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Input elements. Unified Financial Analysis The Risk&Finance Lab. Chapter 3: Financial Contracts Willi Brammertz / Ioannis Akkizidis. Contract: The focal point of finance. The contract is the prime container of the financial rules The contractual agreement is the only hard fact of finance

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  1. Input elements Unified Financial Analysis The Risk&Finance Lab Chapter 3: Financial Contracts Willi Brammertz / Ioannis Akkizidis

  2. Contract: The focal point of finance • The contract is the prime container of the financial rules • The contractual agreement is the only hard fact of finance • „Mechanical“ part of finance, therefore pivotal • Modeling of non-mechanical part: Behavior

  3. Where is the complexity?

  4. The need for standardization • Risk factors have certain degree of standardization • Markets: Bloomberg, Reuters • Counterparties: LEI • Behavior: Must be an open dimension • Financial contract is pivotal element • Most complex part and „mechanically representable“ • Despite this center stage: No standard yet

  5. Stock answers A3 Data … • Data has to be standardized • Semantic Depositories • Data Warehouses A2 A1 An A1 An Contract Events State Contingent Cash Flows Contract Algorithms A2 … A3 Data

  6. Emerging standard

  7. Why unique data is not sufficientThe rational for Contract Types • Example of a set of contract data • Value date: 15.3.00 • Principal: 1000 • Interest payment cycle: quarterly • Interest rate: 5%, fixed • Maturity date: 15.3.05 • What are the expected cash flows?

  8. Possible solution 1:Classical Bond Total Principle . . . . Time Value Date Maturity Date

  9. Possible solution 2:Classical Annuity Total Principle IP+PR . . . . Time Value Date Maturity Date

  10. Possible solution 3:Linear amortizer Total Principle . . . . Time Value Date Maturity Date

  11. Necessary condition for non-ambiguousinterpretation • Well defined data • Knowledge about • intended cash-flow exchange pattern • The underlying algorithms • The algorithms must represent the legally defined intention • A strict separation between data, algorithms and results is not possible in finance

  12. Different stages of standardization • The cash flow generation rules are defined for each real-life contract individually. • Using a set of predefined rules: one defines elementary financial rules such as repricing patterns, amortization patterns and so on. These rules are then combined on an ad hoc basis to replicate the behavior of real life financial contracts. • Using a set of predefined standard contract types, where each contract type is a fixed combination of rules. Each real life financial contract is then mapped into one of these contract types. • Method 3 for the big bulk (100-x%) and method 1 or 2 for the rest.

  13. Principal role of Contract Types(Choice 4) • CT’s describe the exact transmission mechanics between • Financial contract • Risk factor environment • Expected financial events • State contingent cash flows • Given a • Financial contract • Exact risk factor environment • The state contingent cash flows are unambiguously defined • Special solution for contracts outside the standard.

  14. Further reasons for choice 4 • Factual low variety of financial contracts • 98+% of all real life patterns can be represented with two and a half dozen patterns • Historical Experience • Practitioners thinking | transaction systems • Dynamic Simulation

  15. Common sub-mechanisms • Principal amortization • Principal draw-down • Interest payment • Rate adjustment • FX rates • Stock and commodity patterns • Simple options • Exotic options • Credit risk related • Behavioral On-Balance Loans

  16. High level architecture

  17. Basic Contract Types

  18. Combined Contract Types

  19. Parent/child relationships

  20. Real-Life financial contracts Mapping Interface Combined Contract_Types Basic Contract_Types Derivatives Non-Deriv. ex. Dual Currency Bond Fixed Income Symmetric Options Credit Risk FRA Futures Non Maturities Maturities Swaps Basic Exotic 1 Exotic 2 SCI Contracts • • • CFL BNDCP • STK • IRFRA ANN • IRSWP • CAXFL • UMP • CRL • GAR • COL • LIM • • CLM • • CSH ANX • IRFUT • BNCAF IRXOP COM • • FXSWP DSC • • IDX • NGM • SCFUT • SWPTN • SCXOP • FXOUT • FXFUT • ZCB • • IROPT • FXXOP NGX • PAM • PBN • SCOPT • • FXOPT PAX • RGM • CAPFL • RGX Any contract type can have the Collateral role Various underlying basic CT’s Contract TypesTaxonomy

  21. Example 1: Discounted paper

  22. Example 2: PAM fixed

  23. Example 3: PAM variable

  24. Example 4: Classical annuity, fixed

  25. Example 5: Classical annuity, variable

  26. Example 6: Regular amortizer with step-up

  27. Example 7: Plain vanilla swap

  28. Example 8: FRA

  29. Example 9: European bond option

  30. What to do with the 2-%?Non-standard Contract Types

  31. Risk factor states, state contingentevents/cash flows and analysis elements

  32. Dataflow in practice Market Data Counterparty Data Contract Data .... Hierarchy Internal Data .... External Data ...... Reuters Bloomberg Swaps Savings Bonds Qualitative scores Statistical ETL Behavioural + Adjustment up/down Interface V_D M_D C_P … EUR.SWA USD.GOV USD/EUR ... Select Aggregate Behavioral Assumptions Static Analysis Dynamic Analysis ID Name Rating ... Results Historization Central Data Store SummixTM

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