Alpha, the first letter of the Greek alphabet, is used in finance as a measure of risk-adjusted performance. Many define alpha as the difference between the investment return and the benchmark return. However, this does not properly adjust for risk. In fact alpha is generated by regressing the security or investment excess return on the benchmark (for example, the S&P 500 index) excess return. Beta adjusts for the risk (the slope coefficient). Alpha is the intercept.
For example: Suppose a certain mutual fund has a return of 25%, and the short-term interest rate is 5% (excess return is 20%). During the same time the market excess return is 9%. Suppose the beta of that mutual fund is 2.0 (twice as risky as the S&P 500). The expected excess return given the risk is 2 x 9%=18%. The actual excess return is 20%. Hence, the alpha is 2% or 200 basis points.
So, alpha is a mathematical estimate of the return on a security and is derived from a in the formula Ri = a + bRm which measures the return on a security (Ri) for a given return on the market (Rm) where b is beta.
Alpha also refers to an analyst’s estimate of a stock’s potential to gain value based on the rate at which the company’searnings are growing and other fundamental indicators. For example, if a stock is assigned an alpha of 1.15, the analyst expects a 15% price increase in a year when stock pricesare generally flat. One investment strategy is to look for securities with positive alphas, which indicates they may be undervalued.
For many industry veterans, alpha is also known as the “holy grail” because it is as elusive as it is attractive: it’s very rare for any investment professional to achieve consistent alpha over the long term.
For example: A beta of 1.5 forecasts a 1.5% change in the return on an asset for every 1% change in the return on the market. High-beta stocks are best to own in a strong bull market but are worst to own in a bear market.
Betas as low as 0.5 and as high as 4 are fairly common in the US equity markets, depending on the sector and size of the company. However, in recent years, there has been a lively debate about the validity of assigning and using a beta value as an accurate predictor of stock performance.
Compound interest (or compounding interest) is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods. Thought to have originated in 17th-century Italy, compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.
The rate at which compound interest accrues depends on the frequency of compounding, such that the higher the number of compounding periods, the greater the compound interest. Thus, the amount of compound interest accrued on $100 compounded at 10% annually will be lower than that on $100 compounded at 5% semi-annually over the same time period. Because the interest-on-interest effect can generate increasingly positive returns based on the initial principal amount, compounding has sometimes been referred to as the “miracle of compound interest.”
Compound interest is arguably the most powerful force for generating wealth ever conceived. There are records of merchants, lenders, and various businesspeople using compound interest to become rich for literally thousands of years. In the ancient city of Babylon, for example, clay tablets were used over 4,000 years ago to instruct students on the mathematics of compound interest.
Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.
Portfolio holdings can be diversified not just across asset classes, but also within classes by investing in foreign markets as well as domestic markets. The idea is that the positive performance of one area of a portfolio will outweigh the negatives in another.
Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated—that is, they respond differently, often in opposing ways, to market influences.
Economics is a social science concerned with the production, distribution, and consumption of goods and services. It studies how individuals, businesses, governments, and nations make choices about how to allocate resources. Economics focuses on the actions of human beings, based on assumptions that humans act with rational behavior, seeking the most optimal level of benefit or utility. The building blocks of economics are the studies of labor and trade. Since there are many possible applications of human labor and many different ways to acquire resources, it is the task of economics to determine which methods yield the best results.
Economics can generally be broken down into macroeconomics, which concentrates on the behavior of the economy as a whole, and microeconomics, which focuses on individual people and businesses.
One of the earliest recorded economic thinkers was the 8th-century B.C. Greek farmer and poet Hesiod, who wrote that labor, materials, and time needed to be allocated efficiently to overcome scarcity. But the founding of modern Western economics occurred much later, generally credited to the publication of Scottish philosopher Adam Smith’s 1776 book, An Inquiry Into the Nature and Causes of the Wealth of Nations.
The principle (and problem) of economics is that human beings have unlimited wants and occupy a world of limited means. For this reason, the concepts of efficiency and productivity are held paramount by economists. Increased productivity and a more efficient use of resources, they argue, could lead to a higher standard of living.
A fiduciary is a person or organization that acts on behalf of another person or persons, putting their clients’ interests ahead of their own, with a duty to preserve good faith and trust. Being a fiduciary thus requires being bound both legally and ethically to act in the other’s best interests.
A fiduciary may be responsible for the general well-being of another (e.g. a child’s legal guardian), but often the task involves finances; managing the assets of another person, or a group of people, for example. Money managers, financial advisors, bankers, insurance agents, accountants, executors, board members, and corporate officers all have fiduciary responsibility.
If your investment advisor is a Registered Investment Advisor (RIA), they have fiduciary responsibility for the service they provide you. On the other hand, a broker, who works for a broker-dealer, may not. Some brokerage firms don’t want or allow their brokers to be fiduciaries.
Investment advisors, who are usually fee-based, are bound to a fiduciary standard that was established as part of the Investment Advisers Act of 1940. They can be regulated by the SEC or state securities regulators. The act is pretty specific in defining what a fiduciary means, and it stipulates a duty of loyalty and care, which means that the advisor must put their client’s interests above their own.
A government bond is a debt security issued by a government to support government spending and obligations. Government bonds can pay periodic interest payments called coupon payments. Government bonds issued by national governments are often considered low-risk investments since the issuing government backs them. Government bonds may also be known as sovereign debt.
Fixed-rate government bonds can have interest rate risk, which occurs when interest rates are rising, and investors are holding lower paying fixed-rate bonds as compared to the market. Also, only select bonds keep up with inflation, which is a measure of price increases throughout the economy. If a fixed-rate government bond pays 2% per year, for example, and prices in the economy rise by 1.5%, the investor is only earning .5% in real terms.
Local governments may also issue bonds to fund projects such as infrastructure, libraries, or parks. These are known as municipal bonds, and often carry certain tax advantages for investors.
U.S. Treasuries are nearly as close to risk-free as an investment can get. This low-risk profile is because the issuing government backs the bonds. Government bonds from the U.S. Treasury are some of the most secure worldwide, while those floated by other countries may carry a greater degree of risk. Due to this nearly risk-free nature, market participants and analysts use Treasuries as a benchmark in comparing the risk associated with securities. The 10-year Treasury bond is also used as a benchmark and guide for interest rates on lending products. Due to their low risk, U.S. Treasuries tend to offer lower rates of return relative to equities and corporate bonds.
