Finance

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Contents
Articles
Main article
Finance 1 1 7 7 11 11 13 13 21 27 31 54 54 65 65 73 73 76 76 81 81 83 83 95 95

The main techniques and sectors of the financial industry

Financial services

Personal finance
Personal finance

Corporate finance
Corporate finance Financial capital Cornering the market Insurance

Risk Management
Derivative

Finance of states
Public finance

Financial economics
Financial economics

Financial mathematics
Financial mathematics

Experimental finance
Experimental finance

Behavioral finance
Behavioral finance

Intangible asset finance

Intangible asset finance

References
Article Sources and Contributors Image Sources, Licenses and Contributors 98 101

Article Licenses
License 102

Main article
Finance
Finance is often defined simply as the management of money or funds management. [1] Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created for transacting and trading assets, liabilities, and risks. Finance is conceptualized, structured, and regulated by a complex system of power relations within political economies across state and global markets. Finance is both art (e.g. product development) and science (e.g. measurement), although these activities increasingly converge through the intense technical and institutional focus on measuring and hedging risk-return relationships that underlie shareholder value. Networks of financial businesses exist to create, negotiate, market, and trade in evermore-complex financial products and services for their own as well as their clients accounts. Financial performance measures assess the efficiency and profitability of investments, the safety of debtors claims against assets, and the likelihood that derivative instruments will protect investors against a variety of market risks. The financial system consists of public and private interests and the markets that serve them. It provides capital from individual and institutional investors who transfer money directly and through intermediaries (e.g. banks, insurance companies, brokerage and fund management firms) to other individuals, firms, and governments that acquire resources and transact business. With the expectation of reaping profits, investors fund credit in the forms of (1) debt capital (e.g. corporate and government notes and bonds, mortgage securities and other credit instruments), (2) equity capital (e.g. listed and unlisted company shares), and (3) the derivative products of a wide variety of capital investments including debt and equity securities, property, commodities, and insurance products. Although closely related, the disciplines of economics and finance are distinctive. The economy is a social institution that organizes a societys production, distribution, and consumption of goods and services, all of which must be 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. In practice, however, emerging research is demonstrating that such assumptions are unreliable. Instead, financial markets are subject to human error and emotion. [2] 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 themsometimes in a single day. Three overarching divisions exist within the academic discipline of finance and its related practices: 1) personal finance: the finances of individuals and families concerning household income and expenses, credit and debt management, saving and investing, and income security in later life, 2) corporate finance: the finances of for-profit organizations including corporations, trusts, partnerships and other entities, and 3) public finance: the financial affairs of domestic and international governments and other public entities. [3] Areas of study within (and the interactions among) these three levels affect all dimensions of social life: politics, taxes, art, religion, housing, health care, poverty and wealth, consumption, sports, transportation, labor force participation, media, and education. While each has a vast accumulated literature of its own, the effects of macro and micro level financing that mold and impact these and other domains of human and societal life typically have been treated by researchers as policy, welfare, work, stratification, and so forth, or have been largely unexplored. Recent research in "behavioral finance" is promising, albeit a relative newcomer, to the existing body of financial research that focuses primarily on measurement.

Finance Loans have become increasingly packaged for resale, meaning that an investor buys the loan (debt) from a bank or directly from a corporation. Bonds are debt instruments sold to investors for organizations such as companies, governments or charities.[4] The investor can then hold the debt and collect the interest or sell the debt on a secondary market. Banks are the main facilitators of funding through the provision of credit, although private equity, mutual funds, hedge funds, and other organizations have become important as they invest in various forms of debt. Financial assets, known as investments, are financially managed with careful attention to financial risk management to control financial risk. Financial instruments allow many forms of securitized assets to be traded on securities exchanges such as stock exchanges, including debt such as bonds as well as equity in publicly traded corporations. 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.[5]

Overview of techniques and sectors of the financial industry

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

Areas of finance
Personal finance
Questions in personal finance revolve around How much money will be needed by an individual (or by a family), and when? 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 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.

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 firm.

Finance of public entities

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

Finance

Financial risk management

Financial risk management 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.

Finance 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 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.

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.

Finance

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. 2. 3. 4. Empirical studies that demonstrate significant deviations from classical theories. Models of how psychology affects trading and prices Forecasting based on these methods. 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 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.

Related 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),, 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)

Finance

References
[1] Gove, P. et al. 1961. Finance. Webster's Third New International Dictionary of the English Language Unabridged. Springfield, Massachusetts: G. & C. Merriam Company. [2] 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 [3] Encyclopdia Britannica Online: britannica.com (http:/ / www. britannica. com/ EBchecked/ topic/ 207147/ finance) [4] Charitytimes.com (http:/ / www. charitytimes. com/ pages/ ct_news/ news archive/ July_06_news/ 030706_wellcome_trust_charity_bond. htm) [5] Board of Governors of Federal Reserve System of the United States. Mission of the Federal Reserve System. Federalreserve.gov (http:/ / www. federalreserve. gov/ aboutthefed/ mission. htm) Accessed: 2010-01-16. (Archived by WebCite at Webcitation.org (http:/ / www. webcitation. org/ 5mpS52OAl))

External links
OECD work on financial markets (http://www.oecd.org/finance) Observation of UK Finance Market Wharton Finance Knowledge Project (http://knowledge.wharton.upenn.edu/category.cfm?cid=1) - aimed to offer free access to finance knowledge for students, teachers, and self-learners. Professor Aswath Damodaran (http://pages.stern.nyu.edu/~adamodar/) (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 States.[1]

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...

Banks
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 business) 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. Provide internet banking system to facilitate the customers to view and operate their respective accounts through internet.

Financial services 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 check. 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 $100 trillion.[5]

Insurance
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

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. These can include debt consolidation, debt settlement and refinancing.

Financial crime
UK
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

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References
[1] "The Mistakes Of Our Grandparents?" (http:/ / www. contraryinvestor. com/ 2004archives/ mofeb04. htm). Contrary Investor.com. 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 Words.com. . 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 2009-02-06. [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. ISBN1-4039-3608-0.

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 (http://www.hks.harvard.edu/ m-rcbg/CSRI/publications/report_19_EO Finance Final.pdf) What is Financial Consulting (http://www.wisegeek.com/what-is-financial-consulting.htm) What Does a Financial Management Consultant Do? (http://www.wisegeek.com/ what-does-a-financial-management-consultant-do.htm)

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Personal finance
Personal finance
Personal finance is the application of the principles of finance to the monetary decisions of an individual or family unit. It addresses the ways in which individuals or families obtain, budget, save, and spend monetary resources over time, taking into account various financial risks and future life events. Components of personal finance might include checking and savings accounts, credit cards and consumer loans, investments in the stock market, retirement plans, social security benefits, insurance policies, and income tax management.

Personal financial planning

A key component of personal finance is financial planning, which is a dynamic process that requires regular monitoring and reevaluation. In general, it has five steps: 1. Assessment: One's personal financial situation can be assessed by compiling simplified versions of financial 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. Setting goals: Two examples are "1. Retire at age 65 with a personal net worth of $1,000,000," and, "2. Buy a house in 3 years while paying a monthly mortgage servicing cost that is no more than 25% of my gross income." Having multiple goals is common, including a mix of short term and long term goals. 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 your goals. It could include, for example, reducing unnecessary expenses, increasing one's employment income, or investing in the stock market. 4. Execution: Execution of one's personal 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, one's personal financial plan must be monitored for possible adjustments or reassessments. 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). The six key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are [1]: 1. Financial position: this area 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

Personal finance 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 your income grows, you pay a higher marginal rate of tax. Understanding how to take advantage of the myriad tax breaks when planning your personal finances can make a significant impact upon your success. 4. Investment and Accumulation Goals: planning how to accumulate enough money to acquire items with a high price is what most people consider to be financial planning. The major reasons to accumulate assets is for the following: 1. 2. 3. 4. 5. purchasing a house purchasing a car starting a business paying for education expenses accumulating money for retirement, to generate a stream of income to cover lifestyle expenses.

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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: 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. 6. Estate Planning: involves planning for the disposition of your asset when you die. 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.

References
[1] http:/ / www. fpsb. org/ component/ docman/ doc_download/ 1008-financial-planning-curriculum-framework. html

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

External links
Free Journal of Financial Counseling and Planning articles (http://www.afcpe.org/publications/ journal-articles.php). Free Center for Financial Planning and Investment personal finance education resources for all ages (http:// www.cfpionline.org/education/) .

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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 Further information: Business valuation,stock valuation,andfundamental analysis 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.

Corporate finance 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 investmenti.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured by volatility of cash flows, and must take into account the project-relevant financing mix. 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 assets.) 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 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.[6] 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. 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)[7][8] and Real options analysis (ROA);[9] 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 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. ROA 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.)

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Corporate finance Quantifying uncertainty Further information: Sensitivity analysis,Scenario planning,andMonte Carlo methods in finance Given the uncertainty inherent in project forecasting and valuation,[8][10] 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": NPV / factor. 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",[11] (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. 5% for "Worst Case", 10% for "Likely Case" and 25% 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. A further advancement is to construct stochastic[12] or probabilistic financial models as opposed to the traditional static and deterministic models as above.[10] For this purpose, the most common method is to use Monte Carlo simulation to analyze the projects 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;" [13] 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.

