Financial programming

Financial programming encompass different types of techniques, methodologies, computer languages and resources. The topic is extensive, so I selected two representative programming design practices: the market-oriented programming paradigm and financial real-time computing/competitive analysis.

Market-oriented programming

Market price systems constitute a reasonable well-understood economic class of mechanisms.

Market-oriented programming is seen as a programming paradigm based on abstractions such as prices, demands and other concepts, terminology and theory from microeconomics. Architecturally, the foundation of the paradigms rests on a highly distributed system of components (computational agents) which main goal is to solve a resource allocation problem through a price system that under certain conditions provide effective decentralization of decision making with minimal communication overhead. In an economic sense, the problem is to compute the competitive equilibrium of an artificial economy.¹⁶² A correct specification of data structures representing ‘goods and services traded’ is essential for the system performance. Furthermore, some relations between standard optimization/resource allocation approaches and markets have to be also described¹⁶³. Because allocation problem representation allows a wide variety of abstractions, the market-oriented paradigm can be productively used in non-computer science contexts. Take as an example, the use of the market paradigm to model the resource allocation problem for air conditioning control of building by Shigei, et. al. (2011).¹⁶⁴

Financial real-time computing/competitive analysis

Computational finance applications have unique needs originated in ubiquitous networking systems and increasingly automated business processes. To be effective, such applications require rapid processing of a continuous and unending data stream. Managing this data stream encompasses query processing over dynamic data and the ability to incorporate the results into ongoing business processes incrementally—all with extremely low latency. Another feature the system must also

162 Wellman Michael P. “Market-oriented programming (Abstract)”. In: Wainer J. & Carvalho A.

(Editors) Advances in Artificial Intelligence. SBIA 1995. Lecture Notes in Computer Science (Artificial Intelligence), Vol. 991, pp. 26-27. Springer, 1995.

Wellman Michael P. “A Market-Oriented Programming Environment and its Application to Distributed Multicommodity Flow Problems”. Journal of Artificial Intelligence Research 1, pp. 1-23. 1993.

163 Ygge, Fredrik. “Market-Oriented Programming and its Application to Power Load Management”.

Ph.D. Dissertation. Lund University, Sweden. Publically defended on June 6, 1998.

164 Shigei, Noritaka; Miyajima, Hiromi and Osako, Tsukasa. ” Market-oriented Programming Using Small-world Networks for Controlling Building Environments”. Transactions of the Institute of Systems, Control and Information Engineers, Vol. 24, No. 4, pp. 77-87. 2011.

51 support is the processing of data archived for historical analysis, which involves mining and back-testing real-time queries over raw or processed time series¹⁶⁵.

On the other hand, financial problems are very attractive candidates for competitive analysis. Such problems are typically online in nature in that the presence of uncertainty: information about the future is scarce and/or unreliable. For example, competitive analysis can be an effective tool for searching the maximum or minimum price in the market for trading purposes, the portfolio selection, and time series search problems.¹⁶⁶

Case study 3.2 ‒ Algorithmic hell: pricing synthetic CDO’s.

The sheer growth of the credit derivatives market in the last 20 years poses definitive challenges to algorithmics in finance. The most popular portfolio credit derivative is the collateralized debt obligation (CDO).

A CDO is a type of structured asset-backed financial product¹⁶⁷ that pools together cash flow-generating assets and repackages (splits) this asset pool into different risk classes knows as tranches that can be sold to investors on the secondary market¹⁶⁸. A CDO is so-called because the pooled assets are essentially debt obligations which receivables (promised repayments) serve as collateral for the CDO –mortgages, corporate debt (bonds), credit card debt, auto loans and even student loans –. So, a CDO is a basket credit derivative that consists of multiple tranches, each having a different risk return profile. Returns on CDOs are paid in tranches. These instruments are also referred as cash CDOs¹⁶⁹.

When the debt is split into different tranches, each tranche is assigned a different payment priority and interest rate. This process is known as securitisation. In the securitisation process mortgages are sold by the originating financial institution to a specially created company or trust –usually referred to as a special-purpose vehicle (SPV)– which finances the purchase by issuing securities to investors, using the bonds and loans as collateral. Cash CDOs developed when traditional securitization techniques used to create mortgage-backed or asset-backed securities were applied to transfer credit risk. Both pricing and risk management draw on traditional securitization

165 Chandramouli, Badrish; Ali, Mohamed; Goldstein, Jonathan; Sezgin, Beysim and Raman, Balan Sethu. “DATA STREAM MANAGEMENT SYSTEMS FOR COMPUTATIONAL FINANCE”. Computer. IEEE Computer Society. December, 2010.

