S 11 - Machine Learning and
Financial Applications
B B Chakrabarti
Professor of Finance
Concept of Learning (Credit Management)
% Down pmt Recent Other Accts Credit score High debt Good risk
Delinquency
10 N Y 0.32 N Y
10 N N 0.25 Y Y
5 Y N 0.30 N N
20 N Y 0.31 N Y
5 N N 0.42 N N
10 Y N 0.38 Y N
10 N N 0.25 Y Y
• Given the above data, some reasonable rules may be:
• Grant credit if
a) Recent delinquency = 0 and % Down payment > 5
b) (100*Credit score - % Down payment) < 25
B B Chakrabarti: [email protected] 2
What is Machine Learning?
• Machine learning is an application of artificial
intelligence (AI) that provides systems the ability to
automatically learn and improve from experience. ML
focuses on the development of computer
programs that can access data and use it learn for
themselves.
• The process of learning begins with observations or
data, such as examples, direct experience, or
instruction, in order to look for patterns in data and
make better decisions in the future based on the
examples that we provide. The primary aim is to allow
the computers learn automatically without human
intervention or assistance and adjust actions
accordingly. B B Chakrabarti: [email protected] 3
Traditional Programming
Data
Computer Output
Program
Machine Learning
Data
Computer Program
Output
Some Machine Learning Methods
• Supervised ML algorithms can apply what has been learned
in the past to new data using labeled examples to predict
future events.
• In contrast, unsupervised ML algorithms are used when the
information used to train is neither classified nor labeled.
Unsupervised learning studies how systems can infer a
function to describe a hidden structure from unlabeled data.
• Semi-supervised ML algorithms fall somewhere in between
supervised and unsupervised learning, since they use both
labeled and unlabeled data for training – typically a small
amount of labeled data and a large amount of unlabeled data.
• Reinforcement ML algorithms is a learning method that
interacts with its environment by producing actions and
discovers errors or rewards. Trial and error search is the main
feature.
B B Chakrabarti: [email protected] 5
ML Applications in Finance
• ML is about digesting large amounts of data and learning
from that data in how to carry out a specific task, such as
distinguishing fraudulent legal documents from authentic
documents.
• ML excels at handling large and complex volumes of data,
something the finance industry has in excess of.
• Due to the high volume of historical financial data
generated in the industry, ML has found many useful
applications in finance.
• The technology has come to play an integral role in many
phases of the financial ecosystem, from approving loans
and carrying out credit scores, to managing assets and
assessing risk.
B B Chakrabarti: [email protected] 6
ML Applications in Finance
• The following are some of the current applications of
machine learning in finance.
• Portfolio Management – Robo-Advisors
• Algorithmic Trading
• High-Frequency Trading (HFT)
• Fraud Detection
• Loan/ Insurance Underwriting
• Risk Management
• Chatbots
• Document Analysis
• Trade Settlements
• Money-Laundering Prevention
B B Chakrabarti: [email protected] 7
AI and Credit Decision
• AI provides a faster, more accurate assessment of a potential
borrower, at less cost, and accounts for a wider variety of factors,
which leads to a better-informed, data-backed decision.
• Credit scoring provided by AI is based on more complex and
sophisticated rules compared to those used in traditional credit
scoring systems. It helps lenders distinguish between high default
risk applicants and those who are credit-worthy but lack an
extensive credit history.
• Objectivity is another benefit of the AI-powered mechanism. Unlike
a human being, a machine is not likely to be biased.
• Digital banks and loan-issuing apps use machine learning algorithms
to use alternative data (e.g., smartphone data) to evaluate loan
eligibility and provide personalized options.
• Automobile lending companies in the U.S. have reported success
with AI for their needs as well. For example, this report shows that
bringing AI on board cut losses by 23% annually.
B B Chakrabarti: [email protected] 8
AI and Credit Decision - Examples
• ZESTFINANCE, USA (https://www.zestfinance.com/)
• It provides an AI-powered underwriting solution that helps
companies assess borrowers with little to no credit information or
history.
• The platform utilizes thousands of data points and helps lenders
better assess populations traditionally considered "at risk.“
• UNDERWRITE.AI, USA (https://www.underwrite.ai/)
• It analyzes thousands of data points from credit bureau sources to
assess credit risk for consumer and small business loan applicants.
• The platform acquires portfolio data and applies ML to find patterns
and determine good and bad applications. Because of its accuracy,
it claims it can reduce defaults by 25-50%.
