Modern Portfolio Theory-Effect of Diversification on the Optimal Portfolio-Portfolio Management in Python

In the previous installments, we presented the concept of Modern Portfolio Theory. We also provided an optimization algorithm, written in Python, for searching for the optimal portfolio.

To continue, we are going to perform some numerical experiments. Specifically, we are going to use the portfolio optimization program developed in the previous post in order to study the effect of diversification.

In finance, diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets. If asset prices do not change in perfect synchrony, a diversified portfolio will have less variance than the weighted average variance of its constituent assets, and often less volatility than the least volatile of its constituents.

... Every equally weighted, uncorrelated asset added to a portfolio can add to that portfolio's measured diversification. When assets are not uniformly uncorrelated, a weighting approach that puts assets in proportion to their relative correlation can maximize the available diversification. Read more

It’s well-known that if we add an asset that is negatively correlated with the existing assets in the portfolio, then it will likely result in a higher risk-adjusted return, i.e. a higher Sharpe ratio. For this reason, in the previous examples, Gold was included as a diversifier.

In this post, we expand our 3-ETF portfolio by adding volatility-related instruments that are known to be negatively correlated with the equity market. We will use our Python program and explore whether the inclusion of a negatively correlated asset would enhance the portfolio’s risk-adjusted return.

Adding VXX ETF

We first add VXX, a volatility Exchange Traded Fund, to the portfolio and run the Python program. The picture below shows the optimal portfolio’s composition and the Sharpe ratio.

It’s interesting to note that the program determined the weight of VXX to be zero, and consequently, the Sharpe ratio is unchanged. This is probably because the return of VXX is too negative (-66% per annum) so there is no benefit of adding it to the portfolio. Also, the volatility of VXX is high, and adding a volatile asset to a portfolio is not diversification.

Adding spot VIX

We next add spot VIX to the portfolio. Note that spot VIX is not a tradable asset. We do this exercise merely for the sake of numerical experimentation.

The figure below shows the optimal portfolio’s composition and the Sharpe ratio.  This time we obtained indeed a higher Sharpe ratio (an increase from 1.17 to 1.45). It’s interesting to note that Gold is now eliminated from the portfolio.

In summary, this post is an exploration of how to use the optimization algorithm to study the effect of diversification. Readers are encouraged to experiment with other asset classes.

Last and not least, do not forget the assumptions of the Modern Portfolio Theory.

 

Click on the link below to download the Python program and data files.

Originally Published Here: Modern Portfolio Theory-Effect of Diversification on the Optimal Portfolio-Portfolio Management in Python

What Is a Special Dividend?

A dividend is a payment made from companies to their shareholders. These payments come from the earnings the companies generate from their financial activities. Most companies distribute these payments to compensate their shareholders for their investments. Paying dividends is prevalent among companies. Sometimes, however, companies may also pay their shareholders special dividends.

What is a Special Dividend?

A special dividend, as the name implies, is a dividend paid by companies on special occasions. There are no requirements for companies to pay these dividends. However, they may still make payments to shareholders if they wanted. Special dividends are non-recurring payments, usually in monetary form. These are also a higher amount compared to normal dividends. Another name for special dividends is extra dividends.

How do Special Dividends work?

Special dividends are one-time payments made to shareholders. However, the process behind it is similar to that of usual dividends. Companies pay special dividends based on the current number of shares that shareholders own. Once a company’s management realizes it has substantial cash resources that there is no use for, they may consider paying out special dividends.

Compared to regular dividends, special dividends are unpredictable. Regular dividends usually come during specific periods, such as quarterly or annually. The amount the companies pay as dividends may vary but, usually, follow historical trends. On the other hand, there are no requirements for how much companies may pay as special dividends.

Special dividends are significantly different in their nature from regular dividends. These don’t come at specific periods. Similarly, they don’t come after a company has calculated its financial performance. Investors and analysts do not consider these dividends when calculating a company’s expected returns.

Usually, special dividends come from stable companies with substantial cash resources. Other companies may use the resources for projects. However, for some companies, the cash may not suffice for projects. Similarly, some companies may not have any plans for their extra resources. Therefore, they may distribute it as special dividends.

Why do companies pay Special Dividends?

Companies don't need a reason to distribute special dividends to shareholders. However, that does not mean these occur after usual, predictable intervals. Usually, companies pay dividends for several purposes. As mentioned above, the most common reason is to distribute extra cash reserves to shareholders for which companies have no use.

Some companies may also use special dividends to send a positive signal to the market. By paying one-time dividends, companies can give shareholders and investors confidence in their ability to make profits. Similarly, some companies going through financial structure changes may also use special dividends to restructure their capital.

What are the disadvantages of Special Dividends for companies?

While paying special dividends has its benefits, it can also be disadvantageous for companies. Firstly, by paying dividends, companies lose cash reserves. While it is not necessarily a bad thing, by investing the cash, companies can generate extra returns. Similarly, some shareholders and the market may perceive special dividends as a company’s lack of plans. It may also end up hurting the company’s future.

Conclusion

Aside from regular dividends, companies may also pay special dividends. However, special dividends are one-time payments. The process of special dividends is similar to regular dividends. There are various reasons why companies pay special dividends. However, it may have some disadvantages for the company.

Post Source Here: What Is a Special Dividend?

Is Reverse Stock Split Good or Bad

What Is a Reverse Stock Split?

A reverse stock split is a process used by companies to reduce the number of their outstanding shares in the market. Companies use reverse stock splits to consolidate their existing shares into fewer but proportionately more valuable shares. Reverse stock splits can provide a boost to a company's stock prices.

Through a reverse stock split, companies divide their existing total outstanding shares by a number. For example, companies can use a 1-for-5 reverse split to convert every five shares into one. Other names used for the reverse stock split is stock consolidation, stock merge, or share rollback. Companies may use it according to their situation.

How does a Reverse Stock Split work?

Companies usually don't use reverse stock splits. However, due to market situations, they may take action to restructure their capital structure. One of these actions includes reverse stock splits, where company merge their existing shares. It allows them to reduce the number of their outstanding shares while also increasing the proportional value. However, it does not impact a company's overall valuation.

While restructuring their capital structure is a reason to use a reverse stock split, companies usually use it to boost their share prices. It may go in a company's favour or against it. However, it depends on how a company uses reverse stock splits and the market conditions that accompany them. Usually, reverse stock splits come from a company's management but still have to go through a shareholders' approval.

What are the advantages of Reverse Stock Splits?

Reverse stock splits can have some advantages. These advantages are the reason why some companies may opt to use reverse stock splits. Firstly, some companies may use these splits to stay on a major stock exchange. Some exchanges have rules for how far a company's stock prices can fall before they get removed. Therefore, companies nearing that limit may prevent their removal by using reverse stock splits.

Companies may also use reverse stock splits to satisfy regulations. Some companies may face specific regulations related to the number of their outstanding shares. By reducing the number, they can avoid these regulations. Some companies may also use reverse stock splits to attract affluent investors. By increasing their outstanding shares, they can improve their exposure to investors that select high-priced shares for their portfolios.

Is Reverse Stock Split good or bad?

Reverse stock splits can be beneficial for companies if used correctly. However, they may send a negative signal about a company. Usually, companies that use reverse stock splits do so to increase their share prices. However, investors may see it as a last effort by a company's management to avoid removal from a major stock exchange.

For existing investors, theoretically, reverse stock splits shouldn't be problematic. It is because the company's valuation remains unchanged. However, once a company uses a reverse stock split, its stock prices may go down in the market due to the negative perception that comes with it. Therefore, it can also impact existing shareholders adversely

Conclusion

Companies use reverse stock splits to reduce the number of their outstanding shares in the market. There are various advantages of using reverse stock splits. However, they are usually bad for investors. It is because they come with a negative signal, which can affect investors adversely.

Originally Published Here: Is Reverse Stock Split Good or Bad

Is Stock Split Good or Bad?

What is a Stock Split?

A stock split is when companies divide their existing shares into multiple new shares. Usually, the goal with stock splits is to decrease stock prices and boost liquidity. Usually, companies use multiples to increase their shares outstanding. For example, companies may use 3-for-1 or 4-for-1 stock splits. It means that they will convert each share that shareholders own to 3 or 4 shares.

While companies may use a stock split to reduce their share prices, it does not affect their overall valuation. Therefore, stock splits do not impact a company's shareholders' total equity or their wealth. Instead, it aims to increase the number of shares that a company has in circulation in the market.

How does a Stock Split work?

Stock splits are prevalent among publicly traded companies. Companies usually grow in size due to their past performances, new acquisitions, new product, or share repurchases. This growth in size brings various benefits for the company, such as an increased share price in the market. However, some investors may not be able to purchase their shares at higher prices.