166 Borodin, Allan and El-Yaniv Ran. Online Computation and Competitive Analysis. Chapter 14

“Search, Trading and Portfolio Selection”, p. 264. Cambridge University Press, 1998.

167 CDOs are described as structured asset-backed securities because they pay cash flows to investors in a prescribed sequence, based on how much cash flow is collected from the package of assets owned. For example, CDOs are called asset-backed commercial paper if the package consists of corporate debt. Banks call them mortgage-backed securities if the loans are mortgages,.

Sources:

Amadeo, Kimberley. ‘CDOs (Collateralized Debt Obligations)’. The Balance, August, 2017. Available at: https://www.thebalance.com/cdos-collateralized-debt-obligations-3305822.

Investing Answers. At: http://www.investinganswers.com/financial-dictionary/bonds/collateralized-debt-obligation-cdo-2123

‘Down the Rabbit Hole: Deciphering CDOs’. Forbes. May, 2017. Available at https://www.forbes.com/2010/05/17/what-are-collateralized-debt-obligations-personal-finance-cdos.html

168 Tranches are pieces, portions or slices of debt or structured financing. Each tranche may consist of several related securities offered at the same time but with different risks, rewards and maturities.

Source: Investopedia.

169 This denomination comes from the fact that the reference portfolio of cash CDOs is made up of cash assets such as corporate bonds or commercial loans.

52 techniques. The main pricing model for pricing CDOs is the Gaussian copula¹⁷⁰, which is not perfectly fitted to the task. The problem is that the underlying asset pool of the CDOs simultaneously encompasses credit risk and market risk. However, the standard CDO pricing model not only underestimates the risk to the asset pool due to a poor description of the correlation structure among obligors but is also incapable of reflecting the impacts of interdependent markets, credit risks and systematic sudden shocks on the asset pool¹⁷¹. An appropriate risk assessment is essential for adequate pricing. Among others, pricing techniques (not models) for pricing/valuation of CDOs are:

Monte Carlo simulation, Fast Fourier Transform (FFT –quasi-analytic method) and, under the one-factor copula model, default correlation calibration.¹⁷²

But matters can turn a lot worse. CDOs are appreciated by loan originators, because they mean an extra income, they allow banks and corporations to sell off debt and free up capital to re-invest or loan, they serve to transfer of credit risk to CDO investors and to improve capital ratios¹⁷³. But it can happen that there is a lack of debt to securitise, so it is possible to create a synthetic product by pooling all of the lowest (junk) tranches (highest interest payments, highest risk) to create a new product known as synthetic CDO. Synthetic CDOs developed as an outgrowth of cash CDOs. They are not based on any mortgage or debt or any other security¹⁷⁴: instead, they are made up of credit default swaps (CDS).¹⁷⁵ The theory behind this is that even though the assets behind the bonds are risky, by pooling large amounts together it is possible to minimize risk whilst still receiving the high interest rates. The concept here is reasonably complex, but in essence banks sold tranches of insurance (CDS) on tranches of mortgage CDOs. Buying the top tranche of a synthetic CDO would be equivalent to write a credit default swap on the top tranche of another CDO which was based on actual mortgages. As long as that 'real' tranche did not default, the speculator continues to collect the premiums on the written CDS's. The real problem with this extension of the CDO machine was that one euro in mortgages no longer meant just 1 euro in CDOs, it could mean 10, 20 or even more.

There is no reason why multiple parties cannot write different insurance contracts on the same mortgage. So for example if Lehman Brothers structured a one hundred million euro CDO, Goldman Sachs, Morgan Stanley, Citi and others could then go and create a synthetic CDO comprising CDS's

170 Wang, Dezhong; Rachev, Svetlozar T. and J. Fabozzi, Frank. “Pricing Tranches of a CDO and a CDS Index: Recent Advances and Future Research “. Conference paper. In Bol G., Rachev S.T., and Würth R. (Editors) Risk Assessment. Contributions to Economics. Physica-Verlag HD isk Assessment, pp.

263-286. 2009.

171 Hu, Conghui ;Zhang, Xun & Gao, Qiuming. “Synthetic CDO pricing: the perspective of risk integration”. Applied Economics, Vol. 47 , Issue 15, 2015.

172 ‘HOW TO VALUE SYNTHETIC COLLATERALIZED DEBT OBLIGATIONS (CDOS)’. FINCAD. Available at:

http://www.fincad.com/resources/resource-library/article/how-value-synthetic-collateralized-debt-obligations-cdos.

