Can the SP500 Index be Predicted?

In a previous post, we presented a time series analysis of the SP500 index and demonstrated its mean-reverting and trending behaviour. Subsequently, we designed trading strategies exploiting these mean-reverting and trending properties of SP500.

Does this mean that the SP500, and stock market indices in general, can be predicted?

In a recent publication [1], the author utilized multiple linear regression in order to study the predictability of the SP500 index. We note that,

In statistics, linear regression is a linear approach to modelling the relationship between a scalar response and one or more explanatory variables (also known as dependent and independent variables). The case of one explanatory variable is called simple linear regression; for more than one, the process is called multiple linear regression. This term is distinct from multivariate linear regression, where multiple correlated dependent variables are predicted, rather than a single scalar variable. Read more

The article concluded that by using relevant market variables, investors can accurately predict financial markets to a certain extent.

In this study, we used multiple linear regression for the stock prediction of the SPX index. Here we created three different regression models on a daily, weekly, and monthly basis. The models obtained were used for predicting the closing price of the SPX index. Each model proved statistically significant. From the results of each model, we can conclude that our monthly model forecasted better than our weekly and daily models.

The author also emphasized that the prediction is more accurate in the monthly timeframe than in the daily and weekly timeframes.

We concluded that our monthly frame held the best adjusted AR 2 value of 0.95, meaning 95% of the variance in the closing price of the SPX is explained by our independent variables. Therefore, we conclude that investors and analysts must use higher-timeframe models to see general trends. Our forecasting error shows that our MAPE value for our best model is 5.2% whereas our worst model MAPE value is 5.6%. As such, our models underestimate by creating more negative errors where MPE = -0.45 and -0.48. When analyzing the results obtained from comparing our predicted line to our actual line, our models identify and follow the trend within the market index. Thus, we can conclude that the pricing model of the markets is predictable to a certain extent.

This finding is consistent with the well-known observation that the markets are less noisy in the higher timeframe than in the lower one. Design your strategies accordingly.

References

[1] LT.  Martinez, The Effective Predictors of the SPX Index, The Michigan Journal of Business, Volume XII, Issue I, 2021

Article Source Here: Can the SP500 Index be Predicted?

Interest Rate Swap Tax Treatment

Interest rate swaps are a primary type of hedging method used by participants to mitigate their risks. With these swap contracts, participants can exchange their interest payments with another party to receive favourable terms in the future. There are several types of interest rate swaps that participants can use for that purpose.

The most prevalent type of interest rate swaps includes exchanging floating and fixed interest payments. This way, one party gets to pay fixed interests, which is more secure and involves lower risks. If the interest rates in the market increase, the party responsible for fixed interest payments will be at an advantage. In contrast, the party with the floating rate interest payments can also benefit. However, the interest rates in the market must go down for that to happen.

Interest rate swaps are complicated contracts. It is because each participant assumes responsibility for the other party’s interest payments. However, the debtholder is ultimately responsible for their own interest payments. The tax treatment for interest rate swaps can also be an area of confusion for both the involved parties.

What is a Notional Principal Contract?

Under the taxation rules, interest rate swaps fall under notional price contracts. It is a term of art used by the US federal income tax professionals. Notional price contracts describe contracts based on an underlying notional amount. In these contracts, neither party actually holds the property that comprises the underlying amount.

As mentioned, with interest rate swaps, each party is ultimately responsible for its own debt payments. However, one party pays the other an amount after each period depending on the underlying notional amount. They do so by multiplying a floating and a fixed rate with the other party’s principal amount. For this reason, interest rate swaps fall under notional principal contracts.

What is Interest Rate Swap tax treatment?

The tax treatment of interest rate swaps is the same as notional price contracts. Any party involved in these contracts must recognize any amount under a swap contract in accordance with the rules governing the recognition of such payments. It may go against or override the party’s usual method of accounting for federal income tax purposes.

Any party that receives an amount under interest rate swaps must recognize it as ordinary income. These amounts do not constitute capital gains for federal tax purposes. The source for this income is the residence of the recipient. For the party making the periodic payments under an interest rate swap, these payments constitute deductible expenses.

Notional principal contracts may also come with nonperiodic payments, which are different from periodic payments. These payments are recognized over the term of a contract in a manner that reflects the contract’s economic substance. Each party must also treat nonperiodic payments as ordinary income or expense.

Lastly, some notional principal contracts may have terminational payments associated with them. For these payments, each party must recognize a capital gain or loss if the contract is a capital asset for the taxpayer. Each party must recognize any termination payments in the year of the extinguishment, assignment, or exchange.

Conclusion

Interest rate swaps allow participants to exchange their interest payments with another party. For taxation purposes, interest rate swaps meet the definition of notional principal contracts. Therefore, the taxation treatments for interest rate swaps are the same as notional principal contracts.

Article Source Here: Interest Rate Swap Tax Treatment

What Is A Convertible Bond Fund

Investors have many options when it comes to investing in bonds. Usually, investors can get bonds directly from the issuer. These issuers may include municipalities, government agencies, or companies. On the other hand, investors can also invest in funds that offer convertible bond investments. Among these investments, investors can choose to include convertible bond funds in their portfolio.

What are Convertible Bonds?

Convertible bonds allow the holder to convert their bonds into the issuing company's equity in the future. These bonds are a type of hybrid security that has characteristics of both debt and equity finance. The equity characteristic comes from the option to convert the bonds into equity in the future. The debt characteristic is inherent to the bond, similar to traditional bonds.

In essence, convertible bonds are debt instruments. It is because these bonds come with a face value, a maturity date, a coupon rate, etc. These are all characteristics that are common to all traditional bonds. The equity component is only applicable if the investor or bondholder chooses to convert their investment into equity.

Apart from the terms associated with traditional bonds, convertible bonds also come with conversion terms. These usually include the number of shares that investors can get for each unit of conversion. For example, a convertible bond may come with the option to convert each $100 of bond face value to 5 ordinary shares.

What is a Convertible Bond Fund?

Convertible bonds aren't as common as other types of bonds. However, these are still significant as they consist of an element of both equity and debt. For investors, convertible bonds are important as these come with a call option. For the issuing company, convertible bonds mean a potential increase in future equity balances and dilution of control.

Stable companies don’t usually issue convertible bonds. Only companies that have a low credit rating but come with a high growth potential use convertible bonds. It makes identifying and investing convertible bonds complicated for convertible bond investors. Therefore, investors can simply invest in convertible bond funds.

Convertible bond funds represent a pool of funds from investors that want to invest in convertible instruments. These usually come in the form of mutual funds and have all the characteristics of mutual funds. However, the underlying investment for convertible bond funds is any bonds that come with a convert option.

What are the advantages and disadvantages of Convertible Bond Funds?

Convertible bond funds allow investors to focus their investments on convertible bonds only. Usually, there is a manager who manages these investments. Therefore, investors don't need to manage their investments actively. Similarly, investors have the option to convert their bonds at maturity. It allows them to significantly increase their wealth if a company experiences growth during the bond period.

However, convertible bond funds come with some disadvantages. By allowing managers to manage these funds, investors lose control of their investment. Similarly, there are some fees and expenses associated with convertible bond funds. On top of that, convertible bonds usually come from companies that a low credit rating. Therefore, these can prove to be high-risk investments.

Conclusion

Convertible bonds are debt instruments that also have equity instrument characteristics. These are bonds that allow investors to convert their bonds into ordinary shares. Investors can pool their funds and invest in convertible bond funds. Usually, these are mutual funds that enable investors to invest in several convertible bonds.

Post Source Here: What Is A Convertible Bond Fund

The Bird in Hand Theory

What is the Bird in Hand Theory?

The bird-in-hand theory suggests that investors would prefer dividends from stock investments over capital gains. This theory believes that investors are likely to favour returns that are certain rather than uncertain. Because of the uncertainty involved around capital gains, the bird-in-hand theory assumes investors will always prioritize dividend investments.

The bird-in-hand theory comes from the old saying, "a bird in hand is worth two in the bush". Therefore, this theory believes that investors prefer dividend investments because they are more secure than capital gains. Similarly, the theory suggests that even though capital gain investments may promise higher returns in the future, investors are likely to ignore them in favour of safer returns.

Where does the Bird in Hand Theory originate from?

Developed by Myron Gordon and John Lintner, the bird-in-hand theory opposes the dividend irrelevance theory. The dividend irrelevance theory suggests that dividends don't have any effect on a company's stock price. The irrelevance theory also proposes that investors are indifferent to whether they get returns from dividends or capital gains.

However, the bird-in-hand theory opposes the view by suggesting that dividends affect a company's stock price. Similarly, it says that dividend payments also affect investors' behaviours. The premise behind the bird-in-hand theory is that low dividend payouts lead to an increase in a company's cost of capital. Therefore, a higher dividend payout rate increases a company's stock price.

How does the Bird in Hand theory affect investors’ decision making?

When it comes to capital gains, investors have to face a significant amount of uncertainty. There is no metric that can reliably estimate how much capital gain a specific stock will experience. A stock's ultimate capital gain performance depends on several factors. Some of these factors are unpredictable and outside a company's control.

