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how to find a strategic alliance | forming a strategic alliance requires creativity forward thinking and savvy business sense though many strategic alliances are not the same each is rooting in common steps outlined below advantages and disadvantages of a strategic alliancea strategic alliance allows a company to embark on opportunities it may otherwise not have been able to embark upon this includes earning new clients engaging in different markets or selling different products each of these avenues has the potential to increase a company s revenue and profitability strategic alliances are also a way to diversify a company s revenue stream and generate different opportunities to mitigate company wide financial risk risk is also mitigated with the help of the alliance members as each entity may have resources that can be used to solve unique challenges or navigate unfamiliar business scenarios last strategic alliances allow a company to operate differently than it normally would this means using resources it doesn t have this might be physical goods access to markets or labor with specific expertise this may also mean the company can leverage the market presence of another firm to more positively gain public perception about their own company entering into an alliance with a company with a strong public reputation helps create brand trust and recognition of your own entity a strategic alliance is most likely to succeed if there is strong communication this means both parties must continually expend resources to manage the alliance to ensure both sides are in agreement should the transmission of information or strategy fail it will be more difficult for the alliance to succeed though strategic alliances may seem fair and romantic they are often not equally balanced one company will almost always naturally benefit more than the other and there may not be a simple solution to balance the trade there may also develop an unnatural reliance on one side or the other in terms of resources consumed or expertise relied upon just like how a strategic alliance can help boost a company s public image the wrongdoing of an alliance company may do harm one company s reputation may rely on the other though they have no control over how the other company handles itself in public similar difficulty may exist if there are conflicts between the alliance members should there be strategic disagreements resources may be wasted on resolving interpersonal conflicts that would not have existed without the alliance may result in gaining customers especially ones in unfamiliar marketsmay generate additional revenue and increase profitabilitymay diversify a company s revenue streammay reduce operational risk of a company due to the addition of unique assetsmay positively influence the brand and perception of the companymay require more work in collaborating and communicating with larger teamsmay result in one side getting a better deal than the other even if this wasn t what was planned may result in conflict should the alliance members disagree on longer term strategymay negatively influence the brand and perception of the companyexamples of strategic alliancesthe deal between starbucks and barnes noble is a classic example of a strategic alliance starbucks brews the coffee barnes noble stocks the books both companies do what they do best while sharing the costs of space to the benefit of both companies strategic alliances can come in many sizes and forms | |
why are strategic alliances important | strategic alliances are important because it enables a company to further benefit in areas it would not because of its personal lack of resources whether it is forming an alliance to gain entry into a market labor from skilled workers or resources from limited sources successful companies work with other companies this is important as it allows a company to personally benefit by leveraging the assets of another company | |
what is the difference between a partnership and a strategic alliance | an alliance is a collaboration between two companies in which each individual company is expected to profit or benefit from the agreement a partnership is a more formal type of agreement in which partners merge to create a single shared economic interest | |
what is the most important factor in a strategic alliance | a strategic alliance is a relationship between two entities for this reason the most important factor in the alliance is the trust and collaboration between the two teams there must be a mutual commitment to joint success for strategic alliances to be successful and the alliance must be guided by clear objectives strategic and conversations to make sure both sides are continually on the same page the bottom linea strategic alliance is an agreement between two parties for the mutual benefit of both the concept of the shapley value describes the fair distribution of costs and profits to each participant each side often provides some resource it allows the other party to use by collaborating with another entity both parties are poised to benefit in some way | |
what is strategic financial management | strategic financial management means not only managing a company s finances but managing them with the intention to succeed that is to attain the company s long term goals and objectives and maximize shareholder value over time understanding strategic financial managementstrategic financial management is about creating profit for the business and ensuring an acceptable return on investment roi financial management is accomplished through business financial plans setting up financial controls and financial decision making before a company can manage itself strategically it first needs to define its objectives precisely identify and quantify its available and potential resources and devise a specific plan to use its finances and other capital resources toward achieving its goals strategic management also involves understanding and properly controlling allocating and obtaining a company s assets and liabilities including monitoring operational financing items like expenditures revenues accounts receivable and payable cash flow and profitability strategic financial management encompasses furthermore involves continuous evaluating planning and adjusting to keep the company focused and on track toward long term goals when a company is managing strategically it deals with short term issues on an ad hoc basis in ways that do not derail its long term vision strategic financial management includes assessing and managing a company s capital structure the mix of debt and equity finance employed to ensure a company s long term solvency strategic vs tactical financial managementthe term strategic refers to financial management practices that are focused on long term success as opposed to tactical management decisions which relate to short term positioning if a company considers strategic considerations instead of tactical ones it makes financial decisions based on long term objectives rather than short term metrics to realize those results a firm sometimes must tolerate losses in the present strategic management focuses on long term success and tactical management relates to short term positioning part of effective strategic financial management thus may involve sacrificing or readjusting short term goals in order to attain the company s long term objectives more efficiently for example if a company suffered a net loss for the previous year then it may choose to reduce its asset base through closing facilities or reducing staff thereby decreasing its operating expenses taking such steps may result in restructuring costs or other one time items that negatively affect the company s finances further in the short term but which position the company better to succeed in the long term these short term versus long term tradeoffs often need to be made with various stakeholders in mind for instance shareholders of public companies may discipline management for decisions that negatively affect a company s share price in the short term even though the long term health of the company becomes more solid by the same decisions the average salary of a strategic finance manager in the united states according to ziprecruiter that amounts to about 57 per hour 1the elements of strategic financial managementa company will apply strategic financial management throughout its organizational operations which involves designing elements that will maximize the firm s financial resources and use them efficiently here a firm needs to be creative as there is no one size fits all approach to strategic management and each company will devise elements that reflect its own particular needs and goals however some of the more common elements of strategic financial management could include the following strategies based on industryjust as financial management strategies will vary from company to company they also can differ according to industry and sector firms that operate in fast growing industries like information technology or technical services would want to choose strategies that cite their goals for growth and specify movement in a positive direction their objectives for example might include launching a new product or increasing gross revenue within the next 12 months on the other hand companies in slow growing industries like sugar manufacturing or coal power production could choose objectives that focus on protecting their assets and managing expenses such as reducing administrative costs by a certain percentage | |
what are the benefits of strategic management | having a long term focus helps a company maintain its goals even as short term rough patches or opportunities come and go as a result strategic management helps keep a firm profitable and stable by sticking to its long run plan strategic management not only sets company targets but sets guidelines for achieving those objectives even as challenges appear along the way | |
what is the scope of strategic financial management | strategic management can encompass all aspects of a firm s long term objectives financial management often plays a key role in this which involves cost reduction risk management and budgeting | |
what is the ultimate objective of strategic financial management | the goal of strategic financial management is to ensure that long term goals are properly planned for and ultimately met the bottom linestrategic financial management refers to the long term plans a company makes to grow in the long term and ultimately maximize value for the shareholders although exact strategies will vary this typically entails setting precise objectives and analyzing the company s advantages and resources in order to achieve those goals | |
what is strategic management | strategic management is the management of an organization s resources to achieve its goals and objectives strategic management involves setting objectives analyzing the competitive environment analyzing the internal organization evaluating strategies and ensuring that management rolls out the strategies across the organization understanding strategic managementstrategic management is divided into several schools of thought a prescriptive approach to strategic management outlines how strategies should be developed while a descriptive approach focuses on how strategies should be put into practice these schools differ on whether strategies are developed through an analytic process in which all threats and opportunities are accounted for or are more like general guiding principles to be applied business culture the skills and competencies of employees and organizational structure are all important factors that influence how an organization can achieve its stated objectives inflexible companies may find it difficult to succeed in a changing business environment creating a barrier between the development of strategies and their implementation can make it difficult for managers to determine whether objectives have been efficiently met while an organization s upper management is ultimately responsible for its strategy the strategies are often sparked by actions and ideas from lower level managers and employees an organization may have several employees devoted to strategy rather than relying solely on the chief executive officer ceo for guidance because of this reality organizational leaders focus on learning from past strategies and examining the environment at large the collective knowledge is then used to develop future strategies and to guide the behavior of employees to ensure that the entire organization is moving forward for these reasons effective strategic management requires both an inward and outward perspective strategic management extends to internal and external communication practices as well as to tracking which ensures that the company meets goals as defined in its strategic management plan the 5 phases of strategic managementstrategic management involves managing an organization s resources analyzing internal and external forces and developing strategies to realize goals and objectives there are five key phases that can help businesses execute their strategies example of strategic managementfor example a for profit technical college wishes to increase new student enrollment and enrolled student graduation rates over the next three years the purpose is to make the college known as the best buy for a student s money among five for profit technical colleges in the region with a goal of increasing revenue in that case strategic management means ensuring the school has funds to create high tech classrooms and hire the most qualified instructors the college also invests in marketing and recruitment and implements student retention strategies the college s leadership assesses whether its goals have been achieved on a periodic basis | |
why is strategic management important | helping their company find ways to be more competitive is the purpose of strategic management to that end putting strategic management plans into practice is the most important aspect of the planning itself plans in practice involve identifying benchmarks realigning resources financial and human and putting leadership resources in place to oversee the creation sale and deployment of products and services in business strategic management is important because it allows a company to analyze areas for operational improvement in many cases they can follow either an analytical process which identifies potential threats and opportunities or simply follow general guidelines given the structure of the organization a company may choose to follow either a prescriptive or descriptive approach to strategic management under a prescriptive model strategies are outlined for development and execution by contrast a descriptive approach describes how a company can develop these strategies | |
what is strategic management | strategic management is the process of setting goals procedures and objectives in order to make a company or organization more competitive typically strategic management looks at effectively deploying staff and resources to achieve these goals often strategic management includes strategy evaluation internal organization analysis and strategy execution throughout the company | |
what is an example of strategic management | consider a large company that wants to achieve more ambitious online sales rates to meet these goals the company will develop a strategy communicate this strategy apply it across various units and departments in the organization integrate this with employee goals and execute accordingly if an effective strategy is applied ideally it will help the company achieve its targets through a single coordinated process | |
