Are Accounting Numbers Useful?

Accounting numbers are prevalent in financial reporting, business valuation, and investment management. They’re so frequently used that the practitioners rarely asked pragmatic questions such as: are they useful, do they account for some meaningful risks, can they be used to price assets.

A recent article [1] attempts to bring some answers to these questions,

This paper is a treatise on handling accounting numbers in building factor models.  Those numbers include book value, investment, return on equity (ROE), and other profitability measures that appear in standard models, but often from data mining without a clear explanation of why they indicate investment risk. The numbers are generated by accounting principles that deal with risk, providing an explanation but also a critique of how the numbers enter extant models.

The authors investigated the usefulness of book value, investment, and return on equity (ROE) numbers. They concluded,

…the expected return is given by the expected future earnings yield on current price, for which the current earnings-to-price, E/P, is a predictor. However, it is an imperfect predictor, for current earnings are typically disturbed by accounting principles that convey the risk to expected earnings that discounts their pricing. By recognizing this accounting and combining it with the current earnings-to-price, the paper produces a factor that explains stock returns well relative to existing models. That is complemented with an investment factor based on complementary accounting in the balance sheet under double entry. Accounting measures in standard models, like book value, investment, and ROE enter, but in a different way —in a way that conveys risk and return under accounting principles.

In brief, accounting numbers are useful, but only under some circumstances. This result is consistent with our experience in working with credit-risk models. We have observed that not all accounting numbers are useful in modeling probabilities of default. Their usefulness depends on the type of business and many other factors. Moreover, they must be used in conjunction with other types of market indicators such as macroeconomic, volatility, technical, etc.

The research results imply that we can incorporate accounting numbers into the development of investment strategies. But as in the case of credit-risk models, they must be used in conjunction with other types of market indicators.

Last and not least, by the same token, there is a growing number of people in the financial service industry who promote alternative data and many of them sell their data services at the same time. We ask ourselves again the same question: is the alternative data really useful. What do you think?

References

[1] S. Penman, XJ. Zhang, Accounting for Asset Pricing Factors,  2021, https://ssrn.com/abstract=3881177

Originally Published Here: Are Accounting Numbers Useful?

Risks of Leveraged Investing

Leverage represents the use of borrowed capital to fund activities. For investors, it involves using loans or other borrowed funds to invest in securities. These borrowed funds come with some charges, usually in the form of interest payments. For investors, the returns they get from their investments must exceed these payments. Leveraged investing can be significantly beneficial. However, there are also some risks associated with it.

What is Leveraged Investing?

Leveraged investing is a process through which investors use borrowed funds for investing. It involves borrowing a large amount of money upfront and using it to finance their activities. By doing so, investors can scale their portfolios significantly without having to wait for the money to become available for investing. With leveraged investing, investors can remove any obstacles associated with limited capital.

For investors, leveraged investing can be significantly beneficial. It helps them scale their operations. It, in turn, helps increase the dividends or capital gains that investors receive. However, the charges that investors must pay on the leverage may lower their returns. Therefore, it is crucial for their returns to exceed the costs of leveraged investing.

What are the Risks of Leveraged Investing?

While leveraged investing can significantly increase investors’ returns, it can also amplify their risks. These risks may relate to the borrowed capital or their operations. Some of the primary risks of leveraged investing for investors include the following.

Subpar portfolio performance

As mentioned, investors must ensure that their returns are higher than their borrowing costs. One of the primary risks that investors face with leveraged investing is subpar portfolio performance. Investors may invest in stocks or securities that do not perform well in the market. However, their borrowing costs always stay the same. Therefore, they may end up making a loss on the transaction.

Loss of collateral

In some loan transactions, investors may have to provide the lender with collateral. In case investors can't repay the borrowed amount or face delay with interest payments, they may end up losing this collateral. If investors choose to provide their investments as collateral, they may have to sell these investments prematurely if the time comes. Hence, they may make a loss on that as well.

Amplify losses

Leveraged investing can decrease the returns that investors get. It is because they also have to pay interest on the borrowed capital. However, if investors suffer a loss instead of gains, it will amplify their losses. Not only do they have to pay their interest payments, but they also have to bear investment losses. If investors use leveraged investing to scale their operations, the losses can be even bigger.

Interest rate risks

Investors may also have to suffer interest rate risks with the leverage they use for investing. In case of increasing interest rates, investors will have to pay more. It can also affect their cash flows. On top of that, it may make them susceptible to falling short on their interest payments and losing their collateral. Overall, interest rate risks can be a significant risk of leveraged investing.

Conclusion

The use of leverage in investing can provide investors with significant benefits. Not only can it help them increase their returns but also scale their operations. However, leveraged investing can come with some risks. Some of the primary risks associated with it include subpar portfolio performance, loss of collateral, amplification of losses, and interest rate risks.

Originally Published Here: Risks of Leveraged Investing

What is Securities Lending

A loan is a transaction between two parties, a lender and a borrower. The lender is the party offering a resource in exchange for an incentive. This transaction may also include collateral, which provides the lender with higher security. Usually, loan transactions involve paying a monetary amount. However, investors also have the option to dive into securities lending.

What is Securities Lending?

As the name implies, securities lending is the process of lending securities. Like other loan transactions, this transaction also involves two parties, the lender and the borrower. The lender is a party that owns stocks, bonds, or other securities. The lender temporarily transfers these securities to a borrower. Securities lending is usually a secured transaction. Therefore, the borrower must also provide collateral, usually in the form of cash or other securities.

Like other transactions, securities lending also involves an agreement that dictates the transaction's terms. For example, it may include details about the transaction's length, the collateral provided, any fees involved, etc. Usually, securities lending also requires a monthly lending fee, which acts as an incentive for the lender. Once the transaction ends, the borrower has to return the loaned securities.

How does Securities Lending work?

Securities lending starts from a borrower requesting some securities from a lender. Both parties negotiate the contract and its details. As mentioned, they put these terms in the form of a contract. Once they complete the initial requisites, they can exchange the securities and the collateral. Subsequently, the lender will transfer the title and ownership of the given securities to the borrower.

During the time the borrower holds the said securities, they have to pay a monthly fee. This fee includes a combination of the loan fee and interest fee for the loan. The borrower also has to pass any accrued interest or dividends on the securities to the lender. This process continues during the total loan period. Once the agreement ends, the borrower must return the securities to the lender.

What is the importance of Securities Lending?

Securities lending can be of high significance to many investors. Most primarily, it facilitates short selling in the market. With this, investors can loan securities and sell them and bet on the security prices falling in the market. Therefore, short-sellers can buy securities at a low price and sell them at a high point. If things go as planned, investors can make high profits. Therefore, securities lending allows investors to benefit from security trading without having to buy them.

Additionally, securities lending can help allow investors to buy on margin. This process can also be beneficial to the market as it encourages trading. However, it isn't of significance to investors only. Lenders can also benefit from securities trading. This benefit usually comes in the form of the fee that the borrower provides in exchange for the securities.

Nonetheless, the success that investors can get with this strategy can differ based on several factors. On top of that, they also have to account for the risks involved with it. The primary risk investors face consists of insolvency risk. If they fail to pay the fee or return the securities, they will lose their collateral. Similarly, investors can also make losses while short selling, which can impact them adversely.

Conclusion

Securities lending is a transaction in which a lender loans securities to a borrower. In exchange, the borrower pays a fee. Securities lending allows investors to short sell the securities to benefit significantly. However, this process also comes with some risks that they must consider.

Article Source Here: What is Securities Lending

Pricing Convertible Bonds Using Monte-Carlo Simulations

Convertible bonds are complex securities that are part debt, part equity. The main feature of a convertible bond is the conversion that allows the bondholder to convert debt to equity. In addition, there can be many other “exotic” features such as callable, puttable, forced conversion, soft call, contingent conversion, etc.

Given their complexities, convertible bonds’ pricing is often very involved. A convertible bond is usually priced by using a lattice (binomial or trinomial tree) model or the Partial Differential Equation (PDE) approach. Another method is the Monte-Carlo simulation [1]. This method is less popular than the lattice or PDE approaches, but it has an advantage in that it can account for path-dependent features such as contingent conversion or 20/30 soft calls.

The pricing of a convertible bond under the Monte-Carlo approach starts with simulating the underlying price which is assumed to follow a Geometrical Brownian Motion. This is a common assumption in practice to model stock prices. The time to expiration is divided into equal time intervals; and in each time interval, the stock price is simulated using an exact scheme. This procedure generates price paths and we repeat it many times.

Since the conversion option can be exercised at any time during a given period, the valuation of a convertible bond is similar to that of an American option. Using dynamic programming principles, the value of a convertible bond can be determined recursively in a similar manner as in the tree or partial differential equation approaches.

