y reason people use these products. Another example is the legal infrastructure
which allows life insurance to be held in an irrevocable trust which is used to
pay an estate tax while the proceeds themselves are immune from the estate tax.
See also
• • • • • • • • • • • • • • • • • • • • ACORD Agent of Record Earthquake loss Financial ser
ich insurance belongs) Five for one Geneva Association (the International Associ
ation for the Study of Insurance Economics) Global assets under management Insur
ance fraud Insurance Hall of Fame Insurance law Insurance Premium Tax (UK) Inter
governmental 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 Univers
al health care Welfare state
Country-specific articles: • • • • Insurance in Australia Insurance in India Insurance i
n 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 In
surance 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_cont
ent& 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 injur
ed parties have direct access to coverage. [6] Dembe AE, Boden LI. (2000). Moral
hazard: A question of morality? (http:/ / baywood. metapress. com/ index/ 1GU8E
QN802J62RXK. pdf). New Solutions. [7] Kunreuther H. (1996). Mitigating Disaster
Losses Through Insurance (http:/ / opim. wharton. upenn. edu/ risk/ downloads/ a
rchive/ arch167. pdf). Journal of Risk and Uncertainty. [8] Brown RL. (1993). In
troduction to Ratemaking and Loss Reserving for Property and Casualty Insurance
(http:/ / books. google. com/ books?id=1j4O50JENE4C). ACTEX Publications. [9] Fe
ldstein, Sylvan G.; Fabozzi, Frank J. (2008). The Handbook of Municipal Bonds (h
ttp:/ / books. google. com/ ?id=Juc4fb1Fx1cC& lpg=PA614& pg=PA614#v=onepage& f=f
alse). 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/ abstrac
t=690316) 10 Conn. Ins. L.J. 255 (2004). [12] Berger, Allen N.; Cummins, J. Davi
d; Weiss, Mary A. (October 1997). "The Coexistence of Multiple Distribution Syst
ems 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 o
f our Shipp in Guiana which is in mine owne name, if we miscarry by the waie (wh
ich 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 tym
e 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 Can
terbury, Catalogue Reference PROB 11/163 [16] Dickson (1960): 4 [17] Dickson (19
60): 7 [18] Insurance Information Institute. "Business insurance information. Wh
at does a businessowners policy cover?" (http:/ / www. iii. org/ individuals/ bu
siness/ basics/ bop/ ). . Retrieved 2007-05-09. [19] Insurance Information Insti
tute. "What is homeowners insurance?" (http:/ / www. iii. org/ individuals/ home
i/ 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] U
S application 20060287896 (http:/ / v3. espacenet. com/ textdoc?DB=EPODOC& IDX=U
S20060287896) “Method for providing crop insurance for a crop associated with a de
fined attribute” [22] http:/ / www. business. gov/ manage/ business-insurance/ ins
urance-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] Ran
dall 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: Maki
ng 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 I
mpact of the European Union Insurance Directives on Insurance Company Stocks (ht
tp:/ / people. hofstra. edu/ Anoop_Rai/ research/ JORI70-1Campbell. pdf). The Jo
urnal of Risk and Insurance. [28] Insurance Law of the People's Republic of Chin
a - 1995 (http:/ / www. lehmanlaw. com/ resource-centre/ laws-and-regulations/ i
nsurance/ insurance-law-of-the-peoples-republic-of-china-1995. html). Lehman, Le
e & Xu. [29] Thomas JE. (2002). The role and powers of the Chinese insurance reg
ulatory 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 A
nswer - The true nature of insurance and the rulings concerning it" (http:/ / is
lamqa. com/ en/ ref/ 8889/ insurance). . Retrieved 2010-01-18.
Insurance
[31] "Life Insurance from an Islamic Perspective" (http:/ / www. islamonline. ne
t/ servlet/ Satellite?pagename=IslamOnline-English-Ask_Scholar/ FatwaE/ FatwaE&
cid=1119503543412). . Retrieved 2010-01-18. [32] "Jewish Association for Busines
s Ethics - Insurance" (http:/ / www. jabe. org/ insurance. html). . Retrieved 20
08-03-25. [33] "CIC Insurance - Insurance and the Church" (http:/ / www. cic. co
. ke/ template/ t02. php?menuId=72). . Retrieved 2010-01-18. [34] Rubinkam, Mich
ael (October 5, 2006). "Amish Reluctantly Accept Donations" (http:/ / www. washi
ngtonpost. 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 Encycl
opedia Online, Insurance" (http:/ / www. gameo. org/ encyclopedia/ contents/ I58
3ME. html). . Retrieved 2010-01-18. [37] Gregory D. Squires (2003) Racial Profil
ing, Insurance Style: Insurance Redlining and the Uneven Development of Metropol
itan Areas Journal of Urban Affairs Volume 25 Issue 4 Page 391-410, November 200
3 [38] Credit-Based Insurance Scores: Impacts on Consumers of Automobile Insuran
ce (http:/ / ftc. gov/ opa/ 2007/ 07/ facta. shtm), Federal Trade Commission (Ju
ly 2007) [39] Consumers Dispute FTC Report on Insurance Credit Scoring (http:/ /
www. consumeraffairs. com/ news04/ 2007/ 07/ insurance_credit. html) www.consum
eraffairs.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", Insur
ance IP Bulletin, August 15, 2008 (http:/ / www. marketsandpatents. com/ bulleti
n/ IPB-08152008. html) [45] http:/ / www. peertopatent. org/ patent/ 20090055227
/ activity [46] Bakos, Nowotarski, “An Experiment in Better Patent Examination”, Ins
urance IP Bulletin, December 15, 2008 (http:/ / www. marketsandpatents. com/ bul
letin/ IPB-12152008. html)
55
Bibliography
• Dickson, P.G.M. (1960). The Sun Insurance Office 1710-1960: The History of Two a
nd a half Centuries of British Insurance. London: Oxford University Press. pp. 324
.
External links
• Congressional Research Service (CRS) Reports regarding the U.S. Insurance indust
ry (http://digital.library.unt. edu/govdocs/crs/search.tkl?type=subject&q=Insura
nce 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 antiqu
e insurance policies and ephemera • National Association of Insurance Commissioner
s (http://www.naic.org/) • The British Library (http://www.bl.uk/collections/busin
ess/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 agreemen
t between two parties) that has a value, based on the expected future price move
ments of the asset to which it is linked—called the underlying asset—[1] such as a s
hare or a currency. There are many kinds of derivatives, with the most common be
ing swaps, futures, and options. Derivatives are a form of alternative investmen
t. A derivative is not a stand-alone asset, since it has no value of its own. Ho
wever, 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 futu
res, which have been traded on the Dojima Rice Exchange since the eighteenth cen
tury.[2] Derivatives are usually broadly categorized by: • the relationship betwee
n the underlying asset and the derivative (e.g., forward, option, swap); • the typ
e of underlying asset (e.g., equity derivatives, foreign exchange derivatives, i
nterest rate derivatives, commodity derivatives or credit derivatives); • the mark
et in which they trade (e.g., exchange-traded or over-the-counter); • their pay-of
f profile. Another arbitrary distinction is between:[3] • vanilla derivatives (sim
ple 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 valu
e 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 o
ut 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 opp
osite 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 under
lying (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 reac
hing 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 rela
ted to the price of the underlying asset to be transferred from one party to ano
ther. 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 futur
e. Both parties have reduced a future risk: for the wheat farmer, the uncertaint
y 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 contrac
t. Although a third party, called a clearing house, insures a futures contract,
not all derivatives are insured
Derivative against counter-party risk. From another perspective, the farmer and
the miller both reduce a risk and acquire a risk when they sign the futures cont
ract: the farmer reduces the risk that the price of wheat will fall below the pr
ice specified in the contract and acquires the risk that the price of wheat will
rise above the price specified in the contract (thereby losing additional incom
e that he could have earned). The miller, on the other hand, acquires the risk t
hat the price of wheat will fall below the price specified in the contract (ther
eby paying more in the future than he otherwise would have) and reduces the risk
that the price of wheat will rise above the price specified in the contract. In
this sense, one party is the insurer (risk taker) for one type of risk, and the
counter-party is the insurer (risk taker) for another type of risk. Hedging als
o occurs when an individual or institution buys an asset (such as a commodity, a
bond that has coupon payments, a stock that pays dividends, and so on) and sell
s it using a futures contract. The individual or institution has access to the a
sset for a specified amount of time, and can then sell it in the future at a spe
cified price according to the futures contract. Of course, this allows the indiv
idual or institution the benefit of holding the asset, while reducing the risk t
hat the future selling price will deviate unexpectedly from the market's current
assessment of the future value of the asset. Derivatives serve a legitimate bus
iness purpose. For example, a corporation borrows a large sum of money at a spec
ific interest rate.[4] The rate of interest on the loan resets every six months.
