Classifications

• • G—PHYSICS
  • G06—COMPUTING; CALCULATING OR COUNTING
  • G06Q—INFORMATION AND COMMUNICATION TECHNOLOGY [ICT] SPECIALLY ADAPTED FOR ADMINISTRATIVE, COMMERCIAL, FINANCIAL, MANAGERIAL OR SUPERVISORY PURPOSES; SYSTEMS OR METHODS SPECIALLY ADAPTED FOR ADMINISTRATIVE, COMMERCIAL, FINANCIAL, MANAGERIAL OR SUPERVISORY PURPOSES, NOT OTHERWISE PROVIDED FOR
  • G06Q40/00—Finance; Insurance; Tax strategies; Processing of corporate or income taxes
  • G06Q40/06—Asset management; Financial planning or analysis

Definitions

• TITLE METHOD AND SYSTEM FOR PROVIDING TIMELY ACCURATE AND COMPLETE PORTFOLIO VALUATIONS
• the present invention relates to a method and a system for pricing financial instruments in a manner as to allow timely accurate and complete valuations of portfolios.
• Instruments traded in financial markets have evolved significantly from the stocks and bonds that used to make up investor's portfolios.
• Financial innovators have devised ever more complicated derivative instruments and these "derivatives" are finding their way into the portfolios of private and institutional investors.
• structured products i.e. combinations of derivative instruments; offering specific advantages (e.g. a guaranteed return, albeit at a price) have become popular.
• most of these instruments and products are not listed on a regular exchange, are traded only infrequently, and have pricing and risk properties that re not obvious to most investors. Nevertheless, their number is growing, and they certainly outnumber the traditional exchange traded stocks and bonds many times over.
• the fair value yield of bonds can be valued based on the corresponding risk-free interest rate plus a risk spread that depends on the rating of the bond as well as on the specific characteristics of the issuer and of the issue.
• Black and Scholes have demonstrated a method for establishing the fair value of options. What is common to all these methods is that they involve an unknown parameter: the issuer or bond- specific risk spread in the case fixed income instruments and the expected volatility of the price of the underlying instrument between now and the time of expiration for an option. Before any method can be applied, a value for these parameters must be determined.
• the only part of the system that has not kept up with this acceleration is the valuation of portfolios and the tasks dependent on it (i.e. exposure measurement, risk control etc.). It is still customary to value all financial instruments, even those traded only infrequently, at the "last paid price", which often means yesterday's closing price. If the instrument is not traded very often, this price may well be a few days, if not weeks old. Worse still, the instrument may not even be included in the database for which a standard price provider such as Bloomberg, Reuters, Bridge etc. provides information. In this case the asset manager is stuck with what he or she considers the best guess, or the Asset Manager is forced to calculate and re-calculate prices and risk parameters on an ad-hoc basis.
• a standard price provider such as Bloomberg, Reuters, Bridge etc.
• the present invention provides a method and a system for valuing all financial instruments held in a portfolio in a timely accurate and complete manner.
• a structured database of financial instruments that accurately reflects the different links and dependencies among various instruments.
• the information contained in the structure of an instrument is used to infer "fair values", (i.e. price-proxies) in those instances when no satisfactory market price is available.
• a satisfactory market price is an observed price either from a recent trade, or from buy-sell prices posted by a bona-fide market maker.
• “recent” varies by type of instrument. For equities that are traded on a public stock market, for example, “recent” would mean within the last 20 to 30 minutes. For fixed income instruments and other instruments traded less frequently, “recent” might be within the last hour or two.
• the database is structured in a hierarchical manner. Depending on their structure, financial instruments are place in groups ("classes") that share relevant characteristics. The lowest classes contain exchange rates, interest rates and exchange-traded securities, i.e. financial instruments for which valid market prices are almost always available.
• the present invention is contained in a method and system, the Deductive Pricing Method and System (DPMS), that calculates prices and risk parameters of each higher class of instruments referring only to information from instruments in lower classes, and ultimately from the lowest classes for which valid market data is almost always available.
• DPMS Deductive Pricing Method and System
• the unknown parameters are not based on historical data, but are also inferred from current market data, on those occasions when market prices are available.
• the invention comprises a method and system whereby the yield to maturity of the instrument as established whenever the issue is traded is disaggregated into (i) a risk free yield (i.e. treasury yield), (ii) a rating specific risk spread and (iii) an instrument specific risk spread.
• a risk free yield i.e. treasury yield
• a rating specific risk spread i.e. treasury yield
• an instrument specific risk spread i.e. treasury yield
• the "rating specific” risk spread is the average risk spread of instruments the are rated as comparable by the different rating agencies (Moody's. S&P, Fitch etc.), while the "instrument-specific" risk spread is the extent to which the risk spread of the instrument in questions deviates from this average.
• the DPMS disaggregates these instruments into their components and then values each component separately.
• a convertible bond is disaggregated into a bond and an option and each is valued separately by the corresponding method described above.
• the individual fair value estimates are then combined into a composite fair value estimate for the convertible bond.
• Derived instruments including composite instruments, are almost always traded much less frequently than the underlying instruments themselves. While a specific stock may be traded daily, a call or put option on that stock (the derived instrument) may be traded only a few time a month. The DPMS will use those instances when the derived instruments are traded to update the estimates of the unknown parameters and with these estimates will produce fair value estimates for the derived instruments based on the prices of the underlying instruments, including risk free interest rates and rating specific risk spreads, whenever the derived instruments themselves are not traded.
• the system will always give precedence to market information.
• Observed market data is used to infer estimates of non-observable parameters, i.e. the instrument specific spread for fixed income instruments and the volatility for options.
• the fair value estimates produced by the DPMS have to substantially coincide with these market prices. Accordingly, the fair value estimates produced by the DPMS will be at least as good as market prices, which currently rule portfolio valuation methods, and offer a significant improvement over these whenever market prices for the derived instrument are not available.
• Fig. 1 illustrates the different classes of instruments in the hierarchical order in which they are included in the structured central database.
• Fig. 2 illustrates how complex instruments (i.e. instruments of classes higher than simple instruments) are disaggregated into embedded instruments in lower classes.
• Figs. 3A, 3B-1 and 3B-2 comprise a flow chart describing the preferred embodiment of the Deductive Pricing Method and System (DMPS) wherein Fig. 3 A illustrates how the database is updated if a valid and recent market price observation is available and Figs. 3B-1 and 3B-2 illustrate the method and system when the markets price is not valid or not recent, i.e. is "stale".
• DMPS Deductive Pricing Method and System
• Fig. 1 illustrates the structured database of financial instruments that is at the core of the current invention.
• Financial instruments such as securities, options and other instruments are placed into groups ("classes") depending on their characteristics. The categories reflect the way in which different instruments are dependent on each other.
