What are Lagging Economic Indicators?

A country's economy dictates many factors, including how businesses or investments perform. Therefore, it is crucial for investors to consider these factors to make well-informed decisions. For that, they need to identify some economic indicators. However, it is crucial to understand what economic indicators first.

What are Economic Indicators?

Economic indicators are metrics that measure and analyze current or future investment possibilities. By doing so, they look at a nation's health of macroeconomy. For investors, these indicators are crucial as they dictate the systematic risk that affects their investments. There are many economic indicators that may exist, usually categorized into several categories.

The primary economic indicator for any nation is its gross domestic product (GDP). It is a type of coincident indicator. Apart from GDP, consumer confidence index, consumer price index, new housing starts, money supply, personal income, etc., are economic indicators examples. All of these measures a nation's economic health based on the timing of fluctuation in economic activity.

What are Lagging Economic Indicators?

Lagging economic indicators are any economic indicators that measure fluctuations in economic activity after they occur. It is why it gets the name 'lagging', as it does not indicate changes until after they happen. For most investors, lagging economic indicators are a method to look at historical performances. However, these indicators are not beneficial in predicting future economic outcomes.

Lagging economic indicators are quantifiable metrics. However, they only change once the associated economic or financial variables change. These indicators benefit investors as they allow investors to establish a trend in a nation's economic activity. Based on that, they can make decisions related to their investments.

Lagging economic indicators also have other uses. They are helpful tools in business operations and strategy. These indicators usually confirm patterns that occur over time. They also help identify when there is a change in a country's business cycle. Some investors may consider lagging economic indicators to be futile. However, used with other economic indicators, lagging economic indicators can be significantly beneficial.

What are the types of Lagging Economic Indicators?

There are several economic indicators that classify as lagging. These indicators only identify economic activity fluctuations after they occur. Therefore, they fall under the lagging economic indicators category. Some of the types of lagging economic indicators are as below.

Unemployment

Unemployment is one of the primary types of lagging economic indicators. It is when people in an economy lose their jobs. Unemployment also stems from not having enough jobs while workers are available. Unemployment exists during all stages of a business cycle.

Consumer Confidence Index

Another lagging economic indicator that people consider is the Consumer Confidence Index. It measures people's attitude toward the economic conditions prevalent in a country, whether future or current. This index represents people's trust in the economic conditions.

Gross National Product (GNP)

The gross national product is also a lagging economic indicator. It represents an estimate of the total value of all final products and services produced by the residents of a specific country. It differs from the GDP, which does not require the product to be from residents.

Conclusion

Economic indicators measure a country's economic health. These are beneficial for investors to base their decisions. There are several types of economic indicators. Lagging economic indicators only measure economic events after they occur. These may include the unemployment rates, consumer confidence index, gross national product, etc.

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What is Econometrics And Its Importance?

Several theories or models explain how economics works. These models usually seek to explain any relationships between economic principles. However, most of them are theoretical. They do not consider actual quantifiable statistics. However, it is still possible to quantify some economic phenomena, usually through econometrics.

What is Econometrics?

Econometrics is a term in economics used to describe using mathematics, statistics, and economic theory to quantify economic phenomena. It works by using data to develop economic theories. Similarly, it helps test them to establish trends or relationships between historical data. Econometrics allows for the quantitative analysis of actual economic phenomena based on the concurrent development of theory and observation.

The term econometrics comes from a Polish Economist Pawel Ciompa in 1910. However, it only became relevant in 1969 after the work of Ragnar Frisch and Jan Tinberg. Their work defined the term and set the path for future use. There are several tools within econometrics that economists can use. As mentioned, these tools use mathematical statistics and statistical theory to evaluate and develop economic hypotheses.

How does Econometrics work?

Econometrics uses both statistical and mathematical theories to test economic phenomena. It combines statistics, mathematics, and economic theory to quantify any data. Using econometrics, economists can help describe relationships between economic phenomena. In short, econometrics tests economic theories by using quantifiable data. Using this, economists can also establish trends that can be useful in forecasting.

Econometrics starts by obtaining a set of data that correlates to a specific economic theory. Once users do so, they need to analyze the data. Then, they can use various econometrics tools to establish a relationship between the data. Usually, it may involve determining a linear relationship. However, users can also use complex tools to include multiple variables.

What are the tools used in Econometrics?

Economists can use several tools as a part of econometrics. These may include time-series analysis or regression analysis. Furthermore, it consists of multiple linear regression. Some other econometrics tools include linear programming, correlation, and regression, simulation equation, frequency or a probability distribution, etc.

These tools can help economists apply econometrics in their work. While most of these are possible to use through calculations, economists can also use software packages. However, the results may differ from one dataset to another based on several variables. Economists also need to make certain assumptions during their calculations, which can affect the results.

What is the importance of Econometrics?

Econometrics is important in economics for several reasons. Most importantly, it helps economists test theories or hypotheses, whether existing or new. On top of that, they can convert data into a specific model to make decisions that support empirical data. Econometrics allows economists to convert economic theories into quantifiable metrics.

Econometrics is also crucial for establishing trends between datasets. Based on these trends, economists can also forecast future financial or economic trends. It also helps them get a specific pattern or result from cluttered data. Usually, economists can use prepackaged software that allows for straightforward analysis.

Conclusion

Economics includes theories or models, which are usually qualitative statements. By using econometrics, economists can convert them into quantitative statements. Econometrics uses statistics, economic theories, and mathematics to test economic phenomena. It is of high importance for several reasons, as discussed above.

Originally Published Here: What is Econometrics And Its Importance?

Emerging Market GDP Growth

Gross Domestic Product (GDP) represents an estimate of a country’s total value of finished goods and services. It considers these goods and services over a specific period, usually every year. Overall, GDP is an indicator of a country’s total economic activity. High GDPs represent higher production of goods and services.

For some countries, GDP may remain constant or have minimal movement over a period. These usually include developed or stable countries. For others, however, the GDP rate may fluctuate significantly. Usually, these consist of emerging markets or countries. Before understanding emerging market GDP growth, it is crucial to understand what emerging markets are.

What is an Emerging Market?

Emerging markets are economies that have similar characteristics as developed economies. However, some factors prevent their classification as a developed economy. In emerging markets, the per capita income is low to medium. These nations also become a part of the global market with their growth. There are several characteristics that emerging markets exhibit.

In emerging markets, the trading volume usually grows. Similarly, the economy attracts investors from around the globe. One reason for this is the increase in the liquidity of both equity and debt markets in the nation. However, these countries still need regulations. One characteristic of emerging markets is the development of enhanced financial regulations. It, in turn, helps investors gain more confidence in its investment markets.

How do Emerging Markets work?

There are no specific requirements for a nation to be an emerging market. Usually, however, countries that go through significant positive economic changes may qualify as emerging markets. One feature that these countries exhibit is simulating developing countries. However, these changes are unquantifiable. Instead, most experts look at the economy’s GDP growth to establish whether it classifies as an emerging market.

There are several characteristics that differentiate emerging markets from others. Usually, if a country exhibits these characteristics, it may classify as an emerging market. The primary feature of these markets is low or medium per capita income. Usually, this income is lower than average. It occurs because of rapid growth in the economy.

Emerging markets also illustrate high volatility. It comes due to the rapid social changes that occur in the economy. Similarly, the country's currency exchange rates may also fluctuate rapidly due to it. Despite these, emerging markets experience active economic growth. On top of that, these countries have a substantial potential for growth in the future as well.

What is Emerging Market GDP Growth?

GDP growth represents the difference between a nation's GDP over a specific period. The GDP growth rate for most emerging markets has been over 4%. This rate is higher than the GDP growth rate for developed countries, which stayed low at 2%-3%. Among the emerging markets, countries in Asia showed the best GDP growth.

In Asia, the two largest emerging markets are India and China. These two countries are responsible for over 35% of the world's population and labour force. Outside Asia, countries such as Brazil and Russia are on top of the list. These four countries also account for 30% of global production. Together, emerging market economies make up almost 70% of the world's total GDP growth.

Conclusion

Emerging markets include countries that show similar characteristics as developed nations. These countries are in the process of undergoing a substantial change. The emerging-market GDP growth rate is usually 4% or above.

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Impact of Negative Interest Rate

Interest rate defines the rate at which a borrower pays interest on a loan's principal amount from a lender. Every loan transaction will include an interest rate. For borrowers, lower interest rates are preferable as it means they have to bear lower expenses. On the other hand, lenders will prefer their interest rates to be higher as it suggests they will get higher returns.

