During audits, auditors can use various techniques or methods to obtain audit evidence. These methods come into two categories, including the test of controls and substantive procedures. Substantive procedures have two types, consisting of analytical procedures and the test of details. Within this process, auditors can use several techniques. Two of these techniques include tracing and vouching. Both tracing and vouching involve following a trail that includes supporting documents. However, the approach that both techniques use is different. Overall, both tracing and vouching differ fundamentally. Before discussing the differences, it is crucial to look at both individually. What is Tracing in Auditing?Tracing in auditing is a substantive procedure that auditors use to test for details. This process involves obtaining source documents based on a sample and following them to the accounting records. From there, it examines whether these accounting records become a part of the financial statements. Tracing also involves checking the presentation of these items in those statements. Tracing allows auditors to check for the controls that companies have over their transactions. Following the trail of source documents to the financial statements helps auditors confirm the completeness and accuracy assertions of the financial statements. Similarly, it provides them assurance regarding the client's accounting and financial records. What is Vouching in Auditing?Vouching refers to the process of examining a client’s financial records and the supporting evidence with them. However, it does not begin from the source documents. Instead, it involves selecting a sample of transactions from the accounting system and checking the supporting evidence. Therefore, it takes an opposite approach to the tracing procedure used in auditing. Vouching does not involve confirming the completeness assert of the financial statements. Instead, it helps auditors confirm all other assertions. However, it primarily focuses on the occurrence of transactions. Through this process, auditors can ensure that the client has recorded transactions properly in the accounts. Tracing vs Vouching: What is the difference?Tracing and vouching are very similar in various regards. Both of them look at how source documents connect to the financial system. Similarly, both are a part of the substantive procedures that auditors perform. However, there are many differences between tracing and vouchers as well. These differences include the following. ApproachThe primary difference between tracing and vouching is the approach auditors take. As mentioned, with tracing, auditors begin with the source documents. From there, they track the transactions to the financial statements. However, vouching takes the opposite approach. When it comes to the vouching process, auditors begin with the financial statements. From there, they track the transaction to the source documents. AssertionsThe primary assertions tested with both approaches also differ. As mentioned, auditors use tracing to confirm the completeness and accuracy assertions of the financial statements. This way, auditors can check if all source documents become a part of the financial statements based on a sample. With vouching, auditors primarily focus on the occurrence assertion. Through that approach, auditors check if the transactions recorded have source documents to support them. MisstatementsTracing involves identifying source documents that the client may not have included in the financial statements. Therefore, it helps auditors locate any understatements in the financial statements. On the other hand, vouching takes the opposite approach. Hence, it allows auditors to identify any overstatements in the financial statements. ConclusionTracing in auditing is a technique that auditors use to test the completeness assertion. This technique involves picking source documents and trailing them to the financial statements. In contrast, vouching allows auditors to test the occurrence assertion. Auditors select transactions from the accounts and track them to the source documents with this approach. Originally Published Here: Tracing vs Vouching
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If you are looking to manage your portfolio’s risk-return profile, why not join the growing number of investors who have been using structured notes? Structured notes can be a great addition to your investment portfolio, allowing you to gain exposure to a desired market or index at an effective cost, and providing the added benefit of potential gains from any rise in that index. A structured note is a great combination of pure investment (i.e., shares or bonds), and insurance that can provide downside protection in times of economic stress, while offering the potential for performance when the market is moving in the favourite direction. In this article, we'll explore the benefits of structured notes, how they work and who should consider them. What are structured notesA structured note is a financial instrument issued by an investment firm that has embedded derivatives to provide downside protection or upside participation to an underlying index or other reference assets, such as commodity prices. Structured notes pay either a fixed or floating interest rate. They are issued by investment banks, insurance companies, and specialist structured product companies, such as Guggenheim Partners and Pacific Investment Management. The value of a structured note is directly linked to the underlying asset and pays a fixed return if held to maturity under certain market conditions. If the market moves against the investor, there is potential to lose some of your initial investment. Structured notes are a good idea for an investor who wants to protect his investment when the market crashes. They can protect his portfolio if something bad happens. But unlike options or futures contracts, most structured notes are not traded