Posted by
maddy
Labels:
Foreign exchange market
The foreign exchange market is unique because of
-
- its trading volumes,
- the extreme liquidity of the market,
- the large number of, and variety of, traders in the market,
- its geographical dispersion,
- its long trading hours: 24 hours a day (except on weekends),
- the variety of factors that affect exchange rates.
- the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)
As such, it has been referred to as the market closest to the ideal perfect competition, notwithstanding authorized market manipulation by central banks. According to the BIS,[1] average daily turnover in traditional foreign exchange markets is estimated at $3.21 trillion. Daily averages in April for different years, in billions of US dollars, are presented on the chart below:
This $3.21 trillion in global foreign exchange market "traditional" turnover was broken down as follows:
-
- $1,005 billion in spot transactions
- $362 billion in outright forwards
- $1,714 billion in forex swaps
- $129 billion estimated gaps in reporting
In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.
Exchange-traded forex futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. Forex futures volume has grown rapidly in recent years, and accounts for about 7% of the total foreign exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).
Average daily global turnover in traditional foreign exchange market transactions totaled $2.7 trillion in April 2006 according to IFSL estimates based on semi-annual London, New York, Tokyo and Singapore Foreign Exchange Committee data. Overall turnover, including non-traditional foreign exchange derivatives and products traded on exchanges, averaged around $2.9 trillion a day. This was more than ten times the size of the combined daily turnover on all the world’s equity markets. Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more than doubled since 2001. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds. The diverse selection of execution venues such as internet trading platforms has also made it easier for retail traders to trade in the foreign exchange market. [2]
Because foreign exchange is an OTC market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. The biggest geographic trading centre is the UK, primarily London, which according to IFSL estimates has increased its share of global turnover in traditional transactions from 31.3% in April 2004 to 32.4% in April 2006. RPP
The ten most active traders account for almost 73% of trading volume, according to The Wall Street Journal Europe, (2/9/06 p. 20). These large international banks continually provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask", or "offer") and the price at which a market-maker will buy ("bid") from a wholesale customer. This spread is minimal for actively traded pairs of currencies, usually 0–3 pips. For example, the bid/ask quote of EUR/USD might be 1.2200/1.2203 on a retail broker. Minimum trading size for most deals is usually 100,000 units of currency, which is a standard "lot".
These spreads might not apply to retail customers at banks, which will routinely mark up the difference to say 1.2100 / 1.2300 for transfers, or say 1.2000 / 1.2400 for banknotes or travelers' checks. Spot prices at market makers vary, but on EUR/USD are usually no more than 3 pips wide (i.e. 0.0003). Competition is greatly increased with larger transactions, and pip spreads shrink on the major pairs to as little as 1 to 2 pips.
| Rank | Name | Volume |
|---|---|---|
| 1 |  Deutsche Bank | 21.7% |
| 2 |  UBS AG | 14.85% |
| 3 |  Citi | 9.00% |
| 4 |  Royal Bank of Scotland | 8.90% |
| 5 | Barclays Capital | 8.80% |
| 6 | Bank of America | 5.29% |
| 7 | HSBC | 4.36% |
| 8 | Goldman Sachs | 4.14% |
| 9 | JPMorgan | 3.33% |
| 10 | Morgan Stanley | 2.86% |
Unlike a stock market, where all participants have access to the same prices, the forex market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. As you descend the levels of access, the difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the forex market are determined by the size of the “line” (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller investment banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail forex market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks also participate in the forex market to align currencies to their economic needs.
The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account.
Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.
An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants
National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high — that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.
The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.[4] Several scenarios of this nature were seen in the 1992–93 ERM collapse, and in more recent times in Southeast Asia.
Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager with an international equity portfolio will need to buy and sell foreign currencies in the spot market in order to pay for purchases of foreign equities. Since the forex transactions are secondary to the actual investment decision, they are not seen as speculative or aimed at profit-maximization.
Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.
Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.
There are two types of retail broker: brokers offering speculative trading and brokers offering physical delivery i.e. the bought currency is delivered to a bank account.
Retail forex brokers or market makers handle a minute fraction of the total volume of the foreign exchange market. According to CNN, one retail broker estimates retail volume at $25–50 billion daily, which is about 2% of the whole market. Retail traders (individuals) are a small fraction of this market and may only participate indirectly through brokers or banks, and might be subject to forex scams[5] [6].
There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currency instruments are traded. This implies that there is not a single dollar rate but rather a number of different rates (prices), depending on what bank or market maker is trading. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously. A joint venture of the Chicago Mercantile Exchange and Reuters, called FxMarketSpace opened in 2007 and aspires to the role of a central market clearing mechanism.
The main trading centers are in London, New York, Tokyo, Hong Kong and Singapore, but banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends.
There is little or no 'inside information' in the foreign exchange markets. Exchange rate fluctuations are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in GDP growth, inflation, interest rates, budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.
Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX is expressed (called base currency). For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.3045 dollar. Out of convention, the first currency in the pair, the base currency, was the stronger currency at the creation of the pair. The second currency, counter currency, was the weaker currency at the creation of the pair.
The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes positive currency correlation between XXX/YYY and XXX/ZZZ.
On the spot market, according to the BIS study, the most heavily traded products were:
-
- EUR/USD: 28 %
- USD/JPY: 18 %
- GBP/USD (also called sterling or cable): 14 %
and the US currency was involved in 88.7% of transactions, followed by the euro (37.2%), the yen (20.3%), and the sterling (16.9%) (see table). Note that volume percentages should add up to 200%: 100% for all the sellers and 100% for all the buyers.
Although trading in the euro has grown considerably since the currency's creation in January 1999, the foreign exchange market is thus far still largely dollar-centered. For instance, trading the euro versus a non-European currency ZZZ will usually involve two trades: EUR/USD and USD/ZZZ. The exception to this is EUR/JPY, which is an established traded currency pair in the interbank spot market.
Although exchange rates are affected by many factors, in the end, currency prices are a result of supply and demand forces. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.
These include economic policy, disseminated by government agencies and central banks, economic conditions, generally revealed through economic reports, and other economic indicators.
Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
Economic conditions include:
Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.