The corporation is concerned that the rate of interest may be much higher in si
x months. The corporation could buy a forward rate agreement (FRA), which is a c
ontract to pay a fixed rate of interest six months after purchases on a notional
amount of money.[5] If the interest rate after six months is above the contract
rate, the seller will pay the difference to the corporation, or FRA buyer. If t
he rate is lower, the corporation will pay the difference to the seller. The pur
chase of the FRA serves to reduce the uncertainty concerning the rate increase a
nd stabilize earnings.
57
Derivatives traders at the Chicago Board of Trade.
Speculation and arbitrage
Derivatives can be used to acquire risk, rather than to insure or hedge against
risk. Thus, some individuals and institutions will enter into a derivative contr
act to speculate on the value of the underlying asset, betting that the party se
eking insurance will be wrong about the future value of the underlying asset. Sp
eculators will want to be able to buy an asset in the future at a low price acco
rding to a derivative contract when the future market price is high, or to sell
an asset in the future at a high price according to a derivative contract when t
he future market price is low. Individuals and institutions may also look for ar
bitrage opportunities, as when the current buying price of an asset falls below
the price specified in a futures contract to sell the asset. Speculative trading
in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a tra
der at Barings Bank, made poor and unauthorized investments in futures contracts
. Through a combination of poor judgment, lack of oversight by the bank's manage
ment and regulators, and unfortunate events like the Kobe earthquake, Leeson inc
urred a US$1.3 billion loss that bankrupted the centuries-old institution.[6]
Derivative
58
Types of derivatives
OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distingu
ished by the way they are traded in the market: • Over-the-counter (OTC) derivativ
es are contracts that are traded (and privately negotiated) directly between two
parties, without going through an exchange or other intermediary. Products such
as swaps, forward rate agreements, and exotic options are almost always traded
in this way. The OTC derivative market is the largest market for derivatives, an
d is largely unregulated with respect to disclosure of information between the p
arties, since the OTC market is made up of banks and other highly sophisticated
parties, such as hedge funds. Reporting of OTC amounts are difficult because tra
des can occur in private, without activity being visible on any exchange. Accord
ing to the Bank for International Settlements, the total outstanding notional am
ount is US$684 trillion (as of June 2008).[7] Of this total notional amount, 67%
are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign
exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12%
are other. Because OTC derivatives are not traded on an exchange, there is no c
entral counter-party. Therefore, they are subject to counter-party risk, like an
ordinary contract, since each counter-party relies on the other to perform. • Exc
hange-traded derivative contracts (ETD) are those derivatives instruments that a
re traded via specialized derivatives exchanges or other exchanges. A derivative
s exchange is a market where individuals trade standardized contracts that have
been defined by the exchange.[8] A derivatives exchange acts as an intermediary
to all related transactions, and takes Initial margin from both sides of the tra
de to act as a guarantee. The world's largest[9] derivatives exchanges (by numbe
r of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Opt
ions), Eurex (which lists a wide range of European products such as interest rat
e & index products), and CME Group (made up of the 2007 merger of the Chicago Me
rcantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the
New York Mercantile Exchange). According to BIS, the combined turnover in the w
orld's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types
of derivative instruments also may trade on traditional exchanges. For instance
, hybrid instruments such as convertible bonds and/or convertible preferred may
be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed
on equity exchanges. Performance Rights, Cash xPRTs and various other instrumen
ts that essentially consist of a complex set of options bundled into a simple pa
ckage are routinely listed on equity exchanges. Like other derivatives, these pu
blicly traded derivatives provide investors access to risk/reward and volatility
characteristics that, while related to an underlying commodity, nonetheless are
distinctive.
Common derivative contract types
There are three major classes of derivatives: 1. Futures/Forwards are contracts
to buy or sell an asset on or before a future date at a price specified today. A
futures contract differs from a forward contract in that the futures contract i
s a standardized contract written by a clearing house that operates an exchange
where the contract can be bought and sold, whereas a forward contract is a non-s
tandardized contract written by the parties themselves. 2. Options are contracts
that give the owner the right, but not the obligation, to buy (in the case of a
call option) or sell (in the case of a put option) an asset. The price at which
the sale takes place is known as the strike price, and is specified at the time
the parties enter into the option. The option contract also specifies a maturit
y date. In the case of a European option, the owner has the right to require the
sale to take place on (but not before) the maturity date; in the case of an Ame
rican option, the owner can require the sale to take place at any time up to the
maturity date. If the owner of the contract exercises this right, the counter-p
arty has the obligation to carry out the transaction.
Derivative 3. Swaps are contracts to exchange cash (flows) on or before a specif
ied future date based on the underlying value of currencies/exchange rates, bond
s/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.
59
Examples
The overall derivatives market has five major classes of underlying asset: • • • • • inter
est rate derivatives (the largest) foreign exchange derivatives credit derivativ
es equity derivatives commodity derivatives
Some common examples of these derivatives are:
UNDERLYING Exchange-traded futures Equity DJIA Index future Single-stock future
CONTRACT TYPES Exchange-traded options Option on DJIA Index future Single-share
option Option on Eurodollar future Option on Euribor future OTC swap OTC forward
OTC option
Equity swap
Back-to-back Repurchase agreement
Stock option Warrant Turbo warrant
Interest rate
Eurodollar future Euribor future
Interest rate swap Forward rate agreement Interest rate cap and floor Swaption B
asis swap Bond option Credit default Repurchase agreement swap Total return swap
Currency swap Currency forward Credit default option
Credit
Bond future
Option on Bond future
Foreign exchange Currency future
Option on currency future
Currency option
Commodity
WTI crude oil futures
Weather derivatives
Commodity swap Iron ore forward contract
Gold option
Other examples of underlying exchangeables are: • Property (mortgage) derivatives •
Economic derivatives that pay off according to economic reports[10] as measured
and reported by national statistical agencies • Freight derivatives • Inflation deri
vatives • Weather derivatives • Insurance derivatives • Emissions derivatives[11]
Derivative
60
Valuation
Market and arbitrage-free prices
Two common measures of value are: • Market price, i.e., the price at which traders
are willing to buy or sell the contract; • Arbitrage-free price, meaning that no
risk-free profits can be made by trading in these contracts; see rational pricin
g.
Determining the market price
For exchange-traded derivatives, market price is usually transparent (often publ
ished in real time by the exchange, based on all the current bids and offers pla
ced on that particular contract at any one time). Complications can arise with O
TC or floor-traded contracts though, as trading is handled manually, making it d
ifficult to automatically broadcast prices. In particular with OTC contracts, th
ere is no central exchange to collate and disseminate prices.
[12] Total world derivatives from 1998-2007 compared to total world wealth in th
e year [13] 2000
Determining the arbitrage-free price
The arbitrage-free price for a derivatives contract is complex, and there are ma
ny different variables to consider. Arbitrage-free pricing is a central topic of
financial mathematics. The stochastic process of the price of the underlying as
set is often crucial. A key equation for the theoretical valuation of options is
the Black–Scholes formula, which is based on the assumption that the cash flows f
rom a European stock option can be replicated by a continuous buying and selling
strategy using only the stock. A simplified version of this valuation technique
is the binomial options model. OTC represents the biggest challenge in using mo
dels to price derivatives. Since these contracts are not publicly traded, no mar
ket price is available to validate the theoretical valuation. And most of the mo
del's results are input-dependant (meaning the final price depends heavily on ho
w we derive the pricing inputs).[14] Therefore it is common that OTC derivatives
are priced by Independent Agents that both counterparties involved in the deal
designate upfront (when signing the contract).
Criticism
Derivatives are often subject to the following criticisms:
Possible large losses
The use of derivatives can result in large losses because of the use of leverage
, or borrowing. Derivatives allow investors to earn large returns from small mov
ements in the underlying asset's price. However, investors could lose large amou
nts if the price of the underlying moves against them significantly. There have
been several instances of massive losses in derivative markets, such as: • The nee
d to recapitalize insurer American International Group (AIG) with US$85 billion
of debt provided by the US federal government.[15] An AIG subsidiary had lost mo
re than US$18 billion over the preceding three quarters on Credit Default Swaps
(CDS) it had written.[16] It was reported that the recapitalization was
Derivative necessary because further losses were foreseeable over the next few q
uarters. 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 Adv
isors, which was long natural gas in September 2006 when the price plummeted. Th
e 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 M
etallgesellschaft AG.[17] The loss of US$1.2 billion equivalent in equity deriva
tives in 1995 by Barings Bank.[18]
61
• • • • •
Members of President Clinton's Working Group on Financial Markets: Larry Summers
, Alan Greenspan, Arthur Levitt, and Robert Rubin, have been criticized for torp
edoing an effort to regulate the derivatives' markets, and thereby helping to br
ing down the financial markets in Fall 2008. President George W. Bush has also b
een criticized because he was President for 8 years preceding the 2008 meltdown
and did nothing to regulate derivative trading. Bush has stated that deregulatio
n 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, b
ut finding that banks only offer variable rates, swaps payments with another bus
iness who wants a variable rate, synthetically creating a fixed rate for the per
son. However if the second business goes bankrupt, it can't pay its variable rat
e and so the first business will lose its fixed rate and will be paying a variab
le rate again. If interest rates have increased, it is possible that the first b
usiness may be adversely affected, because it may not be prepared to pay the hig
her variable rate. Different types of derivatives have different levels of count
er-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 b
etween two companies, for example, there may not be benchmarks for performing du
e diligence and risk analysis.
