Financial Investment & Risk Management

Money and Finance

2011-01-19T23:09:00.001-08:00

Monetary venture and finance planning is often found to be helpful in helping an private to earn requisite profits from the money markets. Managing money in finance markets, however, is not highly easy. One needs to have a approved understanding of his/her own money assets and other personal finance issues, in order to form sufficient financial plans. For investing and finance plan-making, investors often require the expert guidance of professional financial planners too.

Personal money finance planning is required to generate a blue-print of the way in which money should ideally be spent. Strategic management of personal finances is generally done in any of the following three ways:

Persanl Financial Investment

i) Keeping monetary savings in banks,
ii) Finance planning and investing money in an informed manner, and
iii) Choosing ideal venture instruments, that would yield profits even over the long-run.

As stated above, one of the most popular ways to conduct money/personal finance is to open bank accounts. The banking sector is one of the most foremost components of money and finance markets. Typically, you can avail of any one (or, more) of the different types of bank accounts. If you are finding to boost your level of savings, you should ideally put your money in a savings account. On the other hand, for ease in deposit and withdrawal of money, current accounts of banks are deemed suitable. These accounts, however, do not yield interests on money deposits. You can also make a fixed deposit, so that you can enjoy interest revenue as well as be able to withdraw money, as and when necessary.

Investing and finance planning also form a potentially rewarding channel of money management. There are some venture tools in the money and capital markets in an economy. Mutual funds, bonds, stocks and securities and personal guarnatee policies are some of the most popular of such tools. Each of them differs in their rates of return and their linked risk-levels. Investors can pick from among these, and other, base channels of investment, according to their tastes and preferences.

Long term personal money finance management also requires individuals to have proper withdrawal plans and estate plans. There generally exists a trade-off between these two types of planning (more money set aside for withdrawal planning means less funds are ready for current estate purchases), and financial condition can be optimized by striking the precise balance between the two.

Money and finance issues are highly important, and can appear to be rather involved to a beginner in these fields. With the help of professional planners, however, individuals can recognize favorable profit-yielding finance plans and investing opportunities. With sound personal money finance plans as the basis, one can actually earn rich rewards from the money and prestige markets in the economy.

Money and Finance

Risk supervision

2011-01-17T08:10:00.001-08:00

In each human endeavour there is an element of risk; personal, scheme or financial, or a mixture of them all. The job of the responsible individual is to recognize the risk and act accordingly. We all do these 'risky' things, roughly daily, aware that we are taking a risk. Rather than staying away from the risk we come to be adept at identifying it and having a strategy for dealing with it if the risk materialises. This is what risk management is about, and is an ability that is foremost in virtually every endeavour.

The popular misconception that risk management is difficult or complex stems from the bureaucratic methodology of some system-oriented organisations and managers. It is neither complex or bureaucratic, and need not be. Risk management is basically a straightforward proposition with a complexity dictated by the nature of the situation to which it applies - ordinarily a project, and the parties involved. In its basic form risk management involves:

Personal Risk Management

1. Identifying risk - seeing for anything that threatens the successful completion of the scheme against the original requirement. Risks can be environmental, organisational, technical, legal, economic or commercial.

2. Counteracting risk - Taking activity to take off or sell out the probability of a risk being realised. The response depends on the nature or seriousness of the risk.

3. Acting when the risk event occurs - Invoking anything contingency measures were devised for the risk that has materialised.

And for this to happen requires:

4. Monitoring at all stages - This typically means documenting a risk assessment in a profile that identifies the risk, the probability of its occurrence, and the impact if it does materialise. Factors that score supreme are those that wish the many concentration and monitoring. A good risk employer will devise contingency plans that sell out either the probability or the impact of these occurrences, and so take off them from the scene.

Working within a formal structured management law similar to that defined by Iso9001 requires the application of risk assessment practices to satisfy the requirements of the Standard. Auditors of such systems may not find specific references to risk management in these areas even though the identification of inherent failure (8.5.3) is completely concerned with a topic that is nothing less than risk management.

Well managed risk taking is an significant highlight of any send mental enterprise, since risk is an element of any progression or advancement. It is the adoption of efficient risk management in conjunction with the continuing need to drive send from a comfortable position that leads to improve and advancement. Doing what we all the time do purely because the risks appear to be negligible or are well known is to be 'risk averse', and for progressive organisations cannot be acceptable. Neither is it approved to pursue new ideas without an understanding of their inherent benefit, allowable planning, a clear idea of the threats to these benefits being achieved , and a strategy for dealing with them should they materialise. We need to manage in a manner that is neither predictable or reckless. Risk assessment is an significant tool to hold this strategy. We ignore it at our peril...

Risk supervision

Personal Finance Software

2011-01-16T01:09:00.001-08:00

Do you need to make best decisions about your personal finances? Do you struggle retention track of your spending and investments? Personal finance software can provide you with a sophisticated suite of financial calculators and tools to take the worry and frustration out of managing your personal finances.

Let's face it. Not everybody has the mindset or attitude of a bookkeeper or accountant. If you are not very organized and disciplined managing your finances, investments and paying bills can come to be spectacular, and a very time-consuming task.

Persanl Financial Investment

Personal finance software is easy to use and it can transform your financial situation by helping you gain control of your investments, budget, debt, spending and even help you recognize immediate savings. Here are just a few of the things that a good personal finance supervision software can do for you:

1. Categorization of all your spending
2. Automatically develop and administrate a funds based on your spending patterns
3. Track the operation of your investments
4. provide procure online entrance to all of your bank, prestige card and investment accounts
5. Pay bills and make electronic payments
6. Intuit your net worth
7. Track your 401K
8. Receive real time stock reports
9. Graph your spending and investments
10. Originate a personal financial statement
11. Export tax information
12. Find the best prestige card, bank, mortgage and brokerage catalogue deals based on your spending patterns
13. Help you plan for retirement
14. provide reminders for bill payments
15. Sms for real time investment briefcase management
16. Help you with a plan to get out of debt sooner

Personal finance software is an prominent part of comprehension and making attractive financial decisions. Finance calculators do all the tough math calculations to provide you with exact numbers on investment returns, savings, interest, debt consolidation, taxes, retirement, Iras and a 401K. Many software packages automate the calculations for you and provide self-acting analysis of all your financial information.

Budget planner can provide you with guidance on investing, the best loans, information about Ira accounts and withdrawal plans, or just finding good money rescue tips, debt supervision and more. Some packages are even completely Free. Put an accountant and bookkeeper at your fingertips 24/7 with personal finance software and have peace of mind that your finances are being managed verily and effectively colse to the clock.

Personal Finance Software

NCAV/MV in Thailand Stock Market Part 4

2010-05-01T03:43:00.000-07:00

1) Graham and Dodd (1934), Graham (1976)

2) Graham and Chatman (1956)

Graham used the NCAV/MV criterion extensively in the operations of the Graham-Newman Corporation and report that shares selected on the basis of the NCAV/MV rule earn, on average, about 20 percent per year over the 30-year period to 1956.

3) Oppenheimer (1986)

Oppenheimer tested returns of NCAV/MV portfolios with returns on both the NYSE-AMEX value-weighted index and the small-firm index from 1971 through 1983. He found that returns are rank-ordered: securities with the smallest purchase price as a percentage of NCAV show the largest returns.

4) Cheh and Zutshi (1993)

They Focuses on the Japanese market from 1975 to 1988. In order to maintain a sample large enough for cross-sectional analysis, Graham’s criterion was relaxed so that firms are required to merely have an NCAV/MV ratio greater than zero. They found the mean market-adjusted return of the aggregate portfolio is around 1 percent per month (13 percent per year).

5) Fama and French (1993)

They create a three-factor asset pricing model, where expected returns were function of a stock’s

exposure to market risk, the relative returns of small versus large stock, and the relative returns of high versus low book-to-market stocks. This model was able to explain almost variation of US

stock returns and the majority of its explanatory power was attributable to the size variable.

6) Ying Xiao and Glen C. Arnold (2008): Testing Benjamin Graham’s net current value strategy in London

Because of potential problems defining accounting variables and equity capitalisation, they exclude companies with more than one class of ordinary share and foreign companies. Also excluded are companies on the lightly regulated markets and companies belong to the financial sector. They include companies that have been de-listed from the exchange due to merger, liquidation or any other reason in the holding period, thus avoiding survivorship bias. Returns for each company, including dividends, are adjusted for changes in stock splits, rights issues and stock repurchases.

NCAV/MV in Thailand Stock Market Part 3

2010-05-01T03:36:00.001-07:00

This individual study is base on the research paper called “Testing Benjamin Graham’s Net Current Asset Value Strategy in London” by Ying Xiao and Glen C Arnold. The authors illustrated the return from portfolio using net current asset value strategy is more than return from market index. The main paper concluded that the interpretation of the excess returns to value strategies is controversial and has been explained in two ways. First, the excess return associated with value stocks is due to the propensity of value portfolios to be disproportionately small firms, and so what is really being observed is a low market capitalisation effect. Second, value strategies are fundamentally riskier. For example, Fama and French (1993, 1996) created their three-factor pricing model (market factor, small minus big size factor and high minus low book-to-market factor) in an attempt to provide a risk compensation explanation of value premiums. However, many other researchers, particularly behavioural finance adherents, dispute whether the FF3M really measures risk induced equity return premiums. According to this view high returns to small companies and high returns to low market-to-book ratio companies are caused by investors being less than completely rational, leading to neglected, under-researched stocks and temporary under-pricing, followed by a convergence to intrinsic value.

Amongst the array of value strategies the net current asset value (NCAV/MV) approach has been successfully used in practice, most famously by Benjamin Graham in the early twentieth century, bringing high profits from the 1930s to 1956. There have been very few studies examining the NCAV/MV strategy. Graham’s NCAV/MV strategy calls for the purchase of stocks at a price 2/3 or less of the NCAV. Per share NCAV, as defined by Graham (Graham and Dodd (1934), Graham (1976)), is the balance sheet current assets minus all the firm's (current and long-term) liabilities divided by the number of shares outstanding. Long-term assets (e.g. intangible assets and fixed assets) values are not counted. Graham found that companies satisfying the NCAV/MV strategy were often priced at significant discounts to estimates of the value that stockholders could receive in an actual sale or liquidation of the entire corporation. Thus, the NCAV/MV rule, in theory, not only protects capital from significant permanent loss but also generates a portfolio of stocks with excellent prospects for advance in price.

‘It is clear that these issues were selling at a price well below the value of the enterprise as a private business. No proprietor or majority holder would think of selling what he owned at so ridiculously low a figure…In various ways practically all these bargain issues turned out to be profitable and the average annual result proved much more remunerative than most other investments’ Graham (2003).

An adherent to the efficient markets hypothesis would advance the argument that investors rationally push down a stock’s price to below NCAV in anticipation of the corporation continuing to invest its resources in wasteful ways, gradually draining the company of much of its shareholder wealth. However, Graham reasoned that the majority of these value stocks will survive and produce good returns because of the potential for one of a number of developments to occur preventing management from continuing on a path of value destruction through the gradual dissipation of assets:

· Earning power would be lifted to the point where it was commensurate with the company’s asset level. This could come about in two ways: a general improvement in the industry – entry and exit dynamics mean that low industry profitability is frequently not as persistent as many market pessimists believe - and; a change in the company’s operating policies – management running a company with such a low stock price relative to assets either respond voluntarily to take corrective action or they (or their replacements) are forced to by stockholders, such as adopting more efficient methods or abandonment of unprofitable lines.

· A sale or merger with another corporation that could employ the firm’s assets would take place. It would pay at least the liquidation value.

· Complete or partial liquidation could release value. The management of a corporation selling at below liquidation value need to provide a frank justification for continuing to operate.

The objective of this paper is to study NCAV/MV strategy in Thailand since I am not aware of any work done on the Thailand stock market. However my individual study does not follow all step of original the research paper due to some limitations. This individual study does not use the criteria that stocks in portfolio must have NCAV/MV greater than 1.5 because there are only few stocks which can pass the criteria so that it cannot be the good sample size. These individual study the criteria that stocks in portfolio must have NCAV/MV greater than 1.0 instead. This individual study also not apply Fama and French (three-factor pricing model) model because there are some researches that apply Fama and French model in Thailand Stock exchange and the result show that it cannot clearly explain fundamentally riskier in Thailand Stock market. The results of this individual study not exactly the same as the original paper by the way it shows the trend that NCAV/MV strategy could be applied in Thailand stock exchange.

