What is the Sortino Ratio

If you want to invest in something, you should not only think about the rate of return. It is better to also think about the risk. The risk can be high or low. It refers to how different an asset's or security's financial performance will be than what is expected.

Unfortunately, many performance metrics do not account for the variation in risk of investing. They calculate how much money they will make.

But when it comes to the Sortino ratio, it has a different way that it is calculated. The indicator is looking at changes in the risk-free rate. That way, investors can make better-informed decisions. It becomes really helpful because it helps investors to reduce the risk.

In this article, we are going to look at what the Sortino ratio is, how it works and why it is different from other performance measures.

What is the Sortino Ratio

The term "Sortino" was named after Frank Sortino, who was a former head of the Quantitative research group at Bell Investment. He was a pioneer in promoting a risk-adjusted return.

So what is this ratio

The Sortino ratio is different from other ratios because it focuses on downside risk instead of the overall return. It measures how well the investment does in regards to the risks that are involved. That makes it a valuable tool for investors who want to reduce risk in their portfolios.

The formula for the Sortino ratio is as follows

Sortino Ratio = (Average Realized Return - Expected rate of Return) / Downside Risk

How does the Sortino Ratio work

To calculate the Sortino ratio, you will need to know what is called the downside deviation. This is how much an investment will vary from its expected value regarding risk. It can be expressed as a negative number.

The downside deviation is not always possible to know exactly because it will require having specific market data at hand. It is also difficult to measure because there are many different ways that it can be presented over a certain period.

What the Sortino Ratio does is to decrease this downside deviation by focusing on high, positive returns. That way, you will get a ratio that is increasing whenever a portfolio's performance actions move more advantageously.

What makes the Sortino Ratio different from other ratios

Some factors make the Sortino ratio different from other performance measures.

The first is that it reduces the effects of volatility on returns. The traditional way of measuring an investment's success was to look at its return over a certain year, which can be misleading because there can be negative returns. But by subtracting this downside risk and focusing on positive returns, the investor can get a more accurate picture.

Another thing is that it helps in identifying periods when investments are doing well regarding risk. This gives investors an idea of when they will need to reduce risk in their portfolios or limit losses. It also shows you what impact different market conditions have on your portfolio's performance.

The last factor is that it has a great way of benchmarking. It can compare how well an investment or portfolio is doing against another that uses different return and risk criteria.

Why use the Sortino Ratio

There are several reasons why you should think about using the Sortino ratio for your investments. Here are they:

1. It helps in assessing risk and returns

The Sortino ratio is a great way to compare an investment's return and its downside risks. That makes it easier to determine whether the investment is good for you or not.

2. It's useful when making decisions

It will help you make important decisions about your portfolio, such as switching out investments that are bad performers. It will also help you make other certain adjustments to make sure that your portfolio can improve its overall performance.

3. It's a great way to compare investments

The Sortino ratio is especially useful for investors who want to compare different types of investment portfolios with each other. You can use it as an initial step when investing and it will help you know what kind of risks the investment is involved in.

Conclusion

The Sortino ratio provides investors with a more accurate way of measuring investment performance. It helps in assessing how well an investment is doing regarding its risk factors and it can be very useful when making other decisions about your portfolio.

Article Source Here: What is the Sortino Ratio

How Liquidity of Stock Affects Its Future Expected Return

The liquidity of a stock is of concern to traders who want to execute a large order at reasonable prices without making a big impact on the market. A stock liquidity level is, however, also a factor influencing the stock expected return. Along this line, Reference [1] examined how a stock’s liquidity volatility affects its future performance.

Chordia et al. (2001) find an interesting and puzzling result that the volatility of turnover ratio is negatively related to subsequent stock returns in the U.S. market. We extend the analysis to 43 global equity markets, and test this liquidity-volatility-return relationship using not only the turnover ratio but also other liquidity measures such as the Amihud illiquidity ratio and the percentage of zero-return days. We find that the negative premium of liquidity volatility is not limited to the U.S. market or a particular liquidity measure. Instead, it is robust in the majority of global equity markets and across different liquidity measures, and holds up to the inclusion of additional controls such as the idiosyncratic return volatility.

In other words, the article pointed out that the negative volatility premium is a universal phenomenon that occurs in the majority of global equity markets and across different liquidity measures.  Practically speaking, when a stock's liquidity decreases, it will likely decline in the following months.

Consistent with the literature, we show that liquidity decrease has much stronger impact on the next-month stock returns than liquidity increase, because of the collateral-constraint effect as proposed by Brunnermeier and Pedersen (2009) and others. Hence, for a stock with high liquidity volatility, it is more likely to have a large price decline following a large magnitude of liquidity decrease, and such large price decline cannot be fully offset by the price appreciation even following the same magnitude of liquidity increase because of the asymmetric pattern mentioned above.

In summary, a stock's liquidity is important not only because of the issues associated with the order execution but also because it affects the future performance of the stock. Therefore, fund managers should take liquidity into consideration when constructing investment portfolios.

References

[1] Feng, Frank Yulin and Kang, Wenjin and Zhang, Huiping, Liquidity Shocks and the Negative Premium of Liquidity Volatility Around the World (2021). https://ssrn.com/abstract=3930591

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Bermudan Option: Definition, Example, Pricing

An option is a contract that provides its holder with the right to buy or sell an underlying asset or security. It involves a specific price before or on a predetermined date. However, it does not obligate them to do so. There are several option styles, which represent the class into which an option falls.

Usually, the dates on which holders can exercise the option define its style. The most prevalent of these include American and European options. However, investors can also acquire less common exercise rights. One of these is the Bermudan option, which combines the characteristics of both of the above.

What is a Bermudan Option?

A Bermudan option is an option that gives the holder the right to exercise a set number of times. These options fall between European and American options. Usually, European options only allow the holder to exercise at the expiration date. On the other hand, American options provide the right to exercise at any time. Bermudan options do not have the right to exercise at expiration or any time. Instead, they allow holders to exercise several set dates.

A Bermudan option differs from the traditional options and, therefore, falls under exotic options. It comes with predetermined dates, which are when the holder can exercise the option. Usually, these dates come after regular intervals, for example, on a specific day each month. Apart from this, Bermudan options have the same features as other options.

Bermudan options allow investors to buy or sell an underlying asset or security at a preset price. However, it does not specify a single date or allow exercise at any time. Instead, it sets several dates along the expiration date to exercise. These exercise dates fall close to the option's expiration date. Due to these features, Bermudan options fall between American and European options.

Example

An investor purchases a company's stocks for $100. However, they are unsure whether the stock's price will decrease in the future. Therefore, they acquire a Bermudan put option with an expiry of a year. This option protects the investor from a decrease in the stock's price below $95 for the year. Similarly, it contains a feature to exercise on the fifth of each month after the 8^th month.

The Bermudan option provides the investor with various benefits. Firstly, it allows them to stay protected against any price falling beneath $95. Similarly, it provides them with the opportunity to sell the stock at the exercise price on the fifth of each month. Regardless of how much the stock's worth will be at the time, investors can use the option to gain benefits.

What is the pricing of Bermudan Options?

The pricing of Bermudan options introduces various challenges. These challenges stem from the several set of dates that these options define. In this regard, Bermudan options are similar to American options. Unlike European options, both of these options pose challenges when it comes to pricing. However, several techniques can help determine the value of Bermudan options.

Bermudan options can be valued by using the Binomial Tree approach.  Analysts can also use a Monte-Carlo framework to value Bermudan options. However, it will not take the traditional approach to evaluate options that require the value of the options. Instead, it involves an optimal exercise strategy. There are several approaches that analysts can take when using Monte Carlo simulations for evaluating Bermudan options.

One approach to pricing Bermudan options is the dynamic programming approach. With this approach, the option value for each set date becomes the maximum of the payoff associated with immediate exercise. This value is known as the intrinsic value. It also involves determining the continuation value, although this process is more challenging.

Conclusion

An option provides the holder with the right to buy or sell an underlying asset or security at a specific price at or during a predetermined time. Bermudan options allow the holder to exercise on a set of specified dates, usually at regular intervals. The pricing of Bermudan options is a challenging process. There are several methods that analysts may use for this process.

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Return over Maximum Drawdown

In the hedge fund industry, return over maximum drawdown is the best measure of how well the fund manager has managed risks. It measures the average return of a portfolio over its worst loss, or "maximum drawdown."

This is a relatively new indicator for managers to track and compare since the industry only started tracking this statistic in the 1990s. The drawdown must be observed from the peak profit or peak value of equity. A drawback of the return over maximum drawdown metric is that it does not directly measure how profitable returns are, but rather measures how well a hedge fund has managed risks.

So now let's find out what is "Return over Maximum Drawdown".