Large notional value
Derivatives typically have a large notional value. As such, there is the danger
that their use could result in losses that the investor would be unable to compe
nsate for. The possibility that this could lead to a chain reaction ensuing in a
n economic crisis, has been pointed out by famed investor Warren Buffett in Berk
shire Hathaway's 2002 annual report. Buffett called them 'financial weapons of m
ass destruction.' The problem with derivatives is that they control an increasin
gly larger notional amount of assets and this may lead to distortions in the rea
l capital and equities markets. Investors begin to look at the derivatives marke
ts to make a decision to buy or sell securities and so what was originally meant
to be a market to transfer risk now becomes a leading indicator. (See Berkshire
Hathaway Annual Report for 2002) [19]
Leverage of an economy's debt
Derivatives massively leverage the debt in an economy, making it ever more diffi
cult for the underlying real economy to service its debt obligations, thereby cu
rtailing real economic activity, which can cause a recession or even depression.
In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November,
1934 to February, 1948, too high a level of debt was one of the primary causes
of the 1920s-30s Great Depression. (See Berkshire Hathaway Annual Report for 200
2)
Derivative
62
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 no
t adversely affect the economic system because it is not zero sum in utility. • Fo
rmer Federal Reserve Board chairman Alan Greenspan commented in 2003 that he bel
ieved that the use of derivatives has softened the impact of the economic downtu
rn at the beginning of the 21st century.
Definitions
• Bilateral netting: A legally enforceable arrangement between a bank and a counte
r-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 ins
olvency 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 c
redit 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, inter
est rates, currency exchange rates, or indexes. Derivative transactions include
a wide assortment of financial contracts including structured debt obligations a
nd deposits, swaps, futures, options, caps, floors, collars, forwards and variou
s combinations thereof. • Exchange-traded derivative contracts: Standardized deriv
ative contracts (e.g., futures contracts and options) that are transacted on an
organized futures exchange. • Gross negative fair value: The sum of the fair value
s 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-partie
s 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 co
unter-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 net
ting of contracts, and the bank holds no counter-party collateral. • High-risk mor
tgage 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 th
at is used to calculate payments made on swaps and other risk management product
s. This amount generally does not change hands and is thus referred to as notion
al. • 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-base
d capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of com
mon shareholders equity, perpetual preferred shareholders equity with non-cumula
tive dividends, retained earnings, and minority interests in the equity accounts
of consolidated subsidiaries. Tier 2 capital consists of subordinated debt, int
ermediate-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 st
aple 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 Ha
ll [4] Chisolm, Derivatives Demystified (Wiley 2004) [5] Chisolm, Derivatives De
mystified (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 Lees
on broke the bank - BBC Economy" [7] BIS survey: The Bank for International Sett
lements (BIS) semi-annual OTC derivatives statistics (http:/ / www. bis. org/ st
atistics/ derstats. htm) report, for end of June 2008, shows US$683.7 billion to
tal 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 Hal
l, c2009 [9] Futures and Options Week: According to figures published in F&O Wee
k 10 October 2005. See also FOW Website (http:/ / www. fow. com). [10] "Biz.Yaho
o.com" (http:/ / biz. yahoo. com/ c/ e. html). Biz.Yahoo.com. 2010-08-23. . Retr
ieved 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 Dis
tribution 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/ 156
0286/ otc-pricing-deal-struck-fitch-solutions-pricing-partners [15] Derivatives
Counter-party Risk: Lessons from AIG and the Credit Crisis (http:/ / www. compou
ndinghappens. com/ opinion/ DerivativesCounterPartyRisk. htm) [16] Kelleher, Jam
es B. (2008-09-18). ""Buffett s Time Bomb Goes Off on Wall Street" by James B. K
elleher of Reuters" (http:/ / www. reuters. com/ article/ newsOne/ idUSN18371540
20080918). Reuters.com. . Retrieved 2010-08-29. [17] Edwards, Franklin (1995), "
Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft" (ht
tp:/ / www0. gsb. columbia. edu/ faculty/ fedwards/ papers/ DerivativesCanBeHaza
rdous. 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 Managemen
t A Handbook of Structuring, Pricing & Investor Applications (Financial Times) A
mazon listing (http://www.amazon.com/ Structured-Derivatives-Investment-Structur
ing-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) • Deriva
tives in Africa (http://www.mfw4a.org/capital-markets/derivatives-derivatives-ex
changes-commodities. html)
64
Finance of states
Public finance
Public finance is a field of economics concerned with paying for collective or g
overnmental activities, and with the administration and design of those activiti
es. The field is often divided into questions of what the government or collecti
ve organizations should do or are doing, and questions of how to pay for those a
ctivities. 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) d
istribution of income, and (3) macroeconomic stabilization.
Overview
The proper role of government provides a starting point for the analysis of publ
ic finance. In theory, under certain circumstances private markets will allocate
goods and services among individuals efficiently (in the sense that no waste oc
curs and that individual tastes are matching with the economy's productive abili
ties). If private markets were able to provide efficient outcomes and if the dis
tribution of income were socially acceptable, then there would be little or no s
cope for government. In many cases, however, conditions for private market effic
iency are violated. For example, if many people can enjoy the same good at the s
ame time (non-rival, non-excludable consumption), then private markets may suppl
y too little of that good. National defense is one example of non-rival consumpt
ion, or of a public good. "Market failure" occurs when private markets do not al
locate goods or services efficiently. The existence of market failure provides a
n efficiency-based rationale for collective or governmental provision of goods a
nd services. Externalities, public goods, informational advantages, strong econo
mies of scale, and network effects can cause market failures. Public provision v
ia a government or a voluntary association, however, is subject to other ineffic
iencies, termed "government failure." Under broad assumptions, government decisi
ons about the efficient scope and level of activities can be efficiently separat
ed from decisions about the design of taxation systems (Diamond-Mirlees separati
on). In this view, public sector programs should be designed to maximize social
benefits minus costs (cost-benefit analysis), and then revenues needed to pay fo
r 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 com
plicated and often results in inefficient practices. Government can pay for spen
ding by borrowing (for example, with government bonds), although borrowing is a
method of distributing tax burdens through time rather than a replacement for ta
xes. A deficit is the difference between government spending and revenues. The a
ccumulation of deficits over time is the total public debt. Deficit finance allo
ws governments to smooth tax burdens over time, and gives governments an importa
nt fiscal policy tool. Deficits can also narrow the options of successor governm
ents. Public finance is closely connected to issues of income distribution and s
ocial equity. Governments can reallocate income through transfer payments or by
designing tax systems that treat high-income and low-income households different
ly. The Public Choice approach to public finance seeks to explain how self-inter
ested voters, politicians, and bureaucrats actually operate, rather than how the
y should operate.
Public finance
65
Public finance management
Collection of sufficient resources from the economy in an appropriate manner alo
ng with allocating and use of these resources efficiently and effectively consti
tute good financial management. Resource generation, resource allocation and exp
enditure management (resource utilization) are the essential components of a pub
lic financial management system. Public Finance Management (PFM) basically deals
with all aspects of resource mobilization and expenditure management in governm
ent. Just as managing finances is a critical function of management in any organ
ization, similarly public finance management is an essential part of the governa
nce process. Public finance management includes resource mobilization, prioritiz
ation of programmes, the budgetary process, efficient management of resources an
d exercising controls. Rising aspirations of people are placing more demands on
financial resources. At the same time, the emphasis of the citizenry is on value
for money, thus making public finance management increasingly vital.
Government expenditures
Economists classify government expenditures into three main types. Government pu
rchases of goods and services for current use are classed as government consumpt
ion. Government purchases of goods and services intended to create future benefi
ts--- such as infrastructure investment or research spending--- are classed as g
overnment investment. Government expenditures that are not purchases of goods an
d services, and instead just represent transfers of money--- such as social secu
rity 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 rul
es and laws within a civil, corporate, religious, academic, or other organizatio
n or group.[2] In its broadest sense, "to govern" means to rule over or supervis
e, 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 inte
nded to transfer income from some groups to others. For example, governments som
etimes transfer income to people that have suffered a loss due to natural disast
er. Likewise, public pension programs transfer wealth from the young to the old.
Other forms of government expenditure which represent purchases of goods and se
rvices also have the effect of changing the income distribution. For example, en
gaging in a war may transfer wealth to certain sectors of society. Public educat
ion transfers wealth to families with children in these schools. Public road con
struction 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 insuran
ce • Health Care
Public finance
66
Financing of government expenditures
Government expenditures are financed in two ways: • Government revenue • Taxes • Non-t
ax revenue (revenue from government-owned corporations, sovereign wealth funds,
sales of assets, or Seigniorage) • Government borrowing
Budgeted revenues of governments in 2006.