publicly. How do structured notes workTypically, a structured note has the following structure: the amount invested is used to pay for a derivative contract that references an underlying asset. For example, if an investor wants to buy a stock market index at its current value, he might buy 100 shares of an exchange-traded fund (ETF) tracking it. On the other hand, he could buy a call option on the index or a futures contract. Alternatively, an investor could consider buying an equity-linked structured note. This would give him direct exposure to the market without having to find 100 shares of an index fund and paying brokerage fees and taxes. The downside is that if he buys the stock market index with a structured note, he will not benefit greatly if it goes up. On the other hand, if the market falls, the investor will not lose his entire investment. The embedded derivative contract provides protection for his portfolio. Benefits of Structured NotesHere are some of the benefits of structured notes
ConclusionStructured notes have several advantages that make them an attractive option for those looking to manage their security risk-return profiles. They allow you to get exposure to markets without paying huge up-front costs and taking on additional risks. You can also enjoy added returns, without accepting too much risk. Article Source Here: What are Structured Notes For profit-based companies and organizations, revenues are highly critical. These represent the income they make during an accounting period. However, some items may also adversely impact these revenues. According to accounting standards, companies must record and report these items separately. This process is crucial in calculating a company's net sales, which goes on the income statement. What is Net Sales?When a company makes sales, it records the amount as revenues. These revenues contribute to a company's gross sales. However, accounting standards require companies to report their net sales on the income statement. Through this, companies can give a more accurate and better representation of the operations involving their revenues. Net sales is a company's gross sales less its sales returns, allowances, and discounts. It represents the first item on the income statement. Usually, companies also provide a calculation of their net sales in the notes to the financial statements. However, the net sales figure may not be a part of every company's financials. Some companies may not offer discounts, returns, or allowances at all. But for companies that do provide these, the net sales figure is crucial. What are the components of Net Sales?The most critical component of the net sales figure is gross sales. For most companies, this amount represents the total revenues generated during an accounting period. However, gross sales does not impact the net sales if the other critical components do not exist. An explanation of each of these components is as below. Sales ReturnsWhen companies sell physical products, they may also offer their customers the option to return them. Usually, they attach specific terms and conditions to these returns. Sales returns include any products received back from customers due to various reasons. For companies, these returns decrease the total revenues generated during an accounting period. Sales AllowancesIn some circumstances, companies may also offer their customers sale allowances. They are similar to discounts but differ from trade or cash discounts. Companies grant sales allowances after customers receive goods. Usually, it involves giving customers an incentive to reduce the possibility of sales returns. Companies often offer sales allowances to customers when their delivered products have issues. Sales DiscountsSales discounts are cash discounts provided to customers. With these discounts, companies do not reduce the price of the goods delivered. Instead, it entails decreasing the overall sum paid for those goods in case of early payment for credit sales. Therefore, sales discounts offer the customers an incentive to compensate the company before the credit term. What is the formula for Net Sales?The formula for net sales is straightforward after understanding its definition. As mentioned, it is a company’s gross sales after reducing returns, allowances, and discounts. Therefore, the net sales formula will be as follows. Net Sales = Gross Sales - Sales Returns - Sales Allowances - Sales Discounts As mentioned, companies usually present this formula in the notes to the financial statements. The net figure then goes into the income statement. ExampleA company, Green Co., made sales of $500,000 during an accounting period. However, some of its customers returned goods worth $50,000 during the period. Similarly, Green Co. offered sales allowances worth $30,000 to customers to avoid sales returns. Lastly, the company provided discounts of $20,000 during the period for early settlements. Therefore, Green Co.’s net sales will be as follows. Net Sales = Gross Sales - Sales Returns - Sales Allowances - Sales Discounts Net Sales = $500,000 - $50,000 - $30,000 - $20,000 Net Sales = $400,000 ConclusionNet sales is a company's gross sales minus sales returns, allowances, and discounts. This figure is a part of a company's income statement. Similarly, companies may provide a breakup in the notes to the financial statements. Apart from the gross sales, three components are critical for calculating net sales. These include returns, allowances, and discounts. Originally Published Here: Net Sales: Definition, Formula, Examples In the financial world, many different terms may be unfamiliar to you. One of these could be an "Interest Rate Cap," which can help you protect your investments or savings from any drastic changes in interest rates. Interest rate caps have been around for over 50 years and have proven to be an effective way for investors to minimize risk while maximizing their potential return on investment. In this blog post, we