• financial data that have an influence on the valuation of financial instruments, but that are not financial instruments themselves. These data include exchange rates for foreign currencies, government bond yields as proxies for risk-free interest rates, etc. These financial data are identified as Zero Class Instruments 101.
• Simple (financial) Instruments 102 are instruments that are not dependent on other instruments (e.g. exchange traded equities).
• the market usually a regulated exchange, determines their prices and there is no legitimate alternative to valuing them other than by market prices.
• Fig. 1 to indicate that for these instruments there exist no alternative to the market price. Availability of market prices for these two classes is a necessary, if not sufficient, condition for the DPSM to be applied.
• Aggregate Instruments 103 are instruments whose price is a function of the prices of Simple and Zero Class Instruments and all parameters are known a priori.
• the most common types of aggregate instruments are indexes and baskets, where the price of the instrument is a linear combination of the prices of Simple Instruments
• the Dow Jones industrials Index for example, is a weighted average of the prices of 30 stocks traded on the New York Stock Exchange, with the individual weights known.
• Other examples are American Depository Receipts and similar certificates whose price is a function of the price of a simple instrument, traded on a non-US exchange, multiplied by the appropriate exchange rate.
• the parameters necessary for calculating the price of the Aggregate Instruments 103 from the prices of the simple underlying instruments are stored in the Relationship Table (see Fig. 2). It follows that if the prices of the Simple 102 and Zero Class 101 Instruments are known, the price of the Aggregate Instruments 103 can be calculated as well. Thus, even if the Aggregate Instruments 103 are not traded, or a market price is not available for some other reason, this invention will produce an accurate proxy (the "fair value") for the price at all times.
• Derived Instruments 104 include not only equity options and derivatives, but also corporate bonds and other debt instruments issued by private borrowers.
• the value of ⁇ can be estimated, whenever a market transaction involving the corporate bond is observed. This can then be used to value the bonds at its' "fair value" from that point on forwards, varying the bond price in accordance with changes in the risk-free interest rates, until a new market observation on the corporate bond causes us to update the value of ⁇ .
• Composite Instruments 105 are composites of instruments from lower classes.
• a convertible bond can be represented as a composite of a straight corporate bond and an equity option.
• a structured note typically exists of a money market instrument and a short position in an equity-, exchange rate- or index option.
• these embedded instruments are also explicitly included as instruments in their own right. Since they are instruments of lower classes, they can be valued, even if no separate (market) prices can be observed for them. And since these components can be valued, so can the composite instrument.
• FIG. 2 illustrates the database represented by its two main tables, the Instruments Table 201 and the Relationship Table 202.
• the Instruments Table 201 contains one row for each instrument, containing all the instrument specific information.
• the Relationship Table 202 contains one or several rows for each instruments that is related to one or several other instruments of a lower class, regardless of whether these instruments are exchange-traded or not.
• any instrument other than Simple Instruments 102 or Zero Class Instruments 101, several entries in the Instrument Table will be relevant.
• a convertible bond a Composite instrument 105.
• the embedded bond in turn is related to the corresponding risk-free interest rate, a Zero Class Instrument 101, and the option is related to the underlying instrument (usually an equity, i.e. a Simple Instrument 102). If the underlying instrument itself was an Aggregate Instrument 103, as is not uncommon, then this underlying Aggregate Instrument 103 would itself be related to one or several Simple 102 or Zero Class 101 Instruments.
• the composite instrument With estimates for the parameters ⁇ and ⁇ we can value the composite instrument as follows: from the risk-free interest rate and from ⁇ we can infer the fair value of the embedded bond. From the price of the underlying and ⁇ we can infer the fair value of the embedded option.
• the fair value of the convertible bond is the weighted sum of these two valuations, and it will change if either the interest rate of the price of the underlying instruments changes. Note that it will not be possible to simultaneously infer both ⁇ and ⁇ from a single observation of the market price for the convertible bond; there are not enough degrees of freedom. It will thus be necessary to manually fix the value of one of the parameters, ⁇ , by reference to similar bonds issued by the same issuer.
• the fair value of the bond can be calculate without reference to the market price of the convertible bond, and the market value of the embedded option can be obtained by deducting the fair value of the embedded bond from the market price of the convertible bond.
• the parameter ⁇ can then be estimated as described above.
• FIGs. 3A, 3B-1 and 3B-2 are flow-chart representations of the steps of the
• DPSM Deductive Pricing System and Method
• the current instrument is a Derived Instrument 104, 305
• the parameters ⁇ or ⁇ are estimated and updated 306 and the system and method then proceeds to the next instruments.
• the system and method tests whether it is a Composite Instrument 105, 307. If it is not a Composite Instrument 105, then it must be a Zero Class-, Simple- or Aggregate Instrument 101, 102, 103, in which case the system and method proceeds directly to the next instrument in the update queue.
• the fair value of the bond portion has to be calculated first 308, whereupon the market value of the option portion (or "warrant") can be inferred by subtracting the fair value of the bond from the market value of the Composite Instrument 105 as shown in step 309. This results in an estimate of the value of the option or warrant portion of the convertible bond which can now be updated 310. Based on these estimates, we can infer and update the parameter ⁇ 311.
• the DPSM proceeds in the manner shown in Figs 3B-1 and 3B-2. If the current instrument is a Zero Class or Simple Instrument 101, 102, 332, and if "bid” and “ask” prices are posted by a bona-fide market maker 333, the mid-point between these two posted prices is used as a proxy for the market price 334, and after updating the time stamp 338 the DPSM proceeds to the next instrument in the update queue 339. If "bid” and "ask” prices are not available, nothing can be done, and the old "stale" last trade price is still the best price obtainable for the current instrument.
• the DPSM that tests whether it is a Composite Instrument 105, 342 or a Derived Instrument 104, 352. If it is neither, there is still the possibility of a manual price update steps 392-394, and resetting of the time stamp 338 prior to proceeding to the next instrument in the update queue 339. If no manual price update is undertaken, the DPSM proceeds to the next instrument directly.
• the Composite Instrument 105 is valued by the mid-price between the posted bid and ask prices 344. From that point on, the process proceeds exactly as in the case of a valid last trade price (see above steps 344 through 311). If no "bid” and "ask” prices are posted, the fair values of the embedded instruments are calculated and the fair value of the convertible bond is obtained as a weighted sum of the embedded components 345 before proceeding to the next instrument in the update queue.
• this invention provides for a structured database of financial instruments and a method and system, the deductive pricing method and system, that assure that the largest possible number of financial instruments in a portfolio are valued with prices that are accurate, timely and complete.

