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Category Archives: FIN

Financial engineering, 10 Definitions

03 Jan

What is financial engineering? Here are 10 definitions about FE.

Based on International Association of Financial Engineers (IAFE) definition, Financial Engineering is the creation of new and improved financial products through innovative design or repackaging of existing financial instruments.

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Financial engineering is an engineering discipline which deals with the creation of new and improved financial products through innovative design or repackaging of existing financial instruments. Financially, engineered products like American Depository Receipt (ADR) and Global Depository Receipt (GDR) have provided companies access to international financial markets to raise funds. However, financial engineering is considered as being responsible for triggering the global financial crisis by increasing leverage and price risks (Shah & Srinivasan, 2010).

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Financial Engineering is a multidisciplinary field involving financial theory, the methods of engineering, the tools of mathematics and the practice of programming. It is about the securities, banking, and financial management and consulting industries, or as quantitative analysts in corporate treasury and finance departments of general manufacturing and service firms (Swishchuk & Manca, 2010).

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Mainstream financial engineering as a study of methods that stand upon the  assumptions of behavior, markets and institutions of the neoclassical vintage is critically examined (Choudhury, 2009).

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Financial engineering is a process in which financial securities are designed and packaged with innovative features. Typically, financial engineering involves creating certain type of derivative securities. House construction is to civil engineering what security packaging is to financial engineering. They both involve putting raw materials together to come up with something for a particular purpose.  Civil engineers wear hard hats and heavy boots for protection and safety while financial engineers “wrap” themselves in legal papers full of cryptic fine prints (Wei, 2005).

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FINANCIAL ENGINEERING is a process involving the creation and combination of a variety of financial instruments in order achieve a defined financial objective within certain cost, tax and legal constraints, e.g. combining or dividing existing financial products to create new financial products (Gastineau & Kritzman, 1999).

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Financial engineering sometimes also refers to the strategies companies use to maximize profits or other important performance metrics. Examples include creating derivatives that address unusual risks faced by a party to a transaction, structuring a purchase or sale in a way that better addresses the interests of the buyer and the seller, and using new methods to compute the fair market value of new or existing financial instruments (Zopounidis, 1999).

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Financial engineering works in other environments as well. The financial theory of offering several existing products under one package has become very common in the telecommunications industry. Many providers today offer bundled service packages that include local phone service, unlimited national long distance, Internet service, and cable or digital satellite television. The end result of this type of arrangement means one lower price to obtain three or more services at significant cost savings to the consumer (Smithson, 1998).

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Financial engineering is the innovation and creation of new financial instruments. The most important products of financial engineering are speculative bonds, zero coupon, securities assets, financial derivatives and repurchase agreements (Moles & Terry, 1997).

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Computational finance, also called financial engineering, is a cross-disciplinary field which relies on computational intelligence, mathematical finance, numerical methods and computer simulations to make trading, hedging and investment decisions, as well as facilitating the risk management of those decisions. Utilizing various methods, practitioners of computational finance aim to precisely determine the financial risk that certain financial instruments create (Bradman, Rouge, Pentecostalism, Pentecostal, & Woroniecki).

 

References

Bradman, D., Rouge, B., Pentecostalism, O., Pentecostal, O., & Woroniecki, M. P. Encyclopedia> Cheminformatics.

Choudhury, M. A. (2009). Islamic Critique and Alternative to Financial Engineering Issues. Islamic Economics, 22(2).

Gastineau, G. L., & Kritzman, M. P. (1999). The dictionary of financial risk management (Vol. 52): Wiley.

Moles, P., & Terry, N. (1997). The handbook of international financial terms: Oxford University Press, USA.

Shah, V., & Srinivasan, P. (2010). Financial Engineering and Innovation as Risk Management Tools: The Case of Indian Companies During Global Financial Crisis. IUP Journal of Risk & Insurance, Vol. 7, Nos. 1 & 2, pp. 50-66, January & April 2010.

Smithson, C. W. (1998). Managing financial risk: a guide to derivative products, financial engineering, and value maximization: McGraw-Hill Professional.

Swishchuk, A., & Manca, R. (2010). Modeling and Pricing of Variance and Volatility Swaps for Local Semi-Markov Volatilities in Financial Engineering. Mathematical Problems in Engineering, 2010.

Wei, J. Z. ( 2005). A Layman’s Guide to Financial Terms. 24.

Zopounidis, C. (1999). Multicriteria decision aid in financial management. European Journal of Operational Research, 119(2), 404-415.

