The Paris Agreement

The Paris Agreement

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) talks the Paris Agreement.

Introduction

The Paris Agreement is a global agreement that intends to keep global average temperatures below 2 degrees Celsius above pre-industrial levels by the end of the 21st century, with efforts to keep it below 1.5 degrees.

The Paris Agreement was drafted during the Conference of the Parties (COP 21) of the United Nations Framework Convention on Climate Change (UNFCCC21) and signed on December 12, 2015. The agreement was ratified on April 22, 2016, which was recognized as Earth Day by the United Nations, and was signed by all 196 UNFCCC members. In June 2017, President Donald Trump announced that the United States would withdraw from the Paris Agreement, claiming that it was not in the country’s best interests to do so.

Greenhouse gas emissions are considered as the primary cause of global warming.
To accomplish the agreement’s objectives, scientists have agreed that global greenhouse gas emissions must be reduced. As a result, the 20/20/20 targets were established: a 20% reduction in carbon dioxide (CO2) emissions, a 20% increase in renewable energy market share, and a 20% increase in energy efficiency through current technology such as insulation. The signatories are obligated to put efforts through Nationally Determined Contributions (NDCs), and to continue to do so in the future. This includes the duty to report on national emissions and decarbonization initiatives on a regular basis.

To keep global warming to a maximum of two degrees Celsius by 2100, scientists agree that the world will need to become carbon neutral by 2050. The International Panel on Climate Change (IPCC) issued a study in October 2018 warning that in order to meet the lower 1.5-degree objective, emissions must be reduced by 40-60% from 2010 levels by 2030, with net zero by 2050. To meet the less ambitious 2-degree objective, emissions must be reduced by 25%. Failure to do either will result in irreversible climate change beginning around 2030, according to the paper. According to the IPCC, if current levels of (in)activity continue, the 2-degree target will most likely be met by 2030, with global warming of 3 degrees by the end of the century becoming increasingly likely. The IPCC also warned in September 2019 that unless the world takes action now, sea levels will increase by at least one meter by 2100.

According to studies, CO2 produced by burning fossil fuels for power, heating, cooling, and transportation is the primary cause of global warming. Carbon dioxide levels in the atmosphere in 2017 were last seen on Earth three million years ago, according to research from the Potsdam Institute for Climate Impact. Before humans originated, the average surface temperature was 2-3 degrees Celsius higher than pre-industrial levels, and the average sea level was up to 25 meters higher than it is today during the Pliocene Era.

The Working Process

The Paris Agreement’s implementation necessitates economic and societal transformations based on the best available knowledge. The Paris Agreement is structured on a five-year cycle in which countries take more ambitious climate action each year. Countries must submit their climate action plans, known as Nationally Determined Contributions (NDCs) by 2020.

NDCs

Countries need to establish the steps that they will take to alleviate greenhouse gas emissions in their NDCs to align with the Paris Agreement’s agendas. Countries also outline the activities they plan to take to build resilience and adapt to the effects of rising temperatures.

Long-Term Planning

The Paris Agreement called for nations to draft and submit long-term low-carbon development strategies by 2020 in order to effectively define their efforts toward the long-term goal (LT-LEDS).

The long-term vision offered by LT-LEDS is beneficial to Nationally Determined Contributions (NDCs). They are not required, unlike NDCs. Irrespective, they place the NDCs in the context of countries’ long-term planning and development goals, giving them a vision and direction for future development.

How are countries supporting one another?

The Paris Agreement establishes a framework for assisting developing countries with financial, technical, and capacity-building support.

Finance

The Paris Agreement maintains that affluent countries should lead in providing financial support to less developed and vulnerable countries, while also encouraging voluntary contributions from other Parties for the first time. Since large financial resources are required to adjust to the negative effects of climate change and mitigate its consequences, it is imperative to adapt climate finance (financing that supports projects to contribute to climate change).

Technology

The Paris Agreement outlines a goal of fully implementing technological development and transfer in order to improve climate change resilience while also lowering greenhouse gas emissions (GHG) emissions. Through its policy and implementation arms, the mechanism is increasing technology development and transfer.

Capacity-Building

Many of the issues posed by climate change are beyond the capabilities of many developing countries. As a result, the Paris Agreement places a strong emphasis on developing nations’ climate-related capacity-building efforts and calls on all wealthy countries to increase their assistance for such efforts.

How are we tracking progress?

Countries adopted a more transparent framework with the Paris Agreement known as the Enhanced Transparency Framework (or ETF) to report information. Starting in 2024, countries will be required to report honestly on their activities and progress in climate change mitigation, adaptation, and support offered or received under the ETF. It also establishes worldwide protocols for the examination of reports provided.

The data from the ETF will be incorporated into the Global Stocktake, which will assess how far we’ve progressed toward our long-term climate goals. This will lead to recommendations for countries to establish more ambitious targets in the next phase.

What have we achieved so far?

Even though massive improvements in climate change action are required to reach the Paris Agreement’s goals, low-carbon solutions and new markets have already emerged in the years after it went into effect. A growing number of governments, regions, cities, and corporations are setting carbon neutrality goals. Zero-carbon solutions are becoming more competitive across a variety of economic sectors that account for 25% of total emissions. This trend is especially obvious in the electricity and transportation sectors, and it has opened up a slew of new business opportunities for those who get in early.

By 2030, zero-carbon solutions may be competitive in industries that account for more than 70% of world emissions.

Useful resources

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About the author

The article was written in May 2022 by Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

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Social Impact Bonds

Social Impact Bonds

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) talks about Social Impact Bonds.

