Financial Modelling: An imperative sound for decision making

What is Financial Modelling? Financial modeling is the task of building an abstract representation of a financial decision making situation. This is a mathematical model, such as a computer simulation, designed to represent the performance of a financial asset or a portfolio, of a business, a project, or any other form of financial investment. Theoretically speaking, a financial model is a set of assumptions about future business conditions that drive projections of a companys revenue, earnings, cash flows and balance sheet accounts. However, financial modeling is a general term that means different things to different users. In the US and particularly in business schools it means the development of a mathematical model, often using complex algorithms, and the associated computer implementation to simulate scenarios of financial events, such as asset prices, market movements, portfolio returns and the like. Or it might mean the development of optimization models for managing and controlling the risk of a financial investment. In Europe and in the accounting profession financial modelling is defined as cash flow forecasting, involving the preparation of large, detailed spreadsheets for management decision making purposes. What is the Objective of Financial Modelling? The objective of a financial model is to position clients for success in their foreign investments. Whats the cost of doing business in a given country? Whats the breakeven point? When might you exceed the profitability of a similar operation in the United States? The importance of financial modelling cannot be overstated. and financial models often are a key element in most major business decisions. For instance, a financial model is prepared whenever any organization is considering project finance, bidding for a project, evaluating acquisition target, carrying out monthly financial planning, conducting capital structure studies, etc. The proponents of the model must first undertake a qualitative review - i.e. determine whether the story underpinning the model makes sense. There needs to be a logic behind the adoption of the model and a compelling case that it will be supported by its intended target audience. This useful tool also allows business options and risks to be evaluated in a cost-effective manner against a range of assumptions, identify optimal solutions in evaluating financial returns and understand the impact of resource constraints to make the most effective business decisions. What is the characteristics of a sound Financial Model? A good financial model is: (a) Easy to understand - uses a transparent design; (b) Reliable - uses control checks so that an error is automatically flashed; (c) Easy to use - so that one can be more productive in using the model for analysis rather than struggling just to produce simple results from a badly designed model; (d) Focussed on the key issues - so that one does not waste too much time in development of immaterial items; Related posts: 1. Risk Management from Project Managers Perspective Risk Management from Project Manager's Perspective... 2. GARP confers Risk Management award to Chinese Banking Regulators GARP confers award to Chinese Banking Regulators... 3. Lehman Bros fancy accounting Lehman Bros fancy accounting... 4. Magic behind Financial Projections in a Startup This is the article by Amit Grover, Founder, Nurture Talent... 5. Greeks and Goldman Sachs Greeks and Goldman Sachs...