will break down what an interest rate cap is and how it can work for you. What is an Interest Rate CapInterest rate caps are one of many types of options you can put on investments or savings that have a variable interest rate. The most common products that have a variable interest rate are certificates of deposit (CDs), adjustable-rate mortgages, bond funds, and individual bonds. By purchasing a cap option, the buyer is protected from any increases in the underlying interest rate. If interest rates increase and exceed a certain pre-determined level (cap), the buyer only pays the cap-level interests. For example, if you purchased a five-year adjustable-rate mortgage (ARM) with an interest rate cap of 3% above the initial rate of 2%, then your maximum payable interest rate is capped at 5%. In the above example, you own an interest option that pays off if the interest rate rises above the cap level. This option is also called an embedded derivative. It is the exact opposite of the interest rate floor which we have discussed before in this blog. How do Interest Rate Caps WorkYou can purchase an interest rate cap for a specific time frame and a certain pre-determined percentage. The cap option will protect you from any increase in interest rate. To enjoy the protection provided by the interest rate cap, you will have, however, to pay a premium upfront. For example, you purchase an interest rate cap for five years and set your cap at 2% above your initial rate for this time. If the interest rate increases above the cap level, your payoff will be the difference between the interest rate and the cap level. This means that if you own an adjustable-rate mortgage (ARM), the interest rate cap will prevent your mortgage rate from rising above the cap level. What are some benefits of Interest Rate CapsAn interest rate cap brings a lot of benefits to an investor. Here are a few of the most common benefits of an interest rate cap:
ConclusionInterest rate caps have been around for a long time and can be an effective tool for managing interest rate risks. From adjusting a fixed return rate for a certain period to protecting yourself from rising interest rates, this financial tool can be a good addition to your financial toolbox. Article Source Here: Interest Rate Caps: Definition, Example, Usage Pairs trading is a quantitative trading strategy that is often discussed in the academic as well as practitioners’ literature. We have written about this trading strategy extensively from different perspectives. In this post, we’re going to look at the risk/PnL drivers of the pairs trading strategy. Reference [1] pointed out that the profit of pairs trading comes from the spreads between small- and large-cap stocks and between value and growth stocks in addition to the spread between high- and intermediate-grade corporate bonds and shifts in the yield curve. These profits are uncorrelated to the S&P 500; however, they do exhibit low sensitivity to the spreads between small and large stocks and between value and growth stocks in addition to the spread between high- and intermediate-grade corporate bonds and shifts in the yield curve. In addition to risk and transaction cost, we rule out several explanations for the pairs trading profits, including mean reversion as previously documented in the literature, unrealized bankruptcy risk, and the inability of arbitrageurs to take advantage of the profits because of short-sale constraints However, in a recent publication [2], other authors linked the profitability of pairs trading to market liquidity, Our results have shown that a simple pairs trading strategy building on an unsupervised machine learning approach does not generate sufficient excess returns to cover a conservative estimate of explicit transaction costs on the S&P500. Conversely, the same trading strategy appears to be profitable on OSE even when adjusting for both explicit and implicit transaction costs. We have shown that the profitability of pairs trading appears to be closely related to the market liquidity of the stocks that are traded, which might explain why the trading strategy appears to be more profitable at OSE. In other words, using their proposed approach, which consists of first using Principal Component Analysis to divide stocks into clusters and then using cointegration to select the pairs, the strategy is not profitable in SP500, but in OSE, and the profitability is closely related to the market liquidity. These articles raised some interesting questions,
Let us know what you think. References [1] E. Gatev, WN. Goetzmann, KG. Rouwenhorst, Pairs Trading: Performance of a Relative-Value Arbitrage Rule, The Review of Financial Studies, Volume 19, Issue 3, Fall 2006 [2] A. Høeg, EK. Aares, Statistical Arbitrage Trading using an unsupervised machine learning approach: is liquidity a predictor of profitability?, BI Norwegian Business School, 2021. Article Source Here: Pairs Trading Strategy-What are the Sources of Excess Returns? An auditor’s opinion is a statement that auditors provide after auditing a company’s financial statements. Usually, this process involves examining these statements and collecting audit evidence. Based on this process, auditors come to a conclusion to form an opinion. Usually, this conclusion entails ensuring the financial statements are free from material misstatements. Similarly, it includes commenting on fair and true presentation. There are different types of audit opinions that auditors may provide. Usually, auditors state an unmodified audit opinion, which assures stakeholders of the integrity and objectivity of the financial statements. However, auditors may also give an unmodified opinion. This opinion has three types, including qualified opinion, adverse opinion, and disclaimer of opinion. What is the Disclaimer Audit Opinion?Auditors consider two factors crucial to the audit opinion they provide. The first includes the financial statements being free from material