How a government chooses to finance its activities can have important effects on
the distribution of income and wealth (income redistribution) and on the effici
ency of markets (effect of taxes on market prices and efficiency). The issue of
how taxes affect income distribution is closely related to tax incidence, which
examines the distribution of tax burdens after market adjustments are taken into
account. Public finance research also analyzes effects of the various types of
taxes and types of borrowing as well as administrative concerns, such as tax enf
orcement.
Taxes
Taxation is the central part of modern public finance. Its significance arises n
ot only from the fact that it is by far the most important of all revenues but a
lso 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 taxat
ion 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 redi
stribution of wealth and thereby reducing inequalities. Taxation in a modern Gov
ernment 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 th
e 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 i
s 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, secessionis
t movements or revolutionary movements). Taxes could also be imposed by a subnat
ional entity. Taxes consist of direct tax or indirect tax, and may be paid in mo
ney or as corvée labor. A tax may be defined as a "pecuniary burden laid upon indi
viduals or property to support the government [ . . .] a payment exacted by legislativ
e authority."[5] A tax "is not a voluntary payment or donation, but an enforced
contribution, exacted pursuant to legislative authority" and is "any contributio
n imposed by government [ . . .] whether under the name of toll, tribute, tallage, gab
el, 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 p
roportional) and indirect tax (which is differential in nature): • Stamp duty, lev
ied on documents • Excise tax (tax levied on production for sale, or sale, of a ce
rtain good) • Sales tax (tax on business transactions, especially the sale of good
s and services) • Value added tax (VAT) is a type of sales tax • Services taxes on s
pecific services • Road tax; Vehicle excise duty (UK), Registration Fee (USA), Reg
co (Australia), Vehicle Licensing Fee (Brazil) etc. • Gift tax
Public finance • • • • Duties (taxes on importation, levied at customs) Corporate income
tax on corporations (incorporated entities) Wealth tax Personal income tax (may
be levied on individuals, families such as the Hindu joint family in India, uni
ncorporated associations, etc.)
67
Debt
Governments, like any other legal entity, can take out loans, issue bonds and ma
ke 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 f
ederal government, municipal government or local government. Some local governme
nts issue bonds based on their taxing authority, such as tax increment bonds or
revenue bonds.
Map of countries by foreign currency reserves and gold minus external debt based
on 2009 data from CIA Factbook.
As the government represents the people, government debt can be seen as an indir
ect 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 bi
lls. Less creditworthy countries sometimes borrow directly from commercial banks
or international institutions such as the International Monetary Fund or the Wo
rld Bank. Most government budgets are calculated on a cash basis, meaning that r
evenues are recognized when collected and outlays are recognized when paid. Some
consider all government liabilities, including future pension payments and paym
ents for goods and services the government has contracted for but not yet paid,
as government debt. This approach is called accrual accounting, meaning that obl
igations are recognized when they are acquired, or accrued, rather than when the
y are paid.
Seigniorage
Seigniorage is the net revenue derived from the issuing of currency. It arises f
rom the difference between the face value of a coin or bank note and the cost of
producing, distributing and eventually retiring it from circulation. Seigniorag
e is an important source of revenue for some national banks, although it provide
s a very small proportion of revenue for advanced industrial countries.
Public finance in socialist economies
Public finance in centrally planned economies has differed in fundamental ways f
rom that in market economies. Some state-owned enterprises generated profits tha
t helped finance government activities. The government entities that operate for
profit are usually manufacturing and financial institutions, services such as n
ationalized healthcare do not operate for a profit to keep costs low for consume
rs. The Soviet Union relied heavily on turnover taxes on retail sales. Sales of
natural resources, and especially petroleum products, were an important source o
f revenue for the Soviet Union. In Venezuela, the state-run oil company PSDVA pr
ovides revenue for the government to fund its operations and programs that would
otherwise be profit for private owners. Various market socialist systems or pro
posals utilize
Public finance revenue generated by state-run enterprises to fund social dividen
ds, eliminating the need for taxation altogether. In various mixed economies, th
e revenue generated by state-run or state-owned enterprises are used for various
state endeavors; typically the revenue generated by state and government agenci
es goes into a sovereign wealth fund. An example of this is the Alaska Permanent
Fund and Singapore's Temasek Holdings.
68
Government Finance Statistics and Methodology
Macroeconomic data to support public finance economics are generally referred to
as fiscal or government finance statistics (GFS). The Government Finance Statis
tics Manual 2001 (GFSM 2001) [7] is the internationally accepted methodology for
compiling fiscal data. It is consistent with regionally accepted methodologies
such as the European System of Accounts 1995 [8] and consistent with the methodo
logy of the System of National Accounts (SNA1993) [9] and broadly in line with i
ts most recent update, the SNA2008 [10].
Challenges in measuring government
The size of governments, their institutional composition and complexity, their a
bility to carry out large and sophisticated operations, and their impact on the
other sectors of the economy warrant a well-articulated system to measure govern
ment economic operations. The GFSM 2001 addresses the institutional complexity o
f government by defining various levels of government. The main focus of the GFS
M 2001 is the general government sector defined as the group of entities capable
of implementing public policy through the provision of primarily nonmarket good
s and services and the redistribution of income and wealth, with both activities
supported mainly by compulsory levies on other sectors. The GFSM 2001 disaggreg
ates the general government into subsectors: central government, state governmen
t, and local government (See Figure 1). The concept of general government does n
ot include public corporations. The general government plus the public corporati
ons comprise the public sector (See Figure 2).
Figure 1: General Government (IMF Government Finance Statistics Manual 2001(Wash
ington, 2001) pp.13
Public finance
69
Figure 2: Public Sector(IMF Government Finance Statistics Manual 2001(Washington
, 2001) pp.15
The GFSM 2001 framework is similar to the financial accounting of businesses. Fo
r example, it recommends that governments produce a full set of financial statem
ents including the statement of government operations (akin to the income statem
ent), the balance sheet, and a cash flow statement. Two other similarities betwe
en the GFSM 2001 and business financial accounting are the recommended use of ac
crual accounting as the basis of recording and the presentations of stocks of as
sets and liabilities at market value. It is an improvement on the prior methodol
ogy 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 th
at meet a broad group of users including policy makers, researchers, and investo
rs in sovereign debt. Government finance statistics should offer data for topics
such as the fiscal architecture, the measurement of the efficiency and effectiv
eness of government expenditures, the economics of taxation, and the structure o
f public financing. The GFSM 2001 provides a blueprint for the compilation, reco
rding, and presentation of revenues, expenditures, stocks of assets, and stocks
of liabilities. The GFSM 2001 also defines some indicators of effectiveness in g
overnment’s expenditures, for example the compensation of employees as a percentag
e of expense. The GFSM 2001 includes a functional classification of expense as d
efined by the Classification of Functions of Government (COFOG) . This functiona
l classification allows policy makers to analyze expenditures on categories such
as health, education, social protection, and environmental protection. The fina
ncial statements can provide investors with the necessary information to assess
the capacity of a government to service and repay its debt, a key element determ
ining sovereign risk, and risk premia. Like the risk of default of a private cor
poration, 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 fi
nancial statements contain the relevant information for this analysis. The gover
nment’s balance sheet presents the level of the debt; that is the government’s liabi
lities. The memorandum items of the balance sheet provide additional information
on the debt including its maturity and whether it is owed to domestic or extern
al residents. The balance sheet also presents a disaggregated classification of
financial and non-financial assets.
Public finance These data help estimate the resources a government can potential
ly access to repay its debt. The statement of operations (“income statement”) contai
ns the revenue and expense accounts of the government. The revenue accounts are
divided into subaccounts, including the different types of taxes, social contrib
utions, 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.
70
Fiscal Data Using the GFSM 2001 Methodology
GFS can be accessible through several sources. The International Monetary Fund p
ublishes GFS in two publications: International Financial Statistics and the Gov
ernment Finance Statistics Yearbook. The World Bank gathers information on exter
nal debt. On a regional level, the Organization for Economic Co-operation and De
velopment (OECD) compiles general government account data for its members, and E
urostat, following a methodology compatible with the GFSM 2001, compiles GFS for
the members of the European Union.
See also
• Constitutional economics • Corporate finance • Fiscal incidence • • • • • • • Functional
overnment 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 En
glish 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/ n
ationalaccount/ 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/ book
s?id=jEnjN7dKrzcC&printsec=frontcover&source=gbs_atb#v=onepage&q&f=false) • Richar
d 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. (ht
tp://www. dictionaryofeconomics.com/article?id=pde2008_P000244&edition=current&q
=public finance&topicid=&
Public finance 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.
