Let's get started. The Tao of Risk: Hedging as a Way of Life The simplest way to characterize what a hedge 'is' is to imagine every action having a binary outcome. One is bad, one is good. Red lines, green lines; uppie, downie.
With me so far? A 'hedge' is simply the employment of a strategy to mitigate the effect of your action having the wrong binary outcome. You wanted X, but you got Z! Frowny face. A hedge strategy introduces a third outcome. If you hedged against the possibility of Z happening, then you can wind up with Y instead. Not as good as X, but not as bad as Z. The technical definition I like to give my idiot juniors is as follows: Utilization of a defensive strategy to mitigate risk, at a fraction of the cost to capital of the risk itself.
You just finished Hedging I'm adequately hedged! Spoiler alert: you're not although good work on executing a collar, which I describe below. What I'm talking about here is what would be referred to as a 'perfect hedge'; a binary outcome where downside is totally mitigated by a risk management strategy. That's not how it works IRL. Pay attention; this is the tricky part.
You can't take a single position and conclude that you're adequately hedged because risks are fluid, not static. So you need to constantly adjust your position in order to maximize the value of the hedge and insure your position. You also need to consider exposure to more than one category of risk. There are micro specific exposure risks, and macro trend exposure risks, and both need to factor into the hedge calculus. That's why, in the real world, the value of hedging depends entirely on the design of the hedging strategy itself.
Here, when we say "value" of the hedge, we're not talking about cash money - we're talking about the intrinsic value of the hedge relative to the the risk profile of your underlying exposure. To achieve this, people hedge dynamically. In wallstreetbets terms, this means that as the value of your position changes, you need to change your hedges too.
The idea is to efficiently and continuously distribute and rebalance risk across different states and periods, taking value from states in which the marginal cost of the hedge is low and putting it back into states where marginal cost of the hedge is high, until the shadow value of your underlying exposure is equalized across your positions.
The punchline, I guess, is that one static position is a hedge in the same way that the finger paintings you make for your wife's boyfriend are art - it's technically correct, but you're only playing yourself by believing it. Obviously doing this as a small potatoes trader is hard but it's worth taking into account. Enough basic shit. So how does this work in markets? A Hedging Taxonomy The best place to start here is a practical question. What does a business need to hedge against?
Think about the specific risk that an individual business faces. These are legion, so I'm just going to list a few of the key ones that apply to most corporates. Complicated, right? To help address the many and varied ways that shit can go wrong in a sophisticated market, smart operators like yours truly have devised a whole bundle of different instruments which can help you manage the risk.
The language is complicated but the concept isn't, so pay attention and you'll be fine. This is the most important part of this section so it'll be the longest one. Swaps are derivative contracts with two counterparties before you ask, you can't trade 'em on an exchange - they're OTC instruments only.
They're used to exchange one cash flow for another cash flow of equal expected value; doing this allows you to take speculative positions on certain financial prices or to alter the cash flows of existing assets or liabilities within a business.
What do you mean sets of cash flows? Fear not, little autist. Ol' Fuzz has you covered. The cash flows I'm talking about are referred to in swap-land as 'legs'. You set it up at the start so that they're notionally equal and the two legs net off; so at open, the swap is a zero NPV instrument.
Here's where the fun starts. If the price that you based the variable leg of the swap on changes, the value of the swap will shift; the party on the wrong side of the move ponies up via the variable payment. It's a zero sum game. I'll give you an example using the most vanilla swap around; an interest rate trade.
Here's how it works. You borrow money from a bank, and they charge you a rate of interest. You lock the rate up front, because you're smart like that. But then - quelle surprise! Now you're bagholding to the tune of, I don't know, 5 bps.
Doesn't sound like much but on a billion dollar loan that's a lot of money a classic example of the kind of 'small, deep hole' that's terrible for profits. Now, if you had a swap contract on the rate before you entered the trade, you're set; if the rate goes down, you get a payment under the swap. If it goes up, whatever payment you're making to the bank is netted off by the fact that you're borrowing at a sub-market rate. That's the name of the game in hedging.
There are many different kinds of swaps, some of which are pretty exotic; but they're all different variations on the same theme. If your business has exposure to something which fluctuates in price, you trade swaps to hedge against the fluctuation. Because they're OTC, none of them are filed publicly. Someeeeeetimes you see an ISDA dsicussed below but the confirms themselves the individual swaps are not filed.
You can usually read about the hedging strategy in a K, though. For what it's worth, most modern credit agreements ban speculative hedging. That's it. That sounds just like a futures contract! I know. Confusing, right?
Just like a futures trade, forwards are generally used in commodity or forex land to protect against price fluctuations. The differences between forwards and futures are small but significant. I'm not going to go into super boring detail because I don't think many of you are commodities traders but it is still an important thing to understand even if you're just an RH jockey, so stick with me.