Therefore, capital gains investing can face investors with uncertain conditions and returns. For the substantial risks that investors face, they also get higher rewards. However, the risks may also result in significantly low or no returns at all. For some investors, the risks may not be acceptable for the returns they get.

The bird-in-hand theory works on that idea. It suggests that investors are more likely to choose safer investments rather than risky ones. Compared to capital gains, dividends are easier to predict and calculate. They also represent lower risks for investors. However, they also come with lower returns, which are significantly lower than capital gains sometimes.

What are the limitations of the Bird in Hand Theory?

The bird-in-hand theory goes against the idea that investors want to maximize their profits. By suggesting that investors will ignore high capital gains for dividends, this theory may offer higher security. However, it does not allow investors to maximize their returns. In the short-term, some investors may benefit from dividend investing. However, capital gains will almost always exceed any returns from dividends received in the long run.

Conclusion

The bird-in-hand theory states that investors prefer dividends returns rather than capital gains when investing in stocks. It is because it believes that investors are more likely to favour safer returns compared to uncertain earnings. The bird-in-hand theory opposes the dividend irrelevance theory, which suggests dividends do not impact a company's stock price.

Post Source Here: The Bird in Hand Theory

High-Water Mark in Hedge Funds

Hedge funds represent alternative investments where investors pool funds and employ different strategies. The goal with hedge funds, as with any other investment, is to earn active returns. Hedge fund managers gather funds from investors and invest them according to a promised strategy. However, hedge funds are mostly available to affluent investors only.

In exchange for managing hedge funds, hedge fund managers get paid by the investors. Usually, their payments include a combination of fixed and performance-based fees. This structure allows managers to benefit from making the right decisions while also getting compensated for their management.

There are two benchmarks that hedge funds can use to collect incentive or performance-based fees from investors. These include the high-water mark and the hurdle rate.

What is High-Water Mark in Hedge Funds?

A high-water mark represents the highest peak that investments have reached in value. The high-water mark in hedge funds shows the peak value that the funds achieve since their initial establishment. Hedge funds use the high-water mark as a measure for incentives for fund managers. However, it can also work as a protection for investors.

As mentioned, hedge funds include both fixed and performance-based fees for managers. Usually, these include 20% of the profits the managers help generate for investors. While it provides managers with an incentive to increase profits, it does not protect investors. Investors will want to establish a benchmark for managers below which they will not receive an incentive.

Investors use the high-water mark as that benchmark. While hedge fund managers will receive a profit-based incentive, they only get it if the fund's total value exceeds the high-water mark. This way, managers don't get paid when they demonstrate poor market performance. Only if they succeed to increase profits beyond the high-water mark, they will receive an incentive.

How does the High-Water Mark work in Hedge Funds?

The high-water mark ensures that investors do not compensate hedge fund managers for poor performances. More importantly, however, it allows investors to avoid paying incentives twice for the same results. It is because investors will only pay for increases in hedge fund performance. If there is a drop or decrease in hedge fund value, investors can avoid paying a fee for subsequent increases.

The high-water mark is similar in function to the hurdle rate. A hurdle rate in hedge funds represents the minimum amount of profits that managers must achieve to get performance-based incentives. However, managers cannot receive any incentives if the performance does not exceed the high-water mark level. It means that managers may still generate a minimum return on hedge funds and achieve the hurdle rate. However, the high water-mark is more important.

What are the advantages and disadvantages of High-Water Mark?

A high-water mark provides an incentive for managers. With a high-water mark level in place, hedge fund managers must perform at a level to increase the fund's performance. However, the high-water mark is ultimately more beneficial to investors. Not only does it help them maximize their wealth, but it protects them as well. It does so in two ways. Firstly, it protects investors against paying for poor performances. Similarly, it helps them avoid paying double incentives.

However, setting an unrealistic high-water mark level can also be demotivating for managers. If managers can't achieve the level despite their maximizing profits, it can have an adverse effect. Similarly, the high-water mark can expose investors to significantly high risks. When trying to achieve the high-water mark level, managers may take unnecessary risks that can cause significant losses.

Conclusion

Hedge funds are fund pools where managers collect funds from investors and invest them according to a specific strategy. Hedge funds come with two benchmarks for management incentives, which include high-water mark and hurdle rate. The high-water mark represents the highest peak that a hedge fund performance must reach in value for managers to receive incentives.

Originally Published Here: High-Water Mark in Hedge Funds

Mean-Reverting Trading System-Quantitative Trading in Python

In a previous post, we demonstrated the mean-reverting and trending properties of SP500. In this follow-up post, we will develop a simple trading system exploiting the mean-reverting behaviour of this market index.

To generate buy and sell signals, we will use simple moving averages as noise filters. The simple moving average takes an average value of a stock over a certain period of time. It has been used for decades by technical traders and investors around the world.  There exist other types of moving averages such as exponential moving averages, but we will use the simple ones in this post.

Since we know that the SP500 is mean-reverting in a short term, we will use short-term moving averages. The trading rules are as follows,

If 3-day simple moving average < 20-day simple moving average, buy $10000 worth of stock

Exit if 3-day simple moving average >= 20-day simple moving average

We downloaded SPY data from Yahoo Finance and implemented the above trading rules in a Python program. The picture below shows the equity line of the strategy. We note that using the 3-  and 20-day simple moving averages the strategy is overall profitable.

Next, we proceed to test the robustness of this system. To do so, we vary the length of the second moving averages (20 days in the previous example).  The graph below shows the total PnL as a function of the length of the second moving average. We observe that the overall profit remains positive when we change the length of the moving average. This would indicate that the strategy performance is stable in this parameter regime.

In summary, we developed a simple trading strategy exploiting the mean-reverting behavior of SP500. In the next installment, we will design a trend-following system on this market index.

Click on the link below to download the Python program

Post Source Here: Mean-Reverting Trading System-Quantitative Trading in Python

Internal Credit Rating System

Default risk is a type of risk that accompanies all debt obligations. Default risk represents the uncertainty associated with repayments from borrowers. In case these risks realize, lenders can suffer a substantial amount of losses. Therefore, they need to protect against such occurrences. Usually, lenders check the borrower's creditworthiness to decide on providing the loan.

What is a Credit Rating?

A credit rating is a quantification of an individual or company's creditworthiness. Lenders may use creditworthiness to evaluate the default risk of a particular borrower. Most lenders require borrowers to have a history of past credit transactions, based on which they can calculate their credit rating. Usually, credit ratings apply to both individuals and organizations.

Credit ratings mostly come from credit rating agencies. Therefore, the credit rating signifies the agency's opinion of the borrower's creditworthiness. Despite its many uses, a credit rating that comes from these agencies can have some limitations. For example, they may not address a particular issue that lenders want to consider.

What is Internal Credit Rating System?

An internal credit rating system describes a borrower’s creditworthiness for a particular sector or industry. Usually, this system bases the calculation on the assessment criteria for the sector or industry in question. Through an internal rating system, lenders can manage and control their credit risks by grouping and managing borrowers’ creditworthiness and quality of credit transactions.

Internal credit rating systems analyze a borrower's ability to repay a loan based on their financial condition. These may include factors, such as determining their cash flows, profitability, debt profile, industry and operational background, liquidity, etc. For most banks, an internal credit rating system is a crucial part of their credit risk management process.

In the past, lenders managed their credit risks by evaluating a borrower’s creditworthiness only. Due to several financial crises, however, they realized the system was ineffective in preventing losses. Therefore, more lenders started adopting internal credit rating systems. It made the process of decision-making simpler while also minimizing loss occurrences.

What are the advantages of using the Internal Credit Rating System?

Using an internal credit rating system can have several advantages for lenders. Firstly, it allows for a more efficient decision-making process while minimizing the administrative burden. It also considers various factors and combines them into a single measure, making it easier to understand. An internal credit rating system can also help lenders develop credit management strategies, such as establishing lending rates.

More importantly, an internal credit rating system allows lenders to get more specific information about borrowers. It allows lenders to customize the process of evaluating a borrower's creditworthiness according to their requirements. Overall, an internal credit rating system can provide lenders with a basis for a consistent, comprehensive, and objective credit management process.

What are the uses of the Internal Credit Rating System?

Internal credit rating systems have several use cases for lenders. Firstly, they can help lenders establish credit limits based on rating grades. By setting rating grades, lenders can also determine which loans will need active monitoring. This way, they can avoid any unexpected circumstances in the future. Similarly, an internal credit system can help in establishing a PD for each grade. They can then use this to quantify the credit risk and in other further calculations.

Conclusion

Credit rating is a term used to describe a borrower’s creditworthiness in quantitative form. Lenders may use an internal credit rating system when making decisions. With this system, they can analyze a borrower’s ability to repay based on their financial situation. Similarly, they can use it to describe a borrower’s creditworthiness for a specific sector and establish rating grades for borrowers.

Originally Published Here: Internal Credit Rating System

Expected Credit Loss Formula

What is an Expected Credit Loss?