What is the Return over Maximum Drawdown

Return over maximum drawdown is a risk metric used in the hedge fund industry, which measures how well the fund managers have managed risk. It measures the average return of an investment over its worst loss since the beginning of the period under consideration. The drawdown must be calculated from the peak value or peak profit.

How to calculate the Return over Maximum Drawdown

To calculate the return over maximum drawdown, start by getting the average return on investment. Then, get its worst loss or maximum drawdown. Next, divide the two to find the return over maximum drawdown. The drawback to this measurement is that it only measures how well an investment manager has managed risks and does not directly measure how profitable returns are.

For example, imagine that an investment has a -15% maximum drawdown and averages +25.2%. Return over maximum drawdown would be 25.2% /15% = 1.68

In this example, the return of investment is higher than its worst loss or maximum drawdown, which means it had a good risk management system compared to other investments.

Benefits of Return over Maximum Drawdown

The main benefit of return over maximum drawdown is that it's a relatively new measure used in the hedge fund industry, which first started tracking this statistic in the 1990s. Many investors use the return over maximum drawdown to compare how different investment managers manage risks. Here are some benefits of Return over Maximum Drawdown:

1. It's a relatively new measure, so it has only been tracked in the hedge fund industry since the 1990s.
2. Good risk management is best measured by return over maximum drawdown because it measures how well an investment manager has managed risk, rather than the profitability of returns.
3. Return over maximum drawdown can be used to compare investments and compare how different investment managers manage risk.
4. Return over maximum drawdown can be used as a benchmark for performance since it is a relatively new performance metric.

Drawbacks of Return over Maximum Drawdown

There are some drawbacks of the Return over maximum drawdown

1. It is only a measure of risk and does not directly measure profitability even though it can be used as a benchmark for performance.
2. In order to use the return over maximum drawdown, there must be at least 12 months of historical data available to calculate statistics.
3. Return over maximum drawdown becomes less reliable at the extremes of the range, which makes it difficult to use for very risky or very safe investments.

Conclusion

Return over maximum drawdown is a risk metric used in the hedge fund industry, which measures how well investment managers have managed risk. It measures the average return of an investment over its worst loss since the beginning of the period under consideration. The drawback to this measurement is that it only measures how well an investment manager has managed risk and does not directly measure how profitable returns are. Return over maximum drawdown can be used to compare investments and to measure performance, but it does not directly measure profitability.

Originally Published Here: Return over Maximum Drawdown

Econometrics With R, Python and MATLAB

What is Econometrics?

Econometrics is a field in economics that applies statistical and mathematical methods to economic theories. It has become more relevant over the years as it helps economists quantify their economic theories and hypotheses. Econometrics helps economists test those theories by using statistical tools with mathematical equations. Therefore, it has become a crucial part of economic policymaking.

Econometrics usually involves establishing relationships between various economic variables. For that, economists use mathematical and statistical methods. Usually, economists must perform multiple calculations using complex models. Some economists use programming languages and other tools to expedite the process. These may include R, Python and MATLAB.

What is “R”?

"R" is a programming language that economists use for statistical computing and graphical representation. It offers an extensive list of statistical and graphical techniques. These include machine learning algorithms, time series, statistical inference, linear regression, etc. Furthermore, these are all tools that are an essential part of econometrics. Apart from econometrics, R is also prevalently used in other fields.

R is one of the most popular languages used by statisticians, researchers, analysts, and economists. Through it, they can extract, filter, analyze, visualize and present the data. It is also free to use and open-source, making it more accessible. It is among the top ten popular programming languages in the world. R has existed since the ‘90s but has gained popularity recently for its extensive features and runtime environment.

Base R contains a lot of functionality useful for econometrics, in particular in the stats package. In addition, there are many other econometrics packages available for free on the Internet.

What is Python?

Python is another powerful and high-level object-oriented programming language. It is the world’s most popular programming language. Like R, Python is also well-known among statisticians, economists, data scientists, and researchers. Similarly, most of the packages in R are available in Python as well, making it an all-in-one option for users. Apart from its usage for data processing, Python also has various other uses.

Python has existed since the ‘80s. However, the language has gained popularity recently due to its extensive list of libraries and ease of use. Most programmers recommend it as the best language for beginners to get started. Like R, Python is also open-source, making it available to the public. Most large companies in the technology industry use Python, including Google, Microsoft, Reddit, Mozilla, etc.

There exist many specialized libraries for performing econometrics studies in Python. Amongst them, Statsmodels is a frequently used package.

What is MATLAB?

MATLAB is a programming platform that focuses specifically on the needs of scientists, engineers, and data analysts. It allows users to make complex calculations, implement algorithms, create user interfaces, plot functions and data, and much more. It includes a vast library of mathematical functions for linear algebra, numerical integration, statistics, and differential equations.

MATLAB has some pre-programmed procedures that can help economists with their research. On top of that, there is a wide variety of open-source code available from other users online that is available to the public. Although it may not be as fast as Python or R, it is still the most famous program among high-level econometricians. Similarly, unlike Python and R, MATLAB is neither free nor open-source.

Econometrics studies can be performed by using the Econometrics Toolbox in Matlab.

Conclusion

Econometrics involves the use of statistical and mathematical methods to test economic theories. There are several tools or programming languages that can help econometricians. Usually, econometricians prefer R, Python, and MATLAB. All of these can help econometricians perform complex computations. Based on the needs and usage, each tool or language has its benefits and drawbacks.

Article Source Here: Econometrics With R, Python and MATLAB

Tail Value at Risk: Formula, Definition

The Tail Value at Risk (TVaR) is a financial measure of a potential loss in a portfolio. Tail Value at risk uses the same statistical principles as the traditional value at risk with the only difference being that it measures an expectation of the remaining potential loss given a probability level has occurred.

Conceptually, tail value at risk is similar to Value-at-Risk (VaR), except it measures the maximum amount of loss that is anticipated with an investment portfolio over a specified period, with a degree of confidence

In this article, we'll first look at the basic theory behind the value at risk, and then we will introduce tail value at risk.

What is the Standard Deviation

Value at Risk is the measure of the downside or risky part of an investment. To be more precise, it answers this question: "What is the potential loss in a portfolio?".

To understand how Value at Risk works, we should first understand what a standard deviation is.

The standard deviation is one of the most commonly used tools for measuring variability and dispersion of data. If you are not familiar with the concept of standard deviation, you may want to check out "Standard Deviation and Variance: Statistics for Stock Traders" first.

Standard deviation can be used to measure both upside and downside variability in a portfolio. In order to get a better grip on this idea, let's look at a simple example below:

Suppose that you have a well-diversified portfolio, which you are tracking on daily basis. For the sake of simplicity, let's assume that this portfolio has 10 securities in it.

Daily returns are normally distributed with an average return of 0% and a standard deviation of 2%. So, one day you noticed that your overall return is -4%, instead of 0%. This is definitely not good news.

You have a look at the largest losses for each of the 10 securities and you notice that some of them are making significant contributions to your loss. Next, you looked into historical data and noticed that the securities that made a negative contribution to your portfolio on that day also did so in 50% of all cases. In other words, they have a downside correlation of 50%.

In order to assess the risk inherent in the portfolio going forward, you want to calculate how much money you may lose going forward.

So now let's find out how to calculate Value at Risk of a portfolio.

Calculating Value at Risk

Here is how you calculate value at risk

Value at Risk = [Expected Weighted Return of the Portfolio− (z-score of the confidence interval× standard deviation of the portfolio)] × portfolio value

​The standard deviation in portfolio returns is usually smaller than the individual securities' standard deviation since diversification helps to reduce dispersion. Also, you can expect that there will be more negative values than positive values in your tail distribution. This is because in reality the return distribution is not normally distributed (left-skewed).

Calculating Tail Value at Risk

Now, let’s examine what Tail Value at Risk is,

There are a number of related, but subtly different, formulations for TVaR in the literature. A common case in literature is to define TVaR and average value at risk as the same measure. Under some formulations, it is only equivalent to expected shortfall when the underlying distribution function is continuous at VaR(X) the value at risk of level alpha. Under some other settings, TVaR is the conditional expectation of loss above a given value, whereas the expected shortfall is the product of this value with the probability of it occurring.The former definition may not be a coherent risk measure in general, however it is coherent if the underlying distribution is continuous. The latter definition is a coherent risk measure. TVaR accounts for the severity of the failure, not only the chance of failure. The TVaR is a measure of the expectation only in the tail of the distribution. Read more

If X is the payoff of a portfolio that has f as the probability density function and F as the cumulative distribution function, then the left Tail Value at Risk can be expressed as follows,

Conclusion

As you can see Tail Value at Risk is very useful when it comes to measuring the downside risks of your portfolio. Although this method does have its limitations, it is definitely a step in the right direction.

