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Delta-Gamma – Delta-Gamma Approximation Helps with Derivative Analysis

Okay, if you are looking for “delta gamma” you are looking for one of two things: the Delta Gamma sorority or the Greek options used in financing. This article works to explain the delta-gamma approximation in investing analysis.

Derivatives make up a significant part of the portfolio value of major investors as well as average ones. Derivative instruments are those financial instruments that get their value from the value of another financial instrument. For example, a stock option is a derivative because it gets its real value from the current value of the stock. The stock itself is a cash instrument, not derivative. The trading value of the derivative can vary in different ways from the actual underlying instrument from which it gets its underlying value.

To understand the way that the value of a derivative will fluctuate based on the value of the underlying instrument, financial analysts developed different ways to measure the sensitivity of the derivative to the changes in value of the underlying security. Two of those measurements are the delta and the gamma.

Delta measures the sensitivity of an option’s theoretical value to the underlying change in price of the asset. There are two ways to display delta. It is either between -1 and 1 or between -100 and 100. In either measurement, the idea is to show how much value you would gain or lose if the underlying financial instrument gains $1 of value.

Gamma is a calculus formula that compares an entire portfolio’s value with the value of an underlying asset. The value of gamma is actually the second derivative of the portfolio’s value divided by the value of the underlier.

When brought together, the delta and gamma offer a good approximation of how much a portfolio’s value will change in response to underlying asset value changes. To calculate the delta-gamma approximation, there are several items to consider:

  1. Original stock price
  2. Stock price after change
  3. Call option price
  4. Different from original stock price and stock price after change
  5. Delta calculation
  6. Gamma calculation

The formula used is as follows:

C(St+h) = C(St) + є∆(St) + (1/2)є2Γ(St)

This is a theoretical calculation. However, many investors find this approximation, in combination with other calculation can provide a good indication of what will happen to a portfolio if an underlying asset value changes. The delta and gamma calculations alone give great information. Together, they are even better.

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Debt to Equity Ratio Explained – Debt to Equity Ratio Explained in Simple Terms

When looking at financial reports, one of the measures that experienced investors consider about any company is the debt to equity ratio. However, what exactly is it?

In simple terms, this number calculates as follows:

Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity

In some cases, the financial reports may use a slightly different calculation:

Debt to Equity Ratio = Long-Term Debt / Shareholder’s Equity

The reason for taking this calculation is to measure how much of the company’s equity is leveraged for debt. The higher this ratio number, the higher the amount of leveraged equity exists. And, in general, the higher the amount of leveraged equity the more likely the chance is of a company having liquidity problems. On the other hand, having too low a debt to equity ratio can mean the company is not leveraging its equity enough. That can slow growth and indicate a lack of management focus.

Debt is not a bad thing for companies. It can offer chances to expand in new directions. It offers the ability to increase shareholder returns also. Smart use of debt is a great opportunity for a company to remain healthy. However, during times of financial crisis, too much debt can cause problems in meeting debt payments and can bring a company into the red zone. Managing debt amounts is important for any company, large or small. Smart management means growth. Poor management can mean bankruptcy.

When looking at the debt-to-equity ratio, you also need to take your comfort level for risk into consideration. A higher than average ratio means a bit more risk is involved with investing in a particular company. Much higher than average ratios present much higher risk.

Understand it from the other side of the equation. When you go out and get a mortgage, your debt to equity ratio makes a big difference in whether a company is willing to give you a mortgage or not. If you already have a great deal of debt, the company may not want to give you a mortgage due to the high level of risk you present. If the mortgage company will give you a mortgage, it may be at a high interest rate in order to cover the risk you present. You pay that price when you carry a great deal of debt without much equity in your assets. A company pays the price when they try to get investors.

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Collateralized Debt Obligations (CDO’S) – Understanding Collateralized Debt Obligations

When looking at investment options, you may have come across the term collateralized debt obligations or CDO.

What are collateralized debt obligations? This is an investment security with underlying bonds, loans, and other collateralized debt. They generally do not contain mortgage loans or bonds. The mixture completely depends on the particular CDO in question. Depending on the particular CDO, the mixture contains a good blend of debts with different maturity dates and differing risks associated with them. The higher the risk that the overall CDO presents, the more it will pay to the investor in the long term.