The term expected credit loss represents the amount of loss the companies estimate to have on their credits. It is a term used in accounting under the IFRS 9. Before the expected credit losses, companies recognized bad debts or credit losses only when they occurred. However, with IFRS 9, companies must account for expected credit losses as well.

With expected credit losses, companies must look at how their current and future economic conditions affect the value of expected losses. While some may consider credit losses to be an issue for financial institutions or lenders only, they also apply to businesses. Therefore, any company that makes credit sales and accumulates account receivable balances must deal with expected credit losses.

Expected credit loss represents the probability-weight estimate of credit losses over a financial instrument's lifecycle. The losses come in the form of the present value of any cash shortfalls. Cash shortfalls represent the difference between cash flows due in accordance with the contract and the cash flow that a company expects to receive.

What is the Expected Credit Loss formula?

The IFRS 9 standard does not provide a specific method to calculate expected credit losses. However, companies can use the probability of default approach to calculate it. This approach considers the exposure at default, probability of default, and loss given default of a particular instrument. Most financial institutions calculate it as a part of their internal risk management.

Exposure at Default

Exposure at default is the value of the financial asset exposed to credit risk. It is the amount at risk at the time when the company expects the default to occur after deducting the value of any collateral. Exposure at default does not represent the carrying value of a financial asset.

Probability of Default

Probability of Default shows the chances of default from a borrower over a specific period of time. Usually, the higher the credit period is, the higher the probability of default will be as well.

Loss Given Default

Loss given default shows the percentage of the amount that the lender expects to lose in case of a default. It is the opposite of the recovery rate that lenders can expect from a loan.

Expected Credit Loss Calculation

Companies will need to establish various scenarios and calculate the probability of default and loss given default for each of them. Once they do so, they must determine the total loss for each scenario, which would be equal to the product of exposure at risk and loss given default. They must then calculate the weighted-average expected loss.

The weighted-average expected loss is the product of the total loss and probabilities of default for each scenario. Lastly, companies must discount the expected credit losses at the effective interest rate of the financial asset in consideration. The final form for the expected credit loss formula will be as follows.

Expected Credit Loss = [EAD x (LGD₁ x PD₁ + LGD₂ x PD₂ + … + LGD_n x PD_n)] / (1 + r)ⁿ

In the above formula, EAD represents exposure at default, LGD is the loss given default, and PD is the probability of default. 'n' denotes the number of scenarios for which companies calculate the above three.

Conclusion

Expected credit loss represents the amount of loss that companies may estimate to have on their credits. Usually, it applies to accounts receivable balances as these are financial instruments. Companies can calculate the expected credit loss using the probability of default approach, as shown above.

Originally Published Here: Expected Credit Loss Formula

Loss Given Default Formula

Default risk represents the chance that a borrower does not repay their debt obligation. Almost every loan or debt obligation comes with default risk. The higher the default risk is, the more unlikely it is for lenders to recover their loaned amount. Default risks can be crucial for lenders when deciding on whether to provide a loan or not.

There are various precautions that lenders or investors may take to mitigate default risks on their loans. While these steps may decrease the default chances, they do no eliminate those risks. Therefore, defaults on loans are always possible and cause losses for the lender. A term often associated with these losses is the loss given default.

What is Loss Given Default?

Loss given default (LGD) refers to the amount of money that financial institutions lose when a borrower fails to repay a loan. Usually, they calculate it as a percentage of the total exposure at the time of default. Loan given default is a common metric used for calculating a lender’s expected losses when making decisions about loan provision.

There are several factors that may dictate the chances of defaults by borrowers. Usually, the borrower's credit rating can indicate whether they will repay the loan or not. Similarly, any ongoing financial crisis may significantly increase the probability of defaults by borrowers. When these chances are high, the loss given default of the lender will also be high.

What is the Loss Given Default formula?

Measuring the loss given default for a particular loan is crucial for lenders. They can calculate the LGD in one of two ways. Firstly, they can use the loss given default formula below.

Loss Given Default = Total Loss / Total Loan Value x 100

In the above formula, the total loss represents the loan value after deducting the amount recovered. Similarly, the total loan value represents the amount of loan that the lender provided.

The loss given default of debt also depends on its recovery rate. The higher the recovery rate of a loan is, the lower its loss given default will be and vice versa. Since both of these are a percentage of the total amount of loan provided, lenders can also use the recovery rate to calculate the loss given default. They can use the following formula to do so.

Loss Given Default = 1 - Recovery Rate

Example

An investor provides a loan of $100,000 to a company. The company repays $80,000 of the debt. However, it fails to repay the remaining amount and defaults on the payment. Therefore, the loss given default for the investor will be as follows.

Loss Given Default = Total Loss / Total Loan Value x 100

Loss Given Default = ($100,000 - $80,000) / $100,000 x 100

Loss Given Default = 20%

Similarly, the loan’s recovery rate will be 80% as the investor only lost 20% of the loan due to default.

What is the importance of Loss Given Default?

Loss given default is crucial for lenders for several reasons. Firstly, it is useful in the calculation of expected loss, economic capital, and regulatory capital. Lenders can also use the LGD in various models, such as the Basel Model. If used properly, LGD can help lenders forecast any possible defaults and work towards maximizing recoverability.

Conclusion

Loss given default is a term used to describe the amount of money that lenders lose in case of a default from the borrower. Lenders can calculate the LGD as a percentage of the total value of the loan they provide. There are two loss given default formulas that they can use to do so, both of which are easy to use.

Originally Published Here: Loss Given Default Formula

Net Operating Profit After Tax

What is Net Operating Profit After Tax?

Net Operating Profit After Tax (NOPAT) is a term that shows a company’s income from operations without considering interests. Since the interest payments for different companies depend on their capital structure, comparisons between them can be challenging. However, NOPAT removes the effects of interest payments from a company’s operations to allow better comparability.

NOPAT is a financial metric that investors can use to evaluate a company's operations. Without the impact of interest, investors can determine how the company has performed due to its core operations. Since the capital structure of companies may differ, NOPAT can provide a better indicator of operational efficiency.

How to calculate Net Operating Profit After Tax?

As mentioned, net operating profit after tax shows a company's earnings by excluding any interest expenses from it. However, the calculation of NOPAT isn't as straightforward as adding interest expenses back to a company's net income. It is because there may be some tax implications associated with interest payments as well.

Investors can use one of the two formulas below to calculate a target company’s net operating profit after tax.

Net Operating Profit After Tax = Operating Income (or Income from Operations) x (1 - Tax Rate)

The above formula calculates the net operating profit after tax by not including interest while also accounting for taxes. It uses operating income that is generally available in a company’s income statement. Similarly, investors can use the formula below, which may need more information for NOPAT calculation.

Net Operating Profit After Tax = (Net Income + Interest Income + Tax + Non-Operating Gains or Losses) x (1 - Tax Rate)

The above formula also provides the same net operating profit after tax. However, it adds the company's tax and interest expenses back to its net income. It also adds any non-operating gains or losses to the net income. Lastly, it removes the effect of taxation from the residual amount to reach the NOPAT. The information necessary to calculate the NOPAT using the above formula is also available in the income statement.

Example

A company, Red Co., reported a net income of $200,000 during the last financial period. It also showed an interest expense of $30,000, tax expense of $25,000, and non-operating losses of $20,000. Red Co. pays a corporation tax of 20%. Therefore, its net operating profit after tax will be as follows.

Net Operating Profit After Tax = (Net Income + Interest Income + Tax + Non-Operating Gains or Losses) x (1 - Tax Rate)

Net Operating Profit After Tax = ($200,000 + $30,000 + $25,000 + $20,000) x (1 - 20%)

Net Operating Profit After Tax = $125,000 x 80%

Net Operating Profit After Tax = $100,000

What is the importance of Net Operating Profit After Tax?

Net operating profit after tax is useful in various calculations. It can help investors in calculating economic value added (EVA) or unleveled free cash flow. It also allows investors to compare companies with different capital structures. Some experts consider NOPAT to be a better measure of a company's performance than its net income. NOPAT is also useful in acquisitions and mergers as a company's capital structure is likely to change significantly after them.

Conclusion

Net operating profit after tax considers a company’s income after taking out the effects of interest payments. It is useful for comparisons between companies of varying capital structures. Investors can calculate a company’s NOPAT using the information provided in its income statement.

Post Source Here: Net Operating Profit After Tax

How Bond Recovery Rate Is Calculated

Credit risk refers to the uncertainty associated with repayments from borrowers. When a lender provides a loan to a borrower, they expect future interest and principal repayments. However, borrowers may not fulfill their end of the bargain. For every debt transaction, credit risk will exist. Therefore, lenders always have to make provisions in case the risk realizes.

Sometimes, however, credit risks may be inevitable. Lenders will always suffer from a borrower's inability to repay the loan. Sometimes, they may lose the full amount of the loan. In other cases, they may be able to recover a portion of the debt. For that, they can calculate the recovery rate of the debt obligation.

What is the Recovery Rate?