Originally Published Here: Tail Value at Risk: Formula, Definition

Fair Value Hierarchy: Definition, Levels, Examples

Most companies use the historical value method of deriving their asset’s value. This process includes taking the asset’s cost and deducting any impairment and depreciation to reach the book value. The same method applies to deriving the value of liabilities. However, some accounting standards also require or allow companies to measure items at fair value.

What is a Fair Value?

The term “fair value” has various definitions in accounting and finance. It usually refers to the price a willing buyer and seller will pay or receive for an asset in an orderly transaction. The fair value of an item will also depend on the measurement date. Similarly, it may also be the price paid to transfer a liability in similar market conditions at a specific date.

In short, the fair value represents the market value of an asset or liability. However, there are several criteria attached to it. As mentioned, it requires the market participants to be willing to transact. It also needs an orderly transaction or one considered an arm's length transaction. The criterion for a measurement date is also crucial to establish a fair value for an item.

Sometimes, however, the fair value of an item may not be straightforward to determine. Since fair value is market-based and not entity-specific, there are several hurdles that companies may face. For example, companies may come across several fair values for a specific item from different markets. These inputs can confuse how to determine an item's fair value. For that, companies must use the fair value hierarchy.

What is the Fair Value Hierarchy?

The fair value hierarchy refers to the different classes in which accounting standards classify inputs. As mentioned, companies may come across several sources that provide information about an item's fair value. These values may differ based on the input they take. Similarly, the markets where these prices generate also impact the fair value.

The fair value hierarchy categorizes inputs used in fair value determination into three levels. This hierarchy provides the highest priority to Level 1 inputs. In case these inputs are not available, companies must use Level 2 inputs. Lastly, companies can use Level 3 inputs when the above two cannot be determined. Each of these differs from the others, as discussed below.

Level 1 Inputs

Level 1 inputs include quoted prices for identical items in an active market on the measurement date. For example, it may be a bid price for an asset or an ask price for a liability. Level 1 inputs are the most reliable evidence for fair value.

Level 2 Inputs

Level 2 inputs are directly or indirectly observable inputs rather than quoted prices. These may include the value of similar items in active or inactive markets. For example, a valuation multiple for a business unit based on the sale of similar entities is a level 2 input. After Level 1, level 2 inputs take priority.

Level 3 Inputs

In some cases, identifying level 1 and 2 inputs may not be possible. Therefore, companies must use level 3 inputs that are unobservable. It may include prices from a company's own data, adjusted for specific conditions. For example, cash or profit forecasts used to evaluate an asset would fall into this category. Level 3 inputs have the lowest priority in the fair value hierarchy.

Conclusion

Fair value is the market price for an asset or liability at a specific date between willing market participants. The fair value hierarchy identifies three categories for inputs. Usually, companies use level 1 inputs that have the highest priority. When level 1 inputs are not available, companies must use level 2 inputs. Lastly, companies can use level 3 inputs if none of the above can be determined. Level 3 inputs take the lowest priority.

Article Source Here: Fair Value Hierarchy: Definition, Levels, Examples

Using the Hurst Exponent and Stock Comovements for Pairs Trading

Pairs trading, or statistical arbitrage, is an effective market-neutral trading strategy. Usually fundamental or quantitative analysis is used in order to determine which pairs are suitable for trading. We have previously discussed several pairs selection methods based on quantitative measures such as stock cointegration, correlation, pair distances, etc.

Reference [1] introduced a new pairs selection method based on the Hurst exponent,

One of the critical steps in [Pairs] Trading is the pairs selection, but not too much attention has been given to the stock universe before pairs selection. In this paper, we have introduced a preselection procedure based on the stocks comovement measure through comovement functions based on comovement studies on physical particle systems. Therefore, portfolios with less volatile stocks have been selected, and it has been observed that, with this new modification, [Pairs] Trading is also profitable in periods of low volatility.

We find the paper interesting. Our comments are as follows,

• We’re of the same opinion that candidate selection is one of the most important steps in pairs trading. It is our understanding that the proposed selection method consists of 2 steps: i-selection of the underlying stocks based on comovements, ii-selection of tradable pairs based on the Hurst exponent.
• The pair selection method based on the Hurst exponent makes sense. Here the Hurst exponent of the weighted difference of the logarithm of prices is calculated, pairs are then selected and trading signals are generated directly using the difference. In contrast, other pairs selection methods make use of indirect measures such as cointegration or correlation.
• We think that it’s worth trying the pair selection method based on the difference of price, instead of the logarithm of price.
• The method for selecting the underlyings (step i) based on price comovements resulted in low-volatility stocks. This does not seem consistent with the empirical observation that pairs trading is considered an implicit short volatility trading strategy.

Regarding the last bullet point, the authors also noted,

However, on high volatility conditions, the strategy does not work as good. A plausible explanation of this phenomenon could be that, during periods with prolonged downward movements in the markets, volatility of the stocks is increased, and the model proposed in this paper is too slow to capture this faster change in the volatility of the preselected stocks.

Regarding the first bullet point, we believe that the pairs selection method can be improved by further performing, e.g., a robustness test in order to minimize divergence risks.

References

[1] J. P. Ramos-Requena, M. N. López-García, M. A. Sánchez-Granero, J. E. Trinidad-Segovia, A Cooperative Dynamic Approach to Pairs Trading, Complexity, vol. 2021, Article ID 7152846, 2021.

Originally Published Here: Using the Hurst Exponent and Stock Comovements for Pairs Trading

What is Risk-Adjusted Return on Capital

For a time, it was widely believed that the only way to determine how good an investment is, was by looking at its return. But in recent years, investors have come to realize that a high return doesn't always equal a good investment.

For example: if one company has a higher return than another but is also riskier - then the lower-returning but lower-risk company might be the better choice for many people. In order to account for risk when evaluating investments, some experts now use what's called "RAROC" or "Risk-Adjusted Return of Capital."

The idea behind this calculation is simple: you look at both returns and risks and calculate which investment will provide more money on average over time (taking into account the risks involved).

In this article, we will be looking at what is Risk-Adjusted Return on Capital (RAROC ) is, how it is calculated, and what the advantages and disadvantages are to using it.

What is Risk-Adjusted Return on Capital (RAROC)

Risk-Adjusted Return on Capital (RAROC) is a way of determining whether an investment's returns are reasonable, given the amount of risk it carries. The calculation for RAROC will reveal how much money an investor can expect to earn, per unit of risk that he or she takes. You calculate RAROC by taking the return of investment and adjusting it for risk.

How to Calculate Risk-Adjusted Return on Capital (RAROC)

Calculating RAROC is a fairly straightforward process. You take the estimated return of investment and divide it by the standard deviation to get a number known as "beta." The beta which you will be using in your calculation will depend on what type of risk-adjusted return on capital you are calculating.

RAROC = average return/ standard deviation

Riske-Adjusted Return on Capital can be used to show how much money an investor will earn, per unit of risk taken.

Risk-Adjusted Return on Capital (RAROC) Advantages

There are several advantages to the use of RAROC

1. It provides a good way of evaluating different investments with different risks
2. It allows you to make more precise comparisons among risky assets
3. By understanding the risk-return tradeoff, investors can better plan their portfolios and make smarter financial decisions. One of the biggest causes of bankruptcy is risk management
4. It enables you to estimate the value of a business
5. It allows you to make accurate decisions about the efficiency of your company

Risk-Adjusted Return on Capital (RAROC) Disadvantages

While RAROC provides a number of advantages, there are also several disadvantages to its use

1. Calculating returns for investment often involves looking at past performance, which can be misleading if you don't take into account the effects of inflation or other factors over time
2. Risk-adjusted return on capital only works in a theoretically perfect market, but not in a real-world setting where you can't assume that all risk is priced into an investment
3. Different measures for risk are used by different companies/individuals and come with their own sets of disadvantages
4. The market prices of risk can change quickly and unpredictably, which means that RAROC can become obsolete very fast
5. Risk-adjusted return on capital doesn't tell you what the returns are expected to be in the future

Conclusion

Risk-Adjusted Return on Capital (RAROC) provides a good way to get a snapshot of an investment's risk-reward profile. It allows you to compare the expected returns on different investments that are taking on different amounts of risk. Additionally, it can give you insight into business value by giving you a benchmark for estimating the present value of future cash flows.

Article Source Here: What is Risk-Adjusted Return on Capital

Salary Payable: Journal Entry, Calculation, Example

The accrual principle in accounting is a concept that requires entities to record transactions in the period in which they occur. This concept goes against the cash accounting method in which entities only account for cash transactions. However, the accrual principle does not consider the timing of the cash flows. There are several accounts that entities must maintain to follow this principle. One of these includes salary payable.