Usually, the lender decides the interest rate on a loan transaction. They consider various factors while establishing the percentage. Most importantly, lenders account for their risks for any loan transaction by setting the interest rate. Interest rates are generally positive. In some instances, however, they may also be negative. Negative interest rates may sound impossible, but it is still possible.

What is a Negative Interest Rate?

Negative interest rates occur due to a country's monetary policies. Usually, a country's central bank dictates these policies. Therefore, the bank may, in some circumstances, set the interest rates to be negative. While these cases as rare, they may still occur. With negative interest rates, the central bank can decrease the borrowing cost prevalent in the economy. Through this, the bank can increase economic activity.

Negative interest rates sound counterintuitive. While these may be costly to the government, they can also be beneficial. Negative interest rates allow the central bank to control the economy during economic recessions. Usually, it causes investors to obtain loans and use them towards investments. Similarly, people may use loans for other activities, which generally increases the consumption in the economy.

How does a Negative Interest Rate work?

With usual interest rates, a lender provides a borrower with a loan. After a predetermined period, the borrower pays interest to the lender. This interest depends on the interest rate set on the transaction. However, the same does not apply to negative interest rates. After the predetermined period, the lender pays the borrower interest.

Therefore, with negative interest rates, borrowers actually earn income rather than bear expenses. The lender, on the other hand, suffers expenses related to the interest rate. As mentioned, however, the lender, in this case, is the government or the central bank. These entities usually have other benefits they receive from paying interest on the loans they provide.

During specific circumstances, such as recessions, people usually accumulate money. They refrain from investing or spending the money. It causes the aggregate demand in the economy to decline. During these periods, the central bank can use negative interest rates to encourage investments. This strategy is a part of the monetary policy.

What is the impact of the Negative Interest Rate?

The negative interest rate encourages most commercial banks to borrow more. It is because they can earn on these loans. In turn, these banks also decrease the interest rates in the market. The lower or negative market interest rates attract more investors and individuals to obtain a loan. Through investments and spending, they contribute to the country's economic activity.

The above is the intended impact of a negative interest rate and can lead to increased aggregate demand. Apart from that, the negative interest rate may also affect a country's economy. Negative interest rates also influence the forex exchange rate. Due to the decrease in interest rates, a country's currency value falls. This devaluation can promote export activities in the country.

Conclusion

Interest rates are the percentage that lenders charge on their loans. In some cases, these rates may be negative as well. Negative interest rates are a part of a country's monetary policy, dictated by its central bank. With these rates, borrowers can earn interest income rather than bear expenses. A negative interest rate can have several impacts, as discussed above.

Originally Published Here: Impact of Negative Interest Rate

What Is Quantitative Easing?

A country's monetary policy defines the policies its central bank employs to control its money supply. Usually, the bank does so to achieve macroeconomic goals. In this process, the central bank manages the growth and volume rate of the money supply in the economy. There are several steps involved in establishing a monetary policy for a country.

The primary control source using the monetary policy is money supply and interest rates. Using these, the central bank can also dictate other factors such as the country's growth, consumption, and inflation rates. There are several strategies that the central bank can use when establishing a monetary policy. One such policy is quantitative easing. However, it is not as prevalent as other techniques.

What is Quantitative Easing?

Quantitative easing is a strategy used by a country’s central bank when establishing a monetary policy. The bank acquires long-term securities from its member banks. By doing so, the central bank releases money into the economy. This technique causes the interest rates in the economy to fall. Therefore, it increases the money supply to decrease interest rates.

Unlike some other techniques, quantitative easing isn't as prevalently used by the central bank. It is considered a non-traditional policy. Quantitative easing aims to encourage investment and borrowing by decreasing interest rates. On top of that, it provides banks with better liquidity. Some central banks may utilize quantitative easing to lower their fund rate to zero.

How does Quantitative Easing work?

When establishing a country's monetary policy, a central bank can use several techniques. With quantitative easing, the central bank picks all government securities from its member banks. These may include commercial banks or even private financial institutions. Through this, the central bank releases a money supply into the economy, causing a decrease in short-term interest rates.

The decline in short-term interest rates encourages individuals to borrow funds. Similarly, the prices of financial assets in the market also rise, further benefiting investments. Since the member banks receive a money stream, they can use it to increase their lending activities. As a result of the increase in money supply, the interest rates decrease.

On top of that, quantitative easing can also have other benefits. One of these comes from its effect on the country's currency. As this technique keeps the currency's value low, it also makes investments attractive to foreign investors. Similarly, the exports increase as the lower currency value makes it a viable option. Overall, quantitative easing can have several impacts on a country’s economy.

What are some limitations of Quantitative Easing?

While quantitative easing can be significantly beneficial, it also comes with some limitations. Firstly, it relies on member banks to reuse the money supply for lending activities. Some banks may, however, choose to invest this amount instead. While it may be beneficial in other ways, it does not achieve the objective of quantitative easing.

Similarly, quantitative easing requires governments to control and overlook the process. If the central bank causes a sudden increase in money supply, it may have detrimental effects. Furthermore, while this technique can increase imports, it may also damage the country's import industry.

Conclusion

A country's monetary policy dictates its money supply and interest rates. Usually, the central bank is responsible for setting this policy. One technique they can use for monetary policy is quantitative easing. Quantitative easing allows the central bank to acquire long-term securities from its member banks. By doing so, it releases the money supply while also decreasing interest rates.

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What Is The Difference Between Deflation and Disinflation?

Inflation is a term used in economics to represent increasing goods and services prices. Similarly, it signifies a decline in a currency's purchasing power. Inflation can be good or bad, depending on various factors. There are two terms associated with inflation that people often confuse. These include deflation and disinflation. While they may sound similar, both are different from each other.

What is Deflation?

Deflation represents a decline in prices for goods or services over a specific period in an economy. It also entails the increase in a currency’s purchasing power. Deflation is when an economy experiences no inflation. Instead, it goes through a period when the inflation is negative. That is why another name used for deflation is negative inflation.

There are two factors that contribute to deflation in an economy. These factors come under two categories. These include a fall in aggregate supply and aggregate demand. In both these cases, the consumption in an economy decreases. It then causes item prices to fall. Some consumers stop spending during this period as they may expect item prices to decline even further.

What is Disinflation?

Disinflation does not represent negative inflation in an economy. Instead, it signifies a decrease in the inflation rate in the economy. It often portrays events when the inflation rate in an economy reduces marginally over a relatively short period. In simple terms, disinflation represents the rate of change in the inflation rate rather than the direction in which it fluctuates.

Disinflation, unlike deflation, does not have the same adverse characteristics. It is because it does not cause item prices to decrease or purchasing power to increase. It also does not indicate an economy is slowing down. Disinflation is a relative term that describes the change from inflation from one period to another.

What is the difference between Deflation and Disinflation?

There are several differences between deflation and disinflation. These are as below.

Definition

The primary differences between deflation and disinflation come from their definitions. As mentioned, deflation represents negative inflation. On the other hand, disinflation signifies a reduction in the inflation rate over a period.

Impact

Deflation can have adverse impacts on an economy. It usually causes higher unemployment, lower production, lesser economic activity, etc. On the other hand, disinflation does not have the same impacts as it is not negative inflation. Instead, it carries all the effects of inflation but at a slower rate.

Frequency

Deflation is relatively rare compared to disinflation. It is because the prices for goods and services seldom decrease compared to previous periods. However, disinflation is more common.

Countermeasures

Deflation can cause countries to suffer from a recession or even a depression. Therefore, most economies use countermeasures to safeguard against such effects. On the other hand, disinflation is not concerning for governments. Therefore, there are no countermeasures against it.

Consumer behaviour

Deflation can adversely impact consumer behaviours. As mentioned, consumers usually refrain from spending money due to deflation. It further amplifies the existing issues. However, the same does not apply to disinflation. Most people don't even notice it. Therefore, there is no change in consumer behaviour due to disinflation.

Conclusion

Inflation represents the increase in the prices of goods and services in an economy. Two terms associated with it include deflation and disinflation. Deflation is the negative inflation in an economy. However, disinflation signifies a decrease in the inflation rate. Both are different in several regards, as mentioned above.

Originally Published Here: What Is The Difference Between Deflation and Disinflation?

Is Recession Good or Bad?

A nation or region's economy may go through many fluctuations over a defined period. Usually, countries experience positive changes, which increases employment, production, demand, etc. Sometimes, however, some countries may also go through adverse changes. These changes have the opposite effect. These fluctuations represent the country or nation's business cycle.

In almost every situation, countries will prefer to go through a positive expansion period. It is because this period promises better circumstances for businesses, individuals, and all participants in an economy. However, these periods also follow a recession, which is inevitable most of the time. However, a recession isn't necessarily bad. Before understanding whether a recession is good or bad, it is necessary to define it.

