List of Figures List of Tables Acknowledgments Preface xv xix xxi xxiii PART I INTRODUCTION 1 1 The Evolution of Financial Analysis 3 1.1 Bookkeeping 3 1.2 Modern finance 8 1.3 Departments, silos and analysis 10 1.4 The IT system landscape 11 1.5 New approach 15 1.6 Hazards of a single solution 17 2 Finding the Elements 19 2.1 The notion of elements 19 2.1.1 Elements and science 19 2.1.2 Analyzing analysis 21 2.2 Elements of financial analysis 21 2.2.1 Liquidity 22 2.2.2 Value and income 22 2.2.3 Risk and sensitivity analysis 23 2.3 Input elements 25 2.4 Financial events and expected cash flows 26 2.5 Risk factors and risk categories 29 2.6 The time dimension 31 2.6.1 Time and the calendar time 31 2.6.2 The role of intervals 32 2.6.3 Double existence of time 32
vi Contents 2.7 Classification of analysis 33 2.7.1 Liquidation and going-concern view 33 2.7.2 Analysis types 35 2.8 Nonfinancial cash flows 37 2.9 The methodology as an image 39 PART II INPUT ELEMENTS 41 3 Financial Contracts 43 3.1 Modeling of financial contracts 43 3.2 Standard contract types 46 3.3 Rules and mechanisms of standard contracts 51 3.3.1 Principal amortization patterns 51 3.3.2 Principal draw-down patterns (step-up) 53 3.3.3 Interest payment patterns 54 3.3.4 Fixed/variable (rate adjustments) 55 3.3.5 FX rates 57 3.3.6 Stock patterns 57 3.3.7 Commodity patterns 58 3.3.8 Plain vanilla option patterns 58 3.3.9 Exotic option patterns 59 3.3.10 Credit risk 60 3.3.11 Behavioral patterns 61 3.4 Examples 62 3.4.1 Principal at maturity (PAM) 62 3.4.2 Annuities (ANN) 63 3.4.3 Regular amortizer (RGM) 64 3.4.4 Interest rate swap (IRSWP) 65 3.4.5 Forward rate agreement (FRA) 66 3.4.6 Bond and interest rate options (IROPT) 67 3.5 Nonstandard contract types 68 3.5.1 Input elements and events 69 3.5.2 Analysis elements 70 Appendix: Practical considerations 70 3.A.1 Mapping process 71 3.A.2 Data quality 71 4 Market Risk Factors 73 4.1 Expectations 74 4.1.1 Economic expectations 74 4.1.2 Arbitrage-free markets and risk-neutral valuation 75 4.1.3 Absence of arbitrage and economic expectation 79 4.1.4 Linear and nonlinear effects 80 4.2 Static modeling 81 4.2.1 Interest rates 81 4.2.2 Stocks, exchange rates and commodities 84 4.2.3 Spreads as risk factors 85
vii 4.3 Stochastic market models: the arbitrage-free world 87 4.3.1 Stock price models 87 4.3.2 Beyond geometric Brownian motion 90 4.3.3 Interest rates: general considerations 91 4.3.4 Short rate models 92 4.3.5 Forward rate models 93 4.4 Stochastic market models: the real world 96 4.4.1 Economic scenario generation 97 4.4.2 Modeling individual products: stocks and commodities 98 4.4.3 Product rates 100 4.5 Alternative valuation techniques 101 4.5.1 Arbitrage-free and complete markets 102 4.5.2 Arbitrage-free incomplete markets 103 4.5.3 Discounting with deflators 105 4.5.4 Arbitrage opportunities and deflators 107 Further reading 108 5 Counterparty 111 5.1 Exposure, rating and probabilities of default 111 5.2 Data determining gross exposure 113 5.2.1 Counterparty descriptive data 113 5.2.2 Counterparty hierarchies and group structures 114 5.2.3 Counterparty and financial contracts 115 5.3 Credit enhancements 115 5.3.1 Credit enhancements and financial contracts 116 5.3.2 Guarantees 118 5.3.3 Credit derivatives 120 5.3.4 Collaterals 124 5.3.5 Close-out netting agreement 125 5.3.6 Double default 126 5.4 Credit line and limits 127 5.4.1 Credit lines 127 5.4.2 Credit line exposure 128 5.4.3 Credit limits 130 5.5 Credit ratings 131 5.5.1 Measurement of credit rating 131 5.5.2 Classifying credit ratings 132 5.5.3 Ratings classes and exposures 132 5.5.4 Rating techniques 134 Further reading 134 6 Behavior 135 6.1 Risk sources and behavior 136 6.2 Market-related behavior 138 6.2.1 Replication 138 6.2.2 Prepayment 143