Recovery rate refers to the amount that lenders recover when a borrower defaults on loan repayments. Lenders can calculate the recovery rate of a bond or loan as a percentage of the total amount. For securities, the recovery rate may represent the value when the securities emerge from default or bankruptcy. There are several factors that may play a role in the recovery rate.

For bonds, the recovery rate shows the extent to which lenders can recover the principal and accrued interest on a defaulted bond. The recovery rate comes in the form of a percentage of the bond's face value. Using the recovery rate, lenders can estimate the loss that they would make if the bond defaults. The higher a bond's recovery rate is, the lower the loss will be for the lender.

How does Recovery Rate work?

As mentioned, various factors may affect a debt's recovery rate. The credit rating of the borrower and the type of instrument play a significant role in it. Similarly, the instrument's seniority within the issuer's capital structure also plays a role in it. The relationship between recovery rate and instrument seniority is direct.

As mentioned, the concept of recovery rate is close to that of credit risk. The concept of recovery rate also applies to cash loans or credits that lenders recover through bankruptcy or foreclosure. Calculating the recovery rate accurately can be helpful for lenders in deciding the terms for their credit transactions. This concept applies to all loans. For example, the lower the borrower's credit rating is, the higher the interest rate on the debt will be.

How bond Recovery Rate is calculated?

The formula to calculate the recovery rate of a loan is as below.

Recovery Rate = Amount Recovered / Loan Value

The amount recovered signifies the total repayment that the lender receives over the loan's lifecycle. On the other hand, the loan value shows the total amount that the lender provided to the borrower.

For bond recovery rate calculation, the formula will become as follows.

Recovery Rate = Amount Recovered / Face Value of the Bond

Therefore, if a bond issuer recovers $80 on a bond with a face value of $100, the recovery rate will be 80%. Lenders can also use the above formula for a specific time period or type of bond to get more specific results.

Conclusion

Recovery rate is a term often associated with credit risk. The recovery rate shows the amount that lenders can recover from borrowers in case of a default. The calculation for the recovery rate is straightforward. Lenders need to calculate the amount they have recovered from debt and divide it by its total value. The higher the recovery rate is, the better it is for the lender.

Article Source Here: How Bond Recovery Rate Is Calculated

Autocorrelation Properties of SP500-Quantitative Trading in Python

A technical or quantitative trading system on a linear (i.e. delta 1) instrument is basically a bet on the autocorrelation of the underlying. The autocorrelation properties of the underlying can be examined directly through autocorrelation functions or indirectly through the Hurst exponent.

In this post, we are going to examine the mean-reverting and trending properties of SP500 directly using the autocorrelation functions. We do so with the goal of designing quantitative trading systems on stock indices.

Recall that,

Autocorrelation, also known as serial correlation, is the correlation of a signal with a delayed copy of itself as a function of delay. Informally, it is the similarity between observations as a function of the time lag between them. The analysis of autocorrelation is a mathematical tool for finding repeating patterns, such as the presence of a periodic signal obscured by noise, or identifying the missing fundamental frequency in a signal implied by its harmonic frequencies. It is often used in signal processing for analyzing functions or series of values, such as time domain signals. Read more

We implemented the autocorrelation functions in Python. We downloaded SPY data from 2009 to the present from Yahoo Finance. We then applied the Python program to the daily and monthly returns of SPY.

The graph below shows the autocorrelation (ACF) and partial autocorrelation (PACF) functions of daily SPY returns. We note that SPY returns are negatively correlated at lags 2-4, i.e. SPY is mean-reverting in the short term. This is consistent with the findings in the previous study performed using the Hurst exponent.

The graph below shows the autocorrelation and partial autocorrelation functions of monthly SPY returns. We observe that the monthly returns are positively correlated around lag 9. This means that in a long term, SPY is trending.

In summary, using the autocorrelation functions, we demonstrated that the SP500 is mean-reverting in the short term and trending in the long term. In the next installment, we will design a trading system based on the mean-reverting and trending properties of SPY.

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

Article Source Here: Autocorrelation Properties of SP500-Quantitative Trading in Python

What Is The Law Of One Price?

What is the Law of One Price?

The Law of One Price (LOOP) is an economic theory that suggests that after accounting for the difference in currency exchange rates, the prices of identical goods in various markets will be the same. This law applies to financial markets and the securities traded on them. However, it makes some assumptions, which must be true for it to work.

The law of one price depends on various principles. These include free-market competition, price stability, and lack of trade restrictions. In an efficient market, the law of one price will always apply. It also provides the basis for the purchasing power parity principle in economics.

How does the Law of One Price work?

The law of one price works in an efficient market, where no legal restrictions, transactions costs, or transportation costs exist. Similarly, it assumes that the currency exchange rates are the same. Lastly, it works on the basis that buyers or sellers cannot manipulate prices in various markets. This law applies to a wide range of securities.

The law of one price exists due to arbitrage opportunities. When security prices differ across various markets, investors can profit from buying in the market with lower rates and selling in higher rate markets. For those securities, an arbitrage opportunity exists. However, due to the exploitation of these opportunities, the securities' prices would reach an equilibrium.

Without the law of one price, the concept of purchasing power parity is not achievable. The law of one price states that the price of securities would remain the same in different markets. It is one of the crucial assumptions made for the purchasing power parity. However, because security prices may differ in various markets or due to investors' inability to access markets, it may not apply.

The law of one price is prevalent in financial markets. Due to the lower trade barriers and the high regulations that apply in these markets, this law is more applicable. The law of one price also works best with commodities. These prices remain similar throughout various markets. Therefore, commodities conserve the law of one price.

What are the limitations of the Law of One Price?

The primary limitations of the law of one price come from its assumptions. As mentioned, the law of one price makes several assumptions, which may not always apply. Firstly, it assumes that there are no transportation costs. If the difference between commodity prices does not come due to transportation costs, it may signify a shortage or excess within a region.

Similarly, the law assumes that there are no transaction costs. In the real world, however, transaction costs exist for all assets and securities. Likewise, the law of one price does not consider the legal restrictions between various countries or markets. However, these can have a similar impact on prices as transaction and transportation costs.

Conclusion

The law of one price is a theory in economics. It suggests that the prices of identical goods across various markets will remain the same after considering the difference in forex exchange rates. This law is more prevalent in the financial markets than for other goods or services. The law of one price makes several assumptions, which can result in some limitations.

Originally Published Here: What Is The Law Of One Price?

What Is A Swap Rate?

What is a Swap Rate?

A swap rate is a fixed rate that comes with swaps. The rate differs based on the parties involved in the contract and the market in which they transact. There are various types of swap rates, such as the interest rate swap or currency swap. With swap rates, there are usually two parties, the payer and the receiver. The receiver is the party that receives or demands the fixed rate. The payer, on the other hand, is the party that pays or offers the fixed rate.

With swap rates, receivers get compensated for any uncertainty revolving around floating interest rates. This way, they can mitigate the risks that come with fluctuations in floating-rate instruments. For interest-rate swaps, the payer exchanges a fixed interest rate for a benchmark rate. There are various types of currency swaps. These may include exchanging the fixed rate of one currency for the floating rate of another.

How does a Swap Rate work?

Swap rates may come with different instruments or swaps. As mentioned, there are two types of swap rates. With interest swap rates, two parties exchange floating and fixed interest rates. Usually, they do so to avoid the uncertainty associated with floating interest rates that come with instruments. After a period, one party compensates the other for the differences in the interest payments.

On the other hand, a currency swap may come in different forms. It may include the exchange of a fixed rate in one currency for the fixed rate in another. It may also consist of exchanging a fixed rate to floating rate and floating rate to floating rate between two currencies. The purpose of currency swaps is to avoid the risk associated with forex exchange rates.

What is an Interest Rate Swap?

An interest rate swap involves a contract between two parties to exchange their future interest payments on a loan or bond. It may exist between individuals, companies, or financial institutions. Swaps are derivative contracts. Therefore, interest rate swaps get their value from the underlying value of the interest payment streams.

With interest rate swaps, both parties can exchange their interest payments from their respective loan or bond. However, the underlying debt instruments remain with the original borrower. Since interest rate swaps involve the exchange of floating and fixed interest rates, the interest payment on them may differ. At the end of each period, one of the involved parties pays or receives the excess interest payments.

What is a Currency Swap?

While interest rate swaps focus on mitigating the uncertainty that comes with interest rates, currency swaps involve currency exchange rates. The parties involved in currency swaps don't net off the difference in interest payments. Instead, they calculate and pay the difference in the currencies involved.

Both parties will also fix the date or time for payments throughout the contract's lifecycle. Most investors use it to hedge long-term investments. Some parties may also use it to change the interest rate exposure of the parties involved. Some parties may also use it to get more favourable loan rates at a foreign location than they can get in their country of origin.

Conclusion

Swap rates involved the exchange of interest payments at a fixed rate. There are two types of interest rate swaps prevalent in the market, including interest rate swaps and currency swaps. The focus of interest rate swaps is to mitigate the risks involved in interest payments. For currency swaps, the focus may be currency exchange rate variations.

Originally Published Here: What Is A Swap Rate?