What is a Recession?

A recession is a term in economics used to describe a significant decline in a country's economic activity. Usually, experts consider two consecutive quarters to establish whether a country is in a recession. During these periods, the country suffers from a decline in economic activity, also reflected in its Gross Domestic Product (GDP). However, there are some instances where economies have not suffered from a recession despite two consecutive economic downfall quarters.

In general, a recession represents a widespread decline in economic activity over several months. It differs from a depression that lasts over several years. Multiple recessions can cause an economy to go into a depression. Usually, recessions occur after the GDP growth in a region slows down for several quarters before it becomes negative.

There are several indicators of recession. These include lower employment rates, GDP downfalls, falling asset prices, lowering production, etc. However, more deeply, it comes due to a loss of business or consumer confidence. When either party stops having confidence in the future, business activity goes down. It further causes all the problems mentioned above.

Is a Recession good or bad?

Recession can be good or bad depending on several factors. As mentioned, there are several factors that determine whether a nation is going through a recession. Most of these factors cause an adverse impact on the country's economic activity. For that reason, most people consider recession to be bad. On top of that, as mentioned above, a recession can lead to depression. It also further signifies why a recession is bad.

In most markets, recessions cause a decline in asset prices. Therefore, investors may suffer due to prolonged recession periods. It is also difficult for them to dispose of their assets during this period. The country's currency also loses its value, which can further exaggerate the problem. On top of that, consumers also generally refrain from buying new goods or using services. This way, the economic activity in the country declines even further.

In some cases, a recession may also be good. Some businesses thrive under a recession, which can help the country and its economy. Similarly, efficiencies rise in markets, which can have a positive impact on production and consumption. Recessional periods are also well-known for giving rise to new ideas, leading to increased economic activity. Despite that, the adverse impacts of a recession usually exceed the positive effects.

Conclusion

A recession represents two consecutive downfalls in a country’s economic activity. There are several factors that indicate a recession. These may include lower production, increasing unemployment, lower consumption, etc. Most of these signify that recession is bad. However, there are some circumstances in which recession can be good as well, as mentioned above.

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Recession and the Housing Market

Investors need a diversified portfolio to mitigate any systematic or unsystematic risks. For that reason, they will include a variety of investments in their portfolio. While investing in the stock and bond market is common for most investors, they may also look towards the housing market. The housing market, however, does not perform similarly to the stock or bond market.

The housing market does not suffer regular fluctuations compared to other markets. However, there are times when this market takes a hit. Historically, the housing market has not suffered an impact due to economic downturns. Several factors may contribute to it. Nonetheless, the housing market may experience some changes during a recession.

What is a Recession?

A recession is a period when there is a significant downturn in economic activity in a country or region. Usually, recessions follow consecutive periods of economic decline. During a recession, the economic activity in a nation declines. There are several factors that may indicate a recession. These include higher unemployment, lower incomes, falling interest rates, lower industrial production, etc.

Most experts suggest that when a country enters into a recession, its GDP shrinks for two consecutive quarters. However, there is evidence that suggests that might not be true. Nonetheless, a recession occurs when a region or country experiences continuing economic downturns. For example, a nation that goes through several periods of deflation may enter into a recession.

What is the relationship between a Recession and the Housing Market?

There is no conclusive evidence that suggests a direct relationship between recession and the housing market. The actual connection between these two may depend on several factors. Recession may not actually be bad for the housing market. During a recession, the market interest rates fall. It means that investors can obtain loans at a lower interest rate and invest it in the housing market.

Falling interest rates also means that investors have to pay lower mortgage payments. Therefore, they can actually afford to pay their mortgage even when they don’t have a steady income source. However, this advantage only applies to new homeowners. For those who have already invested in the housing market, it may be a different story.

For existing homeowners, a recession can be significantly detrimental. They suffer due to the decreasing house prices. On top of that, they have to pay higher interest rates on their mortgages because they obtained the loan before the recession. As mentioned, however, that may not be the case for every recession. Sometimes, existing homeowners may also benefit from an appreciation of home values.

Should investors invest in the Housing Market during a Recession?

Historical data suggests that a recession is the best period for investing in the housing market. As mentioned above, it is because the interest rates are lower during this period. For investors, the housing market is a stable investment market during a recession. However, obtaining such facilities may not be possible for everyone.

Another issue for investors to consider is whether they can dispose of their assets during a recession. Therefore, they will need to account for the illiquidity that comes with such investments. Overall, a recession has minimal or no impact on the housing market. Therefore, it presents a valuable investment for most. As mentioned, however, some factors may suggest otherwise.

Conclusion

A recession is a period of consecutive downfalls in a country or region's economic activity. The housing market is often a stable investment for most investors during this period. However, it may also impact existing homeowners adversely. Nonetheless, several factors dictate whether a recession will impact the housing market.

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What is Maturity Premium

Investors have to consider various factors when contemplating the decision related to an investment. Usually, the main aspects they take into account are the risks and returns they get from it. However, other factors also play a role in their decision-making process. One of these includes the timing of the returns and initial investment made.

For most securities, the maturity period defines the time when investors can get their initial investments back. The longer this period is, the more investors have to wait. It also means that investors can't use their invested money for other projects or investments. Therefore, investors need compensation for investing their money for prolonged periods of time.

What is Maturity Premium?

Maturity premium, also known as maturity risk premium, is the compensation investors expect for investing in securities with late maturity dates. Usually, maturity risk premium entails two types of risks, including interest rate risk and reinvestment risk. The longer investors hold an investment, the higher these risks will be. Therefore, for long maturity period investments, investors will require a higher maturity premium.

In short, the maturity risk premium for investment increases with an increase in the time to its maturity. Investors can calculate the maturity premium for specific security by comparing it with identical securities. The maturity risk premium will depend on the difference between each securities maturity period. Usually, maturity premium applies to debt instruments, such as bonds.

Maturity premium applies to all long-term securities. Most of these instruments carry higher interest rates, which is due to the extended maturity period. The market premium also plays a role in establishing bond prices. It is because the price of a security or investments carries higher fluctuations due to fluctuating market interest rates.

How to calculate the Market Premium?

Investors can calculate the market premium, as mentioned above. However, this calculation is merely an estimate and does not measure the market premium accurately. As stated above, the longer the maturity period for security is, the higher the market premium will be. Therefore, securities with a 5-year maturity will carry a lower maturity premium than 3-year securities.

Investors can use the following market premium formula to estimate the market premium for security.

Market Risk Premium = Yield_n+m - Yield_n

In the above formula for maturity premium, Yield_n+m represents the yield on a bond with a maturity of n+m. Yield_n, on the other hand, represents the yield on a bond with n years maturity. As mentioned above, these bonds need to be identical.

Why is the Maturity Premium important?

The maturity premium is important for investors as they can get higher returns on longer maturity investments. It is because these investments lose value before they reach maturity. Therefore, investors need compensation to cover this risk. It also helps companies and other issuers in securing finance for prolonged periods.

Investors also face other risks associated with these investments, including the interest rate risk and reinvestment risk. Both of these can be detrimental to investors. Therefore, they need the market premium to cover these risks. Overall, the market premium provides investors with an extra incentive to invest in long-maturity securities.

Conclusion

Investors face various risks when investing in long-maturity investments. Therefore, they need to get compensation for it. The maturity premium is any additional payment that investors can get on long-maturity investments. It is important for both the issuer and the bondholder, as stated above.

Originally Published Here: What is Maturity Premium

Illiquidity Premium for Private Companies

Investors need to weigh in various factors when evaluating private companies. These may include the company’s book value, its profits, its cash flows, etc. Usually, public companies are easier to evaluate since most of the information is available through the stock market. However, the same does not apply to private companies. On top of other factors, investors also need to consider the illiquidity premium for these companies.

What is Illiquidity?

Illiquidity is a term that refers to the state of securities that investors cannot readily convert into cash. Illiquidity is the opposite of liquidity, which specifies how easy it is for investors to exchange assets for cash. The more liquid assets are, the easier it is for investors to get cash in exchange. However, illiquidity is the opposite. The more illiquid assets are, the more difficult it becomes for investors to exchange them for cash.

Illiquidity is highly crucial for investments as they are riskier compared to liquid assets. These assets have lower demand due to that reason. Similarly, illiquid assets experience more price volatility compared to liquid assets. The lack of high-volume market trading also contributes to the illiquidity of these assets. Despite that, investors may invest in illiquid assets for the illiquidity premium they can get on them.

What is the Illiquidity Premium?

The illiquidity premium is the returns that investors expect to get from illiquid investments above the market average. While the illiquidity premium may sound negative, it represents the higher returns investors get from illiquid assets. Therefore, it can be a positive thing for investors. The higher the illiquidity premium on investment is, the more investors will make from it.

