1. Unified Financial Analysis Risk & Finance Lab
Chapter 8: Financial Events and Liquidity
Willi Brammertz / Ioannis Akkizidis
We are done now with the input elements which are necessary inputs to calculate all this which will come from now on.

2. From input to analysis elements
Hello
From input to analysis elements
Cost
While the input elements describe the influencing factors, the analysis elements are the basic elements of all types of financial analysis as long as the analysis is in the risk return spectrum (which is financial analysis proper). It follows as a corollary: after deriving these elements we can combine any known financial analysis. Not covered is the forensic part of financial analysis such as anti money laundering or detective work like terrorist financing, which must be considered outside the realm of financial analysis. In chapter 18 we will discuss this claim further.
Very important concepts to introduce in this lecture are:
Input vs. analysis elements
Static vs. dynamic analysis (also: static view is based on the liquidation principle)
Liquidity view vs. value view
Financial events and cash-flows
Discuss in this slide the difference between input and analysis elements
Plus: A detailed discussion of events and Liquidity on the examples given in chapter 3

3. Static analysis (liquidation view) Type I and II analysis
Existing Business
Assets
Existing Business
Time
Liabilities t0
NPV
Time to Maturity
Volatility in t0 ()
Yield

4. Contract events and cash flows
Contract events are the expression of the input elements on the time line given a state of the risk factors (state contingent cash flows)
Contract events are a level higher than cash-flows
Contract events are interpreted in two principally different ways
The idea of financial event is very important and it is necessary to dwell on it, since it is normally not treated in finance. Finance, in general, jumps directly to cash flows which is just one step too fast.
Financial events: the execution of all implied rules of the contract on the time line.
Financial events are one level higher than cash flows. They are necessary, because in finance we have the two views: liquidity and value view. A balance sheet (and P&L) represent the value view. Modern finance is preoccupied almost 100% with the value view. It has however become clear, that the liquidity view cannot be forgotten.
Events constitute rock bottom of finance!
The lack of the event level in book keeping and modern finance can be explained with the following two examples:
From book keeping: It is a very tedious exercise to derive a cash flow statement from a balance sheet and some would say, it is impossible to do it propperly. This is so, because when establishing value the input elements do play a role but they are not properly stored (no event level is stored). The event level is the bridge between the balance sheet (value stream, right side) and the liquiidty statement (liquidity view, left stream). Since this level is lost book keepers try to overcome this by using ancilliary information which is sometimes there and sometimes not.
From option pricing: Liquidity effects related to option pricing are hardly an issue in finance courses on option pricing. Everythign focusses on value only.
This picture demonstrates also, why the focus on value as a starting point of financial thinking is a desaster. Value is already a result containing all the assumptions made with the risk factors. Having condensed all these assumptions into one number of course never lets disentangle anymore the causing factors. The starting point of financial thinking must be the input elements fromw here value and liquidity can be derived not only under current conditions but alos under shocked conditions and even probabilistically.

5. Importance of event level
Rock bottom: The event level contains all information that is possible in finance
Precondition: The input elements must be rich
Contracts and behavior as open dimensions
All financial contracts are homogenous on the event level
E.g. a saving contract and an option „are equal“!
Question: Where are the events in option pricing?
The event level contains all information necessary for financial analysis.
Another very nice property of financial events: on this level all financial contracts become homogenous (e.g. A saving account and an exotic option!)

6. The five analysis elements
Anything of interest in finance can be derived from the financial events
There are only five analysis information of relevance
Liquidity
Value
Income
Sensitivity
Risk
Any financial information is either one of these items directly or a combination of these items

7. Two main distinctions Liquidity vs value-income view
Make a distinction between Liquidation view and liquidity.
Here we talk of liquidity and distinguish it from the value/income view.
This distinction cannot be stressed enough. In this lecture and chapter we discuss mainly events and the liquidity view and in chapter 10 the value view. Since this is not totally separateable we will also point (as far as it is necessary) to the value view in this chapter.
Liquidity ZES (Chapter 10)

8. List of important event types (RiskPro™)
Example of some most important event types

9. Events on the time line Example: Variable annuity
Hello
Events on the time line Example: Variable annuity
This is an example of a variable annuity that reprices every two months and pays interest every quarter (shown are the first six months)

10. Example of events Mathematics (Valuation) kicks in only after the
This is a list of events for an interest rate swap (first eight lines), an FX-swap (next four lines), a fixed PAM (next five lines), a credit line and a limit contract.
It is obvious, that event generation is not a rocket scientist exercise but rather a tedious exercise deriving everything that happens to the contract under the conditions of the risk factors (which are – as a base case – forward conditons in static analysis).
Column H shows the date, I the event type and M the calculated value. Column O shows the effect on the value view and column P the effect on the liquidity view from where all other analysis elements follow.
Mathematics (Valuation) kicks in only after the
Explicit representation of the events.

11. Example 1: Money market Hello
Now we come to the financial events. Each of the following examples is linked to the contracts already described in chapter three (which example links to which contract is described in the book where these examples are taken from).
Important is the differentiation between the last two columns “Liquidity” and “ZES” which refer to the liquidity and the value view. We start with simple examples where liquidity and ZES is the same. The more complex the example get, the more the two drift apart. The exact description is found in the book.
ZES is linked to value but even more to the derivation of sensitivity of value to the risk factors. The meaning of ZES will become even more clear in chapter 10.
For people familiar with Asset&Liability management there is a simple way to explain the difference between the two: A liquidity gap represents the liquidity column and an interest rate sensitivity gap the ZES column.

12. Example 2: Fixed bond Hello Discuss
Why do the interest payments differ? (day count convention)
Why do the dates shift? (business day convention)

13. Example 3: RGM with draw down
Hello
Example 3: RGM with draw down

14. Example 4: Variable rate bond
Hello
Example 4: Variable rate bond
Here we have the first drifting apart of liquidity and ZES.

15. Example 5: Variable annuity Pattern
Hello
Example 5: Variable annuity Pattern

16. Example 5: Variable annuity Events
Hello
Example 5: Variable annuity Events
Here it is interesting to point to the annuity recalculation part

17. Example 6: Swap
A swap is the simple sum of two basic contracts (example 2 + example 4)

18. Example 6: Swap
These are the two legs of a swap. The encircled elements cancel. Note also: the principal events cancel at value date and maturity date in the liquidity view. In the value view it only cancels at value date.

19. Example 7: FRA
This is a very intersting example to demonstrate the difference between value and liquidity view.

20. Example 8: Effect of behavior
Here we show the effect of behavioral elements. The example is on prepayment (lower right matrix)
Since behavior can take any functional form, their derivation and therefore ZES is not clear a priory. The effect can always be derived via shifting the variable of interest and recalculation.

21. Liquidity gap Cash management vs. Liquidity gap
Gap: numerical or graphical representation of liquidity flows on the time line
Needs definition of time buckets
Calculation:
Sum expected cash flows (forward scenario) over all relevant contracts
Group per time bucket
Liquidity gap shows the liquidity line

22. Example: Liquidity gap results Data: Examples 1-6
This is an example of a liquidity gap if the bank would exist only of the four examples in chapter and 8.2.2
Discuss the differrence between marginal and cumulative gap

23. Marginal and cumulative liquidity gap
This is the same result (marginal and cumulative gap) graphically represented. The cumulative gap shows that the position is generally liqudity short, a postion that lasts until H2 02.