Inflation levels and trends: Typically, a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
Economic growth and health: Reports such as gross domestic product (GDP), employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
Internal, regional, and international political conditions and events can have a profound effect on currency markets.
For instance, political upheaval and instability can have a negative impact on a nation's economy. The rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.
Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:
Flights to quality: Unsettling international events can lead to a "flight to quality," with investors seeking a "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts.
Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends. [7]
"Buy the rumor, sell the fact:" This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".[8] To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.
Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns. [9]
Electronic trading is growing in the FX market, and algorithmic trading is becoming much more common. According to financial consultancy Celent estimates, by 2008 up to 25% of all trades by volume will be executed using algorithm, up from about 18% in 2005.
A Spot transaction is a two-day delivery transaction, as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the spot market. Spot has the largest share by volume in FX transactions among all instruments.
One way to deal with the Forex risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a few days, months or years.
Foreign currency futures are forward transactions with standard contract sizes and maturity dates — for example, 500,000 British pounds for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.
The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.
A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.
such as the Exchange-traded funds (or ETFs) are Open Ended investment companies that can be traded at any time throughout the course of the day. Typically, ETFs try to replicate a stock market indexS&P 500 (e.g. SPY), but recently they are now replicating investments in the currency markets with the ETF increasing in value when the US Dollar weakness versus a specific currency, such as the Euro. Certain of these funds track the price movements of world currencies versus the US Dollar, and increase in value directly counter to the US Dollar, allowing for speculation in the US Dollar for US and US Dollar denominated investors and speculators.
Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, many economists (e.g. Milton Friedman) have argued that speculators perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do. Other economists (e.g. Joseph Stiglitz) however, may consider this argument to be based more on politics and a free market philosophy than on economics.[citation needed]
Large hedge funds and other well capitalized "position traders" are the main professional speculators.
Currency speculation is considered a highly suspect activity in many countries. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona[10]. Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.[11]
Gregory Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.
In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and forex speculators allegedly made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions. Given that Malaysia recovered quickly after imposing currency controls directly against IMF advice, this view is open to doubt.
Managerial or corporate finance is the task of providing the funds for a corporation's activities. For small business, this is referred to as SME finance. It generally involves balancing risk and profitability, while attempting to maximize an entity's wealth and the value of its stock.
Long term funds are provided by ownership equity and long-term credit, often in the form of bonds. The balance between these forms the company's capital structure. Short-term funding or working capital is mostly provided by banks extending a line of credit.
Another business decision concerning finance is investment, or fund management. An investment is an acquisition of an asset in the hope that it will maintain or increase its value. In investment management -- in choosing a portfolio -- one has to decide what, how much and when to invest. To do this, a company must:
- Identify relevant objectives and constraints: institution or individual goals, time horizon, risk aversion and tax considerations;
- Identify the appropriate strategy: active v. passive -- hedging strategy
- Measure the portfolio performance
Financial management is duplicate with the financial function of the Accounting profession. However, financial accounting is more concerned with the reporting of historical financial information, while the financial decision is directed toward the future of the firm.
Questions in personal finance revolve around
- How much money will be needed by an individual (or by a family) at various points in the future?
- Where will this money come from (e.g. savings or borrowing)?
- How can people protect themselves against unforeseen events in their lives, and risk in financial markets?
- How can family assets be best transferred across generations (bequests and inheritance)?
- How do taxes (tax subsidies or penalties) affect personal financial decisions?
- How does credit affect an individual's financial standing?
- How can one plan for a secure financial future in an environment of economic instability?
Personal financial decisions may involve paying for education, financing durable goods such as real estate and cars, buying insurance, e.g. health and property insurance, investing and saving for retirement.
Personal financial decisions may also involve paying for a loan.
This concerns fixed asset requirements for the next five years and how these will be financed
- Size of business
- Stage of development
- Time of production
- Rate of stock turnover ratio
- Buying and selling terms
- Seasonal consumption
- Seasonal production
- Nature of business
- Size of business
- Stage of development
- Capital invested by the owners
- location of that area
This is money which is used to purchase assets that will remain permanently in the business and help it to make a profit.
- Shareholders are effectively owners; debenture-holders are creditors.
- Shareholders may vote at AGMs and be elected as directors; debenture-holders may not vote at AGMs or be elected as directors.
- Shareholders receive profit in the form of dividends; debenture-holders receive a fixed rate of interest.
- If there is no profit, the shareholder does not receive a dividend; interest is paid to debenture-holders regardless of whether or not a profit has been made.
- In case of dissolution of firms debenture holders are paid first as compared to shareholder.
Depreciation
Depreciation is the decrease in the value of an asset due to wear and tear or obsolescence. It is calculated yearly to ensure realistic book values for assets.
Insurance
Insurance is the undertaking of one party to indemnify another, in exchange for a premium, against a certain eventuality.
- Uninsurable risks
- Bad debt
- Changes in fashion
- Time lapses between ordering and delivery
- New machinery or technology
- Different prices at different places
- Requirements of an insurance contract
- Insurable interest
- The insured must derive a real financial gain from that which he is insuring, or stand to lose if it is destroyed or lost.
- The item must belong to the insured.
- One person may take out insurance on the life of another if the second party owes the first money.
- Must be some person or item which can, legally, be insured.
- The insured must have a legal claim to that which he is insuring.
- Good faith
- Uberrimae fidei refers to absolute honesty and must characterise the dealings of both the insurer and the insured.
There is currently a move towards converging and consolidating Finance provisions into shared services within an organization. Rather than an organization having a number of separate Finance departments performing the same tasks from different locations a more centralized version can be created.
Country, state, county, city or municipality finance is called public finance. It is concerned with
- Identification of required expenditure of a public sector entity
- Source(s) of that entity's revenue
- The budgeting process
- Debt issuance (municipal bonds) for public works projects
Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance.
It studies:
- Valuation - Determination of the fair value of an asset
- How risky is the asset? (identification of the asset appropriate discount rate)
- What cash flows will it produce? (discounting of relevant cash flows)
- How does the market price compare to similar assets? (relative valuation)
- Are the cash flows dependent on some other asset or event? (derivatives, contingent claim valuation)
- Financial markets and instruments
- Commodities - topics
- Stocks - topics
- Bonds - topics
- Money market instruments- topics
- Derivatives - topics
- Financial institutions and regulation
Financial Econometrics is the branch of Financial Economics that uses econometric techniques to parameterise the relationships.