Illiquidity premium only applies to illiquid assets. These usually include real estate or private company stocks. These assets are not as liquid as other options. Despite that, these offer higher returns than some liquid assets. These higher returns represent an incentive for investors that invest in illiquid assets. As mentioned, however, these also come with higher risks that investors have to take.

With illiquid investments, investors have to tie up their money for a long time. During this time, they can make income on other investments that are liquid. Since investors choose to invest in these illiquid assets, they expect these assets to provide higher returns than liquid investments. Therefore, they look at the investment’s illiquidity premium to determine how much returns they will generate.

What is the Illiquidity Premium for Private Companies?

As mentioned above, investing in private companies is usually more complex compared to public companies. Due to the low trading volume for these companies, their stocks are highly illiquid. However, some private companies offer higher returns compared to public companies. For investors, this represents the illiquidity premium for private companies.

However, quantifying the illiquidity premium for private companies is complex. Nonetheless, investors can use it to evaluate private companies. Investors can add the illiquidity premium to the cost of equity for a private firm. They can use it to compensate for the risks associated with investing in private companies. This premium will differ for each private company.

Conclusion

Investors prefer to invest in liquid assets. Liquidity represents how easy it is for investors to convert assets into cash. On the other hand, assets that investors can't readily exchange for cash are illiquid assets. Illiquidity premium is the returns above the market average that investors expect to make on these assets.

Article Source Here: Illiquidity Premium for Private Companies

Volatility Term Structure of the DAX Index

Volatility term structure is believed to be a common phenomenon across asset classes. In equity indices, it’s well-known that implied volatility (IV) is generally greater than realized volatility (RV) (i.e. there exists a so-called volatility risk premium), and out-of-the-money (OTM) IV is greater than at-the-money (ATM) IV (i.e. there exists a so-called volatility skew). The existence of the volatility risk premium makes developing long volatility strategies a very difficult, if not impossible, task. Similarly, volatility skew makes tail risk hedging expensive.

Many studies have been carried out on the US equity indices. Little research has been devoted to international equity indices. Among few studies, Reference [1] examines the volatility structure of the DAX index. Specifically, it investigates PnLs of delta-hedged short options trading strategies. One of the simulated strategies is as follows,

Delta-neutral hedge without transaction costs. Hedge-volatility equal to the implied volatility of an option. Options are sold at bid/ask midpoint and DAX-index is traded at the closing price of DAX 30.

Table 19 of Reference [1] summarizes the PnL of the above strategy. From the results, we observe that,

• For Deep OTM options, their PnLs are consistent with ours,
• For OTM put options, 1-Month delta-hedged short options show negative PnL; this means that we would be able to design a cheap tail hedge,
• Results for ATM options are even more surprising. Except for 3-Month put options, all other ATM options yielded negative PnL. This means that we would be able to design long-volatility trading strategies that have positive expectancies [2].

In short, the results are quite surprising. This may be due to the followings,

• DAX volatility term structure is different from SP500’s,
• The period covered by data used in the study was not long enough. The options data covers only the 2018-2019 period.

We believe that #2 is likely the cause. It’s well-known that after the crash of February 2018, US equity indices’ RVs exceeded IVs, thus making short volatility trading strategies such as butterflies unprofitable. To make any conclusion regarding #1, more data should be used.

References

[1] J. Juvakka, Profit potential of DAX index option trading based on implied volatility surfaces, LUT School of Business and Management, 2020.

[2] Transaction costs are not accounted for.

Originally Published Here: Volatility Term Structure of the DAX Index

What is the Default Risk Premium on the Corporate Bond?

Lenders assess various factors when providing a loan to a borrower. These factors may include the borrower's credit ratings, history, security offered, etc. Based on this evaluation, lenders decide on whether to provide the loan or not. It also helps lenders measure the return they want to get from the loan. Apart from the nominal interest rate, lenders may also charge a default risk premium.

What is the Default Risk Premium?

Default risk premium represents the difference between the risk-free rate and a debt instrument's interest rate. In essence, it is the additional interest lenders charge on their debt instruments to compensate for the related risks. Through this premium, lenders can receive higher interest on debts that are riskier than others. The default risk premium may differ depending on several factors.

The default risk premium on a debt instrument is directly proportional to the default risk on it. For every borrower, this risk will differ. Therefore, lenders will decide how much default premium they will charge for each loan. For the lender, the default risk premium acts as a reward for the risk undertaken on any debt transaction.

How does the Default Risk Premium work?

As mentioned above, the default risk premium is the additional interest borrowers pay above the risk-free rate. Every corporation or borrower has to pay a default risk premium on debt transactions. It is because there is always an inherent risk for borrowers to default. In theory, it implies that any entity that does not have a default risk will pay the risk-free rate on debt instruments.

As mentioned above, the default risk premium on debts depends on the default risk for it. The higher this risk is, the more the default risk premium lenders will charge. However, the default risk isn't the only factor that dictates the rates that lenders will charge. Borrowers will also make a decision on whether to avail of a loan or not based on the default risk premium.

What is the Default Risk Premium on the Corporate Bond?

The default risk premium on the corporate bond represents its interest rate above the risk-free rate. For every corporate bond, the default risk premium will differ. Usually, it depends on the bond's credit rating, which it gets from credit rating agencies. Usually, the higher the rating is, the lower the default premium will be. It is because higher rating bonds are less susceptible to default. Therefore, investors take a minimal risk with these.

For investors investing in corporate bonds, the default premium is the yield they get above government bond yields. For a better comparison, investors must calculate the default risk premium on a corporate bond by comparing it to identical government bonds. Therefore, the face value, coupon, and maturity of both bonds must be similar.

How to calculate the Default Risk Premium on the Corporate Bond?

As mentioned above, the default risk premium on the corporate bond is the difference between its coupon rate and the risk-free rate. Therefore, the default risk premium formula will be as below.

Default Risk Premium = Coupon rate of corporate bond - Risk-free rate of interest

For example, a company issues a bond to the public with a coupon rate of 5%. The risk-free rate of interest in the market is 3%. Therefore, the default risk premium on the corporate bond will be 2% (5% - 3%).

Conclusion

For every debt transaction, lenders have to undertake several risks, including default risk. The default risk premium is the compensation that lenders receive for the default risk they take on debts. It represents the difference between the risk-free rate and the interest rate on the debt instrument in consideration. The higher the default risk is, the higher the default risk premium will be.

Article Source Here: What is the Default Risk Premium on the Corporate Bond?

Can Inflation Be Negative?

Inflation is the decline in the purchasing power of a given currency over a specific time. Usually, it represents the rate at which the price level of a basket of selected goods and services in an economy increase. The selection of this basket will depend on the index which measures the inflation rate. For most countries, experiencing inflation is common from one year to another.

While inflation can have positive effects, some people consider it to be detrimental to the economy. However, it is natural for economies to go through inflation regularly. Inflation also causes a currency’s value to fall, which translates to the loss of purchasing power. There are two primary reasons why inflation may occur. These include demand-pull and cost-push inflation. In some cases, inflation can also be negative.

Can Inflation be negative?

While it is common for most economies to experience a regular rise in prices, inflation can also be negative. In that case, the purchasing power of a currency will increase while item prices will fall. This process is known as deflation or negative inflation. Deflation is not as common as inflation. While it is the opposite of inflation, deflation can also adversely affect an economy or currency.

What is Deflation?

Deflation is when the prices of goods and services fall in an economy. It also accompanies a rise in the purchasing power of the currency. Deflation occurs when the demand for goods or services falls in the economy or when the supply exceeds it. In other circumstances, the money supply in the economy also affects whether it will experience inflation or deflation.

Deflation can be beneficial for the people in the economy. However, it may also signal a future recession. When the prices of goods and services in the economy fall, people may not prefer to spend. It is because they usually wait until these prices fall even further. However, this may also cause other economic issues, such as declining jobs, unemployment, lower supply, etc.

How does Deflation work?

Like inflation, the Consumer Price Index (CPI) can help measure deflation. Deflation occurs due to two primary reasons. Firstly, it arises from the increase in the aggregate supply in an economy. If there is no demand to meet the increased supply, deflation will occur. It is also another cause of deflation. When the aggregate demand in an economy falls, deflation will occur.

There are even further causes of deflation. It may include a reduction in the money supply in an economy, lower production costs, technological advancements, etc. In most of these cases, the aggregate supply and demand will fluctuate, which will also cause deflation. Several periods of continuous deflation can cause the economy to suffer from a recession.