What is Salary Payable?

Salary payable is an account that entities maintain to record unpaid salary expenses. It represents the amount of liability that entities owe their employees. Usually, entities pay their employees after the month in which they work. However, as every month ends, entities incur salary expenses. Under the accrual principle, entities must record these expenses.

Entities usually pay off salary expenses after the end of the month. Despite the cash flows being on a different date, entities must record salary payable. Although named "salary" payable, the account may also contain various other employee-related expenses. These may include basic salaries, overtime, bonuses, benefits, and other allowances.

Usually, entities settle salaries payable within a few days. Therefore, the account does not often include any balances. However, when entities close their accounts and prepare financial statements, they must report salary payable. Since the liability gets settled within a few days, it will fall under current liabilities on the balance sheet. The related salaries expense will get reported on the income statement.

How to calculate Salary Payable?

Calculating salary payable is straightforward. Entities can calculate the amount by aggregating all employee-related expenses for a month. As mentioned, these will include employee salaries, wages, taxes, overtime, bonuses, and other related amounts. A sample formula for salary payable is as follows.

Salary Payable = Salaries + Wages + Bonuses + Employment Benefits + Overtime + Other Allowances

However, the above salary payable formula may not apply to every entity. Furthermore, the calculation is more complex in practice. Entities must calculate the salary expense for every employee separately. After that, they must aggregate those amounts to reach salary payable.

What is the journal entry for Salary Payable?

The journal entry for salary payable involves recording salary expenses and creating a liability. At the end of every month, entities must record this expense. Since there is no cash settlement involved at the date, increasing current liabilities is mandatory. Therefore, the salary payable journal entry will be as follows.

Dr Salary Expense

Cr Salary Payable

When entities settle the salaries at the start of next month, they must decrease the salary payable account balance. Therefore, this account also has another journal entry. The entry involves removing any remaining balances from the account that an entity settles. Nonetheless, the second journal entry for salary payable will be as follows.

Dr Salary Payable

Dr Cash/Bank

Example

A company, Kite Co., has over 100 employees. The total salaries expense at the end of each month for these employees is $100,000. Similarly, the company pays its employees on the 5^th of next month for their work. At the end of each month, Kite Co. must record a salary expense and payable. Therefore, the company must use the following journal entries.

Dr Salary Expense $100,000

Cr Salary Payable $100,000

On the 5^th of the next month, the company settles the entire amount through the bank. Therefore, Kite Co. must remove the balance from the liability account. The journal entries will be as follows.

Dr Salary Payable $100,000

Dr Bank $100,000

Conclusion

Salary payable is an account that entities use to record accrued salary expenses. This account exists due to the accrual principle in accounting. Salary payable includes various expenses, including salaries, wages, bonuses, overtime, allowances, etc. Once entities settle the amount, they must decrease the account balance.

Post Source Here: Salary Payable: Journal Entry, Calculation, Example

Earnings at Risk and Cash Flow at Risk

It's an important distinction to be made in the world of finance. Earnings at risk are when a company's future earnings are threatened due to factors such as unfavorable economic conditions or changes in consumer tastes. Cash flow at risk, on the other hand, is when a company's current cash flow is threatened by factors such as debt repayments and unexpected expenses.

Both the earnings and cash flow metrics are extremely important to shareholders. When a company's future earnings are in jeopardy, its long-term value is also affected. Thus, a shareholder may choose to sell the stock if the risk of diminished earnings is too high. However, this will have no impact on the company's current cash flow situation since it doesn't have any effect on the current cash flow that is coming in.

So now let's find out the key differences between earnings at risk and cash flow at risk.

What is Earnings at risk

Earnings at risk are earnings that can be threatened by factors such as unfavorable economic conditions or changes in consumer tastes. These factors may exist in the present and/or future.

A company's future earnings can be threatened when:

1. Unfavorable economic conditions occur in either their own industry, economy, or environment
2. Changes in consumer tastes affect a company's products
3. The costs of materials increase due to energy prices, inflation, or other issues
4. Product or service quality is diminished
5. New competitors enter the industry that causes competitive pressures
6. External factors such as bad weather, strikes, government regulations, etc affect production capacity

What is Cash flow at risk

Cash flow at risk is when a company's current cash flow is threatened by factors such as debt repayments and unexpected expenses.

A company's current cash flow can be threatened by

1. Expenses that are greater than the income stream
2. Increasing interest rates or an inability to borrow money at a reasonable rate
3. Inability to meet upcoming loan covenants
4. Inability to pay creditors on time
5. Downsizing initiatives that include significant layoffs or cuts in pay
6. Increased costs of production

What is the difference between Earnings at risk and Cash flow at risk

Earnings at risk are earnings that can be threatened by factors such as unfavorable economic conditions or changes in consumer tastes. Cash flow at risk, on the other hand, is when a company's current cash flow is threatened by factors such as debt repayments and unexpected expenses.

As you can see above that both earnings at risk and cash flow at risk are important to shareholders, but they are two different types of risks.

Earnings at risk affect long-term value since it primarily affects future earnings, whereas cash flow at risk does not affect the current cash flow situation.

Conclusion

Earnings at risk can be defined as earnings that can be threatened by factors such as unfavorable economic conditions or changes in consumer tastes. Cash flow at risk, on the other hand, is when a company's current cash flow is threatened by factors such as debt repayments and unexpected expenses. Both these factors are important to shareholders, but they are different types of risks.

Article Source Here: Earnings at Risk and Cash Flow at Risk

How Options Imbalances Affect Price Dynamics

As discussed several times, markets can be loosely divided into two regimes: trending, and mean-reverting. The majority of trading literature has been devoted to exploiting these market characteristics. Less attention, however, is paid to the explanation of their existence. They are often attributed to investors’ over-, underreaction and/or market inefficiencies.

Reference [1] looked at these market properties from a different perspective. It examined how the options gamma imbalances contribute to the market intraday momentum or reversal.

Recall that an option gamma is,

Gamma measures the rate of change in the delta with respect to changes in the underlying price. Gamma is the second derivative of the value function with respect to the underlying price.

Most long options have positive gamma and most short options have negative gamma. Long options have a positive relationship with gamma because as price increases, Gamma increases as well, causing Delta to approach 1 from 0 (long call option) and 0 from −1 (long put option). The inverse is true for short options

When a trader seeks to establish an effective delta-hedge for a portfolio, the trader may also seek to neutralize the portfolio's gamma, as this will ensure that the hedge will be effective over a wider range of underlying price movements. Read more

The article pointed out,

Establishing delta-neutrality may cause either return momentum or reversal depending on the sign and size of the imbalance vis-a-vis market prevailing liquidity. We find that a large and negative (positive) aggregated gamma imbalance, relative to the average dollar volume, gives rise to an economically and statistically significant end-of-day momentum (reversal).

It further showed that rebalancing of leveraged Exchange Traded Funds at the end of day also has the same effect on the price dynamics,

We compare this channel to the rebalancing of leveraged ETFs and find that the effect generated by leveraged ETFs is economically larger. Consistent with the notion of temporary price pressure, the documented effects quickly revert at the next day's open.

In short, both delta hedging and rebalancing of leveraged ETFs contribute to the stock market intraday momentum or reversal. The authors even managed to develop trading strategies based on these imbalances and they earned superior risk-adjusted returns.

We found the authors’ explanation of the intraday price dynamics plausible; however, we think that their strategies are rather difficult to implement.

What do you think?

References

[1] A. Barbon, H. Beckmeyer, A. Buraschi, and M. Moerke, The Role of Leveraged ETFs and Option Market Imbalances on End-of-Day Price Dynamics, 2021. https://ssrn.com/abstract=3925725

Originally Published Here: How Options Imbalances Affect Price Dynamics

Amortization Expenses: Formula, Journal Entry, Examples

What is Amortization?

Amortization is a method through which businesses lower the book value of their loans or intangible assets. It is similar to depreciation for assets. Both of these techniques help companies record the gradual decrease in an asset’s book value. However, depreciation only applies to property, plant, and equipment, or fixed assets. In contrast, amortization is only for intangible assets.

For loans, amortization helps companies spread out the book value into various fixed payments. Usually, this process involves using an amortization schedule to record principal and interest payments. In essence, amortization for assets and loans works similarly. However, the accounting treatments for both differ due to the underlying accounts involved.

How does Amortization work?

The matching concept in accounting requires companies to match expenses to the revenues they help generate. Therefore, companies must expense out the relative value of their assets for the period they provide means to make sales. This expense-out process usually comes in the form of depreciation. However, depreciation does not apply to intangible assets. Therefore, companies must use amortization to achieve a similar result.

