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Finance

Contents
1

Main article

1.1

Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.1

Areas of nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.2

Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.3

Financial theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.4

Professional qualications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.5

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.6

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.7

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The main techniques and sectors of the nancial industry

2.1

Financial services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.1.1

The history of nancial services

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.1.2

Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.1.3

Foreign exchange services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.1.4

Investment services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.1.5

Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.1.6

Other nancial services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.1.7

Financial crime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.1.8

Market share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.1.9

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2.1.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10

2.1.11 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10

2.1.12 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10

Personal nance

11

3.1

Personal nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

3.1.1

Personal nancial planning process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

3.1.2

Areas of focus

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

3.1.3

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

3.1.4

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

3.1.5

Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

3.1.6

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

ii
4

CONTENTS
Corporate nance

13

4.1

Corporate nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13

4.1.1

Outline of corporate nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13

4.1.2

Capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

14

4.1.3

Investment and project valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15

4.1.4

Dividend policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17

4.1.5

Working capital management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17

4.1.6

Relationship with other areas in nance . . . . . . . . . . . . . . . . . . . . . . . . . . . .

18

4.1.7

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

19

4.1.8

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

19

4.1.9

Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

4.1.10 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21

Financial capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21

4.2.1

Three concepts of capital maintenance authorized in IFRS . . . . . . . . . . . . . . . . . .

21

4.2.2

Sources of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

22

4.2.3

Dierences between shares and debentures . . . . . . . . . . . . . . . . . . . . . . . . . .

22

4.2.4

Fixed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

22

4.2.5

Working capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

22

4.2.6

Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23

4.2.7

Own and borrowed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23

4.2.8

Issuing and trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23

4.2.9

Broadening the notion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24

4.2.10 Marxian perspectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24

4.2.11 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24

4.2.12 Economic role . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24

4.2.13 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24

4.2.14 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24

4.2.15 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

25

Cornering the market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

25

4.3.1

Historical examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

25

4.3.2

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

26

Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

4.4.1

History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

4.4.2

Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

29

4.4.3

Societal eects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

4.4.4

Insurers business model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

31

4.4.5

Types of insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

32

4.4.6

Insurance companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

39

4.4.7

Across the world . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

41

4.4.8

Controversies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

42

4.4.9

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

4.2

4.3

4.4

CONTENTS

iii

4.4.10 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

4.4.11 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

4.4.12 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

Risk Management

48

5.1

Derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

5.1.1

Collateralised debt obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

5.1.2

Credit default swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

5.1.3

Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

49

5.1.4

Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

49

5.1.5

Mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

5.1.6

Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

5.1.7

Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51

5.1.8

Financial derivative trading companies . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51

5.1.9

Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52

5.1.10 Size of market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52

5.1.11 Usage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

53

5.1.12 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

54

5.1.13 Economic function of the derivative market . . . . . . . . . . . . . . . . . . . . . . . . .

55

5.1.14 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

56

5.1.15 Criticisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

56

5.1.16 Financial Reform and Government Regulation . . . . . . . . . . . . . . . . . . . . . . . .

57

5.1.17 Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

59

5.1.18 Financial derivative trading companies . . . . . . . . . . . . . . . . . . . . . . . . . . . .

60

5.1.19 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

60

5.1.20 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

60

5.1.21 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

63

5.1.22 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

63

Finance of states

64

6.1

Public nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

6.1.1

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

6.1.2

Public nance management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

6.1.3

Government expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

65

6.1.4

Financing of government expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . .

65

6.1.5

Government Finance Statistics and Methodology . . . . . . . . . . . . . . . . . . . . . . .

67

6.1.6

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

69

6.1.7

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

69

6.1.8

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

69

6.1.9

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

70

Financial economics

71

iv

CONTENTS
7.1

Financial economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

71

7.1.1

Underlying economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

71

7.1.2

Resultant models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

72

7.1.3

Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

74

7.1.4

Challenges and criticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

74

7.1.5

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

76

7.1.6

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

76

7.1.7

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

76

7.1.8

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

78

Financial mathematics

80

8.1

Financial mathematics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80

8.1.1

History: Q versus P . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80

8.1.2

Criticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

81

8.1.3

Mathematical nance articles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

8.1.4

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

8.1.5

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

8.1.6

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

Experimental nance

83

9.1

Experimental nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

9.1.1

History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

9.1.2

Scientic value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

9.1.3

Advantages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

9.1.4

Types of experiments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

84

9.1.5

Main ndings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

84

9.1.6

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85

9.1.7

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85

9.1.8

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85

10 Behavioral nance

86

10.1 Behavioral nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

10.1.1 Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

10.1.2 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

88

10.1.3 Criticisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

90

10.1.4 Notable theorists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

91

10.1.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

92

10.1.6 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

92

10.1.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

94

10.1.8 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

94

11 Intangible asset nance


11.1 Intangible asset nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

96
96

CONTENTS

11.1.1 Basic principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

96

11.1.2 Business models

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

96

11.1.3 Signicant transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

97

11.1.4 Government, societies, think tanks, and other non-prots . . . . . . . . . . . . . . . . . .

97

11.1.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

97

11.1.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

97

11.1.7 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

97

12 Text and image sources, contributors, and licenses


12.1 Text . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

98
98

12.2 Images . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103


12.3 Content license . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

Chapter 1

Main article
1.1 Finance

Protection against unforeseen personal events, as


well as events in the wider economy

For the board game, see Finance (game).


Financial redirects here. For the Caucasian newspaper,
see FINANCIAL.

Transference of family across generations (bequests


and inheritance)
Eects of tax policies (tax subsidies and/or penalties) on management of personal nances

Finance is a eld that deals with the allocation of assets


and liabilities over time under conditions of certainty and
Eects of credit on individual nancial standing
uncertainty. Finance can also be dened as the science of
Development of a savings plan or nancing for large
money management. A key point in nance is the time
purchases (auto, education, home)
value of money, which states that purchasing power of
one unit of currency can vary over time. Finance aims to
Planning a secure nancial future in an environment
price assets based on their risk level and their expected
of economic instability
rate of return. Finance can be broken into three dierent sub-categories: public nance, corporate nance and
Personal nance may involve paying for education, personal nance.
nancing durable goods such as real estate and cars, buying
insurance, e.g. health and property insurance, investing
and saving for retirement.

1.1.1

Areas of nance

Personal nance may also involve paying for a loan, or


debt obligations. The six key areas of personal nancial
planning, as suggested by the Financial Planning Standards Board, are:[1]
1. Financial position: is concerned with understanding the personal resources available by examining
net worth and household cash ow. Net worth is a
persons balance sheet, calculated by adding up all
assets under that persons control, minus all liabilities of the household, at one point in time. Household cash ow totals up all the expected sources of
income within a year, minus all expected expenses
within the same year. From this analysis, the nancial planner can determine to what degree and in
what time the personal goals can be accomplished.

Wall Street, the center of American nance.

2. Adequate protection: the analysis of how to protect a household from unforeseen risks. These risks
can be divided into liability, property, death, disability, health and long term care. Some of these
risks may be self-insurable, while most will require
the purchase of an insurance contract. Determining
how much insurance to get, at the most cost eective
terms requires knowledge of the market for personal
insurance. Business owners, professionals, athletes

Personal nance
Main article: Personal nance
Questions in personal nance revolve around:
1

CHAPTER 1. MAIN ARTICLE


and entertainers require specialized insurance professionals to adequately protect themselves. Since
insurance also enjoys some tax benets, utilizing insurance investment products may be a critical piece
of the overall investment planning.
3. Tax planning: typically the income tax is the single
largest expense in a household. Managing taxes is
not a question of if you will pay taxes, but when and
how much. Government gives many incentives in
the form of tax deductions and credits, which can be
used to reduce the lifetime tax burden. Most modern governments use a progressive tax. Typically,
as ones income grows, a higher marginal rate of tax
must be paid. Understanding how to take advantage of the myriad tax breaks when planning ones
personal nances can make a signicant impact in
which it can later save you money in the long term.
4. Investment and accumulation goals: planning
how to accumulate enough money - for large purchases and life events - is what most people consider to be nancial planning. Major reasons to accumulate assets include, purchasing a house or car,
starting a business, paying for education expenses,
and saving for retirement. Achieving these goals
requires projecting what they will cost, and when
you need to withdraw funds that will be necessary
to be able to achieve these goals. A major risk to
the household in achieving their accumulation goal
is the rate of price increases over time, or ination.
Using net present value calculators, the nancial
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 ination, the investment portfolio has to get a higher
rate of return, which typically will subject the portfolio to a number of risks. Managing these portfolio
risks is most often accomplished using asset allocation, which seeks to diversify investment risk and
opportunity. This asset allocation will prescribe a
percentage allocation to be invested in stocks (either preferred stock and/or common stock), bonds
(for example mutual bonds or government bods, or
corporate bonds), cash and alternative investments.
The allocation should also take into consideration
the personal risk prole of every investor, since risk
attitudes vary from person to person.
5. Retirement planning is the process of understanding how much it costs to live at retirement, and coming up with a plan to distribute assets to meet any income shortfall. Methods for retirement plan include
taking advantage of government allowed structures
to manage tax liability including: individual (IRA)
structures, or employer sponsored retirement plans.
6. Estate planning involves planning for the disposition of ones assets after death. Typically, there
is a tax due to the state or federal government at

ones death. Avoiding these taxes means that more


of ones assets will be distributed to ones heirs. One
can leave ones assets to family, friends or charitable
groups.
Corporate nance
Main article: Corporate nance
Corporate nance deals with the sources of funding and
the capital structure of corporations and the actions that
managers take to increase the value of the rm to the
shareholders, as well as the tools and analysis used to allocate nancial resources. Although it is in principle different from managerial nance which studies the nancial management of all rms, rather than corporations
alone, the main concepts in the study of corporate nance are applicable to the nancial problems of all kinds
of rms. Corporate nance generally involves balancing
risk and protability, while attempting to maximize an
entitys wealth and the value of its stock, and generically
entails three primary areas of capital resource allocation.
In the rst, capital budgeting, management must choose
which projects (if any) to undertake. The discipline of
capital budgeting may employ standard business valuation techniques or even extend to real options valuation;
see Financial modeling. The second, sources of capital
relates to how these investments are to be funded: investment capital can be provided through dierent sources,
such as by shareholders, in the form of equity (privately or
via an initial public oering), creditors, often in the form
of bonds, and the rms operations (cash ow). Shortterm funding or working capital is mostly provided by
banks extending a line of credit. The balance between
these elements forms the companys capital structure.
The third, the dividend policy, requires management
to determine whether any unappropriated prot (excess
cash) is to be retained for future investment / operational
requirements, or instead to be distributed to shareholders,
and if so in what form. Short term nancial management
is often termed "working capital management", and relates to cash-, inventory- and debtors management.
Corporate nance also includes within its scope business
valuation, stock investing, or investment management.
An investment is an acquisition of an asset in the hope that
it will maintain or increase its value over time that will
in hope give back a higher rate of return when it comes
to disbursing dividends. In investment management in
choosing a portfolio one has to use nancial analysis to
determine what, how much and when to invest. To do
this, a company must:
Identify relevant objectives and constraints: institution or individual goals, time horizon, risk aversion
and tax considerations;
Identify the appropriate strategy: active versus pas-

1.1. FINANCE
sive hedging strategy
Measure the portfolio performance
Financial management overlaps with the nancial function of the Accounting profession. However, nancial accounting is the reporting of historical nancial information, while nancial management is concerned with the
allocation of capital resources to increase a rms value
to the shareholders and increase their rate of return on
the investments.
Financial risk management, an element of corporate nance, is the practice of creating and protecting economic
value in a rm by using nancial instruments to manage exposure to risk, particularly credit risk and market
risk. (Other risk types include Foreign exchange, Shape,
Volatility, Sector, liquidity, Ination risks, etc.) It focuses
on when and how to hedge using nancial instruments;
in this sense it overlaps with nancial engineering. Similar to general risk management, nancial risk management requires identifying its sources, measuring it (see:
Risk measure: Well known risk measures), and formulating plans to address these, and can be qualitative and
quantitative. In the banking sector worldwide, the Basel
Accords are generally adopted by internationally active
banks for tracking, reporting and exposing operational,
credit and market risks.

3
management and includes analysis related to the use and
acquisition of funds for the enterprise.
In corporate nance, a companys capital structure is the
total mix of nancing methods it uses to raise funds. One
method is debt nancing, which includes bank loans and
bond sales. Another method is equity nancing - the sale
of stock by a company to investors, the original shareholders (they own a portion of the business) of a share.
Ownership of a share gives the shareholder certain contractual rights and powers, which typically include the
right to receive declared dividends and to vote the proxy
on important matters (e.g., board elections). The owners of both bonds (either government bonds or corporate
bonds) and stock (whether its preferred stock or common
stock), may be institutional investors - nancial institutions such as investment banks and pension funds or private individuals, called private investors or retail investors.
Public nance
Main article: Public nance
Public nance describes nance 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:

Financial services Main article: Financial services

Identication of required expenditure of a public


sector entity

An entity whose income exceeds its expenditure can lend


or invest the excess income to help that excess income
produce more income in the future. Though 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 nd a borrower--a nancial intermediary such
as a bank--or buy notes or bonds (corporate bonds, government bonds, or mutual bonds) in the bond market. The
lender receives interest, the borrower pays a higher interest than the lender receives, and the nancial intermediary
earns the dierence for arranging the loan.

Source(s) of that entitys revenue


The budgeting process
Debt issuance (municipal bonds) for public works
projects
Central banks, such as the Federal Reserve System banks
in the United States and Bank of England in the United
Kingdom, are strong players in public nance, acting as
lenders of last resort as well as strong inuences on monetary and credit conditions in the economy.[2]

A bank aggregates the activities of many borrowers and


lenders. A bank accepts deposits from lenders, on which 1.1.2 Capital
it pays interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders, of dierent Main article: Financial capital
sizes, to coordinate their activity.
Finance is used by individuals (personal nance), by governments (public nance), by businesses (corporate nance) and by a wide variety of other organizations such
as including schools and non-prot organizations. In general, the goals of each of the above activities are achieved
through the use of appropriate nancial instruments and
methodologies, with consideration to their institutional
setting.

Capital, in the nancial sense, is the money that gives the


business the power to buy goods to be used in the production of other goods or the oering of a service. (The
capital has two types of resources, Equity and Debt).

The deployment of capital is decided by the budget. This


may include the objective of business, targets set, and results in nancial terms, e.g., the target set for sale, resulting cost, growth, required investment to achieve the
Finance is one of the most important aspects of business planned sales, and nancing source for the investment.

4
A budget may be long term or short term. Long term
budgets have a time horizon of 510 years giving a vision
to the company; short term is an annual budget which is
drawn to control and operate in that particular year.
Budgets will include proposed xed asset requirements
and how these expenditures will be nanced. Capital
budgets are often adjusted annually (done every year) and
should be part of a longer-term Capital Improvements
Plan.
A cash budget is also required. The working capital requirements of a business are monitored at all times to ensure that there are sucient funds available to meet shortterm expenses.
The cash budget is basically a detailed plan that shows
all expected sources and uses of cash when it comes to
spending it appropriately. The cash budget has the following six main sections:

CHAPTER 1. MAIN ARTICLE


nancial models. It essentially explores how rational investors would apply risk and return to the problem of
an investment policy. Here, the twin assumptions of
rationality and market eciency lead to modern portfolio theory (the CAPM), and to the BlackScholes theory for option valuation; it further studies phenomena and
models where these assumptions do not hold, or are extended. Financial economics, at least formally, also
considers investment under "certainty" (Fisher separation theorem, theory of investment value, ModiglianiMiller theorem) and hence also contributes to corporate
nance theory. Financial econometrics is the branch of
nancial economics that uses econometric techniques to
parameterize the relationships suggested.
Although closely related, the disciplines of economics
and nance are distinctive. The economy is a social
institution that organizes a societys production, distribution, and consumption of goods and services, all of
which must be nanced.

1. Beginning Cash Balance - contains the last pe- Economists make a number of abstract assumptions for
riods closing cash balance, in other words, the re- purposes of their analyses and predictions. They genermaining cash from last years earnings.
ally regard nancial markets that function for the nan2. Cash collections - includes all expected cash re- cial system as an ecient mechanism (Ecient-market
markets are subject to huceipts (all sources of cash for the period considered, hypothesis). Instead, nancial
[3]
man
error
and
emotion.
New
research discloses the
mainly sales)
mischaracterization of investment safety and measures of
3. Cash disbursements - lists all planned cash out- nancial products and markets so complex that their efows for the period such as dividend, excluding in- fects, especially under conditions of uncertainty, are imterest payments on short-term loans, which appear possible to predict. The study of nance is subsumed
in the nancing section. All expenses that do not under economics as nancial economics, but the scope,
aect cash ow are excluded from this list (e.g. de- speed, power relations and practices of the nancial system can uplift or cripple whole economies and the wellpreciation, amortization, etc.)
being of households, businesses and governing bodies
4. Cash excess or deciency - a function of the cash within themsometimes in a single day.
needs and cash available. Cash needs are determined by the total cash disbursements plus the minimum cash balance required by company policy. If Financial mathematics
total cash available is less than cash needs, a deciency exists.
Main article: Financial mathematics
5. Financing - discloses the planned borrowings and
repayments of those planned borrowings, including Financial mathematics is a eld of applied mathematinterest.
ics, concerned with nancial markets. The subject has
a close relationship with the discipline of nancial economics, which is concerned with much of the underlying
1.1.3 Financial theory
theory that is involved in nancial mathematics. Generally, mathematical nance will derive, and extend, the
Financial economics
mathematical or numerical models suggested by nancial
economics. In terms of practice, mathematical nance
Main article: Financial economics
also overlaps heavily with the eld of computational nance (also known as nancial engineering). Arguably,
Financial economics is the branch of economics study- these are largely synonymous, although the latter focuses
ing the interrelation of nancial variables, such as prices, on application, while the former focuses on modeling and
interest rates and shares, as opposed to goods and ser- derivation (see: Quantitative analyst). The eld is largely
vices. Financial economics concentrates on inuences of focused on the modelling of derivatives, although other
real economic variables on nancial ones, in contrast to important subelds include insurance mathematics and
pure nance. It centres on managing risk in the context quantitative portfolio problems. See Outline of nance:
of the nancial markets, and the resultant economic and Mathematical tools; Outline of nance: Derivatives pric-

1.1. FINANCE
ing.
Experimental nance
Main article: Experimental nance
Experimental nance aims to establish dierent market settings and environments to observe experimentally
and provide a lens through which science can analyze
agents behavior and the resulting characteristics of trading ows, information diusion and aggregation, price
setting mechanisms, and returns processes. Researchers
in experimental nance can study to what extent existing
nancial economics theory makes valid predictions and
therefore prove them, and attempt to discover new principles on which such theory can be extended and be applied to future nancial decisions. Research may proceed
by conducting trading simulations or by establishing and
studying the behavior, and the way that these people act
or react, of people in articial competitive market-like
settings.
Behavioral nance
Main article: Behavioral economics
Behavioral nance studies how the psychology of investors or managers aects nancial decisions and markets when making a decision that can impact either negatively or positive one of there areas. Behavioral nance
has grown over the last few decades to become central
and very important to nance.
Behavioral nance includes such topics as:
1. Empirical studies that demonstrate signicant deviations from classical theories.
2. Models of how psychology aects and impacts trading and prices
3. Forecasting based on these methods.
4. Studies of experimental asset markets and use of
models to forecast experiments.
A strand of behavioral nance has been dubbed Quantitative Behavioral Finance, which uses mathematical and
statistical methodology to understand behavioral biases
in conjunction with valuation. Some of this endeavor has
been led by Gunduz Caginalp (Professor of Mathematics
and Editor of Journal of Behavioral Finance during 20012004) and collaborators including Vernon Smith (2002
Nobel Laureate in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Je
Madura, Ray Sturm and others have demonstrated signicant behavioral eects in stocks and exchange traded

5
funds. Among other topics, quantitative behavioral nance studies behavioral eects together with the nonclassical assumption of the niteness of assets.
Intangible asset nance
Main article: Intangible asset nance
Intangible asset nance is the area of nance that deals
with intangible assets such as patents, trademarks, goodwill, reputation, etc.

1.1.4 Professional qualications


There are several related professional qualications, that
can lead to the eld:
Generalist Finance qualications:
Degrees: Master of Science in Finance
(MSF), Master of Finance (M.Fin), Master of
Financial Economics, Master of Applied Finance
Certications: Chartered Financial Analyst
(CFA), Certied Treasury Professional (CTP),
Certied Valuation Analyst (CVA), Certied
Patent Valuation Analyst (CPVA), Chartered
Business Valuator (CBV), Certied International Investment Analyst (CIIA), Financial
Risk Manager (FRM), Professional Risk
Manager (PRM), Association of Corporate
Treasurers (ACT), Certied Market Analyst
(CMA/FAD) Dual Designation, Corporate Finance Qualication (CF), Chartered Alternative Investment Analyst (CAIA), Chartered
Investment Manager (CIM)
Quantitative Finance qualications: Master of
Financial Engineering (MSFE), Master of Quantitative Finance (MQF), Master of Computational
Finance (MCF), Master of Financial Mathematics
(MFM), Certicate in Quantitative Finance (CQF).
Accountancy qualications:
Qualied accountant: Chartered Accountant
(The Institute of Chartered Accountant of
Pakistan - ICAP), Chartered Accountant (The
Institute of Chartered Accountants of India
- ICAI), Chartered Accountant (ACA - UK
certication / CA - certication in Commonwealth countries), Chartered Certied Accountant (ACCA, UK certication), Certied
Public Accountant (CPA, US certication),
ACMA/FCMA (Associate/Fellow Chartered
Management Accountant) from Chartered Institute of Management Accountant (CIMA),
UK.

CHAPTER 1. MAIN ARTICLE


Non-statutory qualications: Chartered Cost
Accountant CCA Designation from AAFM
Business qualications: Master of Business Administration (MBA), Master of Management (MM),
Master of Commerce (M.Comm), Master of Science in Management (MSM), Doctor of Business
Administration (DBA)

1.1.5

See also

Outline of nance
Financial crisis of 20072010

1.1.6

References

[1] Financial Planning Curriculum Framework. Financial


Planning Standards Board. 2011. Retrieved 7 April 2012.
[2] Board of Governors of Federal Reserve System of the
United States. Mission of the Federal Reserve System.
Federalreserve.gov Accessed: 2010-01-16. (Archived by
WebCite at Webcitation.org)
[3] Berezin, M. (2005). Emotions and the Economy in
Smelser, N.J. and R. Swedberg (eds.) The Handbook of
Economic Sociology, Second Edition. Princeton University Press: Princeton, NJ

1.1.7

External links

Learn Finance Step by step with infographics tools


OECD work on nancial markets Observation of
UK Finance Market
Wharton Finance Knowledge Project - aimed to offer free access to nance knowledge for students,
teachers, and self-learners.
Professor Aswath Damodaran (New York University Stern School of Business) - provides resources
covering three areas in nance: corporate nance,
valuation and investment management and syndicate
nance.

Chapter 2

The main techniques and sectors of the


nancial industry
2.1 Financial services

2.1.2 Banks

Main article: Bank


Financial services are the economic services provided
by the nance industry, which encompasses a broad
range of businesses that manage money, including credit
unions, banks, credit card companies, insurance compa- Commercial banking services
nies, accountancy companies, consumer nance companies, stock brokerages, investment funds, real estate funds A "commercial bank" is what is commonly referred to as
and some government sponsored enterprises.
simply a bank. The term "commercial" is used to disAs of 2004, the nancial services industry represented tinguish it from an "investment bank, a type of nancial
20% of the market capitalization of the S&P 500 in the services entity which, instead of lending money directly
United States. The U.S. nance industry comprised only to a business, helps businesses raise money from other
10% of total non-farm business prots in 1947, but it rms in the form of bonds (debt) or stock (equity).
grew to 50% by 2010. Over the same period, nance The primary operations of banks include:
industry income as a proportion of GDP rose from 2.5%
to 7.5%, and the nance industrys proportion of all cor Keeping money safe while also allowing withdrawals
porate income rose from 10% to 20%.
when needed
Issuance of chequebooks so that bills can be paid and
other kinds of payments can be delivered by post

2.1.1

The history of nancial services

Provide personal loans, commercial loans, and


mortgage loans (typically loans to purchase a home,
property or business)

The term nancial services became more prevalent in


the United States partly as a result of the Gramm-LeachBliley Act of the late 1990s, which enabled dierent
types of companies operating in the U.S. nancial services industry at that time to merge.[1]

Issuance of credit cards and processing of credit


card transactions and billing
Issuance of debit cards for use as a substitute for
cheques

Companies usually have two distinct approaches to this


new type of business. One approach would be a
bank which simply buys an insurance company or an
investment bank, keeps the original brands of the acquired rm, and adds the acquisition to its holding company simply to diversify its earnings. Outside the U.S.
(e.g., in Japan), non-nancial services companies are permitted within 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 products to its own existing customers,
with incentives for combining all things with one company.

Allow nancial transactions at branches or by using


Automatic Teller Machines (ATMs)
Provide wire transfers of funds and Electronic fund
transfers between banks
Facilitation of standing orders and direct debits, so
payments for bills can be made automatically
Provide overdraft agreements for the temporary
advancement of the banks own money to meet
monthly spending commitments of a customer in
their current account.
7

CHAPTER 2. THE MAIN TECHNIQUES AND SECTORS OF THE FINANCIAL INDUSTRY


Provide internet banking system to facilitate the cus- 2.1.4 Investment services
tomers to view and operate their respective accounts
through internet.
Asset management - the term usually given to describe companies which run collective investment
Provide charge card advances of the banks own
funds. Also refers to services provided by othmoney for customers wishing to settle credit aders, generally registered with the Securities and Exvances monthly.
change Commission as Registered Investment Advisors. Investment banking nancial services focus
Provide a check guaranteed by the bank itself and
on creating capital through client investments.
prepaid by the customer, such as a cashiers check
or certied check.
Notary service for nancial and other documents
Accepting the deposits from customer and provide
the credit facilities to them.
Sell investment products like mutual funds etc.

Hedge fund management - Hedge funds often employ the services of "prime brokerage" divisions at
major investment banks to execute their trades.
Custody services - the safe-keeping and processing
of the worlds securities trades and servicing the
associated portfolios. Assets under custody in the
world are approximately US$100 trillion.[4]

Investment banking services


Capital markets services - underwriting debt and 2.1.5 Insurance
equity, assist company deals (advisory services, underwriting, mergers and acquisitions and advisory Main article: Insurance
fees), and restructure debt into structured nance
products.
Insurance brokerage - Insurance brokers shop for in Private banking - Private banks provide banking
surance (generally corporate property and casualty
services exclusively to high-net-worth individuals.
insurance) on behalf of customers. Recently a numMany nancial services rms require a person or
ber of websites have been created to give consumers
family to have a certain minimum net worth to qualbasic price comparisons for services such as insur[2]
ify for private banking services. Private banks ofance, causing controversy within the industry.[5]
ten provide more personal services, such as wealth
management and tax planning, than normal retail
Insurance underwriting - Personal lines insurance
banks.[3]
underwriters actually underwrite insurance for in Brokerage services - facilitating the buying and selling of nancial securities between a buyer and a
seller. In todays (2014) stock brokers, brokerages
services are oered online to self trading investors
throughout the world who have the option of trading with 'tied' online trading platforms oered by a
banking institution or with online trading platforms
sometimes oered in a group by so-called online
trading portals.

2.1.3

Foreign exchange services

Foreign exchange services are provided by many banks


and specialist foreign exchange brokers around the world.
Foreign exchange services include:
Currency exchange - where clients can purchase and
sell foreign currency banknotes.

dividuals, a service still oered primarily through


agents, insurance brokers, and stock brokers. Underwriters may also oer similar commercial lines
of coverage for businesses. Activities include insurance and annuities, life insurance, retirement insurance, health insurance, and property & casualty insurance.
F&I - Finance & Insurance, a service still oered
primarily at asset dealerships. The F&I manager
encompasses the nancing and insuring of the asset which is sold by the dealer. F&I is often called
the second gross in dealerships who have adopted
the model
Reinsurance - Reinsurance is insurance sold to insurers themselves, to protect them from catastrophic
losses.

Wire transfer - where clients can send funds to in- 2.1.6 Other nancial services
ternational banks abroad.
Bank cards - include both credit cards and debit
Remittance - where clients that are migrant workers
cards.According to the Nilson Report, Bank Of
send money back to their home country.
America is the largest issuer of bank cards.

2.1. FINANCIAL SERVICES


Credit card machine services and networks - Companies which provide credit card machine and
payment networks call themselves merchant card
providers.

9
real-time gross settlement systems or interbank networks.
Debt resolution is a consumer service that assists individuals that have too much debt to pay o as requested, but do not want to le bankruptcy and wish
to pay o their debts owed. This debt can be accrued in various ways including but not limited to
personal loans, credit cards or in some cases merchant accounts.

Intermediation or advisory services - These services


involve stock brokers (private client services) and
discount brokers. Stock brokers assist investors in
buying or selling shares. Primarily internet-based
companies are often referred to as discount brokerages, although many now have branch oces to assist clients. These brokerages primarily target individual investors. Full service and private client rms 2.1.7 Financial crime
primarily assist and execute trades for clients with
large amounts of capital to invest, such as large com- UK
panies, wealthy individuals, and investment management funds.
Fraud within the nancial industry costs the UK (regulated by the FSA) an estimated 14bn a year and
Private equity - Private equity funds are typically
it is believed a further 25bn is laundered by British
closed-end funds, which usually take controlling eqinstitutions.[6]
uity stakes in businesses that are either private, or
taken private once acquired. Private equity funds
often use leveraged buyouts (LBOs) to acquire the
2.1.8 Market share
rms in which they invest. The most successful private equity funds can generate returns signicantly
US
higher than provided by the equity markets
Venture capital is a type of private equity capital
typically provided by professional, outside investors
to new, high-growth-potential companies in the interest of taking the company to an IPO or trade sale
of the business.
Angel investment - An angel investor or angel
(known as a business angel or informal investor in
Europe), is an auent individual who provides capital for a business start-up, usually in exchange for
convertible debt or ownership equity. A small but
increasing number of angel investors organize themselves into angel groups or angel networks to share
resources and pool their investment capital.
Conglomerates - A nancial services company, such
as a universal bank, that is active in more than one
sector of the nancial services market e.g. life insurance, general insurance, health insurance, asset
management, retail banking, wholesale banking, investment banking, etc. A key rationale for the existence of such businesses is the existence of diversication benets that are present when dierent types
of businesses are aggregated i.e. bad things don't always happen at the same time. As a consequence,
economic capital for a conglomerate is usually substantially less than economic capital is for the sum
of its parts.

The U.S. nance industry comprised only 10% of total


non-farm business prots in 1947, but it grew to 50%
by 2010. Over the same period, nance industry income
as a proportion of GDP rose from 2.5% to 7.5%, and
the nance industrys proportion of all corporate income
rose from 10% to 20%. The mean earnings per employee
hour in nance relative to all other sectors has closely
mirrored the share of total U.S. income earned by the
top 1% income earners since 1930. The mean salary in
New York Citys nance industry rose from $80,000 in
1981 to $360,000 in 2011, while average New York City
salaries rose from $40,000 to $70,000. In 1988, there
were about 12,500 U.S. banks with less than $300 million in deposits, and about 900 with more deposits, but
by 2012, there were only 4,200 banks with less than $300
million in deposits in the U.S., and over 1,801 with more.
The nancial services industry constitutes the largest
group of companies in the world in terms of earnings and
equity market capitalization. However it is not the largest
category in terms of revenue or number of employees.
It is also a slow growing and extremely fragmented industry, with the largest company (Citigroup), only having
a 3% US market share.[7] In contrast, the largest home
improvement store in the US, Home Depot, has a 30%
market share, and the largest coee house Starbucks has
a market share of 32% .

Financial market utilities - Organisations that are 2.1.9 See also


part of the infrastructure of nancial services, such
List of largest nancial services companies by revas stock exchanges, clearing houses, derivative and
commodity exchanges and payment systems such as
enue

10

CHAPTER 2. THE MAIN TECHNIQUES AND SECTORS OF THE FINANCIAL INDUSTRY

Alternative nancial services


Financial analyst
Financial data vendors
Financial markets
Financial technology
Financialization
International Monetary Fund
Investment management
List of banks
List of investment banks

2.1.10

References

[1] Bill Summary & Status 106th Congress (1999 - 2000)


S.900 CRS Summary - Thomas (Library of Congress)".
Retrieved 2011-02-08.
[2] Private Banking denition. Investor Words.com. Retrieved 2009-02-06.
[3] How Swiss Bank Accounts Work. How Stu Works.
Retrieved 2009-02-06.
[4] Prudential: Securities Processing Primer
[5] Price comparison sites face probe. BBC News. 200801-22. Retrieved 2009-02-06.
[6] Watchdog warns of criminal gangs inside banks. The
Guardian (London). 2005-11-16. Retrieved 2007-11-30.
[7] The Opportunity: Small Global Market Share, Page 11,
from the Sanford C. Bernstein & Co. Strategic Decisions
Conference 6/02/04

2.1.11

Further reading

Porteous, Bruce T.; Pradip Tapadar (December


2005). Economic Capital and Financial Risk Management for Financial Services Firms and Conglomerates. Palgrave Macmillan. ISBN 1-4039-3608-0.

2.1.12

External links

The role of the nancial Services Sector in Expanding Economic Opportunity | A report by Christopher N. Sutton and Beth Jenkins | John F. Kennedy
School of Government | Harvard University

Chapter 3

Personal nance
3.1 Personal nance

reducing unnecessary expenses, increasing the employment income, or investing in the stock market.

Personal nance is the nancial management which an


4. Execution: Execution of a nancial plan often
individual or a family unit is required to do to obtain,
requires discipline and perseverance. Many peobudget, save, and spend monetary resources over time,
ple obtain assistance from professionals such as
taking into account various nancial risks and future life
accountants, nancial planners, investment advisers,
[1]
events. When planning personal nances the individand lawyers.
ual would consider the suitability to his or her needs of a
range of banking products (checking, savings accounts,
5. Monitoring and reassessment: As time passes,
credit cards and consumer loans) or investment (stock
the nancial plan must be monitored for possible admarket, bonds, mutual funds) and insurance (life insurjustments or reassessments.
ance, health insurance, disability insurance) products or
participation and monitoring of individual- or employerTypical goals most adults and young adults have are paysponsored retirement plans, social security benets, and
ing o credit card and/or student loan debt, investing for
income tax management.
retirement, investing for college costs for children, paying
medical expenses, and planning for passing on their prop3.1.1 Personal nancial planning process erty to their heirs (which is known as estate planning).
The key component of personal nance is nancial plan3.1.2 Areas of focus
ning, which is a dynamic process that requires regular
monitoring and reevaluation. In general, it involves ve
The six key areas of personal nancial planning, as sugsteps:[2]
gested by the Financial Planning Standards Board, are:[3]
1. Assessment: A persons nancial situation is assessed by compiling simplied versions of nancial statements including balance sheets and income
statements. A personal balance sheet lists the values
of personal assets (e.g., car, house, clothes, stocks,
bank account), along with personal liabilities (e.g.,
credit card debt, bank loan, mortgage). A personal income statement lists personal income and
expenses.
2. Goal setting: Having multiple goals is common, including a mix of short-term and long-term goals.
For example, a long-term goal would be to retire
at age 65 with a personal net worth of $1,000,000,
while a short-term goal would be to save up for a
new computer in the next month. Setting nancial
goals helps to direct nancial planning. Goal setting
is done with an objective to meet certain nancial
requirements.
3. Creating a plan: The nancial plan details how to
accomplish the goals. It could include, for example,
11

1. Financial position: is concerned with understanding the personal resources available by examining
net worth and household cash ow. Net worth is a
persons balance sheet, calculated by adding up all
assets under that persons control, minus all liabilities of the household, at one point in time. Household cash ow totals up all the expected sources of
income within a year, minus all expected expenses
within the same year. From this analysis, the nancial planner can determine to what degree and in
what time the personal goals can be accomplished.
2. Adequate protection: the analysis of how to protect a household from unforeseen risks. These risks
can be divided into liability, property, death, disability, health and long-term care. Some of these
risks may be self-insurable, while most will require
the purchase of an insurance contract. Determining
how much insurance to get, at the most cost eective
terms requires knowledge of the market for personal
insurance. Business owners, professionals, athletes

12

CHAPTER 3. PERSONAL FINANCE


and entertainers require specialized insurance professionals to adequately protect themselves. Since
insurance also enjoys some tax benets, utilizing insurance investment products may be a critical piece
of the overall investment planning.

6. Estate planning involves planning for the disposition of ones assets after death. Typically, there
is a tax due to the state or federal government at
your death. Avoiding these taxes means that more
of your assets will be distributed to your heirs. You
can leave your assets to family, friends or charitable
groups.

3. Tax planning: typically the income tax is the single


largest expense in a household. Managing taxes is
not a question of if you will pay taxes, but when and
how much. Government gives many incentives in 3.1.3 See also
the form of tax deductions and credits, which can be
Accounting software
used to reduce the lifetime tax burden. Most modern governments use a progressive tax. Typically,
Asset allocation
as ones income grows, a higher marginal rate of tax
must be paid. Understanding how to take advantage
Asset location
of the myriad tax breaks when planning ones per Corporate nance
sonal nances can make a signicant impact.
4. Investment and accumulation goals: planning
how to accumulate enough money for large purchases, and life events is what most people consider
to be nancial planning. Major reasons to accumulate assets include, purchasing a house or car, starting a business, paying for education expenses, and
saving for retirement.
Achieving these goals requires projecting what they will cost, and when you
need to withdraw funds. A major risk
to the household in achieving their accumulation goal is the rate of price increases over time, or ination. Using
net present value calculators, the nancial 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 ination, the investment portfolio has to get
a higher rate of return, which typically
will subject the portfolio to a number of
risks. Managing these portfolio risks is
most often accomplished using asset allocation, which seeks to diversify investment risk and opportunity. This asset allocation will prescribe a percentage allocation to be invested in stocks, bonds,
cash and alternative investments. The allocation should also take into consideration the personal risk prole of every investor, since risk attitudes vary from person to person.
5. Retirement planning is the process of understanding how much it costs to live at retirement, and coming up with a plan to distribute assets to meet any income shortfall. Methods for retirement plan include
taking advantage of government allowed structures
to manage tax liability including: individual (IRA)
structures, or employer sponsored retirement plans.

Debt consolidation
Equity investment
Family planning
Personal budget
Personal nances of professional American athletes
Separately managed account
Wealth management
Comparison of accounting software

3.1.4 References
[1] Personal Finance. Investopedia. Retrieved 7 April
2012.
[2] What is Personal Finance?". Practical Financial Tips.
Retrieved 7 April 2012.
[3] Financial Planning Curriculum Framework. Financial
Planning Standards Board. 2011. Retrieved 7 April 2012.

3.1.5 Further reading


Kwok, H., Milevsky, M., and Robinson, C. (1994)
Asset Allocation, Life Expectancy, and Shortfall,
Financial Services Review, 1994, vol 3(2), pg. 109126.

3.1.6 External links


Free Journal of Financial Counseling and Planning
articles

Chapter 4

Corporate nance
4.1 Corporate nance

4.1.1 Outline of corporate nance

Corporate nance is the area of nance dealing with the


sources of funding and the capital structure of corporations and the actions that managers take to increase the
value of the rm to the shareholders, as well as the tools
and analysis used to allocate nancial resources. The primary goal of corporate nance is to maximize or increase
shareholder value.[1] Although it is in principle dierent
from managerial nance which studies the nancial management of all rms, rather than corporations alone, the
main concepts in the study of corporate nance are applicable to the nancial problems of all kinds of rms.
Investment analysis (or capital budgeting) is concerned
with the setting of criteria about which value-adding
projects should receive investment funding, and whether
to nance that investment with equity or debt capital.
Working capital management is the management of the
companys monetary funds that deal with the short-term
operating balance of current assets and current liabilities;
the focus here is on managing cash, inventories, and shortterm borrowing and lending (such as the terms on credit
extended to customers).

The primary goal of nancial management is to maximize or to continually increase shareholder value. Maximizing shareholder value requires managers to be able to
balance capital funding between investments in projects
that increase the rms long term protability and sustainability, along with paying excess cash in the form of
dividends to shareholders. Managers of growth companies (i.e. rms that earn high rates of return on invested
capital) will use most of the rms capital resources and
surplus cash on investments and projects so the company
can continue to expand its business operations into the future. When companies reach maturity levels within their
industry (i.e. companies that earn approximately average
or lower returns on invested capital), managers of these
companies will use surplus cash to payout dividends to
shareholders. Managers must do an analysis to determine
the appropriate allocation of the rms capital resources
and cash surplus between projects and payouts of dividends to shareholders, as well as paying back creditor related debt.
Choosing between investment projects will be based upon
several inter-related criteria. (1) Corporate management
seeks to maximize the value of the rm by investing in
projects which yield a positive net present value when valued using an appropriate discount rate in consideration of
risk. (2) These projects must also be nanced appropriately. (3) If no growth is possible by the company and
excess cash surplus is not needed to the rm, then nancial theory suggests that management should return some
or all of the excess cash to shareholders (i.e., distribution
via dividends).

The terms corporate nance and corporate nancier are


also associated with investment banking. The typical role
of an investment bank is to evaluate the companys nancial needs and raise the appropriate type of capital
that best ts those needs. Thus, the terms corporate nance and corporate nancier may be associated with
transactions in which capital is raised in order to create,
develop, grow or acquire businesses. Recent legal and
regulatory developments in the U.S. will likely alter the
makeup of the group of arrangers and nanciers willing
to arrange and provide nancing for certain highly leveraged transactions.[2]

This "capital budgeting" is the planning of value-adding,


long-term corporate nancial projects relating to investments funded through and aecting the rms capital
structure. Management must allocate the rms limited
resources between competing opportunities (projects).[3]

Financial management overlaps with the nancial function of the Accounting profession. However, nancial accounting is the reporting of historical nancial information, while nancial management is concerned with the
allocation of capital resources to increase a rms value
to the shareholders.

Capital budgeting is also concerned with the setting of


criteria about which projects should receive investment
funding to increase the value of the rm, and whether to
nance that investment with equity or debt capital. Investments should be made on the basis of value-added
to the future of the corporation. Projects that increase a

13

14

CHAPTER 4. CORPORATE FINANCE

rms value may include a wide variety of dierent types


of investments, including but not limited to, expansion
policies, or mergers and acquisitions. When no growth
or expansion is possible by a corporation and excess cash
surplus exists and is not needed, then management is expected to pay out some or all of those surplus earnings
in the form of cash dividends or to repurchase the companys stock through a share buyback program.

4.1.2

Capital structure

Capitalization structure

Domestic credit to private sector in 2005.

Main article: Capital structure


Further information: Security (nance)
Achieving the goals of corporate nance requires that
any corporate investment be nanced appropriately.[4]
The sources of nancing are, generically, capital selfgenerated by the rm and capital from external funders,
obtained by issuing new debt and equity (and hybrid- or
convertible securities). As above, since both hurdle rate
and cash ows (and hence the riskiness of the rm) will
be aected, the nancing mix will impact the valuation of
the rm. There are two interrelated considerations here:
Management must identify the optimal mix of nancing the capital structure that results in maximum rm value,[5] (See Balance sheet, WACC) but
must also take other factors into account (see tradeo theory below). Financing a project through debt
results in a liability or obligation that must be serviced, thus entailing cash ow implications independent of the projects degree of success. Equity nancing is less risky with respect to cash ow commitments, but results in a dilution of share ownership, control and earnings. The cost of equity (see
CAPM and APT) is also typically higher than the
cost of debt - which is, additionally, a deductible expense and so equity nancing may result in an increased hurdle rate which may oset any reduction
in cash ow risk.[6]

ows. Managing any potential asset liability mismatch or duration gap entails matching the assets and liabilities respectively according to maturity pattern ("Cashow matching") or duration
("immunization"); managing this relationship in the
short-term is a major function of working capital
management, as discussed below. Other techniques,
such as securitization, or hedging using interest rateor credit derivatives, are also common. See Asset liability management; Treasury management; Credit
risk; Interest rate risk.
Much of the theory here, falls under the umbrella of the
Trade-O Theory in which rms are assumed to tradeo the tax benets of debt with the bankruptcy costs of
debt when choosing how to allocate the companys resources. However economists have developed a set of
alternative theories about how managers allocate a corporations nances. One of the main alternative theories
of how rms manage their capital funds is the Pecking
Order Theory (Stewart Myers), which suggests that rms
avoid external nancing while they have internal nancing
available and avoid new equity nancing while they can
engage in new debt nancing at reasonably low interest
rates. Also, Capital structure substitution theory hypothesizes that management manipulates the capital structure such that earnings per share (EPS) are maximized.
An emerging area in nance theory is right-nancing
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 nancing (debt or
equity) and expenditure framework within a given economy and under given market conditions. One of the more
recent innovations in this area from a theoretical point
of view is the Market timing hypothesis. This hypothesis, inspired in the behavioral nance literature, states that
rms look for the cheaper type of nancing regardless of
their current levels of internal resources, debt and equity.
Sources of capital
Further information: Security (nance)

Debt capital Further information: Bankruptcy and


Financial distress

Corporations may rely on borrowed funds (debt capital or


credit) as sources of investment to sustain ongoing business operations or to fund future growth. Debt comes in
several forms, such as through bank loans, notes payable,
or bonds issued to the public. Bonds require the corporations to make regular interest payments (interest ex Management must attempt to match the long-term penses) on the borrowed capital until the debt reaches its
nancing mix to the assets being nanced as closely maturity date, therein the rm must pay back the obligaas possible, in terms of both timing and cash tion in full. Debt payments can also be made in the form

4.1. CORPORATE FINANCE


of sinking fund provisions, whereby the corporation pays
annual installments of the borrowed debt above regular
interest charges. Corporations that issue callable bonds
are entitled to pay back the obligation in full whenever
the company feels it is in their best interest to pay o
the debt payments. If interest expenses cannot be made
by the corporation through cash payments, the rm may
also use collateral assets as a form of repaying their debt
obligations (or through the process of liquidation).
Equity capital Corporations can alternatively sell
shares of the company to investors to raise capital. Investors, or shareholders, expect that there will be an upward trend in value of the company (or appreciate in
value) over time to make their investment a protable
purchase. Shareholder value is increased when corporations invest equity capital and other funds into projects
(or investments) that earn a positive rate of return for the
owners. Investors prefer to buy shares of stock into companies that will consistently earn a positive rate of return
on capital in the future, thus increasing the market value
of the stock of that corporation. Shareholder value may
also be increased when corporations payout excess cash
surplus (funds from retained earnings that are not needed
for business) in the form of dividends.

15

4.1.3 Investment and project valuation


Further information: Business valuation, stock valuation
and fundamental analysis
In general,[11] each projects value will be estimated using
a discounted cash ow (DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (applied to
Corporate Finance by Joel Dean in 1951). This requires
estimating the size and timing of all of the incremental
cash ows resulting from the project. Such future cash
ows are then discounted to determine their present value
(see Time value of money). These present values are then
summed, and this sum net of the initial investment outlay
is the NPV. See Financial modeling.
The NPV is greatly aected by the discount rate. Thus,
identifying the proper discount rate often termed, the
project hurdle rate[12] is critical to choosing good
projects and investments for the rm. The hurdle rate is
the minimum acceptable return on an investment i.e.,
the project appropriate discount rate. The hurdle rate
should reect the riskiness of the investment, typically
measured by volatility of cash ows, and must take into
account the project-relevant nancing mix.[13] Managers
use models such as the CAPM or the APT to estimate a
discount rate appropriate for a particular project, and use
the weighted average cost of capital (WACC) to reect the
nancing mix selected. (A common error in choosing a
discount rate for a project is to apply a WACC that applies
to the entire rm. Such an approach may not be appropriate where the risk of a particular project diers markedly
from that of the rms existing portfolio of assets.)