Landscapes

• Engineering & Computer Science (AREA)
• Business, Economics & Management (AREA)
• Finance (AREA)
• Accounting & Taxation (AREA)
• Development Economics (AREA)
• Operations Research (AREA)
• Game Theory and Decision Science (AREA)
• Human Resources & Organizations (AREA)
• Entrepreneurship & Innovation (AREA)
• Economics (AREA)
• Marketing (AREA)
• Strategic Management (AREA)
• Technology Law (AREA)
• Physics & Mathematics (AREA)
• General Business, Economics & Management (AREA)
• General Physics & Mathematics (AREA)
• Theoretical Computer Science (AREA)
• Financial Or Insurance-Related Operations Such As Payment And Settlement (AREA)

Applications Claiming Priority (3)

Publications (2)

Family

ID=23087038

Family Applications (1)

Country Status (3)

Families Citing this family (8)

Family Cites Families (5)

• 2002
  • 2002-04-12 WO PCT/US2002/011516 patent/WO2002084435A2/en not_active Application Discontinuation
  • 2002-04-12 EP EP02723833A patent/EP1388102A4/de not_active Withdrawn
  • 2002-04-12 AU AU2002254596A patent/AU2002254596A1/en not_active Abandoned

Non-Patent Citations (2)

Also Published As

Similar Documents

Legal Events