 
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Posted by on January 3, 2012 in FIN, MBA

 

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Different types of derivatives market

30 Oct

Derivatives are financial instruments used to manage one’s exposure to today’s volatile markets. A derivative product’s value depends upon and is derived from an underlying instrument, such as commodities, interest rates, indices or stocks.

In other words, a derivative is a financial contract with a value linked to the expected future price movements of an underlying asset it is linked. It is used as a tool for hedging, speculating and arbitraging.

Forward

Forward contract forms the oldest type of derivatives market. Forward by definition is an agreement to buy and sell a specified security at a specified price to be delivered at the maturity date in the future. The agreement is privately arranged to fulfill the need of both contracting parties, a buyer and seller. If one party intends to close out the contract it must be at the consent of the other party. Therefore a forward contract is technically referred to as a privately negotiated agreement.

Futures

Futures are traded on a futures exchange and represent an obligation to buy or sell a specified underlying instrument on a specified date (the delivery date or final settlement date) in the future at a specified price (the futures price). The settlement price is the price of the underlying asset on the delivery date. Both parties to a futures contract are legally bound to fulfill the contract on the delivery date. If the holder of a futures position wishes to exit their obligation before the delivery date, they must offset it either by selling a long position or buying back a short position. Such an action effectively closes the futures position and its contractual obligations.

Future market develops as a result of insufficient trading requirement of forward transactions. Either party justifies this because forward as a private agreement does not guarantee the fulfillment of the contract. A third party is required to act as a guarantor, namely the clearing house. It serves as a buyer for every seller and vice versa.

Options

An option is a financial instrument that gives the holder the right to engage in a future transaction on an underlying security or futures contract. The holder is under no obligation to exercise this right. There are two main types of option. A call option gives the holder the right to purchase a specified quantity of a security at a fixed price (the strike price) on or before the specified expiration date. A put option gives the holder the right to sell. If the holder chooses to exercise the option, the party who sold, or wrote, the option is obliged to fulfill the terms of the contract.

Since forward and futures trading obligates both buyer and seller to fulfill their contracts, a third form of derivatives is introduced that provides a right to one party and obligation to the other party. Options trading are a contract that gives a right without obligation to the buyer, while the seller has an obligation if requested by the buyer to buy or sell at a specified security at specified price and time.

 Swap

A swap is a derivative in which two parties agree to exchange a set of cash flows (or leg) for another set. A notional principal amount is used to calculate each cash flow; these are rarely exchanged by the parties. A swap is usually used to hedge a risk, such as an interest-rate risk, or to speculate on a price change. It may also be used to access an underlying asset in order to earn a profit or loss from any change in price while avoiding posting the notional amount in cash or collateral.

Below are some of the uses of derivatives like futures and options, as listed by John C. Hull in his 1999 book titled ‘Options, Futures and Other Derivatives’.

  • Derivatives are very good risk management tools and are mainly used to hedge risks that a trader is routinely exposed to. Derivative instruments offer the trader, the option of passing on some of the risk that he’s bearing over to another party. He either takes on another risk in return or makes a cash payment in exchange for the risk transfer.
  • Derivative instruments like forwards and futures play a key role in giving directions to the market prices of the future. Forwards and futures prices are good reflectors of the price directions as well as the expected change in the future prices of the underlying asset.
  • Derivatives offer the traders an option to change the nature of their liabilities and exchange the risks associated with some of their unwanted liabilities with some more bearable ones.
  • Derivatives can be used to make arbitrage profits. Arbitrage profit opportunities are those opportunities that allow for risk-free, zero net investment profits, by capitalizing on price differentials on the same commodity in different markets. The intention is to buy low and sell high in two different markets and pocket the differential profits.
  • Derivatives allow for large portfolio position changes without incurring the buying and selling transaction costs.

 

Advantages

The use of derivatives means that some financial risks can be transferred to other parties who are more willing or better suited to take or manage those risks and can thus be a useful tool for risk management.

Purchasing derivatives can be a safer choice if there is a possibility of a looming bear market as they are hedged, unlike equities.

Buying now at a future price can be cheaper than buying at market price in the future, bearing in mind that the spot price could be less expensive. A long call option requires no obligation when it is due.

Disadvantages

If the market changes dramatically, it is possible to lose financially if the derivatives are being used as a speculative instrument.

If you hold the put option on a derivative, you are obliged to adhere to it if the holder of the call chooses to exercise their right to sell or buy.

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If you are interested to the famous companies name etymologies maybe you would like to take a look at this list of company names with their name origins explained. Some origins are disputed.

List of company name etymologies

 
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Posted by on October 30, 2011 in FIN, MBA

 

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Financial engineering

22 Sep

What Does Financial Engineering Mean?

