## Archive for the ‘Finance’ Category

### Project finance funding: a simple Excel model

May 4, 2012

Financing of infrastructure projects is a hot topic at the moment.

Penny Lynch has kindly made a simple cashflow Excel model available which shows the key components (equity vs debt) of project finance funding.

### What does ‘reduce the balance sheet’ mean?

April 26, 2012

This post is a LeanPost: it will be developed further depending on feedback from my readers.

See my note here on what a LeanPost is.

Many companies are these days talking about reducing the balance sheet.

Another term used is de-leveraging.

In the simplest terms, this just means that a company is reducing the number of loans it has taken out. As a consequence, it will be probably be selling off assets to pay back those loans.

In this post we have a give some details on the borrowing/assets relationship for companies and mention some of the main concepts in corporate accounting that are useful to know if you are on the trading floor.

I always like to think in terms of concrete examples, so for this post I develop a story of setting up a business and show how we naturally come across the concepts of balance-sheet optimization, cost of capital, and other topics which are part of the standard courses in corporate finance.

### Calculating option prices in your head

April 5, 2012

We all know that option prices are calculated with the Black-Scholes formula, using a volatility, time-to-maturity, strike and forward. Typically you just chuck them all into your computer and let it spit out the number.

Trouble with this is how do you get an intuition for prices, especially when you are looking at options trades like conditional steepeners or calendar spreads?

Recently I set myself the problem of getting some simple way to cross-check the numbers coming out of my PC, and to get some intuition for the way an option’s value decays to its intrinsic value as the forward moves (which is what you definitely need for options trading).

In this post I show you a simple approximation I have found which does a pretty stellar job of accurately telling you the price of an option at any strike, and which you can calculate in your head!

### Fixed-income investment strategies in the age of the New Normal

March 27, 2012

I came across an interesting presentation given by one of the senior members of PIMCO UK, a chap called Mike Amey.

What I especially like about this presentation is that it covers a lot of the main topics that I hear investors discussing at the moment, ranging from the bigger themes like EMs vs developed markets or the general Health of Economies, global inflation, tail risk, through to the more technical strategies like carry.

In this post I give background and thoughts on some of the topics and terms that Mr Amey uses in his presentation.

### Why does the yield curve slope upwards?

January 26, 2012

In this post I give a short, but I think rather usefully direct reason for why the yield curve should slope upwards. All it requires is for you to put yourself in the shoes of an investor that has to lock up their money in a bond for a fixed amount of time (and a very simple piece of algebra).

Yes, you can find plenty of papers which give complicated economic reasons for why this should be the case, but I tend to think that it is the simple insights that explain most of what you see happening in financial markets.

### What is the risk-neutral measure?

January 24, 2012

Here is a short list of the most common ‘big-concept’ questions that I was asked throughout my years as a quant (whether coming from people on the trading floor, in control functions, or from newcomers to the team), in no particular order:

What is the risk-neutral measure?

What is arbitrage-free pricing?

What is a change of numeraire?

What is the ‘market price of risk’?

I don’t know of a single book on financial mathematics that attempts to give answers to these questions for a reader that is not familiar with stochastic calculus (which most traders are not, of course). Over a series of posts I will put down my own user-friendly answers to these questions, and we’ll end up with a grand Guide to Financial Derivatives Pricing for a Non-Technical User!

This post covers the first: what is the risk-neutral measure?

### The value of Good Explanations

January 12, 2012

I am a firm believer in the value of good explanations, and I’d say a lot of my time is spent on finding the right explanation or intuition for a process or event (this blog itself is an example).

Rather like a good user interface, a good explanation can be the difference between a success and failure in a project. Here are some qualities of good explanations:

• they are intellectually satisfying when you find them,
• they allow you to reach out to a larger audience than just your fellow specialists, and therefore are a better way to have an external audit of the work you are doing,
• they can show the direction your research should go,
• a good explanation of a trade/model/etc inspires confidence in your traders & clients that you know what you are doing and are taking care with their money.

The key to all this is that:

and that itself is the basis of good research.

### Everything you wanted to know about Repo but were afraid to ask

January 11, 2012

Well the title is a bit of an overstatement!

This post is actually just a short note with a link to a document which covers the concept of specialness in the repo market, and which is actually a good description of the repo market as a whole. Such things are hard to find, you know.

### How to calculate carry

January 11, 2012

Positive carry can be an obsession for fixed-income investors.

For a simple explanation of carry for a bond position have a look at this well-written post: click here.

### Facts, rules of thumb, and intuition for swap spreads

January 11, 2012

The N-year swap spread is defined as:

N-yr swap spread := N-yr swap rate – N-yr government bond yield.

Since most quants spend much less time on the bond market than on the swaps market,  they often don’t come to appreciate the central importance of the swap spread. Here is an unordered list of why the swap spread is important:

• it is the unhedgeable part left over after you hedge a bond portfolio with swaps,
• it is a value measure of whether investors should buy their exposure with swaps or bonds,
• it makes up one of the standard collection of arbitrage strategies in the fixed income space,
• it moves a lot (sometimes up, sometimes down) in times of market stress.

The swap spread is fascinating, believe it.

This post collects a few of my personal notes on the swap spread, including my tricks for remembering the rules-of-thumb, and gives links to well-written articles across the web.