However, government-backed bonds, particularly those in emerging markets, can carry risks that include country risk, political risk, and central-bank risk, including whether the banking system is solvent. Investors saw a bleak reminder of how risky some government bonds can be during the Asian financial crisis of 1997 and 1998. During this crisis, several Asian nations were forced to devalue their currency which sent reverberations around the globe. The crisis even caused the Russian government to default on part of its debt at that time (local currency bonds), as well as the collapse of a huge hedge fund called Long Term Capital Management (LTCM). This was significant because LTCM was the hedge fund of Robert Merton and Myron Scholes, two economics Nobel prize winners and key proponents of options pricing theory.
High Net Worth Individual
The term high-net-worth individual (HWNI) refers to a financial industry classification denoting an individual with liquid assets above a certain figure. People who fall into this category generally have at least $1 million in liquid financial assets.
The assets held by these individuals must be easily liquidated and cannot include things like property or fine art. HNWIs often seek the assistance of financial professionals in order to manage their money. Their high net worth often qualifies these individuals for additional benefits and opportunities.
Almost 63% of the world’s HNWI population lives in the United States, Japan, Germany, and China, according to the Capgemini World Wealth Report. The U.S. had about 6.6 million HNWIs in 2020, up 11.3% from the year before.
As a group, the HNWI population saw its assets grow 7.6% in 2020, reaching $79.6 trillion in wealth. North America led the world’s HNWI wealth with $24.3 trillion, followed by Asia with $24 trillion. HNWI wealth in Europe was at $17.5 trillion, followed by Latin America with $8.8 trillion, the Middle East with $3.2 trillion, and Africa with $1.7 trillion.
Capgemini separates the HNWI population into three wealth bands:
- ‘Millionaires next door’ who have $1 million to $5 million in investable wealth
- ‘Mid-tier millionaires’ with $5 million to $30 million in investable wealth
- ‘Ultra-HNWIs’ which includes those with more than $30 million in investable wealth
Globally, the ultra-HNWI population numbered 200,900 in 2020. Mid-tier millionaires numbered 1.89 million, while the millionaires next door category made up the largest group at 18.7 million.
Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
Inflation can be contrasted with deflation, which occurs when the purchasing power of money increases and prices decline.
There are three main causes of inflation: demand-pull inflation, cost-push inflation, and built-in inflation. Demand-pull inflation refers to situations where there are not enough products or services being produced to keep up with demand, causing their prices to increase.
Cost-push inflation, on the other hand, occurs when the cost of producing products and services rises, forcing businesses to raise their prices.
Lastly, built-in inflation—sometimes referred to as a “wage-price spiral”—occurs when workers demand higher wages to keep up with rising living costs. This in turn causes businesses to raise their prices in order to offset their rising wage costs, leading to a self-reinforcing loop of wage and price increases.
Too much inflation is generally considered bad for an economy, while too little inflation is also considered harmful. Many economists advocate for a middle-ground of low to moderate inflation, of around 2% per year.
Generally speaking, higher inflation harms savers because it erodes the purchasing power of the money they have saved. However, it can benefit borrowers because the inflation-adjusted value of their outstanding debts shrinks over time.
Junk bonds are bonds that carry a higher risk of default than most bonds issued by corporations and governments. A bond is a debt or promise to pay investors interest payments along with the return of invested principal in exchange for buying the bond. Junk bonds represent bonds issued by companies that are financially struggling and have a high risk of defaulting or not paying their interest payments or repaying the principal to investors. Junk bonds are also called high-yield bonds since the higher yield is needed to help offset any risk of default. From a technical viewpoint, a high-yield, or “junk” bond is very similar to regular corporate bonds. Both represent debt issued by a firm with the promise to pay interest and to return the principal at maturity. Junk bonds differ because of their issuers’ poorer credit quality as indicated by their credit rating.
Companies that issue junk bonds are typically start-ups or companies that are struggling financially. Junk bonds carry risk since investors are unsure whether they’ll be repaid their principal and earn regular interest payments. As a result, junk bonds pay a higher yield than their safer counterparts to help compensate investors for the added level of risk. Companies are willing to pay the high yield because they need to attract investors to fund their operations.
Know Your Client
The Know Your Client or Know Your Customer (KYC) definition is a standard in the investment industry that ensures investment advisors know detailed information about their clients’ risk tolerance, investment knowledge, and financial position. KYC protects both clients and investment advisors. Clients are protected by having their investment advisor know what investments best suit their personal situations. Investment advisors are protected by knowing what they can and cannot include in their client’s portfolio. KYC compliance typically involves requirements and policies such as risk management, customer acceptance policies, and transaction monitoring.
The KYC rule is an ethical requirement for those in the securities industry who are dealing with customers during the opening and maintaining of accounts. There are two rules which were implemented in July 2012 that cover this topic together: Financial Industry Regulatory Authority(FINRA) Rule 2090 (Know Your Customer) and FINRA Rule 2111 (Suitability). These rules are in place to protect both the broker-dealer and the customer and so that brokers and firms deal fairly with clients.
Account owners generally must provide a government-issued ID as proof of identity. Some institutions require two forms of ID, such as a driver’s license, birth certificate, social security card, or passport. In addition to confirming identity, the address must be confirmed. This can be done with proof of ID or with an accompanying document confirming the client’s address of record.
Investment advisors and firms are responsible for knowing each customer’s financial situation by exploring and gathering the client’s age, other investments, tax status, financial needs, investment experience, investment time horizon, liquidity needs, and risk tolerance. The SEC requires that a new customer provide detailed financial information that includes name, date of birth, address, employment status, annual income, net worth, investment objectives, and identification numbers before opening an account.
The U.S. Financial Crimes Enforcement Network (FinCEN) has set baseline requirements for KYC in conjunction with the core requirements for a firm’s due diligence program. To prevent money laundering, financial institutions are required to conduct deeper assessments of their clients’ risk profiles. FinCEN requires that financial institutions verify the identities of their customers and their respective beneficial owners—owners with at least 25% ownership. For entities with a high anti-money laundering and terrorism finance (AML) risk, additional scrutiny is required and the threshold for ownership is lowered. There is also greater scrutiny for elected officials, diplomats, and government officials in general under the Political Exposed Person (PEP) category.
Financial institutions and investment advisors must also maintain current and accurate customer information and continue to monitor their accounts for suspicious and illegal activities. When detected, they are required to promptly report their findings.
Leverage results from using borrowed capital as a funding source when investing to expand the firm’s asset base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets. The result is to multiply the potential returns from a project. At the same time, leverage will also multiply the potential downside risk in case the investment does not pan out.
Leverage is a multi-faceted, complex tool. The theory sounds great and, in reality, the use of leverage can be profitable, but the reverse is also true. Leverage magnifies both gains and losses. If an investor uses leverage to make an investment and the investment moves against the investor, their loss would be much greater than it would have been if they had not leveraged the investment.
