Financial Modelling: An imperative sound for decision making

What is Financial Modelling? Financial modeling is the task of building an abstract representation of a financial decision making situation. This is a mathematical model, such as a computer simulation, designed to represent the performance of a financial asset or a portfolio, of a business, a project, or any other form of financial investment. Theoretically speaking, a financial model is a set of assumptions about future business conditions that drive projections of a companys revenue, earnings, cash flows and balance sheet accounts. However, financial modeling is a general term that means different things to different users. In the US and particularly in business schools it means the development of a mathematical model, often using complex algorithms, and the associated computer implementation to simulate scenarios of financial events, such as asset prices, market movements, portfolio returns and the like. Or it might mean the development of optimization models for managing and controlling the risk of a financial investment. In Europe and in the accounting profession financial modelling is defined as cash flow forecasting, involving the preparation of large, detailed spreadsheets for management decision making purposes. What is the Objective of Financial Modelling? The objective of a financial model is to position clients for success in their foreign investments. Whats the cost of doing business in a given country? Whats the breakeven point? When might you exceed the profitability of a similar operation in the United States? The importance of financial modelling cannot be overstated. and financial models often are a key element in most major business decisions. For instance, a financial model is prepared whenever any organization is considering project finance, bidding for a project, evaluating acquisition target, carrying out monthly financial planning, conducting capital structure studies, etc. The proponents of the model must first undertake a qualitative review - i.e. determine whether the story underpinning the model makes sense. There needs to be a logic behind the adoption of the model and a compelling case that it will be supported by its intended target audience. This useful tool also allows business options and risks to be evaluated in a cost-effective manner against a range of assumptions, identify optimal solutions in evaluating financial returns and understand the impact of resource constraints to make the most effective business decisions. What is the characteristics of a sound Financial Model? A good financial model is: (a) Easy to understand - uses a transparent design; (b) Reliable - uses control checks so that an error is automatically flashed; (c) Easy to use - so that one can be more productive in using the model for analysis rather than struggling just to produce simple results from a badly designed model; (d) Focussed on the key issues - so that one does not waste too much time in development of immaterial items; Related posts: 1. Risk Management from Project Managers Perspective Risk Management from Project Manager's Perspective... 2. GARP confers Risk Management award to Chinese Banking Regulators GARP confers award to Chinese Banking Regulators... 3. Lehman Bros fancy accounting Lehman Bros fancy accounting... 4. Magic behind Financial Projections in a Startup This is the article by Amit Grover, Founder, Nurture Talent... 5. Greeks and Goldman Sachs Greeks and Goldman Sachs...