• Since working with Underwriter.ai in 2015, a major online lender
providing dental financing reduced its default rate from 17.8% to
5.4%.
B B Chakrabarti: [email protected] 9
AI and Risk Management
• It’s difficult to overestimate the impact of AI in financial
services when it comes to risk management.
• Enormous processing power allows vast amounts of data to
be handled in a short time, and cognitive computing helps to
manage both structured and unstructured data, a task that
would take far too much time for a human to do.
• Algorithms analyze the history of risk cases and identify early
signs of potential future issues.
• AI in finance is a powerful ally when it comes to analyzing
real-time activities in any given market or environment; the
accurate predictions and detailed forecasts it provides are
based on multiple variables and vital to business planning.
B B Chakrabarti: [email protected] 10
AI and Risk Management - Example
• AYASDI, USA (https://www.ayasdi.com/)
• It creates cloud-based and on-premise machine intelligence
solutions for enterprises and organizations to solve complex
challenges.
• For companies in the fintech space, Ayasdi solution is
deployed to understand and manage risk, anticipate the
needs of customers and even aid in anti-money laundering
processes.
• It is helping banks combat money laundering with its anti-
money laundering (AML) detection solutions. The sheer
volume of investigations has been a major strain on financial
institutions. Using the company's AML solution, one major
bank saw a 20% reduction in investigative volume.
B B Chakrabarti: [email protected] 11
AI and Fraud Prevention
• For a number of years now, AI has been very successful in
battling financial fraud – and the future is looking brighter
every year, as machine learning is catching up with the
criminals.
• AI is especially effective at preventing credit card fraud,
which has been growing exponentially in recent years due to
the increase of e-commerce and online transactions. Fraud
detection systems analyze clients’ behavior, location, and
buying habits and trigger a security mechanism when
something seems out of order and contradicts the
established spending pattern.
• Banks also employ AI to reveal and prevent another infamous
type of financial crime: money laundering. Machines
recognize suspicious activity and help to cut the costs of
investigating the alleged money-laundering schemes.
One Case study reported a 20% reduction in the investigative
workload. B B Chakrabarti: [email protected] 12
AI and Fraud Prevention - Example
• SHAPE SECURITY, USA (https://www.shapesecurity.com/)
• Utilized by top banks in the U.S., Shape Security curbs credit
application fraud, credential stuffing and gift card cracking
by pinpointing fake users.
• The company's machine learning models are trained on
billions of requests, allowing the software to effectively
distinguish between real consumers and bots (automated
program). Shape Security's Blackfish network also uses AI-
enabled bots to detect compromised login credentials,
alerting both customers and companies to security breaches
instantly.
• Shape's solutions have helped one major bank protect
customers from account highjacking and detected one
million credential stuffing attacks in the first week of use.
B B Chakrabarti: [email protected] 13
AI and Trading
• Algorithmic, quantitative or HFT have been expanding rapidly
across the world’s stock markets, and for good reason: AI
offers multiple significant benefits.
• Intelligent Trading Systems monitor both structured
(databases, spreadsheets, etc.) and unstructured (social
media, news, etc.) data in a fraction of the time. Faster
processing means faster decisions and transactions.
• The predictions for stock performance are more accurate,
due to the fact that algorithms can test trading systems based
on past data and bring the validation process to a whole new
level before pushing it live.
• AI puts together recommendations for the strongest
portfolios depending on a specific investor’s short- and long-
term goals.
B B Chakrabarti: [email protected] 14
AI and Trading - Examples
• ALPACA, USA (https://www.alpaca.ai/)
• Alpaca combines proprietary deep learning technology and
high-speed data storage to provide short and long-term
forecasting applications.
• Alpaca’s technology identifies patterns in market price-
changes and translates its findings into multi-
market dashboards.
• The company recently partnered with Bloomberg to provide
users with its "AlpacaForecast AI Prediction Market" to predict
short-term forecasts in real-time for major markets.
• ALPHASENSE, USA (https://www.alpha-sense.com/)
• An AI-powered search engine utilizes NLP to analyze keyword
searches within filings, transcripts, research and news to
discover changes and trends in financial markets.
B B Chakrabarti: [email protected] 15
Algo Trading
• Algorithmic trading (automated trading, black-box
trading or simply algo-trading) is the process of using
computers programmed to follow a defined set of
instructions (an algorithm) for placing a trade in order to
generate profits at a speed and frequency that is
impossible for a human trader. The defined sets of rules are
based on timing, price, quantity or any mathematical model.
