How to Determine Credit Risks of a Startup

There is a very interesting discussion on stackexchange on how to determine the credit risks of a startup.

What would be the ideal way to develop the IFRS9 ECL model for startup fintech when there is no historical data.

There are 2 answers to this question (as of November 2021)

1. This is more of an educated guess than an actual answer, I may be completely off track - take this at a discount: I would identify and quantify my targeted clientele („EUR <region> retail: x %, EUR <Region> corporates y %...“) and I would then buy default data / credit histories / model parameter from data vendors. Another idea could be to reach out to companies that offer outsourcing for risk models / model estimates, at least during the initial phase of your product.
2. According to the regulations of IFRS 9, the valuation for the ECL is not permitted exclusively on the basis of historical values. (For example, IFRS 9.B5.5.17). The inclusion of macroeconomic data and the economic environment is also desired. Similar companies can also be included in the valuation.

This is in fact a very tough question. We have faced this situation frequently in our consulting practice. To determine the credit risks of a startup, or a private company in general, we usually utilize

• Data of comparable public companies,
• The startup’s recent debts,
• Relevant high yield credit indices,
• A structural credit risk model,
• Combination of the above.

Another possible solution is to develop a predictive model, but again, lack of data will be an issue.

Let us know what you think.

Article Source Here: How to Determine Credit Risks of a Startup

Auction Market: Definition, Examples, Comparison with Dealer Market

One general goal for investing is to own assets that will appreciate over time. As an investor, note that there are different types of markets to consider when you want to execute a trade. The auction market is primarily concerned with executing trades among buyers and sellers.

Having a lot of buyers who are interested in buying a financial instrument will make that asset more valuable. Also, when liquidating the asset to cash, the market gets to set the prices realized for the assets being sold.

In this article, you will get to know what an auction market is, how it works, and differentiate between the auction market and the dealer market.

What is an Auction Market?

An auction market is a trading market where buyers and sellers trade assets. In this market, a trade is executed when the highest price from the buyer matches with the lowest price the seller is willing to accept. It's an environment where a bidding process facilitates competition between buyers and sellers.

How Does an Auction Market Work?

This market strategy is quite different from OTC (over-the-counter) market strategy, where trade is carried out directly between two parties without a broker. The auction market can be done physically and also via the computer. But there's no direct negotiation between the buyers and sellers.

Here, the seller place offers in the desired financial instrument. Also, buyers place multiple bids in the desired financial instrument that is available in the market. Then the trade executes when the highest bid price is matched with the lowest ask price.

In this process, there could either be multiple buyers and multiple sellers or multiple buyers and one seller.

Examples

We'll use the case scenario where there are multiple buyers and multiple sellers to explain further.

Three buyers are interested in buying a share of company ABC with the bid prices of $5.00, $5.03, and $ 5.5 respectively. Whereas, three sellers had offered to sell their shares of company ABC for $5.5, $5.7, and $5. 9 respectively.

In this scenario, the highest bid price of $5.5 will be matched with the lowest sell price of $5.5 and the trade will be executed. However, the rest of the orders will not be executed immediately and the current market price of company ABC will be adjusted to $5.5.

Auction Market vs Dealer Market

Going through the characteristics of the dealer market,  it is quite different from the auction market in various ways.

As explained earlier, an auction market is a competitive market where trade is executed by matching the buyer's highest bid price with that of the lowest sell price. On the other hand, a dealer market is a market where dealers post a fixed price to sell a desired financial instrument. Without involving a third party, trade is executed when an investor accepts the dealer’s fixed price.

In the auction market, there's a single platform where buyers and sellers post the prices they want to buy and sell. However, this process ensures that the financial security is sold at a good price. In the dealer’s market, buyers and sellers get to know the bid price and offer price electronically but the trade is executed through dealers.

The auction market operates an order-driven market where buyers and sellers engage in competitive bidding. On the other hand, dealers get to fix the sell and buy prices. That is to say, the dealer market operates a quote-driven system.

Conclusion

The main focus of the auction market is to connect buyers and sellers. In doing this, brokers stand in place of the individual owners of the securities. It's important to note that, no matter how intense trading might be, each market operates with a set of guiding rules.

Post Source Here: Auction Market: Definition, Examples, Comparison with Dealer Market

Is It Better To Be Lucky Than Good?

In financial markets, the logarithms of asset prices are often modeled as a normal distribution. Elsewhere in life, many things are normally distributed: people's height, education levels, talents, working hours in a day, etc. Success, as measured by wealth, however, is not normally distributed. In fact, it’s heavily skewed and follows the Pareto rule: 20% of the world’s population own 80% of the wealth. Indeed, the world’s 8 richest people have a total wealth equivalent to that of the world’s poorest 3.8 billion people.

Why is that?

In Reference [1], the authors showed that a large part of a person's success can be attributed to luck. They used computer simulation to reach that conclusion,

In this paper, starting from few very simple and reasonable assumptions, we have presented an agent-based model which is able to quantify the role of talent and luck in the success of people's careers. The simulations show that although talent has a Gaussian distribution among agents, the resulting distribution of success/capital after a working life of 40 years, follows a power law which respects the "80-20" Pareto law for the distribution of wealth found in the real world. An important result of the simulations is that the most successful agents are almost never the most talented ones, but those around the average of the Gaussian talent distribution – another stylised fact often reported in the literature. The model shows the importance, very frequently underestimated, of lucky events in determining the final level of individual success. Since rewards and resources are usually given to those that have already reached a high level of success, mistakenly considered as a measure of competence/talent, this result is even a more harmful disincentive, causing a lack of opportunities for the most talented ones. Our results highlight the risks of the paradigm that we call "naive meritocracy", which fails to give honors and rewards to the most competent people, because it underestimates the role of randomness among the determinants of success.

We find the article very interesting. It

• Quantified and formally demonstrated the role of luck in one’s success.
• Proved the adage “luck happens when opportunity meets preparation”. According to the study, in order to become successful, a person has to be moderately talented and lucky events have to happen in his/her life. He/She doesn’t have, however, to be the most talented person.

The article raised the following questions,

• Is “the harder you work, the luckier you get” still true? Does working harder increase the likelihood of lucky events?
• How do we minimize the role of unluck, and increase luck in portfolio management practice?
• How can we do that in business and life in general?

To this effect, the authors also proposed some schemes for improving meritocracy in research funding,

…several different scenarios have been investigated in order to discuss more efficient strategies, which are able to counterbalance the unpredictable role of luck and give more opportunities and resources to the most talented ones - a purpose that should be the main aim of a truly meritocratic approach. Such strategies have also been shown to be the most beneficial for the entire society, since they tend to increase the diversity of ideas and perspectives in research, thus fostering also innovation.

References

[1] A. Pluchino, A.E. Biondoy, A. Rapisardaz, Talent vs Luck: the role of randomness in success and failure, Advances in Complex Systems, Vol. 21, (2018)

Article Source Here: Is It Better To Be Lucky Than Good?

Net Purchases: Definition, Formula, Examples

Companies incur various expenses that are crucial for their operations. One of these includes purchases, which are direct costs. Usually, they involve expenses incurred on purchasing raw materials or products. Companies report these costs in the income statement as a part of the cost of goods sold. However, most companies usually include them as net purchases.

What are Net Purchases?

When companies purchase products for resale or manufacturing, their expenses rise. These expenses also increase the purchase costs reported on the income statement. However, several items exist, which can result in a decrease in this amount. Accounting standards require companies to disclose these items in the income statement. These disclosures fall under net purchases as deductions from gross purchases.

Net purchase is the gross amount of purchase made by a company minus deductions for specific items. For most companies, these deductions include purchase discounts, returns, and allowances. In accounting, a purchase is an expense account, while these accounts form contra expense accounts.

What are the components of Net Purchases?

Net purchases have several components which affect the final figure reported on the income statement. The most significant of these is a company's purchases. As mentioned, it usually includes costs incurred on manufacturing materials or resalable products. Without any deductions, it is known as gross purchases. When converting this figure into net purchases, the following three components are crucial.

Purchase returns

Purchase returns include any items that companies return to the supplier. Companies may return goods to suppliers for various reasons, for example, when they receive damaged items. Since companies have already recorded the purchase expense in the accounts, they cannot reverse it. Instead, they use the purchase returns account to reduce the figure through a contra account.

Purchase Discounts

When companies purchase goods on credit, they may receive a cash discount. This discount involves paying the value of those goods within a specific time period. For example, a supplier may offer its customer a 10% discount if they pay within 15 days with a credit term of 30 days. For the purchaser, this discount reduces the cost of the goods purchased. Therefore, they result in a deduction from the gross purchases.