what are the key elements of strategic management | strategic management is not a one size fits all strategy however there are key elements that are found to be critical these include goal setting industry and organizational analyses strategy formation strategy implementation and the measurement monitoring and controlling of strategies the bottom linestrategic management is the assembling and management of resources to achieve a company s goals and objectives although it is often segmented into either prescriptive or descriptive schools of thought many businesses subscribe to a combined philosophy defining how a strategy should be developed and how the strategies will be employed strategic management helps companies set goals gain a competitive edge better manage their resources and more there is not one prescription for all companies must create and adapt a strategic management process that works best for their company and those they serve strategic management does not end with the successful implementation of strategies it continues for the life of the business | |
what is swot analysis | swot strengths weaknesses opportunities and threats analysis is a framework used to evaluate a company s competitive position and to develop strategic planning swot analysis assesses internal and external factors as well as current and future potential a swot analysis is designed to facilitate a realistic fact based data driven look at the strengths and weaknesses of an organization initiatives or within its industry understanding swot analysisswot analysis is a technique for assessing the performance competition risk and potential of a business as well as part of a business such as a product line or division an industry or other entity using internal and external data the technique can guide businesses toward strategies more likely to be successful and away from those in which they have been or are likely to be less successful independent swot analysts investors or competitors can also guide them on whether a company product line or industry might be strong or weak and why swot analysis was first used to analyze businesses now it s often used by governments nonprofits and individuals including investors and entrepreneurs there is seemingly limitless applications to the swot analysis components of swot analysisinvestopedia julie bangevery swot analysis will include the following four categories though the elements and discoveries within these categories will vary from company to company a swot analysis is not complete without each of these elements strengths describe what an organization excels at and what separates it from the competition a strong brand loyal customer base a strong balance sheet unique technology and so on for example a hedge fund may have developed a proprietary trading strategy that returns market beating results it must then decide how to use those results to attract new investors weaknesses stop an organization from performing at its optimum level they are areas where the business needs to improve to remain competitive a weak brand higher than average turnover high levels of debt an inadequate supply chain or lack of capital opportunities refer to favorable external factors that could give an organization a competitive advantage for example if a country cuts tariffs a car manufacturer can export its cars into a new market increasing sales and market share threats refer to factors that have the potential to harm an organization for example a drought is a threat to a wheat producing company as it may destroy or reduce the crop yield other common threats include things like rising costs for materials increasing competition tight labor supply and so on swot tableanalysts present a swot analysis as a square segmented into four quadrants each dedicated to an element of swot this visual arrangement provides a quick overview of the company s position although all the points under a particular heading may not be of equal importance they all should represent key insights into the balance of opportunities and threats advantages and disadvantages and so forth the swot table is often laid out with the internal factors on the top row and the external factors on the bottom row in addition the items on the left side of the table are more positive favorable aspects while the items on the right are more concerning negative elements | |
how to do a swot analysis | a swot analysis can be broken into several steps with actionable items before and after analyzing the four components in general a swot analysis will involve the following steps a swot analysis can be broad though more value will likely be generated if the analysis is pointed directly at an objective for example the objective of a swot analysis may focused only on whether or not to perform a new product rollout with an objective in mind a company will have guidance on what they hope to achieve at the end of the process in this example the swot analysis should help determine whether or not the product should be introduced every swot analysis will vary and a company may need different data sets to support pulling together different swot analysis tables a company should begin by understanding what information it has access to what data limitations it faces and how reliable its external data sources are in addition to data a company should understand the right combination of personnel to have involved in the analysis some staff may be more connected with external forces while various staff within the manufacturing or sales departments may have a better grasp of what is going on internally having a broad set of perspectives is also more likely to yield diverse value adding contributions for each of the four components of the swot analysis the group of people assigned to performing the analysis should begin listing ideas within each category examples of questions to ask or consider for each group are in the table below internal factors | |
what occurs within the company serves as a great source of information for the strengths and weaknesses categories of the swot analysis examples of internal factors include financial and human resources tangible and intangible brand name assets and operational efficiencies | potential questions to list internal factors are external factors | |
what happens outside of the company is equally as important to the success of a company as internal factors external influences such as monetary policies market changes and access to suppliers are categories to pull from to create a list of opportunities and weaknesses 1 | potential questions to list external factors are companies may consider performing this step as a white boarding or sticky note session the idea is there is no right or wrong answer all participants should be encouraged to share whatever thoughts they have these ideas can later be discarded in the meantime the goal should be to come up with as many items as possible to invoke creativity and inspiration in others with the list of ideas within each category it is now time to clean up the ideas by refining the thoughts that everyone had a company can focus on only the best ideas or largest risks to the company this stage may require substantial debate among analysis participants including bringing in upper management to help rank priorities armed with the ranked list of strengths weaknesses opportunities and threats it is time to convert the swot analysis into a strategic plan members of the analysis team take the bulleted list of items within each category and create a synthesized plan that provides guidance on the original objective for example the company debating whether to release a new product may have identified that it is the market leader for its existing product and there is the opportunity to expand to new markets however increased material costs strained distribution lines the need for additional staff and unpredictable product demand may outweigh the strengths and opportunities the analysis team develops the strategy to revisit the decision in six months in hopes of costs declining and market demand becoming more transparent use a swot analysis to identify challenges affecting your business and opportunities that can enhance it however note that it is one of many techniques not a prescription common mistakes when preparing swot analysis | |
when preparing a swot analysis several common mistakes can undermine its effectiveness let s take a look at some ways your swot analysis may go awry | one easy error to make when preparing a swot analysis is failing to be objective and honest in the assessment companies often tend to overemphasize their strengths while downplaying weaknesses resulting in an overly optimistic and unrealistic analysis this bias can lead to missed opportunities for improvement and leave the organization vulnerable to unforeseen threats as difficult as it may be to be honest in your analysis the validity of underlying assumptions is the cornerstone of how useful the swot analysis will be another significant mistake is conducting the analysis in isolation without input from diverse key stakeholders you should try get to input from employees at various levels customers suppliers and industry experts each may have a unique view of your company and each may come up with different items to be listed in each quadrant based on how they specifically interact with the company yet another common pitfall is neglecting to prioritize or weight the factors identified in the swot analysis not all strengths weaknesses opportunities and threats are equally important or impactful failing to distinguish between major and minor factors can lead to misallocation of resources and misguided strategic decisions it can be easy for the important items to be buried if too many non material items are identified another frequent error is treating the swot analysis as a one time exercise you should be prepared to do a swot analysis periodically the business environment is constantly changing and a swot analysis should be regularly updated to remain relevant in addition the analysis itself is just the beginning its true value lies in using the findings to develop and implement strategic actions you can then check future swot analysis to make sure the company is addressing the major points benefits of swot analysisa swot analysis won t solve every major question a company has however there s a number of benefits to a swot analysis that make strategic decision making easier swot analysis examplelet s perform a swot analysis together by analyzing the strengths weaknesses opportunities and threats of tesla | |
what are the 4 steps of swot analysis | the four steps of swot analysis comprise the acronym swot strengths weaknesses opportunities and threats these four aspects can be broken into two analytical steps first a company assesses its internal capabilities and determines its strengths and weaknesses then a company looks outward and evaluates external factors that impact its business these external factors may create opportunities or threaten existing operations | |
how do you write a good swot analysis | creating a swot analysis involves identifying and analyzing the strengths weaknesses opportunities and threats of a company it is recommended to first create a list of questions to answer for each element the questions serve as a guide for completing the swot analysis and creating a balanced list the swot framework can be constructed in list format as free text or most commonly as a 4 cell table with quadrants dedicated to each element strengths and weaknesses are listed first followed by opportunities and threats | |
why is swot analysis used | a swot analysis is used to strategically identify areas of improvement or competitive advantages for a company in addition to analyzing thing that a company does well swot analysis takes a look at more detrimental negative elements of a business using this information a company can make smarter decisions to preserve what it does well capitalize on its strengths mitigate risk regarding weaknesses and plan for events that may adversely affect the company in the future | |
what are the limitations of swot analysis | while swot analysis is a powerful tool it does have some limitations it can sometimes oversimplify complex situations and is susceptible to the subjectivity and bias of participants the analysis also doesn t provide specific guidance on how to address identified issues and can lead to analysis paralysis if not followed by concrete action the bottom linea swot analysis is a great way to guide business strategy meetings it s powerful to have everyone in the room discuss the company s core strengths and weaknesses define the opportunities and threats and brainstorm ideas oftentimes the swot analysis you envision before the session changes throughout to reflect factors you were unaware of and would never have captured if not for the group s input a company can use a swot for overall business strategy sessions or for a specific segment such as marketing production or sales this way you can see how the overall strategy developed from the swot analysis will filter down to the segments below before committing to it you can also work in reverse with a segment specific swot analysis that feeds into an overall swot analysis although a useful planning tool swot has limitations it is one of several business planning techniques to consider and should not be used alone also each point listed within the categories is not prioritized the same swot does not account for the differences in weight therefore a deeper analysis is needed using another planning technique | |
what is stress testing | stress testing is a computer simulation technique used to test the resilience of institutions and investment portfolios against possible future financial situations such testing is customarily used by the financial industry to help gauge investment risk and the adequacy of assets and help evaluate internal processes and controls in recent years regulators have also required financial institutions to carry out stress tests to ensure their capital holdings and other assets are adequate understanding stress testingcompanies that manage assets and investments commonly use stress testing to determine portfolio risk then set in place any hedging strategies necessary to mitigate against possible losses specifically their portfolio managers use internal proprietary stress testing programs to evaluate how well the assets they manage might weather certain market occurrences and external events asset and liability matching stress tests are widely used too by companies that want to ensure they have the proper internal controls and procedures in place retirement and insurance portfolios are also frequently stress tested to ensure that cash flow payout levels and other measures are well aligned regulatory stress testingfollowing the 2008 financial crisis regulatory reporting for the financial industry specifically for banks was significantly expanded focusing on stress testing and capital adequacy mainly due to the 2010 dodd frank act beginning in 2011 new regulations in the united states required the submission of comprehensive capital analysis and review ccar documentation by the banking industry these regulations require banks to report on their internal procedures for managing capital and carry out various stress test scenarios in addition to ccar reporting banks in the united states deemed too big to fail by the financial stability board typically those with more than 50 billion in assets must provide stress test reporting on planning for a bankruptcy scenario in the government s most recent reporting review of these banks in 2018 22 international banks and eight based in the united states were designated as too big to fail currently basel iii is also in effect for global banks much like the u s requirements this international regulation requires documentation of banks capital levels and the administration of stress tests for various crisis scenarios stress testing involves running computer simulations to identify hidden vulnerabilities in institutions and investment portfolios to evaluate how well they might weather adverse events and market conditions types of stress testingstress testing involves running simulations to identify hidden vulnerabilities the literature about business strategy and corporate governance identifies several approaches to these exercises among the most popular are stylized scenarios hypotheticals and