viii Contents 6.2.3 Sales 145 6.2.4 Draw-down 146 6.3 Insurance-related behavior 148 6.3.1 Mortality, longevity and invalidity 148 6.3.2 Surrender/lapse 149 6.3.3 Annuity conversion 150 6.4 Credit risk-related behavior 151 6.4.1 Migration and probability of default 151 6.4.2 Recovery 152 6.4.3 Used at default 153 6.5 Sequence of behavioral effects 154 Further reading 155 7 Costs 157 7.1 Introduction to cost accounting 157 7.1.1 Fixed and variable costs 158 7.1.2 Standard cost accounting 159 7.1.3 Activity-based cost accounting 161 7.1.4 Examples of cost allocation 162 7.2 Allocating costs to financial contracts 164 7.2.1 Cost, contracts and counterparties 164 7.2.2 Cost patterns in the financial service sector 166 7.3 Integration of costs into the general framework 166 7.3.1 Costs as a financial event 167 7.3.2 Dealing with costs in different temporal modes 168 7.3.3 Costs and risk 169 7.4 Summary and conclusions 171 Further reading 172 PART III ANALYSIS LIQUIDATION VIEW 173 8 Financial Events and Liquidity 175 8.1 Financial event processing 176 8.2 Examples 178 8.2.1 Fixed rate instruments 178 8.2.2 Variable rate instruments 180 8.2.3 Swaps 182 8.2.4 Forward rate agreements 183 8.3 Behavioral events 183 8.4 Liquidity reports 186 8.4.1 Cash management 186 8.4.2 Liquidity gap 186 Further reading 190
ix 9 Value, Income and FTP 191 9.1 Valuation principles 191 9.1.1 Value and income 192 9.1.2 Overview of valuation principles 194 9.1.3 Parallel valuation techniques and balance sheets 195 9.2 The big four 197 9.2.1 Nominal value 197 9.2.2 Amortized cost 198 9.2.3 Historic/write-off at end 199 9.2.4 Mark-to-market/fair value 200 9.3 Other valuation principles 202 9.3.1 Linear write-off 202 9.3.2 Lower of cost or market 202 9.3.3 Minimal value 203 9.4 Special cases 203 9.4.1 Multicurrency 204 9.4.2 Credit-related impairment 205 9.4.3 Operational considerations 206 9.5 IFRS 32, 39 207 9.6 Funds transfer pricing 210 9.6.1 The problem 210 9.6.2 The accrual method 213 9.6.3 The NPV method 215 9.6.4 Nonmaturity contracts 216 Further reading 218 10 Sensitivity 219 10.1 Challenges of sensitivity calculation 219 10.2 Interest rate sensitivities from events 221 10.3 Other market sensitivities 225 10.4 Behavioral sensitivities 226 10.4.1 Credit default sensitivity 226 10.4.2 Mortality sensitivity 230 10.5 Sensitivity reports 231 10.5.1 Interest sensitivity gap 231 10.5.2 Duration and key rate duration 234 10.5.3 Other market sensitivity reports 235 10.5.4 Credit exposure 236 10.5.5 Limits 237 11 Risk 241 11.1 Risk and VaR 241 11.1.1 Risk 241 11.1.2 VaR 243
x Contents 11.2 Analytical VaR methods 244 11.2.1 Market risk 244 11.2.2 CreditRisk+ 246 11.2.3 Insurance risk 250 11.2.4 Combining risks 252 11.3 Numerical VaR methods 253 11.3.1 Market risk 253 11.3.2 Credit risk 254 11.3.3 Insurance risk 258 11.3.4 Liquidity risk and earning at risk 258 11.4 Expected shortfall 259 11.5 Stress and shock scenarios 260 11.6 Regulatory risk measures 262 11.7 Backtesting 263 11.7.1 Type I and type II errors 263 11.7.2 Market risk: VaR model backtesting 264 11.7.3 Credit risk: rating backtesting 266 11.7.4 Liquidity risk methods 269 Appendix: Historization 271 11.A.1 Granularity 273 11.A.2 Data reduction 274 11.A.3 Intraday and parallel histories 275 Further reading 275 12 Operational Risk 277 12.1 Basic indicator and standardized approach 279 12.2 Statistical basis of the advanced measurement approach 280 12.2.1 Definitions 280 12.2.2 Self-assessment approach 281 12.2.3 Loss distribution approach 281 12.2.4 Risk indicators approach 283 12.2.5 Output 284 12.3 Operational value at risk 285 12.3.1 Static 285 12.3.2 Dynamic 286 Further reading 288 PART IV ANALYSIS GOING-CONCERN VIEW 289 13 General Mechanisms 293 13.1 Market conditions and general risk factors 293 13.2 New financial production 294 13.2.1 Volume 294 13.2.2 Characteristics 296 13.2.3 Pricing 298