For this reason, leverage should often be avoided by first-time investors until they get more experience under their belts. In the business world, a company can use leverage to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroy shareholder value.
Monetary policy is a set of tools that a nation’s central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation’s banks, its consumers, and its businesses. Monetary policy is enacted by a central bank with the mandate to keep the economy on an even keel. The aim is to keep unemployment low, protect the value of the currency, and maintain economic growth at a steady pace. It achieves this mostly by manipulating interest rates, which in turn raises or lowers borrowing, spending, and savings rates.
On the other hand, fiscal policy is enacted by a national government. It involves spending taxpayer dollars in order to spur economic recovery. It sends money, directly or indirectly, to increase spending and turbo-charge growth. The U.S. Treasury Department has the ability to create money, but the Federal Reserve influences the supply of money in the economy, largely through open market operations (OMO). Essentially, this means buying financial securities when easing monetary policy and selling financial securities when tightening monetary policy. The Fed’s preferred securities for OMO are U.S. Treasuries and agency mortgage-backed securities.
Monetary policy is formulated based on inputs from a variety of sources. The monetary authority may look at macroeconomic numbers such as gross domestic product (GDP) and inflation, industry and sector-specific growth rates, and associated figures. Geopolitical developments are monitored. Oil embargos or the imposition (or lifting) of trade tariffs are examples of actions that can have a far-reaching impact. The central bank may also consider concerns raised by groups representing specific industries and businesses, survey results from private organizations, and inputs from other government agencies.
The goal is to keep the economy humming along at a rate that is neither too hot nor too cold. The central bank may force up interest rates on borrowing in order to discourage spending or force down interest rates to inspire more borrowing and spending. The main weapon at its disposal is the nation’s money. The central bank sets the rates it charges to loan money to the nation’s banks (the Federal Funds rate). When it raises or lowers its rates, all financial institutions tweak the rates they charge all of their customers, from big businesses borrowing for major projects to home buyers applying for mortgages. All of those customers are rate-sensitive. They’re more likely to borrow when rates are low and put off borrowing when rates are high.
New York Stock Exchange
Located on Wall Street in New York City, the NYSE—also known as the “Big Board“— consists of one trading floor for equities and another for the NYSE American options exchange. The main building located at 18 Broad St. and the one at 11 Wall St. were both designated historical landmarks in 1978. The NYSE is the world’s largest stock exchange by market capitalization, estimated to be $26.64 trillion as of August 2021.
The New York Stock Exchange dates back to May 17, 1792. On that day, 24 stockbrokers from New York City signed the Buttonwood Agreement at 68 Wall St. The New York Stock Exchange kicked off with five securities, which included three government bonds and two bank stocks. Thanks to the NYSE’s head start as the major U.S. stock exchange, many of the oldest publicly traded companies are on the exchange. Consolidated Edison (ED) is the longest-listed NYSE stock, joining in 1824 as the New York Gas Light Company. Along with American stocks, foreign-based corporations can also list their shares on the NYSE if they adhere to certain listing standards.
Formerly run as a private organization, the NYSE became a public entity on March 8, 2006, following the acquisition of electronic trading exchange Archipelago. In 2007, a merger with Euronext—the largest stock exchange in Europe—led to the creation of NYSE Euronext, which was later acquired by Intercontinental Exchange, Inc. (ICE), the current parent of the New York Stock Exchange.
The NYSE relied for many years on floor trading only, using the open outcrysystem. Many NYSE trades have transitioned to electronic systems relying mainly on designated market makers (DMMs) to conduct both the physical and automated auctions. Quotes offered by DMMs are on par with what floor tradersand other market participants offer.
The opening and closing bells of the exchange mark the beginning and end of the trading day. The opening bell is rung at 9:30 a.m., and the closing bell is rung at 4:00 p.m., closing trading for the day. But trading days did not always begin and end with a bell—the original signal was actually a gavel. During the late 1800s, the NYSE changed the gavel to a gong. The bell became the official signal for the exchange in 1903 when the NYSE moved to 18 Broad St.
Prior to 1995, the exchange’s floor managers rang the bells. But the NYSE began inviting company executives to ring the opening and closing bells on a regular basis, which later became a daily event. The executives are from companies listed on the exchange, who sometimes coordinate their appearances with marketing events, such as the launch of a new product or innovation, or a merger or acquisition. Sometimes, other public figures, such as athletes and celebrities, ring the bell.
Opportunity costs represent the potential benefits that an individual, investor, or business misses out on when choosing one alternative over another. Because opportunity costs are unseen by definition, they can be easily overlooked. Understanding the potential missed opportunities when a business or individual chooses one investment over another allows for better decision making.
The formula for calculating an opportunity cost is simply the difference between the expected returns of each option. Say that you have option A—to invest in the stock market, hoping to generate capital gain returns. Meanwhile, option B is to reinvest your money back into the business, expecting that newer equipment will increase production efficiency, leading to lower operational expenses and a higher profit margin. Assume the expected return on investment (ROI) in the stock market is 12% over the next year, and your company expects the equipment update to generate a 10% return over the same period. The opportunity cost of choosing the equipment over the stock market is (12% – 10%), which equals two percentage points. In other words, by investing in the business, you would forgo the opportunity to earn a higher return.
In economics, risk describes the possibility that an investment’s actual and projected returns are different and that the investor loses some or all of the principal. Opportunity cost concerns the possibility that the returns of a chosen investment are lower than the returns of a forgone investment.
The key difference is that risk compares the actual performance of an investment against the projected performance of the same investment, while opportunity cost compares the actual performance of an investment against the actual performance of another investment. Because opportunity cost is a forward-looking consideration, the actual rate of return (RoR) for both options is unknown today, making this evaluation tricky in practice.
It is important to compare investment options that have a similar risk. Comparing a Treasury bill, which is virtually risk free, to investment in a highly volatile stock can cause a misleading calculation. Both options may have expected returns of 5%, but the U.S. government backs the RoR of the T-bill, while there is no such guarantee in the stock market. While the opportunity cost of either option is 0%, the T-bill is the safer bet when you consider the relative risk of each investment.
Still, one could consider opportunity costs when deciding between two risk profiles. If investment A is risky but has an ROI of 25%, while investment B is far less risky but only has an ROI of 5%, even though investment A may succeed, it may not. And if it fails, then the opportunity cost of going with option B will be significant.
Price to Earnings Ratio
The price-to-earnings (P/E) ratio is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
P/E ratios are used by investors and analysts to determine the relative value of a company’s shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time.