It means the creation of new and improved financial products through innovative design or repackaging of existing financial instruments.

Financial Engineering is a multidisciplinary field involving financial theory, the methods of engineering, the tools of mathematics and the practice of programming. It is about the securities, banking, and financial management and consulting industries, or as quantitative analysts in corporate treasury and finance departments of general manufacturing and service firms.

Financial engineering works in other environments as well. The financial theory of offering several existing products under one package has become very common in the telecommunications industry. Many providers today offer bundled service packages that include local phone service, unlimited national long distance, Internet service, and cable or digital satellite television. The end result of this type of arrangement means one lower price to obtain three or more services at significant cost savings to the consumer.

AIMS

Sometimes known as computational finance, financial engineering relies heavily on mathematically calculating the outcome if various combinations of financial instruments are offered under one umbrella as a package deal. Usually, the calculations indicate that the providers stand to do very well with the new hybrid financial product, as the product holds the potential to attract new consumers who would have foregone use of one or more of the instruments if the only option was to purchase them individually.

Areas of application:

  • Investment banking
  • Forecasting
  • Corporate strategic planning
  • Securities trading and financial risk management
  • Derivatives trading and risk management
  • Investment management
  • Pension scheme
  • Insurance policy
  • • Credit default swap
  • • Market mechanism design

INSTROUMENTS

The convention in financial markets is to divide these instruments according to the following sectors:

1. Fixed income instruments. These are interbank certificates of deposit (CDs), or deposits (depos), commercial paper (CP), banker’s acceptances, and Treasury bill (T-Bills). These are considered to be money market instruments. Bonds, notes, and Floating Rate Notes (FRNs) are bond market instruments.

2. Equities. These are various types of stock issued by public companies.

3. Currencies and commodities.

4. Derivatives, the major classes of which are interest rate, equity, currency, and commodity derivatives.

5. Credit instruments, which are mainly high-yield bonds, corporate bonds, credit derivatives, CDSs, and various guarantees that are early versions of the former.

Financial engineering is a process that utilizes existing financial instruments to create a new and enhanced product of some type. Just about any combination of financial instruments and products can be used in financial engineering. The process may involve a simple union between two products, or make use of several different products to create a new product that provides benefits that none of the other instruments could manage on their own.

A financial engineer works with a variety of different tools to determine the risks and potential of financial investment. These specialists work extensively with mathematical formulas and computer programs in order to create sophisticated models of market trends and risks. Though companies may employ a person with an advanced degree in financial engineering as such an engineer, it is more common for these specialists to work as traders, bankers, or investment managers, and to utilize their financial engineering background in these careers in order to improve the quality of services they can provide to their clients.

One of the main responsibilities of a financial engineer is to know a great deal about financial theory and the behavior of various financial markets. These engineers use this knowledge when creating tools or simulations that will help them to make predictions about the future behavior of a market. Though unexpected events can arise in any financial market, knowledge of past market behavior and the theory that explains that behavior will help the financial engineer extrapolate from the past to make predictions about the future.

In addition to having a strong foundation in this knowledge base, the financial engineer needs to be adept at computer programming. The engineer uses programs to design simulations of market behavior. Though these programs cannot always predict the way the market will shift, a financial engineer is expected to be able to come up with reasonably accurate results based on the simulations the engineer has designed.

Many financial engineers work in the field of financial risk management. Using a knowledge of the market and computer simulations, a financial engineer can form an investment plan that includes as much of a risk factor as a person or company desires. While it may seem counter-intuitive to desire a greater amount of risk, riskier investments tend to pay off at higher yields than investments that are considered to be more stable. A person or company may turn to a financial engineer to design an investment portfolio that places some, all, or none of the investment capital at risk.

A financial engineer may also work as a financial analyst. These engineers use their knowledge and computer simulations to make predictions about the future behavior of the market. Many people with these skills may work for banks or other financial institutions, though there are also government jobs available for specialists in this field. These specialists may be employed to make recommendations to local, state, or federal government with regard the economy.

EXAMPLE

One excellent example of financial engineering is financial reinsurance. Companies that offer reinsurance options essentially provide a way for the ceding insurer to minimize a drain on available resources when a major shift in premium growth or reduction is taking place. In this scenario, the process of financial engineering helps to create a stable environment that will allow the insurer to remain solvent and stable even when extreme conditions exist.

Financial Reinsurance (or fin re), is a form of reinsurance which is focused more on capital management than on risk transfer. In the non-life segment of the insurance industry this class of transactions is often referred to as finite reinsurance.