There are several factors that may indicate the occurrence of deflation in an economy. These include a decrease in the price of goods or services and an increase in unemployment or job losses. On top of that, an increase in interest rates in an economy also indicates deflation. Once these events take place, they can give rise to a ripple effect, causing a recession.

Conclusion

Inflation represents the increase in the price level of goods and services over a specific time. It also causes the loss of purchasing power for a currency. Inflation can also be negative, known as negative inflation or deflation. Deflation is when the purchasing power of a currency increase over time. While deflation is theoretically positive, it can cause several problems, leading to a recession.

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What is Inflation Premium?

For investors, investing in various assets or income streams presents several risks. These risks can be specific to the asset class or the market that investors enter. Some risks may apply to all investments regardless of the type of asset or market. One of these risks includes inflationary risk associated with inflation in an economy.

What is Inflationary Risk?

Inflationary risk represents the uncertainty associated with inflation affecting the future value of an investment or asset. Inflationary risk comes with inflation, which is the rise in prices in an economy. It also causes the loss of purchasing power. Therefore, the inflationary risk is the risk that an increase in prices or reduction in purchasing power impacts asset or investment value.

For investors, it is crucial to ensure that the returns from any investment at least exceed the inflation rate. If it doesn’t, then the investment is loss-making. Similarly, it results in a reduction in the value of the investment. Therefore, inflationary risk can cause investors to lose money on their investments. This risk depends on how inflation fluctuates in an economy. Investors will also require an inflation premium for the inflation risk they take.

What is Inflation Premium?

Inflation premium represents the compensation that investors require to make on investments impacted by inflation risk. Inflation premium is a component of the required return. With an inflation premium, investors can earn from these risks of loss of purchasing power or increasing prices. It arises from investors holding nominal assets that suffer due to unanticipated changes in inflation.

Investors require an inflation premium to compensate them for the risk they take associated with inflation fluctuations. Since these risks are unpredictable, investors use the inflation premium to account for such uncertainty. Inflation premium represents an interest rate that investors can add to the real risk-free rate to compensate for fluctuations in inflation.

How to calculate the Inflation Premium?

Investors can calculate the inflation premium by taking the ratio of two identical bonds. One of these bonds must carry inflation risk while the other doesn't. In most cases, investors can use government bonds to calculate the inflation premium. Some treasury bonds come as inflation-protected. Therefore, these bonds account for inflation in both the face value and coupon payments.

Investors can use these inflation-protected treasury bonds and compare their yield to the yield from nominal treasury bonds. This way, they can calculate the inflation premium. In this case, the inflation premium formula will be as follows.

Inflation Premium = Yield on treasury bonds - Yield on inflation-protected treasury bonds

Investors can also calculate the inflation premium through nominal and real rates. The formula for inflation premium using these rates is as follows.

Inflation Premium = (1 + Nominal Rate / 1 + Real Rate) - 1

Example

The treasury yield curve for 10-year bonds on 03 May 2021 was 1.63%. The real treasury yield curve for 10-year bonds on the same date was -0.79%. Therefore, the inflation premium at the time will be as follows.

Inflation Premium = Yield on treasury bonds - Yield on inflation-protected treasury bonds

Inflation Premium = 1.63% - (-0.79%)

Inflation Premium = 2.42%

Conclusion

Inflationary risk represents the risk that investment values will fluctuate due to fluctuations in the inflation rate. Inflation premium is the compensation that investors can expect for these fluctuations. It arises from the fact that investors hold nominal assets which are subject to inflation. Investors can calculate the inflation premium using one of the two ways discussed above.

Originally Published Here: What is Inflation Premium?

What is the Real Risk-Free Rate?

Every investment comes with risks, which also dictate the returns that investors can expect on it. Usually, investors expect to earn returns that exceed the income they will get for zero-risk investments. For that purpose, they can use the risk-free rate. This rate also adjusts for any inflation changes in the economy.

Sometimes, however, investors may want to calculate their rate of return without accounting for inflation. For that purpose, they can use the real risk-free rate. Before looking at the real risk-free rate, it is crucial to understand what the risk-free rate is.

What is the Risk-Free Rate?

The risk-free rate is a theoretical rate of return on an investment that does not carry any risk. However, every investment includes some form of risk. Therefore, the risk-free rate usually represents the rate of return on treasury bonds or other government securities. While these carry some risk, these risks are negligible and qualify them for usage at risk-free rates.

The risk-free rate is not achievable in practical conditions. However, these allow investors to analyze the returns they get on their investments. The risk-free rate is also predictable, making it a great tool for investors. The risk-free rate is beneficial in several models and calculations. For example, investors can use it to calculate the risk premium on their investments. The risk premium, in turn, is a part of the Capital Asset Pricing Model, Sharpe Ratio, and Treynor ratio.

What is the Real Risk-Free Rate?

The real risk-free rate is a risk-free rate that removes inflation from the risk-free rate. While the risk-free rate does not include any risks, the risk of inflation is inherent to it. By excluding inflation from this rate, investors can better analyze their returns on investments. As with the risk-free rate, the real risk-free rate is not achievable and is a theoretical concept.

In essence, the real risk-free rate is the rate of return that investors can expect on a zero-risk financial instrument without inflation. Although it is a theoretical rate, investors can calculate the real risk-free rate using the risk-free rate and vice versa. The relationship between the nominal and real rate depends on the inflation rates.

How to calculate the Real Risk-Free Rate?

Investors can calculate the real risk-free rate by subtracting the expected inflation rate from the nominal risk-free rate. The real risk-free rate formula is as below.

Real Risk-Free Rate = Risk-Free Rate - Expected Inflation

For example, the U.S. 10 Year Treasury Note was 1.640% on May 18, 2021. As mentioned, while this note isn’t wholly risk-free, it is still substitutable for the risk-free rate. Similarly, the expected inflation during April 2021 was 4.2%. Therefore, the real risk-free rate for the period will be as follows.

Real Risk-Free Rate = 1.64% - 4.2%

Real Risk-Free Rate = -2.56%

In the above example, although the risk-free rate is positive, the real risk-free rate is negative. It is because the inflation rate exceeds the risk-free rate. Furthermore, this difference suggests that the investors will lose money on risk-free investments.

Conclusion

The risk-free rate represents a rate at which investors can expect to earn income on risk-free investments. However, this rate is theoretical and impractical. Investors can, nonetheless, use the rate on Treasury notes to substitute for this rate. The real risk-free rate represents the rate of return on zero-risk investments without inflation.

Article Source Here: What is the Real Risk-Free Rate?

How Does an Endowment Fund work?

What is an Endowment Fund?

An endowment fund represents a restricted financial asset. Endowment funds are common among nonprofit organizations. These contain capital investments and any income leveraged by the nonprofit organization to fund the overall mission. For endowment funds, nonprofit organizations can only use the earnings made through them. They cannot use the underlying investment that constitutes the endowment fund.

Endowment funds, like any other funds, need management. Therefore, professional fund managers oversee the funds to ensure it performs as expected. For endowment funds, the initial capital investment comes from donations. These donations are tax-deductible for the donors. It is common for organizations such as hospitals, universities, and schools to use endowment funds.

How do Endowment Funds work?

Endowment funds begin with charitable contributions from donors to a trust. These donors invest in the trust for a specific purpose. Using a trust structure for donations helps segregate the underlying organizations from the funds. However, these donors are not the beneficiaries of the endowment funds. It does not behave similarly to other typical funds. Instead, the beneficiary of endowment funds is a nonprofit organization.

Endowment funds may consist of several types of investments. These include cash, stocks, bonds, commodities, etc. The fund manager decides on which investments will be a part of the endowment funds. The amount initially invested in an endowment fund always remains intact. However, any investment income from the funds is available for use.

Endowment funds usually aim to serve a purpose. This purpose comes from the donors who specify the reason for making any donations to these funds. Once they donate their money to the endowment fund, these funds become restricted. The fund manager may also need to spend a portion of the investment income on these funds to ensure the original funds grow over time.

What are the advantages of Endowment Funds?

Through endowment funds, many nonprofits can raise money for charitable causes. These funds help new nonprofit organizations in generating funds while also giving them a source of continuous funds. With endowment funds, nonprofit organizations can diversify their income and reduce the risks associated with volatility in the economy.

For the donors, endowment funds are also a viable option to support causes in which they believe. They can restrict these funds, ensuring the funds get used for their specified purpose only. On top of that, any donations to endowment funds are tax-deductible, making them a great option for tax planning. Overall, endowment funds can be beneficial for both donors and nonprofit organizations.

What are the disadvantages of Endowment Funds?