Basic Project Portfolio Manager Functions

Pipeline Management and the Project Portfolio Manager It is not only in-flight and pending approval projects that should be visible to an enterprise project office. A project office should also have line of forward sight to possible projects and those that are yet to commence. The term for this is the pipeline. Pipeline management is generally another responsibility of the Project Portfolio Manager. Some of the key pipeline management activities, to be undertaken by the Project Portfolio Manager are as follows: * Liaison with all areas of the enterprise to remain informed of initiatives that they are proposing to progress in the coming 1 to 3 years * Ongoing liaison with areas of the enterprise to ensure previously flagged initiatives are still on track to progress * Maintenance of a pipeline view to ensure appropriate long term resource management activities are undertaken (e.g. Recruitment of appropriately skilled staff) * Communicating the pipeline view to all relevant areas of the enterprise Project Portfolio Resource Coordination Increasingly, project resource supply and demand management is the responsibility of the Project Portfolio Manager. The fundamental theory behind this is that as the Project Portfolio Manager has a clear pipeline view and the best understanding of project portfolio priorities then they are best placed to make decisions about the allocation of project resources. Resource groups that the Project Portfolio Manager may be responsible for coordinating supply and demand for could include, but not be limited to, the following: * Project Managers and other administrative project staff * Software development resources * Business Analysts * Testing resources and environments Organisation Risk Management via Project Portfolio Management A key function of project portfolio management is the responsibility for identifying, reporting and mitigating as far as possible any risks that affect the project portfolio as a whole. Portfolio level risk reporting should form an integral part of the organisations risk management practices. The risk register used for this purpose may be very similar in layout and function to that which would be used by an individual project as part of the project risk management framework. Portfolio Dependency Management Project portfolio management has an important role to play with respect to identifying and managing portfolio-level dependencies. Portfolio-level dependencies are those project dependencies related to the portfolio as a whole, which could potentially impact multiple in-flight projects across the enterprise portfolio. For example, if three development projects all require the skills of a single team of programmers then completion of Project A and Project B might be dependant on the completion of work for Project C. With multiple projects linked by this dependency, the dependency itself should be identified, documented and managed at the portfolio level. Provision of Management Information by Project Portfolio Managers Provision of project-related reporting, on an aggregated basis, is traditionally the responsibility of an enterprise project office. Some of this reporting is the responsibility of the Project Portfolio Manager. Although the reporting provided through the project portfolio management process may vary as a function of organisation size, maturity, complexity and nature of business, there remains some general reporting areas that should be developed as part of this function. Some such areas are: * Pipeline status (e.g. Number of pending projects, projects in-flight) * Current work in progress broken down into areas such as resource requirements and capital spent against proposed project budget) * Resource utilisation (i.e. supply and demand tables and charts) * Project portfolio composition in terms of project types, enterprise strategy alignment and size of capital investment What does Project Portfolio Management Deliver the Organisation? With the fundamentals of PPM established, the question remaining is, what does effective project portfolio management provide an organisation. Varying benefits are postulated by numerous theories and specific approaches to PPM, but the common benefits of a PPM approach to enterprise project management and coordination are, at minimum, the following: * An optimised project portfolio which delivers projects aligned with organisation strategy * Ability to more closely govern and guide projects across the enterprise * Transparency and better management of organisational risk born of projects across the organisation * Optimal resource utilisation and reduced resourcing costs on a per-unit-delivered basis * Improved project risk management through the identification and management of portfolio-level risks * Greater forward planning through pipeline view management In summation, Project portfolio management is essentially a simple collection of fundamentals, aimed at improving the management and coordination of projects, project resources, organisation capital and risk. As with other enterprise project management approaches, there are a myriad of variations on the theme. Regardless, the basics of project portfolio management remain unchanged.

Basic Project Portfolio Manager Functions

Pipeline Management and the Project Portfolio Manager It is not only in-flight and pending approval projects that should be visible to an enterprise project office. A project office should also have line of forward sight to possible projects and those that are yet to commence. The term for this is the pipeline. Pipeline management is generally another responsibility of the Project Portfolio Manager. Some of the key pipeline management activities, to be undertaken by the Project Portfolio Manager are as follows: * Liaison with all areas of the enterprise to remain informed of initiatives that they are proposing to progress in the coming 1 to 3 years * Ongoing liaison with areas of the enterprise to ensure previously flagged initiatives are still on track to progress * Maintenance of a pipeline view to ensure appropriate long term resource management activities are undertaken (e.g. Recruitment of appropriately skilled staff) * Communicating the pipeline view to all relevant areas of the enterprise Project Portfolio Resource Coordination Increasingly, project resource supply and demand management is the responsibility of the Project Portfolio Manager. The fundamental theory behind this is that as the Project Portfolio Manager has a clear pipeline view and the best understanding of project portfolio priorities then they are best placed to make decisions about the allocation of project resources. Resource groups that the Project Portfolio Manager may be responsible for coordinating supply and demand for could include, but not be limited to, the following: * Project Managers and other administrative project staff * Software development resources * Business Analysts * Testing resources and environments Organisation Risk Management via Project Portfolio Management A key function of project portfolio management is the responsibility for identifying, reporting and mitigating as far as possible any risks that affect the project portfolio as a whole. Portfolio level risk reporting should form an integral part of the organisations risk management practices. The risk register used for this purpose may be very similar in layout and function to that which would be used by an individual project as part of the project risk management framework. Portfolio Dependency Management Project portfolio management has an important role to play with respect to identifying and managing portfolio-level dependencies. Portfolio-level dependencies are those project dependencies related to the portfolio as a whole, which could potentially impact multiple in-flight projects across the enterprise portfolio. For example, if three development projects all require the skills of a single team of programmers then completion of Project A and Project B might be dependant on the completion of work for Project C. With multiple projects linked by this dependency, the dependency itself should be identified, documented and managed at the portfolio level. Provision of Management Information by Project Portfolio Managers Provision of project-related reporting, on an aggregated basis, is traditionally the responsibility of an enterprise project office. Some of this reporting is the responsibility of the Project Portfolio Manager. Although the reporting provided through the project portfolio management process may vary as a function of organisation size, maturity, complexity and nature of business, there remains some general reporting areas that should be developed as part of this function. Some such areas are: * Pipeline status (e.g. Number of pending projects, projects in-flight) * Current work in progress broken down into areas such as resource requirements and capital spent against proposed project budget) * Resource utilisation (i.e. supply and demand tables and charts) * Project portfolio composition in terms of project types, enterprise strategy alignment and size of capital investment What does Project Portfolio Management Deliver the Organisation? With the fundamentals of PPM established, the question remaining is, what does effective project portfolio management provide an organisation. Varying benefits are postulated by numerous theories and specific approaches to PPM, but the common benefits of a PPM approach to enterprise project management and coordination are, at minimum, the following: * An optimised project portfolio which delivers projects aligned with organisation strategy * Ability to more closely govern and guide projects across the enterprise * Transparency and better management of organisational risk born of projects across the organisation * Optimal resource utilisation and reduced resourcing costs on a per-unit-delivered basis * Improved project risk management through the identification and management of portfolio-level risks * Greater forward planning through pipeline view management In summation, Project portfolio management is essentially a simple collection of fundamentals, aimed at improving the management and coordination of projects, project resources, organisation capital and risk. As with other enterprise project management approaches, there are a myriad of variations on the theme. Regardless, the basics of project portfolio management remain unchanged.