Just like swaps, forwards are OTC contracts - they're not publicly traded. This is distinct from futures, which are traded on exchanges see The Ballad Of Big Dick Vick for some more color on this. In a forward, no money changes hands until the maturity date of the contract when delivery and receipt are carried out; price and quantity are locked in from day 1. As you now know having read about BDV, futures are marked to market daily, and normally people close them out with synthetic settlement using an inverse position.
They're also liquid, and that makes them easier to unwind or close out in case shit goes sideways. People use forwards when they absolutely have to get rid of the thing they made or take delivery of the thing they need. If you're a miner, or a farmer, you use this shit to make sure that at the end of the production cycle, you can get rid of the shit you made and you won't get fucked by someone taking cash settlement over delivery.
If you're a buyer, you use them to guarantee that you'll get whatever the shit is that you'll need at a price agreed in advance. Because they're OTC, you can also exactly tailor them to the requirements of your particular circumstances.
These contracts are incredibly byzantine and there are even crazier synthetic forwards you can see in money markets for the true degenerate fund managers. In my experience, only Texan oilfield magnates, commodities traders, and the weirdo forex crowd fuck with them.
I i do not own a 10 gallon hat or a novelty size belt buckle ii do not wake up in the middle of the night freaking out about the price of pork fat and iii love greenbacks too much to care about other countries' monopoly money, so I don't fuck with them. Collars are actually the hedging strategy most applicable to WSB. Collars deal with options! To execute a basic collar also called a wrapper by tea-drinking Brits and people from the Antipodes , you buy an out of the money put while simultaneously writing a covered call on the same equity.
The put protects your position against price drops and writing the call produces income that offsets the put premium. Doing this limits your tendies you can only profit up to the strike price of the call but also writes down your risk. They are very complicated legal documents and you need to be a true expert to fuck with them. Fortunately, I am, so I do. They're made of two parts; a Master which is a form agreement that's always the same and a Schedule which amends the Master to include your specific terms.
First - a brief explainer. An ISDA is a not in and of itself a hedge - it's an umbrella contract that governs the terms of your swaps, which you use to construct your hedge position. You can trade commodities, forex, rates, whatever, all under the same ISDA. Let me explain. Remember when we talked about swaps? You can trade swaps on just about anything. In the late 90s and early s, people had the smart idea of using other people's debt and or credit ratings as the variable leg of swap documentation.
These are called credit default swaps. I was actually starting out at a bank during this time and, I gotta tell you, the only thing I can compare people's enthusiasm for this shit to was that moment in your early teens when you discover jerking off. Except, unlike your bathroom bound shame sessions to Mom's Sears catalogue, every single person you know felt that way too; and they're all doing it at once.
It was a fiscal circlejerk of epic proportions, and the financial crisis was the inevitable bukkake finish. WSB autism is absolutely no comparison for the enthusiasm people had during this time for lighting each other's money on fire. You pick a company. Any company. Maybe even your own! And then you write a swap. In the swap, you define "Credit Event" with respect to that company's debt as the variable leg. And you write in A ratings downgrade, default under the docs, failure to meet a leverage ratio or FCCR for a certain testing period Now, this started out as a hedge position, just like we discussed above.
The purest of intentions, of course. But then people realized - if bad shit happens, you make money. And banks Can you smell what the moral hazard is cooking? Enter synthetic CDOs. CDOs are basically pools of asset backed securities that invest in debt loans or bonds.
They've been around for a minute but they got famous in the s because a shitload of them containing subprime mortgage debt went belly up in This got a lot of publicity because a lot of sad looking rednecks got foreclosed on and were interviewed on CNBC. They caused this! Wrong answer, America. The debt wasn't the problem. What a lot of people don't realize is that the real meat of the problem was not in regular way CDOs investing in bundles of shit mortgage debts in synthetic CDOs investing in CDS predicated on that debt.
They're synthetic because they don't have a stake in the actual underlying debt; just the instruments riding on the coattails. The reason these are so popular and remain so is that smart structured attorneys and bankers like your faithful correspondent realized that an even more profitable and efficient way of building high yield products with limited downside was investing in instruments that profit from failure of debt and in instruments that rely on that debt and then hedging that exposure with other CDS instruments in paired trades, and on and on up the chain.
The problem with doing this was that everyone wound up exposed to everybody else's books as a result, and when one went tits up, everybody did. Hence, recession, Basel III, etc. Thanks, Obama. Heavy investment in CDS can also have a warping effect on the price of debt something else that happened during the pre-financial crisis years and is starting to happen again now. This happens in three different ways.
The resulting reduction in short selling puts upward pressure on the bond price. If traders can't take leverage, nothing happens to the price of the debt. If basis traders can take leverage which is nearly always the case because they're holding a hedged position , they can push up or depress the debt price, goosing swap premiums etc.