Before the recent economic issues, many CDOs contained mortgage backed loans in their mix. The number of CDOs grew a great deal before 2007. During the mortgage bust in the US, many of these collateralized debt obligations lost a great deal of their value. Today, there are fewer of these instruments available on the market. And the vast majority does not have mortgage backed securities in their portfolio.

You will find there are multiple forms of collateralized debt obligations from which you can select if you choose to go with this investment option. There are four primary forms of these obligations:

  1. Collateralized loan obligations (CLO) have leveraged bank loans as their main underlying asset.
  2. Collateralized synthetic obligations (CSO) have a mixture of credit derivatives as their underliers.
  3. Structured finance CDOs are those backed by asset backed securities and mortgage backed securities
  4. Collateralized bond obligations (CBO) are backed by fixed income assets.

Each of these brings their own mixture of benefits and risks to the average investors. Before the mortgage bust, most of these products fell into the structured finance area or the CLO area. Today, the mixture is much diversified.

Typical collateralized debt obligations are an offering of an investment bank. The bank structures the CDO with a mixture of debt obligations. They determine what level of risk they will present to the investor. The new CDO goes to the credit rating agencies to see what ratings will go with each underlying investment. When it’s ready, the bank appoints an asset manager to keep the CDO on track. The investors then get the chance to buy the financial instrument as an investment.

Before investing in collateralized debt obligations, it is important to know exactly what the CDO offers as well as the associated risks. Speaking with investment professionals is a good way to get that information clearly.

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Buying Puts to Protect a Portfolio

One day the stock market is up. The next day it’s down. While ups and downs are part of the stock market, wild swings can give even the most hardened investor a bit of upset. In order to combat those wild swings, there are financial instruments you can put in your portfolio to help keep your portfolio on healthy during the worst swings in the market. These are called put options, or puts.

What are put options? Put options are stock derivatives. When you buy puts, you get the right to sell a specific amount of the underlying stock at a predetermined “strike price.” You buy put options in specific companies. These put options usually have a specific period associated with them from one to three months in length. During that time, you can opt to sell those underlying shares or not. If you do not do it in the specified time line, you just let the put option lapse. The only money you are out is the initial premium you paid for the put option.

So how does buying puts to protect a portfolio really work? There are two scenarios: the underlying stock price goes up or the underlying stock price goes down. Let’s look at each scenario and see how put options work.

If the price of the stock goes down, you will exercise your put options. For example, let’s say you bought a put option for one share of XYZ Co stock with a strike price of $100. The price on XYZ stock goes down to $90 per share. You can exercise your put option and sell the stock at $100. You have not lost the $10 per share in stock price loss on the general market by exercising the put.

What happens if the stock goes up? In this example, you bought another put option for one share of XYZ Co stock with a strike price of $100. The stock price for XYZ goes up to $110. What do you do then? You let the put option lapse. The put option would sell at $100 no matter what the price of the underlying stock was. So, you would not gain anything by exercising the put.

But who is silly enough to buy a stock that is worth less than the strike price? Actually, it’s the seller or underwriter of the put. They are placing the guarantee on the price and they are obligated to cover the price at which they offered the put.

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Auto Regressive Integrated Moving Average, the Model Explained.

You might have heard the phrase “auto regressive integrated moving average” in passing when looking through investment forums or magazines. This model is also known as ARIMA. The basic principle of this model is to predict behavior into the future based on past performance. In the world of economics and investing, it is a model often used to predict how well a certain investment or security will perform into the future based on the values of the past.

The ARIMA model has many uses outside of investing or economics. It is a general model that looks at the differences between successive values instead of the values themselves.

For example, let’s say you had three values that you measured successively: 2, 4, 5. The ARIMA model would look at the differences between the first and second values as well as the second and third. The difference between 2 and 4 is 2. The difference between 4 and 5 is 1. The model would look at those differences: the 2 and the 1. The model would try to predict, based on those past differences, what the next observed value in the series would be.

When you look at an investment, you want to have a good idea of what the future holds as to its value. In order to do that you can use the auto regressive integrated moving average model to predict the future value of the investment based on past performance. In order to do that, you need to have a good set of data. Many statisticians want at least 40 data points to get a good calculation within the ARIMA model. The more data points you have, the more likely the prediction will prove accurate.

Let’s say you are looking at a particular stock price. You can get stock prices for the past 40 weeks and plug it into an ARIMA model. With that data, the model can predict what the future trends for the stock price will be in the future. Of course, the further into the future that you try to predict, the less likely the prediction will be accurate.