Therefore, companies announce stock splits. As mentioned, companies used multiples for stock splits. For example, a company using a 2-for-1 stock split will double its total number of outstanding shares. If the shares were worth $10 each before the split, their value becomes $5 after. Shareholders will have the same worth of shares before and after the process. However, the number of shares will differ.

Investors who couldn’t afford a company’s shares at $10 may be able to afford it at half the price. For the company using the stock split, it opens up more sources of finance. That is why it is most common among large companies that want to increase their share liquidity.

What are the advantages of Stock Splits?

The most beneficial consequence of stock splits is that it makes a company's shares more liquid. It doesn't only benefit new investors looking to purchase the company's shares. It also helps the existing shareholders by allowing them to dispose of their holding easily. It also makes it easier for portfolio managers to rebalance their portfolios.

Unlike reverse stock splits, stock splits can actually result in higher share prices in the future. It is because the reduced prices increase the demand for a company’s shares. The increased demand, in turn, increases the company’s share prices. Most companies have experienced a growth in share prices after announcing stock splits.

Is Stock Split good or bad?

Stock splits can be good if used properly. However, most experts believe that they are bad. Firstly, stock splits decrease a company's share prices. Doing so attracts retail investors and may discourage quality investors from investing in a company. Similarly, stock splits could increase volatility in the market because of the new share price. While an increased demand in a company's stock can increase its share prices, it also makes it more volatile.

Lastly, stock splits don’t always result in increased prices. These can lead to risks that investors or the market may view the split as a negative signal. Thus, it can also result in a decrease in a company’s share prices in the market.

Conclusion

Companies use a stock split to divide their existing shares into multiple new shares. It allows them to boost their share's liquidity. Stock splits are the most common among large companies. These can be advantageous and can increase a company's share prices in the future. However, stock splits may also be bad as they cause volatility. They also bring low-quality investors.

Post Source Here: Is Stock Split Good or Bad?

Book Value Per Share

What is Book Value Per Share?

Book value per share (BVPS) is a metric used to calculate a company's per-share book value. It uses the common shareholders' equity balance of a company. Therefore, it is also known as the book value per common share. Calculating a company’s book value per share is relatively easier as the figures are available in the company’s Financial Statements.

What is the formula to calculate the Book Value Per Share?

The formula to calculate the book value per share of a company is as below.

Book Value Per Share (BVPS) = (Shareholders’ Equity - Preferred Stock) / Average Shares Outstanding

Investors may also use the total shares outstanding of a company at the end of its accounting period. However, for companies with variable shares outstanding during a period, the average shares outstanding formula produces a better result. Using the closing number of shares may produce inaccurate or misleading results if there are fluctuations in the number of outstanding stocks during a period.

Example

A company, Red Co., has shareholders’ equity equal to $10 million. Out of this balance, $2 million relates to preferred stocks. Red Co. had 3 million shares outstanding at the start of the period. However, its closing shares outstanding were 5 million. Therefore, Red Co.’s book value per share will be as follows.

Book Value Per Share (BVPS) = (Shareholders’ Equity - Preferred Stock) / Average Shares Outstanding

Book Value Per Share (BVPS) = ($10 million - $2 million) / [(3 million + 5 million) / 2]

Book Value Per Share (BVPS) = $8 million / 4 million

Book Value Per Share (BVPS) = $2/share

How can investors use a company’s Book Value Per Share?

For most investors, the Book Value Per share can be crucial in exploiting profitability opportunities. Investors use a company’s BVPS as a comparative tool with its market value per share (MVPS). Both these valuations come from various sources. What investors look for when comparing both these figures is how they differ from each other.

A company’s BVPS can be higher, lower, or equal to its MVPS. If its BVPS is higher than its MVPS, then it means that the company’s stock is undervalued in the market. Therefore, investors prefer to buy the stock and profit from it when the company’s BVPS and MVPS equalize. A BVPS lower than MVPS can have the opposite effect. In these cases, investors prefer to dispose of their shares at the earliest possible. Lastly, an equal BVPS and MVPS indicate a proper market valuation of a company’s stocks.

What are the limitations of Book Value Per Share?

The book value per share can have some limitations as a valuation method. It uses a company’s book value, which companies can manipulate to get better results. Similarly, it does not consider other material factors that may affect a company's share prices. For some companies, the book value may not represent the best valuation measure, especially those with high liabilities.

Conclusion

Book value per share is a metric that investors use to calculate a company's per-share book value. It takes the ratio of a company's equity available to shareholders against the number of its shares outstanding. Investors can use a company’s BVPS to find under or overvalued stocks to profit from these opportunities.

Originally Published Here: Book Value Per Share

What Is an Income Trust?

What is an Income Trust?

An income trust is an investment that may hold various types of securities. These may include equities, debt instruments, real estate, etc. It is beneficial for the financial requirements of institutional investors, such as pension funds. Similarly, old-age investors may also prefer income trust that can provide a steady return.

The primary reason why income trusts are attractive is the promise of paying investors a steady income. These become more attractive when the prevalent bonds in the market yield low cash returns. Most investors prefer income trusts because they do not target unrelated investments. If an income trust is for stock investments, it cannot target real estate investments or vice versa.

There are various structures for income trusts. They may either come in the form of personal investment funds or commercial trusts with publicly traded fund shares. Usually, income trusts have managers that actively manage it and seek to build a diversified portfolio for investors. The goal with these portfolios is to include assets that produce a steady income.

What is a Personal Income Trust?

Income trusts may come in the form of trust funds used to manage the portfolios for a closed group of people. It is common for families to use income trusts to manage their collective assets or structure inheritances. The goal for income trusts is to contain income-producing assets. Usually, a trustee manages these trusts on behalf of the trustor to pass the asset to the trust's beneficiary.

Personal income trusts may include various terms. These may consist of terms related to the beneficiary's involvement and inheritance transfer. These terms will also provide details about how the trustee should manage and administrate the trust. Apart from these, they may also include more detailed terms associated with various aspects of trust.

What are Publicly Traded Income Trusts?

Publicly traded income trusts are different from private income trusts. Investors can buy the shares to public income trusts on the financial market. However, they can only find income trusts registered as corporations in the financial markets. The most common form of publicly traded income trusts is Real Estate Investment Trusts (REIT).

REITs offer publicly traded shares on the open market. The purpose of REITs is to build a portfolio of income-paying investments. However, these investments are only in real estate. It represents a great investment for investors looking to diversify their portfolio through asset allocation. Similarly, it is a suitable option for income-focused investors.

What are the risks of Income Trusts for investors?

Income trusts have similar risks for investors as dividend-paying stocks. It is because income trusts are equity investments and not fixed-income securities. Therefore, they share the same risks that come with stock ownership for investors. However, they may not come with the same rights and responsibilities. For example, they do not come with voting rights like traditional stock.

Some other risks also accompany income trusts. These risks may sometimes come due to their similarities with stocks. For example, like most stocks, they do not come with guaranteed income. Similarly, investors get exposed to interest rate risk when investing in income trusts.

Conclusion

Income trusts are an investment which comes with various types of securities. They usually promise a steady income, which makes them more attractive to some investors. There are two prominent types of income trusts, which include personal and publicly traded income trusts.

Post Source Here: What Is an Income Trust?

What Is Behavioral Finance

What is Behavioral Finance?

Behavioral finance is the study of how psychological factors influence the behavior of investors or financial analysts. It is a topic closely related and a part of behavioral economics. Behavioral finance suggests that psychological influences and biases can affect an investor or financial analyst's behavior. It also attempts to explain the sources for all types of market anomalies, especially in the stock market.

There are various perspectives through which one can analyze behavioral finance. It is mostly relevant to stock markets and returns for investors. It is an area that behavioral finance suggests psychological behaviors can influence market outcomes and returns. It is because investors can look at these factors in different ways.

What are the differences between Behavioral and Traditional Finance Theories?

The behavioral finance theory goes against the traditional finance theory in some aspects. The traditional finance theory treats the market and investors as perfectly rational. However, the behavioral finance theory treats investors as "normal" not "rational". The traditional finance theory also suggests that investors have perfect self-control. In contrast, the behavioral theory suggests investors have limits to their self-control.

The traditional finance theory also suggests that investors truly care about utilitarian characteristics. However, the behavioral finance theory implies that investors get influenced by their own biases. Lastly, the traditional finance theory also suggests that investors don't allow cognitive or information processing errors to affect their decisions. The behavioral finance theory believes that investors make cognitive errors which can lead to wrong conclusions.

What are the concepts in Behavioral Finance?

Behavioral finance has five main concepts. The first concept is that of mental accounting. It refers to the propensity for people to allocate money for specific purposes. Behavior finance also includes herd behavior. This concept suggests that financial participants are likely to imitate the financial behavior of the majority.