historical scenarios in a historical scenario the business or asset class portfolio or individual investment is run through a simulation based on a previous crisis examples of historical crises include the stock market crash of october 1987 the asian crisis of 1997 and the tech bubble that burst in 1999 2000 a hypothetical stress test is generally more specific often focusing on how a particular company might weather a particular crisis for example a firm in california might stress test against a hypothetical earthquake or an oil company might do so against the outbreak of war in the middle east stylized scenarios are a little more scientific in the sense that only one or a few test variables are adjusted at once for example the stress test might involve the dow jones index losing 10 of its value in a week as for the methodology for stress tests monte carlo simulation is one of the most widely known this type of stress testing can be used for modeling probabilities of various outcomes given specific variables factors considered in the monte carlo simulation for example often include various economic variables companies can also turn to professionally managed risk management and software providers for various types of stress tests moody s analytics is one example of an outsourced stress testing program that can be used to evaluate risk in asset portfolios advantages and disadvantages of stress testingstress tests are forward looking analytical tools that help financial institutions and banks better understand their financial position and risks they help managers identify what measures to take if certain events arise and what they should do to mitigate risks as a result they are better able to form action plans to thwart threats and prevent failure for investment managers they are better able to assess how well managed assets might perform during economic downturns to perform stress tests financial institutions need to create the framework and processes for which the tests can be performed 1 this restructuring is complex and is often associated with costly mistakes for example it s possible that the test scenario does not represent the types of risks a bank may face this may be due to insufficient data or the test designer s inability to create a relevant test in the end the results of the test may lead to the creation of plans for events not likely to occur this misrepresentation can cause institutions to ignore the risks that are possible lastly banks with unfavorable results may be barred from paying dividends to their customers and shareholders as well as may be penalized helps mitigate risksenables better financial planninghighlights banks or assets strengths and weaknessesmay produce unfavorable consequences | |
is complex and costly to administer | may result in inadequate planningexample of stress testingbanks and financial institutions often use the federal reserve s dodd franklin act stress test dfast and comprehensive capital analysis and review ccar stress test 2 the federal reserve administers the comprehensive capital analysis and review stress test annually for banks with at least 100 billion in assets this test identifies whether banks have sufficient capital to operate during economic downturns and plans in place to address such events and other associated risks specifically the federal reserve looks at the bank s capital its plans for its capital e g dividends and how it assesses capital needs the dodd franklin act stress test dfast required for banks with at least 250 billion in assets is often used in conjunction with the ccar 3 this test can be conducted directly by the federal reserve or by financial institutions under the direction of the fed this like the ccar reviews whether a bank or financial institution has enough capital to account for losses and continue operations in the event of economic turmoil as of march 2020 federal home loan banks are no longer required to conduct dodd frank act stress tests 3 although both tests have similar goals they are administered differently to address as many possible events and risks stress testing faqsstress testing is an analytical technique to show how a financial services company or bank will be affected by certain financial events or situations in other words it shows what can happen and how well prepared institutions are when certain stressors are introduced the federal reserve requires banks of a certain size to perform stress tests such as the dodd frank act stress test dfast or the comprehensive capital analysis and review ccar these tests review the bank s capital and how well it can meet obligations and operate during trying economic times stress testing is often performed using computer simulations running different scenarios companies might use historical events hypothetical situations or simulations to test how well a company would operate under specific conditions if a company fails a stress test it may be required to increase its capital reserves or form contingency plans to address threats in the banking and financial services industry some failures result in fines or the prohibition of certain activities such as paying dividends the bottom linestress tests can be effective analytical tools in identifying whether a company has sufficient capital strong assets and effective plans to weather an economic storm companies can use historical hypothetical or simulated events to create test scenarios or they may be required by a regulatory body to perform certain tests the results can help companies better understand their strengths weaknesses and areas of opportunity | |
what is a strike price | long options contracts are derivatives that give the holders the right but not the obligation to buy or sell an underlying security at some point in the future at a pre specified price this price is known as the option s strike price or exercise price the strike price of a call option is where the security can be bought by the option holder the strike price of a put option is the price at which the security can be sold an option s value is informed by the difference between the fixed strike price and the market price of the underlying security known as the option s moneyness call option strikes that are lower than the market price are said to be in the money itm because you can exercise the option to buy the stock for less than the market and immediately sell it at the higher market price in the money puts are those with strikes higher than the market price giving the holder the right to sell the option above the current market price this feature grants itm options intrinsic value calls with strikes that are higher than the market or puts with strikes lower than the market are instead out of the money otm and only have extrinsic value also known as time value investopedia sydney saporitounderstanding strike pricesthe strike price is a key variable of call and put options it defines at which price the option holder can buy or sell the underlying security respectively options are listed with several strike prices both above and below the current market value say that a stock is trading at 100 per share the 110 strike call option would give the holder the right to buy the stock at 110 on or before the date when the contract expires the option would lose value if the stock falls in value as the underlying stock increases in price but the call will expire worthless if it never reaches 110 before the expiration date because you could buy the stock for less you could still exercise the option to pay 110 if the stock did rise above 110 even though the market price is higher put options would work similarly but give you the right to sell rather than buy the underlying security the strike prices listed are also standardized they re at fixed dollar amounts such as 31 32 33 100 or 105 they may also have 2 50 intervals such as 12 50 15 00 and 17 50 the distance between strikes is known as the strike width strike prices and widths are set by the options exchanges strikes 1 apart are generally the tightest available on most stocks you may have strikes that result in 0 50 or tighter due to stock splits or other events the relationship between strike price and the underlying securitythe price of an options contract is known as its premium it s the amount of money that the buyer of an option pays to the seller for the right but not the obligation to exercise the option the price difference between the underlying security s market price and the strike price determines an option s value in what s known as the moneyness of the option the more in the money an option is the higher its premium options become more valuable as the difference between the strike and the underlying gets smaller they re in the money when the strike becomes greater an option will lose value as the difference between the strike and the underlying price becomes larger and as the option falls out of the money moneyness the three types of strike pricesoptions can be in the money itm out of the money otm or at the money atm 1the option is out of the money otm for buyers of the call option if the strike price is higher than the underlying stock price the option doesn t have intrinsic value but it s likely to still have extrinsic value based on volatility and time until expiration because either of these two factors could put the option in the money in the future the option will have intrinsic value and be in the money if the underlying stock price is above the strike price puts with strike prices higher than the current price will be in the money because you can sell the stock higher than the market price and then buy it back for a guaranteed profit a put option will instead be in the money when the underlying stock price is below the strike price and be out of the money when the underlying stock price is above the strike price again an otm option won t have intrinsic value but it may still have value based on the volatility of the underlying asset and the time left until option expiration finally an option with a strike price at or very near to the current market price is known as at the money atm atm options are often the most liquid and active options traded in a name investopedia sabrina jiangstrike price and option deltaan option s delta is how much its premium will change given a 1 move in the underlying security a call with a 0 40 delta will rise by 40 cents if the underlying rises by a dollar at the money calls have a delta of 0 50 at the money puts have a delta of 0 50 options that are in the money will have deltas greater than 0 50 positively for calls and negatively for puts and out of the money options will have deltas of less than 0 50 an option with a delta of 1 00 is so deep in the money that it essentially behaves like the stock itself examples would be call options very far below the current price and puts with strikes very high above it deep out of the money options have deltas very close to zero and are essentially worthless because they re calls that have strikes so high above the market or puts with strikes so far below it that it s extremely unlikely they ll ever be in the money before expiry | |
what determines an options value | pricing models such as the black scholes model and the binomial tree model were developed in the 1970s and 80s to help understand the fair value of an options contract theoretically an option s premium should be related to the probability that it finishes in the money the higher that probability the greater the value of the right that the option grants options prices always depend on the following five inputs regardless of what model is used the difference between the market price and the strike price fits into the equation the time to expiration and volatility inputs indicate how likely it is for an option to finish in the money before it expires the more time there is to go and or the more volatile the underlying price moves are the more likely it is that the market price will reach the strike price volatile moves happen due to acquisitions earnings reports company news and other factors options with longer times until expiration and those with greater volatility will therefore have higher premiums strike price exampleassume there are two option contracts one is a call option with a 100 strike price the other is a call option with a 150 strike price the current price of the underlying stock is 145 assume both call options are the same the only difference is the strike price we can look at the current stock price to see which option has value if we have two put options both about to expire and one has a strike price of 40 and the other has a strike price of 50 the 50 put option has a 5 value if the underlying stock is trading at 45 because the underlying stock is below the strike price of the put the 40 put option has no value because the underlying stock is above the strike price remember that put options allow the option buyer to sell at the strike price there s no point using the option to sell at 40 when they can sell at 45 in the stock market so the 40 strike price put is worthless at expiration | |
are some strike prices more desirable than others | the question of what strike price is most desirable will depend on factors such as the risk tolerance of the investor and the options premiums available from the market many investors will look for options whose strike prices are relatively close to the current market price of the security based on the logic that those options have a higher probability of being exercised at a profit some investors will deliberately seek options that are far out of the money options whose strike prices are very far from the market price in the hopes of realizing very large returns if the options do become profitable | |
are strike prices and exercise prices the same | yes the terms strike price and exercise price are synonymous some traders will use one term over the other and may use the terms interchangeably but their meanings are the same both terms are widely used in derivatives trading | |
what determines how far apart strike prices are | strike prices for listed options are set by criteria established by the occ or an exchange typically with a 2 50 distance for strikes below 25 5 increments for those trading from 25 through 200 and 10 increments for strikes above 200 2the strikes will generally be wider for stocks with higher prices and with less liquidity or trading activity new strikes may also be requested to be added by contacting the occ or an exchange | |
what s the difference between strike price and spot price | the strike price of an option tells you the price at which you can buy or sell the underlying security when the option is exercised the spot price is another term used for the current market price of the underlying security the difference between the strike price and the spot price determines an option s moneyness and greatly informs its value the bottom linean option s strike price tells you at what price you can buy or sell the underlying security before the contract expires the difference between the strike price and the current market price is called the option s moneyness it s a measure of its intrinsic value in the money options have intrinsic value because they can be exercised at a strike price that s more favorable than the current market price for a guaranteed profit out of the money options don t have intrinsic value but they still contain extrinsic or time value because the underlying may move to the strike before expiration at the money options have strikes at or very close to the current market price and they re often the most liquid and active contracts in a name disclosure this article is not intended to provide investment advice investing in securities entails varying degrees of risk and can result in partial or total loss of principal the trading strategies discussed in this article are complex and should not be undertaken by novice investors readers seeking to engage in such trading strategies should seek out extensive education on the topic | |