Introduction

Social impact bonds (also known as a social benefit goods or social bonds) are one-of-a-kind public-private partnerships that use performance-based contracts to fund effective social services. They are a type of financial security that provides capital to the government to fund projects that improve social outcomes while saving money. Impact investors provide capital to help high-quality service providers scale their operations. If and when the project achieves outcomes that generate public value, the government repays those investors.

Social impact bonds transfer the risk from the public sector to the private sector and further align project partners on the achievement of meaningful impact projects. For example, these projects can help low-income mothers have healthy births, reduce carbon emission, or support refugees through job training. In 2010, Social Finance UK issued the first ever social impact bond in the market. Over 160 social impact bonds have been issued in 28 countries, with more than 25 in the United States.

Purpose of Social Impact Bonds

The goal of social impact bonds is more than just to make money. The securities are designed to bring together the interests of various entities, such as governments, investors, social enterprises, and the general public, in order to develop effective solutions to public-sector problems.

Despite the fact that these securities are called bonds, they lack many of the characteristics of traditional bonds. Social impact bonds have a fixed term, but investors do not receive a fixed interest rate of return. Instead, the success of the project that was subsidized with the bonds is what determines whether the bonds are repaid or not.

If a project is successful, the government repays the investors by using the savings generated by the project. The investors, on the other hand, receive nothing if the project fails. As a result, social impact bonds carry a high level of risk for investors.

How Does a Social Impact Bond Work?

Social impact bonds are often differentiated from other fixed-income securities by the number of key players involved in the capital-raising process. It is further illustrated by Figure 1 and the steps involved are mentioned below.

Figure 1. Social Impact Bond Working Process.

 Social Impact Bond Working Process

Source: Social Finance, UK .

1. Partner

The government determines the social issue and the goal by working with an intermediary, such as Social Finance, and high-performing service providers (organizations with a track record of success and evidence that their programs work) to achieve its goal.

2. Develop & finance

The project’s design, negotiation, and financial structure are all driven by Social Finance in collaboration with the government and the provider. Then, to provide upfront, flexible funding, the project raises capital from impact investors.

3. Deliver services

With ongoing support from Social Finance, the provider provides services to the target population, including governance oversight, performance management, course corrections, financial management, and investor relations.

4. Attain positive results

People in need can improve their lives by having healthy births, raising kindergarten-ready children, staying out of prison, and finding and keeping good jobs with the help of high-quality services.

5. Measure the outcomes

The impact of the project is measured by an independent evaluator using predetermined outcome metrics. If the project is a success, the government reimburses the project’s backers. The government, on the other hand, only pays based on the level of results achieved.

A Social Impact Bond in Practice

In 2010, the United Kingdom’s Peterborough Prison issued one of the world’s first social impact bonds. The bond raised £5 million from 17 social investors to fund a pilot project aimed at lowering short-term prisoner re-offending rates. Over the course of six years, the relapse or re-conviction rates of Peterborough inmates will be compared to the relapse rates of a control group of inmates.

The Peterborough Social Impact Bond was declared a success by the Ministry of Justice in 2017, with a 9 percent reduction in reoffending of short-sentenced offenders compared to a control group, exceeding the bond’s target of a reduction 7.5 percent. As a result, investors received a yearly return of 3%.

Useful resources

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About the author

The article was written in May 2022 by Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

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The World 10 Most Sustainable Companies in 2021

The World 10 Most Sustainable Companies in 2021

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) talks about the World 10 Most Sustainable Companies in 2021.

Introduction

The Corporate Knights’ yearly list is a ranking of the 100 most sustainable companies. It is based on the analysis of companies with revenues over $1 billion (8,080 companies in 2021). This year marks the 17th year of the list.

This list is usually revealed during the World Economic Forum in Davos. The Davos Agenda is a ground-breaking gathering of world leaders to shape the values, policies, and alliances required in this difficult new environment. The World Economic Forum has been a trusted venue for leaders from business, government, international organizations, civil society, and academia to assemble at the start of each year to discuss crucial issues.

In 2021, the breakdown of the most sustainable firms by geographical areas is as follows:

  • 46 in Europe
  • 33 in North America
  • 18 in Asia
  • 2 in South America
  • 1 in Africa

The top 10 most sustainable corporations of 2021 are as follows:

1. Schneider Electric SE, France
2. Orsted A/S, Denmark
3. Banco do Brazil SA, Brazil
4. Neste Oyj, Finland
5. Stantec Inc, Canada
6. McCormick & Company Inc, United States
7. Kering SA, France
8. Metso Outotec, Finland
9. American Water Works Company Inc, United States
10. Canadian National Railway Co, Canada

We detail below the characteristic of each company in the dimension of sustainability.

1. Schneider Electric SE

Industry: Electrical Equipment
Location: France
Year Founded: 1836

Schneider Electric has been named the world’s most environmentally friendly firm. This European energy and automation multinational corporation was praised for its quick and consistent response to ESG – environmental, social, and governance – issues, moving up from 29th place in 2020.

Schneider Electric is helping to reduce CO2 emissions and the rise of the Earth’s temperature by focusing on innovative and renewable alternatives. Its efforts are assisting in the prevention of global warming and the production of ecologically friendly goods that improve energy access.

The core of Schneider Electric’s strategy, according to Chair and CEO Jean-Pascal Tricoire, is to build a sustainable business and organization. Schneider has long been committed to environmental issues, and it continues to raise the bar for itself, its customers, and its partners.

2. Ørsted A/S

Industry: Electricity Generation
Location: Denmark
Year Founded: 2006

After vowing to combat climate change with renewable energy, Ørsted was voted the world’s second most sustainable company. Despite dropping to second position in 2020, the Danish power company is still the world’s most sustainable energy provider, a title it has held for three years.

The corporation, which is also renowned as one of the top renewable energy generators, has switched its operations from fossil fuels to renewable energy and has set a goal of becoming carbon neutral by 2025.