Briefly, for each price path, the convertible bond’s continuation value is approximated using Least-Squares regression as suggested in the paper of Longstaff and Schwartz [2] for the valuation of the American option. The main steps involved in valuing a convertible bond using Monte Carlo simulation are as follows,

1. Simulate the stock price.
2. For each path, calculate the convertible bond value at maturity.
3. Move on to the previous time step and calculate the continuation value using Longstaff and Schwartz scheme. Choose the first 4 Laguerre polynomials and a constant as basis functions [3].
4. If the conversion is allowed, check if early exercise is optimal by comparing the continuation value to the conversion value. If early exercise is optimal, the cash flow at this time for this particular path is set equal to the conversion value, and all other cash flows afterward are set to nil.
5. Continue in this manner backward until the inception.
6. Finally, the value of the convertible bond given certain exercise strategies is determined by averaging the discounted cash flows of all the simulated paths.

This pricing method is more computationally involved than the lattice or PDE approaches. However, it offers greater flexibilities regarding the implementation of more complex, exotic features, especially path-dependent ones. Using this method, the precision of the pricing is approximately 0.5% of the convertible bond’s value.

References

[1] See for example M. Ammann, A. Kind, C. Wilde, Simulation-based pricing of convertible bonds, Journal of Empirical Finance 15 (2008) 310–331

[2] F. Longstaff and E. Schwartz, Valuing American options by simulation: A simple least-squares approach, Review of Financial Studies, Spring 2001, pp. 113–147.

[3] Other basis functions can also be used.

Article Source Here: Pricing Convertible Bonds Using Monte-Carlo Simulations

What is Roll Yield?

Futures contracts are agreements that allow investors to deal in specific commodity assets or securities. With these contracts, investors can fix their future prices for a particular time in the future. Futures contracts allow investors to hedge against various risks associated with price changes. With these contracts, investors undertake an obligation to conduct the transaction in the future.

Futures contracts are primarily helpful for hedging purposes. However, investors can also invest in these contracts through various markets. These can provide the diversity necessary for investors when managing their portfolios. Like other investments, futures contracts can also be highly beneficial to investors. These contracts produce returns in various forms, one of which includes roll yields.

What is Roll Yield?

Roll yield is a term often associated with futures markets. It represents the yield or returns investors can generate in the futures market by rolling a short-term contract into a long-term one. Due to the difference in the price of these contracts, investors can make a profit. This profit constitutes the roll yield for investors. Effectively, it allows investors to benefit from the convergence of futures prices toward the spot price.

The roll yield arises due to the difference between the holding period return for futures contracts varying from the spot price return during the same period. Once futures contracts expire, investors have to pay compensation or settlement. However, they can avoid this by closing their position or rolling over their futures contracts. This way, they can sell contracts close to maturity and buy similar contracts with longer maturity periods.

How does the Roll Yield work?

Roll yield is a type of profit that investors can make from future markets, among various others. This profit occurs due to the price difference between futures contracts with varying maturity or expiration dates. Roll yields can either be positive or negative based on whether the market is in contango or backwardation. Regardless, investors can profit from both circumstances.

Roll yields come from investors' obligations due to future contracts. When investors acquire these contracts, they must buy or sell securities in the future. However, they also have the option to roll over their position before the delivery date. Due to this, investors can close their position before expiration by selling their futures contracts with short expiration dates. Instead, they invest in similar contracts with longer expiration dates.

How to calculate the Roll Yield?

Investors can calculate the roll yield by using the formula for roll yield. As mentioned, the roll yield can either be positive or negative. In the case of contango in the futures market, the futures prices of longer-dated contracts are higher than those of short-dated contracts. For backwardation, the opposite applies. The roll yield in contango is negative, while for backwardation, it is positive.

Investors can use the following roll yield formula to calculate the returns they can get from rolling over.

Roll Yield = Price of short-term contract - Price of long-term contract / Price of short-term contract

Conclusion

The futures market, like other investments, provides a decent opportunity for an investor to diversify their portfolios. Investors can also benefit from roll yields. Roll yield represents the returns investors can get from rolling over their short-term futures contracts for long-term ones. The price difference between both contracts represents the roll yield that investors can achieve.

Article Source Here: What is Roll Yield?

Static Vs Dynamic Hedging

Hedging is a technique that investors use to mitigate any specific risks that they face with investments. Usually, it includes investing in derivatives to counterbalance the adverse impacts of any risks. There are many types of hedge instruments that investors may use for that purpose. For example, investors can use options, futures, swaps, etc., to mitigate their investment risks.

With hedging, investors take an opposite position to their current one. This way, they don't have to suffer in case their investments perform adversely. Due to the number of options available to investors, there are several techniques that they can use during this process. These may include static or dynamic hedging. Both of these are different in various regards.

What is Static Hedging?

As mentioned, investors use a hedge to protect against any risks facing a specific investment. However, once investors hedge against those risks, some variables may change. A static hedge is a type of hedge that does not require investors to rebalance it actively. It means that investors do not take steps to adjust these hedges when some characteristics of their securities change.

Static hedges have a finite life period. While investors may need to adjust these hedges when their investments expire or mature, they do not do it as often as dynamic hedges. Usually, this rebalancing occurs after long intervals. One example of a static hedge is a future in which investors can hedge a position against an investment. Through these derivatives, investors can hedge against price or foreign exchange risks.

What is a Dynamic Hedge?

A dynamic hedge is a type of hedge that requires investors to rebalance actively. It means that as the factors concerning their portfolios alter, investors will need to adjust their position. Dynamic hedges may require more regular rebalancing compared to static hedges. In some cases, dynamic hedges may be the only option for investors as static hedges may not cover the risks.

Dynamic hedges look at several factors when considering rebalancing. The most common of these is the price of an investor's portfolio. However, other factors may also require attention, such as volatility. One example of a dynamic hedge is options. Investors can use these to hedge against several risks. However, these require regular rebalancing to be effective.

What is the difference between Static and Dynamic Hedging?

As mentioned above, the primary difference between both hedges is the need for investors to rebalance them. Static hedges do not require regular rebalancing. In some cases, these may not be effective for longer periods. Similarly, investors will need to rebalance eventually. However, this rebalancing occurs after a long period of time.

Dynamic hedges, on the other hand, take a more active approach towards hedging. It requires investors to monitor their investments and adjust their hedge instruments accordingly. Despite being more active, it does not imply that dynamic hedges are more effective. During high volatility periods, they may not be as effective in hedging either.

Conclusion

Hedging is a process through which investors can mitigate the risks associated with their investments. There are several approaches to hedging, which may be more applicable to specific situations. Static hedges do not require investors to rebalance their hedge instruments regularly. However, with dynamic hedges, the process occurs more actively.

Article Source Here: Static Vs Dynamic Hedging

Are Index Options Markets Efficient?

Options market efficiency is a topic of interest not only to academics but also to practitioners. There is a body of research focusing on market inefficiency. For example, we recently highlighted a research paper dealing with sector ETFs’ implied volatilities and correlations. The research result implies that the options market is not efficient, as one can earn extra returns by using trading signals generated from the implied correlation premium.

There is, however, an opposite school of thought that promotes the idea that the options market is efficient and excess returns cannot be earned. A recent example is Reference [1] in which the authors calculated the index options implied volatilities and used them to generate trading signals,

We test the Index options market efficiency by means of a statistical arbitrage strategy, i.e. pairs trading. Using data on five Stock Indexes of the Euro Area, we first identify any potential option mispricing based on deviations from the  long-run relationship linking their implied volatilities.  Then,  we evaluate the profitability of a simple pair trading strategy on the mispriced options. 

The article went on to conclude that the index options market is efficient,

Using data on one-month maturity ATM call options written on five European Indexes, over the 2007-2019 period, we find that arbitrage opportunities, despite frequent, are short-lived and mostly lead to non-significant profits, in both the self-financing strategy (in which the quantities traded in the two stocks are such that no initial capital investment is required) and in the beta-arbitrage (in which the quantities traded are a function of the regression slope estimates). Market forces are thus able to quickly identify and reabsorb potential mispricing, further confirmed by the fact that the average trade closes within 4 days. Consistently with previous works on European index option market (Capelle Blancard and Chaudhury, 2001, Mittnik and Rieken,  2000, Cavallo and Mammola, 2000, and Brunetti and Torricelli, 2005), our final conclusion is in favor of index option market efficiency. 

We respect the authors’ research effort and conclusion, and we will consider their results in our trading strategy development process. However, we’d like to point out that the PnL drivers of an index options pair are the constituents’ not only implied volatilities but also realized volatilities. The authors did not take into account the realized volatilities explicitly when generating trading signals and constructing the option positions. The realized volatilities were taken into account implicitly as they manifested themselves through the moneyness of options,

Investigating the main drivers of options’  pair trading, we find that the realized returns are mostly driven by the moneyness of both the options involved.  Consistently with expectations, the strategy returns are on average higher whenever the option sold is OTM  and/or the option on which a long position is taken is ITM, while on average lower when the sold option is  ITM  and/or the option bought is  OTM.