Despite many advantages, endowment funds also have some drawbacks. Some endowment funds come with unrealistic endowments. These organizations may face criticism for their use of resources or requiring more funds. On top of that, endowment funds also undergo the same process as other funds as these involve investments. Whether the endowment fund grows depends on how the underlying investments perform.

Some nonprofit organizations may not have the resources to manage endowment funds. While they have the option to hire investment managers, these come with additional costs. On top of that, there are some other regulatory compliances that these organizations need to consider. Therefore, endowment funds can be costly to manage.

Conclusion

Endowment funds represent restricted financial assets comprising donations from donors into a trust. These funds exist to serve a specific purpose. The money in endowment funds always remains intact. However, organizations can use any investment income from it. There are several advantages and disadvantages of endowment funds, as mentioned above.

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Does Intraday Momentum Exist in Stock Indices?

Most of the studies on time-series momentum have been performed in the daily, weekly, and monthly timeframes. Relatively less research has been conducted in the intraday timeframe. So naturally, we would ask the question: Does the momentum exist intraday?

Reference [1] examined the time-series momentum of the SP500 index in the intraday timeframe. It concluded that the momentum indeed exists intraday. Specifically, the authors pointed out that the first half-hour return on the market since the previous day’s market close predicts the last half-hour return.

Our paper documents that the market return in the first half-hour predicts the market return in the last half-hour. This intraday predictability is statistically significant both in- and out- of-sample. In terms of market timing and asset allocation, the economic gains of using the predictability are substantial.

They also found that the return predictability is stronger on high-volatility days. Further, the time-series momentum exists not only in the SP500 index but also in other broad market and sector indices.

We also find that the market intraday momentum is stronger on high volatility days, high trading volume days, recession days, and important economic news (MCSI, GDP, CPI, FOMC) release days. Moreover, the intraday momentum is strong not only for the S&P 500 ETF, but also for ten other most actively traded ETFs. Theoretically, the market intraday momentum is consistent with the trading behavior of investors who either infrequently rebalance their portfolios, or trade late from early information.

The implication of this article is useful not only for high-frequency traders but also for options and portfolio risk managers. Since the SP500 index is highly correlated with the volatility index, i.e. VIX, one can use the results of this article to design better options trading and hedging strategies.

Finally, based on our experience, we believe that the intraday time-series momentum also exists in other markets than equities such as commodities, interest rates.

References

[1] L Gao, Y Han, SZ Li, G Zhou, Market intraday momentum,  Journal of Financial Economics, 129, 394-414, 2018

Article Source Here: Does Intraday Momentum Exist in Stock Indices?

What does an Investment Fund Manager do?

A fund represents a pool of money collected by investors that aims to meet a particular purpose. There are various types of funds that have specific goals. Based on these goals, investors can select a fund and invest in it. Usually, investors also appoint an investment fund manager responsible for managing the fund according to the fund's purpose.

What is an Investment Fund Manager?

An investment fund manager is a person, group of persons, or a firm responsible for ensuring a fund meets its investing strategy. The manager also overlooks the whole portfolio and manages it accordingly. The investment fund manager acts and makes decisions on behalf of their clients, who are investors. Their goal is always to achieve the highest returns on any funds.

When managing a portfolio, investment fund managers consider various factors. These may include their clients' goals, risk tolerance levels, expected returns, etc. In exchange for managing these funds, these managers receive compensation. This compensation usually depends on how well the underlying funds perform. Some fund managers may also get a fixed payment. However, a substantial portion of their income is performance-based.

What does an Investment Fund Manager do?

Investment fund managers are responsible for various activities when handling funds. Most of these responsibilities relate to how they manage their clients' funds. Some of the primary duties that investment fund managers undertake are as below.

Analyzing and selecting investments

As mentioned above, investment fund managers are responsible for investing on their clients' behalf. For that purpose, they need to analyze various investments. Similarly, they will have a goal that is common for the fund. Based on this goal, they will choose appropriate investments to include in the funds. Investment fund managers also aim to analyze and select investments that maximize returns for investors.

Managing funds

Investment fund managers also need to manage their funds actively. It is one of their primary responsibilities as a fund manager. This responsibility will include directing client investment activities within the fund for stocks, debt instruments, and other securities. Similarly, they need to decide which securities they need to incorporate into the fund's product mix.

Monitoring performance

Investment fund managers are also responsible for monitoring investments incorporated within a fund. For this, they need to decide which investments meet the fund’s purpose and how it performs. They will also identify any shortcomings and develop strategies to offset losses. Based on this analysis, they will make decisions on whether to keep those investments or sell them.

Managing risks

Investment fund managers are also responsible for managing the fund’s overall risks. They need to ensure these risks are in line with investors’ risk tolerance levels. Investment fund managers usually set the risk level at the beginning of their work. This responsibility also includes using diversification strategies to avoid potential from specific assets or asset classes.

Complying with regulations

On top of the duties, investment fund managers need to ensure their activities follow the set regulations. These regulations may include industry regulations and best practices. By doing so, investment fund managers can ensure they don't have to pay any fines or penalties.

Conclusion

Investors can pool their investments into funds that meet specific objectives. Usually, an investment fund manager is responsible for managing these funds. Investment fund managers also analyze and select investments, manage the funds, monitor the performance, manage risks and comply with regulations.

Originally Published Here: What does an Investment Fund Manager do?

What Does an Investment Committee Do?

Most companies offer their employees pension plans which allow those employees to earn after retirement. These companies manage any contributions through investments. The employer invests these amounts on the employee's behalf. These earnings then generate income, which funds future pension payments to employees. Companies may also hire an investment committee to look after these plans.

What is an Investment Committee?

An investment committee represents a committee responsible for planning and overseeing an investment plan. Usually, companies use investment committees to manage retirement plans. However, these committees also have other responsibilities. The scope of their work depends on the company and its needs. However, investment committees can handle all sorts of responsibilities associated with investments.

Investment committees are only responsible for planning and oversight. Usually, a company's Chief Investment Officer performs the duties associated with managing investments. Therefore, both a company's CIO and its investment committee must work in unison to achieve its investment goals. Unlike some other committees, having an investment committee is not mandatory. However, companies may still establish one as a part of their risk management strategy.

What does an Investment Committee do?

As mentioned, the scope of the work that an investment committee performs depends on the company. Typically, however, some of the common responsibilities that the members of an investment committee share are as follows.

Develop investment policy

The primary role of an investment committee within any company is to help establish an investment policy. The committee does so through a written document known as the investment policies statement. This policy signifies what investment the company needs to make, how it should manage those investments, and how to choose its managers. The investment policy statement also defines the criteria for measuring the plan’s performance.

Gauge investment performance

The investment committee, due to its oversight responsibility, is also responsible for gauging investment performance. The committee overlooks every investment and measures its performance against the criteria defined in the investment policy statement. The committee also tracks changes in the investment management team, the fees and expenses for it, the investment style, and much more.

Manage implementation of investment strategies

The investment committee not only defines the investment policies for a company but also manages the implementation. While the committee cannot finalize investments, all these decisions must get approved by the investment committee. Usually, they assess whether the investment meets the objectives set in the investment policy statement.

Perform financial reviews

The investment committee within a company is also responsible for reviewing the financial aspects of an investment. As mentioned, they usually compare these financials with the expected amounts according to the investment policy statement. The investment committee also prepares a report that it then presents to the board of directors.

Ensure regulatory compliance

The investment committee is also responsible for ensuring a company complies with all applicable regulations. However, these regulations only apply to investments. As mentioned, the investment committee is usually responsible for pension plan management. In that case, the committee is responsible for ensuring compliance with The Employee Retirement Income Security Act.

Conclusion

When companies make an investment, they may hire an investment committee to plan and oversee the operations. This committee usually helps companies with pension plan management but can also perform other duties. Within any company, investment committees have several responsibilities. Some of these responsibilities are above.

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How do Profit-Sharing Plans work?

Pension or retirement plans are typical for employees working in companies. Through these plans, they can ensure they receive income after retirement. There are several retirement plans where they, their employer, or both contribute an amount. Some plans offer a fixed contribution upon retirement. However, some others come with uncertain future income. One such retirement plan is the profit-sharing plan.

What is the Profit Sharing Plan?

The profit-sharing plan is a pension plan in which the employee receives a share of the company's profits as benefits. Another name used for this plan is the deferred profit-sharing plan. Each employee registered in this plan gets a portion of the company profits. The company sets a percentage for them, and their benefits depend on the company's annual or quarterly earnings.

Although profit-sharing plans offer varying incomes, they have a higher motivational impact on employees. Due to the variable income received by employees, the profit-sharing plan falls under the category of the defined contribution plan. The employee makes specific contributions during their employment. The company or their employer can also choose to contribute to the scheme.