Ørsted CEO Mads Nipper said the company’s strong placement in the Global 100 report underlines both its commitment to driving a successful and sustainable business and its resolve to become a catalyst for green energy change. He also stated that in order to be effective in the fight against climate change – and to stay in business – all businesses must adopt a sustainable business model.

3. Banco do Brazil SA

Industry: Financial Services
Location: Brazil
Year Founded: 1808

Banco do Brazil, Brazil’s, and Latin America’s largest bank by assets, is also one of the most sustainable companies. The 212-year-old bank aspires to be inclusive and contribute to digitally improving society by providing internet access and supporting education by fostering innovation and motivating entrepreneurs.

In 2020, the government-owned corporation was ranked ninth, but it has quickly risen through the ranks this year.

4. Neste Oyj

Industry: Oil and Gas Industry
Location: Finland
Year Founded: 1948

Neste is a global pioneer in sustainability, with products such as renewable diesel, sustainable aviation fuel, chemical recycling to reduce plastic waste, and raw material refining innovation. The Finnish company dropped from third to fourth place in a year, but it has been on the Corporate Knights Global 100 Index for the 15th year in a row, far longer than any other global energy company.

The company’s mission of making the world a better place for our children, according to Peter Vanacker, President and CEO of Neste, drives them to strive for greater heights every day. Many companies are constantly improving their sustainability programs, making it more difficult to make the list each year. More businesses are actively implementing sustainability into their operations, which is encouraging.

5. Stantec Inc.

Industry: Engineering, Architectural Design
Location: Canada
Year Founded: 1954

Stantec is not only one of the most ecologically responsible companies in the world, but it is also a leader in North America. Clean earnings and clean investment, which are goods and services with a demonstrated environmental and social impact, accounted for half of the company’s overall score.

Gord Johnston, President and CEO of Stantec, remarked that its remarkable track record on sustainability is the result of its people’s deep commitment and good leadership throughout the company’s global operations. Its teams are striving to improve sustainability in its own operations and aiding clients in developing and achieving sustainability goals.

6. McCormick & Company Inc.

Industry: Processed & Packaged goods
Location: U.S.A.
Year Founded: 1889

McCormick & Company is not just the world’s sixth most sustainable company, but it is also the leader in the food market. Since the index’s debut five years ago, the packaged and processed foods industry in the United States has advanced 16 points to its highest position.

According to Lawrence E Kurzius, Chairman, President of McCormick & Company, it has never been more important to work together for the future of flavor and to limit its impact on the environment. The company is dedicated to producing clean revenue, providing renewable energy projects, and making the transition to 100% circular packaging.

7. Kering SA

Industry: Luxury
Location: France
Year Founded: 1963

Gucci, Saint Laurent, Bottega Veneta, Ulysse Nardin, and Pomellato’s parent business are the only luxury brands to make the top 10 sustainable companies list.

When measured against 24 quantitative key performance indicators (KPIs), including resource management, people management, financial management, clean revenue and investment, and supplier performance, Kering maintained its strong position. In order to build the future of luxury, sustainability is promoted at every level of governance, from the Board of Directors to the operational managers.

Kering’s vow to protect the environment on which it relies, according to the CEO Dr. M Sanjayan, is a big step forward for the fashion business, and it offers a massive doorway for the luxury sector to influence the people and help rethink fashion and luxury goods.

8. Metso Outotec

Industry: Industrial Machinery
Location: Finland
Year Founded: 2020

Metso Outotec is ranked 8th on the Global 100 Index, a global leader in sustainable technology and services for the recycling, aggregates, and mineral processing industries. In order to have a good impact on the globe as a sustainable leader, the Finland-based firm has set a number of lofty goals, including reducing global warming to 1.5 degrees Celsius.

Piia Karhu, Senior Vice President Business Development at Metso Outotec, remarked that their customers in the aggregates and metals and minerals industries are focused on producing sustainable goods and services. They collaborate with their customers, partners, and communities to advance sustainable innovation.

9. American Water Works Company

Industry: Utilities, Water and Wastewater
Location: U.S.A.
Year Founded: 1886

Because of its leadership and transparency, American Water is one of the top ten sustainable firms. The largest publicly listed water and wastewater utility firm in the world, founded in 1886 and employing over 6,800 people, is based in the United States.

Despite serving 15 million people in 46 states, the company saves 12.5 billion liters of water each year through efficiency measures. It has also promised to reducing greenhouse gas emissions by 40% by 2025.

10. Canadian National Railway Company

Industry: Rail Transport
Location: Canada
Year Founded: 1919

The lone railway company on the list for 2021 was the Canadian National Railway. The railway conglomerate adheres to a global standard for sustainability activities, adhering to the UN Global Compact principles and the Sustainable Development Goals of the United Nations (SDGs).

Useful resources

General resources

Top 10 sustainable companies

Related posts on the SimTrade blog

About the author

The article was written in May 2022 by Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

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Dow Jones Sustainability Index

Dow Jones Sustainability Index

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) talks about Dow Jones Sustainability Index (DJSI).

Introduction

The Dow Jones Sustainability Index (DJSI) was established in 1999 to honor publicly traded companies that excel in the field of sustainability. As of 2021, it includes 323 companies from a variety of industries that stand out for their outstanding environmental, social, and governance (ESG) performance.

The DJSI was created by S&P Dow Jones Indices (one of the world’s leading resources for benchmark and investable indices) and SAM (corporate sustainability assessment issued by S&P Global) to select the most sustainable companies from 61 industries, combining the experience of an established index provider with the expertise of a specialist in Sustainable Investing.

The indices act as a benchmark for investors who incorporate sustainability considerations into their portfolios, as well as a platform for investors who want to encourage companies to improve their corporate sustainability practices.

