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Finance Software Projects New York University Adjunct Instructor Scott Burton

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FSP Introduction Professor Bio Plan for Semester First half: Individual submissions weekly Build foundational components 1 quiz Second half: Form 2 person teams Build a risk management app Presentation/demo at the end Periodic quizes to check your programs and domain knowledge Programming phases evolving to final product Each team votes for best product and presentation

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FSP Introduction (cont) Class Objectives Software Development! Organization Extensibility Testability Clarity Speed Size ? Rigor around regression testing! Implement living specs provided as spreadsheets Teacher Objectives Student Objectives

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FSP Introduction (cont) Grading: Weekly programming phases 3 tests Presentation of final app Class participation Attending all classes will help your grade Missing more than two classes will hurt your grade

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Financial engineering is built on 3 basic principles Put a financial engineer on a desert island and give him only a few tools, such as the means to calculate the time value of money, the ability to contract on random outcomes, and a legal structure that allows the transferability of financial claims, and most of todays financial instruments could be re-constructed. Origins of Value

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Financial engineering is built on 3 basic principles 1.Time Is Money Inter-temporal value transfer Otherwise known as a Loan 2.Negotiability Suppose you have loaned someone money for a year. Now you need the cash. You could become a borrower yourself OR you could sell the contract to another person. It saves the trouble of a second contract and creates instance money 3.Contingent Claims Allows people to hedge themselves against the risk of an unknown future

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Capital Raising Has Money Needs Money Borrows money Issues a bond Financial firms facilitate Charge fee Wants a return (yield) Buys a bond Owns a security Can sell security later

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Securitization Turns cumbersome, illiquid financial contracts with governments or other entities (e.g., corporations) into liquid instruments of a smaller denomination that can be easily bought and sold in a capital market.

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Pricing function for a financial instrument To value a financial instrument and facilitate making them transferable we need a standard formula to price them. Allows us to calculate the price of a bond given the interest it is contracted to pay and takes into account the current prevailing market (interest rate you could get elsewhere for a similar instrument). Allows us to calculate sensitivities and hedge For a bond its the Yield To Maturity formula.

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For Next Week Set up UNIX dev environment on your laptop From the command line: Hello World in C++ Write a Makefile Run your executable from shell script run.sh

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Break

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Time Value of Money The cumulative present value of future cash flows can be calculated by summing the contributions of FVt, the value of cash flow at time=t The present value (PV) formula has four variables each of which can be solved for: 1)PV is the value at time=0 2)FV is the value at time=n 3) i is the rate at which the amount will be compounded each period (in decimal) 4) n is the number of periods M - Maturity (amount loaned) C - Coupon (return on loan) i - Prevailing interest rate

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Yield to Maturity Equation - Closed Form (started with a geometric series) Calculate price of bond with par value of $1,000 to be paid in 10 years, a coupon of 10% and YTM of 12%. Assume coupons are paid semi-annually to bond holders: 1)Determine number of coupon payments (2 per year for 10 years = 20) 2)Determine value of each coupon payment (divide coupon in half since semi- annual). Each payment will be $50 ($1000 * 0.05). 3)Determine the semi-annual yield: Like the coupon rate, the YTM of 12% must be divided by 2.

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YTM - Frequency Parameterized Accounting for different payment frequencies: Most bonds pay semi-annually but to make our formula more general we extend formula with parameter F below. if a bond was paying annual coupons F = 1, quarterly = 4 What is implemented spreadsheet living spec

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See spreadsheet living spec Yield Goes up/price goes down Standard sensitivity calculation

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Capital markets terminology Primary / Secondary Sell-side / Buy-side Long / Short Relative Pricing Risk Transfer Proprietary / Flow Trading Exchange traded / Over the Counter Securitization

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Class Example Debt Issuance Buy a Bond Transact on Secondary Market Short