what is structural unemployment | structural unemployment is a longer lasting form of unemployment caused by fundamental shifts in an economy and exacerbated by extraneous factors such as technology competition and government policy structural unemployment occurs because workers lack the requisite job skills or live too far from regions where jobs are available and cannot move closer jobs are available but there is a serious mismatch between what companies need and what workers can offer | |
how structural unemployment works | structural unemployment is caused by forces other than the business cycle this means that structural unemployment can last for decades and may need radical change to redress the situation if structural unemployment is not addressed it can increase the unemployment rate long after a recession is over and increase the natural rate of unemployment which is also known as frictional unemployment hundreds of thousands of well paying manufacturing jobs were lost in the united states over the past three decades as production jobs migrated to lower cost areas in china and elsewhere this decline in the number of jobs is responsible for a higher natural rate of unemployment growing technology in all areas of life increases future structural unemployment because workers without adequate skills will get marginalized even those with skills may face redundancy given the high rate of technological obsolescence and the growing use of artificial intelligence ai structural unemployment is influenced by more than just the business cycle impacted by major mismatches in the employment system causes of structural unemploymentthere are several common triggers that cause structural unemployment one of the primary causes of structural unemployment is technological changes as industries move from one process to another and harness technological capabilities many jobs and roles become obsolete companies may also seek ways to leverage technology as cost cutting measures putting their workforce at risk as the business seeks more efficient ways to operate by extension structural unemployment may be caused by poor training or a lack of education programs as workers get replaced by more efficient processes workers must adapt by learning new business practices should they fail to do so they may perpetuate structural unemployment by not having an appropriate skillset structural unemployment may also be caused by competition and globalization consider how different wage rates around the world may entice companies to see offshore manufacturing processes companies may choose to forgo hiring more skilled domestic workers that demand higher compensation in favor of workers willing to be employed for less | |
how to overcome structural unemployment | as a society there are several ways an economy can prioritize overcoming structural unemployment as a result of industry shifts or technological advancements in 1933 the united states experienced its highest rate of unemployment during the great depression unemployment peaked at 24 7 1structural unemployment vs other types of unemploymentstructural unemployment and cyclical unemployment are both referred to as involuntary forms of unemployment this means individuals are unwillingly without a job though they may be looking for employment they simply haven t found a role the difference between the two often resides in the depth length and severity of unemployment cyclical unemployment occurs in large part due to spending habits recessions and government monetary or fiscal policy as many industries ebb and flow with success so does the labor market cyclical unemployment is often marked by shorter term unemployment that rises and falls with economic cycles certain industries may be more exposed to cyclical unemployment rather than structural unemployment for example consider long standing industries such as real estate while the real estate sector does undergo innovation it is more prone to cyclical unemployment as a result of economic recessions or contractionary monetary policy frictional unemployment is defined as a voluntary form of unemployment individuals often leave their jobs to develop other skillsets return to school or prioritize work life balance by taking on less demanding roles individuals who are frictionally unemployed are usually actively seeking roles or simply between jobs these individuals can often return to their old form of work but choose not to this is in strong contrast to structural employment in which people do not have a say in being unemployed in addition frictional unemployment is often marked by the election to learn something new as opposed to being forced out of a market via structural changes frictional unemployment is often on a case by case basis though the pandemic might have prioritized work life balance for many whereas structural unemployment is more heavily rooted in entire industries or markets while structural unemployment is deeply rooted in the economy seasonal unemployment is caused by temporary fluctuations in the market often spurred by the holidays or the seasons some jobs simply come and go each year snow plow operators or tax return preparers may not work the entire year in their roles due to changing demand throughout the year like frictional unemployment seasonal unemployment is usually considered voluntary as it is implied that a role will not be for the full year when it is awarded it is also different from structural unemployment in that it usually lasts a short period of time often less than a full calendar year disadvantages of structural unemploymentwhile the 2007 2009 global recession caused cyclical unemployment it also increased structural unemployment in the united states as the jobless rate peaked over 10 in october 2009 the average unemployment period for millions of workers rose significantly 2 these workers skills deteriorated during this time of prolonged unemployment causing structural unemployment this has the severe downside of making it even harder for workers to find and retain jobs the depressed housing market also affected the job prospects of the unemployed and therefore increased structural unemployment relocating to a new job in another city would have meant selling a home at a substantial loss which not many people were willing to do creating a mismatch of skills and job availability therefore structural has the distinct disadvantage of being solved by potentially incurring major personal financial losses the same can be said about education or training if a company is unable or unwilling to invest in either for their employee it may be the employee s burden to seek opportunities on their own not only does this mean the employee will have to pay for the learning opportunities the employee will likely be burdened with developing their skillset while working at their potentially full time job the bureau of labor statistics releases unemployment numbers each month on the first friday at 8 30am est 3structural unemployment and covid 19during the covid 19 pandemic the united states economy underwent unprecedented changes in structural unemployment and cyclical unemployment at its peak the united states unemployment rate more than quadrupled at the start of the pandemic reaching 14 0 in april 2020 4 it s important to note that many of these job losses were temporary however consider the following examples of roles that were structurally impacted by covid 19 also as a result of covid 19 many individuals voluntarily left the workforce though total unemployment has dropped to 3 5 as of the end of 2022 jerome powell suggested this number may be understated due to those who are not looking for work 56 as a result it is implied that true unemployment may be higher as a result of deeper more structural changes to the economy stemming from the pandemic real world exampleover the past decade france has also been hit hard by structural unemployment thise often arises from the fact that a large portion of france s workforce is participating in temporary second level jobs with little chance of being promoted to long term contracts forcing them to strike this results in a lack of job flexibility and little job mobility sidelining many french workers who have not adapted to new tasks and skills president emmanuel macron came into office in may 2017 when the unemployment rate stood at 9 5 7 he vowed to address the country s strict labor laws and make it more business friendly labor unions and the macron government began negotiating to help reduce the ranks of the structurally unemployed and the trends have been encouraging as of the end of 2019 france s unemployment stood at 8 1 down from 8 7 at the start of the year and the lowest since 2009 macron s stated goal was to get to 7 by the year 2022 8 for most of the year unemployment remained stable fairly close to this level reaching 7 3 in q3 2022 in the q3 2022 unemployment report france s long term unemployment rate those without work for at least one year stood at 2 0 4 less than its lowest level hit in q2 2009 9 | |
what is the best example of structural unemployment | as cell phone became more popular the industry shifted away from landline telephones and technology as a result those that gained technical knowledge in the mobile phone industry likely found new jobs while those that fell behind didn t due to the structural change of the world some people who did not adapt from the world moving towards cell phones may have experienced structural unemployment | |
what tends to cause structural unemployment | structural unemployment is caused when there are major changes to how the world operates consider the implications of covid 19 as consumer trends change and the world adapts to new preferences workers must adapt or they risk losing their jobs due to obsolescence | |
is cyclical unemployment better than structural unemployment | in many ways cyclical unemployment is often more preferential than structural unemployment cyclical unemployment usually lasts for a shorter amount of time cyclical unemployment also usually follows the ebb and flow of the economy and market cycles structural unemployment is more deeply rooted in markets and skillsets making it harder to overcome | |
why is structural unemployment bad | structural unemployment is tough to overcome because of how engrained some jobs used to be in the economy yet these jobs are no longer needed to overcome structural unemployment workers usually need to be willing to learn new skills adapt to using new products change industries or physically move to new locations as opposed to cyclical unemployment that is resolved through market cycles or seasonal unemployment that changes with time structural unemployment requires deliberate action to overcome the bottom linestructural unemployment occurs when there are fundamental changes to the economy that change the demand of services in these cases people lose their jobs because they are simply no longer needed mainly because of consumer preferences structural unemployment is a more severe type of unemployment compared to cyclical frictional or seasonal unemployment | |
what is structured finance | structured finance is a heavily involved financial instrument presented to large financial institutions or companies with complicated financing needs that are unsatisfied with conventional financial products since the mid 1980s structured finance has become popular in the finance industry collateralized debt obligations cdos synthetic financial instruments collateralized bond obligations cbos and syndicated loans are examples of structured finance instruments michela buttignol investopediaunderstanding structured financestructured finance is typically indicated for borrowers mostly extensive corporations that have highly specified needs that a simple loan or another conventional financial instrument will not satisfy in most cases structured finance involves one or several discretionary transactions to be completed as a result evolved and often risky instruments must be implemented benefits of structured financestructured financial products are typically not offered by traditional lenders generally because structured finance is required for major capital injection into a business or organization investors are required to provide such financing structured financial products are almost always nontransferable meaning that they cannot be shifted between various types of debt in the same way that a standard loan can increasingly structured financing and securitization are used by corporations governments and financial intermediaries to manage risk develop financial markets expand business reach and design new funding instruments for advancing evolving and complex emerging markets for these entities using structured financing transforms cash flows and reshapes the liquidity of financial portfolios in part by transferring risk from sellers to buyers of the structured products structured finance mechanisms have also been used to help financial institutions remove specific assets from their balance sheets examples of structured finance products | |
when a standard loan is not enough to cover unique transactions dictated by a corporation s operational needs a number of structured finance products may be implemented along with cdos and cbos collateralized mortgage obligations cmos credit default swaps cdss and hybrid securities combining elements of debt and equity securities are often used | securitization is the process through which a financial instrument is created by combining financial assets commonly resulting in such instruments as cdos asset backed securities abss and credit linked notes clns various tiers of these repackaged instruments are then sold to investors securitization much like structured finance promotes liquidity and is used to develop the structured financial products used by qualified businesses and other customers there are many benefits of securitization including being a less expensive source of funding and better use of capital mortgage backed securities mbss are a model example of securitization and its risk transferring utility mortgages may be grouped into one large pool leaving the issuer the opportunity to divide the pool into pieces that are based on the risk of default inherent to each mortgage the smaller pieces may then be sold to investors | |
what does structured finance involve | structured finance most often involves one or several discretionary transactions to be completed evolved and often risky instruments must be implemented as a result | |
what is structured finance used for | structured financing and securitization are increasingly used to manage risk develop financial markets expand business reach and design new funding instruments for advancing evolving and complex emerging markets they are also used to help financial institutions remove specific assets from their balance sheets | |
what are structured finance product types | structured finance instruments include the bottom linestructured finance is a financial instrument available to large financial institutions or companies that have complex financing needs that cannot be ordinarily solved with conventional financing it is used to manage risk and develop financial markets for complex emerging markets and its forms include collateralized debt obligations cdos synthetic financial instruments collateralized bond obligations cbos and syndicated loans | |