Behavioral finance also consists of the emotional gap concept. It refers to decision-making based on extreme emotions or emotional strains. It suggests that investors may allow emotions, such as anxiety, anger, excitement, or fear to influence their decisions. Behavioral finance also proves that emotions are often the primary factors for irrational decisions.

The fourth concept within behavioral finance is anchoring. It refers to attaching a spending level to a particular reference. It can give rise to anchoring bias which can cause investors to make incorrect financial decisions. Lastly, behavioral finance also includes the concept of self-attribution. It refers to the tendency of financial participants to make choices based on confidence in self-based knowledge.

What are the different types of biases in Behavioral Finance?

Behavioral finance tries to explain the impact of personal biases on investors and their decision-making. These biases may relate to various factors and can stem from several sources. Among the top biases in behavioral finance, the most prevalent ones are as below.

• Overconfidence in investing and the illusion of control.
• Hindsight bias.
• Anchoring bias.
• Herding mentality.
• Confirmation bias.
• Self-attribution bias.
• The narrative fallacy.
• Representative bias.
• Framing bias.
• Loss aversion.

Conclusion

Behavioral finance is a sub-field in behavioral economics. It studies how psychological factors can influence the behavior of financial participants. It also seeks to explain the sources for an explanation for all types of market anomalies. There are various concepts in behavioral finance. Similarly, it also has different types of biases.

Originally Published Here: What Is Behavioral Finance

Initial Public Offering Process and Example

What is an Initial Public Offering (IPO)?

An initial public offering (IPO) is a process that companies use to offer their shares to the public. These companies are private entities that want to go public with new stock issuance. Issuing shares to the public allows companies to raise funds from public investors. Therefore, it gives them access to a high number of investors, allowing them access to theoretically unlimited funds.

Most companies that go through an initial public offering experience significant change. It allows them to transition from a private to public status. It is also a crucial period for private investors to realize gains from their investments. It is because IPOs include share premiums for current private investors. Similarly, it lets public investors participate in a company's offerings.

What is the Initial Public Offering process?

An initial public offering signifies the first time a company goes public. Before the process, it is private. Most private companies have a limited scope for growth and funds. It is because they have a relatively small number of investors, which mostly consist of its founders. By going public, companies can tap into a theoretically unlimited amount of funds by allowing the public to contribute to their finances.

When a private company reaches a growth stage, it may decide to go through an IPO. However, IPOs usually come with strict rules and regulations from the SEC. Therefore, companies must ensure that they can go through the process before deciding to go public. Once the company finalizes its decision, it will advertise its interest in going public to grab public attention.

The next step for companies is to select an investment bank. It is a company or bank that advises the company on its IPO and provides underwriting services. Companies may look at various criteria when selecting an investment bank, including its reputation, quality of research, industry expertise, etc. With underwriting services, the investment bank acts as a broker between the company and the public.

The next step in the IPO process is to carry out due diligence and make regulatory filings. These are all steps that the investment bank carries out. Through due diligence, underwriters can decide the share price of a company’s initial issues. Similarly, regulatory findings are crucial and required as a part of the SEC’s regulations.

The next step in the IPO process is the pricing of shares. There are several factors that companies and underwriters may consider before pricing shares. The due diligence process also helps in this process. Once the underwriter and company decide on the share price, they bring the issue to the market. The underwriter provides analyst recommendations, after-market stabilization and creates a market for the issued stock.

The final stage in the IPO process is the transition to market competition. It starts after 25 days of the IPO when the quiet period mandated by the SEC ends. During this period, investors transition from relying on the mandated disclosures and prospectus to relying on the market forces for information regarding their shares.

Example

Facebook went public in May 2012 through an Initial Public Offering. The company managed to raise funds over $16 billion through the IPO. It ranks among the world’s largest IPOs to date. Saudi Aramco still has the record for the world’s largest IPO. The company went public in December 2019 and raised over $29 billion.

Conclusion

An initial public offering is a process that private companies use to offer their newly issued shares to the public. It allows them to generate more finance than if they use their limited number of existing shareholders. The initial public offering process has several steps, as mentioned above.

Originally Published Here: Initial Public Offering Process and Example

Private Placement vs Public Offering

For most companies, raising capital through issuing stocks is a prevalent option to get funds. However, there are different ways they can generate those funds. For most companies, obtaining funds from existing financiers is a great option. However, there is a limited amount of funds that companies can generate. Therefore, they must get those funds from other parties, usually the general public.

When it comes to generating funds through the public, companies also have several options. Among these, private placements and public offerings are most common. There are differences between both options, which is crucial to understand.

What is a Private Placement?

A private placement allows companies to issue their stocks or bonds to a pre-selected pool of investors and institutions. They don't go to the open market to get these funds. It is a great alternative to public offerings, especially for companies looking to stay private. For public offerings, companies have to change their status to the public.

Usually, companies select investors from different sources. These may include wealthy investors, banks and other financial institutions, insurance companies, pension funds, mutual funds, etc. The selection process of these investors differs according to every company. However, companies always target investors that can provide a sizeable investment.

Private placements, unlike public offerings, have relatively fewer requirements and standards. For most companies, going through the additional regulatory procedures may not be worth generating the finance. Therefore, they may prefer private placements as opposed to public offerings. Companies don’t have to provide detailed information to investors either. However, they may still do it.

Private placements are most common for startups that want to raise finance. Mostly, startups within the e-commerce and financial technology sectors benefit from private placements. Private placements allow companies to grow and develop while avoiding regulations that come with public offerings. The process is also quicker, making it easier for startups to generate funds.

What is a Public Offering?

Unlike private placements, companies do not limit their options with public offerings. Companies that use public offerings offer their stocks or securities to the public through a market. During the process, the company also becomes public, allowing its securities to trade in the market. Before public offerings, companies have to offer their securities in private.

Companies start public offerings by selecting an investment bank for the process. Once they do so, they perform due diligence and make the necessary filings. Similarly, companies also decide on a price for their securities. There are several factors that they weigh in to make a pricing decision. Once they go public, companies perform further analysis to ensure after-market stabilization. Next, companies have to go through a quiet period after which they can transition to market competition.

Public offerings allow companies to generate significantly more finance. In theory, companies don’t have to stay limited to a few selected investors. They can receive funds from an unlimited number of investors. Similarly, once a company goes public, it can use the same process in the future to generate more funds. However, public offerings come with stricter regulations to which companies must oblige.

There's also an extra party involved in public offerings known as underwriters, or the investment bank. These are institutions or firms that bring a company's issues to the market. These firms sell shares to their clients at the initial sales price. Once these shares go through their investors, other investors can obtain them after the company's shares start trading in the market.

Conclusion

Companies can generate funds through several sources. For this process, they may either use private placements or public offerings. With a private placement, companies offer their shares to a pre-selected pool of investors. With public offerings, companies can get funds from the public, not limited to a pool of investors.

 

Article Source Here: Private Placement vs Public Offering

Money Market vs Capital Market

A market is a place for buyers and sellers to come together and connect. Financial markets are similar as they bring market participants together for financial transactions. These usually include financial assets, such as stocks, bonds, commodities, currencies, derivatives, etc. Their objective is to regulate prices for trading, increase capital and transfer risk and liquidity.

There are two prominent types of financial markets. These are the money market and the capital market, both of which have specific purposes and regulations. Therefore, it is crucial to understand the difference between them.

What is a Money Market?

A money market is a financial market where buyers and sellers trade in short-term debt investments. It involves a large volume of trades between institutions and traders, usually at a wholesale level. Similarly, smaller money markets include money market mutual funds bought by individual investors. Likewise, they may also consist of money market accounts available to bank customers.

Money markets have various characteristics. Among these, the most prominent is a high degree of safety and relatively low returns. However, they play a crucial role in the global financial system. Institutions, including banks, participate in a money market and lend money to other entities. Similarly, individuals can also participate in the market.

What is a Capital Market?

A capital market is a financial market where transfers of capital between investors happen. Usually, investors dispose of funds to individuals and businesses that need them for projects. Two types of instruments are most common in capital markets, equity securities, and debt securities. Apart from these, capital markets may also include currencies, commodities, or derivatives.

There are two types of capital markets, primary and secondary. Primary capital markets involve the issuance and sale of new securities. In contrast, secondary capital markets involve the issuance and sale of already-issued securities. Stock markets, bond markets, and currency and foreign exchange markets are all examples of capital markets.

What are the differences between Money and Capital Markets?

There are several differentiating features between money and capital markets. Among those, the most prominent are as below.

Definition

A money market is a financial market where borrowing and lending take place for a short period. A capital market is a financial market where borrowing and lending take place for a long period.

Instruments involved

A money market usually involves promissory notes, bills of exchange, call money, commercial paper, etc. A capital market involves deals in equity and debt instruments along with derivatives and other instruments.

