Trading Using Twitter Data, a Strategy Based on President Trump’s Twits

Trading using market sentiment indicators is an approach that analyzes the market sentiment data to make trading and investing decisions. Due to the increasing popularity of social networks, social media data in general and Twitter data in particular have been used growingly in the construction of sentiment indicators.

Sentiment analysis can use natural language processing, artificial intelligence, text analysis and computational linguistics to identify the attitude of a writer with respect to a topic. It’s an important cornerstone of behavioral finance, where theorists believe that markets are irrational and that asset prices are driven by human emotion (e.g., fear, greed, hope and overconfidence, among others). With the growth in global conversation on social media - Twitter in particular - where a vast amount of real-time market conversation occurs on a daily basis, academics and practitioners have been studying and measuring the global conversation to understand if it can meaningfully impact markets. Most concur that Twitter sentiment is correlated to asset price moves, but the debate has been about the predictive nature of Tweets on price. Well, the results are in and the early movers in this space are seeing success. Read more

A recent paper [1] analyzes president Trump's Twitter data and how it impacts the financial markets.  Their findings are as follow,

We start our analysis by evaluation of the impact of Mr. Trump’s tweets in general, irrespective of the actual content of the tweet. We find that the US stock market tends to decline the first 30 minutes following his publishing of a tweet and that trading volume and volatility are significantly higher after Trump has tweeted.

Next, we classify tweets depending on whether they contain a specific word. We find that tweets containing the words “products” and “tariff” have a negative impact on the stock market, i.e. these tweets are followed by decline in the market, increased trading volume and increased uncertainty (level of VIX futures).

Finally, we use Latent Dirichlet Allocation as a topic extraction technique, which assigns each tweet a degree of affiliation to a set of topics without any human input or interpretation. We analyze the short-term impact of each topic on financial markets. We find that tweets affiliated with the topics “Trade war” and “Border Security” are followed by negative returns on the S&P 500 index, increased volatility and increased trading volume. Furthermore, we find a significant decrease in the Hang Seng index, and a significant increase in the gold price after these tweets were published. This is consistent with previous results, as tweets which imply possible restrictions in international trade are often negative news for affected countries, whereas gold is safe haven and often appreciates in uncertain periods.

Based on their findings, the authors developed a simple trading strategy and it was shown to outperform Buy and Hold.

References

[1] P. Gjerstad, P.F. Meyn, P. Molnár, and T.D. Næss, Do President Trump’s tweets affect financial markets?, Decision Support Systems, April 2021, 113577

Article Source Here: Trading Using Twitter Data, a Strategy Based on President Trump’s Twits

Value at Risk Formula

What is Value at Risk?

Value at Risk (VaR) refers to a financial metric used in finance that investors use to estimate the risk of their investments. It involves measuring and quantifying the level of financial risk within investors’ portfolios for a specific period. However, it doesn’t only apply to portfolios. Businesses and companies may also use value at risk to estimate the level of risk within their businesses.

Through VaR, investors can measure the amount of potential loss that they could make in any investment portfolio for a specific time. Investors can also use it to estimate the probability of losing more than a specified amount in any given portfolio. In short, VaR is a measure of the risk of loss that investors face for any given investment.

What is the Value at Risk formula?

There are various methods that investors can use to calculate the VaR for any given investment for a specific time. These include the historical and variance-covariance methods. Investors can also calculate the VaR for an investment using Monte Carlo simulations. Using the historical method, investors can use the following value at risk formula.

Value at Risk = V_m (V_i / V_{i - 1})

In the above formula, ‘V_i' represents the number of variables on a day, 'i’. ‘m’ denotes the number of days from which historical data is taken. Under the variance-covariance method, the value at risk formula is as below.

Value at Risk = [Expected Weighted Return of The Portfolio) - (Z-Score of The Confidence Interval X Standard Deviation of Portfolio)] X Portfolio Value

What are the benefits of using Value at Risk?

Using value at risk has several advantages. Firstly, it is also easy to understand as it represents the degree of risk for any investment. Unlike other concepts, VaR provides a quantifiable measure of risk. Due to its ease of use, most investors use it as an accepted standard when investing. It further adds to its understandability.

Value at risk is also a concept that applies to almost every investment, such as stocks, bonds, commodities, etc. Therefore, it is a reliable tool for investors to assess the profitability of risk for different investments. On top of that, it allows for easier comparability of risks for various asset classes.

What is the limitation of Value at Risk?

Value at risk has some limitations which may hinder its use. Firstly, VaR makes some assumptions, which may not apply every time. For example, it assumes there is no trading in the portfolio. On top of that, there are three different methods that investors can use to calculate VaR. Each of these methods makes several assumptions and can provide varying results.

Lastly, VaR is historically well-known not to provide accurate results for large portfolios. It is because large portfolios have various assets. For each asset, investors have to calculate several figures, which may not be possible. Furthermore, the more of these calculations investors have to make, the less accurate the result obtained will be.

Conclusion

Value at risk is a financial metric that investors can use to estimate the risk of their investments for a specific period. Using VaR, investors can quantify the level of risk within their portfolios. There are three methods that investors can use to calculate the figure. Using VaR has several benefits. However, it also comes with some limitations.

 

Article Source Here: Value at Risk Formula

Market Timing vs Buy and Hold

Investors with varying risk tolerances will select different investing strategies. Some of these strategies promise higher returns. However, these also come with higher risks. On the other hand, some strategies may come with low risks and rewards. Similarly, investors may also choose strategies based on the time it takes for them to materialize their returns. Two such strategies, often the opposite of each other, are market timing and buy and hold.

Both market timing and buy and hold investing strategies offer returns at varying rates. Therefore, these strategies differ from each other. Before understanding their differences, it is crucial to understand what each of these is.

What is Market Timing?

Market timing is an investment strategy that investors use to invest in a financial market using predictions. Using this strategy, investors perform several types of analysis to analyze trends. Using those trends, they identify stocks and securities that will experience a price increase or decrease in the future. Once they do so, they can invest in the stock or security and profit in the future.

Market timing is a short-term strategy that investors use to maximize their returns. Once investors identify potential investments, they can either take a long or short position in the market. Usually, investors wait for the investment to reach the predicted position and buy or sell it accordingly. This way, they can profit from short-term price fluctuations.

What is Buy and Hold?

Buy and hold is another strategy that investors use when investing in financial markets. However, this strategy is relatively long-term. The buy and hold strategy requires investors to identify stocks that will provide returns after a long period. This strategy does not depend on short-term market price fluctuations. Instead, it ignores any short-term movements and requires investors to wait a long time before taking action.

With the buy and hold investing strategy, investors don't have to identify patterns and trends actively. Instead, it is a passive strategy that investors can use to benefit in the long term. The buy and hold strategy is relatively low risk compared to the market timing strategy. However, it has the potential to provide significantly high returns.

What are the differences between Market Timing and Buy and Hold strategies?

The differences between both strategies are clear from the above explanation of each of these. The first difference between the two strategies is the timeframe. Usually, market timing is short-term, while the buy and hold strategy is long-term. On top of that, the market timing strategy requires active management and participation from the investor. The buy and hold strategy, in contrast, does not.

Both investing strategies include risks. However, the risks associated with the marketing timing strategy are significantly higher due to its dependence on market price fluctuations. In contrast, the buy and hold strategy includes lower risks. While both of these strategies can also provide high returns, the market timing strategy can return significantly more profits.

Usually, the market timing strategy provides more returns because investors can earn higher in a shorter time. The buy and hold strategy can also deliver high returns. However, it takes longer for these returns to materialize. Lastly, both investing strategies have some advantages and disadvantages. However, most experts prefer the buy-and-hold strategy over the market timing.

Conclusion

Investors use various investment strategies to maximize their returns in the market. For some investors, the timing of these returns might also be crucial. The market timing strategy provides returns in a short time. However, it requires active management. On the other hand, the buy and hold strategy is a passive strategy. However, it takes longer for returns to materialize from this strategy.

Article Source Here: Market Timing vs Buy and Hold

What is Market Timing?

Every investor in the market has an investing strategy that helps them maximize their returns. These strategies are usually flexible and differ according to the investor's risk tolerance, financial situation, budget, etc. Investors can either use a single strategy or a combination of various strategies to achieve their goals. One of the investing strategies commonly used by investors is market timing.

What is Market Timing?

