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Main article                                                 1
    Finance                                                  1

The main techniques and sectors of the financial industry    8
    Financial services                                       8

Personal finance                                            12
    Personal finance                                        12

Corporate finance                                           15
    Corporate finance                                       15
    Financial capital                                       23
    Cornering the market                                    29
    Insurance                                               33

Risk Management                                             57
    Derivative                                              57

Finance of states                                           69
    Public finance                                          69

Financial economics                                         78
    Financial economics                                     78

Financial mathematics                                       81
    Financial mathematics                                   81

Experimental finance                                        86
    Experimental finance                                    86

Behavioral finance                                          87
    Behavioral finance                                      87

Intangible asset finance                                    98
    Intangible asset finance                                98
   Article Sources and Contributors           101
   Image Sources, Licenses and Contributors   104

Article Licenses
   License                                    105

                                            Main article

Finance is the study of how people allocate
their assets over time under conditions of
certainty and uncertainty. A key point in
finance, which affects decisions, is the time
value of money, which states that a unit of
currency today is worth more than the same
unit of currency tomorrow. Finance aims to
price assets based on their risk level, and
expected rate of return. Finance can be
broken into three different sub categories:
public finance, corporate finance and
personal finance.

Areas of finance                                                   Wall Street, the center of American finance.

Personal finance
Questions in personal finance revolve around
•   How can people protect themselves against unforeseen personal events, as well as those in the external economy?
•   How can family assets best be transferred across generations (bequests and inheritance)?
•   How does tax policy (tax subsidies and/or penalties) affect personal financial decisions?
•   How does credit affect an individual's financial standing?
•   How can one plan for a secure financial future in an environment of economic instability?
Personal financial decisions may involve paying for education, financing durable goods such as real estate and cars,
buying insurance, e.g. health and property insurance, investing and saving for retirement.
Personal financial decisions may also involve paying for a loan, or debt obligations. The six key areas of personal
financial 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 flow. Net worth is a person's balance sheet, calculated by adding up all assets under that
   person's control, minus all liabilities of the household, at one point in time. Household cash flow totals up all the
   expected sources of income within a year, minus all expected expenses within the same year. From this analysis,
   the financial 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 effective terms requires knowledge of the market for personal insurance. Business owners,
   professionals, athletes and entertainers require specialized insurance professionals to adequately protect
   themselves. Since insurance also enjoys some tax benefits, utilizing insurance investment products may be a
   critical piece of the overall investment planning.
Finance                                                                                                                      2

    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 one's income grows, a higher marginal rate of tax must be paid. Understanding how
       to take advantage of the myriad tax breaks when planning one's personal finances can make a significant 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 financial 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 inflation. Using
       net present value calculators, the financial 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 inflation, 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 profile 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 one's 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.

    Corporate finance
    Managerial or corporate finance is the task of providing the funds for a corporation's activities (for small business,
    this is referred to as SME finance). Corporate finance generally involves balancing risk and profitability, while
    attempting to maximize an entity's wealth and the value of its stock, and generically entails three interrelated
    decisions. In the first, "the investment decision", management must decide which "projects" (if any) to undertake.
    The discipline of capital budgeting is devoted to this question, and may employ standard business valuation
    techniques or even extend to real options valuation; see Financial modeling. The second, "the financing decision"
    relates to how these investments are to be funded: capital here is provided by shareholders, in the form of equity
    (privately or via an initial public offering), creditors, often in the form of bonds, and the firm's operations (cash
    flow). Short-term funding or working capital is mostly provided by banks extending a line of credit. The balance
    between these elements forms the company's capital structure. The third, "the dividend decision", requires
    management to determine whether any unappropriated profit is to be retained for future investment / operational
    requirements, or instead to be distributed to shareholders, and if so in what form. Short term financial management is
    often termed "working capital management", and relates to cash-, inventory- and debtors management. These areas
    often overlap with the firm's accounting function, however, financial accounting is more concerned with the
    reporting of historical financial information, while these financial decisions are directed toward the future of the
    Another business decision concerning finance is investment, or fund management. An investment is an acquisition of
    an asset in the hope that it will maintain or increase its value. In investment management – in choosing a portfolio –
    one has to decide 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
Finance                                                                                                                      3

    • Identify the appropriate strategy: active versus passive hedging strategy
    • Measure the portfolio performance
    Financial management is duplicate with the financial function of the Accounting profession. However, financial
    accounting is more concerned with the reporting of historical financial information, while the financial decision is
    directed toward the future of the firm.
    Financial risk management, an element of corporate finance, is the practice of creating and protecting economic
    value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk.
    (Other risk types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc.) It focuses on
    when and how to hedge using financial instruments; in this sense it overlaps with financial engineering. Similar to
    general risk management, financial 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.

    Financial services
    An entity whose income exceeds its expenditure can lend or invest the excess income. 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 find a borrower, a financial intermediary such as a bank, or buy
    notes or bonds in the bond market. The lender receives interest, the borrower pays a higher interest than the lender
    receives, and the financial intermediary earns the difference for arranging the loan.
    A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it
    pays interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders, of different sizes,
    to coordinate their activity.
    Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate
    finance) and by a wide variety of other organizations, including schools and non-profit organizations. In general, the
    goals of each of the above activities are achieved through the use of appropriate financial instruments and
    methodologies, with consideration to their institutional setting.
    Finance is one of the most important aspects of business management and includes decisions related to the use and
    acquisition of funds for the enterprise.
    In corporate finance, a company's capital structure is the total mix of financing methods it uses to raise funds. One
    method is debt financing, which includes bank loans and bond sales. Another method is equity financing - the sale of
    stock by a company to investors, the original shareholders 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 and stock, may be institutional
    investors - financial institutions such as investment banks and pension funds  or private individuals, called private
    investors or retail investors.
Finance                                                                                                                       4

    Public finance
    Public finance describes finance 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:
    •     Identification of required expenditure of a public sector entity
    •     Source(s) of that entity's 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 finance, acting as lenders of last resort as well as strong influences on
    monetary and credit conditions in the economy.[2]

    Capital, in the financial sense, is the money that gives the business the power to buy goods to be used in the
    production of other goods or the offering 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 financial terms, e.g., the target set for sale, resulting cost, growth, required investment to achieve the
    planned sales, and financing source for the investment.
    A budget may be long term or short term. Long term budgets have a time horizon of 5–10 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 fixed asset requirements and how these expenditures will be financed. Capital budgets
    are often adjusted annually 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 sufficient funds available to meet short-term expenses.
    The cash budget is basically a detailed plan that shows all expected sources and uses of cash. The cash budget has
    the following six main sections:
    1. Beginning Cash Balance - contains the last period's closing cash balance.
    2. Cash collections - includes all expected cash receipts (all sources of cash for the period considered, mainly sales)
    3. Cash disbursements - lists all planned cash outflows for the period, excluding interest payments on short-term
       loans, which appear in the financing section. All expenses that do not affect cash flow are excluded from this list
       (e.g. depreciation, amortization, etc.)
    4. Cash excess or deficiency - a function of the cash needs and cash available. Cash needs are determined by the
       total cash disbursements plus the minimum cash balance required by company policy. If total cash available is
       less than cash needs, a deficiency exists.
    5. Financing - discloses the planned borrowings and repayments, including interest.

    Financial theory

    Financial economics
    Financial economics is the branch of economics studying the interrelation of financial variables, such as prices,
    interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on
    influences of real economic variables on financial ones, in contrast to pure finance. It centres on decision making
    under uncertainty in the context of the financial markets, and the resultant economic and financial models. It
    essentially explores how rational investors would apply decision theory to the problem of investment. Here, the twin
    assumptions of rationality and market efficiency lead to modern portfolio theory (the CAPM), and to the
Finance                                                                                                                      5

    Black–Scholes 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", Modigliani-Miller theorem) and hence also contributes to
    corporate finance theory. Financial Econometrics is the branch of Financial Economics that uses econometric
    techniques to parameterize the relationships suggested.
    Although closely related, the disciplines of economics and finance are distinctive. The “economy” is a social
    institution that organizes a society’s production, distribution, and consumption of goods and services,” all of which
    must be financed.
    Economists make a number of abstract assumptions for purposes of their analyses and predictions. They generally
    regard financial markets that function for the financial system as an efficient mechanism (Efficient-market
    hypothesis). Instead, financial markets are subject to human error and emotion.[3] New research discloses the
    mischaracterization of investment safety and measures of financial products and markets so complex that their
    effects, especially under conditions of uncertainty, are impossible to predict. The study of finance is subsumed under
    economics as financial economics, but the scope, speed, power relations and practices of the financial system can
    uplift or cripple whole economies and the well-being of households, businesses and governing bodies within
    them—sometimes in a single day.

    Financial mathematics
    Financial mathematics is a field of applied mathematics, concerned with financial markets. The subject has a close
    relationship with the discipline of financial economics, which is concerned with much of the underlying theory.
    Generally, mathematical finance will derive, and extend, the mathematical or numerical models suggested by
    financial economics. In terms of practice, mathematical finance also overlaps heavily with the field of computational
    finance (also known as financial engineering). Arguably, these are largely synonymous, although the latter focuses
    on application, while the former focuses on modeling and derivation (see: Quantitative analyst). The field is largely
    focused on the modelling of derivatives, although other important subfields include insurance mathematics and
    quantitative portfolio problems. See Outline of finance: Mathematical tools; Outline of finance: Derivatives pricing.

    Experimental finance
    Experimental finance aims to establish different market settings and environments to observe experimentally and
    provide a lens through which science can analyze agents' behavior and the resulting characteristics of trading flows,
    information diffusion and aggregation, price setting mechanisms, and returns processes. Researchers in experimental
    finance can study to what extent existing financial economics theory makes valid predictions, and attempt to
    discover new principles on which such theory can be extended. Research may proceed by conducting trading
    simulations or by establishing and studying the behaviour of people in artificial competitive market-like settings.

    Behavioral finance
    Behavioral Finance studies how the psychology of investors or managers affects financial decisions and markets.
    Behavioral finance has grown over the last few decades to become central to finance.
    Behavioral finance includes such topics as:
    1.    Empirical studies that demonstrate significant deviations from classical theories.
    2.    Models of how psychology affects 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 finance 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
Finance                                                                                                                                          6

    been led by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during
    2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don
    Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, Ray Sturm and others have demonstrated
    significant behavioral effects in stocks and exchange traded funds. Among other topics, quantitative behavioral
    finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.

    Intangible asset finance
    Intangible asset finance is the area of finance that deals with intangible assets such as patents, trademarks, goodwill,
    reputation, etc.

    Professional qualifications
    There are several related professional qualifications, that can lead to the field:
    • Generalist Finance qualifications:
          • Degrees: Masters degree in Finance (MSF), Master of Financial Economics, Master of Finance & Control
            (MFC), Master Financial Manager (MFM), Master of Financial Administration (MFA)
      • Certifications: Chartered Financial Analyst (CFA), Certified Treasury Professional (CTP), Certified Valuation
        Analyst (CVA), Certified International Investment Analyst (CIIA), Financial Risk Manager (FRM),
        Professional Risk Manager (PRM), Association of Corporate Treasurers (ACT), Certified Market Analyst
        (CMA/FAD) Dual Designation, Corporate Finance Qualification (CF), Chartered Alternative Investment
        Analyst (CAIA)
    • Quantitative Finance qualifications: Master of Financial Engineering (MSFE), Master of Quantitative Finance
      (MQF), Master of Computational Finance (MCF), Master of Financial Mathematics (MFM), Certificate in
      Quantitative Finance (CQF).
    • Accountancy qualifications:
      • Qualified accountant: Chartered Accountant (ACA - UK certification / CA - certification in Commonwealth
        countries), Chartered Certified Accountant (ACCA, UK certification), Certified Public Accountant (CPA, US
        certification), ACMA/FCMA ( Associate/Fellow Chartered Management Accountant) from Chartered Institute
        of Management Accountant(CIMA), UK.
      • Non-statutory qualifications: Chartered Cost Accountant CCA Designation from AAFM
    • Business qualifications: 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] "Financial Planning Curriculum Framework" (http:/ / www. fpsb. org/ component/ docman/ doc_download/
        1008-financial-planning-curriculum-framework. html). 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. (http:/ /
        www. federalreserve. gov/ aboutthefed/ mission. htm) Accessed: 2010-01-16. (Archived by WebCite at (http:/ / www.
        webcitation. org/ 5mpS52OAl))
    [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
Finance                                                                                                             7

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

        The main techniques and sectors of the
                  financial industry

Financial services
Financial services are the economic services provided by the finance industry, which encompasses a broad range of
organizations that manage money, including credit unions, banks, credit card companies, insurance companies,
consumer finance companies, stock brokerages, investment funds and some government sponsored enterprises. As of
2004, the financial services industry represented 20% of the market capitalization of the S&P 500 in the United

History of financial services
The term "financial services" became more prevalent in the United States partly as a result of the
Gramm-Leach-Bliley Act of the late 1990s, which enabled different types of companies operating in the U.S.
financial services industry at that time to merge.[2]
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 firm, and adds
the acquisition to its holding company simply to diversify its earnings. Outside the U.S. (e.g., in Japan),
non-financial 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.

A "commercial bank" is what is commonly referred to as simply a "bank". The term "commercial" is used to
distinguish it from an "investment bank," a type of financial services entity which, instead of lending money directly
to a business, helps businesses raise money from other firms in the form of bonds (debt) or stock (equity).

Banking services
The primary operations of banks include:
• Keeping money safe while also allowing withdrawals when needed
• Issuance of checkbooks so that bills can be paid and other kinds of payments can be delivered by post
• Provide personal loans, commercial loans, and mortgage loans (typically loans to purchase a home, property or
• Issuance of credit cards and processing of credit card transactions and billing
• Issuance of debit cards for use as a substitute for checks
• Allow financial 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 Bank's own money to meet monthly spending
  commitments of a customer in their current account.
Financial services                                                                                                         9

     • Provide internet banking system to facilitate the customers to view and operate their respective accounts through
     • Provide Charge card advances of the Bank's own money for customers wishing to settle credit advances monthly.
     • Provide a check guaranteed by the Bank itself and prepaid by the customer, such as a cashier's check or certified
     • Notary service for financial and other documents
     • Accepting the deposits from customer and provide the credit facilities to them.

     Other types of bank services
     • Private banking - Private banks provide banking services exclusively to high net worth individuals. Many
       financial services firms require a person or family to have a certain minimum net worth to qualify for private
       banking services.[3] Private banks often provide more personal services, such as wealth management and tax
       planning, than normal retail banks.[4]
     • Capital market bank - bank that underwrite debt and equity, assist company deals (advisory services, underwriting
       and advisory fees), and restructure debt into structured finance products.
     • Bank cards - include both credit cards and debit cards. Bank Of America is the largest issuer of bank cards.
     • Credit card machine services and networks - Companies which provide credit card machine and payment
       networks call themselves "merchant card providers".

     Foreign exchange services
     Foreign exchange services are provided by many banks around the world. Foreign exchange services include:
     • Currency exchange - where clients can purchase and sell foreign currency banknotes.
     • Foreign Currency Banking - banking transactions are done in foreign currency.
     • Wire transfer - where clients can send funds to international banks abroad.

     Investment services
     • Asset management - the term usually given to describe companies which run collective investment funds. Also
       refers to services provided by others, generally registered with the Securities and Exchange Commission as
       Registered Investment Advisors.
     • 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 world's securities trades and servicing the associated
       portfolios. Assets under custody in the world are approximately US$100 trillion.[5]

     • Insurance brokerage - Insurance brokers shop for insurance (generally corporate property and casualty insurance)
       on behalf of customers. Recently a number of websites have been created to give consumers basic price
       comparisons for services such as insurance, causing controversy within the industry.[6]
     • Insurance underwriting - Personal lines insurance underwriters actually underwrite insurance for individuals, a
       service still offered primarily through agents, insurance brokers, and stock brokers. Underwriters may also offer
       similar commercial lines of coverage for businesses. Activities include insurance and annuities, life insurance,
       retirement insurance, health insurance, and property & casualty insurance.
     • Reinsurance - Reinsurance is insurance sold to insurers themselves, to protect them from catastrophic losses.
Financial services                                                                                                             10

     Other financial services
     • 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 offices to assist clients. These brokerages
       primarily target individual investors. Full service and private client firms primarily assist and execute trades for
       clients with large amounts of capital to invest, such as large companies, wealthy individuals, and investment
       management funds.
     • Private equity - Private equity funds are typically closed-end funds, which usually take controlling equity stakes
       in businesses that are either private, or taken private once acquired. Private equity funds often use leveraged
       buyouts (LBOs) to acquire the firms in which they invest. The most successful private equity funds can generate
       returns significantly 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-potential-growth 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
       affluent 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 research and pool their investment capital.
     • Conglomerates - A financial services conglomerate is a financial services firm that is active in more than one
       sector of the financial 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 diversification benefits that are present when different 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.
     • Debt resolution is a consumer service that assists individuals that have too much debt to pay off as requested, but
       do not want to file bankruptcy and wish to pay off 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. There are many
       services/companies that can assist with this.

     Financial crime

     Fraud within the financial industry costs the UK (regulated by the FSA) an estimated £14bn a year and it is believed
     a further £25bn is laundered by British institutions.[7]

     Market share
     The financial 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.[8] In contrast, the largest home improvement store in the US, Home Depot, has a 30% market share,
     and the largest coffee house Starbucks has a 32% market share.
Financial services                                                                                                                                     11

     [1] "The Mistakes Of Our Grandparents?" (http:/ / www. contraryinvestor. com/ 2004archives/ mofeb04. htm). Contrary February
         2004. . Retrieved 2009-02-06.
     [2] "Bill Summary & Status 106th Congress (1999 - 2000) S.900 CRS Summary - Thomas (Library of Congress)" (http:/ / thomas. loc. gov/
         cgi-bin/ bdquery/ z?d106:SN00900:@@@D& summ2=m& ). . Retrieved 2011-02-08.
     [3] "Private Banking definition" (http:/ / www. investorwords. com/ 5946/ private_banking. html). Investor . Retrieved 2009-02-06.
     [4] "How Swiss Bank Accounts Work" (http:/ / money. howstuffworks. com/ personal-finance/ banking/ swiss-bank-account. htm). How Stuff
         Works. . Retrieved 2009-02-06.
     [5] Prudential: Securities Processing Primer (http:/ / www. cm1. prusec. com/ rschrpts. nsf/ $$rschidxw/
         4A2ACD93260C58E785256FA3005F8D0E/ $FILE/ PROCESSINGPRIMER25-0076. PDF)
     [6] "Price comparison sites face probe" (http:/ / news. bbc. co. uk/ 1/ hi/ business/ 7201345. stm). BBC News. 2008-01-22. . Retrieved
     [7] "Watchdog warns of criminal gangs inside banks" (http:/ / money. guardian. co. uk/ news_/ story/ 0,1456,1643860,00. html). The Guardian
         (London). 2005-11-16. . Retrieved 2007-11-30.
     [8] The Opportunity: Small Global Market Share (http:/ / www. citigroup. com/ citigroup/ fin/ data/ p040602. pdf), Page 11, from the Sanford C.
         Bernstein & Co. Strategic Decisions Conference – 6/02/04

     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.

     External links
     • The role of the financial Services Sector in Expanding Economic Opportunity | A report by Christopher N. Sutton
       and Beth Jenkins | John F. Kennedy School of Government | Harvard University (
       m-rcbg/CSRI/publications/report_19_EO Finance Final.pdf)

                                      Personal finance

Personal finance
Personal finance refers to the financial decisions which an individual or a family unit is required to make to obtain,
budget, save, and spend monetary resources over time, taking into account various financial risks and future life
events.[1] When planning personal finances the individual would consider the suitability to his or her needs of a
range of banking products (checking, savings accounts, credit cards and consumer loans) or investment (stock
market, bonds, mutual funds) and insurance (life insurance, health insurance, disability insurance) products or
participation and monitoring of individual- or employer-sponsored retirement plans, social security benefits, and
income tax management.

Personal financial planning process
A key component of personal finance is financial planning, which is a dynamic process that requires regular
monitoring and reevaluation. In general, it involves five steps:[2]
1. Assessment: A person's financial situation is assessed by compiling simplified versions of financial 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 financial goals helps to direct financial
   planning. Goal setting is done with an objective to meet certain financial requirements.
3. Creating a plan: The financial plan details how to accomplish the goals. It could include, for example, reducing
   unnecessary expenses, increasing the employment income, or investing in the stock market.
4. Execution: Execution of a financial plan often requires discipline and perseverance. Many people obtain
   assistance from professionals such as accountants, financial planners, investment advisers, and lawyers.
5. Monitoring and reassessment: As time passes, the financial plan must be monitored for possible adjustments or
Typical goals most adults and young adults have are paying off credit card and/or student loan debt, investing for
retirement, investing for college costs for children, paying medical expenses, and planning for passing on their
property to their heirs (which is known as estate planning).

Areas of focus
The six key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are:[3]
1. Financial position: is concerned with understanding the personal resources available by examining net worth
   and household cash flow. Net worth is a person's balance sheet, calculated by adding up all assets under that
   person's control, minus all liabilities of the household, at one point in time. Household cash flow totals up all the
   expected sources of income within a year, minus all expected expenses within the same year. From this analysis,
   the financial 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
Personal finance                                                                                                                                      13

       self-insurable, while most will require the purchase of an insurance contract. Determining how much insurance to
       get, at the most cost effective terms requires knowledge of the market for personal insurance. Business owners,
       professionals, athletes and entertainers require specialized insurance professionals to adequately protect
       themselves. Since insurance also enjoys some tax benefits, 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 one's income grows, a higher marginal rate of tax must be paid. Understanding how
       to take advantage of the myriad tax breaks when planning one's personal finances can make a significant 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 financial 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 inflation.
          Using net present value calculators, the financial 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 inflation, 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 profile 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 one's 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.

    [1] "Personal Finance" (http:/ / www. investopedia. com/ terms/ p/ personalfinance. asp#axzz1rNwPldro). Investopedia. . Retrieved 7 April 2012.
    [2] "What is Personal Finance?" (http:/ / www. practicalfinancialtips. com/ personal-finance/ what-is-personal-finance/ ). Practical Financial
        Tips. . Retrieved 7 April 2012.
    [3] "Financial Planning Curriculum Framework" (http:/ / www. fpsb. org/ component/ docman/ doc_download/
        1008-financial-planning-curriculum-framework. html). Financial Planning Standards Board. 2011. . Retrieved 7 April 2012.

    Further reading
    • Kwok, H., Milevsky, M., and Robinson, C. (1994) Asset Allocation, Life Expectancy, and Shortfall, Financial
      Services Review, 1994, vol 3(2), pg. 109-126.
Personal finance                                                                                                     14

    External links
    • Free Journal of Financial Counseling and Planning articles (
    • Free Center for Financial Planning and Investment personal finance education resources for all ages (http:// .
    • Certified Financial Planner Board website (

                                   Corporate finance

Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the
tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder
value.[1] Although it is in principle different from managerial finance which studies the financial decisions of all
firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the
financial problems of all kinds of firms.
The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions
are long-term choices about which projects receive investment, whether to finance that investment with equity or
debt, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the
short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and
short-term borrowing and lending (such as the terms on credit extended to customers).
The terms corporate finance and corporate financier are also associated with investment banking. The typical role
of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best
fits those needs. Thus, the terms “corporate finance” and “corporate financier” may be associated with transactions in
which capital is raised in order to create, develop, grow or acquire businesses.

Capital investment decisions
Capital investment decisions[2] are long-term corporate finance decisions relating to fixed assets and capital
structure. Decisions are based on several inter-related criteria. (1) Corporate management seeks to maximize the
value of the firm 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 financed appropriately. (3) If no such
opportunities exist, maximizing shareholder value dictates that management must return excess cash to shareholders
(i.e., distribution via dividends). Capital investment decisions thus comprise an investment decision, a financing
decision, and a dividend decision.

The investment decision
Management must allocate limited resources between competing opportunities (projects) in a process known as
capital budgeting.[3] Making this investment, or capital allocation, decision requires estimating the value of each
opportunity or project, which is a function of the size, timing and predictability of future cash flows.

Project valuation
In general,[4] each project's value will be estimated using a discounted cash flow (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; see also Fisher separation theorem, John Burr Williams#Theory). This
requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future
cash flows 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 affected by the discount rate. Thus, identifying the proper discount rate – often termed, the
project "hurdle rate"[5] – is critical to making an appropriate decision. The hurdle rate is the minimum acceptable
return on an investment—i.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the
Corporate finance                                                                                                              16

    investment, typically measured by volatility of cash flows, and must take into account the project-relevant financing
    mix. [6] 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 reflect the financing mix selected. (A common error
    in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may
    not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of
    In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance.
    These are visible from the DCF and include discounted payback period, IRR, Modified IRR, equivalent annuity,
    capital efficiency, and ROI. Alternatives (complements) to NPV include Residual Income Valuation, MVA / EVA
    (Joel Stern, Stern Stewart & Co) and APV (Stewart Myers). See list of valuation topics.