For loans, amortization follows the same concept. It helps spread out the loan into various fixed payments for each period. Using amortization, companies can split these fixed payments into both interest and principal payment components. However, amortization does not apply to all loans, for example, credit cards or balloon loans.

How to calculate Amortization?

There is no specific formula for amortization. However, companies usually use the straight-line method to calculate amortization for intangible assets. The amortization formula under this method is as follows.

Amortization Expense = Asset’s Cost / Asset’s Useful Life

For loans, the amortization formula is more complex. However, most financial institutions and lenders provide an amortization schedule to borrowers. This schedule includes a calculation of all the interest and principal payments payable on a loan. Companies can use it to spread the loan over the number of total payments.

What are the journal entries for Amortization?

The journal entries for amortization differ based on whether it is for assets or liabilities. For intangible assets, the amortization journal entries are similar to depreciation. The value for the double-entry will depend on the amortization calculation based on the above formula. Nonetheless, the journal entries will be as follows.

Dr Amortization Expense

Cr Accumulated Amortization

For loans, on the other hand, the journal entries will differ. Every time a company makes a repayment, it must record amortization. It must also split the amount into the principal and interest components. As mentioned, this information is readily available from the amortization schedule. Nonetheless, the journal entries for the amortization of loans will be as follows.

Dr Interest Expense

Dr Loan (principal amount)

Cr Cash/Bank

Example

A company, Rage Co., owns software that costs $100,000. The company intends to use it for ten years. Therefore, the company will record an amortization expense for the software each year for its useful life. The annual amortization expense will be $10,000 ($100,000 / 10 years). Therefore, the journal entries will be as follows.

Dr Amortization Expense $10,000

Cr Accumulated Amortization $10,000

On the other hand, the company also obtained a loan from a financial institution. The loan requires Rage Co. to repay $20,000 annually, consisting of both interest and principal components. For the latest payment, the interest component amounts to $15,000. Therefore, the amortization expense journal entries for the loan will be as follows.

Dr Interest Expense $15,000

Dr Loan (principal amount) $5,000

Cr Cash/Bank $20,000

Conclusion

Amortization is a term that refers to the process of decreasing an asset or loan's book value. For assets, amortization works similarly to depreciation, but for intangible assets only. For loans, on the other hand, amortization spreads the loan payments over time. The accounting treatment for both of these will differ, as discussed above.

Article Source Here: Amortization Expenses: Formula, Journal Entry, Examples

How to Backtest a Trading System

Backtesting can become a key factor in the success of a system. Not even all experienced traders understand how to correctly implement a backtest, which often results in erroneous outcomes. If it is done correctly, we can expect some excellent results.

In this article, we are going to talk about the key factors to be considered for a backtest, and what steps should be followed in order to obtain great results.

What is a backtest

A backtest is generally understood as an evaluation of a trading system, where the historical price series data of security prices are used for testing. Every trader knows that it is virtually impossible to survive in this business without the ability to correctly and efficiently analyze a trading system.

Trading signals may be generated using many different techniques, among which we can name technical analysis patterns, algorithmic trading systems, as well as financial modeling methods. Regardless of what methodology has been used for generating trading signals, every system must be tested thoroughly before it is put into use.

A backtest is used for evaluating trading systems because it offers the possibility of using actual market data to test trading ideas without actually trading (which can become very risky). In addition, a backtest allows for testing a system as though its signals had been generated at that time, which makes it possible to generate reliable projections about how profitable the system may be in the future.

How to backtest

The following are the basic steps that should be followed in order to correctly implement a backtest:

1. Define system rules and variable definitions
2. Select a period for backtesting/simulation
3. Type in the starting capital
4. Set up a trading account
5. Run simulation/backtest and analyze results

First of all, system rules and variable definitions should be defined coherently. The next step is to select the period for backtesting. Even if the algorithm has been developed using long-term data, it is important to test it on at least one year's worth of historical price series data so that its behavior over various periods can be evaluated.

Once we have defined system rules and variable definitions, as well as selected the period for backtesting/simulation, we need to type in the starting capital - which is important because it will define initial equity and cash flows.

For example: If a system has been developed using $100,000 as its starting capital, and a 100% allocation of capital has been used for each trade, then the total amount of invested cash will be equal to $100,000. In this way, we need to type in the starting capital so that it can be properly taken into account when calculating equity growth/decline.

The next step is setting up a trading account. In this case, we need to define an account number as well as a broker from whom trades will be executed. Once the backtest is performed, all transactions generated by the algorithm will be reflected on a chart of a particular broker with which the system has been set up for testing purposes.

The final step before running a simulation/backtest is to define transaction costs. Many traders make the mistake of forgetting about transaction costs, which may lead to losing a big portion of trading capital due to the high fees charged by brokers.

Once all steps mentioned above have been implemented, we need to launch the algorithm/system that has been developed for backtesting purposes. The results can be analyzed in a variety of different ways. In addition, depending on the type of system being tested, it is possible to run multiple iterations to increase accuracy by obtaining more reliable results.

Conclusion

Backtesting is an important and integral part of developing a profitable trading strategy. It enables traders to estimate how their strategies would have performed historically without actually trading, which makes it possible to run market projections that define the expected profitability of a system for future use.

By following the steps described above, anyone can perfectly implement backtesting. In addition, by running simulation/backtest multiple times, it is possible to obtain more reliable results.

Post Source Here: How to Backtest a Trading System

What is an Unqualified Audit Opinion

Stakeholders use financial statements to make decisions about their relationship with a company or organization. However, they also need certainty related to the figures reported in those statements. Hence, they refer to the audit report, which includes an independent auditor's audit opinion. This opinion may be of four types. However, stakeholders usually prefer an unqualified audit opinion.

What is an Unqualified Audit Opinion?

An unqualified audit opinion, or unmodified audit opinion, is a standard opinion provided by auditors. This audit opinion states that the financial statements do not contain any material misstatements. Similarly, auditors will express that the financial statements meet the suitable criteria identified before the audit commenced.

The unqualified audit opinion provides certainty to stakeholders about their relationship with a company or organization. This opinion implies that there are no issues with the financial statements. However, it is not a guarantee of no concerns existing in the financial statements. It is the only audit opinion that does not have adverse implications.

How does the Unqualified Audit Opinion differ from other Audit Opinions?

The unqualified audit opinion differs from other audit opinions in various fundamental regards. Among the four types of audit opinions, the unqualified audit opinion is the only positive opinion. Since an unqualified audit opinion is a part of an unmodified report, it does not modify the audit report. In contrast, the other audit opinions do.

For auditors to provide an unqualified audit report, the client's financial statements must meet two conditions. First, these statements should be free from material misstatements as a whole. Second, auditors must be able to obtain sufficient appropriate audit evidence related to them. If financial statements don’t meet these criteria, auditors won't express an unqualified opinion.

An unqualified audit opinion is significantly helpful to companies and organizations. For entities seeking positive relations with their stakeholders, this opinion can help strengthen their dealings. In contrast, any other opinion may undermine the relations. Therefore, the unqualified audit opinion is of significant importance to most entities.

While an unqualified audit opinion is a part of an unmodified audit report, it may also appear on modified reports. In contrast, the other audit opinions can only appear on modified audit reports. These opinions cannot appear on unmodified audit reports. Each opinion will also have its corresponding basis paragraph in the audit report.

What does the Unqualified Audit Opinion express?

An unqualified audit opinion sends a positive signal to stakeholders. When a company or organization receives an unqualified opinion, its stakeholders become confident in its financial statements. In contrast, any other audit opinion can adversely impact the relations between stakeholders and the audited entity.

However, the unqualified audit opinion does not provide a complete guarantee to stakeholders. It only implies that the auditors were unable to find any issues in the client's financial statements. However, audits may include sampling and selective work. Therefore, the unqualified opinion implies that the auditors didn't find any misstatements or presentational errors in their tested work.

Conclusion

An unqualified audit opinion is a positive opinion issued by auditors. There are two criteria that a client’s financial statements must meet for auditors to provide this opinion. These include being free from material misstatements and being backed by sufficient and appropriate audit evidence. The unqualified audit opinion differs from modified opinions.

Originally Published Here: What is an Unqualified Audit Opinion

Backtesting and Forward Testing

Both backtesting and forward testing can and should be used to test a trading strategy. A trading strategy is a set of rules for when to buy and sell an investment, usually in the form of computer code or a trading algorithm.

A trading algorithm can be viewed as a black box that takes in money as input and outputs either the amount of money made from investing according to the trading strategy or the amount of money lost if the strategy is bad. In order to measure how good a system is we need a way to simulate trading with it and thus be able to determine its future profitability given a set of parameters. This is where backtesting and forward testing methods come into play.

In this article, we will find out what backtesting and forward testing are and their benefits.

What is Backtesting

Backtesting is used to check how a trading strategy would have performed in the past.