Purchase Allowances

Purchase allowances have similar features as purchase discounts. However, it does not entail a prompt or early payment. Instead, it involves the reduction in prices of goods for various reasons. For example, a supplier may offer a company a reduction in price for damaged goods. Purchase allowances are a decrease in the price of goods purchased to avoid purchase returns.

What is the formula for Net Purchases?

The formula for net purchases is straightforward after considering its components. As mentioned, it is the residual amount after deducting returns, discounts, and allowances from gross purchases. Therefore, the net purchases formula is as below.

Net Purchases = Gross Purchases - Purchase Returns - Purchase Discounts - Purchase Allowances

Usually, companies report this figure in the notes to the financial statements. The net purchases amount goes into the income statement.

Example

A company, Blue Co., made total purchases of $100,000 during an accounting period. Of these purchases, the company returns $10,000 worth of goods to suppliers. Blue Co. also received discounts of $6,000 during the year for early payments. Lastly, the company accepted allowances of $4,000 for purchases that included faulty products. Therefore, the company's net purchases will be as follows.

Net Purchases = Gross Purchases - Purchase Returns - Purchase Discounts - Purchase Allowances

Net Purchases = $100,000 - $10,000 - $6,000 - $4,000

Net Purchases = $80,000

Conclusion

Net purchases include a company's gross purchases minus returns, discounts, and allowances. Similarly, three components are crucial to this amount. These include purchase returns, discounts, and allowances. Companies report net purchases in the income statement. However, these deductions appear on the notes to the financial statements.

Article Source Here: Net Purchases: Definition, Formula, Examples

Bid-Ask Spread: Understanding, How to Read, Example, Liquidity

What is the Bid-Ask Spread?

Bid-ask spreads are most commonly found in the market for stocks, futures, and options. A bid-ask spread is a difference between the price that a buyer is willing to pay for an asset and the price at which a seller is willing to sell the same asset.

Bid-ask spreads exist because investors may not immediately agree on a price, so they need time to negotiate. As a result, the price is set at a point where the lowest ask price equals the highest bid price.

In this article, we'll explore what Bid-ask Spread is and how it works.

Definition of Bid-Ask spread

Bid-ask spread is the difference between the price at which you can sell an asset and the price at which you must buy it. An easy way to understand Bid-ask spread is thinking of it as being similar to a commission when buying or selling something in real life.

The Bid-ask spread is used by traders to determine the impact of an order on the market. The wider the spread, the less liquid a security or asset is and the more difficult it is to execute the order.

Why does Bid-Ask exist?

Bid-ask spreads are actually not that hard to understand once you get familiar with how trading works. A bid-ask spread represents the difference between the lowest asking price for a stock and its highest bid price.

To understand the Bid-Ask spreads better, let's take an example of an investor who wants to enter a market order. When placing this kind of order, you'll be selling at whatever price is available in the exchange, which means that you might not get as much as you would like for it.

On the other hand, if you place a limit order to buy at $100 and somebody places an offer to sell the stock under that price then your order is going to be filled. This means that you don't have to buy for a higher price than what you're willing to because someone else is willing to sell under that price.

For simplicity's sake, let's say that the bid-ask spread for Company inc. shares is $4.95 and $5.00. This means that investors can sell the shares at $4.95 and simultaneously buy at $5.00. The difference between these two prices ($0.05) will be given to whoever operates this exchange.

Use of Bid-Ask Spread

The Bid-Ask spread is used mostly to gauge market liquidity and to decide what type of order we should place. For example, if the Bid-Ask spread is tight, then it’s safer to use the market order. On the other hand, if the Bid-Ask spread is wide, then a limit order should be used.

Here are some of the benefits of Bid-ask Spread

• Helps to determine the fair price of an asset
• Used by traders to determine how much impact their orders will have on the market
• Identifies high-volatility assets
• Helps traders to determine a price range for an asset

Conclusion

The bid-ask spread is the difference between the lowest selling price for a share and the highest buying price. As you can see from our example above, traders can either sell at a lower price or buy under a certain price depending on which order they place.

Article Source Here: Bid-Ask Spread: Understanding, How to Read, Example, Liquidity

Tax Audit: Definition, Types, Examples

There are many types of audits that companies may go through. The most common of these include an external or statutory audit required by laws and regulations. Being a taxpayer, companies may also fall under tax audits. These audits also apply to individuals or any entity that may be considered a taxpayer. Tax audits differ from other types of audits.

What is a Tax Audit?

A tax audit involves the examination of a taxpayer's tax returns by a tax regulatory body. Every country will have an organization that is responsible for overlooking its tax matter. For example, in the US, it is the Internal Revenue Services (IRS), and in the UK, it is the HM Revenues and Customs (HMRC). These bodies do not have a specific requirement for organizations to conduct tax audits.

Instead, they examine taxpayers’ tax returns and select taxpayers based on their criteria. Usually, it involves choosing taxpayers with unusual transactions or figures reported. In tax audits, the tax authority investigates a taxpayer's tax returns more accurately. Through this process, it verifies the incomes and deductions reported in the tax return.

A tax audit allows tax authorities to determine whether taxpayers’ financial records and transactions on the tax returns are accurate. It also allows them to confirm that their returns reflect their actual income and deductions that they have claimed. The audit procedures performed in these audits differ from other audits, for example, external or internal audits. It also involves a special tax compliance audit report, which the auditors submit directly to the tax office.

What are the types of Tax Audits?

There are various types of tax audits that a tax authority may conduct. Usually, the complications of the audit will dictate which form of tax audit will occur. However, there are other criteria that tax authorities will also consider before choosing the type. Some of those types are as below.

Mail tax audit

Mail tax audits are the simplest forms of tax audits. With these audits, the complications are lower, resulting in lesser details required. Regardless of the tax audit type, taxpayers will receive a notice for the audit through the mail. However, not all of these audits fall under mail audits. Overall, mail tax audits involve requesting taxpayers for additional evidence to support their claims on their returns. Mail tax audits are also known as correspondence tax audits.

Office tax audits

Office tax audits involve questioning a taxpayer in the tax authority office. Usually, there is an audit officer who will investigate the taxpayer in person. The taxpayer will receive a notice in advance entailing the requirements for the audit and the supporting evidence they must bring. The taxpayer can also choose to get represented by advocates, for example, accountants or lawyers.

Field tax audits

Field tax audits are the broadest tax audits conducted by a tax authority. These audits involve an agent visiting and investigating a taxpayer. The taxpayer chooses the location for this audit, which usually includes their home or office. Field audits are more thorough and have higher requirements compared to the other types of tax audits.

Conclusion

Tax audits involve examining a taxpayer's financial records and transactions for tax purposes. With these audits, the auditors confirm whether the tax returns reflect accurate information. There are several types of tax audits that taxpayers may go through. These include mail, office, and field tax audits. Usually, the complications of the process dictate under which type a taxpayer will fall.

Post Source Here: Tax Audit: Definition, Types, Examples

Does Intraday Momentum Exist in the Crude Oil Market

Day trading is a popular discussion topic in the practitioners’ literature, the blogosphere, and social media. It receives,  however, less attention in the academic community.

We have previously discussed a paper on the intraday momentum in the stock indices. Reference [1] extended the research to the oil market. It used USO, an oil ETF, 1- minute data to conduct studies. The authors reached several interesting conclusions,

First, our study reveals that the first half-hour return of a trading day significantly predicts the last half hour return of that day, both in sample (IS) and out of sample (OS). For the IS analysis, the predictive value is 0.729%, and the predictive power of the first half-hour returns is further confirmed with an OS R-squared value of 0.659%, both values being economically sizable and much higher than those of monthly predictors…

Second, since intraday predictability varies across crisis and noncrisis periods, we split our sample into crisis and non-crisis periods, the former encompassing two crises: the global financial crisis from June 1, 2008, to January 31, 2009, and the oil market crisis from June 1, 2014, to January 31, 2016 (e.g., Gao et al., 2018). We find that predictability is especially strong during the crisis periods, with a predictive value of 1.923%, a level of predictability that substantially exceeds the predictive value of 0.335% during non-crisis periods…

Third, we find that the predictive power of the first half-hour returns is stronger when the first half hour’s trading has higher realized volatility, higher trading volume, and significant overnight return jumps, all of which are associated with high overnight uncertainty…

Fourth, our next step is to assess economic values by using the predictability of the first half-hour return as a trading signal in a market timing strategy. Specifically, if r1 is positive (negative), we take a long (short) position at the beginning of the first half hour and close the position at the end of the last half hour. Our results show that this market timing strategy significantly outperforms two other benchmark strategies

In brief, intraday momentum also exists in the crude oil market, and a profitable day trading strategy can be developed.

These findings are consistent with our observations and experience. It would be interesting to see how the trading strategy would perform during the pandemic, especially when the price of the front-month oil futures went negative.