    Valuing flexibility
    In many cases, for example R&D projects, a project may open (or close) various paths of action to the company, but
    this reality will not (typically) be captured in a strict NPV approach.[7] Some analysts account for this uncertainty by
    adjusting the discount rate (e.g. by increasing the cost of capital) or the cash flows (using certainty equivalents, or
    applying (subjective) "haircuts" to the forecast numbers).[8][9] Even when employed, however, these latter methods
    do not normally properly account for changes in risk over the project's lifecycle and hence fail to appropriately adapt
    the risk adjustment.[10] Management will therefore (sometimes) employ tools which place an explicit value on these
    options. So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted,
    here the “flexible and staged nature” of the investment is modelled, and hence "all" potential payoffs are considered.
    See further under Real options valuation. The difference between the two valuations is the "value of flexibility"
    inherent in the project.
    The two most common tools are Decision Tree Analysis (DTA)[11][12] and Real options valuation (ROV);[13] they
    may often be used interchangeably:
    • DTA values flexibility by incorporating possible events (or states) and consequent management decisions. (For
      example, a company would build a factory given that demand for its product exceeded a certain level during the
      pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the
      factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" – each scenario must be
      modelled separately.) In the decision tree, each management decision in response to an "event" generates a
      "branch" or "path" which the company could follow; the probabilities of each event are determined or specified
      by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to
      management; (2) given this “knowledge” of the events that could follow, and assuming rational decision making,
      management chooses the branches (i.e. actions) corresponding to the highest value path probability weighted; (3)
      this path is then taken as representative of project value. See Decision theory#Choice under uncertainty.
    • ROV is usually used when the value of a project is contingent on the value of some other asset or underlying
      variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low,
      management will abandon the mining rights, if sufficiently high, management will develop the ore body. Again, a
      DCF valuation would capture only one of these outcomes.) Here: (1) using financial option theory as a
      framework, the decision to be taken is identified 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 finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options
      was originally per Timothy Luehrman, in the late 1990s.) See also Option pricing approaches under Business
Corporate finance                                                                                                               17

    Quantifying uncertainty
    Given the uncertainty inherent in project forecasting and valuation,[12][14] analysts will wish to assess the sensitivity
    of project NPV to the various inputs (i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst
    will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change
    in that factor is then observed, and is calculated as a "slope": ΔNPV / Δfactor. For example, the analyst will
    determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%,
    0%, 5%....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and
    their various combinations produce a "value-surface",[15] (or even a "value-space",) where NPV is then a function of
    several variables. See also Stress testing.
    Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular
    outcome for economy-wide, "global" factors (demand for the product, exchange rates, commodity prices, etc...) as
    well as for company-specific factors (unit costs, etc...). As an example, the analyst may specify various revenue
    growth scenarios (e.g. 0% for "Worst Case", 10% for "Likely Case" and 20% for "Best Case"), where all key inputs
    are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each. Note that for
    scenario based analysis, the various combinations of inputs must be internally consistent (see discussion at Financial
    modeling), whereas for the sensitivity approach these need not be so. An application of this methodology is to
    determine an "unbiased" NPV, where management determines a (subjective) probability for each scenario – the NPV
    for the project is then the probability-weighted average of the various scenarios. See First Chicago Method.
    A further advancement which "overcomes the limitations of sensitivity and scenario analyses by examining the
    effects of all possible combinations of variables and their realizations." [16] is to construct stochastic[17] or
    probabilistic financial models – as opposed to the traditional static and deterministic models as above.[14] For this
    purpose, the most common method is to use Monte Carlo simulation to analyze the project’s NPV. This method was
    introduced to finance 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 risk-analysis add-in, such as @Risk
    or Crystal Ball. Here, the cash flow components that are (heavily) impacted by uncertainty are simulated,
    mathematically reflecting 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;" [18] 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 project's "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.
Corporate finance                                                                                                              18

    The financing decision
    Achieving the goals of corporate
    finance requires that any corporate
    investment          be         financed
    appropriately.      The sources of
    financing are, generically, capital
    self-generated by the firm 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                        Domestic credit to private sector in 2005.
    flows (and hence the riskiness of the
    firm) will be affected, the financing mix will impact the valuation of the firm (as well as the other long-term
    financial management decisions). There are two interrelated considerations here:

    • Management must identify the "optimal mix" of financing—the capital structure that results in maximum firm
      value.[20] (See Balance sheet, WACC, Fisher separation theorem; but, see also the Modigliani-Miller theorem.)
      Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow
      implications independent of the project's degree of success. Equity financing is less risky with respect to cash
      flow 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 financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.[21]
    • Management must attempt to match the long-term financing mix to the assets being financed as closely as
      possible, in terms of both timing and cash flows. Managing any potential asset liability mismatch or duration gap
      entails matching the assets and liabilities respectively according to maturity pattern ("Cashflow 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 rate- or credit
      derivatives, are also common. See Asset liability management; Treasury management; Credit risk; Interest rate
    Much of the theory here, falls under the umbrella of the Trade-Off Theory in which firms are assumed to trade-off
    the tax benefits of debt with the bankruptcy costs of debt when making their decisions. However economists have
    developed a set of alternative theories about financing decisions. One of the main alternative theories of how firms
    make their financing decisions is the Pecking Order Theory (Stewart Myers), which suggests that firms avoid
    external financing while they have internal financing available and avoid new equity financing while they can
    engage in new debt financing 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 finance theory is right-financing 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 financing (debt or equity) and expenditure framework within a given economy and
    under given market conditions. One of the more recent innovations in this are from a theoretical point of view is the
    Market timing hypothesis. This hypothesis, inspired in the behavioral finance literature, states that firms look for the
    cheaper type of financing regardless of their current levels of internal resources, debt and equity.
Corporate finance                                                                                                             19

    The dividend decision
    Whether to issue dividends,[22] and what amount, is calculated mainly on the basis of the company's unappropriated
    profit and its earning prospects for the coming year. The amount is also often calculated based on expected free cash
    flows i.e. cash remaining after all business expenses, and capital investment needs have been met.
    If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then – finance theory
    suggests – management must return excess cash to shareholders as dividends. This is the general case, however there
    are exceptions. For example, shareholders of a "growth stock", expect that the company will, almost by definition,
    retain earnings so as to fund growth internally. In other cases, even though an opportunity is currently NPV negative,
    management may consider “investment flexibility” / potential payoffs and decide to retain cash flows; see above and
    Real options.
    Management must also decide on 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, firms 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. Today, it is
    generally accepted that dividend policy is value neutral – i.e. the value of the firm would be the same, whether it
    issued cash dividends or repurchased its stock (see Modigliani-Miller theorem).

    Working capital management
    Decisions relating to working capital and short term financing are referred to as working capital management.[23]
    These involve managing the relationship between a firm's 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 firm value. In the context of long
    term, capital investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive
    investments. These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of
    Working Capital (i.e. short term) management is therefore to ensure that the firm is able to operate, and that it has
    sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational
    expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See
    Economic value added (EVA). Managing short term finance and long term finance is one task of a modern CFO.

    Decision criteria
    Working capital is the amount of capital which is readily available to an organization. That is, working capital is the
    difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements
    (Current Liabilities). As a result, the decisions relating to working capital are always current, i.e. short term,
    decisions. In addition to time horizon, working capital decisions differ from capital investment decisions in terms of
    discounting and profitability 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).
    Working capital management decisions are therefore not taken on the same basis as long term decisions, and
    working capital management applies different criteria in decision making: the main considerations are (1) cash flow /
    liquidity and (2) profitability / return on capital (of which cash flow is probably the most important).
    • The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle. This represents
      the time difference between cash payment for raw materials and cash collection for sales. The cash conversion
      cycle indicates the firm's ability to convert its resources into cash. Because this number effectively corresponds to
      the time that the firm's cash is tied up in operations and unavailable for other 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 it does not take into account the creditors deferral period.)
Corporate finance                                                                                                             20

    • In this context, the most useful measure of profitability 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 firm's shareholders. As above, firm value is enhanced when, and if, the return on
      capital, exceeds the cost of capital. ROC measures are therefore useful as a management tool, in that they link
      short-term policy with long-term decision making.

    Management of working capital
    Guided by the above criteria, management will use a combination of policies and techniques for the management of
    working capital.[24] These policies aim at managing the current assets (generally cash and cash equivalents,
    inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.
    • Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but
      reduces cash holding costs.
    • 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 flow. Note that
      "inventory" is usually the realm of operations management: given the potential impact on cash flow, and on the
      balance sheet in general, finance typically "gets involved in an oversight or policing way".[25]: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 flows and the cash conversion cycle will be
      offset 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.
    • Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the
      inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan
      (or overdraft), or to "convert debtors to cash" through "factoring".

    Relationship with other areas in finance

    Investment banking
    Use of the term “corporate finance” varies considerably across the world. In the United States it is used, as above, to
    describe activities, decisions and techniques that deal with many aspects of a company’s finances and capital. In the
    United Kingdom and Commonwealth countries, the terms “corporate finance” and “corporate financier” tend to be
    associated with investment banking – i.e. with transactions in which capital is raised for the corporation.[26] 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
    • Management buy-out, buy-in or similar of companies, divisions or subsidiaries – typically backed by private
    • Equity issues by companies, including the flotation of companies on a recognised stock exchange in order to raise
      capital for development and/or to restructure ownership
    • Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and
      restructuring of businesses
    • Financing joint ventures, project finance, infrastructure finance, public-private partnerships and privatisations
Corporate finance                                                                                                              21

    • Secondary equity issues, whether by means of private placing or further issues on a stock market, especially
      where linked to one of the transactions listed above.
    • Raising debt and restructuring debt, especially when linked to the types of transactions listed above

    Financial risk management
          See also: Credit risk; Default (finance); Financial risk; Interest rate risk; Liquidity risk; Operational risk;
          Settlement risk; Value at Risk; Volatility risk.
    Risk management [27][17] is the process of measuring risk and then developing and implementing strategies to
    manage ("hedge") that risk. Financial risk management, typically, is focused on the impact on corporate value due 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 treasury management; see above. It is common for large
    corporations to have risk management teams; often these overlap with the internal audit function. While it is
    impractical for small firms to have a formal risk management function, many still apply risk management informally.
    See also Enterprise risk management.
    The discipline typically focuses on risks that can be hedged using traded financial instruments, typically derivatives;
    see Cash flow hedge, Foreign exchange hedge, Financial engineering. Because company specific, "over the counter"
    (OTC) contracts tend to be costly to create and monitor, derivatives that trade on well-established financial markets
    or exchanges are often preferred. These standard derivative instruments include options, futures contracts, forward
    contracts, and swaps; the "second generation" exotic derivatives usually trade OTC. Note that hedging-related
    transactions will attract their own accounting treatment: see Hedge accounting, Mark-to-market accounting, FASB
    133, IAS 39.
    This area is related to corporate finance in two ways. Firstly, firm exposure to business and market risk is a direct
    result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of enhancing, or
    preserving, firm value. There is a fundamental debate [28] relating to "Risk Management" and shareholder value. Per
    the Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care
    about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the probability
    of financial distress. A further question, is the shareholder's desire to optimize risk versus taking exposure to pure
    risk (a risk event that only has a negative side, such as loss of life or limb). The debate links the value of risk
    management in a market to the cost of bankruptcy in that market. See Fisher separation theorem.

    Personal and public finance
    Corporate finance utilizes tools from almost all areas of finance. Some of the tools developed by and for corporations
    have broad application to entities other than corporations, for example, to partnerships, sole proprietorships,
    not-for-profit organizations, governments, mutual funds, and personal wealth management. But in other cases their
    application is very limited outside of the corporate finance arena. Because corporations deal in quantities of money
    much greater than individuals, the analysis has developed into a discipline of its own. It can be differentiated from
    personal finance and public finance.

    Alternate Approaches
    A standard assumption in Corporate finance is that shareholders are the residual claimants and that the primary goal
    of executives should be to maximize shareholder value. Recently, however, legal scholars (e.g. Lynn Stout [29]) have
    questioned this assumption, implying that the assumed goal of maximizing shareholder value is inappropriate for a
    public corporation. This criticism in turn brings into question the advice of corporate finance, particularly related to
    stock buybacks made purportedly to "return value to shareholders," which is predicated on a legally erroneous
Corporate finance                                                                                                                                        22

    [1] See Corporate Finance: First Principles (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/ AppldCF/ other/ Image2. gif), Aswath
        Damodaran, New York University's Stern School of Business
    [2] The framework for this section is based on Notes (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/ AppldCF/ other/ Image2. gif)
        by Aswath Damodaran at New York University's Stern School of Business
    [3] See: Investment Decisions and Capital Budgeting (http:/ / www. duke. edu/ ~charvey/ Classes/ ba350_1997/ vcf2/ vcf2. htm), Prof. Campbell
        R. Harvey; The Investment Decision of the Corporation (http:/ / www. bus. lsu. edu/ academics/ finance/ faculty/ dchance/ Instructional/
        FinancialManagementDecisions. ppt#257,2,Slide), Prof. Don M. Chance
    [4] See: Valuation (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/ lectures/ val. html), Prof. Aswath Damodaran; Equity
        Valuation (http:/ / www. duke. edu/ ~charvey/ Classes/ ba350_1997/ vcf1/ vcf1. htm), Prof. Campbell R. Harvey
    [5] See for example Campbell R. Harvey's Hypertextual Finance Glossary (http:/ / biz. yahoo. com/ f/ g/ hh. html) or (http:/ /
        www. investopedia. com/ terms/ h/ hurdlerate. asp)
    [6] Prof. Aswath Damodaran: Estimating Hurdle Rates (http:/ / people. stern. nyu. edu/ adamodar/ pdfiles/ acf3E/ presentations/ hurdlerate. pdf)
    [7] See: Real Options Analysis and the Assumptions of the NPV Rule (http:/ / www. realoptions. org/ papers2002/ SchockleyOptionNPV. pdf. ),
        Tom Arnold & Richard Shockley
    [8] Aswath Damodaran: Risk Adjusted Value (http:/ / pages. stern. nyu. edu/ ~adamodar/ pdfiles/ valrisk/ ch5. pdf); Ch 5 in Strategic Risk
        Taking: A Framework for Risk Management. Wharton School Publishing, 2007. ISBN 0-13-199048-9
    [9] See: §32 "Certainty Equivalent Approach” & §165 "Risk Adjusted Discount Rate" in: Joel G. Siegel; Jae K. Shim; Stephen Hartman (1
        November 1997). Schaum's quick guide to business formulas: 201 decision-making tools for business, finance, and accounting students (http:/
        / books. google. com/ books?id=4JpojQPk8YsC). McGraw-Hill Professional. ISBN 978-0-07-058031-2. . Retrieved 12 November 2011.
    [10] Dan Latimore: Calculating value during uncertainty (http:/ / www-935. ibm. com/ services/ uk/ igs/ pdf/
        esr-calculating-value-during-uncertainty. pdf). IBM Institute for Business Value
    [11] See: Decision Tree Analysis (http:/ / www. mindtools. com/ pages/ article/ newTED_04. htm),; Decision Tree Primer (http:/ /
        www. public. asu. edu/ ~kirkwood/ DAStuff/ decisiontrees/ index. html), Prof. Craig W. Kirkwood Arizona State University; Using Decision
        Trees In Finance (http:/ / www. investopedia. com/ articles/ financial-theory/ 11/ decisions-trees-finance. asp),
    [12] See: "Capital Budgeting Under Risk". Ch.9 in Schaum's outline of theory and problems of financial management (http:/ / books. google.
        com/ books?id=_lnmxnhoAUEC& printsec=frontcover& dq=related:ISBN0070580316#v=onepage& q& f=false), Jae K. Shim and Joel G.
    [13] See: Identifying real options (http:/ / faculty. fuqua. duke. edu/ ~charvey/ Teaching/ BA456_2002/ Identifying_real_options. htm), Prof.
        Campbell R. Harvey; Applications of option pricing theory to equity valuation (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/
        lectures/ opt. html), Prof. Aswath Damodaran; How Do You Assess The Value of A Company's "Real Options"? (http:/ / www.
        expectationsinvesting. com/ tutorial11. shtml), Prof. Alfred Rappaport Columbia University & Michael Mauboussin
    [14] See Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations (http:/ / www. stern. nyu. edu/ ~adamodar/ pdfiles/
        papers/ probabilistic. pdf), Prof. Aswath Damodaran
    [15] 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" (https:/ / www. u-cursos. cl/ ingenieria/ 2008/ 1/ MI75E/ 1/
        material_docente/ bajar?id_material=167438) 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" (http:/ / downloads. cyestcorp. com/ Technical
        Papers/ Practical Application of an Economic Optimisation Model in an Underground Mining Environment. pdf).
    [16] Virginia Clark, Margaret Reed, Jens Stephan (2010). Using Monte Carlo simulation for a capital budgeting project (http:/ / findarticles. com/
        p/ articles/ mi_m0OOL/ is_1_12/ ai_n57086241/ ), Management Accounting Quarterly, Fall, 2010
    [17] See: Quantifying Corporate Financial Risk (http:/ / www. qfinance. com/ financial-risk-management-best-practice/
        quantifying-corporate-financial-risk?full), David Shimko.
    [18] The Flaw of Averages (http:/ / www. analycorp. com/ uncertainty/ flawarticle. htm), Prof. Sam Savage, Stanford University.
    [19] See: The Financing Decision of the Corporation (http:/ / www. bus. lsu. edu/ academics/ finance/ faculty/ dchance/ Instructional/
        FinancialManagementDecisions. ppt#256,1,Slide), Prof. Don M. Chance; Capital Structure (http:/ / pages. stern. nyu. edu/ ~adamodar/ pdfiles/
        ovhds/ capstr. pdf), Prof. Aswath Damodaran
    [20] Capital Structure: Implications (http:/ / www. qfinance. com/ mergers-and-acquisitions-best-practice/ capital-structure-implications?full),
        Prof. John C. Groth, Texas A&M University; A Generalised Procedure for Locating the Optimal Capital Structure (http:/ / rdcohen. 50megs.
        com/ genOCS. pdf), Ruben D. Cohen, Citigroup
    [21] See: Optimal Balance of Financial Instruments: Long-Term Management, Market Volatility & Proposed Changes (http:/ / www.
        lawyersclubindia. com/ articles/
        Optimal-Balance-of-Financial-Instruments-Long-Term-Management-Market-Volatility-Proposed-Changes-3765. asp), Nishant Choudhary,
        LL.M. 2011 (Business & finance), George Washington University Law School
    [22] See Dividend Policy (http:/ / pages. stern. nyu. edu/ ~adamodar/ pdfiles/ ovhds/ divid. pdf), Prof. Aswath Damodaran
    [23] See Working Capital Management (http:/ / www. studyfinance. com/ lessons/ workcap/ index. mv),; Working Capital
        Management (http:/ / www. treasury. govt. nz/ publicsector/ workingcapital/ chap2. asp),
Corporate finance                                                                                                                                  23

    [24] See The 20 Principles of Financial Management (http:/ / www. bus. lsu. edu/ academics/ finance/ faculty/ dchance/ Instructional/
        PrinciplesofFinancialManagement. htm), Prof. Don M. Chance, Louisiana State University
    [25] William Lasher (2010). Practical Financial Management. South-Western College Pub; 6 ed. ISBN 1-4390-8050-X
    [26] Beaney, Shaun, "Defining corporate finance in the UK" (http:/ / www. icaew. com/ en/ technical/ corporate-finance/
        corporate-finance-faculty/ what-is-corporate-finance-122299), Corporate Finance Faculty, ICAEW, April 2005 (revised January 2011)
    [27] See: Global Association of Risk Professionals (GARP) (http:/ / www. garp. com/ ); Professional Risk Managers' International Association
        (PRMIA) (http:/ / www. primia. org/ )
    [28] See for example: Prof. Jonathan Lewellen, MIT: Financial Management Notes: Risk Management (http:/ / ocw. mit. edu/ courses/
        sloan-school-of-management/ 15-414-financial-management-summer-2003/ lecture-notes/ lec19_options. pdf)
    [29] Lynn A. Stout (2002). Bad and Not-So-Bad Arguments for Shareholder Primacy (http:/ / www. uclouvain. be/ cps/ ucl/ doc/ etes/
        documents/ Stout_-SSRN-id331464. pdf), University of California, Los Angeles School of Law Research Paper No. 25; Lynn A. Stout (2007).
        The Mythical Benefits of Shareholder Control (http:/ / www. lccge. bbk. ac. uk/ publications-and-resources/ docs/ Stout 2007. pdf),
        REGULATION Spring 2007.

    Financial capital
    Financial capital is money used by entrepreneurs and businesses to
    buy what they need to make their products or provide their services or
    to that sector of the economy based on its operation, i.e. retail,
    corporate, investment banking, etc.

    Three concepts of capital maintenance                                                                   Capital exports in 2006

    authorized in IFRS
    Financial capital or just capital in finance and accounting, is funds
    provided by lenders (and investors) to businesses to purchase real
    capital equipment for producing goods/services. Real capital or
    economic capital comprises physical goods that assist in the
    production of other goods and services, e.g. shovels for gravediggers,
    sewing machines for tailors, or machinery and tooling for factories.                                   Capital imports in 2006

    Financial capital generally refers to saved-up financial wealth,
    especially that used to start or maintain a business. A financial concept of capital is adopted by most entities in
    preparing their financial reports. Under a financial concept of capital, such as invested money or invested purchasing
    power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as
    operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output
    per day.[1] Financial capital maintenance can be measured in either nominal monetary units or units of constant
    purchasing power.[2][3] There are thus three concepts of capital maintenance in terms of International Financial
    Reporting Standards (IFRS): (1) Physical capital maintenance (2) Financial capital maintenance in nominal monetary
    units (3) Financial capital maintenance in units of constant purchasing power.[4][5]

    Financial capital is provided by lenders for a price: interest. Also see time value of money for a more detailed
    description of how financial capital may be analyzed.
    Furthermore, financial capital, is any liquid medium or mechanism that represents wealth, or other styles of capital.
    It is, however, usually purchasing power in the form of money available for the production or purchasing of goods,
    etcetera. Capital can also be obtained by producing more than what is immediately required and saving the surplus.
    Financial capital can also be in the form of purchasable items such as computers or books that can contribute directly
    or indirectly to obtaining various other types of capital.[7] [6]
Financial capital                                                                                                         24

     Financial capital has been subcategorized by some academics as economic or "productive capital" necessary for
     operations, signaling capital which signals a company's financial strength to shareholders, and regulatory capital
     which fulfills capital requirements.[8]

     Sources of capital
     • Long term - usually above 7 years
        •   Share Capital
        •   Mortgage loan
        •   Retained Profit
        •   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
        •   Long-term loans, often with a mortgage bond as security
        •   Reserve funds
        •   Euro Bonds
        •   Law Firms

     Money market
     • Financial institutions can use short-term savings to lend out in the form of short-term loans:
        •   Credit on open account
        •   Bank overdraft
        •   Short-term loans
        •   Bills of exchange
        •   Factoring of debtors
Financial capital                                                                                                                25

     Differences between shares and debentures
     • Shareholders are effectively owners; debenture-holders are creditors.
     • Shareholders may vote at AGMs (Annual General Meetings) and be elected as directors; debenture-holders may
       not vote at AGMs or be elected as directors.
     • Shareholders receive profit in the form of dividends; debenture-holders receive a fixed rate of interest.
     • If there is no profit, the shareholder does not receive a dividend; interest is paid to debenture-holders regardless of
       whether or not a profit has been made.
     • In case of dissolution of firms debenture holders are paid first as compared to shareholder.

     Fixed capital
     This is money which is used to purchase assets that will remain permanently in the business and help it to make a

     Factors determining fixed capital requirements
     • Nature of business
     • Size of business
     • Stage of development
     • Capital invested by the owners
     • location of that area

     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 finance credit.

     Factors determining working capital requirements
     •   Size of business
     •   Stage of development
     •   Time of production
     •   Rate of stock turnover ratio
     •   Buying and selling terms
     •   Seasonal consumption
     •   Seasonal product
     •   profit level
     •   growth and expansion
     •   production cycle
     •   general nature of business
     •   business cycle
     business policies
Financial capital                                                                                                              26

     A contract regarding any combination of capital assets is called a financial instrument, and may serve as a
     •   medium of exchange,
     •   standard of deferred payment,
     •   unit of account, or
     •   store of value.
     Most indigenous forms of money (wampum, shells, tally sticks and such) and the modern fiat money is only a
     "symbolic" storage of value and not a real storage of value like commodity money.