Market timing is an investment strategy through which investors make investments in asset classes based on predictive methods. With this strategy, investors have to make assumptions about what a security price will be at a future time. Investors can either speculate on the prices rising or falling in the future.

Market timing represents the predictions made by investors about security price movements. Using market timing, investors can speculate on when a stock or security's price will move. This way, they can invest according to their speculation to profit later if it turns out to be true. The aim of this strategy is to outperform the market by taking a long or short position.

How does Market Timing work?

The market timing strategy starts from a prediction that investors make. Investors can select a stock and predict whether its price will increase or decline in the future. There are several tools that investors may use to reach a conclusion about the prediction. Once an investor makes a prediction, they can invest in the selected stock and security.

There are two investment positions that investors can take in a market timing strategy. It may include a long position, where an investor buys the security or stock. This approach works when the investor believes the price of the selected instrument will increase in the future. Instead, investors may also take a short position to sell the stock or security. This approach works when the investor predicts the price to fall in the future.

What are the advantages and disadvantages of the Market Timing strategy?

The most prominent advantage of using the market timing strategy is the return investors get. Investors can earn significantly more with this strategy, given that they can make the correct predictions. This strategy also allows investors to make profits at a quicker rate compared to other strategies. The market timing strategy is riskier. However, the higher returns that investors get can offset the risks undertaken.

However, the market timing strategy requires more effort from investors. Investors need to track market behaviour and trends continuously to identify future positions. Similarly, due to the higher risks, this strategy can expose investors to high losses. Furthermore, investors have to pay higher taxes due to the short-term nature of these investments.

When should investors use the Market Timing strategy?

The market timing strategy isn't for everyone. This strategy is only beneficial for experienced investors that can identify market trends and patterns and make predictions accordingly. For novice investors, the market timing strategy is attractive due to the high rewards it promises. However, it also has the potential to cause significant losses.

Conclusion

Market timing is a strategy that investors use to make predictions on future stock or security prices. Using these predictions, investors can either buy or sell the selected stock or security in the market. The market timing strategy can be highly profitable if used correctly. However, it can also result in substantial losses. This strategy is best if used by experienced investors.

Post Source Here: What is Market Timing?

Using Push-Response, Variance-Ratio, and P+/P- Tests to Characterize the Markets.

We typically divide the markets into 2 regimes: trending or mean-reverting. In a recent paper [1], the authors not only divided the markets into these 2 regimes but also added a third one, a so-called random walk regime.

Investors generally go long when the market is rising and short when the market is falling. In order to implement trading strategies more effectively, it is very important to mine the market direction and the timing of long and short positions. This article divides the direction of the market into three categories: Random Walk (RW), Trend Following (TF) caused by negative reflection, and Mean Reverting (MR) caused by overreaction.

Usually, we utilize the Autocorrelation function or Hurst exponent in order to characterize the markets. There exist, however, other methods that can be used for this purpose, such as

1. Push-Response test,
2. Variance-Ratio test, and
3. P+/P- test.

These methods were utilized in the above-mentioned article.

Push-Response Test, Variance Ratio Test, and P+, P- Test are used to determine the direction of the market, and finally formulate specific trading strategies according to the market type to achieve profitability. This article summarizes the market of certain indexes of US futures, such as HO, GC, etc., which have TF trends in recent years. Taking the ES (E-mini S&P 500) contract as an example, the results show that ES has a trend of TF in the last 6 years, and a trend of MR in 97-09. This article proposes quantitative strategies based on TF and MR market respectively, and applies it to the ES index to verify the effectiveness of the trading strategies.

After analyzing the market characteristics, the authors developed two low-frequency trading strategies, one is a trend-following (TF) strategy, and the other is a mean-reverting (MR) one. The Sharpe ratios of the TF and MR strategies are 2.8 and 0.14 respectively.

From the results, we notice that the TF strategy has a much higher risk-adjusted return than the MR one. It is a surprise to us. This is probably due to the fact that the authors developed trading strategies that include commodities, and not just stock market indices.

References

[1] C. Zheng, G. Gan, J. Zhao, H. Li, Mining Market Directions: A Type of Trading Strategy for Trend Following and Mean Reverting Index, 2021 International Conference on Electronic Commerce, Engineering Management and Information Systems.

Originally Published Here: Using Push-Response, Variance-Ratio, and P+/P- Tests to Characterize the Markets.

What is Commodity Price Index

What are commodities?

Commodities represent basic goods available in the market. These goods are interchangeable with other goods of the same type. Similarly, investors can also buy and sell them on dedicated markets. Some examples of commodities include precious metals, food items, oil, natural gases, etc. Usually, these goods come from producers, who are responsible for providing the market.

However, commodities are volatile investments compared to other assets. It is usually because these assets experience continuous price fluctuations. Investors can include any specific commodity in their portfolio by acquiring it from the market. However, they also have the option to invest in a commodity index.

What is a Commodity Index?

The term commodity index refers to an investment vehicle that tracks the prices and returns on commodity investments. These investments usually consist of a basket of commodities. When investors want to include commodities in their investment portfolio, they can invest in these indexes. These investments are available on various exchanges.

Using commodity indexes, investors can access the commodities market. Like other indexes, these commodity indexes use the underlying commodities to derive a value. Therefore, any fluctuations in the underlying commodities' prices can also impact the index's overall price. Investors can trade this value on an exchange.

There are many types of commodity price indexes from which investors can choose. The difference comes in the way each index is weighted. One of the types of commodity indexes is the commodity price index.

What is a Commodity Price Index?

A commodity price index is a type of fixed-weighted commodity index. Sometimes, a commodity price index may also be a weighted average of underlying commodity prices. The index value for commodity price indexes comes from a spot or future price. Commodity price indexes are representative of a wide range of commodities. Some indexes may also include a specific type of commodity.

Commodity price indexes track a basket of commodities that measure their prices. Any fluctuations in the price of the underlying commodities can cause movements in the index price as well. Investors can access these indexes on exchanges. Therefore, investors can enter the commodities market without having to enter the futures market.

How do Commodity Indexes work?

Different commodity indexes track the market price of a specific or broad range of commodities. Each index has a different structure based on which commodities it includes. On top of that, the weighting process of each index may differ. For example, an index weighted based on an underlying commodity is known as a commodity price index.

Commodity indexes have been a popular choice among investors for over a decade. Its popularity comes from the fact that commodity indexes allow investors to invest in commodities without active management. Similarly, investors don't need to track each commodity's price by themselves. Instead, they can invest in a commodity index to bring all of these under one roof.

Conclusion

Commodities are basic goods available in the market which are interchangeable with goods of the same type. A commodity index represents an investment vehicle that tracks the prices and returns on commodities. A commodity price index derives its value from the prices of underlying commodities. This value for this index comes from a spot or future price.

Article Source Here: What is Commodity Price Index

What is a Commodity Swap?

Financial derivatives are instruments that derive their value from an underlying asset or group of assets. These derivatives are a crucial part of the market. Most investors use financial derivatives to mitigate any risk they face with their investments. There are many types of these derivatives that investors can use to hedge against any future losses. One of these includes swaps.

What are Swaps?

A swap is a type of financial derivative contract that allows two parties to exchange the cash flows from their financial instruments. These usually include agreements where one party compensates the other for the difference between the cash flows from the underlying financial instrument. In swaps, the principal amount of financial instruments do not change hands. Instead, these contracts only include the exchange of cash flows.

Since there are two parties involved in a swap contract, one party will almost always suffer from a loss. While swaps mitigate some risks associated with investments, these contracts also introduce other risks. For example, they include counterparty risk for both parties. There are many types of swap contracts that investors can use for their financial instruments. For commodities, investors can use commodity swaps.

What is a Commodity Swap?

A commodity swap is a type of swap contract that derives its value from an underlying commodity or group of commodities. In these contracts, two parties agree to exchange the cash flows from an underlying commodity's price changes. Commodity swaps represent customized deals that allow two investors to mitigate against losses for their respective commodity investments.

Commodity swaps are contracts prevalently used by commodity producers and customers to lock a set price for a specified commodity. Unlike other types of financial derivatives, commodity swaps are not available on financial markets or exchanges. Instead, producers can enter into these contracts with their customers or financial services companies.

How do Commodity Swaps work?