A backtest simulates the trades that would have been made over some time period using historical data. A trading strategy is considered "backtested" if it uses both buys and sells signals, resulting in an overall increase or decrease of funds over a certain time period.

Backtesting can be performed using open source software or with a paid service depending on how much data you are dealing with. Remember that backtesting is only as good as the quality of your historical data, but it's still important to perform due diligence over the most crucial step in any trading algorithm development process - testing the strategy on historical data.

Backtesting Benefits

Backtesting allows you to check if a strategy would have been profitable in the past. So it can definitely help you avoid a loss by backtesting a strategy with a competitor.

Here are some benefits of backtesting

• Backtesting your algorithm on historical data ensures that it is actually trading within the parameters you choose
• You can get an idea of how many trades will be made and their size. This allows you to calculate the transaction fees which you will incur when using your strategy in real life
• The transaction costs for your entire portfolio can be calculated, something that is almost impossible to do when trading manually
• Your backtesting results will tell you with what certainty the performance of your strategy can be expected in real life

What is Forward Testing

Forward testing is used to test how a trading strategy would have performed if it had actually been in the market.

It's highly recommended that you perform some kind of forward testing on your strategy before deploying real money. If you are serious about using an algorithmic approach to manage your trades then you definitely need to be considering future testing as part of your process.

Forward testing benefits

Performing a forward test on a trading strategy will provide insights into how the strategy may perform going forward.

Here are some benefits of forward testing

• You can plan your trade entries and exits ahead of time
• The strategy would have been tested in a different market condition from the past data used for backtesting
• Your forward testing results will tell you with what certainty the performance of your strategy can be expected in real life
• A mathematical model of the algorithm is created so that it can be simulated before you actually use it in real life

Conclusion

The choice of which to use will depend on the nature of your algorithm. If you are predicting the price of something one day in advance then forward testing is best. However, if you are looking at things over a longer time frame then backtesting may be better.

Post Source Here: Backtesting and Forward Testing

Conversion Costs: Formula and Examples

Manufacturing companies incur various costs within different processes. These costs are vital in helping companies generate revenues and make profits. One of the essential items for those companies includes raw materials, which contribute to a significant portion of the overall expenses. However, there are other costs as well, which can be substantial. One of these includes conversions costs.

What are Conversion Costs?

Conversion costs are all costs sustained by a company that relate to converting raw materials into finished goods. Similarly, the finished goods need to be sellable in the market for the conversion cost to be capitalizable. Conversion costs do not include raw materials or any direct material expenses. Instead, it consists of labour costs and manufacturing overheads.

Conversion costs involve a combination of both direct and indirect production costs. With these costs, companies can get better insights into their production costs. Similarly, removing direct material costs from the overall production costs provides better metrics to measure operational efficiency. These costs can also help companies identify any wastage within the production process.

What are the components of Conversion Costs?

As mentioned, there are two components that contribute to the conversion costs that companies incur. These include direct labour costs and manufacturing overheads. An explanation of what each of these is is as below.

Direct Labor Costs

Direct labour costs are total costs incurred by companies in expenses paid to production workers. For these costs to be direct, it is crucial for the workers to have directly contributed to the manufacturing process. Payroll expenses outside of this process, for example, administrative staff salaries, do not fall under direct labour costs. Direct labour costs may include salaries, wages, bonuses, taxes, benefits, overtime, etc., paid to production workers.

Manufacturing Overheads

Apart from direct labour expenses, conversion costs also incorporate manufacturing overheads. These include indirect overheads that are a part of the production process. However, these do not directly contribute to a single cost unit. Therefore, companies have to allocate these expenses based on an appropriate metric. Manufacturing overheads may include utilities, taxes, depreciation, maintenance, etc.

What is the difference between Conversion Costs and Prime Costs?

Some people often confuse conversion costs with prime costs. Although both of these relate to the production process, they are different from each other. As mentioned, conversion costs include direct labour costs and manufacturing overheads. These costs exclude any expenses incurred on acquiring raw materials.

On the other hand, prime costs include all direct costs that contribute to a production unit's costs. These will primarily include direct material and direct labour. In some cases, it will also contain direct expenses. Therefore, prime costs include direct material but do not consider manufacturing overheads.

How to calculate Conversion Costs?

Conversions costs are the sum of a company's direct labour costs and manufacturing overheads. Based on the definition, companies can use the following formula for conversions costs.

Conversion Costs = Direct Labor Costs + Manufacturing Overheads

Example

A company, Aqua Co., produced 10,000 units of its product in a year. The company incurred $10 on raw materials per unit. Similarly, it paid salaries and wages to its workers, which amounted to $5 per unit. Lastly, the company also incurred $100,000 in manufacturing overheads. Based on the above data, Aqua Co.’s conversion costs for the year will be as follows.

Conversion Costs = Direct Labor Costs + Manufacturing Overheads

Conversion Costs = (10,000 units x $5 per unit) + $100,000

Conversion Costs = $150,000

Conclusion

Conversion costs are the sum of all expenses incurred by a company to convert raw materials into finished goods. There are two components that contribute to these costs, direct labour costs and manufacturing overheads. Conversion costs are different from prime costs due to the inclusion of manufacturing overheads and the exclusion of raw material costs.

Originally Published Here: Conversion Costs: Formula and Examples

Predicting Firm Profit Using Machine Learning Techniques

In a previous post, we presented an article on using an econometric model for predicting the P/E ratio. In this post, we will discuss a different approach for predicting a firm’s financials.

Reference [1] utilized the Gradient boosting method for predicting a firm’s profitability. Gradient boosting is a method that belongs to the family of Machine Learning techniques. It allows us to treat a large number of factors and build a predictive model,

Gradient boosting is a machine learning technique for regression, classification and other tasks, which produces a prediction model in the form of an ensemble of weak prediction models, typically decision trees. When a decision tree is the weak learner, the resulting algorithm is called gradient boosted trees, which usually outperforms random forest. It builds the model in a stage-wise fashion like other boosting methods do, and it generalizes them by allowing optimization of an arbitrary differentiable loss function. Read more

The authors used the Gradient boosting method to predict firm profit, and they compared results to those predicted by Fama-MacBeth regressions,

This paper compares firm profit predictions based on Fama-MacBeth regressions to predictions based on gradient boosting. Gradient boosting provides higher quality predictions due to their ability to include many more factors. The predictions are evaluated directly and also in three test settings; one from behavioral finance, one from corporate finance, and one from asset pricing.

They found that,

…the gradient boosting approach (denoted GBRT), due to Friedman (2002) produces better firm protfit predictions than does the Fama and MacBeth (1973) approach (denoted FM). This is true both in-sample and out-of-sample. It is primarily due to the ability to include many more factors without over-fitting the data.

… we find that large firms and investment grade firm profits are more predictable than average firms. Firms with high R&D, market-to-book, and cash flow volatility have less predictable profits than average firms. Among publicly traded firms that exit, unprofitable firms tend to be liquidated or bankrupt; while protable firms tend to be involved in an acquisition, a merger, an LBO, or to become a private firm. During the financial crisis of 2007-2009 and during NBER recessions, firm profits become less predictable. The reduced predictability during bad times affects average firms much more than it affects investment grade firms.

In short, using the Gradient boosting method, the authors were able to predict firm profit. We found it impressive that they used 140 factors to build a predictive model without overfitting.

References

[1] MZ. Frank, K. Yang, Predicting Firm Profits: From Fama-MacBeth to Gradient Boosting, 2021. https://ssrn.com/abstract=3919194

Originally Published Here: Predicting Firm Profit Using Machine Learning Techniques

How to Assess Environmental, Social, and Governance (ESG) Risks

In recent years, ESG (environmental, social, and governance) risks have received increased attention from investors due to the growing awareness of the impact these issues can have on their investments. Regulators are also increasingly requiring companies to disclose them in annual reports. Investors who want to assess ESG risks should develop a framework for evaluating their potential impacts on company performance, which will vary depending on the industry that they invest in.

Assessing ESG can be a challenge because it requires a different approach to traditional financial analysis. ESG issues can be diffuse and complex, whereas the financial risk is normally located in clearly measurable positions such as earnings, capital expenditure, or currency exposures.

In this article, we are going to look at what are ESG risks and how to assess them, and the key considerations that you should keep in mind when measuring ESG risks.

What are ESG risks

ESG risks refer to the impact of an organization's activities and business operations on environmental, social, and governance (ESG) factors such as political stability, human rights, labor practices, corruption, or bribery.

For example. A company may suffer from ESG problems due to

• The inferior quality of its products; poor management; inadequate corporate governance
• Bribery or corruption of employees, suppliers, distributors, and customers
• Unsafe working conditions in its factories; deforestation brought about by the company's paper pulp mills

Such issues could have a direct impact on financial performance if they damage company reputation with current or prospective customers, affect the working conditions of the company's workforce, trigger high legal fees to defend against lawsuits, or lead to an expensive remedial program that impacts the company's net earnings.