Most investors use the ARIMA model for those types of investments that tend to have a narrow range of fluctuation. When looking at highly volatile investments, the ARIMA model is not accurate enough to use for any type of forecasting. Most investors use the ARIMA as one tool in their investment analysis process.

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The Proxy Statement – The Key to Knowing More about Your Investment

Unless you are pretty heavily involved in the stock market and investments, you might not have heard of the proxy statement before. The proxy statement is what all companies that are traded on the stock exchange have to release every year detailing some very important information. Some of the information that is included is:

  • Things that shareholders are in need of voting on
  • Biographical information for the Board of Directors for the company
  • The salary and benefit information for the company’s top executives
  • The amount of stock shares that are held by the top executives

All of this information is supposed to help the investor make an informed decision when it comes to deciding whether or not to initially invest their money in the company or if they want to continue investing money in it.

With all of the information included on the proxy statement, it is easy to see why it is considered to be probably the most interesting thing to do with investing. It tells you how much top executives of the company make and all of their benefits to being in their position. Information like that is highly sought out by some people, like gossip magazine reporters and other journalists. It seems like a way to justifiably be nosy about a company and its dealings. Of course, a potential investor and even current investors need to know if the company is being cheated out of money by the top executives. This has happened so many times before that it would make anyone a little gun shy about investing in major companies.

Not only does the proxy statement have to be released to current and potential investors, it also must be filed with the SEC. That way the current and potential investors know that the SEC is aware of what that company is doing and how much the top executives make. This is important because sometimes investors do not know everything that they should know about the information they see on the proxy statement. If the SEC notices something amiss, however, that is an extra protection for the investor.

If you are looking to invest your money into a company, it is definitely in your best interest to, not only read the proxy statement, but also to have a more knowledgeable person explain everything on the statement to you. That way there is no question about whether or not you understand the business dealings of the company in question and you can make an informed decision about investing in it.

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The Dow Theory – What Does the Dow Truly Mean?

People who invest in the stock market know all about the Dow Theory. This is what helps determine stock price. The sustainability of a publicly traded company and its futures depends heavily on what the theory determines for it. The theory is named after Charles H. Dow who was a journalist. He founded the Wall Street Journal and served as its first editor. During his time as editor of the Wall Street Journal, he wrote several editorials that served as the basis for the theory. Contrary to what some might believe, he never used the terminology himself nor did he think of the editorials as a theory of any kind. Instead, it was after his death that three other men collected the editorials and used them to base the theory on.

There are six aspects of the Dow Theory:

  1. The market has three movements – The first movement may last only less than a year, but then again it could last several years. The second movement is called the medium swing and lasts generally from 10 days to a few months. The third movement is called the short swing. It can vary by the hour, day or even by the month. All three movements can be going on at the same time.
  2. There are three phases to market trends – There is an accumulation phase, which is when investors who are considered to be in the know are buying and selling stock that goes against what the market determines. This phase generally has no change in stock price. The next phase is the public participation phase. This is when the public gets wind of what is going on and begins to buy and sell the same stocks. This causes the price to change significantly. The third phase is the distribution phase. This is when the initial investors sell their stocks back to the market.
  3. The stock market discounts news – Stock prices change on a regular basis because of new news that is made available.
  4. Stock market averages confirm one another – Profits and production/shipping values should be going in the same direction. If they are not, then that means there is change coming to that company and it is not safe to invest.
  5. Market trends are confirmed by volume – In the Dow Theory, it is believed that market trends depend on volume. If price movements come right along with high volume, this is believed to be the actual market value.
  6.  Market trends will exist until there are definite signals that they have ended – Just because a trend may move in an opposite direction for a short period of time, the Dow Theory suggests that it will eventually go back to its initial path. Of course, it is not easy to determine what a temporary trend is and what a permanent trend is.
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Stock Purchase Agreements – Everything You Need to Know About Stock Purchase Agreements

It is probably quite easy to figure out what stock purchase agreements are. These are contracts that transfer the sale of the stock from one party to another. If you invest in any type of stock, you will enter into stock purchase agreements with someone – probably even multiple people at one time. You are not limited to making these contracts for publicly held companies. You can also have them for privately held companies as well. So, that means they are not just for stocks traded on the exchange market.