Commodity swaps are contracts between two parties. Usually, these swaps include a fixed-leg and a floating-leg component. The fixed-leg element is the price set in the swap contract. The floating-leg component relates to the market price of the underlying commodity or agreed-upon commodity index. Usually, commodity swaps are prevalent for oil or precious metal investors.

With commodity swaps, the commodity consumer gets a fixed price for a specific period of time. The commodity swap also provides the provider with protection against a decline in the commodity's price over the specified time. At the end of the contract, one party compensates the other through cash or physical delivery.

Why are Commodity Swaps important?

Commodity swaps are critical for several reasons. Most commonly, these contracts allow parties to protect against any losses associated with commodity price fluctuations. In turn, it enables them to reduce their risks related to commodity price volatility. The other party will also receive a guarantee of a stable selling price for their commodity.

Commodity swaps can also be beneficial for investors looking for more exposure to the underlying commodity. Usually, these contracts are cash-settled. Therefore, there is no physical of the underlying commodity involved.

Conclusion

Swaps are contracts that allow investors to exchange the cash flows associated with an underlying asset or group of assets. Commodity swaps are a type of swap contract. These allow one party to transfer the cash flows from the price fluctuations of an underlying commodity. These swaps are crucial for mitigating risks and getting a fixed price in the future.

Article Source Here: What is a Commodity Swap?

What is Commodity Hedging?

For most investors, having a diversified investment portfolio is crucial in mitigating risks associated with a single asset class. Therefore, investors may choose to invest in different assets, such as stocks, debt instruments, real estate, etc. One of these investments includes commodities, such as precious metals, grains, food items, etc.

Like other asset classes, commodities also have dedicated markets where investors can find specific items. Similarly, these assets have similar characteristics to other investments. However, commodities may have a volatile nature compared to assets such as socks or debt instruments. Therefore, investors will need to manage the risks associated with these investments through various techniques. One of these includes commodity hedging.

What is Commodity Hedging?

Commodity hedging is a process that investors can use to mitigate associated with their commodity investments. Hedging is a technique that allows investors to get protection against any adverse movements in the market. Similarly, it involves using techniques to offset any investing losses by taking the opposite position for a relative asset.

Commodity hedging involves using hedging techniques to manage the volatility and risks of investing in several commodities. For example, it may include the use of commodity swaps or futures to limit the losses investors make. Usually, commodity hedging consists of using derivatives, such as the ones above.

How does Commodity Hedging work?

Commodity hedging works in a similar way as hedging for any other asset or class of assets. When investors suspect to make a loss at a point in the future with the commodities, they may employ hedging techniques to prevent or limit the losses. While doing so, they may also reduce the potential profits they would have made if they hadn't utilized hedging techniques.

Once investors identify the commodity at risk, they will make a trade-in with another asset. Usually, this asset is a derivate that the investor can use, such as futures, swaps, forwards, etc. Through these financial instruments, investors can offset the risk of future adverse price movements. However, this technique also has the potential to fail.

When an investor uses commodity hedging, they hedge against future market price decreases. In case the prices decline in the future, the investor will successfully hedge against the adverse effects. However, if the prices increase, the investor will lose their potential profits from fixing the commodity's price or hedging against it.

Why is Commodity Hedging important?

Commodity hedging is crucial for various reasons. Firstly, it allows investors to mitigate against any potential future losses. This way, the investor does not suffer from any adverse effects caused by price fluctuations. Successful hedging can provide investors with protection against commodity price changes. In essence, it can help investors in maximizing their returns.

In the commodity market, the use of hedging techniques is crucial. Due to the volatile nature of these investments, investors need to monitor their investment position continuously. Through hedging, investors can achieve peace of mind by locking their profits. Therefore, they don't need to monitor their portfolio constantly due to market volatility.

Conclusion

Commodity hedging is the use of hedging techniques by investors to protect themselves against commodity price fluctuations. Investors can use various derivatives, such as futures, forwards, or swaps, to do so. Commodity hedging is crucial for investors, especially due to the volatile nature of most commodity investments.

Article Source Here: What is Commodity Hedging?

What is a Commodity Futures Contract?

The term commodity refers to basic, interchangeable goods used in commerce. These may include items such as precious metals, natural gases, food items, etc. Commodities play a significant role in any given economy. They are also essential in the production of goods and services in a county. Commodities are often available for exchange, which makes them an investable asset for investors.

Like any other asset investment, commodities have some risks and rewards associated with them. Similarly, these are often available on specialized markets or exchanges. Usually, investors prefer to include commodities in their investment portfolios as a part of the asset allocation strategy. Like other investments, investors can also hedge against the risks associated with commodities.

What is a Commodity Future?

A commodity future is a futures contract that investors can enter into to buy or sell a specific number of commodities in the future. This contract also allows investors to set the price for future transactions and specifies the date for it. Commodity futures are a prevalent method that investors use to hedge or protect their investment position. Sometimes, investors can also use commodity futures as a part of the speculation strategy.

Commodity futures include all characteristics of future contracts. As futures contracts, commodity futures contracts are derivatives that get their value from the underlying commodity or commodities. These contracts obligate the parties to exchange or transact an asset in the future at a specific date and price. Commodity futures are crucial to hedge against the volatility related to some commodities.

How do Commodity Futures work?

Commodity futures work like any other futures contract. However, the underlying asset in these contracts is commodities. Two parties enter into a commodity future contract that allows them to fix a price at a specified date. At that date, if the commodity price has increased, the futures contract buyer will profit. If not, the seller will benefit.

Commodity futures contracts may also differ from other contracts. These contracts usually do not include the actual transfer of a commodity to the buyer. Instead, the seller provides proof that the specific asset exists at a disclosed location. At the expiration date, the contracts are either netted or closed out. One party then settles the difference between the original and closing trade through cash.

What are the advantages and disadvantages of Commodity Futures?

Commodity futures can play a significant role in helping investors mitigate the risks associated with commodity investments. On top of that, these contracts ascertain that commodity producer benefits from a fixed sales price in the future. In cases such as when the commodity is grains or food items, the contracts can be significantly beneficial for the producer.

However, commodity futures can also harm the producer if the market prices increase by the expiration date. Therefore, trading in commodity futures can be risky due to the volatility associated with some commodities. Commodity prices may also fluctuate due to events beyond control and can, thus, cause even more harm. Usually, commodity futures are not for novice-level investors.

Conclusion

Commodity futures are contracts that allow two parties to fix the price for a commodity in the future. Commodity futures contracts play a significant role in allowing investors to mitigate risks associated with commodity investments. These contracts have similar characteristics to other futures contracts. Like any other type of investment, commodity futures have some benefits and drawbacks, as discussed above.

Originally Published Here: What is a Commodity Futures Contract?

What is Capitalization Rate?

What is Capitalization Rate?

Capitalization rate (or simply Cap Rate) refers to the rate of return used for real estate valuation. Cap rate is the rate of return that investors can expect to generate on a real estate investment property. This rate uses the net income generated through properties and is calculated by taking the net operating income and dividing it by the property asset value.

The capitalization rate is critical for investors for several reasons. Firstly, it allows investors to estimate the returns they will get on their investment in the market. In addition to that, the cap rate is also necessary for calculating a property's value under some valuation models. Cap rate is also helpful in comparing the relative value of several real estate investments in the market.

What is the Capitalization Rate formula?

While the capitalization rate is similar to the rate of return, the calculation is relatively straightforward. The capitalization rate formula divides the net operating income by the current market value of the property. Mathematically, it is as below.

Capitalization Rate = Net Operating Income / Asset’s Current Market Value

In the above formula, net operating income represents the annual income that the property in consideration generates. This income constitutes the total income after deducting any expenses incurred from operations. These operations may include managing the property, paying for repairs, paying taxes, etc. On the other hand, the current market value represents the value of the property in the market at the time.

Example

An investor wants to invest in real estate. The investor has the option to invest in one of three different properties. Given below are details of each property.

Property	Operating Income	Expenses	Market Value
A	100,000	15,000	1,500,000
B	75,000	6,500	1,200,000
C	90,000	9,000	1,400,000

All properties are within the investor's investment limit. However, all of these have varying incomes and values. Therefore, the investor must determine each property's capitalization rate to decide which one will maximize their return. Property A has the highest net operating income of $85,000 ($100,000 - $15,000). However, it only has a cap rate of 5.67%.

Property B has the lowest net operating income of $68,500 among the three options. However, it also requires minimum investment. It means that Property B will have a cap rate of 5.71%, which is higher than Property A. Lastly, Property C has a net operating income of $81,000, which is higher than Property B but lower than Property A. Despite that, it has a cap rate of 5.79%.