References

[1] Z. Wen, X. Gong, D. Ma, Y. Xu, Intraday momentum and return predictability: Evidence from the crude oil market, Economic Modelling, Volume 95, February 2021, p. 374

Article Source Here: Does Intraday Momentum Exist in the Crude Oil Market

Market Order: Definition, Types, Example

What is a market order

When an investor wants to buy or sell a security, he can use several types of orders to execute the trade. One of the most frequently used order types is the market order. Market order ensures that your trade is executed. In this article, we'll take a closer look at market order, its types, and its benefits. So let's get started.

Definition

A market order is an order to buy or sell a security at the current market price. Basically, you instruct your broker to purchase or sell securities at whatever the current market price is upon his/her receiving the order.

Market orders are completely FIFO (first in, first out) meaning they will be executed based on when they were placed. This is different from other types of orders such as limit orders, which can be canceled.

A market order does not guarantee the price that you will get for your trade, but it does ensure that your quoted price is within the stock's trading range. You may get a slightly worse quote if there are no buyers or sellers at that given time.

Different types of Market Order

There are mainly three types of Market Order

1. Limit Market Orders

A limit market order is an order to buy or sell a security at no worse than a specified price (or better). The execution will only occur if the market moves to that given price (or better). For example, if you place an order to buy shares of Google at $610, the order will only be executed if/when it moves to that price or lower.

2. Stop Market Orders

When you place a stop market order, the deal is carried out when the market price reaches your specific stop loss level. What this means is that you won't receive the best possible price since the trade is only executed when there's a sharp drop or rise in price. Sometimes, we also see stop-limit orders.

This type of order is often called stop loss in the financial media. Many investors believe that it provides protection for their portfolios. This is only true if the market moves slowly and there is sufficient liquidity. In a fast-moving market, stop loss might not be an effective risk-management tool.

3. Market-If-Touched (MIT) Orders

A market-if-touched order is an order type that specifies to buy or sell a security at the best possible price, but only if the market price touches or goes through a given stop loss level.

Example

If you place a limit market order to buy shares of Google at $610, the order will only be executed if/when it moves to that price or lower.

Market Order Benefits

Market orders have clear benefits as compared to limit and other types of orders, especially when it comes to low liquidity issues. Here are some of them:

• Market orders provide a guarantee of execution
• Market orders can help detect patterns in a security's behavior
• Market orders provide flexibility and ease of use

Conclusion

A market order is a type of trading order that guarantees the execution of your trade, but it doesn't guarantee the price. When you place a market order to buy or sell, you instruct your broker to purchase or sell securities at whatever the current market price is upon his/her receiving the order.

 

Originally Published Here: Market Order: Definition, Types, Example

Equity Vs Capital

Both equity and capital are terms used in the world of finance to describe ownership in a business. These two terms are closely related but they have key differences depending on the context for which they are being used.

If you run a business or have an interest in the financial industry, it’s important to understand the difference between equity and capital.

In this article, we will define equity and capital and outline their differences.

What is Equity?

Equity refers to the claim that shareholders have in a business once all liabilities have been deducted. In other words, equity describes the amount of money the owners of a business will receive once the liabilities have been deducted from business assets. Equity is also referred to as owner’s equity or shareholder’s equity.

How to Calculate Equity

Mathematically, an equation of equity is represented as:

Equity = Assets – Liabilities

Suppose a company whose total assets are valued at $500,000 has liabilities of $150,000. The calculation of its total equity is:

$500,000- $150, 000 = $350, 000   

A business is considered to have positive equity when it has enough assets to cover its liabilities. On the other hand, if a company’s total liabilities are greater than total assets, the company is said to have negative equity.

Why Is Equity Important?

Equity is included in a company’s balance sheet to help a company’s owners assess the overall value of a business. By knowing a company’s equity, you’ll be able to tell if it’s financially stable. Furthermore, equity represents the claim that shareholders have in a company, so each shareholder can know the amount to expect in case the company liquidates.

By analyzing a company’s total equity, investors can determine the worth of a company and decide whether they should invest.

The common items that impact a company’s equity include retained earnings, treasury shares, net income, and dividend payments.

What Is Capital?

Capital refers to the money or resources that a company’s owners invest in a business. Capital is used to purchase assets, run a business and fund its future growth. It can be cash, equipment, property, receivable accounts, or anything that increases a business’s ability to generate value.  Capital is a subcategory of owner’s equity. There are two main sources of capital—debt financing and equity financing.

There are three types of capital:

• Economic capital: This is the amount of capital that a business requires to stay solvent considering its risk profile.
• Human capital: This refers to intangible resources that workers possess. These resources include knowledge, skills, education, training, intelligence, health, and more. Human capital is an intangible asset and it’s not listed on a company’s balance sheet.
• Natural capital: These are renewable and non-renewable resources owned by a business.

Conclusion

As you can see, these two terms can be confusing, especially for those who are new in the business. In a nutshell, equity is a business’s book value, which is attributable to the owners of the business; while capital is the money that a business’s owners invest in a business.

Post Source Here: Equity Vs Capital

Currency Swaps: Definition, Meaning, Examples, Usage

Currency swaps were originally conceived as a way to avoid the foreign exchange transaction costs that were associated with international trade. By using an intervening currency, parties would be able to reduce these costs and improve their terms of trade by locking in a favorable rate for future transactions.

Today, currency swaps are used by corporations and governments alike as a means of hedging against adverse movements in exchange rates. They also allow companies the opportunity to capitalize on interest rate differentials (although these days cross-currency basis swaps are often used for this purpose).

In this article, we are going to dig in and look at what currency swaps are, some examples, and their benefits.

Currency Swap Definition

A currency swap is a derivative contract between two parties, also known as counter-parties. It involves an exchange of principal and interest in one currency for the same in another currency at certain intervals for a pre-agreed period.

Swap contracts normally state that the original principal amounts should be repaid in full at the end of the period, though this can be extended if both parties agree.

The contract defines the dates on which interest payments are due and how the exchanged principal amounts are calculated.

Currency Swap Example

For example, if Mr. A wants to borrow $1 million for 3 years from Mr. B; Mr. A may enter into a currency swap deal with Mr. B, to exchange 3 yearly £1 million interest payments for a single $1 million interest payment at the end of the period.

In this example, if Mr. A borrows from an American bank and wants to exchange his GBP interest payments for USD interest payments during the 3 years, he can enter into a currency swap contract with Mr. B, and exchange his GBP interest payments for USD interest payments.

At the end of the period, he would repay $1 million to Mr. B as well as pay $1 million worth of GBP revenue to Mr. A (although this figure may change over time due to changes in FX rates).

Currency Swap Benefits

The principal benefit of a currency swap is that it allows an individual or business to manage exchange rate risks. This can be done by taking out a hedge between two currencies so that the value of liabilities and assets remains constant in either one currency or another.

Here are a few benefits of Currency Swap

• It allows businesses to reduce their risk by transferring interest rates or currency exposures to another party
• It allows banks to be exposed to the credit quality of the borrower while fully hedging against exchange rate risk
• It allows for more complex transactions with greater customization, which is difficult with cross-currency basis swaps
• It provides a mechanism that enables businesses to lock in a specific exchange rate for future transactions
• It allows banks and borrowers to capitalize on interest rate differentials between two currencies without exchanging principal amounts until the final maturity date (although this is also available with cross-currency basis swaps)

Conclusion

Currency swaps are powerful derivatives that can be used to manage the risks of foreign currencies and interest rates. They are particularly useful for businesses that depend on cross-currency transactions, or for banks that want to lock in future exchange rates. They are flexible contracts with many uses, but it is important not to focus too much on what they cannot do, and instead on how they can help you.

Article Source Here: Currency Swaps: Definition, Meaning, Examples, Usage

Tracing vs Vouching

During audits, auditors can use various techniques or methods to obtain audit evidence. These methods come into two categories, including the test of controls and substantive procedures. Substantive procedures have two types, consisting of analytical procedures and the test of details. Within this process, auditors can use several techniques. Two of these techniques include tracing and vouching.

Both tracing and vouching involve following a trail that includes supporting documents. However, the approach that both techniques use is different. Overall, both tracing and vouching differ fundamentally. Before discussing the differences, it is crucial to look at both individually.

What is Tracing in Auditing?

Tracing in auditing is a substantive procedure that auditors use to test for details. This process involves obtaining source documents based on a sample and following them to the accounting records. From there, it examines whether these accounting records become a part of the financial statements. Tracing also involves checking the presentation of these items in those statements.

Tracing allows auditors to check for the controls that companies have over their transactions. Following the trail of source documents to the financial statements helps auditors confirm the completeness and accuracy assertions of the financial statements. Similarly, it provides them assurance regarding the client's accounting and financial records.

What is Vouching in Auditing?