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The financing decision

Achieving the goals of corporate finance requires that any corporate investment be financed [14] 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 decisions here: Management must identify the "optimal mix" of financingthe capital structure that results in maximum value.[15] (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 is also typically higher than the cost of debt (see CAPM and WACC), and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.[16] 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 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 risk. One of the main 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. Another major theory is 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. 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 last theory about this decision is the Market timing hypothesis which states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity.

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The dividend decision

Whether to issue dividends,[17] 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.[18] 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).

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 more 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 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.

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Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital.[19] 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; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity (EPQ). 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 companys 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.[20] 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 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 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

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Financial risk management

See also: Financial engineering; Financial risk; Default (finance); Credit risk; Interest rate risk; Liquidity risk; Operational risk; Volatility risk; Settlement risk; Value at Risk. Risk management [21] 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. It is common for large corporations to have risk management teams; often these overlap with the internal audit function. While it is impractical for many small firms to have formal risk management teams, many still apply risk management informally. The discipline typically focuses on risks that can be hedged using traded financial instruments; see Cash flow hedge, Foreign exchange hedge. Derivatives are often employed here. 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 relating to "Risk Management" and shareholder value: in 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 [22]) 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 assumption.

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References
[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 investopedia.com (http:/ / www. investopedia. com/ terms/ h/ hurdlerate. asp) [6] See: Real Options Analysis and the Assumptions of the NPV Rule (http:/ / www. realoptions. org/ papers2002/ SchockleyOptionNPV. pdf. ), Tom Arnold & Richard Shockley [7] See: Decision Tree Analysis (http:/ / www. mindtools. com/ pages/ article/ newTED_04. htm), mindtools.com; Decision Tree Primer (http:/ / www. public. asu. edu/ ~kirkwood/ DAStuff/ decisiontrees/ index. html), Prof. Craig W. Kirkwood Arizona State University [8] 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. Siegel. [9] 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 [10] See Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations (http:/ / www. stern. nyu. edu/ ~adamodar/ pdfiles/ papers/ probabilistic. pdf), Prof. Aswath Damodaran [11] For example, mining companies sometimes employ the Hill of Value methodology in their planning; see, e.g., B. E. Hall, "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) [12] See: Quantifying Corporate Financial Risk (http:/ / www. qfinance. com/ financial-risk-management-best-practice/ quantifying-corporate-financial-risk?full), David Shimko. [13] The Flaw of Averages (http:/ / www. analycorp. com/ uncertainty/ flawarticle. htm), Prof. Sam Savage, Stanford University. [14] 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 [15] 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 [16] 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 [17] See Dividend Policy (http:/ / pages. stern. nyu. edu/ ~adamodar/ pdfiles/ ovhds/ divid. pdf), Prof. Aswath Damodaran [18] See Working Capital Management (http:/ / www. studyfinance. com/ lessons/ workcap/ index. mv), Studyfinance.com; Working Capital Management (http:/ / www. treasury. govt. nz/ publicsector/ workingcapital/ chap2. asp), treasury.govt.nz [19] 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 [20] 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) [21] See: Global Association of Risk Professionals (GARP) (http:/ / www. garp. com/ ); Professional Risk Managers' International Association (PRMIA) (http:/ / www. primia. org/ ) [22] 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.

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Financial capital
Financial capital can refer to 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 authorized in IFRS

Financial capital or just capital in finance and accounting, refers to the 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 exports in 2006

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 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.[6]

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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

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Differences between shares and debentures

Shareholders are effectively owners; debenture-holders are creditors. Shareholders may vote at AGMs 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 profit.

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

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Instruments
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 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.

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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 Marxist theory to refer to the role of "Finance Capital" as the determining and ruling class interest in capitalist society, particularly in the latter stages.[7][8]

Valuation
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"[9] conventions are three different approaches to reconciling financial capital value units of account.

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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.

Notes
[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 accounting [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 accounting [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] The Risk Report, April 2009. Volume XXXI No. 8. IRMI (http:/ / www. irmi. com/ ). [7] 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) [8] 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] [9] 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

References
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

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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 Lefvre 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 BCE: 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 Lefvre

Journalist Edwin Lefvre lists several examples of corners from the mid-19th century. He distinguishes corners as the result of manipulations from corners as the result of competitive buying. Cornelius Vanderbilt and the Harlem Railroad One of the few cornerers whose rationale was published and 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 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. Lefvre thoughts on corners of the old days In chapter 19 of his book, Edwin Lefvre tries to summarize the rationale for the corners of the 19th century.

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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 Lefvre's original account in chapter 3 as well as modern annotations explaining the actual locations and personalities on the page margins.

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 2011.

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 sentence.[8]

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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 shortsenabling 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 committed suicide after shorting Volkswagen shares.[12]

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] This example demonstrates that 7 per cent of a perishable good is enough to allow profit taking via cornering a market.

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.

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Fictional examples
An attempt to corner the market on orange juice futures plays a key role in the 1983 movie Trading Places. The two protagonists (played by Eddie Murphy and Dan Aykroyd) eventually foil their rivals' plan by short-selling the futures, causing hundreds of millions of dollars in losses for the latter.

References
[1] http:/ / financial-dictionary. thefreedictionary. com/ Cornering+ the+ Market [2] Lefvre, 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 2008-06-29 [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 VWs 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). "Traders 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 2011. [17] http:/ / finance. yahoo. com/ news/ Obamas-SPR-oil-release-cnnm-1977710904. html

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Insurance
Insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer 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.

Principles
Insurance involves pooling funds from many insured entities (known as exposures) to pay for the losses that some may incur. The insured entities are therefore protected from risk for a fee, with the fee being dependent upon the frequency and severity of the event occurring. In order to be 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]

Insurability
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, it is not likely that the insurance will be purchased, even if on offer. Further, as the accounting profession formally recognizes in financial accounting

Insurance 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, 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.

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Legal
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. 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 the loss to a minimum, as if the asset was not insured.

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Indemnification
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 two types of insurance contracts that seek to indemnify an insured: 1. an "indemnity" policy, and 2. a "pay on behalf" or "on behalf of"[4] policy. The difference is significant on paper, but rarely material in practice. An "indemnity" policy will never pay claims until the insured has paid out of pocket to some third party; for example, a visitor to your home slips on a floor that you left wet and sues you for $10,000 and wins. Under an "indemnity" policy the homeowner would have to come up with the $10,000 to pay for the visitor's fall and then would be "indemnified" by the insurance carrier for the out of pocket costs (the $10,000).[4][5] Under the same situation, a "pay on behalf" policy, the insurance carrier would pay the claim and the insured (the homeowner in the above example) would not be out of pocket for anything. Most modern liability insurance is written on the basis of "pay on behalf" language.[4] 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.

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]

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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 and the investment gains thereon, 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]

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Claims
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 ACORD. 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 claim. 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).

Marketing
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 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 practised by Chinese and Babylonian traders as long ago as the 3rd and 2nd millennia BC, respectively.[13] Chinese merchants travelling treacherous river

Insurance 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 practised 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 of the general average. Merchants whose goods were being shipped 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 developed.

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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 Lloyd's of London, pictured in 1991, is one of the London, which in 1666 devoured more than 13,000 houses. The world's leading and most famous insurance devastating effects of the fire converted the development of insurance markets "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 Office.[18] 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 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]

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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 collision. 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 coverage.

Home insurance
Home insurance provides coverage for damage or destruction of the policyholder's home. In some geographical areas, the policy may 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.[22]

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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.

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.

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

Casualty
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.

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Life
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. 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 AD 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
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 below:
This tornado damage to an Illinois home would be considered an "Act of God" for insurance purposes

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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 damage to boilers, equipment or machinery.

US Airways Flight 1549 was written off after 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.[23] 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.[24] 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), is the type of property insurance that covers private homes, as outlined above.

Hurricane Katrina caused over $80 billion of storm and flood damage

Landlord insurance covers residential and commercial properties which are rented to others. Most homeowners' insurance covers only owner-occupied homes. Marine insurance and marine cargo insurance cover the loss or damage of vessels at sea or on inland waterways, and of cargo in transit, regardless of the method of transit. When the owner of the cargo and the carrier are separate corporations, marine cargo insurance typically compensates the owner of cargo for losses sustained from 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 other business expenses attributable to the delay caused by a covered loss.

Fire aboard MV Hyundai Fortune

Insurance 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. Windstorm insurance is an insurance covering the damage that can be caused by wind events such as hurricanes.

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The demand for terrorism insurance surged after 9/11

Liability
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. 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 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

Insurance insurance.

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Credit
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 debt. Many credit cards offer payment protection plans which are a form of credit insurance. Accounts receivable insurance, also known as credit or trade credit insurance is business insurance over the accounts receivables of the insured. The policy pays the policy holder for covered accounts receivable if the debtor defaults on payment.

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 foal. Business interruption insurance covers the loss of income, and the expenses incurred, after a covered peril interrupts normal business operations. Collateral protection insurance (CPI) insures property (primarily vehicles) held as collateral for loans made by lending institutions.
High-value horses may be insured under a 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.

Insurance 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. 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

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Insurance financing vehicles

Fraternal insurance is provided on a cooperative basis by fraternal benefit societies or other social organizations.[26] 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

Insurance 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): National Insurance Social safety net Social security Social Security debate (United States) Social Security (United States) Social welfare provision

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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

Insurance 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] 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 insurer.[27] 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 stock companies. Mutual companies are owned by the policyholders, while stockholders (who may or may not own policies) own stock insurance companies. 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.