Financial mathematics is a main branch of applied mathematics concerned with the financial markets. Financial mathematics is the study of financial data with the tools of mathematics, mainly statistics. Such data can be movements of securities—stocks and bonds etc.—and their relations. Another large subfield is insurance mathematics.
Experimental finance aims to establish different market settings and environments to observe experimentally and provide a lens through which science can analyze agents' behavior and the resulting characteristics of trading flows, information diffusion and aggregation, price setting mechanisms, and returns processes. Researchers in experimental finance can study to what extent existing financial economics theory makes valid predictions, and attempt to discover new principles on which such theory can be extended. Research may proceed by conducting trading simulations or by establishing and studying the behaviour of people in artificial competitive market-like settings.
Quantitative Behavioral Finance is a new discipline that uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation. Some of this endeavor has been lead by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during 2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran, Huseyin Merdan). Studies by Jeff Madura, Ray Sturm and others have demonstrated significant behavioral effects in stocks and exchange traded funds.
The research can be grouped into the following areas:
1. Empirical studies that demonstrate significant deviations from classical theories.
2. Modeling using the concepts of behavioral effects together with the non-classical assumption of the finiteness of assets.
3. Forecasting based on these methods.
4. Studies of experimental asset markets and use of models to forecast experiments.
An entity whose income exceeds its expenditure can lend or invest the excess income. On the other hand, an entity whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its expenses, or increasing its income. The lender can find a borrower, a financial intermediary, such as a bank or buy notes or bonds in the bond market. The lender receives interest, the borrower pays a higher interest than the lender receives, and the financial intermediary pockets the difference.
A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it pays the interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders, of different sizes, to coordinate their activity. Banks are thus compensators of money flows in space.
A specific example of corporate finance is the sale of stock by a company to institutional investors like investment banks, who in turn generally sell it to the public. The stock gives whoever owns it part ownership in that company. If you buy one share of XYZ Inc, and they have 100 shares outstanding (held by investors), you are 1/100 owner of that company. Of course, in return for the stock, the company receives cash, which it uses to expand its business in a process called "equity financing". Equity financing mixed with the sale of bonds (or any other debt financing) is called the company's capital structure.
Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate finance), as well as by a wide variety of organizations including schools and non-profit organizations. In general, the goals of each of the above activities are achieved through the use of appropriate financial instruments, with consideration to their institutional setting.
Finance is one of the most important aspects of business management. Without proper financial planning a new enterprise is unlikely to be successful. Managing money (a liquid asset) is essential to ensure a secure future, both for the individual and an organization.
Bond markets in most countries remain decentralized and lack common exchanges like stock, future and commodity markets. This has occurred, in part, because no two bond issues are exactly alike, and the number of different securities outstanding is far larger.
However, the New York Stock Exchange (NYSE) is the largest centralized bond market, representing mostly corporate bonds. The NYSE migrated from the Automated Bond System (ABS) to the NYSE Bonds trading system in April 2007 and expects the number of traded issues to increase from 1000 to 6000The Securities Industry and Financial Markets Association classifies the broader bond market into five specific bond markets.
- Corporate
- Government & Agency
- Municipal
- Mortgage Backed, Asset Backed, and Collateralized Debt Obligation
- Funding
Bond market participants are similar to participants in most financial markets and are essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both.
Participants include:
- Institutional investors;
- Governments;
- Traders; and
- Individuals
Because of the specificity of individual bond issues, and the lack of liquidity in many smaller issues, the majority of outstanding bonds are held by institutions like pension funds, banks and mutual funds. In the United States, approximately 10% of the market is currently held by private individuals.
For market participants who own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal and interest are received according to a pre-determined schedule.
But participants who buy and sell bonds before maturity are exposed to many risks, most importantly changes in interest rates. When interest rates increase, the value of existing bonds fall, since new issues pay a higher yield. Likewise, when interest rates decrease, the value of existing bonds rise, since new issues pay a lower yield. This is the fundamental concept of bond market volatility: changes in bond prices are inverse to changes in interest rates. Fluctuating interest rates are part of a country's monetary policy and bond market volatility is a response to expected monetary policy and economic changes.
Economists' views of economic indicators versus actual released data contribute to market volatility. A tight consensus is generally reflected in bond prices and there is little price movement in the market after the release of "in-line" data. If the economic release differs from the consensus view the market usually undergoes rapid price movement as participants interpret the data. Uncertainty (as measured by a wide consensus) generally brings more volatility before and after an economic release. Economic releases vary in importance and impact depending on where the economy is in the business cycle.
Investment companies allow individual investors the ability to participate in the bond markets through bond funds, closed-end funds and unit-investment trusts. In 2006 total bond fund net inflows increased 97% from $30.8 billion in 2005 to $60.8 billion in 2006.[4] Exchange-traded funds (ETFs) are another alternative to trading or investing directly in a bond issue. These securities allow individual investors the ability to overcome large initial and incremental trading sizes.
A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The most common American benchmarks are the Lehman Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity and/or sector for managing specialized portfolios.'
The bond market (also known as the debt, credit, or fixed income market) is a financial market where participants buy and sell debt securities, usually in the form of bonds. As of 2006, the size of the international bond market is an estimated $45 trillion, of which the size of the outstanding U.S. bond market debt was $25.2 trillion.[1]
Nearly all of the $923 billion average daily trading volume (as of early 2007) in the U.S. Bond Market[2] takes place between broker-dealers and large institutions in a decentralized, over-the-counter (OTC) market. However, a small number of bonds, primarily corporate, are listed on exchanges.
References to the "bond market" usually refer to the government bond market, because of its size, liquidity, lack of credit risk and, therefore, sensitivity to interest rates. Because of the inverse relationship between bond valuation and interest rates, the bond market is often used to indicate changes in interest rates or the shape of the yield curve.
In finance a bond is a debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity.
A bond is simply a loan in the form of a security with different terminology: The issuer is equivalent to the borrower, the bond holder to the lender, and the coupon to the interest. Bonds enable the issuer to finance long-term investments with external funds. Note that certificates of deposit (CDs) or commercial paper are considered to be money market instruments and not bonds.