71
External links
• Taxation and Public Finance course at the Harris School of Public Policy Studies
(http://harrisschool.uchicago. edu/Programs/courses/description.html?course=329
00) • State and Local Public Finance course at the Harris School of Public Policy
Studies (http://harrisschool. uchicago.edu/Programs/courses/description.html?cou
rse=32100) • IMF--Dissemination Standards Bulletin Board-- Subscribing ... (http:/
/dsbb.imf.org/Applications/web/ sddsnsdppage/) (see "fiscal sector") • The IMF s P
ublic Financial Management Blog (http://blog-pfm.imf.org) • US Debt Clock.org (htt
p://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 an
d deployment of economic resources, both spatially and across time, in an uncert
ain environment".[1] It is additionally characterised by its "concentration on m
onetary 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 typic
ally framed in terms of "time, uncertainty, options and information".[2] • Time: m
oney 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 t
ransaction can make a decision at a later time that will affect subsequent trans
fers of money. • Information: knowledge of the future can reduce, or possibly elim
inate, 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 fin
ancial 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 studi
es: • Valuation - Determination of the fair value of an asset • • • • How risky is the ass
et? (identification of the asset appropriate discount rate) What cash flows will
it produce? (discounting of relevant cash flows) How does the market price comp
are 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 -
opics Money market instruments- topics Derivatives - topics
• Financial institutions and regulation Financial Econometrics is the branch of Fi
nancial Economics that uses econometric techniques to parameterise the relations
hips.
Financial economics
73
Models in Financial economics
Financial economics is primarily concerned with building models to derive testab
le or policy implications from acceptable assumptions. Some fundamental ideas in
financial economics are portfolio theory, the Capital Asset Pricing Model. Port
folio theory studies how investors should balance risk and return when investing
in many assets or securities. The Capital Asset Pricing Model describes how mar
kets should set the prices of assets in relation to how risky they are. The Modi
gliani-Miller Theorem describes conditions under which corporate financing decis
ions are irrelevant for value, and acts as a benchmark for evaluating the effect
s of factors outside the model that do affect value. A common assumption is that
financial decision makers act rationally (see Homo economicus; efficient market
hypothesis). However, recently, researchers in experimental economics and exper
imental finance have challenged this assumption empirically. They are also chall
enged - theoretically - by behavioral finance, a discipline primarily concerned
with the limits to rationality of economic agents. Other common assumptions incl
ude market prices following a random walk, or asset returns being normally distr
ibuted. Empirical evidence suggests that these assumptions may not hold, and in
practice, traders and analysts, and particularly risk managers, frequently modif
y the "standard models".
See also
• • • • List of economics topics List of economists List of finance topics List of maste
r 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/ind
ex.htm), Eugene Fama, University of Chicago Graduate School of Business • Macro-In
vestment Analysis (http://www.stanford.edu/~wfsharpe/mia/int/mia_int2.htm), Prof
essor William Sharpe, Stanford Graduate School of Business • Lecture Notes in Fina
ncial 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-mon
ey.com/artandpap/II+Modigliani-Miller+Theorem.doc), "III" (http://web.archive. o
rg/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/arta
ndpap/III Short-Sales and Stock Prices. doc) on 2007-09-27.; IVa (http://web.arc
hive.org/web/20070927123029/http://www.in-the-money.com/ artandpap/IV+Fundamenta
l+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 on 2007-09-27.. Prof. Mark Rubinstein, Haas School of Busine
ss Microfoundations of Financial Economics (http://www.ulb.ac.be/cours/solvay/fa
rber/PhD.htm) Prof. André Farber Solvay Business School Handbook of the Economics
of Finance (http://ideas.repec.org/b/eee/finhes/2.html#related), G.M. Constantin
ides, M. Harris, R. M. Stulz Financial economics (http://www.sciencedirect.com/s
cience?_ob=RefWorkIndexURL&_idxType=SC& _cdi=23486&_refWorkId=21&_explode=151000
131,151000133&_alpha=&_acct=C000050221& _version=1&_userid=10&md5=f2c773b7457530
22e1cccc9a38d83508&refID=151000133#151000133), International Encyclopedia of the
Social & Behavioral Sciences, Oxford: Elsevier, 2001. Financial economics topic
s (http://www.dictionaryofeconomics.com/articles_by_topic?topicid=G) with Abstra
cts, The New Palgrave Dictionary of Economics, 2008. An introduction to investme
nt theory (http://viking.som.yale.edu/will/web_pages/will/finman540/ classnotes/
notes.html), Prof. William Goetzmann, Yale School of Management Notes on General
Equilibrium Asset Pricing (http://pascal.iseg.utl.pt/~pbrito/cursos/mestrado/fe
f/fef2009. pdf), Prof. Paulo Brito, ISEG, Technical University of Lisbon
74
• • •
• • •
Context and history
• Finance Theory (http://cepa.newschool.edu/het/schools/finance.htm), The History
of Economic Thought Website, The New School • The Scientific Evolution of Finance
(http://www.finance-and-physics.org/Library/Articles3/ scienceandfinance/science
.htm) Prof. Don Chance, Prof. Pamela Peterson • 50 Years of Finance (http://www.ul
b.ac.be/cours/solvay/farber/VUB/01 Inaugurale rede.pdf) Prof. André Farber, Univer
sité Libre de Bruxelles • "A Short History of Investment Forecasting" (http://web.ar
chive.org/web/20071012112134/http:// roundtable.informs.org/public-access/min061
a.htm). Archived from the original (http://roundtable.informs. org/public-access
/min061a.htm) on 2007-10-12., Professor Michael Phillips, California State Unive
rsity, Northridge • Pioneers of Finance (http://campus.murraystate.edu/academic/fa
culty/larry.guin/FinancialHistory.htm), Prof. Larry Guin, Murray State Universit
y
Links and portals
• • • • • Financial Economics Links on WebEc (http://www.helsinki.fi/WebEc/webecg.html) JE
L Classification Codes Guide (http://www.aeaweb.org/jel/guide/jel.php?class=G) F
inancial Economics Links on RFE (http://rfe.org/showCat.php?cat_id=56) SSRN Fina
ncial Economics Network (http://www.ssrn.com/fen/index.html) "Books on Financial
Economics": list on economicsnetwork.ac.uk (http://www.economicsnetwork.ac.uk/
books/FinancialEconomics.htm)
75
Financial mathematics
Financial mathematics
Mathematical finance is applied mathematics concerned with financial markets. Th
e subject has a close relationship with the discipline of financial economics, w
hich is concerned with much of the underlying theory. Generally, mathematical fi
nance 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 financia
l mathematician may take the share price as a given, and attempt to use stochast
ic calculus to obtain the fair value of derivatives of the stock (see: Valuation
of options). In terms of practice, mathematical finance also overlaps heavily w
ith the field of computational finance (also known as financial engineering). Ar
guably, 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 (publi
shed 1900) by Louis Bachelier, which discussed the use of Brownian motion to eva
luate stock options. However, it hardly caught any attention outside academia. T
he first influential work of mathematical finance is the theory of portfolio opt
imization by Harry Markowitz on using mean-variance estimates of portfolios to j
udge investment strategies, causing a shift away from the concept of trying to i
dentify the best individual stock for investment. Using a linear regression stra
tegy 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 var
iance in the return. Simultaneously, William Sharpe developed the mathematics of
determining the correlation between each stock and the market. For their pionee
ring 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 mat
hematics to the “black art” of investment management. With time, the mathematics has
become more sophisticated. Thanks to Robert Merton and Paul Samuelson, one-peri
od models were replaced by continuous time, Brownian-motion models, and the quad
ratic utility function implicit in mean–variance optimization was replaced by more
general increasing, concave utility functions [1] . The next major revolution i
n mathematical finance came with the work of Fischer Black and Myron Scholes alo
ng with fundamental contributions by Robert C. Merton, by modeling financial mar
kets 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 pri
ze because of his death in 1995. More sophisticated mathematical models and deri
vative pricing strategies were then developed but their credibility was damaged
by the financial crisis of 2007–2010. Bodies such as the Institute for New Economi
c Thinking are now attempting to establish more effective theories and methods.[
2]
Financial mathematics
76
Mathematical finance articles
Mathematical tools
• • • • • • • • • • • • • • • • • • • Asymptotic analysis Calculus Copulas Differential equ
ic theory Feynman–Kac formula Fourier transform Gaussian copulas Girsanov s theore
m Itô s lemma Martingale representation theorem Mathematical models Monte Carlo me
thod Numerical analysis Real analysis Partial differential equations Probability
Probability distributions
• Binomial distribution • Log-normal distribution • Quantile functions • Heat equation • R
adon–Nikodym derivative • Risk-neutral measure • Stochastic calculus • Brownian motion • Lé
y process • Stochastic differential equations • Stochastic volatility • Numerical part
ial 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 • • • • Pu
l parity (Arbitrage relationships for options) Intrinsic value, Time value Money
ness Pricing models • • • • • Black–Scholes model Black model Binomial options model Monte
arlo 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
ss model • Chen model • LIBOR Market Model • Heath–Jarrow–Morton framework
See also
• • • • • • • • • • • • Computational finance Quantitative Behavioral Finance Derivative (f
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 market
s
• Master of Mathematical Finance
Financial mathematics
78
Notes
[1] Karatzas, I., Methods of Mathematical Finance, Secaucus, NJ, USA: Springer-V
erlag New York, Incorporated, 1998 [2] Gillian Tett (April 15 2010), Mathematici
ans must get out of their ivory towers (http:/ / www. ft. com/ cms/ s/ 0/ cfb9c4
3a-48b7-11df-8af4-00144feab49a. html), Financial Times,
References
• Harold Markowitz, Portfolio Selection, Journal of Finance, 7, 1952, pp. 77–91 • Willia
m 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 res
ulting characteristics of trading flows, information diffusion and aggregation,
price setting mechanism and returns processes. This can happen for instance by c
onducting trading simulations or establishing and studying the behaviour of peop
le in artificial competitive market-like settings. Researchers in experimental f
inance can study to what extent existing financial economics theory makes valid
predictions and attempt to discover new principles on which theory can be extend
ed. The methodology of experimental finance is closely related to that of Experi
mental economics.