what is a structured note | a structured note is a debt obligation that also contains an embedded derivative component that adjusts the security s risk return profile the return performance of a structured note will track both the underlying debt obligation and the derivative embedded within it this type of note is a hybrid security that attempts to change its profile by including additional modifying structures thus increasing the bond s potential return understanding structured notesa structured note is a debt security issued by financial institutions its return is based on equity indexes single equity a basket of equities interest rates commodities or foreign currencies the performance of a structured note is linked to the return on an underlying asset group of assets or index all structured notes have two underlying pieces a bond component and a derivative component the bond portion of the note takes up most of the investment and provides principal protection the rest of the investment not allocated to the bond is used to purchase a derivative product and provides upside potential to investors the derivative portion is used to provide exposure to any asset class 1an example of a structured note would be a five year bond coupled with a futures contract on almonds common structured notes include principal protected notes reverse convertible notes and leveraged notes structured notes are often too risky and complicated for individual investors advantages and disadvantages of structured notesthe flexibility of structured notes allows them to provide a wide variety of potential payoffs that are difficult to find elsewhere they may offer increased or decreased upside potential downside risk and overall volatility for instance they may consist of a fairly stable bond coupled with out of the money call options on risky stocks this combination limits losses while creating the potential for large gains but it may lead to repeated small losses if the call options are too far out of the money a structured note offers limited losses in exchange for limited gains compared to other assets for instance the structured note might be linked to the s p 500 with gains capped at 10 and maximum losses set at 15 structured notes can also be used to make unconventional bets on specific outcomes a structured note might depend on stock market volatility as measured by the vix a different structured note based on bull put spreads might offer significant gains even in flat markets however such a note would have high downside risk when the stock market has small losses derivatives are complicated even when they are not combined with other financial products for instance commodities futures contracts require specific knowledge on the part of the investor to understand their full implications that makes a structured note a very complex product as it is both a debt instrument and a derivative instrument it is vital to know how to calculate a structured note s expected payoffs market risk is prevalent in all investments and structured notes have pitfalls some structured notes have principal protection for the ones that don t it is possible to lose some or all of the principal 2 this risk arises when the underlying derivative becomes volatile that can happen with equity prices interest rates commodity prices and foreign exchange rates low liquidity is often a problem for holders of structured notes the flexibility of structured notes makes it difficult for large markets to develop particular notes that makes it very hard to buy or sell a structured note on a secondary market investors who want a structured note should expect to hold the instrument to its maturity date thus great care must be taken when investing in a structured note structured notes also suffer from higher default risk than their underlying debt obligations and derivatives if the issuer of the note defaults the entire value of the investment could be lost 1 investors can reduce this default risk by buying debt and derivatives directly for example it is possible to buy u s treasury bonds from the government and buy options separately that would protect most of the funds from default risk flexibleoffer variety of potential payoffslimited losses for limited gainscan be used for unconventional bets on certain outcomescomplicated assets on their ownpotential to lose part or all of the principallow liquidityhard to trade on the secondary markethigher default risk than underlying debt obligations and derivativestypes of structured notesthe following are several common types of structured notes buffer exchange traded funds etfs are a more liquid alternative to structured notes for investors who are looking to limit losses in exchange for smaller potential gains | |
how do structured notes work | a structured note is a complicated investment it is a derivative that brings together the features of different investments into one vehicle as such they track the performance of an underlying asset put simply it is a debt obligation with a derivative embedded into it there is some degree of flexibility that provides limited losses with limited gains but they provide investors with low levels of liquidity and can be hard to trade on the secondary market who invests in structured notes structured notes are considered complicated investments because of the intricacies involved since they involved both a debt obligation and a derivative it s important for investors to understand how these two elements work having said that investment banks typically create structured notes for more sophisticated investors like hedge funds and institutional investors can you lose money in a structured note that depends on the type of structured note certain notes offer some sort of principal protection if you invest in a note that doesn t have this protection you could lose some or all of your principal investment balance the bottom linethe investment world is full of different investments each of these comes with its own complexities risks and rewards structured notes may not be on the minds of average investors but it s still a good idea to understand how they work combining the features of two different types of investments into one structured notes allow traders to limit their losses albeit while they limit their gains but before diving in it s always a good idea to understand how they work and what risks may come with investing in them | |
what is student loan forgiveness | student loan forgiveness releases borrowers from their obligation to repay part or all of their federal student loan debt these borrowers have taken out loans to pay for their post secondary education forgiveness is available for some types of loans but eligibility is limited to borrowers in certain public service educational or military professions in addition to income driven repayment idr plans president biden announced a new idr plan on june 30 2023 in response to the same day supreme court decision that halted his previous student loan forgiveness plan 1 called the saving on a valuable education plan save it offers enhanced financial benefits to student loan borrowers three important features of the plan launched during the summer of 2023 while the full regulations were scheduled to take effect on july 1 2024 | |
what is subjective probability | subjective probability is a type of probability derived from an individual s personal judgment or own experience about whether a specific outcome is likely to occur it contains no formal calculations and only reflects the subject s opinions and past experience an example of subjective probability is a gut instinct when making a trade investopedia paige mclaughlin | |
how subjective probability works | subjective probabilities differ from person to person and contain a high degree of personal bias subjective probability can be contrasted with objective probability which is the computed probability that an event will occur based on an analysis in which each measure is based on a recorded observation or a long history of collected data subjective probabilities are the foundation for common errors and biases observed in the market that stem from old wives tales or rules of thumb the probability of an event is based on the likelihood of that event occurring in most forms of probability quantitative information is gathered and interpreted to help determine this likelihood through a mathematical mechanism normally relating to the mathematical field of statistics the percentage chance of a flipped coin landing on heads or tails can be interpreted as a probability expressed as a 50 chance that it will land heads up and a 50 chance it will land tails up subjective probability on the other hand is highly flexible even in terms of one individual s belief while an individual may believe the chance of a specified event occurring is 25 they could have a different belief when given a specific range from which to choose such as 25 to 30 this can occur even if no additional hard data is behind the change subjective probability can be affected by a variety of personal beliefs held by an individual these could relate back to upbringing as well as other events the person has witnessed throughout his life even if the individual s belief can be rationally explained it does not make the prediction an actual fact it is often based on how each individual interprets the information presented to him example of subjective probabilityan example of subjective probability is asking new york yankees fans before the baseball season starts about the chances of new york winning the world series while there is no absolute mathematical proof behind the answer to the example fans might still reply in actual percentage terms such as the yankees having a 25 chance of winning the world series in another scenario consider a person who is asked to predict the percentage chance of whether a flipped coin will land with heads or tails up his initial response may be the mathematically true 50 if 10 coin flips occur all resulting in the coin landing tails up the person may change his percentage chance to a number other than 50 such as saying the chance of it landing tails up is 75 even knowing that the new prediction is mathematically inaccurate the individual s personal experience of the previous 10 coin flips has created a situation in which he chooses to use subjective probability | |
what is a sublease | a sublease is the re renting of property by an existing tenant to a new third party for a portion of the tenant s existing lease contract the sublease agreement may also be called a sublet subleasing may or may not be permitted in the terms of the original lease and may be subject to additional restrictions by jurisdiction even if a sublease is permitted the original tenant is still liable for the obligations stated in the lease agreement such as the payment of rent each month | |
how a sublease works | a lease is a contract between a property owner and a tenant that transfers the owner s rights to the exclusive possession and use of the real estate property to the tenant for an agreed upon period the lease states the length of time the contract is to run and the amount of the tenant s rent in legal terms the tenant s legal right to possess the property is deemed tenancy subleasing occurs when the tenant transfers a part of their legal tenancy to a third party as a new tenant subleasing can be established unless the original lease forbids it however in most cases the owner must be notified and must approve any subletting arrangement created by the tenant control over the subletting process could be written into the original lease so that the owner has some control over who uses and or occupies their property a tenant who sublets property must understand that subleasing does not release them from their obligations on the original contracted lease the tenant is responsible for paying rent and for repairs or damage to the property that means that if a new subtenant does not pay rent for three months the original tenant that subleased the property is liable to the landlord for the overdue rent amount and any late fees in turn the subtenant is liable to the original tenant for the unpaid rent subleasing and state lawsthe laws of many states and local municipalities affect a tenant s right to sublease these laws may allow an individual to sublease under certain conditions even if their contract with the landlord forbids it for example in new york city a tenant who lives in a building with four or more units has the right to sublease as long as the landlord consents or if they deny the sublet on unreasonable grounds any lease provision restricting a tenant s right to sublease is void as a matter of public policy 1in san francisco a tenant can replace a roommate with another even when prohibited by a written lease as long as the replacement meets the landlord s application screening standards 2 for example a landlord might demand a certain credit score where a tenant is concerned subleases can apply to both residential and commercial properties | |
when subleasing it s standard for only the original tenant s name to be on the lease even if the sublessee pays the landlord directly 3 | example of a subleasebecause a lease is generally for a predefined term situations can arise that make it difficult or impossible for the original tenant to complete the lease term for example if a tenant is renting an apartment in chicago with a 12 month lease and during month four that tenant receives a job offer in boston the tenant may decide to sublease the apartment to another tenant for the remaining eight months the sublease means that the original tenant can accept the job and move and does not have to pay expensive fees to get out of the lease or pay rent on two apartments the landlord also benefits because they receive all 12 rent payments and are saved the expense and effort of finding a replacement tenant the sublease arrangement also means that the original tenant retains an interest in the apartment thus if the original tenant decides to move back to chicago they may be able to renew their lease on their old apartment | |
what is subordinated debt | subordinated debt also known as a subordinated debenture is an unsecured loan or bond that ranks below other more senior loans or securities with respect to claims on assets or earnings subordinated debentures are thus also known as junior securities in the case of borrower default creditors who own subordinated debt will not be paid out until after senior bondholders are paid in full investopedia candra huffunderstanding subordinated debtsubordinated debt is riskier than unsubordinated debt subordinated debt is any type of loan that s paid after all other corporate debts and loans are repaid in the case of borrower default borrowers of subordinated debt are usually larger corporations or other business entities subordinated debt is the exact opposite of unsubordinated debt in that senior debt is prioritized higher in bankruptcy or default situations subordinated debt repayment mechanics | |