For the investor, investing in Property C will generate the maximum return for their given investment. The runner-up among these three properties will be Property B, with a cap rate of 5.71% despite having the lowest net operating income. Lastly, Property A will provide the lowest returns for the investor, although it generates the maximum operating income.

Conclusion

Capitalization rate is the rate of return investors can expect to generate on real investment properties. It takes the net operating income from a property and divides it by its current market value. The cap rate can be useful for several reasons, including making investing decisions, valuing real estate, estimating the payback period of an investment, etc.

Article Source Here: What is Capitalization Rate?

Direct Capitalization Method of Valuation

When it comes to investing, investors have various options. Most commonly, investors prefer to invest in stocks or debt instruments. However, these investments do not represent a truly diversified portfolio of investments. Therefore, investors use techniques, such as asset allocation, to include other asset classes in their investment portfolios.

One preferred type of investment for investors after stocks and debt instruments is real estate. Real estate represents any land and improvements on it, such as buildings, roads, fences, water, trees, etc. Usually, real estate offers two types of returns for investors. Firstly, it allows them to earn regular and steady income in the form of rent from tenants. On the other hand, it may also include property appreciation.

What are the methods to valuing real estate?

Investors interested in real estate investing can determine its value using three approaches. These include the income, sales comparison, and cost approaches. Each of these has some benefits and drawbacks. The income approach is complex and is similar to the discounted cash flow valuation method n finance.

The income approach estimates a property's market value based on the income from it. Investors can calculate a property's value by discounting its future cash flows to its present value. There are two methods that investors can use for this process. These include the direct capitalization and yield capitalization method of valuation.

What is the Direct Capitalization Method of valuation?

The direct capitalization method of valuation comes under the income approach for real estate valuation. This method estimates a property's value by taking a single year's income forecast. Under this method, investors use the income recorded over time and dividing it by the capitalization rate for that period. Capitalization rate represents the rate of return that investors expect to generate on a real estate investment property.

Investors can use the direct capitalization method of valuation in instances where a property generates income. In other cases, this method will not produce accurate results. It is because the income approach to valuing real estate relies on earnings produced from the real estate in consideration. This method differs from the yield capitalization method, which uses net operating income estimates for an investment holding period.

What is the Direct Capitalization Method formula?

Investors can calculate a property's value by dividing the net operating income from the property over the capitalization rate. Therefore, the formula for the direct capitalization method of valuation is as follows.

Property Value = Net Operating Income (NOI) / Capitalization Rate

For example, an apartment has a net operating income of $3 million. The capitalization rate is 5%. Therefore, the apartment’s value under the direct capitalization method will be $60 million.

When do investors use the Direct Capitalization Method?

Investors usually use the direct capitalization approach during two circumstances. Firstly, investors can use this method when the property in consideration is operating on a stabilized basis. For unstable properties, such as those with high vacancy rates, this method will not produce accurate results. Secondly, the direct capitalization method is also useful when there are enough similar properties for investors to estimate the capitalization rate.

Conclusion

Investors looking for a diversified portfolio of investments usually consider real estate as a viable investment. Real estate includes land and any improvements on it. There are various approaches and methods of valuing real estate. One of these methods is the direct capitalization method. This method estimates a property's value by taking the net operating income and dividing it by the capitalization rate.

Post Source Here: Direct Capitalization Method of Valuation

Commercial Real Estate vs Residential Real Estate

Investors often face the difficult decision of choosing between investing in commercial real estate vs residential real estate. Each of these investments has its own benefits and drawbacks. There are some differences between both of these that investors must understand. Before that, however, investors must understand what constitutes real estate and what it means.

What is Real Estate?

Real estate is a term used to describe property that consists of land, buildings, and other improvements. These improvements may include furniture and fixtures, utility systems, roads, structures, fences, etc. Real estate presents a diversified investment for investors and can be a crucial part of the asset allocation process. There are various types of real estate in which investors can invest, including residential and commercial real estate.

What is Commercial Real Estate?

Commercial real estate is any property used exclusively by businesses, such as companies, organizations, and other similar entities. Usually, these businesses can obtain commercial real estate through leases. The type of commercial real estate that each business uses will depend on its needs. There are several types of these properties, such as restaurants, hotels, stores, office space, malls, etc.

What is Residential Real Estate?

Residential real estate is any property used for residence purposes. These may include family homes, duplexes, mansions, condos, cooperatives, etc. Similarly, residential real estate is not available to businesses but only to individuals. These individuals can get the right to these properties through leases or acquiring them through mortgages.

What are the differences between Commercial Real Estate and Residential Real Estate?

There are many differences between commercial and residential real estate, some of which are as below.

Risks

Investors face risks investing in both types of real estate. However, due to the stable nature of cash flows from commercial real estate, these risks are relatively lower than residential real estate. Residential real estate leases are generally short-term and favour the tenant. For that reason, residential real estate investments are relatively high-risk.

Returns

Both commercial and residential real estate can provide decent returns for investors. However, commercial real estate returns are higher compared to residential real estate. It is mostly because investors can charge more rent per square meter for commercial property than residential real estate. On top of that, investors also have to account for maintenance costs for residential spaces. These are not usually an issue for commercial properties.

Barrier of Entry

Due to the lower prices of residential real estate, the barrier to entry is lower for investors. Usually, residential properties require less capital investment compared to other types of real estate. In contrast, commercial real estate has relatively higher barriers to entry. Besides, investors cannot obtain debt for commercial real estate easily due to the lower loan-to-value ratios for these properties.

Volatility

Both commercial and residential real estate investments provide investors to develop diversified portfolios. However, residential property usually performs better in times of economic downturns compared to commercial real estate. Commercial properties experience higher volatility due to businesses failing in economic crises.

Conclusion

Real estate represents any property that consists of land and improvements, such as buildings, furniture, and fixtures, utility systems, structures, etc. Investors can invest in commercial or residential real estate as a part of developing a diversified portfolio. However, both of these are different from each other. Residential real estate is different from commercial real estate in risks, returns, barriers to entry, and volatility, among other things.

Article Source Here: Commercial Real Estate vs Residential Real Estate

Trend-Following Trading System, Quantitative Trading in Python

In a previous post, we demonstrated the mean-reverting and trending properties of SP500. We subsequently developed a trading system based on the mean-reverting behavior of the index. In this installment, we will develop a trend-following trading strategy.

Trend following or trend trading is a trading strategy according to which one should buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue.

There are a number of different techniques, calculations and time-frames that may be used to determine the general direction of the market to generate a trade signal (forex signals), including the current market price calculation, moving averages and channel breakouts. Traders who employ this strategy do not aim to forecast or predict specific price levels; they simply jump on the trend and ride it. Due to the different techniques and time frames employed by trend followers to identify trends, trend followers as a group are not always strongly correlated to one another. Read more

We continue to use simple moving averages as noise filters in order to generate buy and sell signals. Recall that the SP500 index is trending in the long term, therefore we will use a long-term moving average along with a shorter one.

The trading rules are as follows,

If 3-day simple moving average > 200-day simple moving average, buy $10000 worth of stock

Exit if 3-day simple moving average < 200-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 200-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 (200 days in the above 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 second moving average. This would indicate that the strategy performance is stable in this parameter regime.

In summary, we developed a simple trading strategy based on the trending property of the SP500 index. The strategy appears to be profitable and stable.

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

Post Source Here: Trend-Following Trading System, Quantitative Trading in Python

What is an Interest Rate Derivative?

A derivative is a financial instrument that derives its value from an underlying asset or group of assets. This derivative usually comes in the form of a contract between two parties. Any movements in the underlying asset's value cause a fluctuation in the derivative's value as well. Derivatives may have various underlying assets, such as stocks, bonds, commodities, interest rates, etc.

What is an Interest Rate Derivative?

An interest rate derivative is a type of financial derivative that derives its value from movements in an interest rate or several interest rates. Interest rate derivatives are financial instruments most commonly used in hedging or speculation on interest rate fluctuations. Usually, these include financial instruments, such as futures, options, swaps, forwards, etc.

Interest rate derivatives are prevalent among both individual, business, and institutional investors. All these parties use interest rate derivatives in some form to protect against the adverse effects of interest rate fluctuations. However, some investors may also use interest rate derivatives as a diversification tool or to alter their risk profile.