Understanding DJSI

Companies that are included in the DJSI gain not only public recognition and a high level of acceptance from their stakeholders (for their best practices in this field), but they also become a benchmark for many other companies that aspire to be included in the index and want to improve their ranking to be among the best in the world. It is also a key tool for investors, who find these companies appealing and trustworthy, and value them for including policies like these in their strategy, which outperforms other organizations in terms of long-term profitability.

Being accepted into the Dow Jones Sustainability Index is a difficult task. Companies need to pass a rigorous assessment questionnaire with approximately 600 indicators that measure various criteria relating to their corporate governance, code of ethics and conduct, risk management, business, and providers in order to be included in this demanding ranking. Other environmental aspects are also investigated, such as the development of products and programs that are more environmentally friendly and promote efficiency, as well as initiatives aimed at defending human rights, encouraging talent retention and financial inclusion, and improving employee health and well-being.

S&P Global, the world’s largest index provider, is in charge of verifying each of the indicators using a questionnaire with 100 questions about the companies’ environmental, social, and governance performance. The businesses are then graded on a scale of one to one hundred points. Analysts at S&P Global also look at how companies break down public information in their communications with analysts and investors. Only those who achieve the highest ranking in their field of activity are invited to join the DJSI.

Example

MAPFRE is included in the Dow Jones Sustainability World Index for the third year in a row (from 2016 to 2019), with a total score of 77 out of 100. In the areas of customer relationship management, principles for sustainable insurance, social and environmental reporting, and financial inclusion, the company has improved its environmental and social rating and received the highest score (100 points).

MAPFRE has set more than 30 objectives for 2021 to address global issues such as climate change and inequality. It does so as part of its commitment to sustainability and in accordance with its Sustainability Plan 2019–2021, a roadmap that lays out a series of projects aimed at helping the company achieve carbon neutrality, become a leader in the circular economy, promote women’s leadership, and improve financial education, among other objectives.

Methodology

Based on the companies’ Total Sustainability Scores from the annual S&P Global Corporate Sustainability Assessment, the DJSI uses a transparent, rules-based component selection process (CSA). For inclusion in the Dow Jones Sustainability Index family, only the top-ranked companies in each industry are chosen. This process does not exclude any industries. The methodology used by S&P Global to build the DJSI index family is illustrated in Figure 1.

Figure 1. S&P Global methodology for the DJSI index family.
MSCI ESG Classification
Source: S&P Global.

As mentioned by S&P Global on its website, the DJSI is rebalanced quarterly and is reviewed each year in September based on the S&P Global ESG Scores resulting from the annual SAM CSA.

Index family

As shown in the following list, the Dow Jones Sustainability Index family includes global, regional, and country benchmarks:

  • DJSI World
  • DJSI North America
  • DJSI Europe
  • DJSI Asia Pacific
  • DJSI Emerging Markets
  • DJSI Korea
  • DJSI Australia
  • DJSI Chile
  • DJSI MILA Pacific Alliance

S&P Dow Jones Indices also offers DJSI Indices with exclusion criteria such as Armaments & Firearms, Alcohol, Tobacco, Gambling, and Adult Entertainment for investors who want to limit their exposure to controversial activities.

All DJSI indices are calculated and disseminated in real time, in both price and total return versions.

Useful resources

Related posts on the SimTrade blog

About the author

The article was written in May 2022 by Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

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Implied Volatility

Jayati WALIA

In this article, Jayati WALIA (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) explains how implied volatility is computed from option market prices and a option pricing model.

Introduction

Volatility is a measure of fluctuations observed in an asset’s returns over a period of time. The standard deviation of historical asset returns is one of the measures of volatility. In option pricing models like the Black-Scholes-Merton model, volatility corresponds to the volatility of the underlying asset’s return. It is a key component of the model because it is not directly observed in the market and cannot be directly computed. Moreover, volatility has a strong impact on the option value.

Mathematically, in a reverse way, implied volatility is the volatility of the underlying asset which gives the theoretical value of an option (as computed by Black-Scholes-Merton model) equal to the market price of that option.

Implied volatility is a forward-looking measure because it is a representation of expected price movements in an underlying asset in the future.

Computation methods for implied volatility

The Black-Scholes-Merton (BSM) model provides an analytical formula for the price of both a call option and a put option.

The value for a call option at time t is given by:

 Call option value

The value for a put option at time t is given by:

Put option value

where the parameters d1 and d2 are given by:,

call option d1 d2

with the following notations:

St : Price of the underlying asset at time t
t: Current date
T: Expiry date of the option
K: Strike price of the option
r: Risk-free interest rate
σ: Volatility of the underlying asset
N(.): Cumulative distribution function for a normal (Gaussian) distribution. It is the probability that a random variable is less or equal to its input (i.e. d₁ and d₂) for a normal distribution. Thus, 0 ≤ N(.) ≤ 1

From the BSM model, both for a call option and a put option, the option price is an increasing function of the volatility of the underlying asset: an increase in volatility will cause an increase in the option price.

Figures 1 and 2 below illustrate the relationship between the value of a call option and a put option and the level of volatility of the underlying asset according to the BSM model.

Figure 1. Call option value as a function of volatility.
Call option value as a function of volatility
Source: computation by the author (BSM model)

Figure 2. Put option value as a function of volatility.
Put option value as a function of volatility
Source: computation by the author (BSM model)

You can download below the Excel file for the computation of the value of a call option and a put option for different levels of volatility of the underlying asset according to the BSM model.

Excel file to compute the option value as a function of volatility

We can observe that the call and put option values are a monotonically increasing function of the volatility of the underlying asset. Then, for a given level of volatility, there is a unique value for the call option and a unique value for the put option. This implies that this function can be reversed; for a given value for the call option, there is a unique level of volatility, and similarly, for a given value for the put option, there is a unique level of volatility.