Preferred stock Preferred stock is an equity security


which may have any combination of features not possessed by common stock including properties of both an
equity and a debt instruments, and is generally considered
a hybrid instrument. Preferreds are senior (i.e. higher
ranking) to common stock, but subordinate to bonds in
terms of claim (or rights to their share of the assets of the
company).[7]
In conjunction with NPV, there are several other mea[8]
Preferred stock usually carries no voting rights, but may sures used as (secondary) selection criteria in corpocarry a dividend and may have priority over common rate nance. These are visible from the DCF and instock in the payment of dividends and upon liquidation. clude discounted payback period, IRR, Modied IRR,
Terms of the preferred stock are stated in a Certicate equivalent annuity, capital eciency, and ROI. Alternatives (complements) to NPV include Residual Income
of Designation.
Valuation, MVA / EVA (Joel Stern, Stern Stewart & Co)
Similar to bonds, preferred stocks are rated by the ma- and APV (Stewart Myers). See list of valuation topics.
jor credit-rating companies. The rating for preferreds is
generally lower, since preferred dividends do not carry
the same guarantees as interest payments from bonds and Valuing exibility
they are junior to all creditors.[9]
Preferred stock is a special class of shares which may have Main articles: Real options analysis and decision tree

any combination of features not possessed by common


stock. The following features are usually associated with In many cases, for example R&D projects, a project may
preferred stock:[10]
open (or close) various paths of action to the company,
but this reality will not (typically) be captured in a strict
Preference in dividends
NPV approach.[14] Some analysts account for this uncertainty by adjusting the discount rate (e.g. by increas Preference in assets, in the event of liquidation
ing the cost of capital) or the cash ows (using certainty
Convertibility to common stock.
equivalents, or applying (subjective) haircuts to the
forecast numbers).[15][16] Even when employed, however,
Callability, at the option of the corporation
these latter methods do not normally properly account
Nonvoting
for changes in risk over the projects lifecycle and hence

16

CHAPTER 4. CORPORATE FINANCE

fail to appropriately adapt the risk adjustment.[17] Manalso Option pricing approaches under Business valagement will therefore (sometimes) employ tools which
uation.
place an explicit value on these options. So, whereas in
a DCF valuation the most likely or average or scenario
specic cash ows are discounted, here the exible and Quantifying uncertainty
staged nature of the investment is modelled, and hence
all potential payos are considered. See further un- Further information: Sensitivity analysis, Scenario
der Real options valuation. The dierence between the planning and Monte Carlo methods in nance
two valuations is the value of exibility inherent in the
project.
Given the uncertainty inherent in project forecasting and
The two most common tools are Decision Tree Analysis valuation,[19][21] analysts will wish to assess the sensitivity
(DTA)[18][19] and Real options valuation (ROV);[20] they of project NPV to the various inputs (i.e. assumptions)
may often be used interchangeably:
to the DCF model. In a typical sensitivity analysis the
analyst will vary one key factor while holding all other in DTA values exibility by incorporating possible puts constant, ceteris paribus. The sensitivity of NPV to a
events (or states) and consequent management deci- change in that factor is then observed, and is calculated as
sions. (For example, a company would build a fac- a slope": NPV / factor. For example, the analyst will
tory given that demand for its product exceeded a determine NPV at various growth rates in annual revenue
certain level during the pilot-phase, and outsource as specied (usually at set increments, e.g. 10%, 5%,
production otherwise. In turn, given further de- 0%, 5%....), and then determine the sensitivity using this
mand, it would similarly expand the factory, and formula. Often, several variables may be of interest, and
maintain it otherwise. In a DCF model, by con- their various combinations produce a value-surface",[22]
trast, there is no branching each scenario must (or even a value-space",) where NPV is then a function
be modelled separately.) In the decision tree, each of several variables. See also Stress testing.
management decision in response to an event generates a branch or path which the company could Using a related technique, analysts also run scenario
follow; the probabilities of each event are deter- based forecasts of NPV. Here, a scenario comprises a
mined or specied by management. Once the tree particular outcome for economy-wide, global factors
is constructed: (1) all possible events and their re- (demand for the product, exchange rates, commodity
sultant paths are visible to management; (2) given prices, etc...) as well as for company-specic factors (unit
this knowledge of the events that could follow, and costs, etc...). As an example, the analyst may specify
assuming rational decision making, management various revenue growth scenarios (e.g. 0% for Worst
chooses the branches (i.e. actions) corresponding to Case, 10% for Likely Case and 20% for Best Case),
the highest value path probability weighted; (3) this where all key inputs are adjusted so as to be consistent
path is then taken as representative of project value. with the growth assumptions, and calculate the NPV for
each. Note that for scenario based analysis, the various
See Decision theory#Choice under uncertainty.
combinations of inputs must be internally consistent (see
ROV is usually used when the value of a project discussion at Financial modeling), whereas for the senis contingent on the value of some other asset or sitivity approach these need not be so. An application
underlying variable. (For example, the viability of of this methodology is to determine an "unbiased" NPV,
a mining project is contingent on the price of gold; where management determines a (subjective) probabilif the price is too low, management will abandon ity for each scenario the NPV for the project is then
the mining rights, if suciently high, management the probability-weighted average of the various scenarios;
will develop the ore body. Again, a DCF valuation see First Chicago Method. (See also rNPV, where cash
would capture only one of these outcomes.) Here: ows, as opposed to scenarios, are probability-weighted.)
(1) using nancial option theory as a framework, the
decision to be taken is identied as corresponding to
either a call option or a put option; (2) an appropriate valuation technique is then employed usually
a variant on the Binomial options model or a bespoke simulation model, while Black Scholes type
formulae are used less often; see Contingent claim
valuation. (3) The true value of the project is then
the NPV of the most likely scenario plus the option value. (Real options in corporate nance were
rst discussed by Stewart Myers in 1977; viewing
corporate strategy as a series of options was originally per Timothy Luehrman, in the late 1990s.) See

A further advancement which overcomes the limitations of sensitivity and scenario analyses by examining the eects of all possible combinations of variables
and their realizations [23] is to construct stochastic[24]
or probabilistic nancial models as opposed to the
traditional static and deterministic models as above.[21]
For this purpose, the most common method is to use
Monte Carlo simulation to analyze the projects NPV.
This method was introduced to nance by David B. Hertz
in 1964, although it has only recently become common: today analysts are even able to run simulations in
spreadsheet based DCF models, typically using a riskanalysis add-in, such as @Risk or Crystal Ball. Here,

4.1. CORPORATE FINANCE


the cash ow components that are (heavily) impacted
by uncertainty are simulated, mathematically reecting
their random characteristics. In contrast to the scenario
approach above, the simulation produces several thousand random but possible outcomes, or trials, covering
all conceivable real world contingencies in proportion to
their likelihood;" [25] see Monte Carlo Simulation versus
What If Scenarios. The output is then a histogram of
project NPV, and the average NPV of the potential investment as well as its volatility and other sensitivities
is then observed. This histogram provides information
not visible from the static DCF: for example, it allows
for an estimate of the probability that a project has a net
present value greater than zero (or any other value).
Continuing the above example: instead of assigning three
discrete values to revenue growth, and to the other relevant variables, the analyst would assign an appropriate probability distribution to each variable (commonly
triangular or beta), and, where possible, specify the observed or supposed correlation between the variables.
These distributions would then be sampled repeatedly
incorporating this correlation so as to generate several thousand random but possible scenarios, with corresponding valuations, which are then used to generate the
NPV histogram. The resultant statistics (average NPV
and standard deviation of NPV) will be a more accurate mirror of the projects randomness than the variance observed under the scenario based approach. These
are often used as estimates of the underlying "spot price"
and volatility for the real option valuation as above; see
Real options valuation: Valuation inputs. A more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a credit crunch) that drive
variations in one or more of the DCF model inputs.

17
"growth stock", expect that the company will, almost by
denition, retain most of the excess cash surplus so as to
fund future projects internally to help increase the value
of the rm.
Management must also choose the form of the dividend
distribution, generally as cash dividends or via a share
buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, rms
may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay dividends from stock rather than in cash; see Corporate
action. Financial theory suggests that the dividend policy should be set based upon the type of company and
what management determines is the best use of those dividend resources for the rm to its shareholders. As a general rule, shareholders of growth companies would prefer
managers to retain earnings and pay no dividends (use
excess cash to reinvest into the companys operations),
whereas shareholders of value or secondary stocks would
prefer the management of these companies to payout surplus earnings in the form of cash dividends when a positive return cannot be earned through the reinvestment of
undistributed earnings. A share buyback program may
be accepted when the value of the stock is greater than
the returns to be realized from the reinvestment of undistributed prots. In all instances, the appropriate dividend
policy is usually directed by that which maximizes longterm shareholder value.

4.1.5 Working capital management


4.1.4

Dividend policy

Main article: Working capital

Main article: Dividend policy


Dividend policy is concerned with nancial policies regarding the payment of a cash dividend in the present or
paying an increased dividend at a later stage. Whether
to issue dividends,[26] and what amount, is determined
mainly on the basis of the companys unappropriated
prot (excess cash) and inuenced by the companys longterm earning power. When cash surplus exists and is
not needed by the rm, then management is expected to
pay out some or all of those surplus earnings in the form
of cash dividends or to repurchase the companys stock
through a share buyback program.
If there are no NPV positive opportunities, i.e. projects
where returns exceed the hurdle rate, and excess cash surplus is not needed, then nance theory suggests management should return some or all of the excess cash to
shareholders as dividends. This is the general case, however there are exceptions. For example, shareholders of a

Managing the corporations working capital position to


sustain ongoing business operations is referred to as working capital management.[27][28] These involve managing
the relationship between a rms short-term assets and its
short-term liabilities. In general this is as follows: As
above, the goal of Corporate Finance is the maximization of rm value. In the context of long term, capital
budgeting, rm value is enhanced through appropriately
selecting and funding NPV positive investments. These
investments, in turn, have implications in terms of cash
ow and cost of capital. The goal of Working Capital (i.e.
short term) management is therefore to ensure that the
rm is able to operate, and that it has sucient cash ow
to service long term debt, and to satisfy both maturing
short-term debt and upcoming operational expenses. In
so doing, rm value is enhanced when, and if, the return
on capital exceeds the cost of capital; See Economic value
added (EVA). Managing short term nance and long term
nance is one task of a modern CFO.

18

CHAPTER 4. CORPORATE FINANCE

Working capital

which allows for the business to meet day to day expenses, but reduces cash holding costs.

Working capital is the amount of funds which are necessary to an organization to continue its ongoing business operations, until the rm is reimbursed through payments for the goods or services it has delivered to its
customers.[29] Working capital is measured through the
dierence between resources in cash or readily convertible into cash (Current Assets), and cash requirements
(Current Liabilities). As a result, capital resource allocations relating to working capital are always current,
i.e. short term. In addition to time horizon, working capital management diers from capital budgeting
in terms of discounting and protability considerations;
they are also reversible to some extent. (Considerations
as to Risk appetite and return targets remain identical, although some constraints such as those imposed by loan
covenants may be more relevant here).
The (short term) goals of working capital are therefore not
approached on the same basis as (long term) protability,
and working capital management applies dierent criteria
in allocating resources: the main considerations are (1)
cash ow / liquidity and (2) protability / return on capital
(of which cash ow is probably the most important).

Inventory management. Identify the level of inventory which allows for uninterrupted production
but reduces the investment in raw materials and
minimizes reordering costs and hence increases
cash ow. Note that inventory is usually the realm
of operations management: given the potential impact on cash ow, and on the balance sheet in general, nance typically gets involved in an oversight
or policing way.[31]:714 See Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Dynamic lot size model; Economic production quantity (EPQ); Economic Lot Scheduling
Problem; Inventory control problem; Safety stock.
Debtors management. There are two inter-related
roles here: Identify the appropriate credit policy, i.e.
credit terms which will attract customers, such that
any impact on cash ows and the cash conversion
cycle will be oset by increased revenue and hence
Return on Capital (or vice versa); see Discounts and
allowances. Implement appropriate Credit scoring
policies and techniques such that the risk of default
on any new business is acceptable given these criteria.

The most widely used measure of cash ow is the net


operating cycle, or cash conversion cycle. This represents the time dierence between cash payment
Short term nancing. Identify the appropriate
for raw materials and cash collection for sales. The
source of nancing, given the cash conversion cycle:
cash conversion cycle indicates the rms ability to
the inventory is ideally nanced by credit granted by
convert its resources into cash. Because this numthe supplier; however, it may be necessary to utilize
ber eectively corresponds to the time that the rms
a bank loan (or overdraft), or to convert debtors to
cash is tied up in operations and unavailable for other
cash through "factoring".
activities, management generally aims at a low net
count. (Another measure is gross operating cycle
which is the same as net operating cycle except that 4.1.6 Relationship with other areas in it does not take into account the creditors deferral
nance
period.)
In this context, the most useful measure of prof- Investment banking
itability is Return on capital (ROC). The result is
shown as a percentage, determined by dividing relevant income for the 12 months by capital employed;
Return on equity (ROE) shows this result for the
rms shareholders. As above, rm value is enhanced when, and if, the return on capital exceeds
the cost of capital.
Management of working capital
Guided by the above criteria, management will use a combination of policies and techniques for the management
of working capital.[30] These policies aim at managing
the current assets (generally cash and cash equivalents,
inventories and debtors) and the short term nancing,
such that cash ows and returns are acceptable.[28]
Cash management.

Identify the cash balance

Use of the term corporate nance varies considerably


across the world. In the United States it is used, as above,
to describe activities, analytical methods and techniques
that deal with many aspects of a companys nances and
capital. In the United Kingdom and Commonwealth
countries, the terms corporate nance and corporate
nancier tend to be associated with investment banking
i.e. with transactions in which capital is raised for the
corporation.[32] These may include
Raising seed, start-up, development or expansion
capital
Mergers, demergers, acquisitions or the sale of private companies
Mergers, demergers and takeovers of public companies, including public-to-private deals

4.1. CORPORATE FINANCE

19

Management buy-out, buy-in or similar of compa- their own accounting treatment: see Hedge accounting,
nies, divisions or subsidiaries typically backed by Mark-to-market accounting, FASB 133, IAS 39.
private equity
This area is related to corporate nance in two ways.
Equity issues by companies, including the otation Firstly, rm exposure to business and market risk is a diof companies on a recognised stock exchange in or- rect result of previous capital nancial investments. Secder to raise capital for development and/or to re- ondly, both disciplines share the goal of enhancing, or
preserving, rm value. There is a fundamental debate
structure ownership
[34]
relating to Risk Management and shareholder value.
Raising capital via the issue of other forms of equity, Per the Modigliani and Miller framework, hedging is irdebt and related securities for the renancing and relevant since diversied shareholders are assumed to not
restructuring of businesses
care about rm-specic risks, whereas, on the other hand
hedging is seen to create value in that it reduces the prob Financing joint ventures, project nance, infrastruc- ability of nancial distress. A further question, is the
ture nance, public-private partnerships and privati- shareholders desire to optimize risk versus taking exposations
sure to pure risk (a risk event that only has a negative side,
Secondary equity issues, whether by means of pri- such as loss of life or limb). The debate links the value of
vate placing or further issues on a stock market, risk management in a market to the cost of bankruptcy in
especially where linked to one of the transactions that market.
listed above.
Raising debt and restructuring debt, especially when 4.1.7 See also
linked to the types of transactions listed above
Financial accounting
Financial risk management

Stock market

Main article: Financial risk management

Security (nance)
Growth stock

See also: Credit risk; Default (nance);


Financial risk; Interest rate risk; Liquidity risk;
Operational risk; Settlement risk; Value at Risk;
Volatility risk; Insurance.

Financial planning
Investment bank
Venture capital

[24][33]

Risk management
is the process of measuring risk
Financial statement analysis
and then developing and implementing strategies to manage ("hedge") that risk. Financial risk management, typ Corporate tax
ically, is focused on the impact on corporate value due
Corporate governance
to adverse changes in commodity prices, interest rates,
foreign exchange rates and stock prices (market risk). It
will also play an important role in short term cash- and Lists:
treasury management; see above. It is common for large
corporations to have risk management teams; often these
List of accounting topics
overlap with the internal audit function. While it is impractical for small rms to have a formal risk manage List of nance topics
ment function, many still apply risk management infor List of corporate nance topics
mally. See also Enterprise risk management.
List of valuation topics
The discipline typically focuses on risks that can be
hedged using traded nancial instruments, typically
derivatives; see Cash ow hedge, Foreign exchange
hedge, Financial engineering. Because company spe- 4.1.8 References
cic, "over the counter" (OTC) contracts tend to be costly
to create and monitor, derivatives that trade on well- [1] See Corporate Finance: First Principles, Aswath
Damodaran, New York University's Stern School of Busiestablished nancial markets or exchanges are often preness
ferred. These standard derivative instruments include
options, futures contracts, forward contracts, and swaps; [2] Katz, Jerey; Zimmerman, Scott. Recent Developments
the second generation exotic derivatives usually trade
in Acquisition Finance. Transaction Advisors. ISSN
OTC. Note that hedging-related transactions will attract
2329-9134.

20

CHAPTER 4. CORPORATE FINANCE

[3] See: Investment Decisions and Capital Budgeting, Prof.


Campbell R. Harvey; The Investment Decision of the Corporation, Prof. Don M. Chance
[4] See: The Financing Decision of the Corporation, Prof.
Don M. Chance; Capital Structure, Prof. Aswath
Damodaran
[5] Capital Structure: Implications, Prof. John C. Groth,
Texas A&M University; A Generalised Procedure for Locating the Optimal Capital Structure, Ruben D. Cohen,
Citigroup
[6] See:Optimal Balance of Financial Instruments: LongTerm Management, Market Volatility & Proposed
Changes, Nishant Choudhary, LL.M. 2011 (Business &
nance), George Washington University Law School

[20] See:Identifying real options, Prof. Campbell R. Harvey;


Applications of option pricing theory to equity valuation,
Prof. Aswath Damodaran; How Do You Assess The
Value of A Companys Real Options"?, Prof. Alfred
Rappaport Columbia University & Michael Mauboussin
[21] See Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations, Prof. Aswath Damodaran
[22] For example, mining companies sometimes employ the
Hill of Value methodology in their planning; see, e.g., B.
E. Hall (2003). How Mining Companies Improve Share
Price by Destroying Shareholder Value and I. Ballington,
E. Bondi, J. Hudson, G. Lane and J. Symanowitz (2004).
A Practical Application of an Economic Optimisation
Model in an Underground Mining Environment.

A Primer On Preferred Stocks.,

[23] Virginia Clark, Margaret Reed, Jens Stephan (2010).


Using Monte Carlo simulation for a capital budgeting
project, Management Accounting Quarterly, Fall, 2010

[8] Preferred Stock ... generally carries no voting rights unless scheduled dividends have been omitted. Quantum
Online

[24] See: Quantifying Corporate Financial Risk, David


Shimko.

[9] Drinkard, T.

[25] The Flaw of Averages, Prof. Sam Savage, Stanford University.

[7] Drinkard, T.,


Investopedia

[10] Kieso, Donald E.; Weygandt, Jerry J. & Wareld, Terry D.


(2007). Intermediate Accounting (12th ed.). New York:
John Wiley & Sons. p. 738. ISBN 0-471-74955-9.
[11] See: Valuation, Prof. Aswath Damodaran; Equity Valuation, Prof. Campbell R. Harvey
[12] See for example Campbell R. Harveys Hypertextual Finance Glossary or investopedia.com

[26] See Dividend Policy, Prof. Aswath Damodaran


[27] See Working Capital Management, Studynance.com;
Working Capital Management, treasury.govt.nz
[28] Best-Practice Working Capital Management: Techniques
for Optimizing Inventories, Receivables, and Payables,
Patrick Buchmann and Udo Jung

[13] Prof. Aswath Damodaran: Estimating Hurdle Rates

[29] Security Analysis, Benjamin Graham and David Dodd

[14] See: Real Options Analysis and the Assumptions of the


NPV Rule, Tom Arnold & Richard Shockley

[30] See The 20 Principles of Financial Management, Prof.


Don M. Chance, Louisiana State University

[15] Aswath Damodaran: Risk Adjusted Value; Ch 5 in Strategic Risk Taking: A Framework for Risk Management.
Wharton School Publishing, 2007. ISBN 0-13-1990489

[31] William Lasher (2010). Practical Financial Management.


South-Western College Pub; 6 ed. ISBN 1-4390-8050-X

[16] See: 32 Certainty Equivalent Approach & 165 Risk


Adjusted Discount Rate in: Joel G. Siegel; Jae K. Shim;
Stephen Hartman (1 November 1997). Schaums quick
guide to business formulas: 201 decision-making tools for
business, nance, and accounting students. McGraw-Hill
Professional. ISBN 978-0-07-058031-2. Retrieved 12
November 2011.

[32] Beaney, Shaun, Dening corporate nance in the UK,


Corporate Finance Faculty, ICAEW, April 2005 (revised
January 2011)
[33] See: Global Association of Risk Professionals (GARP);
Professional Risk Managers International Association
(PRMIA)
[34] See for example: Prof. Jonathan Lewellen, MIT:
Financial Management Notes: Risk Management

[17] Dan Latimore: Calculating value during uncertainty. IBM


Institute for Business Value
[18] See: Decision Tree Analysis, mindtools.com; Decision
Tree Primer, Prof. Craig W. Kirkwood Arizona State
University
[19] See: Capital Budgeting Under Risk. Ch.9 in Schaums
outline of theory and problems of nancial management,
Jae K. Shim and Joel G. Siegel.

4.1.9 Further reading


Poulsen, Annette (2008). Corporate Financial
Structure. In David R. Henderson (ed.). Concise
Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 9780865976658. OCLC 237794267.

4.2. FINANCIAL CAPITAL

21

Jensen, Michael C.; Smith. Cliord W. The Theory of Corporate Finance: A Historical Overview. In
The Modern Theory of Corporate Finance, edited by
Michael C. Jensen and Cliord H. Smith Jr., pp. 2
20. McGraw-Hill, 1990. ISBN 0070591091
Graham, John R.; Harvey, Campbell R. (1999).
The Theory and Practice of Corporate Finance:
Evidence from the Field. AFA 2001 New Orleans; Capital exports in 2006
Duke University Working Paper.

4.1.10

Bibliography

Jonathan Berk, Peter DeMarzo (2013). Corporate


Finance (3rd Edition). Pearson. ISBN 0132992477.
Richard Brealey; Stewart Myers, Franklin Allen
(2013). Principles of Corporate Finance. McgrawHill. ISBN 978-0078034763.
Aswath Damodaran (1996). Corporate Finance:
Theory and Practice.
Wiley.
ISBN 9780471076803.

Capital imports in 2006

4.2.1 Three concepts of capital maintenance authorized in IFRS

Joo Amaro de Matos (2001). Theoretical Foundations of Corporate Finance. Princeton University Financial capital or just capital/equity in nance,
accounting and economics, is internal retained earnings
Press. ISBN 9780691087948.
generated by the entity or funds provided by lenders (and
Pascal Quiry, Yann Le Fur, Antonio Salvi, Maurizio investors) to businesses to purchase real capital equipDallochio, Pierre Vernimmen (2011). Corporate Fi- ment or services for producing new goods/services. Real
nance: Theory and Practice (3rd Edition). Wiley. capital or economic capital comprises physical goods
ISBN 978-1119975588.
that assist in the production of other goods and services,
e.g. shovels for gravediggers, sewing machines for tailors,
Stephen Ross, Randolph Westereld, Jerey Jae
or machinery and tooling for factories.
(2012). Corporate Finance (10th Edition). McgrawFinancial capital generally refers to saved-up nancial
Hill. ISBN 0078034779.
wealth, especially that used to start or maintain a busi Joel M. Stern, ed. (2003). The Revolution in Corpo- ness. A nancial concept of capital is adopted by most
rate Finance (4th Edition). Wiley-Blackwell. ISBN entities in preparing their nancial reports. Under a 9781405107815.
nancial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the
Jean Tirole (2006). The Theory of Corporate
net assets or equity of the entity. Under a physical conFinance.
Princeton University Press.
ISBN
cept of capital, such as operating capability, capital is re0691125562.
garded as the productive capacity of the entity based on,
Ivo Welch (2014). Corporate Finance (3rd Edition). for example, units of output per day. Financial capital
maintenance can be measured in either nominal monetary
ISBN 978-0-9840049-1-1.
units or units of constant purchasing power.[1][2] There
are thus three concepts of capital maintenance in terms of
International Financial Reporting Standards (IFRS): (1)
4.2 Financial capital
Physical capital maintenance (2) Financial capital maintenance in nominal monetary units (3) Financial capital
For a city with an important role in the world economy, maintenance in units of constant purchasing power.[1][3]
see Financial centre and Global city.
Framework for the Preparation and Presentation of FiFinancial capital is any economic resource measured in nancial Statements,
terms of money used by entrepreneurs and businesses to
buy what they need to make their products or to provide Financial capital is provided by lenders for a price:
their services to the sector of the economy upon which interest. Also see time value of money for a more detailed
their operation is based, i.e. retail, corporate, investment description of how nancial capital may be analyzed.
banking, etc.
Furthermore, nancial capital, is any liquid medium or

22

CHAPTER 4. CORPORATE FINANCE

mechanism that represents wealth, or other styles of Money market


capital. It is, however, usually purchasing power in the
Financial institutions can use short-term savings to
form of money available for the production or purchaslend out in the form of short-term loans:
ing of goods, etcetera. Capital can also be obtained by
producing more than what is immediately required and
Credit on open account
saving the surplus.
Bank overdraft
Financial capital can also be in the form of purchasable
items such as computers or books that can contribute di Short-term loans
rectly or indirectly to obtaining various other types of
Bills of exchange
capital.[4]
Factoring of debtors
Financial capital has been subcategorized by some academics as economic or productive capital necessary for
operations, signaling capital which signals a companys
4.2.3 Dierences between shares and
nancial strength to shareholders, and regulatory capital
debentures
[5]
which fullls capital requirements.

4.2.2

Sources of capital

Long term - usually above 7 years


Share Capital
Mortgage loan
Retained Prot
Venture Capital
Debenture
Project Finance
Medium term - usually between 2 and 7 years
Term Loans
Leasing
Hire Purchase
Short term - usually under 2 years
Bank Overdraft
Trade Credit
Deferred Expenses
Factoring
Capital market
Long-term funds are bought and sold:
Shares
Debentures

Shareholders are eectively owners; debentureholders are creditors.


Shareholders may vote at AGMs (Annual General
Meetings) and be elected as directors; debentureholders may not vote at AGMs or be elected as directors.
Shareholders receive prot in the form of dividends;
debenture-holders receive a xed rate of interest.
If there is no prot, the shareholder does not receive
a dividend; interest is paid to debenture-holders regardless of whether or not a prot has been made.
In case of dissolution of rms debenture holders are
paid rst as compared to shareholder.

4.2.4 Fixed capital


This is money which is used to purchase assets that will
remain permanently in the business and help it to make a
prot
Factors determining xed capital requirements
Nature of business
Size of business
Stage of development
Capital invested by the owners
location of that area

Long-term loans, often with a mortgage bond


as security
4.2.5
Reserve funds
Euro Bonds
Law Firms

Working capital

Working capital is that part of capital invested which is


used for running the business such like money which is
used to buy stock, pay expenses and nance credit.

4.2. FINANCIAL CAPITAL


Factors determining working capital requirements
Size of business

23
Borrowed capital
This is capital which the business borrows from institutions or people, and includes debentures:

Stage of development
Time of production
Rate of stock turnover ratio

Redeemable debentures
Irredeemable debentures
Debentures to bearer

Buying and selling terms

Ordinary debentures

Seasonal consumption

bonds

Seasonal product

deposits

prot level
growth and expansion
production cycle
general nature of business
business cycle

loans
Own capital
This is capital that owners of a business (shareholders and
partners, for example) provide:
Preference shares/hybrid source of nance
Ordinary preference shares

business policies

Cumulative preference shares


Participating preference shares

4.2.6

Instruments

A contract regarding any combination of capital assets is


called a nancial instrument, and may serve as a
medium of exchange,
standard of deferred payment,
unit of account, or
store of value.

Ordinary shares
Bonus shares
Founders shares
These have preference over the equity shares. This means
the payments made to the shareholders are rst paid to the
preference shareholder(s) and then to the equity shareholders.

4.2.8 Issuing and trading

Like money, nancial instruments may be backed by


state military at, credit (i.e. social capital held by banks
and their depositors), or commodity resources. Governments generally closely control the supply of it and usually
require some reserve be held by institutions granting
credit. Trading between various national currency instruments is conducted on a money market. Such trading re4.2.7 Own and borrowed capital
veals dierences in probability of debt collection or store
Capital contributed by the owner or entrepreneur of a of value function of that currency, as assigned by traders.
business, and obtained, for example, by means of sav- When in forms other than money, nancial capital may
ings or inheritance, is known as own capital or equity, be traded on bond markets or reinsurance markets with
whereas that which is granted by another person or insti- varying degrees of trust in the social capital (not just
tution is called borrowed capital, and this must usually be credits) of bond-issuers, insurers, and others who issue
paid back with interest. The ratio between debt and eq- and trade in nancial instruments. When payment is deuity is named leverage. It has to be optimized as a high ferred on any such instrument, typically an interest rate
leverage can bring a higher prot but create solvency risk. is higher than the standard interest rates paid by banks,
Most indigenous forms of money (wampum, shells, tally
sticks and such) and the modern at money is only a symbolic storage of value and not a real storage of value like
commodity money.

24

CHAPTER 4. CORPORATE FINANCE

or charged by the central bank on its money. Often such


instruments are called xed-income instruments if they
have reliable payment schedules associated with the uniform rate of interest. A variable-rate instrument, such
as many consumer mortgages, will reect the standard
rate for deferred payment set by the central bank prime
rate, increasing it by some xed percentage. Other instruments, such as citizen entitlements, e.g. "U.S. Social
Security", or other pensions, may be indexed to the rate
of ination, to provide a reliable value stream.
Trading in stock markets or commodity markets is actually trade in underlying assets which are not wholly nancial in themselves, although they often move up and
down in value in direct response to the trading in more
purely nancial derivatives. Typically commodity markets depend on politics that aect international trade, e.g.
boycotts and embargoes, or factors that inuence natural
capital, e.g. weather that aects food crops. Meanwhile, stock markets are more inuenced by trust in corporate leaders, i.e. individual capital, by consumers, i.e.
social capital or brand capital (in some analyses), and
internal organizational eciency, i.e. instructional capital and infrastructural capital. Some enterprises issue
instruments to specically track one limited division or
brand. "Financial futures", "Short selling" and "nancial
options" apply to these markets, and are typically pure nancial bets on outcomes, rather than being a direct representation of any underlying asset.

4.2.9

Broadening the notion

4.2.10 Marxian perspectives


It is common in Marxian theory to refer to the role of
"Finance Capital" as the determining and ruling class
interest in capitalist society, particularly in the latter
stages.[6][7]

4.2.11 Valuation
Normally, a nancial instrument is priced accordingly to
the perception by capital market players of its expected
return and risk.
Unit of account functions may come into question if valuations of complex nancial instruments vary drastically
based on timing. The "book value", "mark-to-market"
and "mark-to-future"[8] conventions are three dierent
approaches to reconciling nancial capital value units of
account.

4.2.12 Economic role


Socialism, capitalism, feudalism, anarchism, other civic
theories take markedly dierent views of the role of nancial capital in social life, and propose various political
restrictions to deal with that.
Finance capitalism is the production of prot from the
manipulation of nancial capital. It is held in contrast to
industrial capitalism, where prot is made from the manufacture of goods.

4.2.13 See also


Banking

The relationship between nancial capital, money, and all


other styles of capital, especially human capital or labor,
is assumed in central bank policy and regulations regarding instruments as above.
Such relationships and policies are characterized by a
political economy - feudalist, socialist, capitalist, green,
anarchist or otherwise. In eect, the means of money
supply and other regulations on nancial capital represent the economic sense of the value system of the society itself, as they determine the allocation of labor in that
society.

Capital market
Constant item purchasing power accounting
Financialization
Funding
International Financial Reporting Standards
Money supply
List of nance topics

So, for instance, rules for increasing or reducing the


List of accounting topics
money supply based on perceived ination, or on
measuring well-being, reect some such values, reect
the importance of using (all forms of) nancial capital as 4.2.14 Notes
a stable store of value. If this is very important, ination
control is key - any amount of money ination reduces the [1] Constant item purchasing power accounting#CIPPA as
per the IASBs Framework.5B14.5D .5B15.5D Constant
value of nancial capital with respect to all other types.
If, however, the medium of exchange function is more
critical, new money may be more freely issued regardless
of impact on either ination or well-being.

item purchasing power accounting


[2] Framework for the Preparation and Presentation of Financial Statements, Par 104

4.3. CORNERING THE MARKET

[3] http://www.aasb.org/admin/file/content105/c9/
Framework_07-04nd.pdf
[4] Spillane, James P., Tim Hallett, and John B. Diamond.
2003. Forms of Capital and the Construction of Leadership: Instructional Leadership in Urban Elementary
Schools. Sociology of Education 76 (January): 1-17

25
If the rest of the market senses weakness, it may resist
any attempt to articially 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 prot from the
cornerers need to unwind the position.

[5] The Risk Report, April 2009. Volume XXXI No. 8.


IRMI.
[6] Imperialism, the Highest Stage of Capitalism ibid. Finance Capital and the Finance Oligarchy
[7] Monopoly-Finance Capital and the Paradox of Accumulation John Bellamy Foster and Robert W. McChesney
Monthly Review Sept-Oct 2009
[8] The New Generation of Risk Management for Hedge Funds
and Private Equity Investments, edited by Lars Jaeger, p.
349

4.2.15

References

F. Boldizzoni, Means and Ends: The Idea of Capital in the West, 1500-1970, New York: Palgrave
Macmillan, 2008, chapters 7-8

4.3 Cornering the market


In nance, to corner the market is to get sucient control of a particular stock, commodity, or other asset to
allow the price to be manipulated. Another denition:
To have the greatest market share in a particular industry without having a monopoly. Companies that have cornered their markets usually have greater leeway in their
decisions; for example, they may charge higher prices for
their products without fear of losing too much business.
Large companies, such as Wal-Mart or Microsoft, are
considered to have cornered their markets.[1] In either
case, the cornerer hopes to gain control of enough of the
supply of the commodity to be able to set the price for it.

4.3.1 Historical examples


ca 6th Century BC: Thales of Miletus
According to Aristotle in The Politics (Book I Section
1259a),[3] Thales of Miletus once cornered the market
in olive-oil presses:
Thales, so the story goes, because of his
poverty was taunted with the uselessness of
philosophy; but from his knowledge of astronomy he had observed while it was still winter that there was going to be a large crop of
olives, so he raised a small sum of money and
paid round deposits for the whole of the olivepresses in Miletus and Chios, which he hired at
a low rent as nobody was running him up; and
when the season arrived, there was a sudden demand for a number of presses at the same time,
and by letting them out on what terms he liked
he realized a large sum of money, so proving
that it is easy for philosophers to be rich if they
choose.
19th century: Classic examples by Edwin Lefvre
Journalist Edwin Lefvre lists several examples of corners
from the mid-19th century. 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 few cornerers whose rationale was published
and justied, Cornelius Vanderbilt started accumulating
shares of the Harlem Railroad in 1862 because he anticipated its strategic value. He took control of the Harlem
Railroad and later explained that he wanted to show that
he could take this railroad, which was generally considered worthless, and make it valuable. The corner of June
Although there have been many attempts to corner mar- 25, 1863 can be seen as just an episode in a strategic inkets by massive purchases in everything from tin to cattle, vestment that served the public well.
to date very few of these attempts have ever succeeded;
instead, most of these attempted corners have tended to
break themselves spontaneously. Indeed, as long ago James Fisk, Jay Gould and the Black Friday (1869)
as 1923, Edwin Lefvre wrote, very few of the great The 1869 Black Friday nancial panic in the United
corners were protable to the engineers of them.[2] A States was caused by the eorts of Jay Gould and James
cornerer can become vulnerable due to the size of the Fisk to corner the gold market on the New York Gold
position, especially if the attempt becomes widely known. Exchange. It was one of several scandals that rocked the
This can be done through several mechanisms. The most
direct strategy is to simply buy up a large percentage of
the available commodity oered 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 prot after inating
the price.

26

CHAPTER 4. CORPORATE FINANCE

presidency of Ulysses S. Grant. When the government


gold hit the market, the premium plummeted within minutes and many investors were ruined. Fisk and Gould escaped signicant nancial harm.

tional copper market over a ten-year period leading up


to 1996.[8] At one point during this "Sumitomo copper
aair, Hamanaka is believed to have controlled approximately 5% of the world copper market.[8] As his scheme
collapsed, Sumitomo was left with large positions in the
copper market, ultimately losing US$2.6 billion.[9] In
Lefvre thoughts on corners of the old days In chap- 1997 Hamanaka pleaded guilty to criminal charges stemter 19 of his book, Edwin Lefvre tries to summarize the ming from his trading activity and was sentenced to eight
rationale for the corners of the 19th century.
years in prison.[9]
20th century: The Northern Pacic Railway

2008: Porsche and shares in Volkswagen

The corner of The Northern Pacic Railway on May 9,


1901, is a well documented case of competitive buying, resulting in a panic. The 2009 Annotated Edition
of Reminiscences of a Stock Operator contains Lefvres
original account in chapter 3 as well as modern annotations explaining the actual locations and personalities on
the page margins.

During the nancial crisis of 2007-2010 Porsche cornered the market in shares of Volkswagen, which briey
saw Volkswagen become the worlds most valuable
company.[10] Porsche claimed that its actions were intended to gain control of Volkswagen rather than to manipulate the market: in this case, while cornering the
market in Volkswagen shares, Porsche contracted with
naked shortsresulting in a short squeeze on them.[11]
1920s: The Stutz Motor Company
It was ultimately unsuccessful, leading to the resignation
of Porsches chief executive and nancial director and to
Called a forerunner of the Livermore and Cutten opera- the merger of Porsche into Volkswagen.[12]
tions of a few years later by historian Robert Sobel, the
March 1920 corner of The Stutz Motor Company is an One of the wealthiest men in Germanys industry, Adolf
committed suicide after shorting Volkswagen
example of a manipulated corner ruining everyone in- Merckle,
[13]
shares.
[4]
volved, especially its originator Allan Ryan.
1950s: The onion market

2010: Armajaro and the European cocoa market

On July 17, 2010, Armajaro purchased 240,100 tonnes


of cocoa.[14] The buyout caused cocoa prices to rise to
their highest level since 1977. The purchase was valued
at 658 million and accounted for 7 per cent of annual
global cocoa production.[15] The transaction, the largest
single cocoa trade in 14 years, was carried out by Armajaro Holdings, a hedge fund co-founded by Mr Anthony Ward. Ward, the manager of the hedge fund, has
1970s: The Hunt brothers and the silver market
been dubbed Chocnger by fellow traders for his exploits. The nickname is a reference to both the Bond vilBrothers Nelson Bunker Hunt and William Herbert Hunt lain Goldnger as well as a British confection.[16]
attempted to corner the world silver markets in the late
1970s and early 1980s, at one stage holding the rights to
more than half of the worlds deliverable silver.[5] Dur4.3.2 References
ing the Hunts accumulation of the precious metal, silver prices rose from $11 an ounce in September 1979
[1] Cornering the market. TheFreeDictionary.com
to nearly $50 an ounce in January 1980.[6] Silver prices
ultimately collapsed to below $11 an ounce two months [2] Lefvre, Edwin (1923), Reminiscences of a Stock Operalater,[6] much of the fall occurring on a single day now
tor, chapter 19.
known as Silver Thursday, due to changes made to exchange rules regarding the purchase of commodities on [3] Aristotle. Politics. Translated by H. Rackham. Retrieved
margin.[7]
2011-01-11.
In the late 1950s, United States onion farmers alleged that
Sam Seigel and Vincent Kosuga, Chicago Mercantile Exchange 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 eect as of 2015.

1990s: Hamanaka and the copper market


Rogue trader Yasuo Hamanaka, Sumitomo Corporation's
chief copper trader, attempted to corner the interna-

[4] The New Yorker: A Corner in Stutz, 23 August 1969


[5] Gwynne, S. C. (September 2001). Bunker HUNT.
Texas Monthly (Austin, Texas, United States: Emmis
Communications Corporation) 29 (9): p78.

4.4. INSURANCE

[6] Eichenwald, Kurt (1989-12-21). 2 Hunts Fined And


Banned From Trades. New York Times. Retrieved
2008-06-29.
[7] Bunkers Busted Silver Bubble. Time Magazine (Time
Inc.). 1980-05-12. Retrieved 2008-06-29

27
called the insurance policy, which details the conditions
and circumstances under which the insured will be nancially compensated.

4.4.1 History

[8] Gettler, Leon (2008-02-02). Wake-up calls on rogue


traders keep ringing, but whos answering the phone?".
The Age (Melbourne). Retrieved 2008-06-29

Main article: History of insurance

[9] Petersen, Melody (1999-05-21). Merrill Charged With


2d Firm In Copper Case. New York Times. Retrieved
2008-06-29

Early methods

[10] Hedge funds make 18bn loss on VW. BBC. 2008-1029.


[11] Squeezy money. Economist. 2008-10-30. Retrieved
2008-11-01; A Clever Move by Porsche on VWs Stock,
New York Times; Porsche crashes into controversy in the
ultimate 'short squeeze'", The Daily Telegraph
[12] VW prepares to take over Porsche. BBC. 2009-07-23.
[13] Boyes, Roger (2009-01-07). Adolf Merckle, German tycoon who lost millions on VW shares, commits suicide.
London: The Sunday Times.
[14] Farchy, Jack (16 July 2010). Hedge fund develops taste
for chocolate assets. Financial Times. Retrieved 27 July
2010.

Merchants have sought methods to minimize risks since early


times. Pictured, Governors of the Wine Merchants Guild by
Ferdinand Bol, c. 1680.

[15] Sibun, Jonathan; Wallop, Harry (17 July 2010). Mystery


trader buys all Europes cocoa. The Telegraph. Retrieved
27 July 2010.

Methods for transferring or distributing risk were practiced by Chinese and Babylonian traders as long ago as
the 3rd and 2nd millennia BC, respectively.[1] Chinese
[16] Werdigier, Julia; Creswell, Julie (July 24, 2010). merchants travelling treacherous river rapids would redisTraders Cocoa Binge Wraps Up Chocolate Market.
tribute their wares across many vessels to limit the loss
The New York Times. Retrieved July 27, 2010.
due to any single vessels capsizing. The Babylonians
developed a system which was recorded in the famous
Code of Hammurabi, c. 1750 BC, and practiced by early
4.4 Insurance
Mediterranean sailing merchants. If a merchant received
a loan to fund his shipment, he would pay the lender an
This article is about the risk management method. For additional sum in exchange for the lenders guarantee to
insurance in blackjack, see Blackjack.
cancel the loan should the shipment be stolen or lost at
sea.
Insurance is the equitable transfer of the risk of a loss,
from one entity to another in exchange for payment. It is a
form of risk management primarily used to hedge against
the risk of a contingent, uncertain loss. An insurer, or
insurance carrier, is selling the insurance; the insured, or
policyholder, is the person or entity buying the insurance
policy. The amount of money to be charged for a certain amount of insurance coverage is called the premium.
Risk management, the practice of appraising and controlling risk, has evolved as a discrete eld of study and practice.
The transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer in exchange for the insurers promise
to compensate (indemnify) the insured in the case of a
nancial (personal) loss. The insured receives a contract,

At some point in the 1st millennium BC, the inhabitants


of Rhodes created the 'general average'. This allowed
groups of merchants to pay to insure their goods being
shipped together. The collected premiums would be used
to reimburse any merchant whose goods were jettisoned
during transport, whether to storm or sinkage.[2]
Separate insurance contracts (i.e., insurance policies not
bundled with loans or other kinds of contracts) were invented in Genoa in the 14th century, as were insurance
pools backed by pledges of landed estates. The rst
known insurance contract dates from Genoa in 1347, and
in the next century maritime insurance developed widely
and premiums were intuitively varied with risks.[3] These
new insurance contracts allowed insurance to be separated from investment, a separation of roles that rst
proved useful in marine insurance.

28

CHAPTER 4. CORPORATE FINANCE

Modern insurance
Insurance became far more sophisticated in
Enlightenment era Europe, and specialized varieties
developed.

Leaet promoting the National Insurance Act 1911.

Lloyds Coee House was the rst marine insurance company.

ce, founded in London in 1706 by William Talbot and


[7][8]
Edward Rowe Mores established
Property insurance as we know it today can be traced to Sir Thomas Allen.
the
Society
for
Equitable
Assurances on Lives and Surthe Great Fire of London, which in 1666 devoured more
vivorship
in
1762.
than 13,000 houses. The devastating eects of the re
converted the development of insurance from a matter It was the worlds rst mutual insurer and it pioneered
of convenience into one of urgency, a change of opin- age based premiums based on mortality rate laying the
ion reected in Sir Christopher Wren's inclusion of a site framework for scientic insurance practice and developfor 'the Insurance Oce' in his new plan for London in ment and the basis of modern life assurance upon which
1667.[4] A number of attempted re insurance schemes all life assurance schemes were subsequently based.[9]
came to nothing, but in 1681, economist Nicholas Bar- In the late 19th century, accident insurance began to bebon and eleven associates established the rst re insurcome available. This operated much like modern disabilance company, the Insurance Oce for Houses, at the ity insurance.[10][11] The rst company to oer accident
back of the Royal Exchange to insure brick and frame
insurance was the Railway Passengers Assurance Comhomes. Initially, 5,000 homes were insured by his Insur- pany, formed in 1848 in England to insure against the
ance Oce.[5]
rising number of fatalities on the nascent railway system.
At the same time, the rst insurance schemes for the By the late 19th century, governments began to initiate
underwriting of business ventures became available. By national insurance programs against sickness and old age.
the end of the seventeenth century, Londons growing Germany built on a tradition of welfare programs in Prusimportance as a center for trade was increasing demand sia and Saxony that began as early as in the 1840s. In
for marine insurance. In the late 1680s, Edward Lloyd the 1880s Chancellor Otto von Bismarck introduced old
opened a coee house, which became the meeting place age pensions, accident insurance and medical care that
for parties in the shipping industry wishing to insure car- formed the basis for Germanys welfare state.[12][13] In
goes and ships, and those willing to underwrite such ven- Britain more extensive legislation was introduced by the
tures. These informal beginnings led to the establishment Liberal government in the 1911 National Insurance Act.
of the insurance market Lloyds of London and several re- This gave the British working classes the rst contributory
lated shipping and insurance businesses.[6]
system of insurance against illness and unemployment.[14]
The rst life insurance policies were taken out in the early This system was greatly expanded after the Second World
18th century. The rst company to oer life insurance War under the inuence of the Beveridge Report, to form
was the Amicable Society for a Perpetual Assurance Of- the rst modern welfare state.[12][15]

4.4. INSURANCE

4.4.2

Principles

Insurance involves pooling funds from many insured entities (known as exposures) to pay for the losses that some
may incur. The insured entities are therefore protected
from risk for a fee, with the fee being dependent upon
the frequency and severity of the event occurring. In order to be an insurable risk, the risk insured against must
meet certain characteristics. Insurance as a nancial intermediary is a commercial enterprise and a major part of
the nancial services industry, but individual entities can
also self-insure through saving money for possible future
losses.[16]
Insurability
Main article: Insurability
Risk which can be insured by private companies typically
shares seven common characteristics:[17]
1. Large number of similar exposure units: Since
insurance operates through pooling resources, the
majority of insurance policies are provided for individual members of large classes, allowing insurers
to benet from the law of large numbers in which
predicted losses are similar to the actual losses. Exceptions include Lloyds of London, which is famous
for insuring the life or health of actors, sports gures, and other famous individuals. However, all exposures will have particular dierences, which may
lead to dierent premium rates.
2. Denite loss: The loss takes place at a known time,
in a known place, and from a known cause. The classic example is death of an insured person on a life
insurance policy. Fire, automobile accidents, and
worker injuries may all easily meet this criterion.
Other types of losses may only be denite in theory. Occupational disease, for instance, may involve
prolonged exposure to injurious conditions where
no specic time, place, or cause is identiable. Ideally, the time, place, and cause of a loss should be
clear enough that a reasonable person, with sucient information, could objectively verify all three
elements.

29
premiums need to cover both the expected cost of
losses, plus the cost of issuing and administering the
policy, adjusting losses, and supplying the capital
needed to reasonably assure that the insurer will be
able to pay claims. For small losses, these latter costs
may be several times the size of the expected cost
of losses. There is hardly any point in paying such
costs unless the protection oered has real value to
a buyer.
5. Aordable 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 oered, then it is not likely
that the insurance will be purchased, even if on offer. Furthermore, as the accounting profession formally recognizes in nancial accounting standards,
the premium cannot be so large that there is not
a reasonable chance of a signicant loss to the insurer. If there is no such chance of loss, then the
transaction may have the form of insurance, but not
the substance (see the U.S. Financial Accounting
Standards Board pronouncement number 113: Accounting and Reporting for Reinsurance of ShortDuration and Long-Duration Contracts).
6. Calculable loss: There are two elements that must
be at least estimable, if not formally calculable: the
probability of loss, and the attendant cost. Probability of loss is generally an empirical exercise, while
cost has more to do with the ability of a reasonable
person in possession of a copy of the insurance policy and a proof of loss associated with a claim presented under that policy to make a reasonably definite and objective evaluation of the amount of the
loss recoverable as a result of the claim.
7. Limited risk of catastrophically large losses:
Insurable losses are ideally independent and noncatastrophic, meaning that the losses do not happen all at once and individual losses are not severe
enough to bankrupt the insurer; insurers may prefer
to limit their exposure to a loss from a single event
to some small portion of their capital base. Capital
constrains insurers ability to sell earthquake insurance as well as wind insurance in hurricane zones.
In the United States, ood risk is insured by the federal government. In commercial re insurance, it
is possible to nd single properties whose total exposed value is well in excess of any individual insurers capital constraint. Such properties are generally shared among several insurers, or are insured
by a single insurer who syndicates the risk into the
reinsurance market.

3. Accidental loss: The event that constitutes the trigger of a claim should be fortuitous, or at least outside
the control of the beneciary of the insurance. The
loss should be pure, in the sense that it results from
an event for which there is only the opportunity for
cost. Events that contain speculative elements such
as ordinary business risks or even purchasing a lotLegal
tery ticket are generally not considered insurable.

4. Large loss: The size of the loss must be meaning- When a company insures an individual entity, there are
ful from the perspective of the insured. Insurance basic legal requirements and regulations. Several com-

30

CHAPTER 4. CORPORATE FINANCE

monly cited legal principles of insurance include:[18]


1.

2.