Forward Rate vs Spot Rate

Forward rate and spot rate are two terms used to describe different aspects of interest rates. These are common in various markets. However, they have different meanings according to the market where they are prevalent. These are most common in bond markets but may also apply to other contracts or instruments. The differences between forward and spot rates are as below.

What is Forward Rate?

The forward rate represents the expected values of future financial transactions that investors can expect to occur in the future. Therefore, forward rates apply to all financial transactions with a value or maturity in the future. Investors can use the spot rate to calculate an instrument or option's forward rate. In some markets, the forward rate may also refer to the predetermined or fixed rate for financial obligations.

A forward interest rate shows the coupon rate on a bond or interest rate on a loan that will commence sometime in the future. Therefore, the forward interest rate represents the rate that will apply to a transaction in the future. Forward rates are crucial in bond markets. When investors buy a bond in the market, they consider its forward and spot rate.

The price of a bond or instrument depends on its future returns. When buying a bond nearing its maturity, the bond's forward rate will be higher than its interest rate. The difference between spot and forward rate may be significant. Investors can use various models or approaches towards calculating the forward rate.

What is Spot Rate?

The spot interest rate represents the price of a financial instrument on a spot date. The spot date refers to the day when investors pay funds for the transfer of the financial instrument. It may be on the same day as participants complete the transaction. Usually, however, it is two days after the trade. Usually, the spot rate represents the current market rate of security for immediate settlement.

A contract or instrument’s spot rate may vary over time and based on the market. However, the prices stay similar across various markets. This way, there is no room for arbitrage exploitation due to price disparities. The spot rate also plays a significant role in the calculation of the forward rate. Based on the spot rate, investors can estimate the fluctuations in future commodity prices.

Investors use a spot rate when looking to make immediate purchases or sales. However, they use the forward rate to develop expectations for future prices. Investors can use it as an economic indicator of how they expect the future to perform. However, spot rates do not indicate market expectations or future prices.

What are the differences between Forward and Spot Rate?

As mentioned, the meaning of forward and spot rates may differ across various markets. With bonds, the forward rate represents the effective yield on a bond or US Treasury bills. In contrast, the spot rate refers to the price of a financial contract on the spot date. As mentioned, the spot date may be on the same day as the transaction, but it normally occurs within two days after a trade.

Conclusion

There are two terms commonly associated with bonds. These include spot and forward interest rates. The meaning for these may differ based on the market they are used. However, forward rates usually indicate the effective yield on a bond. The spot rate, in contrast, shows the expected price of a bond on the spot date, which is usually two days after the trade.

Originally Published Here: Forward Rate vs Spot Rate

How Do You Value a Private Company

Determining the value of a public company is relatively straightforward. That is primarily due to the vast amount of publicly available information. Some analysts may provide these valuations for free to the general public. However, the same does not apply to private companies. Determining the value of a private company is a complicated process.

What is a Private Company?

A private company is a company that has limited or closed ownership. The shares of these companies are not available in the stock market. However, that does not mean that others cannot buy the company’s shares. Private company stockholders may trade their shares to other existing or new stockholders. However, attracting new stockholders is not as straightforward.

With public companies, the value of shares is available through the stock market. However, new investors may be reluctant to invest in private companies. Usually, private company shares are less liquid compared to public-listed companies. It introduces many challenges for private companies when it comes to obtaining finance.

How to value a Private Company?

The information that investors use to value a public company may not be available for private companies. Therefore, the traditional methods of company valuation are not applicable to private companies. Hence, investors will have to use other methods for valuing private companies. There are various approaches to do so, two of which are as below.

Comparable Company Analysis or Market Approach

With the market approach, investors can use a comparable company analysis (CCA) to value a private company. With this approach, investors identify public companies in the same industry as the company under consideration. Usually, the closer in growth, size, and age the public-listed companies are to the private company, the better it is.

With the market approach, investors can determine a close estimate of the private company's value. Once investors calculate the price and cash flow metrics for the comparable companies, they can use it to calculate the subject company's estimates. They can also calculate the EBITDA multiple for the subject company and use it to calculate its enterprise value.

Investors may also use comparative information from recent IPOs of other companies of similar size for this calculation. However, there are various problems with using comparable company analysis to do so. The primary issue with this approach is the research that investors must perform. Finding companies of similar size may not be possible.

Present Value Approach

The present value method is similar to public companies. Investors can estimate a private company's value based on the present value of its forecasted cash flows. However, this approach also requires investors to make estimations about a company's future cash flows. Once they obtain the relevant information, they must calculate the discount rate to determine the present value of cash flows.

The primary source of calculating a private company’s value under this approach is using its revenues. After an investor establishes a revenue growth rate, they can make forecasts about its future performances. Using this information, they can calculate a company's free cash flows, which they can then use with Discounted Cash Flow (DCF) method.

Investors need to perform various estimations based on which they can calculate the private company’s value. These estimations can significantly alter a company’s value. Therefore, it is crucial for investors to perform accurate calculations and forecasts.

Conclusion

Due to the lack of information available for private companies, investors may find it difficult to determine their value. Private companies represent a closed ownership structure for which investors can't find shares in the public market. However, investors can still use several approaches to calculate their value, including the market and present value approaches.

Article Source Here: How Do You Value a Private Company

Generally Accepted Accounting Principles

What are Generally Accepted Accounting Principles?

Generally Accepted Accounting Principles (GAAP) represent a set of accounting standards, rules, and principles issued by the Financial Accounting Standard Board (FASB). GAAP is one of the two prevalent accounting standards used throughout the world, the other being IFRS. While IFRS has a worldwide application, GAAP is mostly applicable in the US.

GAAP dictates how companies and other organizations prepare their financial statements. It provides rules for each aspect of accounting treatments, allowing a uniform accounting process throughout the US. For publicly-listed companies, using GAAP is mandatory. For other companies or organizations, however, it is not compulsory.

Through GAAP, companies can provide stakeholders with comparable and standardized financial reports. GAAP aims to make the financial reporting process of various companies more consistent and clearer. However, this only applies to financial reports within the US. For financial statements prepared using other standards, comparability with GAAP may not be straightforward.

Who is responsible for regulating Generally Accepted Accounting Principles?

As mentioned, the Financial Accounting Standards Board (FASB) regulates Generally Accepted Accounting Principles. Formed in 1973 as a successor to the Accounting Principles Board, the FASAB establishes and interprets GAAP standards in the US. The FASB handles GAAP standards for companies, government organizations, and nonprofits.

The Financial Accounting Standards Board works under various organizations. These include the Financial Accounting Foundation, the Financial Accounting Standards Advisory Council, the Governmental Accounting Standards Board, and the Governmental Accounting Standards Advisory Council. These organizations aim to improve financial accounting and reporting standards. Ultimately, the purpose is to provide useful information to investors and other users of the financial statements.

What are the 10 Principles of Generally Accepted Accounting Principles?

There are ten principles that define the mission of GAAP standards. These are as below.

1.      Principle of Regularity

This principle states that the accountant has complied with the GAAP rules and regulations.

2.      Principle of Consistency

This principle ensures that accountants use GAAP standards throughout the reporting process. GAAP is not a set of selective standards. Similarly, accountants must fully disclose and explain the reasons behind any changed or updated standards.

3.      Principle of Sincerity

This principle states that accountants must provide an accurate and impartial presentation of a company's financial situation.

4.      Principle of Permanence of Methods

This principle states that accountants should use consistent procedures in their financial reporting.

5.      Principle of Non-Compensation

This principle states that accountants must report all aspects of a company’s performance, whether positive or negative. They should not compensate debts with assets.

6.      Principle of Prudence

This principle states that accountants should report factual financial data and not that based on speculation.

7.      Principle of Continuity

This principle states that when reporting, accountants should assume the business will continue to operate in the future.

8.      Principle of Periodicity

This principle states that accountants should report financial information in the relevant accounting period to which it relates.

9.      Principle of Materiality

This principle states that accountants must fully disclose all financial data and accounting information in financial reports.

10. Principle of Utmost Good Faith

This principle states that all parties should remain honest in their transactions.

Conclusion

Generally Accepted Accounting Principles are a set of rules and standards for financial reporting. These are prevalent in the US and mandatory for public companies to use. GAAP comes from the Financial Accounting Standards Board. GAAP consists of 10 principles, which define how accountants and companies must report their financial information.

Originally Published Here: Generally Accepted Accounting Principles

Interest Rate Swap

What is an Interest Rate Swap?

An interest rate swap is a type of financial derivatives that allows participants to exchange their interest payments. With interest rate swaps, two parties can enter a forward contract to pay off each other's interest payments. Usually, both parties agree on the terms of the agreement. These terms also specify the principal amount for the swap.

Interest rate swaps usually involve exchanging fixed-rate debt instruments with floating-rate ones. The reason why participants do so is to mitigate or reduce their exposure to interest rate fluctuations. Since the rate on both payments differs, each party will be liable to pay a different amount. However, both parties agree to net off the payments and only pay for the residual amount. Therefore, one party will always benefit while the other will make a loss.

