A collateralized loan obligation is a financial instrument that offers investors the chance to invest in the underlying assets of loans. CLOs are attractive because they offer higher yields than other types of investments like stocks or bonds. You may be wondering what exactly a collateralized loan obligation or CLO is, and how it might help you with your investment portfolio? So keep reading to know more about Collateralized Loan Obligations Collateralized Loan Obligation DefinitionA collateralized loan obligation, or CLO, is a type of security that allows investors to pool their cash together and invest in the underlying assets of loans. To make this investment option possible, a corporation will purchase hundreds or thousands of individual loans from banks and financial institutions so that it can wrap them up into one package (the obligations). These obligations are then issued to investors who can collect interest payments and, if all goes well, eventually get their original investments back. Conceptually, a CLO is similar to a real estate investment trust in that it offers the promise of collecting regular payments from individual loans. The key difference is that with the CLOs you can invest in a wide variety of loans, not REITs. How Does Collateralized Loan Obligation WorkLike all other types of loans, collateralized loan obligations are made to those with good credit scores. Investors may also look for borrowers who have little or no debt and many years left before they need to pay off their loans so that they can get the best returns on their investment soon. Loans range from anywhere between $50,000 and $20 million and have terms of anywhere between 4-10 years. After the loan has been issued, investment firms will then pool them together and make a new package that contains all the loans within it. With this new financial instrument for sale, they'll go to potential investors like hedge funds or mutual funds to get capital. CLOs do not offer any of the underlying loan itself, just an interest rate on top of the original. As a general rule, investment firms will keep at least 10% of loans in reserve to handle those who defaulted on their debts. This means that if you plan to invest in this type of security, you've to make sure they screen for quality borrowers and rely on a backup reserve so you can get your money back if you want to. As with any other type of investment, be sure to fully understand all the rules before taking part in this market. This will help you to avoid making any costly mistakes later on down the road. ConclusionA collateralized loan obligation is a type of investment that pools together different types of loans, such as mortgages and corporate bonds. Because it has different types of assets in the pool, it can offer investors more diversification than just buying one kind of asset like stocks or real estate. We hope this article gave you a better idea of what a Collateralized Loan Obligation is, and how it might fit into your investing portfolio. Article Source Here: What is a Collateralized Loan Obligation?
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Investors can manage their overall portfolio risk by allocating their funds across a diversified range of asset classes. Usually, investors can mitigate most of these risks through planning. Sometimes, however, some risks may occur which are beyond prediction. These risks may cause severe implications for investors and adversely affect their portfolios. What is Tail Risk?The term tail refers to the end portions of distribution curves. Tail risk represents an investment’s worst downside performance periods. It occurs when the possibility that the investment will move more than three standard deviations from the mean outweighs what the normal distribution shows. The events that cause these risks are usually unpredictable. Tail risks can cause investors’ wealth to deplete severely. Therefore, investors need to develop a realistic assessment of the true tail risk probabilities for an investment. The tail risk for investment also relates to the normal distribution. Under normal circumstances, an investment's returns will move towards the middle of the curve. However, it is also possible for these returns to gravitate towards the ends of the curve. Nonetheless, there is a low probability of that happening. What is Tail Risk Hedging?The probability of tail risk events occurring and affecting investors' portfolio adversely are low. However, if these risks realize, they can have severe impacts on investors' portfolios and wealth. Therefore, investors may need to use strategies to hedge against these tail events. Tail risk hedging is the process of developing strategies to mitigate tail risks. Tail risk hedging is crucial in protecting investors against any unpredictable risks. Since these risks can have severe implications on investors' portfolios, they can be highly detrimental. Therefore, investors need tail risk hedging to enhance their returns in the long run. In some cases, it may be necessary to do so. Diversification can help investors in tail risk hedging. However, they also have other options. How does Tail Risk Hedging work?There are several options that investors have when hedging against tail risk. One of these options includes portfolio protection. This process, also known as risk management, can be beneficial for investors seeking worthwhile returns while also protecting their portfolios against tail risk. There are several methods within this approach that investors can use for tail risk hedging. One of these methods involves using put options. Investors can buy put potions for major stock indices for their tail risk hedging process. It allows them to enter into an option agreement for the right to sell their investments at a specific price and time in the future. However, buying put options to hedge against tail risk can be complicated, time-consuming, and expensive. Apart from portfolio protection, investors