Bonds and stocks are both securities, but the major difference between the two is that stock-holders are the owners of the company (i.e., they have an equity stake), whereas bond-holders are lenders to the issuing company. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity
(i.e., bond with no maturity).
Riders are modifications to the insurance policy added at the same time the policy is issued. These riders change the basic policy to provide some feature desired by the policy owner. A common rider is accidental death, which used to be commonly referred to as "double indemnity", which pays twice the amount of the policy face value if death results from accidental causes, as if both a full coverage policy and an accidental death policy were in effect on the insured. Another common rider is premium waiver, which waives future premiums if the insured becomes disabled.
Joint life insurance is either a term or permanent policy insuring two or more lives with the proceeds payable on the first death.
Survivorship life or second-to-die life is a whole life policy insuring two lives with the proceeds payable on the second (later) death.
Single premium whole life is a policy with only one premium which is payable at the time the policy is issued.
Modified whole life is a whole life policy that charges smaller premiums for a specified period of time after which the premiums increase for the remainder of the policy.
Group life insurance is term insurance covering a group of people, usually employees of a company or members of a union or association. Individual proof of insurability is not normally a consideration in the underwriting. Rather, the underwriter considers the size and turnover of the group, and the financial strength of the group. Contract provisions will attempt to exclude the possibility of adverse selection. Group life insurance often has a provision that a member exiting the group has the right to buy individual insurance coverageAccidental death is a limited life insurance that is designed to cover the insured when they pass away due to an accident. Accidents include anything from an injury, but do not typically cover any deaths resulting from health problems or suicide. Because they only cover accidents, these policies are much less expensive than other life insurances.
It is also very commonly offered as "accidental death and dismemberment insurance", also known as an AD&D policy. In an AD&D policy, benefits are available not only for accidental death, but also for loss of limbs or bodily functions such as sight and hearing, etc.
Accidental death and AD&D policies very rarely pay a benefit; either the cause of death is not covered, or the coverage is not maintained after the accident until death occurs. To be aware of what coverage they have, an insured should always review their policy for what it covers and what it excludes. Often, it does not cover an insured who puts themselves at risk in activities such as: parachuting, flying an airplane, professional sports, or involvement in a war (military or not). Also, some insurers will exclude death and injury caused by proximate causes due to (but not limited to) racing on wheels and mountaineering.
Accidental death benefits can also be added to a standard life insurance policy as a rider. If this rider is purchased, the policy will generally pay double the face amount if the insured dies due to an accident. This used to be commonly referred to as a double indemnity coverage. In some cases, some companies may even offer a triple indemnity cover.
Endowments are policies in which the cash value built up inside the policy, equals the death benefit (face amount) at a certain age. The age this commences is known as the endowment age. Endowments are considerably more expensive (in terms of annual premiums) than either whole life or universal life because the premium paying period is shortened and the endowment date is earlier.
In the United States, the Technical Corrections Act of 1988 tightened the rules on tax shelters (creating modified endowments). These follow tax rules as annuities and IRAs do.
Endowment Insurance is paid out whether the insured lives or dies, after a specific period (e.g. 15 years) or a specific ageAnother type of permanent insurance is Limited-pay life insurance, in which all the premiums are paid over a specified period after which no additional premiums are due to keep the policy in force. Common limited pay periods include 10-year, 20-year, and paid-up at age 65.
Universal life coverage is a relatively new insurance product intended to provide permanent insurance coverage with greater flexibility in premium payment and the potential for a higher internal rate of return. A universal life policy includes a cash account. Premiums increase the cash account. Interest is paid within the policy (credited) on the account at a rate specified by the company. This rate has a guaranteed minimum but usually is higher than that minimum. Mortality charges and administrative costs are charged against (reduce) the cash account. The surrender value of the policy is the amount remaining in the cash account less applicable surrender charges, if any.
With all life insurance, there are basically two functions that make it work. There's a mortality function and a cash function. The mortality function would be the classical notion of pooling risk where the premiums paid by everybody else would cover the death benefit for the one or two who will die for a given period of time. The cash function inherent in all life insurance says that if a person is to reach age 95 to 100 (the age varies depending on state and company), then the policy matures and endows the face value of the policy.
Actuarially, it is reasoned that out of a group of 1000 people, if even 10 of them live to age 95, then the mortality function alone will not be able to cover the cash function. So in order to cover the cash function, a minimum rate of investment return on the premiums will be required in the event that a policy matures.
Universal life policies guarantee, to some extent, the death proceeds, but not the cash function - thus the flexible premiums and interest returns. If interest rates are high, then the dividends help reduce premiums. If interest rates are low, then the customer would have to pay additional premiums in order to keep the policy in force. When interest rates are above the minimum required, then the customer has the flexibility to pay less as investment returns cover the remainder to keep the policy in force.
The universal life policy addresses the perceived disadvantages of whole life. Premiums are flexible. The internal rate of return is usually higher because it moves with the financial markets. Mortality costs and administrative charges are known. And cash value may be considered more easily attainable because the owner can discontinue premiums if the cash value allows it. And universal life has a more flexible death benefit because the owner can select one of two death benefit options, Option A and Option B.
Option A pays the face amount at death as it's designed to have the cash value equal the death benefit at age 95. Option B pays the face amount plus the cash value, as it's designed to increase the net death benefit as cash values accumulate. Option B does carry with it a caveat. This caveat is that in order for the policy to keep its tax favored life insurance status, it must stay within a corridor specified by state and federal laws that prevent abuses such as attaching a million dollars in cash value to a two dollar insurance policy. The interesting part about this corridor is that for those people who can make it to age 95-100, this corridor requirement goes away and your cash value can equal exactly the face amount of insurance. If this corridor is ever violated, then the universal life policy will be treated as, and in effect turn into, a Modified Endowment Contract (or more commonly referred to as a MEC).
But universal life has its own disadvantages which stem primarily from this flexibility. The policy lacks the fundamental guarantee that the policy will be in force unless sufficient premiums have been paid and cash values are not guaranteed.