     Own and borrowed capital
     Capital contributed by the owner or entrepreneur of a business, and obtained, for example, by means of savings or
     inheritance, is known as own capital or equity, whereas that which is granted by another person or institution is
     called borrowed capital, and this must usually be paid back with interest. The ratio between debt and equity is named
     leverage. It has to be optimized as a high leverage can bring a higher profit but create solvency risk.

     Borrowed capital
     This is capital which the business borrows from institutions or people, and includes debentures:
     •   Redeemable debentures
     •   Irredeemable debentures
     •   Debentures to bearer
     •   Ordinary debentures
     •   bonds
     •   deposits
     •   loans

     Own capital
     This is capital that owners of a business (shareholders and partners, for example) provide:
     • Preference shares/hybrid source of finance
       • Ordinary preference shares
       • Cumulative preference shares
       • Participating preference shares
     • Ordinary shares
     • Bonus shares
     • Founders' shares
     These have preference over the equity shares. This means the payments made to the shareholders are first paid to the
     preference shareholder(s) and then to the equity shareholders.

     Issuing and trading
     Like money, financial instruments may be "backed" by state military fiat, 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 reveals differences in probability of debt collection or store of value
     function of that currency, as assigned by traders.
Financial capital                                                                                                                 27

     When in forms other than money, financial capital may be traded on bond markets or reinsurance markets with
     varying degrees of trust in the social capital (not just credits) of bond-issuers, insurers, and others who issue and
     trade in financial instruments. When payment is deferred on any such instrument, typically an interest rate is higher
     than the standard interest rates paid by banks, or charged by the central bank on its money. Often such instruments
     are called fixed-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 reflect the standard rate for deferred
     payment set by the central bank prime rate, increasing it by some fixed percentage. Other instruments, such as citizen
     entitlements, e.g. "U.S. Social Security", or other pensions, may be indexed to the rate of inflation, to provide a
     reliable value stream.
     Trading in stock markets or commodity markets is actually trade in underlying assets which are not wholly financial
     in themselves, although they often move up and down in value in direct response to the trading in more purely
     financial derivatives. Typically commodity markets depend on politics that affect international trade, e.g. boycotts
     and embargoes, or factors that influence natural capital, e.g. weather that affects food crops. Meanwhile, stock
     markets are more influenced by trust in corporate leaders, i.e. individual capital, by consumers, i.e. social capital or
     "brand capital" (in some analyses), and internal organizational efficiency, i.e. instructional capital and infrastructural
     capital. Some enterprises issue instruments to specifically track one limited division or brand. "Financial futures",
     "Short selling" and "financial options" apply to these markets, and are typically pure financial bets on outcomes,
     rather than being a direct representation of any underlying asset.

     Broadening the notion
     The relationship between financial 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 effect, the means of money supply and other regulations on financial capital represent the
     economic sense of the value system of the society itself, as they determine the allocation of labor in that society.
     So, for instance, rules for increasing or reducing the money supply based on perceived inflation, or on measuring
     well-being, reflect some such values, reflect the importance of using (all forms of) financial capital as a stable store
     of value. If this is very important, inflation control is key - any amount of money inflation reduces the value of
     financial 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 inflation or well-being.

     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.[9][10]

     Normally, a financial 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 financial instruments vary drastically
     based on timing. The "book value", "mark-to-market" and "mark-to-future"[11] conventions are three different
     approaches to reconciling financial capital value units of account.
Financial capital                                                                                                                               28

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

     [1] (http:/ / www. aasb. com. au/ admin/ file/ content105/ c9/ Framework_07-04nd. pdf) Framework for the Preparation and Presentation of
         Financial Statements, Par 102
     [2] Constant item purchasing power accounting#CIPPA as per the IASB's Framework.5B14.5D .5B15.5D Constant item purchasing power
     [3] (http:/ / www. aasb. com. au/ admin/ file/ content105/ c9/ Framework_07-04nd. pdf) Framework for the Preparation and Presentation of
         Financial Statements, Par 104
     [4] Constant item purchasing power accounting#CIPPA as per the IASB's Framework.5B14.5D .5B15.5D Constant item purchasing power
     [5] (http:/ / www. aasb. com. au/ admin/ file/ content105/ c9/ Framework_07-04nd. pdf) Framework for the Preparation and Presentation of
         Financial Statements, Par 104(a)
     [6] http:/ / www. distributedleadership. org/ DLS/ Publications_files/ Spillane,%20Hallett,%20Diamond.
     [7] 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
     [8] The Risk Report, April 2009. Volume XXXI No. 8. IRMI (http:/ / www. irmi. com/ ).
     [9] Imperialism, the Highest Stage of Capitalism ibid. Finance Capital and the Finance Oligarchy (http:/ / www. marxists. org/ archive/ lenin/
         works/ 1916/ imp-hsc/ ch03. htm)
     [10] Monopoly-Finance Capital and the Paradox of Accumulation John Bellamy Foster and Robert W. McChesney [[Monthly Review (http:/ /
         www. monthlyreview. org/ 091001foster-mcchesney. php)] Sept-Oct 2009]
     [11] The New Generation of Risk Management for Hedge Funds and Private Equity Investments (http:/ / books. google. com/
         books?id=2w0bRIv7cygC& pg=PA349& lpg=PA349& dq="mark-to-future"& source=bl& ots=-wAo4Ibldg&
         sig=a8u9-GRjc2ng_8ltgiKnus_cURk& hl=en& ei=l0YSSs_oEpLhtgea6oCSBA& sa=X& oi=book_result& ct=result& resnum=5#PPP1,M1),
         edited by Lars Jaeger, p. 349

     • F. Boldizzoni, Means and Ends: The Idea of Capital in the West, 1500-1970, New York: Palgrave Macmillan,
       2008, chapters 7-8
Cornering the market                                                                                                           29

    Cornering the market
    In finance, to corner the market is to get sufficient control of a particular stock, commodity, or other asset to allow
    the price to be manipulated. Another definition: "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.
    This can be done through several mechanisms. The most direct strategy is to simply buy up a large percentage of the
    available commodity offered 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 profit after inflating the price.
    Although there have been many attempts to corner markets by massive purchases in everything from tin to cattle, 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 as 1923, Edwin Lefèvre wrote, "very few of the great corners were
    profitable to the engineers of them."[2] A cornerer can become vulnerable due to the size of the position, especially if
    the attempt becomes widely known. If the rest of the market senses weakness, it may resist any attempt to artificially
    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 profit from the cornerer's need to unwind the position.
    More success in cornering the market has come by gaining a near-monopoly share in industries such as computers
    (like IBM) and software (like Microsoft).

    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
          olive-presses 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 Lefèvre
    Journalist Edwin Lefèvre 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 justified, 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 25, 1863 can be seen as just an episode in a strategic investment
    that served the public well.
Cornering the market                                                                                                                                     30

    James Fisk, Jay Gould and the Black Friday (1869)
    The 1869 Black Friday financial panic in the United States was caused by the efforts of Jay Gould and James Fisk to
    corner the gold market on the New York Gold Exchange. It was one of several scandals that rocked the 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 significant financial harm.

    Lefèvre thoughts on corners of the old days
    In chapter 19 of his book, Edwin Lefèvre tries to summarize the rationale for the corners of the 19th century.

      A wise old broker told me that all the big operators of the 60s and 70s had one ambition, and that was to work a corner. In many cases this was

      the offspring of vanity; in others, of the desire for revenge. [..] It was more than the prospective money profit that prompted the engineers of
      corners to do their damnedest. It was the vanity complex asserting itself among cold-bloodest operators.

    20th century: The Northern Pacific Railway
    The corner of The Northern Pacific 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 Lefèvre's original
    account in chapter 3 as well as modern annotations explaining the actual locations and personalities on the page

    1920s: The Stutz Motor Company
    Called "a forerunner of the Livermore and Cutten operations of a few years later" by historian Robert Sobel, the
    March 1920 corner of The Stutz Motor Company is an example of a manipulated corner ruining everyone involved,
    especially its originator Thomas Fortune Ryan.

    1950s: The onion market
    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 effect as of 2012.

    1970s: The Hunt brothers and the silver market
    Brothers Nelson Bunker Hunt and William Herbert Hunt 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 world's deliverable silver.[4] During
    the Hunts' accumulation of the precious metal, silver prices rose from $11 an ounce in September 1979 to nearly $50
    an ounce in January 1980.[5] Silver prices ultimately collapsed to below $11 an ounce two months later,[5] much of
    the fall occurring on a single day now known as Silver Thursday, due to changes made to exchange rules regarding
    the purchase of commodities on margin.[6]

    1990s: Hamanaka and the copper market
    Rogue trader Yasuo Hamanaka, Sumitomo Corporation's chief copper trader, attempted to corner the international
    copper market over a ten-year period leading up to 1996.[7] At one point during this "Sumitomo copper affair,"
    Hamanaka is believed to have controlled approximately 5% of the world copper market.[7] As his scheme collapsed,
    Sumitomo was left with large positions in the copper market, ultimately losing US$2.6 billion.[8] In 1997 Hamanaka
    pleaded guilty to criminal charges stemming from his trading activity and was sentenced to an eight-year prison
Cornering the market                                                                                                           31

    2008: Porsche and shares in Volkswagen
    During the financial crisis of 2007-2010 Porsche cornered the market in shares of Volkswagen, which briefly saw
    Volkswagen become the world's most valuable company.[9] 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 shorts—enabling it to perform a short squeeze on them.[10] It was ultimately
    unsuccessful, leading to the resignation of Porsche's chief executive and financial director and to the merger of
    Porsche into Volkswagen.[11]
    One of the wealthiest men in Germany's industry, Adolf Merckle, committed suicide after shorting Volkswagen

    2010: Armajaro and the European cocoa market
    On July 17, 2010, Armajaro purchased 240,100 tonnes of cocoa.[13] 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.[14] 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 been dubbed
    "Chocfinger" by fellow traders for his exploits. The nickname is a reference to both the Bond villain Goldfinger as
    well as a British confection.[15]

    2011: Oil and hedge funds
    All of the above examples had effects that were limited to niche markets. This opens up the question about the
    possibility of cornering one of the markets for strategic commodities that are fundamental to all economies around
    the world. In Summer 2011 Jim Cramer drew the public's attention to a corner of the oil market.[16]
          the cartel of nonconsumers who are using oil futures as part of an investing strategy that includes
          endless attempts to corner the market for crudes in order to make fortunes for them. that's what they did
          in 2008 when they cornered it and took it to $147. we know the futures markets are thin for oil. almost
          all the execs on the show confirm to me these futures are unreliable and easily manipulated. the price
          can be the benchmark for real commerce, meaning they can make a lot of money so long as no one seeks
          to bust the cartel price.
    While Cramer points out frankly that this is a corner (calling into question the proper working of the free market),
    official sources avoid calling this situation a corner. For example, the U.S. Department of Energy explained it would
    release million barrels of oil from the Strategic Petroleum Reserve and called this
          a warning shot to speculators in the oil market
    "Obama's SPR oil release confounds analysts" [17]. Yahoo. 2011-06-24..
    Since this corner is not yet over, it has to be evaluated later if this is a global corner showing how a corner can harm
    the public interest.
Cornering the market                                                                                                                                       32

    [1] Cornering the market (http:/ / financial-dictionary. thefreedictionary. com/ Cornering+ the+ Market).
    [2] Lefèvre, Edwin (1923), Reminiscences of a Stock Operator, chapter 19.
    [3] Aristotle. Politics (http:/ / www. perseus. tufts. edu/ hopper/ text?doc=Aristot. + Pol. + 1. 1259a& redirect=true). Translated by H. Rackham. .
        Retrieved 2011-01-11.
    [4] Gwynne, S. C. (September 2001). "Bunker HUNT". Texas Monthly (Austin, Texas, United States: Emmis Communications Corporation) 29
        (9): p78.
    [5] Eichenwald, Kurt (1989-12-21). "2 Hunts Fined And Banned From Trades" (http:/ / query. nytimes. com/ gst/ fullpage.
        html?res=950DE0DD103FF932A15751C1A96F948260). New York Times. . Retrieved 2008-06-29.
    [6] "Bunker's Busted Silver Bubble" (http:/ / www. time. com/ time/ magazine/ article/ 0,9171,920875-2,00. html). Time Magazine (Time Inc.).
        1980-05-12. . Retrieved 2008-06-29
    [7] Gettler, Leon (2008-02-02). "Wake-up calls on rogue traders keep ringing, but who's answering the phone?" (http:/ / business. theage. com.
        au/ wakeup-calls-on-rogue-traders-keep-ringing-but-whos-answering-the-phone-20080201-1plq. html). The Age (Melbourne). . Retrieved
    [8] Petersen, Melody (1999-05-21). "Merrill Charged With 2d Firm In Copper Case" (http:/ / query. nytimes. com/ gst/ fullpage.
        html?res=9E00E0DC1F3EF932A15756C0A96F958260& sec=& spon=& pagewanted=all). New York Times. . Retrieved 2008-06-29
    [9] "Hedge funds make £18bn loss on VW" (http:/ / news. bbc. co. uk/ 1/ hi/ business/ 7697082. stm). BBC. 2008-10-29. .
    [10] "Squeezy money" (http:/ / www. economist. com/ finance/ displaystory. cfm?story_id=12523898). Economist. 2008-10-30. . Retrieved
        2008-11-01; "A Clever Move by Porsche on VW’s Stock" (http:/ / www. nytimes. com/ 2008/ 10/ 31/ business/ worldbusiness/ 31norris.
        html), New York Times; "Porsche crashes into controversy in the ultimate 'short squeeze'" (http:/ / www. telegraph. co. uk/ finance/
        globalbusiness/ 3362913/ Porsche-crashes-into-controversy-in-the-ultimate-short-squeeze. html), The Daily Telegraph
    [11] "VW prepares to take over Porsche" (http:/ / news. bbc. co. uk/ 1/ hi/ business/ 8165524. stm). BBC. 2009-07-23. .
    [12] Boyes, Roger (2009-01-07). "Adolf Merckle, German tycoon who lost millions on VW shares, commits suicide" (http:/ / business.
        timesonline. co. uk/ tol/ business/ industry_sectors/ banking_and_finance/ article5460281. ece). London: The Sunday Times. .
    [13] Farchy, Jack (16 July 2010). "Hedge fund develops taste for chocolate assets" (http:/ / www. ft. com/ cms/ s/ 0/
        e50feefc-9120-11df-b297-00144feab49a. html). Financial Times. . Retrieved 27 July 2010.
    [14] Sibun, Jonathan; Wallop, Harry (17 July 2010). "Mystery trader buys all Europe's cocoa" (http:/ / www. telegraph. co. uk/ finance/ markets/
        7895242/ Mystery-trader-buys-all-Europes-cocoa. html). The Telegraph. . Retrieved 27 July 2010.
    [15] Werdigier, Julia; Creswell, Julie (July 24, 2010). "Trader’s Cocoa Binge Wraps Up Chocolate Market" (http:/ / www. nytimes. com/ 2010/
        07/ 25/ business/ global/ 25chocolate. html?_r=2). The New York Times. . Retrieved July 27, 2010.
    [16] "No Huddle Offense: Oil 24 Jun 2011" (http:/ / video. cnbc. com/ gallery/ ?video=3000029661). CNBC. 24 June 2011. . Retrieved 25 June
    [17] http:/ / finance. yahoo. com/ news/ Obamas-SPR-oil-release-cnnm-1977710904. html
Insurance                                                                                                                       33

    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 a company selling the insurance; the insured, or policyholder, is the person or
    entity buying the insurance policy. The amount 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 field 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 insurer's promise to compensate (indemnify) the insured in the case of a financial
    (personal) loss. The insured receives a contract, called the insurance policy, which details the conditions and
    circumstances under which the insured will be financially compensated.

    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 insurable, the risk insured against must meet certain
    characteristics in order to be an insurable risk. Insurance is a commercial enterprise and a major part of the financial
    services industry, but individual entities can also self-insure through saving money for possible future losses.[1]

    Risk which can be insured by private companies typically share seven common characteristics:[2]
    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 benefit from the law
       of large numbers in which predicted losses are similar to the actual losses. Exceptions include Lloyd's of London,
       which is famous for insuring the life or health of actors, sports figures and other famous individuals. However, all
       exposures will have particular differences, which may lead to different premium rates.
    2. Definite 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 definite in theory. Occupational disease, for
       instance, may involve prolonged exposure to injurious conditions where no specific time, place or cause is
       identifiable. Ideally, the time, place and cause of a loss should be clear enough that a reasonable person, with
       sufficient information, could objectively verify all three elements.
    3. Accidental loss: The event that constitutes the trigger of a claim should be fortuitous, or at least outside the
       control of the beneficiary 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 lottery ticket, are generally not considered insurable.
    4. Large loss: The size of the loss must be meaningful from the perspective of the insured. Insurance 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 offered has real value to a buyer.
    5. Affordable 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 offered, then it is not likely that the insurance will
       be purchased, even if on offer. Furthermore, as the accounting profession formally recognizes in financial
Insurance                                                                                                                       34

       accounting standards, the premium cannot be so large that there is not a reasonable chance of a significant 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 US Financial Accounting Standards Board standard number 113)
    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 non-catastrophic,
       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 US, flood risk is insured by the federal government. In commercial fire insurance, it is possible to
       find single properties whose total exposed value is well in excess of any individual insurer's 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.

    When a company insures an individual entity, there are basic legal requirements. Several commonly cited legal
    principles of insurance include:[3]
    1. Indemnity – the insurance company indemnifies, or compensates, the insured in the case of certain losses only up
       to the insured's interest.
    2. Insurable interest – the insured typically must directly suffer from the loss. Insurable interest must exist whether
       property insurance or insurance on a person is involved. The concept requires that the insured have a "stake" in
       the loss or damage to the life or property insured. What that "stake" is will be determined by the kind of insurance
       involved and the nature of the property ownership or relationship between the persons. The requirement of an
       insurable interest is what distinguishes insurance from gambling.
    3. Utmost good faith – the insured and the insurer are bound by a good faith bond of honesty and fairness. Material
       facts must be disclosed.
    4. Contribution – insurers which have similar obligations to the insured contribute in the indemnification, according
       to some method.
    5. Subrogation – the insurance company acquires legal rights to pursue recoveries on behalf of the insured; for
       example, the insurer may sue those liable for insured's loss.
    6. Causa proxima, or proximate cause – the cause of loss (the peril) must be covered under the insuring agreement
       of the policy, and the dominant cause must not be excluded
    7. Mitigation - In case of any loss or casualty, the asset owner must attempt to keep loss to a minimum, as if the
       asset was not insured.
Insurance                                                                                                                      35

    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 specified event or peril. Accordingly, life insurance is generally not considered to be
    indemnity insurance, but rather "contingent" insurance (i.e., a claim arises on the occurrence of a specified event).
    There are generally three types of insurance contracts that seek to indemnify an insured:
    1. a "reimbursement" policy, and
    2. a "pay on behalf" or "on behalf of"[4] policy, and
    3. an "indemnification" policy.
    From an insured's standpoint, the result is usually the same: the insurer pays the loss and claims expenses.
    If the Insured has a "reimbursement" policy the insured can be required to pay for a loss and then be "reimbursed" by
    the insurance carrier for the loss and out of pocket costs including, with the permission of the insurer, claim
    Under a "pay on behalf" policy, the insurance carrier would defend and pay a claim on behalf of the insured who
    would not be out of pocket for anything. Most modern liability insurance is written on the basis of "pay on behalf"
    language which enables the insurance carrier to manage and control the claim.
    Under an "indemnification" policy the insurance carrier can generally either "reimburse" or "pay on behalf of"
    whichever is more beneficial to it and the insured in the claim handling process.
    An entity seeking to transfer risk (an individual, corporation, or association of any type, etc.) becomes the 'insured'
    party once risk is assumed by an 'insurer', the insuring party, by means of a contract, called an insurance policy.
    Generally, an insurance contract includes, at a minimum, the following elements: identification of participating
    parties (the insurer, the insured, the beneficiaries), the premium, the period of coverage, the particular loss event
    covered, the amount of coverage (i.e., the amount to be paid to the insured or beneficiary in the event of a loss), and
    exclusions (events not covered). An insured is thus said to be "indemnified" against the loss covered in the policy.
    When insured parties experience a loss for a specified peril, the coverage entitles the policyholder to make a claim
    against the insurer for the covered amount of loss as specified by the policy. The fee paid by the insured to the
    insurer for assuming the risk is called the premium. Insurance premiums from many insureds are used to fund
    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 anticipated losses (called reserves), the remaining
    margin is an insurer's profit.

    Societal effects
    Insurance can have various effects 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 help societies and individuals prepare for catastrophes
    and mitigate the effects of catastrophes on both households and societies.
    Insurance can influence the probability of losses through moral hazard, insurance fraud, and preventive steps by the
    insurance company. Insurance scholars have typically used morale hazard to refer to the increased loss due to
    unintentional carelessness and moral hazard to refer to increased risk due to intentional carelessness or
    indifference.[6] Insurers attempt to address carelessness through inspections, policy provisions requiring certain types
    of maintenance, and possible discounts for loss mitigation efforts. While in theory insurers could encourage
    investment in loss reduction, some commentators have argued that in practice insurers had historically not
    aggressively pursued loss control measures - particularly to prevent disaster losses such as hurricanes - because of
    concerns over rate reductions and legal battles. However, since about 1996 insurers began to take a more active role
    in loss mitigation, such as through building codes.[7]
Insurance                                                                                                                      36

    Insurers' business model

    Underwriting and investing
    The business model is to collect more in premium and investment income than is paid out in losses, and to also offer
    a competitive price which consumers will accept. Profit can be reduced to a simple equation:
            Profit = earned premium + investment income - incurred loss - underwriting expenses.
    Insurers make money in two ways:
    1. Through underwriting, the process by which insurers select the risks to insure and decide how much in premiums
       to charge for accepting those risks;
    2. By investing the premiums they collect from insured parties.
    The most complicated aspect of the insurance business 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
    producing rates, the insurer will use discretion to reject or accept risks through the underwriting process.
    At the most basic level, initial ratemaking involves looking 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.[8] Loss ratios and expense loads are also used. Rating for different risk characteristics involves at the
    most basic level comparing the losses with "loss relativities" - a 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
    insurer's underwriting profit on that policy. Underwriting performance is measured by something called the
    "combined ratio"[9] which is the ratio of expenses/losses to premiums. A combined ratio of less than 100 percent
    indicates an underwriting profit, while anything over 100 indicates an underwriting loss. A company with a
    combined ratio over 100% may nevertheless remain profitable due to investment earnings.
    Insurance companies earn investment profits on "float". 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 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.[10]
    In the United States, the underwriting loss of property and casualty insurance companies was $142.3 billion in the
    five years ending 2003. But overall profit for the same period was $68.4 billion, as the result of float. Some
    insurance industry insiders, most notably Hank Greenberg, do not believe that it is forever possible to sustain a profit
    from float without an underwriting profit as well, but this opinion is not universally held.
    Naturally, the float method is difficult to carry out in an economically depressed period. Bear markets do cause
    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 profitable and unprofitable periods over time is
    commonly known as the underwriting, or insurance, cycle.[11]
Insurance                                                                                                                        37

    Claims and loss handling is the materialized utility of insurance; it is the actual "product" paid for. Claims may be
    filed by insureds directly with the insurer or through brokers or agents. The insurer may require that the claim be
    filed on its own proprietary forms, or may accept claims on a standard industry form, such as those produced by
    Insurance company claims departments employ a large number of claims adjusters supported by a staff of records
    management and data entry clerks. Incoming claims are classified 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.
    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
    Adjusting liability insurance claims is particularly difficult because there is a third party involved, the plaintiff, who
    is under no contractual obligation to cooperate with the insurer and may in fact regard the insurer as a deep pocket.
    The adjuster must obtain legal counsel for the insured (either inside "house" counsel or outside "panel" counsel),
    monitor litigation that may take years to complete, 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 insurance
    company's exposure.
    In managing the claims handling function, insurers seek to balance the elements of customer satisfaction,
    administrative handling expenses, and claims overpayment leakages. As part of this balancing act, fraudulent
    insurance practices are a major business risk that must be managed and overcome. Disputes between insurers and
    insureds over the validity of claims or claims handling practices occasionally escalate into litigation (see insurance
    bad faith).