See also
• Experimental economics • Game theory
80
Behavioral finance
Behavioral finance
Behavioral economics and its related area of study, behavioral finance, use soci
al, cognitive and emotional factors in understanding the economic decisions of i
ndividuals and institutions performing economic functions, including consumers,
borrowers and investors, and their effects on market prices, returns and the res
ource allocation. The fields are primarily concerned with the bounds of rational
ity (selfishness, self-control) of economic agents. Behavioral models typically
integrate insights from psychology with neo-classical economic theory. Behaviora
l analysts are not only concerned with the effects of market decisions but also
with public choice, which describes another source of economic decisions with re
lated biases towards promoting self-interest.
History
During the classical period, economics was closely linked to psychology. For exa
mple, Adam Smith wrote The Theory of Moral Sentiments, which proposed psychologi
cal explanations of individual behavior and Jeremy Bentham wrote extensively on
the psychological underpinnings of utility. However, during the development of n
eo-classical economics economists sought to reshape the discipline as a natural
science, deducing economic behavior from assumptions about the nature of economi
c agents. They developed the concept of homo economicus, whose psychology was fu
ndamentally rational. This led to unintended and unforeseen errors. However, man
y important neo-classical economists employed more sophisticated psychological e
xplanations, including Francis Edgeworth, Vilfredo Pareto, Irving Fisher and Joh
n Maynard Keynes. Economic psychology emerged in the 20th century in the works o
f Gabriel Tarde[1] , George Katona[2] and Laszlo Garai.[3] Expected utility and
discounted utility models began to gain acceptance, generating testable hypothes
es about decision making given uncertainty and intertemporal consumption respect
ively. Observed and repeatable anomalies eventually challenged those hypotheses,
and further steps were taken by the Nobel prizewinner Maurice Allais, for examp
le in setting out the Allais paradox, a decision problem he first presented in 1
953 which contradicts the expected utility hypothesis. In the 1960s cognitive ps
ychology began to shed more light on the brain as an information processing devi
ce (in contrast to behaviorist models). Psychologists in this field, such as War
d Edwards,[4] Amos Tversky and Daniel Kahneman began to compare their cognitive
models of decision-making under risk and uncertainty to economic models of ratio
nal behavior. In mathematical psychology, there is a longstanding interest in th
e transitivity of preference and what kind of measurement scale utility constitu
tes (Luce, 2000).[5]
Prospect theory
In 1979, Kahneman and Tversky wrote Prospect theory: An Analysis of Decision Und
er Risk, an important paper that used cognitive psychology to explain various di
vergences of economic decision making from neo-classical theory.[6] Prospect the
ory is an example of generalized expected utility theory. Although not a convent
ional part of behavioral economics, generalized expected utility theory is simil
arly motivated by concerns about the descriptive inaccuracy of expected utility
theory. In 1968 Nobel Laureate Gary Becker published Crime and Punishment: An Ec
onomic Approach, a seminal work that factored psychological elements into econom
ic decision making. Becker, however, maintained strict consistency of preference
s. Nobelist Herbert Simon developed the theory of Bounded Rationality to explain
how people irrationally seek satisfaction, instead of maximizing utility, as co
nventional economics presumed. Maurice Allais produced
Behavioral finance "Allais Paradox", a crucial challenge to expected utility. Ps
ychological traits such as overconfidence, projection bias, and the effects of l
imited attention are now part of the theory. Other developments include a confer
ence at the University of Chicago,[7] a special behavioral economics edition of
the Quarterly Journal of Economics ('In Memory of Amos Tversky') and Kahneman's
2002 Nobel for having "integrated insights from psychological research into econ
omic science, especially concerning human judgment and decision-making under unc
ertainty".[8]
81
Intertemporal choice
Behavioral economics has also been applied to intertemporal choice. Intertempora
l choice behavior is largely inconsistent, as exemplified by George Ainslie's hy
perbolic discounting (1975) which is one of the prominently studied observations
, further developed by David Laibson, Ted O'Donoghue, and Matthew Rabin. Hyperbo
lic 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 model
s 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 pre
sent and time t+1 the near future. The pattern can actually be explained though
through models of subadditive discounting which distinguishes the delay and inte
rval of discounting: people are less patient (per-time-unit) over shorter interv
als regardless of when they occur. Much of the recent work on intertemporal choi
ce indicates that discounting is a constructed preference. Discounting is influe
nced greatly by expectations, framing, focus, thought listings, mood, sign, gluc
ose levels, and the scales used to describe what is discounted. Some prominent r
esearchers question whether discounting, the major parameter of intertemporal ch
oice, actually describes what people do when they make choices with future conse
quences. Considering the variability of discount rates, this may be the case.
Other areas of research
Other branches of behavioral economics enrich the model of the utility function
without implying inconsistency in preferences. Ernst Fehr, Armin Falk, and Matth
ew Rabin studied "fairness", "inequity aversion", and "reciprocal altruism", wea
kening the neoclassical assumption of "perfect selfishness." This work is partic
ularly applicable to wage setting. Work on "intrinsic motivation" by Gneezy and
Rustichini and on "identity" by Akerlof and Kranton assumes agents derive utilit
y from adopting personal and social norms in addition to conditional expected ut
ility. "Conditional expected utility" is a form of reasoning where the individua
l has an illusion of control, and calculates the probabilities of external event
s and hence utility as a function of their own action, even when they have no ca
usal ability to affect those external events.[9] [10] Behavioral economics caugh
t on among the general public, with the success of books like Dan Ariely's Predi
ctably Irrational and the appointment of well-known behavioral economists such a
s Larry Summers to high government offices. Practitioners of the discipline have
studied quasi-public policy topics such as broadband mapping.[11] [12]
Methodology
Behavioral economics and finance theories developed almost exclusively from expe
rimental observations and survey responses, although in more recent times real w
orld data have taken a more prominent position. Functional magnetic resonance im
aging (fMRI) allows determination of which brain areas are active during economi
c decision making. Experiments simulating markets such as stock trading and auct
ions can isolate the effect of a particular bias upon behavior. Such experiments
can help narrow the range of plausible explanations. Good experiments are incen
tive-compatible, normally involving binding transactions and real money.
Behavioral finance
82
Vs experimental economics
Note that behavioral economics is distinct from experimental economics, which us
es experimental methods to study economic questions. Not all economics experimen
ts are psychological. While many experimental economics studies (such as game th
eory) 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 heavi
ly on theory and on observational studies "in the field."
Key observations
Three themes predominate in behavioral finance and economics:[13] • Heuristics: Pe
ople often make decisions based on approximate rules of thumb, not strict logic.
See also cognitive biases and bounded rationality. • Framing: The collection of a
necdotes and stereotypes that make up the mental emotional filters individuals r
ely on to understand and respond to events. • Market inefficiencies: These include
mis-pricings, non-rational decision making, and return anomalies. Richard Thale
r, in particular, has described specific market anomalies from a behavioral pers
pective. Barberis, Shleifer, and Vishny[14] and Daniel, Hirshleifer, and Subrahm
anyam (1998)[15] built models based on extrapolation (seeing patterns in random
sequences) and overconfidence to explain security market under- and overreaction
s, 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 gener
ally, cognitive biases may also have strong anomalous effects in the aggregate i
f there is social contagion of ideas and emotions (causing collective euphoria o
r fear) leading to phenomena such as herding and groupthink. Behavioral finance
and economics rests as much on social psychology within large groups as on indiv
idual psychology. In some behavioral models, a small deviant group can have subs
tantial 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 heu
ristics and subject to framing effects. In general, economics continues to sit w
ithin the neoclassical framework, though the standard assumption of rational beh
avior is often challenged.