P/E may be estimated on a trailing (backward-looking) or forward (projected) basis.
The P/E ratio helps investors determine whether the stock of a company is overvalued or undervalued compared to its earnings. The ratio is a measurement of what the market is willing to pay for the current operations as well as prospective growth of the company. If a company is trading at a high P/E ratio, the market thinks highly of its growth potential and is willing to potentially overspend today based on future earnings.
P/E is one of the most widely used tools by which investors and analysts determine a stock’s relative valuation. The P/E ratio helps one determine whether a stock is overvalued or undervalued. A company’s P/E can also be benchmarked against other stocks in the same industry or against the broader market, such as the S&P 500 Index.
Sometimes, analysts are interested in long-term valuation trends and consider the P/E 10 or P/E 30 measures, which average the past 10 or past 30 years of earnings, respectively. These measures are often used when trying to gauge the overall value of a stock index, such as the S&P 500, because these longer-term measures can compensate for changes in the business cycle. The P/E ratio of the S&P 500 has fluctuated from a low of around 5x (in 1917) to over 120x (in 2009 right before the financial crisis). The long-term average P/E for the S&P 500 is around 16x, meaning that the stocks that make up the index collectively command a premium 16 times greater than their weighted average earnings.
Like any other fundamental equity data point designed to inform investors as to whether or not a stock is worth buying, the price-to-earnings ratio comes with a few important limitations that are important to take into account because investors may often be led to believe that there is one single metric that will provide complete insight into an investment decision, which is never the case.
One primary limitation of using P/E ratios emerges when comparing the P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due to both the different ways companies earn money and the differing timelines during which companies earn that money. An individual company’s P/E ratio is much more meaningful when taken alongside the P/E ratios of other companies within the same sector. For example, an energy company may have a high P/E ratio, but this may reflect a trend within the sector rather than one merely within the individual company. An individual company’s high P/E ratio, for example, would be less cause for concern when the entire sector has high P/E ratios.
Moreover, because a company’s debt can affect both the prices of shares and the company’s earnings, leverage can skew P/E ratios as well. For example, suppose there are two similar companies that differ primarily in the amount of debt they assume. The one with more debt will likely have a lower P/E value than the one with less debt. However, if business is good, the one with more debt stands to see higher earnings because of the risks it has taken.
Another important limitation of price-to-earnings ratios is one that lies within the formula for calculating P/E itself. Accurate and unbiased presentations of P/E ratios rely on accurate inputs of the market value of shares and of accurate earnings per share estimates. The market determines the prices of shares through its continuous auction. The printed prices are available from a wide variety of reliable sources. However, the source for earnings information is ultimately the company itself. This single source of data is more easily manipulated, so analysts and investors place trust in the company’s officers to provide accurate information. If that trust is perceived to be broken, the stock will be considered riskier and therefore less valuable.
To reduce the risk of inaccurate information, the P/E ratio is but one measurement that analysts scrutinize. If the company were to intentionally manipulate the numbers to look better, and thus deceive investors, they would have to work strenuously to be certain that all metrics were manipulated in a coherent manner, which is difficult to do. That’s why the P/E ratio continues to be one of the most centrally referenced points of data when analyzing a company, but by no means is it the only one.
Quantitative analysis (QA) is a technique that uses mathematical and statistical modeling, measurement, and research to understand behavior. Quantitative analysts represent a given reality in terms of a numerical value. Quantitative analysis is applied to the measurement, performance evaluation, valuation of a financial instrument, and predicting real-world events such as changes in a country’s gross domestic product (GDP).
Quantitative analysis provides analysts with tools to examine and analyze past, current, and anticipated future events. Any subject involving numbers can be quantified; thus, QA is used in many fields including analytical chemistry, financial analysis, social science, and even organized sports. In the financial world, analysts who rely strictly on QA are frequently referred to as “quants.”
In the financial services industry, QA is used to analyze investment opportunities, such as when to purchase or sell securities. Investors perform QA when using key financial ratios, such as the price-earnings ratio (P/E) or earnings per share (EPS), in their investment decision-making process (e.g., whether to purchasing shares of a company’s stock). QA ranges from the examination of simple statistical data (e.g., revenue) to complex calculations (e.g., discounted cash flow or option pricing).
While QA serves as a useful evaluation tool, it is often combined with the complementary research and evaluation tool qualitative analysis. It is common for a company to use quantitative analysis to evaluate figures such as sales revenue, profit margins, or return on assets (ROA).
However, to get a better picture of a company’s performance, analysts also evaluate information that is not easily quantifiable or reduced to numeric values, such as reputation or employee morale. Qualitative analysis focuses on meanings, involves sensitivity to context rather than the desire to obtain universal generalizations, and establishes rich descriptions rather than quantifiable metrics. Qualitative analysis seeks to answer the “why” and “how” of human behavior.
QA is not the opposite of qualitative analysis; they are just different philosophies. Used together, they provide useful information for informed decisions that promote a better society, improve financial positions, and enhance business operations.
Registered Investment Advisor
A registered investment advisor (RIA) is a firm that advises clients on securities investments and may manage their investment portfolios. RIAs are registered with either the U.S. Securities and Exchange Commission (SEC) or state securities administrators.
RIAs have fiduciary obligations to their clients, meaning that they have a fundamental duty to always and only provide investment advice that is in their clients’ best interests.
The rules on investment advisors were formulated by the Investment Advisors Act of 1940. This law requires individuals or businesses that dispense professional investment advice to register with the Securities and Exchange Commission, although there are exemptions for smaller firms.
Investment advisors are permitted, although not required, to register with the SEC if they manage a minimum of $25 million in assets. But it becomes mandatory for those firms that manage $100 million or more, as RIAs managing at least that amount are required quarterly to disclose their holdings to the SEC. Investment advisors who manage smaller sums of investment money typically are required to register with state securities authorities.
Registering as an RIA does not imply any recommendation or endorsement by the SEC or any other regulator. It means only that the investment advisor has fulfilled all of that agency’s requirements for registration. Registering with the SEC requires disclosing information that includes:
- Investment style of the advisor.
- Assets under management (AUM).
- Their fee structure.
- Any disciplinary actions that were taken against the advisor.
- Any current or potential conflicts of interest.
- Key officers
RIAs must annually update their information on file with the SEC, and the information must be made available to the public.
RIAs differ from broker-dealers in important ways. RIAs provide advice on all matters related to finance, including investments, taxation, and estate planning. Broker-dealers tend to focus more narrowly on facilitating purchases and sales of assets like stocks.
