Contents. List of Figures. List of Tables. Acknowledgments PART I INTRODUCTION 1

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1 List of Figures List of Tables Acknowledgments Preface xv xix xxi xxiii PART I INTRODUCTION 1 1 The Evolution of Financial Analysis Bookkeeping Modern finance Departments, silos and analysis The IT system landscape New approach Hazards of a single solution 17 2 Finding the Elements The notion of elements Elements and science Analyzing analysis Elements of financial analysis Liquidity Value and income Risk and sensitivity analysis Input elements Financial events and expected cash flows Risk factors and risk categories The time dimension Time and the calendar time The role of intervals Double existence of time 32

2 vi Contents 2.7 Classification of analysis Liquidation and going-concern view Analysis types Nonfinancial cash flows The methodology as an image 39 PART II INPUT ELEMENTS 41 3 Financial Contracts Modeling of financial contracts Standard contract types Rules and mechanisms of standard contracts Principal amortization patterns Principal draw-down patterns (step-up) Interest payment patterns Fixed/variable (rate adjustments) FX rates Stock patterns Commodity patterns Plain vanilla option patterns Exotic option patterns Credit risk Behavioral patterns Examples Principal at maturity (PAM) Annuities (ANN) Regular amortizer (RGM) Interest rate swap (IRSWP) Forward rate agreement (FRA) Bond and interest rate options (IROPT) Nonstandard contract types Input elements and events Analysis elements 70 Appendix: Practical considerations 70 3.A.1 Mapping process 71 3.A.2 Data quality 71 4 Market Risk Factors Expectations Economic expectations Arbitrage-free markets and risk-neutral valuation Absence of arbitrage and economic expectation Linear and nonlinear effects Static modeling Interest rates Stocks, exchange rates and commodities Spreads as risk factors 85

3 vii 4.3 Stochastic market models: the arbitrage-free world Stock price models Beyond geometric Brownian motion Interest rates: general considerations Short rate models Forward rate models Stochastic market models: the real world Economic scenario generation Modeling individual products: stocks and commodities Product rates Alternative valuation techniques Arbitrage-free and complete markets Arbitrage-free incomplete markets Discounting with deflators Arbitrage opportunities and deflators 107 Further reading Counterparty Exposure, rating and probabilities of default Data determining gross exposure Counterparty descriptive data Counterparty hierarchies and group structures Counterparty and financial contracts Credit enhancements Credit enhancements and financial contracts Guarantees Credit derivatives Collaterals Close-out netting agreement Double default Credit line and limits Credit lines Credit line exposure Credit limits Credit ratings Measurement of credit rating Classifying credit ratings Ratings classes and exposures Rating techniques 134 Further reading Behavior Risk sources and behavior Market-related behavior Replication Prepayment 143

4 viii Contents Sales Draw-down Insurance-related behavior Mortality, longevity and invalidity Surrender/lapse Annuity conversion Credit risk-related behavior Migration and probability of default Recovery Used at default Sequence of behavioral effects 154 Further reading Costs Introduction to cost accounting Fixed and variable costs Standard cost accounting Activity-based cost accounting Examples of cost allocation Allocating costs to financial contracts Cost, contracts and counterparties Cost patterns in the financial service sector Integration of costs into the general framework Costs as a financial event Dealing with costs in different temporal modes Costs and risk Summary and conclusions 171 Further reading 172 PART III ANALYSIS LIQUIDATION VIEW Financial Events and Liquidity Financial event processing Examples Fixed rate instruments Variable rate instruments Swaps Forward rate agreements Behavioral events Liquidity reports Cash management Liquidity gap 186 Further reading 190

5 ix 9 Value, Income and FTP Valuation principles Value and income Overview of valuation principles Parallel valuation techniques and balance sheets The big four Nominal value Amortized cost Historic/write-off at end Mark-to-market/fair value Other valuation principles Linear write-off Lower of cost or market Minimal value Special cases Multicurrency Credit-related impairment Operational considerations IFRS 32, Funds transfer pricing The problem The accrual method The NPV method Nonmaturity contracts 216 Further reading Sensitivity Challenges of sensitivity calculation Interest rate sensitivities from events Other market sensitivities Behavioral sensitivities Credit default sensitivity Mortality sensitivity Sensitivity reports Interest sensitivity gap Duration and key rate duration Other market sensitivity reports Credit exposure Limits Risk Risk and VaR Risk VaR 243

6 x Contents 11.2 Analytical VaR methods Market risk CreditRisk Insurance risk Combining risks Numerical VaR methods Market risk Credit risk Insurance risk Liquidity risk and earning at risk Expected shortfall Stress and shock scenarios Regulatory risk measures Backtesting Type I and type II errors Market risk: VaR model backtesting Credit risk: rating backtesting Liquidity risk methods 269 Appendix: Historization A.1 Granularity A.2 Data reduction A.3 Intraday and parallel histories 275 Further reading Operational Risk Basic indicator and standardized approach Statistical basis of the advanced measurement approach Definitions Self-assessment approach Loss distribution approach Risk indicators approach Output Operational value at risk Static Dynamic 286 Further reading 288 PART IV ANALYSIS GOING-CONCERN VIEW General Mechanisms Market conditions and general risk factors New financial production Volume Characteristics Pricing 298

7 xi 13.3 Behavior and counterparty Cost Balancing Dynamic balancing Static balancing and reconciliation 304 Appendix: Aggregation A.1 Single contract level and performance A.2 Contract aggregation Banks Chart of accounts and portfolio structures Forecasting volume and characteristics Loans and mortgages, bond issues Current accounts, savings and deposits Trading and off-balance sheet Other special accounts Liquidity interbank and equity Adding market forecast, counterparty information and behavior Market forecast and pricing Behavioral shifts and counterparty information Analysis elements Liquidity Value and income FTP Limits, sensitivity and risk Life Insurance Chart of account The life contract Gross and net premiums Cost Risk premium and mortality tables Reserve building Surrender and surrender value Zillmer reserves Survival or retirement benefit Forecasting new production Volume, characteristics and pricing Behavior Cost Balancing and liquidity Analysis elements Solvency II internal models Balance sheet and P&L forecast Economic value 349

8 xii Contents 16 Non-life Insurance Chart of account The non-life contract Premium Receivables Claim patterns IBNRs and reserving risk The reinsurance contract Different types of reinsurance Selecting the ceded primary contracts Forecasting new volume and characteristics Premium written, pricing and characteristics Claims and IBNR Reinsurance and liquidity Cost Analysis elements Value and income Solvency II internal model Nonfinancials Financial and nonfinancial corporates Cash and goods Financial contracts in the nonfinancial world The financial side of nonfinancials Industries that can be modeled Government The nonfinancial model Detail level of the meta model Real production and cash flows Balance sheet, OBS and P&L structure Markets and risk factors Relationship between risk factors, production, BS and P&L Analysis elements Static analysis Dynamic analysis Corporate valuation Going-concern valuation Nonoperating financial assets and market value of debt Net operating free cash flow Terminal and growth value Weighted average cost of capital Practical example of corporate valuation 396

9 xiii PART V OUTLOOK AND CONCLUSIONS The Financial Laboratory Risk and performance measurements Nonrisk ratios Risk ratios Example of an economic risk report Income and expense Capital Return Conclusion Optimization Static optimization Dynamic optimization Consistency Towards a Unified Financial Language The need for a unified financial language Why more information? Exemplifying the lemon problem The power of a unified financial language Structure of a unified financial language Contracts Risk factors Counterparty information Behavior parameters Contract level information and aggregation New finance, new regulation 421 Index 423