Vouching refers to the process of examining a client’s financial records and the supporting evidence with them. However, it does not begin from the source documents. Instead, it involves selecting a sample of transactions from the accounting system and checking the supporting evidence. Therefore, it takes an opposite approach to the tracing procedure used in auditing.

Vouching does not involve confirming the completeness assert of the financial statements. Instead, it helps auditors confirm all other assertions. However, it primarily focuses on the occurrence of transactions. Through this process, auditors can ensure that the client has recorded transactions properly in the accounts.

Tracing vs Vouching: What is the difference?

Tracing and vouching are very similar in various regards. Both of them look at how source documents connect to the financial system. Similarly, both are a part of the substantive procedures that auditors perform. However, there are many differences between tracing and vouchers as well. These differences include the following.

Approach

The primary difference between tracing and vouching is the approach auditors take. As mentioned, with tracing, auditors begin with the source documents. From there, they track the transactions to the financial statements. However, vouching takes the opposite approach. When it comes to the vouching process, auditors begin with the financial statements. From there, they track the transaction to the source documents.

Assertions

The primary assertions tested with both approaches also differ. As mentioned, auditors use tracing to confirm the completeness and accuracy assertions of the financial statements. This way, auditors can check if all source documents become a part of the financial statements based on a sample. With vouching, auditors primarily focus on the occurrence assertion. Through that approach, auditors check if the transactions recorded have source documents to support them.

Misstatements

Tracing involves identifying source documents that the client may not have included in the financial statements. Therefore, it helps auditors locate any understatements in the financial statements. On the other hand, vouching takes the opposite approach. Hence, it allows auditors to identify any overstatements in the financial statements.

Conclusion

Tracing in auditing is a technique that auditors use to test the completeness assertion. This technique involves picking source documents and trailing them to the financial statements. In contrast, vouching allows auditors to test the occurrence assertion. Auditors select transactions from the accounts and track them to the source documents with this approach.

Originally Published Here: Tracing vs Vouching

What are Structured Notes

If you are looking to manage your portfolio’s risk-return profile, why not join the growing number of investors who have been using structured notes?

Structured notes can be a great addition to your investment portfolio, allowing you to gain exposure to a desired market or index at an effective cost, and providing the added benefit of potential gains from any rise in that index.

A structured note is a great combination of pure investment (i.e., shares or bonds), and insurance that can provide downside protection in times of economic stress, while offering the potential for performance when the market is moving in the favourite direction.

In this article, we'll explore the benefits of structured notes, how they work and who should consider them.

What are structured notes

A structured note is a financial instrument issued by an investment firm that has embedded derivatives to provide downside protection or upside participation to an underlying index or other reference assets, such as commodity prices.

Structured notes pay either a fixed or floating interest rate. They are issued by investment banks, insurance companies, and specialist structured product companies, such as Guggenheim Partners and Pacific Investment Management.

The value of a structured note is directly linked to the underlying asset and pays a fixed return if held to maturity under certain market conditions. If the market moves against the investor, there is potential to lose some of your initial investment.

Structured notes are a good idea for an investor who wants to protect his investment when the market crashes. They can protect his portfolio if something bad happens. But unlike options or futures contracts, most structured notes are not traded publicly.

How do structured notes work

Typically, a structured note has the following structure: the amount invested is used to pay for a derivative contract that references an underlying asset.

For example, if an investor wants to buy a stock market index at its current value, he might buy 100 shares of an exchange-traded fund (ETF) tracking it. On the other hand, he could buy a call option on the index or a futures contract.

Alternatively, an investor could consider buying an equity-linked structured note. This would give him direct exposure to the market without having to find 100 shares of an index fund and paying brokerage fees and taxes. The downside is that if he buys the stock market index with a structured note, he will not benefit greatly if it goes up.

On the other hand, if the market falls, the investor will not lose his entire investment. The embedded derivative contract provides protection for his portfolio.

Benefits of Structured Notes

Here are some of the benefits of structured notes

• Diversification of investments
• Market exposure without the risk of losing your shirt
• Added return potential with downside risk management
• High yield potential with low correlation to other assets such as treasuries and corporate bonds

Conclusion

Structured notes have several advantages that make them an attractive option for those looking to manage their security risk-return profiles. They allow you to get exposure to markets without paying huge up-front costs and taking on additional risks. You can also enjoy added returns, without accepting too much risk.

Article Source Here: What are Structured Notes

Net Sales: Definition, Formula, Examples

For profit-based companies and organizations, revenues are highly critical. These represent the income they make during an accounting period. However, some items may also adversely impact these revenues. According to accounting standards, companies must record and report these items separately. This process is crucial in calculating a company's net sales, which goes on the income statement.

What is Net Sales?

When a company makes sales, it records the amount as revenues. These revenues contribute to a company's gross sales. However, accounting standards require companies to report their net sales on the income statement. Through this, companies can give a more accurate and better representation of the operations involving their revenues.

Net sales is a company's gross sales less its sales returns, allowances, and discounts. It represents the first item on the income statement. Usually, companies also provide a calculation of their net sales in the notes to the financial statements. However, the net sales figure may not be a part of every company's financials. Some companies may not offer discounts, returns, or allowances at all. But for companies that do provide these, the net sales figure is crucial.

What are the components of Net Sales?

The most critical component of the net sales figure is gross sales. For most companies, this amount represents the total revenues generated during an accounting period. However, gross sales does not impact the net sales if the other critical components do not exist. An explanation of each of these components is as below.

Sales Returns

When companies sell physical products, they may also offer their customers the option to return them. Usually, they attach specific terms and conditions to these returns. Sales returns include any products received back from customers due to various reasons. For companies, these returns decrease the total revenues generated during an accounting period.

Sales Allowances

In some circumstances, companies may also offer their customers sale allowances. They are similar to discounts but differ from trade or cash discounts. Companies grant sales allowances after customers receive goods. Usually, it involves giving customers an incentive to reduce the possibility of sales returns. Companies often offer sales allowances to customers when their delivered products have issues.

Sales Discounts

Sales discounts are cash discounts provided to customers. With these discounts, companies do not reduce the price of the goods delivered. Instead, it entails decreasing the overall sum paid for those goods in case of early payment for credit sales. Therefore, sales discounts offer the customers an incentive to compensate the company before the credit term.

What is the formula for Net Sales?

The formula for net sales is straightforward after understanding its definition. As mentioned, it is a company’s gross sales after reducing returns, allowances, and discounts. Therefore, the net sales formula will be as follows.

Net Sales = Gross Sales - Sales Returns - Sales Allowances - Sales Discounts

As mentioned, companies usually present this formula in the notes to the financial statements. The net figure then goes into the income statement.

Example

A company, Green Co., made sales of $500,000 during an accounting period. However, some of its customers returned goods worth $50,000 during the period. Similarly, Green Co. offered sales allowances worth $30,000 to customers to avoid sales returns. Lastly, the company provided discounts of $20,000 during the period for early settlements. Therefore, Green Co.’s net sales will be as follows.

Net Sales = Gross Sales - Sales Returns - Sales Allowances - Sales Discounts

Net Sales = $500,000 - $50,000 - $30,000 - $20,000

Net Sales = $400,000

Conclusion

Net sales is a company's gross sales minus sales returns, allowances, and discounts. This figure is a part of a company's income statement. Similarly, companies may provide a breakup in the notes to the financial statements. Apart from the gross sales, three components are critical for calculating net sales. These include returns, allowances, and discounts.

Originally Published Here: Net Sales: Definition, Formula, Examples

Interest Rate Caps: Definition, Example, Usage

In the financial world, many different terms may be unfamiliar to you. One of these could be an "Interest Rate Cap," which can help you protect your investments or savings from any drastic changes in interest rates.

Interest rate caps have been around for over 50 years and have proven to be an effective way for investors to minimize risk while maximizing their potential return on investment. In this blog post, we will break down what an interest rate cap is and how it can work for you.

What is an Interest Rate Cap

Interest rate caps are one of many types of options you can put on investments or savings that have a variable interest rate. The most common products that have a variable interest rate are certificates of deposit (CDs), adjustable-rate mortgages, bond funds, and individual bonds.

By purchasing a cap option, the buyer is protected from any increases in the underlying interest rate. If interest rates increase and exceed a certain pre-determined level (cap), the buyer only pays the cap-level interests. For example, if you purchased a five-year adjustable-rate mortgage (ARM) with an interest rate cap of 3% above the initial rate of 2%, then your maximum payable interest rate is capped at 5%.

In the above example, you own an interest option that pays off if the interest rate rises above the cap level. This option is also called an embedded derivative. It is the exact opposite of the interest rate floor which we have discussed before in this blog.

How do Interest Rate Caps Work

You can purchase an interest rate cap for a specific time frame and a certain pre-determined percentage. The cap option will protect you from any increase in interest rate. To enjoy the protection provided by the interest rate cap, you will have, however, to pay a premium upfront.