• Algo trading is not an attempt to make a trading profit. It is
simply a way to minimize the cost, market impact and risk in
execution of an order. It is widely used by investment
banks, pension funds, mutual funds, and hedge funds because
these institutional traders need to execute large orders in
markets that cannot support all of the size at once.
B B Chakrabarti: [email protected] 16
Algo Trading
• Example:
• Suppose a trader follows these simple trading criteria:
• Buy 50 shares of a stock when its 50-day moving average goes
above the 200-day moving average.
• Sell shares of the stock when its 50-day moving average goes
below the 200-day moving average.
• Using this set of two simple instructions, it is easy to write a
computer program that will automatically monitor the stock
price and the moving average indicators, and place the buy
and sell orders when the defined conditions are met. The
trader no longer needs to keep watch for live prices and
graphs, or put in the orders manually. The algorithmic trading
system automatically does it for him, by correctly identifying
the trading opportunity.
B B Chakrabarti: [email protected] 17
AI and Personalized Banking
• In the banking sector, AI powers the smart chatbots that
provide clients with comprehensive self-help solutions. They
can check balances, schedule payments, look up account
activity and more.
• A number of apps offer personalized financial advice and
help individuals achieve their financial goals. These intelligent
systems track income, essential recurring expenses, and
spending habits and come up with an optimized plan and
financial tips.
• The biggest US banks, such as Wells Fargo, Bank of America
and Chase, have launched mobile banking apps that provide
clients with reminders to pay bills, plan their expenses and
interact with their bank in an easier and more streamlined
way, from getting information to completing transactions.
B B Chakrabarti: [email protected] 18
AI and Personalized Banking - Example
• KASISTO, USA (https://kasisto.com/)
• Kasisto is the creator of KAI, a conversational AI platform
used to improve customer experiences in the finance industry.
• KAI helps banks reduce call center volume by providing
customers with self-service options and solutions.
Additionally, the AI-powered chatbots also
give users calculated recommendations and help with other
daily financial decisions.
• TRIM, USA (https://www.asktrim.com/)
• Trim is a money-saving assistant that connects to user
accounts and analyzes spending.
• The smart app can cancel money-wasting subscriptions, find
better options for services like insurance, and even negotiate
bills. Trim has saved $6.3 million for more than 50,000 people,
B B Chakrabarti: [email protected] 19
AI and Process Automation
• Forward-thinking industry leaders look to robotic process
automation (RPA) when they want to cut operational costs,
boost productivity, comply with KYC regulations etc.
• Intelligent character recognition makes it possible to
automate a variety of mundane, time-consuming tasks that
used to take thousands of work hours and inflate payrolls. AI-
enabled software verifies data and generates reports
according to the given parameters, reviews documents, and
extracts information from applications, agreements, etc.
• Employing robotic process automation for high-frequency
repetitive tasks eliminates the room for human error and
allows a financial institution to refocus workforce efforts on
processes that require human involvement.
B B Chakrabarti: [email protected] 20
Hedge Fund
• Hedge funds are alternative investments using pooled
funds that employ numerous different strategies to
earn active return, or alpha, for their investors.
• Hedge funds may be aggressively managed or make use
of derivatives and leverage in both domestic and
international markets with the goal of generating
high returns (either in an absolute sense or over a specified
market benchmark).
• Hedge funds are less regulated than mutual and other
investment vehicles.
• Each hedge fund is constructed to take advantage of certain
identifiable market opportunities. Hedge funds use
different investment strategies and thus are often classified
according to investment style. There is substantial diversity in
risk attributes and investments among styles.
B B Chakrabarti: [email protected] 21
Hedge Fund – Key Features
1. They are only open to high networth investors: Hedge funds are
registered as Category III Alternative Investment Funds in India
under SEBI AIF Regulations 2012 and the minimum investment
amount is Rs. 1 crore.
2. They offer wider investment latitude than other funds: A hedge
fund's investment universe is only limited by its mandate. A hedge
fund can basically invest in anything—land, real estate,
stocks, derivatives, and currencies (both long and short). Mutual
funds, by contrast, have to basically stick to stocks or bonds, and
are usually long-only.
3. They often employ leverage: Hedge funds will often use borrowed
money to amplify their returns. As we saw during the financial crisis
of 2008, leverage can also wipe out hedge funds.
4. Fee structure: Instead of charging an expense ratio only, hedge
funds charge both an expense ratio and a performance fee. This fee
structure is known as "Two and Twenty"—a 2% asset management
fee and then a 20% cut of any gains generated.