when a corporation takes out debt it normally issues two or more bond types that are either unsubordinated debt or subordinated debt if the company defaults and files for bankruptcy a bankruptcy court will prioritize loan repayments and require that a company repay its outstanding loans with its assets the debt that is considered lesser in priority is the subordinated debt the higher priority debt is considered unsubordinated debt | the bankrupt company s liquidated assets will first be used to pay the unsubordinated debt any cash in excess of the unsubordinated debt will then be allocated to the subordinated debt holders of subordinated debt will be fully repaid if there is enough cash on hand for repayment it s also possible that subordinated debt holders will receive either a partial payment or no payment at all since subordinated debt is risky it s important for potential lenders to be mindful of a company s solvency other debt obligations and total assets when reviewing an issued bond although subordinated debt is riskier for lenders it s still paid out prior to any equity holders bondholders of subordinated debt are also able to realize a higher rate of interest to compensate for the potential risk of default while subordinated debt is issued by a variety of organizations its use in the banking industry has received special attention such debt is attractive for banks because interest payments are tax deductible 1 a 1999 study by the federal reserve recommended that banks issue subordinated debt to self discipline their risk levels the study s authors argued that issuance of debt by banks would require profiling of risk levels which in turn would provide a window into a bank s finances and operations during a time of significant change after a repeal of the glass steagall act 2 in some instances subordinated debt is being used by mutual savings banks to buffer up their balance to meet regulatory requirements for tier 2 capital 3subordinated debt reporting for corporationssubordinated debt like all other debt obligations is considered a liability on a company s balance sheet current liabilities are listed first on the balance sheet senior debt or unsubordinated debt is then listed as a long term liability finally subordinated debt is listed on the balance sheet as a long term liability in order of payment priority beneath any unsubordinated debt when a company issues subordinated debt and receives cash from a lender its cash account or its property plant and equipment ppe account increases and a liability is recorded for the same amount subordinated debt vs senior debt an overviewthe difference between subordinated debt and senior debt is the priority in which the debt claims are paid by a firm in bankruptcy or liquidation if a company has both subordinated debt and senior debt and has to file for bankruptcy or face liquidation the senior debt is paid back before the subordinated debt once the senior debt is completely paid back the company then repays the subordinated debt senior debt has the highest priority and therefore the lowest risk thus this type of debt typically carries or offers lower interest rates meanwhile subordinated debt carries higher interest rates given its lower priority during payback senior debt is generally funded by banks the banks take the lower risk senior status in the repayment order because they can generally afford to accept a lower rate given their low cost source of funding from deposit and savings accounts in addition regulators advocate for banks to maintain a lower risk loan portfolio subordinated debt is any debt that falls under or behind senior debt however subordinated debt does have priority over preferred and common equity examples of subordinated debt include mezzanine debt which is debt that also includes an investment additionally asset backed securities generally have a subordinated feature where some tranches are considered subordinate to senior tranches asset backed securities are financial securities collateralized by a pool of assets including loans leases credit card debt royalties or receivables tranches are portions of debt or securities that have been designed to divide risk or group characteristics so that they can be marketable to different investors | |
what is a subordination agreement | a subordination agreement is a legal document that establishes one debt as ranking behind another in priority for collecting repayment from a debtor the priority of debts can become extremely important when a debtor defaults on their payments or declares bankruptcy the higher a debt s priority the more likely it is to be repaid at least in part | |
how a subordination agreement works | individuals and businesses turn to lending institutions when they need to borrow funds and they may take on multiple debts for a variety of purposes if they declare bankruptcy there may not be enough money to repay all of their creditors when that happens a trustee appointed by the court will attempt to repay as much of the debt as possible starting with the debts that have the highest priority those are often referred to as senior debt lower on the priority list are obligations classified as junior debt or subordinated debt lenders of senior debts have a legal right to be repaid in full before lenders of subordinated debts receive anything as a result the lenders with lower priority debts might receive only partial repayment or none at all | |
why would any lender agree to that one reason is that they may receive a higher interest rate from the borrower in return for taking on the greater risk they may also receive fees 1 | a subordination agreement must be signed and acknowledged by a notary and recorded in the official records of the county to be enforceable examples of subordinationsubordination can come into play when either a business or individual declares bankruptcy in the case of a business suppose a public company has 670 000 in senior debt 460 000 in subordinated debt and total assets with a value of 900 000 the business files for chapter 7 bankruptcy and its assets are liquidated at market value 900 000 the senior debt holders will be paid in full and the remaining 230 000 will be distributed among the subordinated debt holders for cents on the dollar those may include investors who own any bonds the company had issued earlier an exception would be secured bonds which entitle the lender to claim whatever collateral was used to back them stockholders in the company would most likely receive nothing in the liquidation process because stockholders are last in line subordinate to all other types of creditors 2 | |
when an individual declares bankruptcy their obligations will also be paid off in a specified order for example alimony and child support are among the items at the top of the list 3 the person s senior debts would be paid off ahead of any junior or subordinated debts | individuals most often encounter the concept of subordination and subordination agreements with mortgages suppose a person has both an original mortgage and a home equity line of credit heloc on the same property both lenders will have liens on the home but the mortgage will have the first lien and first claim on the collateral because it came first the heloc lender will have a second lien putting it in a subordinate position in the event of a foreclosure the mortgage lender would be paid back first now suppose the homeowner decides to take out a new mortgage to refinance the old one when the old mortgage is paid off the heloc would normally move up into the first lien position because it is now the older debt however the lender of the new mortgage may not agree to those terms and instead insist that the heloc lender accept a subordination agreement the heloc lender may do so in return for a fee as is most likely outlined in the terms of its contract with the homeowner it also has the option to refuse in which case the deal may fall through | |
what is chapter 7 bankruptcy | in a chapter 7 bankruptcy the debtor s assets except for some that are considered exempt will be sold off and the proceeds will be used to pay their creditors to the extent possible both businesses and individuals can file for chapter 7 bankruptcy it is sometimes referred to as a liquidation bankruptcy 4 | |
what is a chapter 11 bankruptcy | chapter 11 bankruptcy is typically used by businesses rather than have their assets liquidated and go out of business as in a chapter 7 bankruptcy chapter 11 allows them to reorganize under a court appointed trustee s supervision and continue to operate at the same time they must agree to a plan to repay their creditors typically over a period of several years 5 | |
what is a chapter 13 bankruptcy | a chapter 13 bankruptcy for individuals is similar to chapter 11 for companies rather than liquidating most of an individual s assets like chapter 7 a chapter 13 bankruptcy allows them to keep more assets if they agree to and adhere to a court approved plan to repay their creditors 6the bottom linesubordination agreements are used to legally establish the order in which debts are to be repaid in the event of a foreclosure or bankruptcy in return for the agreement the lender with the subordinated debt will be compensated in some manner for the additional risk consumers will often encounter a subordinated debt agreement if they have more than one mortgage on their home and decide to refinance it | |
what is a subprime loan | a subprime loan is a type of loan offered at a rate above prime to individuals who do not qualify for prime rate loans quite often subprime borrowers have been turned down by traditional lenders because of their low credit ratings or other factors that suggest they have a reasonable chance of defaulting on the debt repayment | |
when banks lend each other money in the middle of the night to cover their reserve requirements they charge each other the prime rate an interest rate based on the federal funds rate established by the federal open market committee of the federal reserve bank as the fed s website explains it although the federal reserve has no direct role in setting the prime rate many banks choose to set their prime rates based partly on the target level of the federal funds rate the rate that banks charge each other for short term loans established by the federal open market committee 1 | the prime rate has fluctuated from a low of 2 in the 1940s to a high of 21 5 in the 1980s 2 at its march 15 2020 federal open market committee fomc meeting the federal reserve lowered the target range for the fed funds rate to 0 0 25 3 this action was the result of the federal reserve s efforts to combat the economic repercussions of the covid 19 pandemic since the 1990s the prime rate has typically been set to 300 basis points above the fed funds rate translating to a prime rate of 8 5 based on the fed s latest action as of this writing 45the u s prime rate in march 20202 the prime rate plays a large role in determining the interest that banks charge their borrowers traditionally corporations and other financial institutions receive rates equal or very close to the prime rate retail customers with good credit and strong credit histories who take out mortgages small business loans and car loans receive rates slightly higher than but based on the prime rate applicants with low credit scores or other risk factors are offered rates by lenders that are significantly higher than the prime rate hence the term subprime loan the specific amount of interest charged on a subprime loan is not set in stone different lenders may not evaluate a borrower s risk in the same manner this means a subprime loan borrower has an opportunity to save some money by shopping around still by definition all subprime loan rates are higher than the prime rate also borrowers might accidentally stumble into the subprime lending market by for example responding to an advertisement for mortgages when they actually qualify for a better rate than they are offered when they follow up on the ad borrowers should always check to see whether they qualify for a better rate than the one they are originally offered the higher interest rates on subprime loans can translate into tens of thousands of dollars in additional interest payments over the life of a loan special considerations for subprime loanson large term loans such as mortgages the additional percentage points of interest often translate to tens of thousands of dollars worth of extra interest payments over the life of the loan this can make paying off subprime loans difficult for low income borrowers as it did in the late 2000s in 2007 high numbers of borrowers holding subprime mortgages began to default ultimately this subprime meltdown was a significant contributor to the financial crisis and the ensuing great recession 6 as a result a number of big banks got out of the subprime lending business more recently though this has started to change while any financial institution could offer a loan with subprime rates there are lenders that focus on second chance loans and subprime loans with high rates arguably these lenders give borrowers who have trouble getting low interest rates the ability to access capital to invest grow their businesses or buy homes subprime lending is often considered to be predatory lending which is the practice of giving borrowers loans with unreasonable rates and locking them into debt or increasing their likelihood of defaulting nevertheless getting a subprime loan may be a sensible option if the loan is meant to pay off debts with higher interest rates such as credit cards or if the borrower has no other means of obtaining credit | |
what is a subprime mortgage | a subprime mortgage is one that s normally issued to borrowers with low credit ratings a prime conventional mortgage isn t offered because the lender views the borrower as having a greater than average risk of defaulting on the loan lending institutions often charge interest on subprime mortgages at a much higher rate than on prime mortgages to compensate for carrying more risk these are often adjustable rate mortgages arms as well so the interest rate can potentially increase at specified points in time investopedia theresa chiechiunderstanding subprime mortgages subprime doesn t refer to the interest rates often attached to these mortgages but rather the credit score of the individual taking out the mortgage borrowers with fico credit scores below 620 will often be stuck with subprime mortgages and their corresponding higher interest rates 3it can be useful for people with low credit scores to wait for a period of time and build up their credit histories before applying for a mortgage so they might qualify for a prime loan the interest rate associated with a subprime mortgage is dependent on four factors credit score the size of the down payment the number of late payment delinquencies on a borrower s credit report and the types of delinquencies found on the report a mortgage calculator is a good resource to see how different interest rates would affect a monthly payment different lenders will use different rules for what constitutes a subprime loan but fico scores below 640 620 or 600 have typically been classified as subprime cut offs in the past the consumer financial protection bureau classifies credit scores between 619 and 580 as subprime 4subprime mortgages vs prime mortgagesmortgage applicants are typically graded from a to f with a scores going to those with exemplary credit and f scores going to those with no discernible ability to repay a loan at all prime mortgages go to a and b candidates whereas lower rated candidates must typically resign themselves to subprime loans if they re going to get loans at all lenders aren t legally obligated to offer you the best available mortgage terms or even let you know that they re available so consider applying for a prime mortgage first to find out if you do indeed qualify role in the 2008 housing market crashthe 2008 housing market crash was due in large part to widespread defaults on subprime mortgages many borrowers were given what were known as ninja loans an acronym derived from the phrase no income no job and no assets these mortgages were often issued with no down payment required and proof of income was not necessary either a buyer might state earnings of 150 000 a year but did not have to provide documentation to substantiate the claim these borrowers then found themselves underwater in a declining housing market with their home values lower than the mortgage they owed many of these ninja borrowers defaulted because the interest rates associated with the loans were teaser rates variable rates that started low and ballooned over time making it very hard to pay down the principal of the mortgage even after the financial crash subprime mortgages didn t go away wells fargo began offering mortgages to individuals with credit ratings in the low 600s again in 2014 the nonprofit community advocacy and homeownership organization neighborhood assistance corporation of america continued its achieve the dream tour in 2018 hosting events nationwide to help people apply for non prime loans which are effectively the same as subprime mortgages 56covid 19 mortgage reliefthe coronavirus aid relief and economic security cares act signed into law on march 27 2020 provided some temporary relief to those who found themselves unable to make their mortgage payments due to the initial financial fallout from the coronavirus pandemic 7if backed by the federal government or an agency like freddie mac or fannie mae mortgage lenders or loan servicers were not allowed to foreclose on homeowners until july 31 2021 additionally those who experienced financial hardship due to the pandemic were able to request and obtain a loan forbearance for up to 180 days without penalty 7the american rescue plan arp act of 2021 signed by president biden also provided additional support the nearly 2 trillion coronavirus rescue package contained additional funding which provided relief to those behind on mortgages rent and utility bills the legislation issued homeowners in need of assistance with mortgage payments should consult the national low income housing coalition s website which provides a searchable list of all the programs currently available | |