Yield Spread

What is Yield ?

The term yield indicates the amount in cash that the owners of a security will get.

CFA Exam Pattern - Updates

 

If you plan to appear for the CFA exam June 6, 2010, here are some important things you must know as you chalk out your plan, gather study resources and get on with it:
(a) The curriculum for CFA exam has changed
(b) CFAI has introduced some modification regarding the Exam style and formatting convention
(c) Accounting rules and the financial environment have changed and
(d) CFA-2009 exam onwards, the MCQs will have three answer choices instead of four
The curriculum changes each year to meet the dynamic nature and complexity of the global investment profession. CFA Institute, through the oversight of the Educational Advisory Committee (EAC),
regularly conducts a practice analysis survey of investment professionals around the world to determine the knowledge, skills, and competencies that are relevant to the profession. The results of the practice analysis define the Global Body of Investment Knowledge (GBIK) and the CFA Program Candidate Body of Knowledge
(CBOK).
The last change with respect to number answer choices could have significant impact on the way the candidates attempt and score in the exam. Here’s CFA Institute’s rationale behind this change:

“Research and our own experience indicate that the fourth answer option on multiple choice and item set exams is unnecessary to assess a candidate’s knowledge and skills. Three answer choices are sufficient and effective in discriminating between those candidates that possess the knowledge and skills and those that do not. As a result, we are changing the format of the multiple-choice and item set questions on CFA exams from four answer options to three.”
So, would it become easier to crack the exam, now that the candidates have fewer answer choices to consider?
Well, not really. The key thing to note here is that although candidates need to carefully manage their time to perform well on CFA exams, the CFA exams are not merely a test of time management skills. You need to have a certain level of mastery of the knowledge and skills to get through.
The probability of successful guessing on any single MCQ will increase. However, the probability that a candidate would be able to guess correctly enough times to pass the exam is very small. This is true irrespective of whether there are two, three, four or more choices. It is also at least theoretically possible that a candidate
with enough knowledge and skills to achieve a reasonably high score might achieve a higher score through successful guessing on just a few questions. It is important to note that there is not a fixed score that candidates need to achieve to pass a CFA exam. Standard setters evaluate the difficulty of each exam in making their minimum
pass score recommendation. Keep this in mind as you gear up the preparation for the exam and remember - “Work Hard At Working Smart”.
CFAIA
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FRM Coaching Delhi