173 Some financial institutions, such as Deutsche Bank, have repackaged riskier loans on their books into CDOs to sell to investors as a way to raise their capital ratios. The investment bank’s 8,700 million CDO contains a mix of residential mortgage-backed securities, commercial loans, corporate CDOs and other asset-backed securities, according to Reuters. Source: ‘CDOs Are Back: Will They Lead to Another Financial Crisis?’. Knowledge@Wharton, April, 2013. Available at:

http://knowledge.wharton.upenn.edu/article/cdos-are-back-will-they-lead-to-another-financial-crisis/

174 In contrast to other derivatives, synthetic CDOs does not entail any social benefit. When issued, they did not finance the ownership of any additional homes or allocate capital more efficiently; it merely swelled the volume of mortgage-backed securities that lost value when the housing bubble burst in 2008. Source: Soros, George. ‘CDOs and CDSs Must Be Regulated Because They Have No Social Benefit’. April 23, 2010. Available at: http://www.businessinsider.com/george-soros-cdos-are-dangerous-and-must-be-regulated-2010-4 .

175 A credit default swap is a swap designed to transfer the credit exposure of fixed income products between two or more parties. In a credit default swap, the buyer of the swap makes payments to the swap’s seller up until the maturity date of a contract. In return, the seller agrees that, in the event that the debt issuer defaults, the seller will pay the buyer the security’s premium as well as all interest payments that would have been paid between that time and the security’s maturity date.

53 on that original Lehman B. CDO. This magnifies risks, interconnectivity and (perhaps most importantly) profits¹⁷⁶.

The pricing and risk management of synthetic CDOs draw on derivatives techniques, similar to those used to price and risk-manage interest rate swaps and credit default swaps.¹⁷⁷ Much of the risk transfer that occurs in the credit derivatives market is in the form of synthetic CDOs¹⁷⁸. If one of the debts on which it has sold a CDS defaults, then the CDO pays the CDS buyer compensation and the CDO investors see their returns cut – just as they would if the CDO really owned the debt that had defaulted. Pricing is especially challenging not only because the synthetic CDO is based on insurance over debt that requires rating (which can be quite unreliable as shown in the following figure, because it doesn’t matter that the debt is rated AAA as it originates in subprime mortgage debt at the end of the day), but because in several leverage stages, pricing mechanism can only

“see” the current and the immediately past stages:¹⁷⁹ ---

176 ‘What Is A Collateralized Debt Obligation (CDO)?’ Wall Street Oasis (IB Oasis Corp. [US]). At:

https://www.wallstreetoasis.com/finance-dictionary/what-is-a-collateralized-debt-obligation-CDO.

177 Gibson, Michael S. “Understanding the Risk of Synthetic CDOs”. July, 2004.

178 Hall, Keith and Stuart, Erin. “Credit Risk Transfer Markets: An Australian Perspective”. Reserve Bank of Australia Bulletin. May, 2003. The authors present am illustrative diagram of a subordination arrangement securitization scheme:

Available at: https://www.rba.gov.au/publications/bulletin/2003/may/2.html.

179 The figure is based on Durden, Tyler. ‘1,125,000,300 = The Number Of Pages Needed To Be Read For Every CDO Squared Purchase’. November 11, 2010. Available at:

http://www.zerohedge.com/article/1125000300-number-pages-needed-be-read-every-cdo-squared-purchase.

54 Let’s take a look to an example of synthetic CDO pricing located at Europe¹⁸⁰. Last year, European financial institutions sold about $6,000 million of such synthetic risk-transfer notes, protecting as much as $100,000 million of debt on their books. So, this accounts for a price of one euro per 16.67 euros of debt. Therefore, the average price of a 1 million euro synthetic CDO would then be 60,000 euros. As I said before, it is basically impossible (a hell) to decide whether this price is fair considering the risk of the derivative instrument. Also interesting is to know which financial institutions commercialised the instruments:

180 Abramowicz, Lisa. ‘A Synthetic CDO by Any Other Name Is Still Risky’. Bloomberg. February 3, 2017.Available at: https://www.bloomberg.com/gadfly/articles/2017-02-03/a-synthetic-cdo-by-any-other-name-is-still-risky.

55 But this is by no means the end of it. CDS’s and CDOs combine together in synthetic CDOs, granted.

Now, Synthetic CDOs are the new basic building blocks of other credit derivatives: a CDS of a CDO offers protection against a CDO defaulting. CDO² is a CDO comprised of notes issued by another CDO. A CDO³ is comprised of CDO² notes and– you get the idea ☺.¹⁸¹