Universal life policies are sometimes erroneously referred to as self-sustaining policies. In the 1980s, when interest rates were high, the cash value accumulated at a more accelerated rate, and universal life coverage was often sold by agents as a policy that could be self-paying. Many policies did sustain themselves for a prolonged period, but the combination of lower interest rates and an increasing cost of insurance as the insured ages meant that for many policies, the cash option was diminished or depleted.
Variable universal life Insurance (VUL) is not the same as universal life, even though they both have cash values attached to them. These differences are in how the cash accounts are managed. The cash account within a VUL is held in the insurer's "separate account" (generally in mutual funds, managed by a fund manager).
Whole life coverage provides for a level premium, and a cash value table included in the policy guaranteed by the company. The primary advantages of whole life are guaranteed death benefits, guaranteed cash values, fixed and known annual premiums, and mortality and expense charges will not reduce the cash value shown in the policy. The primary disadvantages of whole life are premium inflexibility, and the internal rate of return in the policy may not be competitive with other savings alternatives. Riders are available that can allow one to increase the death benefit by paying additional premium. The death benefit can also be increased through the use of policy dividends. Dividends cannot be guaranteed and may be higher or lower than historical rates over time. Premiums are much higher than term insurance in the short-term, but cumulative premiums are roughly equal if policies are kept in force until average life expectancy.
Cash value can be accessed at any time through policy "loans". Since these loans decrease the death benefit if not paid back, payback is optional. Cash values are not paid to the beneficiary upon the death of the insured; the beneficiary receives the death benefit only. If the dividend option: Paid up additions is elected, dividend cash values will purchase additional death benefit which will increase the death benefit of the policy to the named beneficiary.
Permanent is life insurance that remains in force (in-line) until the policy matures (pays out), unless the owner fails to pay the premium when due (the policy expires OR policies lapse). The policy cannot be canceled by the insurer for any reason except fraud in the application, and that cancellation must occur within a period of time defined by law (usually two years). Permanent insurance builds a cash value that reduces the amount at risk to the insurance company and thus the insurance expense over time. This means that a policy with a million dollars face value can be relatively inexpensive to a 70 year old because the actual amount of insurance purchased is much less than one million dollars. The owner can access the money in the cash value by withdrawing money, borrowing the cash value, or surrendering the policy and receiving the surrender value.
The three basic types of permanent insurance are whole life, universal life, and endowment.
Temporary or 'term assurance' provides for life insurance coverage for a specified term of years for a specified premium. The policy does not accumulate cash value. Term is generally considered "pure" insurance, where the premium buys protection in the event of death and nothing else. (See Theory of Decreasing Responsibility and buy term and invest the difference.) Term insurance premiums are typically low because both the insurer and the policy owner agree that the death of the insured is unlikely during the term of coverage.
The three key factors to be considered in term insurance are: face amount (protection or death benefit), premium to be paid (cost to the insured), and length of coverage (term).
Various (U.S.) insurance companies sell term insurance with many different combinations of these three parameters. The face amount can remain constant or decline. The term can be for one or more years. The premium can remain level or increase. A common type of term is called annual renewable term. It is a one year policy but the insurance company guarantees it will issue a policy of equal or lesser amount without regard to the insurability of the insured and with a premium set for the insured's age at that time. Another common type of term insurance is mortgage insurance, which is usually a level premium, declining face value policy. The face amount is intended to equal the amount of the mortgage on the policy owner’s residence so the mortgage will be paid if the insured dies.
A policy holder insures his life for a specified term. If he dies before that specified term is up, his estate or named beneficiary(ies) receive(s) a payout. If he does not die before the term is up, he receives nothing. In the past these policies would almost always exclude suicide. However, after a number of court judgments against the industry, payouts do occur on death by suicide (presumably except for in the unlikely case that it can be shown that the suicide was just to benefit from the policy). Generally, if an insured person commits suicide within the first two policy years, the insurer will return the premiums paid. However, a death benefit will usually be paid if the suicide occurs after the two year period.
Life insurance may be divided into two basic classes – temporary and permanent or following subclasses - term, universal, whole life, variable, variable universal and endowment life insurance.
Outside the United States, the specific uses of the terms "insurance" and "assurance" are sometimes confused. In general, in these jurisdictions "insurance" refers to providing cover for an event that might happen, while "assurance" is the provision of cover for an event that is certain to happen. However, in the United States both forms of coverage are called "insurance".
When a person insures the contents of their home they do so because of events that might happen (fire, theft, flood, etc.) They hope their home will never be burglarized, or burn down, but they want to ensure that they are financially protected if the worst happens. This example of insurance shows how it is a way of spending a little money to protect against the risk of having to spend a lot of money.
When a person insures their life they do so knowing that one day they will die. Therefore a policy that covers death is assured to make a payment. The policy offers assurance on death; even if the policy has a prescribed termination date the policy is still assured to pay on death and therefore is an assurance policy. Examples include Term Assurance and Whole Life Assurance. An accidental death policy is not assured to pay on death as the life insured may not die through an accident, therefore it is an insurance policy.
A policy might also be assured for other reasons. For example an endowment policy is designed to provide a lump sum on maturity. Under certain types of policy the lump sum is guaranteed. Therefore, this may also be called an assurance policy.
The test of whether a policy is assurance or insurance is that with an assurance policy the insured event will definitely occur (at some point) whereas with an insurance policy there is a risk the insured event might occur.
With regard to Whole Life policies, the question is not whether the insured event (in this case death) will occur, but simply when. If the policy has nonforfeiture values (or cash values) then the policy is assured to pay.
During recent years, the distinction between the two terms has become largely blurred. This is principally due to many companies offering both types of policy, and rather than refer to themselves using both insurance and assurance titles, they instead use just one.
Upon the insured's death, the insurer requires acceptable proof of death before it pays the claim. The normal minimum proof required is a death certificate and the insurer's claim form completed, signed (and typically notarized).[citation needed] If the insured's death is suspicious and the policy amount is large, the insurer may investigate the circumstances surrounding the death before deciding whether it has an obligation to pay the claim.