If the authors took into account the realized volatilities in their strategy development process, the results might have been different.

Notwithstanding the efficient market debate, constructing options positions to take advantage of the mispricings (if any) is not a trivial process.

References

[1]  M. Brunetti, R. De Luca, Pairs trading in the index options market, efmaefm.org, 2020

Originally Published Here: Are Index Options Markets Efficient?

What is a Managed Futures Fund?

Having a diversified portfolio of investment is crucial for any investor. Traditionally, investors have divided their portfolios into equity and debt investments. With the vast number of options available nowadays, however, the same does not apply. Investors have various options when it comes to building a diversified portfolio. One such option is investing in managed futures funds. Before that, however, it is crucial to understand what managed futures are.

What are Managed Futures?

Managed futures are a type of alternative investment strategy through which investors can achieve a diversified portfolio. Instead of investing in the traditional markets, the managed futures strategy focuses on investing in the futures contracts market. Managed futures provide investors with many advantages, including diversification, liquidity, lower risks, higher rewards, etc.

With managed futures, investors can include assets from various asset classes in their portfolios. Therefore, they involve investing in both equity and debt markets, among others. Managed futures have some relationship to stock and bond markets. However, this relationship is not as strong. Despite that, managed futures provide investors with a diversified portfolio.

What is a Managed Futures Fund?

Managed futures funds, also known as managed futures accounts, are similar to other investment funds. With these funds, investors can pool their funds for a manager to handle. The managers, usually Commodity Trading Advisors, make decisions on their clients’ behalf. However, these do not include investing in traditional markets. As the name suggests, managed futures funds focus on investing in managed futures.

Like other funds, managed futures funds may take a long or short position in the market. However, these usually include investments in the commodities or futures markets. Managed futures funds managers may take one of the various approaches towards managing these funds. However, most of these approaches focus on achieving high liquidity investments.

With managed futures funds, diversification is also a focus area. Managers include several future instruments in these funds for that purpose. These may consist of stock, fixed-income or debt, commodity, foreign currency futures, etc. Usually, managers will include their market approach in their trading program that they share with their clients.

How do Managed Futures Funds work?

Managed futures funds work similarly to other funds. These are investment vehicles that trade in derivatives or futures. These may include several instruments, such as futures contracts, futures options, stock options, swaps, etc. These funds may take a long or short position, or both, in the assets they trade. These funds also don't face any restriction in using leverage.

As mentioned, managed futures funds have managers. Usually, these are professionals known as commodity trading advisors (CTA). However, it may also include commodity pool operators (CPO). Managers in managed futures funds are responsible for managing clients’ investments in futures or derivatives. Usually, they aim to reduce portfolio volatility while also focusing on liquidity.

What are the advantages of Managed Futures Funds?

Managed futures funds can provide investors with several advantages. These are leveraged investments, which can increase returns while also reducing risks associated with portfolios. Managed futures funds can also be beneficial in achieving portfolio diversification. These funds can also help in outperforming traditional investments in some circumstances. Overall, they are less risky and provide better rewards.

Conclusion

Managed futures represent an alternative investment strategy for achieving a diversified portfolio. They do so by investing in futures or derivatives instead of traditional assets or securities. Managed futures funds allow investors to invest in managed futures. These can provide investors with better returns while also offering a diversified portfolio.

Originally Published Here: What is a Managed Futures Fund?

Who Are Commodity Trading Advisors?

Who are Commodity Trading Advisors?

Commodity trading advisors are individuals or institutions that provide financial advice to investors related to future options, futures contracts, etc. Usually, commodity training advisors are professionals who go through a registration process to become an advisor. Primarily, these advisors are responsible for providing trading advice or services related to commodity swaps or options and futures contracts.

Commodity trading advisors are responsible for handling managed future accounts. For investors, getting into most of the investments mentioned above may be challenging. It is because futures or foreign exchange contracts involve a significant amount of leverage, making them more complex. Therefore, they may need the help of professionals to help them with it. Commodity trading advisors are the perfect choice for that purpose.

What do Commodity Trading Advisors do?

Primarily, commodity trading advisors are responsible for managing investors' assets through managed futures funds. As mentioned, these assets include future contracts, future options, foreign exchange contracts, etc. For these assets, commodity trading advisors are responsible for setting an investment strategy. This strategy will depend on investors’ goals and objectives.

As a part of their asset management responsibility, commodity trading advisors need to perform various analyses. They will also employ an investment technique to use for their assets. There are several approaches to doing so. For example, they may use technical, quantitative, or fundamental investment approaches. Based on which method they use, these advisors will adjust their working techniques.

What do Commodity Trading Advisors need to become registered?

As mentioned, commodity trading advisors are registered individuals or institutions. Their registration comes from the relevant body that overlooks their work. In the United States, this includes the Commodity Futures Trading Commission (CFTC). They may also need to register or become a member of other regulatory bodies based on the jurisdiction in which they operate. For the US, it involves being a member of the National Future Association (NFA).

Usually, there are several steps involved in obtaining a commodity trading advisor registration. It includes taking a multi-part exam and passing it. Individuals taking the test must also provide an exam fee. Once they pass the exam, they can get a registration of two years. Once they do so, they must also pay a membership fee and complete other relevant requirements.

All individuals that offer commodity trading advisor services must meet these requirements. For institutions, the criteria may differ. For example, in some jurisdictions, the principles of commodity trading advisory firms must have a CTA registration. On top of that, all the employees linked with dealing with clients must also have a CTA registration.

What is the difference between Commodity Trading Advisors and Money Managers?

Both commodity trading advisors and money managers perform similar duties. They are responsible for managing clients’ assets and providing them personalized advice. However, their registration and designation differ. Money managers are usually chartered financial analysts (CFA). They are responsible for making investment decisions focused on balancing clients’ portfolios between equity and bonds.

Money managers usually focus on helping clients achieve their financial goals. For that, they exchange assets on a client's behalf. As mentioned, these assets consist of equity and debt instruments. Commodity trading advisors, however, focus on providing advice related to futures and commodities. Similar to money managers, commodity trading advisors also help clients with achieving specific financial goals.

Conclusion

Commodity trading advisors are individuals or institutions who have a registration. These advisors provide clients with advice about future contracts, options, foreign exchange contracts, etc. They are primarily responsible for managing clients' assets through managed futures funds. Usually, they go through a registration process to get the commodity trading advisor designation.

Originally Published Here: Who Are Commodity Trading Advisors?

Carry Trade in Forex

Forex trading includes buying or selling currencies to profit from the differences in exchange rates. Due to the widespread availability of markets, forex trading has become a popular choice among many investors. There are several strategies that investors may use to profit in the forex market. One such strategy is the carry trade.

What is the Carry Trade in Forex?

The carry trade in forex is a strategy that investors can use to increase their returns. With this strategy, investors buy high-yield currencies against low-yield currencies. In other words, it involves selling currencies that have a low-interest rate and using that to acquire currencies with higher interest rates. This strategy is straightforward and prevalent among many forex traders.

With carry trade, investors pay low interest on the currencies that they sell or borrow. However, they get higher interest on currencies that have high-interest rates. In essence, investors can profit from the yield difference between both currencies. Usually, they get the interest differential between their currencies for every day they hold them.

How does the Carry Trade in Forex work?

The carry trade in forex works by exploiting the interest difference between two currencies. With this strategy, investors identify currencies that provide a low yield. Once they do so, they sell or borrow them. At the same time, they identify currencies that have higher yields against the low-yield currencies they sold. These are the currencies that they buy and keep. In practice, investors must identify currency pairs that illustrate these features.

Investors can earn a profit from the broker every day they hold both the low- and high-yield currencies. In essence, the investor pays a low-interest rate on the currencies they sell. However, they also receive high yields on currencies they buy. The difference between both yields represents the profits that investors make from carry trading.

For example, an investor purchases the Euro, which presents a 4% interest rate. On the other hand, they borrow the US dollar, which has a 3% interest rate. For each day that the investor holds the trade in the market, they will receive 1% interest from the broker. This interest represents the difference between both of these currencies.

What are the advantages and disadvantages of the Carry Trade?

Carry trade can be highly beneficial for investors. Primarily, it presents investors with two gains that they can get from forex trading. The first comes from the trading gains they receive from the difference in exchange rates. The second comes from the interest rate difference between the two currencies. It also allows investors to benefit from using leverage.