One of the particular difficulties of running an insurance company is that its financial results – and hence its profitability – tend to be uneven from one year to the next. Since insurance companies generally want to produce consistent results, they may be attracted to ways of hoarding this year’s profit to pay for next year’s possible losses (within the constraints of the applicable standards for financial reporting). Financial reinsurance is one means by which insurance companies can “smooth” their results.

A pure ‘fin re’ contract for a non-life insurer tends to cover a multi-year period, during which the premium is held and invested by the reinsurer. It is returned to the ceding company – minus a pre-determined profit-margin for the reinsurer – either when the period has elapsed, or when the ceding company suffers a loss. ‘Fin re’ therefore differs from conventional reinsurance because most of the premium is returned whether there is a loss or not: little or no risk-transfer has taken place.

In the life insurance segment, fin re is more usually used as a way for the reinsurer to provide financing to a life insurance company, much like a loan except that the reinsurer accepts some risk on the portfolio of business reinsured under the fin re contract. Repayment of the fin re is usually linked to the profit profile of the business reinsured and therefore typically takes a number of years. Fin re is used in preference to a plain loan because repayment is conditional on the future profitable performance of the business reinsured such that, in some regimes, it does not need to be recognised as a liability for published solvency reporting.

For the consumer, the work of a financial engineer to create new finance product offerings can be a great advantage. In some instances, the new and improved product is simply a repackage of several independent but complimentary products made available at a lower price. For example, the consumer may find that purchasing insurance coverage that provides dental, hospital, and prescription coverage may be significantly less expensive than purchasing individual plans.

 
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Posted by on September 22, 2011 in FIN, MBA

 

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Budget Puzzle

20 Nov

Just for a while imagine that you are about fixing the US annual budget! Imagine that you’re in charge of the nation’s finances. Some of your options have more short-term savings and some have more long-term savings. When you have closed the budget gaps for both 2015 and 2030, you are done. You can make your own plan, and then share it online.

Actually I solved the deficit in this way! It was not as easy as I thought!

Related articles: 16 Ways to cut the deficit

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P. S. : At the University of Central Florida, more than 200 students have come forward to admit to cheating after their professor gave a lecture on ethics that has become a YouTube hit. I recommend don’t miss this lecture!

 
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Posted by on November 20, 2010 in FIN

 

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McDonald’s, Hamburger Business or…?

07 Sep

In 1974, Ray Kroc, the founder of McDonald’s, was asked to speak to the MBA class at university of Texas at Austin. A dear friend of mine, Keith Cunningham, was a student in that MBA class. After a powerful and inspiring talk, the class adjourned and the students asked Ray if he would join them at their favourite hangout to have a few beers. Ray graciously accepted.

“What business am I in?” Ray asked, once the group all had their beers in hand. No one answered, so Ray asked the question again.”What business do you think I am in?”

The students laughed again, and finally one brave soul yelled out, “Ray, who in the world does not know that you’re in the hamburger business.”

Ray chuckled. “That is what I thought you would say.” He paused and then quickly said, “Ladies and gentlemen, I’m not in the hamburger business. My business is real estate.”

Keith said that Ray spent a good amount of time explaining his viewpoint. I their business plan, Ray knew that the primary business focus was to sell hamburger franchises, but what he never lost sight of was the location of each franchise. He knew that the real estate and its location was the most significant factor in the success of each franchise. Basically, the person that bought the franchise was also paying for, buying the land under the franchise for Ray Kroc’s organization.

McDonald’s today is the largest single owner of real estate in the world, owning even more than Catholic Church. Today McDonald’s owns some of the most valuable intersections and street corners in America as well as in other parts of the world.

Robert Kiyosaki, Sharon L. Lechter, Rich dad Poor dad, Hachette Book G, 2009

 
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Posted by on September 7, 2010 in FIN, MBA

 

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Systematic & Unsystematic Risk(Non-diversifiable and Diversifiable risk)

18 Aug

Diversifiable risk (also known as unsystematic risk) represents the portion of an asset’s risk that is associated with random causes that can be eliminated through diversification. It’s attributable to firm-specific events, such as strikes, lawsuit, regulatory actions, and loss of a key account. Unsystematic risk is due to factors specific to an industry or a company like labor unions, product category, research and development, pricing, marketing strategy etc.

While the non-diversifiable risk (also known as systematic risk) is the relevant portion of an asset’s risk attributable to market factors that affect all firms such as war, inflation, international incidents, and political events. It cannot be eliminated through diversification and the combination of a security’s non-diversifiable risk and diversifiable risk is called total risk.