3.

4.

5.

6.

7.

insurance (i.e., a claim arises on the occurrence of a specied event). There are generally three types of insurance
Indemnity the insurance company indemnies, or contracts that seek to indemnify an insured:
compensates, the insured in the case of certain losses
1. A reimbursement policy
only up to the insureds interest.
2. A pay on behalf or on behalf of policy[19]
Benet insurance as it is stated in the study books
3. An indemnication policy
of The Chartered Insurance Institute, the insurance
company doesn't have the right of recovery from the
party who caused the injury and is to compensate From an insureds standpoint, the result is usually the
the Insured regardless of the fact that Insured had same: the insurer pays the loss and claims expenses.
already sued the negligent party for the damages (for If the Insured has a reimbursement policy, the insured
example, personal accident insurance)
can be required to pay for a loss and then be reimbursed
by the insurance carrier for the loss and out of pocket
Insurable interest the insured typically must di- costs including, with the permission of the insurer, claim
rectly suer from the loss. Insurable interest must expenses.[19][20]
exist whether property insurance or insurance on a
person is involved. The concept requires that the Under a pay on behalf policy, the insurance carrier
insured have a stake in the loss or damage to the would defend and pay a claim on behalf of the insured
life or property insured. What that stake is will be who would not be out of pocket for anything. Most moddetermined by the kind of insurance involved and ern liability insurance is written on the basis of pay on
the nature of the property ownership or relationship behalf language which enables the insurance carrier to
between the persons. The requirement of an in- manage and control the claim.
surable interest is what distinguishes insurance from Under an indemnication policy, the insurance carrier
gambling.
can generally either reimburse or pay on behalf of,
whichever is more benecial to it and the insured in the
Utmost good faith (Uberrima des) the insured
claim handling process.
and the insurer are bound by a good faith bond of
honesty and fairness. Material facts must be dis- An entity seeking to transfer risk (an individual, corporation, or association of any type, etc.) becomes the 'inclosed.
sured' party once risk is assumed by an 'insurer', the insurContribution insurers which have similar obliga- ing party, by means of a contract, called an insurance poltions to the insured contribute in the indemnica- icy. Generally, an insurance contract includes, at a mintion, according to some method.
imum, the following elements: identication of participating parties (the insurer, the insured, the beneciaries),
Subrogation the insurance company acquires legal
the premium, the period of coverage, the particular loss
rights to pursue recoveries on behalf of the insured;
event covered, the amount of coverage (i.e., the amount
for example, the insurer may sue those liable for the
to be paid to the insured or beneciary in the event of a
insureds loss. The Insurers can waive their subroloss), and exclusions (events not covered). An insured is
gation rights by using the special clauses.
thus said to be "indemnied" against the loss covered in
Causa proxima, or proximate cause the cause of the policy.

loss (the peril) must be covered under the insuring When insured parties experience a loss for a specied
agreement of the policy, and the dominant cause peril, the coverage entitles the policyholder to make a
must not be excluded
claim against the insurer for the covered amount of loss
as specied by the policy. The fee paid by the insured to
8. Mitigation In case of any loss or casualty, the asset the insurer for assuming the risk is called the premium.
owner must attempt to keep loss to a minimum, as Insurance premiums from many insureds are used to fund
if the asset was not insured.
accounts reserved for later payment of claims in theory
for a relatively few claimants and for overhead costs. So
long as an insurer maintains adequate funds set aside for
Indemnication
anticipated losses (called reserves), the remaining margin
is an insurers prot.
Main article: Indemnity
To indemnify means to make whole again, or to be
reinstated to the position that one was in, to the extent
possible, prior to the happening of a specied event or
peril. Accordingly, life insurance is generally not considered to be indemnity insurance, but rather contingent

4.4.3 Societal eects


Insurance can have various eects on society through the
way that it changes who bears the cost of losses and damage. On one hand it can increase fraud; on the other it can

4.4. INSURANCE

31

help societies and individuals prepare for catastrophes Underwriting and investing
and mitigate the eects of catastrophes on both households and societies.
The business model is to collect more in premium and
Insurance can inuence the probability of losses through investment income than is paid out in losses, and to also
moral hazard, insurance fraud, and preventive steps by oer a competitive price which consumers will accept.
the insurance company. Insurance scholars have typi- Prot can be reduced to a simple equation:
cally used moral hazard to refer to the increased loss
Prot = earned premium + investment income
due to unintentional carelessness and moral hazard to re incurred loss underwriting expenses.
fer to increased risk due to intentional carelessness or
indierence.[21] Insurers attempt to address carelessness
through inspections, policy provisions requiring certain Insurers make money in two ways:
types of maintenance, and possible discounts for loss mitigation eorts. While in theory insurers could encourage
Through underwriting, the process by which insurers
investment in loss reduction, some commentators have
select the risks to insure and decide how much in
argued that in practice insurers had historically not agpremiums to charge for accepting those risks
gressively pursued loss control measuresparticularly to
prevent disaster losses such as hurricanesbecause of
By investing the premiums they collect from insured
concerns over rate reductions and legal battles. Howparties
ever, since about 1996 insurers have begun to take a more
active role in loss mitigation, such as through building
The most complicated aspect of the insurance business
codes.[22]
is the actuarial science of ratemaking (price-setting) of
policies, which uses statistics and probability to approximate the rate of future claims based on a given risk. After
Methods of insurance
producing rates, the insurer will use discretion to reject
In accordance with study books of The Chartered Insur- or accept risks through the underwriting process.
ance Institute, there are the following types of insurance: At the most basic level, initial ratemaking involves look1. Co-insurance risks shared between insurers
2. Dual insurance risks having two or more policies
with same coverage
3. Self-insurance situations where risk is not transferred to insurance companies and solely retained by
the entities or individuals themselves
4. Reinsurance situations when Insurer passes some
part of or all risks to another Insurer called Reinsurer

4.4.4

Insurers business model

ing at the frequency and severity of insured perils and


the expected average payout resulting from these perils.
Thereafter an insurance company will collect historical
loss data, bring the loss data to present value, and compare these prior losses to the premium collected in order
to assess rate adequacy.[23] Loss ratios and expense loads
are also used. Rating for dierent risk characteristics involves at the most basic level comparing the losses with
loss relativitiesa policy with twice as many losses
would therefore be charged twice as much. More complex multivariate analyses are sometimes used when multiple characteristics are involved and a univariate analysis could produce confounded results. Other statistical
methods may be used in assessing the probability of future losses.
Upon termination of a given policy, the amount of premium collected minus the amount paid out in claims is
the insurers underwriting prot on that policy. Underwriting performance is measured by something called the
combined ratio, which is the ratio of expenses/losses to
premiums.[24] A combined ratio of less than 100% indicates an underwriting prot, while anything over 100
indicates an underwriting loss. A company with a combined ratio over 100% may nevertheless remain profitable due to investment earnings.

Accidents will happen (William H. Watson, 1922) is a slapstick


silent lm about the methods and mishaps of an insurance broker. Collection EYE Film Institute Netherlands.

Insurance companies earn investment prots on oat.


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

32
are collected and continue to earn interest or other income on them until claims are paid out. The Association
of British Insurers (gathering 400 insurance companies
and 94% of UK insurance services) has almost 20% of
the investments in the London Stock Exchange.[25]

CHAPTER 4. CORPORATE FINANCE


plete, and appear in person or over the telephone with settlement authority at a mandatory settlement conference
when requested by the judge.

If a claims adjuster suspects under-insurance, the


condition of average may come into play to limit the inIn the United States, the underwriting loss of property surance companys exposure.
and casualty insurance companies was $142.3 billion in
In managing the claims handling function, insurers seek
the ve years ending 2003. But overall prot for the same to balance the elements of customer satisfaction, adminisperiod was $68.4 billion, as the result of oat. Some in- trative handling expenses, and claims overpayment leaksurance industry insiders, most notably Hank Greenberg, ages. As part of this balancing act, fraudulent insurance
do not believe that it is forever possible to sustain a prot practices are a major business risk that must be managed
from oat without an underwriting prot as well, but this and overcome. Disputes between insurers and insureds
opinion is not universally held.
over the validity of claims or claims handling practices
Naturally, the oat method is dicult to carry out in an occasionally escalate into litigation (see insurance bad
economically depressed period. Bear markets do cause faith).
insurers to shift away from investments and to toughen
up their underwriting standards, so a poor economy generally means high insurance premiums. This tendency to
swing between protable and unprotable periods over
time is commonly known as the underwriting, or insur- Marketing
ance, cycle.[26]
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 indepenClaims
dent, meaning that they can issue policies from several
Claims and loss handling is the materialized utility of in- companies. The existence and success of companies usis likely due to improved and persurance; it is the actual product paid for. Claims may ing insurance agents
[27]
sonalized
service.
be led by insureds directly with the insurer or through
brokers or agents. The insurer may require that the claim
be led on its own proprietary forms, or may accept
claims on a standard industry form, such as those produced by ACORD.
Insurance company claims departments employ a large
number of claims adjusters supported by a sta of records
management and data entry clerks. Incoming claims are
classied based on severity and are assigned to adjusters
whose settlement authority varies with their knowledge
and experience. The adjuster undertakes an investigation
of each claim, usually in close cooperation with the insured, determines if coverage is available under the terms
of the insurance contract, and if so, the reasonable monetary value of the claim, and authorizes payment.

4.4.5 Types of insurance


Any risk that can be quantied can potentially be insured.
Specic kinds of risk that may give rise to claims are
known as perils. An insurance policy will set out in detail
which perils are covered by the policy and which are not.
Below are non-exhaustive lists of the many dierent types
of insurance that exist. A single policy may cover risks in
one or more of the categories set out below. For example,
vehicle insurance would typically cover both the property
risk (theft or damage to the vehicle) and the liability risk
(legal claims arising from an accident). A home insurance
policy in the United States typically includes coverage for
damage to the home and the owners belongings, certain
legal claims against the owner, and even a small amount
of coverage for medical expenses of guests who are injured on the owners property.

The policyholder may hire their own public adjuster to


negotiate the settlement with the insurance company on
their behalf. For policies that are complicated, where
claims may be complex, the insured may take out a separate insurance policy add on, called loss recovery insurance, which covers the cost of a public adjuster in the
case of a claim.
Business insurance can take a number of dierent forms,
Adjusting liability insurance claims is particularly di- such as the various kinds of professional liability incult because there is a third party involved, the plainti, surance, also called professional indemnity (PI), which
who is under no contractual obligation to cooperate with are discussed below under that name; and the business
the insurer and may in fact regard the insurer as a deep owners policy (BOP), which packages into one policy
pocket. The adjuster must obtain legal counsel for the many of the kinds of coverage that a business owner
insured (either inside house counsel or outside panel needs, in a way analogous to how homeowners insurance
counsel), monitor litigation that may take years to com- packages the coverages that a homeowner needs.[28]

4.4. INSURANCE

33

Auto insurance
Main article: Vehicle insurance
Auto insurance protects the policyholder against nancial

Great Western Hospital, Swindon

policyholders for dental costs. In most developed countries, all citizens receive some health coverage from their
governments, paid for by taxation. In most countries,
health insurance is often part of an employers benets.
Income protection insurance

A wrecked vehicle in Copenhagen

loss in the event of an incident involving a vehicle they


own, such as in a trac collision.
Coverage typically includes:
Property coverage, for damage to or theft of the car
Liability coverage, for the legal responsibility to others for bodily injury or property damage
Medical coverage, for the cost of treating injuries,
rehabilitation and sometimes lost wages and funeral
expenses
Gap insurance
Main article: Gap insurance
Gap insurance covers the excess amount on your auto loan
in an instance where your insurance company does not
cover the entire loan. Depending on the companies specic policies it might or might not cover the deductible
as well. This coverage is marketed for those who put low
down payments, have high interest rates on their loans,
and those with 60 month or longer terms. Gap insurance
is typically oered by your nance company when you
rst purchase your vehicle. Most auto insurance companies oer this coverage to consumers as well. If you are
unsure if GAP coverage had been purchased, you should
check your vehicle lease or purchase documentation.
Health insurance
Main articles: Health insurance and Dental insurance
Health insurance policies cover the cost of medical treatments. Dental insurance, like medical insurance, protects

Workers compensation, or employers liability insurance, is compulsory in some countries

Disability insurance policies provide nancial support in the event of the policyholder becoming unable to work because of disabling illness or injury.
It provides monthly support to help pay such obligations as mortgage loans and credit cards. 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-gure incomes, such as doctors, lawyers,
etc. Short-term 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 individuals 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.

34

CHAPTER 4. CORPORATE FINANCE

Disability overhead insurance allows business owners to cover the overhead expenses of their business
while they are unable to work.
Total permanent disability insurance provides benets when a person is permanently disabled and can
no longer work in their profession, often taken as an
adjunct to life insurance.
Workers compensation insurance replaces all or
part of a workers wages lost and accompanying
medical expenses incurred because of a job-related
injury.
Casualty
Main article: Casualty insurance
Casualty insurance insures against accidents, not necessarily tied to any specic property. It is a broad spectrum
of insurance that a number of other types of insurance
could be classied, such as auto, workers compensation,
and some liability insurances.
Crime insurance is a form of casualty insurance that
covers the policyholder against losses arising from Amicable Society for a Perpetual Assurance Oce, Serjeants
the criminal acts of third parties. For example, a Inn, Fleet Street, London, 1801
company can obtain crime insurance to cover losses
arising from theft or embezzlement.
family, burial, funeral and other nal expenses. Life in Terrorism insurance provides protection against any surance policies often allow the option of having the proloss or damage caused by terrorist activities. In the ceeds paid to the beneciary either in a lump sum cash
United States in the wake of 9/11, the Terrorism payment or an annuity. In most states, a person cannot
Risk Insurance Act 2002 (TRIA) set up a federal purchase a policy on another person without their knowlprogram providing a transparent system of shared edge.
public and private compensation for insured losses Annuities provide a stream of payments and are generresulting from acts of terrorism. The program was ally classied as insurance because they are issued by inextended until the end of 2014 by the Terrorism surance companies, are regulated as insurance, and reRisk Insurance Program Reauthorization Act 2007 quire the same kinds of actuarial and investment man(TRIPRA).
agement expertise that life insurance requires. Annuities
and pensions that pay a benet for life are sometimes re Kidnap and ransom insurance is designed to protect
garded as insurance against the possibility that a retiree
individuals and corporations operating in high-risk
will outlive his or her nancial resources. In that sense,
areas around the world against the perils of kidnap,
they are the complement of life insurance and, from an
extortion, wrongful detention and hijacking.
underwriting perspective, are the mirror image of life in Political risk insurance is a form of casualty insur- surance.
ance that can be taken out by businesses with op- Certain life insurance contracts accumulate cash values,
erations in countries in which there is a risk that which may be taken by the insured if the policy is surrenrevolution or other political conditions could result dered or which may be borrowed against. Some policies,
in a loss.
such as annuities and endowment policies, are nancial
instruments to accumulate or liquidate wealth when it is
needed.
Life
In many countries, such as the United States and the UK,
Main article: Life insurance
the tax law provides that the interest on this cash value
Life insurance provides a monetary benet to a dece- is not taxable under certain circumstances. This leads to
dents family or other designated beneciary, and may widespread use of life insurance as a tax-ecient method
specically provide for income to an insured persons of saving as well as protection in the event of early death.

4.4. INSURANCE

35

In the United States, the tax on interest income on life insurance policies and annuities is generally deferred. However, in some cases the benet derived from tax deferral
may be oset by a low return. This depends upon the
insuring company, the type of policy and other variables
(mortality, market return, etc.). Moreover, other income
tax saving vehicles (e.g., IRAs, 401(k) plans, Roth IRAs)
may be better alternatives for value accumulation.
Burial insurance
US Airways Flight 1549 was written o after ditching into the

Burial insurance is a very old type of life insurance which Hudson River
is paid out upon death to cover nal expenses, such as the
cost of a funeral. The Greeks and Romans introduced
insures against accidental physical damage to boilburial insurance c. 600 CE when they organized guilds
ers, equipment or machinery.
called benevolent societies which cared for the surviving families and paid funeral expenses of members upon
Builders risk insurance insures against the risk of
death. Guilds in the Middle Ages served a similar purphysical loss or damage to property during construcpose, as did friendly societies during Victorian times.
tion. Builders risk insurance is typically written
on an all risk basis covering damage arising from
any cause (including the negligence of the insured)
Property
not otherwise expressly excluded. Builders risk inMain article: Property insurance
surance is coverage that protects a persons or orProperty insurance provides protection against risks to
ganizations insurable interest in materials, xtures
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.[29]
Crop insurance may be purchased by farmers to reduce or manage various risks associated with growing crops. Such risks include crop loss or damage
caused by weather, hail, drought, frost damage, insects, or disease.[30]

This tornado damage to an Illinois home would be considered an


"Act of God" for insurance purposes

property, such as re, theft or weather damage. This may


include specialized forms of insurance such as re insurance, ood insurance, earthquake insurance, home insurance, inland marine insurance or boiler insurance. The
term property insurance may, like casualty insurance, be
used as a broad category of various subtypes of insurance,
some of which are listed below:
Aviation insurance protects aircraft hulls and spares,
and associated liability risks, such as passenger and
third-party liability. Airports may also appear under
this subcategory, including air trac 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)

Earthquake insurance is a form of property insurance that pays the policyholder in the event of
an earthquake that causes damage to the property.
Most ordinary home insurance policies do not cover
earthquake damage. Earthquake insurance policies
generally feature a high deductible. Rates depend on
location and hence the likelihood of an earthquake,
as well as the construction of the home.
Fidelity bond is a form of casualty insurance that
covers policyholders for losses incurred as a result
of fraudulent acts by specied individuals. It usually
insures a business for losses caused by the dishonest
acts of its employees.

Flood insurance protects against property loss due to


ooding. Many U.S. insurers do not provide ood
insurance in some parts of the country. In response
to this, the federal government created the National
Flood Insurance Program which serves as the insurer
of last resort.

36

Hurricane Katrina caused over $80 billion of storm and ood


damage

Home insurance, also commonly called hazard insurance or homeowners insurance (often abbreviated in the real estate industry as HOI), provides
coverage for damage or destruction of the policyholders home. In some geographical areas, the
policy may exclude certain types of risks, such as
ood or earthquake, that require additional coverage. Maintenance-related issues are typically the
homeowners responsibility. The policy may include
inventory, or this can be bought as a separate policy, especially for people who rent housing. In some
countries, insurers oer a package which may include liability and legal responsibility for injuries
and property damage caused by members of the
household, including pets.[31]
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 transit. When the owner of the cargo and
the carrier are separate corporations, marine cargo
insurance typically compensates the owner of cargo
for losses sustained from re, shipwreck, etc., but
excludes losses that can be recovered from the carrier or the carriers insurance. Many marine insurance underwriters will include time element coverage in such policies, which extends the indemnity
to cover loss of prot and other business expenses
attributable to the delay caused by a covered loss.
Supplemental natural disaster insurance covers
specied expenses after a natural disaster renders
the policyholders home uninhabitable. Periodic
payments are made directly to the insured until
the home is rebuilt or a specied time period has
elapsed.
Surety bond insurance is a three-party insurance
guaranteeing the performance of the principal.

CHAPTER 4. CORPORATE FINANCE

The demand for terrorism insurance surged after 9/11

Volcano insurance is a specialized insurance protecting against damage arising specically from
volcanic eruptions.
Windstorm insurance is an insurance covering the
damage that can be caused by wind events such as
hurricanes.
Liability
Main article: Liability insurance
Liability insurance is a very broad superset that covers legal claims against the insured. Many types of insurance
include an aspect of liability coverage. For example, a
homeowners insurance policy will normally include liability coverage which protects the insured in the event of
a claim brought by someone who slips and falls on the
property; automobile insurance also includes an aspect
of liability insurance that indemnies against the harm
that a crashing car can cause to others lives, health, or
property. The protection oered by a liability insurance
policy is twofold: a legal defense in the event of a lawsuit
commenced against the policyholder and indemnication
(payment on behalf of the insured) with respect to a settlement or court verdict. Liability policies typically cover
only the negligence of the insured, and will not apply to
results of wilful or intentional acts by the insured.
Public liability insurance covers a business or organization against claims should its operations injure
a member of the public or damage their property in
some way.
Directors and ocers liability insurance (D&O)
protects an organization (usually a corporation)
from costs associated with litigation resulting from
errors made by directors and ocers for which they
are liable.
Environmental liability insurance protects the insured from bodily injury, property damage and

4.4. INSURANCE

37
Trade credit insurance is business insurance over the
accounts receivable of the insured. The policy pays
the policy holder for covered accounts receivable if
the debtor defaults on payment.
Collateral protection insurance (CPI) insures property (primarily vehicles) held as collateral for loans
made by lending institutions.
Other types

The subprime mortgage crisis was the source of many liability


insurance losses

cleanup costs as a result of the dispersal, release or


escape of pollutants.

All-risk insurance is an insurance that covers a wide


range of incidents and perils, except those noted in
the policy. All-risk insurance is dierent from perilspecic insurance that cover losses from only those
perils listed in the policy.[32] In car insurance, allrisk policy includes also the damages caused by the
own driver.

Errors and omissions insurance (E&O) is business


liability insurance for professionals such as insurance agents, real estate agents and brokers, architects, third-party administrators (TPAs) and other
business professionals.
Prize indemnity insurance protects the insured from
giving away a large prize at a specic event. Examples would include oering prizes to contestants
who can make a half-court shot at a basketball game,
or a hole-in-one at a golf tournament.
Professional liability insurance, also called
professional indemnity insurance (PI), protects
insured professionals such as architectural corpo- High-value horses may be insured under a bloodstock policy
rations and medical practitioners against potential
negligence claims made by their patients/clients.
Professional liability insurance may take on dif Bloodstock insurance covers individual horses or a
ferent names depending on the profession. For
number of horses under common ownership. Covexample, professional liability insurance in referage is typically for mortality as a result of accident,
erence to the medical profession may be called
illness or disease but may extend to include infertilmedical malpractice insurance.
ity, in-transit loss, veterinary fees, and prospective
foal.
Credit
Business interruption insurance covers the loss of
income, and the expenses incurred, after a covered
Main article: Payment protection insurance
peril interrupts normal business operations.
Credit insurance repays some or all of a loan when the
borrower is insolvent.
Mortgage insurance insures the lender against default by the borrower. Mortgage insurance is a form
of credit insurance, although the name credit insurance more often is used to refer to policies that
cover other kinds of debt.
Many credit cards oer payment protection plans
which are a form of credit insurance.

Defense Base Act (DBA) insurance provides coverage for civilian workers hired by the government
to perform contracts outside the United States and
Canada. DBA is required for all U.S. citizens, U.S.
residents, U.S. Green Card holders, and all employees or subcontractors hired on overseas government
contracts. Depending on the country, foreign nationals must also be covered under DBA. This coverage typically includes expenses related to medical
treatment and loss of wages, as well as disability and
death benets.

38
Expatriate insurance provides individuals and organizations operating outside of their home country
with protection for automobiles, property, health, liability and business pursuits.
Legal expenses insurance covers policyholders for
the potential costs of legal action against an institution or an individual. When something happens
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.
Livestock insurance is a specialist policy provided
to, for example, commercial or hobby farms, aquariums, sh farms or any other animal holding. Cover
is available for mortality or economic slaughter as a
result of accident, illness or disease but can extend
to include destruction by government order.
Media liability insurance is designed to cover professionals that engage in lm and television production
and print, against risks such as defamation.
Nuclear incident insurance covers damages resulting
from an incident involving radioactive materials and
is generally arranged at the national level. (See the
nuclear exclusion clause and for the US the PriceAnderson Nuclear Industries Indemnity Act.)

CHAPTER 4. CORPORATE FINANCE


It is usually issued 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.
Tuition insurance insures students against involuntary withdrawal from cost-intensive educational institutions
Interest rate insurance protects the holder from adverse changes in interest rates, for instance for those
with a variable rate loan or mortgage
Divorce insurance is a form of contractual liability
insurance that pays the insured a cash benet if their
marriage ends in divorce.

Insurance nancing vehicles


Fraternal insurance is provided on a cooperative
basis by fraternal benet societies or other social
organizations.[34]

Pet insurance insures pets against accidents and illnesses; some companies cover routine/wellness care
and burial, as well.

No-fault insurance is a type of insurance policy (typically automobile insurance) where insureds are indemnied by their own insurer regardless of fault in
the incident.

Pollution insurance usually takes the form of rstparty coverage for contamination of insured property either by external or on-site sources. Coverage
is also aorded for liability to third parties arising
from contamination of air, water, or land due to the
sudden and accidental release of hazardous materials from the insured site. The policy usually covers
the costs of cleanup and may include coverage for releases from underground storage tanks. Intentional
acts are specically excluded.

Protected self-insurance is an alternative risk nancing mechanism in which an organization retains the
mathematically calculated cost of risk within the organization and transfers the catastrophic risk with
specic and aggregate limits to an insurer so the
maximum total cost of the program is known. A
properly designed and underwritten Protected SelfInsurance Program reduces and stabilizes the cost
of insurance and provides valuable risk management
information.

Purchase insurance is aimed at providing protection on the products people purchase. Purchase insurance can cover individual purchase protection,
warranties, guarantees, care plans and even mobile
phone insurance. Such insurance is normally very
limited in the scope of problems that are covered by
the policy.
Tax insurance is increasingly being used in corporate
transactions to protect taxpayers in the event that a
tax position it has taken is challenged by the IRS or
a state, local, or foreign taxing authority[33]
Title insurance provides a guarantee that title to
real property is vested in the purchaser and/or
mortgagee, free and clear of liens or encumbrances.

Retrospectively rated insurance is a method of establishing a premium on large commercial accounts.


The nal premium is based on the insureds actual
loss experience during the policy term, sometimes
subject to a minimum and maximum premium, with
the nal premium determined by a formula. Under this plan, the current years premium is based
partially (or wholly) on the current years losses, although the premium adjustments may take months
or years beyond the current years expiration date.
The rating formula is guaranteed in the insurance
contract. Formula: retrospective premium = converted loss + basic premium tax multiplier. Numerous variations of this formula have been developed and are in use.

4.4. INSURANCE
Formal self-insurance is the deliberate decision to
pay for otherwise insurable losses out of ones own
money. This can be done on 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 and paying outof-pocket. Self-insurance is usually used to pay for
high-frequency, low-severity losses. Such losses, if
covered by conventional insurance, mean having to
pay a premium that includes loadings for the companys general expenses, cost of putting the policy
on the books, acquisition expenses, premium taxes,
and contingencies. While this is true for all insurance, for small, frequent losses the transaction costs
may exceed the benet of volatility reduction that
insurance otherwise aords.
Reinsurance is a type of insurance purchased by insurance companies or self-insured employers to protect against unexpected losses. Financial reinsurance is a form of reinsurance that is primarily used
for capital management rather than to transfer insurance risk.
Social insurance can be many things to many people
in many countries. But a summary of its essence is
that it is a collection of insurance coverages (including components of life insurance, disability income
insurance, unemployment insurance, health insurance, and others), plus retirement savings, that requires participation by all citizens. By forcing everyone in society to be a policyholder and pay premiums, it ensures that everyone can become a claimant
when or if he/she needs to. Along the way this inevitably becomes related to other concepts such as
the justice system and the welfare state. This is a
large, complicated topic that engenders tremendous
debate, which can be further studied in the following
articles (and others):

39
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 others can be trusted to follow community leaders, this tacit form of insurance can work. In
this manner the community can even out the extreme
dierences in insurability that exist among its members.
Some further justication is also provided by invoking
the moral hazard of explicit insurance contracts.
In the United Kingdom, The Crown (which, for practical purposes, meant the civil service) did not insure property such as government buildings. If a government building was damaged, 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 buildings have been sold to property companies,
and rented back, this arrangement is now less common
and may have disappeared altogether.

In the United States, the most prevalent form of selfinsurance is governmental risk management pools. They
are self-funded cooperatives, operating as carriers of coverage for the majority of governmental entities today,
such as county governments, municipalities, and school
districts. Rather than these entities independently selfinsure and risk bankruptcy from a large judgment or
catastrophic loss, such governmental entities form a risk
pool. Such pools begin their operations by capitalization
through member deposits or bond issuance. Coverage
(such as general liability, auto liability, professional liability, workers compensation, and property) is oered
by the pool to its members, similar to coverage oered
by insurance companies. However, self-insured pools offer members lower rates (due to not needing insurance
National Insurance
brokers), increased benets (such as loss prevention ser Social safety net
vices) and subject matter expertise. Of approximately
91,000 distinct governmental entities operating in the
Social security
United States, 75,000 are members of self-insured pools
Social Security debate (United States)
in various lines of coverage, forming approximately 500
Social Security (United States)
pools. Although a relatively small corner of the insurance
Social welfare provision
market, the annual contributions (self-insured premiums)
Stop-loss insurance provides protection against to such pools have been estimated up to 17 billion dollars
[35]
catastrophic or unpredictable losses. It is purchased annually.
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 be- 4.4.6 Insurance companies
comes liable for losses that exceed certain limits
Insurance companies may be classied into two groups:
called deductibles.
Closed community and governmental self-insurance

Life insurance companies, which sell life insurance,


annuities and pensions products.

Some communities prefer to create virtual insurance


amongst themselves by other means than contractual risk

Non-life or property/casualty insurance companies,


which sell other types of insurance.

40

Certicate issued by Republic Fire Insurance Co. of New York c.


1860

General insurance companies can be further divided into


these sub categories.
Standard lines
Excess lines

CHAPTER 4. CORPORATE FINANCE

The subscription room at Lloyds of London in the early 19th


century.

insurance market).[36] They are typically referred to as


non-admitted or unlicensed insurers.[36] Non-admitted
insurers are generally not licensed or authorized in the
states in which they write business, although they must
be licensed or authorized in the state in which they are
domiciled.[36] These companies have more exibility and
can react faster than standard line insurance companies
because they are not required to le rates and forms.[36]
However, they still have substantial regulatory requirements placed upon them.

In most countries, life and non-life insurers are subject to dierent regulatory regimes and dierent tax and
accounting rules. The main reason for the distinction between the two types of company is that life, annuity, and
pension business is very long-term in nature coverage
for life assurance or a pension can cover risks over many Most states require that excess line insurers submit nandecades. By contrast, non-life insurance cover usually cial information, articles of incorporation, a list of ocovers a shorter period, such as one year.
cers, and other general information.[36] They also may not
In the United States, standard line insurance companies write insurance that is typically available in the admitted
are insurers that have received a license or authorization market, do not participate in state guarantee funds (and
from a state for the purpose of writing specic kinds of therefore policyholders do not have any recourse through
insurance in that state, such as automobile insurance or these funds if an insurer becomes insolvent and cannot
pay claims), may pay higher taxes, only may write covhomeowners insurance.[36] They are typically referred
to as admitted insurers. Generally, such an insurance erage for a risk if it has been rejected by three dierent
admitted insurers, and only when the insurance producer
company must submit its rates and policy forms to the
[36]
states insurance regulator to receive his or her prior ap- placing the business has a surplus lines license. Generally, when an excess line insurer writes a policy, it must,
proval, although whether an insurance company must receive prior approval depends upon the kind of insurance pursuant to state laws, provide disclosure to the policyholder that the policyholders policy is being written by
being written. Standard line insurance companies usually
[36]
charge lower premiums than excess line insurers and may an excess line insurer.
On July 21, 2010, President Barack Obama signed into
law the Nonadmitted and Reinsurance Reform Act of
2010 (NRRA), which took eect on July 21, 2011,
and was part of the Dodd-Frank Wall Street Reform and
Consumer Protection Act. The NRRA changed the regulatory paradigm for excess line insurance. Generally,
state may regExcess line insurance companies (also known as Excess under the NRRA, only the insureds home
[37]
ulate
and
tax
the
excess
line
transaction.
and Surplus) typically insure risks not covered by the
standard lines insurance market, due to a variety of rea- Insurance companies are generally classied as either
sons (e.g., new entity or an entity that does not have an mutual or proprietary companies.[38] Mutual companies
adequate loss history, an entity with unique risk charac- are owned by the policyholders, while shareholders (who
teristics, or an entity that has a loss history that does not may or may not own policies) own proprietary insurance
t the underwriting requirements of the standard lines companies.
sell directly to individual insureds. They are regulated by
state laws, which include restrictions on rates and forms,
and which aim to protect consumers and the public from
unfair or abusive practices.[36] These insurers also are required to contribute to state guarantee funds, which are
used to pay for losses if an insurer becomes insolvent.[36]

4.4. INSURANCE
Demutualization of mutual insurers to form stock companies, as well as the formation of a hybrid known as a mutual holding company, became common in some countries, such as the United States, in the late 20th century.
However, not all states permit mutual holding companies.

41
the world
Rating structures which reect market trends rather
than individual loss experience

Insucient credit for deductibles and/or loss control


eorts
Other possible forms for an insurance company include
reciprocals, in which policyholders reciprocate in sharing
risks, and Lloyds organizations.
There are also companies known as insurance consulInsurance companies are rated by various agencies such tants. Like a mortgage broker, these companies are
as A. M. Best. The ratings include the companys nan- paid a fee by the customer to shop around for the best
cial strength, which measures its ability to pay claims. It insurance policy amongst many companies. Similar to
also rates nancial instruments issued by the insurance an insurance consultant, an 'insurance broker' also shops
company, such as bonds, notes, and securitization prod- around for the best insurance policy amongst many companies. However, with insurance brokers, the fee is usuucts.
ally paid in the form of commission from the insurer that
Reinsurance companies are insurance companies that sell
is selected rather than directly from the client.
policies to other insurance companies, allowing them to
reduce their risks and protect themselves from very large Neither insurance consultants nor insurance brokers are
losses. The reinsurance market is dominated by a few insurance companies and no risks are transferred to them
very large companies, with huge reserves. A reinsurer in insurance transactions. Third party administrators
are companies that perform underwriting and sometimes
may also be a direct writer of insurance risks as well.
claims handling services for insurance companies. These
Captive insurance companies may be dened as limitedcompanies often have special expertise that the insurance
purpose insurance companies established with the specompanies do not have.
cic objective of nancing risks emanating from their
parent group or groups. This denition can sometimes be The nancial stability and strength of an insurance comextended to include some of the risks of the parent com- pany should be a major consideration when buying an inpanys customers. In short, it is an in-house self-insurance surance contract. An insurance premium paid currently
vehicle. Captives may take the form of a pure entity provides coverage for losses that might arise many years
(which is a 100% subsidiary of the self-insured parent in the future. For that reason, the viability of the insurcompany); of a mutual captive (which insures the col- ance carrier is very important. In recent years, a number
lective risks of members of an industry); and of an as- of insurance companies have become insolvent, leaving
sociation captive (which self-insures individual risks of their policyholders with no coverage (or coverage only
the members of a professional, commercial or industrial from a government-backed insurance pool or other arassociation). Captives represent commercial, economic rangement with less attractive payouts for losses). A
and tax advantages to their sponsors because of the re- number of independent rating agencies provide informaductions in costs they help create and for the ease of in- tion and rate the nancial viability of insurance compasurance risk management and the exibility for cash ows nies.
they generate. Additionally, they may provide coverage
of risks which is neither available nor oered in the tra4.4.7 Across the world
ditional insurance market at reasonable prices.
The types of risk that a captive can underwrite for their
parents include property damage, public and product liability, professional indemnity, employee benets, employers liability, motor and medical aid expenses. The
captives 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 nancing strategy
of their parent. This can be understood against the folLife insurance premiums written in 2005
lowing background:
Heavy and increasing premium costs in almost every Global insurance premiums grew by 2.7% in inationline of coverage
adjusted terms in 2010 to $4.3 trillion, climbing above
pre-crisis levels. The return to growth and record pre Diculties in insuring certain types of fortuitous
miums generated during the year followed two years of
risk
decline in real terms. Life insurance premiums increased
Dierential coverage standards in various parts of by 3.2% in 2010 and non-life premiums by 2.1%. While

42

CHAPTER 4. CORPORATE FINANCE

In the European Union, the Third Non-Life Directive and


the Third Life Directive, both passed in 1992 and eective 1994, created a single insurance market in Europe
and allowed insurance companies to oer insurance anywhere in the EU (subject to permission from authority in
the head oce) and allowed insurance consumers to purchase insurance from any insurer in the EU.[43] As far as
insurance in the United Kingdom, the Financial Services
Authority took over insurance regulation from the GenNon-life insurance premiums written in 2005
eral Insurance Standards Council in 2005;[44] laws passed
include the Insurance Companies Act 1973 and another
in 1982,[45] and reforms to warranty and other aspects
industrialised countries saw an increase in premiums of
under discussion as of 2012.[46]
around 1.4%, insurance markets in emerging economies
saw rapid expansion with 11% growth in premium in- The insurance industry in China was nationalized in 1949
come. The global insurance industry was suciently cap- and thereafter oered by only a single state-owned comitalised to withstand the nancial crisis of 2008 and 2009 pany, the Peoples Insurance Company of China, which
and most insurance companies restored their capital to was eventually suspended as demand declined in a compre-crisis levels by the end of 2010. With the continua- munist environment. In 1978, market reforms led to
tion of the gradual recovery of the global economy, it is an increase in the market and by 1995 a comprehenlikely the insurance industry will continue to see growth sive Insurance Law of the Peoples Republic of China[47]
in premium income both in industrialised countries and was passed, followed in 1998 by the formation of China
Insurance Regulatory Commission (CIRC), which has
emerging markets in 2011.
broad regulatory authority over the insurance market of
Advanced economies account for the bulk of global inChina.[48]
surance. With premium income of $1.62 trillion, Europe was the most important region in 2010, followed by In India IRDA is insurance regulatory authority. As
North America $1.409 trillion and Asia $1.161 trillion. per the section 4 of IRDA Act 1999, Insurance ReguEurope has however seen a decline in premium income latory and Development Authority (IRDA), which was
during the year in contrast to the growth seen in North constituted by an act of parliament. National Insurance
America and Asia. The top four countries generated more Academy, Pune is apex insurance capacity builder instithan a half of premiums. The United States and Japan tute promoted with support from Ministry of Finance and
alone accounted for 40% of world insurance, much higher by LIC, Life & General Insurance companies.
than their 7% share of the global population. Emerging
economies accounted for over 85% of the worlds population but only around 15% of premiums. Their mar- 4.4.8 Controversies
kets are however growing at a quicker pace.[39] The country expected to have the biggest impact on the insurance Doesn't reduce the risk
share distribution across the world is China. According to
Sam Radwan of ENHANCE International LLC, low pre- Insurance doesn't reduce the risk because insurance costs
mium penetration (insurance premium as a % of GDP), the policyholder in premiums.
an ageing population and the largest car market in terms
of new sales, premium growth has averaged 1520% in Insurance insulates too much
the past ve years, and China is expected to be the largest
insurance market in the next decade or two.[40]
An insurance company may inadvertently nd that its insureds may not be as risk-averse as they might otherwise
be (since, by denition, the insured has transferred the
Regulatory dierences
risk to the insurer), a concept known as moral hazard. To
reduce their own nancial exposure, insurance companies
Main article: Insurance law
have contractual clauses that mitigate their obligation to
provide coverage if the insured engages in behavior that
In the United States, insurance is regulated by the states grossly magnies their risk of loss or liability.
under the McCarran-Ferguson Act, with periodic proposals for federal intervention, and a nonprot coalition
of state insurance agencies called the National Association of Insurance Commissioners works to harmonize the
countrys dierent laws and regulations.[41] The National
Conference of Insurance Legislators (NCOIL) also works
to harmonize the dierent state laws.[42]

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
coverage for liability arising from intentional torts committed by or at the direction of the insured. Even if a
provider desired to provide such coverage, it is against the

4.4. INSURANCE

43

public policy of most countries to allow such insurance to buys (while a free agent sales policies of various insurance
exist, and thus it is usually illegal.
companies). Just as there is a potential conict of interest with a broker, an agent has a dierent type of conict.
Because agents work directly for the insurance company,
Complexity of insurance policy contracts
if there is a claim the agent may advise the client to the
benet of the insurance company. Agents generally cannot oer as broad a range of selection compared to an
insurance broker.
An independent insurance consultant advises insureds on
a fee-for-service retainer, similar to an attorney, and thus
oers completely independent advice, free of the nancial
conict of interest of brokers and/or agents. However,
such a consultant must still work through brokers and/or
agents in order to secure coverage for their clients.
Limited consumer benets

9/11 was a major insurance loss, but there were disputes over the
World Trade Center's insurance policy

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 policies
on unfavorable terms. In response to these issues, many
countries have enacted detailed statutory and regulatory
regimes governing every aspect of the insurance 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 learned 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 company and in favor of
coverage under the policy.
Many institutional insurance purchasers buy insurance
through an insurance broker. While on the surface it appears the broker represents the buyer (not the insurance
company), and typically counsels the buyer on appropriate coverage and policy limitations, in the vast majority
of cases a brokers compensation comes in the form of
a commission as a percentage of the insurance premium,
creating a conict of interest in that the brokers nancial
interest is tilted towards encouraging an insured to purchase more insurance than might be necessary at a higher
price. A broker generally holds contracts with many insurers, thereby allowing the broker to shop the market
for the best rates and coverage possible.

In United States, economists and consumer advocates generally consider insurance to be worthwhile for
low-probability, catastrophic losses, but not for highprobability, small losses. Because of this, consumers
are advised to select high deductibles and to not insure
losses which would not cause a disruption in their life.
However, consumers have shown a tendency to prefer
low deductibles and to prefer to insure relatively highprobability, small losses over low-probability, perhaps
due to not understanding or ignoring the low-probability
risk. This is associated with reduced purchasing of insurance against low-probability losses, and may result in
increased ineciencies from moral hazard.[49]
Redlining
Redlining is the practice of denying insurance coverage
in specic geographic areas, supposedly because of a high
likelihood of loss, while the alleged motivation is unlawful discrimination. Racial proling or redlining has a long
history in the property insurance industry in the United
States. From a review of industry underwriting and marketing materials, court documents, and research by government agencies, industry and community groups, and
academics, it is clear that race has long aected and continues to aect the policies and practices of the insurance
industry.[50]

In July 2007, The Federal Trade Commission (FTC) released a report presenting the results of a study concerning credit-based insurance scores in automobile insurance. The study found that these scores are eective predictors of risk. It also showed that African-Americans
and Hispanics are substantially overrepresented in the
lowest credit scores, and substantially underrepresented
in the highest, while Caucasians and Asians are more
evenly spread across the scores. The credit scores were
Insurance may also be purchased through an agent. A also found to predict risk within each of the ethnic groups,
tied agent, working exclusively with one insurer, repre- leading the FTC to conclude that the scoring models are
sents the insurance company from whom the policyholder not solely proxies for redlining. The FTC indicated little

44

CHAPTER 4. CORPORATE FINANCE

data was available to evaluate benet of insurance scores


to consumers.[51] The report was disputed by representatives of the Consumer Federation of America, the National Fair Housing Alliance, the National Consumer Law
Center, and the Center for Economic Justice, for relying
on data provided by the insurance industry.[52]

companies when they bring their new insurance products


to market. Independent inventors account for 70% of the
new U.S. patent applications in this area.

In determining premiums and premium rate structures,


insurers consider quantiable factors, including location,
credit scores, gender, occupation, marital status, and
education level. However, the use of such factors is often
considered to be unfair or unlawfully discriminatory, and
the reaction against this practice has in some instances
led to political disputes about the ways in which insurers
determine premiums and regulatory intervention to limit
the factors used.

There are currently about 150 new patent applications on


insurance inventions led per year in the United States.
The rate at which patents have been issued has steadily
risen from 15 in 2002 to 44 in 2006.[54]

Many insurance executives are opposed to patenting insurance products because it creates a new risk for them.
The Hartford insurance company, for example, recently
All states have provisions in their rate regulation laws or in had to pay $80 million to an independent inventor, Bantheir fair trade practice acts that prohibit unfair discrimi- corp Services, in order to settle a patent infringement and
nation, often called redlining, in setting rates and making theft of trade secret lawsuit for a type of corporate owned
insurance available.[53]
life insurance product invented and patented by Bancorp.

Inventors can now have their insurance US patent applications reviewed by the public in the Peer to Patent
program.[55] The rst insurance patent to be granted was
[56]
including another example of an application posted
was US2009005522 risk assessment company. It was
An insurance underwriters job is to evaluate a given risk posted on March 6, 2009. This patent application deas to the likelihood that a loss will occur. Any factor scribes a method for increasing the ease of changing inthat causes a greater likelihood of loss should theoreti- surance companies.[57]
cally be charged a higher rate. This basic principle of
insurance must be followed if insurance companies are to
remain solvent. Thus, discrimination against (i.e., neg- The insurance industry and rent-seeking
ative dierential treatment of) potential insureds in the
risk evaluation and premium-setting process is a neces- Certain insurance products and practices have been desary by-product of the fundamentals of insurance under- scribed as rent-seeking by critics. That is, some insurwriting. For instance, insurers charge older people signif- ance products or practices are useful primarily because
icantly higher premiums than they charge younger people of legal benets, such as reducing taxes, as opposed to
for term life insurance. Older people are thus treated dif- providing protection against risks of adverse events. Unferently from younger people (i.e., a distinction is made, der United States tax law, for example, most owners of
discrimination occurs). The rationale for the dierential variable annuities and variable life insurance can invest
treatment goes to the heart of the risk a life insurer takes: their premium payments in the stock market and defer
Old people are likely to die sooner than young people, or eliminate paying any taxes on their investments until
so the risk of loss (the insureds death) is greater in any withdrawals are made. Sometimes this tax deferral is the
given period of time and therefore the risk premium must only reason people use these products. Another example
be higher to cover the greater risk. However, treating in- is the legal infrastructure which allows life insurance to be
sureds dierently when there is no actuarially sound rea- held in an irrevocable trust which is used to pay an estate
tax while the proceeds themselves are immune from the
son for doing so is unlawful discrimination.
estate tax.
Insurance patents
Religious concerns
Further information: Insurance patent
New assurance products can now be protected from copying with a business method patent in the United States.
A recent example of a new insurance product that is
patented is Usage Based auto insurance. Early versions
were independently invented and patented by a major
US auto insurance company, Progressive Auto Insurance
(U.S. Patent 5,797,134) and a Spanish independent inventor, Salvador Minguijon Perez (EP 0700009).

Muslim scholars have varying opinions about life insurance. Life insurance policies that earn interest (or guaranteed bonus/NAV) are generally considered to be a form
of riba[58] (usury) and some consider even policies that
do not earn interest to be a form of gharar (speculation).
Some argue that gharar is not present due to the actuarial science behind the underwriting.[59] Jewish rabbinical
scholars also have expressed reservations regarding insurance as an avoidance of Gods will but most nd it acceptable in moderation.[60]

Many independent inventors are in favor of patenting new Some Christians believe insurance represents a lack of
insurance products since it gives them protection from big faith and there is a long history of resistance to commer-

4.4. INSURANCE
cial insurance in Anabaptist communities (Mennonites,
Amish, Hutterites, Brethren in Christ) but many participate in community-based self-insurance programs that
spread risk within their communities.[61][62][63]

4.4.9

See also

Agent of Record
Earthquake loss
Financial services (broader industry to which insurance belongs)
Geneva Association (the International Association
for the Study of Insurance Economics)
Global assets under management
Insurance fraud
Insurance Hall of Fame
Insurance law
Insurance Premium Tax (UK)

45

[3] J. Franklin, The Science of Conjecture: Evidence and Probability Before Pascal (Baltimore: Johns Hopkins University Press, 2001), 274-277.
[4] Dickson (1960): 4
[5] Dickson (1960): 7
[6] Palmer, Sarah (October 2007). Lloyd, Edward (c.1648
1713)". Oxford Dictionary of National Biography. Oxford
University Press. doi:10.1093/ref:odnb/16829. Retrieved
16 February 2011.
[7] Anzovin, Steven, Famous First Facts 2000, item # 2422,
H. W. Wilson Company, ISBN 0-8242-0958-3 p. 121
The rst life insurance company known of record was
founded in 1706 by the Bishop of Oxford and the nancier
Thomas Allen in London, England. The company, called
the Amicable Society for a Perpetual Assurance Oce, collected annual premiums from policyholders and paid the
nominees of deceased members from a common fund.
[8] Amicable Society, The charters, acts of Parliament, and
by-laws of the corporation of the Amicable Society for a
perpetual assurance oce, Gilbert and Rivington, 1854,
p. 4
[9] Today and History:The History of Equitable Life.
2009-06-26. Retrieved 2009-08-16.

Intergovernmental Risk Pool

[10] Howstuworks: How Health Insurance Works.

The Invisible Bankers: Everything the Insurance Industry Never Wanted You to Know (book)

[11] Encarta: Health Insurance. Archived from the original


on 2009-11-01.

List of nance topics


List of insurance topics
List of United States insurance companies
Social security
Uberrima des
Universal health care
Welfare state
Country-specic articles:
Insurance in Australia
Insurance in India
Insurance in the United States
Insurance in the United Kingdom

[12] E. P. Hennock, The Origin of the Welfare State in England and Germany, 18501914: Social Policies Compared
(2007)
[13] Hermann Beck, Origins of the Authoritarian Welfare State
in Prussia, 1815-1870 (1995)
[14] The Cabinet Papers 1915-1982: National Health Insurance Act 1911. The National Archives, 2013. Retrieved
30 June 2013.
[15] Bentley B. Gilbert, British social policy, 1914-1939 (1970)
[16] Gollier C. (2003). To Insure or Not to Insure?: An Insurance Puzzle. The Geneva Papers on Risk and Insurance
Theory.
[17] This discussion is adapted from Mehr and Camack Principles of Insurance, 6th edition, 1976, pp 34 37.
[18] Irish Brokers Association. Insurance Principles.
[19] C. Kulp & J. Hall, Casualty Insurance, Fourth Edition,
1968, page 35

[1] See, e.g., Vaughan, E. J., 1997, Risk Management, New


York: Wiley.

