1 14:00/15:30 - Panel 5 Research in Financial Engineering: the French and Indian Experience.

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14:00/15:30 - Panel 5

Research in Financial Engineering: Research in Financial Engineering: the French and Indian Experiencethe French and Indian Experience


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Arnaud de BRESSONArnaud de BRESSONManaging DirectorManaging Director Europlace Institute of Finance (EIF)Europlace Institute of Finance (EIF)

Rama CONT Rama CONT Research Scientist,Research Scientist, Ecole Polytechnique, Ecole Polytechnique, Director,Director, Center for Financial Engineering, Columbia University Center for Financial Engineering, Columbia University

Conrad VINCENT, Conrad VINCENT, Vice President,Vice President, JM Financial Products Ltd, JM Financial Products Ltd, Visiting Professor,Visiting Professor, Indian Institute of Management Indian Institute of Management

14:00/15:30 - Panel 5

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Arnaud de BRESSON,

Managing Director Paris EUROPLACE

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The “Driving forces” of The “Driving forces” of

the Paris Financial Market Placethe Paris Financial Market Place

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The French BanksThe French Banks

The 10 first European Banks

0

10

20

30

40

50

60

70

80

HSBC Holding BNP Paribas Crédit

Agricole

Crédit Suisse UBS Deutsche Bank HBOS ABN AMRO Barclays Société

Générale

(earnings in B$)

The French banks are strong key players within the European financial industry. Their leadership in the equity derivatives business line is an example of their ability to manage sophisticated innovation and of their specific knowhow in risk management

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Derivatives: Paris, a world leaderDerivatives: Paris, a world leader

France represents 25% of the European market

Other EuropeanOther EuropeanCountriesCountries

75%75%

FranceFrance25%25%

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€uro Corporate Bond Market Primary Market

United Kingdom

27%

Germany10%

Others21%

The Netherlands

9%

France33%

In % of total issues

French Euro Commercial Paper Market Leads Europe

198

277

443

Outstanding growth

Paris, the largest corporate bond market Paris, the largest corporate bond market in Europe in Europe

Source: BIS, Q2 2006

Source: Banque de France

€ 250 billion of outstanding ahead of London

67 62 60,6

3379 69,1

98

136

331,4

1998 2000 2006

BMTNs BT (corporates) CDs 'Financial institutions)

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Source : IFSL estimates based on Bridgewell, Merrill Lynch, Compeer

Pension funds Insurance companies Mutual funds TotalTotal

UKUKUKUK 1,4061,406 1,6761,676 397397 3,4793,4793,4793,479

France France France France 143143 918918 1,1481,148 2,2092,2092,2092,209

GermanyGermanyGermanyGermany 229229 984984 276276 1,4891,4891,4891,489

The NetherlandsThe NetherlandsThe NetherlandsThe Netherlands 615615 271271 9797 983983983983

SwitzerlandSwitzerlandSwitzerlandSwitzerland 388388 241241 9191 720720720720

in $ bn

The Strengths of the French Asset Management The Strengths of the French Asset Management IndustryIndustry

9The French Asset Management Industry The French Asset Management Industry in Europein Europe

UCIT*s in Europe

European fund money management industry7,574 bn euro at end of December 2006 (Source : EFAMA / AFG)

Others16.7%

Germany17.7%

France 21.7% UK

18.7%

Ireland*2.1%

*estimate basedon IFIA data

Italy 7.8%

Spain3.8%Switzerland

6.8%Belgium

3.8%

Luxembourg* 0.8%

* Estimate based on CSSF data

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2,4

6,0

6,2

8,0

2003 2004 2005 2006

Growth in French Private Equity Market

(in Terms of Capital Raised, in € Bn)

Source : AFIC

Computer systems and

Software27%

Biotech17%IT

11%

Consumer goods12%

Industry21%

Others12%

Investments Broken-down by Sectors

(in Terms of % of the Total Investment)

UK France Germany Italy TheNetherlands

Sweden

Leading European private equity markets(in € millions)

A Growing Private Equity MarketA Growing Private Equity Market

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Market capitalisations

Source: FIBV, March 2007

Listed companies

NYSE - Euronext NYSE - Euronext

The size of a global Stock Exchange

in € bn25452

NYSE

Euronext

4545

Tokyo SE

3758

Nasdaq

3758

L.S.E

1709

HongKong

1659

Deutsche

Börse

923

Shanghai SE

3490

NYSE Euronext

3256

L.S.E

3133

Nasdaq

2416

Tokyo SE

1173

Hong Kong SE

842

Shanghai SE

760

Deutsche Börse

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NYSE-Euronext NYSE-Euronext

Creating the first truly international Stock Exchange

Creating new efficiencies and economies of scale

Creating the most efficient and most liquid markets in the world.

Offering corporate issuers the opportunity to get listed in two of the world's three major currencies, the dollar and the euro.