NCAV/MV in Thailand Stock Market Part 2

2010-05-01T03:28:00.000-07:00

It is widely recognized that value strategies - those that invest in stocks with low market values relative to measures of their fundamentals (e.g. low prices relative to earnings, dividends, book assets and cash flows) - tend to show higher returns. This paper was focused on the early value metric devised and employed by Benjamin Graham - net current asset value to market value (NCAV/MV) - to see if it is still useful in the modern context. Examining stocks listed on the Thailand Stock Exchange for the period 1991 to 2004 was observed that those with an NCAV/MV greater than 1.0 display significantly positive market-adjusted returns over five holding years. This testing was allowed for the possibility that the phenomenon being observed is due to the additional return experienced on smaller companies (the ‘size effect’) and still find an NCAV/MV premium. The profitability of this NCAV/MV strategy in Thailand cannot use Capital Asset Pricing Model (CAPM) to explain the abnormal return of the NCAV/MV strategy. These premiums might be due to irrational pricing.

NCAV/MV in Thailand Stock Market Part 1

2010-05-01T02:47:00.001-07:00

There are several stock investing approaches that could make a great profit and equity return, however; one of the very effective and reliable approaches is the value investment which primarily determines the return by such fundamentals as the revenue of the company, dividends, assets and cash flow. In the past, using Benjamin Graham’s net current asset value to market value (NCAV/MV) was one of the best possibilities. However, it’s still in doubt that such a strategy could be used in Thailand stock exchange or not.

Due to the great respond of Warren Buffett’s investing strategy which makes value investment is widely recognized in the current stock market. Although such strategy is very successful, it may not suit for Thailand stock investment. Therefore, this research is created in order to find out whether Benjamin Graham’s investing method could be adapted to fit the stock investing strategy in Thailand.

Understanding Sarbanes Oxley

2010-02-17T08:32:00.000-08:00

There are a few things you can do to learn how Sarbanes Oxley works. First, read reviews and synopses of the Sarbanes Oxley Act on the SEC website; they give an excellent overview of what the law is about. Second, you can get training focused in several different ways on the part of Sarbanes Oxley you need to understand.

The main thing to understand about Sarbanes Oxley, though, is that it primarily affects how you do your accounting, and thus how you run your IT services. Electronic controls must properly manage your financial information, so that you have clear, easy-to-access real-time information on your company's finances. Corporate finances must be kept separate from executive finances, payroll, and other moneys. Auditing for accountability is crucial, so that if errors or misinformation enter the data stream you will be able to determine the source.

With Sarbanes Oxley, even if you were ignorant of what was going on in your accounting, if you are a major executive you will be both civilly and criminally liable for any errors released to the public, or the failure to release certain information in a timely manner. You must learn about Sarbanes Oxley, not just to comply with more government regulations, but to protect your personal life.

What Is Sarbanes Oxley?

2010-02-17T08:31:00.000-08:00

When the Enron and MCI scandals broke, it became clear to the US government as well as everyone else that something needed to be done to prevent financial abuses from harming the public. A bipartisan team of legislators led by Senator Paul Sarbanes and Representative Michael G. Oxley put together the Sarbanes Oxley Act, also titled the Public Company Accounting Reform and Investor Protection Act of 2002, and more manageably called SOX for short. It was overwhelmingly passed by the House of Representatives, and the Senate voted unanimously to pass the Sarbanes Oxley bill.

The Sarbanes Oxley Act was signed into federal law on July 30, 2002. Its primary purpose is to protect investors by making corporate information released about accounting and finance more accurate and reliable. It addresses issues like the establishment of a public company, creation of an accounting oversight board, auditor independence, corporate responsibility, and enhanced financial disclosure.According to President Bush, Sarbanes Oxley includes 'the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt.'

That may be true, but it's also one of the most complex and difficult to understand reforms ever passed. It covers topics such as:PERSONAL LOANs by the company to executive officers or directors,Financial report certification,More timely insider trading reporting, Strong limitations on insider trades.

Public reporting of top executive real compensation and company profits Auditing independence Personal accountability by the chief officers of the company, backed up by criminal and civil penalties including serious jail time and financial penalties on individuals who misstate financial statements and commit securities violations.You can see how a bill covering so many different topics might be seen as discouragingly complex.

Mortgage

2009-07-10T00:14:00.000-07:00

From Wikipedia, the free encyclopedia


Property law
Part of the common law series
Acquisition
Gift · Adverse possession · Deed Conquest · Discovery · Accession Lost, mislaid, and abandoned property Treasure trove · Bailment · License Alienation
Estates in land
Allodial title · Fee simple · Fee tail Life estate · Defeasible estate Future interest · Concurrent estate Leasehold estate · Condominiums
Conveyancing
Bona fide purchaser Torrens title · Strata title Estoppel by deed · Quitclaim deed Mortgage · Equitable conversion Action to quiet title · Escheat
Future use control
Restraint on alienation Rule against perpetuities Rule in Shelley's Case Doctrine of worthier title
Nonpossessory interest
Easement · Profit Covenant running with the land Equitable servitude
Related topics
Fixtures · Waste · Partition Riparian water rights Lateral and subjacent support Assignment · Nemo dat Property and conflict of laws
Other common law areas
Contract law · Tort law Wills, trusts and estates Criminal law · Evidence
v • d • e

A mortgage is the transfer of an interest in property (or the equivalent in law - a charge) to a lender as a security for a debt - usually a loan of money. While a mortgage in itself is not a debt, it is the lender's security for a debt. It is a transfer of an interest in land (or the equivalent) from the owner to the mortgage lender, on the condition that this interest will be returned to the owner when the terms of the mortgage have been satisfied or performed. In other words, the mortgage is a security for the loan that the lender makes to the borrower.

This comes from the Old French "dead pledge," apparently meaning that the pledge ends (dies) either when the obligation is fulfilled or the property is taken through foreclosure.^[1]

In most jurisdictions mortgages are strongly associated with loans secured on real estate rather than on other property (such as ships) and in some jurisdictions only land may be mortgaged. A mortgage is the standard method by which individuals and businesses can purchase real estate without the need to pay the full value immediately from their own resources. See mortgage loan for residential mortgage lending, and commercial mortgage for lending against commercial property.

The cost to the borrower is measured by the annual percentage rate (APR), which is an effective annual rate of interest and fees paid by the borrower.

In many countries, though not all (Iran) or (Bali, Indonesia is one exception^[2]), it is normal for home purchases to be funded by a mortgage. Few individuals have enough savings or liquid funds to enable them to purchase property outright. In countries where the demand for home ownership is highest, strong domestic markets have developed, notably in Ireland, Spain, the United Kingdom, Australia and the United States.

Participants and variant terminology

Legal systems in different countries, while having some concepts in common, employ different terminology. However, in general, a mortgage of property involves the following parties.

Mortgage lender

Mortgagee is a party to whom property is mortgaged, usually a lender. Mortgage provides security to the lender. Given the large sum of money involved in financing a property, a mortgage lender will usually want security for the loan that will provide a claim upon that security and will take precedence over other creditors. A mortgage accomplishes this security.

The lender loans the money and registers or records the mortgage with the title to the property. The borrower gives the lender the mortgage as security for the loan, receives the funds, makes the required payments and maintains possession of the property. The borrower has the right to have the mortgage discharged from the title once the debt is paid. If the mortgagor fails to repay the loan according to the conditions set forth by the lender, then the mortgagee reserves the right to foreclose on the property.

Borrower

A mortgagor is the borrower in a mortgage—they owe the obligation secured by the mortgage. Generally, the debtor must meet the conditions of the underlying loan or other obligation and the conditions of the mortgage. Otherwise, the debtor usually runs the risk of foreclosure of the mortgage by the creditor to recover the debt. Typically the debtors will be the individual home-owners, landlords or businesses who are purchasing their property by way of a loan.

Most buyers of real property would have difficulty saving enough money to make an outright purchase of real estate. The use of debt increases a buyer's ability to buy through a combination of down payment and debt. As a result a real estate transaction seldom occurs without buyers relying on borrowed funds.

Borrowing for investment purposes

Aside from the absence of large amount of available money, there are several reasons why an investor (including a buyer of real estate) might borrow funds. Some of these include:

To diversify investments and reduce overall risk by using only part of the available funds for any one investment. However the mortgage loan enables him to purchase more assets than he would otherwise been able to, and therefore in general increases investment risk rather than reducing it.

To invest the borrowed funds at a higher rate of interest (yield) than the borrowing rate; for example, a sum is borrowed at an annual interest rate of 7% per year and used to invest in a project that returns 10% per year. This is likely to be speculative and there is usually a possibility that the project may turn out to return less than 7% per year or to lose money.

To free up equity for other purposes; for example, a commercial enterprise may prefer to use funds to purchase inventory or equipment instead of investing only in land and buildings.

To obtain a tax benefit. In some countries (such as Canada), mortgage interest is not tax deductible, but loans made for investment purposes are.

Other participants

Because of the complicated legal exchange, or conveyance, of the property, one or both of the main participants are likely to require legal representation. The terminology varies with legal jurisdiction; see lawyer, solicitor and conveyancer.

Because of the complex nature of many markets the debtor may approach a mortgage broker or financial adviser to help them source an appropriate creditor, typically by finding the most competitive loan.

The debt is, in civil law jurisdictions, referred to as hypothecation, which may make use of the services of a hypothecary to assist in the hypothecation.

Default on divided property

When a tract of land is purchased with a mortgage and then split up and sold, the "inverse order of alienation rule" applies to decide parties liable for the unpaid debt.

When a mortgaged tract of land is split up and sold, upon default, the mortgagee first forecloses on lands still owned by the mortgagor and proceeds against other owners in an 'inverse order' in which they were sold. For example, A acquires a 3-acre (12,000 m²) lot by mortgage then splits up the lot into three 1-acre (4,000 m²) lots (A, B, and C), and sells lot B to X, and then lot C to Y, retaining lot A for himself. Upon default, the mortgagee proceeds against lot A first, the mortgagor. If foreclosure or repossession of lot A does not fully satisfy the debt, the mortgagee proceeds against lot B, then lot C. The rationale is that the first purchaser should have more equity and subsequent purchasers receive a diluted share.

Legal aspects

Mortgages may be legal or equitable. Furthermore, a mortgage may take one of a number of different legal structures, the availability of which will depend on the jurisdiction under which the mortgage is made. Common law jurisdictions have evolved two main forms of mortgage: the mortgage by demise and the mortgage by legal charge.

Mortgage by demise

In a mortgage by demise, the mortgagee (the lender) becomes the owner of the mortgaged property until the loan is repaid or other mortgage obligation fulfilled in full, a process known as "redemption". This kind of mortgage takes the form of a conveyance of the property to the creditor, with a condition that the property will be returned on redemption.

Mortgages by demise were the original form of mortgage, and continue to be used in many jurisdictions, and in a small minority of states in the United States. Many other common law jurisdictions have either abolished or minimised the use of the mortgage by demise. For example, in England and Wales this type of mortgage is no longer available, by virtue of the Land Registration Act 2002.

Mortgage by legal charge

In a mortgage by legal charge or technically "a charge by deed expressed to be by way of legal mortgage",^[3] the debtor remains the legal owner of the property, but the creditor gains sufficient rights over it to enable them to enforce their security, such as a right to take possession of the property or sell it.

To protect the lender, a mortgage by legal charge is usually recorded in a public register. Since mortgage debt is often the largest debt owed by the debtor, banks and other mortgage lenders run title searches of the real property to make certain that there are no mortgages already registered on the debtor's property which might have higher priority. Tax liens, in some cases, will come ahead of mortgages. For this reason, if a borrower has delinquent property taxes, the bank will often pay them to prevent the lienholder from foreclosing and wiping out the mortgage.

This type of mortgage is most common in the United States and, since the Law of Property Act 1925,^[3] it has been the usual form of mortgage in England and Wales (it is now the only form – see above).

In Scotland, the mortgage by legal charge is also known as Standard Security.^[4]

In Pakistan, the mortgage by legal charge is most common way used by banks to secure the financing.^{[citation needed]} It is also known as registered mortgage. After registration of legal charge, the bank's lien is recorded in the land register stating that the property is under mortgage and cannot be sold without obtaining an NOC (No Objection Certificate) from the bank.