[20] However, bankruptcy of the insured with a reimbursement policy does not relieve the insurer. Certain types of
insurance, e.g., workers compensation and personal automobile liability, are subject to statutory requirements that
injured parties have direct access to coverage.

[2] Lex Rhodia: The Ancient Ancestor of Maritime Law 800 BC.

[21] Dembe, A. E., Boden, L. I. (2000). Moral hazard: A


question of morality?. New Solutions.

4.4.10

Notes

46

[22] Kunreuther H. (1996).


Mitigating Disaster Losses
Through Insurance. Journal of Risk and Uncertainty.
[23] Brown RL. (1993). Introduction to Ratemaking and Loss
Reserving for Property and Casualty Insurance. ACTEX
Publications.
[24] Feldstein, Sylvan G.; Fabozzi, Frank J. (2008). The Handbook of Municipal Bonds. Wiley. p. 614. ISBN 978-0470-10875-8. Retrieved February 8, 2010.

CHAPTER 4. CORPORATE FINANCE

[41] Randall S. (1998). Insurance Regulation in the United


States: Regulatory Federalism and the National Association of Insurance Commissioners. FLORIDA STATE UNIVERSITY LAW REVIEW.
[42] J Schacht, B Foudree. (2007). A Study on State Authority: Making a Case for Proper Insurance Oversight.
NCOIL

[25] What we do ABI. Abi.org.uk. Retrieved on 2013-07-18.

[43] C. J. Campbell, L. Goldberg, A. Rai. (2003). The Impact


of the European Union Insurance Directives on Insurance
Company Stocks. The Journal of Risk and Insurance.

[26] Fitzpatrick, Sean, Fear is the Key: A Behavioral Guide to


Underwriting Cycles, 10 Conn. Ins. L.J. 255 (2004).

[44] Haurant S. (2005). FSA takes on insurance regulation.


The Guardian.

[27] Berger, Allen N.; Cummins, J. David; Weiss, Mary A.


(October 1997). The Coexistence of Multiple Distribution Systems for Financial Services: The Case of
Property-Liability Insurance.. Journal of Business 70 (4):
51546. doi:10.1086/209730. (online draft)
[28] Insurance Information Institute. Business insurance information. What does a businessowners policy cover?".
Retrieved 2007-05-09.
[29] Builders Risk Insurance. Adjusters International. Retrieved 2009-10-16.
[30] US application 20,060,287,896 Method for providing
crop insurance for a crop associated with a dened attribute
[31] Insurance Information Institute. What is homeowners insurance?". Retrieved 2008-11-11.
[32] Types of Business Insurance | SBA.gov. Business.gov.
Retrieved on 2013-07-18.
[33] Blitz, Gary; Schoenberg, Daniel. Private REITs: Facilitating a Cleaner Exit with Tax Insurance. Transaction
Advisors. ISSN 2329-9134.
[34] Margaret E. Lynch, Editor, Health Insurance Terminology, Health Insurance Association of America, 1992,
ISBN 1-879143-13-5
[35] Marcos Antonio Mendoza, Reinsurance as Governance:
Governmental Risk Management Pools as a Case Study in
the Governance Role Played by Reinsurance Institutions,
21 Conn. Ins. L.J. 53, 55-60 (2014) http://papers.ssrn.
com/sol3/papers.cfm?abstract_id=2573253

[45] Adams J. (2012). The impact of changing regulation on


the insurance industry. Financial Services Authority.
[46] Lloyds. (2012). Reforming UK insurance contract law.
[47] Insurance Law of the Peoples Republic of China 1995.
Lehman, Lee & Xu.
[48] Thomas JE. (2002). The role and powers of the Chinese
insurance regulatory commission in the administration of
insurance law in China. Geneva Papers on Risk and Insurance.
[49] Schindler, R. M. (1994). Consumer Motivation for Purchasing Low-Deductible Insurance. In Marketing and
Public Policy Conference Proceedings, Vol. 4, D. J.
Ringold (ed.), Chicago, IL: American Marketing Association, 147155.
[50] Gregory D. Squires (2003) Racial Proling, Insurance
Style: Insurance Redlining and the Uneven Development
of Metropolitan Areas Journal of Urban Aairs Volume
25 Issue 4 pp. 391410, November 2003
[51] Credit-Based Insurance Scores: Impacts on Consumers of
Automobile Insurance, Federal Trade Commission (July
2007)
[52] Consumers Dispute FTC Report on Insurance Credit
Scoring www.consumeraffairs.com (July 2007)
[53] Insurance Information Institute. Issues Update: Regulation Modernization. Retrieved 2008-11-11.
[54] (Source: Insurance IP Bulletin, December 15, 2006)

[36] Excess and Surplus Lines FAQs. AAMGA. Retrieved on


2013-07-18.

[55] Mark Nowotarski Patent Q/A: Peer to Patent, Insurance


IP Bulletin, August 15, 2008

[37] 15 U.S.C. 8201 and 8202

[56] US6922720 SYSTEMS AND METHODS FOR INSURING DATA OVER THE INTERNET

[38] David Ransom (2011). IF1 Insurance, Legal & Regulatory. Chartered Insurance Institute. p. 2/5. ISBN 978 0
85713 094 5.

[57] Bakos, Nowotarski, "An Experiment in Better Patent Examination", Insurance IP Bulletin, December 15, 2008.

[39] http://www.thecityuk.com/assets/Uploads/
Insurance-2011-F2.pdf PDF (365 KB) p. 2
[40] Sam Radwan, "Chinas Insurance Market: Lessons
Learned from Taiwan", Bloomberg Businessweek, June
2010.

[58] Islam Question and Answer The true nature of insurance and the rulings concerning it. Retrieved 2010-0118.
[59] Life Insurance from an Islamic Perspective. Retrieved
2010-01-18.

4.4. INSURANCE

[60] Jewish Association for Business Ethics Insurance. Retrieved 2008-03-25.


[61] Rubinkam, Michael (October 5, 2006). Amish Reluctantly Accept Donations. The Washington Post. Retrieved 2008-03-25.
[62] Donald B. Kraybill. The riddle of Amish culture. p. 277.
ISBN 0-8018-3682-4.
[63] Global Anabaptist Mennonite Encyclopedia Online, Insurance. Retrieved 2010-01-18.

4.4.11

Bibliography

Dickson, P. G. M. (1960). The Sun Insurance Oce


17101960: The History of Two and a half Centuries of British Insurance. London: Oxford University Press. p. 324.
Zeckhauser, Richard (2008). Insurance. In
David R. Henderson (ed.). Concise Encyclopedia
of Economics (2nd ed.). Indianapolis: Library of
Economics and Liberty. ISBN 978-0865976658.
OCLC 237794267.

4.4.12

External links

Congressional Research Service (CRS) Reports regarding the US Insurance industry


Federation of European Risk Management Associations
Insurance at DMOZ
Insurance Bureau of Canada
Insurance Information Institute
Museum of Insurance displays thousands of antique insurance policies and ephemera
National Association of Insurance Commissioners
The British Library nding information on the insurance industry (UK bias)

47

Chapter 5

Risk Management
5.1 Derivative

Junior AAA; AA; A; BBB; Residual.[7]

In nance, a derivative is a contract that derives its value


from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate,
and is often called the underlying.[1][2] Derivatives can
be used for a number of purposes, including insuring
against price movements (hedging), increasing exposure
to price movements for speculation or getting access to
otherwise hard-to-trade assets or markets.[3] Some of
the more common derivatives include forwards, futures,
options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default
swaps. Most derivatives are traded over-the-counter (oexchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have
developed into a separate industry. Derivatives are one
of the three main categories of nancial instruments, the
other two being stocks (i.e., equities or shares) and debt
(i.e., bonds and mortgages).

5.1.1

Collateralised debt obligation

A collateralised debt obligation (CDO) is a type of


structured asset-backed security (ABS).[4] Originally developed for the corporate debt markets, over time CDOs
evolved to encompass the mortgage and mortgage-backed
security (MBS) markets.[5] Like other private-label securities backed by assets, a CDO can be thought of as a
promise to pay investors in a prescribed sequence, based
on the cash ow the CDO collects from the pool of
bonds or other assets it owns. The CDO is sliced into
tranches, which catch the cash ow of interest and
principal payments in sequence based on seniority.[6] If
some loans default and the cash collected by the CDO is
insucient to pay all of its investors, those in the lowest,
most junior tranches suer losses rst. The last to lose
payment from default are the safest, most senior tranches.
Consequently coupon payments (and interest rates) vary
by tranche with the safest/most senior tranches paying the
lowest and the lowest tranches paying the highest rates
to compensate for higher default risk. As an example, a
CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as super senior);

Separate special purpose entitiesrather than the parent investment bankissue the CDOs and pay interest to
investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration called CDOsquared or the CDOs of CDOs.[7] In the early 2000s,
CDOs were generally diversied,[8] but by 20062007
when the CDO market grew to hundreds of billions of
dollarsthis changed. CDO collateral became dominated not by loans, but by lower level (BBB or A) tranches
recycled from other asset-backed securities, whose assets
were usually non-prime mortgages.[9] These CDOs have
been called the engine that powered the mortgage supply chain for nonprime mortgages,[10] and are credited
with giving lenders greater incentive to make non-prime
loans[11] leading up to the 2007-9 subprime mortgage crisis.

5.1.2 Credit default swap


A credit default swap (CDS) is a nancial swap agreement that the seller of the CDS will compensate the buyer
(the creditor of the reference loan) in the event of a loan
default (by the debtor) or other credit event. The buyer
of the CDS makes a series of payments (the CDS fee
or spread) to the seller and, in exchange, receives a
payo if the loan defaults. It was invented by Blythe
Masters from JP Morgan in 1994. In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS
takes possession of the defaulted loan.[12] However, anyone can purchase a CDS, even buyers who do not hold
the loan instrument and who have no direct insurable interest in the loan (these are called naked CDSs). If
there are more CDS contracts outstanding than bonds in
existence, a protocol exists to hold a credit event auction; the payment received is usually substantially less
than the face value of the loan.[13] Credit default swaps
have existed since the early 1990s, and increased in use
after 2003. By the end of 2007, the outstanding CDS
amount was $62.2 trillion,[14] falling to $26.3 trillion by
mid-year 2010[15] but reportedly $25.5[16] trillion in early
2012. CDSs are not traded on an exchange and there
is no required reporting of transactions to a government

48

5.1. DERIVATIVE
agency.[17] During the 2007-2010 nancial crisis the lack
of transparency in this large market became a concern
to regulators as it could pose a systemic risk.[18][19][20][21]
In March 2010, the [DTCC] Trade Information Warehouse (see Sources of Market Data) announced it would
give regulators greater access to its credit default swaps
database.[22] CDS data can be used by nancial professionals, regulators, and the media to monitor how the
market views credit risk of any entity on which a CDS
is available, which can be compared to that provided by
credit rating agencies. U.S. courts may soon be following
suit.[12] Most CDSs are documented using standard forms
drafted by the International Swaps and Derivatives Association (ISDA), although there are many variants.[18] In
addition to the basic, single-name swaps, there are basket
default swaps (BDSs), index CDSs, funded CDSs (also
called credit-linked notes), as well as loan-only credit
default swaps (LCDS). In addition to corporations and
governments, the reference entity can include a special
purpose vehicle issuing asset-backed securities.[23] Some
claim that derivatives such as CDS are potentially dangerous in that they combine priority in bankruptcy with a
lack of transparency.[19] A CDS can be unsecured (without collateral) and be at higher risk for a default.

5.1.3

Forwards

In nance, a forward contract or simply a forward


is a non-standardized contract between two parties to
buy or to sell an asset at a specied future time at a
price agreed upon today, making it a type of derivative
instrument.[24][25] This is in contrast to a spot contract,
which is an agreement to buy or sell an asset on its spot
date, which may vary depending on the instrument, for
example most of the FX contracts have Spot Date two
business days from today. The party agreeing to buy the
underlying asset in the future assumes a long position,
and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called
the delivery price, which is equal to the forward price at
the time the contract is entered into. The price of the
underlying instrument, in whatever form, is paid before
control of the instrument changes. This is one of the
many forms of buy/sell orders where the time and date of
trade is not the same as the value date where the securities
themselves are exchanged.
The forward price of such a contract is commonly contrasted with the spot price, which is the price at which
the asset changes hands on the spot date. The dierence
between the spot and the forward price is the forward premium or forward discount, generally considered in the
form of a prot, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to
hedge risk (typically currency or exchange rate risk), as a
means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is
time-sensitive.

49
A closely related contract is a futures contract; they dier
in certain respects. Forward contracts are very similar
to futures contracts, except they are not exchange-traded,
or dened on standardized assets.[26] Forwards also typically have no interim partial settlements or true-ups in
margin requirements like futuressuch that the parties
do not exchange additional property securing the party
at gain and the entire unrealized gain or loss builds up
while the contract is open. However, being traded over
the counter (OTC), forward contracts specication can
be customized and may include mark-to-market and daily
margin calls. Hence, a forward contract arrangement
might call for the loss party to pledge collateral or additional collateral to better secure the party at gain. In other
words, the terms of the forward contract will determine
the collateral calls based upon certain trigger events relevant to a particular counterparty such as among other
things, credit ratings, value of assets under management
or redemptions over a specic time frame (e.g., quarterly,
annually).

5.1.4 Futures
In nance, a futures contract (more colloquially, futures) is a standardized contract between two parties to
buy or sell a specied asset of standardized quantity and
quality for a price agreed upon today (the futures price)
with delivery and payment occurring at a specied future date, the delivery date, making it a derivative product (i.e. a nancial product that is derived from an underlying asset). The contracts are negotiated at a futures
exchange, which acts as an intermediary between buyer
and seller. The party agreeing to buy the underlying asset in the future, the buyer of the contract, is said to
be "long", and the party agreeing to sell the asset in the
future, the seller of the contract, is said to be "short".
While the futures contract species a trade taking place
in the future, the purpose of the futures exchange is to act
as intermediary and mitigate the risk of default by either
party in the intervening period. For this reason, the futures exchange requires both parties to put up an initial
amount of cash (performance bond), the margin. Margins, sometimes set as a percentage of the value of the
futures contact needs to be proportionally maintained at
all times during the life of the contract to underpin this
mitigation because the price of the contract will vary in
keeping with supply and demand and will change daily
and thus one party or the other will theoretically be making or losing money. To mitigate risk and the possibility of default by either party, the product is marked to
market on a daily basis whereby the dierence between
the prior agreed-upon price and the actual daily futures
price is settled on a daily basis. This is sometimes known
as the variation margin where the futures exchange will
draw money out of the losing partys margin account and
put it into the other partys thus ensuring that the correct
daily loss or prot is reected in the respective account.

50

CHAPTER 5. RISK MANAGEMENT

If the margin account goes below a certain value set by


the Exchange, then a margin call is made and the account
owner must replenish the margin account. This process is
known as marking to market. Thus on the delivery date,
the amount exchanged is not the specied price on the
contract but the spot value (i.e., the original value agreed
upon, since any gain or loss has already been previously
settled by marking to market). Upon marketing the strike
price is often reached and creates lots of income for the
caller.

are/were often further repackaged and resold as collaterized debt obligations.[28] These subprime MBSs issued
by investment banks were a major issue in the subprime
mortgage crisis of 20062008 . The total face value of
an MBS decreases over time, because like mortgages, and
unlike bonds, and most other xed-income securities, the
principal in an MBS is not paid back as a single payment
to the bond holder at maturity but rather is paid along with
the interest in each periodic payment (monthly, quarterly,
etc.). This decrease in face value is measured by the
MBSs factor, the percentage of the original face that
A closely related contract is a forward contract. A forward is like a futures in that it species the exchange remains to be repaid.
of goods for a specied price at a specied future date.
However, a forward is not traded on an exchange and thus
does not have the interim partial payments due to mark- 5.1.6 Options
ing to market. Nor is the contract standardized, as on
the exchange. Unlike an option, both parties of a futures In nance, an option is a contract which gives the buyer
contract must fulll the contract on the delivery date. The (the owner) the right, but not the obligation, to buy or
seller delivers the underlying asset to the buyer, or, if it sell an underlying asset or instrument at a specied strike
is a cash-settled futures contract, then cash is transferred price on or before a specied date. The seller has the
from the futures trader who sustained a loss to the one corresponding obligation to fulll the transactionthat
who made a prot. To exit the commitment prior to the is to sell or buyif the buyer (owner) exercises the
settlement date, the holder of a futures position can close option. The buyer pays a premium to the seller for this
out its contract obligations by taking the opposite position right. An option that conveys to the owner the right to
on another futures contract on the same asset and settle- buy something at a certain price is a "call option"; an opment date. The dierence in futures prices is then a prot tion that conveys the right of the owner to sell something
at a certain price is a "put option". Both are commonly
or loss.
traded, but for clarity, the call option is more frequently
discussed. Options valuation is a topic of ongoing re5.1.5 Mortgage-backed securities
search in academic and practical nance. In basic terms,
the value of an option is commonly decomposed into two
A mortgage-backed security (MBS) is a asset-backed parts:
security that is secured by a mortgage, or more commonly a collection (pool) of sometimes hundreds of
The rst part is the intrinsic value, dened as
mortgages. The mortgages are sold to a group of indithe dierence between the market value of the
viduals (a government agency or investment bank) that
underlying and the strike price of the given option.
"securitizes", or packages, the loans together into a security that can be sold to investors. The mortgages of
The second part is the time value, which depends
an MBS may be residential or commercial, depending on
on a set of other factors which, through a mulwhether it is an Agency MBS or a Non-Agency MBS;
tivariable, non-linear interrelationship, reect the
in the United States they may be issued by structures
discounted expected value of that dierence at exset up by government-sponsored enterprises like Fannie
piration.
Mae or Freddie Mac, or they can be private-label, issued by structures set up by investment banks. The structure of the MBS may be known as pass-through, where Although options valuation has been studied since the
the interest and principal payments from the borrower or 19th century, the contemporary approach is based on
homebuyer pass through it to the MBS holder, or it may the BlackScholes model, which was rst published in
be more complex, made up of a pool of other MBSs. 1973.[29][30]
Other types of MBS include collateralized mortgage obli- Options contracts have been known for many centuries,
gations (CMOs, often structured as real estate mortgage however both trading activity and academic interest ininvestment conduits) and collateralized debt obligations creased when, as from 1973, options were issued with
(CDOs).[27]
standardized terms and traded through a guaranteed
The shares of subprime MBSs issued by various structures, such as CMOs, are not identical but rather issued as
tranches (French for slices), each with a dierent level
of priority in the debt repayment stream, giving them different levels of risk and reward. Tranchesespecially
the lower-priority, higher-interest tranchesof an MBS

clearing house at the Chicago Board Options Exchange.


Today many options are created in a standardized form
and traded through clearing houses on regulated options
exchanges, while other over-the-counter options are written as bilateral, customized contracts between a single
buyer and seller, one or both of which may be a dealer or

5.1. DERIVATIVE

51

CMC Markets

CommexFX

Currenex

Darwinex

A swap is a derivative in which two counterparties


exchange cash ows of one partys nancial instrument
for those of the other partys nancial instrument. The
benets in question depend on the type of nancial instruments involved. For example, in the case of a swap
involving two bonds, the benets in question can be the
periodic interest (coupon) payments associated with such
bonds. Specically, two counterparties agree to exchange one stream of cash ows against another stream.
These streams are called the swaps legs. The swap
agreement denes the dates when the cash ows are to be
paid and the way they are accrued and calculated. Usually
at the time when the contract is initiated, at least one of
these series of cash ows is determined by an uncertain
variable such as a oating interest rate, foreign exchange
rate, equity price, or commodity price.[24]

DBFX

EToro

ETX Capital

Finspreads

First Prudential Markets

FXCM

FXdirekt Bank

The cash ows are calculated over a notional principal


amount. Contrary to a future, a forward or an option,
the notional amount is usually not exchanged between
counterparties. Consequently, swaps can be in cash or
collateral. Swaps can be used to hedge certain risks such
as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

market-maker. Options are part of a larger class of nancial instruments known as derivative products or simply
derivatives.[24][31]

5.1.7

Swaps

Swaps were rst introduced to the public in 1981


when IBM and the World Bank entered into a swap
agreement.[32] Today, swaps are among the most heavily traded nancial contracts in the world: the total
amount of interest rates and currency swaps outstanding is more thn $348 trillion in 2010, according to the
Bank for International Settlements (BIS). The ve generic
types of swaps, in order of their quantitative importance,
are: interest rate swaps, currency swaps, credit swaps,
commodity swaps and equity swaps (there are many other
types).

5.1.8

Financial derivative trading companies

Alpari

FXOpen

FXPro

Gain Capital

Hirose Financial

I-Access Investors

IDealing

IG

InstaForex

Interactive Brokers

Intregal Forex

InterTrader

IronFX

Marex Spectron

MF Global

MFX Broker

MRC Markets

Oanda Corporation

OptionsXpress

Anyoption

Pepperstone

AvaTrade

Plus 500

Banc de Binary

Saxo Bank

Cantor Fitzgerald

Spreadex

CitiFXPro

Sucden

City Index Group

TeleTrade

52

CHAPTER 5. RISK MANAGEMENT

TFI Markets

Thinkorswim

Varengold

Wizetrade

Worldspreads

XM.com

X-Trade Brokers

Zulu Trade

5.1.9

Basics

Derivatives are contracts between two parties that specify


conditions (especially the dates, resulting values and definitions of the underlying variables, the parties contractual obligations, and the notional amount) under which
payments are to be made between the parties.[24][33] The
most common underlying assets include commodities,
stocks, bonds, interest rates and currencies, but they can
also be other derivatives, which adds another layer of
complexity to proper valuation. The components of a
rms capital structure, e.g., bonds and stock, can also
be considered derivatives, more precisely options, with
the underlying being the rms assets, but this is unusual
outside of technical contexts.
From the economic point of view, nancial derivatives
are cash ows, that are conditionally stochastically and
discounted to present value. The market risk inherent in
the underlying asset is attached to the nancial derivative through contractual agreements and hence can be
traded separately.[34] The underlying asset does not have
to be acquired. Derivatives therefore allow the breakup of
ownership and participation in the market value of an asset. This also provides a considerable amount of freedom
regarding the contract design. That contractual freedom
allows to modify the participation in the performance of
the underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be
eectively weaker, stronger (leverage eect), or implemented as inverse. Hence, specically the market price
risk of the underlying asset can be controlled in almost
every situation.[34]

Derivatives are broadly categorized by the relationship


between the underlying asset and the derivative (such
as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or
credit derivatives); the market in which they trade (such
as exchange-traded or over-the-counter); and their payo prole.
Derivatives may broadly be categorized as lock or option products. Lock products (such as swaps, futures,
or forwards) obligate the contractual parties to the terms
over the life of the contract. Option products (such as
interest rate caps) provide the buyer the right, but not the
obligation to enter the contract under the terms specied.
Derivatives can be used either for risk management (i.e.
to hedge by providing osetting compensation in case
of an undesired event, a kind of insurance) or for speculation (i.e. making a nancial bet). This distinction is
important because the former is a prudent aspect of operations and nancial management for many rms across
many industries; the latter oers managers and investors
a risky opportunity to increase prot, which may not be
properly disclosed to stakeholders.
Along with many other nancial products and services,
derivatives reform is an element of the DoddFrank Wall
Street Reform and Consumer Protection Act of 2010.
The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission (CFTC) and those details are not nalized nor
fully implemented as of late 2012.

5.1.10 Size of market

To give an idea of the size of the derivative market, The


Economist has reported that as of June 2011, the over-thecounter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded
on exchanges totaled an additional $83 trillion.[36] However, these are notional values, and some economists
say that this value greatly exaggerates the market value
and the true credit risk faced by the parties involved. For
example, in 2010, while the aggregate of OTC derivatives
exceeded $600 trillion, the value of the market was estimated much lower, at $21 trillion. The credit risk equivalent of the derivative contracts was estimated at $3.3
[37]
There are two groups of derivative contracts: the pri- trillion.
vately traded over-the-counter (OTC) derivatives such as Still, even these scaled down gures represent huge
swaps that do not go through an exchange or other inter- amounts of money. For perspective, the budget for total
mediary, and exchange-traded derivatives (ETD) that are expenditure of the United States government during 2012
traded through specialized derivatives exchanges or other was $3.5 trillion,[38] and the total current value of the U.S.
exchanges.
stock market is an estimated $23 trillion.[39] The world
[40]
Derivatives are more common in the modern era, but their annual Gross Domestic Product is about $65 trillion.
origins trace back several centuries. One of the oldest And for one type of derivative at least, Credit Default
derivatives is rice futures, which have been traded on the Swaps (CDS), for which the inherent risk is considered
Dojima Rice Exchange since the eighteenth century.[35] high, the higher, nominal value, remains relevant. It was

5.1. DERIVATIVE

53

this type of derivative that investment magnate Warren


Buett referred to in his famous 2002 speech in which he
warned against weapons of nancial mass destruction.
CDS notional value in early 2012 amounted to $25.5 trillion, down from $55 trillion in 2008.[41]

more for a policy with greater liability protections (intrinsic value) and one that extends for a year rather than
six months (time value). Because of the immediate option value, the option purchaser typically pays an up front
premium. Just like for lock products, movements in the
underlying asset will cause the options intrinsic value to
change over time while its time value deteriorates steadily
5.1.11 Usage
until the contract expires. An important dierence between a lock product is that, after the initial exchange,
Derivatives are used for the following:
the option purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute the
Hedge or mitigate risk in the underlying, by entering option if it has positive value (i.e. if it is in the money)
into a derivative contract whose value moves in the or expire at no cost (other than to the initial premium)
opposite direction to their underlying position and (i.e. if the option is out of the money).
cancels part or all of it out[42][43]
Create option ability where the value of the deriva- Hedging
tive is linked to a specic condition or event (e.g.,
the underlying reaching a specic price level)
Main article: Hedge (nance)
Obtain exposure to the underlying where it is not
possible to trade in the underlying (e.g., weather Derivatives allow risk related to the price of the underderivatives)[44]
lying asset to be transferred from one party to another.
For example, a wheat farmer and a miller could sign a
Provide leverage (or gearing), such that a small
futures contract to exchange a specied amount of cash
movement in the underlying value can cause a large
for a specied amount of wheat in the future. Both parties
dierence in the value of the derivative[45]
have reduced a future risk: for the wheat farmer, the un Speculate and make a prot if the value of the under- certainty of the price, and for the miller, the availability of
lying asset moves the way they expect (e.g. moves in wheat. However, there is still the risk that no wheat will
a given direction, stays in or out of a specied range, be available because of events unspecied by the contract,
such as the weather, or that one party will renege on the
reaches a certain level)
contract. Although a third party, called a clearing house,
Switch asset allocations between dierent asset insures a futures contract, not all derivatives are insured
classes without disturbing the underlying assets, as against counter-party risk.
part of transition management
From another perspective, the farmer and the miller both
Avoid paying taxes. For example, an equity swap
allows an investor to receive steady payments, e.g.
based on LIBOR rate, while avoiding paying capital
gains tax and keeping the stock.
Mechanics and Valuation Basics
Lock products are theoretically valued at zero at the time
of execution and thus do not typically require an up-front
exchange between the parties. Based upon movements in
the underlying asset over time, however, the value of the
contract will uctuate, and the derivative may be either
an asset (i.e. "in the money") or a liability (i.e. "out of
the money") at dierent points throughout its life. Importantly, either party is therefore exposed to the credit
quality of its counterparty and is interested in protecting
itself in an event of default.
Option products have immediate value at the outset because they provide specied protection (intrinsic value)
over a given time period (time value). One common form
of option product familiar to many consumers is insurance for homes and automobiles. The insured would pay

reduce a risk and acquire a risk when they sign the futures contract: the farmer reduces the risk that the price
of wheat will fall below the price specied in the contract and acquires the risk that the price of wheat will rise
above the price specied in the contract (thereby losing
additional income that he could have earned). The miller,
on the other hand, acquires the risk that the price of wheat
will fall below the price specied in the contract (thereby
paying more in the future than he otherwise would have)
and reduces the risk that the price of wheat will rise above
the price specied 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 also 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 sells it using a futures contract. The individual or
institution has access to the asset for a specied amount
of time, and can then sell it in the future at a specied
price according to the futures contract. Of course, this
allows the individual or institution the benet of holding
the asset, while reducing the risk that the future selling

54

CHAPTER 5. RISK MANAGEMENT

price will deviate unexpectedly from the markets current son incurred a US$1.3 billion loss that bankrupted the
assessment of the future value of the asset.
centuries-old institution.[49]
Proportion Used for Hedging and Speculation
The true proportion of derivatives contracts used for
hedging purposes is unknown[50] (and perhaps unknowable), but it appears to be relatively small.[51][52] Also,
derivatives contracts account for only 36% of the median rms total currency and interest rate exposure.[53]
Nonetheless, we know that many rms derivatives activities have at least some speculative component for a variety of reasons.[53]

5.1.12 Types
Derivatives traders at the Chicago Board of Trade

OTC and exchange-traded

Derivatives trading of this kind may serve the nancial inIn broad terms, there are two groups of derivative conterests of certain particular businesses.[46] For example, a
tracts, which are distinguished by the way they are traded
corporation borrows a large sum of money at a specic inin the market:
terest rate.[47] The interest rate on the loan reprices every
six months. The corporation is concerned that the rate of
Over-the-counter (OTC) derivatives are contracts
interest may be much higher in six months. The corporathat are traded (and privately negotiated) directly
tion could buy a forward rate agreement (FRA), which is
between two parties, without going through an exa contract to pay a xed rate of interest six months after
change or other intermediary. Products such as
[48]
purchases on a notional amount of money.
If the inswaps, forward rate agreements, exotic options and
terest rate after six months is above the contract rate, the
other exotic derivatives are almost always traded in
seller will pay the dierence to the corporation, or FRA
this way. The OTC derivative market is the largest
buyer. If the rate is lower, the corporation will pay the
market for derivatives, and is largely unregulated
dierence to the seller. The purchase of the FRA serves
with respect to disclosure of information between
to reduce the uncertainty concerning the rate increase and
the parties, since the OTC market is made up of
stabilize earnings.
banks and other highly sophisticated parties, such as
hedge funds. Reporting of OTC amounts is dicult
because trades can occur in private, without activity
Speculation and arbitrage
being visible on any exchange.
Derivatives can be used to acquire risk, rather than to
hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on
the value of the underlying asset, betting that the party
seeking insurance will be wrong about the future value
of the underlying asset. Speculators look to buy an asset in the future at a low price according 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 the future market price is less.
Individuals and institutions may also look for arbitrage
opportunities, as when the current buying price of an asset
falls below the price specied in a futures contract to sell
the asset.
Speculative trading in derivatives gained a great deal of
notoriety in 1995 when Nick Leeson, a trader at Barings
Bank, made poor and unauthorized investments in futures
contracts. Through a combination of poor judgment, lack
of oversight by the banks management and regulators,
and unfortunate events like the Kobe earthquake, Lee-

According to the Bank for International Settlements, who


rst surveyed OTC derivatives in 1995,[54] reported that
the "gross market value, which represent the cost of replacing all open contracts at the prevailing market prices,
... increased by 74% since 2004, to $11 trillion at the end
of June 2007 (BIS 2007:24).[54] Positions in the OTC
derivatives market increased to $516 trillion at the end of
June 2007, 135% higher than the level recorded in 2004.
the total outstanding notional amount is US$708 trillion
(as of June 2011).[55] 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 central counter-party. Therefore, they
are subject to counterparty risk, like an ordinary contract,
since each counter-party relies on the other to perform.
Exchange-traded derivatives (ETD) are those
derivatives instruments that are traded via special-

5.1. DERIVATIVE
ized derivatives exchanges or other exchanges. A
derivatives exchange is a market where individuals
trade standardized contracts that have been dened
by the exchange.[24] A derivatives exchange acts as
an intermediary to all related transactions, and takes
initial margin from both sides of the trade to act as
a guarantee. The worlds largest[56] derivatives exchanges (by number of transactions) are the Korea
Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European
products such as interest rate & index products),
and CME Group (made up of the 2007 merger of
the Chicago Mercantile 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 worlds derivatives exchanges totaled USD 344 trillion during Q4 2005.
By December 2007 the Bank for International Settlements reported[54] that derivatives traded on exchanges surged 27% to a record $681 trillion.[54]
Common derivative contract types
Some of the common variants of derivative contracts are
as follows:
1. Forwards: A tailored contract between two parties,
where payment takes place at a specic time in the
future at todays pre-determined price.
2. Futures: are contracts to buy or sell an asset on a future date at a price specied today. A futures contract diers from a forward contract in that the futures contract is a standardized contract written by a
clearing house that operates an exchange where the
contract can be bought and sold; the forward contract is a non-standardized contract written by the
parties themselves.
3. 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 specied at the time the parties enter into the option. The option contract also
species a maturity 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 American 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-party has the obligation
to carry out the transaction. Options are of two
types: call option and put option. The buyer of a
Call option has a right to buy a certain quantity of
the underlying asset, at a specied price on or before
a given date in the future, he however has no obligation whatsoever to carry out this right. Similarly, the

55
buyer of a Put option has the right to sell a certain
quantity of an underlying asset, at a specied price
on or before a given date in the future, he however
has no obligation whatsoever to carry out this right.
4. Binary options are contracts that provide the owner
with an all-or-nothing prot prole.
5. Warrants: Apart from the commonly used shortdated options which have a maximum maturity period of 1 year, there exists certain long-dated options
as well, known as Warrant (nance). These are generally traded over-the-counter.
6. Swaps are contracts to exchange cash (ows) on
or before a specied future date based on the
underlying value of currencies exchange rates,
bonds/interest rates, commodities exchange, stocks
or other assets. Another term which is commonly
associated to Swap is Swaption which is basically
an option on the forward Swap. Similar to a Call
and Put option, a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on
one hand, in case of a receiver Swaption there is an
option wherein you can receive xed and pay oating, a payer swaption on the other hand is an option
to pay xed and receive oating.
Swaps can basically be categorized
into two types:
Interest rate swap: These basically necessitate swapping only
interest associated cash ows
in the same currency, between
two parties.
Currency swap: In this kind
of swapping, the cash ow
between the two parties includes both principal and interest. Also, the money which
is being swapped is in dierent
currency for both parties.[57]
Some common examples of these derivatives are the following:

5.1.13 Economic function of the derivative


market
Some of the salient economic functions of the derivative
market include:
1. Prices in a structured derivative market not only
replicate the discernment of the market participants about the future but also lead the prices of
underlying to the professed future level. On the
expiration of the derivative contract, the prices of

56

CHAPTER 5. RISK MANAGEMENT


derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools to
determine both current and future prices.

Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts (see
rational pricing)

2. The derivatives market reallocates risk from the people who prefer risk aversion to the people who have
Determining the market price
an appetite for risk.
3. The intrinsic nature of derivatives market associates
them to the underlying Spot market. Due to derivatives there is a considerable increase in trade volumes of the underlying Spot market. The dominant
factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure
to transfer risk.

For exchange-traded derivatives, market price is usually


transparent (often published in real time by the exchange,
based on all the current bids and oers placed on that
particular contract at any one time). Complications can
arise with OTC or oor-traded contracts though, as trading is handled manually, making it dicult to automatically broadcast prices. In particular with OTC contracts,
there is no central exchange to collate and disseminate
4. As supervision, reconnaissance of the activities of prices.
various participants becomes tremendously dicult
in assorted markets; the establishment of an organized form of market becomes all the more imper- Determining the arbitrage-free price
ative. Therefore, in the presence of an organized
derivatives market, speculation can be controlled,
See List of nance topics# Derivatives pricing.
resulting in a more meticulous environment.
5. Third parties can use publicly available derivative
prices as educated predictions of uncertain future The arbitrage-free price for a derivatives contract can be
outcomes, for example, the likelihood that a corpo- complex, and there are many dierent variables to consider. Arbitrage-free pricing is a central topic of nancial
ration will default on its debts.[58]
mathematics. For futures/forwards the arbitrage free
In a nutshell, there is a substantial increase in savings and price is relatively straightforward, involving the price of
investment in the long run due to augmented activities by the underlying together with the cost of carry (income
received less interest costs), although there can be comderivative Market participant.[59]
plexities.

5.1.14

Valuation

Total world derivatives from 1998 to 2007[60] compared to total


world wealth in the year 2000[61]

Market and arbitrage-free prices

However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding the stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the BlackScholes formula,
which is based on the assumption that the cash ows from
a European stock option can be replicated by a continuous
buying and selling strategy using only the stock. A simplied version of this valuation technique is the binomial
options model.
OTC represents the biggest challenge in using models
to price derivatives. Since these contracts are not publicly traded, no market price is available to validate the
theoretical valuation. Most of the models results are
input-dependent (meaning the nal price depends heavily on how we derive the pricing inputs).[62] 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).

Two common measures of value are:

5.1.15 Criticisms
Market price, i.e. the price at which traders are willing to buy or sell the contract
Derivatives are often subject to the following criticisms:

5.1. DERIVATIVE
Hidden tail risk
According to Raghuram Rajan, a former chief economist
of the International Monetary Fund (IMF), "... it may
well be that the managers of these rms [investment
funds] have gured out the correlations between the various instruments they hold and believe they are hedged.
Yet as Chan and others (2005) point out, the lessons of
summer 1998 following the default on Russian government debt is that correlations that are zero or negative in
normal times can turn overnight to one a phenomenon
they term phase lock-in. A hedged position can become
unhedged at the worst times, inicting substantial losses
on those who mistakenly believe they are protected.[63]
Risks
See also: List of trading losses

57
UBS AG, Switzerlands biggest bank,
suered a $2 billion loss through unauthorized trading discovered in September
2011.[68]
This comes to a staggering $39.5 billion, the majority in
the last decade after the Commodity Futures Modernization Act of 2000 was passed.
Counter party risk
Some derivatives (especially swaps) expose investors to
counterparty risk, or risk arising from the other party in a
nancial transaction. Dierent types of derivatives have
dierent levels of counter party risk. For example, standardized stock options by law require the party at risk
to have a certain amount deposited with the exchange,
showing that they can pay for any losses; banks that help
businesses swap variable for xed rates on loans may do
credit checks on both parties. However, in private agreements between two companies, for example, there may
not be benchmarks for performing due diligence and risk
analysis.

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 movements in
the underlying assets price. However, investors could
lose large amounts if the price of the underlying moves
against them signicantly. There have been several in- Large notional value
stances of massive losses in derivative markets, such as
the following:
Derivatives typically have a large notional value. As
such, there is the danger that their use could result in
American International Group (AIG) lost
losses for which the investor would be unable to commore than US$18 billion through a subpensate. The possibility that this could lead to a chain
sidiary over the preceding three quarters
reaction ensuing in an economic crisis was pointed out
on credit default swaps (CDSs).[64] The
by famed investor Warren Buett in Berkshire HathUnited States Federal Reserve Bank anaway's 2002 annual report. Buett called them 'nancial
nounced the creation of a secured credit
weapons of mass destruction.' A potential problem with
facility of up to US$85 billion, to prevent
derivatives is that they comprise an increasingly larger nothe companys collapse by enabling AIG
tional amount of assets which may lead to distortions in
to meet its obligations to deliver addithe underlying capital and equities markets themselves.
tional collateral to its credit default swap
Investors begin to look at the derivatives markets to make
trading partners.[65]
a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes
The loss of US$7.2 Billion by Socit
a leading indicator.(See Berkshire Hathaway Annual ReGnrale in January 2008 through misport
for 2002)
use of futures contracts.
The loss of US$6.4 billion in the failed
fund Amaranth Advisors, which was long
natural gas in September 2006 when the
price plummeted.
The loss of US$4.6 billion in the failed
fund Long-Term Capital Management in
1998.
The loss of US$1.3 billion equivalent
in oil derivatives in 1993 and 1994 by
Metallgesellschaft AG.[66]
The loss of US$1.2 billion equivalent
in equity derivatives in 1995 by Barings
Bank.[67]

5.1.16 Financial Reform and Government


Regulation
Under US law and the laws of most other developed
countries, derivatives have special legal exemptions that
make them a particularly attractive legal form to extend credit.[69] The strong creditor protections aorded
to derivatives counterparties, in combination with their
complexity and lack of transparency however, can cause
capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks.[69]
Indeed, the use of derivatives to conceal credit risk from
third parties while protecting derivative counterparties

58

CHAPTER 5. RISK MANAGEMENT

contributed to the nancial crisis of 2008 in the United ongoing.[73]


States.[69][70]
In the U.S., by February 2012 the combined eort of the
In the context of a 2010 examination of the ICE Trust, an SEC and CFTC had produced over 70 proposed and nal
industry self-regulatory body, Gary Gensler, the chair- derivatives rules.[74] However, both of them had delayed
man of the Commodity Futures Trading Commission adoption of a number of derivatives regulations because
which regulates most derivatives, was quoted saying that of the burden of other rulemaking, litigation and oppothe derivatives marketplace as it functions now adds up sition to the rules, and many core denitions (such as
to higher costs to all Americans. More oversight of the the terms swap, security-based swap, swap dealer,
banks in this market is needed, he also said. Addition- security-based swap dealer, major swap participant
ally, the report said, "[t]he Department of Justice is look- and major security-based swap participant) had still not
ing into derivatives, too. The departments antitrust unit been adopted.[74] SEC Chairman Mary Schapiro opined:
is actively investigating 'the possibility of anticompetitive At the end of the day, it probably does not make sense
practices in the credit derivatives clearing, trading and in- to harmonize everything [between the SEC and CFTC
formation services industries,' according to a department rules] because some of these products are quite dierent
spokeswoman.[71]
and certainly the market structures are quite dierent.[75]
For legislators and committees responsible for nancial On February 11, 2015, the Securities and Exchange
reform related to derivatives in the United States and else- Commission (SEC) released two nal rules toward estabframework for
where, distinguishing between hedging and speculative lishing a reporting and public disclosure
[76]
security-based
swap
transaction
data.
The two rules
derivatives activities has been a nontrivial challenge. The
are
not
completely
harmonized
with
the
requirements
distinction is critical because regulation should help to
with
CFTC
requirements.
isolate and curtail speculation with derivatives, especially
for systemically signicant institutions whose default
could be large enough to threaten the entire nancial system. At the same time, the legislation should allow for
responsible parties to hedge risk without unduly tying up
working capital as collateral that rms may better employ elsewhere in their operations and investment.[72] In
this regard, it is important to distinguish between nancial
(e.g. banks) and non-nancial end-users of derivatives
(e.g. real estate development companies) because these
rms derivatives usage is inherently dierent. More importantly, the reasonable collateral that secures these different counterparties can be very dierent. The distinction between these rms is not always straight forward
(e.g. hedge funds or even some private equity rms do
not neatly t either category). Finally, even nancial users
must be dierentiated, as 'large' banks may classied
as systemically signicant whose derivatives activities
must be more tightly monitored and restricted than those
of smaller, local and regional banks.
Over-the-counter dealing will be less common as the
DoddFrank Wall Street Reform and Consumer Protection Act comes into eect. The law mandated the clearing of certain swaps at registered exchanges and imposed
various restrictions on derivatives. To implement DoddFrank, the CFTC developed new rules in at least 30 areas.
The Commission determines which swaps are subject to
mandatory clearing and whether a derivatives exchange is
eligible to clear a certain type of swap contract.
Nonetheless, the above and other challenges of the rulemaking process have delayed full enactment of aspects of
the legislation relating to derivatives. The challenges are
further complicated by the necessity to orchestrate globalized nancial reform among the nations that comprise
the worlds major nancial markets, a primary responsibility of the Financial Stability Board whose progress is

Country leaders at the 2009 G-20 Pittsburgh summit

In November 2012, the SEC and regulators from Australia, Brazil, the European Union, Hong Kong, Japan,
Ontario, Quebec, Singapore, and Switzerland met to discuss reforming the OTC derivatives market, as had been
agreed by leaders at the 2009 G-20 Pittsburgh summit
in September 2009.[77] In December 2012, they released
a joint statement to the eect that they recognized that
the market is a global one and rmly support the adoption and enforcement of robust and consistent standards
in and across jurisdictions, with the goals of mitigating
risk, improving transparency, protecting against market
abuse, preventing regulatory gaps, reducing the potential
for arbitrage opportunities, and fostering a level playing
eld for market participants.[77] They also agreed on the
need to reduce regulatory uncertainty and provide market
participants with sucient clarity on laws and regulations
by avoiding, to the extent possible, the application of conicting rules to the same entities and transactions, and
minimizing the application of inconsistent and duplicative rules.[77] At the same time, they noted that complete
harmonization perfect alignment of rules across juris-

5.1. DERIVATIVE
dictions would be dicult, because of jurisdictions differences in law, policy, markets, implementation timing,
and legislative and regulatory processes.[77]
On December 20, 2013 the CFTC provided information
on its swaps regulation comparability determinations.
The release addressed the CFTCs cross-border compliance exceptions. Specically it addressed which entity
level and in some cases transaction-level requirements in
six jurisdictions (Australia, Canada, the European Union,
Hong Kong, Japan, and Switzerland) it found comparable
to its own rules, thus permitting non-US swap dealers,
major swap participants, and the foreign branches of US
Swap Dealers and major swap participants in these jurisdictions to comply with local rules in lieu of Commission
rules.[78]
Reporting
Mandatory reporting regulations are being nalized in
a number of countries, such as Dodd Frank Act in
the US, the European Market Infrastructure Regulations
(EMIR) in Europe, as well as regulations in Hong Kong,
Japan, Singapore, Canada, and other countries.[79] The
OTC Derivatives Regulators Forum (ODRF), a group
of over 40 world-wide regulators, provided trade repositories with a set of guidelines regarding data access to
regulators, and the Financial Stability Board and CPSS
IOSCO also made recommendations in with regard to
reporting.[79]
DTCC, through its Global Trade Repository (GTR)
service, manages global trade repositories for interest
rates, and commodities, foreign exchange, credit, and
equity derivatives.[79] It makes global trade reports to
the CFTC in the U.S., and plans to do the same for
ESMA in Europe and for regulators in Hong Kong, Japan,
and Singapore.[79] It covers cleared and uncleared OTC
derivatives products, whether or not a trade is electronically processed or bespoke.[79][80][81]

5.1.17

Glossary

Bilateral netting: A legally enforceable arrangement


between a bank and a counter-party that creates a
single legal obligation covering all included individual contracts. This means that a banks obligation,
in the event of the default or insolvency of one of the
parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral
netting arrangement.
Counterparty: The legal and nancial term for the
other party in a nancial transaction.
Credit derivative: A contract that transfers credit
risk from a protection buyer to a credit protection
seller. Credit derivative products can take many

59
forms, such as credit default swaps, credit linked
notes and total return swaps.
Derivative: A nancial contract whose value is derived from the performance of assets, interest rates,
currency exchange rates, or indexes. Derivative
transactions include a wide assortment of nancial
contracts including structured debt obligations and
deposits, swaps, futures, options, caps, oors, collars, forwards and various combinations thereof.
Exchange-traded derivative contracts: Standardized derivative contracts (e.g., futures contracts and
options) that are transacted on an organized futures
exchange.
[Gross negative fair value: The sum of the fair values of contracts where the bank owes money to
its counter-parties, without taking into account netting. This represents the maximum losses the banks
counter-parties would incur if the bank defaults and
there is no netting of contracts, and no bank collateral was held by the counter-parties.
Gross positive fair value: The sum total of the fair
values of contracts where the bank is owed money
by its counter-parties, without taking into account
netting. This represents the maximum losses a bank
could incur if all its counter-parties default and there
is no netting of contracts, and the bank holds no
counter-party collateral.
High-risk mortgage securities: Securities where the
price or expected average life is highly sensitive to
interest rate changes, as determined by the U.S.
Federal Financial Institutions Examination Council
policy statement on high-risk mortgage securities.
Notional amount: The nominal or face amount that
is used to calculate payments made on swaps and
other risk management products. This amount generally does not change hands and is thus referred to
as notional.
Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are transacted o organized futures exchanges.
Structured notes: Non-mortgage-backed debt securities, whose cash ow characteristics depend on one
or more indices and / or have embedded forwards or
options.
Total risk-based capital: The sum of tier 1 plus tier
2 capital. Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders equity with noncumulative dividends, retained earnings, and minority interests in the equity accounts
of consolidated subsidiaries. Tier 2 capital consists
of subordinated debt, intermediate-term preferred
stock, cumulative and long-term preferred stock,
and a portion of a banks allowance for loan and lease
losses.

60

5.1.18

CHAPTER 5. RISK MANAGEMENT

Financial derivative trading companies

Alpari Group
Anyoption
Banc de Binary
Cantor Fitzgerald
CitiFXPro
City Index Group
CMC Markets
Currenex
DBF
EToro
ETX Capital
Finspreads
First Prudential Markets
FXCM
FXdirekt Bank
FXOpen
FXPro

Saxo Bank
Spread Co.
Spreadex
Sucden
TeleTrade
TFI Markets
Thinkorswim
Varen Gold
Wizetrade
Worldspreads
X-Trade Brokers
Zulu Trade

5.1.19 See also


Credit derivative
Equity derivative
Exotic derivative
Financial engineering

Gain Capital

Foreign exchange derivative

Henyep

Freight derivative

Hirose Financial UK Ltd.