However, carry trade can have some drawbacks as well. The primary disadvantage of carry trading comes from the volatility associated with currencies. Therefore, it can significantly increase the risks that investors take using such a strategy. On top of that, while it allows investors to profit from using leverage, it can also be highly volatile.

Conclusion

Forex trading, like other assets, can be a viable investment option for investors. A strategy that they can use during this process is carry trading. A carry trade in forex is when investors identify two currencies with high and low-interest rates. By selling the low-yield currencies and buying high-yield ones, they can benefit from the interest rate differences.

Post Source Here: Carry Trade in Forex

Further on Trending/Mean-Reverting Properties of Stock Indices

We previously demonstrated that stock indices exhibit mean-reverting property in the short term and trending property in the long term. Reference [1] further explored the trending/mean-reverting properties in a longer timeframe and pointed out that in the very long term, the markets mean-revert,

We provide further evidence that markets trend on the medium term (months) and mean-revert on the long term (several years). Our results bolster Black’s intuition that prices tend to be off roughly by a factor of 2, and take years to equilibrate. The story behind these results fits well with the existence of two types of behaviour in financial markets: “chartists”, who act as trend followers, and “fundamentalists”, who set in when the price is clearly out of line. Mean-reversion is a self-correcting mechanism, tempering (albeit only weakly) the exuberance of financial markets.

Such trending/mean-reverting properties exist not only in equity indices but also in bonds, FX, and commodity markets. The article concluded,

…we have provided some further evidence that markets trend on the medium term (months) and mean-revert on the long term (several years). This dovetails with Black’s intuition that prices tend to be off by a factor of two: it takes roughly six years for the price of an asset with 20 % annual volatility to vary by 50 %.

As a result, the authors recommended diversifying investment strategies, i.e. mixing trending and mean-reverting strategies. This is indeed a common practice in the industry,

From a very practical point of view, our results suggest that universal trend following strategies should be supplemented by universal “value” strategies that mean-revert on long term returns. As is well known, trend following strategies offer a hedge against market drawdowns; value strategies offer a hedge against over-exploited trends. As a consequence, we find that mixing both strategies significantly improves the profitability of the resulting portfolios.

References

[1] J. P. Bouchaud, S. Ciliberti, Y. Lempérière, A. Majewski, P. Seager, K. Sin Ronia, Black was right: Price is within a factor 2 of Value, arXiv:1711.04717

Article Source Here: Further on Trending/Mean-Reverting Properties of Stock Indices

What is Availability Bias?

In any decision-making process, bias can be significantly critical. Simply put, it is an irrational prejudice towards a specific factor. For most individuals, these include tendencies to make decisions without critical thinking or consideration. There are several biases that individuals may face during their decisions. One such bias consists of the availability bias.

What is the Availability Bias?

Availability bias is a type of heuristic that individuals face during their decisions. This bias involves the tendency to prefer readily available information. It also includes the inclination to use information that comes to an individual's mind quickly and easily. Another name used for the availability bias is the availability heuristic.

Availability bias can hamper an individual’s critical thinking skills and result in wrong decisions. It results from mental shortcuts that individuals develop over time. When individuals rely on information that they can readily think of, it is known as availability bias. It may also relate to recency bias as it is common for individuals to recall recent information.

How does Availability Bias work?

When considering various options, it is common for the mind to rely on mental shortcuts to make quick decisions. Usually, individuals rely on historical information from their memory to make such decisions. Whenever someone thinks of a situation, they may get a sudden thought related to it. In these cases, they are more likely to allow this thought to influence their decisions.

When individuals put reliance on the information that is readily available to them, it cultivates availability bias. Usually, individuals are likely to give more preference to this information and overestimate its importance. It is also possible that they think of such events repeating in the future are high. In reality, however, such circumstances may not occur, which will impact their decision-making.

For example, an investor considers investing in two different stocks. The first stock relates to the technology industry. As soon as the investor thinks of this stock, they recall a previous bad experience with similar investments. The second stock relates to the finance sector. However, the investor does not have any information related to it. Due to availability bias, the investor is likely to prefer investing in the second stock.

How can the Availability Bias influence decision-making?

The availability bias may have several unfavourable impacts on an individual's decision-making process. In essence, it leads individuals into making wrong decisions, which will have adverse outcomes. Since availability bias relies on information that individuals can easily recall, it is insufficient to make decisions. The lack of sufficient information can lead to low-quality judgments.

How to avoid the Availability Bias?

The availability bias stems from mental shortcuts that help individuals make quick decisions. However, these shortcuts do not provide the best background for decision-making. While it is crucial to understand how this bias works to avoid it, it is not sufficient to eliminate it. Usually, the availability bias may stem from several mental shortcuts going off at the same time.

Individuals must always consider all factors when making a decision. Through critical thinking and proper consideration, individuals can avoid this bias. However, this process may not be as straightforward. Individuals overly involved in a specific event are also likely to have information related to that event readily available. Therefore, distancing oneself from the decision-making process for a period may also be beneficial.

Conclusion

Biases are common in decision-making. Availability bias is a bias in which individuals put reliance on information that readily comes to their mind. This bias can hamper an individual’s decision-making ability and result in wrong decisions. However, it is possible to avoid it. With critical thinking and proper consideration, individuals can combat availability bias.

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What is Framing Bias?

When making decisions, individuals may come across various biases or heuristics. These biases can impact their decisions adversely. Usually, biases stem from pre-existing beliefs or how individuals perceive information. These biases may also have an impact on financial decisions. One such bias that may exist in finance is the framing bias.

What is the Framing Bias?

The framing bias stems from the information that individuals use to make decisions. By highlighting specific features of the presented information, individuals may perceive it differently. In other words, the framing bias comes from how an individual's decision may get influenced by how information gets presented to them.

Framing bias, also known as the framing effect, can influence individuals' decisions differently for identical scenarios. It may occur when decision-makers choose varying solutions for similar or identical problems. The only difference between both scenarios is the way the information gets presented to them. By doing so, the framing bias can significantly impact the decisions that individuals make in various circumstances.

How does the Framing Bias work?

Framing bias primarily relates to how individuals perceive information. This perception usually depends on how this information gets presented to them. For the same information presented differently, individuals may get differing insights. The framing bias can be significantly influential in any decision-making process. It can also help manipulate individuals’ perceptions of information by altering its presentation.

The framing bias may also relate to anchoring bias, which is when individuals put over-reliance on the first piece of information they receive. As both of these relate to how individuals perceive any information presented to them, they can influence each other. It may also relate to the status-quo bias, where individuals are likely to prefer default options compared to a different choice.

What is the Framing Bias in finance?

As mentioned, the framing bias also applies to investors and other financial decision-makers. Most investors come across various decisions during their activities. Similarly, they also consider several investments before choosing the best option. Sometimes, however, their perception of information may differ based on several factors. This variation in opinion constitutes framing bias.

For example, an investor considers two stocks for investing. The information presented for the first stock states that the investor has a 60% chance of making a loss. The second one shows that the investor has a 40% chance of making a profit. While both have similar probabilities, the investor is likely to consider both options differently due to framing bias. In this case, the investor will choose the second option as the first one presents a high loss percentage.

How to avoid Framing Bias?

Like any other bias or heuristic that may exist, framing bias is also avoidable. Individuals must understand what this bias is and be aware of its existence. By doing so, they can identify any instances where they may allow the presentation of information to impact their decisions. However, there are also other methods that individuals can use to protect against framing bias.

Individuals that make choices can also avoid framing bias by being aware of their decisions. The more information they have about those decisions, the more likely they are to mitigate framing bias. Giving more thought to each decision can significantly help them make well-informed choices. Similarly, individuals can consider the logic for each decision they make to avoid framing bias.

Conclusion

Biases or heuristics may exist in all areas for decision-makes. Framing bias is when individuals allow the presentation of their information to influence their decisions. In other words, it relates to how individuals get presented with information and how they perceive it. It is possible to avoid framing bias through awareness and other methods listed above.

Originally Published Here: What is Framing Bias?

What is a Sovereign Wealth Fund?

What is a Sovereign Wealth Fund?

A sovereign wealth fund represents a pool of funds owned by governments. These funds usually include any surplus reserves that countries accumulate over a period. The government may consist of both central and sub-national governments. Sovereign wealth funds include investments in foreign financial assets that follow a specific financial objective. Usually, this objective requires the highest returns possible.

There are several sources that government may use to finance sovereign wealth funds. These include trade surpluses, bank reserves, unutilized government budget funds, government transfer payments, receipts from resource exports, etc. However, sovereign wealth funds do not include every fund owned by governments. Therefore, public pension funds, central bank reserves, state-owned enterprises, etc., are not a part of it.

How does a Sovereign Wealth Fund work?