The BSM formula can be reverse-engineered to compute the implied volatility i.e., if we have the market price of the option, the market price of the underlying asset, the market risk-free rate, and the characteristics of the option (the expiration date and strike price), we can obtain the implied volatility of the underlying asset by inverting the BSM formula.

Example

Consider a call option with a strike price of 50 € and a time to maturity of 0.25 years. The market risk-free interest rate is 2% and the current price of the underlying asset is 50 €. Thus, the call option is ‘at-the-money’. If the market price of the call option is equal to 2 €, then the associated level of volatility (implied volatility) is equal to 18.83%.

You can download below the Excel file below to compute the implied volatility given the market price of a call option. The computation uses the Excel solver.

Excel file to compute implied volatility of an option

Volatility smile

Volatility smile is the name given to the plot of implied volatility against different strikes for options with the same time to maturity. According to the BSM model, it is a horizontal straight line as the model assumes that the volatility is constant (it does not depend on the option strike). However, in practice, we do not observe a horizontal straight line. The curve may be in the shape of the alphabet ‘U’ or a ‘smile’ which is the usual term used to refer to the observed function of implied volatility.

Figure 3 below depicts the volatility smile for call options on the Apple stock on May 13, 2022.

Figure 3. Volatility smile for call options on Apple stock.
Apple volatility smile
Source: Computation by author.

Excel file for implied volatility from Apple stock option

We can also observe that the for a specific time to maturity, the implied volatility is minimum when the option is at-the-money.

Volatility surface

An essential assumption of the BSM model is that the returns of the underlying asset follow geometric Brownian motion (corresponding to log-normal distribution for the price at a given point in time) and the volatility of the underlying asset price remains constant over time until the expiration date. Thus theoretically, for a constant time to maturity, the plot of implied volatility and strike price would be a horizontal straight line corresponding to a constant value for volatility.

Volatility surface is obtained when values for implied volatilities are calculated for options with different strike prices and times to maturity.

CBOE Volatility Index

The Chicago Board Options Exchange publishes the renowned Volatility Index (also known as VIX) which is an index based on the implied volatility of 30-day option contracts on the S&P 500 index. It is also called the ‘fear gauge’ and it is a representation of the market outlook for volatility for the next 30 days.

Useful resources

Academic articles

Black F. and M. Scholes (1973) “The Pricing of Options and Corporate Liabilities” The Journal of Political Economy, 81, 637-654.

Dupire B. (1994). “Pricing with a Smile” Risk Magazine 7, 18-20.

Merton R.C. (1973) “Theory of Rational Option Pricing” Bell Journal of Economics, 4, 141–183.

Business

CBOE Volatility Index (VIX)

CBOE VIX tradable products

Related posts on the SimTrade blog

   ▶ Gupta A. Options

   ▶ Walia J. Black-Scholes-Merton option pricing model

   ▶ Walia J. Brownian Motion in Asset Pricing

   ▶ Walia J. Standard deviation

About the author

The article was written in May 2022 by Jayati WALIA (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

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A quick presentation of the Private Equity field…

Louis DETALLE

In this article, Louis DETALLE (ESSEC Business School, Grande Ecole – Master in Management, 2020-2023) explains what does an M&A daily life looks like.

What does Private Equity consist in?

Private Equity, represents fundamental and indispensable funding-support throughout the life cycle of the company.
Private equity consists in taking (minority or majority) stakes in the capital of (small or medium) companies which are generally unlisted on the stock exchange. It is therefore a method of financing companies in order to support them on the path to growth in the relatively short term. Indeed, the objective of the private equity fund is obviously to realize a capital gain at the exit, after 5 to 8 years in general, the time for the invested capital to generate a return on investment.

What are the main categories of Private Equity?

Venture capital

This type of capital investment is mainly aimed at small businesses/start-ups. Its target is to launch the activity of a company in the creation or start-up phase. Indeed, for a start-up, it is often difficult and premature to call on bank loans that follow very specific and very standardized covenants.

Development capital / growth capital

It aims at entering the capital of a company that has reached a certain maturity and profitability. The funds collected will then be used for internal and external growth: respectively the development of the company’s offers in order to develop its activities or the acquisition of competitors.

Turnaround capital

This type of capital investment aims at restructuring a company in difficulty. The call for bank financing having generally become impossible when the company experiences a major crisis, the turnaround capital fund will enter the capital to allow the company to reconnect with profitability and profits.

Transmission capital

This mode of capital entry is observed when a change of owner occurs. The objective is to ensure the gradual transition and preserve the profitability of the company. Traditionally, the LBO “leveraged buy-out” or the LMBO “leveraged management buy-out” is used, i.e. its buyout by the debt of a holding company constituted especially for the occasion.

What does an analyst in private equity work on?

The tasks of a Private Equity analyst are diverse and include, for example, the producing and challenging a business plan, modelling different scenarios and strategies in Excel. The analyst and the investment teams of the private equity teams thoroughly analyze the companies seeking for funding. They try to determine whether the projections of the seeked investment are reasonable and not overestimated. Indeed, bear in mind that private equity funds intend to fund companies trough equity. And as equity investors (shareholders) are reimbursed at last in the event of a bankruptcy, their work is to determine if the company will really generate growth with the capital at stake. That’s why deep sector-analysis are also required from a private equity analyst.

About the author

The article was written in April 2022 by Louis DETALLE (ESSEC Business School, Grande Ecole – Master in Management, 2020-2023).

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A quick presentation of the M&A job…

Louis DETALLE

In this article, Louis DETALLE (ESSEC Business School, Grande Ecole – Master in Management, 2020-2023) explains what does an M&A daily life looks like.