also have the option to recoup losses. This process involves waiting for some time and recoups their losses. However, this process may require a significant time investment, usually lasting over several years. Recouping losses may be a viable option for investors with a long-term investment plan. However, investors may not be willing to put in the effort for this approach for tail risk hedging. ConclusionTail risk constitutes the risk of an event that has a low probability. Therefore, it may rarely realize. However, investors may still need to employ tail risk hedging strategies to protect their wealth. There are several approaches to this process that they may use. These include risk management or recouping losses. Post Source Here: How Does Tail Risk Hedging Work? The term embedded option refers to an option included in financial instruments that provides the issuer or holder with a right to perform some actions at a future time. However, this right does not obligate the issuer or holder to do so. Embedded options can be a part of financial securities, including stocks and bonds. Investors can use the nominal spread to measure the difference between the yield of the bond and the yield to maturity of similar treasury bonds. However, the same does not apply when embedded options are a part of the bond. Instead of using the nominal spread, investors can use the option-adjusted spread. What is the Option Adjusted Spread?The option-adjusted spread measures the spread of a fixed-income instrument and the risk-free rate of return. Subsequently, it adjusts this spread to account for the embedded option. Simply put, it converts the difference between a fixed-income security's market and fair price into yield. After that, it calculates a spread to make both of these prices equal. Option-adjusted spread is common in mortgage-backed securities as they usually carry an embedded option. This option exists to hedge the prepayment risk associated with the mortgage. Analysts can adjust the risk-free rate to the embedded option. By doing so, they can calculate the expected cash flows and the present value of the mortgage-backed securities and how they may fluctuate. How does the Option Adjusted Spread work?The option-adjusted spread is crucial in helping investors evaluate embedded options against general market volatility. As mentioned, these apply to all bonds that carry an embedded option. This spread represents the spread after adjusting for the embedded option. That is how it gets its name. With option-adjusted spreads, investors can evaluate how the embedded option affects the bond and its value. Embedded options may exist in various bonds. However, they create additional risks. For investors, looking at the option-adjusted spread for a bond can indicate whether they should invest in it. It also helps them evaluate whether the bond is worth the given price after accounting for the risks. Therefore, option-adjusted spreads can play a substantial role in determining the value of bonds with embedded options. How to calculate the Option Adjusted Spread?Investors looking to calculate the option-adjusted spread can do so by using the option-adjusted spread formula. This formula considers the difference between the Z-spread and the embedded option cost. Therefore, it will be as below. Option adjusted spread = Z-spread - Option cost What are the advantages and disadvantages of Option Adjusted Spread?There are several advantages of the option-adjusted spread. Most importantly, it allows investors to separate bonds from their embedded option. It can help investors decide whether an investment is worthwhile. Similarly, it provides investors with an accurate picture of embedded option contracts. Overall, it can be substantial in helping investors calculate a security's price that includes an embedded option. However, there are some disadvantages that come with the option-adjusted spread. This spread uses advanced modes like Monte Carlo analysis in simulation. However, it may make the calculations much more complex. Similarly, it is prone to model risk and can distort investors' perception of how bonds behave if calculated inaccurately. ConclusionEmbedded options may exist in financial instruments. These options provide one party with a right to perform some specific actions at a specific time. However, these may carry some risks. Therefore, investors will need to calculate the option-adjusted spread. This spread measures the value of a bond by removing the cost of the embedded option from it. Originally Published Here: What is the Option Adjusted Spread Smart beta and factor investing are two terms often used interchangeably. These are both investing strategies that investors may use. However, there are various factors that differentiate both these investing strategies. Before understanding how they differ, it is critical to look at what each of these is. What is Smart Beta Investing?Smart beta investing is an investment strategy that allows investors to benefit from active and passive investing strategies. It combines both of these aspects to allow investors to maximize their gains. Smart beta portfolios are theoretically efficient compared to other portfolios. They try to strike a balance between the efficient market hypothesis and value investing. Smart beta investing seeks to achieve several objectives for investors. These may include low-risk investments, highly diversified portfolios with low cost, or alpha. This approach to investing applies to all well-known asset classes, including stocks, commodities, bonds, etc. The smart beta investing strategy stems from the work of Harry Markowitz through the modern portfolio theory. What is Factor Investing?Factor investing is another strategy used by investors. Unlike smart beta investing, factor investing involves investing in assets based on predetermined factors. Each investor will specify or decide on which attributes they want their investments to match. Once