However, ESG issues might not be immediately apparent and their impact on financial performance could take considerable time (for example, deforestation and its effects).

How to assess ESG risks

The assessment of ESG risks is a complex process that requires an integrated, systematic approach. Questions to consider include

• What are the ESG risks that might pose a risk to my investment?
• What are the principles I want my investments to follow in respect of ESGs issues? How am I going to monitor these risks?
• How can I measure their impact on company performance, and how large could they be?
• How will they impact my investment?

The process of ESG risk analysis should be integrated into the application of fundamental analysis and technical analysis.

The first thing to do is build awareness about the company's ESG issues; this can be achieved either by visiting its manufacturing site, attending annual meetings and investor forums or conducting extensive internet research (for example, NGOs' websites).

You can focus on ESG issues that are more relevant to your investment by identifying the company's products and customers ahead of time. For example, if you are investing in a paper pulp mill, deforestation is likely to be an important ESG issue for you. You can then devote more time to investigate this area further.

Identify the company's major ESG issues, starting with the worst case. This will help you get a clearer idea of what are the risks it faces in this area.

Start with disclosing information about its ESG risks by reading through the relevant sections in annual reports. You can take things further by visiting company websites or subscribing to services that monitor ESG issues, or by attending its annual general meeting (AGM) to ask questions.

You can calculate the company's exposure to these risks by estimating net earnings per share, revenue, cash flow from operations, gross margin, and capital expenditure in each year

These figures will help you get a sense of how large an impact ESG issues could have on the company's financial performance.

Key considerations

You can calculate the company's exposure to ESG risks by estimating net earnings per share, revenue, cash flow from operations, gross margin, and capital expenditure in each year.

These figures will help you get a sense of how large an impact ESG issues could have on the company's financial performance.

ESG risks that affect profitability are the best candidates for further analysis.

You can assess the impact of ESG risks on company performance by carrying out a sensitivity analysis, which is where you stress-test the effect of these risks on your investment.

Figures that are likely to be most sensitive to an ESG issue include net earnings per share, revenue, gross margin, and capital expenditure.

For example, if you are assessing the impact of ESG risks on an oil company's net earnings per share, look for its exposure to government regulations about greenhouse gas emissions or safety standards.

Conclusion

ESG risks are difficult to predict, but you can start by identifying the major ESG issues that matter to your investment. You should then carry out a thorough assessment of their potential impact on company performance. Finally, use sensitivity analysis techniques (stress testing) to assess the magnitude of this risk and how it might change in different scenarios.

Article Source Here: How to Assess Environmental, Social, and Governance (ESG) Risks

Net Operating Assets: Definition, Formula and Examples

Efficiency is one of the primary factors in a company’s success. There are several metrics that provide valuable insights into a company’s operating efficiency. One of these includes the net operating assets. However, it is crucial to know about operating assets and liabilities first.

What are Operating Assets and Liabilities?

Operating assets are any resources owned or controlled by a company used in daily operations. These assets play a significant role in helping companies generate revenues from their business activities. When companies acquire an operating asset, they use it to run ongoing operations. These assets may include non-current and current assets, for example, inventory, machinery, equipment, patents, licenses, etc.

Operating liabilities are similar to operating assets. These are liabilities that companies accrue as a result of their operations. Usually, these liabilities relate to expenses that companies bear due to their operations. For example, operating liabilities include accounts payables, unpaid utility expenses, accrued salaries, and wages, etc.

What are Net Operating Assets?

The term "net operating assets" (NOA) refers to operating assets after deducting operating liabilities. In other words, it is a company's operating assets minus its operating liabilities. Calculating NOA requires companies to separate their operating assets and liabilities from their total assets and liabilities. This metric helps companies remove financial assets from their total assets for better comparisons.

Net operating assets represent the overall assets and liabilities that companies own from their operating activities. NOA allows companies to measure their operational efficiency. They can also compare it with their net operating profit for better insights into their operations. With NOA, companies can value their operating performance independently of financing performance.

What is the Net Operating Assets formula?

The formula for net operating assets is straightforward. From its definition, NOA is the residual operating assets after deducting operating liabilities. Therefore, the net operating assets formula is as follows.

Net Operating Assets = Operating Assets - Operating Liabilities

This approach to calculating net operating assets also requires companies to calculate their operating assets and liabilities. The formula for operating assets is as follows.

Operating Assets = Total Assets - Financial Assets - Excess Cash

Similarly, the formula for operating liabilities is as follows.

Operating Liabilities = Total Liabilities - Long-term Debt - Non-operational Liabilities

Alternatively, companies can also use a different net operating assets formula, which is as below.

Net Operating Assets = (Total Assets - Total Financial Assets) - (Total Liabilities - Total Financial Liabilities)

Example

A company, Mars Co., has operating assets of $30 million and operating liabilities of $20 million. Therefore, the company's net operating assets will be as follows.

Net Operating Assets = Operating Assets - Operating Liabilities

Net Operating Assets = $30 million - $20 million

Net Operating Assets = $10 million

What is the importance of Net Operating Assets?

Net operating assets have several uses for companies. Primarily, it allows companies to calculate their net assets after removing all financial assets and liabilities. Companies can then compare it with their operating profits to get valuable insights into their operational efficiency. Net operating assets also help calculate other figures, including free cash flows, discounted operating earnings, etc.

Net operating assets allows comparisons between various companies. The metric helps investors and stakeholders measure a company's operating performance against others. In short, net operating assets help companies determine the relationship between operating assets, liabilities, and income.

Conclusion

Net operating assets refers to a company’s operating assets minus its operating liabilities. It represents the overall assets and liabilities that companies own from their operations. There are several formulas to calculate NOA. Net operating assets can help companies measure operating efficiency and make better comparisons.

Article Source Here: Net Operating Assets: Definition, Formula and Examples

What are Political Risks?

In the past, there was a global trend for investors to seek out low-risk investment opportunities. However, this has changed in recent years with many investors looking at higher-risk investments as a way of generating more returns on their capital. This is especially true when considering political risk in investment.

Investors are now keenly aware that they must consider not only macroeconomic factors but also country and regional risks such as political instability or potential regime change before deciding which type of investment portfolio to pursue. The reason for this is that most countries have become reliant on foreign capital flows and so any disruption to these can be devastating for the economy and currency.

So let's find out what are political risks and how to avoid them.

Political risks: Explained

When an investor looks at a company, they will weigh up the risk of doing business with them. This means looking at the value and demand for their product or service as well as issues such as country risk.

Simply put, country risk is how likely investors think it is that political instability could affect the economy and currency of a given market. Therefore, if investors perceive that there is a high likelihood of political instability occurring in a country, they will be much less likely to invest - even if the investment opportunity may be profitable.

As such, investors should avoid regions where they expect significant political unrest or changes in the government as this could put their investments at risk and lead to significant capital losses.

At the same time, investors should understand that political risk is not only limited to actual regime change. For example, in many countries, concerns over a new government's ability to maintain peace domestically can be enough to deter an investor from putting capital into the economy. Moreover, any changes in government policy that could affect the country's economy or other investment opportunities could also have a negative effect.

What causes political risks

Many different factors can lead to an increase in political risk. The main one is the election of a new government - either at the federal, regional, or local level.

For instance, after a long period of unquestioned leadership, an election could lead to changes in the government's policies. Investors will then look at this and consider if they are likely to benefit or be negatively affected by these decisions. If they perceive that there is a good chance of being negatively impacted, they may delay investing until they have more information about how the government will act.

Another key factor that can lead to a rise in political risk is social unrest. This can include things like civil wars, protests against economic reforms, or even widespread violence against particular groups of people within the country. When investors consider this level of risk, they will either wait until it has passed or simply avoid investing in the country as a whole.

Some events may not lead to an increase in political risk but could still pose a problem for investors. This includes things like natural disasters, terrorism, and economic downturns.

How to avoid political risks

So how can investors avoid political risk when investing abroad? The first thing is to identify which countries may be affected by a change in government and which are likely to remain stable. In addition, investors should look at whether or not the country has been prone to political instability in the past and use this to identify and avoid potential trouble areas.

Another solution is to diversify investments as much as possible. For example, an investor could spread their risk by investing in a range of countries or even markets rather than putting all their capital into one place. This reduces risk because if any political risk does lead to a downturn in a particular country, the other investments should be able to balance this out and provide some returns.

Finally, investors can use political risk insurance - also known as a Foreign Exchange (FX) or Currency Swap Guarantee - to protect their currency against potential losses caused by negative changes to foreign exchange rates. This would allow an investor to secure their position as well as guarantee the return on their investment.