Basic Project Portfolio Manager Functions

Pipeline Management and the Project Portfolio Manager It is not only in-flight and pending approval projects that should be visible to an enterprise project office. A project office should also have line of forward sight to possible projects and those that are yet to commence. The term for this is the pipeline. Pipeline management is generally another responsibility of the Project Portfolio Manager. Some of the key pipeline management activities, to be undertaken by the Project Portfolio Manager are as follows: * Liaison with all areas of the enterprise to remain informed of initiatives that they are proposing to progress in the coming 1 to 3 years * Ongoing liaison with areas of the enterprise to ensure previously flagged initiatives are still on track to progress * Maintenance of a pipeline view to ensure appropriate long term resource management activities are undertaken (e.g. Recruitment of appropriately skilled staff) * Communicating the pipeline view to all relevant areas of the enterprise Project Portfolio Resource Coordination Increasingly, project resource supply and demand management is the responsibility of the Project Portfolio Manager. The fundamental theory behind this is that as the Project Portfolio Manager has a clear pipeline view and the best understanding of project portfolio priorities then they are best placed to make decisions about the allocation of project resources. Resource groups that the Project Portfolio Manager may be responsible for coordinating supply and demand for could include, but not be limited to, the following: * Project Managers and other administrative project staff * Software development resources * Business Analysts * Testing resources and environments Organisation Risk Management via Project Portfolio Management A key function of project portfolio management is the responsibility for identifying, reporting and mitigating as far as possible any risks that affect the project portfolio as a whole. Portfolio level risk reporting should form an integral part of the organisations risk management practices. The risk register used for this purpose may be very similar in layout and function to that which would be used by an individual project as part of the project risk management framework. Portfolio Dependency Management Project portfolio management has an important role to play with respect to identifying and managing portfolio-level dependencies. Portfolio-level dependencies are those project dependencies related to the portfolio as a whole, which could potentially impact multiple in-flight projects across the enterprise portfolio. For example, if three development projects all require the skills of a single team of programmers then completion of Project A and Project B might be dependant on the completion of work for Project C. With multiple projects linked by this dependency, the dependency itself should be identified, documented and managed at the portfolio level. Provision of Management Information by Project Portfolio Managers Provision of project-related reporting, on an aggregated basis, is traditionally the responsibility of an enterprise project office. Some of this reporting is the responsibility of the Project Portfolio Manager. Although the reporting provided through the project portfolio management process may vary as a function of organisation size, maturity, complexity and nature of business, there remains some general reporting areas that should be developed as part of this function. Some such areas are: * Pipeline status (e.g. Number of pending projects, projects in-flight) * Current work in progress broken down into areas such as resource requirements and capital spent against proposed project budget) * Resource utilisation (i.e. supply and demand tables and charts) * Project portfolio composition in terms of project types, enterprise strategy alignment and size of capital investment What does Project Portfolio Management Deliver the Organisation? With the fundamentals of PPM established, the question remaining is, what does effective project portfolio management provide an organisation. Varying benefits are postulated by numerous theories and specific approaches to PPM, but the common benefits of a PPM approach to enterprise project management and coordination are, at minimum, the following: * An optimised project portfolio which delivers projects aligned with organisation strategy * Ability to more closely govern and guide projects across the enterprise * Transparency and better management of organisational risk born of projects across the organisation * Optimal resource utilisation and reduced resourcing costs on a per-unit-delivered basis * Improved project risk management through the identification and management of portfolio-level risks * Greater forward planning through pipeline view management In summation, Project portfolio management is essentially a simple collection of fundamentals, aimed at improving the management and coordination of projects, project resources, organisation capital and risk. As with other enterprise project management approaches, there are a myriad of variations on the theme. Regardless, the basics of project portfolio management remain unchanged.

What is Margin, Margin Call, Margin Requirements …

What is Margin?
Margin is essentially the difference between a product’s selling price and the cost of production.

A margin is a collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk of his counterparty (most often his broker). This risk can arise if the holder has done any of the following:

* borrowed cash from the counterparty to buy securities or options,
* sold securities or options short, or
* entered into a futures contract.

Margin buying
Margin buying is buying securities with cash borrowed from a broker, using other securities as collateral. This has the effect of magnifying any profit or loss made on the securities. The securities serve as collateral for the loan. The net value, i.e. the difference between the value of the securities and the loan, is initially equal to the amount of one’s own cash used. This difference has to stay above a minimum margin requirement, the purpose of which is to protect the broker against a fall in the value of the securities to the point that the investor can no longer cover the loan.

In the 1920s, margin requirements were loose. In other words, brokers required investors to put in very little of their own money. Whereas today, the Federal Reserve’s margin requirement limits debt to 50 percent, during the 1920s leverage rates of up to 90 percent debt were not uncommon.[1] When the stock market started to contract, many individuals received margin calls. They had to deliver more money to their brokers or their shares would be sold. Since many individuals did not have the equity to cover their margin positions, their shares were sold, causing further market declines and further margin calls. This was one of the major contributing factors which led to the Stock Market Crash of 1929, which in turn contributed to the Great Depression [1], a troubling financial time in the 1930s.

Illustration:
Assume that the initial margin required to buy or sell a particular commodity contract is $1,000 and the maintenance margin requirement is $750. Should losses on open positions reduce the funds in your trading account $700, you would receive a margin call for the $300 needed to restore your account back to the initial $1,000. If there were not excess funds in the account in order to bring the initial amount back up to $1,000, that position would create a margin call, a situation in which the account would need to be either immediately met with additional funds or the position liquidated to cover the margin call.

Types of margin requirements

Current liquidating margin

The current liquidating margin is the value of a securities position if the position were liquidated now. In other words, if the holder has a short position, this is the money needed to buy back; if he is long, it is the money he can raise by selling it.

Variation margin

The variation margin or maintenance margin is not collateral, but a daily offsetting of profits and losses. Futures are marked-to-market every day, so the current price is compared to the previous day’s price. The profit or loss on the day of a position is then paid to or debited from the holder by the futures exchange. This is possible, because the exchange is the central counterparty to all contracts, and the number of long contracts equals the number of short contracts. Certain other exchange traded derivatives, such as options on futures contracts, are marked-to-market in the same way.