    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 independent, meaning that they can issue policies from several
    companies. The existence and success of companies using insurance agents is likely due to improved and
    personalized service.[12]

    History of insurance
    In some sense we can say that insurance appears simultaneously with the appearance of human society. We know of
    two types of economies in human societies: natural or non-monetary economies (using barter and trade with no
    centralized nor standardized set of financial instruments) and more modern monetary economies (with markets,
    currency, financial instruments and so on). The former is more primitive and the insurance in such economies entails
    agreements of mutual aid. If one family's house is destroyed the neighbours are committed to help rebuild. Granaries
    housed another primitive form of insurance to indemnify against famines. Often informal or formally intrinsic to
    local religious customs, this type of insurance has survived to the present day in some countries where a modern
    money economy with its financial instruments is not widespread.
    Turning to insurance in the modern sense (i.e., insurance in a modern money economy, in which insurance is part of
    the financial sphere), early methods of transferring or distributing risk were practiced by Chinese and Babylonian
    traders as long ago as the 3rd and 2nd millennia BC, respectively.[13] Chinese merchants travelling treacherous river
Insurance                                                                                                                   38

    rapids would redistribute their wares across many vessels to limit the loss due to any single vessel's capsizing. The
    Babylonians developed a system which was recorded in the famous Code of Hammurabi, c. 1750 BC, and practiced
    by early Mediterranean sailing merchants. If a merchant received a loan to fund his shipment, he would pay the
    lender an additional sum in exchange for the lender's guarantee to cancel the loan should the shipment be stolen or
    lost at sea.
    Achaemenian monarchs of Ancient Persia were the first to insure their people and made it official by registering the
    insuring process in governmental notary offices. The insurance tradition was performed each year in Norouz
    (beginning of the Iranian New Year); the heads of different ethnic groups as well as others willing to take part,
    presented gifts to the monarch. The most important gift was presented during a special ceremony. When a gift was
    worth more than 10,000 Derrik (Achaemenian gold coin) the issue was registered in a special office. This was
    advantageous to those who presented such special gifts. For others, the presents were fairly assessed by the
    confidants of the court. Then the assessment was registered in special offices.
    The purpose of registering was that whenever the person who
    presented the gift registered by the court was in trouble, the monarch
    and the court would help him. Jahez, a historian and writer, writes in
    one of his books on ancient Iran: "[W]henever the owner of the present
    is in trouble or wants to construct a building, set up a feast, have his
    children married, etc. the one in charge of this in the court would check
    the registration. If the registered amount exceeded 10,000 Derrik, he or
    she would receive an amount of twice as much."[14]

    A thousand years later, the inhabitants of Rhodes invented the concept  The subscription room at Lloyd's of London in
    of the general average. Merchants whose goods were being shipped                   the early 19th century.
    together would pay a proportionally divided premium which would be
    used to reimburse any merchant whose goods were deliberately jettisoned in order to lighten the ship and save it
    from total loss.
    The ancient Athenian "maritime loan" advanced money for voyages with repayment being cancelled if the ship was
    lost. In the 4th century BC, rates for the loans differed according to safe or dangerous times of year, implying an
    intuitive pricing of risk with an effect similar to insurance.[15] The Greeks and Romans introduced the origins of
    health and life insurance c. 600 BCE when they created guilds called "benevolent societies" which cared for the
    families of deceased members, as well as paying funeral expenses of members. Guilds in the Middle Ages served a
    similar purpose. The Talmud deals with several aspects of insuring goods. Before insurance was established in the
    late 17th century, "friendly societies" existed in England, in which people donated amounts of money to a general
    sum that could be used for emergencies.
    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. These new
    insurance contracts allowed insurance to be separated from investment, a separation of roles that first proved useful
    in marine insurance. Insurance became far more sophisticated in post-Renaissance Europe, and specialized varieties
Insurance                                                                                                                           39

    Some forms of insurance had developed in London by the early
    decades of the 17th century. For example, the will of the English
    colonist Robert Hayman mentions two "policies of insurance" taken
    out with the diocesan Chancellor of London, Arthur Duck. Of the value
    of £100 each, one relates to the safe arrival of Hayman's ship in
    Guyana and the other is in regard to "one hundred pounds assured by
    the said Doctor Arthur Ducke on my life". Hayman's will was signed
    and sealed on 17 November 1628 but not proved until 1633.[16]
    Toward the end of the seventeenth century, London's growing
    importance as a centre for trade increased demand for marine
    insurance. In the late 1680s, Edward Lloyd opened a coffee house that
    became a popular haunt of ship owners, merchants, and ships' captains,
    and thereby a reliable source of the latest shipping news. It became the
    meeting place for parties wishing to insure cargoes and ships, and
    those willing to underwrite such ventures. Today, Lloyd's of London
    remains the leading market (note that it is an insurance market rather
    than a company) for marine and other specialist types of insurance, but
    it operates rather differently than the more familiar kinds of insurance.
    Insurance as we know it today can be traced to the Great Fire of
    London, which in 1666 devoured more than 13,000 houses. The                Lloyd's of London, pictured in 1991, is one of the
                                                                                  world's leading and most famous insurance
    devastating effects of the fire converted the development of insurance
    "from a matter of convenience into one of urgency, a change of opinion
    reflected in Sir Christopher Wren's inclusion of a site for 'the Insurance
    Office' in his new plan for London in 1667."[17] A number of attempted fire insurance schemes came to nothing, but
    in 1681 Nicholas Barbon, and eleven associates, established England's first fire insurance company, the 'Insurance
    Office for Houses', at the back of the Royal Exchange. Initially, 5,000 homes were insured by Barbon's Insurance

    The first insurance company in the United States underwrote fire insurance and was formed in Charles Town
    (modern-day Charleston), South Carolina, in 1732. Benjamin Franklin helped to popularize and make standard the
    practice of insurance, particularly against fire in the form of perpetual insurance. In 1752, he founded the
    Philadelphia Contributionship for the Insurance of Houses from Loss by Fire.[19] Franklin's company was the first to
    make contributions toward fire prevention. Not only did his company warn against certain fire hazards, it refused to
    insure certain buildings where the risk of fire was too great, such as all wooden houses.
    In the United States, regulation of the insurance industry primary resides with individual state insurance departments.
    The current state insurance regulatory framework has its roots in the 19th century, when New Hampshire appointed
    the first insurance commissioner in 1851.[19] Congress adopted the McCarran-Ferguson Act in 1945, which declared
    that states should regulate the business of insurance and to affirm that the continued regulation of the insurance
    industry by the states is in the public's best interest.[19] The Financial Modernization Act of 1999, commonly referred
    to as "Gramm-Leach-Bliley", established a comprehensive framework to authorize affiliations between banks,
    securities firms, and insurers, and once again acknowledged that states should regulate insurance.[19]
    Whereas insurance markets have become centralized nationally and internationally, state insurance commissioners
    operate individually, though at times in concert through the National Association of Insurance Commissioners. In
    recent years, some have called for a dual state and federal regulatory system (commonly referred to as the Optional
    federal charter (OFC)) for insurance similar to the banking industry.
    In 2010, the federal Dodd-Frank Wall Street Reform and Consumer Protection Act established the Federal Insurance
    Office ("FIO").[20] FIO is part of the U.S. Department of the Treasury and it monitors all aspects of the insurance
Insurance                                                                                                                      40

    industry, including identifying issues or gaps in the regulation of insurers that may contribute to a systemic crisis in
    the insurance industry or in the U.S. financial system.[20] FIO coordinates and develops federal policy on prudential
    aspects of international insurance matters, including representing the U.S. in the International Association of
    Insurance Supervisors.[20] FIO also assists the U.S. Secretary of Treasury with negotiating (with the U.S. Trade
    Representative) certain international agreements.[20]
    Moreover, FIO monitors access to affordable insurance by traditionally underserved communities and consumers,
    minorities, and low- and moderate-income persons.[20] The Office also assists the U.S. Secretary of the Treasury
    with administering the Terrorism Risk Insurance Program.[20] However, FIO is not a regulator or supervisor.[20] The
    regulation of insurance continues to reside with the states.[20]

    Types of insurance
    Any risk that can be quantified can potentially be insured. Specific 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 different 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 US typically includes coverage for damage to the home and the owner's belongings, certain legal claims
    against the owner, and even a small amount of coverage for medical expenses of guests who are injured on the
    owner's property.
    Business insurance can take a number of different forms, such as the various kinds of professional liability insurance,
    also called professional indemnity (PI), which are discussed below under that name; and the business owner's policy
    (BOP), which packages into one policy many of the kinds of coverage that a business owner needs, in a way
    analogous to how homeowners' insurance packages the coverages that a homeowner needs.[21]

    Auto insurance
    Auto insurance protects the policyholder against financial loss in the
    event of an incident involving a vehicle they own, such as in a traffic
    Coverage typically includes:
    1. Property coverage, for damage to or theft of the car;
    2. Liability coverage, for the legal responsibility to others for bodily
       injury or property damage;
    3. Medical coverage, for the cost of treating injuries, rehabilitation and
       sometimes lost wages and funeral expenses.                                      A wrecked vehicle in Copenhagen
    Most countries, such as the United Kingdom, require drivers to buy
    some, but not all, of these coverages. When a car is used as collateral for a loan the lender usually requires specific

    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 specific 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 offered by your finance company when you first
    purchase your vehicle. Most auto insurance companies offer 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.
Insurance                                                                                                                         41

    Health insurance
    Health insurance policies cover the cost of medical treatments. Dental
    insurance, like medical insurance protects policyholders for dental
    costs. In the US and Canada, dental insurance is often part of an
    employer's benefits package, along with health insurance.

                                                                                       Great Western Hospital, Swindon

    Accident, sickness and unemployment insurance
    • Disability insurance policies provide financial 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-figure 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.                                 Workers' compensation, or employers' liability
                                                                                  insurance, is compulsory in some countries
    • Long-term disability insurance covers an individual's 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.
    • 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 benefits 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 worker's wages lost and accompanying medical
      expenses incurred because of a job-related injury.

    Casualty insurance insures against accidents, not necessarily tied to any specific property. It is a broad spectrum of
    insurance that a number of other types of insurance could be classified, 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 the
      criminal acts of third parties. For example, a company can obtain crime insurance to cover losses arising from
      theft or embezzlement.
    • Political risk insurance is a form of casualty insurance that can be taken out by businesses with operations in
      countries in which there is a risk that revolution or other political conditions could result in a loss.
Insurance                                                                                                                          42

    Life insurance provides a monetary benefit to a decedent's family or other designated beneficiary, and may
    specifically provide for income to an insured person's family, burial, funeral and other final expenses. Life insurance
    policies often allow the option of having the proceeds paid to the beneficiary either in a lump sum cash payment or
    an annuity. In most states, a person cannot purchase a policy on another person without their knowledge.
    Annuities provide a stream of payments and are generally classified as insurance because they are issued by
    insurance companies, are regulated as insurance, and require the same kinds of actuarial and investment management
    expertise that life insurance requires. Annuities and pensions that pay a benefit for life are sometimes regarded as
    insurance against the possibility that a retiree will outlive his or her financial resources. In that sense, they are the
    complement of life insurance and, from an underwriting perspective, are the mirror image of life insurance.
    Certain life insurance contracts accumulate cash values, which may be taken by the insured if the policy is
    surrendered or which may be borrowed against. Some policies, such as annuities and endowment policies, are
    financial instruments to accumulate or liquidate wealth when it is needed.
    In many countries, such as the US and the UK, the tax law provides that the interest on this cash value is not taxable
    under certain circumstances. This leads to widespread use of life insurance as a tax-efficient method of saving as
    well as protection in the event of early death.
    In the US, the tax on interest income on life insurance policies and annuities is generally deferred. However, in some
    cases the benefit derived from tax deferral may be offset 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
    Burial insurance is a very old type of life insurance which is paid out upon death to cover final expenses, such as the
    cost of a funeral. The Greeks and Romans introduced burial insurance circa 600 CE when they organized guilds
    called "benevolent societies" which cared for the surviving families and paid funeral expenses of members upon
    death. Guilds in the Middle Ages served a similar purpose, as did friendly societies during Victorian times.

    Property insurance provides protection against risks to property, such
    as fire, theft or weather damage. This may include specialized forms of
    insurance such as fire insurance, flood 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

                                                                                   This tornado damage to an Illinois home would
                                                                                    be considered an "Act of God" for insurance
Insurance                                                                                                                           43

    • 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 traffic 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) insures against accidental physical             US Airways Flight 1549 was written off after
      damage to boilers, equipment or machinery.                                           ditching into the Hudson River

    • Builder's risk insurance insures against the risk of physical loss or
      damage to property during construction. Builder's risk insurance is typically written on an "all risk" basis covering
      damage arising from any cause (including the negligence of the insured) not otherwise expressly excluded.
      Builder's risk insurance is coverage that protects a person's or organization's insurable interest in materials,
      fixtures 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.[22]

    • 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.[23]
    • 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 specified individuals. It usually insures a business for losses caused by the dishonest acts of its employees.
    • Flood insurance protects against property loss due to flooding.
      Many insurers in the US do not provide flood 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.
    • 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
                                                                                  Hurricane Katrina caused over $80 billion of
      policyholder's home. In some geographical areas, the policy may                       storm and flood damage
      exclude certain types of risks, such as flood or earthquake, that
      require additional coverage. Maintenance-related issues are typically the homeowner's 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 offer a package which may include liability and legal responsibility for injuries and property
      damage caused by members of the household, including pets.[24]

    • Landlord insurance covers residential and commercial properties which are rented to others. Most homeowners'
      insurance covers only owner-occupied homes.
Insurance                                                                                                                           44

    • 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 fire, shipwreck, etc., but excludes losses that can be
      recovered from the carrier or the carrier's insurance. Many marine
      insurance underwriters will include "time element" coverage in such
      policies, which extends the indemnity to cover loss of profit and                  Fire aboard MV Hyundai Fortune
      other business expenses attributable to the delay caused by a
      covered loss.

    • Supplemental natural disaster insurance covers specified expenses after a natural disaster renders the
      policyholder's home uninhabitable. Periodic payments are made directly to the insured until the home is rebuilt or
      a specified time period has elapsed.
    • Surety bond insurance is a three-party insurance guaranteeing the performance of the principal.
    • Terrorism insurance provides protection against any loss or damage
      caused by terrorist activities. In the US in the wake of 9/11, the
      Terrorism Risk Insurance Act 2002 (TRIA) set up a federal Program
      providing a transparent system of shared public and private
      compensation for insured losses resulting from acts of terrorism.
      The program was extended until the end of 2014 by the Terrorism
      Risk Insurance Program Reauthorization Act 2007 (TRIPRA).

    • Volcano insurance is a specialized insurance protecting against
      damage arising specifically from volcanic eruptions.                        The demand for terrorism insurance surged after
    • Windstorm insurance is an insurance covering the damage that can                                 9/11

      be caused by wind events such as hurricanes.

    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 homeowner's 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 indemnifies against the harm that a crashing
    car can cause to others' lives, health, or property. The protection offered by a liability insurance policy is twofold: a
    legal defense in the event of a lawsuit commenced against the policyholder and indemnification (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.
Insurance                                                                                                                         45

    • 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 officers liability insurance (D&O) protects an
      organization (usually a corporation) from costs associated with
      litigation resulting from errors made by directors and officers for
      which they are liable.
    • Environmental liability insurance protects the insured from bodily
      injury, property damage and cleanup costs as a result of the
                                                                                 The subprime mortgage crisis was the source of
      dispersal, release or escape of pollutants.                                       many liability insurance losses
    • 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 specific event. Examples would
      include offering 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 corporations and medical practitioners against potential negligence claims made by their
      patients/clients. Professional liability insurance may take on different names depending on the profession. For
      example, professional liability insurance in reference to the medical profession may be called medical malpractice

    Credit insurance repays some or all of a loan when certain circumstances arise to the borrower such as
    unemployment, disability, or death.
    • 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
    • Many credit cards offer payment protection plans which are a form of credit insurance.
    • 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.
Insurance                                                                                                                       46

    Other types
    • 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 different from peril-specific insurance that cover losses from only those perils listed
      in the policy.[25] In car insurance, all-risk policy includes also the damages caused by the own driver.
    • Bloodstock insurance covers individual horses or a number of
      horses under common ownership. Coverage is typically for
      mortality as a result of accident, illness or disease but may extend to
      include infertility, in-transit loss, veterinary fees, and prospective
    • Business interruption insurance covers the loss of income, and the
      expenses incurred, after a covered peril interrupts normal business
    • Collateral protection insurance (CPI) insures property (primarily              High-value horses may be insured under a
      vehicles) held as collateral for loans made by lending institutions.                      bloodstock policy

    • Defense Base Act (DBA) insurance provides coverage for civilian
      workers hired by the government to perform contracts outside the US and Canada. DBA is required for all US
      citizens, US residents, US 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 benefits.
    • Expatriate insurance provides individuals and organizations operating outside of their home country with
      protection for automobiles, property, health, liability and business pursuits.
    • Kidnap and ransom insurance is designed to protect individuals and corporations operating in high-risk areas
      around the world against the perils of kidnap, extortion, wrongful detention and hijacking.
    • 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.
    • Locked funds insurance is a little-known hybrid insurance policy jointly issued by governments and banks. It is
      used to protect public funds from tamper by unauthorized parties. In special cases, a government may authorize
      its use in protecting semi-private funds which are liable to tamper. The terms of this type of insurance are usually
      very strict. Therefore it is used only in extreme cases where maximum security of funds is required.
    • Livestock insurance is a specialist policy provided to, for example, commercial or hobby farms, aquariums, fish
      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 film 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 Price-Anderson
      Nuclear Industries Indemnity Act.)
    • Pet insurance insures pets against accidents and illnesses; some companies cover routine/wellness care and burial,
      as well.
    • Pollution insurance usually takes the form of first-party coverage for contamination of insured property either by
      external or on-site sources. Coverage is also afforded 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 specifically excluded.
Insurance                                                                                                                    47

    • 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.
    • 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. 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

    Insurance financing vehicles
    • Fraternal insurance is provided on a cooperative basis by fraternal benefit societies or other social
    • No-fault insurance is a type of insurance policy (typically automobile insurance) where insureds are indemnified
      by their own insurer regardless of fault in the incident.
    • Protected self-insurance is an alternative risk financing mechanism in which an organization retains the
      mathematically calculated cost of risk within the organization and transfers the catastrophic risk with specific and
      aggregate limits to an insurer so the maximum total cost of the program is known. A properly designed and
      underwritten Protected Self-Insurance Program reduces and stabilizes the cost of insurance and provides valuable
      risk management information.
    • Retrospectively rated insurance is a method of establishing a premium on large commercial accounts. The final
      premium is based on the insured's actual loss experience during the policy term, sometimes subject to a minimum
      and maximum premium, with the final premium determined by a formula. Under this plan, the current year's
      premium is based partially (or wholly) on the current year's losses, although the premium adjustments may take
      months or years beyond the current year's 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.
    • Formal self-insurance is the deliberate decision to pay for otherwise insurable losses out of one's 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 out-of-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 company's 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 benefit of volatility reduction that insurance
      otherwise affords.
    • 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):
Insurance                                                                                                                     48

      • National Insurance
      • Social safety net
      • Social security
      • Social Security debate (United States)
      • Social Security (United States)
      • Social welfare provision
    • Stop-loss insurance provides protection against catastrophic or unpredictable losses. It is purchased 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 becomes liable for losses that exceed certain limits called deductibles.

    Closed community self-insurance
    Some communities prefer to create virtual insurance amongst themselves by other means than contractual risk
    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 differences in insurability that exist among its members. Some further
    justification 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.

    Insurance companies
    Insurance companies may be classified into two groups:
    • Life insurance companies, which sell life insurance, annuities and pensions products.
    • Non-life, general, or property/casualty insurance companies, which sell other types of insurance.
    General insurance companies can be further divided into these sub categories.
    • Standard lines
    • Excess lines
    In most countries, life and non-life insurers are subject to different regulatory regimes and different 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
    decades. By contrast, non-life insurance cover usually covers a shorter period, such as one year.
    In the United States, standard line insurance companies are insurers that have received a license or authorization
    from a state for the purpose of writing specific kinds of insurance in that state, such as automobile insurance or
    homeowners' insurance.[27] They are typically referred to as "admitted" insurers. Generally, such an insurance
    company must submit its rates and policy forms to the state's insurance regulator to receive his or her prior approval,
    although whether an insurance company must receive prior approval depends upon the kind of insurance being
    written. Standard line insurance companies usually charge lower premiums than excess line insurers and may 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.[27] These insurers also are required
    to contribute to state guarantee funds, which are used to pay for losses if an insurer becomes insolvent.[27]
Insurance                                                                                                                           49

    Excess line insurance companies (also known as Excess and Surplus) typically insure risks not covered by the
    standard lines insurance market, due to a variety of reasons (e.g., new entity or an entity that does not have an
    adequate loss history, an entity with unique risk characteristics, or an entity that has a loss history that does not fit the
    underwriting requirements of the standard lines insurance market).[27] They are typically referred to as non-admitted
    or unlicensed insurers.[27] 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.[27] These
    companies have more flexibility and can react faster than standard line insurance companies because they are not
    required to file rates and forms.[27] However, they still have substantial regulatory requirements placed upon them.
    Most states require that excess line insurers submit financial information, articles of incorporation, a list of officers,
    and other general information.[27] They also may not write insurance that is typically available in the admitted
    market, do not participate in state guarantee funds (and therefore policyholders do not have any recourse through
    these funds if an insurer becomes insolvent and cannot pay claims), may pay higher taxes, only may write coverage
    for a risk if it has been rejected by three different admitted insurers, and only when the insurance producer placing
    the business has a surplus lines license.[27] Generally, when an excess line insurer writes a policy, it must, pursuant
    to state laws, provide disclosure to the policyholder that the policyholder's policy is being written by an excess line
    On July 21, 2010, President Barack Obama signed into law the Nonadmitted and Reinsurance Reform Act of 2010
    ("NRRA"), which took effect 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, under the NRRA,
    only the insured's home state may regulate and tax the excess line transaction.[28]
    Insurance companies are generally classified as either mutual or proprietary companies.[29] Mutual companies are
    owned by the policyholders, while shareholders (who may or may not own policies) own proprietary 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.
    Other possible forms for an insurance company include reciprocals, in which policyholders reciprocate in sharing
    risks, and Lloyd's organizations.
    Insurance companies are rated by various agencies such as A. M. Best. The ratings include the company's financial
    strength, which measures its ability to pay claims. It also rates financial instruments issued by the insurance
    company, such as bonds, notes, and securitization products.
    Reinsurance companies are insurance companies that sell policies to other insurance companies, allowing them to
    reduce their risks and protect themselves from very large losses. The reinsurance market is dominated by a few very
    large companies, with huge reserves. A reinsurer may also be a direct writer of insurance risks as well.
    Captive insurance companies may be defined as limited-purpose insurance companies established with the specific
    objective of financing risks emanating from their parent group or groups. This definition can sometimes be extended
    to include some of the risks of the parent company's customers. In short, it is an in-house self-insurance vehicle.
    Captives may take the form of a "pure" entity (which is a 100% subsidiary of the self-insured parent company); of a
    "mutual" captive (which insures the collective risks of members of an industry); and of an "association" captive
    (which self-insures individual risks of the members of a professional, commercial or industrial association). Captives
    represent commercial, economic and tax advantages to their sponsors because of the reductions in costs they help
    create and for the ease of insurance risk management and the flexibility for cash flows they generate. Additionally,
    they may provide coverage of risks which is neither available nor offered in the traditional insurance market at
    reasonable prices.
Insurance                                                                                                                         50

    The types of risk that a captive can underwrite for their parents include property damage, public and product
    liability, professional indemnity, employee benefits, employers' liability, motor and medical aid expenses. The
    captive's 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 financing strategy of
    their parent. This can be understood against the following background:
    •   heavy and increasing premium costs in almost every line of coverage;
    •   difficulties in insuring certain types of fortuitous risk;
    •   differential coverage standards in various parts of the world;
    •   rating structures which reflect market trends rather than individual loss experience;
    •   insufficient credit for deductibles and/or loss control efforts.
    There are also companies known as 'insurance consultants'. Like a mortgage broker, these companies are paid a fee
    by the customer to shop around for the best insurance policy amongst many companies. Similar to an insurance
    consultant, an 'insurance broker' also shops around for the best insurance policy amongst many companies. However,
    with insurance brokers, the fee is usually paid in the form of commission from the insurer that is selected rather than
    directly from the client.
    Neither insurance consultants nor insurance brokers are insurance companies and no risks are transferred to them in
    insurance transactions. Third party administrators are companies that perform underwriting and sometimes claims
    handling services for insurance companies. These companies often have special expertise that the insurance
    companies do not have.
    The financial stability and strength of an insurance company should be a major consideration when buying an
    insurance contract. An insurance premium paid currently provides coverage for losses that might arise many years in
    the future. For that reason, the viability of the insurance carrier is very important. In recent years, a number of
    insurance companies have become insolvent, leaving their policyholders with no coverage (or coverage only from a
    government-backed insurance pool or other arrangement with less attractive payouts for losses). A number of
    independent rating agencies provide information and rate the financial viability of insurance companies.