46

Insurance 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. 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.

47

Across the world

Global insurance premiums grew by 2.7% in inflation-adjusted terms in 2010 to $4.3 trillion, climbing abovepre-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

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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 alone accounted for 40% of world insurance, much higher than their 7% share of the global population. Emerging economies accounted forover 85% of the worlds population but only around 15% of premiums. Their markets are however growing at a quicker pace. [29]

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.[30] The National Conference of Insurance Legislators (NCOIL) also works to harmonize the different state laws.[31] 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.[32] 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[33] was passed, followed in 1998 by the formation of China Insurance Regulatory Commission (CIRC), which has broad regulatory authority over the insurance market of China.[34] 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 compnies.

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Controversies
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.

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 when the judges themselves cannot understand what the policies are saying. Typically, courts construe ambiguities in insurance policies against the insurance company and in favor of coverage under the policy.

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

Many institutional insurance purchasers buy insurance through an insurance broker. While on the surface it appears the broker represents the buyer (not the insurance company), and typically counsels the buyer on appropriate coverage and policy limitations, it should be noted that 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. Unlike a broker, who represents the policyholder, an agent represents the insurance company from whom the policyholder buys. 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. It should also be noted that agents generally can not 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.

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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.[35] This is associated with reduced purchasing of insurance against low-probability losses, and may result in increased inefficiencies from moral hazard.[35]

Redlining
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 industry.[36] 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.[37] 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. [38] 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.[39] 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

Insurance 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).

51

Insurance patents
Further information: Insurance patent New assurance products can now be protected from copying with a business method patent in the United States. A recent example of a new insurance product that is patented is Usage Based auto insurance. Early versions were independently invented and patented by a major US auto insurance company, Progressive Auto Insurance (U.S. Patent 5797134 [40]) and a Spanish independent inventor, Salvador Minguijon Perez (EP 0700009 [41]). 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 issued has steadily risen from 15 in 2002 to 44 in 2006.[42] Inventors can now have their insurance US patent applications reviewed by the public in the Peer to Patent program.[43] The first insurance patent application to be posted was US2009005522 Risk assessment company [44]. It was posted on March 6, 2009. This patent application describes a method for increasing the ease of changing insurance companies.[45]

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[46] (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.[47] Jewish rabbinical scholars also have expressed reservations regarding insurance as an avoidance of God's will but most find it acceptable in moderation.[48] Some Christians believe insurance represents a lack of faith[49] 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.[50][51][52]

Insurance

52

Notes
[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 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. ISBN978-0470108758. . 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 (2004). [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): 51546. 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] Insurance Information Institute. "What is homeowners insurance?" (http:/ / www. iii. org/ individuals/ homei/ hbasics/ whatis/ ). . Retrieved 2008-11-11. [23] "Builder's Risk Insurance" (http:/ / www. adjustersinternational. com/ AdjustingToday/ ATfullinfo. cfm?start=1& page_no=1& pdfID=4). Adjusters International. . Retrieved 2009-10-16. [24] US application 20060287896 (http:/ / worldwide. espacenet. com/ textdoc?DB=EPODOC& IDX=US20060287896) Method for providing crop insurance for a crop associated with a defined attribute [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] http:/ / www. thecityuk. com/ assets/ Uploads/ Insurance-2011-F2. pdfPDF(365KB) page 2 [30] 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 REVIEW. [31] 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 [32] 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. [33] 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.

Insurance
[34] 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. [35] 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. [36] 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 [37] Credit-Based Insurance Scores: Impacts on Consumers of Automobile Insurance (http:/ / ftc. gov/ opa/ 2007/ 07/ facta. shtm), Federal Trade Commission (July 2007) [38] Consumers Dispute FTC Report on Insurance Credit Scoring (http:/ / www. consumeraffairs. com/ news04/ 2007/ 07/ insurance_credit. html) www.consumeraffairs.com (July 2007) [39] Insurance Information Institute. "Issues Update: Regulation Modernization" (http:/ / www. iii. org/ media/ hottopics/ insurance/ ratereg/ ). . Retrieved 2008-11-11. [40] http:/ / www. google. com/ patents?vid=5797134 [41] http:/ / worldwide. espacenet. com/ textdoc?DB=EPODOC& IDX=EP0700009 [42] (Source: Insurance IP Bulletin, December 15, 2006) (http:/ / marketsandpatents. com/ IPB-12152006. mht) [43] Mark Nowotarski "Patent Q/A: Peer to Patent", Insurance IP Bulletin, August 15, 2008 (http:/ / www. marketsandpatents. com/ bulletin/ IPB-08152008. html) [44] http:/ / www. peertopatent. org/ patent/ 20090055227/ activity [45] Bakos, Nowotarski, An Experiment in Better Patent Examination, Insurance IP Bulletin, December 15, 2008 (http:/ / www. marketsandpatents. com/ bulletin/ IPB-12152008. html) [46] "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. [47] "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. [48] "Jewish Association for Business Ethics - Insurance" (http:/ / www. jabe. org/ insurance. html). . Retrieved 2008-03-25. [49] "CIC Insurance - Insurance and the Church" (http:/ / www. cic. co. ke/ template/ t02. php?menuId=72). . Retrieved 2010-01-18. [50] 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. [51] Donald B. Kraybill. The riddle of Amish culture. p.277. ISBN0801836824. [52] "Global Anabaptist Mennonite Encyclopedia Online, Insurance" (http:/ / www. gameo. org/ encyclopedia/ contents/ I583ME. html). . Retrieved 2010-01-18.

53

Bibliography
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 (http://www.ferma.eu/) Insurance (http://www.dmoz.org/Home/Personal_Finance/Insurance/) at the Open Directory Project Insurance Bureau of Canada (http://www.ibc.ca/) Insurance Information Institute (http://www.iii.org/) Museum of Insurance (http://www.immediateannuities.com/museumofinsurance/) - displays thousands of antique insurance policies and ephemera National Association of Insurance Commissioners (http://www.naic.org/) The British Library (http://www.bl.uk/collections/business/insurind.html) - finding information on the insurance industry (UK bias)

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Risk Management
Derivative
A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments, or payoffs, are to be made between the parties.[1][2] Under US law and the laws of most other developed countries, derivatives have special legal exemptions that make them a particularly attractive legal form through which to extend credit.[3] However, the strong creditor protections afforded to derivatives counterparties, in combination with their complexity and lack of transparency, can cause capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks.[3] Indeed, the use of derivatives to mask credit risk from third parties while protecting derivative counterparties contributed to both the financial crisis of 2008 in the United States and the European sovereign debt crises in Greece and Italy.[3][4] Financial reforms within the US since the financial crisis have served only to reinforce special protections for derivatives, including greater access to government guarantees, while minimizing disclosure to broader financial markets.[5] One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[6] 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 can be used for speculating purposes ("bets") or to hedge ("insurance"). For example, a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies. Third parties can use publicly available derivatives prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts.[7]

Usage
Derivatives are used by investors for the following: provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative;[8] 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); 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;[9] obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);[10] 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).

Derivative

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Hedging
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. 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. 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 seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.

Derivatives traders at the Chicago Board of Trade

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.

Derivative 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]

56

Types
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, the total outstanding notional amount is US$708 trillion (as of June 2011).[14] 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.[15] 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[16] 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. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

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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, while the former is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, the latter 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. 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 over-the-counter. 5. 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.[17]

Examples
The overall derivatives market has five major classes of underlying asset: interest rate derivatives (the largest) foreign exchange derivatives credit derivatives equity derivatives commodity derivatives

Some common examples of these derivatives are the following:

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UNDERLYING Exchange-traded futures Equity DJIA Index future Single-stock future

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

Option on DJIA Index future Single-share option Option on Eurodollar future Option on Euribor future

Equity swap

Back-to-back Repurchase agreement

Stock option Warrant Turbo warrant

Interest rate

Eurodollar future Euribor future

Interest rate swap

Forward rate agreement Interest rate cap and floor Swaption Basis swap Bond option Repurchase agreement Credit default option

Credit

Bond future

Option on Bond future

Credit default swap Total return swap Currency swap

Foreign exchange Commodity

Currency future

Option on currency future

Currency forward

Currency option

WTI crude oil futures

Weather derivatives

Commodity swap

Iron ore forward contract

Gold option

Other examples of underlying exchangeables are: Property (mortgage) derivatives Economic derivatives that pay off according to economic reports[18] as measured and reported by national statistical agencies Freight derivatives Inflation derivatives Weather derivatives Insurance derivatives[19] Emissions derivatives[20]

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 environment. 5. A significant accompanying benefit which is a consequence of derivatives trading is that it acts as a facilitator for new Entrepreneurs. The derivatives market has a history of alluring many optimistic, imaginative and well

Derivative educated people with an entrepreneurial outlook, the benefits of which are colossal. In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative Market participant.[21]

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

Determining the market price

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.

[22] Total world derivatives from 19982007 compared to total world wealth in the year [23] 2000

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 BlackScholes 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-dependant (meaning the final price depends heavily on how we derive the pricing inputs).[24] 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).