Premium margin

The seller of an option has the obligation to deliver the underlying of the option if it is exercised. To ensure he can fulfil this obligation, he has to deposit collateral. This premium margin is equal to the premium that he would need to pay to buy back the option and close out his position.

Additional margin

Additional margin is intended to cover a potential fall in the value of the position on the following trading day. This is calculated as the potential loss in a worst-case scenario.

Margin call
When the margin posted in the margin account is below the minimum margin requirement, the broker or exchange issues a margin call. The investor now either has to increase the margin that they have deposited, or they can close out their position. They can do this by selling the securities, options or futures if they are long and by buying them back if they are short. If they don’t do any of this the broker can sell his securities to meet the margin call.

Return on margin
Return on margin (ROM) is often used to judge performance because it represents the net gain or net loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The annualized ROM is equal to

(ROM + 1)(year/trade_duration) - 1

For example if a trader earns 10% on margin in two months, that would be about 77% annualized

(ROM +1)1/6 - 1 = 0.1 thus ROM = 1.16 - 1

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Black Swans

What Does Black Swan Mean?
A Black Swan is an event or occurrence that varies from what is generally expected of a situation and which is be extremely difficult to predict.

Black Swan Events were described by Nassim Nicholas Taleb in his 2007 book, The Black Swan. He is a finance professor and former Wall Street trader.

He used “The Black Swan Theory” to explain the existence and occurrence of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations.

Characteristics of a Black Swan Event

1. The event is a surprise (to the observer).
2. The event has a major impact.
3. After the fact, the event is rationalized by hindsight, as if it had been expected.

Ten Principles for a Black Swan Robust World

Taleb enumerates ten principles for building systems that are robust to Black Swan Events:

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail.
Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks and hence the most fragile become the biggest.

2. No socialisation of losses and privatisation of gains.
Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.
The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.

4. Do not let someone making an “incentive” bonus manage a nuclear plant or your financial risks.
Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

5. Counter-balance complexity with simplicity.
Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

6. Do not give children sticks of dynamite, even if they come with a warning.
Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”.
Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

8. Do not give an addict more drugs if he has withdrawal pains.
Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement.
Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

10. Make an omelette with the broken eggs.
Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself.

You can read more about Nassim Nicholas Taleb here.

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Lehman Bros’ fancy accounting

There has been much furore in financial sphere over the recent revelation of misleading accounting techniques used by Lehman Bros.
An accounting trick, known as the Repo 105 aided financial relief to Lehman Brothers just before its supernova collapse. It now seems that the shenanigans spells used by them may cast a legal jeopardy for executives of Lehman and its auditors Ernst & Young.

The implosion of Lehman Brothers Holdings Inc. into the biggest bankruptcy in U.S. history in September 2008 led the financial meltdown that plunged the economy into the most severe recession since the 1930s, which now thankfully shows some signs of recovery.

How did they do it ?
After puffing itself with billions of troubled assets that couldn’t easily be sold, Lehman camouflaged its debt and financial condition by using the accounting gimmick, the examiner appointed by the bankruptcy court revealed in a 2,200-page report on a yearlong investigation.

The report also unveiled that Lehman put together complex transactions that allowed the firm to sell “toxic,” securities at the end of a quarter wiping them off its balance sheet when regulators and shareholders were examining it and then to quickly buy them back.
The “Repo” here means repurchase.

Now, Repo 105 has entered the list of names of vehicles for accounting tweaks, along with others like Raptor partnerships etc.
In the sagas of those two companies, the role of the accounting firms was central.

Here are some of the accounting scandals that came to light in recent years:

(a) AIG - Accounting of structured financial deals
(b) Bernard L. Madoff Investment Securities - Ponzi scheme run by Bernard Madoff. David G. Friehling was charged with securities fraud, aiding and abetting investment adviser fraud, and four counts of filing false audit reports with the Securities and Exchange Commission in regards to this Ponzi scheme. He faces up to 105 years in prison on all of the charges.[33]
(c) Anglo Irish Bank - hidden loans controversy
(d) Satyam Computers - Falsified accounts

In the meltdown’s wake, Justice and the SEC launched wide-ranging investigations of companies across the financial services industry, believed to include insurer American International Group Inc. and mortgage giants Fannie Mae and Freddie Mac as well as Lehman. A year and a half after the financial crisis struck, charges haven’t yet come in most of the probes.