    Across the world
    Global insurance premiums grew by 2.7% in inflation-adjusted terms
    in 2010 to $4.3 trillion, climbing above pre-crisis levels. The return to
    growth and record premiums generated during the year followed two
    years of decline in real terms. Life insurance premiums increased by
    3.2% in 2010 and non-life premiums by 2.1%. While industrialised
    countries saw an increase in premiums of around 1.4%, insurance                   Life insurance premiums written in 2005
    markets in emerging economies saw rapid expansion with 11% growth
    in premium income. The global insurance industry was sufficiently
    capitalised to withstand the financial crisis of 2008 and 2009 and most
    insurance companies restored their capital to pre-crisis levels by the
    end of 2010. With the continuation of the gradual recovery of the
    global economy, it is likely the insurance industry will continue to see
    growth in premium income both in industrialised countries and
    emerging markets in 2011.                                                       Non-life insurance premiums written in 2005

    Advanced economies account for the bulk of global insurance. With
    premium income of $1,620bn, Europe was the most important region in 2010, followed by North America $1,409bn
    and Asia $1,161bn. Europe has however seen a decline in premium income during the year in contrast to the growth
    seen in North America and Asia. The top four countries generated more than a half of premiums. The US and Japan
Insurance                                                                                                                      51

    alone accounted for 40% of world insurance, much higher than their 7% share of the global population. Emerging
    economies accounted for over 85% of the world’s population but only around 15% of premiums. Their markets are
    however growing at a quicker pace. [30] The country expected to have the biggest impact on the insurance share
    distribution across the world is China. According to Sam Radwan of Enhance International, low premium
    penetration (insurance premium as a % of GDP), an ageing population and the largest car market in terms of new
    sales, premium growth has averaged 15–20% in the past five years, and China is expected to be the largest insurance
    market in the next decade or two.[31]

    Regulatory differences
    In the United States, insurance is regulated by the states under the McCarran-Ferguson Act, with "periodic proposals
    for federal intervention", and a nonprofit coalition of state insurance agencies called the National Association of
    Insurance Commissioners works to harmonize the country's different laws and regulations.[32] The National
    Conference of Insurance Legislators (NCOIL) also works to harmonize the different state laws.[33]
    In the European Union, the Third Non-Life Directive and the Third Life Directive, both passed in 1992 and effective
    1994, created a single insurance market in Europe and allowed insurance companies to offer insurance anywhere in
    the EU (subject to permission from authority in the head office) and allowed insurance consumers to purchase
    insurance from any insurer in the EU.[34]
    The insurance industry in China was nationalized in 1949 and thereafter offered by only a single state-owned
    company, the People's Insurance Company of China, which was eventually suspended as demand declined in a
    communist environment. In 1978, market reforms led to an increase in the market and by 1995 a comprehensive
    Insurance Law of the People's Republic of China[35] was passed, followed in 1998 by the formation of China
    Insurance Regulatory Commission (CIRC), which has broad regulatory authority over the insurance market of
    In India, IRDA is insurance regulatory authority. As per the section 4 of IRDA Act' 1999, Insurance Regulatory and
    Development Authority (IRDA), which was constituted by an act of parliament. National Insurance Academy, Pune
    is apex insurance capacity builder institute promoted with support from Ministry of Finance and by LIC, Life &
    General Insurance companies.


    Insurance insulates too much
    An insurance company may inadvertently find that its insureds may not be as risk-averse as they might otherwise be
    (since, by definition, the insured has transferred the risk to the insurer), a concept known as moral hazard. To reduce
    their own financial exposure, insurance companies have contractual clauses that mitigate their obligation to provide
    coverage if the insured engages in behavior that grossly magnifies their risk of loss or liability.
    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 were so
    irrational as to want to provide such coverage, it is against the public policy of most countries to allow such
    insurance to exist, and thus it is usually illegal.
Insurance                                                                                                                           52

    Complexity of insurance policy contracts
    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
                                                                                  9/11 was a major insurance loss, but there were
    when the judges themselves cannot understand what the policies are
                                                                                 disputes over the World Trade Center's insurance
    saying. Typically, courts construe ambiguities in insurance policies                              policy
    against the insurance company and in favor of coverage under the

    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 broker's compensation comes in the form of a
    commission as a percentage of the insurance premium, creating a conflict of interest in that the broker's financial
    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.

    Insurance may also be purchased through an agent. A tied agent, working exclusively with one insurer, represents
    the insurance company from whom the policyholder buys (while a free agent sales policies of various insurance
    companies). Just as there is a potential conflict of interest with a broker, an agent has a different type of conflict.
    Because agents work directly for the insurance company, if there is a claim the agent may advise the client to the
    benefit of the insurance company. Agents generally cannot offer 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
    offers completely independent advice, free of the financial conflict 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 benefits
    In United States, economists and consumer advocates generally consider insurance to be worthwhile for
    low-probability, catastrophic losses, but not for high-probability, 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 high-probability, small
    losses over low-probability, perhaps due to not understanding or ignoring the low-probability risk.[37] This is
    associated with reduced purchasing of insurance against low-probability losses, and may result in increased
    inefficiencies from moral hazard.[37]
Insurance                                                                                                                       53

    Redlining is the practice of denying insurance coverage in specific geographic areas, supposedly because of a high
    likelihood of loss, while the alleged motivation is unlawful discrimination. Racial profiling 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 affected and continues to affect the policies and practices of the insurance
    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 effective 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 also found to predict risk within each of the ethnic groups, leading the FTC to
    conclude that the scoring models are not solely proxies for redlining. The FTC indicated little data was available to
    evaluate benefit of insurance scores to consumers.[39] 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. [40]
    All states have provisions in their rate regulation laws or in their fair trade practice acts that prohibit unfair
    discrimination, often called redlining, in setting rates and making insurance available.[41]
    In determining premiums and premium rate structures, insurers consider quantifiable 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.
    An insurance underwriter's job is to evaluate a given risk as to the likelihood that a loss will occur. Any factor that
    causes a greater likelihood of loss should theoretically 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., negative
    differential treatment of) potential insureds in the risk evaluation and premium-setting process is a necessary
    by-product of the fundamentals of insurance underwriting. For instance, insurers charge older people significantly
    higher premiums than they charge younger people for term life insurance. Older people are thus treated differently
    than younger people (i.e., a distinction is made, discrimination occurs). The rationale for the differential treatment
    goes to the heart of the risk a life insurer takes: Old people are likely to die sooner than young people, so the risk of
    loss (the insured's death) is greater in any given period of time and therefore the risk premium must be higher to
    cover the greater risk. However, treating insureds differently when there is no actuarially sound reason for doing so
    is unlawful discrimination.
    What is often missing from the debate is that prohibiting the use of legitimate, actuarially sound factors means that
    an insufficient amount is being charged for a given risk, and there is thus a deficit in the system. The failure to
    address the deficit may mean insolvency and hardship for all of a company's insureds. The options for addressing the
    deficit seem to be the following: Charge the deficit to the other policyholders or charge it to the government (i.e.,
    externalize outside of the company to society at large).
Insurance                                                                                                                     54

    Insurance patents
    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 [42]) and a Spanish independent inventor, Salvador Minguijon Perez (EP 0700009 [43]).
    Many independent inventors are in favor of patenting new insurance products since it gives them protection from big
    companies when they bring their new insurance products to market. Independent inventors account for 70% of the
    new US patent applications in this area.
    Many insurance executives are opposed to patenting insurance products because it creates a new risk for them. The
    Hartford insurance company, for example, recently had to pay $80 million to an independent inventor, Bancorp
    Services, in order to settle a patent infringement and theft of trade secret lawsuit for a type of corporate owned life
    insurance product invented and patented by Bancorp.
    There are currently about 150 new patent applications on insurance inventions filed 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.[44]
    Inventors can now have their insurance US patent applications reviewed by the public in the Peer to Patent
    program.[45] The first insurance patent application to be posted was US2009005522 “Risk assessment company” [46].
    It was posted on March 6, 2009. This patent application describes a method for increasing the ease of changing
    insurance companies.[47]

    The insurance industry and rent-seeking
    Certain insurance products and practices have been described as rent-seeking by critics. That is, some insurance
    products or practices are useful primarily because of legal benefits, such as reducing taxes, as opposed to providing
    protection against risks of adverse events. Under United States tax law, for example, most owners of variable
    annuities and variable life insurance can invest their premium payments in the stock market and defer or eliminate
    paying any taxes on their investments until withdrawals are made. Sometimes this tax deferral is the only reason
    people use these products. Another example is the legal infrastructure which allows life insurance to be held in an
    irrevocable trust which is used to pay an estate tax while the proceeds themselves are immune from the estate tax.

    Religious concerns
    Muslim scholars have varying opinions about insurance. Insurance policies that earn interest are generally
    considered to be a form of riba[48] (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.[49]
    Jewish rabbinical scholars also have expressed reservations regarding insurance as an avoidance of God's will but
    most find it acceptable in moderation.[50]
    Some Christians believe insurance represents a lack of faith[51] and there is a long history of resistance to
    commercial 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.[52][53][54]
Insurance                                                                                                                                                55

    [1] Gollier C. (2003). To Insure or Not to Insure?: An Insurance Puzzle (http:/ / dhenriet. perso. egim-mrs. fr/ gollier. pdf). The Geneva Papers
        on Risk and Insurance Theory;).
    [2] This discussion is adapted from Mehr and Camack “Principles of Insurance”, 6th edition, 1976, pp 34 – 37.
    [3] Irish Brokers Association. Insurance Principles (https:/ / www. iba. ie/ development2009/ index. php?option=com_content& view=article&
        id=76& Itemid=167).
    [4] C. Kulp & J. Hall, Casualty Insurance, Fourth Edition, 1968, page 35
    [5] 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.
    [6] Dembe AE, Boden LI. (2000). Moral hazard: A question of morality? (http:/ / baywood. metapress. com/ index/ 1GU8EQN802J62RXK. pdf).
        New Solutions.
    [7] Kunreuther H. (1996). Mitigating Disaster Losses Through Insurance (http:/ / opim. wharton. upenn. edu/ risk/ downloads/ archive/ arch167.
        pdf). Journal of Risk and Uncertainty.
    [8] Brown RL. (1993). Introduction to Ratemaking and Loss Reserving for Property and Casualty Insurance (http:/ / books. google. com/
        books?id=1j4O50JENE4C). ACTEX Publications.
    [9] Feldstein, Sylvan G.; Fabozzi, Frank J. (2008). The Handbook of Municipal Bonds (http:/ / books. google. com/ ?id=Juc4fb1Fx1cC&
        lpg=PA614& pg=PA614#v=onepage& f=false). Wiley. p. 614. ISBN 978-0-470-10875-8. . Retrieved February 8, 2010.
    [10] http:/ / www. abi. org. uk/ About_The_ABI/ role. aspx
    [11] Fitzpatrick, Sean, Fear is the Key: A Behavioral Guide to Underwriting Cycles, (http:/ / ssrn. com/ abstract=690316) 10 Conn. Ins. L.J. 255
    [12] 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): 515–46. doi:10.1086/209730. ( online draft (http:/ / fic.
        wharton. upenn. edu/ fic/ papers/ 95/ 9513. pdf))
    [13] See, e.g., Vaughan, E. J., 1997, Risk Management, New York: Wiley.
    [14] http:/ / www. iran-law. com/ article. php3?id_article=61
    [15] Franklin, J., 2001, The Science of Conjecture: Evidence and Probability Before Pascal, Baltimore:Johns Hopkins University Press, 259.
    [16] "And whereas I have left in the hands of Doctor Ducke Channcellor of London two pollicies of insurance the one of one hundred pounds for
        the safe arivall of our Shipp in Guiana which is in mine owne name, if we miscarry by the waie (which God forbid) I bequeath the advantage
        thereof to my said Cosin Thomas Muchell...whereas there is an other insurance of one hundred pounds assured by the said Doctor Arthur
        Ducke on my life for one yeare if I chance to die within that tyme I entreat the said doctor Ducke to make it over to the said Thomas Muchell
        his kinsman..." Will of Robert Hayman, 1628:Records of the Prerogative Court of Canterbury, Catalogue Reference PROB 11/163
    [17] Dickson (1960): 4
    [18] Dickson (1960): 7
    [19] http:/ / www. naic. org/ documents/ consumer_state_reg_brief. pdf
    [20] http:/ / www. treasury. gov/ about/ organizational-structure/ offices/ Pages/ Federal-Insurance. aspx
    [21] Insurance Information Institute. "Business insurance information. What does a businessowners policy cover?" (http:/ / www. iii. org/
        individuals/ business/ basics/ bop/ ). . Retrieved 2007-05-09.
    [22] "Builder's Risk Insurance" (http:/ / www. adjustersinternational. com/ AdjustingToday/ ATfullinfo. cfm?start=1& page_no=1& pdfID=4).
        Adjusters International. . Retrieved 2009-10-16.
    [23] US application 20,060,287,896 (http:/ / worldwide. espacenet. com/ textdoc?DB=EPODOC& IDX=US20,060,287,896) “Method for
        providing crop insurance for a crop associated with a defined attribute”
    [24] Insurance Information Institute. "What is homeowners insurance?" (http:/ / www. iii. org/ individuals/ homei/ hbasics/ whatis/ ). . Retrieved
    [25] http:/ / www. business. gov/ manage/ business-insurance/ insurance-types. html
    [26] Margaret E. Lynch, Editor, "Health Insurance Terminology," Health Insurance Association of America, 1992, ISBN 1-879143-13-5
    [27] http:/ / www. aamga. org/ faqs
    [28] 15 U.S.C. §§ 8201 and 8202
    [29] David Ransom (2011). IF1 - Insurance, Legal & Regulatory. Chartered Insurance Institute. p. 2/5. ISBN 978 0 85713 094 5.
    [30] http:/ / www. thecityuk. com/ assets/ Uploads/ Insurance-2011-F2. pdf PDF (365 KB) page 2
    [31] China's Insurance Market: Lessons Learned from Taiwan, by Sam Radwan, Bloomberg Businessweek, June 2010 (http:/ / www.
        businessweek. com/ globalbiz/ content/ jun2010/ gb20100615_642092. htm)
    [32] Randall S. (1998). Insurance Regulation in the United States: Regulatory Federalism and the National Association of Insurance
        Commissioners (http:/ / www. law. fsu. edu/ Journals/ lawreview/ downloads/ 263/ rand. pdf). FLORIDA STATE UNIVERSITY LAW
    [33] J Schacht, B Foudree. (2007). A Study on State Authority: Making a Case for Proper Insurance Oversight (http:/ / www. ncoil. org/ policy/
        Docs/ 2007/ ILFStudy. pdf). NCOIL
    [34] CJ Campbell, L Goldberg, A Rai. (2003). The Impact of the European Union Insurance Directives on Insurance Company Stocks (http:/ /
        people. hofstra. edu/ Anoop_Rai/ research/ JORI70-1Campbell. pdf). The Journal of Risk and Insurance.
Insurance                                                                                                                                                 56

    [35] Insurance Law of the People's Republic of China - 1995 (http:/ / www. lehmanlaw. com/ resource-centre/ laws-and-regulations/ insurance/
        insurance-law-of-the-peoples-republic-of-china-1995. html). Lehman, Lee & Xu.
    [36] Thomas JE. (2002). The role and powers of the Chinese insurance regulatory commission in the administration of insurance law in China
        (http:/ / www. genevaassociation. org/ PDF/ Geneva_papers_on_Risk_and_Insurance/ GA2002_GP27(3)_Thomas. pdf). Geneva Papers on
        Risk and Insurance.
    [37] Schindler RM. (1994). Consumer Motivation for Purchasing Low-Deductible Insurance (http:/ / www. business. camden. rutgers. edu/
        FacultyStaff/ research/ schindler/ Schindler (1994). pdf). In Marketing and Public Policy Conference Proceedings, Vol. 4, D.J. Ringold (ed.),
        Chicago, IL: American Marketing Association, 147-155.
    [38] Gregory D. Squires (2003) Racial Profiling, Insurance Style: Insurance Redlining and the Uneven Development of Metropolitan Areas
        Journal of Urban Affairs Volume 25 Issue 4 Page 391-410, November 2003
    [39] Credit-Based Insurance Scores: Impacts on Consumers of Automobile Insurance (http:/ / ftc. gov/ opa/ 2007/ 07/ facta. shtm), Federal Trade
        Commission (July 2007)
    [40] Consumers Dispute FTC Report on Insurance Credit Scoring (http:/ / www. consumeraffairs. com/ news04/ 2007/ 07/ insurance_credit.
        html) (July 2007)
    [41] Insurance Information Institute. "Issues Update: Regulation Modernization" (http:/ / www. iii. org/ media/ hottopics/ insurance/ ratereg/ ). .
        Retrieved 2008-11-11.
    [42] http:/ / www. google. com/ patents?vid=5797134
    [43] http:/ / worldwide. espacenet. com/ textdoc?DB=EPODOC& IDX=EP0700009
    [44] (Source: Insurance IP Bulletin, December 15, 2006) (http:/ / marketsandpatents. com/ IPB-12152006. mht)
    [45] Mark Nowotarski "Patent Q/A: Peer to Patent", Insurance IP Bulletin, August 15, 2008 (http:/ / www. marketsandpatents. com/ bulletin/
        IPB-08152008. html)
    [46] http:/ / www. peertopatent. org/ patent/ 20090055227/ activity
    [47] Bakos, Nowotarski, “An Experiment in Better Patent Examination”, Insurance IP Bulletin, December 15, 2008 (http:/ / www.
        marketsandpatents. com/ bulletin/ IPB-12152008. html)
    [48] "Islam Question and Answer - The true nature of insurance and the rulings concerning it" (http:/ / islamqa. com/ en/ ref/ 8889/ insurance). .
        Retrieved 2010-01-18.
    [49] "Life Insurance from an Islamic Perspective" (http:/ / www. islamonline. net/ servlet/
        Satellite?pagename=IslamOnline-English-Ask_Scholar/ FatwaE/ FatwaE& cid=1119503543412). . Retrieved 2010-01-18.
    [50] "Jewish Association for Business Ethics - Insurance" (http:/ / www. jabe. org/ insurance. html). . Retrieved 2008-03-25.
    [51] "CIC Insurance - Insurance and the Church" (http:/ / www. cic. co. ke/ template/ t02. php?menuId=72). . Retrieved 2010-01-18.
    [52] Rubinkam, Michael (October 5, 2006). "Amish Reluctantly Accept Donations" (http:/ / www. washingtonpost. com/ wp-dyn/ content/
        article/ 2006/ 10/ 05/ AR2006100501360. html). The Washington Post. . Retrieved 2008-03-25.
    [53] Donald B. Kraybill. The riddle of Amish culture. p. 277. ISBN 0-8018-3682-4.
    [54] "Global Anabaptist Mennonite Encyclopedia Online, Insurance" (http:/ / www. gameo. org/ encyclopedia/ contents/ I583ME. html). .
        Retrieved 2010-01-18.

    • Dickson, P.G.M. (1960). The Sun Insurance Office 1710-1960: The History of Two and a half Centuries of British
      Insurance. London: Oxford University Press. pp. 324.

    External links
    • Congressional Research Service (CRS) Reports regarding the US Insurance industry (http://digital.library.unt.
      edu/govdocs/crs/search.tkl?type=subject&q=Insurance companies &q2=LIV)
    • Federation of European Risk Management Associations (
    • Insurance ( at the Open Directory Project
    • 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 ( - finding information on the
      insurance industry (UK bias)

                                    Risk Management

A derivative is a term that refers to a wide variety of financial instruments or "contract whose value is derived from
the performance of underlying market factors, such as market securities or indices, interest rates, currency exchange
rates, and commodity, credit, and equity prices. Derivative transactions include a wide assortment of financial
contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards
and various combinations thereof." [1] In practice, it is a contract between two parties that specifies 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.[2][3] The most common
underlying assets include: commodities, stocks, bonds, interest rates and currencies.
There are two groups of derivative contracts, the privately traded Over-the-counter (OTC) derivatives such as swaps
that do not go through an exchange or other intermediary and Exchange-traded derivative contracts (ETD)
that are traded through specialized derivatives exchanges or other exchanges.
Derivatives are more common in the modern era, but their origins trace back several centuries. One of the oldest
derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[4]
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 pay-off profile.
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 specified.
Derivatives can be used either for risk management (i.e. to “hedge” by providing offsetting compensation in case of
an undesired event, “insurance”) or for speculation (i.e. making a financial "bet"). This distinction is important
because the former is a legitimate, often prudent aspect of operations and financial management for many firms
across many industries; the latter offers managers and investors a seductive opportunity to increase profit, but not
without incurring additional risk that is often undisclosed to stakeholders.
In December 2007 the Bank for International Settlements reported [5]that "derivatives traded on exchanges surged
27% to a record $681 trillion in the third quarter" (Stever et al. BIS 2007-12 Page 20) [5] of 2007 as "investors bet on
losses linked to record U.S. mortgage foreclosures" and Federal Reserve and the European Central Bank policy
changes intended to offset the credit slump. [6]
Along with many other financial products and services, derivatives reform is an element of the Dodd–Frank 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 and those details are not finalized nor fully implemented
as of late 2012.
Derivative                                                                                                                       58

    Derivatives are used by investors for the following:
    • hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite
      direction to their underlying position and cancels part or all of it out;[7]
    • create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying
      reaching a specific price level);
    • obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);[8]
    • provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in
      the value of the derivative;[9]
    • speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given
      direction, stays in or out of a specified range, reaches a certain level).