For example, you purchase an interest rate cap for five years and set your cap at 2% above your initial rate for this time. If the interest rate increases above the cap level, your payoff will be the difference between the interest rate and the cap level. This means that if you own an adjustable-rate mortgage (ARM), the interest rate cap will prevent your mortgage rate from rising above the cap level.

What are some benefits of Interest Rate Caps

An interest rate cap brings a lot of benefits to an investor. Here are a few of the most common benefits of an interest rate cap:

• Protects from rising interest rates
• You are rewarded for the difference between the current interest rate and your original rate
• Helps better manage potential risks
• Helps to adjust a floating rate for a certain time

Conclusion

Interest rate caps have been around for a long time and can be an effective tool for managing interest rate risks. From adjusting a fixed return rate for a certain period to protecting yourself from rising interest rates, this financial tool can be a good addition to your financial toolbox.

Article Source Here: Interest Rate Caps: Definition, Example, Usage

Pairs Trading Strategy-What are the Sources of Excess Returns?

Pairs trading is a quantitative trading strategy that is often discussed in the academic as well as practitioners’ literature. We have written about this trading strategy extensively from different perspectives. In this post, we’re going to look at the risk/PnL drivers of the pairs trading strategy.

Reference [1] pointed out that the profit of pairs trading comes from the spreads between small- and large-cap stocks and between value and growth stocks in addition to the spread between high- and intermediate-grade corporate bonds and shifts in the yield curve.

These profits are uncorrelated to the S&P 500; however, they do exhibit low sensitivity to the spreads between small and large stocks and between value and growth stocks in addition to the spread between high- and intermediate-grade corporate bonds and shifts in the yield curve. In addition to risk and transaction cost, we rule out several explanations for the pairs trading profits, including mean reversion as previously documented in the literature, unrealized bankruptcy risk, and the inability of arbitrageurs to take advantage of the profits because of short-sale constraints

However, in a recent publication [2], other authors linked the profitability of pairs trading to market liquidity,

Our results have shown that a simple pairs trading strategy building on an unsupervised machine learning approach does not generate sufficient excess returns to cover a conservative estimate of explicit transaction costs on the S&P500. Conversely, the same trading strategy appears to be profitable on OSE even when adjusting for both explicit and implicit transaction costs. We have shown that the profitability of pairs trading appears to be closely related to the market liquidity of the stocks that are traded, which might explain why the trading strategy appears to be more profitable at OSE.

In other words, using their proposed approach, which consists of first using Principal Component Analysis to divide stocks into clusters and then using cointegration to select the pairs, the strategy is not profitable in SP500, but in OSE, and the profitability is closely related to the market liquidity.

These articles raised some interesting questions,

• Is pairs trading still profitable in the US markets,
• What truly is the source of excess return, if any,
• Does the profitability depend on strategy design?

Let us know what you think.

References

[1] E. Gatev, WN. Goetzmann, KG. Rouwenhorst, Pairs Trading: Performance of a Relative-Value Arbitrage Rule, The Review of Financial Studies, Volume 19, Issue 3, Fall 2006

[2] A. Høeg, EK. Aares, Statistical Arbitrage Trading using an unsupervised machine learning approach: is liquidity a predictor of profitability?, BI Norwegian Business School, 2021.

Article Source Here: Pairs Trading Strategy-What are the Sources of Excess Returns?

Disclaimer Audit Opinion

An auditor’s opinion is a statement that auditors provide after auditing a company’s financial statements. Usually, this process involves examining these statements and collecting audit evidence. Based on this process, auditors come to a conclusion to form an opinion. Usually, this conclusion entails ensuring the financial statements are free from material misstatements. Similarly, it includes commenting on fair and true presentation.

There are different types of audit opinions that auditors may provide. Usually, auditors state an unmodified audit opinion, which assures stakeholders of the integrity and objectivity of the financial statements. However, auditors may also give an unmodified opinion. This opinion has three types, including qualified opinion, adverse opinion, and disclaimer of opinion.

What is the Disclaimer Audit Opinion?

Auditors consider two factors crucial to the audit opinion they provide. The first includes the financial statements being free from material misstatements. The second entails collecting sufficient appropriate audit evidence related to items in those statements. The disclaimer of audit opinion relates to the audit evidence that auditors obtain. It differs from other qualified audit opinions.

Auditors provide the disclaimer audit opinion when they can’t obtain sufficient appropriate audit evidence. There are various reasons why auditors cannot collect audit evidence. Sometimes, it may include the management not cooperating. In other circumstances, it may also involve the audit evidence not existing at all. Whatever the reason, if auditors cannot obtain audit evidence to support their audit opinion, they will provide the disclaimer audit opinion.

The unavailability of audit opinion may also fall under the qualified audit opinion. However, auditors use the disclaimer audit opinion when the impact of the audit evidence is pervasive. In auditing, a matter becomes pervasive when its effects spread to the financial statements as a whole. In some cases, it may also include misstatements being a substantial portion of those statements.

How does the Disclaimer Audit Opinion work?

The audit process involves the auditors obtaining sufficient appropriate evidence. Usually, clients provide supporting documents or information with their transactions or events. In some cases, however, it may not be available. For example, a company may not have the supporting documents required to back up its sale transactions. Sometimes, clients may also have evidence, but the auditors may not consider it sufficiently appropriate.

If the effect of the unavailable sufficient appropriate audit evidence is immaterial, auditors may ignore it. Similarly, if they have a material impact, the auditors may provide a qualified opinion. In some cases, it may be pervasive. Therefore, the auditors must use the disclaimer audit opinion. With this opinion, auditors state that they couldn't obtain audit evidence to form an opinion.

A disclaimer audit opinion does not involve providing or expressing an opinion. Instead, it states that auditors cannot form an audit opinion due to the absence or unavailability of sufficient appropriate audit evidence. With this opinion, auditors withdraw any responsibility that comes with auditing the financial statements.

Example

Given below is an example of the disclaimer of audit opinion for a client that auditors may provide.

Disclaimer of Opinion

We were engaged to audit the financial statements of Red Co., which comprise the statement of financial position as at December 31, 2021, and the statement of profit or loss and other comprehensive income, statement of changes in retained earnings and statement of cash flows for the year then ended, and notes to the financial statements, including a summary of significant accounting policies.

We do not express an opinion on the accompanying financial statements of Red Co. Because of the significance of the matter described in the Basis for Disclaimer of Opinion section of our report, we have not cannot obtain sufficient appropriate audit evidence to provide a basis for an audit opinion on these financial statements.

In the above example, the auditors state that they do not express an audit opinion on the subject matter. Therefore, it forms the disclaimer audit opinion. Auditors will provide their reasons for this opinion in the 'Basis for Opinion' paragraph.

Conclusion

Auditors reach a conclusion regarding an audit engagement and provide it in the form of an audit opinion. With the disclaimer audit opinion, auditors do not provide an audit opinion. Instead, they express that they were unable to obtain sufficient appropriate audit evidence. However, its impact must be pervasive, or else it would fall under a qualified audit opinion.

Post Source Here: Disclaimer Audit Opinion

Interest Rate Floors: Definition, Example, Usage

Interest rates are often subject to fluctuations, which can be either upward or downward. When a bank sets an interest rate floor for their customers, it means that the banks will not allow the customer's interest rates to change below a certain level. This protects the lender in case of dramatic changes in market conditions and provides stability.

Interest rate floors are the exact opposite of interest rate caps, which allow the interest rates to not go higher than a certain level. Oftentimes an interest rate floor is used in conjunction with adjustable-rate mortgages (ARMs), as it protects the lender from fluctuating market conditions and guarantees stability.

Let's dig deep into the interest rate floor.

Interest Rate Floor Definition

Interest Rate Floors are financial derivative contracts. They are in fact options contracts that can be used to hedge the fluctuations in interest rates. For example, a bank can use them to set an interest rate in the lower range of rates associated with a floating rate loan product. Interest Rate Floors often protect the lender and provide stability to financial transactions such as adjustable-rate mortgages (ARMs). Interest Rate Floors are also used in loan agreements, which is quite interesting as the name says it all.

Interest Rate Floor Example

If you have an adjustable-rate mortgage (ARM) and your interest rate floor is set to a level that covers any associated costs, then if market conditions change drastically, your predefined minimum rate will remain at this same level. This provides stability and protection for the lender in case of dramatic changes in market conditions.

How do Interest Rate Floors Work

Interest Rate Floors are a form of protection for the lender involved in a financial transaction. Interest Rate Floors define the minimum possible interest rate during an ARM’s lifetime, which helps to protect against dramatic changes and ensures stability for the bank. At times, this is also referred to as gap risk protection.