Sometimes, however, participants may also exchange floating interest rate instruments with other floating-rate debts. Participants may do so to avoid the risks involved with a specific type of debt. This type of interest rate swap is known as a basis swap.

How do Interest Rate Swaps work?

Interest rate swaps include two parties. As mentioned, one party usually receives fixed rate interest payments while the other gets floating-rate interest. Both parties mutually agree to the exchange and specify the conditions for the agreement. The reason why they may do so differs according to each party's requirements. Usually, however, it includes mitigating risks associated with a specific type of interest payments.

However, it does not imply that one party will be loss-making. The party receiving fixed-rate payments gets the advantage of paying fixed interests. If the market interest rates increase, the receiver of the fixed-rate payments will be at an advantage. However, the other party also benefits if the interest rates go down. In that case, they will have to pay lower interests than they would if they paid fixed rates.

Interest rate swaps only include the exchange of interest payments. The underlying debt instruments stay with the original receiver. The contract only specifies that each party will pay the difference in loan payments according to the agreement’s specifications. Therefore, they do not have to make full payments. Instead, they only compensate the other party for the additional interest payment on their debt instrument.

What are the risks associated with Interest Rate Swaps?

Interest rate swaps include two types of risks. These include credit risk and interest rate risks. When two parties exchange their interest payments, they face the risk that the opposing party will fail to honour their obligations. Since the contract does not involve exchanging the underlying debt instrument, the original receiver will be liable for the default.

Similarly, interest rate swaps come with interest rate risks. The risk that fluctuations in interest rates may cause higher or lower obligations for each party is a part of the contract. While one party can benefit from transferring their interest rate risks, the other party will always be at risk. Apart from these, interest rate swaps may include more other risks, such as market risk or counterparty risk.

What are the types of Interest Rate Swaps?

Based on the underlying debt instruments involved, there are three prominent types of interest rate swaps. The most common among these is the fixed-to-floating and floating-to-fixed interest rate swaps. Sometimes, however, both parties in a swap agreement may also enter into a float-to-float swap contract. All of these types of interest rate swaps have different characteristics.

Fixed-to-Floating

A fixed to floating interest rate allows one party to exchange their fixed-rate debt for a floating rate debt. There are several reasons to do so. While floating rate interest payments come with higher uncertainty, they can also offer more rewards. An entity may enter a fixed-to-floating interest rate swap to get better cash flows or reduce its risks. This type of interest rate swap can be significantly beneficial when market interest rates are decreasing.

Floating-to-Fixed

The floating-to-fixed interest rate swap agreement allows a party to exchange a floating interest debt for a fixed-rate one. With this agreement, the party can get better security when it comes to interest payments. Fixed interest payments are easier to predict and, therefore, better to manage. By disposing of floating rate interest payments for fixed instruments, the party can reduce their risks. This type of swap is beneficial when market interest rates are growing.

Float-to-Float

A float-to-float interest rate swap allows one party to exchange their floating rate debt for another floating rate one. This type of interest rate swap is known as a basis swap. It is not as common as exchanging floating debt for fixed-rate debt. However, it still can be beneficial to get more favourable terms for interest payments. For example, one party may exchange their three-month LIBOR debt instrument for a six-month LIBOR or vice versa.

What is an Interest Rate Swap example?

Two companies, Red Co. and Blue Co., enter into an interest rate swap agreement. Red Co. holds a fixed-rate instrument that comes with a 5% fixed coupon rate. On the other hand, Blue Co. carries a floating rate debt with a LIBOR rate plus a 1% interest rate. At the time of the swap, the LIBOR rate is 4%. Both debts also have a nominal value of $100,000 with annual interest payments. After the swap agreement, Red Co. has to pay for the floating rate debt while Blue Co. has to handle fixed-rate payments.

At the end of the first year, the LIBOR rate decreases to 3.5%. Therefore, Red Co. must make an interest payment of $4,500 ($100,000 x [3.5% + 1%]). On the other hand, Blue Co. must make an interest payment of $5,000 ($100,000 x 5%). Both parties net off their payments, and subsequently, Blue Co. will pay Red Co. the $500 difference.

At the end of the next year, the LIBOR rates rise to 4.5%. In this case, Red Co. will be liable to pay $5,500 ($100,000 x [4.5% + 1%]). On the other hand, Blue Co.’s liability will remain fixed at $5,000. During the second year, Red Co. will pay Blue Co. the $500 difference in both payments.

How to price an Interest Rate Swap?

To value an interest rate swap, fixed and floating legs are priced separately using the discounted cash flow approach. Specifically, The valuation of an interest rate swap proceeds as follows,

1. Construction of the zero-coupon curve
2. Determination of the payment schedules
3. Calculation of the net present value of future cash flows

This method for valuing an Interest Rate Swap can be implemented in Excel or Python.

How to account for Interest Rate Swaps?

The accounting for interest rate swaps considers the adjustment amount receive or paid to the other party. As mentioned, both parties in the interest rate swap do not pay each other’s interest payments. They pay or receive the adjusted difference between the interest payments on both instruments.

When a company pays interest on its debt instruments, it can use the following double entry.

Dr	Interest Expense
Cr	Interest Payable

The company can then make the payment to the lender as usual. However, once the other party calculates the interest rate, the company must adjust the interest expense. When the other party's interest is lower, the company will record the receipt for the difference. In that case, the double-entry will be as follows.

Dr	Cash
Cr	Interest Expense

However, if the other party’s interest expense is higher, the company has to pay the net difference. In that case, the adjustment will be as follows.

Dr	Interest Expense
Cr	Cash

The company must also calculate any changes in the fair value of the debt and record it. If there is an increase in its value, it can use the following double entry.

Dr	Swap contract
Cr	Unrealized gain

In case of a loss, it can use the reverse of the above entry.

Conclusion

An interest rate swap is a contract that involves the exchange of one type of interest payment for another. Usually, it includes the exchange of fixed-rate and floating-rate interest payments. There are two parties involved in an interest rate swap. With interest rate swaps, the involved parties don’t exchange the underlying debt instruments.

Article Source Here: Interest Rate Swap

P/E to Growth Ratio (PEG)

The price-to-earnings ratio is among the most prominent metrics that investors use when making investment decisions. It is straightforward to calculate and also provides a tool for investors to compare various stocks. Another reason why investors prefer the P/E ratio is that they can use it in other useful ratios. One of these includes the P/E to Growth ratio.

What is the P/E to Growth Ratio?

The P/E to Growth ratio (PEG) considers a stock's P/E ratio and the growth rate of its earnings for a specific period. The PEG ratio enhances the P/E ratio by considering any estimated growth in a company's income. It is one of the limitations of the P/E ratio, which the PEG ratio addresses. Through the PEG ratio, investors can get valuable insights into a stock's level of valuation.

How to calculate the P/E to Growth Ratio?

Investors can use the following formula to calculate a company’s P/E to Growth ratio.

P/E to Growth Ratio = P/E Ratio / EPS Growth

Similarly, investors can expand the formula as follows.

P/E to Growth Ratio = (Price / EPS) / EPS Growth

Usually, calculating the P/E ratio is straightforward. It is also available on most stock markets for publicly-listed companies. However, obtaining an accurate EPS growth rate for a specific stock may be difficult. Investors can get these estimates from specialized sources for publicly-listed companies. Once they have both the figures, they can easily calculate the PEG ratio for the stock.

Example

An investor wants to decide between investing in two stocks. The first stock is from Red Co., which has a market price of $100. The company’s EPS in the previous accounting period was $25 per share. Stock analysts believe that the EPS will grow by 20% in the next period. Red Co.’s P/E ratio is as below.

P/E Ratio = Current Share Market Price / Earnings Per Share

P/E Ratio = $100 / $25

P/E Ratio = 4

Similarly, Red Co.’s P/E to growth ratio will be as below.

P/E to Growth Ratio = P/E Ratio / EPS Growth

P/E to Growth Ratio = 4 / 20

P/E to Growth Ratio = 0.2

On the other hand, the investor has the option to invest in Blue Co.’s stock as well. Blue Co.’s current stock price in the market is $100 as well. Similarly, its EPS for the last period was $32. Market analysts believe the company’s EPS will grow by 10% in the next period. Therefore, the company’s P/E ratio is as below.

P/E Ratio = Current Share Market Price / Earnings Per Share

P/E Ratio = $100 / $32

P/E Ratio = 3.125

Similarly, Blue Co.’s PEG ratio is as below.

P/E to Growth Ratio = P/E Ratio / EPS Growth

P/E to Growth Ratio = 3.125 / 10

P/E to Growth Ratio = 0.3125

Some investors may prefer investing in Red Co.'s stocks due to the lower P/E ratio. However, according to the PEG ratio, Blue Co.'s stocks have a better potential for growth. Regardless, investors must understand that the PEG ratio depends on the accuracy of the forecasted EPS growth.

Conclusion

P/E ratio is a widely used financial metric that allows investors to make decisions between investments in stocks. However, it fails to reflect the potential growth in earnings in the future. That is where the P/E to growth ratio is useful. The PEG ratio considers the relationship between a stock's P/E ratio and its growth rate.