Equitable mortgage

In an equitable mortgage the lender is secured by taking possession of all the original title documents of the property and by borrower's signing a Memorandum of Deposit of Title Deed (MODTD). This document is an undertaking by the borrower that he/she has deposited the title documents with the bank with his own wish and will, in order to secure the financing obtained from the bank.

History

At common law, a mortgage was a conveyance of land that on its face was absolute and conveyed a fee simple estate, but which was in fact conditional, and would be of no effect if certain conditions were met – usually, but not necessarily, the repayment of a debt to the original landowner. Hence the word "mortgage" (a legal term in French meaning "dead pledge"). The debt was absolute in form, and unlike a "live pledge" was not conditionally dependent on its repayment solely from raising and selling crops or livestock or simply giving the crops and livestock raised on the mortgaged land. The mortgage debt remained in effect whether or not the land could successfully produce enough income to repay the debt. In theory, a mortgage required no further steps to be taken by the creditor, such as acceptance of crops and livestock in repayment.

The difficulty with this arrangement was that the lender was absolute owner of the property and could sell it or refuse to reconvey it to the borrower, who was in a weak position. Increasingly the courts of equity began to protect the borrower's interests, so that a borrower came to have an absolute right to insist on reconveyance on redemption. This right of the borrower is known as the "equity of redemption".

This arrangement, whereby the lender was in theory the absolute owner, but in practice had few of the practical rights of ownership, was seen in many jurisdictions as being awkwardly artificial. By statute the common law's position was altered so that the mortgagor would retain ownership, but the mortgagee's rights, such as foreclosure, the power of sale, and the right to take possession, would be protected.

In the United States, those states that have reformed the nature of mortgages in this way are known as lien states. A similar effect was achieved in England and Wales by the Law of Property Act 1925, which abolished mortgages by the conveyance of a fee simple.

Foreclosure and non-recourse lending

In most jurisdictions, a lender may foreclose on the mortgaged property if certain conditions – principally, non-payment of the mortgage loan – apply. Subject to local legal requirements, the property may then be sold. Any amounts received from the sale (net of costs) are applied to the original debt.

In some jurisdictions, mortgage loans are non-recourse loans: if the funds recouped from sale of the mortgaged property are insufficient to cover the outstanding debt, the lender may not have recourse to the borrower after foreclosure. In other jurisdictions, the borrower remains responsible for any remaining debt, through a deficiency judgment. In some jurisdictions, first mortgages are non-recourse loans, but second and subsequent ones are recourse loans.

Specific procedures for foreclosure and sale of the mortgaged property almost always apply, and may be tightly regulated by the relevant government. In some jurisdictions, foreclosure and sale can occur quite rapidly, while in others, foreclosure may take many months or even years. In many countries, the ability of lenders to foreclose is extremely limited, and mortgage market development has been notably slower.

At the start of 2008, 5.6% of all mortgages in the United States were delinquent.^[5] By the end of the first quarter that rate had risen, encompassing 6.4% of residential properties. This number did not include the 2.5% of homes in foreclosure.^[6]

Mortgages in the United States

Types of mortgage instruments

Two types of mortgage instruments are commonly used in the United States: the mortgage (sometimes called a mortgage deed) and the deed of trust.^[7]

The mortgage

In all but a few states, a mortgage creates a lien on the title to the mortgaged property. Foreclosure of that lien almost always requires a judicial proceeding declaring the debt to be due and in default and ordering a sale of the property to pay the debt.^{[citation needed]}

Security deed

The deed to secure debt is a mortgage instrument used in the state of Georgia. Unlike a mortgage, however, a security deed is an actual conveyance of real property in security of a debt. Upon the execution of such a deed, title passes to the grantee or beneficiary (usually lender), however the grantor (debtor) maintains equitable title to use and enjoy the conveyed land subject to compliance with debt obligations.

Security deeds must be recorded in the county where the land is located. Although there is no specific time within which such deeds must be filed, the failure to timely record the deed to secure debt may affect priority and therefore the ability to enforce the debt against the subject property.^[8]

The deed of trust

The deed of trust is a deed by the borrower to a trustee for the purposes of securing a debt. In most states, it also merely creates a lien on the title and not a title transfer, regardless of its terms. It differs from a mortgage in that, in many states, it can be foreclosed by a non-judicial sale held by the trustee.^[9] It is also possible to foreclose them through a judicial proceeding.^{[citation needed]}

Most "mortgages" in California are actually deeds of trust.^[10] The effective difference is that the foreclosure process can be much faster for a deed of trust than for a mortgage, on the order of 3 months rather than a year. Because the foreclosure does not require actions by the court the transaction costs can be quite a bit less.^{[citation needed]}

Deeds of trust to secure repayments of debts should not be confused with trust instruments that are sometimes called deeds of trust but that are used to create trusts for other purposes, such as estate planning. Though there are superficial similarities in the form, many states hold deeds of trust to secure repayment of debts do not create true trust arrangements.^{[citation needed]}

Mortgage lien priority: "title theory" and "lien theory"

Except in those few states in the United States that adhere to the title theory of mortgages,^[11] either a mortgage or a deed of trust will create a mortgage lien upon the title to the real property being mortgaged. The lien is said to "attach" to the title when the mortgage is signed by the mortgagor and delivered to the mortgagee and the mortgagor receives the funds whose repayment the mortgage secures. Subject to the requirements of the recording laws of the state in which the land is located, this attachment establishes the priority of the mortgage lien with respect to most other liens^[12] on the property's title.^[13] Liens that have attached to the title before the mortgage lien are said to be senior to, or prior to, the mortgage lien. Those attaching afterward are said to be junior or subordinate.^[14] The purpose of this priority is to establish the order in which lien holders are entitled to foreclose their liens in an attempt to recover their debts. If there are multiple mortgage liens on the title to a property and the loan secured by a first mortgage is paid off, the second mortgage lien will move up in priority and become the new first mortgage lien on the title. Documenting this new priority arrangement will require the release of the mortgage securing the paid off loan.

Stock

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Stock

From Wikipedia, the free encyclopedia

In business and finance, a share of stock (also referred to as equity share) means a share of ownership in a corporation (company). In the plural, stocks is often used as a synonym for shares especially in the United States, but it is less commonly used that way outside of North America.[1]

In the United Kingdom, South Africa, and Australia, stock can also refer to completely different financial instruments such as government bonds or, less commonly, to all kinds of marketable securities.[2]

Types of stock

Stock typically takes the form of shares of either common stock or preferred stock. As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions. Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders.^[1]^[2] Convertible preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually anytime after a predetermined date. Shares of such stock are called "convertible preferred shares" (or "convertible preference shares" in the UK)

Although there is a great deal of commonality between the stocks of different companies, each new equity issue can have legal clauses attached to it that make it dynamically different from the more general cases. Some shares of common stock may be issued without the typical voting rights being included, for instance, or some shares may have special rights unique to them and issued only to certain parties. Note that not all equity shares are the same.^[1]^[2]

Stock derivatives

For more details on this topic, see equity derivatives.

A stock derivative is any financial instrument which has a value that is dependent on the price of the underlying stock. Futures and options are the main types of derivatives on stocks. The underlying security may be a stock index or an individual firm's stock, e.g. single-stock futures.

Stock futures are contracts where the buyer is long, i.e., takes on the obligation to buy on the contract maturity date, and the seller is short, i.e., takes on the obligation to sell. Stock index futures are generally not delivered in the usual manner, but by cash settlement.

A stock option is a class of option. Specifically, a call option is the right (not obligation) to buy stock in the future at a fixed price and a put option is the right (not obligation) to sell stock in the future at a fixed price. Thus, the value of a stock option changes in reaction to the underlying stock of which it is a derivative. The most popular method of valuing stock options is the Black Scholes model.^[3] Apart from call options granted to employees, most stock options are transferable.

History

During Roman times, the empire contracted out many of its services to private groups called publicani. Shares in publicani were called "socii" (for large cooperatives) and "particulae" which were analogous to today's Over-The-Counter shares of small companies. Though the records available for this time are incomplete, Edward Chancellor states in his book Devil Take the Hindmost that there is some evidence that a speculation in these shares became increasingly widespread and that perhaps the first ever speculative bubble in "stocks" occurred.^{[citation needed]}

The first company to issue shares of stock after the Middle Ages was the Dutch East India Company in 1606. The innovation of joint ownership made a great deal of Europe's economic growth possible following the Middle Ages. The technique of pooling capital to finance the building of ships, for example, made the Netherlands a maritime superpower. Before adoption of the joint-stock corporation, an expensive venture such as the building of a merchant ship could be undertaken only by governments or by very wealthy individuals or families.

Economic historians find the Dutch stock market of the 1600s particularly interesting: there is clear documentation of the use of stock futures, stock options, short selling, the use of credit to purchase shares, a speculative bubble that crashed in 1695, and a change in fashion that unfolded and reverted in time with the market (in this case it was headdresses instead of hemlines). Dr. Edward Stringham also noted that the uses of practices such as short selling continued to occur during this time despite the government passing laws against it. This is unusual because it shows individual parties fulfilling contracts that were not legally enforceable and where the parties involved could incur a loss. Stringham argues that this shows that contracts can be created and enforced without state sanction or, in this case, in spite of laws to the contrary.^[4]^[5]

In middle 2008 the Stock Market dropped drastically.

Shareholder

Stock certificate for ten shares of the Baltimore and Ohio Railroad Company.

Main article: Shareholder

A shareholder (or stockholder) is an individual or company (including a corporation) that legally owns one or more shares of stock in a joint stock company. Companies listed at the stock market are expected to strive to enhance shareholder value.

Shareholders are granted special privileges depending on the class of stock, including the right to vote (usually one vote per share owned) on matters such as elections to the board of directors, the right to share in distributions of the company's income, the right to purchase new shares issued by the company, and the right to a company's assets during a liquidation of the company. However, shareholder's rights to a company's assets are subordinate to the rights of the company's creditors.

Shareholders are considered by some to be a partial subset of stakeholders, which may include anyone who has a direct or indirect equity interest in the business entity or someone with even a non-pecuniary interest in a non-profit organization. Thus it might be common to call volunteer contributors to an association stakeholders, even though they are not shareholders.

Although directors and officers of a company are bound by fiduciary duties to act in the best interest of the shareholders, the shareholders themselves normally do not have such duties towards each other.

However, in a few unusual cases, some courts have been willing to imply such a duty between shareholders. For example, in California, USA, majority shareholders of closely held corporations have a duty to not destroy the value of the shares held by minority shareholders.^[6]^[7]

The largest shareholders (in terms of percentages of companies owned) are often mutual funds, and especially passively managed exchange-traded funds.

Application

The owners of a company may want additional capital to invest in new projects within the company. They may also simply wish to reduce their holding, freeing up capital for their own private use.

By selling shares they can sell part or all of the company to many part-owners. The purchase of one share entitles the owner of that share to literally share in the ownership of the company, a fraction of the decision-making power, and potentially a fraction of the profits, which the company may issue as dividends.

In the common case of a publicly traded corporation, where there may be thousands of shareholders, it is impractical to have all of them making the daily decisions required to run a company. Thus, the shareholders will use their shares as votes in the election of members of the board of directors of the company.

In a typical case, each share constitutes one vote. Corporations may, however, issue different classes of shares, which may have different voting rights. Owning the majority of the shares allows other shareholders to be out-voted - effective control rests with the majority shareholder (or shareholders acting in concert). In this way the original owners of the company often still have control of the company.

Shareholder rights

Although ownership of 50% of shares does result in 50% ownership of a company, it does not give the shareholder the right to use a company's building, equipment, materials, or other property. This is because the company is considered a legal person, thus it owns all its assets itself. This is important in areas such as insurance, which must be in the name of the company and not the main shareholder.

In most countries, including the United States, boards of directors and company managers have a fiduciary responsibility to run the company in the interests of its stockholders. Nonetheless, as Martin Whitman writes:

...it can safely be stated that there does not exist any publicly traded company where management works exclusively in the best interests of OPMI [Outside Passive Minority Investor] stockholders. Instead, there are both "communities of interest" and "conflicts of interest" between stockholders (principal) and management (agent). This conflict is referred to as the principal/agent problem. It would be naive to think that any management would forgo management compensation, and management entrenchment, just because some of these management privileges might be perceived as giving rise to a conflict of interest with OPMIs.^[8]

Even though the board of directors runs the company, the shareholder has some impact on the company's policy, as the shareholders elect the board of directors. Each shareholder typically has a percentage of votes equal to the percentage of shares he or she owns. So as long as the shareholders agree that the management (agent) are performing poorly they can elect a new board of directors which can then hire a new management team. In practice, however, genuinely contested board elections are rare. Board candidates are usually nominated by insiders or by the board of the directors themselves, and a considerable amount of stock is held and voted by insiders.