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Criticism
Derivatives are often subject to the following criticisms:

Erroneous Analysis of Benefits

Economists and bankers claimed derivatives made markets safer. But instead, they made them [the markets] unstable.[25]

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 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."[26]

Risk
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).[27] 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 was necessary because over the next few quarters, the company was likely to lose more money. The loss of US$7.2 Billion by Socit Gnrale 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.[28] The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[29] UBS AG, Switzerlands biggest bank, suffered a $2 billion loss through unauthorized trading discovered in September, 2011.[30]

Counter party risk

Some derivatives (especially swaps) expose investors to counter party risk. 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.

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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.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. 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) [31]

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations, thereby curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, US Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the Great Depression. (See Berkshire Hathaway Annual Report for 2002)

Benefits
The use of derivatives also has its benefits: Derivatives facilitate the buying and selling of risk, and many financial professionals consider this to have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero-sum in utility.

Government regulation
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 departments antitrust unit is actively investigating 'the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,' according to a department spokeswoman."[32] Over-the-counter dealing will be less common as the 2010 Dodd-Frank Wall Street Reform 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 [33]. 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.

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Glossary
Bilateral netting: A legally enforceable arrangement between a bank and a counter-party that creates a single legal obligation covering all included individual contracts. This means that a banks obligation, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement. 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 banks counter-parties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was held by the counter-parties. Gross positive fair value: The sum total of the fair values of contracts where the bank is owed money by its counter-parties, without taking into account netting. This represents the maximum losses a bank could incur if all its counter-parties default and there is no netting of contracts, and the bank holds no counter-party collateral. High-risk mortgage securities: Securities where the price or expected average life is highly sensitive to interest rate changes, as determined by the U.S. Federal Financial Institutions Examination Council policy statement on high-risk mortgage securities. Notional amount: The nominal or face amount that is used to calculate payments made on swaps and other risk management products. This amount generally does not change hands and is thus referred to as notional. Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are transacted 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 banks allowance for loan and lease losses.

References
[1] Rubinstein, Mark (1999). Rubinstein on derivatives. Risk Books. ISBN1899332537. [2] Hull, John C. (2006). Options, Futures and Other Derivatives, Sixth Edition. Prentice Hall. pp.1. [3] Michael Simkovic, Secret Liens and the Financial Crisis of 2008, American Bankruptcy Law Journal, Vol. 83, p. 253, 2009 (http:/ / ssrn. com/ abstract=1323190) [4] Michael Simkovic, Bankruptcy Immunities, Transparency, and Capital Structure, Presentation at the World Bank, January 11, 2011 (http:/ / ssrn. com/ abstract=1738539) [5] Michael Simkovic, Paving the Way for the Next Financial Crisis, Banking & Financial Services Policy Report, Vol. 29, No. 3, 2010 (http:/ / ssrn. com/ abstract=1585955) [6] Kaori Suzuki and David Turner (December 10, 2005). "Sensitive politics over Japan's staple crop delays rice futures plan" (http:/ / www. ft. com/ cms/ s/ 0/ d9f45d80-6922-11da-bd30-0000779e2340. html). The Financial Times. . Retrieved October 23, 2010. [7] Michael Simkovic and Benjamin Kaminetzky, Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution (August 29, 2010). Columbia Business Law Review, Vol. 2011, No. 1, p. 118, 2011 (http:/ / ssrn. com/ abstract=1632084)

Derivative
[8] Shirreff, David (2004). "Derivatives and leverage" (http:/ / books. google. com/ books?id=mwirEO_f1DkC). Dealing With Financial Risk. USA: The Economist. p.23. ISBN1-57660-162-5. . Retrieved 14 September 2011. [9] Khullar, Sanjeev (2009). "Using Derivatives to Create Alpha" (http:/ / books. google. com/ books?id=uv73DVVSgAsC). In John M. Longo. Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance. Singapore: World Scientific. p.105. ISBN978-981-283-465-2. . Retrieved 14 September 2011. [10] Don M. Chance; Robert Brooks (2010). "Advanced Derivatives and Strategies" (http:/ / books. google. com/ books?id=DT0nnLDMYTgC). Introduction to Derivatives and Risk Management (8th ed.). Mason, Ohio: Cengage Learning. pp.483515. ISBN978-0-324-60120-6. . Retrieved 14 September 2011. [11] Chisolm, Derivatives Demystified (Wiley 2004) [12] Chisolm, Derivatives Demystified (Wiley 2004) Notional sum means there is no actual principal. [13] News.BBC.co.uk (http:/ / news. bbc. co. uk/ 2/ hi/ business/ 375259. stm), "How Leeson broke the bank BBC Economy" [14] BIS survey: The Bank for International Settlements (BIS) semi-annual OTC [derivatives market (http:/ / www. bis. org/ publ/ otc_hy1111. pdf) report, for end of June 2008, shows US$683.7 trillion total notional amounts outstanding of OTC derivatives with a gross market value of US$20 trillion. See also Prior Period Regular OTC Derivatives Market Statistics (http:/ / www. bis. org/ publ/ otc_hy1111. htm). [15] Hull, J.C. (2009). Options, futures, and other derivatives . Upper Saddle River, NJ : Pearson/Prentice Hall, c2009 [16] Futures and Options Week: According to figures published in F&O Week 10 October 2005. See also FOW Website (http:/ / www. fow. com). [17] "Financial Markets: A Beginner's Module" (http:/ / www. nseindia. com/ education/ content/ module_ncfm. htm). . [18] "Biz.Yahoo.com" (http:/ / biz. yahoo. com/ c/ e. html). Biz.Yahoo.com. 2010-08-23. . Retrieved 2010-08-29. [19] Canter, Michael S.; Cole, Joseph B.; Sandor, Richard L. (1996). "Insurance Derivatives A New Asset Class for the Capital Markets and a New Hedging Tool for the Insurance Industry". Journal of Derivatives 4 (2): 89104. doi:10.3905/jod.1996.407966. [20] FOW.com (http:/ / www. fow. com/ Article/ 1385702/ Issue/ 26557/ Emissions-derivatives-1. html), Emissions derivatives, 1 December 2005 [21] "Currency Derivatives: A Beginner's Module" (http:/ / www. nseindia. com/ education/ content/ module_ncfm. htm). . [22] "Bis.org" (http:/ / www. bis. org/ statistics/ derstats. htm). Bis.org. 2010-05-07. . Retrieved 2010-08-29. [23] "Launch of the WIDER study on The World Distribution of Household Wealth: 5 December 2006" (http:/ / www. wider. unu. edu/ events/ past-events/ 2006-events/ en_GB/ 05-12-2006/ ). . Retrieved 9 June 2009. [24] Boumlouka, Makrem (2009),"Alternatives in OTC Pricing", Hedge Funds Review, 10-30-2009. http:/ / www. hedgefundsreview. com/ hedge-funds-review/ news/ 1560286/ otc-pricing-deal-struck-fitch-solutions-pricing-partners [25] Ferguson, Charles (Director) (May 16, 2010). [[Inside Job (film)|Inside Job (http:/ / www. imdb. com/ title/ tt1645089/ )]] (Television Documentary (DVD)). Sony Pictures Classics. Event occurs at 22:58. . [26] Raghuram G. Rajan (September 2006). "Has Financial Development Made the World Riskier?" (http:/ / ssrn. com/ abstract=923683). EUROPEAN FINANCIAL MANAGEMENT (EUROPEAN FINANCIAL MANAGEMENT) 12 (4): 499-533. doi:10.1111/j.1468-036X.2006.00330.x. . Retrieved January 17, 2012. [27] Kelleher, James B. (2008-09-18). ""Buffett's Time Bomb Goes Off on Wall Street" by James B. Kelleher of Reuters" (http:/ / www. reuters. com/ article/ newsOne/ idUSN1837154020080918). Reuters.com. . Retrieved 2010-08-29. [28] Edwards, Franklin (1995), "Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft" (http:/ / www0. gsb. columbia. edu/ faculty/ fedwards/ papers/ DerivativesCanBeHazardous. pdf), Derivatives Quarterly (Spring 1995): 817, [29] Whaley, Robert (2006). Derivatives: markets, valuation, and risk management (http:/ / books. google. com/ books?id=Hb7xXy-wqiYC& printsec=frontcover& cad=0#v=onepage& q& f=false). John Wiley and Sons. p.506. ISBN0471786322. . [30] http:/ / www. businessweek. com/ news/ 2011-09-15/ ubs-loss-shows-banks-fail-to-learn-from-kerviel-leeson. html [31] http:/ / www. berkshirehathaway. com/ 2002ar/ 2002ar. pdf [32] 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. [33] http:/ / www. cftc. gov/ LawRegulation/ DoddFrankAct/ index. htm

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1. http://www.sebi.gov.in/faq/derivativesfaq.html

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Further reading
Hull, John C. (2011). Options, Futures and Other Derivatives (8th ed.). Harlow: Pearson Education. ISBN9780132604604. Durbin, Michael (2011). All About Derivatives (2nd ed.). New York: McGraw-Hill. ISBN9780071743518. Mattoo, Mehraj (1997). Structured Derivatives: New Tools for Investment Management: A Handbook of Structuring, Pricing & Investor Applications. London: Financial Times. ISBN0273611208.

