Introduction to Financial

Analytics
Faculty Development Programme
Prof. Alok Pandey
Professor & Area Chair Finance
Lal Bahadur Shastri Institute of Management, Delhi

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 Bloom’s Taxonomy
• Bloom's Taxonomy was created in 1956 under
the leadership of educational psychologist Dr
Benjamin Bloom in order to promote higher
forms of thinking in education, such as
analyzing and evaluating concepts, processes,
procedures, and principles, rather than just
remembering facts (rote learning).

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Bloom’s Taxonomy

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 What is Analytics
• Analytics has become the term used for
describing the iterative process of proposing
models and finding how well the data fit the
models, and how to predict future outcomes
from the models.

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 Analytics
• Analytics is a practical and pragmatic approach
where statistical rules and discrete structures
are automated on the datasets as outcomes
are observed in the laboratory and in the
business world.

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 Analytics & Data
• Businesses as well as consumers & investors are
affected by fluctuations in consumer prices,
industrial production, interest rates, financial
markets and the price of commodities.
• Now that large datasets are widely available &
market practitioners are stepping up their efforts
to use algorithms to measure econometric
patterns and examine their expected trends.

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 Big Data
• “Big Data” means datasets that are too large to
fit into common memory, disk hardware
traditional files and relational databases.
• Sophisticated algorithms and processing are
required to analyze “Big Data”.
• Analytics are applied to “Big Data” in order to
take advantage of the large sample sizes.
• Insights and discovery are simply more
realistically possible with large datasets.
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 Financial Analytics
• Application of Classical Statistical Models and
computerized algorithms to financial market
data and investment portfolios.
• Financial analytics is the creation of models for
analysis to answer specific business questions
and forecast possible future financial scenarios.
• Its multidisciplinary and combines statistics,
finance, and computer science.

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 Financial Analytics
• Along with robust and accurate data,
designing models is a key component of the
professional practice of analytics.
• Practicing financial analytics trains, informs,
and makes us more prepared for unexpected
situations.

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 Financial Analytics
• Requires understanding of :
1. Financial Statistics & Time-series models,
2. Financial Securities including Derivatives & their
pricing,
3. Portfolio theory & models of investment,
4. Risk measurement & management,
5. Market microstructure & trading strategies.
6. Spreadsheet programs along with some
understanding of open source & commercial tools
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 Usefulness of Financial Analytics
• Investment firms in developed countries (now in
India as well) have helped investors meet
retirement goals or send their children to college
by carefully delivering positive market exposure.
• It helps in personal financial planning (including
retirement planning), individual and corporate
risk management, better understanding of
financial markets and undertaking informed
corporate financial decisions.

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 Best Tools for Analytics- Excel
• Excel – Excel is of course the most widely used analytics
tool in the world. You will seldom come across a data
scientist who does not use Excel.
• Whether you are an expert in programming languages &
tools such as R, Python or Tableau, you will still use Excel
for the basic work.
• Non-analytics professionals will usually not have access to
tools like SAS or R on their machines. But everyone has
Excel.
• Excel becomes vital when the analytics team interfaces
with the business steam.
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 Best Tools for Financial Analytics-SAS
• SAS continues to be widely used in the industry.
Some flexibility on pricing from the SAS
Institute has helped its cause.
• SAS is a robust, versatile and easy to learn tool.
• SAS has several specialized modules that have
been added in the recent past are – SAS
analytics for IOT, SAS Anti-money Laundering,
and SAS Analytics Pro for Midsize Business.

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 Best Tools for Financial Analytics-Tableau

• Tableau is an easy to learn tool that does an

effective job of slicing and dicing your data and
creating great visualizations and dashboards.
• Tableau can create better visualizations than
Excel and can most definitely handle much
more data than Excel can.
• If you want interactivity in your graphs, then
Tableau is surely the way to go.

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Best Tools for Financial Analytics-R
• R is now the most popular analytics tool in the
industry and has surpassed SAS in usage and is
now the tool of choice even for companies
that can easily afford SAS.
• Over the years, R has become a lot more
robust. It handles large data sets much better
than it used to, say even a decade earlier.
• It has also become a lot more versatile.

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Best Tools for Financial Analytics-R
• 1800 new packages were introduced in R
between April 2015 and April 2016.
• The total number of R packages is now over
8000.
• There are some concerns about the sheer
number of packages but this has certainly added
a lot to R’s capabilities.
• R also integrates very well with many Big Data
platforms which has contributed to its success.
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Best Tools for Financial Analytics-Python
• Python has been a favourite of programmers for long.
• This is mainly because it’s an easy to learn language
that is also quite fast.
• Today it offers a comprehensive coverage of
statistical and mathematical functions.
• Increasingly, we are seeing programmers and other
tech folks moving into analytics.
• Most are already familiar with Python and therefore it
has become a tool of choice for many data scientists.