Owning shares does not mean responsibility for liabilities. If a company goes broke and has to default on loans, the shareholders are not liable in any way. However, all money obtained by converting assets into cash will be used to repay loans and other debts first, so that shareholders cannot receive any money unless and until creditors have been paid (most often the shareholders end up with nothing).

Means of financing

Financing a company through the sale of stock in a company is known as equity financing. Alternatively, debt financing (for example issuing bonds) can be done to avoid giving up shares of ownership of the company. Unofficial financing known as trade financing usually provides the major part of a company's working capital (day-to-day operational needs).

Trading

A stock exchange is an organization that provides a marketplace for either physical or virtual trading shares, bonds and warrants and other financial products where investors (represented by stock brokers) may buy and sell shares of a wide range of companies. A company will usually list its shares by meeting and maintaining the listing requirements of a particular stock exchange. In the United States, through the inter-market quotation system, stocks listed on one exchange can also be bought or sold on several other exchanges, including relatively new so-called ECNs (Electronic Communication Networks like Archipelago or Instinet).

In the USA stocks used to be broadly grouped into NYSE-listed and NASDAQ-listed stocks. Until a few years ago there was a law that NYSE listed stocks were not allowed to be listed on the NASDAQ or vice versa.

Many large non-U.S companies choose to list on a U.S. exchange as well as an exchange in their home country in order to broaden their investor base. These companies have then to ship a certain number of shares to a bank in the US (a certain percentage of their principal) and put it in the safe of the bank. Then the bank where they deposited the shares can issue a certain number of so-called American Depositary Shares, short ADS (singular). If someone buys now a certain number of ADSs the bank where the shares are deposited issues an American Depository Receipt (ADR) for the buyer of the ADSs.

Likewise, many large U.S. companies list themselves at foreign exchanges to raise capital abroad.

Arbitrage trading

Although it makes sense for some companies to raise capital by offering stock on more than one exchange, a keen investor with access to information about such discrepancies could invest in expectation of their eventual convergence, known as an arbitrage trade. In today's era of electronic trading, these discrepancies, if they exist, are both shorter-lived and more quickly acted upon. As such, arbitrage opportunities disappear quickly due to the efficient nature of the market.

Buying

There are various methods of buying and financing stocks. The most common means is through a stock broker. Whether they are a full service or discount broker, they arrange the transfer of stock from a seller to a buyer. Most trades are actually done through brokers listed with a stock exchange, such as the New York Stock Exchange.

There are many different stock brokers from which to choose, such as full service brokers or discount brokers. The full service brokers usually charge more per trade, but give investment advice or more personal service; the discount brokers offer little or no investment advice but charge less for trades. Another type of broker would be a bank or credit union that may have a deal set up with either a full service or discount broker.

There are other ways of buying stock besides through a broker. One way is directly from the company itself. If at least one share is owned, most companies will allow the purchase of shares directly from the company through their investor relations departments. However, the initial share of stock in the company will have to be obtained through a regular stock broker. Another way to buy stock in companies is through Direct Public Offerings which are usually sold by the company itself. A direct public offering is an initial public offering in which the stock is purchased directly from the company, usually without the aid of brokers.

When it comes to financing a purchase of stocks there are two ways: purchasing stock with money that is currently in the buyer's ownership, or by buying stock on margin. Buying stock on margin means buying stock with money borrowed against the stocks in the same account. These stocks, or collateral, guarantee that the buyer can repay the loan; otherwise, the stockbroker has the right to sell the stock (collateral) to repay the borrowed money. He can sell if the share price drops below the margin requirement, at least 50% of the value of the stocks in the account. Buying on margin works the same way as borrowing money to buy a car or a house, using the car or house as collateral. Moreover, borrowing is not free; the broker usually charges 8-10% interest.

Selling

Selling stock is procedurally similar to buying stock. Generally, the investor wants to buy low and sell high, if not in that order (short selling); although a number of reasons may induce an investor to sell at a loss, e.g., to avoid further loss.

As with buying a stock, there is a transaction fee for the broker's efforts in arranging the transfer of stock from a seller to a buyer. This fee can be high or low depending on which type of brokerage, full service or discount, handles the transaction.

After the transaction has been made, the seller is then entitled to all of the money. An important part of selling is keeping track of the earnings. Importantly, on selling the stock, in jurisdictions that have them, capital gains taxes will have to be paid on the additional proceeds, if any, that are in excess of the cost basis.

Stock price fluctuations

Robert Shiller's plot of the S&P Composite Real Price Index, Earnings, Dividends, and Interest Rates, from Irrational Exuberance, 2d ed.^[9] In the preface to this edition, Shiller warns that "[t]he stock market has not come down to historical levels: the price-earnings ratio as I define it in this book is still, at this writing [2005], in the mid-20s, far higher than the historical average. … People still place too much confidence in the markets and have too strong a belief that paying attention to the gyrations in their investments will someday make them rich, and so they do not make conservative preparations for possible bad outcomes."

Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert Shiller (Figure 10.1^[9], source). The horizontal axis shows the real price-earnings ratio of the S&P Composite Stock Price Index as computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Data from different twenty year periods is color-coded as shown in the key. See also ten-year returns. Shiller states that this plot "confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."^[9]

The price of a stock fluctuates fundamentally due to the theory of supply and demand. Like all commodities in the market, the price of a stock is directly proportional to the demand. However, there are many factors on the basis of which the demand for a particular stock may increase or decrease. These factors are studied using methods of fundamental analysis and technical analysis to predict the changes in the stock price. A recent study shows that customer satisfaction, as measured by the American Customer Satisfaction Index (ACSI), is significantly correlated to the stock market value. Stock price is also changed based on the forecast for the company and whether their profits are expected to increase or decrease.

Derivatives

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Derivatives are financial contracts, or financial instruments, whose prices are derived from the price of something else (known as the underlying). The underlying price on which a derivative is based can be that of an asset (e.g., commodities, equities (stock), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items. Credit derivatives are based on loans, bonds or other forms of credit.

The main types of derivatives are forwards, futures, options, and swaps.

Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

Uses

Hedging

Derivatives allow risk about the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available due to causes unspecified by the contract, like the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counterparty risk.

From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: The farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counterparty is the insurer (risk taker) for another type of risk.

Hedging also occurs when an individual or institution buys an asset (like a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and then can sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset.

Derivatives traders at the Chicago Board of Trade.

Speculation and arbitrage

Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low.

Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.

Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and by regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution.^[1]

Types of derivatives

OTC and exchange-traded

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market:

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is $684 trillion (as of June 2008)^[2]. Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the other to perform.

Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largest^[3] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges totalled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

Common derivative contract types

There are three major classes of derivatives:

Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, while a forward contract is a non-standardized contract written by the parties themselves.
Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction.
Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date.

Examples

Some common examples of these derivatives are:

UNDERLYING	CONTRACT TYPES
UNDERLYING	Exchange-traded futures	Exchange-traded options	OTC swap	OTC forward	OTC option
Equity Index	DJIA Index future NASDAQ Index future	Option on DJIA Index future Option on NASDAQ Index future	Equity swap	Back-to-back	n/a
Money market	Eurodollar future Euribor future	Option on Eurodollar future Option on Euribor future	Interest rate swap	Forward rate agreement	Interest rate cap and floor Swaption Basis swap
Bonds	Bond future	Option on Bond future	Total return swap	Repurchase agreement	Bond option
Single Stocks	Single-stock future	Single-share option	Equity swap	Repurchase agreement	Stock option Warrant Turbo warrant
Credit	n/a	n/a	Credit default swap	n/a	Credit default option

Other examples of underlying exchangeables are:

Property (mortgage) derivatives
Economic derivatives that pay off according to economic reports [1] as measured and reported by national statistical agencies
Energy derivatives that pay off according to a wide variety of indexed energy prices. Usually classified as either physical or financial, where physical means the contract includes actual delivery of the underlying energy commodity (oil, gas, power, etc.)
Commodities
Freight derivatives
Inflation derivatives
Insurance derivatives^{[citation needed]}
Weather derivatives
Credit derivatives

Cash flow

The payments between the parties may be determined by:

The price of some other, independently traded asset in the future (e.g., a common stock);
The level of an independently determined index (e.g., a stock market index or heating-degree-days);
The occurrence of some well-specified event (e.g., a company defaulting);
An interest rate;
An exchange rate;
Or some other factor.

Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the terms of the contract, the potential gain or loss on a derivative can be much higher than if they had traded the underlying security or commodity directly.

Valuation

Total world derivatives from 1998-2007^[4] compared to total world wealth in the year 2000^[5]

Market and arbitrage-free prices

Two common measures of value are:

Market price, i.e. the price at which traders are willing to buy or sell the contract
Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts; see rational pricing

Determining the market price

For exchange-traded derivatives, market price is usually transparent (often published in real time by the exchange, based on all the current bids and offers placed on that particular contract at any one time). Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.

Determining the arbitrage-free price

The arbitrage-free price for a derivatives contract is complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. The stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the Black–Scholes formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the binomial options model.

Criticisms

Derivatives are often subject to the following criticisms:

Possible large losses

Counter-party risk

Derivatives (especially swaps) expose investors to counter-party risk.

For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the first business may be adversely affected, because it may not be prepared to pay the higher variable rate.

Different types of derivatives have different levels of risk for this effect. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; Banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.

Unsuitably high risk for small/inexperienced investors

Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Because derivatives offer the possibility of large rewards, they offer an attraction even to individual investors. However, speculation in derivatives often assumes a great deal of risk, requiring commensurate experience and market knowledge, especially for the small investor, a reason why some financial planners advise against the use of these instruments. Derivatives are complex instruments devised as a form of insurance, to transfer risk among parties based on their willingness to assume additional risk, or hedge against it.

[edit] Large notional value

Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren Buffett in Berkshire Hathaway's annual report. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator.

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the 1920s-30s Great Depression. (See Berkshire Hathaway Annual Report for 2002)

Benefits

Nevertheless, the use of derivatives also has its benefits:

Derivatives facilitate the buying and selling of risk, and many people consider this to have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility.
Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.^{[citation needed]}

Commodity

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Commodity

From Wikipedia, the free encyclopedia

A commodity is something for which there is demand, but which is supplied without qualitative differentiation across a market. It is a product that is the same no matter who produces it, such as petroleum, notebook paper, or milk.^[1] In other words, copper is copper. The price of copper is universal, and fluctuates daily based on global supply and demand. Stereos, on the other hand, have many levels of quality. And, the better a stereo is [perceived to be], the more it will cost.

One of the characteristics of a commodity good is that its price is determined as a function of its market as a whole. Well-established physical commodities have actively traded spot and derivative markets. Generally, these are basic resources and agricultural products such as iron ore, crude oil, coal, ethanol, salt, sugar, coffee beans, soybeans, aluminum, rice, wheat, gold and silver.

Commoditization occurs as a goods or services market loses differentiation across its supply base, often by the diffusion of the intellectual capital necessary to acquire or produce it efficiently. As such, goods that formerly carried premium margins for market participants have become commodities, such as generic pharmaceuticals and silicon chips.

Etymology

The word commodity came into use in English in the 15th century, it came from the French, "commodité", to benefit or profit. Going further back, the French word derived from the Latin commoditatem (nominative commoditas) meaning "fitness, adaptation,". The Latin root commod- meant variously "appropriate", "proper measure, time or condition" and advantage, or benefit.

Commodity trade

In the original and simplified sense, commodities were things of value, of uniform quality, that were produced in large quantities by many different producers; the items from each different producer are considered equivalent. It is the contract and this underlying standard that define the commodity, not any quality inherent in the product.

Commodities exchanges include:

Chicago Board of Trade
Kansas City Board of Trade
Euronext.liffe
Kuala Lumpur Futures Exchange
Bhatinda Om & Oil Exchange
London Metal Exchange
New York Mercantile Exchange
Multi Commodity Exchange
Dalian Commodity Exchange

Markets for trading commodities can be very efficient, particularly if the division into pools matches demand segments. These markets will quickly respond to changes in supply and demand to find an equilibrium price and quantity. In addition, investors can gain passive exposure to the commodity markets through a commodity price index.