xi 13.3 Behavior and counterparty 299 13.4 Cost 300 13.5 Balancing 301 13.5.1 Dynamic balancing 301 13.5.2 Static balancing and reconciliation 304 Appendix: Aggregation 305 13.A.1 Single contract level and performance 305 13.A.2 Contract aggregation 307 14 Banks 309 14.1 Chart of accounts and portfolio structures 309 14.2 Forecasting volume and characteristics 311 14.2.1 Loans and mortgages, bond issues 312 14.2.2 Current accounts, savings and deposits 313 14.2.3 Trading and off-balance sheet 314 14.2.4 Other special accounts 316 14.2.5 Liquidity interbank and equity 316 14.3 Adding market forecast, counterparty information and behavior 318 14.3.1 Market forecast and pricing 318 14.3.2 Behavioral shifts and counterparty information 320 14.4 Analysis elements 321 14.4.1 Liquidity 321 14.4.2 Value and income 325 14.4.3 FTP 330 14.4.4 Limits, sensitivity and risk 332 15 Life Insurance 335 15.1 Chart of account 335 15.2 The life contract 337 15.2.1 Gross and net premiums 338 15.2.2 Cost 338 15.2.3 Risk premium and mortality tables 339 15.2.4 Reserve building 340 15.2.5 Surrender and surrender value 342 15.2.6 Zillmer reserves 342 15.2.7 Survival or retirement benefit 343 15.3 Forecasting new production 344 15.3.1 Volume, characteristics and pricing 344 15.3.2 Behavior 345 15.3.3 Cost 346 15.3.4 Balancing and liquidity 346 15.4 Analysis elements 347 15.4.1 Solvency II internal models 347 15.4.2 Balance sheet and P&L forecast 348 15.4.3 Economic value 349
xii Contents 16 Non-life Insurance 353 16.1 Chart of account 353 16.2 The non-life contract 355 16.2.1 Premium 355 16.2.2 Receivables 356 16.2.3 Claim patterns 356 16.2.4 IBNRs and reserving risk 358 16.3 The reinsurance contract 359 16.3.1 Different types of reinsurance 359 16.3.2 Selecting the ceded primary contracts 360 16.4 Forecasting new volume and characteristics 361 16.4.1 Premium written, pricing and characteristics 361 16.4.2 Claims and IBNR 362 16.4.3 Reinsurance and liquidity 363 16.4.4 Cost 364 16.5 Analysis elements 364 16.5.1 Value and income 365 16.5.2 Solvency II internal model 367 17 Nonfinancials 369 17.1 Financial and nonfinancial corporates 371 17.1.1 Cash and goods 371 17.1.2 Financial contracts in the nonfinancial world 373 17.1.3 The financial side of nonfinancials 374 17.1.4 Industries that can be modeled 375 17.1.5 Government 375 17.2 The nonfinancial model 376 17.2.1 Detail level of the meta model 376 17.2.2 Real production and cash flows 377 17.2.3 Balance sheet, OBS and P&L structure 378 17.2.4 Markets and risk factors 380 17.2.5 Relationship between risk factors, production, BS and P&L 380 17.3 Analysis elements 383 17.3.1 Static analysis 383 17.3.2 Dynamic analysis 384 17.4 Corporate valuation 387 17.4.1 Going-concern valuation 387 17.4.2 Nonoperating financial assets and market value of debt 390 17.4.3 Net operating free cash flow 391 17.4.4 Terminal and growth value 392 17.4.5 Weighted average cost of capital 394 17.4.6 Practical example of corporate valuation 396
xiii PART V OUTLOOK AND CONCLUSIONS 397 18 The Financial Laboratory 401 18.1 Risk and performance measurements 401 18.1.1 Nonrisk ratios 401 18.1.2 Risk ratios 403 18.2 Example of an economic risk report 405 18.2.1 Income and expense 405 18.2.2 Capital 406 18.2.3 Return 408 18.2.4 Conclusion 408 18.3 Optimization 408 18.3.1 Static optimization 408 18.3.2 Dynamic optimization 410 18.4 Consistency 411 19 Towards a Unified Financial Language 413 19.1 The need for a unified financial language 413 19.1.1 Why more information? 413 19.1.2 Exemplifying the lemon problem 414 19.1.3 The power of a unified financial language 417 19.2 Structure of a unified financial language 417 19.2.1 Contracts 417 19.2.2 Risk factors 419 19.2.3 Counterparty information 419 19.2.4 Behavior parameters 420 19.2.5 Contract level information and aggregation 421 19.3 New finance, new regulation 421 Index 423