External links
BBC News Derivatives simple guide (http://news.bbc.co.uk/1/hi/business/2190776.stm) European Union proposals on derivatives regulation 2008 onwards (http://ec.europa.eu/internal_market/ financial-markets/derivatives/index_en.htm) Derivatives in Africa (http://www.mfw4a.org/capital-markets/derivatives-derivatives-exchanges-commodities. html) Derivatives Litigation (http://derivatives-litigation.blogspot.com/)

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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.

Overview
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 differently. 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.

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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 system. 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

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Financing of government expenditures

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

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.

Taxes
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 heavy 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 corve 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 name."[7] 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) etc. Gift tax

Public finance 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.)

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Debt
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.

Foreign currency reserves and gold minus external debt based on 2010 data from CIA Factbook.

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
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

Further information: State-owned 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.

Public finance 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.

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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) [8] is the internationally accepted methodology for compiling fiscal data. It is consistent with regionally accepted methodologies such as the European System of Accounts 1995 [9] and consistent with the methodology of the System of National Accounts (SNA1993) [10] and broadly in line with its most recent update, the SNA2008 [11].

Challenges in measuring government

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

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Figure 2: Public Sector(IMF Government Finance Statistics Manual 2001(Washington, 2001) pp.15

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 governments 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 governments financial statements contain the relevant information for this analysis. The governments balance sheet presents the level of the debt; that is the governments liabilities. The memorandum items of the balance sheet provide additional information on the debt including its maturity and whether it is owed to domestic or external residents. The balance sheet also presents a disaggregated classification of financial and non-financial assets.

Public finance 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.

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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.

Notes
[1] Gruber, Jonathan (2005). Public Finance and Public Policy. New York: Worth Publications. pp.2. ISBN0-7167-8655-9. [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] http:/ / www. imf. org/ external/ pubs/ ft/ gfs/ manual/ index. htm [9] http:/ / circa. europa. eu/ irc/ dsis/ nfaccount/ info/ data/ esa95/ esa95-new. htm [10] http:/ / unstats. un. org/ unsd/ sna1993/ toctop. asp?L1=4 [11] http:/ / unstats. un. org/ unsd/ nationalaccount/ sna2008. asp

References
Anthony B. Atkinson and Joseph E. Stiglitz (1980). Lectures in Public Economics, McGraw-Hill Economics Handbook Series James M. Buchanan and Richard A. Musgrave (1989). Public Finance and Public Choice: Two Contrasting Visions of the State. MIT Press. Scroll down to chapter-preview links. (http://books.google.com/ books?id=jEnjN7dKrzcC&printsec=frontcover&source=gbs_atb#v=onepage&q&f=false) Richard A. Musgrave (1959). The Theory of Public Finance: A Study in Public Economy. J.M. Buchanan review, 1st page. (http://www.jstor.org/pss/1054956) R.A. Musgrave (2008). "public finance," The New Palgrave Dictionary of Economics Abstract. (http://www. dictionaryofeconomics.com/article?id=pde2008_P000244&edition=current&q=public finance&topicid=& result_number=1) Richard A. Musgrave and Peggy B. Musgrave (1973). Public Finance in Theory and Practice Joseph E. Stiglitz (2000). Economics of the Public Sector, 3rd ed. Norton. Greene, Joshua E (2011). Public Finance: An International Perspective (http://www.worldscibooks.com/ economics/8219.html). Hackensack, New Jersey: World Scientific. pp.500. ISBN978-981-4365-04-8.

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External links
Taxation and Public Finance course at the Harris School of Public Policy Studies (http://harrisschool.uchicago. edu/Programs/courses/description.html?course=32900) State and Local Public Finance course at the Harris School of Public Policy Studies (http://harrisschool. uchicago.edu/Programs/courses/description.html?course=32100) IMF--Dissemination Standards Bulletin Board-- Subscribing ... (http://dsbb.imf.org/Applications/web/ sddsnsdppage/) (see "fiscal sector") The IMF's Public Financial Management Blog (http://blog-pfm.imf.org) Other Public Financing Resource (http://dpfg.com/services/public.php) US Debt Clock.org (http://www.usdebtclock.org/) - Real Time U.S. Debt Clock Canadian Governments Compared (http://etatscanadiens-canadiangovernments.enap.ca/fr/index.aspx)

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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 information".[2] 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 money. Information: knowledge of the future can reduce, or possibly eliminate, the uncertainty associated with future monetary value (FMV). 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 relationships.

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Models in financial economics

Financial economics is primarily concerned with building models to derive testable or policy implications from acceptable 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 value. 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".

References
[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). Stanford.edu. . Retrieved 2009-08-06.

External links
Theory
Foundations of Finance (http://faculty.chicagogsb.edu/eugene.fama/research/index.htm), Theory of Finance (http://faculty.chicagogsb.edu/eugene.fama/research/index.htm), Eugene Fama, University of Chicago Graduate School of Business Macro-Investment Analysis (http://www.stanford.edu/~wfsharpe/mia/int/mia_int2.htm), Professor William Sharpe, Stanford Graduate School of Business Lecture Notes in Financial Economics (http://personal.lse.ac.uk/mele/files/fin_eco.pdf), Antonio Mele, London School of Economics Great Moments in Financial Economics I (http://web.archive.org/web/20070927123033/http://www. in-the-money.com/artandpap/I+Present+Value.doc), II (http://web.archive.org/web/20070927123027/ http://www.in-the-money.com/artandpap/II+Modigliani-Miller+Theorem.doc), "III" (http://web.archive. org/web/20070927123024/http://www.in-the-money.com/artandpap/III+Short-Sales+and+Stock+Prices. doc). Archived from the original (http://www.in-the-money.com/artandpap/III Short-Sales and Stock Prices. doc) on 2007-09-27.; IVa (http://web.archive.org/web/20070927123029/http://www.in-the-money.com/ artandpap/IV+Fundamental+Theorem+-+Part+I.doc); "IVb" (http://web.archive.org/web/ 20070927123021/http://www.in-the-money.com/artandpap/IV+Fundamental+Theorem+-+Part+II.doc). Archived from the original (http://www.in-the-money.com/artandpap/IV Fundamental Theorem - Part II.doc) on 2007-09-27.. Prof. Mark Rubinstein, Haas School of Business Microfoundations of Financial Economics (http://www.ulb.ac.be/cours/solvay/farber/PhD.htm) Prof. Andr Farber Solvay Business School Handbook of the Economics of Finance (http://ideas.repec.org/b/eee/finhes/2.html#related), G.M. Constantinides, M. Harris, R. M. Stulz

Financial economics Financial economics (http://www.sciencedirect.com/science?_ob=RefWorkIndexURL&_idxType=SC& _cdi=23486&_refWorkId=21&_explode=151000131,151000133&_alpha=&_acct=C000050221& _version=1&_userid=10&md5=f2c773b745753022e1cccc9a38d83508&refID=151000133#151000133), International Encyclopedia of the Social & Behavioral Sciences, Oxford: Elsevier, 2001. Financial economics topics (http://www.dictionaryofeconomics.com/articles_by_topic?topicid=G) with Abstracts, The New Palgrave Dictionary of Economics, 2008. An introduction to investment theory (http://viking.som.yale.edu/will/web_pages/will/finman540/ classnotes/notes.html), Prof. William Goetzmann, Yale School of Management Notes on General Equilibrium Asset Pricing (http://pascal.iseg.utl.pt/~pbrito/cursos/mestrado/fef/fef2009. pdf), Prof. Paulo Brito, ISEG, Technical University of Lisbon

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Context and history

Finance Theory (http://cepa.newschool.edu/het/schools/finance.htm), The History of Economic Thought Website, The New School The Scientific Evolution of Finance (http://www.finance-and-physics.org/Library/Articles3/ scienceandfinance/science.htm) Prof. Don Chance, Prof. Pamela Peterson 50 Years of Finance (http://www.ulb.ac.be/cours/solvay/farber/VUB/01 Inaugurale rede.pdf) Prof. Andr Farber, Universit Libre de Bruxelles "A Short History of Investment Forecasting" (http://web.archive.org/web/20071012112134/http:// roundtable.informs.org/public-access/min061a.htm). Archived from the original (http://roundtable.informs. org/public-access/min061a.htm) on 2007-10-12., Professor Michael Phillips, California State University, Northridge Pioneers of Finance (http://campus.murraystate.edu/academic/faculty/larry.guin/FinancialHistory.htm), Prof. Larry Guin, Murray State University

Links and portals

Financial Economics Links on WebEc (http://www.helsinki.fi/WebEc/webecg.html) JEL Classification Codes Guide (http://www.aeaweb.org/jel/guide/jel.php?class=G) Financial Economics Links on RFE (http://rfe.org/showCat.php?cat_id=56) SSRN Financial Economics Network (http://www.ssrn.com/fen/index.html) "Books on Financial Economics": list on economicsnetwork.ac.uk (http://www.economicsnetwork.ac.uk/ books/FinancialEconomics.htm)

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Financial mathematics
Financial mathematics
Mathematical finance 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. 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 fair value of derivatives of the stock (see: Valuation of options). 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), often by help of stochastic asset models. The fundamental theorem of arbitrage-free pricing is one of the key theorems in mathematical finance. Many universities around the world now 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 on the one hand, and risk and portfolio management on the other hand. One of the main differences is that they use different probabilities, namely the risk-neutral probability, denoted by "Q", and the actual probability, denoted by "P".