Institutions involved

The money market consists of financial institutions, including financial, commercial, and central banks. On the other hand, capital markets involve brokers, mutual funds, investors, banks, stock exchanges, and many more.

Liquidity

Money markets and investments within them are more liquid. For investors looking for investment liquidity, money markets are the best option. Capital markets, while still liquid, are relatively less so.

Risks

Due to their high liquidity and short period, money markets offer less risky investments. In contrast, the risks involved in capital markets are comparatively higher.

Returns

Money markets, due to their stability, offer lower returns to investors. In contrast, capital markets provide higher returns due to the higher risks involved.

Conclusion

Money and capital markets are two prominent types of financial markets. Both are viable options for investors. Money markets are for short-term debt investments but have larger volumes of trades. Capital markets are for long-term investments, including stocks, debt, commodities, and other instruments.

Article Source Here: Money Market vs Capital Market

What Is Tactical Asset Allocation

Investors can use various active management strategies to manage their portfolios. Usually, they hire a portfolio manager to track the performance of their portfolio. The managers can make decisions regarding the portfolio with the goal of outperforming the market. However, they must also manage the risks associated with it. One strategy that is common in active management is Tactical Asset Allocation.

What is Tactical Asset Allocation?

Tactical Asset Allocation (TAA) is an active management portfolio strategy that focuses on three primary asset classes. These include stocks, bonds, and cash. The goal with TAA is to shift the percentage of assets held in these categories to benefit from market pricing anomalies. With this strategy, portfolio managers can create extra value by exploiting various market events or situations.

Usually, managers determine a balanced mix of several asset categories. However, they may change this mix to benefit from anomalies. Once they have exploited the market situations, they can revert to their original asset mix. This way, they can ensure both diversification of portfolios and higher returns.

How does Tactical Asset Allocation work?

Investors can use the tactical asset allocation by themselves or hire a portfolio manager to take care of it. Usually, the portfolio manager determines a prudent mix of assets that suits the investors' risk tolerance. Similarly, the manager also considers the investment objectives for the portfolio when deciding on the asset mix. Managers divide the portfolio into three asset categories, which include stocks, bonds, and cash. They use the determined mix for the allocation.

However, the mix does not remain constant. The manager will change the allocation depending on the prominent market and economic conditions. The allocation to a particular asset may vary according to these conditions and the investors' objectives. Therefore, it may be neutral-, over-, or under-weighted. Managers may include these factors as a part of the investment policy statement.

For example, managers may use the following simple mix of assets in a typical portfolio allocation. The percentage for each asset class represents its weight.

Stocks = 50%

Bonds = 30%

Cash = 20%

The above is an example of the long-term mix that managers will follow to help investors reach their specific goals. However, they may change it when they can find any anomalies in the market. Once they exploit those conditions, they will return to the long-term mix.

What is the importance of Tactical Asset Allocation?

Tactical asset allocation can be beneficial for investors for several reasons. Firstly, it allows investors to increase their returns. By changing their asset mix within a portfolio to benefit from market conditions, investors can increase their returns.

Similarly, it allows for adaption according to market conditions. Unlike passive management strategies, tactical asset allocation changes according to the market. Therefore, investors can benefit from any changes in the market and not suffer due to adverse fluctuations.

Most importantly, tactical asset allocation promotes diversification. Investors can diversify their portfolios by allocating them to different asset categories. Similarly, TAA allows investors to choose their own asset mix, allowing for even better flexibility.

Conclusion

Tactical asset allocation is an active management strategy. Investors use it to divide their portfolio into various asset categories. Once they identify any market anomalies that they can exploit, they can change the asset mix to generate higher returns. After that, they can revert to their original mix and wait for the next opportunity.

Article Source Here: What Is Tactical Asset Allocation

Treynor Ratio vs Sharpe Ratio

Investors can use both the Treynor and the Sharpe ratio to measure the risk-adjusted rate of return. However, both are different from each other. While both can help investors gauge the risk on their investments, they both use a different approach to do so. Therefore, it is crucial to understand how both of these work for investors.

What is the Treynor Ratio?

The Treynor Ratio is a metric to determine how much excess return investors can generate for each unit of risk they take on their portfolio. The ratio calculates the return that investors earn above what they could get on a risk-free investment. For this purpose, investors can use the risk-free rate of return, usually taken as the rate on government treasury bills.

The Treynor ratio takes the systematic risk of a portfolio in the form of beta. It produces a meaningful result if an investment’s beta is positive. Similarly, it measures a portfolio return’s tendency to change with fluctuations in the overall market. An alternative name used for the Treynor ratio is the reward-to-volatility ratio.

The formula for Treynor Ratio is as below.

Treynor Ratio = (Portfolio return - Risk-free rate of return) / Beta of the portfolio

The purpose of investors with this ratio is to measure how successful an investment is in compensating them for taking investment risk. It depends on a portfolio's beta to judge risk. Investors always want to take risks only if they can receive compensation in the form of higher returns. However, these are risks inherent to the portfolio, which they cannot mitigate through diversification.

What is the Sharpe Ratio?

The Sharpe Ratio helps investors determine the return of an investment compared to its risk. It takes the average return that investors earn more than the risk-free rate per unit of volatility or total risk. Volatility is a measure of the price fluctuations of an investment or portfolio. The Sharpe Ratio also considers the rate on government treasury bills as the risk-free rate.

Through the Sharpe Ratio, investors can determine whether they are getting excess returns due to their investment decisions or taking up more risk. Investors can use the ratio to evaluate a portfolio’s past and expected performance. Unlike the Treynor Ratio, the Sharpe Ratio considers the diversifiable risks of a portfolio.

The formula to calculate the Sharpe Ratio of a portfolio is as below.

Sharpe Ratio = (Return on portfolio - Risk-free rate of return) / Standard deviation of the portfolio’s excess return

The Sharpe Ratio focuses on maximizing returns and reducing volatility for investors. Usually, a higher Sharpe Ratio is preferable for investors. It is because it indicates a higher investment return relative to the amount of risk that investors take.

What are the differences between Treynor and Sharpe Ratios?

The difference between both the ratios comes down to the risks they consider. The Treynor Ratio takes the systematic risk of a portfolio, the beta, to measure volatility. On the other hand, the Sharpe Ratio considers the portfolio's standard deviation to do so.

Both ratios also have different meanings. The Treynor determines the excess return generated for each unit of risk in a portfolio. In contrast, the Sharpe Ratio helps investors understand their investment’s return compared to its risk.

Conclusion

Investors can use two ratios to measure the risk-adjusted rate of return for their portfolios. These include the Treynor and Sharpe Ratios. The Treynor Ratio looks at the excess return that investors can get for each unit of risk they take on their portfolios. The Sharpe Ratio measures the return on investment compared to its risk.

Originally Published Here: Treynor Ratio vs Sharpe Ratio

Short Selling of Stocks

Investors use various investment strategies to ensure they maximize their returns. Some of these strategies may be long-term, while others may last for a short time. Each type of strategy has its own benefits and drawbacks. One strategy often used by investors and speculators is short selling.

What is Short Selling of Stocks?

Short selling is an investment strategy in which investors speculate about the decline in a stock's price. Based on these speculations, they buy or sell stocks in the market. Short selling is a risky strategy because it has the potential to result in high losses. Therefore, it is crucial that only experienced investors with knowledge of the market use this strategy.

Short selling involves selling stock that sellers don't own or that they have obtained through a loan from a broker. Short sellers use this technique because they may speculate a stock's price will go down. They believe that if they sell the stock now, they can buy that stock later for a lower price. By doing so, they make a profit from the difference between the buy and sell prices.

What are the risks associated with Short Selling?

As mentioned, short selling involves significant risks, especially for investors without any market knowledge. When investors buy a stock, they take a risk with the amount they pay to purchase it. The maximum amount that the investor risks is the value paid for the purchased stock. However, with short selling, the risk is not limited to that price.

Investors can make losses more significant than the price they pay for a stock. In theory, they can lose an infinite amount of money. Investors can continuously make losses because the stock may continue to go up in value indefinitely. In some cases, investors may end up in a net liability position and owe money to the brokerage.

What are the advantages and disadvantages of Short Selling?

There are various pros and cons of short selling. Investors can benefit if they make the right speculations. Usually, they don't need a large initial capital as most of the strategy involves borrowing from brokers. It is also possible to make leveraged investments through short selling. Through the right short selling strategy, investors can hedge against other holdings, providing a balance to their overall portfolio.

However, short selling can also potentially result in unlimited losses for the investor. It is also a strategy that only experienced investors can use beneficially. For newer investors, short selling can be substantially risky. Short selling also requires a margin account. This strategy also comes with margin interest, which can be a significant expense when margin trading.

When should investors use a Short Selling strategy?