Profit-sharing plans aren't restricted retirement plans. Companies may also offer other retirement plans, such as IRAs alongside these plans. The company also chooses the terms for the profit-sharing scheme. On top of that, the company can set the qualifying criteria for employees who can join this plan. Companies don't have to be profitable to offer these plans.

How do Profit-Sharing Plans work?

Profit-sharing plans work similarly to other defined-contribution schemes. With profit-sharing plans, employees can make contributions to the plan. Usually, these contributions are specific. As mentioned, the employer may also choose to contribute to the plan, although it isn't mandatory. Any contributions go to a qualified tax-deferred retirement account which allows penalty-free distributions.

After retiring, employees can receive their share of profits. These benefits usually start after the employee has reached the age of 59 and a half. Profit-sharing plans allow employees to choose between either cash compensations or company stock.  Some profit-sharing plans also provide employees with loans, which they can take before their retirement age.

The company offering such plans decides on how much each employee will get allotted. It can use a formula for profit allocation. The company can also adjust the plan as needed. Using this, the company can determine the total of the overall employees' compensation. After that, it is possible to find each employee's percentage by dividing each employee's annual compensation by that total.

What are the advantages and disadvantages of Profit Sharing Plans?

Profit-sharing plans can be significantly beneficial to both the company and its employees. Through these plans, companies can keep their employees motivated and gain a competitive advantage. Profit-sharing plans align the company’s objectives with those of the employee. Overall, the efficiency and productivity rates within the company can increase substantially.

However, profit-sharing plans can also be demotivating. When some employees receive higher profit portions, others will become demotivated. Similarly, these plans can introduce additional costs, which can impact a company's operations. On top of that, employees get no guarantee they will receive income in the future if the company makes losses.

Conclusion

Profit-sharing plans are retirement plans in which employees can receive a portion of the company's profits on retirement. These plans are a type of defined-contribution plan. The company that set up this plan decides on its terms and how much each employee will receive. Profit-sharing plans can be beneficial but may also come with some disadvantages.

Originally Published Here: How do Profit-Sharing Plans work?

What is the difference between Defined Benefit Plans and Defined Contribution Plans?

When it comes to retirement plans, individuals have many options. For employees, there are some employer-sponsored plans to which they can contribute. Usually, these include defined benefit and defined contribution plans. These are two different retirement plans according to their composition, returns, and management. Before understanding the differences between these, it is crucial to look at each individually.

What is a Defined Benefit Plan?

A defined-benefit plan is a retirement plan in which an employee gets defined benefits. These benefits depend on several factors such as their salary, age, and employment period. In essence, these plans provide a fixed income to the employee that is similar to receiving salaries. Similarly, defined benefit plans are qualified plans, implying that the receiver can get tax benefits under the tax laws.

As mentioned, the benefits that the individual gets depends on several factors. However, there is no specific method for calculating these benefits. Individuals can either take their benefits as a lump-sum amount or an annuity that provides them with payments throughout their life. Pensions and cash balance plans are primary examples of defined benefit plans.

What is a Defined Contribution Plan?

A defined contribution plan is a retirement plan in which an employee makes defined contributions to the scheme. The benefits, on the other hand, are not specific. Instead, the employee receives payments based on how the funds perform, managed by the company or the employer. Like defined-benefit plans, defined contribution plans also come with some tax benefits.

The employer providing this plan specifies the options offered by it and is responsible for organizing it. The employer can also choose to contribute to the scheme. Each employee gets their own pension account. The amount they contribute to the plan depends on their employment contract or terms. 401(k)s and IRAs are examples of defined contribution schemes.

What is the difference between Defined Benefit Plans and Defined Contribution Plans?

There are several differences between defined-benefit and defined-contribution plans. Some of these differences are apparent from the explanation above. Some of the aspects in which defined-benefit and defined-contribution plans differ from each other are as below.

Benefits

With defined-benefit plans, employees get a predictable income in the future. As mentioned, this income depends on their employment period, age, the formula used, etc. In defined contribution plans, the benefits that employees receive depend on their contributions. It also depends on their employer's contributions and investment gains or losses.

Contributions

For most defined-benefit and defined-contribution plans, the contributions come from employees' pre-tax contributions. Employers may also choose to contribute to these plans. However, for defined-benefit schemes, these will vary according to the plan design or actuarial valuation annually. For defined contribution plans, the contributions are specific.

Responsibilities

In a defined-benefit plan, the responsibility of contributing money and managing investments lies with the employer. If the investments perform adversely, the employee is responsible for funding the defined-benefit scheme. In contrast, these responsibilities reside with the employee for defined contribution plans. If the underlying investments perform adversely, employees get lower compensation.

Conclusion

Defined benefit and defined contribution plans are employer-sponsored retirement plans. With defined-benefit plans, employees make varying contributions but get a fixed income. Their income depends on several factors mentioned above. With defined contribution plans, this income varies on how the underlying investments perform. However, the contributions are specific. Both plans also differ according to the responsibilities of employees and employers.

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Does Trend Following Work on Single-Name Stocks?

Trend following is a popular trading strategy used by Commodity Trading Advisors (CTA) and Hedge Funds around the world. The traded assets are often futures on commodities, FX, fixed-income, and equity indices. We previously demonstrated that stock indices exhibit trending property in the long term, i.e. their returns are positively autocorrelated. We subsequently developed a simple trading strategy exploiting this trending property.

We’re now asking ourselves the question: can trend following be applied to single-name stocks? Reference [1] provided empirical evidence that trend following indeed works in the universe of stocks.

The evidence suggests that trend following can work well on stocks. Buying stocks at new all time highs and exiting them after they’ve fallen below a 10 ATR trailing stop would have yielded a significant return on average. The evidence also suggests that such trading would not have resulted in significant tax burdens relative to buy & hold investing. Test results show the potential for diversification exceeding that of the typical mutual fund. The trade results distribution shows significant right skew, indicating that large outlier trades would have been concentrated among winning trades rather than losing trades. At this stage we are comfortable answering the question “Does trend following work on stocks?” The evidence strongly suggests that it does.

Based on our experience, we believe that it is possible to develop winning trend-following strategies on stocks, i.e. the article’s finding is consistent with our experience. The points below would be, however, an area for further research,

• Does trading a basket of stocks instead of an equity index offer the benefit of diversification?
• Some studies on autocorrelation would provide further insights as to why trend following works on single-name stocks.
• The result was published in 2005; we would like to see an updated, formal result.

References

[1] C. Wilcox, & E. Crittenden, Does Trend-Following Work on Stocks? The Technical Analyst, 14, 1-19, 2005

Article Source Here: Does Trend Following Work on Single-Name Stocks?

Variable Annuities for Retirement

For individuals in their retirement period, annuities are a decent income stream that provides regular payments. Annuity or annuity contracts are agreements where one party pays another party a steady source of income. These contracts include details about the payments made to the beneficiary. The terms will also state whether it is a fixed or variable annuity.

What is a Variable Annuity?

Variable annuity represents a type of annuity contract that gets its value based on how the underlying investment portfolio performs. Usually, it includes sub-account portfolios. The receiver, based on the portfolio's performance, may get variable income. If the underlying portfolio performs decently, the variable annuities increase, meaning the receiver will get higher returns. The opposite will apply when the portfolio performs adversely.

Variable annuity contracts are prevalent among two parties. The first party is the annuity provider, which is usually an insurance company. The other party is the receiver who enters into the contract with the provider. The receiver, through this contract, purchases the ability to receive a steady income stream in the future for a set amount of time.

What are Variable Annuities for retirement?

Variable annuities for retirement refers to contracts that retirees use to ensure a steady source of income in their retirement period. Due to the potential endless payments from these contracts, retirees can secure their future with considerable income. Unlike fixed annuities, retirees can't expect a guaranteed source of income. However, they can receive higher than what fixed annuities offer if the underlying investment portfolio performs well.

Variable annuity for retirement is a decent option for individuals that have a high-risk tolerance. With variable annuities, these individuals don't have to stick to fixed payments. Instead, they can generate higher returns. However, it also has the potential to backfire on them. Retirees may also get significantly lower income than fixed annuities if the underlying investment portfolio does not perform as expected.

How do Variable Annuities work?

Variable annuities allow individuals to select between several options for investing their funds in a portfolio. These options may include mutual funds, money market accounts, and other investments. These are known as sub-accounts. By choosing their underlying portfolio, individuals get more control over the process. Similarly, they can benefit significantly if their selected option performs well.

Variable annuities consist of two phases. These include the accumulation phase and the payout phase. During the accumulation phase, the variable annuity contract increases in value. It is the period when individuals make contributions to the variable contract. The payout phase is when they get to reap the benefits from the contract. During this period, they can get their payments in monthly or lump-sum amounts.

