How to calculate p2p platform risk Part 1

Measuring the risk in any investment is very important. While much material is found to measure risk in traditional investments (stocks, bonds, etf) it is not easy to find risk measures in p2p investments. In this post I will try to provide material and risk measures for this type of investment

What is an investment in a p2p platform

The p2p investment we have 3 actors a borrower who needs a loan a lender who lends his money and a web platform through which the deal takes place. The most obvious risk is that the borrower does not pay or the lender. To eliminate this type of risk, many platforms offer a “buy back” formality so that if the borrower does not pay, the p2p platform will pay the lender.
Apparently it might seem like a zero risk investment but it is not.
The platform could fail or could implement a ponzi scheme. The p2p platforms are very young and it is often difficult to quantify the platform risk.

Some examples of platform defaults

The most recent default that unfortunately also saw me involved is the failure of Eurocent. Eurocent, a Polish lender that issued loans on Mintos failed, and is being liquidated. It appears that this was mainly a result of poor lending quality, which led to funding difficulties. Collateral UK, a British lender that operated its own P2P site, was closed down by British regulators earlier this year. The circumstances behind this closure have still not been made fully public, but it has led to a substantial risk that investors in this platform will not be able to fully recover the amounts they invested in this site.

How to measure the platform risk

I have found on the internet many times phrases like “p2p lending is too young to have reliable data”. True
But if the data is not available we can still propose a model through which to measure the platform risk. To do this simulation, we would have assumed that we could invest in n p2p platforms all capable of providing “buy back guarantee”. We would also suppose that all platforms are stochastically independent from each other, ie the probability of failure of one is independent of the other.

From my point of view, a p2p platform is a sort of black box in which I invest money and which will then give me a return or it will fail without giving any return. So the return of a p2p platform is given by the product of a bernoulli random variable  which is 0 or 1multiplied by a normal random variable. The random variable of bernoulli is worth 1 if the platform is alive at the end of the year, 0 if during the year it has failed. So my return if the platform fails year (Bernoulli = 0) will be 0 * interest rate * invested capital = 0.

if instead the platform survives (Bernoulli 1) my return will be 1 * interest rate * invested capital.

At the end of each year I will invest a new additional sum, the savings made during the year that will be distributed equally among the p2p platforms. I will carry out the analysis with 4 platforms and with 100 platforms to measure how diversification can change the risk of an investment. After that I used a Montecarlo simulation

How Monte Carlo Simulation Works

Monte Carlo simulation performs risk analysis by building models of possible results by substituting a range of values—a probability distribution—for any factor that has inherent uncertainty. It then calculates results over and over, each time using a different set of random values from the probability functions. Depending upon the number of uncertainties and the ranges specified for them, a Monte Carlo simulation could involve thousands or tens of thousands of recalculations before it is complete. Monte Carlo simulation produces distributions of possible outcome values. By using probability distributions, variables can have different probabilities of different outcomes occurring. Probability distributions are a much more realistic way of describing uncertainty in variables of a risk analysis.

The tools used

To perform the simulation I used two tools: Excel and an addin en addin risk amp
This add in easily allows you to perform a simulation montecarlo on an excel model. Excellent tool unfortunately paid. I then used the trial version

The simulation lasts 5 years, starting with a value of 100,000 distributed evenly across the different platforms. the platforms have a normal distribution and the probability of retura  a platform to remain alive during the year is 90%.

Number of year 5
Starting Balance  $ 100.000,00
Expected return for each platform 10,00%
Standard deviation of return 1,00%
Added Balance every year  $   12.000,00
probability of survival for each platform 90%

curious to know the results? you will know a little patience in the next post

 

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E-Fire model: a new model for financial independence

The fire movement suggests a very simple model to free oneself from the slavery of work. Multiply your annual expenses between 300 and 400 and you will have the amount that, if invested in low-cost etf will allow you to live a lifetime. In my case the annual expenses are 24k euros so I need a figure between 600k and 800k  euto to be financial independent. So, as shown in the following figure, you must first create your nest egg and then from this, withdraw the money you need.

There are two main criticisms of this model, the first which is a model for the rich. Indeed 600k-800k euros are a huge sum for me.

Secondly in this  model you could be a victim  of “Capital Depletion”. Not knowing the performance of the stock or bond markets you could remain without money. It is certainly not necessary to be a “wolf of wall street”  to understand that if you  you are so unlucky to start your journey at the wrong time you could remain without money.

There are many solutions that can make this model less rigid but I would like to introduce a new variable.

Today the Fintech world offers us important new opportunities such as p2p lending. In this model, the investment takes place both in low-cost etf but also in p2p platform that do not suffer from the fluctuating trend of the stock exchanges but have a constant return (around 10% at the time of writing).

In this way it is possible to balance the fluctuating trend of the stock exchanges by investing in the p2p platforms, withdrawing the capital from the ETFs when the stock exchanges are high and vice versa by investing in the stock exchanges when they are low withdrawing the capital from the p2p platforms.
In practice, a flow is generated as shown in the following figure.

I called this model e-fire model where it stands for European as this model will be described in the next posts only with tools easily available for a European citizen.
Stay tuned

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The meaning of “passive income”

 

A few days ago I wrote in a forum that a real estate investment (rent a house for example) is a passive investment.
This statement has triggered a series of unpleasant comments to me.
Many argued that a real estate investment was not entirely passive
What does “passive income” mean?
I work 40 hours a week.  If I count travel, I spend 30 minutes to go to work and another 30 to go home. At least two days a week I have to go to customers so instead of 60 minutes I have about 180 minutes. So travel is about 9 hours a week

Often I have to do unpaid overtime say on average 3 hours a week.
This is the time I spend at work:

  • Ordinary work    40 per week
  • Trave 9 hours per week
  • Extraordinary 3 hours

Total 52 hours per week
I do not think my situation is different from that of many of you.

But if you have for example 4 houses with a rent of 500 euros per month.

How long will it take for managing your business? 8 hours a month for each house? 16 hours a month for each house?
So  from my point of view a real estate investment is passive.because the time I waste is very small
Probably things would improve if instead of real estate I had an investment of ETF and apply a strategy “Buy and hold”.

In this case, probably the wasted time ta would be a few hours a month.

From my point of view, financial independence means making money work for you in order to free up enough time to be happier so a real estate investment could be a choice

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