Heuristics
• • • • • • Prospect theory Loss aversion Status quo bias Gambler's fallacy Self-serving bi
s Money illusion
Behavioral finance
83
Framing
• Cognitive framing • Mental accounting • Anchoring
Anomalies (economic behavior)
• • • • • • • • • • Disposition effect Endowment effect Inequity aversion Reciprocity Inter
consumption Present-biased preferences Momentum investing Greed and fear Herd be
havior Sunk-cost fallacy
Anomalies (market prices and returns)
• • • • • • • Equity premium puzzle Efficiency wage hypothesis Price stickiness Limits to a
trage Dividend puzzle Fat tails Calendar effect[15]
Criticisms and support
Critics of behavioral economics typically stress the rationality of economic age
nts.[16] They contend that experimentally observed behavior has limited applicat
ion to market situations, as learning opportunities and competition ensure at le
ast a close approximation of rational behavior. Others note that cognitive theor
ies, such as prospect theory, are models of decision making, not generalized eco
nomic behavior, and are only applicable to the sort of once-off decision problem
s presented to experiment participants or survey respondents. Traditional econom
ists are also skeptical of the experimental and survey-based techniques which be
havioral economics uses extensively. Economists typically stress revealed prefer
ences over stated preferences (from surveys) in the determination of economic va
lue. Experiments and surveys are at risk of systemic biases, strategic behavior
and lack of incentive compatibility. Rabin (1998)[17] dismisses these criticisms
, claiming that consistent results are typically obtained in multiple situations
and geographies and can produce good theoretical insight. Behavioral economists
have also responded to these criticisms by focusing on field studies rather tha
n lab experiments. Some economists see a fundamental schism between experimental
economics and behavioral economics, but prominent behavioral and experimental e
conomists tend to share techniques and approaches in answering common questions.
For example, behavioral economists are actively investigating neuroeconomics, w
hich is entirely experimental and cannot be verified in the field. Other propone
nts of behavioral economics note that neoclassical models often fail to predict
outcomes in real world contexts. Behavioral insights can influence neoclassical
models. Behavioral economists note that these revised
Behavioral finance models not only reach the same correct predictions as the tra
ditional models, but also correctly predict some outcomes where the traditional
models failed.
84
Behavioral finance
Topics
The central issue in behavioral finance is explaining why market participants ma
ke systematic errors. Such errors affect prices and returns, creating market ine
fficiencies. It also investigates how other participants arbitrage such market i
nefficiencies. Behavioral finance highlights inefficiencies such as under- or ov
er-reactions to information as causes of market trends and in extreme cases of b
ubbles and crashes). Such reactions have been attributed to limited investor att
ention, overconfidence, overoptimism, mimicry (herding instinct) and noise tradi
ng. Technical analysts consider behavioral economics' academic cousin, behaviora
l finance, to be the theoretical basis for technical analysis.[18] Other key obs
ervations 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 inve
stor 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 unabl
e to do so far.[20] Experimental finance applies the experimental method, e.g. c
reating 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 b
ehavioral 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, ov
erreaction occurs if the market reacts too strongly or for too long to news, thu
s requiring adjustment in the opposite direction. As a result, outperforming ass
ets 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. T
hey contend that behavioral finance is more a collection of anomalies than a tru
e branch of finance and that these anomalies are either quickly priced out of th
e market or explained by appealing to market microstructure arguments. However,
individual cognitive biases are distinct from social biases; the former can be a
veraged out by the market, while the other can create positive feedback loops th
at drive the market further and further from a "fair price" equilibrium. Similar
ly, for an anomaly to violate market efficiency, an investor must be able to tra
de 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 e
quity premium puzzle. It is argued that the cause is entry barriers (both practi
cal 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 investment funds are managed through superannuation funds, mi
nimizing 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.
85
Quantitative
Quantitative behavioral finance uses mathematical and statistical methodology to
understand behavioral biases. Leading contributors include Gunduz Caginalp (Edi
tor of the Journal of Behavioral Finance from 2001–2004) and collaborators includi
ng 2002 Nobelist Vernon Smith, David Porter, Don Balenovich,[23] Vladimira Iliev
a and Ahmet Duran[24] and Ray Sturm.[25] The research can be grouped into the fo
llowing areas: 1. Empirical studies that demonstrate significant deviations from
classical theories 2. Modeling using the concepts of behavioral effects togethe
r with the non-classical assumption of the finiteness of assets 3. Forecasting b
ased on these methods 4. Testing models against experimental asset markets
Key figures
Economics
• • • • • • • • • • • • • • • Dan Ariely[26] Colin Camerer Ernst Fehr Daniel Kahneman David
wenstein 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 T
ance Odean Charles Plott
• Hersh Shefrin • Robert Shiller • Andrei Shleifer
Behavioral finance • Richard Thaler
86
See also
• • • • • • • • • • • • • • • • • • • • • • • Adaptive market hypothesis Behavioral Operati
ve psychology Confirmation bias Cultural economics Culture change Culture specul
ation Economic sociology Emotional bias Experimental economics Experimental fina
nce Habit (psychology) Hindsight bias Important publications in behavioral finan
ce(economics) Journal of Behavioral Finance List of cognitive biases Neuroeconom
ics Observational Techniques Rationality Repugnancy costs Socioeconomics Sociono
mics
Notes
[1] Tarde, G. Psychologie économique (http:/ / classiques. uqac. ca/ classiques/ t
arde_gabriel/ psycho_economique_t1/ psycho_eco_t1. html) (1902), [2] The Powerfu
l Consumer: Psychological Studies of the American Economy. 1960. [3] Garai,L. Id
entity Economics - An Alternative Economic Psychology. (http:/ / www. staff. u-s
zeged. hu/ ~garai/ Identity_Economics. htm) 1990-2006. [4] "Ward Edward Papers"
(http:/ / www. usc. edu/ libraries/ archives/ arc/ libraries/ collections/ recor
ds/ 427home. html). Archival Collections. . Retrieved 2008-04-25. [5] Luce 2000
[6] Kahneman 2003 [7] Hogarth 1987 [8] "Nobel Laureates 2002" (http:/ / nobelpri
ze. org/ nobel_prizes/ lists/ 2002. html). Nobelprize.org. . Retrieved 2008-04-2
5. [9] Grafstein R (1995). "Rationality as Conditional Expected Utility Maximiza
tion" (http:/ / jstor. org/ stable/ 3791450). Political Psychology 16 (1): 63–80.
doi:10.2307/3791450. . [10] Shafir E, Tversky A (1992). "Thinking through uncert
ainty: nonconsequential reasoning and choice". Cognitive Psychology 24 (4): 449–47
4. doi:10.1016/0010-0285(92)90015-T. PMID 1473331. [11] "US National Broadband Pla
n: good in theory" (http:/ / www. telco2. net/ blog/ 2010/ 03/ us_national_broad
band_plan_qui. html). Telco 2.0. March 17, 2010. . Retrieved 2010-09-23. "... Sa
ra 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 2010-0
9-23. "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
[16] see Myagkov and Plott (1997) amongst others [17] Rabin & 1998 11-46 [18] Ki
rkpatrick 2007, p. 49 [19] Genesove & Mayer, 2001 [20] Benartzi 1995 [21] http:/ /
www. dimensional. com/ famafrench/ 2009/ 08/ fama-on-market-efficiency-in-a-vol
atile-market. html Fama on Market Efficiency in a Volatile Market [22] See Freem
an, 2004 for a review [23] "Dr. Donald A. Balenovich" (http:/ / www. ma. iup. ed
u/ people/ dabalen. html). Indiana University of Pennsylvania, Mathematics Depar
tment. . [24] "Ahmet Duran" (http:/ / www. umich. edu/ ~durana). Department of M
athematics, University of Michigan-Ann Arbor. . [25] "Dr Ray R. Sturm, CPA" (htt
p:/ / www. bus. ucf. edu/ rsturm). College of Business Administration. . [26] "P
redictably Irrational" (http:/ / www. predictablyirrational. com/ ?page_id=5). D
an Ariely. . Retrieved 2008-04-25. [27] Sendhil Mullainathan: Solving social pro
blems with a nudge (http:/ / www. ted. com/ talks/ sendhil_mullainathan. html) [
28] How Obama Is Using the Science of Change (http:/ / www. time. com/ time/ mag
azine/ article/ 0,9171,1889153,00. html). Michael Grunwald, TIME, April 2, 2009.