B B Chakrabarti: [email protected] 22
Hedge Fund Strategy Classification (HFR)
https://www.hedgefundresearch.com/hfr-hedge-fund-strategy-classification-system
Equity Hedge Event Driven Macro Relative Fund of Risk Parity Block
Value Funds chain
Eq. Mkt. Activist Active FI – Asset Conser Vol Target Crypto
Neutral Trading backed vative 10% currency
Fundamental Credit Com - FI – Convert Diversified Vol Target Infra
Growth Arbitrage Agriculture Arbitrage 12% structure
Fundamental Distressed Com – FI – Market Vol Target
Value Restructure Energy Corporate Defensive 15%
Quant. Merger Com – FI – Strategic Vol Target
Directional Arbitrage Metals Sovereign 20%
Energy/Basic Private Iss. Com – Multi Volatility
Materials Reg. D
Healthcare Special Currency Yield –
Sirtuations Dicretion Energy,Infra
Multi Multi Multi Multi
Strategy Strategy Strategy Strategy
Technology Curr – Syst. Yield - RE
Short Bias Thematic
Diversified
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Hedge Funds - AUM
B B Chakrabarti: [email protected] 24
Quantopian
B B Chakrabarti: [email protected] 25
Quantopian - Objectives
• Established in August, 2011.
• First web-based platform that allowed professional and
amateur quantitative traders to develop, test and
execute their strategies.
• Goal: Create a trading strategy on our platform which
will continue to make money in the future.
• Ambition: If barriers to algo trading were lowered and
the development process standardized, thousands of
talented quants would form a commuity around the
platform. Talented minds could come together to
create unlimited possibilities.
B B Chakrabarti: [email protected] 26
Quantopian – Business Model
• The company has a two-sided market business model:
• The first side consists of algorithm-developer members who
develop and test for free, focusing on algorithm development
for factors that can be added to Quantopian's offerings
to institutional investors.
• All members can compete against other members in a series
of contests called the "Quantopian Open.” Anyone can join
the site and (optionally) enter the contests: no particular
educational qualification nor work experience are
required. Quantopian provides them with free data sources
and tools, largely built in the Python programming language.
• The second side is institutional investors. Serving them will
become the main focus of Quantopian. These members have
their investments managed by the winning algorithms.
B B Chakrabarti: [email protected] 27
Quantopian – Business Model
• Successful developer-members can get a royalty or
commission from investor-members, who profit from the
former's algorithm.
• Quantopian aims for modest number of users and a large
average revenue per user (ARPU); more like Bloomberg than
Facebook.
• Quantopian provided brokerage integrations to individual
investors. These integrations were continued by developing a
backtesting tool named Zipline-Live in 2012. Over 9 million
backtesting done so far.
• In 2018, the company announced the availability of an
enterprise software product for asset managers, in
partnership with FactSet.
.
B B Chakrabarti: [email protected] 28
Crowdsourcing Models
• Crowd Judgment: This model pools judgments or ratings from
a large member pool to reach a collective opinion.
• Ex:
1) Vetr (https://www.vetr.com.au/) – Stock advisory firm –
Stock monitoring, rating and prediction done by crowd users
2) Estimize: (https://www.estimize.com/) – Market
forecasting business – Crowdsourced earnings and economic
forecasts
3) Augur: (https://www.augur.net/) - Market forecasting
business – It is a decentralized oracle and peer to peer
protocol for prediction markets.
B B Chakrabarti: [email protected] 29
Crowdsourcing Models
• Crowd Resource: This model pools resources from a crowd of
unknowns to achieve its business goals. This model, at almost
no cost, asks the crowd to contribute resources such as
financial capital or slack computing power.
• Ex:
1) Kickstarter (https://www.kickstarter.com/) – Venture
funding business – Seed funding for new ventures
2) CircleUp: (https://circleup.com/ ) – Venture funding
business – Equity crowd funding for consumer product
ventures
B B Chakrabarti: [email protected] 30
Crowdsourcing Models
• Crowd Wisdom: This model curates thoughts and synthesizes
collective intelligence from a crowd of unknowns to
accomplish more sophisticated business tasks.
• Ex:
1) Quantopian (https://www.quantopian.com/) – Hedge Fund
– Quant hedge fund trading algorithms
2) Numerai: (https://numer.ai) – Hedge Fund – Macro hedge
fund with crowd sourced mathematical models
B B Chakrabarti: [email protected] 31