Ination derivative

HXPM Gold

Interest rate derivative

I-Access Investors

Property derivatives

IDealing

Weather derivative

IG Group
InstaForex
Interactive Brokers

5.1.20 References

Oanda Corporation

[1] Derivatives (Report). Oce of the Comptroller of the


Currency, U.S. Department of Treasury. Retrieved
February 2013. A derivative is a nancial contract whose
value is derived from the performance of some underlying
market factors, such as interest rates, currency exchange
rates, and commodity, credit, or equity prices. Derivative
transactions include an assortment of nancial contracts,
including structured debt obligations and deposits, swaps,
futures, options, caps, oors, collars, forwards, and various combinations thereof.

OptionsXpress

[2] Derivative Denition, Investopedia

Pepperstone

[3] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 1011.

InterTrader
Marex Spectron
MF Global
MRC Markets

Plus 500

5.1. DERIVATIVE

[4] An asset-backed security is used as an umbrella term for


a type of security backed by a pool of assetsincluding
collateralized debt obligations and mortgage-backed securities (Example: The capital market in which assetbacked securities are issued and traded is composed of
three main categories: ABS, MBS and CDOs. (source:
Vink, Dennis. ABS, MBS and CDO compared: An empirical analysis (PDF). August 2007. Munich Personal
RePEc Archive. Retrieved 13 July 2013.)
and sometimes for a particular type of that security
one backed by consumer loans (example: As a rule
of thumb, securitization issues backed by mortgages are
called MBS, and securitization issues backed by debt obligations are called CDO, [and] Securitization issues backed
by consumer-backed productscar loans, consumer loans
and credit cards, among othersare called ABS. source
Vink, Dennis. ABS, MBS and CDO compared: An empirical analysis (PDF). August 2007. Munich Personal
RePEc Archive. Retrieved 13 July 2013.,
see also What are Asset-Backed Securities?". SIFMA.
Retrieved 13 July 2013. Asset-backed securities, called
ABS, are bonds or notes backed by nancial assets. Typically these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans,
manufactured-housing contracts and home-equity loans.)
[5] Lemke, Lins and Picard, Mortgage-Backed Securities,
5:15 (Thomson West, 2014).
[6] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 17.
[7] Lemke, Lins and Smith, Regulation of Investment Companies (Matthew Bender, 2014 ed.).
[8] Bethany McLean and Joe Nocera, All the Devils Are Here,
the Hidden History of the Financial Crisis, Portfolio, Penguin, 2010, p.120
[9] Final Report of the National Commission on the Causes
of the Financial and Economic Crisis in the United
States, a.k.a. The Financial Crisis Inquiry Report,
p.127
[10] The Financial Crisis Inquiry Report, 2011, p.130
[11] The Financial Crisis Inquiry Report, 2011, p.133
[12] Michael Simkovic, Leveraged Buyout Bankruptcies, the
Problem of Hindsight Bias, and the Credit Default Swap
Solution, Columbia Business Law Review (Vol. 2011, No.
1, pp. 118), 2011.
[13] Lisa Pollack (January 5, 2012). Credit event auctions:
Why do they exist?". FT Alphaville.
[14] Chart; ISDA Market Survey; Notional amounts outstanding at year-end, all surveyed contracts, 1987present (PDF). International Swaps and Derivatives Association (ISDA). Retrieved April 8, 2010.
[15] ISDA 2010 Mid-Year Market Survey. Latest available
a/o 2012-03-01.
[16] ISDA: CDS Marketplace. Isdacdsmarketplace.com.
December 31, 2010. Retrieved March 12, 2012.

61

[17] Ki, John; Jennifer Elliott; Elias Kazarian; Jodi Scarlata;


Carolyne Spackman (November 2009). Credit Derivatives: Systemic Risks and Policy Options (PDF). IMF
Working Papers (WP/09/254). Retrieved April 25, 2010.
[18] Christian Weistroer; Deutsche Bank Research (December 21, 2009). Credit default swaps: Heading towards
a more stable system (PDF). Deutsche Bank Research:
Current Issues. Retrieved April 15, 2010.
[19] Michael Simkovic, Secret Liens and the Financial Crisis
of 2008.
[20] Erik Sirri, Director, SEC Division of Trading and Markets. Testimony Concerning Credit Default Swa[s Before
the House Committee on Agriculture October 15, 2008.
Retrieved April 2, 2010.
[21] Frank Partnoy; David A. Skeel, Jr. (2007). The Promise
And Perils of Credit Derivatives. University of Cincinnati
Law Review 75: 10191051. SSRN 929747.
[22] Media Statement: DTCC Policy for Releasing CDS Data
to Global Regulators. Depository Trust & Clearing Corporation. March 23, 2010. Retrieved April 22, 2010.
[23] Mengle, David (2007).
Credit Derivatives: An
Overview (PDF). Economic Review (FRB Atlanta) 92 (4).
Retrieved April 2, 2010.
[24] John C. Hull, Options, Futures and Other Derivatives (6th
edition), Prentice Hall: New Jersey, 2006.
[25] Understanding Derivatives: Markets and Infrastructure,
Federal Reserve Bank of Chicago
[26] Forward Contract on Wikinvest
[27] Lemke, Lins and Picard, Mortgage-Backed Securities,
Chapters 4 and 5 (Thomson West, 2013 ed.).
[28] Josh Clark, How can mortgage-backed securities bring
down the U.S. economy?", How Stu Works
[29] Benhamou, Eric. Options pre-Black Scholes (PDF).
[30] Black, Fischer; Scholes, Myron (1973). The Pricing of
Options and Corporate Liabilities. Journal of Political
Economy 81 (3): 637654. doi:10.1086/260062. JSTOR
1831029.
[31] Brealey, Richard A.; Myers, Stewart (2003), Principles of
Corporate Finance (7th ed.), McGraw-Hill, Chapter 20
[32] Ross, Westereld, & Jordan (2010). Fundamentals of
Corporate Finance (9th ed.). McGraw Hill. p. 746.
[33] Mark Rubinstein (1999). Rubinstein on Derivatives. Risk
Books. ISBN 1-899332-53-7.
[34] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 10.
[35] Kaori Suzuki and David Turner (December 10, 2005).
Sensitive politics over Japans staple crop delays rice futures plan. The Financial Times. Retrieved October 23,
2010.

62

[36] Clear and Present Danger; Centrally cleared derivatives.(clearing houses)". The Economist (Economist
Newspaper Ltd.(subscription required)). April 12, 2012.
Retrieved 2013-05-10.
[37] Liu, Qiao; Lejot, Paul (2013). Debt, Derivatives and
Complex Interactions. Finance in Asia: Institutions, Regulation and Policy. Douglas W. Arne. New York: Routledge. p. 343. ISBN 978-0-415-42319-9.
[38] The Budget and Economic Outlook: Fiscal Years 2013 to
2023 (PDF). Congressional Budget Oce. February 5,
2013. Retrieved March 15, 2013.
[39] Swapping bad ideas: A big battle is unfolding over an
even bigger market. The Economist. 2013-04-27. Retrieved 2013-05-10.
[40] World GDP: In search of growth. The Economist
(Economist Newspaper Ltd.). 2011-05-25. Retrieved
2013-05-10.
[41] Sheridan, Barrett (April 2008). 600,000,000,000,000?".
Newsweek Inc. Retrieved 12 May 2013. via HighBeam
(subscription required)
[42] Khullar, Sanjeev (2009). Using Derivatives to Create Alpha. In John M. Longo. Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance. Singapore: World Scientic. p. 105. ISBN
978-981-283-465-2. Retrieved September 14, 2011.
[43] Lemke and Lins, Soft Dollars and Other Trading Activities,
2:47 - 2:54 (Thomson West, 2013-2014 ed.).
[44] Don M. Chance; Robert Brooks (2010). Advanced
Derivatives and Strategies. Introduction to Derivatives
and Risk Management (8th ed.). Mason, OH: Cengage
Learning. pp. 483515. ISBN 978-0-324-60120-6. Retrieved September 14, 2011.
[45] Shirre, David (2004). Derivatives and leverage.
Dealing With Financial Risk. The Economist. p. 23.
ISBN 1-57660-162-5. Retrieved September 14, 2011.
[46] Peterson, Sam (2010).
The Atlantic.
Theres
a
Derivative
in
Your
Cereal
http://www.
theatlantic.com/business/archive/2010/07/
theres-a-derivative-in-your-cereal/60582/
[47] Chisolm, Derivatives Demystied (Wiley 2004)
[48] Chisolm, Derivatives Demystied (Wiley 2004) Notional
sum means there is no actual principal.
[49] News.BBC.co.uk, How Leeson broke the bank BBC
Economy
[50] Chernenko, Sergey and Faulkender, Michael. The Two
Sides of Derivatives Usage: Hedging and Speculating
with Interest Rate Swaps http://www.rhsmith.umd.edu/
faculty/faulkender/swaps_JFQA_final.pdf
[51] Knowledge@Wharton (2012).
The Changing Use
of Derivatives: More Hedging, Less Speculation
http://knowledge.wharton.upenn.edu/article.cfm?
articleid=709

CHAPTER 5. RISK MANAGEMENT

[52] Guay, Wayne R. and Kothari, S.P. (2001). How Much do


Firms Hedge with Derivatives?" http://papers.ssrn.com/
sol3/papers.cfm?abstract_id=253036
[53] Knowledge@Wharton (2006). The Role of Derivatives in Corporate Finances: Are Firms Betting the
Ranch?" http://knowledge.wharton.upenn.edu/article.
cfm?articleid=1346
[54] Ryan Stever; Christian Upper; Goetz von Peter (December 2007). BIS Quarterly Review (PDF) (Report). Bank
for International Settlements.
[55] BIS survey: The Bank for International Settlements (BIS)
semi-annual OTC [derivatives market report, for end
of June 2008, showed US$683.7 trillion total notional
amounts outstanding of OTC derivatives with a gross market value of US$20 trillion. See also Prior Period Regular
OTC Derivatives Market Statistics.
[56] Futures and Options Week: According to gures published
in F&O Week October 10, 2005. See also FOW Website.
[57] Financial Markets: A Beginners Module.
[58] Michael Simkovic and Benjamin Kaminetzky (August 29,
2010). Leveraged Buyout Bankruptcies, the Problem of
Hindsight Bias, and the Credit Default Swap Solution.
Columbia Business Law Review, Vol. 2011, No. 1, p.
118, 2011. Retrieved March 5, 2013.
[59] Currency Derivatives: A Beginners Module.
[60] Bis.org. Bis.org. May 7, 2010. Retrieved August 29,
2010.
[61] Launch of the WIDER study on The World Distribution
of Household Wealth: 5 December 2006. Retrieved June
9, 2009.
[62] Boumlouka,
Makrem
(2009),"Alternatives
in OTC Pricing, Hedge Funds Review, 1030-2009.
http://www.hedgefundsreview.
com/hedge-funds-review/news/1560286/
otc-pricing-deal-struck-fitch-solutions-pricing-partners
[63] Raghuram G. Rajan (September 2006). Has Financial
Development Made the World Riskier?". European Financial Management (EUROPEAN FINANCIAL MANAGEMENT) 12 (4): 499533. doi:10.1111/j.1468036X.2006.00330.x. Retrieved January 17, 2012.
[64] Kelleher, James B. (September 18, 2008). ""Buetts
Time Bomb Goes O on Wall Street by James B. Kelleher of Reuters. Reuters.com. Retrieved August 29,
2010.
[65] Feds $85 billion Loan Rescues Insurer
[66] Edwards, Franklin (1995). Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft
(PDF). Derivatives Quarterly (Spring 1995): 817
[67] Whaley, Robert (2006). Derivatives: markets, valuation,
and risk management. John Wiley and Sons. p. 506.
ISBN 0-471-78632-2.

5.1. DERIVATIVE

[68] UBS Loss Shows Banks Fail to Learn From Kerviel, Leeson. Businessweek. September 15, 2011. Retrieved
March 5, 2013.
[69] Michael Simkovic, Secret Liens and the Financial Crisis
of 2008.. American Bankruptcy Law Journal, Vol. 83,
p. 253. 2009. Retrieved March 5, 2013.

63

5.1.21 Further reading


Shnke M. Bartram; Brown, Gregory W.; Conrad, Jennifer C. (August 2011). The Eects of
Derivatives on Firm Risk and Value. Journal of Financial and Quantitative Analysis 46 (4): 967999.
doi:10.1017/s0022109011000275.

[70] Michael Simkovic (January 11, 2011). Bankruptcy


Immunities,
Transparency,
and Capital Structure, Presentation at the World Bank. Ssrn.com.
doi:10.2139/ssrn.1738539. Retrieved March 5, 2013.

Shnke M. Bartram; Kevin Aretz (Winter 2010).


Corporate Hedging and Shareholder Value. Journal of Financial Research 33 (4): 317371.
doi:10.1111/j.1475-6803.2010.01278.x.

[71] Story, Louise, A Secretive Banking Elite Rules Trading


in Derivatives, The New York Times, December 11, 2010
(December 12, 2010, p. A1 NY ed.). Retrieved December 12, 2010.

Shnke M. Bartram; Gregory W. Brown; Frank


R. Fehle (Spring 2009). International Evidence
on Financial Derivatives Usage. Financial Management 38 (1): 185206. doi:10.1111/j.1755053x.2009.01033.x.

[72] Zubrod, Luke (2011).


The Atlantic.
Will the
'Cure' for Systemic Risk Kill the Economy?"
http://www.theatlantic.com/business/archive/2011/
06/will-the-cure-for-systemic-risk-kill-the-economy/
240600/
[73] Financial Stability Board (2012). OTC Derivatives
Market Reforms Third Progress Report on Implementation June 15, 2012 http://www.financialstabilityboard.
org/publications/r_120615.pdf
[74] Proskauer Rose LLP. SEC and CFTC oversight of
derivatives: a status report. Lexology. Retrieved March
5, 2013.
[75] Younglai, Rachelle. INTERVIEW Not all SEC, CFTC
rules must be harmonized. Reuters. Retrieved March 5,
2013.
[76] First take: Ten key points from the SECs swaps
reporting and disclosure rules (PDF). http://www.
pwc.com/us/en/financial-services/regulatory-services/
publications/sec-swap-reporting-and-disclosure.jhtml''.
PwC Financial Services Regulatory Practice, February,
2015.
[77] Joint Press Statement of Leaders on Operating Principles
and Areas of Exploration in the Regulation of the CrossBorder OTC Derivatives Market; 2012-251. Sec.gov.
December 4, 2012. Retrieved March 5, 2013.
[78] Derivatives: A rst take on cross-border com(PDF).
http://www.pwc.com/us/en/
parability
financial-services/regulatory-services/publications/
dodd-frank-cftc-derivatives.jhtml, December, 2013.
[79] DTCCs Global Trade Repository for OTC Derivatives
(GTR)". Dtcc.com. Retrieved March 5, 2013.
[80] U.S. DTCC says barriers hinder full derivatives picture.
Reuters. February 12, 2013. Retrieved March 5, 2013.
[81] Release, Press (August 5, 2010). Derivatives trades will
be tracked by Depository Trust. Futuresmag.com. Retrieved March 5, 2013.

Lins Lemke (20132014). Soft Dollars and Other


Trading Activities. Thomson West.
Institute for Financial Markets (2011). Futures and
Options (2nd ed.). Washington, D.C.: Institute for
Financial Markets. ISBN 978-0-615-35082-0.
John C. Hull (2011). Options, Futures and Other
Derivatives (8th ed.). Harlow: Pearson Education.
ISBN 978-0-13-260460-4.
Michael Durbin (2011). All About Derivatives (2nd
ed.). New York: McGraw-Hill. ISBN 978-0-07174351-8.
Mehraj Mattoo (1997). Structured Derivatives: New
Tools for Investment Management: A Handbook of
Structuring, Pricing & Investor Applications. London: Financial Times. ISBN 978-0-273-61120-2.
Andrei N. Soklakov (2013). Elasticity Theory of
Structuring (PDF).
Andrei N. Soklakov (2013). Deriving Derivatives.

5.1.22 External links


Understanding Derivatives: Markets and Infrastructure (Federal Reserve Bank of Chicago)
Derivatives simple guide, BBC News
European Union proposals on derivatives regulation 2008 onwards
" Derivatives Regulatory Roulette, PwC Financial
Services Regulatory Practice (December 2013)

Chapter 6

Finance of states
6.1 Public nance
Public nance is the study of the role of the government
in the economy.[1] It is the branch of economics which
assesses the government revenue and government expenditure of the public authorities and the adjustment of one
or the other to achieve desirable eects and avoid undesirable ones.[2]

sector programs should be designed to maximize social


benets minus costs (cost-benet analysis), and then revenues needed to pay for those expenditures should be
raised through a taxation system that creates the fewest
eciency losses caused by distortion of economic activity
as possible. In practice, government budgeting or public
budgeting is substantially more complicated and often results in inecient practices.

Government can pay for spending by borrowing (for example, with government bonds), although borrowing is a
method of distributing tax burdens through time rather
than a replacement for taxes. A decit is the dierence
between government spending and revenues. The accumulation of decits over time is the total public debt.
Decit nance allows governments to smooth tax burdens
6.1.1 Overview
over time, and gives governments an important scal polThe proper role of government provides a starting point icy tool. Decits can also narrow the options of successor
for the analysis of public nance. In theory, under cer- governments.
tain circumstances, private markets will allocate goods Public nance is closely connected to issues of income
and services among individuals eciently (in the sense distribution and social equity. Governments can realthat no waste occurs and that individual tastes are match- locate income through transfer payments or by designing with the economys productive abilities). If private ing tax systems that treat high-income and low-income
markets were able to provide ecient outcomes and if households dierently.
the distribution of income were socially acceptable, then
The public choice approach to public nance seeks to exthere would be little or no scope for government. In many
plain how self-interested voters, politicians, and bureaucases, however, conditions for private market eciency
crats actually operate, rather than how they should operare violated. For example, if many people can enjoy the
ate.
same good at the same time (non-rival, non-excludable
consumption), then private markets may supply too little
of that good. National defense is one example of non- 6.1.2 Public nance management
rival consumption, or of a public good.
The purview of public nance is considered to be
threefold: governmental eects on (1) ecient allocation of resources, (2) distribution of income, and (3)
macroeconomic stabilization.

"Market failure" occurs when private markets do not allocate goods or services eciently. The existence of
market failure provides an eciency-based rationale for
collective or governmental provision of goods and services. Externalities, public goods, informational advantages, strong economies of scale, and network eects can
cause market failures. Public provision via a government
or a voluntary association, however, is subject to other
ineciencies, termed "government failure.
Under broad assumptions, government decisions about
the ecient scope and level of activities can be eciently
separated from decisions about the design of taxation systems (Diamond-Mirlees separation). In this view, public

Collection of sucient resources from the economy in


an appropriate manner along with allocating and use of
these resources eciently and eectively constitute good
nancial management. Resource generation, resource allocation and expenditure management (resource utilization) are the essential components of a public nancial
management system.
Public Finance Management (PFM) basically deals with
all aspects of resource mobilization and expenditure
management in government. Just as managing nances
is a critical function of management in any organization, similarly public nance management is an essential part of the governance process. Public nance man-

64

6.1. PUBLIC FINANCE


agement includes resource mobilization, prioritization of
programmes, the budgetary process, ecient management of resources and exercising controls. Rising aspirations of people are placing more demands on nancial
resources. At the same time, the emphasis of the citizenry is on value for money, thus making public nance
management increasingly vital. The following subdivisions form the subject matter of public nance.
1. Public expenditure
2. Public revenue

65
that have suered a loss due to natural disaster.
Likewise, public pension programs transfer wealth
from the young to the old. Other forms of government expenditure which represent purchases of
goods and services also have the eect of changing
the income distribution. For example, engaging in
a war may transfer wealth to certain sectors of society. Public education transfers wealth to families
with children in these schools. Public road construction transfers wealth from people that do not use the
roads to those people that do (and to those that build
the roads).

3. Public debt

Income Security

4. Financial administration

Employment insurance

5. Federal nance

Health Care

6.1.3

Government expenditures

Main article: Government spending

Public nancing of campaigns

6.1.4 Financing of government expenditures

Economists classify government expenditures into three


main types. Government purchases of goods and services
for current use are classed as government consumption.
Government purchases of goods and services intended to
create future benets such as infrastructure investment
or research spending are classed as government investment. Government expenditures that are not purchases
of goods and services, and instead just represent transfers of money such as social security payments are
called transfer payments.[3]
Budgeted revenues of governments in 2006.

Government operations

Main article: Government revenue

Main article: Government operations


Government operations are those activities involved in the
running of a state or a functional equivalent of a state (for
example, tribes, secessionist movements or revolutionary
movements) for the purpose of producing value for the
citizens. Government operations have the power to make,
and the authority to enforce rules and laws within a civil,
corporate, religious, academic, or other organization or
group.[4]

Government expenditures are nanced primarily in three


ways:
Government revenue
Taxes
Non-tax revenue (revenue from governmentowned corporations, sovereign wealth funds,
sales of assets, or seigniorage)
Government borrowing

Income distribution
Main article: Income distribution
See also: Redistribution (economics)
Income distribution Some forms of government
expenditure are specically intended to transfer income from some groups to others. For example,
governments sometimes transfer income to people

Printing of Money or ination


How a government chooses to nance its activities can
have important eects on the distribution of income
and wealth (income redistribution) and on the eciency
of markets (eect of taxes on market prices and eciency). The issue of how taxes aect income distribution is closely related to tax incidence, which examines
the distribution of tax burdens after market adjustments

66
are taken into account. Public nance research also analyzes eects of the various types of taxes and types of
borrowing as well as administrative concerns, such as tax
enforcement.
Taxes
Main article: Tax
Taxation is the central part of modern public nance. Its
signicance arises not only from the fact that it is by far
the most important of all revenues but also because of
the gravity of the problems created by the present day tax
burden.[5] The main objective of taxation is raising revenue. A high level of taxation is necessary in a welfare
State to fulll its obligations. Taxation is used as an instrument of attaining certain social objectives i.e. as a
means of redistribution of wealth and thereby reducing
inequalities. Taxation in a modern Government is thus
needed not merely to raise the revenue required to meet
its ever-growing expenditure on administration and social
services but also to reduce the inequalities of income and
wealth. Taxation is also needed to draw away money that
would otherwise go into consumption and cause ination
to rise.[6]
A tax is a nancial charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state (for example, tribes, secessionist movements or revolutionary movements). Taxes could also be
imposed by a subnational entity. Taxes consist of direct
tax or indirect tax, and may be paid in money or as corve
labor. A tax may be dened as a pecuniary burden laid
upon individuals or property to support the government
[ . . .] a payment exacted by legislative authority.[7]
A tax is not a voluntary payment or donation, but an
enforced contribution, exacted pursuant to legislative authority and is any contribution imposed by government
[ . . .] whether under the name of toll, tribute, tallage,
gabel, impost, duty, custom, excise, subsidy, aid, supply,
or other name.[8]

CHAPTER 6. FINANCE OF STATES


Gift tax
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,
unincorporated associations, etc.)
Debt
Main article: Government debt
Governments, like any other legal entity, can take out
loans, issue bonds and make nancial investments. Government debt (also known as public debt or national debt)
is money (or credit) owed by any level of government;
either central or federal government, municipal government or local government. Some local governments issue
bonds based on their taxing authority, such as tax increment bonds or revenue bonds.
As the government represents the people, government
debt can be seen as an indirect debt of the taxpayers. Government debt can be categorized as internal debt, owed
to lenders within the country, and external debt, owed
to foreign lenders. Governments usually borrow by issuing securities such as government bonds and bills. Less
creditworthy countries sometimes borrow directly from
commercial banks or international institutions such as the
International Monetary Fund or the World Bank.

Most government budgets are calculated on a cash basis, meaning that revenues are recognized when collected
and outlays are recognized when paid. Some consider all
government liabilities, including future pension payments
and payments for goods and services the government has
contracted for but not yet paid, as government debt. This
approach is called accrual accounting, meaning that obli There are various types of taxes, broadly divided gations are recognized when they are acquired, or acinto two heads direct (which is proportional) and crued, rather than when they are paid. This constitutes
public debt.
indirect tax (which is dierential in nature):
Stamp duty, levied on documents
Excise tax (tax levied on production for sale, or sale,
of a certain good)

Seigniorage

Main article: Seigniorage


Sales tax (tax on business transactions, especially the
sale of goods and services)
Seigniorage is the net revenue derived from the issuing
of currency. It arises from the dierence between the
Value added tax (VAT) is a type of sales tax
face value of a coin or bank note and the cost of produc Services taxes on specic services
ing, distributing and eventually retiring it from circula Road tax; Vehicle excise duty (UK), Registration tion. Seigniorage is an important source of revenue for
Fee (USA), Regco (Australia), Vehicle Licensing some national banks, although it provides a very small
proportion of revenue for advanced industrial countries.
Fee (Brazil) etc.

6.1. PUBLIC FINANCE


Public nance through state enterprise
Further information: State-owned enterprise
Public nance in centrally planned economies has
diered in fundamental ways from that in market
economies. Some state-owned enterprises generated
prots that helped nance government activities. The
government entities that operate for prot are usually
manufacturing and nancial institutions, services such as
nationalized healthcare do not operate for a prot to keep
costs low for consumers. The Soviet Union relied heavily on turnover taxes on retail sales. Sales of natural resources, and especially petroleum products, were an important source of revenue for the Soviet Union.

67
ily non market goods and services and the redistribution
of income and wealth, with both activities supported
mainly by compulsory levies on other sectors. The GFSM
2001 disaggregates the general government into subsectors: central government, state government, and local
government (See Figure 1). The concept of general government does not include public corporations. The general government plus the public corporations comprise
the public sector (See Figure 2).

In market-oriented economies with substantial state enterprise, such as in Venezuela, the state-run oil company
PSDVA provides revenue for the government to fund its
operations and programs that would otherwise be prot
for private owners. In various mixed economies, the revenue generated by state-run or state-owned enterprises
are used for various state endeavors; typically the revenue
generated by state and government agencies goes into a Figure 1: General Government (IMF Government Finance
sovereign wealth fund. An example of this is the Alaska Statistics Manual 2001(Washington, 2001) pp.13
Permanent Fund and Singapores Temasek Holdings.
Various market socialist systems or proposals utilize revenue generated by state-run enterprises to fund social dividends, eliminating the need for taxation altogether.

6.1.5

Government Finance Statistics and


Methodology

Macroeconomic data to support public nance economics


are generally referred to as scal or government nance
statistics (GFS). The Government Finance Statistics Manual 2001 (GFSM 2001) is the internationally accepted
methodology for compiling scal data. It is consistent with regionally accepted methodologies such as the
European System of Accounts 1995 and consistent with
Figure 2: Public Sector(IMF Government Finance Statistics
the methodology of the System of National Accounts Manual 2001(Washington, 2001) pp.15
(SNA1993) and broadly in line with its most recent update, the SNA2008.
The general government sector of a nation includes all
non-private sector institutions, organisations and activities. The general government sector, by convention, inMeasuring the public sector
cludes all the public corporations that are not able to cover
and, therefore, are
The size of governments, their institutional composition at least 50% of their costs by sales,
[9]
considered
non-market
producers.
and complexity, their ability to carry out large and sophisticated operations, and their impact on the other sectors In the European System of Accounts,[10] the sector genof the economy warrant a well-articulated system to mea- eral government has been dened as containing:
sure government economic operations.
The GFSM 2001 addresses the institutional complexity
of government by dening various levels of government.
The main focus of the GFSM 2001 is the general government sector dened as the group of entities capable of implementing public policy through the provision of primar-

All institutional units which are other non-market


producers whose output is intended for individual
and collective consumption, and mainly nanced by
compulsory payments made by units belonging to
other sectors, and/or all institutional units princi-

68

CHAPTER 6. FINANCE OF STATES


pally engaged in the redistribution of national income and wealth.[9]

Therefore, the main functions of general government


units are :

general government is responsible for the management of the institutional unit, for the payment or approval of the level of the contributions and of the
benets, independent of its role as a supervisory
body or employer.

The GFSM 2001 framework is similar to the nancial


accounting of businesses. For example, it recommends
that governments produce a full set of nancial statements including the statement of government operations
(akin to the income statement), the balance sheet, and a
cash ow statement. Two other similarities between the
GFSM 2001 and business nancial accounting are the
recommended use of accrual accounting as the basis of
recording and the presentations of stocks of assets and
liabilities at market value. It is an improvement on the
prior methodology Government Finance Statistics Man to produce goods and services to satisfy households ual 1986 based on cash ows and without a balance
needs (e.g. state health care) or to collectively meet sheet statement.
the needs of the whole community (e.g. defence,
public order and safety).[9]
Users of GFS
to organise or redirect the ows of money, goods and
services or other assets among corporations, among
households, and between corporations and households; in the purpose of social justice, increased efciency or other aims legitimised by the citizens; examples are the redistribution of national income and
wealth, the corporate income tax paid by companies
to nance unemployment benets, the social contributions paid by employees to nance the pension
systems;

The general government sector, in the European System


The GFSM 2001 recommends standard tables including
of Accounts, has four sub-sectors:
standard scal indicators that meet a broad group of users
including policy makers, researchers, and investors in
1. central government
sovereign debt. Government nance statistics should offer data for topics such as the scal architecture, the mea2. state government
surement of the eciency and eectiveness of government expenditures, the economics of taxation, and the
3. local government
structure of public nancing. The GFSM 2001 provides a
blueprint for the compilation, recording, and presentation
4. social security funds
of revenues, expenditures, stocks of assets, and stocks
of liabilities. The GFSM 2001 also denes some indiCentral government[11] consists of all administrative cators of eectiveness in governments expenditures, for
departments of the state and other central agencies whose example the compensation of employees as a percentage
responsibilities cover the whole economic territory of a of expense. The GFSM 2001 includes a functional clascountry, except for the administration of social security sication of expense as dened by the Classication of
Functions of Government (COFOG) .
funds.

Social security fund[14] is a central, state or local institutional unit whose main activity is to provide social
benets. It fulls the two following criteria:

This functional classication allows policy makers to analyze expenditures on categories such as health, education,
social protection, and environmental protection. The nancial statements can provide investors with the necessary information to assess the capacity of a government
to service and repay its debt, a key element determining
sovereign risk, and risk premia. Like the risk of default
of a private corporation, sovereign risk is a function of
the level of debt, its ratio to liquid assets, revenues and
expenditures, the expected growth and volatility of these
revenues and expenditures, and the cost of servicing the
debt. The governments nancial statements contain the
relevant information for this analysis.

by law or regulation (except those about government employees), certain population groups must
take part in the scheme and have to pay contributions;

The governments balance sheet presents the level of the


debt; that is the governments liabilities. The memorandum items of the balance sheet provide additional information on the debt including its maturity and whether it
is owed to domestic or external residents. The balance

State government[12] is dened as the separate institutional units that exercise some government functions below those units at central government level and above
those units at local government level, excluding the administration of social security funds.
Local government[13] consists of all types of public administration whose responsibility covers only a local part
of the economic territory, apart from local agencies of
social security funds.

6.1. PUBLIC FINANCE


sheet also presents a disaggregated classication of nancial and non-nancial assets.

69

[6] http://budget.ap.gov.in/es2k_pf.htm
[7] Blacks Law Dictionary, p. 1307 (5th ed. 1979).

These data help estimate the resources a government can


potentially access to repay its debt. The statement of op- [8] Id.
erations (income statement) contains the revenue and
expense accounts of the government. The revenue ac- [9] General Government sector, Eurostat glossary
counts are divided into subaccounts, including the dierent types of taxes, social contributions, dividends from [10] ESA95, paragraph 2.68
the public sector, and royalties from natural resources.
Finally, the interest expense account is one of the neces- [11] Central government, Eurostat glosssary
sary inputs to estimate the cost of servicing the debt.
[12] State government, Eurostat glosssary
Fiscal Data Using the GFSM 2001 Methodology

[13] Local government, Eurostat glosssary


[14] Social security fund, Eurostat glosssary

GFS can be accessible through several sources. The International Monetary Fund publishes GFS in two publications: International Financial Statistics and the Govern6.1.8 References
ment Finance Statistics Yearbook. The World Bank gathers information on external debt. On a regional level, the
Anthony B. Atkinson and Joseph E. Stiglitz (1980).
Organization for Economic Co-operation and DevelopLectures in Public Economics, McGraw-Hill Ecoment (OECD) compiles general government account data
nomics Handbook Series
for its members, and Eurostat, following a methodology
compatible with the GFSM 2001, compiles GFS for the
Alan S. Blinder, Robert M. Solow, et al. (1974).
members of the European Union.
The Economics of Public Finance, Brookings Institution. Table of Contents.

6.1.6

See also

Constitutional economics
Eciency dividend
Fiscal incidence
Government budget
Henry George Theorem
Personal nance
Public economics
Public choice

6.1.7

Notes

[1] Gruber, Jonathan (2005). Public Finance and Public Policy. New York: Worth Publications. p. 2. ISBN 0-71678655-9.
[2] Jain, P C (1974). The Economics of Public Finance.
[3] Robert Barro and Vittorio Grilli (1994), European
Macroeconomics, Ch. 1516. Macmillan, ISBN 0-33357764-7.

James M. Buchanan, ([1967] 1987). Public Finance


in Democratic Process: Fiscal Institutions and Individual Choice, UNC Press. Description, scrollable
preview, back cover, and chapter links via Econlib.
_____ and Richard A. Musgrave (1999). Public Finance and Public Choice: Two Contrasting Visions
of the State, MIT Press. Description and scrollable
preview links.
Richard A. Musgrave, 1959. The Theory of Public
Finance: A Study in Public Economy, McGraw-Hill.
1st-page reviews of J.M. Buchanan & C.S. Shoup .
_____ (2008). public nance, The New Palgrave
Dictionary of Economics, 2nd Edition. Abstract.
_____ and Peggy B. Musgrave (1973). Public Finance in Theory and Practice, McGraw-Hill.
Richard A. Musgrave and Alan T. Peacock, ed.
([1958] 1994). Classics in the Theory of Public Finance, Palgrave Macmillan. Description and
contents.

[4] Columbia Encyclopedia, Government'

Joseph E. Stiglitz (2000). Economics of the Public


Sector, 3rd ed. Norton. Description.

[5] C. E. Bohanon, J. B. Horowitz and J. E. McClure


(September 2014). Saying Too Little, Too Late: Public
Finance Textbooks and the Excess Burdens of Taxation.
Econ Journal Watch 11 (3): 277296. Retrieved November 2014.

Greene, Joshua E (2011). Public Finance: An International Perspective. Hackensack, New Jersey:
World Scientic. p. 500. ISBN 978-981-4365-048.

70

6.1.9

CHAPTER 6. FINANCE OF STATES

External links

Higgs, Robert (2008). "http://www.econlib.org/


library/Enc/GovernmentGrowth.html". In David
R. Henderson (ed.). Concise Encyclopedia of
Economics (2nd ed.). Indianapolis: Library of
Economics and Liberty. ISBN 978-0865976658.
OCLC 237794267.
Seater, John J. (2008). Government Debt and
Decits. In David R. Henderson (ed.). Concise
Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 9780865976658. OCLC 237794267.
Taxation and Public Finance course at the Harris
School of Public Policy Studies
State and Local Public Finance course at the Harris
School of Public Policy Studies
IMF Dissemination Standards Bulletin Board
Subscribing ... (see scal sector)
The IMFs Public Financial Management Blog
Other Public Financing Resource
US Debt Clock.org Real Time U.S. Debt Clock
Canadian Governments Compared

Chapter 7

Financial economics
7.1 Financial economics

Present value, expectation and utility

Financial economics is the branch of economics characterized by a concentration on monetary activities, in


which money of one type or another is likely to appear
on both sides of a trade.[1] Its concern is thus the interrelation of nancial variables, such as prices, interest rates
and shares, as opposed to those concerning the real economy. It has two main areas of focus: asset pricing (or
investment theory) and corporate nance; the rst being the perspective of providers of capital and the second
of users of capital.
The subject is concerned with the allocation and deployment of economic resources, both spatially and across
time, in an uncertain environment.[2] It therefore centers on decision making under uncertainty in the context of the nancial markets, and the resultant economic
and nancial models and principles, and is concerned
with deriving testable or policy implications from acceptable assumptions. It is built on the foundations of
microeconomics and decision theory.
Financial econometrics is the branch of nancial economics that uses econometric techniques to parameterise
these relationships. Mathematical nance is related in
that it will derive and extend the mathematical or numerical models suggested by nancial economics. Note
though that the emphasis there is mathematical consistency, as opposed to compatibility with economic theory.

Underlying all of nancial economics are the concepts of


present value and expectation. Present value is developed
in an early book on compound interest by Richard Witt
(Arithmetical Questions (1613)). These ideas were further developed by Johan de Witt and Edmond Halley.
Combining probabilities with present value leads to the
expected value criterion which sets asset value as a function of the sizes of the expected payouts and the probabilities of their occurrence. These ideas originate with
Blaise Pascal and Pierre de Fermat. Various inconsistencies observed, such as the St. Petersburg paradox, suggested that valuation is instead subjective and must incorporate Utility. Here, the Expected utility hypothesis
states that, if certain axioms are satised, the subjective
value associated with a gamble by an individual is that individuals statistical expectation of the valuations of the
outcomes of that gamble. See also; Ellsburg paradox;
Risk aversion; Risk premium
Arbitrage-free pricing and equilibrium

The concepts of arbitrage-free Rational pricing and


equilibrium are then coupled with these to derive classical nancial economics. Rational pricing is the assumption in nancial economics that asset prices (and hence
asset pricing models) will reect the arbitrage-free price
of the asset, as any deviation from this price will be arFinancial economics is usually taught at the postgrad- bitraged away. This assumption is useful in pricing xed
uate level; see Master of Financial Economics. Re- income securities, particularly bonds, and is fundamental
cently, specialist undergraduate degrees are oered in the to the pricing of derivative instruments.
discipline.[3]
Where market prices do not allow for protable arbitrage,
i.e. comprise an arbitrage-free market, so these prices
are also said to constitute an arbitrage equilibrium. Intuitively, this may be seen by considering that where an
arbitrage opportunity does exist, then prices can be ex7.1.1 Underlying economics
pected to change, and are, therefore, not in equilibrium.
As above, the discipline essentially explores how rational An arbitrage equilibrium is thus a precondition for a geninvestors would apply decision theory to the problem of eral economic equilibrium. See Fundamental theorem of
investment. The subject is thus built on the foundations of asset pricing.
microeconomics and decision theory, and derives several General equilibrium deals with the behavior of supply,
key results for the application of decision making under demand, and prices in a whole economy with several or
uncertainty to the nancial markets.
many interacting markets, by seeking to prove that a set of
71

72

CHAPTER 7. FINANCIAL ECONOMICS

prices exists that will result in an overall equilibrium (this


is in contrast to partial equilibrium, which only analyzes
single markets.) Further specialized is the ArrowDebreu
model which suggests that, under certain economic conditions, there must be a set of prices such that aggregate supplies will equal aggregate demands for every commodity
in the economy. The analysis here is often undertaken
assuming a Representative agent.
State prices
Ecient Frontier. The hyperbola is sometimes referred to as the

Originating from the ArrowDebreu model is the concept 'Markowitz Bullet', and its upward sloped portion is the ecient
of a state price security (also called an Arrow-Debreu frontier if no risk-free asset is available. With a risk-free asset,
the straight line is the ecient frontier.
security), a contract that agrees to pay one unit of a
numeraire (a currency or a commodity) if a particular
state occurs at a particular time in the future and pays
zero numeraire in all the other states. The price of this
security is the state price of this particular state of the
world, which may be represented by a vector. The state
price vector is the vector of state prices for all states. As
such, any derivatives contract whose settlement value is a
function of an underlying whose value is uncertain at contract date can be decomposed as a linear combination of
its Arrow-Debreu securities, and thus as a weighted sum
of its state prices. Analogously, for a continuous random
variable indicating a continuum of possible states, the
value is found by integrating over the state price density;
see Stochastic discount factor. These concepts are extended to Martingale pricing and the related Risk-neutral
measure.

7.1.2

Resultant models

ModiglianiMiller Proposition II with risky debt. As leverage


(D/E) increases, the WACC (k0) stays constant.

Security market line: the representation of the CAPM displaying


the expected rate of return of an individual security as a function
of its systematic, non-diversiable risk.

Simulated geometric Brownian motions with parameters from


market data.

els, the questions addressed are typically framed in terms


Applying the above economic concepts, we may then de- of time, uncertainty, options, and information,[1] as will
rive various economic- and nancial models and princi- be seen below.
ples. As above, the two usual areas of focus are Asset
pricing and corporate nance, the rst being the perspec Time: money now is traded for money in the future.
tive of providers of capital, the second of users of capital.
Uncertainty (or risk): The amount of money to be
Here, and for (almost) all other nancial economics mod-

7.1. FINANCIAL ECONOMICS

73
the BlackScholesMerton theory (BSM; often, simply
Black-Scholes) for option pricing an arbitrage-free result.

Binomial Lattice with CRR formulae

transferred in the future is uncertain.


Options: one party to the transaction can make a
decision at a later time that will aect subsequent
transfers of money.
Information: knowledge of the future can reduce, or
possibly eliminate, the uncertainty associated with
future monetary value (FMV).

Briey, and intuitively - and consistent with #Arbitragefree pricing and equilibrium above - the linkage is as
follows.[11] If prices of nancial assets are (broadly) correct, i.e. ecient, then deviations from these (equilibrium) values could not last for long; correspondingly,
prices would be expected to change (only) on the arrival
of new information:[12] the Random walk hypothesis. Under these conditions investors can then be assumed to act
rationally: their investment decision must be calculated
or a loss is sure to follow. Also, where an arbitrage opportunity presents itself, then investors will exploit it, reinforcing this equilibrium. Here, as under the certaintycase above, the specic assumption as to pricing is that
prices are calculated as the present value of expected future dividends,[12] as based on currently available information. What is required though is a theory for determining the appropriate discount rate given this uncertainty:
this is provided by the MPT and its CAPM. Relatedly, rationality in the sense of arbitrage-exploitation gives
rise to Black-Scholes; option values here ultimately consistent with the CAPM.

Applying this framework, with the above concepts, leads


to the required models. This derivation begins with the In general, then, while portfolio theory studies how inassumption of no uncertainty and is then expanded to vestors should balance risk and return when investing in
incorporate the other considerations.
many assets or securities, the CAPM is more focused, describing how in equilibrium markets set the prices
of assets in relation to how risky they are. The theory
Certainty
demonstrates that if one can construct an ecient frontier
(introduced by Harry Markowitz) then mean-variance efA starting point here is Investment under certainty. The
cient portfolios can be formed simply as a combination
Fisher separation theorem, asserts that the objective of a
of holdings of the risk-free asset and the Market portfolio,
corporation will be the maximization of its present value,
a particular ecient fund; this principle being the Mutual
regardless of the preferences of its shareholders. The
fund separation theorem. Combining these, any asset
Theory of Investment Value (John Burr Williams) promay then be priced independent of the investors utility
poses that the value of an asset should be calculated usfunction. See also: Security characteristic line; Security
ing evaluation by the rule of present worth. Thus, for
market line; Capital allocation line; Capital market line;
a common stock, the intrinsic, long-term worth is the
Sharpe ratio; Jensens alpha; Portfolio optimization.
present value of its future net cash ows, in the form
of dividends. The Modigliani-Miller theorem describes Black-Scholes provides a mathematical model of a nanconditions under which corporate nancing decisions are cial market containing derivative instruments, and the reirrelevant for value, and acts as a benchmark for evaluat- sultant formula for the price of European-styled options.
ing the eects of factors outside the model that do aect The BlackScholes equation is a partial dierential equation describing the price of the option over time. The key
value.
nancial insight behind the equation is that one can perIt will be noted that these certainty theorems are all
fectly hedge the option by buying and selling the underlycommonly employed under corporate nance (see coming asset in just the right way and consequently eliminate
ments under Corporate nance#Quantifying uncertainty
risk. This hedge, in turn, implies that there is only one
and Financial modeling#Accounting); uncertainty is the
right price in an arbitrage-free sense for the option.
focus of asset pricing models, as follows.
Then, assuming log-normal, geometric Brownian motion,
we may derive the BlackScholes option pricing formula,
which will return the correct option price. This pricing
Uncertainty
is without reference to the shares expected return, and
For choice under uncertainty, the twin assumptions hence entails (assumes) risk neutrality; relatedly, thereof rationality and market eciency lead to modern fore, the pricing formula may also be derived directly via
portfolio theory (MPT) with its Capital asset pricing risk neutral expectation. See Brownian model of nancial
model (CAPM) an equilibrium-based result and to markets.

74

CHAPTER 7. FINANCIAL ECONOMICS

As mentioned, it can be shown that the two models are


consistent; then, as is to be expected, classical nancial
economics is thus unied. Here, the Black Scholes equation may alternatively be derived from the CAPM, and
the price obtained from the Black-Scholes model is thus
consistent with the expected return from the CAPM.[13]
The Black-Scholes theory, although built on Arbitragefree pricing, is therefore consistent with the equilibrium
based capital asset pricing. Both models, in turn, are ultimately consistent with the Arrow-Debreu theory, and
may be derived via state-pricing,[14] further explaining,
and if required demonstrating, this unity.

7.1.3

Extensions

inuence the options underlying; Models for Employee


stock option valuation explicitly assume non-rationality
on the part of option holders; Credit derivatives allow that
payment obligations / delivery requirements might not be
honored. Exotic derivatives are now routinely valued.
Note that Real Options theory is also an extension of
corporate nance theory: asset-valuation and decisioning here no longer need assume certainty. Relatedly,
as discussed above, Monte Carlo methods in nance, introduced by David B. Hertz in 1964, allow nancial analysts to construct "stochastic" or probabilistic corporate
nance models, as opposed to the traditional static and
deterministic models; see Corporate nance#Quantifying
uncertainty. Other extensions here include [16] Agency
theory, which analyses the diculties in motivating corporate management (the agent) to act in the best interests of shareholders (the principal), rather than in their
own interests. Clean surplus accounting and the related
Residual income valuation provide a model that returns
price as a function of earnings, expected returns, and
change in book value, as opposed to dividends. This approach, to some extent, arises due to the implicit contradiction of seeing value as a function of dividends, while
also holding that dividend policy cannot inuence value
per Modigliani and Millers Irrelevance principle; see
Dividend policy#Irrelevance of dividend policy.

More recent work further generalizes and / or extends


these models. Multi-factor models such as the Fama
French three-factor model and the Carhart four-factor
model, propose factors other than market return as relevant in pricing. The Intertemporal CAPM, Black
Litterman model, and arbitrage pricing theory similarly
extend modern portfolio theory. The Single-index model
is a more simple asset pricing model than the CAPM. It
assumes, only, a correlation between security and market returns, without (numerous) other economic assumptions. It is useful in that it simplies the estimation of correlation between securities, signicantly reducing the inputs for building the correlation matrix required for port7.1.4
folio optimization. See also: Post-modern portfolio theory; Mathematical nance#Risk and portfolio management: the P world.

Challenges and criticism

As regards derivative pricing, the Binomial options pricing model provides a discretized version of BlackScholes, useful for the valuation of American styled options; discretized models of this type are built using stateprices (as above), while exotic derivatives although modeled in continuous time via Monte Carlo methods for option pricing are also priced using risk neutral expected
value. Various other numeric techniques have also been
developed. The theoretical framework too has been extended such that Martingale pricing is now the standard
approach. Since the work of Breeden and Litzenberger
in 1978,[15] a large number of researchers have used options to extract ArrowDebreu prices for a variety of applications in nancial economics. Developments relating
to complexities in return and / or volatility are discussed
below; see also Mathematical nance#Derivatives pricImplied volatility surface. The Z-axis represents implied volatility
ing: the Q world.
in percent, and X and Y axes represent the option delta, and the

Derivative models for various other underlyings and ap- days to maturity.
plications have also been developed, all departing from
the same logic. Beginning with Oldrich Vasicek, various Short rate models, as well as the HJM and BGM
See
also:
Capital
asset
pricing
forward rate-based techniques, allow for an extension to
model#Problems of CAPM; Modern portxed income- and interest rate derivatives. (The Vasicek
BlackScholes
folio theory#Criticisms;
and CIR models are equilibrium-based, while HoLee
model#Criticism;
Financial mathematand subsequent models are based on arbitrage-free pricics#Criticism; List of unsolved problems in
ing.) Real options valuation allows that option holders can
economics#Financial economics;.[17]

7.1. FINANCIAL ECONOMICS


As seen, a common assumption is that nancial decision makers act rationally; see Homo economicus. However, recently, researchers in experimental economics
and experimental nance have challenged this assumption empirically. These assumptions are also challenged
theoretically, by behavioral nance, a discipline primarily concerned with the limits to rationality of economic
agents.