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List of FRM Core Readings

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FRM Part I
Foundations of Risk Management
René Stulz, “Risk Management Failures: What are They and When Do They Happen?” Fisher College of Business Working Paper Series (Oct. 2008). Fisher College of Business Working Paper No. 2008-03-017.
GARP Code of Conduct
Valuation and Risk Models
“Principles for Sound Stress Testing Practices and Supervision” (Basel Committee on Banking Supervision Publication, May 2009)
FRM Part II
Credit Risk Measurement and Management
Adam Ashcroft and Til Schuermann, “Understanding the Securitization of Subprime Mortgage Credit” , Federal Reserve Bank of New York Staff Reports, no. 318 (March 2008).
Eduardo Canabarro and Darrell Duffie, “Measuring and Marking Counterparty Risk” in ALM of Financial Institutions, ed. Leo Tilman (London: Euromoney Institutional Investor, 2003).

Darrell Duffie, “Innovations in Credit Risk Transfer: Implications for Financial Stability” (July 2008) .
Studies on credit risk concentration: an overview of the issues and a synopsis of the results from the Research Task Force project” (Basel Committee on Banking Supervision Publication, November 2006).
Operational and Integrated Risk Management
Andrew Kuritzkes, Til Schuermann and Scott M. Weiner. “Risk Measurement, Risk Management and Capital Adequacy in Financial Conglomerates” , in Brookings-Wharton Papers on Financial Services Robert E. Litan and Richard Herring (eds) (Brookings Institutional Press, Washington, DC: 2003).
Brian Nocco and René Stulz, “Enterprise Risk Management: Theory and Practice” , Journal of Applied Corporate Finance 18, No. 4 (2006): 8-20.
Falko Aue and Michael Kalkbrener, “LDA at Work” Deutsche Bank White Paper, 2007.
Til Schuermann and Andrew Kuritzkes, “What We Know, Don’t Know and Can’t Know About Bank Risk: A View from the Trenches” , (March 2008).
“Principles for Sound Liquidity Risk Management and Supervision” (Basel Committee on Banking Supervision Publication, September 2008).
“Range of practices and issues in economic capital modeling” (Basel Committee on Banking Supervision Publication, March 2009)
Readings for Basel Reference
“Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework-Comprehensive Version” (Basel Committee on Banking Supervision Publication, June 2006).
“Supervisory guidance for assessing banks’ financial instrument fair value practices” (Basel Committee on Banking Supervision Publication, April 2009).
“Guidelines for computing capital for incremental risk in the trading book -final version” (Basel Committee on Banking Supervision Publication, July 2009).
“Revisions to the Basel II market risk framework -final version” (Basel Committee on Banking Supervision Publication, July 2009).
Risk Management and Investment Management
René Stulz, “Hedge Funds: Past, Present and Future.” Fisher College of Business Working Paper No. 2007-03-003; Charles A Dice Center WP No. 2007-3.
Manmohan Singh and James Aitken, “Deleveraging after Lehman — Evidence from Reduced Rehypothecation” , (March 2009).
Stephen Dimmock and William Gerken, “Finding Bernie Madoff: Detecting Fraud by Investment Managers” , (December 2009).
Current Issues in Financial Markets
Gary Gorton, “The Panic of 2007″ , (August 2008).
Raghuram Rajan, “Has Financial Development Made The World Riskier?” (September 2005).
Senior Supervisory Group, “Observations on Risk Management Practices during the Recent Market Turbulence,” (March 2008).
UBS, “Shareholder Report on UBS?s Write-Downs” , (April 2008).
Martin Hellwig, “Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis” , (November 2008). MPI Collective Goods Preprint, No. 2008/43.
Carmen Reinhart and Kenneth Rogoff, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises” , (April 2008).
Darrell Duffie, “The Failure Mechanics of Dealer Banks” , (June 2009).

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Options Trading Strategies

The simmering Sino-US relationships, paroxysms in European bond market and the domestic budget of this fiscal around the corner are the contributors of high volatility in NIFTY.

The latest fuel to burn the superficial bonhomie between the two super powers is the America’s decision to sell Taiwan $6 billion-worth of weaponry. This is playing an active role in bringing the confidence indexes to their all time lows.