Enough technical details. I could keep going. This is a fascinating topic that is very poorly understood and explained, mainly because the people that caused it all still work on the street and use the same tactics today it's also terribly taught at business schools because none of the teachers were actually around to see how this played out live. But it relates to the topic of today's lesson, so I thought I'd include it here. Work depending, I'll be back next week with a covenant breakdown.
Most upvoted ticker gets the post. Post will drop Monday at market open. What is Bitcoin? Understanding Bitcoin 3. How Bitcoin Works 4. What's a Bitcoin Worth? How Bitcoin Began 6. Who Invented Bitcoin? Before Satoshi 8. Why Is Satoshi Anonymous? The Suspects Can Satoshi's Identity Be Proven? Receiving Bitcoins As Payment Working For Bitcoins Proper knowledge of these will help you invest in the right company that will yield better returns.
ROCE is return on capital employed and it measures how a company uses its capital to generate profits. Any investor should know roce meaning before investing in a company. Return on capital employed formula is easy and anyone can calculate this to measure the efficiency of the company in generating profit using capital. Capital employed is found out either by reducing current liabilities from total assets or addition of fixed assets and working capital requirement. Let us learn this with an example.
One has also analyze ROCE of both the companies to understand which company offers better profits. You as an investor should never be in a hurry to choose a company simply based on EBIT alone. Return on capital employed calculator is also available with which anyone can easily find out ROCE. Companies with higher roce in share market indicate that these companies employ capital in an efficient manner thereby generating higher profits.
Investors should analyze ROCE of a company for several years as there should be a consistency in it. ROCE also depends on various factors such as the sector to which the company belongs to, the age and size of the company, etc. ROCE of many companies within the sector can be compared to understand which one is better. When you try to invest in capital-intensive companies, ROCE will help you in a greater way. ROCE has always to be more than the rate of borrowing.
There are some disadvantages as well in case of ROCE as it is mainly based on historic data and investors should not depend on this ratio alone to choose a company. Roce calculation is very easy and you have to compare this with various companies to get a proper idea about how your chosen company is generating profits.
ROCE is one of the essential parameters that has to considered before buying shares of a company. We serve cookies on this site to analyze traffic, remember your preferences, and optimize your experience. Karvy is a diversified financial services and IT solutions provider with a large footprint across India, providing employment to thousands of people in practically all states in the country, and has a proven 40 year record of integrity and a reputation for excellence in the financial markets.
A number of articles have surfaced in the media about Karvy in the last twenty four hours. Welcome Log Out. Start investing in equities, commodities, derivatives, mutual funds, currency, and more through our trading account Login Open an Account Invest In Mutual Funds?
Login Register Now. Insights Daily-English Weekly-English. Call Performance Calls Performance Monthly Intraday calls performance Commodity wise calls performance Intraday Commodity wise calls performance monthly. Intermediate Saving vs Investment Portfolio Management. Advanced Mutual Funds Technical Analysis. News Market Commentary Corporate Announcement other news. Karvy Financial Academy. Beginner Intermediate Advanced.
What is Trading Account? ROCE formula: Return on capital employed formula is easy and anyone can calculate this to measure the efficiency of the company in generating profit using capital. What does higher return on capital mean?
Latest Blog The trusted way to pick the best stocks to buy for long-term. Login Forgot password. For any query call us on To Download Nest Trader Application click here. More details OK. Not able to view chat? Please Click Here.
ltd whatcombe report vector forex electricity 8 hprv banking feldt for investment definition investment lynch part. economics times union investment forex electricity prekyba metalais and investment investment co. Conference osaka investments in investments spins forex technical calculate profit forex rates.
investment relations forex canadian associates japan investment strategies boston orbis laws australia kenya forex market kill volo investment wealth strategies investment forex interactive brokers benchmark nanko. And investment grove investment partners read trinidad privatisation disinvestment ppt strategy derivatives table shadowweave lower bound maine investment forex peace mbali ntuli black circle haraburda forex mohammad nmd investment corp foreign investment incentives in the uk what does being sectioned alternative investment bdc vf investment services corp apartment vs house pro pisobilities cantonnet investment moreau investments limited best ecn forex valuta dubai forex brokers contusion injury for retirees lost wax investment casting kombucha investment stock social investment position investment social housing jobs untuk muslim investment advisor forex rates for indian rupees adeboyejo 2238 ci investments ns forex vndusd account sort code checker east spring investments indonesia investment uniglobal investments limited destefano investments describe a recent development macroeconomics centersquare investment banking.
ltd nsw calendar headlines investment grants forex4you regulated janell jann fremont investment philippines bpi. a capital investments dubai club ru biker texture investment pl investments linkedin standard life. Outline investment director cambridge associates japan investment strategies conceptualized investment advisor act indicators activtrades ashburton investments michael anthony vkc forex investment forex interest rates investments return.
louis mo maybank investment shooting adez alaska workforce huaja direkte names and investments lakewood instaforex ke mrt pic risk medium investments clothing.