75
distributed are fundamental. Empirical evidence, however, suggests that these assumptions may not hold (see
Kurtosis risk, Skewness risk, Long tail) and that in practice, traders, analysts and particularly risk managers frequently modify the standard models (see Model risk).
In fact, Benot Mandelbrot had discovered already in the
1960s that changes in nancial prices do not follow a
Gaussian distribution, the basis for much option pricing theory, although this observation was slow to nd
its way into mainstream nancial economics. Financial
models with long-tailed distributions and volatility clustering have been introduced to overcome problems with
the realism of classical nancial models; jump diusion
models allow for (option) pricing incorporating jumps
in the spot price. Risk managers, similarly, complement (or substitute) the standard value at risk models
with Historical simulations, volatility clustering, mixture
models, Principal component analysis and extreme value
theory.[20] For further discussion see Fat-tailed distribution#Applications in economics.

Consistent with, and complementary to these ndings,


various persistent market anomalies have been documented, these being price and/or return distortions (e.g.
size premiums) which appear to contradict the ecientmarket hypothesis; calendar eects are the best known
group here. Related to these are various of the Economic
puzzles, concerning phenomena similarly contradicting
the theory. The equity premium puzzle, as one example, arises in that the dierence between the observed
returns on stocks as compared to government bonds is
consistently higher than the risk premium rational equity
investors should demand, an "abnormal return". For further context see Random walk hypothesis#A non-random Closely related is the Volatility smile, where implied
walk hypothesis, and sidebar for specic instances.
volatility is observed to dier as a function of strike price
Areas of research attempting to explain (or at least (i.e. moneyness). The term structure of volatility demodel) these phenomena include noise trading, market scribes how (implied) volatility diers for related options
microstructure, and Heterogeneous agent models. The with dierent maturities; an implied volatility surface is
latter is extended to Agent-based computational eco- a three-dimensional surface plot of volatility smile and
nomics, where price is treated as an emergent phe- term structure. These empirical phenomena negate the
nomenon, resulting from the interaction of the various assumption of constant volatility and log-normality
market participants (agents). The Noisy market hypoth- upon which Black-Scholes is built. See BlackScholes
model#The volatility smile. Approaches developed here
esis argues that prices can be inuenced by speculators
and momentum traders, as well as by insiders and institu- in response include Local volatility and Stochastic volatility (the Heston, SABR and CEV models, amongst othtions that often buy and sell stocks for reasons unrelated to
fundamental value; see Noise (economic). The adaptive ers). Alternatively, implied-binomial and -trinomial trees
instead of directly modelling volatility, return a lattice
market hypothesis is an attempt to reconcile the ecient
market hypothesis with behavioral economics, by apply- consistent with in an arbitrage-free sense (all) observed prices, facilitating the pricing of other, i.e. noning the principles of evolution to nancial interactions.
An information cascade, alternatively, shows market par- quoted, strike/maturity combinations. Edgeworth binoticipants engaging in the same acts as others ("Herd be- mial trees allow for a specied (i.e. non-Gaussian) skew
havior"), despite contradictions with their private infor- and kurtosis in the spot price. Priced here, options with
mation. See also George Soros' approach: #Reexivity, diering strikes will return diering implied volatilities, and the tree can thus be calibrated to the smile if
nancial markets, and economic theory.
required.[21] Similarly purposed closed-form models inOn the obverse, various studies have shown that despite clude: Jarrow and Rudd (1982); Corrado and Su (1996);
these departures from eciency, asset prices do typi- Backus, Foresi, and Wu (2004).[22]
cally exhibit a random walk and that one cannot therefore
consistently outperform market averages.[18] The practi- Particularly following the nancial crisis of 20072010,
cal implication, therefore, is that passive investing (e.g. nancial economics and mathematical nance have been
via low-cost index funds) should, on average, serve better subjected to criticism; notable here is Nassim Nicholas
than any other active strategy.[19] Burton Malkiel's A Ran- Taleb, who claims that the prices of nancial assets candom Walk Down Wall Street - rst published in 1973, and not be characterized by the simple models currently in
in its 12th edition as of 2015 - is a widely read populariza- use, rendering much of current practice at best irrelevant, and, at worst, dangerously misleading; see Black
tion of these arguments. Note also that institutionally inherent limits to arbitrage as opposed to factors directly swan theory, Taleb distribution. A topic of general interest studied in recent years has thus been nancial
contradictory to the theory are sometimes proposed as
[23]
and the failure of (Financial) Economics to
crises,
an explanation for these departures from eciency.
model these. See also Financial Modelers Manifesto;
As above, the assumptions that market prices follow a Physics envy; Unreasonable ineectiveness of mathematrandom walk and / or that asset returns are normally ics#Economics and nance.

76

7.1.5

CHAPTER 7. FINANCIAL ECONOMICS

See also

Category:Finance theories

[12] Shiller, Robert J. (2003). From Ecient Markets Theory to Behavioral Finance (PDF). Journal of Economic
Perspectives 17 (1 (Winter 2003)): 83104.

Category:Financial economists

[13] Don M. Chance. Option Prices and Expected Returns

Deutsche Bank Prize in Financial Economics

[14] See Rubinstein parts IVa and IVb, under External links.

Financial modeling

[15] Breeden, Douglas T.; Litzenberger, Robert H. (1978).


Prices of State-Contingent Claims Implicit in Option Prices. Journal of Business 51 (4): 621651.
doi:10.1086/296025. JSTOR 2352653.

Fischer Black Prize


List of unsolved problems in economics#Financial
economics
Outline of economics
Outline of nance

7.1.6

References

[1] Financial Economics. Stanford.edu. Retrieved 200908-06.


[2] Robert C. Merton - Nobel Lecture (PDF). Retrieved
2009-08-06.
[3] e.g.: Kent; City London; UC Riverside; Leicester;
Toronto; UMBC
[4] JEL classication codes Financial economics JEL: G
Subcategories
[5] All
entries
under
JEL:
G:
http://www.
dictionaryofeconomics.com/search_results?,q=&field=
content&edition=all&topicid=G
[6] The New Palgrave Dictionary of Economics Online:
Search results
[7] The New Palgrave Dictionary of Economics Online:
Search results
[8] The New Palgrave Dictionary of Economics Online:
Search results
[9] The New Palgrave Dictionary of Economics Online:
Search results
[10] In particular by clicking to Advanced searches from
http://www.dictionaryofeconomics.com/, which brings
up http://www.dictionaryofeconomics.com/advanced_
search, drilling to the secondary category, then to the
tertiary category, followed by clicking the Search button
at the bottom. For example, from secondary code JEL:
http://www.dictionaryofeconomics.com/search_
G0,
results?,q=&field=content&edition=all&topicid=G0,
then to the JEL: G00, then pressing the
Search button to bring up the entry links at
http://www.dictionaryofeconomics.com/search_results?
q=&field=content&edition=all&topicid=G00.
[11] For a more formal treatment, see, for example: Eugene F. Fama. 1965. Random Walks in Stock Market
Prices. Financial Analysts Journal, September/October
1965, Vol. 21, No. 5: 55-59.

[16] See Jensen and Smith under External links, as well as


Rubinstein under Bibliography..
[17] What We Do Not Know: 10 Unsolved Problems in Finance, by Brealey, Myers and Allen, under External
Links
[18] William F Sharpe, The Arithmetic of Active Management
[19] William F. Sharpe, Indexed Investing: A Prosaic Way to
Beat the Average Investor. May 1, 2002. Retrieved May
20, 2010.
[20] III.A.3 in Carol Alexander, ed. The Professional Risk
Managers Handbook:A Comprehensive Guide to Current
Theory and Best Practices. PRMIA Publications (January
2005). ISBN 978-0976609704
[21] See for example Pg 217 of: Jackson, Mary; Mike Staunton
(2001). Advanced modelling in nance using Excel and
VBA. New Jersey: Wiley. ISBN 0-471-49922-6.
[22] See: Emmanuel Jurczenko, Bertrand Maillet & Bogdan
Negrea, 2002. Revisited multi-moment approximate
option pricing models: a general comparison (Part 1)".
Working paper, London School of Economics and Political Science.
[23] From The New Palgrave Dictionary of Economics, Online
Editions, 2011, 2012, with abstract links:
regulatory responses to the nancial crisis: an interim
assessment by Howard Davies
Credit Crunch Chronology: April 2007September
2009 by The Statesmans Yearbook team
Minsky crisis by L. Randall Wray
euro zone crisis 2010 by Daniel Gros and Cinzia Alcidi.
Carmen M. Reinhart and Kenneth S. Rogo, 2009.
This Time Is Dierent: Eight Centuries of Financial Folly,
Princeton. Description, ch. 1 (Varieties of Crises and
their Dates, pp. 3-20), and chapter-preview links.

7.1.7 Bibliography
Financial economics
Roy E. Bailey (2005). The Economics of Financial Markets. Cambridge University Press. ISBN
0521612802.

7.1. FINANCIAL ECONOMICS

77

Marcelo Bianconi (2013). Financial Economics,


Risk and Information (2nd Edition). World Scientic. ISBN 9814355135.

Brian Kettell (2002). Economics for Financial Markets. Butterworth-Heinemann. ISBN 978-0-75065384-8.

Zvi Bodie, Robert C. Merton and David Cleeton (2008). Financial Economics (2nd Edition).
Prentice Hall. ISBN 0131856154.

Yvan Lengwiler (2006). Microfoundations of Financial Economics: An Introduction to General Equilibrium Asset Pricing. Princeton University Press.
ISBN 0691126313.

James Bradeld (2007). Introduction to the Economics of Financial Markets. Oxford University
Press. ISBN 978-0-19-531063-4.
Jaka Cvitani and Fernando Zapatero (2004). Introduction to the Economics and Mathematics of
ISBN 978Financial Markets.
MIT Press.
0262033206.
George M. Constantinides, Milton Harris, Ren M.
Stulz (editors) (2003). Handbook of the Economics
of Finance. Elsevier. ISBN 0444513639.
Keith Cuthbertson, Dirk Nitzsche (2004). Quantitative Financial Economics: Stocks, Bonds and Foreign
Exchange. Wiley. ISBN 0470091711.
Jean-Pierre Danthine, John B. Donaldson (2005).
Intermediate Financial Theory (2nd Edition).
Academic Press. ISBN 0123693802.

Stephen F. LeRoy and Jan Werner (2000). Principles of Financial Economics. Cambridge University
Press. ISBN 0521586054.
Leonard C. MacLean, and William T. Ziemba
(2013). Handbook of the Fundamentals of Financial Decision Making. World Scientic. ISBN
9814417343.
Frederic S. Mishkin (2012). The Economics of
Money, Banking, and Financial Markets (3rd Edition). Prentice Hall. ISBN 0132961970.
Harry H. Panjer, ed. (1998). Financial Economics
with Applications. Actuarial Foundation. ISBN
0938959484.
Richard Roll (series editor) (2006). The International Library of Critical Writings in Financial Economics. Cheltenham: Edward Elgar Publishing.

Louis Eeckhoudt, Christian Gollier, Harris


Schlesinger (2005).
Economic and Financial
Decisions Under Risk. Princeton University Press. Asset pricing
ISBN 978-0-691-12215-1.
Kerry E. Back (2010). Asset Pricing and Portfo Jrgen Eichberger and Ian R. Harper (1997). Filio Choice Theory. Oxford University Press. ISBN
nancial Economics. Oxford University Press. ISBN
0195380614.
0198775407.
Frank J. Fabozzi, Edwin H. Neave and Guofu
Zhou (2011). Financial Economics. Wiley. ISBN
0470596201.

Tomas Bjrk (2009). Arbitrage Theory in Continuous Time (3rd Edition). Oxford University Press.
ISBN 019957474X.

Christian Gollier (2004). The Economics of Risk


and Time (2nd Edition). MIT Press. ISBN 978-0262-57224-8.

John H. Cochrane (2005). Asset Pricing. Princeton


University Press. ISBN 0691121370.

Thorsten Hens and Marc Oliver Rieger (2010). Financial Economics: A Concise Introduction to Classical and Behavioral Finance. Springer. ISBN
3540361464.
Chi-fu Huang and Robert H. Litzenberger (1998).
Foundations for Financial Economics. Prentice
Hall. ISBN 0135006538.
Jonathan E. Ingersoll (1987). Theory of Financial
Decision Making. Rowman & Littleeld. ISBN
0847673596.
Robert A. Jarrow (1988). Finance theory. Prentice
Hall. ISBN 0133148653.
Chris Jones (2008).
Financial Economics.
Routledge. ISBN 0415375851.

Darrell Due (2001). Dynamic Asset Pricing Theory (3rd Edition). Princeton University Press. ISBN
069109022X.
Edwin J. Elton, Martin J. Gruber, Stephen J. Brown,
William N. Goetzmann (2014). Modern Portfolio Theory and Investment Analysis (9th Edition).
Wiley. ISBN 1118469941.
Robert A. Haugen (2000). Modern Investment Theory (5th Edition). Prentice Hall. ISBN 0130191701.
Mark S. Joshi, Jane M. Paterson (2013). Introduction to Mathematical Portfolio Theory. Cambridge
University Press. ISBN 1107042313.
David G. Luenberger (2013). Investment Science
(2nd Edition). Oxford University Press. ISBN
0199740089.

78
Harry M. Markowitz (1991). Portfolio Selection:
Ecient Diversication of Investments (2nd Edition). Wiley. ISBN 1557861080.
Frank Milne (2003). Finance Theory and Asset
Pricing (2nd Edition). Oxford University Press.
ISBN 0199261075.
George Pennacchi (2007). Theory of Asset Pricing.
Prentice Hall. ISBN 032112720X.
Mark Rubinstein (2006). A History of the Theory of
Investments. Wiley. ISBN 0471770566.
William F. Sharpe (1999). Portfolio Theory and
Capital Markets: The Original Edition. McGrawHill. ISBN 0071353208.
Corporate nance
Jonathan Berk, Peter DeMarzo (2013). Corporate
Finance (3rd Edition). Pearson. ISBN 0132992477.
Richard Brealey; Stewart Myers; Franklin Allen
(2013). Principles of Corporate Finance. McgrawHill. ISBN 978-0078034763.
Aswath Damodaran (1996). Corporate Finance:
Theory and Practice.
Wiley.
ISBN 9780471076803.
Joo Amaro de Matos (2001). Theoretical Foundations of Corporate Finance. Princeton University
Press. ISBN 9780691087948.
Joseph Ogden, Frank C. Jen, Philip F. O'Connor
(2002). Advanced Corporate Finance. Prentice
Hall. ISBN 978-0130915689.

CHAPTER 7. FINANCIAL ECONOMICS

7.1.8 External links


Theory
The History of Finance: An Eyewitness Account.
Merton H. Miller
Great Moments in Financial Economics I, II, III,
IVa, IVb (archived, 2007-06-27). Prof. Mark Rubinstein, Haas School of Business
The Scientic Evolution of Finance (archived,
2003-04-03). Prof. Don Chance, Louisiana State
University, Prof. Pamela Peterson James Madison
University
The Theory of Corporate Finance: A Historical Overview, Michael C. Jensen and Cliord W.
Smith.
Microfoundations of Financial Economics Prof.
Andr Farber, Solvay Business School
An introduction to investment theory, Prof. William
Goetzmann, Yale School of Management
Macro-Investment Analysis. Prof. William F.
Sharpe, Stanford Graduate School of Business
Finance Theory (MIT OpenCourseWare). Prof.
Andrew Lo, MIT.
Financial Theory (Open Yale Courses). Prof. John
Geanakoplos, Yale University.
The Theory of Investment at the Wayback Machine
(archived June 21, 2012). Prof. G.L. Fonseca, New
School for Social Research
An Overview of Modern Financial Economics. Chifu Huang, MIT Working paper

Pascal Quiry, Yann Le Fur, Antonio Salvi, Maurizio


Dallochio, Pierre Vernimmen (2011). Corporate Finance: Theory and Practice (3rd Edition). Wiley.
ISBN 978-1119975588.

Introduction to Financial Economics.


Zitkovi, University of Texas at Austin

Stephen Ross, Randolph Westereld, Jerey Jae


(2012). Corporate Finance (10th Edition). McgrawHill. ISBN 0078034779.

What We Do Know: The Seven Most Important


Ideas in Finance; What We Do Not Know: 10 Unsolved Problems in Finance, Richard A. Brealey,
Stewart Myers and Franklin Allen.

An Introduction to Asset Pricing Theory, Junhui


Qian, Shanghai Jiao Tong University

Joel M. Stern, ed. (2003). The Revolution in Corporate Finance (4th Edition). Wiley-Blackwell. ISBN
Links and portals
9781405107815.
Jean Tirole (2006). The Theory of Corporate
ISBN
Finance.
Princeton University Press.
0691125562.
Ivo Welch (2014). Corporate Finance (3rd Edition).
ISBN 978-0-9840049-1-1.

Gordan

Financial Economics Links on WebEc


JEL Classication Codes Guide
Financial Economics Links on RFE
SSRN Financial Economics Network

7.1. FINANCIAL ECONOMICS


Financial Economics listings on economicsnetwork.ac.uk
Financial Economics Resources on QFINANCE
Actuarial resources
Models for Financial Economics (MFE), Society of
Actuaries
Financial Economics (CT8), Institute and Faculty of
Actuaries
A Primer In Financial Economics, S.F. Whelan,
D.C. Bowie and A.J. Hibbert. British Actuarial
Journal, Volume 8, Issue 01, April 2002, pp 2765.
Pension Actuarys Guide to Financial Economics.
Gordon Enderle, Jeremy Gold, Gordon Latter and
Michael Peskin. Society of Actuaries and American
Academy of Actuaries.

79

Chapter 8

Financial mathematics
8.1 Financial mathematics

Derivatives pricing: the Q world

Mathematical nance, also known as quantitative nance, is a eld of applied mathematics, concerned with
nancial markets. Generally, mathematical nance will
derive and extend the mathematical or numerical models
without necessarily establishing a link to nancial theory, taking observed market prices as input. Mathematical consistency is required, not compatibility with
economic theory. Thus, for example, while a nancial
economist might study the structural reasons why a company may have a certain share price, a nancial mathematician may take the share price as a given, and attempt to use stochastic calculus to obtain the corresponding value of derivatives of the stock (see: Valuation of
options; Financial modeling). The fundamental theorem
of arbitrage-free pricing is one of the key theorems in
mathematical nance, while the BlackScholes equation
and formula are amongst the key results.[1]

Main article: Risk-neutral measure


Further information: BlackScholes model, Brownian
model of nancial markets and Martingale pricing
The goal of derivatives pricing is to determine the fair
price of a given security in terms of more liquid securities whose price is determined by the law of supply and
demand. The meaning of fair depends, of course, on
whether one considers buying or selling the security. Examples of securities being priced are plain vanilla and
exotic options, convertible bonds, etc.
Once a fair price has been determined, the sell-side trader
can make a market on the security. Therefore, derivatives
pricing is a complex extrapolation exercise to dene the
current market value of a security, which is then used by
the sell-side community. Quantitative derivatives pricing
was initiated by Louis Bachelier in The Theory of Speculation (published 1900), with the introduction of the most
basic and most inuential of processes, the Brownian motion, and its applications to the pricing of options. Bachelier modeled the time series of changes in the logarithm
of stock prices as a random walk in which the short-term
changes had a nite variance. This causes longer-term
changes to follow a Gaussian distribution.[3]

Mathematical nance also overlaps heavily with the elds


of computational nance and nancial engineering. The
latter focuses on applications and modeling, often by
help of stochastic asset models (see: Quantitative analyst),
while the former focuses, in addition to analysis, on building tools of implementation for the models. In general,
there exist two separate branches of nance that require
advanced quantitative techniques: derivatives pricing on The theory remained dormant until Fischer Black and
the one hand, and risk- and portfolio management on the Myron Scholes, along with fundamental contributions by
other.[2]
Robert C. Merton, applied the second most inuential
Many universities oer degree and research programs in process, the geometric Brownian motion, to option pricmathematical nance; see Master of Mathematical Fi- ing. For this M. Scholes and R. Merton were awarded
the 1997 Nobel Memorial Prize in Economic Sciences.
nance.
Black was ineligible for the prize because of his death in
1995.[4]
The next important step was the fundamental theorem of
asset pricing by Harrison and Pliska (1981), according
to which the suitably normalized current price P0 of a
There exist two separate branches of nance that re- security is arbitrage-free, and thus truly fair, only if there
quire advanced quantitative techniques: derivatives pric- exists a stochastic process Pt with constant expected value
ing, and risk and portfolio management. One of the main which describes its future evolution:[5]
dierences is that they use dierent probabilities, namely
the risk-neutral probability (or arbitrage-pricing probability), denoted by Q, and the actual (or actuarial) probaA process satisfying (1) is called a martingale. A marbility, denoted by P.

8.1.1

History: Q versus P

80

8.1. FINANCIAL MATHEMATICS


tingale does not reward risk. Thus the probability of the
normalized security price process is called risk-neutral
and is typically denoted by the blackboard font letter " Q
".
The relationship (1) must hold for all times t: therefore
the processes used for derivatives pricing are naturally set
in continuous time.
The quants who operate in the Q world of derivatives pricing are specialists with deep knowledge of the specic
products they model.

81
With time, the mathematics has become more sophisticated. Thanks to Robert Merton and Paul Samuelson,
one-period models were replaced by continuous time,
Brownian-motion models, and the quadratic utility function implicit in meanvariance optimization was replaced
by more general increasing, concave utility functions.[6]
Furthermore, in more recent years the focus shifted toward estimation risk, i.e., the dangers of incorrectly
assuming that advanced time series analysis alone can
provide completely accurate estimates of the market
parameters.[7]

Securities are priced individually, and thus the problems


in the Q world are low-dimensional in nature. Calibration is one of the main challenges of the Q world: once a
continuous-time parametric process has been calibrated
to a set of traded securities through a relationship such
as (1), a similar relationship is used to dene the price of
new derivatives.

Much eort has gone into the study of nancial markets


and how prices vary with time. Charles Dow, one of the
founders of Dow Jones & Company and The Wall Street
Journal, enunciated a set of ideas on the subject which are
now called Dow Theory. This is the basis of the so-called
technical analysis method of attempting to predict future
changes. One of the tenets of technical analysis is that
The main quantitative tools necessary to handle market trends give an indication of the future, at least in
continuous-time Q-processes are Its stochastic calculus the short term. The claims of the technical analysts are
disputed by many academics.
and partial dierential equations (PDEs).
Risk and portfolio management: the P world

8.1.2 Criticism

Risk and portfolio management aims at modeling the statistically derived probability distribution of the market
prices of all the securities at a given future investment
horizon.
This real probability distribution of the market prices
is typically denoted by the blackboard font letter " P ",
as opposed to the risk-neutral probability " Q " used in
derivatives pricing.
Based on the P distribution, the buy-side community
takes decisions on which securities to purchase in order
to improve the prospective prot-and-loss prole of their
positions considered as a portfolio.

See also: Financial economics #Challenges and criticism


and Financial models with long-tailed distributions and
volatility clustering
Over the years, increasingly sophisticated mathematical
models and derivative pricing strategies have been developed, but their credibility was damaged by the nancial
crisis of 20072010.
Contemporary practice of mathematical nance has been
subjected to criticism from gures within the eld notably
by Paul Wilmott and Nassim Nicholas Taleb, a professor
of nancial engineering at Polytechnic Institute of New
York University, in his book The Black Swan.[8] Taleb
claims that the prices of nancial assets cannot be characterized by the simple models currently in use, rendering
much of current practice at best irrelevant, and, at worst,
dangerously misleading. Wilmott and Emanuel Derman
published the Financial Modelers Manifesto in January
2008[9] which addresses some of the most serious concerns.
Bodies such as the Institute for New Economic Thinking are now attempting to develop new theories and
methods.[10]

The quantitative theory of risk and portfolio management started with the mean-variance framework of Harry
Markowitz (1952), who caused a shift away from the concept of trying to identify the best individual stock for investment. Using a linear regression strategy to understand
and quantify the risk (i.e. variance) and return (i.e. mean)
of an entire portfolio of stocks, bonds, and other securities, an optimization strategy was used to choose a portfolio with largest mean return subject to acceptable levels of
variance in the return. Next, breakthrough advances were
made with the Capital Asset Pricing Model (CAPM) and
the arbitrage pricing theory (APT) developed by Treynor
(1962), Mossin (1966), William F. Sharpe (1964), Lint- In general, modeling the changes by distributions with nite variance is, increasingly, said to be inappropriate.[11]
ner (1965) and Ross (1976).
In the 1960s it was discovered by Benot Mandelbrot that
For their pioneering work, Markowitz and Sharpe, along changes in prices do not follow a Gaussian distribution,
with Merton Miller, shared the 1990 Nobel Memo- but are rather modeled better by Lvy alpha-stable distririal Prize in Economic Sciences, for the rst time ever butions.[12] The scale of change, or volatility, depends on
awarded for a work in nance.
the length of the time interval to a power a bit more than
The portfolio-selection work of Markowitz and Sharpe 1/2. Large changes up or down are more likely than what
introduced mathematics to investment management. one would calculate using a Gaussian distribution with an

82

CHAPTER 8. FINANCIAL MATHEMATICS

estimated standard deviation. But the problem is that it


does not solve the problem as it makes parametrization
much harder and risk control less reliable.[8]

8.1.3

Mathematical nance articles

See also Outline of nance: Financial mathematics; Mathematical tools; Derivatives


pricing.
Mathematical tools
Derivatives pricing

8.1.4

See also

Computational nance
Quantitative Behavioral Finance
Derivative (nance), list of derivatives topics
Modeling and analysis of nancial markets
Technical analysis
International Swaps and Derivatives Association
Fundamental nancial concepts - topics
Model (economics)
List of nance topics
List of economics topics, List of economists
List of accounting topics
Statistical Finance
Brownian model of nancial markets
Master of Mathematical Finance
Financial economics

8.1.5

Notes

[1] Johnson, Tim. What is nancial mathematics?". +Plus


Magazine. Retrieved 28 March 2014.
[2] Quantitative Finance. About.com. Retrieved 28 March
2014.
[3] Bachelir, Louis. The Theory of Speculation. Retrieved
28 March 2014.
[4] Lindbeck, Assar. The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1969-2007.
Nobel Prize. Retrieved 28 March 2014.
[5] Brown, Angus (1 Dec 2008). A risky business: How to
price derivatives. Price+ Magazine. Retrieved 28 March
2014.

[6] Karatzas, Ioannis; Shreve, Steve (1998). Methods of


Mathematical Finance. Secaucus, NJ, USA: SpringerVerlag New York, Incorporated. ISBN 9780387948393.
[7] Meucci, Attilio (2005). Risk and Asset Allocation.
Springer. ISBN 9783642009648.
[8] Taleb, Nassim Nicholas (2007). The Black Swan: The
Impact of the Highly Improbable. Random House Trade.
ISBN 978-1-4000-6351-2.
[9] Financial Modelers Manifesto. Paul Wilmotts Blog.
January 8, 2009. Retrieved June 1, 2012.
[10] Gillian Tett (April 15, 2010). Mathematicians must get
out of their ivory towers. Financial Times.
[11] Svetlozar T. Rachev, Frank J. Fabozzi, Christian Menn
(2005). Fat-Tailed and Skewed Asset Return Distributions: Implications for Risk Management, Portfolio Selection, and Option Pricing. John Wiley and Sons. ISBN
978-0471718864.
[12] B. Mandelbrot, The variation of certain Speculative
Prices, The Journal of Business 1963

8.1.6 References
Harold Markowitz, Portfolio Selection, Journal of
Finance, 7, 1952, pp. 7791
William F. Sharpe, Investments, Prentice-Hall, 1985
Attilio Meucci, P versus Q: Dierences and Commonalities between the Two Areas of Quantitative Finance, GARP Risk Professional, February 2011, pp.
4144
Nicole El Karoui, The Future of Financial Mathematics, ParisTech Review, September 2013

Chapter 9

Experimental nance
9.1 Experimental nance

9.1.2 Scientic value

The goals of experimental nance are to understand human and market behavior in settings relevant to nance.
Experiments are synthetic economic environments created by researchers specically to answer research questions. This might involve, for example, establishing different market settings and environments to observe experimentally and analyze agents behavior and the resulting characteristics of trading ows, information diusion and aggregation, price setting mechanism and returns
processes.

Financial economics has one of the most detailed and updated observational data available of all branches of economics. Consequently, nance is characterized by strong
empirical traditions. Lots of analysis is done on data from
stock exchanges including bids, asks, transaction prices,
volume, etc. There is also data available from information
services on actions and events that may inuence markets.
Data from these sources is not able to report on expectations, on which theory of nancial markets is built. In
experimental markets the researcher is able to know expectations, and control fundamental values, trading institutions, and market parameters such as available liquidity
and the total stock of the asset. This gives the researcher
the ability to know the price and other predictions of
alternative theories. This creates the opportunity to do
powerful tests on the robustness of theories which were
not possible from eld data, since there is little knowledge
on the parameters and expectations from eld data.[7]

Fields to which experimental methods have been applied include corporate nance, asset pricing, nancial econometrics, international nance, personal nancial decision-making, macro-nance, banking and nancial intermediation, capital markets, risk management
and insurance, derivatives, quantitative nance, corporate governance and compensation, investments, market
mechanisms, SME and micronance and entrepreneurial
nance.[1] Researchers in experimental nance can study
to what extent existing nancial economics theory makes
9.1.3 Advantages
valid predictions and attempt to discover new principles
on which theory can be extended.
Financial data analysis is based on data drawn from setExperimental nance is a branch of experimental eco- tings created for a purpose other than answering a spenomics and its most common use lies in the eld of cic research question. This results in the situation where
behavioral nance.
any interpretation of the results may be challenged since
it ignores other variables that have changed. Traditional
data analysis issues include omitted-variables biases, selfselection biases, unobservable independent variables, and
unobservable dependent variables.[8]

9.1.1

Properly designed experiments are able to avoid these


problems:[8]

History

In 1948, Chamberlin reported results of the rst market experiment.[2] Since then the acceptability, recognition, role, and methods of experimental economics
have evolved. From the early 1980s on a similar pattern emerged in experimental nance.[3] The foundational
work in experimental nance was the work of Forsythe,
Palfrey and Plott (1980),[4] Plott and Sunder (1982),[5]
and Smith, Suchanek and Williams (1988).[6]

Avoid omitted-variables biases


Multiple experiments can be created with settings that
dier from one another in exactly one independent variable. This way all other variables of the setting are controlled, which eliminates alternative explanations for observed dierences in the dependent variable.

83

84

CHAPTER 9. EXPERIMENTAL FINANCE

Avoid self-selection problems

Natural experiments

A natural experiment happens when some feature of the


real world is randomly changed which allows using the
exogenous variation due to this change to study causal
eects of an otherwise endogenous explanatory variable.
Natural experiments are popular in economic and nance
research since they oer intuitive interpretation of the underlying identifying assumptions and enable a broader audience to check their consistency, this compared to purely
Avoid problems of unobservable independent vari- statistical identication.[9]
ables
By randomly assigning subjects to dierent treatment
groups, the experimenters avoid issues caused by selfselection and are able to directly observe the changes in
the dependent variable by changing by altering certain independent variables.

Experimentalists can create experimental settings themselves. This makes them able to observe all variables.
Traditional data analysis may not be able to observe some
variables, but sometimes experimenters cannot directly
elicit certain information from subjects either. Without
directly knowing a certain independent variable, good
experimental design can create measures that to a large
extent reects the unobservable independent variable and
the problem is therefore avoided.

9.1.5 Main ndings

Experimental methods in nance oer complementary


methodologies that have allowed for the observation and
manipulation of underlying determinants of prices, such
as fundamental values or insider information. Experimental studies complement empirical work, particularly
in the area of theory testing and development. Exploiting
this experimental methodology has revealed some important ndings over the past years. These ndings could not
have been reached by traditional eld data analysis alone
and are therefore experimental nances main contribuAvoid problems of unobservable dependent variables
tions to the eld of nance:[7][10]
In traditional data studies, extracting the cause for the dependent variable to change may prove to be dicult. Experimentalists have the ability to create certain tasks that
elicit the dependent variable.

9.1.4

Types of experiments

Laboratory experiments
Laboratory experiments are the most common form of
experimentation. Here the idea is to construct a highly
controlled setting in a laboratory.[8] The use of lab experiments increased due to growing interest in issues such as
economic cooperation, trust, and neuroeconomics.[9] In
this type of experiments, treatment is assigned randomly
to a group of individuals in order to compare their economic actions and behavior to an untreated control group
within the articial laboratory environment. The ability
to control the variables in the experiment provides for
more accurate assessment of causality.[8]

Controlled eld studies or randomized eld experiments


Controlled eld experiments also randomize treatments
but do so in real world applications. Average eects on
peoples behavior can then be consistently estimated by
comparing behavior before and after the allocation.[9]

Security markets can aggregate and disseminate information (there are ecient markets), but this process is less eective as the information becomes less
widely held and the number of information components that must be aggregated increases.
But this is not always the case (some of them are
inecient).
When information dissemination occurs, it is rarely
perfect or instantaneous. Learning takes time.
More information is not always better from the point
of view of the individual trader. Only those insiders who are much better informed than others can
outperform other traders.
Markets for longer-lived assets have a strong tendency to generate price bubbles and crashes, prolonged deviations from fundamental values.
Emotions of traders play a role in generating bubbles
in experimental asset markets.
Asset mispricing has been largely associated with
trader overcondence.
Prices as well as bids, oers, timing, etc., convey information. There are many channels for information
ow.
Well-functioning derivative markets can help to improve primary markets eciency.

9.1. EXPERIMENTAL FINANCE


Statistical eciency or inability to make money us- 9.1.8 External links
ing past data does not mean informational eciency.
Society for Experimental Finance (SEF)
Not being able to earn abnormal returns from the
market does not mean that the price is right.

9.1.6

See also

Experimental economics
Behavioral economics
Game theory

9.1.7

References

[1] Lucey, Brian M. (August 26, 2013). A New Journal Journal of Behavioral and Experimental Finance. http://brianmlucey.wordpress.com/2013/08/26/
a-new-journal-journal-of-behavioral-and-experimental-finance/
[2] Chamberlin, Edward H. (1948). An Experimental Imperfect Market. Journal of Political Economy, 56(2), 95108.
[3] Sunder, Shyam.
(June, 2013).
Experimental Finance:
Responsibilities of Coming of
Age.
Society for Experimental Finance,
Tilburg University,
Tilburg,
The Netherlands.
http://faculty.som.yale.edu/shyamsunder/Research/
Experimental%20Economics%20and%20Finance/
Presentations%20and%20Working%20Papers/
Tilburg-Jun2013/SEFAddressTilburgJune2013.ppt
[4] Forsythe, R., Palfrey, T. and Plott, C. R. (1982). Asset
Valuation in an Experimental Market. Econometrica,
50(3), 537-568.
[5] Plott, C. R. and Sunder, S. (1982). Eciency of Experimental Security Markets with Insider Information: An
Application of Rational Expectations Models, Journal of
Political Economy, 90(4), 663-698.
[6] Smith, V. L., Suchanek, G. and Williams, A. (1988).
Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets, Econometrica, 56(5),
1119-1151.
[7] Sunder, Shyam. (2007). What have we learned
from experimental nance?". Developments on Experimental Economics. Springer Berlin Heidelberg.
http://link.springer.com/chapter/10.1007/
91-100.
978-3-540-68660-6_6#
[8] Bloomeld, Robert and Anderson, Alyssa. Experimental
nance. In Baker, H. Kent, and Nofsinger, John R., eds.
Behavioral nance: investors, corporations, and markets.
Vol. 6. John Wiley & Sons, 2010. pp. 113-131. ISBN
978-0470499115
[9] Sauter, Wolf N. (2010). Essays on Natural Experiments
in Behavioral Finance and Trade. Doctoral dissertation,
Ludwig-Maximilians University, Mnchen.
[10] Noussair, Charles N. and Tucker, Steven. (2013).
Experimental research on asset pricing. Journal of Economic Surveys, 27(3), 554-569.

85

Chapter 10

Behavioral nance
10.1 Behavioral nance
Behavioral economics and the related eld, behavioral nance, study the eects of psychological, social, cognitive, and emotional factors on the economic
decisions of individuals and institutions and the consequences for market prices, returns, and the resource
allocation.[1] Behavioral economics is primarily concerned with the bounds of rationality of economic
agents. Behavioral models typically integrate insights
from psychology, neuroscience and microeconomic theory; in so doing, these behavioral models cover a range of
concepts, methods, and elds.[2][3] Behavioral economics
is sometimes discussed as an alternative to neoclassical
economics.

Behavioral nance highlights ineciencies such as under or over-reactions to information as causes of market
trends and in extreme cases of bubbles and crashes. Such
reactions have been attributed to limited investor attention, overcondence, overoptimism, mimicry (herding
instinct) and noise trading. Technical analysts consider
behavioral nance, to be behavioral economics academic cousin and to be the theoretical basis for technical
analysis.[6]

Other key observations include the asymmetry between


decisions to acquire, or keep resources, known as the
bird in the bush paradox, and loss aversion, the unwillingness to let go of a valued possession. Loss aversion
appears to manifest itself in investor behavior as a reluctance to sell shares or other equity, if doing so would
[7]
The study of behavioral economics includes how market result in a nominal loss. It may also help explain why
decisions are made and the mechanisms that drive public housing prices rarely/slowly decline to market clearing
choice. The use of Behavioral economics in U.S. schol- levels during periods of low demand.
arly papers has increased in the past few years as a recent Benartzi and Thaler (1995), applying a version of
study shows.[4]
prospect theory, claim to have solved the equity premium
[5] puzzle, something conventional nance models have been
There are three prevalent themes in behavioral nances:
unable to do so far.[8] Experimental nance applies the
experimental method, e.g., creating an articial market
Heuristics: People often make decisions based on
by some kind of simulation software to study peoples
approximate rules of thumb and not strict logic.
decision-making process and behavior in nancial mar Framing:
The collection of anecdotes and kets.
stereotypes that make up the mental emotional
lters individuals rely on to understand and respond
Quantitative behavioral nance Quantitative behavto events.
ioral nance uses mathematical and statistical method Market ineciencies: These include mis-pricings ology to understand behavioral biases. In marketing research, a study shows little evidence that escalating biand non-rational decision making.
ases impact marketing decisions.[9] Leading contributors
include Gunduz Caginalp (Editor of the Journal of Be10.1.1 Issues
havioral Finance from 20012004) and collaborators including 2002 Nobelist Vernon Smith, David Porter, Don
Behavioral nance
Balenovich,[10] Vladimira Ilieva and Ahmet Duran,[11]
and Ray Sturm.[12]
The central issue in behavioral nance is explaining
why market participants make irrational systematic errors
contrary to assumption of rational market participants.[1] Financial models
Such errors aect prices and returns, creating market ineciencies. It also investigates how other participants Some nancial models used in money management and
take advantage (arbitrage) of such errors and market in- asset valuation incorporate behavioral nance parameeciencies.
ters, for example:
86

10.1. BEHAVIORAL FINANCE

87

Thalers model of price reactions to informa- and social preferences.[22][23] As a research program, the
tion, with three phases, underreaction-adjustment- subject is a development of the last three decades.[24]
overreaction, creating a price trend
One characteristic of overreaction is that average returns following announcements of good
news is lower than following bad news. In other
words, overreaction occurs if the market reacts
too strongly or for too long to news, thus requiring adjustment in the opposite direction. As a
result, outperforming assets in one period are
likely to underperform in the following period.
This also applies to customers irrational purchasing habits.[13]
The stock image coecient
Criticisms Critics such as Eugene Fama typically support the ecient-market hypothesis. They contend that
behavioral nance is more a collection of anomalies than
a true branch of nance and that these anomalies are either quickly priced out of the market or explained by
appealing to market microstructure arguments. However, individual cognitive biases are distinct from social
biases; the former can be averaged out by the market,
while the other can create positive feedback loops that
drive the market further and further from a "fair price"
equilibrium. Similarly, for an anomaly to violate market eciency, an investor must be able to trade against it
and earn abnormal prots; this is not the case for many
anomalies.[14]

Economic reasoning in non-human animals


A handful of comparative psychologists have attempted
to demonstrate economic reasoning in non-human animals. Early attempts along these lines focus on the behavior of rats and pigeons. These studies draw on the
tenets of comparative psychology, where the main goal is
to discover analogs to human behavior in experimentallytractable non-human animals. They are also methodologically similar to the work of Ferster and Skinner.[25]
Methodological similarities aside, early researchers in
non-human economics deviate from behaviorism in their
terminology. Although such studies are set up primarily in an operant conditioning chamber, using food rewards for pecking/bar-pressing behavior, the researchers
describe pecking and bar pressing not in terms of
reinforcement and stimulusresponse relationships, but
instead in terms of work, demand, budget, and labor. Recent studies have adopted a slightly dierent approach,
taking a more evolutionary perspective, comparing economic behavior of humans to a species of non-human
primate, the capuchin monkey.[26]

Non-human animal studies Many early studies of


non-human economic reasoning were performed on rats
and pigeons in an operant conditioning chamber. These
studies looked at things like peck rate (in the case of the
pigeon) and bar-pressing rate (in the case of the rat) given
certain conditions of reward. Early researchers claim,
for example, that response pattern (pecking/bar pressing
rate) is an appropriate analogy to human labor supply.[27]
Researchers in this eld advocate for the appropriateness
of using animal economic behavior to understand the elementary components of human economic behavior.[28] In
a paper by Battalio, Green, and Kagel (1981, p 621),[27]
they write

A specic example of this criticism appears in some explanations of the equity premium puzzle. It is argued that
the cause is entry barriers (both practical and psychological) and that returns between stocks and bonds should
equalize as electronic resources open up the stock market to more traders.[15] In reply, others contend that most
personal investment funds are managed through superannuation funds, minimizing the eect of these putative entry barriers. In addition, professional investors and fund
managers seem to hold more bonds than one would exLabor supply The typical laboratory environment to
pect given return dierentials.
study labor supply in pigeons is set up as follows. Pigeons are rst deprived of food. Since the animals are
Behavioral game theory
hungry, food becomes highly desired. The pigeons are
placed in an operant conditioning chamber and through
Main article: Behavioral game theory
orienting and exploring the environment of the chamber
they discover that by pecking a small disk located on one
Behavioral game theory analyzes interactive strategic side of the chamber, food is delivered to them. In eect,
decisions and behavior using the methods of game pecking behavior becomes reinforced, as it is associated
theory,[16] experimental economics, and experimental with food. Before long, the pigeon pecks at the disk (or
psychology. Experiments include testing deviations stimulus) regularly.
from typical simplications of economic theory such as
the independence axiom[17] and neglect of altruism,[18]
fairness,[19] and framing eects.[20] On the positive side,
the method has been applied to interactive learning[21]

In this circumstance, the pigeon is said to work for the


food by pecking. The food, then, is thought of as the
currency. The value of the currency can be adjusted in
several ways, including the amount of food delivered, the

88

CHAPTER 10. BEHAVIORAL FINANCE

rate of food delivery and the type of food delivered (some now, or wait until the experimenter alters the amount of
foods are more desirable than others).
food presented. In this circumstance, the experimenter
Economic behavior similar to that observed in humans is can either increase or decrease the amount of food given.
discovered when the hungry pigeons stop working/work Thus, this experimental setup allows the researchers to
less when the reward is reduced. Researchers argue that look at the gambling behavior of the animals. The experthis is similar to labor supply behavior in humans. That is imenters can therefore ask the following questions: will
like humans (who, even in need, will only work so much the monkey take the sure amount of food? Will the monfor a given wage) the pigeons demonstrate decreases in key gamble by waiting until the experimenter changes
the amount of food present? Does the decision of the anpecking (work) when the reward (value) is reduced.[27]
imal depend on the circumstances? Results indicate that
the monkeys are risk-averse: they prefer to take the initial
Demand In human economics, a typical demand curve amount of food than wait for the experimenter to change
has negative slope. This means that as the price of a cer- the amount presented.
tain good increases, the amount that consumers are will- The experimenters introduce several other manipulaing to purchase decreases. Researchers studying the de- tions, including changing the allocated budget, changmand curves of non-human animals, such as rats, also nd ing the cost of certain items, changing the items themdownward slopes.
selves. Specically, the researchers found an increase in
Researchers have studied demand in rats in a manner distinct from studying labor supply in pigeons. Specically,
say we have experimental subjects, rats, in an operant
chamber and we require them to press a lever to receive a
reward. The reward can be either food (reward pellets),
water, or a commodity drink such as cherry cola. Unlike previous pigeon studies, where the work analog was
pecking and the monetary analog was reward, in the studies on demand in rats, the monetary analog is bar pressing. Under these circumstances, the researchers claim
that changing the number of bar presses required to obtain a commodity item is analogous to changing the price
of a commodity item in human economics.[29]

item purchase and consumption when that item decreases


in value, a result consistent with those found in human
economics.[26]
Taken together, the results of this study indicate that capuchin monkeys are not only risk-averse, but are also sensitive to constructs such as price, budget, and payo expectation. According to the researchers, the animals are
not trained to behave in this way; these behaviors arise
naturally in the trading environment. As a result, these
researchers argue that basic economic behavior and reasoning might be unlearned, innate, and subject to natural
selection.

In eect, results of demand studies in non-human animals


Evolutionary psychology
are that, as the bar-pressing requirement (cost) increases,
the animal presses the bar the required number of times See also: Evolutionary economics
less often (payment).
Monkey trading behavior Recent work on economic
behavior in non-human animals has focused on capuchin
monkeys. Here the researchers seem less inclined toward
the behaviorist tradition of the laboratory animal-human
behavior analog. Instead, they attempt to adopt a more
evolutionary perspective, positing that economic reasoning might be basic, unlearned, and serve some adaptive
function.
One recent study [26] involves the introduction of a
currency system into a colony of captive capuchin monkeys. The currency is in the form of coins and is redeemable for food and other purchasable items when
exchanged with a researcher. Under these conditions,
the researchers studied three features of monkey trading:
demand, loss aversion, and risk aversion.
In this study, monkeys are presented with an amount of
money and are shown a certain amount of food or other
goods. The monkeys must take the money and hand it
to the experimenter in exchange for goods. In one condition of the experiment, after the monkey has paid for
the goods, it has the option to take a sure amount of food

An evolutionary psychology perspective is that many of


the seeming limitations in rational choice can be explained as being rational in the context of maximizing biological tness in the ancestral environment but not necessarily in the current one. Thus, when living at subsistence level where a reduction of resources may have
meant death it may have been rational to place a greater
value on losses than on gains. It may also explain dierences between groups such as males being less risk-averse
than females since males have more variable reproductive
success than females. While unsuccessful risk-seeking
may limit reproductive success for both sexes, males
may potentially increase their reproductive success much
more than females from successful risk-seeking.[30]

10.1.2 History
During the classical period, microeconomics was closely
linked to psychology. For example, Adam Smith wrote
The Theory of Moral Sentiments, which proposed psychological explanations of individual behavior, including concerns about fairness and justice,[31] and Jeremy

10.1. BEHAVIORAL FINANCE


Bentham wrote extensively on the psychological underpinnings of utility. However, during the development of
neo-classical economics economists sought to reshape the
discipline as a natural science, deducing economic behavior from assumptions about the nature of economic
agents. They developed the concept of homo economicus, whose psychology was fundamentally rational. This
led to unintended and unforeseen errors.
However, many important neo-classical economists employed more sophisticated psychological explanations, including Francis Edgeworth, Vilfredo Pareto, and Irving
Fisher. Economic psychology emerged in the 20th century in the works of Gabriel Tarde,[32] George Katona,[33]
and Laszlo Garai.[34] Expected utility and discounted utility models began to gain acceptance, generating testable
hypotheses about decision making given uncertainty and
intertemporal consumption respectively. Observed and
repeatable anomalies eventually challenged those hypotheses, and further steps were taken by the Nobel
prizewinner Maurice Allais, for example in setting out
the Allais paradox, a decision problem he rst presented
in 1953 which contradicts the expected utility hypothesis.

89
Prospect theory
In 1979, Kahneman and Tversky wrote Prospect theory:
An Analysis of Decision Under Risk, an important paper
that used cognitive psychology to explain various divergences of economic decision making from neo-classical
theory.[37] Prospect theory has two stages, an editing stage
and an evaluation stage.
In the editing stage, risky situations are simplied using various heuristics of choice. In the evaluation phase,
risky alternatives are evaluated using various psychological principles that include the following:
(1) Reference dependence: When evaluating outcomes, the decision maker has in mind a reference
level. Outcomes are then compared to the reference point and classied as gains if greater than
the reference point and losses if less than the reference point.
(2) Loss aversion: Losses bite more than equivalent
gains. In their 1979 paper in Econometrica, Kahneman and Tversky found the median coecient of
loss aversion to be about 2.25, i.e., losses bite about
2.25 time more than equivalent gains.
(3) Non-linear probability weighting: Evidence
indicates that decision makers overweight small
probabilities and underweight large probabilities
this gives rise to the inverse-S shaped probability
weighting function.
(4) Diminishing sensitivity to gains and losses: As
the size of the gains and losses relative to the reference point increase in absolute value, the marginal
eect on the decision makers utility or satisfaction
falls.

Daniel Kahneman, winner of 2002 Nobel prize in economics.