The Report doesn’t reach a conclusion on whether executives violated securities laws. It does say that the executives’ decision not to disclose the effects of its business judgments “does give rise to
colorable claims against the senior officers who oversaw and certified misleading financial statements.”

Colorable claims here implies that there appears to be sufficient evidence to support the awarding of civil damages in a trial.

The report says there also are colorable claims against the outside auditors, Ernst & Young, for “its failure to question and challenge improper or inadequate disclosures” in Lehman’s financial statements.

However, EnY said: “We never concluded our review of the matter, because Lehman went into bankruptcy before we completed our audit.”

These incidents certainly reiterate the value of accounting ethics, which have, in recent years gained currency due to the diverse range of accounting services and recent corporate collapses, attention has been drawn to ethical standards accepted within the accounting profession.

Read a related interesting article : Why Lehman Bros went bust; what it means for you

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Yield Spread

What is Yield ?

The term yield indicates the amount in cash that the owners of a security will get.

What is Yield spread ?
Yield spread is the difference between the quoted rates of return on two different investments, usually of different credit quality.

The “yield spread of X over Y” is simply the percentage return on investment (ROI) from financial instrument X minus the percentage return on investment from financial instrument Y (per annum).It is an indication of the risk premium for investing in one investment product over another.
The higher the yield spread, the greater the difference between the yields offered by each instrument.

Implications:
When spreads widen between bonds with different quality ratings it implies that the market is factoring more risk of default on lower grade bonds. For example, if a risk free 10 year Treasury note is currently yielding 5% while junk bonds with the same duration are averaging 7%, the spread between Treasuries and junk bonds is 2%.
If that spread widens to 4% (increasing the junk bond yield to 9%), the market is forecasting a greater risk of default which implies a slowing economy. A narrowing of spreads (between bonds of different risk ratings) implies that the market is factoring in less risk.

There are several measures of yield spread, including Z-spread and option-adjusted spread.

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CFA Exam Pattern - Updates

If you plan to appear for the CFA exam June 6, 2010, here are some important things you must know as you chalk out your plan, gather study resources and get on with it:
(a) The curriculum for CFA exam has changed
(b) CFAI has introduced some modification regarding the Exam style and formatting convention
(c) Accounting rules and the financial environment have changed and
(d) CFA-2009 exam onwards, the MCQs will have three answer choices instead of four
The curriculum changes each year to meet the dynamic nature and complexity of the global investment profession. CFA Institute, through the oversight of the Educational Advisory Committee (EAC),
regularly conducts a practice analysis survey of investment professionals around the world to determine the knowledge, skills, and competencies that are relevant to the profession. The results of the practice analysis define the Global Body of Investment Knowledge (GBIK) and the CFA Program Candidate Body of Knowledge
(CBOK).
The last change with respect to number answer choices could have significant impact on the way the candidates attempt and score in the exam. Here’s CFA Institute’s rationale behind this change:

“Research and our own experience indicate that the fourth answer option on multiple choice and item set exams is unnecessary to assess a candidate’s knowledge and skills. Three answer choices are sufficient and effective in discriminating between those candidates that possess the knowledge and skills and those that do not. As a result, we are changing the format of the multiple-choice and item set questions on CFA exams from four answer options to three.”
So, would it become easier to crack the exam, now that the candidates have fewer answer choices to consider?
Well, not really. The key thing to note here is that although candidates need to carefully manage their time to perform well on CFA exams, the CFA exams are not merely a test of time management skills. You need to have a certain level of mastery of the knowledge and skills to get through.
The probability of successful guessing on any single MCQ will increase. However, the probability that a candidate would be able to guess correctly enough times to pass the exam is very small. This is true irrespective of whether there are two, three, four or more choices. It is also at least theoretically possible that a candidate
with enough knowledge and skills to achieve a reasonably high score might achieve a higher score through successful guessing on just a few questions. It is important to note that there is not a fixed score that candidates need to achieve to pass a CFA exam. Standard setters evaluate the difficulty of each exam in making their minimum
pass score recommendation. Keep this in mind as you gear up the preparation for the exam and remember - “Work Hard At Working Smart”.
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