Derivatives pricing: the Q world

Further information: BlackScholes 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. 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.

Derivatives pricing: the Q world

Goal "extrapolate the present"

Environment risk-neutral probability Processes Dimension Tools Challenges Business continuous-time martingales low Ito calculus, PDEs calibration sell-side

Financial mathematics Quantitative derivatives pricing was initiated by Louis Bachelier in The Theory of 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. However, Bachelier's work hardly caught any attention outside academia. 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 )

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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 derivatives. The main quantitative tools necessary to handle continuous-time Q-processes are Itos stochastic calculus and partial differential equations (PDEs).

Risk and portfolio management: 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.

Risk and portfolio management: the P world

Goal "model the future"

Environment real probability Processes Dimension Tools Challenges Business discrete-time series large multivariate statistics estimation buy-side

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

Financial mathematics 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 meanvariance 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]

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Criticism
More sophisticated mathematical models and derivative pricing strategies were then developed but their credibility was damaged by the financial crisis of 20072010. Contemporary practice of mathematical finance has been subjected to criticism from figures within the field notably by Nassim Nicholas Taleb 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 methods.[5]

Mathematical finance articles

Mathematical tools
Asymptotic analysis Calculus Copulas Differential equations Expected value Ergodic theory FeynmanKac formula Fourier transform Gaussian copulas Girsanov's theorem It's lemma Martingale representation theorem Mathematical models Monte Carlo method

Numerical analysis Real analysis Partial differential equations

Financial mathematics Probability Probability distributions Binomial distribution Log-normal distribution Quantile functions Heat equation RadonNikodym derivative Risk-neutral measure Stochastic calculus Brownian motion Lvy process Stochastic differential equations Stochastic volatility Numerical partial differential equations CrankNicolson method Finite difference method Value at risk Volatility ARCH model GARCH model

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Derivatives pricing
The Brownian Motion Model of Financial Markets Rational pricing assumptions Risk neutral valuation Arbitrage-free pricing Futures contract pricing Options Putcall parity (Arbitrage relationships for options) Intrinsic value, Time value Moneyness Pricing models BlackScholes model Black model Binomial options model Monte Carlo option model Implied volatility, Volatility smile SABR Volatility Model Markov Switching Multifractal The Greeks Finite difference methods for option pricing Vanna Volga method Trinomial tree

Optimal stopping (Pricing of American options) Interest rate derivatives

Financial mathematics Short rate model HullWhite model CoxIngersollRoss model Chen model LIBOR Market Model HeathJarrowMorton framework

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Notes
[1] [2] [3] [4] [5] Karatzas, I., Methods of Mathematical Finance, Secaucus, NJ, USA: Springer-Verlag New York, Incorporated, 1998 Meucci, A., Risk and Asset Allocation, Springer, 2005 Taleb, N. N. (2007) The Black Swan: The Impact of the Highly Improbable, Random House Trade, ISBN 978-1400063512 http:/ / www. wilmott. com/ blogs/ paul/ index. cfm/ 2009/ 1/ 8/ Financial-Modelers-Manifesto 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,

References
Harold Markowitz, Portfolio Selection, Journal of Finance, 7, 1952, pp.7791 William Sharpe, Investments, Prentice-Hall, 1985 Attilio Meucci, versus Q: Differences and Commonalities between the Two Areas of Quantitative Finance (http:// ssrn.com/abstract=1717163''P), GARP Risk Professional, February 2011, pp.41-44

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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.

Method in experimental finance

The methodology of experimental finance is closely related to that of Experimental economics. The fundamental method of experiment economics is to create a setting that implements some institutional features of interest, and then provide participants with incentives to maximize utility within that setting. Following the discussion in Bloomfield, Tayler, and Zhou (2009), experimentalists usually classify models as having three types of assumptions: Structural assumptions describe the institutions in which agents interact, including the distribution of information, possible actions, and incentives; Behavioral assumptions characterize agents preferences and decision-making abilities (such as expected utility maximization and the form of the utility function); Equilibrium assumptions that describe the solution concepts used to predict behavior (such as Bayesian Nash Equilibrium, rational expectations, or arbitrate free pricing). Equilibrium assumptions are particularly important in signaling models. Even in settings with a unique equilibrium, there is no guarantee that the equilibrium can be achieved. An equilibrium is a fixed pointan outcome that, if obtained, will leave no participant wishing to deviate from it. Still, experimentalists are quickly forced to think about the process that would drive participants toward equilibrium if they are not already there (convergence), and also about the process that might drive participants away from an equilibrium if, having attained it, they drift infinitesimally far away (instability).

Testing Models that Cannot Be Solved

A final way to avoid the problem of having no plausible alternative hypothesis is to construct a setting in which theory is simply unable to provide a unique prediction. This alternative is particularly relevant in market microstructure, which deals with extremely complex settings and strategic problems. The most common market used in laboratory settings is the double auction, which is simple in execution, but extremely difficult to model (see Friedman, 1984). Modelers in microstructure will often look at simpler settings, such as Kyle-type or Glosten-Milgrom-type experiments. For example, Bloomfield (1996) uses a Glosten-Milgrom- type setup in which investors and market makers simultaneously submit the best bid and ask at which they are willing to trade. Crossing trades are then executed, all other orders are canceled and trade moves on to the next period. Orders that are not immediately marketable do not have any impact on trade as they would in a limit order market. These types of models of quote- or order-driven markets are much less relevant these days, when most trade takes place in electronic limit order markets.

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Individual Bias and Aggregate Market Behavior

A large literature from psychology shows individual errors in judgment. Some of the biases most relevant in the financial setting, are outlined by Tversky and Kahneman (1974). These biases include representativeness, the tendency to assume commonality between similar objects; availability, which causes probabilities to be assigned based on how easily similar examples can be brought to mind; and anchoring, the reliance on a single piece of information or starting point when making an estimate. A key tenet of traditional finance is that markets eliminate these errors. It is suggested that people learn to avoid these mistakes through experience and incentives,. As people learn, either directly from investment professionals or indirectly through their own experience, irrational investors will be flushed out of the market. Additionally, even if individual biases are present in the market, they will likely cancel each other out so that, on aggregate, the market will be unbiased.

Experimental Finance and Experimental Psychology

Experimentation has a very long tradition in psychology, but is relatively new to finance and economics. In fact, Chamberlain performed the first experiment in 1948 and Smith laid out the tenets of experimental economics in 1976. Camerer (1997) describes many of the differences between the styles of those who conduct experiments based in economics (the Es) and psychology (the Ps). Camerer notes a number of key differences in the experiments run by Es and Ps. Some of the most important are: Es insist that participants receive incentive compensation, while Ps rarely do. Es typically have experiments with groups of people who interact with one another, while Ps often look at individual participants beliefs and decisions. Es typically focus on participant actions that affect aggregate outcomes (e.g., market price) and payoffs, while Ps often focus on stated beliefs. Es typically remove context from their settings, while Ps rarely do. For example, a test of probability assessment by an E would be described in terms of balls drawn randomly from urns with replacement, while a P would more likely present a question like how likely is it that the population of Miami is greater than the population of Paris? Es often include extremely complex tables of raw data and econometric estimates of parameters, while Ps will usually provide only summary statistics (such as means, variances, F- and t-statistics, and p-values).

References
Bloomfield, Robert "Experimental Finance" 2009.10 Bloomfield, Robert J., William B. Tayler, and Flora H. Zhou. Momentum, Reversal, and Uninformed Traders in Laboratory Markets. Journal of Finance, forthcoming. 2009 Tversky, Amos, and Daniel Kahneman. Judgment Under Uncertainty: Heuristics and Biases. Science 185:4157, 1124-1131. 1974

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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.

History
During the classical period, microeconomics was closely linked to psychology. For example, Adam Smith wrote The Theory of Moral Sentiments, which proposed psychological explanations of individual behavior, including concerns about fairness and justice,[2] 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,[3] George Katona[4] and Laszlo Garai.[5] 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,[6] 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).[7]

Prospect theory
In 1979, Kahneman and Tversky wrote Prospect theory: An Analysis of Decision Under Risk, an important paper that used cognitive psychology to explain various divergences of economic decision making from

Daniel Kahneman

Behavioral finance neo-classical theory.[8] 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 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. 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,[9] 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".[10]

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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.[11][12] 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.[13][14]

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Methodology
Behavioral economics and finance theories developed almost exclusively from experimental observations and survey responses, although in more recent times real world data have taken a more prominent position. Functional magnetic resonance imaging (fMRI) allows determination of which brain areas are active during economic decision making. Experiments simulating markets such as stock trading and auctions can isolate the effect of a particular bias upon behavior. Such experiments can help narrow the range of plausible explanations. Good experiments are incentive-compatible, normally involving binding transactions and real money.

Behavioral economics vs experimental economics

Note that behavioral economics is distinct from experimental economics, which uses experimental methods to study economic questions. Not all economics experiments are psychological. While many experimental economics studies probe psychological aspects of decision making, other experiments explore institutional features or serve as "beta testing" for new market mechanisms. Not all behavioral economics uses experiments, either; behavioral economists rely heavily on theory and on observational studies "in the field."

