1. Finance Software Projects New York University Adjunct Instructor Scott Burton

2. FSP Introduction Professor Bio Plan for Semester First half: Individual submissions weekly Build foundational components 1 quiz Second half: Form 2 person teams Build a risk management app Presentation/demo at the end Periodic quizes to check your programs and domain knowledge Programming phases evolving to final product Each team votes for best product and presentation

3. FSP Introduction (cont) Class Objectives Software Development! Organization Extensibility Testability Clarity Speed Size ? Rigor around regression testing! Implement living specs provided as spreadsheets Teacher Objectives Student Objectives

4. FSP Introduction (cont) Grading: Weekly programming phases 3 tests Presentation of final app Class participation Attending all classes will help your grade Missing more than two classes will hurt your grade

5. Financial engineering is built on 3 basic principles “Put a financial engineer on a desert island and give him only a few tools, such as the means to calculate the time value of money, the ability to contract on random outcomes, and a legal structure that allows the transferability of financial claims, and most of today’s financial instruments could be re-constructed.” “Origins of Value”

6. Financial engineering is built on 3 basic principles… 1.“Time Is Money” “Inter-temporal value transfer” Otherwise known as a Loan… 2.“Negotiability” Suppose you have loaned someone money for a year. Now you need the cash. You could become a borrower yourself OR you could sell the contract to another person. It saves the trouble of a second contract and creates instance money 3.“Contingent Claims” Allows people to hedge themselves against the risk of an unknown future…

7. Capital Raising Has Money Needs Money Borrows money Issues a bond Financial firms facilitate Charge fee Wants a return (yield) Buys a bond Owns a security Can sell security later

8. Securitization “Turns cumbersome, illiquid financial contracts with governments or other entities (e.g., corporations) into liquid instruments of a smaller denomination that can be easily bought and sold in a capital market.”

9. Pricing function for a financial instrument To value a financial instrument and facilitate making them transferable we need a standard formula to price them. Allows us to calculate the price of a bond given the interest it is contracted to pay and takes into account the current prevailing market (interest rate you could get elsewhere for a similar instrument). Allows us to calculate sensitivities and hedge For a bond it’s the “Yield To Maturity” formula.

10. For Next Week Set up UNIX dev environment on your laptop From the command line: Hello World in C++ Write a Makefile Run your executable from shell script “run.sh”

11. Break

12. Time Value of Money The cumulative present value of future cash flows can be calculated by summing the contributions of FVt, the value of cash flow at time=t The present value (PV) formula has four variables each of which can be solved for: 1)PV is the value at time=0 2)FV is the value at time=n 3) i is the rate at which the amount will be compounded each period (in decimal) 4) n is the number of periods M - “Maturity” (amount loaned) C - “Coupon” (return on loan) i - “Prevailing” interest rate

13. Yield to Maturity Equation - Closed Form (started with a geometric series…) Calculate price of bond with par value of $1,000 to be paid in 10 years, a coupon of 10% and YTM of 12%. Assume coupons are paid semi-annually to bond holders: 1)Determine number of coupon payments (2 per year for 10 years = 20) 2)Determine value of each coupon payment (divide coupon in half since semi- annual). Each payment will be $50 ($1000 * 0.05). 3)Determine the semi-annual yield: Like the coupon rate, the YTM of 12% must be divided by 2.

14. YTM - Frequency Parameterized Accounting for different payment frequencies: Most bonds pay semi-annually but to make our formula more general we extend formula with parameter “F” below. if a bond was paying annual coupons F = 1, quarterly = 4 What is implemented spreadsheet living spec…

15. See spreadsheet living spec Yield Goes up/price goes down Standard sensitivity calculation

16. Capital markets terminology Primary / Secondary Sell-side / Buy-side Long / Short Relative Pricing Risk Transfer Proprietary / Flow Trading Exchange traded / Over the Counter Securitization

17. Class Example Debt Issuance Buy a Bond Transact on Secondary Market Short