Commodities in Marxism

In classical political economy and especially Karl Marx's critique of political economy, a commodity is any good or service produced by human labour and offered as a product for general sale on the market. Some other priced goods are also treated as commodities, e.g. human labor-power, works of art and natural resources, even although they may not be produced specifically for the market, or be non-reproducible goods.

Marx's analysis of the commodity is intended to help solve the problem of what establishes the economic value of goods, using the labor theory of value. This problem was extensively debated by Adam Smith, David Ricardo and Karl Rodbertus-Jagetzow among others. Value and price are not equivalent terms in economics, and theorising the specific relationship of value to market price has been a challenge for both liberal and Marxist economists.

Spot price

2009-06-24T09:57:00.000-07:00

Spot price

From Wikipedia, the free encyclopedia

The spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate (spot) settlement (payment and delivery). Spot settlement is normally one or two business days from trade date. This is in contrast with the forward price established in a forward contract or futures contract, where contract terms (price) are set now, but delivery and payment will occur at a future date. Spot rates are estimated via the bootstrapping method, which uses prices of the securities currently trading in market, that is, from the cash or coupon curve. The result is the spot curve, which exists for each of the various classes of securities.

For securities, the synonymous term cash price is more often used.

Spot prices and future price expectations

Depending on the item being traded, spot prices can indicate market expectations of future price movements in different ways. For a security or non-perishable commodity (e.g., gold), the spot price reflects market expectations of future price movements. In theory, the difference in spot and forward prices should be equal to the finance charges, plus any earnings due to the holder of the security, according to the cost of carry model. For example, on a share the difference in price between the spot and forward is usually accounted for almost entirely by any dividends payable in the period minus the interest payable on the purchase price. Any other price would yield an arbitrage opportunity and riskless profit (see rational pricing for the arbitrage mechanics).

In contrast, a perishable commodity does not allow this arbitrage - the cost of storage is effectively higher than the expected future price of the commodity. As a result, spot prices will reflect current supply and demand, not future price movements. Spot prices can therefore be quite volatile and move independently from forward prices. According to the unbiased forward hypothesis, the difference between these prices will equal the expected price change of the commodity over the period.

A simple example: even if you know tomatoes are cheap in July and will be expensive in January, you can't buy them in July and take delivery in January, since they will spoil before you can take advantage of January's high prices. The July price will reflect tomato supply and demand in July. The forward price for January will reflect the market's expectations of supply and demand in January. July tomatoes are effectively a different commodity from January tomatoes (contrast contango and backwardation).

Value at Risk

2009-06-24T09:41:00.000-07:00

Value at Risk

From Wikipedia, the free encyclopedia

In financial mathematics and financial risk management, Value at Risk (VaR) is a widely used measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.^[1]

For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 5% probability that the portfolio will fall in value by more than $1 million over a one day period, assuming markets are normal and there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day in 20. A loss which exceeds the VaR threshold is termed a “VaR break.”^[2]

The 10% Value at Risk of a normally distributed portfolio

VaR has five main uses in finance: risk management, risk measurement, financial control, financial reporting and computing regulatory capital. VaR is sometimes used in non-financial applications as well.^[3]

Important related ideas are economic capital, backtesting, stress testing and expected shortfall.^[4]

Details

Common parameters for VaR are 1% and 5% probabilities and one day and two week horizons, although other combinations are in use.^[5]

The reason for assuming normal markets and no trading, and to restricting loss to things measured in daily accounts, is to make the loss observable. In some extreme financial events it can be impossible to determine losses, either because market prices are unavailable or because the loss-bearing institution breaks up. Some longer-term consequences of disasters, such as lawsuits, loss of market confidence and employee morale and impairment of brand names can take a long time to play out, and may be hard to allocate among specific prior decisions. VaR marks the boundary between normal days and extreme events. Institutions can lose far more than the VaR amount; the only thing we can say is they won't do so very often.^[6]

The probability level is about equally often specified as one minus the probability of a VaR break, so that the VaR in the example above would be called a one-day 95% VaR instead of one-day 5% VaR. This generally does not lead to confusion because the probability of VaR breaks is almost always small, certainly less than 0.5.^[1]

Although it virtually always represents a loss, VaR is conventionally reported as a positive number. A negative VaR would imply the portfolio has a high probability of making a profit, for example a one-day 5% VaR of negative $1 million implies the portfolio has a 95% chance of making $1 million or more over the next day. ^[7]

Varieties of VaR

The definition of VaR is nonconstructive, it specifies a property VaR must have, but not how to compute VaR. Moreover, there is wide scope for interpretation in the definition.^[8] This has led to two broad types of VaR, one used primarily in risk management and the other primarily for risk measurement. The distinction is not sharp, however, and hybrid versions are typically used in financial control, financial reporting and computing regulatory capital. ^[9]

To a risk manager, VaR is a system, not a number. The system is run periodically (usually daily) and the published number is compared to the computed price movement in opening positions over the time horizon. There is never any subsequent adjustment to the published VaR, and there is no distinction between VaR breaks caused by input errors (including Information Technology breakdowns, fraud and rogue trading), computation errors (including failure to produce a VaR on time) and market movements.^[10]

A frequentist claim is made, that the long-term frequency of VaR breaks will equal the specified probability, within the limits of sampling error, and that the VaR breaks will be independent in time and independent of the level of VaR. This claim is validated by a backtest, a comparison of published VaRs to actual price movements. In this interpretation, many different systems could produce VaRs with equally good backtests, but wide disagreements on daily VaR values.^[1]

For risk measurement a number is needed, not a system. A Bayesian probability claim is made, that given the information and beliefs at the time, the subjective probability of a VaR break was the specified level. VaR is adjusted after the fact to correct errors in inputs and computation, but not to incorporate information unavailable at the time of computation.^[7] In this context, “backtest” has a different meaning. Rather than comparing published VaRs to actual market movements over the period of time the system has been in operation, VaR is retroactively computed on scrubbed data over as long a period as data are available and deemed relevant. The same position data and pricing models are used for computing the VaR as determining the price movements.^[2]

Although some of the sources listed here treat only one kind of VaR as legitimate, most of the recent ones seem to agree that risk management VaR is superior for making short-term and tactical decisions today, while risk measurement VaR should be used for understanding the past, and making medium term and strategic decisions for the future. When VaR is used for financial control or financial reporting it should incorporate elements of both. For example, if a trading desk is held to a VaR limit, that is both a risk-management rule for deciding what risks to allow today, and an input into the risk measurement computation of the desk’s risk-adjusted return at the end of the reporting period.^[4]

Risk measure and risk metric

The term “VaR” is used both for a risk measure and a risk metric. This sometimes leads to confusion. Sources earlier than 1995 usually emphasize the risk measure, later sources are more likely to emphasize the metric.

The VaR risk measure defines risk as mark-to-market loss on a fixed portfolio over a fixed time horizon, assuming normal markets. There are many alternative risk measures in finance. Instead of mark-to-market, which uses market prices to define loss, loss is often defined as change in fundamental value. For example, if an institution holds a loan that declines in market price because interest rates go up, but has no change in cash flows or credit quality, some systems do not recognize a loss. Or we could try to incorporate the economic cost of things not measured in daily financial statements, such as loss of market confidence or employee morale, impairment of brand names or lawsuits.^[4]

Rather than assuming a fixed portfolio over a fixed time horizon, some risk measures incorporate the effect of expected trading (such as a stop loss order) and consider the expected holding period of positions. Finally, some risk measures adjust for the possible effects of abnormal markets, rather than excluding them from the computation.^[4]

The VaR risk metric summarizes the distribution of possible losses by a quantile, a point with a specified probability of greater losses. Common alternative metrics are standard deviation, mean absolute deviation, expected shortfall and downside risk.^[1]

VaR risk management

Supporters of VaR-based risk management claim the first and possibly greatest benefit of VaR is the improvement in systems and modeling it forces on an institution. In 1997, Philippe Jorion wrote:^[11]

[T]he greatest benefit of VAR lies in the imposition of a structured methodology for critically thinking about risk. Institutions that go through the process of computing their VAR are forced to confront their exposure to financial risks and to set up a proper risk management function. Thus the process of getting to VAR may be as important as the number itself.

Publishing a daily number, on-time and with specified statistical properties holds every part of a trading organization to a high objective standard. Robust backup systems and default assumptions must be implemented. Positions that are reported, modeled or priced incorrectly stand out, as do data feeds that are inaccurate or late and systems that are too-frequently down. Anything that affects profit and loss that is left out of other reports will show up either in inflated VaR or excessive VaR breaks. “A risk-taking institution that does not compute VaR might escape disaster, but an institution that cannot compute VaR will not.” ^[12]

The second claimed benefit of VaR is that it separates risk into two regimes. Inside the VaR limit, conventional statistical methods are reliable. Relatively short-term and specific data can be used for analysis. Probability estimates are meaningful, because there are enough data to test them. In a sense, there is no true risk because you have a sum of many independent observations with a left bound on the outcome. A casino doesn't worry about whether red or black will come up on the next roulette spin. Risk managers encourage productive risk-taking in this regime, because there is little true cost. People tend to worry too much about these risks, because they happen frequently, and not enough about what might happen on the worst days.^[13]

Outside the VaR limit, all bets are off. Risk should be analyzed with stress testing based on long-term and broad market data.^[14] Probability statements are no longer meaningful.^[15] Knowing the distribution of losses beyond the VaR point is both impossible and useless. The risk manager should concentrate instead on making sure good plans are in place to limit the loss if possible, and to survive the loss if not.^[1]

One specific system uses three regimes.^[16]

Out to three times VaR are normal occurrences. You expect periodic VaR breaks. The loss distribution typically has fat tails, and you might get more than one break in a short period of time. Moreover, markets may be abnormal and trading may exacerbate losses, and you may take losses not measured in daily marks such as lawsuits, loss of employee morale and market confidence and impairment of brand names. So an institution that can't deal with three times VaR losses as routine events probably won't survive long enough to put a VaR system in place.
Three to ten times VaR is the range for stress testing. Institutions should be confident they have examined all the foreseeable events that will cause losses in this range, and are prepared to survive them. These events are too rare to estimate probabilities reliably, so risk/return calculations are useless.
Foreseeable events should not cause losses beyond ten times VaR. If they do they should be hedged or insured, or the business plan should be changed to avoid them, or VaR should be increased. It's hard to run a business if foreseeable losses are orders of magnitude larger than very large everyday losses. It's hard to plan for these events, because they are out of scale with daily experience. Of course there will be unforeseeable losses more than ten times VaR, but it's pointless to anticipate them, you can't know much about them and it results in needless worrying. Better to hope that the discipline of preparing for all foreseeable three-to-ten times VaR losses will improve chances for surviving the unforeseen and larger losses that inevitably occur.