What does M&A consist in?

Mergers & Acquisitions (M&A) is a profession that advises companies wishing to develop their external growth, i.e. growth through the acquisition of a company or through a merger with it. M&A mandates are therefore carried out on the side of the company that wishes to acquire another company, “buy-side”, or on the side of a company that wishes to be acquired, “sell-side”.

What does an analyst work on?

The tasks of an M&A analyst are diverse and include, for example, drawing up a business plan, modelling different scenarios and strategies in Excel, and drafting information memorandums (IMs) on the various deals in progress. All these skills are then widely used for the mergers and acquisitions of companies, in the development of their external strategy, in their financial evaluation or in the analysis of databases. Overall, M&A allows you to move into any sector of finance and this is part of the reason why it is so attractive.

Why does M&A jobs appeal so much to students?

First of all, it is the dynamic working atmosphere that investment banking enjoys that also attracts young graduates. M&A is indeed marked by a culture of high standards and maximum commitment, with highly responsive teams and extremely competent colleagues. Working in a quality team is very stimulating, and often makes it possible to approach the workload with less apprehension and to rapidly increase one’s competence. The remuneration is also much higher than in other professions at the beginning of a professional career for a young graduate and it progresses rapidly. Finally, it is also the exit hypotheses that attract young M&A analysts.

What are the main exits for M&A?

Most professionals who started out in M&A move on to other types of activities where experience in this sector is required. This is particularly the case in private equity. After advising companies on their growth and expansion projects, the young investment banker has all the tools needed to work in investment funds. The skills are indeed transposable to the financial and strategic questions that private equity funds ask themselves in order to obtain a return on investment.

Switching to alternative portfolio management (hedge funds) is also a possibility. Hedge funds can invest in different types of assets such as commodities, currencies, corporate or government bonds, real estate or others. As a former M&A analyst, you have the skills to analyse the market and determine the assets that seem to be the most appropriate and profitable.

Finally, some former M&A bankers switch to corporate M&A, which involves determining which companies or subsidiaries the company should buy or sell. This can be a very interesting area as you have the opportunity to follow the acquisition of a company from start to finish and therefore take a long-term view of the company’s strategy.

Useful resources

Décideurs magazine Rankings for M&A banks in France (league tables)

About the author

The article was written in April 2022 by Louis DETALLE (ESSEC Business School, Grande Ecole – Master in Management, 2020-2023).

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Warren Buffet and his basket of eggs

Warren Buffet and his basket of eggs

Rayan AKKAWI

In this article, Rayan AKKAWI (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021-2022) analyzes the two following quotes “Do not put all eggs in one basket” and “Put all your eggs in one basket and watch that basket” often used by Warren Buffet to describe his investment strategy.

“Do not put all eggs in one basket”

I particularly liked this quote first because it is said by the world’s greatest investor and one of the richest people on the planet, Warren Buffet. I aspire this man due to his great investment philosophy which is to invest in great businesses at value for money prices and then by using the “buy and hold strategy” keep the stocks over the long term. He has bought great brands such as Coca Cola, Microsoft, and American Express. Second, I like this quote particularly because it is dedicated to any person who has little or no knowledge in investment, so it is easy to implement.

Analysis

If we analyze the wealthiest people in the world, they are entrepreneurs who have created companies that grew exponentially in value. For example, Bill gates who is the founder of Microsoft (1975), Jeff Bezos who is the founder of Amazon (1994), and Mark Zuckerberg who is the founder of Facebook (2004). And as we continue to analyze these founders, we come to realize that they have made their wealth by putting all their eggs in one basket at least early in their lives. However, not all of us have this entrepreneurial spirit and business success such as these brilliant men. Thus, when Warren Buffet said “do not put all eggs in one basket” he was referring to an average person who has little knowledge in investments. Therefore, he advocates investment into index tracker or passive funds which have the benefit of low charges, better performance, and large diversification than most active managed funds. This involves a buy and hold strategy which keeps share dealing charges low. Thus, it is always recommended to have 80% of investments in passive funds which are low cost, predictable, and conservative funds and 20% of investments in satellite which usually involve higher charges with greater volatility and greater returns.

Another way of looking at it is the following. One might decide to invest a certain number of personal wealth in a new business or in crypto. This would be a risky type of investment because another competitor might release a better and more attractive or even more affordable version of the product or service. Eventually, this might put you out of business if a customer writes a bad review of your product or business or if the bitcoin value drops.

So before you invest more time and money in your business, consider how you can manage your risk. First, you must think about your risk tolerance which depends on your age and current financial obligations. Second, you need to keep sufficient liquidity in your portfolio by setting aside an emergency fund that should be equal to 6 to 8 months’ expenses. For ensuring that there is easy accessibility to emergency funds, you should have low-risk investment options like Liquid Funds and Overnight Funds in your accounts. Then you need to determine an asset allocation strategy that works which refers to investing in more than one asset class for reducing the investment risks and this strategy also provides you with optimal returns. You can invest in a perfect mix of key asset classes like Equity, Debt, Mutual Funds, real estate, etc. One of the asset allocation strategies is to invest in a combination of asset classes that are inversely correlated to each other. After you have found the best mix of asset classes for your portfolio, you can reduce the overall investment risk by diversifying your investment in the same asset class. Think about diversifying by offering more than one product or service. To avoid liquidity risk, it is always better to stay invested in blue chip stock or fund. Investors should check the credit rating of debt securities to avoid default risk.

“Put all your eggs in one basket and watch that basket”

At the same time, Warren Buffet believes that diversification makes little sense if a person doesn’t know exactly what he or she is doing. Diversification is a protection against ignorance and is for people who do not know how to analyze businesses. Sometimes it is enough to invest in two or three companies that are resistant to competition rather than fifty average companies due to less risk. That is why it is as critical for a person to invest in a company where its values and vision are similar to that of the investor and to be able to watch closely the performance of that business and its stocks.

