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Financial Derivatives

By Lucy Thompson, on 29 June 2022

With nearly $700 trillion in notional value – over seven times the market capitalisation of global stocks or over five times global GDP – the sheer volume of Financial Derivatives dwarfs any other forms of financial instrument. In this blog, derivatives expert Philippe Dufournier reflects on the challenges and opportunities presented by these mechanisms.

By definition, Financial Derivatives are a contract by which two parties agree to exchange in the future (i) cash flows or assets (ii) the values of which are indexed to changes in financial variables such as foreign exchange, interest rates, commodities, equity and credit and (iii) at terms agreed upon today. Contracts are bilateral, confidential in nature and involve either two private parties in what is called the Over-the-Counter (OTC) market or a private party and a Derivatives Exchange, in the case of an exchange-traded contract.

Ubiquity is another key attribute of Derivatives, as they enable many financial transactions, both in the business and the retail world. These include:

  • Pre-payable mortgages without penalty
  • Capital guaranteed equity investment products
  • Convertible bonds, forward purchases of crude oil
  • Options to exchange fixed amounts of dollars and euros in 5 years.

At their core, Financial Derivatives enable Party A to transfer to Party B, over a chosen period of time, certain specific market risks it does not wish to keep. In this case, it is also an opportunity for Party B to gain exposure to the risk in question. For example, if a large Telecommunication company borrows money from banks via a 3yr Loan whose rate of interest is Euribor 3 Month + 1%, it may want to eliminate the risk of fluctuation of Euribor by swapping with another bank the quarterly settings of the floating index for a fixed rate over the 3 years of the loan. In that way, it has transferred the floating rate risk to the market and manufactured a synthetic fixed rate Loan. Note that this is achieved without altering the terms of the initial loan agreement.

There are multiple participants to the derivatives markets in the pursuit of different objectives. Investment banks and market-making securities firms are frequent users to provide liquidity to so-called end-users. Participants include:

  • Asset Managers wanting to reduce the risk of a decline in the equity markets or the risk of rising interest rates by respectively selling equity futures contracts and entering into fix paying swaps
  • Corporates wishing to manage their PnL exposure to Foreign Exchange fluctuations by using FX forwards and FX options
  • Banks aiming to protect the credit risk embedded in their loan portfolio using credit default swaps or looking to tailor the risk exposure they want to include in retail investment products vis equity options
  • Hedge Funds looking to source tail-risk exposure to produce returns for investors

In their OTC format, derivatives are limitless in scope and flexibility. Agreements can extend to 30 years or more, payments may refer not just to changes in FX rates or to the S&P but also, for example, to extreme weather events, to relative changes in inflation between two currencies, or to the combination of multiple market events happening at once. Because of their inherent leverage and their relative complexity, derivatives have been seen in the recent past as potentially ‘toxic’ for the financial system. They were infamously the so-called ‘weapons of mass destruction’ of the great financial crisis of 2008. 15 years on however, financial regulators, exchanges, clearing houses and banks have worked hard and gone a long way to make derivatives a transparent, well capitalised and risk-controlled market place.

The author Philippe Dufournier is IFT Industrial Professor. Find out more about our Industrial Professors here.

If you would like to broaden your knowledge and understanding of Financial Derivatives, click here to find out more about our short course led by Philippe, starting in September 2022.

 

Deal or No Deal – Assessing the factors that shape the choices of a VC

By Lucy Thompson, on 16 May 2022

Ideas are never in short supply, but the funding to make them fly is often harder to come by. Venture Capitalists (VCs) have been a huge source of financing for early-stage businesses, and the impact they bring to their portfolio companies makes founders covet them. In this article, Keisi Mancellari and Muideen Abubakar evaluate the critical factors that run through the mind of a VC before making an investment, a valuation and even hiring choices. This report is based on a recent IFT seminar on “Key Drivers in Early Stage Venture Capitalism” with David Grimm, Albion VC and UCL Technology Fund.

Just as every other category of investors, VCs are seeking alpha. This means they are far from a jack-of-all-trades and will not necessarily throw money at start-ups in every industry, in their quest for superior returns. This takes us to the first question that comes to the mind of a VC approaching a founder.

What’s your playing field?

VCs tend to have industry preferences as to where they deploy capital. That way, they can demonstrate their specialised knowledge of an industry, the dynamics, and the potentials. Knowing what kind of companies are being funded by a VC should give direction to founders on which VC they should court as they jostle for cash. As David Grimm highlighted during his seminar at the UCL Institute of Finance and Technology, his VC focuses on enterprise software, deeptech, data analytics and digital healthcare. It is common for VCs to build a specialist fund for every industry that they have an interest in. For instance, Albion VC being a tech-oriented investor manages the specialist UCL Technology Fund in collaboration with UCL Business.