Most importantly, in interactions with clients, RIAs are expected to act in a fiduciary capacity, while broker-dealers are only required to satisfy the standard of suitability. Clients of RIAs can be assured that their advisors always and unconditionally put their best interests first. Clients of broker-dealers need to be aware that the broker-dealer is permitted to dispense advice that is merely “suitable” for their clients’ investment portfolios.
As fiduciary agents, RIAs must follow certain practices and procedures when furnishing advice to their clients. These include:
- Disclosure: RIAs are required to disclose any risks or possible conflicts of interest pertaining to the specific transactions that they recommend to their clients. RIAs must also ensure that the client understands any risks.
- Assumption of burden of proof: RIAs, if confronted by a client about the suitability of an investment, bear the burden of proof—meaning that the RIA must prove that the risk was disclosed and that the investment could be considered as suitable.
- Documentation: RIAs are required to keep extensive documentation in compliance with SEC record-keeping regulations.
The term “security” refers to a fungible, negotiable financial instrument that holds some type of monetary value. It represents an ownership position in a publicly-traded corporation via stock; a creditor relationship with a governmental body or a corporation represented by owning that entity’s bond; or rights to ownership as represented by an option.
Securities can be broadly categorized into two distinct types: equities and debts. However, some hybrid securities combine elements of both equities and debts.
An equity security represents ownership interest held by shareholders in an entity (a company, partnership, or trust), realized in the form of shares of capital stock, which includes shares of both common and preferred stock. Holders of equity securities are typically not entitled to regular payments—although equity securities often do pay out dividends—but they are able to profit from capital gains when they sell the securities (assuming they’ve increased in value). Equity securities do entitle the holder to some control of the company on a pro rata basis, via voting rights. In the case of bankruptcy, they share only in residual interest after all obligations have been paid out to creditors. They are sometimes offered as payment-in-kind.
A debt security represents borrowed money that must be repaid, with terms that stipulate the size of the loan, interest rate, and maturity or renewal date. Debt securities, which include government and corporate bonds, certificates of deposit (CDs), and collateralized securities (such as CDOs and CMOs), generally entitle their holder to the regular payment of interest and repayment of principal (regardless of the issuer’s performance), along with any other stipulated contractual rights (which do not include voting rights). They are typically issued for a fixed term, at the end of which they can be redeemed by the issuer. Debt securities can be secured (backed by collateral) or unsecured, and, if secured, may be contractually prioritized over other unsecured, subordinated debt in the case of a bankruptcy.
Hybrid securities, as the name suggests, combine some of the characteristics of both debt and equity securities. Examples of hybrid securities include equity warrants (options issued by the company itself that give shareholders the right to purchase stock within a certain timeframe and at a specific price), convertible bonds (bonds that can be converted into shares of common stock in the issuing company), and preference shares (company stocks whose payments of interest, dividends, or other returns of capital can be prioritized over those of other stockholders).
The entity that creates the securities for sale is known as the issuer, and those who buy them are, of course, investors. Generally, securities represent an investment and a means by which municipalities, companies, and other commercial enterprises can raise new capital. Companies can generate a lot of money when they go public, selling stock in an initial public offering (IPO), for example.
City, state, or county governments can raise funds for a particular project by floating a municipal bond issue. Depending on an institution’s market demand or pricing structure, raising capital through securities can be a preferred alternative to financing through a bank loan.
On the other hand, purchasing securities with borrowed money, an act known as buying on a margin is a popular investment technique. In essence, a company may deliver property rights, in the form of cash or other securities, either at inception or in default, to pay its debt or other obligation to another entity. These collateral arrangements have been growing of late, especially among institutional investors.
Publicly traded securities are listed on stock exchanges, where issuers can seek security listings and attract investors by ensuring a liquid and regulated market in which to trade. Informal electronic trading systems have become more common in recent years, and securities are now often traded “over-the-counter,” or directly among investors either online or over the phone.
An initial public offering (IPO) represents a company’s first major sale of equity securities to the public. Following an IPO, any newly issued stock, while still sold in the primary market, is referred to as a secondary offering. Alternatively, securities may be offered privately to a restricted and qualified group in what is known as a private placement—an important distinction in terms of both company law and securities regulation. Sometimes companies sell stock in a combination of a public and private placement.
In the secondary market, also known as the aftermarket, securities are simply transferred as assets from one investor to another: shareholders can sell their securities to other investors for cash and/or capital gain. The secondary market thus supplements the primary. The secondary market is less liquid for privately placed securities since they are not publicly tradable and can only be transferred among qualified investors.
In the United States, the U.S. Securities and Exchange Commission (SEC) regulates the public offer and sale of securities. Public offerings, sales, and trades of U.S. securities must be registered and filed with the SEC’s state securities departments. Self Regulatory Organizations (SROs) within the brokerage industry often take on regulatory positions as well. Examples of SROs include the National Association of Securities Dealers (NASD), and the Financial Industry Regulatory Authority (FINRA).
The definition of a security offering was established by the Supreme Court in a 1946 case. In its judgment, the court derives the definition of a security based on four criteria—the existence of an investment contract, the formation of a common enterprise, a promise of profits by the issuer, and use of a third party to promote the offering.
A trade deficit occurs when a country’s imports exceed its exports during a given time period. It is also referred to as a negative balance of trade (BOT).
The balance can be calculated on different categories of transactions: goods (a.k.a., “merchandise”), services, goods and services. Balances are also calculated for international transactions—current account, capital account, and financial account.
A trade deficit occurs when there is a negative net amount or negative balance in an international transaction account. The balance of payments (international transaction accounts) records all economic transactions between residents and non-residents where a change in ownership occurs.
A trade deficit or net amount can be calculated on different categories within an international transaction account. These include goods, services, goods and services, current account, and the sum of balances on the current and capital accounts.
The sum of the balances on the current and capital accounts equals net lending/borrowing. This also equals the balance on the financial account plus a statistical discrepancy. The financial account measures financial assets and liabilities, in contrast to purchases and payments in the current and capital accounts.
The most relevant balance depends on the question being asked and the country about which it is being asked. In the U.S., the International Transaction Accounts are published by the Bureau of Economic Analysis.
The current account includes goods and services, plus primary and secondary income payments.
Primary income includes payments (financial investment returns) from direct investment (greater than 10% ownership of a business), portfolio investment (financial markets), and other.
Secondary income payments include government grants (foreign aid) and pension payments, and private remittances to households in other countries (e.g., sending money to friends and relatives).
The capital account includes exchanges of assets such as insured disaster-related losses, debt cancellation, and transactions involving rights, like mineral, trademark, or franchise.