Conclusion

Investors should consider political risks when putting their money into a company or country since this can affect the value of their investment. However, they should also look out for changes in government policy and social unrest that could lead to an increase in risk. In addition, investors should identify areas where potential negative effects are likely to be low - such as countries with stable governments - and ensure that they spread their risk by diversifying across multiple markets. Finally, investors can use political risk insurance to protect their investment against negative changes in the exchange rate.

Originally Published Here: What are Political Risks?

What is Qualified Audit Opinion

When auditors audit a client's financial statement, they must reach some conclusions. Usually, these conclusions relate to whether the financial statements meet pre-identified suitable criteria. Once they do so, auditors must express their opinion. This opinion may either be unmodified or modified. Among modified audit opinions, auditors may also provide a qualified audit opinion.

What is Qualified Audit Opinion?

A qualified audit opinion is a type of modified opinion expressed by auditors. Auditors use the qualified opinion for two reasons. First, the client’s financial statements contain material misstatements. Second, auditors cannot obtain sufficient and appropriate audit evidence. However, the effects of these events must not be pervasive for auditors to express a qualified audit opinion.

The qualified audit report modifies the audit report. It is the reason why it is a part of the modified audit opinions category. Usually, the qualified audit report sends a negative signal to stakeholders. However, it is less serious compared to other modified opinions. Auditors usually use the qualified audit opinion for misstatements that have effects limited to specific financial statement items.

How does the Qualified Audit Opinion differ from other Modified Audit Opinions?

There are several differences between the qualified audit opinion and the other modified audit opinions. Further types of modified audit opinions include the adverse audit opinion and disclaimer of opinion. Overall, all three of these audit opinions fall under the modified audit opinion category. Therefore, all of these modify the audit report.

However, the qualified audit opinion still differs from the adverse opinion and disclaimer of opinion. The primary difference between these is that the qualified audit opinion is not for pervasive material misstatements. Pervasive is a term associated with how a misstatement affects the economic decisions made by users. If a material misstatement only exists in a specific financial statement item, it is not pervasive.

Another difference between the modified audit opinions is the wording on the audit report. The primary term that auditors use for the qualified audit report is “except for”. With this opinion, auditors specify the areas where material misstatements exist by excluding them from the rest of the financial statements. This way, auditors imply that these misstatements do not affect other areas of the financial statements.

Auditors also use the qualified audit opinion when they cannot obtain sufficient and appropriate audit evidence. Usually, auditors use the qualified opinion when supporting evidence for a specific item, material balance, or material transaction is unavailable. However, the effects of unavailable information are not pervasive.

What does the Qualified Audit Opinion express?

As it is a modified audit opinion, the qualified audit opinion sends a negative signal to stakeholders. However, it is not as serious as the adverse opinion or the disclaimer of opinion. Using the term "except for", auditors exclude the rest of the financial statements from a modified opinion. They also specify the areas which caused them to qualify their opinion.

The qualified audit opinion, although negative, is not as serious. By excluding other items, auditors only point out a specific area where problems may exist. It is still up to users to alter or uphold their decisions related to the client's business. Overall, the qualified opinion does not question the financial statements as a whole but parts of them.

Conclusion

Auditors provide opinions related to their findings during audit engagements. A qualified audit opinion is for material misstatements or audit evidence not being available. However, the effects of these issues must not be pervasive. Auditors use the term "except for" to exclude the rest of the financial statements from the qualified opinion.

Article Source Here: What is Qualified Audit Opinion

What is Tax Risk

Tax risk is the chance that your tax liability will be higher than expected. It's worth considering because it can be a significant expense. There are many ways to reduce or eliminate this risk, but knowing about these opportunities ahead of time can help you plan and save for them in advance.

In this article, we'll look at what is tax risk, how to avoid them, and some other ways you can reduce your exposure.

Tax risk explained

Tax risk is the possibility that your tax liability could be higher than expected. This can happen if you make different choices about how to claim deductions, or because the market value of an asset you hold has increased since you acquired it. While certain kinds of assets are tax-free, many increase your tax liability when you sell them. This is because you'll have to pay capital gains tax on the increase in value.

What causes tax risk

Tax risk can be the result of different choices made at different times. You might have been entitled to a deduction, but decided not to claim it. Or you may have failed to report an expense altogether. Alternatively, your assets could increase in value after acquisition without your realizing it until you sell them.

Here are some of the factors that cause tax risk

• Uncertainty about the applicable tax laws
• Unclaimed deductions
• Assets whose value has increased since purchase
• Economic changes

How to avoid tax risks

The most effective way to reduce your tax liability is by claiming all allowable deductions. Make sure you claim all allowable deductions, and any excess will reduce your tax. You can find out about what is deductible by consulting with a professional tax advisor or online sources.

You can also reduce the chance of facing higher than expected taxes because of assets that have increased in value since purchase by keeping records for every taxable property you own. This will enable you to work out your basis, which is the original value of an asset plus all additions and minus any deductions for wear and tear or depreciation.

If your tax risk has increased because of economic changes, such as a decrease in income or employment, this can often be reduced by asking the IRS for a quick refund of estimated tax. This will ensure that you don't end up owing more than expected at the end of the year.

What are other ways to reduce your exposure

Having a financial cushion can help in unexpected circumstances because it gives you some flexibility when things go wrong. If you don't have this sort of safety net, then building one is one of the most important ways to reduce tax risk. It doesn't have to take a long time, and it's an easy way to ensure that you won't face difficult financial circumstances.

Another option is starting your own business. This can help you get some employment while also allowing you to claim some expenses in order to reduce your tax liability. Additionally, if you work for yourself, then your income is more likely to be stable over a while.

Conclusion

Tax risk is the chance that your tax liability will be higher than expected. It can be significant, and there are many ways to reduce it. Regularly consulting with a professional tax advisor or online services can ensure you fully claim all allowable deductions and reduce your exposure to economic changes. You can also build up a financial cushion and start your own business to reduce taxes.

Article Source Here: What is Tax Risk

Promissory Note: Definition and Examples

What is a Promissory Note?

A promissory note is a document or statement containing a promise from one party to another. This note states that the note’s issuer will pay a predefined sum of money to the noteholder. Usually, it also includes the maturity date or the date on which this transaction will occur. However, some notes may also have terms for payment on-demand.

A promissory note is a method for borrowers to obtain finance without going through a rigid process. These notes make it more straightforward for borrowers to obtain finance. Apart from the date and sum of money, promissory notes also include other terms. These may consist of interest rate, date, and place of issuance, penalties, etc.

Promissory notes are legally binding documents that create an obligation for a party. Usually, these notes are prevalent among smaller companies and individuals. Sometimes, however, financial institutions or larger companies may also issue them. Through these notes, issuers can obtain loans from institutional lenders. This way, issuers can get loans from almost anyone or any source.

How do Promissory Notes work?

When seeking to obtain a loan, issuers will have many options. The most prevalent choice is to acquire funds through financial institutions or institutional lenders. However, this may not be an option sometimes. Therefore, borrowers may need to look for other lenders. For any loans obtained through these lenders, borrowers can issue a promissory note.

As mentioned, a promissory note is simply a document that contains a promise to repay. These notes can be as simple or as complex as the borrower and lender decide them to be. For example, a note payable may include the amount to be repaid or a repayment schedule for multiple installments. Although these notes create an obligation for the borrower, they are more flexible compared to loan contracts.

Promissory notes also contain various elements, some of which may be optional. Any promissory note always includes the name of both parties, their signatures, and the amount of the loan. On top of these, it may contain the interest rates, the terms of the loan, any collateral used, the repayment process, etc. Lastly, promissory notes may also involve on-demand payments. However, those are less common.

Promissory Note Example

A small company, Orange Co., wants to renovate its office building. However, it does not have sufficient funds to do so. Being small, Orange Co. cannot raise capital through financial institutions. Therefore, it must go for other options. Orange Co. identifies another company, Blue Co., that is willing to provide it with a loan. Since it is a small amount of loan, both companies decide to skip a loan contract.

Instead, Orange Co. issues a note payable to Blue Co., stating that it promises to repay the loaned amount. The promissory note also contains the date on which Orange Co. will repay the loan and the interest rate for the length of the loan. Both companies sign off the note. Once the repayment date arrives, Orange Co. repays the loaned amount and the interest payable on it.

Conclusion

A promissory note is a document that states an issuer's promise to repay a lender at a specific date. It creates an obligation and is a type of debt instrument. Promissory notes contain all the terms related to the loan transaction between two parties. Similarly, these notes are more flexible compared to loan contracts or other formal loans.

Originally Published Here: Promissory Note: Definition and Examples