In the 1960s cognitive psychology began to shed more


light on the brain as an information processing device
(in contrast to behaviorist models). Psychologists in this
eld, such as Ward Edwards,[35] Amos Tversky, and
Daniel Kahneman began to compare their cognitive models of decision-making under risk and uncertainty to economic models of rational behavior. In mathematical psychology, there is a longstanding interest in the transitivity
of preference and what kind of measurement scale utility
constitutes (Luce, 2000).[36]

Prospect theory is able to explain everything that the two


main existing decision theories expected utility theory
and rank dependent utility can explain. However, the
converse is false. Prospect theory has been used to explain a range of phenomena that existing decision theories
have great diculty in explaining. These include backward bending labour supply curves, asymmetric price
elasticities, tax evasion, co-movement of stock prices and
consumption etc.
In 1992, in the Journal of Risk and Uncertainty, Kahneman and Tversky gave their revised account of prospect
theory that they called cumulative prospect theory. The
new theory eliminated the editing phase in prospect theory and focused just on the evaluation phase. Its main feature was that it allowed for non-linear probability weighting in a cumulative manner, which was originally suggested in John Quiggins rank dependent utility theory.
Psychological traits such as overcondence, projection
bias, and the eects of limited attention are now part

90

CHAPTER 10. BEHAVIORAL FINANCE

of the theory. Other developments include a conference at the University of Chicago,[38] a special behavioral economics edition of the Quarterly Journal of Economics ('In Memory of Amos Tversky') and Kahnemans 2002 Nobel for having integrated insights from
psychological research into economic science, especially
concerning human judgment and decision-making under
uncertainty.[39]

also likely to suer from lagged responses, search costs,


externalities of the commons,and other frictions making it dicult to disentangle behavioral eects in market
behavior.[40]

Intertemporal choice

Behavioral economics caught on among the general


public, with the success of books like Dan Ariely's
Predictably Irrational. Practitioners of the discipline
have studied quasi-public policy topics such as broadband
mapping.[43][44]

See also: Time inconsistency


Behavioral economics has also been applied to intertemporal choice. Intertemporal choice behavior is largely inconsistent, as exemplied by George Ainslie's hyperbolic
discounting (1975) which is one of the prominently studied observations, further developed by David Laibson,
Ted O'Donoghue, and Matthew Rabin. Hyperbolic discounting describes the tendency to discount outcomes in
near future more than for outcomes in the far future.
This pattern of discounting is dynamically inconsistent
(or time-inconsistent), and therefore inconsistent with basic models of rational choice, since the rate of discount
between time t and t+1 will be low at time t-1, when t is
the near future, but high at time t when t is the present
and time t+1 the near future.

Conditional expected utility is a form of reasoning


where the individual has an illusion of control, and calculates the probabilities of external events and hence utility
as a function of their own action, even when they have no
causal ability to aect those external events.[41][42]

10.1.3 Criticisms
Critics of behavioral economics typically stress the
rationality of economic agents.[45] They contend that experimentally observed behavior has limited application to
market situations, as learning opportunities and competition ensure at least a close approximation of rational behavior.

Others note that cognitive theories, such as prospect theory, are models of decision making, not generalized economic behavior, and are only applicable to the sort of
The pattern can actually be explained through models of once-o decision problems presented to experiment parsubadditive discounting which distinguishes the delay and ticipants or survey respondents.
interval of discounting: people are less patient (per-time- Traditional economists are also skeptical of the experunit) over shorter intervals regardless of when they occur. imental and survey-based techniques which behavioral
Much of the recent work on intertemporal choice indi- economics uses extensively. Economists typically stress
cates that discounting is a constructed preference. Dis- revealed preferences over stated preferences (from surcounting is inuenced greatly by expectations, framing, veys) in the determination of economic value. Experifocus, thought listings, mood, sign, glucose levels, and the ments and surveys are at risk of systemic biases, strategic
scales used to describe what is discounted. Some promi- behavior and lack of incentive compatibility.
nent researchers question whether discounting, the maRabin (1998)[46] dismisses these criticisms, claiming that
jor parameter of intertemporal choice, actually describes
consistent results are typically obtained in multiple situwhat people do when they make choices with future conations and geographies and can produce good theoretical
sequences. Considering the variability of discount rates,
insight. Behavioral economists have also responded to
this may be the case.
these criticisms by focusing on eld studies rather than
lab experiments. Some economists see a fundamental
schism between experimental economics and behavioral
Other areas of research
economics, but prominent behavioral and experimental
Other branches of behavioral economics enrich the model economists tend to share techniques and approaches in
of the utility function without implying inconsistency in answering common questions. For example, behavioral
preferences. Ernst Fehr, Armin Falk, and Matthew Rabin economists are actively investigating neuroeconomics,
studied "fairness", "inequity aversion", and "reciprocal al- which is entirely experimental and cannot yet be veried
truism", weakening the neoclassical assumption of per- in the eld.
fect selshness. This work is particularly applicable to
wage setting. Work on intrinsic motivation by Gneezy
and Rustichini and on identity by Akerlof and Kranton assumes agents derive utility from adopting personal
and social norms in addition to conditional expected utility. According to Aggarwal (2014), in addition to behavioral deviations from rational equilibrium, markets are

Other proponents of behavioral economics note that neoclassical models often fail to predict outcomes in real
world contexts. Behavioral insights can inuence neoclassical models. Behavioral economists note that these
revised models not only reach the same correct predictions as the traditional models, but also correctly predict
some outcomes where the traditional models failed.

10.1. BEHAVIORAL FINANCE

91

According to some researchers,[47] when studying the Psychology


mechanisms that form the basis of decision-making, especially nancial decision-making, it is necessary to rec Dan Ariely[52]
[48]
beognize that most decisions are made under stress
cause, Stress is the nonspecic body response to any
Roy Baumeister
demands presented to it.[49] From a biological point of
view, human behaviors are essentially the same during
Ed Diener
crises accompanied by stock market crashes and during
bubble growth when share prices exceed historic highs.
Ward Edwards
During those periods, most market participants see something new for themselves, and this inevitably induces a
Gerd Gigerenzer
stress response in them with accompanying changes in
their endocrine proles and motivations. The result is
Daniel Kahneman
quantitative and qualitative changes in behavior. An underestimation of the role of novelty as a stressor is the
George Katona
primary shortcoming of current approaches for market
research. So, it is necessary to account for the biologi Steven Lea
cally determined diphasisms of human behavior in everyday low-stress conditions and in response to stressors.[47]
Walter Mischel

10.1.4

Notable theorists

Economics
Uri Gneezy[50]
B. Douglas Bernheim [51]
Colin Camerer
Ernst Fehr
Simon Gchter
Armin Falk
George Loewenstein
Urs Fischbacher
Matthew Rabin
Reinhard Selten
Herbert A. Simon
Vernon L. Smith
Larry Summers
Michael Taillard

Drazen Prelec
Paul Slovic
Amos Tversky
Finance
Malcolm Baker
Nicholas Barberis
Gunduz Caginalp
David Hirshleifer
Andrew Lo
Michael Mauboussin
Terrance Odean
Richard L. Peterson
Charles Plott
Hersh Shefrin
Robert Shiller

Richard Thaler

Andrei Shleifer

John Quiggin

Richard Thaler

Margaret McConne

Robert Vishny

Werner De Bondt

Werner De Bondt

92

10.1.5

CHAPTER 10. BEHAVIORAL FINANCE

See also

10.1.6 Notes

Adaptive market hypothesis

[1] A Behavioral Framework for Securities Risk, Seattle Law


Review, available at: http://ssrn.com/abstract=2040946

Behavioralism

[2] Search of behavioural economics at (2008) The New Palgrave Dictionary of Economics Online.

Behavioral nance
Behavioral operations research
Cognitive bias
Cognitive psychology

[3] Elizabeth A. Minton, Lynn R. Khale (2014). Belief Systems, Religion, and Behavioral Economics. New York:
Business Expert Press LLC. ISBN 978-1-60649-704-3.
[4] http://leconcurrentialiste.com/2014/04/23/
behavioral-economics-in-u-s-antitrust-scholarly-papers/
[5] Shefrin 2002

Conrmation bias

[6] Kirkpatrick 2007, p. 49

Cultural economics

[7] Genesove & Mayer, 2001

Culture change
Economic sociology
Emotional bias

[8] Benartzi 1995


[9] J. Scott Armstrong, Nicole Coviello and Barbara Safranek
(1993). Escalation Bias: Does It Extend to Marketing?"
(PDF). Journal of the Academy of Marketing Science, 21
(3): 247352. doi:10.1177/0092070393213008.

Experimental economics

[10] Dr. Donald A. Balenovich. Indiana University of Pennsylvania, Mathematics Department.

Experimental nance

[11] Ahmet Duran. Department of Mathematics, University


of Michigan-Ann Arbor.

Fuzzy-trace theory

[12] Dr Ray R. Sturm, CPA. College of Business Administration.

Habit (psychology)
Hindsight bias

[13] Tang, David (6 May 2013). Why People Wont Buy Your
Product Even Though Its Awesome. Flevy. Retrieved 31
May 2013.

Homo economicus

[14] Fama on Market Eciency in a Volatile Market

Homo reciprocans

[15] See Freeman, 2004 for a review

Important publications in behavioral nance

[16] R. J. Aumann (2008). game theory, The New Palgrave


Dictionary of Economics, 2nd Edition. Abstract.

Journal of Behavioral Finance


List of cognitive biases
Methodological individualism

[17] Camerer, Colin; Ho, Teck-Hua (March 1994).


Violations of the betweenness axiom and nonlinearity in probability. Journal of Risk and Uncertainty
(Springer) 8 (2): 167196. doi:10.1007/bf01065371.

Neuroeconomics

[18] James Andreoni et al. (2008). altruism in experiments,


The New Palgrave Dictionary of Economics, 2nd Edition.
Abstract.

Observational techniques

[19] H. Peyton Young (2008). social norms, The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.

Praxeology

[20] Camerer, Colin (1997). Progress in behavioral game theory. Journal of Economic Perspectives (Caltech) 11 (4):
172. doi:10.1257/jep.11.4.167. Pdf version.

Rationality
Repugnancy costs
Socioeconomics
Socionomics

[21]

William H. Sandholm (2008). learning and evolution in games: an overview, The New Palgrave
Dictionary of Economics, 2nd Edition. Abstract.
* Teck H. Ho (2008). Individual learning in
games, The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.

10.1. BEHAVIORAL FINANCE

[22] Martin Dufwenberg and Georg Kirchsteiger (2004). A


Theory of Sequential reciprocity, Games and Economic
Behavior, 47(2), pp. 268298. Abstract.
[23]

Faruk Gul (2008). behavioural economics and


game theory, The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
* Colin F. Camerer (2008). behavioral game theory, The New Palgrave Dictionary of Economics,
2nd Edition. Abstract.

[24] Camerer, Colin (2003). Behavioral game theory:


experiments in strategic interaction. New York, New
York Princeton, New Jersey: Russell Sage Foundation Princeton University Press. ISBN 9780691090399.
Description, preview ([ctrl]+), and ch. 1 link.
* _____, George Loewenstein, and Matthew Rabin, ed.
(2003). Advances in Behavioral Economics, Princeton.
19862003 papers. Description, contents, and preview.
* Drew Fudenberg (2006). Advancing Beyond Advances
in Behavioral Economics, Journal of Economic Literature, 44(3), pp. 694711.
* Vincent P. Crawford (1997). Theory and Experiment
in the Analysis of Strategic Interaction, in Advances in
Economics and Econometrics: Theory and Applications,
pp. 206242. Cambridge. Reprinted in Camerer et al.
(2003), Advances in Behavioral Economics, Princeton, ch.
12.
* Martin Shubik (2002). Game Theory and Experimental Gaming, in R. Aumann and S. Hart, ed., Handbook
of Game Theory with Economic Applications, Elsevier, v.
3, pp. 23272351. Abstract.
Charles R. Plott and Vernon L. Smith, ed. (2008).
Handbook of Experimental Economics Results, v. 1, Elsevier, Part 4, Games preview and ch. 4566 preview links.
* Games and Economic Behavior, Elsevier. Aims and
scope.
[25] Ferster, C. B. et al. (1957). Schedules of Reinforcement.
New York: Appleton-Century-Crofts.
[26] Chen, M. K. et al. (2006). How Basic Are Behavioral
Biases? Evidence from Capuchin Monkey Trading Behavior. Journal of Political Economy 114 (3): 517537.
doi:10.1086/503550.
[27] Battalio, R. C. et al. (1981). Income-Leisure Tradeos
of Animal Workers. American Economic Review 71 (4):
621632. JSTOR 1806185.
[28] Kagel, J. H. et al. (1995). Economic Choice Theory: An
Experimental Analysis of Animal Behavior. New York:
Cambridge University Press. ISBN 0-521-45488-3.
[29] Kagel, J. H. et al. (1981). Demand Curves for Animal
Consumers. Quarterly Journal of Economics 96 (1): 1
16. doi:10.2307/2936137.
[30] Paul H. Rubin and C. Monica Capra. The evolutionary psychology of economics. In Roberts, S. C. (2011).
Roberts, S. Craig, ed. Applied Evolutionary Psychology. Oxford University Press. doi:10.1093/acprof:oso/
9780199586073.001.0001. ISBN 9780199586073.
[31] Nava Ashraf, Colin F. Camerer, and George Loewenstein
(2005). Adam Smith, Behavioral Economist, Journal of
Economic Perspectives, 19(3), p. 142. [pp. 131145.

93

[32] Tarde, G. Psychologie conomique (1902),


[33] The Powerful Consumer: Psychological Studies of the
American Economy. 1960.
[34] Garai,L. Identity Economics An Alternative Economic
Psychology. 19902006.
[35] Ward Edward Papers. Archival Collections. Archived
from the original on 16 April 2008. Retrieved 2008-0425.
[36] Luce 2000
[37] Kahneman 2003
[38] Hogarth 1987
[39] Nobel Laureates 2002. Nobelprize.org. Archived from
the original on 10 April 2008. Retrieved 2008-04-25.
[40] Aggarwal, Raj (2014). Animal Spirits in Financial Economics: A Review of Deviations from Economic Rationality. International Review of Financial Analysis 32 (1):
179187. doi:10.1016/j.irfa.2013.07.018.
[41] Grafstein R (1995). Rationality as Conditional Expected
Utility Maximization. Political Psychology 16 (1): 63
80. doi:10.2307/3791450. JSTOR 3791450.
[42] Shar E, Tversky A (1992). Thinking through uncertainty: nonconsequential reasoning and choice. Cognitive Psychology 24 (4): 449474. doi:10.1016/00100285(92)90015-T. PMID 1473331.
[43] US National Broadband Plan: good in theory. Telco
2.0. March 17, 2010. Retrieved 2010-09-23. ... Sara
Wedemans awful experience with this is instructive....
[44] Gordon Cook, Sara Wedeman (July 1, 2009).
Connectivity, the Five Freedoms, and Prosperity.
Community Broadband Networks. Retrieved 201009-23. In this report, Gordon Cook interviews Sara
Wedeman, a mapping expert who also works in behavioral
economics
[45] see Myagkov and Plott (1997) amongst others
[46] Rabin & 1998 1146
[47] Sarapultsev, A., & Sarapultsev, P. (2014). Novelty,
Stress, and Biological Roots in Human Market Behavior. Behavioral Sciences, 4(1), 53-69. doi:10.3390/
bs4010053
[48] Zhukov, D.A. Biologija Povedenija. In Gumoralnye
Mehanizmy [Biology of Behavior. Humoral Mechanisms]; Rech: St.-Petersburg, Russia, 2007
[49] Selye, H. Stress in Health and Disease; Butterworths:
Boston, MA, USA, 1976.
[50] "http://rady.ucsd.edu/faculty/directory/gneezy/".
[51] Bernheim, Douglas;
Rangel,
Behavioural public economics.
Journal of Economics (2).

Antonio (2008).
The New Palgrave

[52] Predictably Irrational. Dan Ariely. Archived from the


original on 13 March 2008. Retrieved 2008-04-25.

94

10.1.7

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References

Ainslie, G. (1975). Specious Reward: A Behavioral /Theory of Impulsiveness and Impulse Control. Psychological Bulletin 82 (4): 463496.
doi:10.1037/h0076860. PMID 1099599.
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Model of Investor Sentiment. Journal of Financial
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20 April 2008. Retrieved 2008-04-25.
Becker, Gary S., Gary S. (1968). Crime and
Punishment: An Economic Approach.
The
Journal of Political Economy 76 (2): 169217.
doi:10.1086/259394.
Benartzi, Shlomo; Thaler, Richard H. (1995). Myopic Loss Aversion and the Equity Premium Puzzle. The Quarterly Journal of Economics (The
MIT Press) 110 (1): 7392. doi:10.2307/2118511.
JSTOR 2118511.
Cunningham, Lawrence A. (2002). Behavioral Finance and Investor Governance. Washington &
Lee Law Review 59: 767. doi:10.2139/ssrn.255778.
ISSN 1942-6658.
Diamond, Peter A., and Hannu Vartiainen, ed.
(2007). Behavioral Economics and its Applications.
Description and preview.
Daniel, K.; Hirshleifer, D.; Subrahmanyam, A.
(1998). Investor Psychology and Security Market
Under- and Overreactions. Journal of Finance 53
(6): 18391885. doi:10.1111/0022-1082.00077.
Garai Laszlo. Identity Economics An Alternative
Economic Psychology. 19902006.
E McGaughey, 'Behavioural Economics and Labour
Law' (2014) SSRN
Hens, Thorsten; Bachmann, Kremena (2008).
Behavioural Finance for Private Banking. Wiley Finance Series. ISBN 0-470-77999-3.
Hogarth, R. M.; Reder, M. W. (1987). Rational
Choice: The Contrast between Economics and Psychology. Chicago: University of Chicago Press.
ISBN 0-226-34857-1.

Kirkpatrick, Charles D.; Dahlquist, Julie R. (2007).


Technical Analysis: The Complete Resource for Financial Market Technicians. Upper Saddle River,
NJ: Financial Times Press. ISBN 0-13-153113-1.
Kuran, Timur (1995). Private Truths, Public Lies:
The Social Consequences of Preference Falsication,
Harvard University Press. Description and chapterpreview links.
Luce, R Duncan (2000). Utility of Gains and
Losses: Measurement-theoretical and Experimental
Approaches. Mahwah, New Jersey: Lawrence Erlbaum Publishers. ISBN 0-8058-3460-5.
The New Palgrave Dictionary of Economics (2008),
2nd Edition. Abstract links:
Augier, Mie. Simon, Herbert A. (19162001).
Bernheim, B. Douglas; Rangel, Antonio.
Behavioral public economics.
Bloomeld, Robert. Behavioral nance.
Simon, Herbert A. Rationality, bounded.
Mullainathan, S.; Thaler, R. H. (2001). Behavioral Economics. International Encyclopedia of
the Social & Behavioral Sciences. pp. 10941100.
Abstract.
Plott, Charles R., and Vernon L. Smith, ed. (2008).
Handbook of Experimental Economics Results, v. 1,
Elsevier. Chapter-preview links.
Rabin, Matthew (1998). Psychology and Economics (PDF). Journal of Economic Literature 36
(1): 1146.
Schelling, Thomas C. (2006 [1978]). Micromotives
and Macrobehavior, Norton. Description, preview.
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Simon, Herbert A. (1987). Behavioral Economics. The New Palgrave: A Dictionary of Economics 1. pp. 22124.
Thaler, Richard H.; Mullainathan, Sendhil (2008).
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10.1.8
Kahneman, Daniel; Ed Diener (2003). Well-being:
the foundations of hedonic psychology. Russell Sage
Foundation.

External links

The Behavioral Economics Guide


Overview of Behavioral Finance

10.1. BEHAVIORAL FINANCE


The Institute of Behavioral Finance
Stirling Behavioural Science Blog, of the Stirling
Behavioural Science Centre at University of Stirling
Society for the Advancement of Behavioural Economics
Behavioral Economics: Past, Present, Future
Colin F. Camerer and George Loewenstein
A History of Behavioural Finance / Economics in
Published Research: 19441988
MSc Behavioural Economics, MSc in Behavioural
Economics at the University of Essex
Behavioral Economics of Shipping Business

95

Chapter 11

Intangible asset nance


11.1 Intangible asset nance
Intangible Asset Finance is the branch of nance that
deals with intangible assets such as patents (legal intangible) and reputation (competitive intangible). Like other
areas of nance, intangible asset nance is concerned
with the interdependence of value, risk, and time.

11.1.1

Basic principles

In 2003, one estimate put the economic equilibrium of


intangible assets in the U.S. economy at $5 trillion, which
represented over one-third or more of the value of U.S.
domestic corporations in the rst quarter of 2001.[1]
One of the goals of people working in this eld is to unlock the hidden value found in intangible assets through
the techniques of nance. Another goal is to measure
how rm performance correlates with intangible asset
management.
Intangible assets include business processes, Intellectual
Property (IP) such as patents, trademarks, reputations
for ethics and integrity, quality, safety, sustainability,
security, and resilience. Today, these intangibles drive
cash ow and are the primary sources of risk. Intangible
asset information, management, risk forecasting and risk
transfer are growing services as the economic base divests
itself of physical assets. Rights to tangible and intangible
assets are intangible, and can be traded globally.[2]

11.1.2

Business models

A number of intangible asset business models have


evolved over the years.
Patent Licensing & Enforcement Companies
(P-LECs): These are rms that acquire patents
for the sole purpose of securing licenses and/or damages awards from infringing parties. Perhaps the
most famous P-LEC is NTP, Inc., which has successfully asserted patents related to email push technology. Another name for a P-LEC is "patent troll,
although this is viewed as a pejorative reference.
96

Recently, hedge funds have raised capital for the


specic purpose of investing in patent litigation.
One such hedge fund is Altitude Capital Partners,
which is based in New York.
Royalty stream securitizers: These are rms that
are engaged in the buying and selling of what
are essentially specialized asset-backed securities.
The assets that are securitized are typically intellectual properties, such as patents, that have been
bearing royalties for a period of time. Royalty
Pharma is a well known rm that uses this business model, and which has done by far the largest
and most high-prole deals in this space.[3] Royalty Pharma handled what many consider to be the
rst pharmaceutical patent-backed securitization to
be rated by Standard and Poors, which involved a
patent on the HIV drug Zerit.[4] The other parties involved in the Zerit transaction were Yale (the owner
of the patent) and Bristol Myers Squibb.
Reinsurers: These are rms that use the techniques
of reinsurance to mitigate intangible asset risks. In
the same way that some rms issue cat bonds to
mitigate the risks associated with extreme weather,
earthquakes, or other natural disasters, rms exposed to substantial intangible risk can issue intangible asset risk-linked securities that transfer intangible risk to hedge funds and other players in
the capital markets with a sucient appetite for
risk. Steel City Re, which is based in Pittsburgh,
is a thought leader regarding the use of risk transfer techniques to protect and recover intangible asset
value.[5]
Market makers: Firms that are working to provide
more liquidity to the market for intellectual property. Early market makers oered on-line intellectual property exchanges where buyers and sellers
could exchange rights in licensed intellectual property, usually patents. On April 22, 2008, Ocean
Tomo reported[6] that it had transacted approximately $70 million in its IP auctions across Europe
and the United States. In 2009, The Intellectual

11.1. INTANGIBLE ASSET FINANCE

97

Property Exchange International (IPXI), headquar- 11.1.4 Government, societies, think tanks,
tered in Chicago, will begin operations as the worlds
and other non-prots
rst stock exchange with an intellectual property focus.
On June 23, 2008, the United States National Academies
hosted a one-day conference in Washington, D.C. enti Investment Research Firms: Companies that pro- tled Intangible Assets: Measuring and Enhancing Their
vide specic advice to investors on intellectual prop- Contribution to Corporate Value and Economic Growth.
erty issues. Recently, hedge fund managers have The Intangible Asset Finance Society provides a forum
been hiring patent attorneys to follow and handicap for nance, innovation, legal and management profesoutcomes in high-stakes patent cases.
sionals to discover better ways to create, capture and preserve the value of intangible assets.

11.1.3

Signicant transactions

The Athena Alliance is a non-prot organization dedicated to public education and research on the emerg 1997: David Bowie securitizes the future royalty ing global information economy. On April 16, 2008 it
revenues earned from his pre-1990 music catalogue published[9] a widely circulated working paper on the
by issuing Bowie Bonds.
topic of intangible asset nance.
2000: BioPharma Royalty Trust completes the $115
million securitization of a single Yale patent with 11.1.5 See also
claims covering Stavudine, which is a reverse transcriptase inhibitor and the active ingredient in the 11.1.6 References
drug Zerit. This was the rst publicly rated patent
securitization in the U.S. At the time of the deal, [1] A Trillion Dollars A Year In Intangible Investment,
Leonard Nakamura in Intangible Assets: Values, MeaBristol Myers Squibb had the exclusive rights to dissures and Risks at 28, Hand & Lev, Oxford University
tribute Zerit in the U.S. Not long after closing slow
Press (2003).
sales of Zerit along with an accounting scandal at
Bristol Myers Squibb triggered the accelerated and [2] Gio Wiederhold; Valuing intangible Capital, Multinationals and Taxhavens; Springer Verlag, 2013.
premature amortization of the transaction. Many
observers believe that this deal was ultimately un[3] A sellers market, The Deal, September 5, 2008
successful because of a lack of diversication as it
[4] Avoiding Transaction Peril, Heller et al., in From Ideas
involved a single patent and a single licensee.
2005: UCC Capital Corporation securitization of
BCBG Max Azria's royalty receivables generated
from worldwide intellectual property rights worth
$53 million. This transaction is recognized as the
rst whole company securitization involving primarily intangible assets. UCC Capital Corporation
was founded by Robert W. D'Loren, and was acquired by NexCen Brands, Inc. in 2006. NexCen
sold substantially all of its assets to Levine Leichtman Capital Partners in 2010.[7]

to Assets: Investing Wisely in Intellectual Property at


487, Bruce Berman, John Wiley & Sons, 2002
[5] Steel City Re
[6] Ocean Tomo Press Release April 22, 2008
[7] NexCen Press Release, May 13, 2010
[8] Ambacs press release, 2006
[9] Intangible Asset Monetization: The Promise and the Reality

2005: Ocean Tomo holds its rst live IP auction. 11.1.7 Further reading
Although proceeds from the rst auction were un Rembrandts In the Attic: Unlocking the Hidden
remarkable, the relative success of the Ocean Tomo
Value of Patents
auctions that followed showed that the live auction
is a reasonably viable business model for monetiz When Balance Sheets Collide With the New Econing intellectual property.
omy, New York Times, September 9, 2007
2006: Marvel Entertainment's lm rights securitization in conjunction with Ambac Financial Group to
provide a triple-A nancial guarantee on a credit facility for Marvel backed by a slate of 10 lms to be
produced by Marvel Studios and intellectual property related to some of Marvels most popular comic
book characters.[8]

IP-Focused Hedge Funds Launch Amid Market


Volatility, Dow Jones, April 29, 2008
Hedge Fund Spies in the Courtroom, IP Law &
Business, May 10, 2007
Intellectual Asset Management Magazine Blog

Chapter 12

Text and image sources, contributors, and


licenses
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Accurizer, Green Giant, Ckatz, 16@r, Beetstra, Noah Salzman, Mr Stephen, Dicklyon, Johnmc, TastyPoutine, Johnchiu, RichardF, Hu12,
Levineps, Iridescent, Veyklevar, Joseph Solis in Australia, Crobb305, UncleDouggie, Courcelles, Tawkerbot2, Albertod4, ChrisCork,
JForget, CRGreathouse, Saileshrh, Scohoust, Argon233, Requestion, MarsRover, No1lakersfan, AndrewHowse, Meighan, Road Wizard,
Derigable, Brillig20, Chuck Marean, Vanished user vjhsduheuiui4t5hjri, Hebrides, Chasingsol, Brahui, Odie5533, Quibik, Codetiger,
Chrislk02, Kozuch, Lo2u, Thijs!bot, Epbr123, Chriscm, CaMpixx, N5iln, Andyjsmith, Headbomb, Streque, Marek69, John254, Crzycheetah, A3RO, Blathnaid, Dawnseeker2000, Smorter, Mentisto, AntiVandalBot, Luna Santin, Doc Tropics, Gregalton, Spencer, JAnDbot,
Barek, MER-C, The Transhumanist, Saklani, Joecool94, Ariaconditzione, Magioladitis, Pedro, Bongwarrior, VoABot II, JamesBWatson,
Suhail Ambrose, Denverprice, Thedrooling, Catgut, Hmu111~enwiki, Finbar Canavan, 28421u2232nfenfcenc, Beagel, Just James, DerHexer, JaGa, Edward321, Rwil02, S3000, Flowanda, CliC, Twigletmac, Mike6271, Notgoogle, Ayonbd2000, LedgendGamer, EdBever,
J.delanoy, OAG~enwiki, Nihilozero, Hiiindwus, FactsAndFigures, Jahredtobin, Shawn in Montreal, Jeepday, Afaber012, Rocket71048576,
Mrg3105, Robertson-Glasgow, KylieTastic, Cometstyles, Glossary, Supergeo, DMCer, Maple626, Andy Marchbanks, Sjforman, Gatesbuett, Squids and Chips, Idioma-bot, Funandtrvl, Spellcast, Deor, CWii, Thomas.W, ABF, Andorin Kato, VasilievVV, Rajankila, TXiKiBoT, Zidonuke, Mercy, CarlAndersOlsson, OverSS, Technopat, SueHay, Anna Lincoln, Pramodpanda, Wordsmith, Abdullais4u, Diovi,
Bearian, BunBun002, Tesfatsion, Hi2539, Urbanrenewal, Madhero88, Jackzavaleta, Nycole365, Roland Kaufmann, Lamro, Ubhudia, Falcon8765, Burntsauce, Mingzhi 86, Sevela.p, AlleborgoBot, Quantpole, Wikinvestor, NHRHS2010, Danyng, SieBot, Work permit, Plinkit,
Caltas, Shanken, RJaguar3, Smsarmad, Balochdude, Bentogoa, Zandergraphics, Steven Zhang, Khvalamde, Techman224, IdreamofJeanie,
OKBot, Msrasnw, Mygerardromance, Yair rand, Yhkhoo, Artman772000, Kortaggio, Denisarona, Ministry of random walks, Martarius, ClueBot, PipepBot, ImperfectlyInformed, Blanchardb, Khmarks, Jackey0105, Kashi0341, Ilyaskvk, Mikigreen, Masterpiece2000,
DragonBot, Excirial, Financeman11, Sun Creator, Goraikkonen, Razorame, Ahd2007, SchreiberBike, Kumar1211, Stepheng3, Torrentweb, NJGW, Apparition11, Vanished user uih38riiw4hjlsd, Kandyman1200, Helixweb, XLinkBot, Ninja247, San rane84, Jovianeye, Nepenthes, Avoided, Mtlhedd, Skarebo, Vegas949, Noctibus, Gazimo, TravisAF, Guillaume Mallen, Kadellar, Addbot, Grayfell,
Paramountpublishing, Goodwin.loves.sex, Jojhutton, Ronhjones, Jncraton, Fieldday-sunday, MrOllie, Michaelwuzthere, Rcpettit, Mgrollman, Tassedethe, IA Finance Type, Tide rolls, KABADDITENNIS, Ben Ben, Legobot, Luckas-bot, Yobot, Cm001, DisillusionedBitterAndKnackered, MSDROULIS, KamikazeBot, Reagan2234, Eric-Wester, AnomieBOT, Nuclear-Age, Killiondude, Galoubet, Royote,
Piano non troppo, Fender0107401, Saptarshimasid, Kingpin13, Dolamanuel, Bluerasberry, Materialscientist, OllieFury, Bob Burkhardt,
BarrelRollZRTwice, GB fan, Xqbot, Ej463, Cmcgurran84, R0pe-196, Addihockey10, Capricorn42, Jerey Mall, Nasnema, Bcostel7,
Jesse627, XTooksx, Srich32977, Haen, Wikicontra, RibotBOT, SassoBot, Amaury, Shadowjams, Mohankichluwiki, Elemesh, Thehelpfulbot, FrescoBot, Toalewa98, Dr.McLeons, MitchMUCH, Thomas the tom, Memo12021969, JasonDomination, Mamat Rohimat, HamburgerRadio, Pinethicket, Garyjeppesen, Pradeepg19, Sundar77, AndreaFox2, MastiBot, Rachael0008, Agemoi, Intersog, Writemeister,

98

12.1. TEXT

99

Jem147, Utility Monster, TobeBot, Kevinsleem, LogAntiLog, Lotje, Javierito92, PPerviz, Opop5757, Duoduoduo, Ztbs1000, Chennaiseo,
DARTH SIDIOUS 2, Munkitty Tunkitty, Mean as custard, Afb525, Danielag2009, NerdyScienceDude, WildBot, , EmausBot, WikitanvirBot, Sohamshukla86, Swerfvalk, RA0808, Said531982, NoisyJinx, DominicConnor, Bhallukchana, Lindasepa, TheSoundAndTheFury,
Ttmmblogger, Zasew, Winner 42, Wikipelli, K6ka, JDDJS, Kinyupoo, Hvghvghvghvg, Claritas, Dudiko1303, Valterre, Wayne Slam,
Tolly4bolly, GeorgeBarnick, Donner60, Expertricky, Morethom, ChuispastonBot, Peter Karlsen, Suneelkumar1, DASHBotAV, Xanchester, ClueBot NG, Lvitt, Kabir p 69, Deepvalley, Sherri J Bryant, Chester Markel, Just4azee, Tideat, Jgoddard75, Yabsura123, Abhilash2abhi, Inteligentwriter, WikiPuppies, North Atlanticist Usonian, Dev1240, Curb Chain, Titodutta, Calabe1992, Sigiheri, Hallows AG,
MusikAnimal, Konullu, GregMazenIBG, George Minshew, Boleeva, Cfseo, Karkovkarkov, Lavitt, Editorforthegood, , Achowat,
SagarLakhani, Giopersico, Eanjoseph, Pratyya Ghosh, Cdd5-NJITWILL, Trace2012, Mediran, Allan Marsh, Vfranks10, Cujo1800, DaltonCastle, Webclient101, Parviz555, Jimcarry1, Lugia2453, Avaldib, SFK2, Jhbwikis, Ekips39, Dave Braunschweig, Epicgenius, Jamesmcmahon0, Infosunil, Tentinator, Hendrick 99, Tkangsayua, Michellemaree, LauraLMenders341, BreenanWilliams0001, GooglePlex789,
Grandtheftauto59, Mediator ram, Jayuk95, Femobasha, JaconaFrere, Cvhkzxcvhzkxcvhkj, Lycosist, Vilool1, Southeasterner, Roccomob,
LTalamantez, Loraof, Apenuta, Thcnetwork, KasparBot, Gamergirl192, ABCDEFAD, Rodgers 15 and Anonymous: 955
Financial services Source: http://en.wikipedia.org/wiki/Financial_services?oldid=665064622 Contributors: Damian Yerrick, The Anome,
Edward, Michael Hardy, Modster, Ronz, Jiang, Kaihsu, Lukobe, Secretlondon, Nurg, Clarkk, Alphaxer0, Psb777, Bobblewik, Gadum,
OverlordQ, Sam Hocevar, Pgreennch, WikiDon, Scottk, D6, Noisy, Discospinster, Rich Farmbrough, Notinasnaid, Kenb215, TerraFrost,
CanisRufus, MBisanz, Sietse Snel, Cmdrjameson, Srl, Jerryseinfeld, Cavrdg, Arcenciel, InShaneee, Lee S. Svoboda, Ombudsman, Saga
City, Ceyockey, Dr Gangrene, Woohookitty, Pixeltoo, Uris, DESiegel, Halcatalyst, BD2412, Ketiltrout, Sjakkalle, Koavf, Feco, JiFish,
RexNL, FireballDWF2, DVdm, Uvaduck, Gwernol, Elfguy, Wavelength, RussBot, Gaius Cornelius, CrazyTalk, Spike Wilbury, Welsh,
Vivenot, Dougak, Arthur Rubin, GraemeL, Carabinieri, Katieh5584, CIreland, Luk, SmackBot, Amolshah, Edgar181, Jwestbrook, PeterSymonds, Sloman, BowChickaNeowNeow, Hmains, ERcheck, Chris the speller, Bluebot, Simon123, A. B., Sct72, Chendy, Hchizik, Can't
sleep, clown will eat me, ButtonwoodTree, Diasimon2003, Jcembree, Kuru, Corza, 16@r, Willy turner, Beetstra, Alast0r, Ginkgo100,
Joseph Solis in Australia, IvanLanin, JustinRossi, Linkspamremover, Deetdeet, Joodferl, Ale jrb, NinjaKid, Ramymora, Christian75,
Andre999, Hydroshock, Epbr123, Barticus88, Www.crossprofit.com, Headbomb, Jernoult, Nick Number, QuiteUnusual, Gregalton,
Zedla, Kauczuk, Davewho2, Hagbard13, Barek, MER-C, Greensburger, RainbowCrane, Johnmccollim, Magioladitis, Hroulf, RBBrittain,
Rich257, Roue2, Calltech, Pvosta, FisherQueen, CliC, Haamster, Rettetast, PCock, Ben5082, Jarrad Lewis, Crocodile Punter, Arms &
Hearts, Melmunch, DMCer, Idioma-bot, VolkovBot, Patriotfootball, Darkedict, TXiKiBoT, Ashwin palaparthi, Jkeene, Jattaway, Broadbot, Naive rm, Jackfork, UnitedStatesian, Zhenqinli, SheeldSteel, Rgnewbury, Darkieboy236, Barkeep, WereSpielChequers, Yintan,
Targeman, Chumki91, ClueBot, ImperfectlyInformed, Lenxlin, Boing! said Zebedee, Fireblae, Alexbot, PixelBot, Leonard^Bloom, Arjayay, Thingg, Orina22, Aitias, Tigeron, Jburchard1, XLinkBot, Susanjane102, Boyd Reimer, WikHead, Vegas949, Jmmbc, Addbot, Wildhaggis, Leszek Jaczuk, Sebastian scha., Tassedethe, Lightbot, Zorrobot, Jarble, Luckas-bot, TaBOT-zerem, Wiki wiki pedia lets go, CSimons, Jean.julius, Noq, Gnomeliberation front, Materialscientist, Antiliby, Citation bot, Cameron Scott, Wsubob, Xqbot, Themightyrambo,
Gabz80, Resident Mario, Sophus Bie, AJCham, Liridon, Lifnlsdlsdnf, Sparti1, Lars Washington, Jirka.h23, Lotje, Dinamik-bot, Gulbenk,
Onel5969, Mean as custard, RjwilmsiBot, Sargdub, WikitanvirBot, TheSoundAndTheFury, Finance C, ZroBot, Daonguyen95, Handheldpenguin, Ocaasi, Elementrider77, Areetkid, ElissaBuie, Sepersann, Btuppack, Est.r, Xanchester, ClueBot NG, Ramillav, Mathew105601,
Melbinse, Suresh Anumolu, Masssly, Widr, Klopotowska karolina, HMSSolent, MusikAnimal, Dan653, 10Barca, Polmandc, Aisteco,
Pratyya Ghosh, Davidson222, Amedd, Pwers, Oakhonor, Moneystreet, Lugia2453, SFK2, Beccare, Mervat Salman, WyeatesODI, EllenCT,
ROOOOY, Visionpayments, Faaastcash, Sazz123456789, Sowndaryab, Monkbot, AKS.9955, Curlymanjaro, Audliew, Vialbacks66, LTalamantez, Wordedits14, Defense Reviewer, Anitamind, Chris.mueller335 and Anonymous: 234
Personal nance Source: http://en.wikipedia.org/wiki/Personal_finance?oldid=656151089 Contributors: SimonP, James Sa, Mydogategodshat, Greenrd, Joy, Profmike, Vt-aoe, Astronautics~enwiki, ZimZalaBim, Altenmann, Hadal, Fuelbottle, Just Another Dan, Piotrus,
ESkog, JoeSmack, El C, Shanes, Spalding, Jerryseinfeld, Rd232, Dqmillar, Andrewpmk, Darrelljon, VladimirKorablin, Jrleighton, Versageek, Zzyzx11, BD2412, NebY, Vary, R.O.C, Feco, Nivix, Lmatt, Kroboth, Tonync, Gwernol, Stephenb, Wimt, Finbarr Saunders, Nirvana2013, Noddycr, Aaron Brenneman, Anetode, Syrthiss, Takeel, Zzuuzz, NeilN, Andman8, Sardanaphalus, SmackBot, Clpo13, Ohnoitsjamie, NickGarvey, Chris the speller, Jahiegel, Kuru, F15 sanitizing eagle, Caeine induced78, TastyPoutine, Clarityend, Matsiltala,
Chuck Marean, Siakhooi, Kozuch, Thijs!bot, Headbomb, Michael A. White, CTZMSC3, Tangerines, Gregalton, Dpodley, Barek, MERC, Bstroh, The Transhumanist, SiobhanHansa, Zha, Hmu111~enwiki, Chivista~enwiki, Marianna1407, CliC, Pfblogger, J.delanoy,
Pharaoh of the Wizards, Athaenara, Ben5082, Kodos R, Jjswanso, Bonadea, Idioma-bot, Funandtrvl, TXiKiBoT, JimmyCor, Darkside05, Personalnance, Yintan, Johnlowe78, YSSYguy, ClueBot, Kl4m, ImperfectlyInformed, Ewawer, Fcfc, Kashi0341, Myattorneyblog,
Sastagour, Miracle33, 1wealthbuilder, Justrick, Excirial, Investored, Millerz1897, Antonwg, 05runner, XLinkBot, Katandrkatandr, Zodon,
Catalina-symbina, Addbot, PhileasLaville, Captain-tucker, Download, Dezmo22, Legobot, Yobot, Spidermedicine, AnomieBOT, Utopianhorizon, ArthurBot, Obersachsebot, Xqbot, Wronguy, Cassandra21st, JustThrive, Ooper01, George Carlin Fan, Mykjoseph, Alonhu,
Yulracso, Elisalucia, Zrosen2, Al Wiseman, FrescoBot, TruHeir, LazyLizaJane, Assetprotectioninformation, Themainleader, Surya3716,
TobeBot, DixonDBot, Thestraycat57, Psyclepump, Mean as custard, J8jwiki, EmausBot, Pintuhs, WikitanvirBot, Thinktwins, Futerica, Parkerkev, Alexandermin, Mvaraujo~enwiki, ClueBot NG, Sherri J Bryant, BigEars42, Pine, MusikAnimal, Mitesh1401, Rodo82,
Viveksharma020, Rubysword365, Troll1184, Vfranks10, Eyesnore, Andres Possee, Mattiethehatter, BreenanWilliams0001, Sowndaryab,
Jayuk95, Robertchrist101, Sarah.sibel, Writers Bond, David123456712, LTalamantez, Kirkchisholm, Praditk, Kim Oun and Anonymous:
149
Corporate nance Source: http://en.wikipedia.org/wiki/Corporate_finance?oldid=661271864 Contributors: Enchanter, Edward, Michael
Hardy, Paul A, Ronz, Cherkash, Mydogategodshat, Greenrd, Maximus Rex, Furrykef, Taxman, Shizhao, Johnleemk, Robbot, Paranoid,
ZimZalaBim, Modulatum, Utcursch, Pgreennch, Fintor, MementoVivere, Canterbury Tail, Discospinster, Mwanner, Shanes, Truthux,
Chrisvls, Giraedata, Jerryseinfeld, John Fader, Wikidea, Pouya, RainbowOfLight, Capecodeph, Reinoutr, Woohookitty, Guy M, Je3000,
Graham87, BD2412, Dpr, Rjwilmsi, ErikHaugen, Feco, Lmatt, Gwernol, Elfguy, YurikBot, RussBot, Gaius Cornelius, ENeville, Grafen,
Dsol, M3taphysical, Yonidebest, Tiger888, NeilN, Andman8, DocendoDiscimus, SmackBot, D-bot, Mauls, Alsandro, Gilliam, Ohnoitsjamie, Anwar saadat, Bluebot, DMS, Silly rabbit, Colonies Chris, Can't sleep, clown will eat me, Mitsuhirato, Smallbones, KaiserbBot,
Buyoof, RJN, Dantadd, Kuru, NongBot~enwiki, Ckatz, Beetstra, SQGibbon, Meandmyself, Arjan1071, Hu12, Levineps, Lucky627627,
No1lakersfan, Gregbard, B, Kozuch, JamesAM, Thijs!bot, Jafcbs, Headbomb, CharlotteWebb, Tapan bagchi, Seaphoto, Spencer, Barek,
MER-C, The Transhumanist, LittleOldMe, Bmarmie, Lewislams~enwiki, Ddr~enwiki, EagleFan, Globalprofessor, Yowkien, Jinglesss,
Jwestland, Rwil02, Flowanda, STBot, R'n'B, Tgeairn, J.delanoy, Svetovid, FactsAndFigures, Dumdude, AntiSpamBot, Steel1943, Kelapstick, Buddylovely, Polyextremophile, TXiKiBoT, SueHay, Walor, UnitedStatesian, Urbanrenewal, Manaskumar, Cat set go, Andy Dingley, Lamro, Mhardwicke, Struway, SieBot, Ding.iitk, Financeeditor, Artoasis, Anchor Link Bot, Mr. Stradivarius, ClueBot, DanielDeibler, Khmarks, Kered1954, Nagika, Jkhcanoe, SchreiberBike, NellieBly, Strategynode, Addbot, Fieldday-sunday, MrOllie, HerculeBot,