The balance of the current account and capital account determines the exposure of an economy to the rest of the world, whereas the financial account (tracking financial assets, rather than products or income flows) explains how it is financed. In principle, the sum of the balances of the three accounts should be zero, but there is a statistical discrepancy because of source data used for the current and capital accounts is different from the source data used for the financial account.
Trade deficits occur when a country lacks efficient capacity to produce its own products – whether due to lack of skill and resources to create that capacity or due to preference to acquire from another country (such as to specialize in its own goods, for lower cost or to acquire luxuries).
The most obvious benefit of a trade deficit is that it allows a country to consume more than it produces. In the short run, trade deficits can help nations to avoid shortages of goods and other economic problems.
In some countries, trade deficits correct themselves over time. A trade deficit creates downward pressure on a country’s currency under a floating exchange rate regime. With a cheaper domestic currency, imports become more expensive in the country with the trade deficit. Consumers react by reducing their consumption of imports and shifting toward domestically produced alternatives. Domestic currency depreciation also makes the country’s exports less expensive and more competitive in foreign markets.
Trade deficits can also occur because a country is a highly desirable destination for foreign investment. For example, the U.S. dollar’s status as the world’s reserve currency creates a strong demand for U.S. dollars. Foreigners must sell goods to Americans to obtain dollars. According to the U.S. Treasury Department, foreign investors held over four trillion dollars in Treasuries as of October 2019. Other nations had to run cumulative trade surpluses with the U.S. totaling over four trillion dollars to buy those Treasuries. The stability of developed countries generally attracts capital, while less developed countries must worry about capital flight.
Trade deficits can create substantial problems in the long run. The worst and most obvious problem is that trade deficits can facilitate a sort of economic colonization. If a country continually runs trade deficits, citizens of other countries acquire funds to buy up capital in that nation. That can mean making new investments that increase productivity and create jobs. However, it may also involve merely buying up existing businesses, natural resources, and other assets. If this buying continues, foreign investors will eventually own nearly everything in the country.
Trade deficits are generally much more dangerous with fixed exchange rates. Under a fixed exchange rate regime, devaluation of the currency is impossible, trade deficits are more likely to continue, and unemployment may increase significantly. According to the twin deficits hypothesis, there is also a link between trade deficits and budget deficits. Some economists believe that the European debt crisis was caused in part by some EU members running persistent trade deficits with Germany. Exchange rates can no longer adjust between countries in the Eurozone, making trade deficits a more serious problem.
The U.S. holds the distinction of having the world’s largest trade deficit since 1975. The U.S. imported and consumed significantly more electronics, raw materials, oil, and other items than it sold to foreign countries.
The unemployment rate is the percentage of the labor force without a job. It is a lagging indicator, meaning that it generally rises or falls in the wake of changing economic conditions, rather than anticipating them. When the economy is in poor shape and jobs are scarce, the unemployment rate can be expected to rise. When the economy is growing at a healthy rate and jobs are relatively plentiful, it can be expected to fall.
The U.S. unemployment rate is released on the first Friday of every month (with a few exceptions) for the preceding month. The current and past editions of the report are available on the website of the Bureau of Labor Statistics (BLS). Users can generate and download tables showing any of the labor market measures named above for a specified date range.
In the U.S., the official and the most commonly cited national unemployment rate is the U-3, which the BLS releases as part of its monthly employment situation report. It defines unemployed people as those who are willing and available to work and who have actively sought work within the past four weeks.
According to the BLS, those with temporary, part-time, or full-time jobs are considered employed, as are those who perform at least 15 hours of unpaid work for a family business or farm. The unemployment rate is seasonally adjusted to account for predictable variations, such as extra hiring during the holidays. The BLS also provides the unadjusted rate.
The U-3 is not the only metric available, and it measures unemployment fairly narrowly. The more comprehensive U-6 rate, often called the “real” unemployment rate, is an alternative measure of unemployment that includes groups such as discouraged workers who have stopped looking for a new job and the underemployed who are working part-time because they can’t find full-time employment. The U-6 “real unemployment” rate for January 2022 was 7.1%, down from 7.3% in December 2021.
To calculate the U-3 unemployment rate, the number of unemployed people is divided by the number of people in the labor force, which consists of all employed and unemployed people. The ratio is expressed as a percentage. The January 2022 U-3 unemployment rate as reported by the BLS was 4%.
Many people who would like to work but cannot (due to a disability, for example) or have become discouraged after looking for work without success, are not considered unemployed under this definition; since they are not employed either, they are categorized as outside the labor force. Critics see this approach as painting an unjustifiably rosy picture of the labor force. U-3 is also criticized for making no distinction between those in temporary, part-time, and full-time jobs, even in cases where part-time or temporary workers would rather work full-time but cannot due to labor market conditions.
Official U.S. employment statistics are produced by the BLS, an agency within the Department of Labor (DOL). Every month the Census Bureau, part of the Department of Commerce (DOC), conducts the Current Population Survey (CPS) using a sample of approximately 60,000 households, or about 110,000 individuals.
The survey collects data on individuals in these households by race, ethnicity, age, veteran status, and gender (but only allowing for categories of men or women), all of which—along with geography—add nuance to the employment data. The sample is rotated so that 75% of the households remain constant from month to month and 50% from year to year. Interviews are conducted in person or by phone.
The survey excludes individuals under the age of 16 and those who are in the Armed Forces (hence references to the “civilian labor force”). People in correctional facilities, mental healthcare facilities, and similar institutions are also excluded. Interviewers ask a series of questions that determine employment status, but do not ask whether respondents are employed or unemployed. Nor do the interviewers themselves assign employment status; they record the answers for the BLS to analyze. Interviewers also collect information on industry, occupation, average earnings, union membership, and—for the jobless—whether they quit or were discharged (fired or laid off).
The U.S. Bureau of Labor Statistics, or BLS, surveys approximately 60,000 households in person or over the phone. The responses are later aggregated by race, ethnicity, age, veteran status, and gender, all of which—along with geography—add greater detail to the employment picture.
Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security. Volatility is often measured as either the standard deviation or variancebetween returns from that same security or market index.
In the securities markets, volatility is often associated with big swings in either direction. For example, when the stock market rises and falls more than one percent over a sustained period of time, it is called a “volatile” market. An asset’s volatility is a key factor when pricing options contracts.
Volatility often refers to the amount of uncertainty or risk related to the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, and tends to be more steady.
One way to measure an asset’s variation is to quantify the daily returns (percent move on a daily basis) of the asset. Historical volatility is based on historical prices and represents the degree of variability in the returns of an asset. This number is without a unit and is expressed as a percentage.