they do so, they can choose investments that relate to those factors. These factors will also decide whether the investments are successful in achieving investors' goals. There are two categorizations of factors that investors may consider during factor investing. These include macroeconomic and style factors. Macroeconomic factors seek to describe the risks associated with several asset classes. Style factors, on the other hand, explain the risks and rewards related to individual asset classes. Factor investing originates from the work of Fama and French as an asset pricing model. What are the differences between Smart Beta and Factor Investing?There are several characteristics that define and differentiate smart beta and factor investing. Both strategies have some commonalities, which can make them similar. However, there are some features that can separate them from each other as well. For investors, it is crucial to understand the differences between both of these to achieve their objectives. Smart beta investing is a strategy that works with all popular asset classes. This approach to investing may emphasize achieving alpha, high diversification, or low-risk investments. For investors, it can help in building a portfolio with lower risks compared to traditional investing strategies. As mentioned, smart beta investing includes the advantages of both passive and active investing. Smart beta investing follows specific rules which are also transparent. However, it seeks to identify ways in which investors can capitalize on any inefficiencies in the market. There are several investment factors that smart beta investing follows. These include value, quality, small size, momentum, and minimum volatility. Factor investing, on the other hand, involves targeting specific return drivers across asset classes. As mentioned, these drivers may include macroeconomic and style factors. Each of these factors consists of various other investment factors within them. Through these, investors can achieve several objectives. These may include reduced volatility, diversification, and better returns. ConclusionSmart beta and factor investing are two common investment strategies that may confuse investors. Smart beta investing follows value investing and efficient market hypothesis. It involves a combination of active and passive investing strategies. On the other hand, factor investing focuses on achieving objectives that may come in the form of style or macroeconomic factors. Originally Published Here: Smart Beta Vs Factor Investing The arbitrage principle is one of the cornerstones of modern finance, and it’s being used widely, from derivative pricing to hedging, trading, and risk management. Theoretically, there is only one arbitrage principle. Practically, however, there are other types of arbitrage, some of which are relaxed forms of the strictest one. Reference [1] examined two seemingly simple trading strategies: the first one is based on the put-call parity, and the second one is the put-write strategy. These strategies are simple, but they can stimulate some interesting thoughts regarding practical aspects of the arbitrage principle, Coming back to the scheme for deriving trading strategies described in the introduction, both strategies started with stating assumptions on the financial market. For the put-call-parity this meant postulating that the no-arbitrage principle holds, for the put-write strategy pricing of options under certain model assumptions was considered. In a further step theoretical results were inferred. The put-call-parity itself in the first case and implicit volatility or expected returns of options in the latter. Testing on real market data quickly showed deviations for both theories. The author first investigated a trading strategy based on the put-call parity and concluded that it is not profitable. The author then examined the put-write strategy and concluded that it works better and can yield an excess return, …the outcome of the two methods differed vastly. Whilst the deviations for the put-call-parity were too low to gain any noteworthy economical success when considering market frictions like margins and transaction costs, the put-write strategy looked much more promising. The article’s results lead us to the following thoughts,
Let us know what you think. References [1] A. Brunhuemer, Computer-Supported Testing of Option Strategies, Johannes Kepler University, July 2020 Post Source Here: Do Arbitrage Opportunities Still Exist? A swap is a financial derivative that allows two parties to exchange their financial instruments or cash flows. These are highly crucial for investors, particularly for hedging. There are various types of swaps that investors can acquire. One of these includes total return swaps. Before understanding what these are, it is crucial to look at what total return means. What is Total Return?When investors acquire financial instruments, they expect some returns in exchange. These returns usually come in the form of interest or dividend payments. However, investors may also make capital gains on their financial instruments. The total return is a metric that allows investors to measure all the returns they generate on their investments. In other words, total return represents the actual rate of return for an investment. It factors in various income sources when measuring the returns from an investment. These include interest payments, dividends, distributions, and capital gains. Total return represents the total income from an investment over a specific period, usually one year. What is a Total Return Swap?A total return swap is a derivative instrument that allows two parties to exchange the returns from their financial instruments. These returns include both the regular payments that investors receive and any capital appreciation. One party in a total return swap agrees to make regular payments to the other based on a set rate. This rate may be variable or fixed. The