87
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Impulse Control". Psychological Bulletin 82 (4): 463–496. doi:10.1037/h0076860. PM
ID 1099599. • Barberis, N.; Shleifer, A.;; Vishny, R. (1998). "A Model of Investor S
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on and the Equity Premium Puzzle" (http:// jstor.org/stable/2118511). The Quarte
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avioral Economics". International Encyclopedia of the Social & Behavioral Scienc
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_udi=B7MRM-4MT09VJ-41P&_rdoc=2&_hierId=151000134&_refWorkId=21& _explode=1510001
31,151000134&_fmt=high&_orig=na&_docanchor=&_idxType=SC&view=c&_ct=28& _acct=C00
0050221&_version=1&_urlVersion=0&_userid=10&md5=691f9ca74480a55183807ed9dcf1933e
) • Rabin, Matthew (1998). "Psychology and Economics". Journal of Economic Literat
ure 36 (1): 11–46 (http:// pages.towson.edu/jpomy/behavioralecon/PsychologyandEcon
omicsRabin98JEL.pdf). Press +. • Shefrin, Hersh (2002). Beyond Greed and Fear: Und
erstanding behavioral finance and the psychology of investing. New York: Oxford
University Press. ISBN 0195161211. • Shleifer, Andrei (1999). Inefficient Markets: A
n Introduction to Behavioral Finance. New York: Oxford University Press. ISBN 0198
292287. • Simon, Herbert (1987). "Behavioral Economics". The New Palgrave: A Dicti
onary of Economics,. 1. pp. 221–24. • Richard H. Thaler and Sendhil Mullainathan (2008
). "Behavioral Economics," (http://www.econlib.org/library/ Enc/BehavioralEconom
ics.html) The Concise Encyclopedia of Economics, 2nd Edition. Liberty Fund. • Abst
racts 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. dictiona
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External links
• Behavioral Finance Initiative (http://icf.som.yale.edu/research/behav_finance.sh
tml) of the International Center for Finance at the Yale School of Management • Ov
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ncement of Behavioural Economics
89
Intangible asset finance
Intangible asset finance
Intangible Asset Finance is the branch of finance that deals with intangible ass
ets such as patents (legal intangible) and reputation (competitive intangible).
Like other areas of finance, intangible asset finance is concerned with the inte
rdependence of value, risk, and time.
Basic principles
In 2003, one estimate put the economic equilibrium of intangible assets in the U
.S. economy at $5 trillion, which represented over one-third or more of the valu
e of U.S. domestic corporations in the first quarter of 2001.[1] One of the goal
s of people working in this field is to unlock the "hidden value" found in intan
gible assets through the techniques of finance. Another goal is to measure how f
irm performance correlates with intangible asset management. Intangible assets i
nclude business processes, Intellectual Property (IP) such as patents, trademark
s, reputations for ethics and integrity, quality, safety, sustainability, securi
ty, 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 physi
cal 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 pate
nts for the sole purpose of securing licenses and/or damages awards from infring
ing 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, hedg
e funds have raised capital for the specific purpose of investing in patent liti
gation. 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 buyin
g and selling of what are essentially specialized asset-backed securities. The a
ssets that are securitized are typically intellectual properties, such as patent
s, that have been bearing royalties for a period of time. Royalty Pharma is a we
ll known firm that uses this business model, and which has done by far the large
st and most high-profile deals in this space.[2] Royalty Pharma handled what man
y consider to be the first pharmaceutical patent-backed securitization to be rat
ed 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 pate
nt) and Bristol Myers Squibb. • Reinsurers: These are firms that use the technique
s of reinsurance to mitigate intangible asset risks. In the same way that some f
irms issue Cat bonds to mitigate the risks associated with extreme weather, eart
hquakes, or other natural disasters, firms exposed to substantial intangible ris
k can issue "intangible asset risk-linked securities" that transfer intangible r
isk to hedge funds and other players in the capital markets with a sufficient ap
petite for risk. Steel City Re, which is based in Pittsburgh, is a thought leade
r regarding the use of risk transfer techniques to protect and recover intangibl
e asset value.[4] • Market makers: Firms that are working to provide more liquidit
y to the market for intellectual property. Early market makers offered on-line i
ntellectual property exchanges where buyers and sellers could exchange rights in
Intangible asset finance licensed intellectual property, usually patents. In 200
8, 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 pro
perty in a completely transparent fashion." Patent Bid Ask now complements Ocean
Tomo's experience in providing multi-lot, live auctions for intellectual proper
ty. On April 22, 2008, Ocean Tomo reported[6] that it had transacted approximate
ly $70 million in its IP auctions across Europe and the United States. In 2009,
The Intellectual Property Exchange International (IPXI), headquartered in Chicag
o, will begin operations as the world’s first stock exchange with an intellectual
property focus. • Investment Research Firms: Companies that provide specific advic
e to investors on intellectual property issues. Recently, hedge fund managers ha
ve been hiring patent attorneys to follow and handicap outcomes in high stakes p
atent cases. IPD Analytics, which is based in Miami, is known for is research re
ports on patent litigation pending in the United States district court as well a
t the United States Court of Appeals for the Federal Circuit.
90
Significant transactions
• 1997: David Bowie securitizes the future royalty revenues earned from his pre-19
90 music catalogue by issuing Bowie Bonds. • 2000: BioPharma Royalty Trust complet
es 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 th
e 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 w
ith 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 securitiza
tion of BCBG Max Azria s royalty receivables generated from worldwide intellectu
al property rights worth $53 million. This transaction is recognized as the firs
t "whole company securitization" involving primarily intangible assets. UCC Capi
tal Corporation has since been acquired by NexCen Brands, Inc., which is current
ly helmed by Robert W. D Loren. NexCen is a vertically integrated global brand m
anagement company focused on assembling a diversified portfolio of intellectual
property-centric companies operating in the consumer branded products and franch
ise industries. On May 19, 2008, NexCen issued a press release in which it state
d that there was substantial doubt about its ability to continue as a going conc
ern.[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 auc
tions that followed showed that the live auction is a reasonably viable business
model for monetizing intellectual property. • 2006: Marvel Entertainment s film r
ights securitization in conjunction with Ambac Financial Group to provide a trip
le-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 som
e of Marvel’s most popular comic book characters.[8]
Intangible asset finance
91
Government, societies, think tanks, and other non-profits
On June 23, 2008, the United States National Academies hosted a one-day conferen
ce in Washington, D.C. entitled "Intangible Assets: Measuring and Enhancing Thei
r Contribution to Corporate Value and Economic Growth." The Intangible Asset Fin
ance Society provides a forum for finance, innovation, legal and management prof
essionals to discover better ways to create, capture and preserve the value of i
ntangible assets. The Athena Alliance is a non-profit organization dedicated to
public education and research on the emerging global information economy. On Apr
il 16, 2008 it published[9] a widely-circulated working paper on the topic of in
tangible asset finance.
References
[1] "A Trillion Dollars A Year In Intangible Investment," Leonard Nakamura in In
tangible Assets: Values, Measures and Risks at 28, Hand & Lev, Oxford University
Press (2003). (http:/ / books. google. com/ books?id=RmFLUk7NydQC& printsec=fro
ntcover& dq=Intangible+ Assets:+ Values,+ Measures+ and+ Risks,& sig=W2d87NPMzvf
WlTDrmUNijOziu-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: Inve
sting Wisely in Intellectual Property at 487, Bruce Berman, John Wiley & Sons, 2
002 (http:/ / books. google. com/ books?id=rESRFPqSKzQC& pg=PA487& lpg=PA487& dq
=zerit+ patent+ securitization& source=web& ots=sN9S5ZWcrM& sig=LhlE-nYfxXddjCKe
oGql6ap5KxM& hl=en#PPA487,M1) [4] Steel City Re (http:/ / www. steelcityre. com/
accelerating_innovation. shtml) [5] [6] [7] [8] [9] Patent Bid Ask (http:/ / ww
w. patentbidask. com/ ) Ocean Tomo Press Release April 22, 2008 (http:/ / www. o
ceantomo. com/ press/ Europe_Auction_Catalogue_Release_4. 22. 08. pdf) NexCen Pr
ess Release, May 19, 2008 (http:/ / www. nexcenbrands. com/ press_release93. htm
l) Ambac s press release, 2006 (http:/ / www. ambac. com/ pdfs\Deals\marvel. pdf
) "Intangible Asset Monetization: The Promise and the Reality" (http:/ / www. at
henaalliance. org/ pdf/ IntangibleAssetMonetization. pdf)
Further reading
• Rembrandts In the Attic: Unlocking the Hidden Value of Patents (http://books.goo
gle.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.ht
ml?ei=5124&en=f04ad9659c3221fa&ex=1346990400& adxnnl=1&partner=permalink&exprod=
permalink) • "IP-Focused Hedge Funds Launch Amid Market Volatility", Dow Jones, Ap
ril 29, 2008 (http://news. morningstar.com/newsnet/ViewNews.aspx?article=/DJ/200
804291343DOWJONESDJONLINE000826_univ. xml) • "Hedge Fund Spies in the Courtroom, I
P Law & Business, May 10, 2007 (http://www.law.com/jsp/article. jsp?id=117870148
3131) • Intellectual Asset Management Magazine Blog (http://www.iam-magazine.com/b
log/default.aspx)
Article Sources and Contributors
92
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nmann, Amorymeltzer, Andman8, AndreaFox2, Andres, AndrewHowse, Andy Marchbanks,
Andycjp, Andyjsmith, Apb123, Apparition11, ArglebargleIV, Argon233, Ariaconditzi
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Calcuscribe, Caltas, CambridgeBayWeather, Can't sleep, clown will eat me, Canter
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Chennaiseo, Chicago god, Chocolateboy, Cholmes75, ChrisCork, Chriscm, Chrislk02
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nversion script, Cookie90, Courcelles, Cretog8, Crobb305, Crzycheetah, Czalex, D
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