While variance captures the dispersion of returns around the mean of an asset in general, volatility is a measure of that variance bounded by a specific period of time. Thus, we can report daily volatility, weekly, monthly, or annualized volatility. It is, therefore, useful to think of volatility as the annualized standard deviation.
One measure of the relative volatility of a particular stock to the market is its beta (β). A beta approximates the overall volatility of a security’s returns against the returns of a relevant benchmark (usually the S&P 500 is used). For example, a stock with a beta value of 1.1 has historically moved 110% for every 100% move in the benchmark, based on price level.
Conversely, a stock with a beta of .9 has historically moved 90% for every 100% move in the underlying index.
Market volatility can also be seen through the VIX or Volatility Index. The VIX was created by the Chicago Board Options Exchange as a measure to gauge the 30-day expected volatility of the U.S. stock market derived from real-time quote prices of S&P 500 call and put options. It is effectively a gauge of future bets investors and traders are making on the direction of the markets or individual securities. A high reading on the VIX implies a risky market.
A variable in option pricing formulas showing the extent to which the return of the underlying asset will fluctuate between now and the option’s expiration. Volatility, as expressed as a percentage coefficient within option-pricing formulas, arises from daily trading activities. How volatility is measured will affect the value of the coefficient used.
Volatility is also used to price options contracts using models like Black-Scholes or binomial tree models. More volatile underlying assets will translate to higher options premiums because with volatility there is a greater probability that the options will end up in-the-money at expiration. Options traders try to predict an asset’s future volatility, so the price of an option in the market reflects its implied volatility.
Implied volatility (IV), also known as projected volatility, is one of the most important metrics for options traders. As the name suggests, it allows them to make a determination of just how volatile the market will be going forward. This concept also gives traders a way to calculate probability. One important point to note is that it shouldn’t be considered science, so it doesn’t provide a forecast of how the market will move in the future.
Unlike historical volatility, implied volatility comes from the price of an option itself and represents volatility expectations for the future. Because it is implied, traders cannot use past performance as an indicator of future performance. Instead, they have to estimate the potential of the option in the market.
Also referred to as statistical volatility, historical volatility (HV) gauges the fluctuations of underlying securities by measuring price changes over predetermined periods of time. It is the less prevalent metric compared to implied volatility because it isn’t forward-looking.
When there is a rise in historical volatility, a security’s price will also move more than normal. At this time, there is an expectation that something will or has changed. If the historical volatility is dropping, on the other hand, it means any uncertainty has been eliminated, so things return to the way they were.
This calculation may be based on intraday changes, but often measures movements based on the change from one closing price to the next. Depending on the intended duration of the options trade, historical volatility can be measured in increments ranging anywhere from 10 to 180 trading days.
Wall Street is literally a street located in New York City—at the southern end of Manhattan, to be precise. But figuratively, Wall Street is much more: a synonym for the financial industry and the firms within it. This connotation has its roots in the fact that so many brokerages and investment banks historically have established HQs in and around the street, all the better to be close to the New York Stock Exchange (NYSE).
While being on Wall Street is no longer de rigueur for a financial-industry firm (many, in fact, are located all around the country) or even to trade stocks (which primarily happens online now), the term “Wall Street” still means business—the investment business—and the interests, motivations, and attitudes of its players.
Although Wall Street and its surrounding southern Manhattan neighborhood—known to locals as “the Financial District”—remains an important location where a number of financial institutions are based, the globalization and digitization of finance and investment have led to many American broker-dealers, registered investment advisors, and investment companies being established around the country.
Still, “Wall Street” remains a collective name for the financial markets, the companies that trade publicly, and the investment community itself: stock exchanges, investment and commercial banks, brokerages and broker-dealers, financial services, and underwriting firms. It’s a globally recognized expression, symbolizing the U.S. investment industry and to some extent the U.S. financial system. Both the New York Stock Exchange (the largest equities-based exchange in the world) and the Federal Reserve Bank of New York—arguably the most important regional bank of the Federal Reserve System—are based in the Wall Street area.
Wall Street is often shortened to “the Street,” which is how the term is frequently used by those in the financial world and in the media. For example, when reporting a company’s earnings, an analyst might compare a company’s revenues to what the Street was expecting. In this case, the analyst is comparing the company’s earnings to what financial analysts and investment firms were expecting for that period.
Wall Street got its name from the wooden wall Dutch colonists built in lower Manhattan in 1653 to defend themselves from the British and Native Americans. The wall was taken down in 1699, but the name stuck.
Wall Street is both a literal street and a symbol. It’s home to a variety of financial and investment firms, along with institutions like the New York Stock Exchange and the Federal Reserve Bank of New York. Globally, it’s also come to connote the U.S. finance and investment community and industry: its interests, attitudes, and behavior.
Xetra is a trading technology platform that is operated by Frankfurter Wertpapierbörse (FWB), the Frankfurt Stock Exchange. It offers electronic trading in stocks, funds, bonds, warrants, and commodities contracts.
Launched in 1997, the majority of all trades transacted in Germany are through the Xetra trading venue: more than 90% of all trading in shares across all German exchanges is now conducted through Xetra, making it the largest of Germany’s seven stock exchanges. In addition, about 30% of all trading in exchange-traded funds (ETFs) in continental Europe is transacted through Xetra.
The Deutsche Börse Group owns Xetra, which is headquartered in Frankfurt, Germany. A diversified exchange organization, Deutsche Börse Group has a range of products and services that span the financial industry’s value chain, including listing, trading, clearing, and settlement, along with custody services, liquidity management, and more. The Xetra platform offers increased flexibility for seeing order depth within the markets. Deutsche Börse Group is headquartered in the financial center of Frankfurt/Rhine-Main and has branches in Luxembourg, Prague, London, Zurich, Moscow, New York, Chicago, Hong Kong, Singapore, Beijing, and Tokyo.
In 1969, the first automated system for direct trading among U.S. institutions launched: Instinet (originally named Institutional Networks). Nasdaq was the second automated system to launch in 1971. In the early automated trading systems, trading occurred over the phone (although broker-dealers were able to see the prices other firms were offering).
Shortly thereafter, the New York Stock Exchange (NYSE) launched its Designated Order Turnaround (DOT) system. This allowed brokers to route orders directly to specialists on the floor. In 1984, SuperDOT emerged, which effectively expanded the number of shares sent to the floor at one time to nearly 100,000. Nasdaq soon offered the Small Order Execution System (SOES) to compete with NYSE.