Sovereign wealth funds primarily include funds owned by the federal or national government. As mentioned, these funds may accumulate from various sources. When a government has surplus funds that it doesn't have other uses for, it may use them as sovereign wealth funds. These funds then use those reserves to invest in various asset classes, including stocks, bonds, commodities, etc.

For most governments, sovereign wealth funds include a specific purpose that they aim to achieve. As mentioned, most of the time, it will consist of maximizing the returns from investments. These funds act similar to other prevalent investments funds. Therefore, they have similar characteristics, such as risk tolerance levels, time horizons, liquidity concerns, etc.

What are the objectives of a Sovereign Wealth Fund?

There are several objectives that sovereign wealth funds may help governments achieve. Often, these may include protecting a nation's economy from any volatility that comes from trades. Some governments may also use it to fund their country's social and economic development. In some cases, governments may also use these funds to build funds for future use.

Sovereign wealth funds may also have other objectives. Overall, it is a part of a government’s political strategy. It can act as a sustainable long-term capital source for most countries. For nations involved in non-renewable commodity exports, sovereign wealth funds can be an option towards diversification. With these funds, governments aim to generate long-term returns that can benefit a country's economy.

What are the advantages and disadvantages of Sovereign Wealth Funds?

Sovereign wealth funds can have many advantages for a country. In most cases, it can help strengthen a nation's economy in times of economic downturns. Therefore, it can be beneficial in countering recession or development in a country. Sovereign wealth funds can also provide governments with an alternative income source. For countries where taxation is not enough to meet developing needs, these funds can be significantly impactful.

However, sovereign wealth funds do not guarantee income. That is a feature that is similar to any other investment fund. On top of that, how governments manage these funds can also play a substantial role in their performance. In some cases, governments may mismanage these funds and cause more harm than good. This mismanagement may also stem from a lack of transparency in governments.

Conclusion

Sovereign wealth funds are funds owned and controlled by governments rather than institutional or individual investors. Governments may use several sources to finance these funds. Usually, there are many objectives that governments can achieve by using these funds. Sovereign wealth funds can be significantly beneficial for most nations. However, they may also have some drawbacks.

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What is Risk Parity?

Investors need a diversified portfolio to mitigate any risks that come with their investments. During this process, they can use several techniques or approaches. Traditionally, most investors make decisions based on their objectives. However, investors can also build a portfolio based on their risk appetite. One approach they can use during this process is risk parity.

What is Risk Parity?

Risk parity is a strategy that investors use when constructing their portfolios. Using this approach, investors first evaluate their risks by considering several factors. For that, investors need to use the risk contribution for each asset class in relation to the overall portfolio. After that, they can establish how to allocate funds across the several asset classes in their investment portfolio.

The risk parity approach to building a portfolio relates to the Modern Portfolio Theory (MPT). MPT seeks to explain a method that investors can use to develop a diversified portfolio. This portfolio focuses on maximizing the expected returns that investors can get for a specific market risk level. Risk parity uses a similar approach by diversifying a portfolio into several asset classes based on the risks and returns of the whole portfolio.

How does Risk Parity work?

Risk parity is a portfolio management strategy that investors can use for their portfolios. It depends on leverage to help investors diversify the risks associated with their investment portfolios. It also focuses on maintaining returns at an expected level in the long run. By allowing investors to incorporate leverage, risk parity helps investors reduce their risks to achieve equity-like returns.

Risk parity focuses on leveraging a portfolio to allocate more funds towards lower-risk assets. Using this approach, we seek to deliver higher returns than investing in higher-risk assets. It also goes against other traditional asset allocation strategies. Unlike those strategies, risk parity focuses on more investments in bonds compared to stocks or equities.

By doing so, risk parity ensures that investors receive similar returns from both their equity and debt investments. However, investors usually consider their risks and return levels before making these decisions. It also goes against other asset allocation strategies that use a fixed or predetermined mix for both asset classes.

What are the advantages and disadvantages of Risk Parity?

Risk parity can be a significantly beneficial strategy for investors as it helps them minimize their returns while minimizing risks. Unlike some other traditional asset allocation strategies, risk parity considers investors' risk and return levels. By doing so, investors can identify their specific risk level and divide it across their overall portfolio to achieve better diversification.

There are several other tools that can also help investors with their objectives. One such tool is the security market line that is a graphical representation of risks and returns. By allowing investors to use leverage, risk parity can help equalize the volatility and risks that investors undertake in their portfolios.

However, there are some limitations that this strategy includes. Some experts believe that using volatility as a basis for asset allocation does not represent an appropriate risk measure. It may also leverage low-risk assets to counterbalance the risks that investors undertake with other asset classes. In some instances, it may cause a portfolio imbalance.

Conclusion

There are several approaches to constructing and managing portfolios. Risk parity is a strategy that allows investors to evaluate their risks when building their investment portfolio. It aims to achieve lower risks at higher returns. There are several advantages of using this strategy. However, it may also come with some drawbacks, as mentioned above.

 

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60/40 Stock to Bond Allocation

Building a portfolio can be a significantly challenging task for investors. Most investors only consider stock and bond investments when constructing their portfolios. This approach has historically been a safe option for investors. While it increased the rewards they received, it also provided them with a safety net for when they suffered losses.

However, it is also difficult for investors to establish an optimal mix for stocks and bonds in their portfolios. Several factors play a substantial role in what this mix should be. For example, it may depend on the investor's risk tolerance level, age, experience level, etc. Investors can also use common heuristics to establish a balanced portfolio. One such rule is the 60/40 stock to bond allocation rule.

What is 60/40 Stock to Bond Allocation?

The 60/40 stock to bond allocation rule is straightforward. When establishing a balanced portfolio, investors can use this rule to split their investments. As the name suggests, using this approach, investors must divide their portfolios into 60% stocks and 40% bonds. This approach to investing has been significantly successful historically. However, it has also had its fair share of drawbacks.

A 60/40 stock to bond allocation portfolio constitutes a high-risk portfolio. Usually, investors include 60% of stocks in their portfolios for growth. However, they also hold 40%bonds and other fixed-income securities to mitigate any specific risk. Investors usually include bonds and securities that can lower the risks associated with their particular stock investments.

How does the 60/40 Stock to Bond Allocation work?

The 60/40 stock to bond allocation technique is an approach towards determining a portfolio mix. Unlike other methods, it has a fixed ratio for allocating investments in a portfolio. As mentioned, it works by using a 60% allocation for stocks or equity instruments. The remaining percentage, 40%, goes towards bonds and other fixed-income instruments.

For example, an investor wants to allocate a portfolio of $10,000 into different asset classes. They settle at using the 60/40 stock to bond allocation technique. Using this approach, they buy stocks worth $6,000 to include in their portfolio. For the remaining amount, $4,000, they acquire various corporation and municipality bonds.

Using the 60/40 stock to bond allocation technique can be helpful. However, there are several factors that play a role in whether investors will use this ratio. Usually, they take a risk assessment to determine whether this technique can help them with their risks. In some cases, they may also opt for a different split, such as 50/50 or 40/60 stock to bond allocation.

Is the 60/40 Stock to Bond Allocation beneficial?

The 60/40 stock to bond allocation technique has been one of the favourites splits for investors. Historically, it was a preferred method for investors to distribute their funds. It can be beneficial in providing investors with protection during market or economic downturns. Similarly, it can also help them increase their returns and achieve growth.

In recent years, however, the 60/40 stock to bond allocation technique has illustrated various drawbacks. In particular, the low or slow return that investors get from their debt instruments is critical with this technique. For most investors, the optimal portfolio split ultimately comes down to their circumstances.

Conclusion

There are several techniques that investors can use when establishing a balanced portfolio. The 60/40 stock to bond allocation technique helps investors split their portfolios into stocks and bonds. With this approach, investors include 60% stocks and 40% bonds in their portfolios. While it can be beneficial, the 60/40 stock to bond allocation split has become outdated.

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120 Minus Your Age Rule

Asset allocation is a technique that helps investors distribute their portfolios into several asset classes. By doing so, it can mitigate any risks associated with a market. There are several approaches to asset allocation that investors can use. In essence, however, it involves establishing an asset mix and distributing investments accordingly.

However, establishing an asset mix may not be as simple. Usually, investors need to contemplate what split will maximize their returns while also minimizing their risks. This split will depend on investors' risk tolerance levels, time horizons, etc. However, investors can also use some rules of thumb that may help them establish an optimal portfolio mix. One such rule is the 120 minus your age rule.

What is the 120 Minus Your Age Rule?

Historically, investors have preferred the 100 minus your age rule when establishing a portfolio mix in asset allocation. Using this rule, investors subtracted their age from 100. The residual amount represented the percentage of stocks that investors must include in their portfolio mix. The remainder amount was the percentage they should invest in bonds and other securities.