When a VC funds a venture, the deal doesn’t end with the handshake. They assume the role of an adviser to the management. This is another reason why they focus on a niche, as they must be able to deploy their specialist knowledge to provide critical guidance to founders, bear the torch for them on the customer acquisition path and perhaps refer them to other investors of interest.

As David also alluded to, valuation plays a key part in why a VC may ignore a pitch if the proposal doesn’t fall within their industry remit. A VC’s knowledge of an industry enables them to put an appropriate price on the table when they are approached and, most importantly, to forecast the viable exit opportunities and magnitude of multiples. After all, the end should justify the wait and the risk. Read the rest of this entry »

The Future Must Be Interdisciplinary

By Lucy Thompson, on 4 May 2022

Credit: UCL Press / Alan Wilson

Global challenges such as climate change, the future of work, and smart cities increasingly require input from a range of subject experts.

Professor Sir Alan Wilson, Director of Research at IFT, reflects on the importance of interdisciplinarity for skills and capacity building, and for research.

His book Being Interdisciplinary was published on 3 May 2022. It is now available for free Open Access download or to purchase via UCL Press here.

 

For those unfamiliar with the concept, how would you define interdisciplinarity, or what it means to be interdisciplinary?

Disciplines can be defined in terms of ‘systems of interest’ – in the broadest terms, the physical, the biological and the social – often subdivided into specialisms. These disciplines all have their research challenges; but most research problems demand the application of elements of more than one discipline – and hence are interdisciplinary. To be interdisciplinary means being prepared to respond to this challenge to have the depth of what might have been your first discipline, and the breadth to be able to draw on concepts more widely.

Can you provide more concrete examples?

Start with perhaps the biggest challenge of all: climate change. It involves all disciplines and perhaps surprisingly, the most important might be social science. Or take cities, my own field. Professional areas such as medicine or engineering are inherently interdisciplinary because their focus is on identifying problems and solving them whether through clinical interventions or innovative, disruptive design.

What is the value of interdisciplinarity in a university setting?

There is an old joke: industry has problems and universities have departments – usually discipline-based. Introducing the idea of interdisciplinarity adds a new kind of thinking to a discipline-based core.

Read the rest of this entry »

Welcome to the UCL Fintech Blog

By Lucy Thompson, on 2 May 2022

Welcome to the official UCL Institute of Finance and Technology (IFT) blog!

This blog is an accessible platform, delivering the latest digital finance and technology related news and research from within IFT and beyond. You can expect monthly reflections from our academics, students and external contributors.

If you’d like to hear about a particular theme or research area, do not hesistate to contact us via email. Please follow us on Twitter and connect with us on LinkedIn, too!

Warm regards, The Institute of Finance and Technology

Interview with our Director, Professor Francesca Medda

By Lucy Thompson, on 4 May 2020

Professor MeddaUCL Professor of Applied Economics and Finance, Francesca Medda, is founding Director of the Institute of Finance and Technology. Her key research areas are digital finance, impact & sustainable finance, and urban & infrastructure investments.

We sat down with Professor Francesca Medda to discuss her career, the Institute and its vision.

 

Q. What does being Director of the Institute of Finance and Technology involve?

It is difficult to pin down exactly what I do on a day-to-day basis – thus far, my role varies and every day is different! I developed this programme expressly to provide students with courses that combine industry with academia – that idea became the overarching umbrella for the entire programme and everything sits underneath it. As these are early days for the programme, I’m working with the department to ensure that the courses meet the highest UCL standards. I’m also speaking with students interested in taking part, as well as liaising with the lecturers. Each day offers new opportunities and – at times – new challenges to overcome. Setting up a new programme is never easy, but I’m very satisfied with the depth and scope of the courses and the interest is overwhelming! My own research comprises another part of my role. Three key emphases: digital finance, impact and sustainable finance, and urban and infrastructure investments means that my research dovetails nicely with the themes of the programme.

Q. Tell us a little bit about yourself – what is your professional and educational background?

My studies have taken me across Europe. My undergraduate degree is in Engineering at a university in Italy. I then moved to London and studied Economics at the London School of Economics (LSE), and from there I went to Amsterdam to continue my studies in Economics at the Tinbergen Institute. I was already working in finance when I started my career in academia. My first position was at LSE, with a move to UCL a few years later. I am also an economic adviser to the UK Ministry of Environment and Agriculture (Defra) and the Ministry of Finance (HM Treasury).

Read the rest of this entry »