Interest Rate Floors can be a component of the adjustable-rate mortgage (ARM) market, as they provide stability to the lender involved in this type of transaction and protect against dramatic changes, which could lead to substantial financial loss.

Interest rate floors will help ensure stable rates by providing a minimum interest rate throughout an ARM’s lifetime for the protection of the lender. This means that he will not have to worry about the interest rate fluctuating below a certain level, regardless of market fluctuations.

Interest Rate Floor Benefits

• Adds stability and predictability to the transaction.
• Prevents dramatic interest rate changes and market fluctuations from negatively affecting the lender.
• Protects the lender by allowing for an agreed-upon minimum rate regardless of the state of the economy or financial markets, which is quite interesting and worth mentioning.
• The interest rate floor can help predict future payments on adjustable-rate mortgages (ARMs) and help manage the cash flow.

Conclusion

Interest rate floors are financial derivative contracts and are often embedded in loan agreements to protect against dramatic changes in interest rates. Interest Rate Floors also help provide stability by defining the minimum possible interest rate through an ARM’s lifetime, which helps the lender better manage the cash flow.

Post Source Here: Interest Rate Floors: Definition, Example, Usage

What Is Econometrics Used For?

Since the inception of the idea of econometrics, many economic analysts have used its model to explain the interrelatedness of fundamental economic factors. These factors include labor, capital, interest rates, as well as government’s fiscal and monetary policies. Econometricians use a ton of data available to them to analyze these simple relationships.

But, does it stop at that? From keen studies, econometrics serves other purposes which strengthen the economic systems. And, these are explained further in this article.

Introduction to Econometrics

Econometrics is the quantitative application of statistical and mathematical data, models, and theories to develop new economic theories, test existing hypotheses, and forecast future trends.

It seeks to transform real-world data into statistical hypotheses and then describes the results with the theory or theories in view for common grounds. This means that these economic models are converted to tools for economic policymaking.

In their book, Stock and Watson wrote “Econometric methods are used in many branches of economics, including finance, labor economics, macroeconomics, microeconomics, and economic policy.”

Econometrics converts qualitative statements into quantitative ones. For instance, describing the positive relationship between two variables, econometrics says: "with every one dollar increase in disposable income, consumers' spending increases by 90 cents". This shows that it uses numbers rather than concepts or theories to explain phenomena.

Ragnar Frisch, Lawrence Klein, and Simon Kuznets are the pioneers of econometrics for which they won the Nobel Prize in 1971.

What are the Types of Econometrics

Econometrics has two major divisions depending on what the analyst seeks to achieve.

Theoretical Econometrics studies existing statistical models to discover their properties and their values. This is relevant in developing new statistical procedures, useful in the field of economics, and are not subject to changes in data.

Applied Econometrics is focused on converting qualitative economic statements into quantitative statements using econometric techniques. It concerns itself with topics around the production of goods, demand for labor, arbitrage pricing theory, and more. And, because of the variance of the data, applied econometrics changes with time.

The Need for Econometrics

The foremost windfall of econometrics is to test economic theories or hypotheses provided by econometricians. The direct relationship between consumption and income or the effect of the quantity demanded of a certain commodity and its price can be tested using econometric.

Secondly, econometrics provides a means to derive numerical estimates for the variables of economic relationships. These numerical estimates are vital for reaching economic-related decisions. For instance, a valid estimate of the coefficient of the relationship between income and consumption is a fundamental tool for policy-making. A policymaker will need them to understand the possible outcome of a proposed tax reduction for instance and make an informed decision.

Lastly, econometrics is pertinent to forecast future economic trends which is also a key tool for effective policy-making. If according to predictions there is a high tendency of low inflation in the future, policymakers can be proactive in their decisions.

So, in all, econometrics can help financiers and economists by making the best financial decisions.

Conclusion

Econometrics facilitate the testing of statistical models, the development of new theories, and the making of inferences. Policy-makers need these inferences to form policies and make crucial decisions.

Post Source Here: What Is Econometrics Used For?

Foreign Currency Risks: Definition, Types, How to Manage

Investing in foreign assets can be a good way to diversify your investment portfolio. But you must first understand the risks involved before diving in head-first.

You can make more money by investing in foreign assets, but you could also lose big if the values of the foreign currencies go down. And given that fluctuations in currency values can occur overnight, it's important to know just how much risk you're prepared to take on.

In this article, we are going to look at some of the potential risks around investing in foreign assets and how you can deal with those risks.

What are foreign currency risks

Currency risk arises when there is a change in the exchange rate between one currency and another. This can be either an appreciation or depreciation of the other currencies (known as foreign currency) or your domestic currency (known as home or domestic currency).

When you invest in overseas assets, you are exposing yourself to three different types of foreign currency risk. These are:

Transaction risk

Transaction risk comes from buying or selling a foreign currency. To buy a foreign investment, you have to first convert your domestic currency into other currencies. If you do this through an intermediary, such as a bank, there may be exchange rate costs and/or fees involved.

Translation risk

Translation risk occurs when the value of the foreign investment is translated into your home currency for reporting or taxation purposes. To do this, you need to know how much the investment is worth in your home currency at a given time. For example, if you have an investment that is denominated in Japanese yen and needs to be converted to Australian dollars, then there is a risk that the value you report for taxation purposes may be different from the actual value.

Economic Risk

Even if the value of a foreign currency is not changing, economic events such as inflation, or deflation can cause changes to its purchasing power. For example, if you invest all your money in Japanese yen and that country experiences deflation for several years, then you would expect the yen to increase in value due to the reduced cost of goods and services. However, your investment returns are likely to be lower than expected because the value of the yen would have fallen.

How to manage foreign currency risks

To manage foreign currency risks well you need a strategy. We look at how you can do this below.

Be mindful of which countries hold importance for your investments

Risk management is as much about knowing which areas to avoid as it is knowing those with potential. Different countries have different levels of exposure to various economic risks, such as deflation, inflation, interest rates changes, political risks like war and government changes, or natural disasters like tsunamis and earthquakes.

Be mindful of your tolerance to risk

For example, if you need the money back in 1 year then you should not invest in long-term assets such as property or shares. This is because their value can fluctuate dramatically over short periods and this may affect what you can get back.

Invest in some form of international diversification

For example, if you had all your money in shares of companies based only in the United States, then your investment would be very exposed to fluctuations in US dollar currency. Just as you can diversify by country of origin or investments of choice, you can diversify by currency. This means that if the value of one currency drops against another, then you are protected to some degree because the investment returns, although in a different currency, are still positive.

Use forward exchange contracts

If you want to exchange your money for another currency at a later point in time and the risk of fluctuations between now and then is too great, then you can use ways to lock in today's rate. This is done through the forward market. It helps you to buy foreign currency at a certain price on a future date.

Practice Hedging

You can reduce the risk of changes in currency rates by using hedging strategies where you lock in today's rate (or better) on future transactions or investments. Hedging is when you agree with someone else to sell at a particular price in the future. This limits your potential loss from a favorable movement in the exchange rate, but it will also reduce your profit if there is a significant rise in that rate. You can use derivatives to hedge your foreign currency exposure or you can "hedge" through spot transactions using forward contracts.

Conclusion

Investing in foreign assets can be very rewarding but it comes with risks. If you are not careful, this can lead to significant losses. By being aware of the main types of risks that are involved and by making sure your investments are diversified, you can manage these risks well.

Article Source Here: Foreign Currency Risks: Definition, Types, How to Manage

Tail Risk Hedging Strategies: Are They Effective?

Portfolio hedging is a risk-management practice that uses a number of strategies to mitigate the risks of any given portfolio. Tail risk hedging in particular is one of the techniques used in equity portfolio management. It basically involves buying put options in a certain amount to partially or fully protect the portfolio.

Reference [1] provided an in-depth study of different tail risk hedging strategies,

In this paper, we contributed to the limited literature on using actively managed put options as tail hedges. We investigated whether a put option monetization strategy can protect an equity portfolio from drawdowns and enhance its returns. We have done so by applying eight different monetization strategies, using S&P 500 put options and an underlying equity portfolio represented by the S&P 500 Total Return index, during the time period 1996 to 2020. We have compared the results from the strategies with an unhedged position in the chosen index, and with a constant volatility strategy applied on the same underlying.

The article pointed out that as compared to an unhedged index position, tail risk hedging yielded worse results both in terms of risk-adjust and total returns.

Over the course of the 25-year period, all the strategies’ total returns and Sharpe ratios are inferior to the unhedged index position. The observed results suggest that rule-based monetization strategies are not able to adequately reduce drawdowns, less, enhance returns of the portfolio compared to the unhedged position.