Short selling works when stocks go down in value. Often, however, the expectation is that stocks go up in value. In these circumstances, therefore, a short-selling strategy is not beneficial. Similarly, buying stocks is less risky compared to short selling. When investors can predict a downfall in stock prices, short selling can prove to be highly beneficial.

Conclusion

Short selling is a strategy that investors use to speculate the downfall in the prices of shares. When investors predict a drop in stock prices, they sell their stocks to purchase them back later at a reduced price. This way, they can profit from the difference in prices. Short selling is a risky strategy. Investors need to have some prior market and investing experience to make the strategy work.

Originally Published Here: Short Selling of Stocks

Systematic Risk and Unsystematic Risk

Risk defines a degree of uncertainty that may come during various stages in an entity's lifecycle. The concept of risk is most prevalent in economics and finance. For businesses or investors, identifying and dealing with risk is crucial. It also helps to understand the differences between the types of risk to understand how to mitigate them.

For investors, the difference between systematic and unsystematic risk is critical to define. These are risks that accompany every financial decision. Therefore, it is crucial to know the differences between both of them.

What is Systematic Risk?

Systematic risk represents the risks that are inherent to the entire market or market segment. It affects all market participants similarly and not just a specific stock or company. Other names for systematic risks are undiversifiable, volatility, or market risk. Systematic risks come from various sources and are unpredictable and inevitable.

Investors can use various strategies to mitigate other types of risks, such as diversification. However, most of these strategies do not work for systematic risk. It is because this risk affects the overall market. However, there are still ways to mitigate these risks. Investors can use strategies, such as asset allocation or hedging, to manage systematic risks.

What is Unsystematic Risk?

Unsystematic risk represents risks that relate to a specific company or industry. This risk is inherent to a particular stock, company, or industry rather than the market as a whole. Other names for unsystematic risk include specific, diversifiable, or residual risk. The unsystematic risk may come from external factors, such as new competitors, or internal factors, such as bad performances.

The most common strategy that investors use to mitigate unsystematic risk is diversification. As unsystematic risks relate to specific investments, investors can construct a diversified portfolio to manage them. Investors can sometimes use various techniques to anticipate or predict unsystematic risks. However, it is not always possible to predict it.

What are the differences between Systematic and Unsystematic Risk?

There are many differences between systematic and unsystematic risk. A few of those differences are as below.

Definition

Systematic risks represent risks that apply to the market as a whole. Unsystematic risks, on the other hand, are risks that are specific to a company or industry.

Nature

Systematic risks are uncontrollable and unpredictable in their nature. Therefore, traditional diversification strategies may not work with systematic risks. However, unsystematic risks are usually controllable and diversifiable.

Measurement

The best measurement of systematic risk is the Beta coefficient. Unsystematic risk, in contrast, does not have a measurement unit. However, investors can calculate these risks by deducting the systematic risk from the total risk.

Sources

Systematic risks come from external sources. These include risks such as interest rate risks, material risks, purchasing power risks, etc. Unsystematic risks may come from internal and external sources. These may consist of financial, business, and operational risks, among others.

Mitigation

As mentioned, the best way to mitigate systematic risk is through asset allocation. However, for unsystematic risk, investors can use diversification to mitigate them.

Conclusion

Systematic and unsystematic risks are critical in finance and investing. Systematic risks represent these risks that apply to the market as a whole. On the other hand, unsystematic risks apply to a specific stock or industry. There are various other differences between both these risks, as mentioned above.

Originally Published Here: Systematic Risk and Unsystematic Risk

Risk Tolerance vs Risk Appetite

There are two terms related to the risk that are crucial for investors to understand. These are risk tolerance and risk appetite. Both of them have various similarities. However, there are also some differences between them.

What is Risk Tolerance?

Risk tolerance represents the amount of risk that investors can tolerate when building their investment portfolio. Risk tolerance shows the degree of uncertainty or variability in investment returns that investors can withstand before exiting the market. Usually, an investor’s risk tolerance level depends on various factors, including their financial situation, time horizon, purpose, preferences, etc.

The most critical factor among those is the investor’s age. Usually, younger investors have a higher risk tolerance level compared to elders. It ties various of the above factors together. For example, younger investors have a longer time horizon. Therefore, their purpose is to make higher returns. Hence, they are also likely to accept higher risks associated with their investments.

There are various categorizations for investors based on their risk tolerance. For example, some investors may not tolerate higher risk. These investors may take a cautious approach to investments. Therefore, they will have conservative risk tolerance. On the other hand, investors with a preference for higher returns and risk will have aggressive risk tolerance. Lastly, those with a balanced approach will have moderate risk tolerance.

What is Risk Appetite?

Risk appetite represents the amount, percentage, or rate of risk that an investor is willing to accept. Risk appetite is the quantification of an entity's willingness to take risks in return for its plan, objectives, and innovation. Risk appetite is closely related to risk tolerance levels. However, it does not represent the level of risk before an entity leaves the market. Instead, it refers to the risk they are willing to accept when executing their plans or strategies.

Most investors or businesses have a risk appetite framework. This framework helps the consciously recognize the risks and acknowledge the potential exposure to their strategies. This framework depends on how entities view the relationship between risks and rewards for their chosen plans or strategies. While risk appetite usually relates to an entity, it may also get affected by regulatory or legal requirements.

Entities with a higher risk appetite are also willing to accept higher uncertainty and volatility in exchange for higher growths. On the other hand, entities with a lower risk appetite will have a risk-averse approach to their plans and strategies. They will prioritize stability and lower growth over market volatility and higher returns.

What is the difference between Risk Tolerance and Risk Appetite?

The difference between both risk-related concepts is subtle. Risk tolerance is when entities would remain comfortable despite losses or uncertainties. Their risk endurance depends on several factors such as age, earning capacity, time horizon, etc. Every investor will have their own personal risk tolerance levels.

Risk appetite represents the amount, rate, or percentage of risk that entities are willing to bear in their planning or strategy. It comes as a direct result of an entity’s goals or objectives. These are risks that entities must accept to move forward with their chosen path.

Conclusion

Risk tolerance and risk appetite are terms associated with risk that have similar meanings. Risk tolerance refers to the level of risk that entities are willing to accept when constructing a portfolio. On the other hand, risk appetite is the risk they must take in their plans or strategies.

Article Source Here: Risk Tolerance vs Risk Appetite

Risk Aversion in Economics and Finance

What is Risk Aversion in economics?

Risk aversion is a term often associated with economics and finance. It describes the tendency of people to prefer low uncertainty outcomes to those with high uncertainty. Risk aversion applies to several other fields of life as well, such as investing. Risk-averse people are likely to reject higher risks even if they can get higher returns from accepting these risks.

Risk aversion explains why people prefer to agree to a situation that is more predictable with lower returns. Risk-averse investors will always choose to get low predictable returns or outcomes rather than high unpredictable ones. For example, these investors may prefer putting their money in the bank and earning steady investing returns. They don't consider any alternatives when the outcome is not predictable.

Why is Risk Aversion essential?

Risk aversion is a crucial concept in economics and for investors. Investors that are significantly risk-averse prefer investments that offer guaranteed outcomes. For these investors, investing in risk-free instruments or those with similar risk levels is the best option. Risk aversion explains why investors may not always prefer high returns, as they come with high risks.

For example, risk-averse investors prefer investing in government treasury bonds and certificate of deposits. On the other hand, risk-loving investors may go with aggressive investing strategies to obtain higher returns. Among both these extremes, there are also risk-neutral investors that prefer moderate risks with moderate returns.

What are the characteristics of Risk-Averse investors?

Risk-averse investors or individuals have various characteristics. Usually, they have a conservative approach to selecting investments or projects. They don't prefer to include any volatile investments in the portfolio. Usually, risk-averse investors prefer highly liquid assets. The demand for liquidity comes due to their preference for financial security over performance.

Several factors can play a role in making someone risk-averse or risk-seeking. Usually, the investor's age is the most critical factor. It is common for older investors to be more risk-averse, as they prefer steady incomes for financial stability. Younger investors, on the other hand, are more risk-seeking on average. However, other factors, such as the investor's background, financial history, and experiences may also dictate their risk level preferences.

What are some investment choices for Risk-Averse investors?

Some investment choices are prevalent among risk-averse investors. The reason for the high demand is that they come with high levels of certainty for investors. Among the most common investment choices for risk-averse investors are the following.

• Savings accounts.
• Municipal, government, and corporate bonds.
• Certificate of deposits.
• Dividend growth stocks.

Almost all of the above investment choices come with high levels of predictability and certainty. Some, like dividend growth stocks, may fluctuate in value. However, these are usually stocks of stable, well-established companies. Therefore, the fluctuations aren’t as substantial compared to other companies. Similarly, the steady source of growing income from dividends is a highly favourable option for risk-averse investors.

