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Unified Financial AnalysisRisk & Finance Lab

Chapter 9: Value and Income

Willi Brammertz / Ioannis Akkizidis

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Value and income

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ValuationWhy can value differ?

Different views on market evolution

Different bookkeeping methods

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On value

> What is book value?

> Difference between market and book value?

> Tension between

> Book keepers and rocket scientists

> Actuaries and asset managers

> The special role of fair value / NPV

> Parallel valuation

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> Must be possible

> Note:

> There is a single set of events

> All values derive from the same set of events

> Full consitency between different valuation methods

Parallel Valuation

5

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Parallel valuation

> Cash flows and events are independent of valuation

> Only the traject of P/D(ß) changes

> Many P/D(ß) can be calculated and stored in parallel

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Overview

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OverviewTime dependent

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OverviewMarket dependent

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Book keeping and Chart of account

> Is a chart of account neccesary for book keeping?

> Chart of account: Representation of a product catalogue

> What is the role of the chart of account

> In static analysis

> In dynamic analysis

> Value and chart of accounts

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Value and incomeScientific bookkeeping

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Scientific book keeping

> The different bookkeeping methods β are only concerned with the calculation of

> P/D (ß)

> ΔP/D (ß)

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Nominal value

=0

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The big four

> Nominal value

> Historic value

> Amortized Cost

> Market value (primus inter pares)

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Nominal value, write off at beginning

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Amortized cost

must be a constant

This is the case under the following condition

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Amortized cost

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Historic value / write off at end

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Mark to market / fair value

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Market value / mark to market / fair value and NPV

> Observed market value is without accruals

> Fair value ≈ mathematically calculated value of non traded positions assuming similar conditions

> NPV is fair value including accruals

> Accruals: difference between market and arbitrage free NPV

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Other book keeping methods in the financial sector

> Linear

> To maturity

> To repricing

> Lower of cost or market

> Minimum value principle

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Linear write off

If rate resets: write off usually till next rate reset point

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Lower of cost or market

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Minimal value

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> Compatible with IFRS?

> Alternative to fair value?

> Trick of regulators?

> Hidden present for the „too big to fail“ banks

> Valuation on a risk neutral or near rick neutral basis

> Excludes the propper risk premium

What is „Expected Cash-Flow“ based value?

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FX

> Only 2 rules (Φ)

> Mark to market

> Historic value

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Impairment

> Impairment: Credit risk (*) related value reductions

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Operational: P&L and capitalization

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Operational: Investments

> What makes investments (and P&L effects) so different?

> Different methods of writing off

> Linear

> Geometric

> Sum of digits

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IFRS 32, 39

> Allowed Book keeping methods

> Nominal

> (Historic)

> Amortized cost

> Fair value / Market value

> Critique on fair value book keeping

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IFRS 32, 39: Hedge AccountingDesignation and de-designation

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IFRS 32, 39: Hedge testingEx ante, ex post

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Funds Transfer Pricing (FTP)Profit Centers

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Profitability of a single financial transaction:

Interest Income (Expense)./. Transfer Expense (Income)= Gross Income (Deckungsbeitrag I, Net Contribution I)

./. Cost of the transaction (Salaries, paper etc.)= Net Income (Deckungsbeitrag II, Net Contribution II)

Cost of transaction: See chapter 7 (Activity Based Cost Allocation)

FTP and profitability

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FTP, cost accounting and contributionanalysis

Profitability of a Profit-Centre (Product, …)

=Sum of Net Income of all transactions belonging to the Profit-centre (Product …)

NII(ti-ti+1) , Allocated Cost(ti-ti+1)

NII(ti-ti+1) , Allocated Cost(ti-ti+1)

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Rate

TimetL tA

VL

V

A

σr

Δ t

RISK

Integrating risk and return

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1

Yield curve

Term to maturity

Interest

5

6 %

5.6 % o

o

TM

Tot

al M

argi

n Y

1

FTP and return

o

o4.5 %

5 %

5

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0 Term to maturity

Interest

o

o6 %

4

5.6 %Yield curve t0

1

Yield curve t1

o

o

Tot

al M

argi

n Y

2

TM

-1

FTP and risk and return

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Funds Transfer Pricing (FTP)Margin calculation

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The NPV view on FTP

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Funds Transfer Pricing (FTP)Non maturity contracts