    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 fluctuate, and the derivative may be either an asset (i.e. "in the money") or a liability (i.e. "out of the
    money") at different points throughout its life. Importantly, either party is therefore exposed to the credit quality of
    its counter party and is interested in protecting itself in an event of default.
    Option products have immediate value at the outset because they provide specified 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 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 option’s intrinsic value to change over time while its time value deteriorates steadily until the contract
    expires. An important difference between a lock product is that, after the initial exchange, the option purchaser has
    no further liability to its counterparty; upon maturity, the purchaser will execute the option if it has positive value
    (i.e. if it is “in the money”) or expire at no cost (other than to the initial premium) (i.e. if the option is “out of the

    Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For
    example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a
    specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty
    of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be
    available because of events unspecified by the contract, such as the weather, or that one party will renege on the
    contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured
    against counter-party risk.
    From another perspective, the farmer and the miller both 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 specified in the contract and
    acquires the risk that the price of wheat will rise above the price specified 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 specified 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 specified 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.
Derivative                                                                                                                      59

    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 specified amount of time, and can then sell it in the future at a specified price according
    to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while
    reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the
    future value of the asset.
    Derivatives can serve legitimate business purposes.[10]
    For example, a corporation borrows a large sum of
    money at a specific interest rate.[11] The rate of interest
    on the loan resets every six months. The corporation is
    concerned that the rate of interest may be much higher
    in six months. The corporation could buy a forward rate
    agreement (FRA), which is a contract to pay a fixed
    rate of interest six months after purchases on a notional
    amount of money.[12] If the interest rate after six
    months is above the contract rate, the seller will pay the
    difference to the corporation, or FRA buyer. If the rate
    is lower, the corporation will pay the difference to the
                                                                          Derivatives traders at the Chicago Board of Trade
    seller. The purchase of the FRA serves to reduce the
    uncertainty concerning the rate increase and stabilize

    Speculation and arbitrage
    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 low.
    Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset
    falls below the price specified 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 bank's management and regulators, and unfortunate events like the Kobe earthquake, Leeson
    incurred a US$1.3 billion loss that bankrupted the centuries-old institution.[13]
Derivative                                                                                                                     60

    Proportion Used for Hedging and Speculation
    Unfortunately, the true proportion of derivatives contracts used for legitimate hedging purposes is unknown [14] (and
    perhaps unknowable), but it appears to be relatively small.[15][16] Also, derivatives contracts account for only 3-6%
    of the median firms’ total currency and interest rate exposure.[17] Nonetheless, we know that many firms’ derivatives
    activities have at least some speculative component for a variety of reasons.[17]


    OTC and exchange-traded
    In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in
    the market:
    • Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between
      two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate
      agreements, exotic options - and other exotic derivatives - are almost always traded in this way. The OTC
      derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of
      information between the parties, since the OTC market is made up of banks and other highly sophisticated parties,
      such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity
      being visible on any exchange.
    According to the Bank for International Settlements, who first surveyed OTC derivatives in 1995, [5], 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)." [5] Positions in the OTC
    derivatives market increased to $516 trillion at the end of June 2007, 135% higher than the level recorded in 2004.
    OTC derivatives were first surveyed by the BIS in 1995. "Gross market values, 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)." [5] the total outstanding notional amount is US$708 trillion (as of June 2011).[18] 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 counter-party risk, like an
    ordinary contract, since each counter-party relies on the other to perform.
    • Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized
      derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade
      standardized contracts that have been defined by the exchange.[19] 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 world's
      largest[20] 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 world's derivatives exchanges totaled USD 344 trillion during Q4 2005. By December 2007 the Bank for
      International Settlements reported [5] they reported that "derivatives traded on exchanges surged 27% to a record
      $681 trillion."[5]
Derivative                                                                                                                      61

    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 specific time in the future at
       today's pre-determined price.
    2. Futures: are contracts to buy or sell an asset on or before a future date at a price specified today. A futures
       contract differs 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 specified at the time the parties enter into the option. The option contract also specifies 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 specified price on or before a given date in the future, he however has
       no obligation whatsoever to carry out this right. Similarly, the buyer of a Put option has the right to sell a certain
       quantity of an underlying asset, at a specified 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 profit profile.
    5. Warrants: Apart from the commonly used short-dated options which have a maximum maturity period of 1 year,
       there exists certain long-dated options as well, known as Warrant (finance). These are generally traded
    6. Swaps are contracts to exchange cash (flows) on or before a specified 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 fixed and pay floating, a payer swaption
       on the other hand is an option to pay fixed and receive floating.
    Swaps can basically be categorized into two types:
    • Interest rate swap: These basically necessitate swapping only interest associated cash flows in the same currency,
      between two parties.
    • Currency swap: In this kind of swapping, the cash flow between the two parties includes both principal and
      interest. Also, the money which is being swapped is in different currency for both parties.[21]
    Some common examples of these derivatives are the following:
Derivative                                                                                                                                     62

    UNDERLYING                                                        CONTRACT TYPES

                         Exchange-traded      Exchange-traded options        OTC swap              OTC forward               OTC option

        Equity        DJIA Index future       Option on DJIA Index        Equity swap          Back-to-back            Stock option
                      Single-stock future     future                                           Repurchase agreement    Warrant
                                              Single-share option                                                      Turbo warrant

      Interest rate   Eurodollar future       Option on Eurodollar        Interest rate swap   Forward rate agreement Interest rate cap and
                      Euribor future          future                                                                  floor
                                              Option on Euribor future                                                Swaption
                                                                                                                      Basis swap
                                                                                                                      Bond option

         Credit       Bond future             Option on Bond future       Credit default       Repurchase agreement    Credit default option
                                                                          Total return swap

        Foreign       Currency future         Option on currency future   Currency swap        Currency forward        Currency option

      Commodity       WTI crude oil futures   Weather derivative          Commodity swap       Iron ore forward        Gold option

    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 derivatives congregate with the prices of the underlying. Therefore, derivatives are essential
       tools to determine both current and future prices.
    2. The derivatives market relocates risk from the people who prefer risk aversion to the people who have 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.
    4. As supervision, reconnaissance of the activities of various participants becomes tremendously difficult in assorted
       markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the
       presence of an organized derivatives market, speculation can be controlled, resulting in a more meticulous
    5. Third parties can use publicly available derivative prices as educated predictions of uncertain future outcomes,
       for example, the likelihood that a corporation will default on its debts.[22]
    In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by
    derivative Market participant.[23]
Derivative                                                                                                                                     63


    Market and arbitrage-free
    Two common measures of value are:
    • Market price, i.e., the price at which
      traders are willing to buy or sell the
    • Arbitrage-free price, meaning that
      no risk-free profits can be made by
      trading in these contracts; see
      rational pricing.

    Determining the market price                   Total world derivatives from 1998 to 2007
                                                                                                  compared to total world wealth in the year
    For     exchange-traded     derivatives,
    market price is usually transparent,
    making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to
    collate and disseminate prices.

    Determining the arbitrage-free price
             See List of finance topics# Derivatives pricing.
    The arbitrage-free price for a derivatives contract can be complex, and there are many different variables to consider.
    Arbitrage-free pricing is a central topic of financial mathematics. For futures/forwards the arbitrage free price is
    relatively straightforward, involving the price of the underlying together with the cost of carry (income received less
    interest costs), although there can be complexities.
    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 Black–Scholes formula, which is based on the assumption that the cash flows
    from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A
    simplified 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 model's results are
    input-dependent (meaning the final price depends heavily on how we derive the pricing inputs).[26] 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).

    Derivatives are often subject to the following criticisms:

    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 firms [investment funds] have figured 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
Derivative                                                                                                                      64

    can turn overnight to one — a phenomenon they term “phase lock-in.” A hedged position can become unhedged at
    the worst times, inflicting substantial losses on those who mistakenly believe they are protected."[27]

    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 asset's price. However, investors could lose
    large amounts if the price of the underlying moves against them significantly. There have been several instances of
    massive losses in derivative markets, such as the following:
       • American International Group (AIG) lost more than US$18 billion through a subsidiary over the preceding
         three quarters on Credit Default Swaps (CDS).[28] The US federal government then gave the company US$85
         billion in an attempt to stabilize the economy before an imminent stock market crash. It was reported that the
         gifting of money, which came to be known as the "Back door bailout" of America's largest trading firms, was
         necessary because over the next few quarters the company was likely to lose more money.
       • The loss of US$7.2 Billion by Société Générale in January 2008 through mis-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.[29]
       • The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[30]
       • UBS AG, Switzerland’s biggest bank, suffered a $2 billion loss through unauthorized trading discovered in
         September, 2011.[31]
    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 counter party risk, or risk arising from the other party in a
    financial transaction. Different types of derivatives have different 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 fixed 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.

    Large notional value
    Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses for
    which the investor would be unable to compensate. The possibility that this could lead to a chain reaction ensuing in
    an economic crisis was pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report.
    Buffett called them 'financial weapons of mass destruction.' A potential problem with derivatives is that they
    comprise an increasingly larger notional amount of assets which may lead to distortions in the underlying capital and
    equities markets themselves. Investors begin to look at the derivatives markets to make a decision to buy or sell
    securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator.(See
    Berkshire Hathaway Annual Report for 2002) [32]
Derivative                                                                                                                       65

    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.[33] The strong creditor protections afforded 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.[33] Indeed, the use of
    derivatives to conceal credit risk from third parties while protecting derivative counterparties contributed to the
    financial crisis of 2008 in the United States.[33][34]
    In the context of a 2010 examination of the ICE Trust, an industry self-regulatory body, Gary Gensler, the chairman
    of the Commodity Futures Trading Commission which regulates most derivatives, was quoted saying that the
    derivatives marketplace as it functions now "adds up to higher costs to all Americans." More oversight of the banks
    in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice is looking into
    derivatives, too. The department’s antitrust unit is actively investigating 'the possibility of anticompetitive practices
    in the credit derivatives clearing, trading and information services industries,' according to a department
    For legislators and committees responsible for financial reform related to derivatives in the United States and
    elsewhere, distinguishing between hedging and speculative derivatives activities has been a nontrivial challenge. The
    distinction is critical because regulation should help to isolate and curtail speculation with derivatives, especially for
    "systemically significant" institutions whose default could be large enough to threaten the entire financial system. At
    the same time, the legislation should allow for responsible parties to hedge risk without undulying tying up working
    capital as collateral that firms may better employ elsewhere in their operations and investment.[36] In this regard, it is
    important to distinguish between financial (e.g. banks) and non-financial end-users of derivatives (e.g. real estate
    development companies) because these firms’ derivatives usage is inherently different. More importantly, the
    reasonable collateral that secures these different counterparties can be very different. The distinction between these
    firms is not always straight forward (e.g. hedge funds or even some private equity firms do not neatly fit either
    category). Finally, even financial users must be differentiated, as ‘large’ banks may classified as “systemically
    significant” 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 Dodd–Frank Wall Street Reform and Consumer Protection Act
    comes into effect. The law mandated the clearing of certain swaps at registered exchanges and imposed various
    restrictions on derivatives. To implement Dodd-Frank, the CFTC developed new rules in at least 30 areas [37]. 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 rule-making process have delayed full enactment of aspects of the
    legislation relating to derivatives. The challenges are further complicated by the necessity to orchestrate globalized
    financial reform among the nations that comprise the world’s major financial markets, a primary responsibility of the
    Financial Stability Board whose progress is ongoing.[38]
Derivative                                                                                                                     66

    • 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 bank’s 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 financial term for the other party in a financial transaction.
    • Credit derivative: A contract that transfers credit risk from a protection buyer to a credit protection seller. Credit
      derivative products can take many forms, such as credit default swaps, credit linked notes and total return swaps.
    • Derivative: A financial contract whose value is derived from the performance of assets, interest rates, currency
      exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including
      structured debt obligations and deposits, swaps, futures, options, caps, floors, 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 bank’s
      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 off
      organized futures exchanges.
    • Structured notes: Non-mortgage-backed debt securities, whose cash flow 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 non-cumulative 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 bank’s allowance
      for loan and lease losses.
Derivative                                                                                                                                                 67

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    [12] Chisolm, Derivatives Demystified (Wiley 2004) Notional sum means there is no actual principal.
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Derivative                                                                                                                                             68

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    [35] Story, Louise, "A Secretive Banking Elite Rules Trading in Derivatives" (http:/ / www. nytimes. com/ 2010/ 12/ 12/ business/ 12advantage.
        html?hp), The New York Times, December 11, 2010 (December 12, 2010, p. A1 NY ed.). Retrieved 2010-12-12.
    [36] 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/
    [37] http:/ / www. cftc. gov/ LawRegulation/ DoddFrankAct/ index. htm
    [38] Financial Stability Board (2012). “OTC Derivatives Market Reforms Third Progress Report on Implementation” 15 June 2012 http:/ / www.
        financialstabilityboard. org/ publications/ r_120615. pdf

    Further reading
    • Institute for Financial Markets (2011). Futures and Options (2nd ed.). Washington DC: Institute for Financial
      Markets. ISBN 978-0-615-35082-0.
    • Hull, John C. (2011). Options, Futures and Other Derivatives (8th ed.). Harlow: Pearson Education.
      ISBN 9780132604604.
    • Durbin, Michael (2011). All About Derivatives (2nd ed.). New York: McGraw-Hill. ISBN 978-0-07-174351-8.
    • Mattoo, Mehraj (1997). Structured Derivatives: New Tools for Investment Management: A Handbook of
      Structuring, Pricing & Investor Applications. London: Financial Times. ISBN 0-273-61120-89.

    External links
    • BBC News – Derivatives simple guide (
    • European Union proposals on derivatives regulation – 2008 onwards (

                                     Finance of states

Public finance
Public finance is the study of the role of the government in the economy.[1]
The purview of public finance is considered to be threefold: governmental effects on (1) efficient allocation of
resources, (2) distribution of income, and (3) macroeconomic stabilization.

The proper role of government provides a starting point for the analysis of public finance. In theory, under certain
circumstances, private markets will allocate goods and services among individuals efficiently (in the sense that no
waste occurs and that individual tastes are matching with the economy's productive abilities). If private markets were
able to provide efficient outcomes and if the distribution of income were socially acceptable, then there would be
little or no scope for government. In many cases, however, conditions for private market efficiency are violated. For
example, if many people can enjoy the 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-rival consumption, or of a
public good.
"Market failure" occurs when private markets do not allocate goods or services efficiently. The existence of market
failure provides an efficiency-based rationale for collective or governmental provision of goods and services.
Externalities, public goods, informational advantages, strong economies of scale, and network effects can cause
market failures. Public provision via a government or a voluntary association, however, is subject to other
inefficiencies, termed "government failure."
Under broad assumptions, government decisions about the efficient scope and level of activities can be efficiently
separated from decisions about the design of taxation systems (Diamond-Mirlees separation). In this view, public
sector programs should be designed to maximize social benefits minus costs (cost-benefit analysis), and then
revenues needed to pay for those expenditures should be raised through a taxation system that creates the fewest
efficiency losses caused by distortion of economic activity as possible. In practice, government budgeting or public
budgeting is substantially more complicated and often results in inefficient 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 deficit is the difference
between government spending and revenues. The accumulation of deficits over time is the total public debt. Deficit
finance allows governments to smooth tax burdens over time, and gives governments an important fiscal policy tool.
Deficits can also narrow the options of successor governments.
Public finance is closely connected to issues of income distribution and social equity. Governments can reallocate
income through transfer payments or by designing tax systems that treat high-income and low-income households
The Public Choice approach to public finance seeks to explain how self-interested voters, politicians, and
bureaucrats actually operate, rather than how they should operate.
Public finance                                                                                                                 70

    Public finance management
    Collection of sufficient resources from the economy in an appropriate manner along with allocating and use of these
    resources efficiently and effectively constitute good financial management. Resource generation, resource allocation
    and expenditure management (resource utilization) are the essential components of a public financial management
    Public Finance Management (PFM) basically deals with all aspects of resource mobilization and expenditure
    management in government. Just as managing finances is a critical function of management in any organization,
    similarly public finance management is an essential part of the governance process. Public finance management
    includes resource mobilization, prioritization of programmes, the budgetary process, efficient management of
    resources and exercising controls. Rising aspirations of people are placing more demands on financial resources. At
    the same time, the emphasis of the citizenry is on value for money, thus making public finance management
    increasingly vital.

    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 benefits--- 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.[2]

    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.[3] In its broadest sense, "to govern" means to rule over
    or supervise, whether over a state, a set group of people, or a collection of people.[4]

    Income distribution
    • Income distribution - Some forms of government expenditure are specifically intended to transfer income from
      some groups to others. For example, governments sometimes transfer income to people that have suffered 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 effect 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).
    • Income Security
    • Employment insurance
    • Health Care
    • Public financing of campaigns
Public finance                                                                                                                    71

    Financing of government expenditures
    Government expenditures are financed
    in three ways:
    • Government revenue
       • Taxes
       • Non-tax revenue (revenue from
         government-owned corporations,
         sovereign wealth funds, sales of
         assets, or Seigniorage)
    • Government borrowing
                                                                     Budgeted revenues of governments in 2006.
    • Printing of Money or Inflation

    • Privatization
    How a government chooses to finance its activities can have important effects on the distribution of income and
    wealth (income redistribution) and on the efficiency of markets (effect of taxes on market prices and efficiency). The
    issue of how taxes affect income distribution is closely related to tax incidence, which examines the distribution of
    tax burdens after market adjustments are taken into account. Public finance research also analyzes effects of the
    various types of taxes and types of borrowing as well as administrative concerns, such as tax enforcement.

    Taxation is the central part of modern public finance. Its significance 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.
    The main objective of taxation is raising revenue. A high level of taxation is necessary in a welfare State to fulfill 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 inflation to rise.[5]
    A tax is a financial 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 corvée
    labor. A tax may be defined as a "pecuniary burden laid upon individuals or property to support the government
    [ . . .] a payment exacted by legislative authority."[6] 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
    • There are various types of taxes, broadly divided into two heads - direct (which is proportional) and indirect tax
      (which is differential in nature):
    • Stamp duty, levied on documents
    • Excise tax (tax levied on production for sale, or sale, of a certain good)
    • Sales tax (tax on business transactions, especially the sale of goods and services)
      • Value added tax (VAT) is a type of sales tax
      • Services taxes on specific services
    • Road tax; Vehicle excise duty (UK), Registration Fee (USA), Regco (Australia), Vehicle Licensing Fee (Brazil)
Public finance                                                                                                               72

    •   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.)

    Governments, like any other legal entity, can take out loans, issue bonds and make financial 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 obligations are recognized when they are acquired, or accrued,
    rather than when they are paid.

    Seigniorage is the net revenue derived from the issuing of currency. It arises from the difference between the face
    value of a coin or bank note and the cost of producing, distributing and eventually retiring it from circulation.
    Seigniorage is an important source of revenue for some national banks, although it provides a very small proportion
    of revenue for advanced industrial countries.

    Public finance through state enterprise
    Public finance in centrally planned economies has differed in fundamental ways from that in market economies.
    Some state-owned enterprises generated profits that helped finance government activities. The government entities
    that operate for profit are usually manufacturing and financial institutions, services such as nationalized healthcare
    do not operate for a profit 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.
    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 profit 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 sovereign
    wealth fund. An example of this is the Alaska Permanent Fund and Singapore's 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.
Public finance                                                                                                                73

    Public finance through coining money
    In the U.S. Congress has the authority to create money. Paper money is considered debt, and coins are considered
    assets. The government can deposit the coins it creates into its bank account without borrowing money. The physical
    difficulty is eliminated by the creation of high-value coins. In fact, in 1996 Congress did pass a law authorizing high
    value coins, high including very high such as a trillion dollar coin. Just one such coin could pay back U.S. debt and
    fund government spending.[8]

    Government Finance Statistics and Methodology
    Macroeconomic data to support public finance economics are generally referred to as fiscal or government finance
    statistics (GFS). The Government Finance Statistics Manual 2001 (GFSM 2001) [9] is the internationally accepted
    methodology for compiling fiscal data. It is consistent with regionally accepted methodologies such as the European
    System of Accounts 1995 [10] and consistent with the methodology of the System of National Accounts (SNA1993) [11]
    and broadly in line with its most recent update, the SNA2008 [12].

    Measuring the public sector
    The size of governments, their institutional composition and complexity, their ability to carry out large and
    sophisticated operations, and their impact on the other sectors of the economy warrant a well-articulated system to
    measure government economic operations.
    The GFSM 2001 addresses the institutional complexity of government by defining various levels of government. The
    main focus of the GFSM 2001 is the general government sector defined as the group of entities capable of
    implementing public policy through the provision of primarily nonmarket 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).

                       Figure 1: General Government (IMF Government Finance Statistics Manual 2001(Washington,
                                                           2001) pp.13
Public finance                                                                                                                74

                         Figure 2: Public Sector(IMF Government Finance Statistics Manual 2001(Washington, 2001)

    The general government sector of a nation includes all non-private sector institutions, organisations and activities.
    The general government sector, by convention, includes all the public corporations that are not able to cover at least
    50% of their costs by sales, and, therefore, are considered non-market producers.[13]
    In the European System of Accounts,[14] the sector “general government” has been defined as containing:
    • “All institutional units which are other non-market producers whose output is intended for individual and
      collective consumption, and mainly financed by compulsory payments made by units belonging to other sectors,
      and/or all institutional units principally engaged in the redistribution of national income and wealth”.[13]
    Therefore, the main functions of general government units are :
    • to organise or redirect the flows of money, goods and services or other assets among corporations, among
      households, and between corporations and households; in the purpose of social justice, increased efficiency or
      other aims legitimised by the citizens; examples are the redistribution of national income and wealth, the
      corporate income tax paid by companies to finance unemployment benefits, the social contributions paid by
      employees to finance the pension systems;
    • to produce goods and services to satisfy households' needs (e.g. state health care) or to collectively meet the needs
      of the whole community (e.g. defence, public order and safety).[13]
    The general government sector, in the European System of Accounts, has four sub-sectors:
    1. central government
    2. state government
    3. local government
    4. social security funds
    "Central government"[15] consists of all administrative departments of the state and other central agencies whose
    responsibilities cover the whole economic territory of a country, except for the administration of social security
    "State government"[16] is defined 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.
Public finance                                                                                                                      75

    "Local government"[17] 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.
    "Social security fund"[18] is a central, state or local institutional unit whose main activity is to provide social benefits.
    It fulfils the two following criteria:
    • by law or regulation (except those about government employees), certain population groups must take part in the
      scheme and have to pay contributions;
    • 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 benefits, independent of its role as a supervisory body or employer.
    The GFSM 2001 framework is similar to the financial accounting of businesses. For example, it recommends that
    governments produce a full set of financial statements including the statement of government operations (akin to the
    income statement), the balance sheet, and a cash flow statement. Two other similarities between the GFSM 2001 and
    business financial 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 Manual 1986 – based on cash flows and without a balance sheet statement.

    Users of GFS
    The GFSM 2001 recommends standard tables including standard fiscal indicators that meet a broad group of users
    including policy makers, researchers, and investors in sovereign debt. Government finance statistics should offer
    data for topics such as the fiscal architecture, the measurement of the efficiency and effectiveness of government
    expenditures, the economics of taxation, and the structure of public financing. The GFSM 2001 provides a blueprint
    for the compilation, recording, and presentation of revenues, expenditures, stocks of assets, and stocks of liabilities.
    The GFSM 2001 also defines some indicators of effectiveness in government’s expenditures, for example the
    compensation of employees as a percentage of expense. The GFSM 2001 includes a functional classification of
    expense as defined by the Classification of Functions of Government (COFOG) .
    This functional classification allows policy makers to analyze expenditures on categories such as health, education,
    social protection, and environmental protection. The financial 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 government’s financial statements contain the
    relevant information for this analysis.
    The government’s balance sheet presents the level of the debt; that is the government’s 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 sheet also presents a disaggregated classification of financial and
    non-financial assets.
    These data help estimate the resources a government can potentially access to repay its debt. The statement of
    operations (“income statement”) contains the revenue and expense accounts of the government. The revenue accounts
    are divided into subaccounts, including the different types of taxes, social contributions, dividends from the public
    sector, and royalties from natural resources. Finally, the interest expense account is one of the necessary inputs to
    estimate the cost of servicing the debt.
Public finance                                                                                                                                            76

    Fiscal Data Using the GFSM 2001 Methodology
    GFS can be accessible through several sources. The International Monetary Fund publishes GFS in two publications:
    International Financial Statistics and the Government Finance Statistics Yearbook. The World Bank gathers
    information on external debt. On a regional level, the Organization for Economic Co-operation and Development
    (OECD) compiles general government account data for its members, and Eurostat, following a methodology
    compatible with the GFSM 2001, compiles GFS for the members of the European Union.

    [1]  Gruber, Jonathan (2005). Public Finance and Public Policy. New York: Worth Publications. pp. 2. ISBN 0-7167-8655-9.
    [2]  Robert Barro and Vittorio Grilli (1994), European Macroeconomics, Ch. 15-16. Macmillan, ISBN 0-333-57764-7.
    [3]  Columbia Encyclopedia, Government, Columbia University Press
    [4]  See for example, The American Heritage Dictionary of the English Language, entry "Govern"
    [5]  http:/ / budget. ap. gov. in/ es2k_pf. htm
    [6]  Black's Law Dictionary, p. 1307 (5th ed. 1979).
    [7]  Id.
    [8]  Mucha, Carlos, 'Beowulf'. January 13, 2013. The Coin. (http:/ / www. nytimes. com/ roomfordebate/ 2013/ 01/ 13/
        proposing-the-unprecedented-to-avoid-default/ platinum-coin-would-create-a-trillion-dollar-in-funds) New York City: The New York Times.
    [9] http:/ / www. imf. org/ external/ pubs/ ft/ gfs/ manual/ index. htm
    [10] http:/ / circa. europa. eu/ irc/ dsis/ nfaccount/ info/ data/ esa95/ esa95-new. htm
    [11] http:/ / unstats. un. org/ unsd/ sna1993/ toctop. asp?L1=4
    [12] http:/ / unstats. un. org/ unsd/ nationalaccount/ sna2008. asp
    [13] General Government sector (http:/ / epp. eurostat. ec. europa. eu/ statistics_explained/ index. php/ Glossary:General_government_sector),
        Eurostat glossary
    [14] ESA95, paragraph 2.68
    [15] Central government (http:/ / epp. eurostat. ec. europa. eu/ statistics_explained/ index. php/ Glossary:Central_government), Eurostat glosssary
    [16] State government (http:/ / epp. eurostat. ec. europa. eu/ statistics_explained/ index. php/ Glossary:State_government), Eurostat glosssary
    [17] Local government (http:/ / epp. eurostat. ec. europa. eu/ statistics_explained/ index. php/ Glossary:Local_government), Eurostat glosssary
    [18] Social security fund (http:/ / epp. eurostat. ec. europa. eu/ statistics_explained/ index. php/ Glossary:Social_security_fund), Eurostat

    • Anthony B. Atkinson and Joseph E. Stiglitz (1980). Lectures in Public Economics, McGraw-Hill Economics
      Handbook Series
    • Alan S. Blinder, Robert M. Solow, et al. (1974). The Economics of Public Finance, Brookings Institution. Table
      of Contents. (
    • James M. Buchanan, ([1967] 1987). Public Finance in Democratic Process: Fiscal Institutions and Individual
      Choice, UNC Press. Description (, scrollable preview, (http://
      back cover (
      f=false#v=onepage&q&f=false), and chapter links (
      html) 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 finance," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract. (http:// finance&
Public finance                                                                                                           77

    •   _____ 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. (
    •   Joseph E. Stiglitz (2000). Economics of the Public Sector, 3rd ed. Norton. Description. (
    •   Greene, Joshua E (2011). Public Finance: An International Perspective (
        economics/8219.html). Hackensack, New Jersey: World Scientific. pp. 500. ISBN 978-981-4365-04-8.