How do Variable Annuities differ from Fixed Annuities?

Fixed annuities, as mentioned above, offer individuals a fixed payout. However, this payout is usually lower compared to variable annuities. In contrast, variable annuities come with more uncertainty related to the amount that the receiver gets. However, with these annuities, they have the benefit of receiving higher returns. However, these can also result in significant losses if the underlying investments don't perform well.

Conclusion

Variable annuities are contracts that allow individuals to get variable income at a steady rate in the future. The amount they receive depends on an underlying investment, which dictates the annuity's value. Individuals can choose the underlying assets, known as sub-accounts. Variable annuities are different compared to fixed annuities, which offer lower but guaranteed payments.

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Is Insurance Liability or Asset?

What is Insurance?

The term insurance represents a contract between two parties to protect an underlying asset. The first party is the insured party, which receives the protection. This party owns the underlying asset. Insured entities may include individuals, businesses, organizations, etc. In contrast, the second party is the insurer. This party promises to compensate the insured party in case of damage to the underlying asset.

Usually, the insured party makes regular payments to the insurer. This payment is known as the insurance premium. During the insurance contract, the insurer is responsible for reimbursing the insured party for damages to their asset. However, the insurance contract terms must cover the type of damage. In most cases, the contract will specify the types of perils it will recover.

Is Insurance Liability or Asset?

Insurance can be a liability or an asset depending on the type of entity that accounts for it. Before understanding how it can be either, it is crucial to know what each of these is.

What is an Asset?

An asset is a resource owned or controlled by an entity and will result in future inflows of economic benefits. Assets include all resources that companies use to generate income. For example, these may consist of property, land, or cash. However, assets don't have to be tangible. Intangible assets such as brand value, trademark, patents also meet the definition of assets. However, they must have measurable values.

What is a Liability?

A liability is an obligation for entities that result in future outflows of economic benefits. For most companies, liabilities represent a type of finance that they can use to run their operations. These funds may be long- or short-term. Regardless, these are obligations that an entity must reimburse in the future. Liabilities may include loans, accounts payable, accruals, etc.

When is Insurance an Asset?

Insurance is an asset for the insured party. Any party that makes a regular insurance premium to an insurance provider must recognize an asset. It is because this asset represents a resource that they own or control. Similarly, it can result in future inflows of economic benefits. However, the insured party must recognize an asset until it hasn't consumed the gains from it. In other words, once the party expenses out the insurance premium, they must derecognize the asset.

For the insured party, insurance is primarily an expense. In most cases, however, insurance providers require payments in advance. Therefore, any payments made in advance become assets until the provider renders the related services.

When is Insurance a Liability?

For the insurance provider, insurance is a liability. The insurance provider must recognize a liability in its financial statements because it matches the definition. For this party, insurance is an obligation towards the insured party and can result in future outflows of economic benefits. When the provider provides the related services to the insured party, they will convert this liability to revenues.

Similar to the insured party, the insurance provider must recognize a liability for advance receipts. These liabilities are known as deferred revenues or earnings. Once the insurance provider provides the services, they can record the related revenues.

Conclusion

Insurance is a contract between two parties for the protection of an asset. For the insured party, insurance is an asset. However, once they receive the services, the amount becomes an expense. In contrast, for the provider, insurance is a liability. Once the provider renders the services, the amount becomes revenue.

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How Does Property Insurance Work

Insurance is a term used to describe any form of protection against financial losses. In the modern day, companies, organizations, and individuals use insurance to mitigate the risks associated with their assets. Based on the type of asset they use, there are several types of insurance they can get. One of these includes property insurance that comes on any real estate they own.

What is Property Insurance?

The term property insurance can describe one of the many types of insurance that property owners can get on their property. It may also refer to insurance that tenants get on leased or rented properties. Property insurance includes liability coverage for any damages to the underlying property. If there is any damage to the property, the insurance provider will reimburse the property owner or renter.

Both parties also agree to the terms for the insurance before its commencement. These terms include the time for which the insurance coverage will be valid, the responsibilities of both parties, the types of damages covered, etc. Usually, the insurance provider is responsible for covering any damages to the property, subject to some conditions. The property owner or renter, in contrast, makes payments in the form of insurance premiums.

How does Property Insurance work?

Property insurance initiates from a property owner or renter. Usually, these parties contact an insurance provider to insure their property. As mentioned, they can choose between various policies based on which damages they are most likely to suffer. For example, flood insurance can protect houses against water or flood damage.

In exchange for the insurance, the property owner or renter makes regular insurance premium payments. These payments may differ according to the type of policy selected, coverage scope, provider’s requirements, etc. Usually, property insurance includes protection against water, electrical, fire, smoke, and other minor damages.

Both parties will also agree on the time for which the insurance will apply. During this time, the renter or property owner is responsible for making regular payments. However, if there is any damage to the insured property during this period, the insurance provider will reimburse the counterparty. As mentioned, if the damage is not a part of the insurance terms, then the insurance provider will not provide any compensation.

What are the advantages and disadvantages of Property Insurance?

Property insurance, like other forms of insurance, can have significant benefits to property owners and renters. Most importantly, it provides them protection against any damage to their property. As mentioned, however, there are some terms that may dictate the coverage scope. Similarly, it can be advantageous for protecting investors against uncontrollable damages.

Property insurance can also be beneficial for companies and businesses. Commercial property insurance allows companies to protect their business premises against any damages. For businesses where the risks of theft or damages are high, property insurance can be significantly beneficial.

However, there are some disadvantages of property insurance as well. These disadvantages primarily relate to the insurance provider. Some providers may deny claims for valid damages even when provided with proper evidence. On the other hand, some providers may also process claims slowly. On top of that, insurance premiums can also be costly based on the property value.

Conclusion

Property insurance refers to a collection of insurance policies that property owners or renters can get on their related properties. If the underlying property suffers from any damages, the insurance provider reimburses the owner or renter. In exchange, the insurance provider receives regular payments in the form of insurance premiums.

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Human Capital Vs Financial Capital

The term capital represents assets that companies use to generate income. In exchange, companies also incur some costs on it. This capital may include fixed assets, such as property or land, or liquid assets, such as cash, receivables. These are crucial for both long- and short-term operational needs. Based on how companies generate capital, there are several categorizations.

What is Human Capital?

Human capital represents the capital companies generate through their workforce. These include the employees a company employs, their skills, abilities, experience, etc. While this capital is not measurable and not a part of financial statements, it is still valuable. Human capital can be a distinguishing factor between a company's success and failure.

For most companies, human capital is highly crucial. Like any other type of capital, companies can invest in this form of capital as well. This investment usually comes in the form of human resource management policies. These may include policies related to recruitment, training, performance appraisal, promotions, etc. If utilized correctly, human capital can be a significant resource for companies.

Unlike other common forms of capital, human capital is not measurable. Therefore, companies cannot assign a value to it and recognize it in their financial statements. For most companies, human capital is an internal resource. External stakeholders cannot evaluate this capital either. Therefore, there is no way for them to gauge a company's value based on human capital.

Despite that, human capital can provide significant rewards to companies. The more productive and experienced a company’s employees are, the better its performance will be. This performance translates to higher profits and can also increase a company’s value. Therefore, human capital has an impact on a company’s value, although not directly.

What is Financial Capital?

Financial capital is different from human capital. Financial capital is a broad term used to describe any capital that has monetary value. Therefore, it represents a company's capital except for its human capital and other non-monetary amounts. Similarly, any capital that does not contribute to a company's revenue-generation process does not constitute financial capital.

Financial capital includes both equity and debt finance. Therefore, a company’s total assets represent its overall financial capital. Although most companies and stakeholders prefer equity finance over debt, debt still forms a part of financial capital. Each type of capital may have further classifications. For example, debt finance may include both short- and long-term obligations.

The term financial capital implies that the capital has a monetary value. Any stakeholder can measure a company's financial capital through its financial statements. Unlike human capital, financial capital is a part of a company's financial statements, precisely the balance sheet. While it does not directly contribute to financial capital, human capital can also increase overall capital.

Overall, the most significant difference between human capital and financial capital is the value. For human capital, companies cannot measure the monetary value. Therefore, this capital also doesn't constitute a part of the financial statements. Financial capital, on the other hand, is the direct opposite. Any capital with monetary value included in the financial statements is financial capital.

Conclusion

Capital is a term used to describe the resources that companies use to generate income. It may come in various forms. These include human and financial capital. Human capital is the capital that companies get from their workforce. However, it does not have a monetary value. In contrast, financial capital is the capital that companies get from financial resources.

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