How do Interest Rate Derivatives work?

Interest rate derivatives help investors mitigate the risks associated with various debt instruments. These risks usually involve interest rate risks that come from market interest rate fluctuations. These derivatives also allow investors to speculate on the direction of future interest rate movements. Investors can either make profits from this speculation or use it to mitigate risks.

Interest rate risks are inherent to any debt instrument that accompanies interest payments. These risks come as a result of any fluctuations in the market interest rates. Therefore, investors need to invest in an interest rate risk management process to mitigate these risks. For that, investors can use interest rate derivatives in various forms.

What are the types of Interest Rate Derivatives?

As mentioned, investors can use interest rate derivatives in various forms. Some of the types of interest rate derivatives are as below.

Forward Rate Agreements

Forward rate agreements are a type of interest rate derivate that investors use to protect against interest rate risks. Forward rate agreements allow investors to fixate interest rates in the future with a counterparty. This way, they can benefit from lower interest rates if the market interest rates rise in the future.

Interest Rate Options

Interest rate options are also a common type of interest rate derivatives that investors can use to mitigate interest rate risks. Interest rate options allow investors to speculate on the direction in which market interest rates will move in the future. Using this method, investors can either make profits from the speculation or protect their securities from interest rate risks.

Swaps

Swaps are a type of interest rate derivatives that allow counterparties to exchange their cash flows from debt instruments. There are two prevalent types of swaps that investors can utilize. These include interest rate swaps and credit default swaps. Usually, investors use interest rate swaps to exchange interest payments from floating rate instruments with fixed-rate ones.

Conclusion

Interest rate derivatives are financial instruments that derive their value from underlying interest rate movements. Interest rate derivatives allow investors to protect against the adverse effects caused by interest rate fluctuations. There are various types of interest rate derivatives that are prevalent in the market. These include, but are not limited to, forward rate agreements, interest rate options, and swaps.

Originally Published Here: What is an Interest Rate Derivative?

How to Hedge Interest Rate Risks?

For investors involved in the bond or debt market, interest rate fluctuations can be critical. Usually, an increase or decrease in interest rates can affect the underlying security’s prices. It also constitutes the interest rate risk that investors face during their transactions. On top of that, interest rate risk is also crucial because it dictates how much premium a borrower has to pay to lenders for the provided finance.

In most cases, investors can ignore interest rate fluctuations as these fluctuations may are temporary. Sometimes, however, the interest rates may change over the long term. In these cases, investors must mitigate the interest rate risk involved with their debt. The primary method that investors can use is to hedge against it.

How to hedge Interest Rate Risks?

Investors that receive fixed-rate interest on debt instruments will make a loss when the market interest rates increase. In contrast, those with floating rate interest instruments will experience favourable increases. If the market interest rates decline, the opposite will be true for both cases. With hedging, the primary objective will always be to protect investors against any losses.

When it comes to hedging interest rate risks, investors have various options. For example, some investors may use forward contracts to mitigate the interest rate risks associated with their debt instruments. Similarly, investors also have the option to use futures or swaps to manage their risks. Each method of hedging against interest rate risks has its benefits and drawbacks.

What is an Interest Rate Option?

An interest rate option is a financial derivative that investors can use to hedge against interest rate risks. Through interest rate options, investors can speculate on whether the market interest rates will increase or decline. Investors can find these options on exchange in the form of different products. Interest rate options’ value depends on the underlying interest rate.

Like most other options, interest rate options also come with two variants. These include call and put options. Interest rate options are also available over the counter. However, these are risky hedging options due to the strike price and expiry date of the option.

What is the importance of Interest Rate Options?

Interest rate options are one of the methods that investors can use to hedge against interest rate risks. Using these instruments, investors can speculate on the direction in which interest rates will move in the future. Using this method, investors can protect their investments against both short-term and long-term interest rate risks.

Usually, investors need to perform several analyses to evaluate the direction in which interest rates will move. On top of that, interest rate options are prevalent in diversification strategies used by investors. Using these instruments, investors can diversify their portfolios to create a better position for themselves. Interest rate options aren’t only crucial for investors. Financial institutions, such as banks, can also benefit from them.

Conclusion

Interest rate risk occurs due to fluctuations in market interest rates. These fluctuations may affect the value of assets held by investors. Investors have various options that they can use to hedge against this risk. One of these includes interest rate options. Interest rate options are financial derivatives that allow investors to speculate on future interest rate movements. That way, investors can hedge against interest rate risks.

Article Source Here: How to Hedge Interest Rate Risks?

Forward Rate Agreement Example

What is a Forward Rate Agreement (FRA)?

Forward rate agreements are customized over-the-counter financial contracts. Through these agreements, two parties can predefine the interest rates for contracts that will commence in the future. One of these counterparties includes a buyer that borrows a principal amount at a fixed interest rate. The other is a lender that agrees to provide the loan at the specified time and rate.

When both counterparties enter the forward rate agreement, they specify some terms for it. Usually, it includes the rate that will be applicable in the future, the notional value, and the termination date. After signing the contract, one party makes cash payments to the other. This payment represents the net difference between the contract’s interest rate and the floating interest rate in the market.

How do Forward Rate Agreements work?

A forward rate agreement involves two parties, known as the buyer and the seller. The buyer is the party that fixes the borrowing rate at the inception of the contract. The seller, on the other hand, sets the lending rate. At the contract's commencement, there is no profit or loss for both parties. However, this position changes as time progresses.

The profit or loss that each party makes in a forward rate agreement depends on whether the market interest rates increase or decrease. Usually, the buyer benefits when the market interest rates increase compared to the fixed rate at inception. However, the seller also profits if the interest rate declines compared to the fixed rate at commencement.

What is the purpose of Forward Rate Agreements?

Forward rate agreements have many use cases. Usually, parties use FRAs to freeze their interest rate for the future. This way, they can protect themselves against any adverse impacts of interest rate fluctuations. For this to happen, the counterparty must agree to enter the agreement. However, the counterparty must believe the interest rates will go the opposite direction to benefit.

What are the advantages and disadvantages of Forward Rate Agreements?

There are various advantages for counterparties that use forward rate agreements. Most importantly, forward rate agreements allow investors to mitigate their interest rate risks. Investors use it for trading based on market participants’ interest rate expectations. For companies, forward rate agreements enable the use of derivative contracts that stay off-balance sheets.

Furthermore, forward rate agreements allow parties to reduce future borrowing and lending risks. If an investor expects any adverse movements in interest rates in the future, they can use these agreements to protect themselves. This way, they can obtain certainty around their transactions in the future. However, these contracts can also beneficial to the opposite party.

However, forward rate agreements involve the transfer of risks associated with future contracts to other parties. In these contracts, either the buyer or seller will bear the loss related to interest rate risk. Therefore, the counterparty risk associated with these agreements is high compared to other futures contracts. Forward rate agreements can also be challenging to close before maturity.

What is a Forward Rate Agreement example?

A company, Red Co., enters into a forward rate agreement with another company, Blue Co. In this agreement, both parties agree that Red Co. will receive a fixed rate of 4% on a nominal amount of $1 million. This interest will be one year from the contract date. The fixed-rate agreement will be 30 basis points lower than the set rate.

In exchange, Blue Co. will receive the six-month LIBOR rate on the nominal amount determined in three years. As with all other forward rate agreements, this agreement is also cash-settled. The parties will make the payment at the beginning of the forward period after discounting the amount using the contract rate.

Conclusion

Forward rate agreements are over-the-counter derivative contracts. Through these agreements, two parties can predefine the interest rate for a future contract. Any fluctuations in the interest rates in the future can cause profits or losses. Forward rate agreements can be highly beneficial for both parties. However, one party has to make a loss for the other to profit.

Post Source Here: Forward Rate Agreement Example

What is Credit Risk Analysis?

Credit risk is the risk associated with defaults from borrowers. In any debt transaction, the lender has to bear some credit risk associated with providing the loan. This risk depends on several factors, such as the borrower's past financial background, current earnings, security provided, etc. In case a borrower defaults on the loan, the lender has to incur significant losses. Therefore, each lender has to evaluate the credit risk associated with a loan before providing it.

What is Credit Risk Analysis?

Credit Risk Analysis is the process through which a lender analyzes the credit risk associated with their loans. It involves techniques and procedures through which lenders decide on whether to provide the borrower with credit or not. Usually, it involves a multi-step process that the lender carries out for every single borrower and loan transaction.