Proceeds from the policy may be paid as a lump sum or as an annuity, which is paid over time in regular recurring payments for either a specified period or for a beneficiary's lifetime
The insurer (the life insurance company) calculates the policy prices with an intent to fund claims to be paid and administrative costs, and to make a profit. The cost of insurance is determined using mortality tables calculated by actuaries. Actuaries are professionals who employ actuarial science, which is based in mathematics (primarily probability and statistics). Mortality tables are statistically-based tables showing expected annual mortality rates. It is possible to derive life expectancy estimates from these mortality assumptions. Such estimates can be important in taxation regulation.[1] [2]
The three main variables in a mortality table have been age, gender, and use of tobacco. More recently in the US, preferred class specific tables were introduced. The mortality tables provide a baseline for the cost of insurance. In practice, these mortality tables are used in conjunction with the health and family history of the individual applying for a policy in order to determine premiums and insurability. Mortality tables currently in use by life insurance companies in the United States are individually modified by each company using pooled industry experience studies as a starting point. In the 1980s and 90's the SOA 1975-80 Basic Select & Ultimate tables were the typical reference points, while the 2001 VBT and 2001 CSO tables were published more recently. The newer tables include separate mortality tables for smokers and non-smokers and the CSO tables include separate tables for preferred classes. [3]
Recent US select mortality tables predict that roughly 0.35 in 1,000 non-smoking males aged 25 will die during the first year of coverage after underwriting.[2] Mortality approximately doubles for every extra ten years of age so that the mortality rate in the first year for underwritten non-smoking men is about 2.5 in 1,000 people at age 65.[3] Compare this with the US population male mortality rates of 1.3 per 1,000 at age 25 and 19.3 at age 65 (without regard to health or smoking status).[4]
The mortality of underwritten persons rises much more quickly than the general population. At the end of 10 years the mortality of that 25 year-old, non-smoking male is 0.66/1000/year. Consequently, in a group of one thousand 25 year old males with a $100,000 policy, all of average health, a life insurance company would have to collect approximately $50 a year from each of a large group to cover the relatively few expected claims. (0.35 to 0.66 expected deaths in each year x $100,000 payout per death = $35 per policy). Administrative and sales commissions need to be accounted for in order for this to make business sense. A 10 year policy for a 25 year old non-smoking male person with preferred medical history may get offers as low as $90 per year for a $100,000 policy in the competitive US life insurance market.
The insurance company receives the premiums from the policy owner and invests them to create a pool of money from which it can pay claims and finance the insurance company's operations. Contrary to popular belief, the majority of the money that insurance companies make comes directly from premiums paid, as money gained through investment of premiums can never, in even the most ideal market conditions, vest enough money per year to pay out claims.[citation needed] Rates charged for life insurance increase with the insured's age because, statistically, people are more likely to die as they get older.
Given that adverse selection can have a negative impact on the insurer's financial situation, the insurer investigates each proposed insured individual unless the policy is below a company-established minimum amount, beginning with the application process. Group Insurance policies are an exception.
This investigation and resulting evaluation of the risk is termed underwriting. Health and lifestyle questions are asked. Certain responses or information received may merit further investigation. Life insurance companies in the United States support the Medical Information Bureau (MIB) [4], which is a clearinghouse of information on persons who have applied for life insurance with participating companies in the last seven years. As part of the application, the insurer receives permission to obtain information from the proposed insured's physicians.[5]
Underwriters will determine the purpose of insurance. The most common is to protect the owner's family or financial interests in the event of the insured's demise. Other purposes include estate planning or, in the case of cash-value contracts, investment for retirement planning. Bank loans or buy-sell provisions of business agreements are another acceptable purpose.
Life insurance companies are never required by law to underwrite or to provide coverage to anyone, with the exception of Civil Rights Act compliance requirements. Insurance companies alone determine insurability, and some people, for their own health or lifestyle reasons, are deemed uninsurable. The policy can be declined (turned down) or rated.[citation needed] Rating increases the premiums to provide for additional risks relative to the particular insured.[citation needed]
Many companies use four general health categories for those evaluated for a life insurance policy. These categories are Preferred Best, Preferred, Standard, and Tobacco.[citation needed] Preferred Best is reserved only for the healthiest individuals in the general population. This means, for instance, that the proposed insured has no adverse medical history, is not under medication for any condition, and his family (immediate and extended) have no history of early cancer, diabetes, or other conditions.[citation needed] Preferred means that the proposed insured is currently under medication for a medical condition and has a family history of particular illnesses.[citation needed] Most people are in the Standard category.[citation needed] Profession, travel, and lifestyle factor into whether the proposed insured will be granted a policy, and which category the insured falls. For example, a person who would otherwise be classified as Preferred Best may be denied a policy if he or she travels to a high risk country.[citation needed] Underwriting practices can vary from insurer to insurer which provide for more competitive offers in certain circumstances.
Life insurance contracts are written on the basis of utmost good faith. That is, the proposer and the insurer both accept that the other is acting in good faith. This means that the proposer can assume the contract offers what it represents without having to fine comb the small print and the insurer assumes the proposer is being honest when providing details to underwriter.[citation needed]
Special provisions may apply, such as suicide clauses wherein the policy becomes null if the insured commits suicide within a specified time (usually two years after the purchase date; some states provide a statutory one-year suicide clause). Any misrepresentations by the insured on the application is also grounds for nullification. Most US states specify that the contestability period cannot be longer than two years; only if the insured dies within this period will the insurer have a legal right to contest the claim on the basis of misrepresentation and request additional information before deciding to pay or deny the claim.
The face amount on the policy is the initial amount that the policy will pay at the death of the insured or when the policy matures, although the actual death benefit can provide for greater or lesser than the face amount. The policy matures when the insured dies or reaches a specified age (such as 100 years old).
There is a difference between the insured and the policy owner (policy holder), although the owner and the insured are often the same person. For example, if Joe buys a policy on his own life, he is both the owner and the insured. But if Jane, his wife, buys a policy on Joe's life, she is the owner and he is the insured. The policy owner is the guarantee and he or she will be the person who will pay for the policy. The insured is a participant in the contract, but not necessarily a party to it.
The beneficiary receives policy proceeds upon the insured's death. The owner designates the beneficiary, but the beneficiary is not a party to the policy. The owner can change the beneficiary unless the policy has an irrevocable beneficiary designation. With an irrevocable beneficiary, that beneficiary must agree to any beneficiary changes, policy assignments, or cash value borrowing.