Late last month the yield on 10-year government bonds issued by Greece vaulted to 7.1%, which is the highest since the country became EU member. This yield is 400bps more than that on German bunds, which are considered to be the safest investment in EU. The panic abated on 3-Feb, when the European Commission endorsed the Greek government’s plan to cut the deficit to 3% of GDP by 2012. The storm in Greece has compelled many sleepers like Portugal and Spain to wake-up and start preparing for the similar crises in domestic bonds.

Latest updates from Central Statistical Organization (CSO) has although updated the growth estimate to 7.2%, many are skeptical about the numbers because of the negative growth in the agriculture, thanks to the monsoon this year.

Traders of imminent I-banks have started getting the margin calls in their vanilla strategies. ABC Bank didn’t have any prior experience and exposure to the options. They want to enter in options trading and want to profit from the present condition of the Indian market.

All the six traders of the ABC Bank have different opinions on the importance and the outcome of the scenario. Depending on the view of the traders, we have to advice the best strategy for the novice traders of the ABC bank.

Case I:

Trader1: I think despite the bad numbers in agriculture by CSO, the good part is that overall Indian economy will grow at much higher rate (7.2%) than previously expected. I think the budget should be investor-friendly. If I talk about Sino-US relationships, it’s not breaking news. It had been going since 4^th Nov, ’09 the day Obama entered white-house.

You: Tell us something about EU bond market and your overall view in Indian context.

Trader1: According to me, EU bond market squall can be another crisis in the offing if not nipped in a week or so. This may affect Indian stock and bond market. Overall I would say I am conservatively bullish and conservatively bearish, but Congress’ investor-friendly budget as expected would lead the show.

You: From your feedback, the best strategy for you would be buy a call option, but as you are bearish because of EU bonds, I would suggest selling a call option at higher strike price. This strategy is also called Bull Spread.

Case II:

Trader2: My expectations are exactly opposite to what Trader1 thinks on the importance of the events.

You: This means that you think the probability of the EU bonds affecting Indian markets would be more than the impact of budget. For this outlook best suited strategy would be to sell call option at lower strike price and to buy a call option. Bear Spread

Case III:

Trader3: I am interested in short term options and for that period only possible outcome is the budget, which has equal chances of being a good or bad news for Indian investors. No matter what the outcome of the budget is going to be, Nifty has got to run. China-US relations and EU bonds are not sufficient factors to move Nifty.

You: Buy a call and buy a put at same strike price. Straddle

Case IV:

Trader4: My expectations are same as Trader3, but I don’t want to spend too much money upfront. Moreover the range boundaries which Nifty is going to break are higher than those expected by Trader3.

You: Buy call and put of different strike prices depending on your range boundaries. Strangle

Case V:

Trader5: I am interested in short term options and for that period only possible outcome is the budget, which has more chances of being good news for Indian investors. No matter what the outcome of the budget is going to be, Nifty has got to run. China-US relations and EU bonds are not sufficient factors to move Nifty. Overall Nifty is going to break the range boundary. There are 90% chances that the broken boundary is going to be the upper one.

You: If you are so much confident about the broken boundary to be the upper boundary, go for Strap strategy. Strap involves buying 2 call options and 1 put option at same strike price.

Case VI:

Trader6: Every year we get a new budget, few years back there were tensions between Middle East and US, now it’s between China and US, few months ago Dubai-world made a new about sovereign debt default, now it’s Greece or any country for that matter. All these so called big news are not going to be very significant unless our market obeys strong market efficient hypothesis. There’s so much of the positive and negative information that it cancels out in the end, only thing that remains is the irrationality and the psychology of the investor. So I think Nifty is going to trade between a range unlike a biotech company about to launch a new drug. So my expectations are that the market would be range bound and don’t want to spend too much upfront.

You: Buy two calls at different strike prices and sell two calls at intermediate strike prices. Butterfly spread.

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Effective Asset allocation Techniques

 

Asset allocation is the strategy used in choosing between the various kinds of possible investments, in other words,
the strategy used in choosing in what asset classes such as stocks and bonds one wants to invest.
A large part of financial planning consists of finding an asset allocation that is appropriate for a given person in
terms of their appetite for and ability to shoulder risk.
Examples of asset classes:
* Cash ( money market accounts)
* Bonds: investment grade or junk (high yield); government or corporate; short-term, intermediate, long-term; domestic, foreign, emerging markets
* Stocks: value or growth; large-cap versus small-cap; domestic, foreign, emerging markets
* Real estate
* Foreign currency
* Natural resources
* Precious metals
* Luxury collectibles such as art, fine wine and automobiles
* Real Estate Investment Trusts (REITs)
* International Investments: Foreign or emerging markets
* Life settlements
What are the various Asset-Allocation Strategies ?