Increasing issuers visibility with millions of new investors around the world.

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Financial research in FranceFinancial research in France

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Research & InnovationResearch & Innovation

The Europlace Institute of Finance (EIF) is a Foundation that aims at developing academic and applied research in finance for the benefit of finance professionals - corporate issuers, asset managers, banks and other financial institutions, insurance companies etc.

• Research Programs

• International Financial Research Forum

• Job Market Forum

• Grants and Chairs

• International Research Mapping

Activities

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> A quantitative approach to risk modeling (Ecole Polytechnique)

> The impact of management techniques on volatility (SGAM, University of Angers)

> Credit spread and risk premia, a structural approach (ESC Toulouse)

> Portfolio management and asset prices when investors have heterogeneous beliefs (IDEI – University of Toulouse I)

> Corporate governance and liquidity in the Paris financial market (CEREG – University of Paris Dauphine)

> Does the pre-opening period facilitate price discovery? An experimental investigation (IDEI – University of Toulouse I)

> The impact of the development of listed index funds on the financial markets quality (CNRS)

> Heterogeneous beliefs and interactions among players in finance: an experimental approach (CREST - INSEE / CEREMADE –

University of Paris Dauphine)

> Corporate finance, banking regulation and principal agent theory (GREMAQ – University of Toulouse I)

> Information inefficiency, risk aversion and stock split: An experimental approach (GREMAQ – IDEI, University of Toulouse I)

> Structured financing (ESCP-EAP)

> Optimum growth portfolios: a non-parameterized approach derived from information theory (CAMS – EHESS)

> International portfolio allocation: a behavioral approach (HEC)

> Finance in Europe: location and its economic impact (MODEM, University of Paris X, CNRS)

> Collateralized Debt Obligations (CDOs) : modélisation, analyse et gestion des risques ”, (Ecole Polytechnique)

> On the relevance of reporting comprehensive income under IAS / IFRS : insight from major European financial markets ”, CEREG,

Université Paris Dauphine

> Emission Permits : Financial Intermediation and Environmental Policy ”, (Université Catholique de Louvain)

> Contract Design and Credit Markets : Implications for the Monetary Transmission Mechanism ”, (Université de Toulouse)

> Insider Trading and Market Efficiency ”, (Université Catholique de Louvain)

Research Programs 2003-2006Research Programs 2003-2006

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Pôle de Compétitivité “Industrie Financière - Technologies Pôle de Compétitivité “Industrie Financière - Technologies et Innovation”et Innovation”

Financial Services ClusterFinancial Services Cluster

5 strategic goals :

- A European financial information provider;

- Developing growing companies in new industrial sectors;

- An international center for financial research andinnovation;

- Promoting Financial education in Universities & High Schools;

- Contributing to innovation in social issues.

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Quantitative research in financeQuantitative research in financeand the emergence of and the emergence of financial engineeringfinancial engineering

Rama CONTCenter for Financial Engineering,

Columbia University (New York)

&

Centre National de la Recherche Scientifique (France)

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Quantitative research and the derivatives market :Quantitative research and the derivatives market : a mutually fruitful relationship a mutually fruitful relationship

In the 1970s and 1980s, issues regarding the pricing, hedging and risk management of derivative products were progressively cast into a quantitative framework and tackled using standard quantitative techniques from probability, statistics and numerical simulation.

Interest in stochastic modeling in finance spurred in turn a vigorous interest in stochastic calculus, turning it from a mathematical curiosity into a mainstream field of applied mathematics, today taught in graduate schools and MBA programs around the world.

The French tradition of research in probability –the Strasbourg school and its offsprings- put French universities in a good position to seize this opportunity and take a leading role.

One of the first graduate programs for training quants was founded in 1989 by Nicole EL KAROUI at Université de Paris VI and Ecole Polytechnique.

20Quantitative research and the derivatives market :Quantitative research and the derivatives market : a mutually fruitful relationship a mutually fruitful relationship

The 1990s: consolidation of the role of quantitative modeling

Quantitative modeling made its way into regulations with Basel I and Basel II accords and, in turn, these regulations stimulated the systematic use of numerical simulations in risk management

At the same time, financial innovation in the derivatives markets led to a new generation of exotic derivatives with increasingly complex payoffs, calling for new quantitative models and more advanced computational methods.

Issues related to pricing and risk analysis of these new products have in turn stimulated new directions for research on quantitative modeling, numerical simulation techniques and risk measurement.