    External links
    • Taxation and Public Finance course at the Harris School of Public Policy Studies (http://harrisschool.uchicago.
    • State and Local Public Finance course at the Harris School of Public Policy Studies (http://harrisschool.
    • IMF--Dissemination Standards Bulletin Board-- Subscribing ... (
      sddsnsdppage/) (see "fiscal sector")
    •   The IMF's Public Financial Management Blog (
    •   Other Public Financing Resource (
    •   US Debt ( - Real Time U.S. Debt Clock
    •   Canadian Governments Compared (

                                 Financial economics

Financial economics
Financial economics is the branch of economics concerned with "the allocation and deployment of economic
resources, both spatially and across time, in an uncertain environment".[1] It is additionally characterised by its
"concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a
trade".[2] The questions within financial economics are typically framed in terms of "time, uncertainty, options, and
• Time: money now is traded for money in the future.
• Uncertainty (or risk): The amount of money to be transferred in the future is uncertain.
• Options: one party to the transaction can make a decision at a later time that will affect subsequent transfers of
• Information: knowledge of the future can reduce, or possibly eliminate, the uncertainty associated with future
  monetary value (FMV).
A topic of general interest studied in recent years has been financial crises.[3]
The subject is usually taught at a postgraduate level; see Master of Financial Economics.

Subject matter
Financial economics is the branch of economics studying the interrelation of financial variables, such as prices,
interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on
influences of real economic variables on financial ones, in contrast to pure finance.
It studies the following:
• Valuation - Determination of the fair value of an asset
   •   How risky is the asset? (identification of the asset appropriate discount rate)
   •   What cash flows will it produce? (discounting of relevant cash flows)
   •   How does the market price compare to similar assets? (relative valuation)
   •   Are the cash flows dependent on some other asset or event? (derivatives, contingent claim valuation)
• Financial markets and instruments
   •   Commodities - topics
   •   Stocks - topics
   •   Bonds - topics
   •   Money market instruments- topics
   •   Derivatives - topics
• Financial institutions and regulation
Financial econometrics is the branch of Financial Economics that uses econometric techniques to parameterise the
In the Journal of Economic Literature classification codes, Financial Economics is one of the 19 primary
classifications, at JEL: G. It follows Monetary and International Economics and precedes Public Economics.
Detailed subclassifications are linked in the following footnote.[4]
Financial economics                                                                                                                                                79

    The New Palgrave Dictionary of Economics (2008, 2nd ed.) also uses the JEL codes to classify its entries in v. 8,
    Subject Index, including Financial Economics at pp. 863-64. The corresponding footnotes below have links to entry
    abstracts of The New Palgrave Online [5] for each primary or secondary JEL category (10 or fewer per page, similar
    to Google searches):
            JEL: G – Financial Economics [6]
            JEL: G0 – General[7]
            JEL: G1 – General Financial Markets[8]
            JEL: G2 – Financial institutions and Services[9]
            JEL: G3 – Corporate finance and Governance[10]
    Tertiary category entries can be also be searched.[11]

    Models in financial economics
    Financial economics is primarily concerned with building models to derive testable or policy implications from
    acceptble assumptions. Some fundamental ideas in financial economics are portfolio theory, the Capital Asset
    Pricing Model. Portfolio theory studies how investors should balance risk and return when investing in many assets
    or securities. The Capital Asset Pricing Model describes how markets should set the prices of assets in relation to
    how risky they are. The Modigliani-Miller Theorem describes conditions under which corporate financing decisions
    are irrelevant for value, and acts as a benchmark for evaluating the effects of factors outside the model that do affect
    A common assumption is that financial decision makers act rationally (see Homo economicus; efficient market
    hypothesis). However, recently, researchers in experimental economics and experimental finance have challenged
    this assumption empirically. They are also challenged, theoretically, by behavioral finance, a discipline primarily
    concerned with the limits to rationality of economic agents.
    Other common assumptions include market prices following a random walk or asset returns being normally
    distributed. Empirical evidence suggests that these assumptions may not hold and that in practice, traders, analysts
    and particularly risk managers frequently modify the "standard models".

    [1] "Robert C. Merton - Nobel Lecture" (http:/ / nobelprize. org/ nobel_prizes/ economics/ laureates/ 1997/ merton-lecture. pdf) (PDF). .
        Retrieved 2009-08-06.
    [2] "Financial Economics" (http:/ / www. stanford. edu/ ~wfsharpe/ mia/ int/ mia_int2. htm). . Retrieved 2009-08-06.
    [3] From The New Palgrave Dictionary of Economics, Online Editions, 2011, 2012, with abstract links:
           • "regulatory responses to the financial crisis: an interim assessment" (http:/ / www. dictionaryofeconomics. com/
        article?id=pde2012_F000330& edition=1) by Howard Davies
           • "Credit Crunch Chronology: April 2007–September 2009" (http:/ / www. dictionaryofeconomics. com/ article?id=pde2011_C000621&
        edition=) by The Statesman's Yearbook team
           • "Minsky crisis" (http:/ / www. dictionaryofeconomics. com/ article?id=pde2011_M000430& edition=current& q=) by L. Randall Wray
           • "euro zone crisis 2010" (http:/ / www. dictionaryofeconomics. com/ article?id=pde2011_E000326& edition=current& q=) by Daniel Gros
        and Cinzia Alcidi.
           • Carmen M. Reinhart and Kenneth S. Rogoff, 2009. This Time Is Different: Eight Centuries of Financial Folly, Princeton. Description
        (http:/ / press. princeton. edu/ titles/ 8973. html), ch. 1 ("Varieties of Crises and their Dates," pp. 3-20) (http:/ / press. princeton. edu/ chapters/
        s8973. pdf), and chapter-preview links. (http:/ / books. google. com/ books?id=ak5fLB24ircC& printsec=frontcover& source=find&
        pg=PR7gbs_atb#v=onepage& q& f=false)
    [4] JEL classification codes — Financial economics JEL: G Subcategories
    [5] http:/ / www. dictionaryofeconomics. com/ dictionary
    [6] All entries under JEL: G: http:/ / www. dictionaryofeconomics. com/ search_results?,q=& field=content& edition=all& topicid=G
    [7] http:/ / www. dictionaryofeconomics. com/ search_results?q=& field=content& edition=all& topicid=G0
    [8] http:/ / www. dictionaryofeconomics. com/ search_results?q=& field=content& edition=all& topicid=G1
    [9] http:/ / www. dictionaryofeconomics. com/ search_results?q=& field=content& edition=all& topicid=G2
Financial economics                                                                                                                                  80

    [10] http:/ / www. dictionaryofeconomics. com/ search_results?q=& field=content& edition=all& topicid=G3
    [11] 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: G0, http:/ / www. dictionaryofeconomics. com/ search_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.

    External links

    • Great Moments in Financial Economics I (, II (, "III" (http://web.archive.
      doc). Archived from the original ( Short-Sales and Stock Prices.
      doc) on 2007-09-27.; IVa (
      artandpap/IV+Fundamental+Theorem+-+Part+I.doc); "IVb" (
      Archived from the original ( Fundamental Theorem - Part II.doc)
      on 2007-09-27.. Prof. Mark Rubinstein, Haas School of Business
    • Microfoundations of Financial Economics ( Prof. André
      Farber Solvay Business School
    • Handbook of the Economics of Finance (, G.M.
      Constantinides, M. Harris, R. M. Stulz
    • An introduction to investment theory (
      classnotes/notes.html), Prof. William Goetzmann, Yale School of Management

    Context and history
    • "A Short History of Investment Forecasting" ( Archived from the original (http://roundtable.informs.
      org/public-access/min061a.htm) on 2007-10-12., Professor Michael Phillips, California State University,

    Links and portals
    • "Books on Financial Economics": list on (

                             Financial mathematics

Financial mathematics
Mathematical finance is a field of applied mathematics, concerned with financial markets. Generally, mathematical
finance will derive and extend the mathematical or numerical models without necessarily establishing a link to
financial theory, taking observed market prices as input. Thus, for example, while a financial economist might study
the structural reasons why a company may have a certain share price, a financial 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 finance, while the Black–Scholes equation and formula are amongst the key results.
Mathematical finance also overlaps heavily with the field of computational finance (as well as financial
engineering). The latter focuses on application, while the former focuses on modeling and derivation (see:
Quantitative analyst), often by help of stochastic asset models. In general, there exist two separate branches of
finance that require advanced quantitative techniques: derivatives pricing on the one hand, and risk- and portfolio
management on the other.
Many universities offer degree and research programs in mathematical finance; see Master of Mathematical Finance.

History: Q versus P
There exist two separate branches of finance that require advanced quantitative techniques: derivatives pricing and
risk and portfolio management. One of the main differences is that they use different probabilities, namely the
risk-neutral probability (or arbitrage-pricing probability), denoted by "Q", and the actual (or actuarial) probability,
denoted by "P".

Derivatives pricing: the Q world

                                         Goal          "extrapolate the present"

                                         Environment risk-neutral probability

                                         Processes     continuous-time martingales

                                         Dimension     low

                                         Tools         Ito calculus, PDE’s

                                         Challenges    calibration

                                         Business      sell-side

|+ The Q world
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 define 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
Financial mathematics                                                                                                             82

    Speculation (published 1900), with the introduction of the most basic and most influential 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 finite variance. This causes
    longer-term changes to follow a Gaussian distribution. Bachelier's work, however, was largely unknown outside
    The theory remained dormant until Fischer Black and Myron Scholes, along with fundamental contributions by
    Robert C. Merton, applied the second most influential process, the geometric Brownian motion, to option pricing.
    For this M. Scholes and R. Merton were awarded the 1997 Nobel Memorial Prize in Economic Sciences. Black was
    ineligible for the prize because of his death in 1995.
    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 security is arbitrage-free, and thus truly fair, only if there exists a
    stochastic process Pt with constant expected value which describes its future evolution: {{{}}}

                                                                            (1 )

    {{{}}} A process satisfying (1) is called a "martingale". A martingale 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 "
    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 specific
    products they model.
    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 define the price of new
    The main quantitative tools necessary to handle continuous-time Q-processes are Ito’s stochastic calculus and partial
    differential equations (PDE’s).

    Risk and portfolio management: the P world

                                                  Goal         "model the future"

                                                  Environment real probability

                                                  Processes    discrete-time series

                                                  Dimension    large

                                                  Tools        multivariate statistics

                                                  Challenges   estimation

                                                  Business     buy-side

    |+ The P world
    Risk and portfolio management aims at modelling the 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 " ", as
    opposed to the "risk-neutral" probability "     " 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 profit-and-loss profile of their positions considered as a portfolio.
Financial mathematics                                                                                                            83

    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 Sharpe (1964), Lintner (1965) and Ross (1976).
    For their pioneering work, Markowitz and Sharpe, along with Merton Miller, shared the 1990 Nobel Memorial Prize
    in Economic Sciences, for the first time ever awarded for a work in finance.
    The portfolio-selection work of Markowitz and Sharpe introduced mathematics to the "black art" of investment
    management. 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 mean–variance optimization was replaced by more general increasing, concave utility
    functions.[1] 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 [2]
    Much effort has gone into the study of financial 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 market trends give an indication of the future, at least in the
    short term. The claims of the technical analysts are disputed by many academics.

    Over the years, increasingly sophisticated mathematical models and derivative pricing strategies have been
    developed, but their credibility was damaged by the financial crisis of 2007–2010.
    Contemporary practice of mathematical finance has been subjected to criticism from figures within the field notably
    by Nassim Nicholas Taleb, a professor of financial engineering at Polytechnic Institute of New York University, in
    his book The Black Swan[3] and Paul Wilmott. Taleb claims that the prices of financial 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[4] which addresses some of the most serious concerns.
    Bodies such as the Institute for New Economic Thinking are now attempting to establish more effective theories and
    In general, modeling the changes by distributions with finite variance is, increasingly, said to be inappropriate.[6] In
    the 1960s it was discovered by Benoît Mandelbrot that changes in prices do not follow a Gaussian distribution, but
    are rather modeled better by Lévy alpha-stable distributions. The scale of change, or volatility, depends on the length
    of the time interval to a power a bit more than 1/2. Large changes up or down are more likely than what one would
    calculate using a Gaussian distribution with an estimated standard deviation.[3] See also Financial models with
    long-tailed distributions and volatility clustering.
Financial mathematics                                                                                                                                          84

       Mathematical finance articles
            See also Outline of finance: § Financial mathematics; § Mathematical tools; § Derivatives pricing.

       Mathematical tools

                 •   Asymptotic analysis                    •   Mathematical models             •       Stochastic calculus
                                                                                                        •       Brownian motion
                                                                                                        •       Lévy process
                 •   Calculus                               •   Monte Carlo method              •       Stochastic differential equations
                 •   Copulas                                •   Numerical analysis              •       Stochastic volatility
                                                                                                        •       Numerical partial differential equations
                                                                                                                •       Crank–Nicolson method
                                                                                                                •       Finite difference method
                 •   Differential equations                 •   Real analysis                   •       Value at risk
                 •   Expected value                         •   Partial differential equations •        Volatility
                                                                                                        •       ARCH model
                                                                                                        •       GARCH model
                 •   Ergodic theory                         •   Probability
                 •   Feynman–Kac formula                    •   Probability distributions
                                                                •   Binomial distribution
                                                                •   Log-normal distribution
                 •   Fourier transform                      •   Quantile functions
                                                                •   Heat equation
                 •   Gaussian copulas                       •   Radon–Nikodym derivative
                 •   Girsanov's theorem                     •   Risk-neutral measure
                 •   Itô's lemma
                 •   Martingale representation theorem

       Derivatives pricing

   •    The Brownian Motion Model of          •   Options                                           •       Interest rate derivatives
        Financial Markets                         •   Put–call parity (Arbitrage                            •       Black model
   •    Rational pricing assumptions                  relationships for options)                                    • caps and floors
        • Risk neutral valuation                  •   Intrinsic value, Time value                                   • swaptions
        • Arbitrage-free pricing                  •   Moneyness                                                     • Bond options
   •    Forward Price Formula                     •   Pricing models                                        •       Short-rate models
   •    Futures contract pricing                      •  Black–Scholes model                                        • Rendleman-Bartter model
   •    Swap Valuation                                •  Black model                                                • Vasicek model
                                                      •  Binomial options model                                     • Ho-Lee model
                                                      •  Monte Carlo option model                                   • Hull–White model
                                                      •  Implied volatility, Volatility smile                       • Cox–Ingersoll–Ross model
                                                      •  SABR Volatility Model                                      • Black–Karasinski model
                                                      •  Markov Switching Multifractal                              • Black–Derman–Toy model
                                                      •  The Greeks                                                 • Kalotay–Williams–Fabozzi model
                                                      •  Finite difference methods for                              • Longstaff–Schwartz model
                                                         option pricing                                             • Chen model
                                                      • Vanna Volga method                                  •       Forward rate-based models
                                                      • Trinomial tree
                                                                                                                    •     LIBOR market model
                                                      • Garman-Kohlhagen model
                                                                                                                          (Brace–Gatarek–Musiela Model, BGM)
                                                  •   Optimal stopping (Pricing of
                                                                                                                    •     Heath–Jarrow–Morton Model (HJM)
                                                      American options)
Financial mathematics                                                                                                                           85

    [1] Karatzas, Ioannis; Shreve, Steve (1998). Methods of Mathematical Finance. Secaucus, NJ, USA: Springer-Verlag New York, Incorporated.
        ISBN 9780387948393.
    [2] Meucci, Attilio (2005). Risk and Asset Allocation. Springer. ISBN 9783642009648.
    [3] Taleb, Nassim Nicholas (2007). The Black Swan: The Impact of the Highly Improbable. Random House Trade. ISBN 978-1-4000-6351-2.
    [4] "Financial Modelers' Manifesto" (http:/ / www. wilmott. com/ blogs/ paul/ index. cfm/ 2009/ 1/ 8/ Financial-Modelers-Manifesto). Paul
        Wilmott's Blog. January 8, 2009. . Retrieved June 1, 2012.
    [5] Gillian Tett (April 15, 2010). "Mathematicians must get out of their ivory towers" (http:/ / www. ft. com/ cms/ s/ 0/
        cfb9c43a-48b7-11df-8af4-00144feab49a. html). Financial Times. .
    [6] 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.

    • Harold Markowitz, Portfolio Selection, Journal of Finance, 7, 1952, pp. 77–91
    • William Sharpe, Investments, Prentice-Hall, 1985
    • Attilio Meucci, versus Q: Differences and Commonalities between the Two Areas of Quantitative Finance (http://''P), GARP Risk Professional, February 2011, pp. 41-44

                              Experimental finance

Experimental finance
The goals of experimental finance are to establish different market settings and environments to observe
experimentally and analyze agents' behavior and the resulting characteristics of trading flows, information diffusion
and aggregation, price setting mechanism and returns processes. This can happen for instance by conducting trading
simulations or establishing and studying the behaviour of people in artificial competitive market-like settings.
Researchers in experimental finance can study to what extent existing financial economics theory makes valid
predictions and attempt to discover new principles on which theory can be extended.
The methodology of experimental finance is closely related to that of Experimental economics.

                                   Behavioral finance

Behavioral finance
Behavioral economics and the related field, behavioral finance, study the effects of social, cognitive, and
emotional factors on the economic decisions of individuals and institutions and the consequences for market prices,
returns, and the resource allocation. The fields are primarily concerned with the bounds of rationality of economic
agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. In so
doing they cover a range of concepts, methods, and fields.[1]
Behavioral analysts are not only concerned with the effects of market decisions but also with public choice, which
describes another source of economic decisions with related biases towards promoting self-interest.
There are three prevalent themes in behavioral finances:[2]
• Heuristics: People often make decisions based on approximate rules of thumb and not strict logic.
• Framing: The collection of anecdotes and stereotypes that make up the mental emotional filters individuals rely
  on to understand and respond to events.
• Market inefficiencies: These include mis-pricings and non-rational decision making.

Issues in behavioral economics

Behavioral finance
The central issue in behavioral finance is explaining why market participants make systematic errors. Such errors
affect prices and returns, creating market inefficiencies. It also investigates how other participants take advantage
(arbitrage) of such market inefficiencies.
Behavioral finance highlights inefficiencies 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, overconfidence, overoptimism, mimicry (herding instinct) and noise trading. Technical analysts consider
behavioral finance, behavioral economics' academic cousin, to be the theoretical basis for technical analysis.[3]
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 result in a nominal
loss.[4] It may also help explain why housing prices rarely/slowly decline to market clearing levels during periods of
low demand.
Benartzi and Thaler (1995), applying a version of prospect theory, claim to have solved the equity premium puzzle,
something conventional finance models have been unable to do so far.[5] Experimental finance applies the
experimental method, e.g. creating an artificial market by some kind of simulation software to study people's
decision-making process and behavior in financial markets.
Behavioral finance                                                                                                             88

    Quantitative behavioral finance
    Quantitative behavioral finance uses mathematical and statistical methodology to understand behavioral biases. In
    marketing research, a study shows little evidence that escalating biases impact marketing decisions.[6] Leading
    contributors include Gunduz Caginalp (Editor of the Journal of Behavioral Finance from 2001–2004) and
    collaborators including 2002 Nobelist Vernon Smith, David Porter, Don Balenovich,[7] Vladimira Ilieva and Ahmet
    Duran,[8] and Ray Sturm.[9]

    Financial models
    Some financial models used in money management and asset valuation incorporate behavioral finance parameters,
    for example:
    • Thaler's model of price reactions to information, with three phases, underreaction-adjustment-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.
    • The stock image coefficient

    Critics such as Eugene Fama typically support the efficient-market hypothesis. They contend that behavioral finance
    is more a collection of anomalies than a true branch of finance 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 efficiency, an investor must be able to trade against it and earn abnormal profits; this is not the case
    for many anomalies.[10]
    A specific 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.[11] In reply, others contend that most personal
    investment funds are managed through superannuation funds, minimizing the effect of these putative entry barriers.
    In addition, professional investors and fund managers seem to hold more bonds than one would expect given return

    Behavioral game theory
    Behavioral game theory is a subject that analyzes interactive strategic decisions and behavior using the methods of
    game theory,[12] experimental economics, and experimental psychology. Experiments include testing deviations
    from typical simplifications of economic theory such as the independence axiom[13] and neglect of altruism,[14]
    fairness,[15] and framing effects.[16] On the positive side, the method has been applied to interactive learning[17] and
    social preferences.[18][19] As a research program, the subject is a development of the last three decades.[20]
Behavioral finance                                                                                                                                       89

    Economic reasoning in non-human animals
    A handful of comparative psychologists at American universities 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 behavioral psychology, where the main goal is to discover analogs to human behavior in
    experimentally-tractable non-human animals. They are also methodologically similar to the work of Ferster and
    Skinner.[21] 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 stimulus–response relationships, but instead in terms of work, demand, budget, and labor. Recent
    studies have adopted a slightly different approach, taking a more evolutionary perspective, comparing economic
    behavior of humans to a species of non-human primate, the capuchin monkey.[22]

    The animal as a human analog
    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 analog to human labor supply.[23] Researchers in this field advocate for
    the appropriateness of using animal economic behavior to understand the elementary components of human
    economic behavior.[24] In a paper by Battalio, Green, and Kagel (1981, p 621),[23] they write

      Space considerations do not permit a detailed discussion of the reasons why economists should take seriously the investigation of economic
      theories using nonhuman subjects....[Studies of economic behavior in non-human animals] provide a laboratory for identifying, testing, and
      better understanding general laws of economic behavior. Use of this laboratory is predicated on the fact that behavior as well as structure vary
      continuously across species, and that principles of economic behavior would be unique among behavioral principles if they did not apply, with
      some variation, of course, to the behavior of nonhumans.                                                                                      ”
    Labor supply
    The typical laboratory environment to study labor supply in pigeons is set up as follows. Pigeons are first deprived of
    food. Since the animals are hungry, food becomes highly desired. The pigeons are placed in an operant conditioning
    chamber and through orienting and exploring the environment of the chamber they discover that by pecking a small
    disk located on one side of the chamber, food is delivered to them. In effect, pecking behavior becomes reinforced,
    as it is associated with food. Before long, the pigeon pecks at the disk (or stimulus) regularly.
    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 rate
    of food delivery and the type of food delivered (some foods are more desirable than others).
    Economic behavior similar to that observed in humans is discovered when the hungry pigeons stop working/work
    less when the reward is reduced. Researchers argue that this is similar to labor supply behavior in humans. That is
    like humans (who, even in need, will only work so much for a given wage) the pigeons demonstrate decreases in
    pecking (work) when the reward (value) is reduced.[23]
Behavioral finance                                                                                                           90

    In human economics, a typical demand curve is negative. This means that as the price of a certain good increases, the
    amount that consumers are able to purchase decreases. Researchers studying demand curves in non-human animals
    such as rats observe that demand curves have negative slopes, consistent with the slope of human demand curves.
    Researchers have studied demand in rats in a manner distinct from studying labor supply in pigeons. Specifically,
    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.[25]
    In effect, results of demand studies in non-human animals are that, as the bar-pressing requirement (cost) increases,
    the animal presses the bar the required number of times 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 [22] 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 now, or wait
    until the experimenter alters the amount of food presented. In this circumstance, the experimenter can either increase
    or decrease the amount of food given. Thus, this experimental setup allows the researchers to look at the gambling
    behavior of the animals. The experimenters can therefore ask the following questions: will the monkey take the sure
    amount of food? Will the monkey “gamble” by waiting until the experimenter changes the amount of food present?
    Does the decision of the animal depend on the circumstances? Results indicate that the monkeys are risk-averse: they
    prefer to take the initial amount of food than wait for the experimenter to change the amount presented.
    The experimenters introduce several other manipulations, including changing the allocated budget, changing the cost
    of certain items, changing the items themselves. Specifically, the researchers found an increase in item purchase and
    consumption when that item decreases in value, a result consistent with those found in human economics.[22]
    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 payoff 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
Behavioral finance                                                                                                          91

    Evolutionary psychology
    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 fitness 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 differences 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.[26]

    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,[27] and Jeremy 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,[28] George Katona[29] and Laszlo Garai.[30] 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 first presented in 1953 which contradicts the expected utility hypothesis.
    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 field, such as Ward Edwards,[31] 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).[32]

    Prospect theory
    In 1979, Kahneman and Tversky wrote Prospect theory: An Analysis of
    Decision Under Risk, an important paper that used cognitive psychology to
                                                                                               Daniel Kahneman
    explain various divergences of economic decision making from
    neo-classical theory.[33] Prospect theory is an example of generalized
    expected utility theory. Although not a conventional part of behavioral economics, generalized expected utility
    theory is similarly motivated by concerns about the descriptive inaccuracy of expected utility theory.