In cases where the policy owner is not the insured (also referred to as the cestui qui vit or CQV), insurance companies have sought to limit policy purchases to those with an "insurable interest" in the CQV. For life insurance policies, close family members and business partners will usually be found to have an insurable interest. The "insurable interest" requirement usually demonstrates that the purchaser will actually suffer some kind of loss if the CQV dies. Such a requirement prevents people from benefiting from the purchase of purely speculative policies on people they expect to die. With no insurable interest requirement, the risk that a purchaser would murder the CQV for insurance proceeds would be great. In at least one case, an insurance company which sold a policy to a purchaser with no insurable interest (who later murdered the CQV for the proceeds), was found liable in court for contributing to the wrongful death of the victim (Liberty National Life v. Weldon, 267 Ala.171 (1957)).
Life insurance or life assurance is a contract between the policy owner and the insurer, where the insurer agrees to pay a sum of money upon the occurrence of the insured individual's or individuals' death or other event, such as terminal illness or critical illness. In return, the policy owner (or policy payer) agrees to pay a stipulated amount called a premium at regular intervals or in lump sums. There may be designs in some countries where bills and death expenses plus catering for after funeral expenses should be included in Policy Premium. In the United States, the predominant form simply specifies a lump sum to be paid on the insured's demise.
As with most insurance policies, life insurance is a contract between the insurer and the policy owner (policyholder) whereby a benefit is paid to the designated Beneficiary (or Beneficiaries) if an insured event occurs which is covered by the policy. To be a life policy the insured event must be based upon life (or lives) of the people named in the policy.
Insured events that may be covered include:
* Sickness
Life policies are legal contracts and the terms of the contract describe the limitations of the insured events. Specific exclusions are often written into the contract to limit the liability of the insurer; for example claims relating to suicide, fraud, war, riot and civil commotion.
Life based contracts tend to fall into two major categories:
* Protection policies - designed to provide a benefit in the event of specified event, typically a lump sum payment. A common form of this design is term insurance.
* Investment policies - where the main objective is to facilitate the growth of capital by regular or single premiums. Common forms (in the US anyway) are whole life, universal life and variable life policies.
A mutual fund is a professionally-managed firm of collective investments that collects money from many investors and puts it in stocks, bonds, short-term money market instruments, and/or other securities.[1] After realizing capital gains or losses, the investment proceeds are then passed along to the individual investors annually, through the fund manager, also known as the portfolio manager. The value of the mutual fund, known as the net asset value per share (NAV), is calculated daily based on the total value of the fund divided by the number of shares currently outstanding.
Since, the Investment Company Act of 1940 a mutual fund is one of three basic types of investment companies available in the United States.[2] However, outside of the United States (with the exception of Canada, which follows the U.S. model), mutual fund may be used as a generic term for various types of collective investment vehicle. In the United Kingdom and western Europe (including offshore jurisdictions), other forms of collective investment vehicle are prevalent, including unit trusts, open-ended investment companies (OEICs), SICAVs and unitized insurance funds. In Australia and New Zealand the term "mutual fund" is generally not used; the name "managed fund" is used instead.
Here are some things that you could consider when you are choosing what to invest in:
Company accounting
Risk
Company valuations
Economic indicators
Trading tactics
Disclaimer
The content of the Education section of this site is intended to be of a general nature and no warranties or representations are give as to the accuracy of the content. Content on this page is based upon information originally provided by Intuition Publishing Limited ©. It is provided without liability on our part or that of Intuition Publishing Limited, and should not be regarded as specific investment advice or a personal recommendation of any kind.
Some knowledge of accounting is crucial for profitable investing.
Ultimately, a company's earnings or profits often drive its stock price. Profits are the amount left over after the company has paid all its expenses.
Remember that a company's earnings can be affected by one-off gains or losses. That means it is important to look at trends over a long periods to assess the company's underlying profitability.
Company reports and brokers' reports are good sources of accounting information. If you have a BrokerLine account, you can access a range of company information from this site. Just log in to your account and choose News and Research.
When choosing what to invest in, you might also want to consider the profits and profitability and cashflow.
There are two types of risks to consider when investing in the stock market - the market risk and unique risks.
Market risk
The values of individual stocks often tend to move in the same general direction as the overall market. And it is unusual for individual stocks to move markedly against the movement of the FTSE 100. That's because they are all driven by the same factors that affect the overall health of the economy (inflation, interest rates, GNP figures, etc). There is obviously a risk that the market overall could fall. That is called the market risk.
Unique risk
Unique risk is specific to a particular stock. For example, if a car manufacturer's production is disrupted by a strike, it would be a source of unique risk because it would only affect that particular manufacturer. Other sources of unique risk include mistakes by company management, new inventions by a competing company and law suits.
In general terms, the riskier an investment, the higher return an investor should expect for taking on that risk.
An investment risk is the possibility that the security (stock or bond) will default or depreciate significantly in value. But in order to assess just what return is required to compensate you for taking a risk, you need to work from a benchmark rate. This rate is known as the risk-free rate.
Risk-free rate
The risk-free rate usually corresponds to the rate available on a risk-free investment. In most cases it corresponds to the rate paid on long-term government bonds, which are considered relatively risk-free.
Risk premiums
The risk premium is essentially the reward an investor expects for taking on risk. This premium depends on the amount a security can be expected to deviate from its purchase price.
Risk-adjusted return
Higher-risk investments (such as small-cap stocks) can be expected to be far more volatile than a government bond, so investors will expect a return - for example, 15% - greater than the risk-free rate.
If a government bond provides a return of 5%, then the risk-adjusted return for the higher-risk investment is 15% - 5% = 10%.
Risk-adjusted returns are not quoted anywhere because they are theoretical, but try to apply the concept when making investment decisions. Estimate the risk-adjusted return by comparing the investment return you are looking at with a risk-free return. Then you need to decide if that return is adequate compensation for taking on the risk.
Unique risk
Diversification can reduce the unique risks of individual investments. That means spreading your money over a number of investments.
Market risk
Diversifying your portfolio will not eliminate market risk. You may be able to reduce market risk by switching your money into less risky investments such as government or savings bonds, but you will have to settle for lower returns.