However, the 100 minus your age rule was not as effective in diversifying a portfolio. On top of that, it took a conservative approach towards investing. Therefore, investors can use the 120 minus your age rule to get better results. This rule is also similar to the 100 minus your age rule. However, instead of subtracting an investor’s age from 100, they deduct it from 120.

How does the 120 Minus Your Age Rule work?

The 120 minus your age rule works similarly to the 100 minus your age rule. With this approach, investors subtract their age from the number 120. The residual amount represents the percentage of their portfolio that must include investment in stocks. The remaining portion will consist of bonds or other securities. This rule can be significantly helpful in asset allocation.

For example, an investor aged 25 wants to establish the percentage of their portfolio that must constitute stocks. Using the 100 minus your age rule, the investor must include 75% (100 - 25) stocks in their portfolio. However, with the 120 minus your age rule, their portfolio must consist of at least 95% (120 - 25) of stocks. Using this rule, they can take more risks and drive their bar up by 20%.

Does the 120 Minus Your Age Rule work?

The 120 minus your age rule is a rule of thumb or, simply, a heuristic. It can be helpful for confused investors who want to establish a portfolio mix. However, it is not a scientific or proved approach towards success. It only serves to provide investors with a base using which they can develop their own optimal mix.

The effectiveness of such rules also depends on other factors. For example, while investors can use it to establish their portfolio mix, their success will come from the stocks they choose. For example, an investor includes 90% of stocks in their portfolio. However, if they invest in relatively low-risk stocks, their rewards will be lower.

Conclusion

Asset allocation can be a great tool for establishing a diversified portfolio. However, it may be difficult for investors to determine an optimal portfolio mix. Using the 120 minus your age rule, they can establish the percentage of stocks they must include in their portfolio. While it can be significantly helpful, its success depends on how investors use it.

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Can Dividend Yield Be Negative?

We previously discussed implied dividend yield and how to extract it from traded financial instruments. Given that dividend is considered a cash payment the shareholder receives when holding a stock, naturally one would think that dividend yield can only be zero or positive. We recently, however,  worked with a client whose implied dividend yield is negative. What does this mean?

In most of the equity derivative pricing models, the number of outstanding shares is treated as a constant. Reference [1], however, incorporated the number of shares as a variable within the context of dilution and stock buyback. It pointed out that stock buyback is viewed as providing a synthetic positive dividend yield, whereas dilution provides a synthetic negative dividend yield.

Our paper is one of the first to provide a theoretical link between payout policy and the pricing of listed derivatives. We have seen that dilutions can be viewed as synthetic negative dividends and buybacks as synthetic positive dividends. Options on equity are dilution protected, and for highly levered firms, they may be more valuable than equity itself. We have seen that dilutions and buybacks can cause the stock price distribution to dramatically depart from the shape of the equity distribution, and that prices of stock-based claims can, therefore, differ from prices of claims based on total equity.

That explains why we obtained an implied negative dividend for our client. They are an airline that suffered economic losses during the pandemic and needed to raise working capital by issuing a convertible bond through a private placement. The conversion of the convertible bond would dilute the outstanding shares up to 13%, which is a large number.

The article also established a relationship between the dilution effect and leverage of a firm. Dilution has a smaller effect in low-leverage firms than in high-leverage ones.

For low leverage, there are few dilutions and the percentage differences are very small, except at very low strikes. The difference increases with leverage, as large coupon payments cause more dilution, making call stock options cheaper and put stock options more expensive relative to their equity counterparts.

References

[1]  Backwell, Alex and McWalter, Thomas and Ritchken, Peter H., On Buybacks, Dilutions, Dividends, and the Pricing of Stock-Based Claims (2019). https://ssrn.com/abstract=3422692

Originally Published Here: Can Dividend Yield Be Negative?

Liability-Relative Asset Allocation

Asset allocation has long been one of the favourite tools for investors that want a diversified portfolio. With this technique, investors can divide their investments into various asset classes. These asset classes have different markets and characteristics. It limits investors' losses when one of the markets in which they own assets goes into a downfall.

Asset allocation can be significantly helpful for investors. However, the traditional approach to this technique may not be as effective for every investor. There are several other variations of asset allocation that allow investors to customize their portfolios accordingly. One such approach that is relatively uncommon is liability-relative asset allocation.

What is Liability-Relative Asset Allocation?

With the traditional asset allocation approach, investors divide their portfolios into various asset classes. Usually, they have an objective based on which they allocate their investments into a specific portfolio mix. However, some investors may want to focus their asset allocation approach based on their liabilities. This approach is most common among pension funds or insurance agencies.

With liability-relative asset allocation, investors can manage their assets to reduce any risks associated with failure to repay liabilities. Usually, pension fund managers use it to choose assets that meet the objectives set to meet their liabilities. Another name used for liability-relative asset allocation is asset-liability management. It goes against the traditional asset-only strategic allocation techniques.

With Liability-relative asset allocation, investors can consider both their assets and liabilities. Usually, they net both of these to calculate whether they have a surplus or deficit of assets. With this approach, investors aim to manage their surplus or deficit to ensure they have enough assets to pay off future obligations. Therefore, they usually incorporate liabilities as a separate asset class when considering the portfolio mix.

How does Liability-Relative Asset Allocation work?

As mentioned, liability-relative asset allocation is prevalent among pension funds. These funds have liabilities that they need to pay off in the future. Liability-relative asset allocation works by defining the liabilities first. These liabilities dictate the asset allocation ratio used by these funds. It, in turn, influences the risks needed to support these liabilities.

Pension fund managers also need to consider the time value of money when estimating their liabilities. Therefore, they use the present value of all their obligations. Once they determine those, managers can establish a funding ratio. Based on this ratio, they can divide their assets into various asset classes. On top of this, the surplus or deficit calculated by the manager will also impact the asset allocation used.

Overall, with the liability-relative asset allocation approach, managers can hedge the risks associated with their funds. Therefore, it involves building a portfolio that recognizes those risks and reacting to them accordingly. Managers use their identified risks to decide on the assets they want to include in their portfolios. As mentioned, these assets need to correlate with the fund's liabilities for liability-relative asset allocation to be effective.

Conclusion

Liability-relative asset allocation is a variation of the traditional asset allocation technique to investing. It is most prevalent among pension funds and insurance companies. Using this approach, fund managers must first identify their liabilities. Once they do so, they identify assets that can help the fund in meeting its obligations. Overall, it allows managers to hedge the risks associated with their funds.

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What is Rebalancing a Portfolio?

Diversification in a portfolio is crucial for investors. It can not only help them reduce their risks but can also increase their returns. There are several strategies that can help them achieve this goal. Most simply, investors can diversify within their asset class. However, that does not reduce their exposure to specific risks. For that, investors may need to use an asset allocation strategy.

What is Asset Allocation?

Asset allocation is an investment strategy through which investors include investments from several asset classes in their portfolios. This strategy is highly beneficial for protecting investors against unsystematic risks that are specific to an asset class. Usually, investors may divide their investments into equities, fixed-income instruments, or cash and cash equivalents.

Investors need to employ an asset allocation that caters to their needs. For that, they need to determine a portfolio mix. This mix establishes the division of their funds into different asset classes. Over time, each investment will earn varying returns. Therefore, the weighted mix of each asset class may differ after a specific time. In these cases, investors will need to consider rebalancing their portfolios.

What is Rebalancing a Portfolio?

As mentioned, investors will establish a portfolio mix that defines how much they invest in each asset class. In some cases, however, this mix may change over time. Therefore, investors will need to rebalance their portfolios. Rebalancing a portfolio is a process that allows investors to buy or sell assets within their portfolio to revert to their original portfolio mix.

Rebalancing a portfolio is crucial for investors to stick to their intended portfolio mix. The portfolio mix does not change due to changes in the assets within a portfolio only. Investors can also rebalance their portfolios when their risk tolerance levels or overall investment strategy changes. Due to any of these reasons, investors may choose to rebalance their portfolios.

How does Rebalancing a Portfolio work?

Portfolio rebalancing allows investors to restructure their portfolios due to any of the reasons stated above. It is a part of the asset allocation strategy that investors use to protect themselves through diversification. Usually, investors have a defined portfolio mix that is a part of this strategy. However, when this mix changes, investors will need to reestablish the original mix.

For that, investors need to work out which asset classes exceed their required limit. Once they do so, they will sell enough assets from that class to revert to the required limit. Similarly, they can also identify asset classes that are below the expected weight. For these classes, investors will buy more assets to raise the mix to the required limit.

What is the importance of Rebalancing a Portfolio?

Investors can get several benefits by rebalancing their portfolios. Asset allocation strategy primarily focuses on diversifying investors' risks. For that, their portfolio must include an optimal mix of assets from various asset classes. Portfolio rebalancing can help them reestablish that mix when things change.