"A risk manager has two jobs: make people take more risk the 99% of the time it is safe to do so, and survive the other 1% of the time. VaR is the border."^[12]

VaR risk measurement

The VaR risk measure is a popular way to aggregate risk across an institution. Individual business units have risk measures such as duration for a fixed income portfolio or beta for an equity business. These cannot be combined in a meaningful way.^[1] It is also difficult to aggregate results available at different times, such as positions marked in different time zones, or a high frequency trading desk with a business holding relatively illiquid positions. But since every business contributes to profit and loss in an additive fashion, and many financial businesses mark-to-market daily, it is natural to define firm-wide risk using the distribution of possible losses at a fixed point in the future.^[4]

In risk measurement, VaR is usually reported alongside other risk metrics such as standard deviation, expected shortfall and “greeks” (partial derivatives of portfolio value with respect to market factors). VaR is a distribution-free metric, that is it does not depend on assumptions about the probability distribution of future gains and losses.^[12] The probability level is chosen deep enough in the left tail of the loss distribution to be relevant for risk decisions, but not so deep as to be difficult to estimate with accuracy.^[17]

Risk measurement VaR is sometimes called parametric VaR. This usage can be confusing, however, because it can be estimated either parametrically (for examples, variance-covariance VaR or delta-gamma VaR) or nonparametrically (for examples, historical simulation VaR or resampled VaR). The inverse usage makes more logical sense, because risk management VaR is fundamentally nonparametric, but it is seldom referred to as nonparametric VaR.^[4]^[6]

History of VaR

The problem of risk measurement is an old one in statistics, economics and finance. Financial risk management has been a concern of regulators and financial executives for a long time as well. Retrospective analysis has found some VaR-like concepts in this history. But VaR did not emerge as a distinct concept until the late 1980s. The triggering event was the stock market crash of 1987. This was the first major financial crisis in which a lot of academically-trained quants were in high enough positions to worry about firm-wide survival.^[1]

The crash was so unlikely given standard statistical models, that it called the entire basis of quant finance into question. A reconsideration of history led some quants to decide there were recurring crises, about one or two per decade, that overwhelmed the statistical assumptions embedded in models used for trading, investment management and derivative pricing. These affected many markets at once, including ones that were usually not correlated, and seldom had discernible economic cause or warning (although after-the-fact explanations were plentiful).^[15] Much later, they were named "Black Swans" by Nassim Taleb and the concept extended far beyond finance.^[18]

If these events were included in quantitative analysis they dominated results and led to strategies that did not work day to day. If these events were excluded, the profits made in between "Black Swans" could be much smaller than the losses suffered in the crisis. Institutions could fail as a result.^[15]^[18]^[12]

VaR was developed as a systematic way to segregate extreme events, which are studied qualitatively over long-term history and broad market events, from everyday price movements, which are studied quantitatively using short-term data in specific markets. It was hoped that "Black Swans" would be preceded by increases in estimated VaR or increased frequency of VaR breaks, in at least some markets. The extent to which has proven to be true is controversial.^[15]

Abnormal markets and trading were excluded from the VaR estimate in order to make it observable.^[13] It is not always possible to define loss if, for example, markets are closed as after 9/11, or severely illiquid, as happened several times in 2008.^[12] Losses can also be hard to define if the risk-bearing institution fails or breaks up.^[13] A measure that depends on traders taking certain actions, and avoiding other actions, can lead to self reference.^[1]

This is risk management VaR. It was well-established in quantative trading groups at several financial institutions, notably Bankers Trust, before 1990, although neither the name nor the definition had been standardized. There was no effort to aggregate VaRs across trading desks.^[15]

The financial events of the early 1990s found many firms in trouble because the same underlying bet had been made at many places in the firm, in non-obvious ways. Since many trading desks already computed risk management VaR, and it was the only common risk measure that could be both defined for all businesses and aggregated without strong assumptions, it was the natural choice for reporting firmwide risk. J. P. Morgan CEO Dennis Weatherstone famously called for a “4:15 report” that combined all firm risk on one page, available within 15 minutes of the market close.^[8]

Risk measurement VaR was developed for this purpose. Development was most extensive at J. P. Morgan, which published the methodology and gave free access to estimates of the necessary underlying parameters in 1994. This was the first time VaR had been exposed beyond a relatively small group of quants. Two years later, the methodology was spun off into an independent for-profit business now part of RiskMetrics Group.^[8]

In 1997, the U.S. Securities and Exchange Commission ruled that public corporations must disclose quantitative information about their derivatives activity. Major banks and dealers chose to implement the rule by including VaR information in the notes to their financial statements.^[1]

Worldwide adoption of the Basel II Accord, beginning in 1999 and nearing completion today, gave further impetus to the use of VaR. VaR is the preferred measure of market risk, and concepts similar to VaR are used in other parts of the accord.^[1]

Mathematics

"Given some confidence level the VaR of the portfolio at the confidence level $α$ is given by the smallest number $l$ such that the probability that the loss $L$ exceeds $l$ is not larger than $(1 - α)$ "^[3]

l)\leq 1-\alpha\}=\inf\{l\in \real:F_L(l)\geq\alpha\}" src="http://upload.wikimedia.org/math/1/a/1/1a16a133a91e2d385cda0694e68c6655.png">

The left equality is a definition of VaR. The right equality assumes an underlying probability distribution, which makes it true only for parametric VaR. Risk managers typically assume that some fraction of the bad events will have undefined losses, either because markets are closed or illiquid, or because the entity bearing the loss breaks apart or loses the ability to compute accounts. Therefore, they do not accept results based on the assumption of a well-defined probability distribution.^[6] Nassim Taleb has labeled this assumption, "charlatanism."^[19] On the other hand, many academics prefer to assume a well-defined distribution, albeit usually one with fat tails.^[1] This point has probably caused more contention among VaR theorists than any other.^[8]

Criticism

VaR has been controversial since it moved from trading desks into the public eye in 1994. A famous 1997 debate between Nassim Taleb and Philippe Jorion set out some of the major points of contention. Taleb claimed VaR:^[20]

Ignored 2,500 years of experience in favor of untested models built by non-traders
Was charlatanism because it claimed to estimate the risks of rare events, which is impossible
Gave false confidence
Would be exploited by traders

More recently David Einhorn and Aaron Brown debated VaR in Global Association of Risk Professionals Review^[12] ^[21] Einhorn compared VaR to “an airbag that works all the time, except when you have a car accident.” He further charged that VaR:

Led to excessive risk-taking and leverage at financial institutions
Focused on the manageable risks near the center of the distribution and ignored the tails
Created an incentive to take “excessive but remote risks”
Was “potentially catastrophic when its use creates a false sense of security among senior executives and watchdogs.”

New York Times reporter Joe Nocera wrote an extensive piece Risk Mismanagement^[22] on January 4, 2009 discussing the role VaR played in the Financial crisis of 2007-2008. After interviewing risk managers (including several of the ones cited above) the article suggests that VaR was very useful to risk experts, but nevertheless exacerbated the crisis by giving false security to bank executives and regulators. A powerful tool for professional risk managers, VaR is portrayed as both easy to misunderstand, and dangerous when misunderstood.

A common complaint among academics is that VaR is not subadditive.^[4] That means the VaR of a combined portfolio can be larger than the sum of the VaRs of its components. To a practicing risk manager this makes sense. For example, the average bank branch in the United States is robbed about once every ten years. A single-branch bank has about 0.004% chance of being robbed on a specific day, so the risk of robbery would not figure into one-day 1% VaR. It would not even be within an order of magnitude of that, so it is in the range where the institution should not worry about it, it should insure against it and take advice from insurers on precautions. The whole point of insurance is to aggregate risks that are beyond individual VaR limits, and bring them into a large enough portfolio to get statistical predictability. It does not pay for a one-branch bank to have a security expert on staff.

As institutions get more branches, the risk of a robbery on a specific day rises to within an order of magnitude of VaR. At that point it makes sense for the institution to run internal stress tests and analyze the risk itself. It will spend less on insurance and more on in-house expertise. For a very large banking institution, robberies are a routine daily occurrence. Losses are part of the daily VaR calculation, and tracked statistically rather than case-by-case. A sizable in-house security department is in charge of prevention and control, the general risk manager just tracks the loss like any other cost of doing business.

As portfolios or institutions get larger, specific risks change from low-probability/low-predictability/high-impact to statistically predictable losses of low individual impact. That means they move from the range of far outside VaR, to be insured, to near outside VaR, to be analyzed case-by-case, to inside VaR, to be treated statistically.^[12]

Even VaR supporters generally agree there are common abuses of VaR:^[8]^[6]

Referring to VaR as a "worst-case" or "maximum tolerable" loss. In fact, you expect two or three losses per year that exceed one-day 1% VaR.
Making VaR control or VaR reduction the central concern of risk management. It is far more important to worry about what happens when losses exceed VaR.
Assuming plausible losses will be less than some multiple, often three, of VaR. The entire point of VaR is that losses can be extremely large, and sometimes impossible to define, once you get beyond the VaR point. To a risk manager, VaR is the level of losses at which you stop trying to guess what will happen next, and start preparing for anything.
Reporting a VaR that has not passed a backtest. Regardless of how VaR is computed, it should have produced the correct number of breaks (within sampling error) in the past. A common specific violation of this is to report a VaR based on the unverified assumption that everything follows a multivariate normal distribution.

Bond convexity

2009-06-24T09:38:00.000-07:00

Bond convexity

From Wikipedia, the free encyclopedia

Calculation of convexity

Duration is a linear measure or 1st derivative of how the price of a bond changes in response to interest rate changes. As interest rates change, the price is not likely to change linearly, but instead it would change over some curved function of interest rates. The more curved the price function of the bond is, the more inaccurate duration is as a measure of the interest rate sensitivity.

Convexity is a measure of the curvature or 2nd derivative of how the price of a bond varies with interest rate, i.e. how the duration of a bond changes as the interest rate changes. Specifically, one assumes that the interest rate is constant across the life of the bond and that changes in interest rates occur evenly. Using these assumptions, duration can be formulated as the first derivative of the price function of the bond with respect to the interest rate in question. Then the convexity would be the second derivative of the price function with respect to the interest rate.

In actual markets the assumption of constant interest rates and even changes is not correct, and more complex models are needed to actually price bonds. However, these simplifying assumptions allow one to quickly and easily calculate factors which describe the sensitivity of the bond prices to interest rate changes....

Why bond convexities differ

The price sensitivity to parallel changes in the term structure of interest rates is highest with a zero-coupon bond and lowest with an amortizing bond (where the payments are front-loaded). Although the amortizing bond and the zero-coupon bond have different sensitivities at the same maturity, if their final maturities differ so that they have identical bond durations they will have identical sensitivities. That is, their prices will be affected equally by small, first-order, (and parallel) yield curve shifts. They will, however start to change by different amounts with each further incremental parallel rate shift due to their differing payment dates and amounts. For two bonds with same par value, same coupon and same maturity convexity may differ depending on at what point on the price yield curve they are located. Suppose both of them have at present the same price yield combination; also you have to take into consideration the profile, rating etc of the issuers; suppose they are issued by different entities. Though both the bonds have same p-y combination bond that may be located on relatively more elastic segment of the p-y curve compared to bond II. This means if yield increases further, price of bond II may fall drastically while price of bond I won’t change, i.e. bond II holder are expecting a price rise any moment and so reluctant to sell it off, while bond I holders are expecting further price-fall and ready to dispose it.

This means bond II has better rating than bond I.

So the higher the rating or credibility of the issuer the less the convexity and the less the gain from risk-return game or strategies; after all less convexity means less price-volatility or risk, less risk means less return.

Algebraic definition

If the flat floating interest rate is r and the bond price is B, then the convexity C is defined as

Another way of expressing C is in terms of the duration D:

Therefore

leaving

How bond duration changes with a changing interest rate

Return to the standard definition of duration:

where P(i) is the present value of coupon i, and t(i) is the future payment date.

As the interest rate increases the present value of longer-dated payments declines in relation to earlier coupons (by the discount factor between the early and late payments). However, bond price also declines when interest rate increase but changes in the present value of all coupons (the numerator) is larger than changes in the bond price (the denominator). Therefore, increases in r must decrease the duration (or, in the case of zero-coupon bonds, leave it constant).

Given the convexity definition above, conventional bond convexities must always be positive.

The positivity of convexity can also be proven analytically for basic interest rate securities. For example, under the assumption of a flat yield curve one can write the value of a coupon-bearing bond as , where c_i stands for the coupon paid at time t_i. Then it is easy to see that

Note that this conversely implies the negativity of the derivative of duration by differentiating .

Application of convexity

Convexity is a risk management figure, used similarly to the way 'gamma' is used in derivatives risks management; it is a number used to manage the market risk a bond portfolio is exposed to. If the combined convexity and duration of a trading book is high, so is the risk. However, if the combined convexity and duration are low, the book is hedged, and little money will be lost even if fairly substantial interest movements occur. (Parallel in the yield curve.)
The second-order approximation of bond price movements due to rate changes uses the convexity:

Bond duration

2009-06-24T09:36:00.000-07:00

Bond duration

From Wikipedia, the free encyclopedia

In finance, the duration of a financial asset measures the sensitivity of the asset's price to interest rate movements. There are various definitions of duration and derived quantities, discussed below. If not otherwise specified, "duration" generally means the Macaulay duration, as defined below.

Duration can be defined to be the percentage change in a bond's price function with respect to interest rate, which is the meaningful underlying (the absolute change with respect to interest rate, divided by the current price); this is known in other settings as the λ or Lambda. The absolute change in a bond's price with respect to interest rate, in other settings referred to as the Δ or Delta, is, in the context of bonds, referred to as the dollar duration.

The units of duration are years, and duration is always^{[note 1]} between 0 years and the time to maturity of the bond, with duration equal to time to maturity if and only if the bond is a zero-coupon bond.