Conclusion

Risk aversion is a concept usually associated with economics and finance. In the world of finance, it has significant importance as well. Risk aversion describes why people tend to prefer low returns if they come with higher certainty. It also explains why some investors may be risk-averse, while others may be risk-seeking or risk-neutral.

Article Source Here: Risk Aversion in Economics and Finance

Risk Transfer in Insurance

When companies or businesses come across risks, they use various risk management techniques. For every type of risk that a company identifies, it must assess its probability, importance, and frequency. Based on that, it must evaluate what strategy to use to manage it. Among the various risk management techniques, companies may use risk transfer to mitigate risks.

What is Risk Transfer?

Risk transfer refers to the risk management technique in which companies transfer their risk to a third party. Usually, the third party will charge these companies to accept it. A risk transfer happens when one party assumes the liabilities of another party. It is often prevalent in insurance transactions, where companies transfer their risk to an insurance agency or company.

However, risk insurance may also happen between various other parties. For example, individuals may transfer their risks to other individuals. Or individuals may transfer their risks to insurance companies. However, the process does not end there. Some insurance companies even further transfer their risks to reinsurers. The chain created by risk transfer may involve several parties at the same time.

How does Risk Transfer work?

As mentioned, risk transfer is most prevalent within insurance transactions. It is the best way to describe how risk transfer works. Firstly, a company or an individual identifies a risk that they want to mitigate through transferring. The risk may come with potential losses or adverse outcomes. Therefore, they may want to shift those losses to a third party.

Once a company decides to transfer risks, it must find a third party willing to accept it. Through risk transfer, companies can't eliminate the risk. However, they shift it to another party. Therefore, the risk always exists, and one party must suffer the consequences arising from them. However, the opposite party may also benefit from the transaction by charging a fee for accepting the risk.

What are the ways in which companies use Risk Transfer?

There are two ways in which companies may transfer their risks. These are as below.

Insurance contracts

Purchasing insurance policies is one of the most prevalent risk transfer techniques that companies use. When an entity purchases insurance, they are shifting their financial risks to an insurance company. In exchange for the fee, the insurance company charges the entity a fee. In the case of insurance contracts, it is an insurance premium.

Indemnification clause

Companies may also include an indemnification clause in their contracts. It is a clause that ensures that any potential losses in an agreement will be the opposite party's responsibility. In short, companies include this clause in their contracts so that they get compensated for any losses.

What is Risk Transfer in the insurance industry?

As mentioned, insurance companies may also transfer their risks to a third party. The third-party, in this case, is known as a reinsurance company. These are companies that provide insurance to insurance companies. Similar to regular insurance transactions, insurance companies can also shift their risk to a reinsurance company. In exchange, the reinsurance company charges the insurance company an insurance premium.

Conclusion

Risk transfer is a risk management technique utilized by companies to mitigate any risks. The most common example of risk transfer is insurance contracts. However, companies may also use indemnification clauses in their contracts for similar purposes.

Originally Published Here: Risk Transfer in Insurance

Types of Non-Financial Risks

For companies and businesses, identifying and managing various types of risks are crucial. Mostly, companies use traditional financial risk management techniques to mitigate them. Due to their nature, financial risks are most prevalent for companies. Therefore, these companies often focus on financial risks compared to other types.

What are Non-Financial Risks?

Apart from financial risks, companies may also come across non-financial risks. These are risks that are not a part of the standard financial risks of a business. Therefore, traditional risk management techniques don't cover them. Despite that, companies must identify and mitigate these risks. While these risks may not be as prevalent, they can still harm a company and its business.

In its lifetime, a company will come across various types of non-financial risks. Identifying each of these non-financial risks allows the company to customize its responses accordingly. Most non-financial risks come from outside the company or due to external factors. However, there are still ways to mitigate these risks once a company identifies them.

What are the types of Non-Financial Risks?

Non-financial risks can come from various sources and can have different consequences. Given below are some of the most prevalent non-financial risks that companies often face.

Reputational Risk

Reputational risk is a risk that can threaten or endanger a company's goodwill. For most companies, developing a brand name or goodwill with customers is crucial to long-term success. However, some factors may impact them adversely. These factors result in reputational risk for the company. These risks can come from within or outside the company.

Reputational risks may come directly from a company's actions. These can stem from the decisions a company makes. Similarly, it may also come indirectly through an employee’s actions. Lastly, reputational risks may also generate tangentially through related or peripheral parties, such as suppliers, customers, or joint venture partners.

Legal Risk

Legal risk represents the risk that legal issues may impact a company's operations or reputation. For companies, legal risks may come directly as a consequence of their actions. For example, if a company sells faulty equipment to a customer that causes damage, it faces legal action. However, legal problems may also arise from external factors.

Legal risks may also come in the form of regulatory risk. Companies abide by various rules and regulations. However, there's always that non-compliance with any of those regulations can impact their reputation or business. Regulatory risks can result in penalties and can give rise to financial risks and business risks.

Model Risk

Model risk represents the type of risk that a company's financial model fails. Usually, companies use their financial model to measure quantitative information, including value transactions or market risks. Companies rely on the results produced from these models for various purposes, including decision-making.

Financial models have become prevalent in most companies. These models come with several calculation techniques or assumptions, which can be risky. Based on the information obtained from these models, companies make various estimates or forecasts. A small error in these models can lead to huge errors later when companies extrapolate the data.

Conclusion

Despite most companies focusing on financial risks, non-financial risks may also impact a company. Non-financial risks are risks that are not part of a company's traditional risk management techniques. There are various types of non-financial risks. Among these, companies most often face reputational, legal, and model risks.

Article Source Here: Types of Non-Financial Risks

Financial Risks in Business

Companies or businesses face various types of risks during their lifetime. Identifying and dealing with these risks is crucial for the long-term survival of those companies. While there are some risks that may not occur often, there are some others that companies must manage continuously. Among these, financial risks are prevalent.

What are Financial Risks?

Financial risks represent the possibility of losing money on investments or projects taken up by companies. These come from uncertainties related to the decision-making regarding investments. They can result in the loss of capital for companies and their stakeholders. However, companies aren’t the only entities that must face financial risks.

Public entities, such as government bodies may also have to deal with financial risks. For these entities, financial risks represent the uncertainties related to the control of their monetary policies. Similarly, it may come as a result of a default on bonds or other debt issues. For government entities, financial risks come as a direct result of their finances or investments.

For companies, on the other hand, financial risks may come from various sources. For example, failures within a company’s operations can result in the loss of profits and lead to capital losses. Similarly, financial risks can come from within or outside the company. There are various types of financial risks in business that companies must identify and mitigate.

What are the types of Financial Risks in business?

As mentioned, financial risks may come in various sizes and shapes. While there are several types of these risks, some of the most prevalent ones are as below.

Market Risk

Market risk is the risk of changing conditions in a marketplace in which a company operates. Another name for market risk commonly used in investing is systematic risk. Various types of market risks can affect a company's performance. These may include interest rate risks, commodity risk, or currency risk.

For each type of market risk, companies must have proper responses. Since the risk depends on a specific company’s situations and processes, market risk can differ between companies.

Credit Risk

Credit risk comes as a direct consequence of a company's credit system. When a company makes credit sales, it also undertakes credit risks. These risks come in the form of bad debts when customers fail to pay their owed money. Companies can also make credit purchases from suppliers. Therefore, credit risks also include risks related to those credits.

Liquidity Risk

Liquidity risk relates to the liquidity of assets or operational funding. This risk usually relates to the company's cash flows or working capital. Since these are vital aspects of a company's business, liquidity risk can prevent companies from making profits. For some companies, liquidity risk may be higher than others due to the nature of their operations.

Conclusion

Financial risks consist of risks related to a company’s investments or projects. These can result in capital losses for a company. There are several types of financial risks in business. These include, but are not limited to, market, credit, and liquidity risks.

Article Source Here: Financial Risks in Business

Modern Portfolio Theory-Searching For the Optimal Portfolio-Portfolio Management in Python

In the previous installment, we presented a description of the Model Portfolio Theory and provided a concrete example in Python. We also explained the concept of an Efficient Frontier and provided a visual presentation of it. Recall that,

... the efficient frontier (or portfolio frontier) is an investment portfolio which occupies the "efficient" parts of the risk–return spectrum. Formally, it is the set of portfolios which satisfy the condition that no other portfolio exists with a higher expected return but with the same standard deviation of return (i.e., the risk). The efficient frontier was first formulated by Harry Markowitz in 1952.