other party makes payments that relate to an underlying asset's returns. The underlying asset involved in a total return swap is called a reference asset and owned by the party receiving the set rate payments. This asset can either be a loan, bond, or equity interest. Total return swap agreements allow investors to get payments from a financial asset without having to own it. However, they also have to pay a set rate to the other party, as mentioned above. What are the advantages and disadvantages of Total Return Swaps?Total return swaps offer investors many advantages. It can be a decent tool for investors that want to participate in leveraged investing. These contracts do not involve the exchange or transfer of an asset between the two parties. Therefore, investors do not need to acquire assets to obtain the benefits or returns from them. This feature can be significantly beneficial for investors that can't afford to invest in financial assets. On top of that, these agreements are also beneficial to the receivers. They do not have to bear the administrative burden related to transferring assets. They also do not have to give away their financial instruments. However, they can still benefit from the payments they get from the other party. Overall, total return swap agreements can be beneficial for both parties. However, total return swaps also come with some risks. One of these includes the interest rate risk, which impacts both parties. Any changes in interest rates can be detrimental to both parties. Additionally, investors may also have to bear losses if the underlying asset's value or total returns fluctuate. They have to pay interest regardless of these losses, which can further harm them. ConclusionThe total return is a term that represents the overall income that investors get on their financial assets. A total return swap is a contract that allows two parties to exchange these returns. One party makes regular payments to the other in exchange for the total returns from an underlying asset. There are several advantages and disadvantages of these swap agreements, as mentioned above. Article Source Here: What is a Total Return Swap? Volatility estimators are a useful tool in volatility trading and risk management. We have discussed several types of volatility estimators, ranging from the simple Close-to-Close Historical Volatility to more complex ones like the Garman-Klass-Yang-Zhang volatility. As discussed in Reference [1], volatility estimators can also be used directly in delta-one trading by Commodity Trading Advisors. It pointed out that using a more efficient volatility estimator, specifically the Yang and Zhang volatility estimator, trading strategies’ turnover can be reduced while maintaining the same level of risk-adjusted returns. Another interesting result is that using a more efficient momentum indicator the turnover can also be improved. First, we show that the turnover of the strategy can be significantly reduced with the use of more efficient volatility estimates like the ones suggested by Yang and Zhang (2000) or the use of alternative trading rules that depart from the typical binary setup (+1: long, and -1: short). The turnover gains can reach levels of up to approximately 36% (for our sample period and underlying universe), when both methodological amendments are employed, without causing a statistically significant performance penalty. Finally, the authors showed that including pairwise correlations in the portfolio construction also improves trading strategy performance, We find that the correlation-adjusted variant of the strategy outperforms its naive implementation and the outperformance is more pronounced in the post-GFC period. Importantly, the higher turnover due to dynamic leverage is fully counter-balanced when the earlier turnover reduction techniques are also employed. Intuitively, the role of correlation in the trading of long/short commodity portfolios is similar to that in pairs or basket trading of other asset classes. These results have interesting implications not only in the management of volatility-target portfolios but also in trading and risk management in general. References [1] Baltas, Nick and Kosowski, Robert, Demystifying Time-Series Momentum Strategies: Volatility Estimators, Trading Rules and Pairwise Correlations. "Market Momentum: Theory and Practice", Wiley, 2020 Post Source Here: An Application of Volatility Estimators There has been an increased demand for businesses to conduct their operations in a socially responsible way. This demand comes due to an increased drive towards sustainability and considering the needs of society as a whole. The idea of socially responsible operations has also translated into the investing world through socially responsible investing. What is Socially Responsible Investing?Socially responsible investing (SRI) is a process that involves investments considered socially responsible. With SRI, investors have to identify companies that conduct their operations in a socially responsible manner. Once they do so, they can invest in the stocks or securities of those companies only. Socially responsible investing relates to how the underlying companies perform their operations. As mentioned, the demand for socially responsible investing stems from a drive towards acting to benefit society. Therefore, SRI builds on that idea. By investing in companies that conduct their operations in that manner, investors can encourage such behaviour. SRI also relates to ethical investing, where investors prefer moral values as their primary investing objectives. What are the advantages of Socially Responsible Investing?There are several advantages that socially responsible investing may include. Most importantly, it allows investors to indulge in ethical investing. By doing so, investors can help businesses that can provide benefits to society as a whole. However, that does not imply that investors have to sacrifice their gains. With