Dynamic Asset Allocation
One of the popular allocation schemes is dynamic asset allocation, with which one actively moderates the mix of assets as markets soar and falter. With this strategy one sells assets which are losing value and buys those assets which are gaining. This strategy can diametrically opposite to a constant-weighting scheme.
Strategic Asset Allocation
Strategic asset allocation is a strategy that establishes and sticks to what is called a ‘Base policy mix’. This is a proportional combination of assets based on expected rates for class of asset.
For instance, if the statistical data shows that stock-market has historically returned 20% per year and bonds have returned 10% per year,
a mix of 50% stocks and 50% bonds would be expected to return 15% (= 0.5 * 20 + 0.5 * 10) per year.
Constant-Weighting Asset Allocation
The Strategic asset allocation usually employs a Buy-and-Hold strategy, even though the variations in the actual worth of the assets cause a dramatic change in the initially established policy mix. For this reason, one might prefer to use a constant-weighting approach for asset allocation. In this scheme, one continually rebalances the portfolio.
For instance, if asset A were declining in value, one would purchase more of that asset, and if that asset value increases, then one would sell it.
There are no rigid rules for the frequency of portfolio rebalancing under strategic/constant-weighting asset allocation techniques. Although, a widely accepted norm is that the portfolio must be rebalanced to its original mix when any given allocated asset varies more than 5% in value.
Tactical Asset Allocation
Over the long run, a strategic asset allocation strategy does not allow much flexibility. So, one may find it useful to engage in short-term, tactical deviations from the mix in order to capitalize on the out-of-the-line
investment opportunities. This flexibility imparts a degree of of market timing to one’s portfolio, letting one participate in economic conditions that are more suited to a particular asset class.
So, in some sense, Tactical asset allocation can be described as a moderately active strategy, since the overall strategic asset mix is returned to when desired short-term profits are achieved.


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Cash Flows Classification

 

The statement of cash flows is divided into three sections:
(A) Financing activities
(B) Operating activities
(C) Investing activities
(A) Cash flow from financing activities (CFF)
CFF is cash flow that comes into play from generating or letting cash through the issuance of additional equity, short or long-term debt for the firm’s operations. This covers:
(a) Cash inflow (+)
1. Sale of equity securities
2. Issuance of debt securities
(b) Cash outflow (-)
1. Dividends to shareholders
2. Redemption of long-term debt
3. Redemption of capital stock
Reporting Noncash Investing and Financing Transactions
Data for the Statement of cash flows(SOCF) is derived from three places:
(a) Comparative balance sheets
(b) Current income statements
(c) Selected transaction data
(B) Cash Flow from Operating Activities (CFO)
CFO is cash flow that comes into play from regular operations such as revenues and cash operating expenses net of taxes.

This category covers:
(a) Cash inflow (+)
1. Revenue from sale of goods and services
2. Dividends (from equities of other entities)
3. Interest (from debt instruments of other entities)
(b) Cash outflow (-)
1. Payments to lenders
2. Payments to employees
3. Payments to suppliers
4. Payments to government
5. Payments for other expenses
2. Cash Flow from Investing Activities (CFI)
CFI is cash flow that comes to play through investment activities such as the acquisition or disposition of current and fixed assets.
This category covers:
(a) Cash inflow (+)
1. Sale of property, plant and equipment
2. Sale of debt or equity securities (other entities)
3. Collection of principal on loans to other entities
(b) Cash outflow (-)
1. Purchase of property, plant and equipment
2. Purchase of debt or equity securities (other entities)
3. Lending to other entities
There are however, some investing and financing activities that don’t flow through the statement of cash flow because they do not engage cash transactions.
Simple instances of this category are:
(1) Acquisition of assets through capital leases
(2) Acquisition of long-term assets by issuing notes payable
(3) Conversion of debt to equity
(4) Conversion of preferred equity to common equity
(5) Acquisition of non-cash assets like patents, licenses in exchange for equity or securities


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What are Exotic Options / Vanilla Options ?

