Saturday 16 February 2013

Dressing and undressing

Sticking to describing packages of cash flows discounted at an appropriate rate, there's a clothed-naked metaphor which springs to my mind.  The clothed element is the financial cultural description of the cash flows - this first one is an up-front fee, this next set are interest plus repayment of capital, that one is a final fee, etc.   The naked element strips away the semantics, leaving just the cash flows, the dates and the discount curve.  In a similar vein, the clothed element of rate interpretation contains cultural artefacts around day-count conventions, business day convention, the practice of holiday dates and weekends, accrued interest calculations, clean and dirty pricing.  And the naked being continuously compounded, year-fraction equivalent.  The operations team, finance team, legal team, trading group, management, they all live in the clothed realm.  The quants and the technologists who implement the quant algorithms live in the naked realm.

The phenomena of this kind of nakedness are cleaner, fewer, more complex to understand.  And the process of dressing and undressing, while prone to many errors and omissions is a technique it pays to do well.

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