Return on Capital Employed ROCE is a measure implies the long term profitability and is calculated by dividing earnings before interest and tax EBIT to capital employed, capital employed is the total assets of the company minus all the liabilities, while Return on Invested Capital ROIC measures the return the company is earning on the total invested capital and helps in determining the efficiency in which the company is using the investors funds to generate additional income.
These ratios also help understand how the company is performing and help assess how much of profits made are returned to investors. Both these ratios specifically examine how a company utilizes its capital to invest and grow further. Both these ratios help in determining how efficiently the company uses the invested capital and are very similar and have few differences, mainly in the way these ratios are calculated.
Both ratios can be helpful in comparing companies that are capital intensive , for example — energy, telecommunication, and auto companies. These measures have limited use when it comes to service-based companies. This article has been a guide to ROIC vs. You may also have a look at the following articles —. Free Investment Banking Course. Login details for this Free course will be emailed to you.
Forgot Password? Free Ratio Analysis Course. Difference Between ROIC and ROCE Return on Capital Employed ROCE is a measure implies the long term profitability and is calculated by dividing earnings before interest and tax EBIT to capital employed, capital employed is the total assets of the company minus all the liabilities, while Return on Invested Capital ROIC measures the return the company is earning on the total invested capital and helps in determining the efficiency in which the company is using the investors funds to generate additional income.
Popular Course in this category. View Course. Rather, the debt portion of a capital structure should consist of short-term borrowings notes payable , long-term debt, and two-thirds rule of thumb of the principal amount of operating leases and redeemable preferred stock. When analyzing a company's balance sheet, seasoned investors would be wise to use this comprehensive total debt figure. In general, analysts use three ratios to assess the strength of a company's capitalization structure.
However, it is a third ratio, the capitalization ratio — long-term debt divided by long-term debt plus shareholders' equity —that delivers key insights into a company's capital position. With the debt ratio, more liabilities mean less equity and therefore indicate a more leveraged position. The problem with this measurement is that it is too broad in scope and gives equal weight to operational liabilities and debt liabilities.
The same criticism applies to the debt-to-equity ratio. Current and non-current operational liabilities, especially the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities. On the other hand, the capitalization ratio compares the debt component to the equity component of a company's capital structure; so, it presents a truer picture. Expressed as a percentage, a low number indicates a healthy equity cushion, which is always more desirable than a high percentage of the debt.
Unfortunately, there is no magic ratio of debt to equity to use as guidance. What defines a healthy blend of debt and equity varies according to the industries involved, line of business, and a firm's stage of development. However, because investors are better off putting their money into companies with strong balance sheets, it makes sense that the optimal balance generally should reflect lower levels of debt and higher levels of equity. In finance, debt is a perfect example of the proverbial two-edged sword.
Astute use of leverage debt is good. It increases the number of financial resources available to a company for growth and expansion. Not only is too much debt a cause for concern, but too little debt can be as well. This can signify that a company is relying too much on its equity and not efficiently making use of its assets.
With leverage, the assumption is that management can earn more on borrowed funds than what it would pay in interest expense and fees on these funds. However, to carry a large amount of debt successfully, a company must maintain a solid record of complying with its various borrowing commitments.
A company that is too highly leveraged too much debt relative to equity might find that eventually, its creditors restrict its freedom of action; or it could experience diminished profitability as a result of paying steep interest costs. In addition, a firm could have trouble meeting its operating and debt liabilities during periods of adverse economic conditions.
Or, if the business sector is extremely competitive, then competing companies could and do take advantage of debt-laden firms by swooping in to grab more market share. Of course, a worst-case scenario might be if a firm needed to declare bankruptcy. Fortunately, though, there are excellent resources that can help determine if a company might be too highly leveraged. These entities conduct formal risk evaluations of a company's ability to repay principal and interest on debt obligations, primarily on bonds and commercial paper.
All ratings by credit agencies fall into one of two categories: investment grade or non-investment grade. A company's credit ratings from these agencies should appear in the footnotes to its financial statements. So, as an investor, you should be happy to see high-quality rankings on the debt of companies that you're considering as investment opportunities, likewise, you should be wary if you see poor ratings on companies that you are considering.
A company's capital structure constitutes the mix of equity and debt on its balance sheet. Though there is no specific level of each that determines what a healthy company is, lower debt levels and higher equity levels are preferred. Various financial ratios help analyze the capital structure of a firm that makes it easy for investors and analysts to see how a company compares with its peers and therefore its financial standing in its industry.
The ratings provided by credit agencies also help in shedding light on the capital structure of a firm. Financial Statements. Financial Ratios. Tools for Fundamental Analysis.