A combination of assets, i.e. a portfolio, is referred to as "efficient" if it has the best possible expected level of return for its level of risk (which is represented by the standard deviation of the portfolio's return). Here, every possible combination of risky assets can be plotted in risk–expected return space, and the collection of all such possible portfolios defines a region in this space. In the absence of the opportunity to hold a risk-free asset, this region is the opportunity set (the feasible set). The positively sloped (upward-sloped) top boundary of this region is a portion of a hyperbola and is called the "efficient frontier". Read more

In this follow-up post, we are going to search for the optimal portfolio, i.e. one that has the highest risk-adjusted return. To do so, we will maximize the portfolio’s Sharpe ratio. The Sharpe Ratio is a financial metric that helps investors determine the return of an investment compared to its risk. It presents the average return that investors earn above the risk-free rate per unit of volatility or risk. The higher the Sharpe Ratio of a portfolio, the better it is in terms of risk-adjusted return.

Our hypothetical portfolio consists of 3 Exchange Traded Funds: SPY, TLT, and GLD which track the S&P500, long-term Treasury bond, and gold respectively.  We downloaded 10 years of data from Yahoo Finance and utilized a Python program to search for the optimal portfolio. The figure below shows the Efficient Frontier along with the optimal portfolio (depicted by the red dot).

The figure below shows the optimal portfolio’s composition, return, volatility, and the Sharpe ratio.

Click on the link below to download the Python program.

Article Source Here: Modern Portfolio Theory-Searching For the Optimal Portfolio-Portfolio Management in Python

What Is Risk Governance

Risk and uncertainty can play a significant role in various fields of life. Lately, they have become more prevalent than ever. In most cases, the prevalence comes from various financial disasters making the headlines in the news. For most of these disasters, the management of risk and uncertainty play a prominent role.

It's challenging to manage risks properly for everyone. In the world of finance, economics, and investing, proper risk management is crucial. Risk management comes as a result of risk governance. Therefore, it is vital to know what it is.

What is Risk Governance?

Risk governance represents the institutions, rules and regulations, processes, and mechanisms through which making decisions about risks is possible. Risk governance aims to formulate a risk management strategy to avoid and reduce costs related to unforeseen circumstances. Risk governance doesn't only include risk analysis.

Risk governance includes the involvement and participation of various stakeholders. Similarly, it also considers all political, economic, social, and legal matters. These matters relate to the evaluation and management of risk. Usually, risk governance is to ensure public health and safety in some organizations. However, broadly, it also includes the environment, finance, old and new technologies, and much more.

For companies, risk governance is an organizational framework developed through involving the board, stakeholders, business strategy, business value, risk appetite, regulatory frameworks, CSR, and much more. It paves the path for a company to come up with risk management strategies. These topics go hand in hand.

What is Risk Management?

Risk management is the process of identifying and analyzing uncertainty in investing decisions. It also involves accepting or mitigating these risks as a part of decision-making. Risk management is when investors analyze and attempt to quantify the potential of losses in an investment. Through the identification and analysis of these risks, investors can develop an expected return on investments.

In the world of finance, risk management is of critical importance. Every organization, whether private or public, has to deal with various risks during its lifetime. Therefore, having a proper system of risk management is crucial for them. In the absence of these strategies or systems, most entities cannot survive in the long run. Several problems come with improper risk management, whether it is for companies or individuals.

Why is Risk Management important?

Risk management is a critical process because it provides companies or businesses with the tools necessary to identify and deal with potential risks. Once they identify those risks, these companies can readily develop strategies to eliminate or mitigate them. It also helps in preparing for events that may hinder a company's performance or growth.

Most companies take a progressive risk management approach. It helps them ensure that high-priority risks receive more attention as compared to low-priority ones. It also allows companies to take a more aggressive approach to volatile risks. A company's management will have the information necessary to identify those risks and deal with them as they occur.

Conclusion

Risk governance includes actions, processes, institutions, and traditions through which making decisions about risks are possible. Risk management is a subset of risk governance and can be crucial for companies and businesses. Risk management includes systems to identify, analyze and mitigate and risks for specific companies.

Article Source Here: What Is Risk Governance

Emerging Markets vs Developed Markets

Investors use various investment strategies to diversify their portfolios. For example, they may use asset allocation, which includes dividing investments into several asset classes. Some investors also prefer building a diversified portfolio by investing in various locations. These may consist of both domestic and international markets or investments.

When it comes to investing internationally, investors have the option to choose between emerging and developed markets. They are both essential for developing a diversified portfolio of stocks. However, there are some differences between both.

What are Emerging Markets?

An emerging market represents a market that has a low to middle per capita income. It is usually a country with an economy similar to a developed market, but it does not fully qualify as developed. Countries with various developments and reforms may come into the emerging markets category. Emerging markets have some characteristics that differentiate them from others.

Usually, countries that are in the process of moving from a closed economy to an open market economy fall under the emerging market category. The characteristic of these economies is that they build accountability within the system by going open. It usually means the country is going through an economic reform program, which will result in stronger and more responsible economic performance levels.

While these countries may be going through rapid growth, they also have low household incomes. They also have capital markets but are usually less matured compared to developed countries. Usually, it takes time for them to catch up with the economic growth that comes with emerging markets.

For investors, investing in emerging markets can come with risks and rewards. These risks come due to factors such as economic or political instability in those countries. Investors also have to deal with risk associated with currency exchange rate fluctuations. These markets may not have the proper standards to regulate the performance of investments. Therefore, it can result in fraudulent reporting.

What are Developed Markets?

Developed markets come from developed countries that have a high level of economic growth and security. These countries have better-developed infrastructures, more mature capital markets, and higher standards of living. Most economically advanced countries fall under the developed market category. The per capita incomes of developed countries are higher than in emerging markets.

There are no strict requirements for countries to classify as either emerging or developed. However, all the above factors can play a crucial role in the process. For countries considered to be difficult to categorize, economists examine other factors to help in the categorization. These may include specific standard-of-living measures, such as mortality rate or life expectancy.

Despite the developed status, investors don't have to bear similar risks to emerging markets. Investing in developed markets means that investors can benefit from more strict regulations. These are also countries that are economically and politically stable. Therefore, investors don't have to compensate for that.

However, these markets also come with risks. For example, equity market valuations in developed markets are significantly higher than the long-term historical average. Therefore, these markets can experience challenging problems in case of unforeseen circumstances.

Conclusion

Investors can invest in emerging and developed markets to diversify their portfolio of investments. Emerging stocks are those with a low or middle per capita income. These markets are going through a change and can convert into developed markets. On the other hand, developed countries have a high per capita income and are more stable. There are risks associated with investing in both markets.

Post Source Here: Emerging Markets vs Developed Markets

Hedge Funds vs Mutual Funds

Investors always try to diversify their portfolios through various techniques. This diversification may come in the form of investing in several asset classes or markets. Among the top investing strategies that investors use for diversification are investing in hedge and mutual funds. Both of them have similar characters. However, they are also different from each other for several reasons.

What are Hedge Funds?

Hedge funds represent a pool of funds from investors for alternative investments. Hedge funds employ different strategies to earn active returns for their investments. Hedge funds can use aggressive or diverse strategies to generate steady returns above the market rate. Usually, hedge funds consist of a few investors but have a healthy base.

Usually, large investors with a high-risk tolerance prefer investing in hedge funds. It's because these funds may come with higher risks. However, they can also generate significant results for investors. Each hedge fund may come with its own requirements on who can invest in the fund pool. There is a manager who actively manages the funds, responsible for employing various strategies.

Hedge funds are similar in their structure to mutual funds. Both represent a pooled fund structure actively managed by a fund manager. However, hedge funds employ more aggressive strategies to generate returns. These strategies may also come with significantly higher risks, which mutual fund investors may not be willing to accept.

Hedge funds offer their investments privately. Therefore, it requires them to include only accredited investors to build their fund structure. These investors usually come with advanced knowledge of financial market investing. These investors also relinquish the standard protection against losses offered by mutual funds to earn more.

What are Mutual Funds?

Mutual funds also represent a pool of funds collected through investors. They are prevalent in the investing world. There is a fund manager that looks after the pooled funds and make investing decisions. The fund manager is responsible for actively managing funds and generating returns for investors. Usually, the fund manager has investment objectives that they must actively manage.

Mutual funds are suitable for smaller investors, giving them access to a diversified portfolio of stocks. With mutual funds, every investor has the option to diversify their portfolio. Similarly, investors that don't want to manage their funds actively can use mutual funds to earn passive income. Through mutual funds, fund managers invest in various securities. They track its performance through the change in the fund's total market cap.

Unlike hedge funds, the performance of mutual funds isn’t private. Usually, they are a part of larger investment companies, having several mutual funds. There are various types of mutual funds that investors can use. These include Equity Funds, Money Market Funds, Fixed-Income Funds, and many more.

Mutual funds come with lower costs to investors with decent returns. However, they can't replicate the high amounts of returns that investors get through hedge funds. Nonetheless, mutual funds also come with lower risks for investors. For most investors, investing in hedge funds is not an option due to the requirements. However, mutual funds are always available.