Portfolio rebalancing can help investors reduce their portfolio risks. Investors can either use this strategy after a specific time interval or when their portfolio becomes unbalanced. It also compels investors to sell their investments when they are at a high point and buy low ones. In the long run, portfolio rebalancing helps investors focus on long-term goals.

Conclusion

Asset allocation is an investment strategy that allows investors to diversify their portfolios. It does so by dividing their portfolios into various asset classes established through a mix. However, this mix may change due to various reasons. For that reason, investors will need to rebalance their portfolios. Portfolio rebalancing is a technique used by investors to bring their portfolios back to their established portfolio mix.

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What is Dynamic Asset Allocation?

Investors need to consider various factors when making decisions about their investments. However, two of the most critical factors among these include the risks and rewards investors can get. These factors often take priority over others. Risks and rewards usually have a direct relationship with each other. The higher the risks that investors take, the higher the rewards will be.

While investors would always prefer maximum returns, they may not be willing to maximize their risks. Therefore, investors usually use investment strategies to strike a balance between both of these. On top of that, investors also need to diversify their risks to ensure they don’t suffer from high unsystematic risks. For that, investors will need to use investment strategies, one of which is dynamic asset allocation.

What is Dynamic Asset Allocation?

Dynamic asset allocation is an investment strategy that comes from the asset allocation strategy. Using asset allocation, investors divide their portfolio into several asset classes, including equities, debts, cash, commodities, etc. Usually, they use a fixed proportion for each asset class within their portfolio. However, dynamic asset allocation does not rely on fixed proportions.

Instead, dynamic asset allocation uses frequent adjustments to alter the mix of these asset classes. The primary factor in deciding the mix using this strategy is a specific asset class's performance in the market. When an asset class performs well, dynamic asset allocation focuses on adjusting the portfolio mix to include more assets from that class.

How does Dynamic Asset Allocation work?

Dynamic asset allocation works similarly to the asset allocation strategy. Investors divide their portfolios into several asset classes to diversify against unsystematic risk. However, by doing so, investors may lose potential rewards from asset classes that perform well. Therefore, dynamic asset allocation takes that point into consideration.

Dynamic asset allocation also involves dividing an investor's portfolio into several asset classes. However, when a specific class performs well in the market, this strategy adjusts the portfolio to include more assets from that class. Once the market settles down, dynamic asset allocation identifies any changes in the market. Then it helps investors readjust their portfolio accordingly.

Dynamic asset allocation does not use the standard static approach used by asset allocation. For that reason, it allows investors to react to the changing risks in the market. However, it does come with an additional cost of requiring active management. Unlike asset allocation, investors need to survey the market and measure risks continuously. According to that review, they must react to any changes in risks and rewards.

What are the advantages and disadvantages of Dynamic Asset Allocation?

With dynamic asset allocation, investors can get several advantages. Most importantly, it allows investors to adjust their portfolios according to fluctuations in risk. This way, they can minimize their risks while also maximizing their returns. This approach takes a reactive approach to market risks, which can allow investors to avoid substantial losses.

However, dynamic asset allocation comes with some additional costs. As mentioned, the most important of these is the time and resources required to manage portfolios actively. Since it does not take a passive approach to investing, it may be more costly. Similarly, investors changing their portfolio mix constantly also have to suffer from the related transaction costs.

Conclusion

Dynamic asset allocation takes an active approach to managing portfolios. It is based on asset allocation in which investors divide their portfolios into several asset classes. Unlike asset allocation, however, dynamic asset allocation is not static. It also involves dividing portfolios into several asset classes. However, it also requires investors to alter the portfolio mix based on risk fluctuations in the market.

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Longevity Risk in Pension Funds

Pension funds refer to investment pools that include funds for retirees. These funds primarily come from an employee who saves for their future. In some cases, employers may also contribute on the employee's behalf. A fund manager then manages these funds and invests them to achieve a specific goal. During this process, the pension funds will face various risks. One of these risks includes longevity risk.

What is Longevity Risk in Pension Funds?

Pension funds face longevity risk for all pensioners. Usually, each pension fund estimates the life expectancies of the pensioners. Based on that estimation, they make decisions. Longevity risk is when the life expectancies of the pensioners exceed the predicted rates by the pension funds. In other words, when retirees live longer than estimated, it constitutes a longevity risk.

Longevity risk in pension funds can be significantly detrimental to the funds. It can lead to increased costs in the form of higher pension payments. When the life expectancy of pensioners is low, the longevity risk will also be low. However, once this expectancy grows, the longevity risk in pension funds also increases. The number of retirees reaching retirement age also contributes to this risk. However, higher mortality rates can decrease this risk.

How does Longevity Risk in Pension Funds work?

Pension funds may have hundreds of pensioners or policyholders. Usually, the higher this number is, the higher the future costs for the pension funds will be. Similarly, employees reaching retirement age will also contribute to the pension funds costs. The longer retirees collect pension payments, the more these funds have to pay them.

Pension funds usually forecast the costs associated with these payments. For that, these funds consider various factors, one of which is the pensioners’ life expectancy. The longer pensioners live past their retirement age, the higher the costs for the pension funds will be. Therefore, longevity risk is when pensioners’ life expectancy exceeds the expected rate by the pension funds.

As mentioned, pension funds seek to forecast their payments to pensioners. However, when the life expectancy rate exceeds the predicted amount, the payout levels for pension funds will increase. But there are also other factors that may impact the longevity risk for pension funds. One of these includes the type of pension funds. Usually, defined-benefit pension funds have the maximum exposure to longevity risk.

How can Pension Funds manage Longevity Risk?

Longevity risk can be detrimental to pension funds. As mentioned, these risks can significantly increase the payout level, which results in added costs. However, pension funds can still manage longevity risk. The most common technique used by pension funds to do so is to transfer the risk. Usually, pension funds use various instruments to manage this risk.

These instruments may include longevity swap transactions or annuities. Pension funds can also use reinsurance as a way to mitigate longevity risk. However, transferring these risks will also come with additional costs. While pension funds can predict life expectancy rates, it is not possible to get accurate predictions. Therefore, these funds must consider whether it would be feasible to transfer these risks.

Conclusion

Pension funds face various risks, including longevity risk. These funds usually estimate their payout costs based on several factors. Among these, a critical factor includes pensioners' life expectancy rates. If these rates exceed the expected level, the longevity risk in pension funds will be high. However, pensions funds can still manage these risks in various ways.

Originally Published Here: Longevity Risk in Pension Funds

Goals-Based Investing

When investing, every investor has an objective in mind. Usually, this objective differs for each investor based on several factors. These factors may include an investor's time horizon, funds available, risk tolerance, etc. Based on each investor’s objective, the investment strategy will differ. One of the strategies that investors can use for this purpose is a goals-based investing strategy.

What is Goals-Based Investing?

Goals-based investing (GBI) is a term used to describe an investment strategy that relates to investors' objectives. As mentioned, each investor will have different investing goals, and, therefore, this strategy will vary accordingly. Investors can link their income and investments with an objective that will seek to streamline their investing strategy.

Investors can use goals-based investing to achieve their life or financial goals. They can also hire a wealth manager to take care of their investments based on the defined objectives. With this investing strategy, investors do not usually focus on wealth maximization unless that is their goal. Instead, GBI works towards achieving the specific goals or objectives that investors have.

How does Goals-Based Investing work?

Goals-based investing does not work similarly to other investing strategies. As mentioned, most other investing strategies focus on maximizing the investor's wealth. Instead, GBI seeks to meet a defined goal. In most circumstances, this goal will be a personal or financial goal that investors seek to achieve. Therefore, most techniques used in other investment strategies may not apply to GBI.

With goals-based investing, the benchmark for success also differs. This benchmark tracks how well the investor or manager achieves the objectives for the investment. GBI also allows investors to pursue several goals. On top of that, it can help investors rank or prioritize specific objectives over others. For example, goals-based investing may be a feasible option for parents who want to put their kids through college.

How can investors use Goal-Based Investing?

There are several steps involved in using goal-based investing for investment needs. The first step during the process is for investors to establish the funds needed for the objective. Similarly, they need to determine the time frame for the goal. These goals can be short-, medium- or long-term. Based on both these factors, investors can establish their investment requirements.

Once investors establish the timeframe and fund requirements, they must estimate the present cost. As mentioned, investors should have an idea of this cost based on their calculations. However, they will also need to adjust it for any expected changes, such as inflation. Once they do so, investors must also measure their future costs. This process may require them to speculate or predict future outcomes. All of these steps need to be accurate to provide the best results.

Based on all this information, investors can start investing through a goal-based investing strategy. Investors can then start making contributions to their plan through their income or savings. Similarly, they will need to choose the right investments that can help them achieve their goals. Practically, it may require investors to choose various investments to reach their objectives.