Today, electronic trading dominates the public markets. However, with greater connectivity come greater cybersecurity threats. While individuals remain at some level of cyber-attack risk, larger entities such as businesses and government systems are often the main targets of cybersecurity attacks. The U.S. Department of Homeland Security uses high-tech cybersecurity measures to protect sensitive government information from other countries, nation-states, and individual hackers. Any financial system that stores credit card information from its users is at high-risk, along with systems like exchanges. The Frankfurt Exchange (FRA) focuses on cybersecurity and data protection as well.
Xetra was one of the first global electronic trading systems; it has grown to account for the majority of all stock trades on the FRA. The FRA is one of the oldest exchanges in the world and includes notable indices, such as the DAX, the VDAX, and the Eurostoxx 50. FRA hours are from 9:00am to 5:30pm on business days. The DAX 30 is Germany’s benchmark stock market index and is run on the Xetra platform, where it is sometimes referred to as the Xetra DAX. In addition to opening up the German markets for increased foreign investment, the DAX 30 index is currently being used by stock exchanges in Ireland, Vienna, and Shanghai.
A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.
There are three main shapes of yield curve shapes: normal (upward sloping curve), inverted (downward sloping curve), and flat.
A yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is used to predict changes in economic output and growth. The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt. Yield curve rates are usually available at the Treasury’s interest rate websites by 6:00 p.m. ET each trading day.
A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of an upcoming recession. In a flat or humped yield curve, the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition.
A normal or up-sloped yield curve indicates yields on longer-term bonds may continue to rise, responding to periods of economic expansion. A normal yield curve thus starts with low yields for shorter-maturity bonds and then increases for bonds with longer maturity, sloping upwards. This is the most common type of yield curve as longer-maturity bonds usually have a higher yield to maturity than shorter-term bonds.
For example, assume a two-year bond offers a yield of 1%, a five-year bond offers a yield of 1.8%, a 10-year bond offers a yield of 2.5%, a 15-year bond offers a yield of 3.0%, and a 20-year bond offers a yield of 3.5%. When these points are connected on a graph, they exhibit a shape of a normal yield curve.
An inverted yield curve instead slopes downward and means that short-term interest rates exceed long-term rates. Such a yield curve corresponds to periods of economic recession, where investors expect yields on longer-maturity bonds to become even lower in the future. Moreover, in an economic downturn, investors seeking safe investments tend to purchase these longer-dated bonds over short-dated bonds, bidding up the price of longer bonds driving down their yield.
A flat yield curve is defined by similar yields across all maturities. A few intermediate maturities may have slightly higher yields, which causes a slight hump to appear along the flat curve. These humps are usually for the mid-term maturities, six months to two years.
As the word flat suggests, there is little difference in yield to maturity among shorter and longer-term bonds. A two-year bond could offer a yield of 6%, a five-year bond 6.1%, a 10-year bond 6%, and a 20-year bond 6.05%.
Such a flat or humped yield curve implies an uncertain economic situation. It may come at the end of a high economic growth period that is leading to inflation and fears of a slowdown. It might appear at times when the central bank is expected to increase interest rates.
In times of high uncertainty, investors demand similar yields across all maturities.
Yield curve risk refers to the risk investors of fixed-income instruments (such as bonds) experience from an adverse shift in interest rates. Yield curve risk stems from the fact that bond prices and interest rates have an inverse relationship to one another. For example, the price of bonds will decrease when market interest rates increase. Conversely, when interest rates (or yields) decrease, bond prices increase.
Investors can use the yield curve to make predictions on where the economy might be headed and use this information to make their investment decisions. If the bond yield curve indicates an economic slowdown might be on the horizon, investors might move their money into defensive assets that traditionally do well during recessionary times, such as consumer staples. If the yield curve becomes steep, this might be a sign of future inflation. In this scenario, investors might avoid long-term bonds with a yield that will erode against increased prices.
Zero Coupon Bond
A zero-coupon bond, also known as an accrual bond, is a debt security that does not pay interest but instead trades at a deep discount, rendering a profit at maturity, when the bond is redeemed for its full face value.
Some bonds are issued as zero-coupon instruments from the start, while other bonds transform into zero-coupon instruments after a financial institution strips them of their coupons, and repackages them as zero-coupon bonds. Because they offer the entire payment at maturity, zero-coupon bonds tend to fluctuate in price, much more so than coupon bonds.
A bond is a portal through which a corporate or governmental body raises capital. When bonds are issued, investors purchase those bonds, effectively acting as lenders to the issuing entity. The investors earn a return in the form of coupon payments, which are made semiannually or annually, throughout the life of the bond.
When the bond matures, the bondholder is repaid an amount equal to the face value of the bond. The par or face value of a corporate bond is typically stated as $1,000. If a corporate bond is issued at a discount, this means investors can purchase the bond below its par value. For example, an investor who purchases a bond for $920 at a discount will receive $1,000. The $80 return, plus coupon payments received on the bond, is the investor’s earnings or return for holding the bond.
But not all bonds have coupon payments. Those that do not are referred to as zero-coupon bonds. These bonds are issued at a deep discount and repay the par value, at maturity. The difference between the purchase price and the par value represents the investor’s return. The payment received by the investor is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield.
The interest earned on a zero-coupon bond is an imputed interest, meaning that it is an estimated interest rate for the bond and not an established interest rate. For example, a bond with a face amount of $20,000, that matures in 20 years, with a 5.5% yield, may be purchased for roughly $6,855. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $6,855 (or $13,145) represents the interest that compounds automatically until the bond matures. Imputed interest is sometimes referred to as “phantom interest.”
The imputed interest on the bond is subject to income tax, according to the Internal Revenue Service (IRS). Therefore, although no coupon payments are made on zero-coupon bonds until maturity, investors may still have to pay federal, state, and local income taxes on the imputed interest that accrues each year. Purchasing a municipal zero-coupon bond, buying zero-coupon bonds in a tax-exempt account, or purchasing a corporate zero-coupon bond that has tax-exempt status are a few ways to avoid paying income taxes on these securities.
Payment of interest, or coupons, is the key differentiator between a zero-coupon and regular bond. Regular bonds, which are also called coupon bonds, pay interest over the life of the bond and also repay the principal at maturity. A zero-coupon bond does not pay interest but instead trades at a deep discount, giving the investor a profit at maturity when they redeem the bond for its full face value.
An investor chooses the zero-coupon bond they would like to purchase based on several criteria, but one of the main ones will be the imputed interest rate that they can earn at maturity. The price of a zero-coupon bond can be calculated with the following equation:
Zero-coupon bond price = Maturity value ÷ (1 + required interest rate)^number years to maturity
Here are some links with definitions of terms and concepts specific to the investing and wealth management business:
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