what does a subprime loan mean | a subprime loan is a type of loan offered at a rate above prime to individuals who do not qualify for prime rate loans quite often subprime borrowers have been turned down by traditional lenders because of their low credit ratings or other factors that suggest they have a reasonable chance of defaulting on the debt repayment | |
what is the difference between a prime loan and a subprime loan | because subprime borrowers are riskier they carry higher interest rates than prime loans the specific amount of interest charged on a subprime loan is not set in stone different lenders may not evaluate a borrower s risk in the same manner this means a subprime loan borrower has an opportunity to save some money by shopping around still by definition all subprime loan rates are higher than the prime rate who offers subprime mortgages while any financial institution could offer a loan with subprime rates there are lenders that focus on subprime loans with high rates arguably these lenders give borrowers who have trouble getting low interest rates the ability to access capital to invest grow their businesses or buy homes at the same time the higher interest rates on subprime loans can translate into tens of thousands of dollars in additional interest payments over the life of a loan | |
what are the drawbacks of subprime loans | for borrowers the higher interest rates will mean a costlier loan over time which may be harder to service for a borrower who already has financial troubles on a systemic level defaults on subprime loans have been identified as a key factor in the 2008 09 financial crisis 1lenders are often seen as the biggest culprits freely granting loans to people who couldn t afford them because of free flowing capital following the dot com bubble of the early 2000s still borrowers that bought homes they truly could not afford contributed as well did subprime lending cause the 2008 09 financial crisis most experts agree that subprime mortgages were an important part of the financial crisis when it comes to the subprime mortgage part of the crisis there was no single entity or individual at whom one could point the finger instead this crisis involved the interplay between the world s central banks homeowners lenders credit rating agencies underwriters and investors the bottom linesubprime mortgages are mortgages offered to borrowers with low credit ratings subprime mortgages are viewed as a greater risk to the lender and therefore come with higher interest rates depending on the personal situation of the borrower it may be beneficial to wait till their credit score improves before taking out a mortgage so that they may obtain better interest rates | |
what is subrogation | subrogation is a term describing the right held by most insurance carriers to legally pursue a third party that caused an insurance loss to an insured this allows the insurance carrier to recover the amount of the claim it paid to the insured for the loss understanding subrogationsubrogation refers to the act of one person or party standing in the place of another person or party it effectively defines the rights of the insurance company both before and after it has paid claims made against a policy also it makes the process of obtaining a settlement under an insurance policy easier | |
how subrogation works | in most cases an individual s insurance company pays its client s claim for losses directly then seeks reimbursement from the other party or their insurance company in such cases the insured typically receives prompt payment then the insurance company may pursue a subrogation claim against the party at fault for the loss 1insurance policies may contain language that entitles an insurer once losses are paid on claims to seek recovery of funds from a third party if that third party caused the loss the insured does not have the right to file a claim with the insurer to receive the coverage outlined in the insurance policy or to seek damages from the third party that caused the losses subrogation enables accident victims to receive claim payments more quickly after a loss subrogation sometimes shortened to subro in the insurance sector especially among auto insurance policies occurs when the insurance carrier takes on the financial burden of the insured as the result of an injury or accident payment and seeks repayment from the at fault party the subrogation process can take weeks months or even years to complete dependng on the complexity of the case state regulations and other factors 2example of subrogationone example of subrogation is when an insured driver s car is totaled through the fault of another driver the insurance carrier reimburses the covered driver under the terms of the policy and then pursues legal action against the driver at fault if the carrier is successful it must divide the amount recovered after expenses proportionately with the insured to repay any deductible paid by the insured subrogation is not only relegated to auto insurers and their policyholders subrogation also occurs within the health care sector if for example a health insurance policyholder is injured in an accident and the insurer pays 20 000 to cover the medical bills that same health insurance company is allowed to collect 20 000 from the at fault party to reconcile the payment subrogation process for the insuredluckily for policyholders the subrogation process is extremely passive for the victim of an accident when another party is at fault the subrogation process is meant to protect insured parties the insurance companies of the two parties involved work largely behind the scense to mediate and come to agreement over the payment 3policyholders are simply covered by their insurance company and can act accordingly the insured party benefits because the at fault party must make a payment during subrogation to the insurer which helps keep the policyholder s insurance rates low insurance companies do most of the work during subrogation freeing the insured from having to participate in the process in the case of any accident it remains important to stay in communication with the insurance company make sure all accidents are reported to the insurer in a timely manner and let the insurer know if there should be any settlement or legal action if a settlement occurs outside of the normal subrogation process between the two parties in a court of law it is often legally impossible for the insurer to pursue subrogation against the at fault party this is due to the fact most settlements include a waiver of subrogation benefits of subrogationin insurance subrogation allows your insurer to recover the costs associated with a claim such as medical bills repairs costs and your deductible from the at fault party s insurer assuming you were not at fault this means that both you and your insurer can recoup the costs of damage or harm caused by somebody else it also means improved loss ratios profits and underwriting revenue for the insurer plus added customer satisfaction and protection 4waivers of subrogationa waiver of subrogation is a contractual provision where an insured waives the right of their insurance carrier to seek redress or compensation for losses from a negligent third party typically insurers charge an additional fee for this special policy endorsement many construction contracts and leases include a waiver of subrogation clause such provisions prevent one party s insurance carrier from pursuing a claim against the other contractual party in an attempt to recover money paid by the insurance company to the insured or to a third party to resolve a covered claim in other words if subrogation is waived the insurance company cannot step into the client s shoes once a claim has been settled and sue the other party to recoup their losses thus if subrogation is waived the insurer is exposed to greater risk | |
what is the legal definition of subrogation | subrogation in the legal context refers to when one party takes on the legal rights of another especially substituting one creditor for another subrogation can also occur when one party takes over another s right to sue 5 | |
does subrogation affect the insured victim | the subrogation process which is meant to protect insured parties is a passive experience for the insured victim of an accident when another insured party is at fault the insurance companies of the two parties involved work to mediate and legally come to a conclusion over payment the insured benefits when the at fault party makes payment during subrogation to the insurer which helps keep the policyholder s insurance rates low | |
what is a waiver of subrogation | a waiver of subrogation is a contractual provision where an insured party waives the right of their insurance carrier to seek redress or seek compensation for losses from a negligent third party typically insurers charge an additional fee for this endorsement as waiving exposes the insurer to greater risk | |
how does subrogation affect claims payments | subrogation allows the accident victim s insurance company to pay claims immediately to their client allows the insured to receive payments more quickly their insurance carrier then seeks to recover that amount from the at fault party or their insurer the bottom linesubrogation allows insurance carriers to legally pursue claims a third party that caused an insurance loss to one of its insureds this enables the insurer to pay claims files by its insurers sooner and then recover the claim amount from the parties who are at fault for the loss subrogation allows insured to receive payments sooner and helps keep their premiums low | |
what is a subscription agreement | a subscription agreement is an investor s application to join a limited partnership lp it is also a two way guarantee between a company and a new shareholder subscriber the company agrees to sell a certain number of shares at a specific price and in return the subscriber promises to buy the shares at the predetermined price understanding subscription agreementsbroadly defined a partnership is a business agreement between two or more people who all have personal ownership in the business the partnership entity does not pay taxes instead the profits and losses flow through to each partner partners will pay taxes on their distributive share of the partnership s taxable income based on a partner agreement 3 law firms and accounting firms are often formed as general partnerships in a lp a general partner manages the partnership entity and brings in limited partners using a subscription agreement candidates subscribe to become limited partners after meeting standard requirements the general partner decides whether to accept the candidate limited partners act as silent partners by providing capital usually a one time investment and have no material participation in the business s operations as a result partners typically have little to no voice in the day to day operations of the partnership and are exposed to less risk than full partners each limited partner s exposure to business losses is limited to that partner s original investment the subscription agreement for joining the lp describes the investment experience sophistication and net worth of the potential limited partner subscription agreements are generally covered by sec rules 506 b and 506 c of regulation d 12 these stipulations define the method of conducting an offering and the amount of material information that companies are required to disclose to investors as new limited partners are added to an offering general partners obtain the consent of existing partners before amending the subscription agreement raising capital through a reg d investment involves meeting significantly less onerous requirements than a public offering this allows companies to save time and sell securities that they might not otherwise be able to issue in some cases subscription agreements with private placements | |
when a company wishes to raise capital it will often issue shares of stock for purchase by either the general public or through a private placement the primary disclosure form for potential general public investors is a prospectus the prospectus is a disclosure document listing information about the business and its underlying security | a private placement is a sale of stock to a limited number of accredited investors who meet specific criteria the criteria for accredited status include having a particular level of investment experience assets and net worth 4 investors will receive a private placement memorandum as an alternative to the prospectus the memorandum provides a less comprehensive description of the investment in many cases a subscription agreement accompanies the memorandum some agreements outline a specific rate of return that will be paid to the investor such as a particular percentage of company net income or lump sum payments also the agreement will define the payment dates for these returns this structure gives priority to the investor as they earn a rate of return on the investment before company founders or other minority owners | |
what is a subsidiary | in the corporate world a subsidiary is a company that belongs to another company which is usually referred to as the parent company or holding company the parent holds a controlling interest in the subsidiary company meaning it owns or controls more than half of its stock in cases where a subsidiary is 100 owned by another company the subsidiary is referred to as a wholly owned subsidiary investopedia paige mclaughlin | |