In the other word Systematic risk is due to risk factors that affect the entire market such as investment policy changes, foreign investment policy, change in taxation clauses, shift in socio-economic parameters, global security threats and measures etc. Systematic risk is beyond the control of investors and cannot be mitigated to a large extent. In contrast to this, the unsystematic risk can be mitigated through portfolio diversification. It is a risk that can be avoided and the market does not compensate for taking such risks.

However the systematic risks are unavoidable and the market does compensate for taking exposure to such risks.

 
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Posted by on August 18, 2010 in FIN, MBA

 

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Future Value of Annuities

23 Dec

Future Value of Annuities

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period.for an annuity due.

Future Value of an Ordinary Annuity

The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of expected or promised future payments will grow to after a given number of periods at a specific compounded interest.
The Future Value of an Ordinary Annuity could be solved by calculating the future value of each individual payment in the series using the future value formula and then summing the results. A more direct formula is:

FVoa = PMT [((1 + i)n - 1) / i]
Where:
FVoa = Future Value of an Ordinary Annuity
PMT = Amount of each payment
i = Interest Rate Per Period
n = Number of Periods

Example: What amount will accumulate if we deposit $5,000 at the end of each year for the next 5 years? Assume an interest of 6% compounded annually.
PV = 5,000
i = .06
n = 5

This video and related videos at youtube.com  may be useful.watch them!

 
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Posted by on December 23, 2009 in FIN, Life & Economy

 

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Why is profit maximization, by itself, an inappropriate goal? What is meant the goal of maximization of shareholders wealth?

24 Jul

Traditionally, finance teaches that managers should act according to the interest of the firm’s owners or its stockholders. There are different viewpoints in this case. Some agree with pure profit maximization and some not. I personally think here the goal is the main keyword .I mean what you want determines what you have to do.

What should you as a financial manager try to maximize?

Some people believe that the manager’s main goal always should be to try to maximize profits. To do it, they should take only those actions that expected to increase revenues more than costs. It means maximizing in EPS (Earning Per Share). It seems a reasonable objective but as a goal suffers from several flows:

  • First of all, figures for EPS are always historical so reflect past performance rather than what is happening now or what will happen in the future. If you as a manager seek only to maximize profits in a limited period, you may ignore the timing of those profits. Large profits that pay off many years in the future may be less valuable than smaller profits received next year.
  • Second, Different accounting principles result differences in profit computing. It means when firms compute profits, they follow certain accounting principles which focus on accrued revenues and costs. A firm that is profitable according to accounting principles may spend more cash that it receives and an unprofitable firm may have larger cash inflows than outflows. There is a famous expression in finance saying:” you cannot pay your bills with earning, only with cash!!” In finance, we place more emphasis on cash than on profit or earning.
  • Finally, as a manager you have to include variability or risk. Focusing only on earning may ignore them. When comparing two investment opportunities, we must consider both the risk and the expected return of the investment and we face a trade-off between risk and expected return.

These three reasons reveal that profit maximization, by itself, is an unsuitable goal.Current theory asserts that the firms’ proper goal is to maximize shareholders’ wealth, as measured by the market price of the firm’s stock. A firm’s stock price reflects the timing, size and risk of the cash flow that investors expect a firm to generate over time. In this theory, financial managers should undertake only those actions that they expect will increase the value of the firm’s future cash flow. Theorical and empirical arguments support the assertion that managers should focus on maximization shareholder wealth. Shareholders of a firm are sometimes called residual claimants, meaning that they have claims only on any of the firm’s cash flows that remain after employees, suppliers, creditors, governments and other stakeholders are paid in full. As you see, shareholders stand at the end of this line so if the firm cannot pay the stakeholders first, shareholders receive nothing! Shareholders also bear most of the risk of running the firm. So if firms did not manage to maximize shareholders wealth, investors would have little incentive to accept the risks necessary for a business to succeed.

Take a look at overall product cycle of the firm shows that the shareholders who make risky, value-increasing investments are the most important part of this cycle. They can force the firm to take on risky, but potentially profitable, ventures.

Although the primary goal of managers should be maximizing the shareholder wealth, in recent years, many firms have focused to include the interests of other stakeholders like employees, customers, tax authorities and etc. considering other constituents’ interests in part of the firm’s “social responsibility ” and keeping other affected groups happy provides long term benefits to shareholders.  In most cases, taking care of stakeholders translates into maximizing shareholders wealth.

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It was one of my assignments on Basic Financial management subject.  I’ve used some notes of this book:” The scope of corporate Finance” (William L. Megginson, Scott B. Smart)

 
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Posted by on July 24, 2009 in FIN, MBA

 

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