 

An exotic option is a derivative which has features making it more complex than commonly traded products (vanilla options). These products are usually traded over-the-counter (OTC), or are embedded in structured notes.
An exotic product could have one or more of the following features:
* The payoff at maturity depends not just on the value of the underlying index at maturity, but at its value at several times during the contract’s life. It could be an Asian option depending on some average, a look-back option depending on the maximum or minimum, a barrier option which ceases to exist if a certain level is reached or not reached by the underlying, a digital option, range options, etc.
* It could depend on more than one index; as in case of a basket options, Himalaya options, or other mountain range options, outperformance options, etc.
* There could be callability and putability rights.
* It could involve foreign exchange rates in various ways, such as a quanto or composite option.
Similarly there are few more important types for classification:

Barrier Options - They let the investor gain from their expectation of share price path movement, for example,  the share will first go down and then Rocket up.
There are several types of barriers:
(a) Binary option
They are options with discontinuous payoffs. Another type of binary option is an asset or nothing call. This payoff nothing if the underlying asset price ends up below the strike price and pays the asset if it ends up above the strike price.
(b) Asian Options
They are a type of averaging option. Most common is to average the share price. The pay out is determined by deducting the average from the strike. This option is far cheaper because the volatility of an
average is lower than that of the price itself.
(c) Compound Option
It is an option on an option. Here, the holder has an Call option that expires 10th March to purchase a Call option for £2.00 which
will then give the holder the right to purchase the shares at £12.00 on 31st October.
The holder pays less up-front,thus effectively making this a highly geared instrument.

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VaR Methodology: Shortcomings

 

 
What is the most I can lose on this investment? This is a question that almost every investor who has invested or is considering investing in a risky asset asks at some point in time. Value at Risk tries to provide an answer, at least within a reasonable bound.
It gives the likelihood that a portfolio will suffer a large loss in some period of time, or the maximum amount that you are likely to lose with some probability (say, 99%).
It finds this by :
(1) looking at historical data about asset price changes and correlations;
(2) using that data to estimate the probability distributions of those asset prices and correlations; and
(3) using those estimated distributions to calculate the maximum amount you will lose 99% of the time.
But the things are not as simple as that. Real markets don’t go by statistics or rules of probabilty.

You must read this elegant article by Joe Nocera that talks about Var inlight of the sub-prime mortgage crisis. Here is interesting excerpt:
“At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn’t measure the possibility of an extreme event was a blessing to the executives. It made black swans [unlikely events] all the easier to ignore. All the incentives — profits, compensation, glory, even job security — went in the direction of taking on more and more risk, even if you half suspected it would end badly. After all, it would end badly for everyone else too. ”
So, here is what’s wrong with the approach:
* Tendency to assume Normal distributions, and thus low probability of ‘extremes’. Reality is that financial returns are more skewed than normality suggests - excessively high and low return days are far more common than would be expected;
* There is often an assumption that history repeats itself, or, the past can predict the future;
* VaR does not describe the losses in the extreme left “tail” of the distribution. (Conditional VaR can help to measure “the expected loss, given the loss exceeds VaR”)
* VaR does not distinguish portfolio liquidity; very different portfolios can have the same VaR i.e. VaR is a static measure of risk and does not capture the dynamics of possible losses if a portfolio were to be unwound;
* Computations can be very complex; there is model risk; precision should not be assumed;
* VaR-constrained traders can game the system i.e. maximize risk subject to keeping VaR steady. The game repeats itself at several levels; and can trigger an avalanche, because everyone misjudges risk in the same way.
Is VAR the Right Methodology? In many situations, VAR may not be the correct risk-management methodology. If we pick a specific loss such as $1 million, VAR allows us to estimate how often we can expect to experience this particular loss. For example, using VAR we might estimate that we will lose at least $1 million on one trading day in 20, on average. During some 20-day periods, we might lose less than $1 million. During other 20-day periods, we might lose more than $1 million on more than one day. VAR tells us how often we can expect to experience particular losses. It doesn’t tell us how large those losses are likely to be.
GARP


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