misstatements. The second entails collecting sufficient appropriate audit evidence related to items in those statements. The disclaimer of audit opinion relates to the audit evidence that auditors obtain. It differs from other qualified audit opinions. Auditors provide the disclaimer audit opinion when they can’t obtain sufficient appropriate audit evidence. There are various reasons why auditors cannot collect audit evidence. Sometimes, it may include the management not cooperating. In other circumstances, it may also involve the audit evidence not existing at all. Whatever the reason, if auditors cannot obtain audit evidence to support their audit opinion, they will provide the disclaimer audit opinion. The unavailability of audit opinion may also fall under the qualified audit opinion. However, auditors use the disclaimer audit opinion when the impact of the audit evidence is pervasive. In auditing, a matter becomes pervasive when its effects spread to the financial statements as a whole. In some cases, it may also include misstatements being a substantial portion of those statements. How does the Disclaimer Audit Opinion work?The audit process involves the auditors obtaining sufficient appropriate evidence. Usually, clients provide supporting documents or information with their transactions or events. In some cases, however, it may not be available. For example, a company may not have the supporting documents required to back up its sale transactions. Sometimes, clients may also have evidence, but the auditors may not consider it sufficiently appropriate. If the effect of the unavailable sufficient appropriate audit evidence is immaterial, auditors may ignore it. Similarly, if they have a material impact, the auditors may provide a qualified opinion. In some cases, it may be pervasive. Therefore, the auditors must use the disclaimer audit opinion. With this opinion, auditors state that they couldn't obtain audit evidence to form an opinion. A disclaimer audit opinion does not involve providing or expressing an opinion. Instead, it states that auditors cannot form an audit opinion due to the absence or unavailability of sufficient appropriate audit evidence. With this opinion, auditors withdraw any responsibility that comes with auditing the financial statements. ExampleGiven below is an example of the disclaimer of audit opinion for a client that auditors may provide. Disclaimer of Opinion We were engaged to audit the financial statements of Red Co., which comprise the statement of financial position as at December 31, 2021, and the statement of profit or loss and other comprehensive income, statement of changes in retained earnings and statement of cash flows for the year then ended, and notes to the financial statements, including a summary of significant accounting policies. We do not express an opinion on the accompanying financial statements of Red Co. Because of the significance of the matter described in the Basis for Disclaimer of Opinion section of our report, we have not cannot obtain sufficient appropriate audit evidence to provide a basis for an audit opinion on these financial statements. In the above example, the auditors state that they do not express an audit opinion on the subject matter. Therefore, it forms the disclaimer audit opinion. Auditors will provide their reasons for this opinion in the 'Basis for Opinion' paragraph. ConclusionAuditors reach a conclusion regarding an audit engagement and provide it in the form of an audit opinion. With the disclaimer audit opinion, auditors do not provide an audit opinion. Instead, they express that they were unable to obtain sufficient appropriate audit evidence. However, its impact must be pervasive, or else it would fall under a qualified audit opinion. Post Source Here: Disclaimer Audit Opinion Interest rates are often subject to fluctuations, which can be either upward or downward. When a bank sets an interest rate floor for their customers, it means that the banks will not allow the customer's interest rates to change below a certain level. This protects the lender in case of dramatic changes in market conditions and provides stability. Interest rate floors are the exact opposite of interest rate caps, which allow the interest rates to not go higher than a certain level. Oftentimes an interest rate floor is used in conjunction with adjustable-rate mortgages (ARMs), as it protects the lender from fluctuating market conditions and guarantees stability. Let's dig deep into the interest rate floor. Interest Rate Floor DefinitionInterest Rate Floors are financial derivative contracts. They are in fact options contracts that can be used to hedge the fluctuations in interest rates. For example, a bank can use them to set an interest rate in the lower range of rates associated with a floating rate loan product. Interest Rate Floors often protect the lender and provide stability to financial transactions such as adjustable-rate mortgages (ARMs). Interest Rate Floors are also used in loan agreements, which is quite interesting as the name says it all. Interest Rate Floor ExampleIf you have an adjustable-rate mortgage (ARM) and your interest rate floor is set to a level that covers any associated costs, then if market conditions change drastically, your predefined minimum rate will remain at this same level. This provides stability and protection for the lender in case of dramatic changes in market conditions. How do Interest Rate Floors WorkInterest Rate Floors are a form of protection for the lender involved in a financial transaction. Interest Rate Floors define the minimum possible interest rate during an ARM’s lifetime, which helps to protect against dramatic changes and ensures stability for the bank. At times, this is also referred to as gap risk protection. Interest Rate Floors can be a component of the adjustable-rate mortgage (ARM) market, as they provide stability to the lender involved in this type of transaction and protect against dramatic changes, which could lead to substantial financial loss. Interest rate floors will help ensure stable rates by providing a minimum interest rate throughout an ARM’s lifetime for the protection of the lender. This means that he will not have to worry about the interest rate fluctuating below a certain level, regardless of market fluctuations. Interest Rate Floor Benefits