The results make sense since buying puts means paying for the convexity, i.e. the volatility risk premium. However, we believe that the hedging costs can be further minimized by optimizing for the strikes and maturities. There should exist optimal strikes and maturities where the volatility risk premium is minimized. Along this line, the authors also noted,

The observed results might be sensitive to the chosen representation of the equity portfolio and the investigated time period. Furthermore, the results could be sensitive to the choices of time to expiry and moneyness of the bought options in the tested strategies. Active money managers could also try and exploit increasing correlations in swift market declines with the use of indirect hedges.

Finally, portfolio managers can also use other hedging strategies such as indirect hedges or diversification.

References

[1] C.V. Bendiksby, MOJ. Eriksson, Tail-Risk Hedging An Empirical Study, Copenhagen Business School, 2021

Originally Published Here: Tail Risk Hedging Strategies: Are They Effective?

Audit Working Paper

The auditing process requires auditors to collect evidence that supports their work. During this process, auditors must ensure the evidence is sufficient and appropriate. This evidence then forms the basis for the auditor's report. Apart from the client's supporting documents, auditors must also possess proof of their plan and the work they perform. Therefore, they prepare audit working papers.

What are Audit Working Papers?

Audit working papers are documents prepared by auditors that show their plan and performance. These papers provide evidence that the auditors planned and performed the audit under the auditing standards. Similarly, they illustrate that the process followed any applicable legal and regulatory requirements. Auditors prepare audit working papers as a part of their work.

Audit working papers summarize the client's nature and processes, the audit program, audit procedures, etc. These documents are a crucial part of any audit and form a part of a client's current file. Similarly, there are several procedures or evidence that audit working papers may include. It will usually differ based on the client's nature and how the auditors tackle the audit.

Overall, audit working papers help auditors document the information they gather during an audit. They also act as evidence of the auditor’s work during an audit service. Similarly, they ascertain that auditors obtained sufficient evidence to support their opinions in the audit report. Audit working papers are also necessary for quality control and risk management in case of future issues.

What do Audit Working Papers include?

There are several documents that audit working papers may include. As mentioned, the auditors' work will differ from one client to another. Accordingly, these working papers will also vary based on the auditor's work performed. There are some prevalent items that the audit working papers may include. Some of these consist of the following.

• Documentation of the client’s nature of business.
• Audit planning documents under the relevant standards, including audit programs.
• Analysis of transactions and account balances.
• Ratio and trend analysis documentation.
• Materiality and performance materiality calculations.
• Risk assessment of the client’s business and material misstatements.
• Record of the nature, timing, extent, and results of audit procedures.
• Evidence of supervision and review of work.
• Extracts of the client’s corporate minutes.
• Flowcharts of the client’s key transaction processes.
• Questionnaires about the client's business, answered by the management.

The above represent some of the prevalent documents that are a part of audit working papers. Apart from these, auditors may also prepare other documents based on their requirements.

What are the factors that affect Audit Working Papers?

As mentioned, several factors dictate the audit working papers that auditors must prepare. The first is the client's nature, which includes its size and complexity. Usually, clients of larger nature and more complexity require more work. Therefore, auditors will perform more procedures which will result in a higher number of working papers. Apart from the client's nature, the audit's nature will also impact these papers.

Similarly, the audit working papers will also get influenced by the client's risk assessment. The higher the risk for an audit service is, the more audit working papers will be required. Furthermore, the significance of the audit evidence obtained will also impact these papers. Lastly, if auditors identify material misstatements, the audit working papers will get affected.

Conclusion

Audit working papers include documentation of the work performed by auditors and their planning. These papers are of high significance for various reasons. Usually, audit working papers differ based on the client's nature. However, several other factors also impact them.

Post Source Here: Audit Working Paper

Cheapest-to-Deliver Bond

When it comes to bond futures contracts, there is a fairly obscure little secret that savvy traders know about. This secret allows those who are aware of it to cash in on the difference between what they need to pay for their bond and what they receive upon delivery. It's called "cheapest-to-deliver" and here we'll show you how it works and how you can use it in your bonds futures trading.

What is the cheapest-to-deliver bond

The term CTD or cheapest-to-deliver refers to the contract with the lowest margin requirement when you are delivering bonds in order to cover a futures position. The CTD bond is related to your futures position because when you go short on bonds, you need to deliver them when the contract expires.

If you sell 10 contracts of bond X at $100 and then deliver them when the contract expires, you will want to deliver the bond with the lowest margin requirement. In this case, that would be a lower-priced bond from the same issuer, so you might deliver bonds worth $90 each.

In practice, you don't have to worry about determining which specific bonds are cheapest-to-deliver because nowadays bond futures exchanges do this for you.

How does cheapest-to-deliver work

The CTD calculation is determined by the futures exchange, not by you. One factor that influences the calculation of cheapest-to-deliver is interest rates, specifically their recent movement. The current 30-day average rate on a bond will factor into its CTD status.

When the price of one bond goes up relative to other bonds in the same issuer's series, its CTD status will go down because it might not be cheaper to deliver than other bonds in the issuer's series. If this happens, that bond may be automatically switched out for a different one when you deliver your position.

The exchange automatically gives you the option of receiving the next CTD bond and takes care of this calculation and transaction for you, so you won't need to worry about this.

Benefits of cheapest-to-deliver bonds

The main benefit of CTD positions is that the bond you receive has the lowest possible margin requirement when you deliver it to close your futures position. This can save you a lot of money, so smart traders know how to take advantage of it by buying or shorting bonds with this in mind.

There are other benefits to using cheapest-to-deliver positions, including:

1. A lower yield

CTD positions will generally have a lower yield than other bonds because the issuer has already hedged its position in the bond futures market and is willing to sell at a lower margin (or deliver it with a higher margin).

2. Less volatility

CTD positions tend to be less volatile because they are hedged. The exchange takes all the risk out of the position for you, so while CTD positions may have a lower yield, their prices tend to hover around par -- unlike other non-CTD issues which fluctuate wildly with market conditions.

3. More security

CTD positions are considered more secure by investors because they are hedged. In the event that a company goes bankrupt, CTD positions will be paid off at par value at maturity, unlike other non-CTD issues which could be worth less than what you bought them for.

Keep in mind that cheapest-to-deliver is only one factor to keep in mind when making your investment decisions.

Conclusion

Investing in cheapest-to-deliver bond futures can help you improve your returns and cut costs, but it's no panacea. As with any investment strategy, trading CTD might work for some traders and not others. So make sure to conduct extensive research before you begin trading.

Originally Published Here: Cheapest-to-Deliver Bond

Accounting for Cost of Services

The cost of goods sold represents all direct costs incurred on manufacturing a product or acquiring it. Usually, it includes a company’s purchases and other similar expenses that directly contribute to the products. This figure is crucial in calculating gross profits. For service-based firms and companies, however, the cost of goods sold is not applicable. Instead, these firms use the cost of services.

What is the Cost of Services?

The cost of services is similar to the cost of goods sold. Instead of purchase expenses, it includes all direct costs incurred on providing a service. For most firms, these costs will involve direct labour expenses incurred for employees. These include salaries, wages, bonuses, overtime, etc., paid to staff who provide services.

In some cases, the cost of services may also include expenses incurred on direct materials. However, these materials are not for manufacturing physical products. Instead, they consist of items that are essential to the provision of services. Apart from these, they may also include any other expenses that contribute to the rendering of services.

Like the cost of goods sold, the cost of services is crucial in measuring gross profits. Similarly, these do not include any indirect expenses incurred for operation or other purposes. Firms report the cost of services in the income statement and deduct it from their revenues to reach gross profits. Overall, the cost of services is highly crucial for companies and firms involved in rendering services.

What is the Accounting for Cost of Services?

The accounting for the cost of services is similar to the cost of goods. As mentioned, this amount includes any expenses incurred directly toward providing services. Usually, it involves the labour costs incurred for employees who render services. In essence, the cost of services is an expense for firms. However, it is crucial that any item in this heading directly contributes to the services provided.

When firms incur an expense, they must determine whether it is a direct or indirect expense. Once they ensure it directly contributes to the services, they can record it as a cost of services item. The journal entry for cost of services is as follows.

Date	Particulars	Dr	Cr
	Material / Labor / Other expenses (Cost of services)	XXXX
	Cash / Bank / Payables		XXXX

In the above journal entry, the debit side will include the account for the expense. Firms will separate these accounts into the cost of services category. The credit side will consist of the source for the expense. Usually, firms pay for them or may also get them on credit. Either way, this entry will increase the firm’s cost of services in the income statement.

Example

A firm, Red Co., provides accountancy services to its clients. During one of its assignments, the firm pays one of its employees $10,000 through a bank account to render accounting services to a client. Since this expense relates directly to the provision of services, Red Co. recorded it as a part of its cost of services. The journal entry for the transaction is as below.