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Lets see, How you can introduce analytics in
Classroom
• For the following data on a stock received
from a stock exchange find the equilibirium
price by creating demand supply schedule,
first in a tabular format and later in MS-Excel.
• The data provided could be for commodity
prices, bond prices and even prices in the
nearby wholesale market of a particular
vegetable.

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Total Demand and Supply of a Stock (or
anything you assume)
Total Supply Price Total Demand
100 Rs20.05 200
200 20.06 500
20.08 100
300 20.08 500
200 20.1
500 20.12
Infinite 200

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 In case its Stock Price then you must
understand types of Orders
Orders are specific trade instructions placed with
brokers by traders without direct access to trading
arenas. The typical brokerage will accept and
place a number of types of orders for clients.
Among these types of orders are the following:

• Market order: execute at the best price available

in the market.
• Limit order: An upper price limit is placed for a
buy order; a lower price limit is placed for a sell
order.
 Solution
• Supply Demand Schedule for Auction Example
.xlsx

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Case Study-Financial Analytics

Investment Analysis & Portfolio

Management

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Some Basic Theory on Investments
• The following material is sourced from the
chapter entitled ‘Optimal Risky Portfolios’ &
‘Index Models’ (Chapter 7& 8)’ form the book:
‘Investments’ by Zvi Bodie, Alex Kane & Alan J
Marcus.

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 Diversification and Portfolio Risk

• Market risk
– Systematic or nondiversifiable
• Firm-specific risk
– Diversifiable or nonsystematic
Figure 7.1 Portfolio Risk as a Function of the
Number of Stocks in the Portfolio
Figure 7.2 Portfolio Diversification
 Covariance and Correlation

• Portfolio risk depends on the correlation

between the returns of the assets in the
portfolio
• Covariance and the correlation coefficient
provide a measure of the way returns two
assets vary
 Two-Security Portfolio: Return

rp  wr
D D
 wEr E
rP  Portfolio Return
wD  Bond Weight
rD  Bond Return
wE  Equity Weight
rE  Equity Return

E ( rp )  wD E ( rD )  wE E (rE )
 Two-Security Portfolio: Risk

  w   w   2 wDw
2
P
2
D
2
D EE Cov (rD , rE )
2
E
2
E

 2
D = Variance of Security D

 2
E = Variance of Security E

Cov (rD , rE )= Covariance of returns for

Security D and Security E
 Two-Security Portfolio: Risk Continued

• Another way to express variance of the portfolio:

 P2  wD wD Cov (rD , rD )  wE wE Cov (rE , rE )  2wD wE Cov (rD , rE )

 Covariance

Cov(rD,rE) = DEDE

D,E = Correlation coefficient of

returns
D = Standard deviation of
returns for Security D
E = Standard deviation of
returns for Security E
Correlation Coefficients: Possible Values

Range of values for 1,2

+ 1.0 > r > -1.0
If r = 1.0, the securities would be perfectly
positively correlated
If r = - 1.0, the securities would be
perfectly negatively correlated
Table 7.1 Descriptive Statistics for Two Mutual
Funds
 Three-Security Portfolio

E (rp )  w1 E ( r1 )  w2 E (r2 )  w3 E (r3 )

2p = w1212 + w2212 + w3232

+ 2w1w2 Cov(r1,r2)
Cov(r1,r3)
+ 2w1w3
+ 2w2w3 Cov(r2,r3)
Table 7.2 Computation of Portfolio Variance From
the Covariance Matrix
Table 7.3 Expected Return and Standard Deviation
with Various Correlation Coefficients
Figure 7.3 Portfolio Expected Return as a Function
of Investment Proportions
Figure 7.4 Portfolio Standard Deviation as a
Function of Investment Proportions
 Minimum Variance Portfolio as Depicted
in Figure 7.4

• Standard deviation is smaller than that of either

of the individual component assets
• Figure 7.3 and 7.4 combined demonstrate the
relationship between portfolio risk
Figure 7.5 Portfolio Expected Return as a Function
of Standard Deviation
 Correlation Effects

• The relationship depends on the correlation

coefficient
• -1.0 <  < +1.0
• The smaller the correlation, the greater the risk
reduction potential
• If r = +1.0, no risk reduction is possible
Figure 7.6 The Opportunity Set of the Debt and
Equity Funds and Two Feasible CALs
 The Sharpe Ratio

• Maximize the slope of the CAL for any possible

portfolio, p
• The objective function is the slope:

E (rP )  rf
SP 
P
Figure 7.7 The Opportunity Set of the Debt and Equity Funds
with the Optimal CAL and the Optimal Risky Portfolio
Figure 7.8 Determination of the Optimal Overall
Portfolio
Figure 7.9 The Proportions of the Optimal Overall
Portfolio
 Markowitz Portfolio Selection Model

• Security Selection
– First step is to determine the risk-return
opportunities available
– All portfolios that lie on the minimum-variance
frontier from the global minimum-variance
portfolio and upward provide the best risk-
return combinations
Figure 7.10 The Minimum-Variance Frontier of
Risky Assets
Markowitz Portfolio Selection Model Continued

• We now search for the CAL with the highest

reward-to-variability ratio
Figure 7.11 The Efficient Frontier of Risky Assets
with the Optimal CAL
Markowitz Portfolio Selection Model Continued

• Now the individual chooses the appropriate mix

between the optimal risky portfolio P and T-bills
as in Figure 7.8
n n
 2
P  w w Cov(r , r )
i j i j
i 1 j 1

n n
 ( P)   wi ij w j
2

i 1 j 1
Figure 7.12 The Efficient Portfolio Set
Capital Allocation and the Separation Property

• The separation property tells us that the portfolio

choice problem may be separated into two
independent tasks
– Determination of the optimal risky portfolio is
purely technical
– Allocation of the complete portfolio to T-bills
versus the risky portfolio depends on personal
preference
Figure 7.13 Capital Allocation Lines with Various
Portfolios from the Efficient Set
 The Power of Diversification
n n
• Remember:   2
P  w w Cov(r , r )
i j i j
i 1 j 1

• If we define the average variance and average

covariance of the securities as:
1 n 2
   i
2

n i 1
n n
1
Cov  
n(n  1) j 1
 Cov(r , r )
i 1
i j

j i

• We can then express portfolio variance as:

1 2 n 1
P   
2
Cov
n n
 Table 7.4 Risk Reduction of Equally Weighted
Portfolios in Correlated and Uncorrelated Universes
Single Index Models (SIM)

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 Advantages of the Single Index Model

• Reduces the number of inputs for diversification

• Easier for security analysts to specialize
• Works on a regression model and hence uses a
sample from the population to calculate
covariance matrix (variance covariance matrix).
• The CAPM is a modified version of SIM with a
security with risk free rate added.
• Additional models are called multi factor models.
 Single Factor Model

ri  E (ri )   i m  ei
ßi = index of a securities’ particular return to the
factor
m = Unanticipated movement related to security
returns
ei = Assumption: a broad market index like the S&P
500 is the common factor.
 Single-Index Model

• Regression Equation:
Rt (t )   i   t RM (t )  ei (t )

• Expected return-beta relationship:

E ( Ri )   i   i E ( RM )
 Single-Index Model Continued

• Risk and covariance:

– Total risk = Systematic risk + Firm-specific risk:
 i2   i2 M2   2 (ei )
– Covariance = product of betas x market index risk:
Cov(ri , rj )  i  j M2
– Correlation = product of correlations with the
market index
i  j M2 i M2  j M2
Corr (ri , rj )    Corr (ri , rM ) xCorr (r j , rM )
 i j  i M  j M
 Index Model and Diversification
• Portfolio’s variance:

      (eP )
2
P
2
P
2
M
2

• Variance of the equally weighted portfolio of

firm-specific components:
2
n
1 2 1 2
 (eP )      (ei )   (e)
2

i 1  n  n
• When n gets large,  2 (eP ) becomes negligible
 The Case (Scenario 1 & 2)

• Requires you to use to apply concepts

discussed in Chapter 7 ‘Optimally Risky
Portfolios’.

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Key Functions for Analytics used in MS-Excel

1. DEFINE
2. AVERAGE
3. SUM & SUMPRODUCT
4. MMULT
5. SOLVER

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 The Case- Scenario 3
• Requires you to use the concepts from
Chapter 8 ‘Index Models’.
• Some additional functions have been used:
1. INTERCEPT
2. SLOPE
3. STEYX
4. SCATTER PLOT

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 Additional Functions Used
1. INTERCEPT
2. SLOPE
3. STEYX
4. SCATTER PLOT

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 Solution
• Case-Solution.xlsx

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For Scenario 1 (can be used for 2 & 3 as well)

• D18=SUMPRODUCT(B14:D14,B16:D16)
• D20=SUMPRODUCT(MMULT(B16:D16,G5:I7),B
16:D16)
• In the Covariance Matrix OFFSET Function has
been used:
• G5=IF(G$4=$F5,100*VAR(B$4:B$13),100*COV
AR(OFFSET(TCS,0,G$4),OFFSET(TCS,0,$F5)))
The entire column under TCS is defined as TCS by using DEFINE
function.

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