ConclusionInterest rate floors are financial derivative contracts and are often embedded in loan agreements to protect against dramatic changes in interest rates. Interest Rate Floors also help provide stability by defining the minimum possible interest rate through an ARM’s lifetime, which helps the lender better manage the cash flow. Post Source Here: Interest Rate Floors: Definition, Example, Usage Since the inception of the idea of econometrics, many economic analysts have used its model to explain the interrelatedness of fundamental economic factors. These factors include labor, capital, interest rates, as well as government’s fiscal and monetary policies. Econometricians use a ton of data available to them to analyze these simple relationships. But, does it stop at that? From keen studies, econometrics serves other purposes which strengthen the economic systems. And, these are explained further in this article. Introduction to EconometricsEconometrics is the quantitative application of statistical and mathematical data, models, and theories to develop new economic theories, test existing hypotheses, and forecast future trends. It seeks to transform real-world data into statistical hypotheses and then describes the results with the theory or theories in view for common grounds. This means that these economic models are converted to tools for economic policymaking. In their book, Stock and Watson wrote “Econometric methods are used in many branches of economics, including finance, labor economics, macroeconomics, microeconomics, and economic policy.” Econometrics converts qualitative statements into quantitative ones. For instance, describing the positive relationship between two variables, econometrics says: "with every one dollar increase in disposable income, consumers' spending increases by 90 cents". This shows that it uses numbers rather than concepts or theories to explain phenomena. Ragnar Frisch, Lawrence Klein, and Simon Kuznets are the pioneers of econometrics for which they won the Nobel Prize in 1971. What are the Types of EconometricsEconometrics has two major divisions depending on what the analyst seeks to achieve. Theoretical Econometrics studies existing statistical models to discover their properties and their values. This is relevant in developing new statistical procedures, useful in the field of economics, and are not subject to changes in data. Applied Econometrics is focused on converting qualitative economic statements into quantitative statements using econometric techniques. It concerns itself with topics around the production of goods, demand for labor, arbitrage pricing theory, and more. And, because of the variance of the data, applied econometrics changes with time. The Need for EconometricsThe foremost windfall of econometrics is to test economic theories or hypotheses provided by econometricians. The direct relationship between consumption and income or the effect of the quantity demanded of a certain commodity and its price can be tested using econometric. Secondly, econometrics provides a means to derive numerical estimates for the variables of economic relationships. These numerical estimates are vital for reaching economic-related decisions. For instance, a valid estimate of the coefficient of the relationship between income and consumption is a fundamental tool for policy-making. A policymaker will need them to understand the possible outcome of a proposed tax reduction for instance and make an informed decision. Lastly, econometrics is pertinent to forecast future economic trends which is also a key tool for effective policy-making. If according to predictions there is a high tendency of low inflation in the future, policymakers can be proactive in their decisions. So, in all, econometrics can help financiers and economists by making the best financial decisions. ConclusionEconometrics facilitate the testing of statistical models, the development of new theories, and the making of inferences. Policy-makers need these inferences to form policies and make crucial decisions. Post Source Here: What Is Econometrics Used For? Investing in foreign assets can be a good way to diversify your investment portfolio. But you must first understand the risks involved before diving in head-first. You can make more money by investing in foreign assets, but you could also lose big if the values of the foreign currencies go down. And given that fluctuations in currency values can occur overnight, it's important to know just how much risk you're prepared to take on. In this article, we are going to look at some of the potential risks around investing in foreign assets and how you can deal with those risks. What are foreign currency risksCurrency risk arises when there is a change in the exchange rate between one currency and another. This can be either an appreciation or depreciation of the other currencies (known as foreign currency) or your domestic currency (known as home or domestic currency). When you invest in overseas assets, you are exposing yourself to three different types of foreign currency risk. These are: Transaction riskTransaction risk comes from buying or selling a foreign currency. To buy a foreign investment, you have to first convert your domestic currency into other currencies. If you do this through an intermediary, such as a bank, there may be exchange rate costs and/or fees involved. Translation riskTranslation risk occurs when the value of the foreign investment is translated into your home currency for reporting or taxation purposes. To do this, you need to know how much the investment