Key observations
Three themes predominate in behavioral finance and economics:[15] Heuristics: People often make decisions based on approximate rules of thumb, not strict logic. See also cognitive biases and bounded rationality. 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, non-rational decision making, and return anomalies. Richard Thaler, in particular, has described specific market anomalies from a behavioral perspective. Barberis, Shleifer, and Vishny[16] and Daniel, Hirshleifer, and Subrahmanyam (1998)[17] built models based on extrapolation (seeing patterns in random sequences) and overconfidence to explain security market under- and overreactions, though their source continues to be debated. These models assume that errors or biases are positively correlated across agents so that they do not cancel out in aggregate. This would be the case if a large fraction of agents look at the same signal (such as the advice of an analyst) or have a common bias. More generally, cognitive biases may also have strong anomalous effects in the aggregate if there is social contagion of ideas and emotions (causing collective euphoria or fear) leading to phenomena such as herding and groupthink. Behavioral finance and economics rests as much on social psychology within large groups as on individual psychology. In some behavioral models, a small deviant group can have substantial market-wide effects (e.g. Fehr and Schmidt, 1999).

Topics
Models in behavioral economics typically address a particular market anomaly and modify standard neo-classical models by describing decision makers as using heuristics and subject to framing effects. In general, economics continues to sit within the neoclassical framework, though the standard assumption of rational behavior is often challenged.

Heuristics
Prospect theory Loss aversion Disappointment Status quo bias

Behavioral finance Gambler's fallacy Self-serving bias Money illusion

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Framing
Cognitive framing Mental accounting Anchoring

Anomalies (economic behavior)

Disposition effect Endowment effect Inequity aversion Reciprocity Intertemporal consumption Present-biased preferences Momentum investing

Greed and fear Herd behavior Sunk-cost fallacy

Anomalies (market prices and returns)

Equity premium puzzle Efficiency wage hypothesis Price stickiness Limits to arbitrage Dividend puzzle Fat tails Calendar effect[17]

Criticisms
Critics of behavioral economics typically stress the rationality of economic agents.[18] 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. Rabin (1998)[19] 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

Behavioral finance 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.

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Behavioral finance
Topics
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 arbitrage 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 economics' academic cousin, behavioral finance, to be the theoretical basis for technical analysis.[20] 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.[21] 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.[22] 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.

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 two 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

Criticisms
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

Behavioral finance for many anomalies.[23] 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.[24] 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 differentials.

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Quantitative
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.[25] Leading contributors include Gunduz Caginalp (Editor of the Journal of Behavioral Finance from 20012004) and collaborators including 2002 Nobelist Vernon Smith, David Porter, Don Balenovich,[26] Vladimira Ilieva and Ahmet Duran[27] and Ray Sturm.[28] The research can be grouped into the following areas: 1. Empirical studies that demonstrate significant deviations from classical theories 2. Modeling using the concepts of behavioral effects together with the non-classical assumption of the finiteness of assets 3. Forecasting based on these methods 4. Testing models against experimental asset markets

Behavioral game theory

Behavioral game theory is a subject that analyzes interactive strategic decisions and behavior using the methods of game theory,[29] experimental economics, and experimental psychology. Experiments include testing deviations from typical simplifications of economic theory such as the independence axiom[30] and neglect of altruism,[31] fairness,[32] and framing effects.[33] On the positive side, the method has been applied to interactive learning[34] and social preferences.[35][36] As a research program, the subject is a development of the last three decades.[37]

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 [38]. 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[39].

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The animal as a human analog

Many early studies of non-human economic reasoning were performed on rats and pigeons in a 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 [40]. Researchers in this field advocate for the appropriateness of using animal economic behavior to understand the elementary components of human economic behavior [41]. In a paper by Battalio, Green, and Kagel (1981, p 621)[40], 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 a couple of different 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 [40].

Demand
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 [42]. 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).

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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 [39]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[39]. 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 selection.

Key figures
Economics
Dan Ariely[43] Colin Camerer Ernst Fehr Daniel Kahneman David Laibson George Loewenstein Sendhil Mullainathan[44] Drazen Prelec Matthew Rabin Herbert Simon Paul Slovic Vernon L. Smith Larry Summers[45]

Richard Thaler Amos Tversky

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Finance
Malcolm Baker Nicholas Barberis Gunduz Caginalp David Hirshleifer Andrew Lo Michael Mauboussin Terrance Odean Charles Plott Hersh Shefrin Robert Shiller Andrei Shleifer Richard Thaler

Notes
[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] 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)]. [3] Tarde, G. Psychologie conomique (http:/ / classiques. uqac. ca/ classiques/ tarde_gabriel/ psycho_economique_t1/ psycho_eco_t1. html) (1902), [4] The Powerful Consumer: Psychological Studies of the American Economy. 1960. [5] Garai,L. Identity Economics An Alternative Economic Psychology. (http:/ / www. staff. u-szeged. hu/ ~garai/ Identity_Economics. htm) 19902006. [6] "Ward Edward Papers" (http:/ / www. usc. edu/ libraries/ archives/ arc/ libraries/ collections/ records/ 427home. html). Archival Collections. . Retrieved 2008-04-25. [7] Luce 2000 [8] Kahneman 2003 [9] Hogarth 1987 [10] "Nobel Laureates 2002" (http:/ / nobelprize. org/ nobel_prizes/ lists/ 2002. html). Nobelprize.org. . Retrieved 2008-04-25. [11] Grafstein R (1995). "Rationality as Conditional Expected Utility Maximization". Political Psychology 16 (1): 6380. doi:10.2307/3791450. JSTOR3791450. [12] Shafir E, Tversky A (1992). "Thinking through uncertainty: nonconsequential reasoning and choice". Cognitive Psychology 24 (4): 449474. doi:10.1016/0010-0285(92)90015-T. PMID1473331. [13] "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 Wedemans awful experience with this is instructive...." [14] 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" [15] Shefrin 2002 [16] Barberis, Shleifer & Vishny 1998 [17] Daniel, Hirshleifer & Subrahmanyam 1998 [18] see Myagkov and Plott (1997) amongst others [19] Rabin & 1998 1146 [20] Kirkpatrick 2007, p.49 [21] Genesove & Mayer, 2001 [22] Benartzi 1995 [23] http:/ / www. dimensional. com/ famafrench/ 2009/ 08/ fama-on-market-efficiency-in-a-volatile-market. html Fama on Market Efficiency in a Volatile Market [24] See Freeman, 2004 for a review [25] J. Scott Armstrong, Nicole Coviello and Barbara Safranek (1993). "Escalation Bias: Does It Extend to Marketing?" (http:/ / www. forecastingprinciples. com/ paperpdf/ Escalation Bias. pdf). 247-352. . [26] "Dr. Donald A. Balenovich" (http:/ / www. ma. iup. edu/ people/ dabalen. html). Indiana University of Pennsylvania, Mathematics Department. .

Behavioral finance
[27] "Ahmet Duran" (http:/ / www. umich. edu/ ~durana). Department of Mathematics, University of Michigan-Ann Arbor. . [28] "Dr Ray R. Sturm, CPA" (http:/ / www. bus. ucf. edu/ rsturm). College of Business Administration. . [29] 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). [30] 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. [31] 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). [32] 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). [33] 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)]. [34] 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=& result_number=1). 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). [35] 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). [36] 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=& result_number=2). 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). [37] 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. [38] Ferster, C.B. et al. (1957). Schedules of Reinforcement. New York: Appleton-Century-Crofts. [39] Chen, M.K. et al. (2006). How basic are behavioral biases? Evidence from capuchin monkey trading behavior. J. Political Economy, 114 (3) 517-537. [40] Battalio, R.C. et al. (1981). Income-leisure tradeoffs of animal workers. Am. Economic Review, 71 (4) 621-632. [41] Kagel, J H. et al. (1995). Economic Choice Theory: An Experimental Analysis of Animal Behavior. New York: Cambridge University Press Syndicate. [42] Kagel, J.H. et al. (1981). Demand curves for animal consumers. Quarterly Journal of Economics, 96 (1), 1-16. [43] "Predictably Irrational" (http:/ / www. predictablyirrational. com/ ?page_id=5). Dan Ariely. . Retrieved 2008-04-25. [44] Sendhil Mullainathan: Solving social problems with a nudge (http:/ / www. ted. com/ talks/ sendhil_mullainathan. html) [45] 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.