SRI, investors can achieve both ethical investing and decent returns. Socially responsible investing also encourages local businesses. By doing so, investors can significantly support companies that make the extra effort to ensure social responsibility. On top of that, more people are supporting socially responsible businesses. Therefore, investors can also expect their investment value to increase due to an increased demand for these businesses. Overall, socially responsible investing can be highly motivational for both companies and investors. Investors can achieve peace of mind and feel rewarded for supporting socially responsible businesses. On top of that, they can actively contribute to social responsibility through their investments. However, it does not imply that they will be making any sacrifices to do so. What are the disadvantages of Socially Responsible Investing?Despite its many advantages, socially responsible investing can have some risks or drawbacks. The most primary of these is the overemphasis on the ethical factor. While investors can still get decent returns on these investments, they may not be maximum. When investors place so much emphasis on social responsibility, they may hinder their returns. Building on the above point, investors may also overlook several investments to find ethical ones. It may impact investors in several ways. The most important of these is the risk of getting lower rewards or higher risks. Similarly, SRI may force them into a position where they can't build a diversified portfolio. Overall, investors have to decide on whether they want to emphasize ethical investing. Lastly, investors must identify the right investments with the socially responsible investing strategy. However, this process is easier said than done. Many companies claim to operate with social responsibility but very few actually do. For investors, this point may introduce several difficulties in their objective to be socially responsible. ConclusionSocially responsible investing is an investment strategy that requires investors to prefer ethical investments over others. There are several advantages of this strategy that can benefit both investors and companies. Despite that, it may come with several disadvantages, as mentioned above. Article Source Here: What is Socially Responsible Investing-Its Advantages and Disadvantages An exchange-traded fund (ETF) is a type of investment that provides investors with a diversified investment. ETFs track a specific index, industry, or other assets. Like other investments, investors can invest in these funds in the market. Usually, ETFs include a variety of underlying investments, such as stocks, bonds, commodities, etc. ETFs can provide investors with better returns than some other investments. Since these funds track a specific index, industry, commodity, or other assets, investors can expect similar returns. However, there are some risks specific to investing in ETFs that investors need to consider. One such risk is the tracking error of ETFs. Before understanding how these affect ETFs, it is crucial to know what tracking errors are. What is a Tracking Error?Tracking error refers to the difference between the variance in returns from an investment portfolio and a chosen benchmark. In other words, it represents the relative risk of an investment portfolio compared to its benchmark. The variance between these returns comes in the form of standard deviations. Tracking errors can have a significant impact on the returns that investors can expect from their investments. Tracking errors are common for investments that track a specific benchmark. These may include exchange-traded funds, mutual funds, etc. Tracking error can help investors gauge the performance of an investment and help compared it with a benchmark. In that context, it can also help investors measure the performance of fund managers. What is the Tracking Error of ETF?As mentioned above, ETFs are funds that usually track an index. The tracking error of ETF represents the difference between the returns from this index and the actual returns of the index fund. Several factors may contribute to it. In most cases, however, the tracking error of ETFs are minor. However, these errors almost always exist and are rarely nil. The tracking error of ETF can be significantly critical to investors. Since investors measure an ETF's performance, it can provide insights into the ETF's consistency against the tracked index. It also provides them with a base to measure an ETF manager's performance. Overall, investors can gauge the volatility in the difference between an ETF and its index using tracking errors. How can investors calculate the Tracking Error of ETF?As mentioned above, tracking error represents the difference between the returns from the fund and those of its index. Therefore, investors can calculate the tracking error using the following formula. Tracking Error = Return(P) - Return(i) In the above formula, Return(P) represents the returns from the ETF or portfolio. On the other hand, Return(i) signifies the returns from the index. However, the above is one of the two methods which investors can use to calculate the tracking error. In addition to the above, investors can also use the following tracking error formula. Tracking Error = Standard deviation of (P - B) In the above formula, ‘P’ represents the returns from the portfolio or the ETF. On the other hand, ‘B’ signifies the returns from the benchmark or index. ConclusionExchange-traded funds are investment funds that usually track a specific index. However, the returns on these funds may differ from those of the index. This difference is known as the tracking error of ETF. Tracking errors can be significantly beneficial for investors to gauge an ETF's performance. Investors can calculate it using one of the two methods given above. Post Source Here: What is the Tracking Error of ETF |
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