Conclusion

For most investors, the primary goal of investing is wealth maximization. However, some investors may also have other objectives in mind. For that, they can use a goal-based investing strategy. GBI is an investment strategy that focuses on achieving investors’ goals. There are several steps involved in ensuring this strategy provides the maximum benefits for users.

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Liability Driven Investing (LDI)

An investment strategy includes a set of rules or principles that investors use to achieve their goals. Usually, investors have investment strategies for their portfolios to help them maximize returns while also minimizing risks. There are several factors that an investment strategy may consider. These include the investor’s goals, risk tolerance, time horizon, etc.

There are several investment strategies from which investors can choose. These strategies don’t relate to individual investors only. It may also be beneficial to institutional investors, such as pension funds, mutual funds, etc. One common investment strategy used by pension funds is liability-driven investing or liability-driven investing.

What is Liability Driven Investing?

The term liability-driven investing (LDI) refers to an investment strategy. With this investment strategy, investors try to obtain enough assets to cover all their liabilities, whether current or future. As mentioned, a liability-driven investing strategy is most common in pension plans, specifically defined-benefit schemes. With these plans, the liabilities can significantly increase over time. Therefore, having enough assets to cover those liabilities is crucial.

Investors using the liability-driven investing strategy must estimate their current and future liabilities. Once they do so, they can work towards obtaining assets that can cover all those liabilities. For that, investors need to use asset management and allocation techniques. LDI is beneficial when investors don't want to focus on beating a benchmark. Instead, it helps them improve their portfolios, which in this case will be the pension plan.

Why do investors use Liability Driven Investing?

The liability-driven investment focuses on stabilizing the underlying plans. Therefore, it seeks to minimize the risks and uncertainty associated with it. With defined-benefit plans, the benefits are predetermined. Therefore, investors can easily predict their current and future liabilities. However, the uncertainty comes with the contributions made to the plan.

With liability-driven investing, investors can focus on reducing the unpredictability of contributions made to the plan. It also seeks to minimize the impact of market fluctuations that cause uncertainty. For that, investors will need to match the interest rate sensitivity of a plan’s assets to its liabilities. Overall, investors can reduce the volatility of future contributions to a defined-benefit plan using the LDI strategy.

For individual investors, the liability-driven investing strategy can also be beneficial. For example, pensioners can use this approach to estimate their total income requirements for the future. They can then deduct any expected income in the future from this amount. The residual value will constitute their liabilities for the liability-driven investing strategy. Pensioners can then make investments to generate returns that meet these liabilities.

What is an example of Liability Driven Investing?

A retiree estimates they will need $15,000 annual income to meet their basic needs. However, they also expect to receive $10,000 from multiple sources, including Social Security and pension income. Nonetheless, it still leaves $5,000, which they must fulfill from other sources. Using LDI, the retiree needs to invest in an asset that will provide at least $5,000 annual income.

Conclusion

Liability-driven investing is an investment strategy through which investors can focus on collecting assets to meet their liabilities. This strategy is most common for defined-benefit plans. However, it is also beneficial for individual investors. Liability-driven investing can help investors minimize their risks and focus on reducing unpredictability.

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Cyclically Adjusted P/E Ratio (CAPE)

The P/E ratio is one of the most critical ratios for investors. It represents the ratio between a stock's price and the underlying company's earnings per share. This way, it helps investors can make decisions about their investments. However, the traditional P/E ratio may not provide information about a company's historical performance. For that, investors may use the cyclically-adjusted P/E ratio.

What is the Cyclically Adjusted P/E Ratio?

The cyclically-adjusted P/E (CAPE) ratio represents the ratio between a company’s stock price and its average earnings for the last ten years. Investors have to adjust these earnings for inflation before using them in the CAPE ratio. Therefore, it measures a company's real earnings per share over a given 10-year period. Using these earnings, investors can adjust for any fluctuations in financial performance caused by a nation's business cycle.

Other names used for the cyclically-adjusted P/E ratio include the Shiller Ratio and the PE 10 Ratio. The CAPE ratio can help investors gauge a company’s financial performance over several periods barring business cycle impacts. Therefore, it accounts for any fluctuations in a company’s profits due to economic expansions or recessions. Using this information, investors can ultimately decide whether a stock is undervalued or overvalued.

How to calculate the Cyclically Adjusted P/E Ratio?

As mentioned, the cyclically-adjusted P/E ratio is the ratio between a company’s stock price and real earnings for ten years. Therefore, the formula for the CAPE ratio is as below.

CAPE Ratio = Company’s stock price /Average earnings for ten years adjusted for inflation

A company's stock price is usually available through the stock market. For private companies, however, it may be challenging to calculate it. On the other hand, the average 10-year real earnings may also require investors to perform some analysis. Once done, however, it should allow smooth out the impact of business cycles on a company's financial performance.

How can investors use the Cyclically Adjusted P/E Ratio?

Investors can use the cyclically adjusted P/E ratio to measure a company's performance over a long period. Usually, the P/E ratio considers current or short-term results. Therefore, it may not be an indicator of a company's long-term performance. The cyclically adjusted P/E ratio solves that issue by considering the company's earnings for ten years. However, it also adjusts for any inflation during the period to account for business cycle impacts.

Investors can also use the CAPE ratio to forecast a company's future earnings. However, they shouldn't use this tool on its own. Overall, the CAPE ratio can allow investors to identify stocks that are undervalued or overvalued. When the calculated CAPE ratio for a company is significantly high, it may indicate its stocks are overvalued. On the other hand, low CAPE ratios indicate undervalued stocks.

Cyclically adjusted P/E ratios also play a significant role in identifying market bubbles. In this case, the P/E ratio may not be helpful. However, by calculating the ratio between a stock's price and its 10-year earnings, investors can get better results. A criticism of the CAPE ratio may include not adjusting for changes in accounting policies or standards. Investors should be aware of it when using the ratio.

Conclusion

The P/E ratio is one of the investors' favourite ratios to use when analyzing various stocks. However, it may not provide accurate information about a company's historical performance. For that, investors may use the cyclically-adjusted ratio. This ratio considers a company's stock price in relation to its earnings for ten years adjusted for inflation.

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Does Government Spending Cause Inflation?

Inflation is an increase in the price of goods and services in a nation over time. It also represents the decrease in the purchasing power of a nation's currency. Inflation can have a positive impact on economic activity. However, there are some cases in which it can also be detrimental. There are several causes of inflation. One of these may include government spending, which influences aggregate demand.

What is Government Spending?

Government spending represents any money the government spends on acquiring goods and services. The government, in this case, refers to the public sector as a whole. Therefore, government spending includes any money spent on healthcare, justice, education, etc. It constitutes a critical aspect of a nation's fiscal policy used to support its economic goals.

There are several factors that governments will try to target with government spending. However, this spending is crucial in keeping a nation's economy active. It is also a part of a government's policy to use spending to shape the economy. Usually, governments use taxpayer payments to fund these policies. In some cases, however, they may also obtain loans for spending.

How does Government Spending work?

Every government has policies to support future economic growth or stability. For that reason, governments will invest in various fields. Government spending can be a critical economic policy tool that governments can use to fulfill that purpose. As mentioned, it is a part of a nation's fiscal policy, which is a combination of government spending and tax policies.

Governments can use government spending in one of two ways. The first includes increasing government spending while decreasing taxes. It is a part of a nation’s expansionary fiscal policy, which governments can use to stimulate the economy during recessions. It may also include decreasing government spending and increasing taxes. These are a part of a nation’s contractionary fiscal policy. This policy is beneficial in cooling the economy down during economic booms.

Does Government Spending cause inflation?

As mentioned, governments may use fiscal policy in one of two ways. During expansionary fiscal policy, governments use government spending to stimulate economic growth. Governments usually spend on acquiring goods and services. By doing so, governments can increase the aggregate demand in the economy. This policy also causes the prices of goods and services in an economy to grow, known as inflation.

The formula for aggregate demand also considers government spending on public goods and services. Therefore, it plays a significant role in influencing the demand in a nation. As mentioned, during expansionary fiscal policies, government spending increases. This increase can then lead to inflation. For contractionary fiscal policies, the opposite may apply.

However, the above connection between government spending and inflation is theoretical. In practical situations, there is no established direct connection between the two. In some cases, an increase in a nation’s government spending has adversely influenced inflation. On top of that, there are several other factors that may play a role in determining the impact of government spending on inflation. One of these includes the source of government spending.

Conclusion

Government spending refers to the money governments spend on acquiring public goods and services. There are several ways in which governments can fund it. Governments can use government spending during the expansionary fiscal policy to increase aggregate demand. It, in turn, may cause inflation in an economy. Practically, however, there is no established direct connection between inflation and government spending.

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