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References
Ainslie, G. (1975). "Specious Reward: A Behavioral /Theory of Impulsiveness and Impulse Control". Psychological Bulletin 82 (4): 463496. doi:10.1037/h0076860. PMID1099599. Barberis, N.; Shleifer, A.;; Vishny, R. (1998). "A Model of Investor Sentiment" (http://jfe.rochester.edu/). Journal of Financial Economics 49 (3): 307343. doi:10.1016/S0304-405X(98)00027-0. Retrieved 2008-04-25. Becker, Gary S. (1968). "Crime and Punishment: An Economic Approach". The Journal of Political Economy 76 (2): 169217. doi:10.1086/259394. Benartzi, Shlomo; Thaler, Richard H. (1995). "Myopic Loss Aversion and the Equity Premium Puzzle". The Quarterly Journal of Economics (The MIT Press) 110 (1): 7392. doi:10.2307/2118511. JSTOR2118511. Cunningham, Lawrence A. (2002). "Behavioral Finance and Investor Governance". Washington & Lee Law Review 59: 767. doi:10.2139/ssrn.255778. ISSN19426658. Diamond, Peter A., and Hannu Vartiainen, ed. (2007). Behavioral Economics and its Applications. Description (http://books.google.com/books?id=1-SVhlC9mVoC&dq=&source=gbs_navlinks_s) and preview (http:// books.google.com/books?id=1-SVhlC9mVoC&printsec=find&pg=PA1#v=onepage&q&f=false). Daniel, K.; Hirshleifer, D.; Subrahmanyam, A. (1998). "Investor Psychology and Security Market Under- and Overreactions". Journal of Finance 53 (6): 18391885. doi:10.1111/0022-1082.00077. Garai Laszlo. Identity Economics An Alternative Economic Psychology. 19902006. Hens, Thorsten; Bachmann, Kremena (2008). Behavioural Finance for Private Banking (http://www.bfpb.ch). Wiley Finance Series. ISBN0-470-77999-3. Hogarth, R. M.; Reder, M. W. (1987). Rational Choice: The Contrast between Economics and Psychology. Chicago: University of Chicago Press. ISBN0226348571. Kahneman, Daniel; Tversky, Amos (1979). "Prospect Theory: An Analysis of Decision under Risk". Econometrica (The Econometric Society) 47 (2): 263291. doi:10.2307/1914185. JSTOR1914185. Kahneman, Daniel; Ed Diener (2003). Well-being: the foundations of hedonic psychology. Russell Sage Foundation. Kirkpatrick, Charles D.; Dahlquist, Julie R. (2007). Technical Analysis: The Complete Resource for Financial Market Technicians. Upper Saddle River, NJ: Financial Times Press. ISBN0131531131. Kuran, Timur (1995). Private Truths, Public Lies: The Social Consequences of Preference Falsification, Harvard University Press. Description (http://www.hup.harvard.edu/catalog.php?isbn=9780674707580) and chapter-preview links. (http://books.google.com/books?id=HlKBaiCpSxYC&printsec=find& pg=PR7#v=onepage&q&f=false) Luce, R Duncan (2000). Utility of Gains and Losses: Measurement-theoretical and Experimental Approaches. Mahwah, New Jersey: Lawrence Erlbaum Publishers. ISBN0805834605. The New Palgrave Dictionary of Economics (2008), 2nd Edition. Abstract links: Augier, Mie. "Simon, Herbert A. (19162001)." (http:/ / www. dictionaryofeconomics. com/ article?id=pde2008_S000455&q=behavioural&topicid=&result_number=8) Bernheim, B. Douglas; Rangel, Antonio. "Behavioral public economics." (http:/ / www. dictionaryofeconomics.com/article?id=pde2008_B000331&q=public &topicid=&result_number=3) Bloomfield, Robert. "Behavioral finance." (http:/ / www. dictionaryofeconomics. article?id=pde2008_B000339&q=Behavioral economics &topicid=&result_number=5) Simon, Herbert. "Rationality, bounded." (http:/ / www. dictionaryofeconomics. article?id=pde2008_B000176&q=behavioural economics&topicid=&result_number=4) com/ com/

Mullainathan, S.; Thaler, R. H. (2001). "Behavioral Economics". International Encyclopedia of the Social & Behavioral Sciences. pp.10941100.. Abstract. (http://www.sciencedirect.com/science?_ob=ArticleURL& _udi=B7MRM-4MT09VJ-41P&_rdoc=2&_hierId=151000134&_refWorkId=21& _explode=151000131,151000134&_fmt=high&_orig=na&_docanchor=&_idxType=SC&view=c&_ct=28&

Behavioral finance _acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=691f9ca74480a55183807ed9dcf1933e) Plott, Charles R., and Vernon L. Smith, ed. (2008). Handbook of Experimental Economics Results, v. 1, Elsevier. Chapter-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). Rabin, Matthew (1998). "Psychology and Economics". Journal of Economic Literature 36 (1): 1146 (http:// pages.towson.edu/jpomy/behavioralecon/PsychologyandEconomicsRabin98JEL.pdf). Press +. Schelling, Thomas C. (2006 [1978]). Micromotives and Macrobehavior, Norton. Description (http://books. wwnorton.com/books/978-0-393-32946-9/), preview (http://books.google.com/ books?id=DenWKRgqzWMC&printsec=find&pg=PA1=#v=onepage&q&f=false). Shleifer, Andrei (1999). Inefficient Markets: An Introduction to Behavioral Finance. New York: Oxford University Press. ISBN0198292287. Simon, Herbert (1987). "Behavioral Economics". The New Palgrave: A Dictionary of Economics,. 1. pp.22124. Thaler, Richard H., and Sendhil Mullainathan (2008). "Behavioral Economics," (http://www.econlib.org/ library/Enc/BehavioralEconomics.html) The Concise Encyclopedia of Economics, 2nd Edition. Liberty Fund.

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External links
Behavioral Finance Initiative (http://icf.som.yale.edu/research/behav_finance.shtml) of the International Center for Finance at the Yale School of Management Overview of Behavioral Finance (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1488110) Geary Behavioural Economics Blog (http://gearybehaviourcenter.blogspot.com/), of the Geary Institute at University College Dublin Society for the Advancement of Behavioural Economics (http://www.sabeonline.org/) Behavioral Economics: Past, Present, Future (http://www.usapr.org/papers/paper.aspx?PaperID=30) - Colin F. Camerer and George Loewenstein A History of Behavioural Finance / Economics in Published Research: 1944 - 1988 (http://www.moneyscience. com/pg/blog/Admin/read/50567/a-history-of-behavioural-finance-in-published-research-1944-1988)

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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 management. Intangible assets include business processes, Intellectual Property (IP) such as patents, trademarks, reputations for ethics and integrity, quality, safety, sustainability, security, and resilience. Today, these intangibles drive cash 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 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 worlds 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. IPD Analytics, which is based in Miami, is known for is research reports on patent litigation pending in the United States district court as well at the United States Court of Appeals for the Federal Circuit.

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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 has since been acquired by NexCen Brands, Inc., which is currently helmed by Robert W. D'Loren. NexCen is a vertically integrated global brand management company focused on assembling a diversified portfolio of intellectual property-centric companies operating in the consumer branded products and franchise industries. On May 19, 2008, NexCen issued a press release in which it stated that there was substantial doubt about its ability to continue as a going concern.[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 Marvels 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.

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References
[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 19, 2008 (http:/ / www. nexcenbrands. com/ press_release93. html) [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 (http://books.google.com/ books?id=jCLqq80CpwwC&dq=rembrandts+in+the+attic&pg=PP1&ots=XpvuUlYAtv& sig=UkrpK3Dt_bFbI8Hcix46iZIQGhU&hl=en&prev=http://www.google.com/search?hl=en& q=rembrandts+in+the+attic&btnG=Search&sa=X&oi=print&ct=title& cad=one-book-with-thumbnail#PPR7,M1) "When Balance Sheets Collide With the New Economy," New York Times, September 9, 2007 (http://www. nytimes.com/2007/09/09/business/09frame.html?ei=5124&en=f04ad9659c3221fa&ex=1346990400& adxnnl=1&partner=permalink&exprod=permalink) "IP-Focused Hedge Funds Launch Amid Market Volatility", Dow Jones, April 29, 2008 (http://news. morningstar.com/newsnet/ViewNews.aspx?article=/DJ/200804291343DOWJONESDJONLINE000826_univ. xml) "Hedge Fund Spies in the Courtroom, IP Law & Business, May 10, 2007 (http://www.law.com/jsp/article. jsp?id=1178701483131) Intellectual Asset Management Magazine Blog (http://www.iam-magazine.com/blog/default.aspx)

Article Sources and Contributors

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Article Sources and Contributors

Finance Source: http://en.wikipedia.org/w/index.php?oldid=481838417 Contributors: .derf, 11B, 16@r, 28421u2232nfenfcenc, A. B., A3RO, ABF, APH, Aaronchall, Abdullais4u, Abhijay, Abhilash2abhi, Addihockey10, Afaber012, Afb525, Agemoi, Ahd2007, Alansohn, Albertod4, Allens, Alphachimp, Altenmann, Amorymeltzer, Andman8, Andorin Kato, AndreaFox2, Andres, AndrewHowse, Andy Marchbanks, Andycjp, Andyjsmith, Apb123, Apparition11, ArglebargleIV, Argon233, Ariaconditzione, Artman772000, Avoided, Ayonbd2000, BD2412, Balochdude, Barek, BarrelRollZRTwice, Bart133, Bcostel7, Beagel, Bearian, Beetstra, Ben Ben, Bentogoa, Berek, Betacommand, Bhallukchana, BiT, Blanchardb, Blathnaid, Bluerasberry, Bob Burkhardt, Bobo192, Boleeva, Bongwarrior, Brahui, Brandon, Brillig20, Bryan Derksen, BunBun002, Burntsauce, C.Fred, COMPFUNK2, CRGreathouse, CaMpixx, Cabe6403, Calabe1992, Calcuscribe, Caltas, CambridgeBayWeather, Can't sleep, clown will eat me, Canterbury Tail, Capricorn42, CarlAndersOlsson, Carnildo, Catgut, Cflm001, Cfseo, Chasingsol, Chennaiseo, Chester Markel, Chicago god, Chocolateboy, Cholmes75, ChrisCork, Chriscm, 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