The primary reason why lenders perform a credit risk analysis is to reduce the chances of default. This way, they can reduce the costs associated with the loan. Usually, credit risk analysis is a part of a lender's risk management and credit allocation process. There are various steps that lenders take during this process. It may include running background checks on the borrower, evaluating their income, examining their financial or bank statements, etc.

How does Credit Risk Analysis work?

The credit risk analysis process involves evaluating the credit risk involved for a specific borrower's loan. Usually, lenders perform various evaluations to measure a borrower's creditworthiness. It includes running credit checks on the borrower, such as background checks, financial history, earning reports, etc. Lenders may also assess the borrower's credit report for this information.

Similarly, lenders may require employer letters for employed individuals applying for a loan. On top of that, lenders will also request bank statements. For businesses, lenders usually require their business plan or financial statements. Similarly, lenders may also ask the borrower to provide a credit reference. Furthermore, borrowers may also have to provide security during the process.

Why do lenders perform Credit Risk Analysis?

The primary purpose of performing credit risk analysis is to quantify the credit risk that each borrower presents to a lender. The credit risk analysis process usually includes measuring the probability of default for each borrower. Through this, lenders can assign measurable values to the default chances for every transaction. This way, the lender gets a quantifiable and comparable statistic for further processing.

Furthermore, credit risk analysis is crucial in the decision-making process performed by lenders. Usually, lenders decide on whether to provide a loan to borrowers after performing a credit risk analysis. This process is also crucial for dictating the terms offered to borrowers. For example, a borrower with an undesirable credit risk will get higher interest rates compared to others.

Every institutional lender has a credit analyst that performs credit risk analysis of its lenders. The primary purpose of this process is to evaluate a borrower's creditworthiness. While credit ratings are also a measure of creditworthiness, most lenders have switched to performing credit risk analysis in-house. This way, each lender can customize the process and get better results from the process.

Conclusion

Credit risk analysis is the process performed by lenders to assess the credit risk involved in a loan transaction. Based on this information, lenders can decide on whether they should provide a loan to a specific borrower. Credit risk analysis is of significant importance. The primary purpose of this process is to quantify a borrower's creditworthiness through several evaluations.

Article Source Here: What is Credit Risk Analysis?

What is a Credit Default Swap?

Investors can use various hedging techniques to mitigate the risks associated with their equity and debt instruments. These techniques include the use of options, swaps, forwards, futures, etc. Usually, these use derivates, which are financial securities that get their value from an underlying asset or group of assets. One method of hedging through swaps is credit default swap.

What is a Credit Default Swap?

A credit default swap is a type of swap contract through which two parties swap their credit risk. Credit risk is the risk of a borrower defaulting on their payments on a given debt instrument. Through credit default swaps, investors can mitigate this risk by exchanging these risks with another party. For example, a lender can exchange the credit risk on their loan with another party if they think the borrower will default.

A credit default swap provides the lender protection against defaults from a borrower. Through these swaps, the lender buying the instrument can shift their risk to the seller. Credit default swaps work similarly to insurance policies. The buyer gets protection against any unforeseen events involving their debt instruments. In exchange, the seller receives periodic payments from the seller.

How do Credit Default Swaps work?

Credit default swaps come into play when buyers expect the credit risk on their instruments to be high. For example, a company issues bonds in the market. A few individuals and other companies purchase these bonds. Later, one of the borrower companies expects the issuer to default on the loan. Therefore, the borrower can acquire credit default swaps to mitigate the risk.

When the buyer purchases the credit default swap, the credit risk associated with the underlying debt instrument gets transferred. The swap seller agrees to bear this risk in exchange for regular payments from the buyer. This way, the buyer can mitigate the credit risk involved with the underlying debt instruments while the lender receives a steady income.

In case the bond issuer defaults on the debt instrument, the credit default swap seller must compensate the buyer. This compensation will include both the principal and interest payments on the loan. Therefore, the buyer gets protection against any defaults from the issuer. In contrast, if there is no default, the seller will collect regular payments from the buyer as an income.

What are the advantages and disadvantages of Credit Default Swaps?

The most prominent advantage of credit default swaps is that it provides lenders protection against credit risk. Usually, these risks come from high-risk instruments that promise high rewards. It also allows the seller to protect themselves through diversification. For the seller, the credit default swap provides a regular source of income.

However, credit risk swaps played a significant role in the 2008 financial crisis. It was primarily because of the unregulated nature of these swaps. Nonetheless, some regulations have been introduced for these derivatives since 2010. Similarly, credit risk swaps can be disadvantageous for the seller in case of default from the borrower. Credit default swaps can also cause lenders to invest in high-risk instruments, hoping the swaps would protect them against the risks.

Conclusion

Credit risk swaps involve the transfer of credit risk associated with an instrument to another party. Usually, the swap seller is a bank, insurance company, or financial institution that accepts this risk. Instead, the buyer makes regular payments to the seller. In case of default from the borrower, the seller has to compensate the buyer for the loan amount.

Post Source Here: What is a Credit Default Swap?

What Does a Credit Analyst Do?

Who is a Credit Analyst?

A credit analyst is someone responsible for evaluating the risk factors that affect loans and debts. Credit analysts are trained individuals who have a financial background in examining loan applications. They are different from loan officers who assist clients throughout the loan process. Instead, credit analysts examine a client's creditworthiness and background.

The use of credit analysts during a loan process has become more prevalent in recent times. Credit analysts may work in financial institutions or credit agencies to carry out their tasks. Credit analysts collect critical financial information about a client and evaluate it using financial ratios and other techniques.

What does a Credit Analyst do?

Primarily, credit analysts examine a client’s creditworthiness through their past transactions. However, they also perform several other duties during the loan application evaluation process. Some of the roles and responsibilities that credit analysts perform are as below.

Credit risk evaluation

One of the primary tasks that credit analysts carry out is evaluating a client's credit risk. They do so by examining their past savings information, earnings from various sources, debt repayment history, and other related dealings. Once they analyze this information, they can form an opinion about the client's creditworthiness using a credit rating.

Client and product support

A credit analyst is also responsible for setting up meetings with existing and potential clients. The analyst is responsible for obtaining information on the client's financial background. The credit analyst also identifies the client’s needs and objectives for receiving the loan. Similarly, the analyst assesses the client’s earnings and spending capacity. Lastly, the credit analyst promotes credit lines and products to clients.

Credit limit control

Credit analysts also review the credit limits for existing customers in case they want to increase their credit. The analyst will evaluate the borrower’s repayment history, default history, and earnings information to make a decision. Similarly, the credit analyst will make recommendations to the lender on whether to increase or decrease a client’s credit limit based on their dealings.

Financial data analysis

Credit analysts also analyze financial data related to potential and existing clients. It is one of their primary responsibilities. Based on this analysis, credit analysts can make decisions about clients. Usually, credit analysts use various financial ratios to determine their suitability for credit terms. The credit analyst also examines the client’s risk levels to evaluate their credit risk.

Assisting the manager

Credit analysts also assist the manager before approving a client. Usually, they do so to ensure the client meets some requirements for obtaining credit. These include collecting information and processing files, contacting other financial institutions to verify information, examining clients' assets and finances, etc. The objective of these checks is to help in the decision-making process.

Record maintenance

Credit analysts are also responsible for maintaining detailed records relating to clients. Credit analysts ensure they have an accurate and up-to-date list of the annual reviews required by credit regulations. Similarly, they handle records related to the progress of new client applications and those already approved. Credit analysts also prepare monthly and quarterly credit reports.

Conclusion

Credit analysts are trained individuals who have a prominent role in a loan application process. These individuals evaluate risk factors that affect loan and debt applications. Similarly, credit analysts perform various duties in an institution. These include credit risk evaluation, client and product support, credit control limit, financial data analysis, assisting the manager, and record maintenance.

Post Source Here: What Does a Credit Analyst Do?

What is Interest Rate Risk?

The term risk represents any chance or uncertainty that an outcome will differ from the expected outcome. Usually, any scenario that consists of uncertain possibilities that can result in losses constitutes the risk for that scenario. There are various types of uncertainties that investors can face according to their active market. One type of risk that is prevalent in debt markets is interest rate risk.

What is Interest Rate Risk?