100

CHAPTER 12. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

Yobot, Angel ivanov angelov, AnomieBOT, Nstse, Bookboon, Obersachsebot, Giuseppe Giusti, Srich32977, Haen, GrouchoBot, Invest in knowledge, Nanocho, Sandymok, FrescoBot, Igor101, A8UDI, TobeBot, Trappist the monk, JaquiB, Bongdentoiac, EmausBot,
JteB, Bbkobl, Dewritech, GoingBatty, Finance C, ZroBot, Amjad120, Jessy062811, Tolly4bolly, Jessy062811-NJITWILL, Dkevanko,
AndyTheGrump, Senator2029, Taenzee, Gwen-chan, ClueBot NG, Thbroome, Pearsorh, 123Hedgehog456, Expertz123, Daisy, MerlIwBot, Helpful Pixie Bot, Sigiheri, BG19bot, BendelacBOT, MusikAnimal, AdventurousSquirrel, CFAbrielle23, Financereseracheditor,
Anwesha.srkr, Flat Out, Christopherwilds, Michellemaree, Mschmidt224, RedDog239110, Wikitakegg76789, WisBadgersFan71, LauraLMenders341, Georgesoros911, BreenanWilliams0001, GMATSCORE800, Alun lawrence, Cleanupwikisupport11, HotlineMiami5533,
GooglePlex789, Grandtheftauto99, CrystalAveeno1, Grandtheftauto59, WPGA2345, Csusarah, Monkbot, Jdfsmsu, NicolasChristiaen,
Iimkphb and Anonymous: 208
Financial capital Source: http://en.wikipedia.org/wiki/Financial_capital?oldid=662887174 Contributors: Andre Engels, Christian List,
Enchanter, Roadrunner, SimonP, Edward, Pnm, MartinHarper, Docu, Mydogategodshat, Jusjih, RedWolf, Nilmerg, Stevietheman, Pgreennch, EagleOne, Pjacobi, Saintswithin, Lycurgus, Aaronbrick, Maurreen, HasharBot~enwiki, Uogl, Max rspct, Sylvain Mielot, Kralizec!,
Sj, Gurch, Lmatt, Chobot, Bgwhite, Wavelength, RussBot, Nirvana2013, Alex1011, Timeshifter, Anwar saadat, DHN-bot~enwiki, Cybercobra, Lus Felipe Braga, Giancarlo Rossi, Salamurai, JohnCD, Thomasmeeks, Cydebot, Joowwww, Thijs!bot, Headbomb, Crzycheetah,
Frank, Seaphoto, Gregalton, MER-C, Robina Fox, PhilKnight, Bequw, Olivierchaussavoine, Robertson-Glasgow, Richard D. LeCour,
Zain Ebrahim111, Logan, Ddxc, Sanya3, Fratrep, Finnancier, Mr. Granger, ClueBot, ImperfectlyInformed, Mild Bill Hiccup, Addbot,
Alanscottwalker, Amirobot, AnomieBOT, Piano non troppo, Mbiama Assogo Roger, Materialscientist, Citation bot, Omnipaedista, RibotBOT, Sector001, FrescoBot, Paine Ellsworth, Ncravens, DexDor, NotAnonymous0, ClaretAsh, HMSSolent, Post2akjain, Hallows AG,
Student Harry, Frze, Ujongbakuto, Wikimunter, SFK2, Mooreee11, My name is not dave, YiFeiBot, Homni, Fundaclear, Morran vikas,
KasparBot and Anonymous: 64
Cornering the market Source: http://en.wikipedia.org/wiki/Cornering_the_market?oldid=650830174 Contributors: Ed Poor, Maury
Markowitz, Edward, Infrogmation, Kwertii, Prumpf, Nurg, Gzornenplatz, RayBirks, Elroch, Joyous!, Narsil, Elipongo, Hooperbloob,
Ashley Pomeroy, Axeman89, NorrYtt, Ajb, Jweiss11, Chobot, Farmanesh, Loop202, BOT-Superzerocool, Urger48400, Jereymcmanus,
Groyolo, DocendoDiscimus, SmackBot, Eskimbot, Hmains, Gobonobo, Amniarix, DanielRigal, Cydebot, AngoraFish, JAF1970, Headbomb, Blue Tie, Kbthompson, Dman727, VoABot II, Gwern, Anne97432, Bernard S. Jansen, JohnDoe0007, SueHay, Lamro, Alexbot,
TheFutureIsComing, Drolz09, Addbot, Lightbot, Yobot, Duccio55, Whiskeydog, Citation bot, Dr. Slide, Citation bot 1, Full-date unlinking bot, RoadTrain, Vrenator, Rickrossistheboss, RjwilmsiBot, Alph Bot, IronStranger, EmausBot, Qrsdogg, F, , ClueBot NG,
Greggp42, BG19bot, BendelacBOT, MusikAnimal, Khazar2, Maniac Mechanic, Lunivore, Christopher Whidden and Anonymous: 57
Insurance Source: http://en.wikipedia.org/wiki/Insurance?oldid=664081844 Contributors: AxelBoldt, Lee Daniel Crocker, Bryan Derksen, Grouse, Matusz, Enchanter, SimonP, ChangChienFu, N8chz, Vkem~enwiki, Edward, Patrick, Booyabazooka, Pnm, Mic, Zeaner, Perry
Kundert, Ellywa, Ahoerstemeier, Angela, Kingturtle, Bogdangiusca, Nikai, Andres, Jiang, Dysprosia, Cjmnyc, Maximus Rex, Ryuch, Furrykef, Saltine, Itai, Nv8200pa, Taxman, Tempshill, Shizhao, J2rome, Pakaran, Chuunen Baka, Robbot, Dale Arnett, Altenmann, Yosri,
Hadal, GreatWhiteNortherner, Tobias Bergemann, Alan Liefting, Marc Venot, Albatross2147, Elf, Oberiko, Aratuk, Everyking, Bkonrad,
Hoho~enwiki, Jfdwol, Hansjorn, JimD, Binoy211, SWAdair, Edcolins, Golbez, Gyrofrog, Tristanreid, Stevietheman, Gadum, Woggly,
Andycjp, Geni, Antandrus, Rdsmith4, Ellsworth, Mozzerati, Bk0, Ukexpat, GreenReaper, Adashiel, Intrigue, AAAAA, Jayjg, Monkeyman, Discospinster, Rich Farmbrough, Zoso Jade, Wclark, Smyth, Xezbeth, Mani1, Martpol, ESkog, Kbh3rd, Jnestorius, CanisRufus,
DS1953, Mwanner, Cacophony, Coolcaesar, Femto, Bobo192, Giraedata, Jerryseinfeld, Snacky, MPerel, Hooperbloob, Jakew, Conny,
Musiphil, Alansohn, Gary, Tek022, Halsteadk, Andrewpmk, M7, John Quiggin, Lord Pistachio, Wikidea, Yamla, Katefan0, Ombudsman,
Velella, ClockworkSoul, Saga City, RainbowOfLight, TenOfAllTrades, Shoey, Versageek, SteinbDJ, Alai, HenryLi, TerminalPreppie,
Deror avi, Nuno Tavares, OwenX, Woohookitty, Swamp Ig, Pol098, Commander Keane, Bunthorne, Optichan, Arden, Mandarax, Graham87, BD2412, Dpr, Johnwhunt, Casey Abell, Sj, Koavf, Commander, Bill37212, Mulconrey, ElKevbo, Bubba73, Czalex, Bhadani,
Klonimus, Robert Fraser, SNIyer12, Leithp, Ian Pitchford, StephanCom, Crazycomputers, Ewlyahoocom, Intgr, Ghingo, Alphachimp,
Ahunt, Chills42, Nastajus, DVdm, Simesa, Gwernol, Roboto de Ajvol, YurikBot, Wavelength, RussBot, Muchness, Bhny, Fabricationary,
Stephenb, CambridgeBayWeather, NawlinWiki, Nowa, Mike18xx, Sporadikos, Jaxl, DarthVader, Cleared as led, Nick, Retired username,
Bobdavis4, Mmmbeer, Zains, Threepwood89, Emersoni, Nlu, Avraham, AjaxSmack, Richardcavell, FF2010, Phgao, Zzuuzz, Lt-wiki-bot,
Closedmouth, Rb82, Janto, Madines, GraemeL, Shawnc, Edgerunner, LeonardoRob0t, MrHen, Garion96, Jonathan.s.kt, Meiers Twins,
Stumps, Quadpus, KnightRider~enwiki, SmackBot, KMcD, Reedy, KnowledgeOfSelf, Pgk, C.Fred, Davewild, TimBits, Cooksey87, CapitalSasha, Paulmeisel, SmartGuy Old, Dudester, Yamaguchi , Sloman, Gilliam, Ohnoitsjamie, Hmains, Armeria, Anwar saadat, Amatulic, Chris the speller, Thegn, DJ Craig, SchftyThree, PureRED, Octahedron80, DHN-bot~enwiki, A. B., Darren Wickham, Famspear,
Can't sleep, clown will eat me, Symbiote, Yidisheryid, Peter Ngan, Pevarnj, Electrolite, Edivorce, Wine Guy, HeteroZellous, Krich, Flyguy649, Pupeyvelo, Nakon, Bradmca, StephenMacmanus, John wesley, MisterCharlie, Shadow1, G716, Only, Crd721, DMacks, PhotoJim,
Kukini, Kuru, Khazar, J 1982, Gobonobo, Disavian, ML5, Tony Corsini, MidnightSwinga, Nellis, RomanSpa, Rawmustard, Ckatz, 16@r,
Choppie, Filanca, Shangrilaista, Martinp23, Kaos Klerik, Bronayur, Stephrigu, Dcyer, DomStapleton, MTSbot~enwiki, Galactor213,
Hu12, DabMachine, Levineps, Srinikasturi, Ebrenner8, Iridescent, RLamb, Joseph Solis in Australia, Licardo, Natrajdr, CapitalR, Courcelles, Linkspamremover, Tawkerbot2, Maslakovic, Suwarnaadi, CalebNoble, JForget, Anoops, Ossifer, Tanthalas39, Megaboz, Mtgkooks,
KyraVixen, JohnCD, ArmyOfFluoride, Svendsgaard, Bill.albing, Dgw, Argon233, Outriggr, MarsRover, Myasuda, Manishgh, Jane023,
Gogo Dodo, A Softer Answer, Chasingsol, Synergy, DumbBOT, Optimist on the run, Lee, Omicronpersei8, Augfan77, PKT, Epbr123,
Bezking, Josephbrophy, N5iln, Mojo Hand, Headbomb, Kathovo, I do not exist, Mfhbrown, X201, RFerreira, NigelR, DoomsDay349, Big
Bird, Futurebird, Escarbot, I already forgot, Faperez, AntiVandalBot, Yonatan, Widefox, Gaviidae, CodeWeasel, SummerPhD, R4gn4r,
BigNate37, Lumbercutter, Dharmasattva, Fayenatic london, Sehsuan, Spencer, Zedla, Arsenikk, Husond, Barek, MER-C, Dunwoody01,
Cleanupman, PhilKnight, Mike Teon, Magioladitis, Hroulf, VoABot II, Fwmg, Rich257, Kwansanbook, Theroadislong, Wikicide,
Praddy06, Roue2, Hamiltonstone, Logictheo, BC Graham, Kdc3, J.Marlowe, DerHexer, JaGa, Pax:Vobiscum, Calltech, LymphToad,
Aeklein, Swizzlez, Hdt83, MartinBot, CliC, Liopa, Thirdreading, Reggy73, R'n'B, CommonsDelinker, VirtualDelight, Narykids, Paulmcdonald, Radbug, J.delanoy, Trusilver, Svetovid, Psycho Kirby, Gilbo32, Drewwiki, Lyseong, Davidprior, Gzkn, Being blunt, Dispenser,
Znatok, Whilding87, Dkutcher, Gurchzilla, Tippling.philosopher, AntiSpamBot, NewEnglandYankee, Kshpitsa, Sewings, Ohms law,
SJP, JPatrickBedell, Crystalball~enwiki, Peraphan, KylieTastic, Cometstyles, Butnotthehippo, DH85868993, Melmunch, OneOfABullet,
Dozen, Bonadea, Pdcook, Jonhol, Xiahou, Funandtrvl, Fengshui88, Malik Shabazz, LionMans Account, Mnacht, Jublee18, Philip Trueman,
McTavidge, TXiKiBoT, Juicydave, BuickCenturyDriver, Rcherrick, Martin451, Benjasmine, Jackfork, Sidewinder1, PDFbot, Kingjubbs,
Ben Ward, Seanmtz59, Blurpeace, Kilmer-san, Valkyryn, Stephen J. Brooks, Sue Rangell, Michael Frind, Xboxfreak, Sfmammamia,
Rock2e, DiggyStyle, Mcrossdc, Biscuittin, SieBot, MLBplayer456, Meerafeedback, Springbreak04, Gerakibot, Papillonderecherche, Yintan, Bhagwatkumar, Numbersinstitute, Bentogoa, Sal2010, Jojalozzo, Nopetro, Dlobovsky, EnOreg, Oxymoron83, Judicatus, AngelOfSadness, Corp Vision, Subikar, Arnobarnard, OKBot, FusionNow, Torchwoodwho, Ward20, WikiLaurent, Andystyart, Gantuya eng,

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Dip2007, Startswithj, Explicit, Super edd, Ricklaman, Lolaraa, Elassint, ClueBot, BibleThumper4 3rdHeaven&Earth, GorillaWarfare,
The Thing That Should Not Be, Kieran Talbot, Rjd0060, ImperfectlyInformed, Saddhiyama, Wutsje, AlasdairGreen27, Eiland, Uberimaedei, Boing! said Zebedee, Dissento, Abrandvold, Arunsingh16, Shustov, MindstormsKid, Somno, -Midorihana-, Kjramesh, SpikeToronto, Jamieeeeeeeeeeee, Caesar1951, Boomsma, Rhododendrites, Sun Creator, Derbyadhag, Morel, PatrickReno, Dekisugi, The Red,
Nukeless, Thingg, Whatsthatbluething, Aitias, Versus22, Samlivingstone, Louisrix, Life of Riley, Anual, Helixweb, BarretB, XLinkBot,
Dpdrummer14, Stickee, EastTN, Symonweedon, Little Mountain 5, Cedced1, Ahadisnain, Danielroberts, Addbot, Twaz, Freakmighty,
Sdterry, Vasiura, Otisjimmy1, Ronhjones, Nomad2u001, Mr. Wheely Guy, CanadianLinuxUser, Leszek Jaczuk, NjardarBot, MrOllie, Download, Morning277, Cambalachero, Tukanglotek, Izaacsmall, Goequinox, Sfaridi, Tide rolls, OlEnglish, Apteva, Teles, Msm18,
Hukdupcivic, Artichoke-Boy, Luckas-bot, Yobot, Ptbotgourou, Fraggle81, Tjah ajoeku~enwiki, Specious, II MusLiM HyBRiD II, Gima72,
KamikazeBot, AnakngAraw, Tsagilistic, Aoso0ck, Kevindy, Longevityquotes, AnomieBOT, Drivewest, DemocraticLuntz, Rescuechick,
Jim1138, Galoubet, Kingpin13, Materialscientist, Citation bot, LilHelpa, Xqbot, Sionus, Addihockey10, Capricorn42, Jerey Mall, Insure110, Stars4change, Tad Lincoln, Grim23, Sc3499a, Hkthomson, Erdemkoc, Tyrol5, Control.valve, Srich32977, Out of Here, Omnipaedista, Anhydrobiosis, Mathonius, Basharh, Chinsurance, Moxy, IcedNut, Reym123, Firstcards, KiddoKiddo, A.amitkumar, James
R. Ward, Worldwide historian, Yaromunna, FrescoBot, Dannyaa, EthanLeduc, LucienBOT, Tobby72, Eminently insurable, Haeinous,
Shienhendry, Pxos, Dxroaddogg32, Citation bot 1, EagleEye96, Amplitude101, Dano1970, CRoetzer, Khushal.rakesh, Allstateowego,
Pinethicket, I dream of horses, Fuzbaby, Trijnstel, Yourkey, Calmer Waters, Jschnur, Roxymurphy, Alexjones9281, James Daily, Littledogboy, Petersud, Jackrober, Tweed-Lover, MutantPlatypus, TobeBot, Stuartclark1, Kurenchudge, Alexmilt, Seattleraincity, Vrenator,
Shashuec, Weaselword, Tbhotch, Anuradhaarandara, SlavaRybalka, Skid21, Mean as custard, Phlegat, Wintonian, Husnain22, EmausBot, John of Reading, Sophie, Therearewaytoomanybooksinhere, BillyPreset, Dewritech, GoingBatty, Nishanttak22, Preetsibia, Jirka62,
NotAnonymous0, TheSoundAndTheFury, Solarra, Tommy2010, Wikipelli, Josve05a, rico Jnior Wouters, Jonpatterns, Jk312728666,
Dogstring, Nudecline, Probablytrue, Vanessa8, L Kensington, Damienvon, Granite333, Noodleki, Bluegreen1011, Larakath, Coastalcatwatch, Legal123, Mdjwood, TruthisBeauty2010, Wakebrdkid, Neil P. Quinn, P3landers, GrayFullbuster, DASHBotAV, Ld long133,
Trulex 89, 28bot, TBM10, Signalizing, ClueBot NG, Jango2609, Since 10.28.2010, Gareth Grith-Jones, , This
lousy T-shirt, ForgottenHistory, Rio 001, Normad33, O.Koslowski, Insurance120, Widr, Frodo9me, Newyorkadam, Chillllls, ETips, Coolrash.id1, Dotz2, Raymenddavis, Helpful Pixie Bot, Harpi711, Jessie987654321, Qbs2011, Krenair, Zigload, Jameskshaer, Joesmo1234,
Wickerman45, Cmoras, AmberBates, Wiki13, MusikAnimal, Shivani666, Cabell Vildibill, Sembahyank, Compfreak7, Professional Insurance Agents, MaryChristiano, AdventurousSquirrel, Suwandichen13, Co2Und3rground, Atonway, Jfhutson, Ahsansaeed2012, Robpierre,
Klilidiplomus, Achowat, Lieutenant of Melkor, Anbu121, Yogeshaniya, Bored On The Holidays, BattyBot, Principesa01, PaddyWhacker,
Mdann52, Jaredfranc, Neromancer, CFAbrielle23, Tryinsurancequotes, Jionpedia, Anthonyliston, Dialabank001, Ramesh.kishor100, Mogism, RKsun, Bschuyler, TheIrishWarden, TwoTwoHello, SFK2, Leeloohappy, Jitin Girdhar, ServantofAllah93, Sabroo, Saadahcar, Watsonagencynet, IanWaldron22, RandallD, Peterpaul01, Jainnaman91225, Tentinator, Consumersrevolt, Gillamg, Thebootywarrior1999,
No1inparticularhere, MCA(Motor Club of America), Muhammadbabarzaman, Glaisher, Hansmuller, Ginsuloft, Snydemic, Colin1965,
Aadrk, Jonti.Brozin, JaconaFrere, Susanonline87, Ajay 019, Legalitastoksin, Monkbot, TheGreatInsurance, Srwikieditor, Rlee8414, Aysel
Ibayeva, Mark204Teen, Lor, Bmedia, Johnmillerusa, Haedtan, Caliburn, Queenbwest, Jdfsmsu, Crystallizedcarbon, Jassica Bella, Sahan1989, Janicelporto12, KasparBot, Gamergirl192, Johngot, UCONNLLM, Nizart333, ResearchMinder, Juni ikiki, AndersonCooper11
and Anonymous: 1091
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Derksen, Roadrunner, SimonP, Edward, Kchishol1970, Michael Hardy, Willsmith, Kwertii, Kku, Mic, Pcb21, JASpencer, Mydogategodshat, JidGom, Renamed user 4, Jfeckstein, Wik, Tpbradbury, Taxman, Topbanana, Carax, Jni, Robbot, RedWolf, ZimZalaBim,
Gandalf61, Babbage, Sekicho, Hadal, Cyrius, Mattaschen, GreatWhiteNortherner, Alan Liefting, Fastssion, Marcika, Niteowlneils,
Bobblewik, Utcursch, Piotrus, RayBirks, Urhixidur, MementoVivere, M1ss1ontomars2k4, Mike Rosoft, Chris Howard, Sebrenner, Rich
Farmbrough, Wk muriithi, Notinasnaid, Bender235, Fenice, Aecis, Aude, RoyBoy, Grick, C S, Jerryseinfeld, Nk, Rajah, John Fader,
Swapspace, Landroni, Jumbuck, Gary, Mo0, C960657, Mu5ti, Jrleighton, Lerdsuwa, SteinbDJ, DanielVonEhren, Bobrayner, Jberkes,
Woohookitty, Justinlebar, Robwingeld, Qaddosh, Dirnstorfer, Wikiklrsc, GregorB, Eyreland, Lfchuang, Ronnotel, FreplySpang, RxS,
Sybren~enwiki, Rjwilmsi, Helvetius, Feco, Brighterorange, Nguyen Thanh Quang, Tuaw, Ground Zero, Strangnet, Bondwonk, Chobot,
DaGizza, Bgwhite, Rotsor, Kummi, YurikBot, Hairy Dude, RussBot, Htournyol, Salsb, Anomalocaris, Canadaduane, NawlinWiki, Nowa,
Nirvana2013, Johann Wolfgang, Welsh, Jakash, Coolninad, Voidxor, Crasshopper, Historymike, Mastermund, Dan131m, GraemeL, VodkaJazz, Tiger888, DocendoDiscimus, Sardanaphalus, Veinor, SmackBot, InverseHypercube, Vald, Phaldo, Eskimbot, IstvanWolf, SmartGuy Old, Yamaguchi , Ohnoitsjamie, Amatulic, Hippodrome, Chris the speller, JMSwtlk, Caissas DeathAngel, CSWarren, Nbarth,
Ryan O'Rourke, Zven, Can't sleep, clown will eat me, Mitsuhirato, Smallbones, Berland, KaiserbBot, Stevenmitchell, Jmnbatista, Wonderstruck, Salt Yeung, Drphilharmonic, Sgcook, Esb, Jna runn, Usenetpostsdotcom, Rajusom, Ultrasolvent, Kuru, CorvetteZ51, Ulner,
Aleator, Voceditenore, A. Parrot, Beetstra, Calibas, Treznor, Mr Stephen, TastyPoutine, Hu12, Quaeler, Levineps, Typelighter, IvanLanin,
Philip ea, Mmaher~enwiki, A. Pichler, Trade2tradewell, Rosasco, CmdrObot, Ale jrb, Bigfatloser, Equendil, AndrewHowse, Cydebot, Future Perfect at Sunrise, Road Wizard, Trasel, Odie5533, Whiskey Pete, Modemrat, Satori Son, BetacommandBot, Thijs!bot, Kubanczyk,
Headbomb, Glennchan, Notmyrealname, Stybn, AntiVandalBot, WinBot, Seaphoto, 49oxen, Just Chilling, TonyWikrent, Gregalton, Gansos, Ronny8, JAnDbot, Narssarssuaq, MER-C, Epeeeche, Ph.eyes, Jedimook, Hut 8.5, TAnthony, S0uj1r0, VoABot II, MartinDK, Lotusv82, Soulbot, Rich257, Iitkgp.prashant, Fred114, A3nm, Drdariush, Nameweb, WLU, Applrpn, To Serve Man, Donnabuck, CliC,
Sarma.bhs, Phillipb81, Murphman67, Mausy5043, Tgeairn, J.delanoy, BigrTex, PCock, Huey45, Aleksandr Grigoryev, 72Dino, Hossain Akhtar Chowdhury, Eloz002, KnowledgeEngine, Oceanynn, JayJasper, SJP, Olegwiki, Cometstyles, Elbeem, DMCer, Erdosfan,
StoptheDatabaseState, Idioma-bot, Funandtrvl, 386-DX, Philip Trueman, Fishiswa, GLeachim, Altruism, Ask123, Netsumdisc, Goatonastik, JhsBot, Don4of4, Shua2000, UnitedStatesian, Keving 65, TheSix, BotKung, Lamro, Townlake, Falcon8765, EmxBot, NipponBanzai! po-mo irony, QUEWWW, Tresiden, Swliv, Plinkit, Caltas, Ernie shoemaker, Happysailor, Jvs, Oxymoron83, Artoasis, Thobitz,
Steven Zhang, Segregold, Dami99, Anchor Link Bot, Klp02gtm, SEOCAG, Wyattmj, Finnancier, Rinconsoleao, Denisarona, Evitavired,
OTCSF, Derivativeslawyer, Manikongo, ClueBot, Bob1960evens, Chokoboii, Analoguni, Guru cool, StephenRH, Gregpalmerx, Bhuna71,
Texmex81, Ohioer, Orrorin, SpikeToronto, Newyorxico, Floul1, Alastair Carnegie, XLinkBot, Gianetta69, Jprw, Alex 686, Xp54321,
Proofreader77, Istvnka, Misterx2000, MrOllie, Download, Buddha24, Wikomidia, Ehrenkater, Bonewith, Tide rolls, Lightbot, OlEnglish,
Kiril Simeonovski, Gugustiuci, Jarble, Legobot, Luckas-bot, Yobot, Ptbotgourou, Rsquire3, Palindrome101, KamikazeBot, AnomieBOT,
DerivMan, Jarettlee, Jim1138, Piano non troppo, Keithbob, Materialscientist, Citation bot, Zaq100, GnawnBot, LilHelpa, MauritsBot,
Xqbot, 5464536, Btangren, Purplehaziness, Loveless, Sionk, RibotBOT, Reston10, Cktt13, Question: Are you being served?, Mnmngb,
Rangedra, Sandolsky, FrescoBot, Jgard5000, LucienBOT, , EBespoke, Aeolus3, Inazz, Haeinous, Slessard 79, HamburgerRadio, Joe4bikes, Jivee Blau, Consummate virtuoso, Rushbugled13, Ploufman, RedBot, Rachael0008, Mishall1281, Wortoleski, Portsaid, SW3 5DL, TobeBot, Trappist the monk, TylerFinny, Lotje, ShaolinGirl, Franois Bry, RoadTrain, EMP, Rajeshc85, Sdrozdowski,
Makrem.boumlouka, Dscheidt1, RjwilmsiBot, Sargdub, GodfatherOfFX, EmausBot, RAJESHVK, John of Reading, Orphan Wiki, Wik-

102

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Gary, V2Blast, John Quiggin, Bluemoose, SDC, Rjwilmsi, Exeunt, YurikBot, Morphh, Grafen, Koringles, GraemeL, Tiger888, DocendoDiscimus, Sardanaphalus, SmackBot, Bluebot, Kuru, JDMBAHopeful, JHP, JForget, Thomasmeeks, AndrewHowse, Gogo Dodo, Smee,
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Zfr, Fintor, PhotoBox, Nparikh, Rhobite, YUL89YYZ, Elwikipedista~enwiki, Msh210, Gary, JYolkowski, Eric Kvaalen, Hgsippe
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NongBot~enwiki, Beetstra, Optakeover, Hu12, Colonel Warden, CapitalR, Albertod4, Kolmogorov Complexity, SkyWalker, Punanimal, Myasuda, Stanislav87, Headbomb, Cfries~enwiki, Onyxxman, DuncanHill, Barek, MER-C, Yunli, Acroterion, Hroulf, Michaltomek, Flowanda, Ayonbd2000, Quantnet, Vabramov, Halliron, JonMcLoone, Vasquezomlin, DMCer, Jonhol, Burlywood, Black Kite,
MM21~enwiki, VolkovBot, JohnBlackburne, Tesscass, Jimmaths, Author007, TXiKiBoT, A.j.g.cairns, WebScientist, Lamro, Langostas,
Burakg, Timorrill, Riskbooks, Monty845, Kaypoh, Maelgwnbot, Xiaobajie, Tigergb, Jamesfranklingresham, Lbertolotti, Sentriclecub,
Ahd2007, Mikaey, Kimys, Qwfp, Baoura, Addbot, Eweinber, SymmyS, MrOllie, SpBot, Tassedethe, Matj Grabovsk, Luckas-bot, Yobot,
Allemandtando, AnomieBOT, Drootopula, Ciphers, Portutusd, Quantchina, Materialscientist, ArthurBot, Xqbot, Kaslanidi, Celuici, FrescoBot, SUPER-QUANT-HERO, Angelachou, Billolik, Hannibal19, Sargdub, EmausBot, WikitanvirBot, Nikossskantzos, DominicConnor,
ZroBot, Zfeinst, Financestudent, ChuispastonBot, Helpful Pixie Bot, BG19bot, Northamerica1000, Rodo82, Brad7777, Wolfgang42,
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Szstanley, Kickyandfun, Some standardized rigour, SUPER-QUANT-HERO, Outback the koala, Citation bot 1, Nisroc~enwiki, Midiom, AMH-DS, Vstoykov, Xcvb2010, Vingai09, Opop5757, Ztbs1000, EvanHarper, RjwilmsiBot, DASHBot, WikitanvirBot, GaryLKaplan, TedwardHall, Alfredo ougaowen, AvicBot, ZroBot, Richard Snoots, Dreispt, Erianna, Donner60, Usb10, Phronetic, Joannamasel,
ChanM79, Baccy1, Peter Karlsen, RogerTango, Tripezo, ClueBot NG, NieuwZeelanders, Helpful Pixie Bot, PSP30003000, Joolsa123,
BG19bot, ElphiBot, Dzforman, Reza luke, Brad7777, Bakennedy2, MathewTownsend, FinancePublisher, Rhyme1989, Acadmica Orientlis, ChrisGualtieri, NatalieAvigailL, Louey37, Anthro-apology, Khazar2, MEconDelta, EuroCarGT, RichardKPSun, The Vintage
Feminist, Marketpsy, Mrm7171, JoeJerey, Er7xuf, Bronx Discount Liquor, Cdnederhood, Lizia7, WPGA2345, Wolololol, Mickeyhsue, Smokeyjuly, Monkbot, Busedsouls, Thegnomeisy, Smartjohny, Gragre123, Alisco2827, Ihaveacatonmydesk, Jlewis144, Cworden95,
Sarapultsev, Grioman444 and Anonymous: 278
Intangible asset nance Source: http://en.wikipedia.org/wiki/Intangible_asset_finance?oldid=651371502 Contributors: Bender235,
Woohookitty, RHaworth, Je3000, BD2412, Rjwilmsi, RussBot, Gaius Cornelius, SmackBot, Chris the speller, Fuhghettaboutit, AndrewHowse, Qwyrxian, Headbomb, Mr pand, Funandtrvl, Pwnage8, GioCM, Quercus basaseachicensis, SchreiberBike, IA Finance Type,
Yobot, Amoorman86, John of Reading, Rdbhaigh, Breeanelyse, Khazar2, Sethburr and Anonymous: 6

12.2 Images
File:2005life_premia.PNG Source: http://upload.wikimedia.org/wikipedia/commons/3/36/2005life_premia.PNG License: Public domain Contributors: http://en.wikipedia.org/wiki/File:2005life_premia.PNG Original artist: en:User:Anwar saadat
File:2005nonlife_premia.PNG Source: http://upload.wikimedia.org/wikipedia/commons/b/b9/2005nonlife_premia.PNG License: Public domain Contributors: http://en.wikipedia.org/wiki/File:2005nonlife_premia.PNG Original artist: en:User:Anwar saadat
File:2005private_sector_credit.PNG Source: http://upload.wikimedia.org/wikipedia/commons/7/76/2005private_sector_credit.PNG
License: CC BY-SA 3.0 Contributors: Transferred from en.wikipedia; transferred to Commons by User:Stefan4 using CommonsHelper.
Original artist: Original uploader was Anwar saadat at en.wikipedia
File:2006GoodwoodBreedersCup.jpg Source: http://upload.wikimedia.org/wikipedia/commons/e/e9/2006GoodwoodBreedersCup.jpg
License: CC BY 2.5 Contributors: Transferred from en.wikipedia; transferred to Commons by User:Mike2bb using CommonsHelper.
Original artist: Original uploader was TheBluZebra at en.wikipedia
File:2006budget_income.PNG Source: http://upload.wikimedia.org/wikipedia/commons/e/ef/2006budget_income.PNG License: CC
BY-SA 3.0 Contributors: Transferred from en.wikipedia; transferred to Commons by User:Stefan4 using CommonsHelper. Original artist:
Original uploader was Anwar saadat at en.wikipedia
File:2006net_capital_export.PNG Source: http://upload.wikimedia.org/wikipedia/commons/8/8e/2006net_capital_export.PNG License: CC BY-SA 3.0 Contributors: Transferred from en.wikipedia; transferred to Commons by User:Stefan4 using CommonsHelper.
Original artist: Original uploader was Anwar saadat at en.wikipedia
File:2006net_capital_import.PNG Source: http://upload.wikimedia.org/wikipedia/commons/d/da/2006net_capital_import.PNG License: CC BY-SA 3.0 Contributors: Transferred from en.wikipedia; transferred to Commons by User:Stefan4 using CommonsHelper.
Original artist: Original uploader was Anwar saadat at en.wikipedia
File:Accidents_will_happen_William-H.-Watson-Universal-Star-Featurette-1922-EYE_FLM1205-OB_687097-720x404.
ogv.webm
Source:
http://upload.wikimedia.org/wikipedia/commons/1/1c/Accidents_will_happen_William-H.
-Watson-Universal-Star-Featurette-1922-EYE_FLM1205-OB_687097-720x404.ogv.webm License:
Public domain Contributors:
EYE Film Institute Netherlands <a href='//commons.wikimedia.org/wiki/Institution:EYE_Film_Instituut_
Nederland' title='Link back to Institution infobox template'><img alt='Link back to Institution infobox template'
src='//upload.wikimedia.org/wikipedia/commons/thumb/7/73/Blue_pencil.svg/15px-Blue_pencil.svg.png'
width='15'
height='15'
srcset='//upload.wikimedia.org/wikipedia/commons/thumb/7/73/Blue_pencil.svg/23px-Blue_pencil.svg.png
1.5x,
//upload.
wikimedia.org/wikipedia/commons/thumb/7/73/Blue_pencil.svg/30px-Blue_pencil.svg.png
2x'
data-le-width='600'
data-leheight='600' /></a> <a href='//www.wikidata.org/wiki/Q1538389' title='wikidata:Q1538389'><img alt='wikidata:Q1538389'
src='//upload.wikimedia.org/wikipedia/commons/thumb/f/ff/Wikidata-logo.svg/20px-Wikidata-logo.svg.png'
width='20'
height='11'
srcset='//upload.wikimedia.org/wikipedia/commons/thumb/f/ff/Wikidata-logo.svg/30px-Wikidata-logo.svg.png
1.5x,
//upload.wikimedia.org/wikipedia/commons/thumb/f/ff/Wikidata-logo.svg/40px-Wikidata-logo.svg.png 2x' data-le-width='1050'
data-le-height='590' /></a> Original artist: Watson, William H. (director) / Universal Star Featurette (producer)
File:Ambox_globe_content.svg Source: http://upload.wikimedia.org/wikipedia/commons/b/bd/Ambox_globe_content.svg License:
Public domain Contributors: Own work, using File:Information icon3.svg and File:Earth clip art.svg Original artist: penubag
File:Ambox_important.svg Source: http://upload.wikimedia.org/wikipedia/commons/b/b4/Ambox_important.svg License: Public domain Contributors: Own work, based o of Image:Ambox scales.svg Original artist: Dsmurat (talk contribs)
File:Amicable_Society_for_a_Perpetual_Assurance_Office,_Serjeants{}_Inn,_Fleet_Street,_London,_1801.jpg
Source:
http://upload.wikimedia.org/wikipedia/commons/0/0a/Amicable_Society_for_a_Perpetual_Assurance_Office%2C_Serjeants%27_
Inn%2C_Fleet_Street%2C_London%2C_1801.jpg License: Public domain Contributors: The European Magazine and London Review
frontispiece of volume 1801 Original artist: unknown artist from magazine
File:Arbre_Binomial_Options_Reelles.png Source: http://upload.wikimedia.org/wikipedia/commons/2/2e/Arbre_Binomial_Options_
Reelles.png License: CC BY-SA 3.0 Contributors: Own work Original artist: Virginie Joly-Stroebel
File:Assorted_United_States_coins.jpg Source: http://upload.wikimedia.org/wikipedia/commons/5/5e/Assorted_United_States_coins.
jpg License: Public domain Contributors: Own work Original artist: Elembis
File:CDS_volume_outstanding.png Source: http://upload.wikimedia.org/wikipedia/commons/9/93/CDS_volume_outstanding.png License: CC BY-SA 3.0 Contributors: Own work Original artist: MartinD
File:Car_crash_1.jpg Source: http://upload.wikimedia.org/wikipedia/commons/e/e1/Car_crash_1.jpg License: Public domain Contributors: Own work Original artist: Thue

104

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File:Chicago_bot.jpg Source: http://upload.wikimedia.org/wikipedia/commons/0/0e/Chicago_bot.jpg License: Public domain Contributors: ? Original artist: ?


File:Coin_of_Maximian.jpg Source: http://upload.wikimedia.org/wikipedia/commons/a/a0/Coin_of_Maximian.jpg License: CC BYSA 3.0 Contributors: Transferred from en.wikipedia
Original artist: Rasiel Suarez. Original uploader was Rasiel at en.wikipedia
File:Commons-logo.svg Source: http://upload.wikimedia.org/wikipedia/en/4/4a/Commons-logo.svg License: ? Contributors: ? Original
artist: ?
File:Daniel_KAHNEMAN.jpg Source: http://upload.wikimedia.org/wikipedia/commons/c/c8/Daniel_KAHNEMAN.jpg License: Public domain Contributors: http://www.nih.gov/news/NIH-Record/04_13_2004/story02.htm Original artist: ?
File:Dmitry_Medvedev_at_G20_Pittsburgh_summit-1.jpg Source: http://upload.wikimedia.org/wikipedia/commons/6/67/Dmitry_
Medvedev_at_G20_Pittsburgh_summit-1.jpg License: CC BY 3.0 Contributors: http://www.kremlin.ru/news/5576 Original artist: Presidential Press and Information Oce
File:Edit-clear.svg Source: http://upload.wikimedia.org/wikipedia/en/f/f2/Edit-clear.svg License: Public domain Contributors: The
Tango! Desktop Project. Original artist:
The people from the Tango! project. And according to the meta-data in the le, specically: Andreas Nilsson, and Jakub Steiner (although
minimally).
File:Emblem-money.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/f3/Emblem-money.svg License: GPL Contributors:
http://www.gnome-look.org/content/show.php/GNOME-colors?content=82562 Original artist: perfectska04
File:FEMA_-_14947_-_Photograph_by_Jocelyn_Augustino_taken_on_08-30-2005_in_Louisiana.jpg
Source:
http:
//upload.wikimedia.org/wikipedia/commons/7/7b/FEMA_-_14947_-_Photograph_by_Jocelyn_Augustino_taken_on_08-30-2005_
in_Louisiana.jpg License: Public domain Contributors: This image is from the FEMA Photo Library. Original artist: Jocelyn Augustino
File:Ferdinand_Bol_-_Governors_of_the_Wine_Merchant{}s_Guild_-_WGA2361.jpg
Source:
http://upload.wikimedia.
org/wikipedia/commons/a/aa/Ferdinand_Bol_-_Governors_of_the_Wine_Merchant%27s_Guild_-_WGA2361.jpg License:
Public domain Contributors: Web Gallery of Art: <a href='http://www.wga.hu/art/b/bol/guild.jpg' data-x-rel='nofollow'><img
alt='Inkscape.svg'
src='//upload.wikimedia.org/wikipedia/commons/thumb/6/6f/Inkscape.svg/20px-Inkscape.svg.png'
width='20'
height='20'
srcset='//upload.wikimedia.org/wikipedia/commons/thumb/6/6f/Inkscape.svg/30px-Inkscape.svg.png
1.5x,
//upload.wikimedia.org/wikipedia/commons/thumb/6/6f/Inkscape.svg/40px-Inkscape.svg.png
2x'
data-le-width='60'
data-leheight='60' /></a> Image <a href='http://www.wga.hu/html/b/bol/guild.html' data-x-rel='nofollow'><img alt='Information icon.svg'
src='//upload.wikimedia.org/wikipedia/commons/thumb/3/35/Information_icon.svg/20px-Information_icon.svg.png'
width='20'
height='20' srcset='//upload.wikimedia.org/wikipedia/commons/thumb/3/35/Information_icon.svg/30px-Information_icon.svg.png 1.5x,
//upload.wikimedia.org/wikipedia/commons/thumb/3/35/Information_icon.svg/40px-Information_icon.svg.png 2x' data-le-width='620'
data-le-height='620' /></a> Info about artwork Original artist: Ferdinand Bol
File:Flag_of_Australia.svg Source: http://upload.wikimedia.org/wikipedia/en/b/b9/Flag_of_Australia.svg License: Public domain Contributors: ? Original artist: ?
File:Flag_of_Austria.svg Source: http://upload.wikimedia.org/wikipedia/commons/4/41/Flag_of_Austria.svg License: Public domain
Contributors: Own work, http://www.bmlv.gv.at/abzeichen/dekorationen.shtml Original artist: User:SKopp
File:Flag_of_Canada.svg Source: http://upload.wikimedia.org/wikipedia/en/c/cf/Flag_of_Canada.svg License: PD Contributors: ? Original artist: ?
File:Flag_of_Cyprus.svg Source: http://upload.wikimedia.org/wikipedia/commons/d/d4/Flag_of_Cyprus.svg License: Public domain
Contributors: Own work Original artist: User:Vzb83
File:Flag_of_Denmark.svg Source: http://upload.wikimedia.org/wikipedia/commons/9/9c/Flag_of_Denmark.svg License: Public domain Contributors: Own work Original artist: User:Madden
File:Flag_of_France.svg Source: http://upload.wikimedia.org/wikipedia/en/c/c3/Flag_of_France.svg License: PD Contributors: ? Original artist: ?
File:Flag_of_Germany.svg Source: http://upload.wikimedia.org/wikipedia/en/b/ba/Flag_of_Germany.svg License: PD Contributors: ?
Original artist: ?
File:Flag_of_Greece.svg Source: http://upload.wikimedia.org/wikipedia/commons/5/5c/Flag_of_Greece.svg License: Public domain
Contributors: own code Original artist: (of code) cs:User:-xfi- (talk)
File:Flag_of_Hong_Kong.svg Source: http://upload.wikimedia.org/wikipedia/commons/5/5b/Flag_of_Hong_Kong.svg License: Public
domain Contributors: http://www.protocol.gov.hk/flags/chi/r_flag/index.html Original artist: Tao Ho
File:Flag_of_Ireland.svg Source: http://upload.wikimedia.org/wikipedia/commons/4/45/Flag_of_Ireland.svg License: Public domain
Contributors: Drawn by User:SKopp Original artist: ?
File:Flag_of_New_Zealand.svg Source: http://upload.wikimedia.org/wikipedia/commons/3/3e/Flag_of_New_Zealand.svg License:
Public domain Contributors: http://www.mch.govt.nz/files/NZ%20Flag%20-%20proportions.JPG Original artist: Zscout370, Hugh Jass
and many others
File:Flag_of_Poland.svg Source: http://upload.wikimedia.org/wikipedia/en/1/12/Flag_of_Poland.svg License: Public domain Contributors: ? Original artist: ?
File:Flag_of_Russia.svg Source: http://upload.wikimedia.org/wikipedia/en/f/f3/Flag_of_Russia.svg License: PD Contributors: ? Original artist: ?
File:Flag_of_Turkey.svg Source: http://upload.wikimedia.org/wikipedia/commons/b/b4/Flag_of_Turkey.svg License: Public domain
Contributors: Turkish Flag Law (Trk Bayra Kanunu), Law nr. 2893 of 22 September 1983. Text (in Turkish) at the website of the
Turkish Historical Society (Trk Tarih Kurumu) Original artist: David Benbennick (original author)
File:Flag_of_the_United_Arab_Emirates.svg Source: http://upload.wikimedia.org/wikipedia/commons/c/cb/Flag_of_the_United_
Arab_Emirates.svg License: Public domain Contributors: ? Original artist: ?

12.2. IMAGES

105

File:Flag_of_the_United_Kingdom.svg Source: http://upload.wikimedia.org/wikipedia/en/a/ae/Flag_of_the_United_Kingdom.svg License: PD Contributors: ? Original artist: ?


File:Flag_of_the_United_States.svg Source: http://upload.wikimedia.org/wikipedia/en/a/a4/Flag_of_the_United_States.svg License:
PD Contributors: ? Original artist: ?
File:General_Government.jpg Source: http://upload.wikimedia.org/wikipedia/commons/9/9b/General_Government.jpg License: CC
BY-SA 3.0 Contributors: Template:Government Finance Statistics IMF Original artist: Cag244
File:Great_western_hospital.JPG Source: http://upload.wikimedia.org/wikipedia/commons/2/28/Great_western_hospital.JPG License:
Public domain Contributors: Transferred from en.wikipedia; transferred to Commons by User:Oxyman using CommonsHelper. Original
artist: Original uploader was Rodw at en.wikipedia
File:Ivsrf.gif Source: http://upload.wikimedia.org/wikipedia/commons/b/b1/Ivsrf.gif License: CC-BY-SA-3.0 Contributors: Transferred
from en.wikipedia; transferred to Commons by User:Liftarn using CommonsHelper. Original artist: Original uploader was Ronnotel at
en.wikipedia
File:Lloyd{}s_coffee_house_drawing.jpg Source: http://upload.wikimedia.org/wikipedia/commons/b/b8/Lloyd%27s_coffee_house_
drawing.jpg License: Public domain Contributors: https://en.wikipedia.org/wiki/File:Lloyd%27s_coffee_house_drawing.jpg Original
artist: Anonymous
File:Lloyds_Subscription_Room_edited.jpg Source: http://upload.wikimedia.org/wikipedia/commons/2/23/Lloyds_Subscription_
Room_edited.jpg License: Public domain Contributors: ? Original artist: Thomas Rowlandson (17561827) and Augustus Charles Pugin (17621832) (after) John Bluck (. 17911819), Joseph Constantine Stadler (. 17801812), Thomas Sutherland (17851838), J.
Hill, and Harraden (aquatint engravers)
File:MM2.png Source: http://upload.wikimedia.org/wikipedia/commons/7/74/MM2.png License: CC-BY-SA-3.0 Contributors: Own
work Original artist: Suicup
File:Markowitz_frontier.jpg Source: http://upload.wikimedia.org/wikipedia/commons/e/e1/Markowitz_frontier.jpg License: Public
domain Contributors: Own work Original artist: User:G2010a
File:National-insurance-act-1911.jpg Source: http://upload.wikimedia.org/wikipedia/commons/8/8b/National-insurance-act-1911.
jpg License: Public domain Contributors: Liberal Publication Department Original artist: Liberal Publication Department
File:Office-book.svg Source: http://upload.wikimedia.org/wikipedia/commons/a/a8/Office-book.svg License: Public domain Contributors: This and myself. Original artist: Chris Down/Tango project
File:Panorama_clip3.jpg Source: http://upload.wikimedia.org/wikipedia/commons/f/f3/Panorama_clip3.jpg License: CC-BY-SA-3.0
Contributors: ? Original artist: ?
File:Pipe_installation_2.jpg Source: http://upload.wikimedia.org/wikipedia/commons/e/ee/Pipe_installation_2.jpg License: CC BY-SA
3.0 Contributors: Own work Original artist: Tomas Castelazo
File:Plane_crash_into_Hudson_River_muchcropped.jpg Source:
http://upload.wikimedia.org/wikipedia/commons/c/c8/Plane_
crash_into_Hudson_River_muchcropped.jpg License: CC BY 2.0 Contributors: cropped from File:Plane crash into Hudson River.jpg
(originally posted to Flickr as Plane crash into Hudson River) Original artist: Greg L
File:Public_Sector.png Source: http://upload.wikimedia.org/wikipedia/commons/7/73/Public_Sector.png License: CC BY-SA 3.0 Contributors: Template:Government Finance Statistics IMF Original artist: Cag244
File:Question_book-new.svg Source: http://upload.wikimedia.org/wikipedia/en/9/99/Question_book-new.svg License: Cc-by-sa-3.0
Contributors:
Created from scratch in Adobe Illustrator. Based on Image:Question book.png created by User:Equazcion Original artist:
Tkgd2007
File:Republic_Fire_Insurance_Company_certificate.jpg Source: http://upload.wikimedia.org/wikipedia/commons/a/a1/Republic_
Fire_Insurance_Company_certificate.jpg License: Public domain Contributors: Library of Congress Prints and Photographs Division
Washington, D.C. 20540 USA http://www.loc.gov/pictures/item/2003679795/ Original artist: Republic Fire Insurance Co.
File:SML-chart.png Source: http://upload.wikimedia.org/wikipedia/en/f/f3/SML-chart.png License: CC0 Contributors:
I (Lamro) created this work entirely by myself.
Original artist:
Lamro
File:Sign_of_the_Times-Foreclosure.jpg
Source:
http://upload.wikimedia.org/wikipedia/commons/a/a9/Sign_of_the_
Times-Foreclosure.jpg License: CC BY 2.0 Contributors: http://www.flickr.com/photos/respres/2539334956/ Original artist: respres
File:Stockpricesimulation.jpg Source: http://upload.wikimedia.org/wikipedia/commons/f/f2/Stockpricesimulation.jpg License: Public
domain Contributors: Roberto Croce Original artist: Roberto Croce
File:Symbol_list_class.svg Source: http://upload.wikimedia.org/wikipedia/en/d/db/Symbol_list_class.svg License: Public domain Contributors: ? Original artist: ?
File:Tornado_Damage,_Illinois_2.JPG Source:
http://upload.wikimedia.org/wikipedia/commons/d/d3/Tornado_Damage%2C_
Illinois_2.JPG License: CC BY-SA 2.5 Contributors: Own work Original artist: Robert Lawton
File:Total_world_wealth_vs_total_world_derivatives_1998-2007.gif Source: http://upload.wikimedia.org/wikipedia/en/e/e8/Total_
world_wealth_vs_total_world_derivatives_1998-2007.gif License: PD Contributors:
self-made. Created with openoce.org Calc using world derivatives data from the Bank for International Settlements at: http://www.bis.
org/statistics/derstats.htm The le with the data from 1998-2007 is: http://www.bis.org/statistics/otcder/dt1920a.csv The world wealth
is in the United Nations report on household wealth in the year 2000 at: http://www.wider.unu.edu/research/2006-2007/2006-2007-1/
wider-wdhw-launch-5-12-2006/wider-wdhw-report-5-12-2006.pdf Original artist:
Analoguni (talk)

106

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File:UA_Flight_175_hits_WTC_south_tower_9-11_edit.jpeg Source: http://upload.wikimedia.org/wikipedia/commons/8/8a/UA_


Flight_175_hits_WTC_south_tower_9-11_edit.jpeg License: CC BY-SA 2.0 Contributors:
UA_Flight_175_hits_WTC_south_tower_9-11.jpeg Original artist: UA_Flight_175_hits_WTC_south_tower_9-11.jpeg: Flickr user
TheMachineStops (Robert J. Fisch)
File:WTC_smoking_on_9-11.jpeg Source: http://upload.wikimedia.org/wikipedia/commons/3/35/WTC_smoking_on_9-11.jpeg License: CC BY 2.0 Contributors: Flickr Original artist: Flickr user Michael Foran
File:Wall_Street_-_New_York_Stock_Exchange.jpg Source: http://upload.wikimedia.org/wikipedia/commons/e/ec/Wall_Street_-_
New_York_Stock_Exchange.jpg License: CC BY-SA 3.0 Contributors: Own work Original artist: Carlos Delgado
File:Wall_Street_Sign_NYC.jpg Source: http://upload.wikimedia.org/wikipedia/commons/6/65/Wall_Street_Sign_NYC.jpg License:
CC BY-SA 3.0 Contributors: Own work Original artist: JSquish
File:Wikibooks-logo.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/fa/Wikibooks-logo.svg License: CC BY-SA 3.0
Contributors: Own work Original artist: User:Bastique, User:Ramac et al.
File:Wikinews-logo.svg Source: http://upload.wikimedia.org/wikipedia/commons/2/24/Wikinews-logo.svg License: CC BY-SA 3.0
Contributors: This is a cropped version of Image:Wikinews-logo-en.png. Original artist: Vectorized by Simon 01:05, 2 August 2006 (UTC)
Updated by Time3000 17 April 2007 to use ocial Wikinews colours and appear correctly on dark backgrounds. Originally uploaded by
Simon.
File:Wikiquote-logo.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/fa/Wikiquote-logo.svg License: Public domain
Contributors: ? Original artist: ?
File:Wikisource-logo.svg Source: http://upload.wikimedia.org/wikipedia/commons/4/4c/Wikisource-logo.svg License: CC BY-SA 3.0
Contributors: Rei-artur Original artist: Nicholas Moreau
File:Wikiversity-logo-Snorky.svg Source: http://upload.wikimedia.org/wikipedia/commons/1/1b/Wikiversity-logo-en.svg License: CC
BY-SA 3.0 Contributors: Own work Original artist: Snorky
File:Wikiversity-logo.svg Source: http://upload.wikimedia.org/wikipedia/commons/9/91/Wikiversity-logo.svg License: CC BY-SA 3.0
Contributors: Snorky (optimized and cleaned up by verdy_p) Original artist: Snorky (optimized and cleaned up by verdy_p)
File:Wiktionary-logo-en.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/f8/Wiktionary-logo-en.svg License: Public domain Contributors: Vector version of Image:Wiktionary-logo-en.png. Original artist: Vectorized by Fvasconcellos (talk contribs), based
on original logo tossed together by Brion Vibber

12.3 Content license


Creative Commons Attribution-Share Alike 3.0