The units may seem surprising; it can be understood via dimensional analysis as the ratio of "percentage change in price" over "change in interest rates": the numerator has no dimensions (or units of %), while the denominator has dimensions of 1/Time (units of %/year, as interest rates are quoted is percentage per year). Thus the ratio has dimension of Time, units of Years.

More concretely, this can be understood because more distant cash flows are more sensitive to interest rates, as measured via yield: when taking the present value via discounted cash flows of a bond, one discounts each future cash flow by (1 plus) the yield to the power of the number of years when that cash flow occurs: $(1 + y) - n$ – thus the present value of more distant future cash flows are more sensitive to changes in yield. In particular, the duration of a zero-coupon bond (one with a single cash flow at maturity) is the time to maturity of the bond. How to define the duration of bonds with intermediate cash flows is subtler, as discussed below.

Price

Duration is useful primarily as a measure of the sensitivity of a bond's market price to interest rate (ie yield) movements. It is approximately equal to the percentage change in price for a given change in yield. For example, for small interest rate changes, the duration is the approximate percentage by which the value of the bond will fall for a 1% per annum increase in market interest rate. So a 15-year bond with a duration of 7 would fall approximately 7% in value if the interest rate increased by 1% per annum. ^[1] In other words, duration is the elasticity of the bond's price with respect to interest rates.

Definition

The standard definition of duration is Macaulay duration, the PV-weighted average number of years to receive each cash flow, defined as:

where:

i indexes the cash flows,
P(i) is the present value of each cash payment from an asset (or each expense from a liability) i,
t(i) is the time in years until each payment will be received (or when each expense is due),
V is the present value of all cash payments from the asset (or all expenses from the liability, thus net present value) until maturity, and
D is the duration.

A more naïve definition is to weight by the size of cash flows, not the present value, but, as Macaulay discusses, this does not provide a good measure of the sensitivity to changes in interest rates.

Both these definitions give a weighted average (weights sum to 1) of time to receive cash flows, and thus fall between 0 (the minimum time), or more precisely $t (1)$ (the time to the first payment) and the time to maturity of the bond (the maximum time), with equality if and only if the bond only has a single payment at maturity, namely is a zero-coupon bond; in symbols, if cash flows are in order:

with the inequalities being strict unless it has a single cash flow.

Cash flow

As stated above, the duration is the weighted average term to payment of the cash flows on a bond. For a zero-coupon the duration will be $Δ T = T f - T 0$ , where $T f$ is the maturity date and $T 0$ is the starting date of the bond. If there are additional cash flows $C i$ at times $T i$ , the duration of every cash flow is $Δ T i = T i - T 0$ . From the current market price of the bond $V$ , one can calculate the yield to maturity of the bond $r$ using the formula

Note that in this and subsequent formulae, the symbol $r$ is used for the force of interest, i.e. the logarithm of (1+j) where j is the interest yield expressed as an annual effective yield.

In a standard duration calculation, the overall yield of the bond is used to discount each cash flow leading to this expression in which the sum of the weights is 1:

The higher the coupon rate of a bond, the shorter the duration (if the term of the bond is kept constant). Duration is always less than or equal to the overall life (to maturity) of the bond. Only a zero coupon bond (a bond with no coupons) will have duration equal to the maturity.

Duration indicates also how much the value V of the bond changes in relation to a small change of the rate of the bond. We see that

so that for a small variation in the redemption yield of the bond we have

That means that the duration gives the negative of the relative variation of the value of a bond with respect to a variation in the redemption yield on the bond, forgetting the quadratic and higher-order terms. The quadratic terms are taken into account in the convexity.

As we have seen above, r = ln(1 + j).

If (which could be defined as the Modified Duration) is required, then it is given by:

and this relationship holds good whatever the frequency of convertibility of j.

Dollar duration

The dollar duration is defined as the product of the duration and the price (value): it is the change in price in dollars, not in percentage, and has units of Dollar-Years (Dollars times Years). It gives the dollar variation in a bond's value for a small variation in the yield.

Application to VaR

Dollar duration $D $$ is commonly used for VaR (Value-at-Risk) calculation. If V = V(r) denotes the value of a security depending on the interest rate r, dollar duration can be defined as

To illustrate applications to portfolio risk management, consider a portfolio of securities dependent on the interest rates as risk factors, and let

denote the value of such portfolio. Then the exposure vector has components

Accordingly, the change in value of the portfolio can be approximated as

that is, a component that is linear in the interest rate changes plus an error term which is at least quadratic. This formula can be used to calculate the VaR of the portfolio by ignoring higher order terms. Typically cubic or higher terms are truncated. Quadratic terms, when included, can be expressed in terms of (multi-variate) bond convexity. One can make assumptions about the joint distribution of the interest rates and then calculate VaR by Monte Carlo simulation or, in some special cases (e.g., Gaussian distribution assuming a linear approximation), even analytically. The formula can also be used to calculate the DV01 of the portfolio (cf. below) and it can be generalized to include risk factors beyond interest rates.

Macaulay duration

Macaulay duration, named for Frederick Macaulay who introduced the concept, is the weighted average maturity of a bond where the weights are the relative discounted cash flows in each period.

It will be seen that this is the same formula for the duration as given above.

Macaulay showed that an unweighted average maturity is not useful in predicting interest rate risk. He gave two alternative measures that are useful:

The theoretically correct Macaulay-Weil duration which uses zero-coupon bond prices as discount factors, and
the more practical form (shown above) which uses the bond's yield to maturity to calculate discount factors.

The key difference between the two is that the Macaulay-Weil duration allows for the possibility of a sloping yield curve, whereas the algebra above is based on a constant value of $r$ , the yield, not varying by term to payment.

With the use of computers, both forms may be calculated, but the Macaulay duration is still widely used.

In case of continuously compounded yield the Macaulay duration coincides with the opposite of the partial derivative of the price of the bond with respect to the yield—as shown above. In case of yearly compounded yield, the modified duration coincides with the latter.

Modified duration

In case of n times compounded yield, the relation

is not valid anymore. That is why the modified duration $D *$ is used instead:

where r is the yield to maturity of the bond, and n is the number of cashflows per year.

Let us prove that the relation

is valid. We will analyze the particular case n = 1. The value (price) of the bond is

where i is the number of years to the cash flow $C i$ . The duration, defined as the weighted average maturity, is then

The derivative of V with respect to r is:

multiplying by we obtain

from which we can deduce the formula

which is valid for yearly compounded yield.

Embedded options and effective duration

For bonds that have embedded options, such as puttable and callable bonds, Macaulay duration will not correctly approximate the price move for a change in yield.

In order to price such bonds, one must use option pricing to determine the value of the bond, and then one can compute its delta (and hence its lambda), which is the duration. The effective duration is a discrete approximation to this latter, and depends on an option pricing model.

Consider a bond with an embedded put option. As an example, a $1,000 bond that can be redeemed by the holder at par at any time before the bond's maturity (ie an American put option). No matter how high interest rates become, the price of the bond will never go below $1,000 (ignoring counterparty risk). This bond's price sensitivity to interest rate changes is different from a non-puttable bond with otherwise identical cashflows. Bonds that have embedded options can be analyzed using "effective duration". Effective duration is a discrete approximation of the slope of the bond's value as a function of the interest rate.

where Δ y is the amount that yield changes, and

V - Δ y and V + Δ y

are the values that the bond will take if the yield falls by y or rises by y, respectively. However this value will vary depending on the value used for Δ y.

Spread duration

Sensitivity of a bond's market price to a change in Option Adjusted Spread (OAS). Thus the index, or underlying yield curve, remains unchanged.

Average duration

The sensitivity of a portfolio of bonds such as a bond mutual fund to changes in interest rates can also be important. The average duration of the bonds in the portfolio is often reported. The duration of a portfolio equals the weighted average maturity of all of the cash flows in the portfolio. If each bond has the same yield to maturity, this equals the weighted average of the portfolio's bond's durations. Otherwise the weighted average of the bond's durations is just a good approximation, but it can still be used to infer how the value of the portfolio would change in response to changes in interest rates.

Bond duration closed-form formula

FV = par value
C = coupon payment per period (half-year)
i = discount rate per period (half-year)
a = fraction of a period remaining until next coupon payment
m = number of coupon dates until maturity
P = bond price (present value of cash flows discounted with rate i)

[edit] Convexity

Main article: Bond convexity

Duration is a linear measure of how the price of a bond changes in response to interest rate changes. As interest rates change, the price does not change linearly, but rather is a convex function of interest rates. Convexity is a measure of the curvature of how the price of a bond changes as the interest rate changes. Specifically, duration can be formulated as the first derivative of the price function of the bond with respect to the interest rate in question, and the convexity as the second derivative.

Convexity also gives an idea of the spread of future cashflows. (Just as the duration gives the discounted mean term, so convexity can be used to calculate the discounted standard deviation, say, of return.)

Note that convexity can be both positive and negative. A bond with positive convexity will not have any call features - ie the issuer must redeem the bond at maturity - which means that as rates fall, its price will rise.

On the other hand, a bond with call features - ie where the issuer can redeem the bond early - is deemed to have negative convexity, which is to say its price should fall as rates fall. This is because the issuer can redeem the old bond at a high coupon and re-issue a new bond at a lower rate, thus providing the issuer with valuable optionality.

Mortgage-backed securities (pass-through mortgage principal prepayments) with US-style 15 or 30 year fixed rate mortgages as collateral are examples of callable bonds.

PV01 and DV01

PV01 is the present value impact of 1 basis point move in an interest rate. It is often used as a price alternative to duration (a time measure). When the PV01 is in USD, it is the same as DV01 (Dollar Value of 1 basis point).

Confused notions

Duration, in addition to having several definitions, is often confused with other notions, particularly various properties of bonds that are measured in years.

Duration is sometimes explained inaccurately as being a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows.^{[note 2]} This quantity is simply , assuming the tenor is this long, or the tenor otherwise (for instance, if a bond pays 5% per annum and was issued at par, it will take 20 years of these payments to repay its price), and is the duration of a perpetual bond, assuming a flat yield curve at the coupon. Note the absurdity of this definition: given a bond paying 5% per annum with a tenor of 5 years, the duration will be approximately 4.37, while the price of the bond will not be repaid in full until maturity (at 5 years).

The Weighted-Average Life is the weighted average of the principal repayments of an amortizing loan, and is longer than the duration.

Bond valuation

2009-06-24T09:33:00.000-07:00

Bond valuation

From Wikipedia, the free encyclopedia

Bond valuation is the process of determining the fair price of a bond. As with any security or capital investment, the fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the price or value of a bond is determined by discounting the bond's expected cash flows to the present using the appropriate discount rate.

General relationships

The present value relationship

The fair price of a straight bond (a bond with no embedded option; see Callable bond) is determined by discounting the expected cash flows:

Cash flows:
- the periodic coupon payments C, each of which is made n times (n is usually 2) every year
- the par or face value F, which is payable at maturity of the bond after T years.(NB final year payments will include the par value plus the coupon payments for the year). In some of the bonds, their Maturity Redemption Price might be more than par value, in this case the F is actually the Redemption Price.

Discount rate: the required (annually compounded) yield or rate of return r
- r is the market interest rate for bonds with similar terms and risk ratings
- m is the number of coupons to be paid over the remaining lifetime of the bond, ie n times T. (It is assumed that the previous coupon has just been paid.)
- u is (1+r)^(1/n) ie an interest accumulation factor over one coupon period

Bond Price =

Because the price is the present value of the cash flows, there is an inverse relationship between price and discount rate: the higher the discount rate the lower the value of the bond

Coupon yield

The coupon yield is simply the coupon payment (C) as a percentage of the face value (F).

Coupon yield = C / F

Coupon yield is also called nominal yield.

Current yield

The current yield is simply the coupon payment (C) as a percentage of the (current) bond price (P).

Current yield =

C / P 0 .

Yield to Maturity

The yield to maturity (YTM) is the discount rate which returns the market price of the bond. It is thus the internal rate of return of an investment in the bond made at the observed price. YTM can also be used to price a bond, where it is used as the required return on the bond.

In other words, it is identical to r in the above equation.

To achieve a return equal to YTM, the bond owner must:

buy the bond at price P₀,
hold the bond until maturity, and
redeem the bond at par.