Stock purchase agreements are contracts that detail not only the name of the stock and the date of the sale, but also the cost per share and how many shares were bought. This is an easy way to see how much your initial investment was in a company and to know when you begin seeing a return on your investment. There are also other things listed on the stock purchase agreement that dictates how the stocks can be used. Those who seek to buy stocks from a publicly held company are not restricted to doing so in a public market. Public companies can have private stock purchasers. It is just best if all stock purchases for a public company are done publicly to keep everything out in the open.

Something to look out for with private companies that you do not have to worry about with public ones is that the stock has no standard for being valued. The private company can slap any price on the share of stock and you would be none the wiser because there are no standards that private companies have to meet. So, you should definitely be alert and beware when entering into stock purchase agreements with a company that is privately held because you do not want to lose money.

As with any type of investment, entering into stock purchase agreements can be risky. You need to do your research on all companies that you plan to buy stock from, no matter if they are publicly held or privately held. The reason is that the stock be made to seem like it is worth more than it really is and you would end up losing, not just your initial investment, but also any hope of seeing a profit in the event that the company goes under. That is not something that any investor wants to see happen.

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Risk Based Pricing – A Helpful Explanation to Better Understand It

The idea of risk based pricing is when the lender determines the interest rate for a loan based upon the risk of the person defaulting on the loan. This is determined by the person’s credit rating. The person who is less likely to not pay back the loan will get a lower interest rate and have to pay less back to the bank in the long run. There are other factors that the lender takes into account when determining the interest rate in risk based pricing. They will also consider the person’s status of employment and possibly even the type of loan being requested.

The risk factors when determining risk based pricing are as follows:

  • Credit rating – How good your credit score is helps to determine the probability that you will pay back any money that is extended to you in a loan or as credit.
  • Loan amount – Usually, the more money you request in a loan, the higher your interest will be if you are determined to be at a higher risk for paying the money back.
  • Loan type – Generally, home loans have higher interest rates than automobile, motorcycle or boat loans do. Again, it goes back to how much money is being requested in the loan.
  • Type of property (if it’s a mortgage loan) – A private home will sometimes have higher interest than a business. The reason for this is because, again, the amount of funds being requested is generally less – unless you are buying a business building and everything in the business.

All of these things can have a tremendous impact on whether or not you are considered to be at a high risk for loan pricing and will affect your interest rate on the loan. The better off you are financially and the better you are at paying your bills, the better your chances are of not having a high interest rate on your loan.

The main concern about risk based pricing is that it makes it more difficult to find a better interest rate. If one lender determines you are at high risk, then others are likely to do the same. It is difficult to know if you can get a low interest rate based on this type of pricing because you do not know how you will measure up to their rating criteria. Even so, others argue that this is a good way to lend money as it enables the bank to get a return on a risky investment.

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Risk Adjusted Performance Measurement – What is It and Why is It Important?

If you are new to the stock exchange scene, then you might not have heard of the risk adjusted performance measurement. Furthermore, even if you have heard of it, you probably have no idea what it means. It may seem complicated, but really all risk adjusted performance measurement is is the way in which mutual funds are compared and evaluated. The formula is simple: take the performance of the mutual fund and factor in the risk level of the stocks that the fund is invested in.

Now that you know what the risk adjusted performance measurement is, you need to know why it is important. In case the definition did not demonstrate to you the importance of the risk adjusted performance measurement, here it is in a nutshell: If you do not weigh the risks of the stocks you invest in, you could end up taking a big fall on your investment. That means that, if you invest in a high-risk stock, you could end up losing all or most of your money. This is not a good thing. So you should always look at the amount of risk involved in a stock you are thinking of putting any of your money in, no matter how much money it is.

Usually, as the investor, you will not have to worry about computing the risk adjusted performance measurement yourself. That is what your stockbroker or trader is for. When you go in to make your stock selections, the broker should have the risk adjusted performance measurement for each stock already available for you to look at. Of course, since the stock market changes almost on an every minute basis, this information can change at the drop of a hat. However, unless drastic rises or falls happen with a stock, it should remain steady as to whether or not it is a high risk investment.

It really cannot be stressed enough how important it is for you to consider the risk adjusted performance measurement when you are making the decision on what stocks to invest your money in. Unless you just have money to burn, you really should not invest in high risk stocks. Sure, there is a chance that everything will turn out okay and you will at least make some sort of profit, but it is just too risky. When it comes to money, especially in this economy, you need to go with safer bets for your investment. At least that way you can be sure of getting at least a small return on your investment.

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