Post Source Here: P/E to Growth Ratio (PEG)

What is a Forward Price-To-Earnings (P/E) Ratio

The Price-To-Earnings ratio is an essential ratio for investors and measures a stock's price in relation to the underlying company's earnings. Other names for it are price or earnings multiple. P/E ratios are a critical comparison tool used by investors to evaluate various investments. There are different types of P/E ratios, which consider several aspects of a company's P/E. One of those includes the forward P/E.

What is a Forward P/E?

The Forward Price-to-Earnings uses a company's forecasted earnings to calculate the P/E ratio rather than its historical profits. Usually, investors forecast a company's earnings per share for the next 12 months and use it as a part of the original P/E ratio. Other names for the forward P/E include the project or leading P/E. The accuracy of the forward P/E depends on the forecast made by the investor.

Forward P/E ratios can be effective in evaluating a company. For most investors, the forward P/E is more useful than using historical information. Investors may use several techniques to forecast a company's earnings to use with the forward P/E ratio. The formula for the forward P/E stays the same as the original one. The only difference is using expected earnings instead of historical information.

How to calculate Forward P/E?

The formula to calculate a company’s P/E ratio is as below.

Price-to-Earnings Ratio = Current Share Market Price / Earnings Per Share

Information about a company’s current share market price is available through the stock market. However, for private companies, obtaining an accurate price may be challenging. Similarly, a company’s Earnings Per Share is available in its Income Statement. Investors can also calculate it using the information available in the company’s financial statements.

As mentioned, the formula for the Forward P/E is similar to that of the original P/E ratio. However, investors use a company's forecasted earnings per share. Therefore, the formula will become:

Forward Price-to-Earnings Ratio = Current Share Market Price / Estimate Future Earnings Per Share

Example

An investor wants to calculate the forward P/E for a company, Red Co. The company’s shares are publicly available in the stock market with a current market price of $100 per share. Red Co.’s earnings per share in the previous period were $20 per share. However, market analysts estimate the company’s EPS to reach $25 per share in the future.

Red Co.'s P/E ratio, based on its historical EPS, is as below.

Price-to-Earnings Ratio = Current Share Market Price / Earnings Per Share

Price-to-Earnings Ratio = $100 / $20

Price-to-Earnings Ratio = 5

On the other hand, Red Co.’s forward P/E will be as below.

Forward Price-to-Earnings Ratio = Current Share Market Price / Estimate Future Earnings Per Share

Forward Price-to-Earnings Ratio = $100 / $25

Forward Price-to-Earnings Ratio = 4

How does Forward P/E work?

Forward P/E uses a company’s estimated earnings rather than its historical profits. When investors acquire stocks, they cannot earn from past performance. However, they can benefit in the future. Hence, it is more relevant for them to consider their future profits. Therefore, the forward P/E provides a better measure of the potential earnings the investors can make.

Other than that, the forward P/E ratio works in a similar way to the trailing P/E ratio. Investors can use it to compare various stocks and make decisions accordingly.

Conclusion

Forward P/E is a financial metric that looks at a stock's price and the future estimated earnings per share of the underlying company. The Forward P/E ratio is crucial for investors as it helps them in decision-making. The accuracy of the calculation depends on the forecast used to calculate the forward P/E.

Originally Published Here: What is a Forward Price-To-Earnings (P/E) Ratio

International Financial Reporting Standards

Businesses and companies follow various accounting standards to prepare and present their financial statements. These standards regulate how companies account for transactions. Some countries may have their specific standards. However, most of these companies use variations of international standards already developed by standardized bodies.

When it comes to international accounting standards, there are two types of commonly used variations. The first one is the International Financial Reporting Standards (IFRS), which many countries and jurisdictions use. Some jurisdictions may customize some parts of those standards. On the other hand, the second one is Generally Accepted Accounting Principles (GAAP). This variation is only applicable in the US.

What are the International Financial Reporting Standards?

International Financial Reporting Standards (IFRS) represent a set of common rules applicable to accounting. These rules apply to any entity that prepares financial statements in jurisdictions where the IFRS is relevant. IFRS allows for a consistent, comparable, and transparent presentation of financial statements around the world.

There are various standards with the IFRS that relate to particular areas of accounting within a company. For example, there are specific standards for Property, Plant & Equipment, Intangible Assets, and Inventory. These all apply to different areas for businesses and other entities. The goal of these standards is to standardize the reporting process.

The International Financial Reporting Standards were previously known as International Accounting Standards (IAS). However, the IFRS got its name from the change in the body responsible for developing these standards.

Who is responsible for developing and maintaining the International Financial Reporting Standards?

The International Financial Reporting Standards (IFRS) come from the International Accounting Standards Board. It is an independent, private-sector body responsible for developing and maintaining the standards within the IFRS. The IASB was the successor of the International Accounting Standards Committee in 2001.

The International Accounting Standards Foundation also changed its name to the International Financial Reporting Standards Foundation (IFRS Foundation). Any standards developed during the previous foundation’s period come with the IAS tag. For example, the IAS 16 is the standard for Property, Plant, and Equipment, which is still applicable.

How do the International Financial Reporting Standards (IFRS) differ from the Generally Accepted Accounting Principles (GAAP)?

As mentioned, IFRS is applicable in several countries in the world. According to the latest count, 120 countries use the IFRS. On the other hand, the Generally Accepted Accounting Principles are only applicable in the US. However, that is not the only difference between these two. They also differ from each other in one other major aspect.

The IFRS takes a principle-based approach towards standardizing accounting. It may require more judgment and interpretation. However, it allows entities much better flexibility with the usage. On the other hand, GAAP uses a rules-based approach to accounting. This approach provides industry-specific rules and guidelines for each entity. However, it does not provide the same level of flexibility as the IFRS.

Apart from that, the IFRS and GAAP also vary from each other in specific accounting areas. For example, IFRS only allows the FIFO and weighted-average cost method of valuing inventory. GAAP, on the other hand, also allows the LIFO method. Similarly, there are various other areas where they may differ from each other as well.

Conclusion

The International Financial Reporting Standards is a set of common rules that aim to bring consistency, comparability, and transparency to financial reports. IFRS comes from the International Accounting Standards Board. These standards are prevalent in 120 countries worldwide. IFRS is different from the Generally Accepted Accounting Principles, which is applicable in the US.

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Enterprise Value to Sales Ratio

What is Enterprise Value to Sales Ratio?

Enterprise Value to Sales Ratio (EV/Sales) is a financial metric that investors use to measure a company’s total value in relation to its sales. The first part of the ratio is the Enterprise Value. A company’s enterprise value is the sum of its current market cap, debt, minority interest, preferred shares after deducting its cash balances.

Enterprise value to sales ratio is a crucial metric that investors use to calculate a stock's market value. Using this ratio, investors can determine whether a company's stock in the market is undervalued or overvalued. Usually, a higher EV/Sales ratio represents an expensive or valuable stock. Another name for the ratio is the Enterprise Value to Revenue ratio or multiple.

How to Calculate the Enterprise Value to Sales Ratio?

Calculating the EV/Sales ratio is straightforward. As the name suggests, it is the ratio of a company’s enterprise value and its sales. Therefore, the formula will be as follows.

Enterprise Value to Sales Ratio = Enterprise Value / Net Sales

A company’s net sales are available in its Income Statement. However, investors need to calculate the Enterprise Value manually. They may need to obtain the information for this calculation from external and internal sources. The formula to calculate Enterprise Value is as below.

Enterprise Value = Market Capitalization + Debt + Preferred Shares + Minority Interest - Cash and Cash Equivalent Balances

Most of the information available for the above formula is available in a company's Balance Sheet. However, the market capitalization may need some external research.

Example

A company, Green Co., has a total market capitalization of $100 million. The company reports total debt of $20 million and preferred shares of $15 million in its balance sheet. Green Co. also has cash and cash equivalent balances of $25 million. The company made total sales of $50 million. Before determining Green Co.'s EV/Sales ratio, it is crucial to calculate its Enterprise Value.

The calculation for Green Co.’s Enterprise Value will be as follows.

Enterprise Value = Market Capitalization + Debt + Preferred Shares + Minority Interest - Cash and Cash Equivalent Balances

Enterprise Value = $100 million + $20 million + $15 million - $25 million

Enterprise Value = $110 million

Therefore, Green Co.’s Enterprise Value to Sales Ratio will be as follows.

Enterprise Value to Sales Ratio = Enterprise Value / Net Sales

Enterprise Value to Sales Ratio = $110 million / $50 million

Enterprise Value to Sales Ratio = 2.2

How does the Enterprise Value to Sales Ratio work?

The EV/Sales ratio allows investors to evaluate a company's stocks. It is similar to the price-to-sales ratio (P/S). However, it uses a company's enterprise value instead. The EV/Sales ratio may range between 1 and 3. Investors usually prefer to invest in companies with a low EV/Sales ratio as it may indicate undervalued stocks. However, that may not always be true.

Sometimes, a high EV/Sales ratio can also mean the companies have a high potential to grow their sales. Similarly, a low EV/Sales ratio may indicate a company has experienced a sudden or one-off increase in its revenues. This ratio provides better results if used comparatively with a company's past performances or the industry as a whole.