The concept of current yield is closely related to other bond concepts, including yield to maturity, and coupon yield. The relationship between yield to maturity and coupon rate is as follows:

When a bond sells at a discount, YTM > current yield > coupon yield.
When a bond sells at a premium, coupon yield > current yield > YTM.
When a bond sells at par, YTM = current yield = coupon yield amt

Bond Pricing

Relative price approach

Here the bond will be priced relative to a benchmark, usually a government security. The yield to maturity on the bond is determined based on the bond's rating relative to a government security with similar maturity or duration. The better the quality of the bond, the smaller the spread between its required return and the YTM of the benchmark. This required return is then used to discount the bond cash flows as above to obtain the price.

Arbitrage-free pricing approach

In this approach, the bond price will reflect its arbitrage-free price (arbitrage=practice of taking advantage of a state of imbalance between two or more markets). Here, each cash flow is priced separately and is discounted at the same rate as the corresponding government issue zero-coupon bond. (Some multiple of the bond (or the security) will produce an identical cash flow to the government security (or the bond in question).) Since each bond cash flow is known with certainty, the bond price today must be equal to the sum of each of its cash flows discounted at the corresponding risk free rate - i.e. the corresponding government security. Were this not the case, arbitrage would be possible - see rational pricing.

Bond market index

2009-06-24T09:32:00.000-07:00

Bond market index

From Wikipedia, the free encyclopedia

The Frankfurt Bond Market

A bond market index is a composite listing of bonds or fixed income instruments and a statistic reflecting the composite value of its components. It is used as a tool in the portfolio management process to represent the aggregate characteristics of the underlying securities.

Types of indices

Bond indices can be categorized based on their broad characteristics, such as whether they are composed of government bonds, corporate bonds, high-yield bonds, mortgage-backed securities, etc. They can also be classified based on their credit rating or maturity.

Bond indices tend to be total rate-of-return indices and are used mostly as such: to look at performance of a market over time. In addition to returns, bond indices generally also have yield, duration, and convexity, which is aggregated up from individual bonds.

Bond indices generally include more individual securities than stock market indices do, and are broader and more rule-based. This allows portfolio managers to predict which type of issues will be eligible for the index.

Weighting

Most bond indices are weighted by market capitalization. This results in the bums problem, in which less creditworthy issuers with a lot of outstanding debt constitute a larger part of the index than more creditworthy ones.^[1]

Indices and passive investment management

Bond indices are harder to replicate compared to stock market indices due to the large number of issues. Usually, portfolio managers define suitable benchmarks for their portfolios, and use an existing index or create blends of indices based on their investment mandates. They then purchase a subset of the issues available in their benchmark, and they use the index as a measure of the market portfolio's return to compare their own portfolio's performance against. Often times, the average duration of the market may not be the most appropriate duration for a given portfolio.^[1] Replication of an index's characteristics can be achieved by using bond futures to match the duration of the bond index.

Bond

2009-06-24T09:28:00.000-07:00

In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals.^[1]

Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) or commercial paper are considered to be money market instruments and not bonds. Bonds must be repaid at fixed intervals over a period of time

Bonds and stocks are both securities, but the major difference between the two is that stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).

Issuing bonds

Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. However government bonds are instead typically auctioned.

Features of bonds

The most important features of a bond are:

nominal, principal or face amount — the amount on which the issuer pays interest, and which has to be repaid at the end.
issue price — the price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees.
maturity date — the date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in euros for bonds with a maturity of fifty years. In the market for U.S. Treasury securities, there are three groups of bond maturities:
- short term (bills): maturities up to one year;
- medium term (notes): maturities between one and ten years;
- long term (bonds): maturities greater than ten years.
coupon — the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.

Bond issued by the Dutch East India Company in 1623

The quality of the issue, which influences the probability that the bondholders will receive the amounts promised, at the due dates. This will depend on a whole range of factors.
- Indentures and Covenants — An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the U.S., federal and state securities and commercial laws apply to the enforcement of these agreements, which are construed by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bondholders.
- High yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are more risky than investment grade bonds, investors expect to earn a higher yield. These bonds are also called junk bonds.
coupon dates — the dates on which the issuer pays the coupon to the bond holders. In the U.S. and also in the U.K. and Europe, most bonds are semi-annual, which means that they pay a coupon every six months.
Optionality: Occasionally a bond may contain an embedded option; that is, it grants option-like features to the holder or the issuer:
- Callability — Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.
- Putability — Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put option. (Note: "Putable" denotes an embedded put option; "Puttable" denotes that it may be putted.)
- call dates and put dates—the dates on which callable and putable bonds can be redeemed early. There are four main categories.
  - A Bermudan callable has several call dates, usually coinciding with coupon dates.
  - A European callable has only one call date. This is a special case of a Bermudan callable.
  - An American callable can be called at any time until the maturity date.
  - A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation. Also known as a "survivor's option".
sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be retired periodically. The entire bond issue can be liquidated by the maturity date. If that is not the case, then the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in open market, then return them to trustees.
convertible bond lets a bondholder exchange a bond to a number of shares of the issuer's common stock.
exchangeable bond allows for exchange to shares of a corporation other than the issuer.

Types of bonds

Bond certificate for the state of South Carolina issued in 1873 under the state's Consolidation Act.

The following descriptions are not mutually exclusive, and more than one of them may apply to a particular bond.

Fixed rate bonds have a coupon that remains constant throughout the life of the bond.

Floating rate notes (FRNs) have a variable coupon that is linked to an interest rate index. Common indices include money market indices, such as LIBOR or Euribor. For example the coupon may be defined as three month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months.

Zero-coupon bonds pay no regular interest. They are issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity (and usually taxed as such). The bondholder receives the full principal amount on the redemption date. An example of zero coupon bonds is Series E savings bonds issued by the U.S. government. Zero-coupon bonds may be created from fixed rate bonds by a financial institution separating "stripping off" the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond may be traded separately. See IO (Interest Only) and PO (Principal Only).

Inflation linked bonds, in which the principal amount and the interest payments are indexed to inflation. The interest rate is normally lower than for fixed rate bonds with a comparable maturity (this position briefly reversed itself for short-term UK bonds in December 2008). However, as the principal amount grows, the payments increase with inflation. The United Kingdom was the first sovereign issuer to issue inflation linked Gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.

Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.

Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs).

Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.

Perpetual bonds are also often called perpetuities. They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today, although the amounts are now insignificant. Some ultra long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century)) are virtually perpetuities from a financial point of view, with the current value of principal near zero.

Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets.^[2] U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local tax-exempt bearer bonds were prohibited in 1983.^[3]

Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner.

Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.

Book-entry bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them.^[4]

Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond.

War bond is a bond issued by a country to fund a war.

Serial bond is a bond that matures in installments over a period of time. In effect, a $100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval.

Revenue bond is a special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. Revenue bonds are typically "non-recourse," meaning that in the event of default, the bond holder has no recourse to other governmental assets or revenues.

Bonds issued in foreign currencies

Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign currencies as it may appear to be more stable and predictable than their domestic currency. Issuing bonds denominated in foreign currencies also gives issuers the ability to access investment capital available in foreign markets. The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company's local currency to be used on existing operations. Foreign issuer bonds can also be used to hedge foreign exchange rate risk. Some of these bonds are called by their nicknames, such as the "samurai bond."

Eurodollar bond, a U.S. dollar-denominated bond issued by a non-U.S. entity outside the U.S^[5]
Kangaroo bond, an Australian dollar-denominated bond issued by a non-Australian entity in the Australian market
Maple bond, a Canadian Dollar-denominated bond issued by a non-Canadian entity in the Canadian market
Samurai bond, a Japanese Yen-denominated bond issued by a non-Japanese entity in the Japanese market
Shibosai Bond is a private placement bond in Japanese market with distribution limited to institutions and banks.
Yankee bond, a US Dollar-denominated bond issued by a non-US entity in the US market
Shogun bond, a non-yen-denominated bond issued in Japan by a non-Japanese institution or government^[6]
Bulldog bond, a pound sterling-denominated bond issued in London by a foreign institution or government
Matrioshka Bond, a Russian rouble-denominated bond issued in the Russian Federation by non-Russian entities. The name derives from the famous Russian wooden dolls, Matrioshka, popular among foreign visitors to Russia
Arirang bond, a Korean won-denominated bond issued by a non-Korean entity in the Korean market^[7]
Kimchi bond, a non-Korean won-denominated bond issued by a non-Korean entity in the Korean market.^[8]
Formosa bond, a non-New Taiwan Dollar-denominated bond issued by a non-Taiwan entity in the Taiwan market^[9]
Panda bond, a Chinese renminbi-denominated bond issued by a non-China entity in the People's Republic of China market^[10]
State of Israel bond, a bond denominated in multiple currencies issued by the State of Israel through the Development Corporation of Israel.

Trading and valuing bonds

The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the creditworthiness of the issuer.

These factors are likely to change over time, so the market price of a bond will vary after it is issued. This price is expressed as a percentage of nominal value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but bond prices converge to par when they approach maturity (if the market expects the maturity payment to be made in full and on time) as this is the price the issuer will pay to redeem the bond. At other times, prices can be above par (bond is priced at greater than 100), which is called trading at a premium, or below par (bond is priced at less than 100), which is called trading at a discount. Most government bonds are denominated in units of $1000, if in the United States, or in units of £100, if in the United Kingdom. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, in the US, bond prices are quoted in points and thirty-seconds of a point, rather than in decimal form.) Some short-term bonds, such as the U.S. Treasury Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond.

The market price of a bond is the present value of all expected future interest and principal payments of the bond discounted at the bond's redemption yield, or rate of return. That relationship defines the redemption yield on the bond, which represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices fall and vice versa. Thus the redemption yield could be considered to be made up of two parts: the current yield (see below) and the expected capital gain or loss: roughly the current yield plus the capital gain (negative for loss) per year until redemption.

The market price of a bond may include the accrued interest since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "full" or "dirty price". (See also Accrual bond.) The price excluding accrued interest is known as the "flat" or "clean price".

The interest rate adjusted for (divided by) the current price of the bond is called the current yield (this is the nominal yield multiplied by the par value and divided by the price).

The relationship between yield and maturity for otherwise identical bonds is called a yield curve.

Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system. Rather, in most developed bond markets such as the U.S., Japan and western Europe, bonds trade in decentralized, dealer-based over-the-counter markets. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.

Bond markets can also differ from stock markets in that, in some markets, investors sometimes do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, the dealers earn revenue by means of the spread, or difference, between the price at which the dealer buys a bond from one investor -- the "bid" price -- and the price at which he or she sells the same bond to another investor--the "ask" or "offer" price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.

Investing in bonds

Bonds are bought and traded mostly by institutions like pension funds, insurance companies and banks. Most individuals who want to own bonds do so through bond funds. Still, in the U.S., nearly 10% of all bonds outstanding are held directly by households.

Sometimes, bond markets rise (while yields fall) when stock markets fall. More relevantly, the volatility of bonds (especially short and medium dated bonds) is lower than that of shares. Thus bonds are generally viewed as safer investments than stocks, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments are often higher than the general level of dividend payments. Bonds are liquid – it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks – and the comparative certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount), whereas the company's stock often ends up valueless. However, bonds can also be risky:

Fixed rate bonds are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market interest rate rises, the market price of bonds will fall, reflecting investors' ability to get a higher interest rate on their money elsewhere — perhaps by purchasing a newly issued bond that already features the newly higher interest rate. Note that this drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors who want a specific amount at the maturity date need not worry about price swings in their bonds and do not suffer from interest rate risk.

Price changes in a bond will also immediately affect mutual funds that hold these bonds. If the value of the bonds held in a trading portfolio has fallen over the day, the value of the portfolio will also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers (irrespective of whether the value is immediately "marked to market" or not). If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", interest rate risk could become a real problem. (Conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003.) One way to quantify the interest rate risk on a bond is in terms of its duration. Efforts to control this risk are called immunization or hedging.

Bond prices can become volatile depending on the credit rating of the issuer - for instance if the credit rating agencies like Standard & Poor's and Moody's upgrade or downgrade the credit rating of the issuer. A downgrade will cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.

A company's bondholders may lose much or all their money if the company goes bankrupt. Under the laws of many countries (including the United States and Canada), bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence.

There is no guarantee of how much money will remain to repay bondholders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom, in 2004 its bondholders ended up being paid 35.7 cents on the dollar. In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.

Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This creates reinvestment risk, meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.

Bond indices

A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The most common American benchmarks are the (ex) Lehman Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity and/or sector for managing specialized portfolios.

from wikipedia