Conclusion

For a diversified portfolio of investments, investors can either choose hedge or mutual funds. Both represent a pool of funds managed by a fund manager. However, hedge funds are high-risk investments, which accompany high-returns. In contrast, mutual funds are publicly available and can range in their risks and returns.

Article Source Here: Hedge Funds vs Mutual Funds

How Do Venture Capital Funds Work

What are Venture Capital Funds?

Venture capital funds represent pooled investment funds that come from various investors. These investors are either institutions or individuals with a high net worth.  Usually, a venture capital firm manages the venture capital funds. Similarly, these firms invest the funds in startups and small or medium-sized entities. These come with higher return potentials but also higher risks.

Venture capital funds represent a type of equity financing that gives small companies the chance to raise finance. Most companies can get these funds even before starting their operations or earning revenues. Venture capital firms managing these funds always look to maximize the returns for their investors. Therefore, they identify high-return companies that may come with high-risks.

How do Venture Capital Funds work?

When entrepreneurs start their business ventures, they look for investors. These investors may come from various sources. However, for startups, it may be challenging to attract investors. However, some financers look for the opportunity to invest in startups with high-growth potentials. Venture capital firms are one of those.

These firms gather investments from various institutional or individual wealthy investors into an investment pool. These constitute venture capital funds. The venture capital firm then identifies various high-growth potential startups or small businesses for investing. They don't go for established companies as they are low-return and low-risk.

However, venture capital funds come with some conditions. Since the venture capital firm undertakes higher risks on startups, it also expects higher returns. Each firm will have its own investment profile detailing the type of businesses in which it will invest. These firms usually provide financing to companies at different times in their lifetime.

Lastly, venture capital firms don't put venture capital funds into one company or startup. They have a diversified portfolio of investments in several companies. Usually, they invest in companies for three to seven years. After that period, a venture capital firm recovers its investment when the investee company goes public or gets acquired. When the company returns venture capital funds, the firm gives them back to the investors.

What are the advantages of using Venture Capital Funds?

Startups can get various benefits from using venture capital funds. Firstly, it provides them with a great way to start their business or expand it. Venture capital firms also bring other valuable resources with them, such as guidance or sharing their expertise. Therefore, these services may be invaluable for startups.

Similarly, venture capital firms also introduce new connections and networks to startups. Through these networks, startups can grow their business better. There are no obligations attached to repaying venture capital funds, which removes the burden from startups. For some startups, venture capital funds may be the only option to get a decent start.

What are the disadvantages of using Venture Capital Funds?

Using venture capital funds can introduce a dilution of ownership and control to a startup. Due to their interjection in a startup's business, venture capital firms can cause some issues. Similarly, the decision-making process of a company may get lengthened due to the extra level of authority.

While startups don't have to repay venture capital funds if they fail, the repayments are significant. The interest in venture capital funds can be too high for some companies to bear. Similarly, obtaining these funds can be a challenging process for some startups.

Conclusion

Venture capital funds are a pool of investments from individual or institutional investors. Venture capital firms manage these funds. These firms look for high-potential startups and provide them with financing. At the end of the term, these firms generate a significant return for their investors.

Article Source Here: How Do Venture Capital Funds Work

Exchange Traded Funds vs Mutual Funds

Investors looking for a diversified portfolio may come across various options. While most investors can create their own portfolio of diversified stocks, they may invest in different funds. There are two types of common funds, including Exchange Traded Funds (ETFs) and mutual funds. There are many similarities and differences between both.

What are Exchange Traded Funds (ETFs)?

Exchange traded funds represent a fund that is a collection of securities, for example, stocks. These funds usually track an underlying security index. Similar to a company's stocks, exchange traded funds get traded on an exchange. The price of these funds reflects the prices of the underlying securities within them. Similarly, the price may fluctuate with fluctuations in their market demand.

ETFs don’t only hold a single type of underlying asset. Instead, they may consist of various assets. Due to this feature, investors can use ETFs to build a diversified portfolio of investments. It is common practice to classify ETFs according to the underlying assets or indexes they track.

What are Mutual Funds?

Mutual funds represent pools of money collected from various investors. These investors may be individuals, companies, or other entities. They allow these investors a straightforward and effortless way to invest in the market. Usually, investors hire a fund manager to invest the money collected by them. In short, mutual funds are a collection of investments owned by a group of investors and managed by a fund manager.

When investing in a mutual fund, investors contribute to it or pool their money with other investors. The fund manager responsible for the funds invests in various financial assets, including stocks, bonds, etc. The manager handles the funds on a daily basis. There are several types of mutual funds that are prevalent, including money market, fixed income, and equity funds.

What are the differences between Exchange Traded Funds and Mutual Funds?

Exchange traded funds differ from mutual funds in several aspects.

Trade

Firstly, ETFs get traded on an exchange just like ordinary stocks. Usually, investors get ETFs through a broker. On the other hand, mutual funds don't have the same characteristic. Investors have to obtain mutual funds directly from a fund company.

Price

Since ETFs have similar characteristics to stocks, their prices also fluctuate throughout the day. As mentioned, the fluctuations depend on several factors, including market factors and demand. On the other hand, mutual funds get priced once per day, usually when the market closes. The price depends on the net asset value.

Tax benefits

ETFs are more tax-efficient. Investors that hold ETFs have to pay taxes only when they sell their shares. The tax classifies as capital gains tax. On the other hand, mutual funds incur capital taxes when the shares within them get traded throughout the investment's lifetime. Therefore, investors may have to incur several tax payments when holding mutual funds.

Transferability

Due to their nature, ETFs are usually straightforward to transfer. These are portable investments and easily disposable. In contrast, transferring mutual funds requires the fund's position to be closed before the transfer can complete.

Management

ETFs don't require active management. Therefore, they are also a more cost-effective option. While there are some ETFs that require active management, they are usually passively managed. On the other hand, mutual funds need a funds manager to manage them actively. Therefore, they may come with higher costs to investors.

Conclusion

Investors can invest in several assets at the same time through exchange traded and mutual funds. Exchange traded funds are a collection of securities traded on the market like regular stocks. Mutual funds, on the other hand, are a collection of investments managed by a fund manager. They differ from each other in several aspects, as mentioned above.

Originally Published Here: Exchange Traded Funds vs Mutual Funds

Top-Down vs Bottom-Up Analysis

Investors need a consistent strategy to analyze stocks for a successful portfolio. Therefore, they use various metrics or ratios to help them in deciding between investments. Usually, investors evaluate how each investment fits into their portfolio. There are several analytical tools that they can use. The two most common types are top-down and bottom-up analysis.

What is a Top-Down Analysis?

In a top-down analysis, investors analyze the environment in which stocks are bought and sold to make decisions. They analyze macroeconomic data to identify trends and make decisions based on them. These decisions relate to their investments. For top-down investors, looking at specific industry trends when evaluating various investment options is crucial.

Top-down investors also usually focus on exchange-traded funds or mutual funds. They don't invest in individual stocks or securities under normal conditions. It allows them a better analysis by comparing the investments against an index. These funds also revolve around large-scale trends and are a collection of assets around a broader issue.

Companies may also perform top-down analysis. In that case, these companies assess the market as a whole. They determine the current market size available for their business and factor in relevant trends. From that information, they can make various predictions.

What is a Bottom-Up Analysis?

In a bottom-up analysis, investors base their decisions on individual assets. They analyze the performance of a specific company or stock. Based on it, they can evaluate a company's performance and build their portfolio around it. With this type of analysis, investors use various financial ratios and metrics to examine several stocks.

For most of the bottom-up analysis, investors only consider specific stocks. They don't consider market factors but rather make decisions based on how they think a company will perform. Despite negative market factors in an industry, a bottom-up investor may invest in a specific stock based on a company's performance. In contrast, a top-down investor won't.

For companies, a bottom-up analysis starts from its operations. They start by analyzing the source of the projections or estimates that they make. They may include plans or forecasts, such as an operating expense plan. A bottom-up analysis starts from within the company, not from its environment. These can help in identifying any operational or functional discrepancies.

Which one is better, Top-Down or Bottom-Up Analysis?

There is no definitive answer to which approach of analysis is better. Several factors can play a crucial role in the decision. Mostly, it depends on the investor and their needs. However, investors also have the option to use both of these approaches for a well-rounded analysis. But, using both may produce contradicting results.

However, investors must understand how to apply each analysis approach properly. Both top-down and bottom-up analysis can have a relationship with each other. For example, if market factors in an industry are adverse, both approaches will notice an impact. Therefore, it is crucial to consider all factors when making investment decisions.

Conclusion

Investors and companies can use various analytical approaches when making decisions. Among those, there are the top-down and bottom-up analysis. A top-down analysis considers external factors, specifically macroeconomic factors, related to an investment. On the other hand, the bottom-down analysis approach considers factors related to a specific investment.

Article Source Here: Top-Down vs Bottom-Up Analysis