Conclusion

The Enterprise Value to Sales Ratio considers the ratio between a company’s Enterprise Value and its Revenues. This financial metric is crucial for investors that want to identify undervalued or overvalued stock in a company. Usually, investors prefer investing in low EV/Sales ratio companies. However, there may be some exceptions to that rule.

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Free Cash Flow to Equity

What is Free Cash Flow to Equity?

Free Cash Flow to Equity (FCFE) represents the cash available to a company’s shareholders or investors. These are the cash flows that come after deducting all the expenses, reinvestment, and debt expenses from a company’s total cash inflows. FCFE is a crucial metric for investors as it allows them to understand how much income they can get from their investments.

Free cash flow to equity shows the cash that companies generate and are available for distribution to shareholders. However, that does not imply that the company must distribute it. There are some factors that may affect how much shareholders can receive. Despite that, FCFE allows shareholders to develop expectations. Similarly, it provides them with a comparison tool to use for various investments.

How does Free Cash Flow to Equity work?

The FCFE is a metric that investors use to measure a company’s value. Usually, investors can use the FCFE as an alternative method to evaluate a company that does not pay dividends. It is also better to use the FCFE for companies that have a stable capital structure. Sometimes, the FCFE calculation may also result in a negative amount.

Investors usually prefer investing in companies with a positive or growing FCFE. It is because a negative FCFE can be an indicator of underperforming stocks. However, some stable companies may also have a negative FCFE due to large capital investments or debt repayments.

How to calculate Free Cash Flow to Equity?

The formula for Free Cash Flow to Equity is similar to that of free cash flow. However, it also considers the net debt issued by a company, which the original does not. Therefore, investors can use the formula below to calculate FCFE.

Free Cash Flow to Equity = Cash from Operations - Capital Expenditure + Net Debt Issued

All of the information required to calculate a company’s FCFE is available on its Cash Flow Statement. Sometimes, however, the information for the above formula may not be available. Therefore, investors may also use another formula to calculate FCFE, as below.

Free Cash Flow to Equity = Net Income + Non-Cash Expenses ± Changes in Working Capital - Capital Expenditure + Net Debt Issued

The above formula expands on the original one in calculating FCFE. The net income and non-cash expenses part of this formula are available in a company's Income Statement. The changes in working capital represent the differences between a company's opening and closing working capital balances. These include inventory, account payable, and account receivable balances. These are all available on the Balance Sheet.

Example

A company, Red Co., has a total net income of $500,000. The non-cash expenses, including depreciation and amortization, for Red Co., amount to $50,000. The net changes in working capital from the balance sheet were -$100,000. The company also incurred a capital expenditure of $150,000 during the period. Lastly, Red Co. also had net debt issued of $75,000.

Therefore, Red Co.’s free cash flow to equity will be as below.

Free Cash Flow to Equity = Net Income + Non-Cash Expenses ± Changes in Working Capital - Capital Expenditure + Net Debt Issued

Free Cash Flow to Equity = $500,000 + $50,000 - $100,000 - $150,000 + $75,000

Free Cash Flow to Equity = $375,000

Conclusion

Free cash flow to equity represents the cash available to a company’s investors. It is after deducting all expenses, reinvestment, and debt repayments from its cash inflows. FCFE is crucial for investors that want to measure a company's value. The calculation of FCFE is straightforward and similar to the FCF.

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Free Cash Flow Valuation Model

What is Free Cash Flow?

Free Cash Flow (FCF) represents any cash that a company or business has left after paying for its operational needs and maintaining capital assets. Operating expenses include items, such as rent, salaries, and wages, taxes, etc., that companies pay to continue their activities. Similarly, capital expenditure consists of any costs borne on acquiring, maintaining, or upgrading assets.

FCF is an alternative for other common types of performance indicators, such as net income. Instead of focusing on all expenses, free cash flow measures a company's profitability, excluding non-cash expenses. However, it includes relevant items, including capital expenditure and working capital changes. This way, FCF provides detailed insights into a company's cash management procedure.

How do Free Cash Flows work?

For most companies, a positive free cash flow indicates better financial health. A high free cash flow means that companies have enough cash to meet their obligations each month. On the other hand, a low or decreasing free cash flow can indicate financial problems. Investors also prefer to invest in companies that have positive or increasing free cash flows.

However, decreasing free cash flows may not always indicate failures. Some one-off transactions can result in sudden dips in free cash flows. For relatively new businesses, free cash flows have significant variance compared to steady companies. Similarly, the industry in which a company operates also defines the norm for free cash flows.

How to use Free Cash Flows in Investment Decisions?

Just like normal cash flows, investors can use free cash flows in investment decisions. In fact, free cash flows are one of the prevalent methods in company valuation. With the FCF method of company valuation,  a company's intrinsic value will be equal to the present value of its operating free cash flows. The formula for operating free cash flows is as follows.

Operating Free Cash Flows = Earnings Before Interest and Tax x (1 - Tax Rate) + Depreciation - Capital Expenditure - Changes in Working Capital - Changes in Other Assets

Once investors determine a company’s operating free cash flows, they can discount it using the Weighted Average Cost of Capital. This way, they can find the underlying company’s value. Therefore, the formula will be as below.

Company Value = Operating Free Cash Flows / (1 + WACC)

Investors can also factor in the expected growth rate for the company in that formula. This way, they can calculate the value of companies that they expect to have constant growth in operating free cash flows. The formula will be as follows.

Company Value = Operating Free Cash Flows / (WACC - Expected Growth Rate of OFCF)

For this variation, investors will need to calculate the expected growth rate. They can do so by calculating the product of a company's average retention rate and its return on invested capital. Once they do so, they can calculate a company's value and use it for further decision-making.

Conclusion

Free cash flow refers to cash that a company has left after accounting for operational needs and maintaining capital assets. Free cash flows can have many uses, one of which is for investment decisions. Investors can calculate a company's operational free cash flows and discount them at the Weighted Average Cost of Capital to determine its value.

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Free Cash Flow to the Firm (FCFF)

What is Free Cash Flow to the Firm?

Free Cash Flow to the Firm (FCFF) represents any cash remaining after deducting a company's depreciation, taxes, working capital, and other investment costs from its revenues. This amount shows any cash flow available for companies to distribute to their financiers, whether debtholders, stockholders, preferred stockholders, or bondholders.

Free Cash Flow to the Firm also represents any surplus cash flows available to companies assuming they were debt-free. Therefore, another name for the FCFF is unlevered free cash flow. FCFF can help investors gauge a company's profitability after deducting all expenses and reinvestments. For most companies, the FCFF may also be an indicator of financial health.

How to calculate the Free Cash Flow to the Firm?

There are several ways in which investors can calculate a company’s Free Cash Flow to the Firm. These are as below.

Free Cash Flow to the Firm = [EBIT x (1 - Tax Rate)] + Non-Cash Expenses + Changes in Working Capital - Capital Expenditure

The [EBIT x (1 - Tax Rate)] part is also known as a company's Net Operating Profits After Taxes (NOPAT). The non-cash expenses part usually includes depreciation. Similarly, changes in working capital represent any investments that a company has made in its working capital. Lastly, capital expenditure includes all long-term investments that companies make.

Another formula that investors can use to calculate the Free Cash Flow to the Firm is as follows.

Free Cash Flow to the Firm = Net Income + Non-Cash Expenses + [Interest x (1 - Tax Rate)] - Capital Expenditure - Changes in Working Capital

This formula uses a company’s Net Income instead of the NOPAT. The rest of the formula is similar to the one before.

The next approach to calculating the Free Cash Flow to the Firm is as below.

Free Cash Flow to the Firm = Cash flow from operations + [Interest x (1 - Tax Rate)] - Capital expenditures

Lastly, investors can also use the formula below to calculate the Free Cash Flow to the Firm.

Free Cash Flow to the Firm = [EBITDA x (1 - Tax Rate)] + (Depreciation x Tax Rate) - Capital Expenditure - Changes in Working Capital

EBITDA is a company’s Earnings Before Interest, Taxes, Depreciation, and Amortization.

What is the importance of Free Cash Flow to the Firm?

Free Cash Flow to the Firm is a metric that is important for several reasons. Firstly, it presents investors with an alternative to the Earnings Per Share, which uses profits. These profits are easily manipulatable, making it difficult for investors to trust them. FCFF is also crucial for dividend-seeking investors. It is because it is a reliable measure of a company's ability to maintain dividend payments.

Free Cash Flow to the Firm is also a great indicator of a company’s cash flow position. Companies that have consistently high FCFFs are likely to have a better cash management process. Similarly, FCFF is also useful for identifying growth-oriented stocks. High FCCFs mean that companies are likely to use their free cash for further investments. These can result in higher profits in the future.

Conclusion

Free Cash Flow to the Firm is a metric that investors can use to calculate a company's free cash flows. These come after deducting the company's depreciation, taxes, working capital, and other investment costs. Investors can use various formulas to calculate the FCFF.

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