Date	Particulars	Dr	Cr
	Salary Expense (Cost of Services)	$  10,000
	Bank		$  10,000

During the assignment, Red Co. also purchased stationery items for the employee to help document progress. The firm acquired $1,000 worth of goods for which it paid through cash. These items contributed directly to the provision of services. Therefore, they will be a part of the cost of services. The journal entry is as below.

Date	Particulars	Dr	Cr
	Stationery Expense (Cost of Services)	$  1,000
	Cash		$  1,000

Overall, Red Co.’s cost of services for the specific client was $11,000 ($10,000 salary expense + $1,000 stationery expense).

Conclusion

Cost of services represents all direct expenses incurred on the provision of services. It includes various items for firms that are in the services industry. The accounting for the cost of services is similar to that of the cost of goods. Firms record any direct expenses in the relative account and treat them as a part of the cost of services.

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What are Government Bonds

Governments use bonds to raise money for various reasons. These may include paying off debts, building infrastructure (such as roads, bridges, railways), or running national programs like social security and medicare. Governments also issue bonds when they want to borrow large sums of money in order to pay for wars or natural disasters that the government can't afford at the time.

Government bonds can also be a secure investment. Since they are issued by the government, they are considered to be low risk, meaning the chance of the government not being able to pay back its debt is extremely low.

In this article, we are going to take a look at what government bonds are, how do they work, and what their benefits are.

What are government bonds

When a government needs to borrow money, it issues bonds. Bonds are essentially debt instruments issued by the government on which interest is paid (just like on your typical bank loan). This means that when a person purchases a bond from the government, they receive a part of the principal and an agreed-upon amount of interest at predetermined dates in the future for lending the government money.

How do government bonds work

Typically, bonds are issued for a specific amount of money that the government must pay back at full value. They can also be issued with certain terms (such as giving the bondholders the option to buy more bonds).

When you purchase a bond, you're actually loaning money to your country's government and in return, you will receive interest at regular intervals (the "coupon payments"). This means that by purchasing a bond, you are essentially lending money to the government. The issuer agrees to pay interest on the bond for an agreed-upon amount of time and repay the principal when the bond matures.

How to invest in government bonds

The most common ways are to purchase them from a brokerage account or over the counter.

If you want to invest in Government Bonds through your brokerage account, all you have to do is pick a bond with a maturity date that best fits within your investing goals.

Once you purchase the bond, it will be held by your broker until it matures

Most brokers will allow you to sell your bond before it matures, however, if the market price isn't as high as the purchase price, they might charge a penalty for making an early sale.

You can also invest in government bonds over the counter. This means that you will buy from someone directly instead of going through a broker.

Benefits of government bonds

Bonds are considered to be low risk since they are issued by the government. This means that if you invest in a bond, your investment is protected against inflation since the purchasing power is not likely to decrease. Also, investing in government bonds can actually lead to higher returns than most other investments.

Here are a few benefits of government bonds

• Tax benefits
• Portfolio diversification
• Safe and secured since it is Government Backed
• Higher interest rates than most other types of investments
• Easier to understand than stocks or mutual funds
• Not affected by market fluctuations
• No risk of losing capital

As you can see, government bonds have a lot of benefits that make them an attractive investment option. For investors who want to diversify their portfolios, investing in government bonds is a great choice.

Conclusion

Government bonds are a low-risk investment option. Investing in them can help investors diversify their portfolios and earn significant returns over time. If you are considering putting your money to work by investing in government bonds or other types of investments, make sure that you consult with a financial adviser first. You can also do some research and read more articles like this one to understand what your options are.

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Econometrics and Operations Research

For those who love to dig into the root of problems and proffer possible solutions, Econometrics and Operations Research could be the right options. In analyzing models, one can make decisions that are apt for the now and future.

However, through an understanding of the focal points of each of them, some differences may be extracted.

What Is Econometrics?

Econometrics is the application of statistical and mathematical methods for the quantitative interpretation of economic phenomena and systems. It involves the use of statistical theories and tools to test hypotheses, to explain and predict future trends.

The goal of econometrics is to convert qualitative statements into quantitative statements. This means that instead of using conceptual words for a descriptive judgment, numbers are used to represent phenomena.

Econometrics is a working tool for practitioners of econometrics (econometricians), to modify economic models into versions that people can use to make estimates.

According to Stock and Watson, “econometric methods are used in many branches of economics, including finance, labor economics, macroeconomics, microeconomics, and economic policy.” Econometrics is essential for making economic policies as it examines their impact on the economic system.

What Is Operations Research?

Operations research (OR) is an analytical method used in organizations for decision-making and problem-solving. It is a useful procedure for organizational management as it breaks down problems into basic components and uses mathematical analysis to seek solutions to them. By providing a step-by-step approach to solving these problems, an organization can make progress.

The theory of operations research was triggered by military planners during World War II. And thereafter, the techniques of this concept have remained relevant in addressing issues in business, the government, and society at large.

Operations research entails five major steps:

• Problem identification
• Creating a model (a representation of real-world system and variables) around the problem
• Developing solutions to the problem using the model
• Testing and examining the success of each solution on the model
• Applying the solution to the actual problem.

The three fundamental traits of all operations research efforts are optimization, simulation and probability, and statistics.

Econometrics and Operations Research

Econometrics and operation research are similar techniques, they both have the goal of using existing data and theories to enhance quantitative decisions. And, of course, these decisions have their relevance in the future.

The use of mathematical data to discover and provide insights valuable for making reliable predictions and possible solutions is their fundamental drive. Also, both use models, improve on them to proffer and test solutions before applying them. In other words, they compare and narrow down options to find the best fit.

However, OR is a vast discipline. Econometrics can be seen as an application of OR with a specialization in economics.

Also, econometrics is more forward-looking in idea, it uses quantitative data and techniques from statistics, mathematics, and algorithms to back up economic decisions. Operations Research uses advanced mathematical tools to solve problems and optimize processes, such as scheduling, transport logistics, etc.

Conclusion

Econometrics is specific to the economic discipline, seeking to strengthen economic decisions. Operations research, on the other hand, can be applied in economics as well as other fields to solve complex issues. Although they slightly differ in core focus, they are complementary.

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Credit Value at Risk (cVAR): Definition, Formula, Calculation, Interpretation

Credit Value at Risk (cVAR) is a measure of the potential economic loss on credit exposures due to credit events. Credit Value at Risk may be calculated for individual assets, portfolios, or even institutions.

It can be expressed in absolute terms, such as Euros or Dollars, or as a percentage of total exposure. The calculation requires three inputs: the current market price, the planned sales price, and their respective default probabilities.

It becomes important to calculate credit value at risk when there is a need to determine the level of an institution's capital adequacy requirement.

In this article, we will be talking about credit value at risk, what causes it, and how to calculate it.

What is Credit Value at Risk

Credit Value at Risk is a number that tells you how risky your credit portfolio is. It will tell you the unexpected losses of the credit portfolio over one year at some confidence level. The losses are expressed in terms of currency units or credit exposure.

It helps banks and financial institutions to determine the level of their capital adequacy requirement. In other words, it is a measure of how much money you stand to lose from exposure to credit risk over one year under normal market conditions.

What causes Credit Value at Risk

Credit Value at Risk is influenced by three factors

1. The probability of default for each obligor in the portfolio
2. The exposure to the obligor at default, or collateralization level which is defined as the percentage of the exposure that would be lost if the counterparty defaults
3. The exposure at default is modified by a credit conversion factor which reflects the expected loss that would be incurred in a worst-case scenario, such as a downturn of the economy or a systemic crisis

Importance of Credit Value at Risk

This is a measure of the amount that you could lose from a credit portfolio over one year under normal market conditions. It is important to determine levels of capital adequacy requirement in order to show prudence in making business decisions and effective management of risk.

How to calculate Credit Value at Risk

In general, there are three steps in calculating Credit Value at Risk

Step 1 - Define the inputs needed. First, list your portfolio of assets or credits. Next, you need to obtain the current market value of each asset or credit. And thirdly, obtain the expected probability that is being assigned for each borrower breaching their loan agreement/contract terms during the year.

Step 2 - Calculate the expected loss for  each instrument in your portfolio

Expected Loss = Probability of Default X Exposure at Default X Loss Given Default

Loss Given Default = 1 – Recovery Rate

Step 3 - Calculate Credit Value at Risk

The loss distribution of the credit portfolio is determined by simulation, and the Credit Value at Risk is calculated as follows,

Credit Value at Risk=Worst Credit Loss-Expected Credit Loss

Conclusion

Credit Value at Risk is a number that tells you how risky your credit portfolio is. This number tells you the unexpected losses over one year at a confidence interval. The losses are expressed in terms of currency units or credit exposure. The capital adequacy ratio helps banks and financial institutions to figure out how much money they need.

Originally Published Here: Credit Value at Risk (cVAR): Definition, Formula, Calculation, Interpretation