Thus, Warren Buffet believes that it is extremely crucial to be able to “watch your basket” or your stocks closely to better understand the stock market. For example, when the stock market is going down, it is the best way to start buying stocks because businesses will be selling at a discount.

Why should I be interested in this post?

One would be interested to read this post because it introduces the basics of investing in stock markets for an average person who has little knowledge in investments or for a student studying business. As a student, it is crucial and important to be able to have at least a general idea of the basic rules of investments and especially those stated by one of the most famous investors in the world such as Mr. Warren Buffet. Whether you are interested in buying stocks yourself or whether you are not, as a business student, you might be asked about investments and the financial market one time in your life and knowing some useful information about investments will be impressive for you. It will allow you to understand the bigger picture of financial markets, give some recommendations for your family and friends, and help you invest yourself in the safest and most successful way.

Useful resources

Berkshire Hathaway

Related posts on the SimTrade blog

   ▶ Louraoui Y. Portfolio

   ▶ Louraoui Y. Passive Investing

   ▶ Louraoui Y. Active Investing

   ▶ El Qamcaoui Y. The Warren Buffett Indicator

About the author

The article was written in May 2022 by Rayan AKKAWI (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021-2022).

Posted in Contributors, Financial techniques | Tagged , , | Leave a comment

Big data in the financial sector

Big data in the financial sector

Rayan AKKAWI

In this article, Rayan AKKAWI (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021-2022) explains the role of big data in the financial sector.

Big data is a term used for contemporary technologies and methodologies that are used to collect, process, and analyze complex data. Today, data is being created at an exponential rate. In fact, and according to a 2015 IBM study, 90% of the data in the world has been created in the past two years. As big data gets bigger, it becomes even more important and essential for executives in the financial sector to stay ahead of the curve. Also, it is expected that data creation will continue to grow moving forward in time.

Big Data in The Financial Sector

For decades, financial analysts have relied on data to extract insights. Today, with the rise of data science and machine learning, automated algorithms and complex analytical tools are being used hand in hand to get a head of the curve in diferetn areas of the financial sector.

Fraud prevention

First, data has helped with fraud prevention such as identity theft and credit card schemes. Abnormally high transactions from conservative spenders and out of region purchases often signal credit card fraud. Whenever this happens, the card is automatically blocked, and a notification is sent out to the card owner. This protects users, insurance companies, and banks from huge financial loses in a small period. This also made things even easier and more practical avoiding the hassle of having to call and cancel the card. Data science comes in the form of tool like random forests that can detect a certain suspicion. In addition, and to lower the chance of identity theft, data has helped ease this process through 3D passwords, text messages, and PINT code which have backed up the safety of online transactions.

Anomaly detection

Second, data has helped the financial sector through anomaly detection. Data analysis is not only created to avoid a problem but also to detect it. For example, data today helps with catching illegal insider traders. To do so, data analysts created anomaly detection algorithms that can analyze history in trading patterns and thus detect and catch abnormal transactions of illegal traders.

Customer analytics

Third, data has helped with improving customer analytics. Data analyzes previous behavioral trends of consumers based on historical transactions and then makes future predictions of how consumers are likely to act. With the help of socioeconomic characteristics, we can create clusters of consumers and group customers based on how much money we expect to gain or lose from each client in the future. Following that, we can come up with decisions to focus on a certain type of clients to make profits and cut on other customers to make savings. Thus, financial institutions minimize human errors by utilizing data science. To achieve that, first, by identifying uncertain interactions and then monitor them going forward. Finally, prioritizing the investments most vulnerable at a given time. For example, banks use this approach to create adaptive real risk score time models to identify risky clients and those who are suitable for a mortgage or a loan.

Algorithmic trading

Fourth and most importantly data has created algorithmic trading. Machines make trading based on algorithms multiple times every second with no need for approval by a stand-by analyst. These trades can be in any market and even in multiple markets simultaneously. Thus, algorithmic trading has mitigated opportunity costs. Thus, there are algorithmic rules that can help in identifying if there is a need to trade or not to trade and reinforces business models where errors are highly penalized and then adjust hyper parameters. We can see algorithms that exploit arbitrage opportunities where they can find inconsistencies and make trades which can cause problems. The huge upside is that it is high frequency trading; whenever it will find an opportunity to make a trading, it will. However, the downside is that imprecision could lead to huge losses due to lack of human supervision. That is why sometimes human interventions are needed.

Conclusion

Thus, we can say that data has become the hottest commodity that results in getting an edge over competition. Financial institutions spend a huge amount of money to get exclusive rights to data. By having more information, they can construct better models. The most valuable commodities are not analysts but the data itself. That is how the data science has revolutionized finance.

Characteristics of Big Data

When talking about Big Data, four main characteristics need to be considered to understand the why Big Data plays a transformational role in the financial sector: volume, variety, velocity, and value.

Volume

First, the amount also known as volume of data being produced on daily basis by users has been increasing exponentially by users. This large output of data has helped create Zettabytes (1012 Gigabyte) and Yottabytes (1015 Gigabyte) of datasets in which companies can benefit by extracting knowledge and insights out of it. However, this amount of data cannot be processed using regular computers and laptops. Since they would require a lot of processing power.

Variety

Second, as the massive amount of data is being generated by multiple sources, the output of this data is unstructured making it hard to organize the data extract insights. Raw data extracted from the source without being processed does not provide any value to business as it does provide stakeholders with the ability to analyze it.