Interest rate risk represents the uncertainty revolving around the interest rates prevalent in the market. For investors who are active in the debt market, an increase or decrease in interest rates can be critical. Therefore, interest rate risk also refers to the probability that unexpected fluctuations in interest rates may cause a decline in the value of an investor's asset.

Usually, interest rate risks are common in bond markets or other fixed-income investment markets. For investors that receive interest on fixed-rate investments, a decline in interest rates is favourable. That is because these investors benefit from an increased earning while the market rates are down. In contrast, an increase in interest rates can be adverse as it means reduced earnings for these investors.

On the other hand, for any party paying interest on loans, the opposite applies. An increase in market interest rates means the party pays lower interest than the market. Contrastingly, a decrease signifies the party pays higher interest than the market. On top of these losses, investors also make losses on the price of the security they hold. Usually, fluctuations in interest rates also cause the security’s price to alter.

How does Interest Rate Risk affect security prices?

As mentioned, the price of various bonds and debt instruments fluctuates with fluctuations in interest rates. Usually, when the interest rates in the market increase, a fixed-income bond or security will experience a favourable price increase. In these circumstances, most floating-rate interest securities will undergo a price increase.

Furthermore, the maturity period of a debt instrument will also play a substantial role in how the prices will affect it. It is because instruments with a longer maturity will undergo fluctuation longer than an instrument with a short maturity. The longer the maturity period of the bond instrument is, the higher movement it will experience. At maturity, the market price and face value of the bond will equalize.

How do investors manage Interest Rate Risks?

For investors managing interest rate risks is crucial for long-term success. In some circumstances, investors may not have to take any action against fluctuations in interest rates. Usually, these changes are short-term, but some fluctuations may also be long-term. Therefore, investors need to monitor their securities to identify the risks.

Investors have several options when it comes to managing interest rate risks. Usually, investors can choose from forwards, forward rate agreements, futures, swaps, options, embedded options, etc. Using these, investors can hedge the interest rate risks associated with their debt instruments. Most of these techniques involve transferring the risk to another party.

Conclusion

Interest rate risk is the risk involved with instruments that generate interest payments or receipts. Interest rate risks represent any uncertainty around interest rates prevalent in the market. Since any fluctuations in interest rates can affect security prices, investors need to manage their risks actively.

Originally Published Here: What is Interest Rate Risk?

What Is A Credit Rating Agency

In the past, it was challenging for lenders to assess a borrower's creditworthiness, which resulted in high credit risks. However, things have changed since that time. It is common practice for most lenders to check a borrower's creditworthiness through credit ratings. These credit ratings usually come from agencies known as credit rating agencies. Before understanding what these agencies are, it is crucial to look at what credit ratings mean.

What is a Credit Rating?

A credit rating is a measure of a borrower's creditworthiness, represented in the form of a quantifiable score. Every borrower with a history of credit dealings will have a credit rating, which they can get from credit rating agencies. However, there is no standard for credit ratings that these agencies give to borrowers. Instead, it represents the agency's opinion of a particular individual's creditworthiness.

Through credit ratings, lenders can assess the default or credit risk associated with their debts. In simpler words, they can gauge the likeliness of the borrower defaulting on the debt. Using credit ratings, lenders can decide whether they should provide a loan to a specific borrower. Similarly, these ratings allow the lender to dictate the terms for each loan.

What is a Credit Rating Agency?

A credit rating agency is a company that measures a borrower's creditworthiness in the form of credit ratings. As mentioned, these agencies provide their opinion of how likely it is for a borrower to default. Credit rating agencies consider several factors when assessing a borrower's credit rating, including their past transaction histories.

There are several agencies that can provide credit ratings to borrowers. Among these, the top names include Moody's Investor Services, Standard and Poor's (S&P), and Fitch Group. These are considered the big three credit agencies around the world. These three companies control 95% of the global credit rating market.

How do Credit Rating Agencies work?

Credit rating agencies analyze borrower's credit histories and assign a rating to them based on those transactions. Borrowers may include individuals, companies, organizations, or any entity that requires loans from a lender. Credit rating agencies may request the borrower to provide documentation related to their past credit dealings.

For example, a credit rating agency may require companies to provide their financial statements, bank records, loan records, etc., to evaluate their credit rating. Using these, the rating agencies assess whether the borrower made timely payments, their future economic potential, current debts held, credit mix, etc. Based on these, they provide a score to the borrower.

Why is the importance of Credit Rating Agencies?

Credit rating agencies are critical for both lenders and borrowers because they issue credit ratings. For lenders, these ratings provide a benchmark to filter any potential defaulters and reduce their default risk. Similarly, it allows them to set interest rates on any loan transactions with potential borrowers. Overall, it provides them with protection against any future losses.

For borrowers, credit ratings can be helpful in securing loans. Similarly, borrowers with a higher credit rating score will get better and more favourable terms in their loan transactions. Usually, the fee charged by credit rating agencies for providing a rating is worth it for borrowers as it can reduce their interest expenses.

Credit rating agencies also provide risk measures for various entities. It allows investors to understand the credit risks for those entities. For example, these agencies rate company bonds and other debt instruments. It helps investors in making better decisions about their investment based on the credit rating.

Conclusion

Credit ratings are a measure of a borrower's creditworthiness that comes from credit rating agencies. Credit rating agencies provide their opinion of a borrower's creditworthiness. Usually, they consider various factors, such as a borrower's history, current financial position, credit mix, etc.

Article Source Here: What Is A Credit Rating Agency

Illiquidity vs Insolvency

When making investment decisions in a company, investors consider various factors. Among these, profits are the most crucial as they can impact the investors' future returns. However, a company's earnings may not be meaningful if it has cash flow problems or operational inefficiencies. There are two terms, closely related to each other, which describe these problems, illiquidity, and insolvency.

Some investors may confuse these two due to their similar nature. However, it is crucial to differentiate between them for better decisions. The term illiquidity is the opposite of liquidity, while insolvency is the antonym of solvency.

What is Illiquidity?

Before understanding what illiquidity is, it is crucial to define liquidity. Liquidity is a company's ability to meet its current liability obligations from the current assets it has. A company's liquidity shows whether it has sufficient resources to repay all its current liabilities without using its long-term assets. Liquidity is a term often associated with a company's cash flow and working capital management.

Illiquidity is the opposite of liquidity. When a company does not have enough current assets to meet its current liabilities, it is considered illiquid. Illiquid companies can face financial problems in the future. Usually, these companies have to reside in obtaining finance to meet their operations or generating assets internally. Investors don't prefer investing in companies that have liquidity issues.

For investors, an investment's liquidity shows how easily they can convert it into cash. Therefore, investors can easily obtain cash for a highly liquid investment as compared to an illiquid one. Usually, if an investment has an active market, investors will find it easier to convert it into cash. These may include stocks, which they can trade on stock markets. Similarly, they may consist of readily convertible government bonds.

Investors can calculate a company’s liquidity ratios to determine whether an investment is illiquid. These include ratios such as current, cash, quick ratios. Although illiquid investments are problematic, these issues usually resolve in a short while.

What is Insolvency?

Insolvency is the opposite of solvency. Solvency shows a company’s ability to run its operations in the long run. A company’s financial position plays a crucial role in its long-term operations. Therefore, solvency defines a company’s long-term financial position. It considers a company’s total assets and liabilities compared to current assets and liabilities for liquidity.

Insolvency represents a state of financial distress for companies in meeting their obligations. It can have a long-lasting effect on a company’s operations. Insolvency can also cause an eventual liquidation or legal actions against the company. There are several factors that can contribute to a company’s insolvency. Unlike illiquidity, the factors that cause insolvency come from long-term decisions.

Similarly, there are different types of insolvencies that companies may face. These may include cash flow or balance sheet insolvencies. For investors, insolvent companies can create many problems. However, companies that face insolvency can also recover. Like illiquid investments, investors also steer clear of investing in insolvent companies.

Investors usually use ratios such as the debt-to-equity ratio, debt-to-asset ratio, interest coverage ratio, etc., to determine if a company is insolvent.

Conclusion

Investors consider various aspects of an investment when making a decision. Among these, two crucial aspects are illiquidity and insolvency. Illiquidity is when a company does not have enough current assets to meet its current liability obligations. On the other hand, insolvency is when a company does not have enough total assets to satisfy its total liabilities.