is worth in your home currency at a given time. For example, if you have an investment that is denominated in Japanese yen and needs to be converted to Australian dollars, then there is a risk that the value you report for taxation purposes may be different from the actual value. Economic RiskEven if the value of a foreign currency is not changing, economic events such as inflation, or deflation can cause changes to its purchasing power. For example, if you invest all your money in Japanese yen and that country experiences deflation for several years, then you would expect the yen to increase in value due to the reduced cost of goods and services. However, your investment returns are likely to be lower than expected because the value of the yen would have fallen. How to manage foreign currency risksTo manage foreign currency risks well you need a strategy. We look at how you can do this below. Be mindful of which countries hold importance for your investmentsRisk management is as much about knowing which areas to avoid as it is knowing those with potential. Different countries have different levels of exposure to various economic risks, such as deflation, inflation, interest rates changes, political risks like war and government changes, or natural disasters like tsunamis and earthquakes. Be mindful of your tolerance to riskFor example, if you need the money back in 1 year then you should not invest in long-term assets such as property or shares. This is because their value can fluctuate dramatically over short periods and this may affect what you can get back. Invest in some form of international diversificationFor example, if you had all your money in shares of companies based only in the United States, then your investment would be very exposed to fluctuations in US dollar currency. Just as you can diversify by country of origin or investments of choice, you can diversify by currency. This means that if the value of one currency drops against another, then you are protected to some degree because the investment returns, although in a different currency, are still positive. Use forward exchange contractsIf you want to exchange your money for another currency at a later point in time and the risk of fluctuations between now and then is too great, then you can use ways to lock in today's rate. This is done through the forward market. It helps you to buy foreign currency at a certain price on a future date. Practice HedgingYou can reduce the risk of changes in currency rates by using hedging strategies where you lock in today's rate (or better) on future transactions or investments. Hedging is when you agree with someone else to sell at a particular price in the future. This limits your potential loss from a favorable movement in the exchange rate, but it will also reduce your profit if there is a significant rise in that rate. You can use derivatives to hedge your foreign currency exposure or you can "hedge" through spot transactions using forward contracts. ConclusionInvesting in foreign assets can be very rewarding but it comes with risks. If you are not careful, this can lead to significant losses. By being aware of the main types of risks that are involved and by making sure your investments are diversified, you can manage these risks well. Article Source Here: Foreign Currency Risks: Definition, Types, How to Manage Portfolio hedging is a risk-management practice that uses a number of strategies to mitigate the risks of any given portfolio. Tail risk hedging in particular is one of the techniques used in equity portfolio management. It basically involves buying put options in a certain amount to partially or fully protect the portfolio. Reference [1] provided an in-depth study of different tail risk hedging strategies, In this paper, we contributed to the limited literature on using actively managed put options as tail hedges. We investigated whether a put option monetization strategy can protect an equity portfolio from drawdowns and enhance its returns. We have done so by applying eight different monetization strategies, using S&P 500 put options and an underlying equity portfolio represented by the S&P 500 Total Return index, during the time period 1996 to 2020. We have compared the results from the strategies with an unhedged position in the chosen index, and with a constant volatility strategy applied on the same underlying. The article pointed out that as compared to an unhedged index position, tail risk hedging yielded worse results both in terms of risk-adjust and total returns. Over the course of the 25-year period, all the strategies’ total returns and Sharpe ratios are inferior to the unhedged index position. The observed results suggest that rule-based monetization strategies are not able to adequately reduce drawdowns, less, enhance returns of the portfolio compared to the unhedged position. The results make sense since buying puts means paying for the convexity, i.e. the volatility risk premium. However, we believe that the hedging costs can be further minimized by optimizing for the strikes and maturities. There should exist optimal strikes and maturities where the volatility risk premium is minimized. Along this line, the authors also noted, The observed results might be sensitive to the chosen representation of the equity portfolio and the investigated time period. Furthermore, the results could be sensitive to the choices of time to expiry and moneyness of the bought options in the tested strategies. Active money managers could also try and exploit increasing correlations in swift market declines with the use of indirect hedges. Finally, portfolio managers can also use other hedging strategies such as indirect hedges or diversification. References [1] C.V. Bendiksby, MOJ. Eriksson, Tail-Risk Hedging An Empirical Study, Copenhagen Business School, 2021 Originally Published Here: Tail Risk Hedging Strategies: Are They Effective? |
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