Velocity

Third, to address the issue of processing technological advancements have brought us to the tipping point where technologies such as cloud computing have enabled companies to process this large amount of data by utilizing the ability to share computational power. Furthermore, cloud platforms have not only helped in the processing part of data but by the emergence or cloud solution such as data lakes and data warehouses. Businesses are able to store this data in its original from to make sure that they can benefit from it.

Value

Finally, this brings us to the most important aspect of Big Data and that in being able to extract insights and value out of the data to understand what it is telling us. This process is tedious and time consuming however with ETL tool (Extract Transform Load) the data in its raw format is transformed so that standardized data sets can be produced. Insights can be extracted through Business Intelligence (BI) tools to create visualization that help business decisions. As well as predictive artificial intelligence models that help business predict when to take a strategic decision. In the case of financial markets, these decisions are when to buy or sell assets, and how much to invest.

Challenges Solved by Big Data in the Financial Industry

Utilizing Big Data in the finance industry presents a lot of benefits and helps the industry to overcome multiple challenges.

Data Quality

As previously mentioned, the multiple data sources present a huge challenge from a data management standpoint. Making it an ongoing and a tedious effort to maintain the integrity and the reliability of the records collected. Therefore, adding information processing systems and standardizing the data gathering and transformation processes helps improve the accuracy of the decision-making process, especially in financial services companies where real-time data enables fast decision making and elevates the performance of companies.

Data Silos

Since financial data comes from multiple sources (applications, emails, documents, and more), the use of data integration tools help simplifies and consolidate the data of the institution. These technologies facilitate processes and make them faster and more agile, which are important characteristics in the financial markets.

Robo-Advisory

Big Data and analytics have had a huge impact on the financial advisory sector. Where financial advisors are being replaced by machine learning algorithms and AI models to manage portfolio and provide customers with personalized advice and without human intervention.

Why should I be interested in this post?

This article is just an eye opener on the trends and the future state of the financial industry.

Like many other industries, the financial sector is becoming one of the most data driven field. Therefore, as future leaders it is vital to keep track and push towards data driven solutions to excel and succeed within the financial sector.

Useful resources

The Future of Cognitive Computing

Five Ways to Use RPA in Finance

About the author

The article was written in May 2022 by Rayan AKKAWI (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021-2022).

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Fiche Métier : Térsorier

Fiche Métier : Térsorier

Emma LAFARGUE

Dans cet article, Emma LAFARGUE (ESSEC Business School, Grande Ecole – Master in Management, 2020-2024) décrit le métier de trésorier.

Que fait un trésorier ?

Le trésorier est la personne en charge des différents flux monétaire de l’entreprise. C’est lui qui gère la répartition et la distribution des liquidités (paiement des prestataires, rémunération des salariés) et qui veille à la stabilité financière. Il doit s’assurer que l’entreprise dispose d’un fonds de roulement suffisant pour son fonctionnement quotidien, c’est lui qui place l’argent et décide du financement et des investissements (en lien avec la direction stratégique)

Concrètement, ses missions au quotidien sont de :

  • Contrôler les dépenses et recettes de l’entreprise
  • Tenir le registre des différents mouvements financiers
  • Gérer les liquidités, c’est-à-dire veiller au remboursement des emprunts et à la rentabilité des investissements
  • Etudier les risques liés aux perspectives de placement

Avec qui travaille un trésorier ?

Le trésorier est en lien constant avec la direction de l’entreprise afin de décider de la stratégie de financement, de se mettre d’accord sur les investissements et les placements à effectuer.
Le trésorier est également le principal interlocuteur des banques et des investisseurs.

Enfin, il travaille en interaction avec les comptables, en charge de l’aspect technique des transactions financières : ils enregistrent les opérations et formulent des déclarations. Le trésorier quand-à-lui, est chargé des fonds directement.

Combien gagne un trésorier ?

Un trésorier gagne entre 3 700€ et 6 000€ brut par mois. Cependant, le salaire d’un trésorier junior varie entre 36 000€ et 48 000€ par an (source : cadremplois.fr 2021)).

Quel positionnement dans la carrière ?

Il est possible d’être trésorier junior. Cependant, les entreprises privilégient les personnes avec de l’expérience, c’est-à-dire ayant déjà exercé des fonctions de contrôleur de gestion ou comptable trésorerie.
Le trésorier peut aspirer à une belle évolution de carrière. Après 5 années, il peut bénéficier d’opportunités et évoluer en tant que directeur financier, responsable du service administratif, chef trésorier ou responsable trésorerie groupe.

Quelle formation ?

Pour être trésorier, un bac +5 est nécessaire en finance, commerce, gestion ou comptabilité.
Les formations peuvent donc être une école de commerce avec spécialisation en finance ou trésorerie ou un diplôme supérieur de comptabilité et de gestion (DSCG). Ces deux formations sont proposées par l’ESSEC : le DSCG peut être passé en parallèle et la spécialisation en finance se fait par le Corporate Finance Track disponible à Cergy et Singapour.

Lien avec le cours et concepts clés :

Pour être trésorier, il faut avoir une très bonne connaissance des différentes normes IFRS (International Financial Reporting Standards), du droit des affaires ainsi que toutes les notions de comptabilité et finance (Compte de résultat, Bilan, Tableau de financement, flux de trésorerie, fonds de roulement etc.)

Resources utiles

Association Française des Trésoriers d’Entreprise

Cadremplois.fr Trésorier

Autes posts sur le blog SimTrade

   ▶ All posts about professional experience in the SimTrade blog

   ▶ Barbero A. Career in finance

   ▶ Verlet A. Classic brain teasers from real-life interviews

A popos de l’auteure

Cet article a été écrit en Mai 2022 Emma LAFARGUE (ESSEC Business School, Grande Ecole – Master in Management, 2020-2024).

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