Risk means the probability that you will lose money on an investment. A more technical definition of risk is the volatility of return on the investment. An asset with erratic returns is considered riskier than an asset whose value is static or moves slowly.
Few investments are risk-free. Investing in stocks, in particular, means accepting some level of risk. If you want to make a killing in the stock market, you are going to have to take risks. If you keep all your life savings in safe investments such as a savings account, you will face virtually no risk, but your returns will be small, and inflation will eat away at the value of your deposit.
There is a trade-off between risk and return. Less risk means less return, while taking on more risk brings the possibility of a higher return.
Levels of risk are a personal decision. They may be affected by your age, investment goals, time of life and how much you can afford to lose.
It is notoriously difficult to value start-ups. Typically, most start-ups make losses for several years, yet many technology start-ups, for example, can have huge valuations.
In the absence of profits, many analysts focus on sales growth as a measure of future growth potential, and this is reflected in the sales-to-stock price ratio.
Sales-to-stock-price ratios
The sales-to-stock-price ratio is calculated by dividing the total annual sales per share by the stock price. To calculate the annual sales per share, divide the annual sales total by the number of shares. So if the company made sales of £10 million and has a total issue of one million shares, than the annual sales-per-share figure is £10.
To calculate the sales-to-stock-price ratio, divide the annual sales-per-share figure by the stock price. So if the same company had a stock price of £20, its sales-to-stock-price ratio would be 0.5.
It is a good idea to compare this ratio to other ratios in the industry. As sales increase, so the sales-to-stock price ratio increases, setting off a further increase in the stock price.
Many analysts contend that the only meaningful value of a company is the value the stock market puts on it. That value is known as market capitalisation and is simply the number of shares in issue multiplied by the market price per share.
If not all of the company shares are available to the public (free float or free capital) then the market capitalisation figure is adjusted upward to take account of this.
If not all of the company shares are available to the public (free float or free capital) then the market capitalisation figure is adjusted upward to take account of this.
Stock prices are constantly fluctuating, so market capitalisations also fluctuate.
Investors try to find companies that are undervalued before other investors. There are a number of common techniques, but valuing a company remains highly subjective. Often it comes down to a matter of opinion.
At the simplest level, a company is worth the value of its assets minus its liabilities. That's called its book value.
Book value is the amount of money that would be available to shareholders if the company's assets (excluding intangibles such as copyright and patents) were sold at their balance-sheet value and all liabilities were paid. For example, if a company has assets of £50m and liabilities of £30m, then the company's book value is £20m.
Book value is often expressed in terms of book value per share (book value divided by the number of outstanding shares). The market price per share is then compared to the book value per share. This is known as the price-to-book value ratio. It is calculated by dividing the price per share by the book value per share.
For example, if the market price of a share is £10, and the book value per share is £5, the price-to-book value ratio is 2. Each business sector typically has an average price-to-book value ratio. Banks, for example, have a low price-to-book ratio of around 1.5, while technology stocks would have a much higher ratio.
Limitations of book value
A major drawback with book value is that it is difficult to value assets accurately. There are a variety of legitimate accounting techniques for measuring tangible assets, all of which arrive at different valuations. It may be unrealistic to assume that the value of a tangible company asset on the balance sheet equals the value it would fetch if it were to be sold off.
The percentage and earnings (P/E) ratio shows the number of years' earnings per share (EPS) contained in the current share price. In other words, it shows the number of years at current earnings needed to cover the current share price.
The price/earnings ratio (P/E ratio) is commonly used to assess the level of confidence investors have in a company. It represents the market's view of a company's growth potential. Investors try to identify undervalued stocks by comparing P/E ratios between companies and across business sectors.
A high price/earnings ratio indicates that investors have a high level of confidence in a company's future. But while a company with a high P/E ratio relative to its sector may have exciting growth prospects, it might equally be considered to be overvalued depending on the prevailing market circumstances. So while P/E can be a useful measure of a company's value, it should also be treated with caution.
How is the P/E ratio calculated?
To calculate P/E ratio, divide the stock price by the post-tax earnings per share (EPS). To calculate earnings per share, divide a company's 12-month earnings by the number of outstanding shares.
If a company's earnings are £2 million and the number of outstanding shares is 1 million, it has an earnings-per-share figure of £2.
Now you can work out the P/E ratio by dividing the stock price by the EPS. So if the stock price is £30 and the EPS is £2, then the P/E ratio is 15.
Using the P/E ratio
Like most performance indicators, the P/E ratio is most revealing if it is monitored over a long period. That way, it is possible to uncover trends rather than relying on snapshots of a given moment.
When using P/E to analyse companies, always use consistent information. Most P/E figures are reported using 'trailing' earnings (ie, the earnings for the past 12-month period). But some brokers report P/E figures on 'leading' earnings (ie, the projected earnings for the next reporting period).
It's also wise to eliminate any one-off gains or losses when comparing P/E ratios so that you can arrive at an accurate earnings figure.
New valuation measures
P/E ratios vary dramatically between sectors. For example, the high-tech economy has seen high valuations of companies that are making huge losses. Some brokers have even begun to calculate negative P/E ratios in order to compare these companies. Other brokers simply refuse to quote a P/E ratio for a loss-maker.
Companies have traditionally been valued using P/E multiples, but it is now commonplace to value companies on the basis of projected turnover - even though they may be making big losses. Meanwhile, high-tech companies that are actually making money carry extremely high P/E multiples.
These measures are a long way removed from standard practice, and their usefulness is questionable. It is vital to exercise discretion and apply balanced judgment when relying on P/E multiples for investment decisions.
There are many factors that might influence your decision to invest in a company - including the company's percentage and earning (P/E) ratio, its book value and market capitalisation. You might also examine sales, profitability and return on investment.
Obviously, the amount of money in the economy has a significant impact on economic activity.
Excessive growth in the money supply often causes inflation as it means that the public has increased spending power. On the other hand, sharp cuts in the money supply can cool off an overheating economy, or even lead to a recession.
If the economy is doing well, a fall in the money supply will be welcomed by the stock market, because it will probably lead to lower inflation rates. Conversely, if the money supply increases when the economy is doing well, investors will be concerned that excess available money will mean higher inflation rates.
Subscribe to:
Comments (Atom)