Article Source Here: Illiquidity vs Insolvency

Pecking Order Theory of Capital Structure

Capital structure defines the mix of debt and equity finance that a company has at its disposal. Every company utilizes a different combination of several finance sources to increase their benefits while decreasing costs. Companies can make a decision about their capital structure by using various models or theories. One of these includes the pecking order theory of capital structure.

What is the Pecking Order Theory?

The pecking order theory suggests that companies should prefer finance sources generated internally to those available from external sources. This internal finance source comes in the form of retained earnings that companies generated from their operations. If a company does not have this option, it can collect funds from external sources.

From external finance sources, the pecking order theory suggests that companies should prefer debt finance first. It is because debt is usually cheaper compared to other sources of finance. If a company does not have the option to raise finance through debt, it can generate finance through equity. According to the theory, companies should only use equity finance as a last resort when none of the other finance sources is available.

How does the Pecking Order Theory work?

Unlike other theories regarding capital structure, the pecking order theory does not establish an optimum capital structure. Instead, it focuses on minimizing costs. As mentioned, this theory suggests that companies must prefer internally-generated finance sources. It is because these sources are the least costly for companies.

Secondly, the pecking order theory prefers debt finance over equity finance. It is because debt finance is inexpensive compared to equity. As a last resort, this theory also allows companies to utilize equity finance. By using finance sources in that order, the pecking order theory enables companies to send a positive signal to their investors and the market.

When a company uses finance that it generates internally, it increases its capital without any additional costs. Similarly, the costs related to debt finance are lower than equity finance. On top of that, using debt finance allows the management to signal that it is confident that a company can meet its repayment obligations. Lastly, using equity finance sends a negative signal, suggesting the company's stock is overvalued.

What is the importance of the Pecking Order Theory?

The pecking order theory is valuable for several reasons. Firstly, it provides a direction for companies to establish a capital structure. Similarly, it allows companies to minimize the costs related to financing. The pecking order theory also provides guidance to verify how information asymmetry affects the cost of financing a company.

As mentioned above, the pecking order theory also allows a company's management to send signals to the market. Usually, using internally-generated finance sources or debt finance can have a positive impact on stock prices.

What are the limitations of the Pecking Order Theory?

The pecking order theory has several limitations. Firstly, this theory establishes an ideal pecking order for capital structure. Practically, it may not be possible for a company to follow that order. Similarly, this theory limits the types of funding that companies can use. It also does not consider other finance sources, such as hybrid instruments.

The primary limitations of the pecking order theory come from its theoretical nature. On top of that, the theory is outdated and does not consider the challenges faced when establishing capital structures.

Conclusion

The pecking order theory proposes an order for companies to use when establishing a capital structure. This theory suggests that companies should prefer internally-generated finance sources first. When that is not possible, these companies should use debt finance. Only as a last resort, companies should utilize equity finance.

Article Source Here: Pecking Order Theory of Capital Structure

What Is Prospect Theory?

Behavioural economics studies the psychology that relates to the decision-making process of investors. It looks at how investors allow psychological factors to impact their decisions. It goes against traditional finance theories, which assume that individuals don't let biases affect their decision-making. Behavioural economics also studies the subsequent effects on the markets of the decisions made by investors.

There are various areas of behavioural economics that are relevant to investors. There are some theories that also describe how individuals make choices when faced when multiple options. One of these is the prospect theory.

What is Prospect Theory?

The prospect theory suggests that investors value gains and losses differently. Therefore, investors make decisions based on the expected gains rather than the estimated losses. In essence, the theory looks at how investors make decisions when presented with various options that involve risks, probability, and uncertainty.

The prospect theory suggests that when investors are given various choices with the same probabilities, they will make decisions based on gains. Therefore, they are more likely to choose decisions that will ascertain that they will retain their wealth rather than increase it. In short, this theory suggests that investors will choose the option shown in terms of gains rather than one presented in loss terms.

How does Prospect Theory work?

The prospect theory of behavioural economics comes from the work of two psychologies, Amos Tversky and Daniel Kahneman. They formed a basis to describe how people make decisions when faced with various choices. They developed the prospect theory by framing risky choices. Their study suggested that people are loss-averse as they dislike losses more than equivalent gains.

Another name for the prospect theory is the "loss-aversion" theory, as it describes the behaviour of risk-averse individuals. The theory primarily proposes that losses cause a greater emotional impact on decision-makers. Therefore, investors react differently to potential losses and potential gains. The theory also suggests that people make decisions based on potential gains or losses relative to their situation.

What are the phases of Prospect Theory?

The prospect theory proposes that there are two faces to the decision-making process of individuals. These are as follows.

Editing Phase

The editing phase is the initial phase when individuals characterize options for a choice. It is known as framing effects. Framing effects describe the way in which the order, method, or wording of the substance of choice differs according to the presentation. Once an individual goes through this phase, they can enter the second phase of prospect theory.

Evaluation Phase

The evaluation phase suggests that individuals are likely to behave as if they can give a value to each outcome. Usually, they make a decision based on the potential consequences and go with the option that has a higher utility. The evaluation phase depends on statistical analysis to measure and compare each outcome of a given decision. This phase consists of two-component elements. These are the value function and the weighting function

Conclusion

Prospect theory comes from behavioural economics and suggests that decision-makers perceive losses and gains differently. This theory describes the risk-averse behaviour shown by individuals when presented with several choices. It also proposes that individuals make decisions based on gains on losses based on their situations. The prospect theory has two phases, including the editing and the evaluation phase.

Post Source Here: What Is Prospect Theory?

Anchoring in Behavioral Finance

What is Behavioural Finance?

Behavioural finance is a field of behavioural economics that deals with investors' psychological influences and biases. It studies how these influences and biases affect the financial behaviour that investors use in investing decisions. Similarly, behavioural finance also explores market anomalies, specifically in the stock market. It looks at how influences and biases can cause these anomalies to exist.

Behavioural finance opposes any traditional finance theories in various regards. For example, some traditional theories assume that investors do not allow biases or influences to affect their decisions. However, behavioural finance tackles that by suggesting that investors make decisions under the influence of biases.

There are several concepts in behavioural finance that explain how investors behave in the stock market. One of these includes anchoring, which can further lead to anchoring bias. Before understanding what anchoring bias is, it is crucial to understand the concept of anchoring in behavioural finance.

What is Anchoring in Behavioural Finance?

Anchoring refers to attaching a spending level to a certain reference. It is when investors put too much reliance on historical information or the first information they find. Usually, this information is irrelevant. Since investors find this information to existing beforehand, they put more reliance on it than they should. Overall, anchoring is the use of irrelevant information for decision-making.

Anchoring gives rise to anchoring bias, which can lead to incorrect financial decisions. For example, when an investor holds to a stock, despite making losses. It is because they stick to their original estimates for profitability. This way, they are oblivious to any relevant data that may exist.

Anchoring occurs when investors make estimates about various stocks. Since they start the process with an initial value and make adjustments to it, they are likely to stick to their initial value. This process of sticking or holding to the initial decisions or estimates is known as anchoring.

Overall, anchoring can lead to incorrect decisions because of initial perception. Investors generally ignore this bias if they isolate the decision. However, since they look at everything from an initially biased perspective, they are likely to make the wrong decision.

What is Anchoring Bias?

Anchoring bias is a bias that stems from the concept of anchoring. Anchoring bias is when investors make incorrect financial decisions by basing these decisions on one point of information. Based on this starting point, investors tend to form an initial opinion. During any subsequent transactions, investors let the bias influence their decisions based on that opinion.

Anchoring bias exists in all markets and for all investors. Usually, it is prevalent in decision-making areas where investors need to make estimates or use historical information. Although this information may not be irrelevant anymore, investors tend to favour it when making decisions. According to behavioural finance, anchoring bias can cause investors to reject rational choices.

Anchoring bias can cause many problems for investors in financial markets. This bias can lead investors to look at past investment performance for a product and assume the same trend will continue in the future. Similarly, it can cause investors to delay their investment decisions, such as selling an investment. Anchoring bias can make investors biased toward new information. Through all of these, investors can make incorrect decisions and suffer losses.

Conclusion

Behavioural finance is an area of behavioural economics that deals with how investors allow psychological influences and biases to affect their decisions. Anchoring is a concept in behavioural finance that relates to when investors put overreliance on irrelevant information. Anchoring bias is the bias that comes from anchoring.

Originally Published Here: Anchoring in Behavioral Finance