    In 1968 Nobel Laureate Gary Becker published Crime and Punishment: An Economic Approach, a seminal work that
    factored psychological elements into economic decision making. Becker, however, maintained strict consistency of
    preferences. Nobelist Herbert A. Simon developed the theory of Bounded Rationality to explain how people
    irrationally seek satisfaction, instead of maximizing utility, as conventional economics presumed. Maurice Allais
    produced "Allais Paradox", a crucial challenge to expected utility.
Behavioral finance                                                                                                             92

    Psychological traits such as overconfidence, projection bias, and the effects of limited attention are now part of the
    theory. Other developments include a conference at the University of Chicago,[34] a special behavioral economics
    edition of the Quarterly Journal of Economics ('In Memory of Amos Tversky') and Kahneman's 2002 Nobel for
    having "integrated insights from psychological research into economic science, especially concerning human
    judgment and decision-making under uncertainty".[35]

    Intertemporal choice
    Behavioral economics has also been applied to intertemporal choice. Intertemporal choice behavior is largely
    inconsistent, as exemplified 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.
    The pattern can actually be explained through models of subadditive discounting which distinguishes the delay and
    interval of discounting: people are less patient (per-time-unit) over shorter intervals regardless of when they occur.
    Much of the recent work on intertemporal choice indicates that discounting is a constructed preference. Discounting
    is influenced greatly by expectations, framing, focus, thought listings, mood, sign, glucose levels, and the scales used
    to describe what is discounted. Some prominent researchers question whether discounting, the major parameter of
    intertemporal choice, actually describes what people do when they make choices with future consequences.
    Considering the variability of discount rates, this may be the case.

    Other areas of research
    Other branches of behavioral economics enrich the model of the utility function without implying inconsistency in
    preferences. Ernst Fehr, Armin Falk, and Matthew Rabin studied "fairness", "inequity aversion", and "reciprocal
    altruism", weakening the neoclassical assumption of "perfect selfishness." 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.
    "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 affect those external events.[36][37]
    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.[38][39]

    Critics of behavioral economics typically stress the rationality of economic agents.[40] 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 once-off decision problems presented to experiment
    participants or survey respondents.
    Traditional economists are also skeptical of the experimental and survey-based techniques which behavioral
    economics uses extensively. Economists typically stress revealed preferences over stated preferences (from surveys)
    in the determination of economic value. Experiments and surveys are at risk of systemic biases, strategic behavior
    and lack of incentive compatibility.
Behavioral finance                                                                                                        93

    Rabin (1998)[41] dismisses these criticisms, claiming that consistent results are typically obtained in multiple
    situations and geographies and can produce good theoretical insight. Behavioral economists have also responded to
    these criticisms by focusing on field studies rather than lab experiments. Some economists see a fundamental schism
    between experimental economics and behavioral economics, but prominent behavioral and experimental economists
    tend to share techniques and approaches in answering common questions. For example, behavioral economists are
    actively investigating neuroeconomics, which is entirely experimental and cannot be verified in the field.
    Other proponents of behavioral economics note that neoclassical models often fail to predict outcomes in real world
    contexts. Behavioral insights can influence 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.

    Notable behavioral economics theorists

    • Dan Ariely[42]
    • Colin Camerer
    • Ernst Fehr
    •   Daniel Kahneman
    •   Laszlo Garai
    •   David Laibson
    •   George Loewenstein
    •   Sendhil Mullainathan[43]
    •   Drazen Prelec
    •   Matthew Rabin
    •   Herbert A. Simon
    •   Paul Slovic
    •   Vernon L. Smith
    •   Larry Summers[44]
    •   Richard Thaler
    •   Amos Tversky

    •   Malcolm Baker
    •   Nicholas Barberis
    •   Gunduz Caginalp
    •   David Hirshleifer
    •   Andrew Lo
    •   Michael Mauboussin
    •   Terrance Odean
    •   Richard L. Peterson
    •   Charles Plott
    •   Hersh Shefrin
    •   Robert Shiller
    •   Andrei Shleifer
    • Richard Thaler
Behavioral finance                                                                                                                                     94

    [1] Search of behavioural economics at (2008-) The New Palgrave Dictionary of Economics Online. (http:/ / www. dictionaryofeconomics. com/
        search_results?q=behavioural+ economics+ & edition=current& button_search=GO)
    [2] Shefrin 2002
    [3] Kirkpatrick 2007, p. 49
    [4] Genesove & Mayer, 2001
    [5] Benartzi 1995
    [6] J. Scott Armstrong, Nicole Coviello and Barbara Safranek (1993). "Escalation Bias: Does It Extend to Marketing?" (http:/ / www.
        forecastingprinciples. com/ paperpdf/ Escalation Bias. pdf). Journal of the Academy of Marketing Science, 21: 247–352. .
    [7] "Dr. Donald A. Balenovich" (http:/ / www. ma. iup. edu/ people/ dabalen. html). Indiana University of Pennsylvania, Mathematics
        Department. .
    [8] "Ahmet Duran" (http:/ / www. umich. edu/ ~durana). Department of Mathematics, University of Michigan-Ann Arbor. .
    [9] "Dr Ray R. Sturm, CPA" (http:/ / www. bus. ucf. edu/ rsturm). College of Business Administration. .
    [10] http:/ / www. dimensional. com/ famafrench/ 2009/ 08/ fama-on-market-efficiency-in-a-volatile-market. html Fama on Market Efficiency in
        a Volatile Market
    [11] See Freeman, 2004 for a review
    [12] R. J. Aumann (2008). "game theory," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ / www.
        dictionaryofeconomics. com/ article?id=pde2008_G000007& q=game theory& topicid=& result_number=3).
    [13] Colin F. Camerer and Teck-Hua Ho (1994). "Violations of the Betweenness Axiom and Nonlinearity in Probability," Journal of Risk and
        Uncertainty, 8(2), pp. 167 (http:/ / www. springerlink. com/ content/ u7w803138w478655/ )-196.
    [14] James Andreoni et al. (2008). "altruism in experiments," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ / www.
        dictionaryofeconomics. com/ article?id=pde008_A000240& edition=current& q=altruism game& topicid=& result_number=2).
    [15] H. Peyton Young (2008). "social norms," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ / www.
        dictionaryofeconomics. com/ article?id=pde2008_S000466& edition=current& q=fairness game & topicid=& result_number=1).
    [16] Colin F. Camerer (1997). "Progress in Behavioral Game Theory," Journal of Economic Perspectives, 11(4), p. 172 [pp. 167-188 (http:/ /
        authors. library. caltech. edu/ 22122/ 1/ 2138470[1]. pdf).
    [17] • William H. Sandholm (2008). "learning and evolution in games: an overview," The New Palgrave Dictionary of Economics, 2nd Edition.
        Abstract (http:/ / www. dictionaryofeconomics. com/ article?id=pde2008_E000241& edition=current& q=learning game& topicid=&
           • Teck H. Ho (2008). "Individual learning in games," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ / www.
        dictionaryofeconomics. com/ article?id=pde2008_L000055).
    [18] Martin Dufwenberg and Georg Kirchsteiger (2004). "A Theory of Sequential reciprocity," Games and Economic Behavior, 47(2), pp.
        268-298. Abstract (http:/ / www. sciencedirect. com/ science/ article/ pii/ S0899825603001908).
    [19] • Faruk Gul (2008). "behavioural economics and game theory," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ /
        www. dictionaryofeconomics. com/ article?id=pde2008_G000210& edition=current& q=behavioural economics & topicid=&
           • Colin F. Camerer (2008). "behavioral game theory," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract (http:/ / www.
        dictionaryofeconomics. com/ article?id=pde2008_B000302& q=Behavioral economics & topicid=& result_number=13).
    [20] • Colin F. Camerer (2003). Behavioral Game Theory, Princeton. Description (http:/ / press. princeton. edu/ chapters/ i7517. html), preview
        (http:/ / books. google. com/ books?id=cr_Xg7cRvdcC& printsec=find& pg=PR7=#v=onepage& q& f=false) ([ctrl]+), and ch. 1 link (http:/ /
        press. princeton. edu/ chapters/ i7517. pdf).
           • _____, George Loewenstein, and Matthew Rabin, ed. (2003). Advances in Behavioral Economics, Princeton. 1986-2003 papers.
        Description (http:/ / press. princeton. edu/ titles/ 8437. html), contents (http:/ / books. google. com/ books?id=sA4jJOjwCW4C&
        printsec=find& pg=PR7=#v=onepage& q& f=false), and .
           • Drew Fudenberg (2006). "Advancing Beyond Advances in Behavioral Economics," Journal of Economic Literature, 44(3), pp. 694 (http:/ /
        www. jstor. org/ pss/ 30032349)-711.
           • Vincent P. Crawford (1997). "Theory and Experiment in the Analysis of Strategic Interaction," in Advances in Economics and
        Econometrics: Theory and Applications, pp. 206-242 (http:/ / weber. ucsd. edu/ ~vcrawfor/ CrawfordThExp97. pdf). 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. 2327-2351. Abstract (http:/ / www. sciencedirect. com/ science/ article/ pii/ S1574000502030254).
           • Charles R. Plott and Vernon L. Smith, ed. (2008). Handbook of Experimental Economics Results, v. 1, Elsevier, Part 4, Games preview
        (http:/ / www. sciencedirect. com/ science/ article/ pii/ S1574072207001217) and ch. 45-66 preview links (http:/ / www. sciencedirect. com/
        science?_ob=PublicationURL& _hubEid=1-s2. 0-S1574072207X00015& _cid=277334& _pubType=HS& _auth=y& _acct=C000228598&
        _version=1& _urlVersion=0& _userid=10& md5=49f8b6d5e3024eac39ed5fad351fe568).
           • Games and Economic Behavior, Elsevier. Aims and scope (http:/ / www. journals. elsevier. com/ games-and-economic-behavior/ ) and,
        article-preview links (http:/ / www. sciencedirect. com/ science/ journal/ 08998256) by year and issue.
    [21] Ferster, C.B. et al. (1957). Schedules of Reinforcement. New York: Appleton-Century-Crofts.
Behavioral finance                                                                                                                                        95

    [22] Chen, M.K. et al. (2006). How basic are behavioral biases? Evidence from capuchin monkey trading behavior. J. Political Economy, 114 (3)
    [23] Battalio, R.C. et al. (1981). Income–leisure tradeoffs of animal workers. Am. Economic Review, 71 (4) 621-632.
    [24] Kagel, J H. et al. (1995). Economic Choice Theory: An Experimental Analysis of Animal Behavior. New York: Cambridge University Press
    [25] Kagel, J.H. et al. (1981). Demand curves for animal consumers. Quarterly Journal of Economics, 96 (1), 1-16.
    [26] Paul H. Rubin and C. Monica Capra. The evolutionary psychology of economics. In Roberts, S. C. (2011). Applied Evolutionary
        Psychology. Oxford University Press. doi:10.1093/acprof:oso/9780199586073.001.0001. ISBN 9780199586073.
    [27] Nava Ashraf, Colin F. Camerer, and George Loewenstein (2005). "Adam Smith, Behavioral Economist," Journal of Economic Perspectives,
        19(3), p. 142. [pp. 131-145 (http:/ / webserver1. pugetsound. edu/ facultypages/ gmilam/ courses/ econ291/ readings/ ASmithBenEcon. pdf).
    [28] Tarde, G. Psychologie économique (http:/ / classiques. uqac. ca/ classiques/ tarde_gabriel/ psycho_economique_t1/ psycho_eco_t1. html)
    [29] The Powerful Consumer: Psychological Studies of the American Economy. 1960.
    [30] Garai,L. Identity Economics – An Alternative Economic Psychology. (http:/ / www. staff. u-szeged. hu/ ~garai/ Identity_Economics. htm)
    [31] "Ward Edward Papers" (http:/ / www. usc. edu/ libraries/ archives/ arc/ libraries/ collections/ records/ 427home. html). Archival Collections.
        Archived (http:/ / web. archive. org/ web/ 20080416235453/ http:/ / www. usc. edu/ libraries/ archives/ arc/ libraries/ collections/ records/
        427home. html) from the original on 16 April 2008. . Retrieved 2008-04-25.
    [32] Luce 2000
    [33] Kahneman 2003
    [34] Hogarth 1987
    [35] "Nobel Laureates 2002" (http:/ / nobelprize. org/ nobel_prizes/ lists/ 2002. html). Archived (http:/ / web. archive. org/ web/
        20080410071445/ http:/ / nobelprize. org/ nobel_prizes/ lists/ 2002. html) from the original on 10 April 2008. . Retrieved 2008-04-25.
    [36] Grafstein R (1995). "Rationality as Conditional Expected Utility Maximization". Political Psychology 16 (1): 63–80. doi:10.2307/3791450.
        JSTOR 3791450.
    [37] Shafir E, Tversky A (1992). "Thinking through uncertainty: nonconsequential reasoning and choice". Cognitive Psychology 24 (4):
        449–474. doi:10.1016/0010-0285(92)90015-T. PMID 1473331.
    [38] "US National Broadband Plan: good in theory" (http:/ / www. telco2. net/ blog/ 2010/ 03/ us_national_broadband_plan_qui. html). Telco
        2.0. March 17, 2010. . Retrieved 2010-09-23. "... Sara Wedeman’s awful experience with this is instructive...."
    [39] Gordon Cook, Sara Wedeman (July 1, 2009). "Connectivity, the Five Freedoms, and Prosperity" (http:/ / www. muninetworks. org/ reports/
        cook-report-broadband-mapping-connectivity-five-freedoms-and-prosperity). Community Broadband Networks. . Retrieved 2010-09-23. "In
        this report, Gordon Cook interviews Sara Wedeman, a mapping expert who also works in behavioral economics"
    [40] see Myagkov and Plott (1997) amongst others
    [41] Rabin & 1998 11–46
    [42] "Predictably Irrational" (http:/ / www. predictablyirrational. com/ ?page_id=5). Dan Ariely. Archived (http:/ / web. archive. org/ web/
        20080313201653/ http:/ / www. predictablyirrational. com/ ?page_id=5) from the original on 13 March 2008. . Retrieved 2008-04-25.
    [43] Sendhil Mullainathan: Solving social problems with a nudge (http:/ / www. ted. com/ talks/ sendhil_mullainathan. html)
    [44] How Obama Is Using the Science of Change (http:/ / www. time. com/ time/ magazine/ article/ 0,9171,1889153,00. html). Michael
        Grunwald, TIME, April 2, 2009.

    • Ainslie, G. (1975). "Specious Reward: A Behavioral /Theory of Impulsiveness and Impulse Control".
      Psychological Bulletin 82 (4): 463–496. doi:10.1037/h0076860. PMID 1099599.
    • Barberis, N.; Shleifer, A.;; Vishny, R. (1998). "A Model of Investor Sentiment" (
      Journal of Financial Economics 49 (3): 307–343. doi:10.1016/S0304-405X(98)00027-0. Archived (http://web. from the original on 20 April 2008. Retrieved
    • Becker, Gary S. (1968). "Crime and Punishment: An Economic Approach". The Journal of Political Economy 76
      (2): 169–217. 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): 73–92. 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 19426658.
    • Diamond, Peter A., and Hannu Vartiainen, ed. (2007). Behavioral Economics and its Applications. Description
      ( and preview (http://
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    •   Daniel, K.; Hirshleifer, D.; Subrahmanyam, A. (1998). "Investor Psychology and Security Market Under- and
        Overreactions". Journal of Finance 53 (6): 1839–1885. doi:10.1111/0022-1082.00077.
    •   Garai Laszlo. Identity Economics – An Alternative Economic Psychology. 1990–2006.
    •   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.
    •   Kahneman, Daniel; Tversky, Amos (1979). "Prospect Theory: An Analysis of Decision under Risk".
        Econometrica (The Econometric Society) 47 (2): 263–291. doi:10.2307/1914185. JSTOR 1914185.
    •   Kahneman, Daniel; Ed Diener (2003). Well-being: the foundations of hedonic psychology. Russell Sage
    •   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 Falsification, Harvard
      University Press. Description ( and
      chapter-preview 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. (1916–2001)." (http:/ / www. dictionaryofeconomics. com/
           Bernheim, B. Douglas; Rangel, Antonio. "Behavioral public economics." (http:/ / www.
           Bloomfield, Robert. "Behavioral finance." (http:/ / www. dictionaryofeconomics.                      com/
           article?id=pde2008_B000339&q=Behavioral economics &topicid=&result_number=5)
           Simon, Herbert A. "Rationality, bounded." (http:/ / www. dictionaryofeconomics.                      com/
           article?id=pde2008_B000176&q=behavioural economics&topicid=&result_number=4)
    • Mullainathan, S.; Thaler, R. H. (2001). "Behavioral Economics". International Encyclopedia of the Social &
      Behavioral Sciences. pp. 1094–1100.. 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". Journal of Economic Literature 36 (1): 11–46 (http:// Press +.
    • Schelling, Thomas C. (2006 [1978]). Micromotives and Macrobehavior, Norton. Description (http://books., preview (
    • Shleifer, Andrei (1999). Inefficient Markets: An Introduction to Behavioral Finance. New York: Oxford
      University Press. ISBN 0-19-829228-7.
Behavioral finance                                                                                                97

    • Simon, Herbert A. (1987). "Behavioral Economics". The New Palgrave: A Dictionary of Economics. 1.
      pp. 221–24.
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      library/Enc/BehavioralEconomics.html) The Concise Encyclopedia of Economics, 2nd Edition. Liberty Fund.

    External links
    • Behavioral Finance Initiative ( of the International
      Center for Finance at the Yale School of Management
    • Overview of Behavioral Finance (
    • Geary Behavioural Economics Blog (, of the Geary Institute at
      University College Dublin
    • 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: 1944 - 1988 (http://www.moneyscience.

                             Intangible asset finance

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

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 first quarter of 2001.[1]
One of the goals of people working in this field is to unlock the "hidden value" found in intangible assets through the
techniques of finance. Another goal is to measure how firm performance correlates with intangible asset
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 flow
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.

Business models
A number of intangible asset business models have evolved over the years.
• Patent Licensing & Enforcement Companies ("P-LECs"): These are firms 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. Recently, hedge funds have raised capital for the
  specific 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 firms 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 firm that uses this
  business model, and which has done by far the largest and most high-profile deals in this space.[2] Royalty
  Pharma handled what many consider to be the first pharmaceutical patent-backed securitization to be rated by
  Standard and Poors, which involved a patent on the HIV drug Zerit.[3] The other parties involved in the Zerit
  transaction were Yale (the owner of the patent) and Bristol Myers Squibb.
• Reinsurers: These are firms that use the techniques of reinsurance to mitigate intangible asset risks. In the same
  way that some firms issue Cat bonds to mitigate the risks associated with extreme weather, earthquakes, or other
  natural disasters, firms 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 sufficient 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.[4]
• Market makers: Firms that are working to provide more liquidity to the market for intellectual property. Early
  market makers offered on-line intellectual property exchanges where buyers and sellers could exchange rights in
Intangible asset finance                                                                                                      99

        licensed intellectual property, usually patents. On April 22, 2008, Ocean Tomo reported[5] that it had transacted
        approximately $70 million in its IP auctions across Europe and the United States. In 2009, The Intellectual
        Property Exchange International (IPXI), headquartered in Chicago, will begin operations as the world’s first stock
        exchange with an intellectual property focus.
     • Investment Research Firms: Companies that provide specific advice to investors on intellectual property issues.
       Recently, hedge fund managers have been hiring patent attorneys to follow and handicap outcomes in high stakes
       patent cases.

     Significant transactions
     • 1997: David Bowie securitizes the future royalty revenues earned from his pre-1990 music catalogue by issuing
       Bowie Bonds.
     • 2000: BioPharma Royalty Trust completes the $115 million securitization of a single Yale patent with claims
       covering Stavudine, which is a reverse transcriptase inhibitor and the active ingredient in the drug Zerit. This was
       the first publicly rated patent securitization in the U.S. At the time of the deal, Bristol Myers Squibb had the
       exclusive rights to distribute Zerit in the U.S. Not long after closing slow sales of Zerit along with an accounting
       scandal at Bristol Myers Squibb triggered the accelerated and premature amortization of the transaction. Many
       observers believe that this deal was ultimately unsuccessful because of a lack of diversification as it 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 first "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.[6]
     • 2005: Ocean Tomo holds its first live IP auction. Although proceeds from the first auction were unremarkable, the
       relative success of the Ocean Tomo auctions that followed showed that the live auction is a reasonably viable
       business model for monetizing intellectual property.
     • 2006: Marvel Entertainment's film rights securitization in conjunction with Ambac Financial Group to provide a
       triple-A financial guarantee on a credit facility for Marvel backed by a slate of 10 films to be produced by Marvel
       Studios and intellectual property related to some of Marvel’s most popular comic book characters.[7]

     Government, societies, think tanks, and other non-profits
     On June 23, 2008, the United States National Academies hosted a one-day conference in Washington, D.C. entitled
     "Intangible Assets: Measuring and Enhancing Their Contribution to Corporate Value and Economic Growth."
     The Intangible Asset Finance Society provides a forum for finance, innovation, legal and management professionals
     to discover better ways to create, capture and preserve the value of intangible assets.
     The Athena Alliance is a non-profit organization dedicated to public education and research on the emerging global
     information economy. On April 16, 2008 it published[8] a widely-circulated working paper on the topic of intangible
     asset finance.
Intangible asset finance                                                                                                                              100

     [1] "A Trillion Dollars A Year In Intangible Investment," Leonard Nakamura in Intangible Assets: Values, Measures and Risks at 28, Hand &
         Lev, Oxford University Press (2003). (http:/ / books. google. com/ books?id=RmFLUk7NydQC& printsec=frontcover& dq=Intangible+
         Assets:+ Values,+ Measures+ and+ Risks,& sig=W2d87NPMzvfWlTDrmUNijOziu-8#PPA28,M1)
     [2] "A seller's market," The Deal, September 5, 2008 (http:/ / www. thedeal. com/ newsweekly/ features/ a-seller's-market. php#bottom)
     [3] "Avoiding Transaction Peril," Heller et al., in From Ideas to Assets: Investing Wisely in Intellectual Property at 487, Bruce Berman, John
         Wiley & Sons, 2002 (http:/ / books. google. com/ books?id=rESRFPqSKzQC& pg=PA487& lpg=PA487& dq=zerit+ patent+ securitization&
         source=web& ots=sN9S5ZWcrM& sig=LhlE-nYfxXddjCKeoGql6ap5KxM& hl=en#PPA487,M1)
     [4] Steel City Re (http:/ / www. steelcityre. com/ accelerating_innovation. shtml)
     [5] Ocean Tomo Press Release April 22, 2008 (http:/ / www. oceantomo. com/ press/ Europe_Auction_Catalogue_Release_4. 22. 08. pdf)
     [6] NexCen Press Release, May 13, 2010 (http:/ / www. reuters. com/ article/ 2010/ 05/ 13/ idUS107689+ 13-May-2010+ BW20100513)
     [7] Ambac's press release, 2006 (http:/ / www. ambac. com/ pdfs\Deals\marvel. pdf)
     [8] "Intangible Asset Monetization: The Promise and the Reality" (http:/ / www. athenaalliance. org/ pdf/ IntangibleAssetMonetization. pdf)

     Further reading
     • Rembrandts In the Attic: Unlocking the Hidden Value of Patents (
     • "When Balance Sheets Collide With the New Economy," New York Times, September 9, 2007 (http://www.
     • "IP-Focused Hedge Funds Launch Amid Market Volatility", Dow Jones, April 29, 2008 (http://news.
     • "Hedge Fund Spies in the Courtroom, IP Law & Business, May 10, 2007 (
     • Intellectual Asset Management Magazine Blog (
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