Massive recruitment of engineers/ quantitative analysts in the financial markets in the 1990s

21Financial engineering: Financial engineering: the emergence of a new professionthe emergence of a new profession

Emergence of a new profession: the ‘quant’

The need for individuals with a broad range of skills:

Understanding of financial markets and derivative instruments

Mathematical modeling skills

Numerical simulation

Concepts and tools for risk management

Computational methods

Data analysis and statistical tools

Numerical simulation and computational methods

IT skills for facing the challenge of increasingly automated markets

22Financial engineering: Financial engineering: the emergence of a new professionthe emergence of a new profession

Quantitative finance has become an autonomous discipline with its own scientific journals,

An increasing demand for quants has led to the emergence of specialized training courses and graduate programs:

Master program in Probabilités et Finance (Ecole polytechnique & Université de Paris VI).

Columbia University School of Engineering’s Master (MSFE) & PhD programs in Financial Engineering.

Programs run by engineering or applied mathematics departments with emphasis on quantitative skills.

Very good positioning of french graduates/ quants on international markets.

23Quantitative research and the derivatives market : Quantitative research and the derivatives market : the case of structured derivativesthe case of structured derivatives

With the search for higher yields and leverage and the standardization of the market for traditional derivatives, structured products increasingly occupy the front scene in the derivatives market.

The design, analysis and management of structured derivatives calls for an even more active role of quantitative modelling

For simpler derivative contracts, the design of the contract does not involve quantitative modelling: the pricing and risk management does.

In the case of structured products, the very design of the contract involves quantitative modelling

Thus, quantitative models play a more important role and financial engineers become involved in the life cycle of the products at a very early stage.

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Collateralized debt obligationsCollateralized debt obligations

Bank

Balance

Sheet

SPV

DE

BTAAA

920m

A35m

BBB25m

980m cash

Euribor + 50bp

Euribor + 150bp

Euribor + 250bp

Excess Cash Flow:“Leftovers” after paying note coupons

EQUITY20m

Liability Cost:

(920m x 50bp) + (35m x 150bp) + (25m x 250bp)

980 million

Liability Cost:

(920m x 50bp) + (35m x 150bp) + (25m x 250bp)

980 million

980m cash

= 59bp

Euribor +150bp Euribor +150bp

Retained by Bank

Loans

25Impact of modeling approaches on the market: Impact of modeling approaches on the market: the case of Collateralized Debt Obligations (CDOs)the case of Collateralized Debt Obligations (CDOs)

The development of the market for Collateralized Debt Obligations, which exploded at the end of the 1990s, hinged on two elements:

The ability to attribute ratings to structured products such as single-tranche CDOs -> development of statistical models for analyzing the credit risk of large portfolios -> assessment of historical default rates

The ability to price the default risk/ exposure to default correlation of large portfolios of debt instruments -> development of first-generation CDO pricing models -> assessment of market-implied default rates

The subsequent surge of interest in the credit derivatives markets can be seen as resulting from discrepancy between historical and market-implied default rates

The systematic spread between market-implied and historical default rates has rendered yields on single tranche CDOs and other leveraged credit derivatives attractive for investors

This perception is based on quantitative indicators of default rates

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The future of quantitative modeling in financeThe future of quantitative modeling in finance

…does not lie in the development of ever-more-complex quantitative models but perhaps in a better understanding of some of the following issues:

The need for portfolio-wide models of volatility and correlation risk While the trend in the last decade of developments in quantitative

modeling has been to develop more detailed models of volatility for individual assets/ risk factors, most applications are directed towards portfolio wide risk monitoring and management

Need for modeling of risk/return at the aggregate level and development of large-scale simulation methods

New accounting standards have imposed the notion of ‘fair value’ as a reference for auditors and

financial risk managers in financial or non-financial corporations Open the way for a wealth of new applications and issues

Assessing the risk of actively managed portfolios Guaranteed funds, options on hedge funds, actively managed CDOs

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Applicability to the Indian marketApplicability to the Indian market

Quantitative approaches to risk management can be fruitfully applied in the context of the Indian market, both by market participants and regulators.

However, traditional modeling approaches are well suited to liquid market situations and may require amendments to be applied to emerging markets.

Emerging markets strongly react to international market factors: cannot be modeled as autonomous entities

Liquidity effects

In emerging markets liquidity is an important risk factor

In a market where total volume/order flow is need to take into account the price impact of their trading and liquidity effects.

Liquidity is strongly impacted by market microstructure and regulations

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Your partner in risk management

Paris : +33 1 53 76 11 46

New York : + 1 212 854 1477

Email: [email protected]

www.finance-concepts.com

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14:00/15:30 - Panel 5



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Mumbai, Wednesday, May 16, 2007Mumbai, Wednesday, May 16, 2007

11STST FRENCH-INDIAN FINANCIAL FORUM FRENCH-INDIAN FINANCIAL FORUM

European Financial Markets:European Financial Markets:Opportunities for Growth Opportunities for Growth

and Value Creationand Value Creation

1 14:00/15:30 - Panel 5 Research in Financial Engineering: the French and Indian Experience.

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Transcript of 1 14:00/15:30 - Panel 5 Research in Financial Engineering: the French and Indian Experience.