how subsidiaries work | subsidiaries are separate and distinct legal entities from their parent companies which is reflected in the independence of their liabilities taxation and governance if a parent company owns a subsidiary in a foreign land the subsidiary must follow the laws of the country where it is incorporated and operates however given their controlling interest parent companies often have considerable influence over their subsidiaries they along with other subsidiary shareholders if any vote to elect a subsidiary company s board of directors and there may often be a board member overlap between a subsidiary and its parent company to be designated a subsidiary at least 50 of a company s equity has to be controlled by another entity anything less and the company is considered an associate or affiliate company subsidiary financialsa subsidiary usually prepares independent financial statements typically these are sent to the parent which will aggregate them as it does financials from all of its operations and carry them on its consolidated financial statements in contrast an associate company s financials are not combined with the parent s instead the parent registers the value of its stake in the associate as an asset on its balance sheet accounting standards generally require that public companies consolidate all majority owned subsidiaries consolidation is viewed as a more meaningful method of accounting than providing separate financials for a parent company and each of its subsidiaries 1an unconsolidated subsidiary is a subsidiary with financials that are not included in its parent company s statements ownership of unconsolidated subsidiaries is typically treated as an equity investment and denoted as an asset on the parent company s balance sheet for regulatory reasons unconsolidated subsidiaries are generally those in which a parent company does not have a significant stake 12the securities and exchange commission sec states that only in rare cases such as when a subsidiary is undergoing bankruptcy should a majority owned subsidiary not be consolidated 2subsidiary pros and consbuying an interest in a subsidiary usually requires a smaller investment on the part of the parent company than a merger would also unlike a merger shareholder approval is not required to purchase or sell a subsidiary a parent company buys or establishes a subsidiary to obtain specific synergies such as a more diversified product line or assets in the form of earnings equipment or property subsidiaries can be the experimental ground for different organizational structures manufacturing techniques and types of products in addition subsidiaries can contain and limit problems for a parent company to some extent with the subsidiary serving as a kind of liability shield in the event of lawsuits entertainment companies often set up individual movies or tv shows as separate subsidiaries for this reason however subsidiaries also have a few drawbacks aggregating and consolidating a subsidiary s financials can make the parent company s accounting more complicated since subsidiaries must remain independent to some degree transactions with the parent may have to be at arm s length and the parent might not have all of the control it wishes and while a subsidiary can help shield the parent company from certain legal problems the parent may still be liable for criminal actions or corporate malfeasance by the subsidiary finally it may have to guarantee the subsidiary s loans leaving it exposed to financial losses contained limited lossespotential tax advantageseasier to establish and sellsynergy with other corporate divisions subsidiariesextra legal and accounting workgreater bureaucracycomplex financial statementsliability for subsidiary s actions debtsreal world examples of subsidiariespublic companies are required by the sec to disclose significant subsidiaries warren buffett s berkshire hathaway inc for example has a long and diverse list of subsidiary companies including international dairy queen clayton homes business wire geico and helzberg diamonds 3berkshire hathaway s acquisition of many diverse businesses follows buffett s oft discussed strategy of buying undervalued assets and holding onto them in return acquired subsidiaries can often continue to operate independently while gaining access to broader financial resources like berkshire hathaway alphabet inc has many subsidiaries the best known of which is google these separate business entities all perform unique operations intended to add value to alphabet through diversification revenue earnings and research and development r d for example sidewalk labs seeks to modernize public transit in the united states the company has developed a public transportation management system that aggregates millions of data points from smartphones cars and wi fi hotspots to analyze and predict where traffic and commuters are most congregated the system can redirect public transportation resources such as buses to these congested areas to keep the public transit system moving efficiently 4 | |
is a subsidiary its own company | yes a subsidiary is independent operating as a separate and distinct entity from its parent company often a parent company may issue exchangable debt that converts into shares of the subsidiary that said the parent company as a majority owner can influence how its subsidiary is run and may be liable for example for the subsidiary s negligence and debt | |
does a subsidiary have its own ceo | as a subsidiary functions as a separate entity it usually has its own management team and ceo however the parent company will get a significant say in who runs the company and who sits on its board of directors | |
what are sister companies | two or more subsidiaries majority owned by the same parent company are called sister companies the bottom linea subsidiary is a company that is completely or partially owned by another company acquiring and establishing subsidiaries is fairly common among publicly traded companies especially in industries like tech and real estate the advantages of these business structures include tax benefits reduced risk increased efficiencies and diversification drawbacks include limited control and greater bureaucracy and legal costs | |
what is a subsidy | a subsidy is a benefit given to an individual business or institution usually by the government it can be direct such as cash payments or indirect such as tax breaks the subsidy is typically given to remove some type of burden and it is often considered to be in the overall interest of the public given to promote a social good or an economic policy investopedia xiaojie liu | |
how a subsidy works | a subsidy is generally some form of payment provided directly or indirectly to the receiving individual or business entity subsidies are generally seen as a privileged type of financial aid as they lessen an associated burden that was previously levied against the receiver or promote a particular action by providing financial support subsidies have an opportunity cost consider the great depression era agricultural subsidy described later in this story it had very visible effects and farmers saw profits rise and hired more workers the invisible costs included what would have happened with all of those dollars without the subsidy money from the subsidies had to be taxed from individual income and consumers were hit again when they faced higher food prices at the grocery store types of subsidiesa subsidy typically supports particular sectors of a nation s economy it can assist struggling industries by lowering the burdens placed on them or encourage new developments by providing financial support for the endeavors often these areas are not being effectively supported through the actions of the general economy or may be undercut by activities in rival economies direct subsidies are those that involve an actual payment of funds toward a particular individual group or industry indirect subsidies are those that do not hold a predetermined monetary value or involve actual cash outlays they can include activities such as price reductions for required goods or services that can be government supported this allows the needed items to be purchased below the current market rate resulting in savings for those whom the subsidy is designed to help there are many forms of subsidies given out by the government two of the most common types of individual subsidies are welfare payments and unemployment benefits the objective of these types of subsidies is to help people who are temporarily suffering economically other subsidies such as subsidized interest rates on student loans are given to encourage people to further their education with the enactment of the affordable care act aca some u s families became eligible for subsidies based on household income and size these subsidies are designed to lower the out of pocket costs for insurance premiums in these instances the funds associated with the subsidies are sent directly to the insurance company to which premiums are due lowering the payment amount required from the household 1subsidies to businesses are given to support an industry that is struggling against international competition that has lowered prices such that the domestic business is not profitable without the subsidy historically the vast majority of subsidies in the united states have gone toward four industries agriculture financial institutions oil companies and utility companies advantages and disadvantages of subsidiesdifferent rationales exist for the provision of public subsidies some are economic some are political and some come from socioeconomic development theory development theory suggests that some industries need protection from external competition to maximize domestic benefit technically speaking a free market economy is free of subsidies introducing one transforms it into a mixed economy economists and policymakers often debate the merits of subsidies and by extension the degree to which an economy should be mixed pro subsidy economists argue that subsidies to particular industries are vital to helping support businesses and the jobs that they create economists who promote a mixed economy often argue that subsidies are justifiable to provide the socially optimal level of goods and services which will lead to economic efficiency in contemporary neoclassical economic models there are circumstances where the actual supply of a good or service falls below the theoretical equilibrium level an unwanted shortage which creates what economists call a market failure one form of correcting this imbalance is to subsidize the good or service being undersupplied the subsidy lowers the cost for the producers to bring the good or service to market if the right level of subsidization is provided all other things being equal then the market failure should be corrected in other words according to general equilibrium theory subsidies are necessary when a market failure causes too little production in a specific area they would theoretically push production back up to optimal levels some theories of development argue that the governments of less developed countries should subsidize domestic industries in their infancy to protect them from international competition this is a popular technique seen in china and various south american nations at present some say goods or services provide what economists call positive externalities a positive externality is achieved whenever an economic activity provides an indirect benefit to a third party however because the third party does not directly enter into the decision the activity will only occur to the extent that it directly benefits those directly involved leaving potential social gains on the table many subsidies are implemented to encourage activities that produce positive externalities that might not otherwise be provided at the socially optimal threshold the counterpart of this kind of subsidy is to tax activities that produce negative externalities meanwhile other economists feel free market forces should determine if a business survives or fails if it fails those resources are allocated to more efficient and profitable use they argue that subsidies to these businesses simply sustain an inefficient allocation of resources free market economists are wary of subsidies for a variety of reasons some argue that subsidies unnecessarily distort markets preventing efficient outcomes and diverting resources from more productive uses to less productive ones similar concerns come from those who suggest that economic calculation is too inexact and that microeconomic models are too unrealistic to ever correctly calculate the impact of market failure others suggest that government spending on subsidies is never as effective as government projections claim it will be the costs and unintended consequences of applying subsidies are rarely worth it they claim another problem antagonists point out is that the act of subsidizing helps corrupt the political process according to political theories of regulatory capture and rent seeking subsidies exist as part of an unholy alliance between big business and the state companies often turn to the government to shield themselves from the competition in turn businesses donate to politicians or promise them benefits after their political careers even if a subsidy is created with good intentions without any conspiracy or self seeking it raises the profits of those receiving beneficial treatment thus creating an incentive to lobby for its continuance even after the need or its usefulness runs out this potentially allows political and business interests to create a mutual benefit at the expense of taxpayers and or competitive firms or industries the politics of subsidiesthere are a few different ways to evaluate the success of government subsidies most economists consider a subsidy a failure if it fails to improve the overall economy however policymakers might still consider it a success if it helps achieve a different objective most subsidies are long term failures in the economic sense but still achieve cultural or political goals an example of these competing evaluations could be seen in the great depression presidents herbert hoover and franklin d roosevelt both set price floors on agricultural products and paid farmers to not produce their policy goal was to stop food prices from falling and to protect small farmers to this extent the subsidy was a success 2but the economic effect was quite different artificially high food prices lowered the standard of living for consumers and forced people to spend more on food than they otherwise would have those outside of the farm industry were worse off in absolute economic terms 3sometimes subsidies may appear to have run their course or continue to create an artificial market but there are other factors that keep them in place production subsidies by g 20 countries averaged 290 billion per year from 2017 to 2019 with 95 going toward oil and gas meanwhile 2019 global consumption subsidies were 320 billion driven largely by oil and gas 4the combination of production and consumption subsidies in the oil and gas industry creates overconsumption by artificially lowering the price of fossil fuels however these subsidies on both the production and consumption sides have lots of political and systemic support and pushback from consumer and energy companies that would be impacted if reform did happen 4in terms of a pragmatic political economy a subsidy is successful from the point of view of its proponents if it succeeds in transferring wealth to its beneficiaries and contributing to the reelection of its political backers the strongest advocates of subsidies tend to be those who directly or indirectly gain from them and the political incentive to bring home the bacon to secure support from special interests is a powerful lure for politicians and policymakers | |
what is the difference between direct and indirect subsidies | direct subsidies are those that involve an actual payment of funds toward a particular individual group or industry indirect subsidies are those that do not hold a predetermined monetary value or involve actual cash outlays these can include activities such as price reductions for required goods or services that can be government supported | |
what is the position of subsidy advocates | subsidies exist in mixed economies proponents argue that subsidies to particular industries are vital to helping support businesses and the jobs that they create proponents further contend that subsidies are justifiable to provide the socially optimal level of goods and services which will lead to economic efficiency | |
what is the position of subsidy opponents | technically speaking a free market economy is free of subsidies subsidy opponents feel free market forces should determine if a business survives or fails if it fails those resources will be allocated to more efficient and profitable use opponents argue that subsidies unnecessarily distort markets preventing efficient outcomes as resources are diverted from more productive uses to less productive ones the bottom linea subsidy given to an individual business or institution usually by the government can be direct or indirect they can assist struggling industries encourage new developments and promote a social good or policy sometimes by helping one sector or group in the economy they hurt another group such as a subsidy that helps farmers but increases food prices for consumers or they can fail economically but achieve cultural or political goals | |
what is substantially equal periodic payment sepp | substantially equal periodic payment sepp is a method of distributing funds from an individual retirement account ira or other qualified retirement plans unless you still work for your employer prior to the age of 59 that avoids incurring irs penalties for the withdrawals typically an individual who removes assets from a plan prior to that age will pay an early withdrawal penalty of 10 of the distributed amount 1funds in sepp plans are withdrawn penalty free through specified annual distributions for a period of five years or until the account holder turns 59 whichever comes later income tax must still be paid on the withdrawals 2 | |
how substantially equal periodic payment sepp plans work | you can use any qualified retirement account with a sepp plan with the exception of a 401 k you hold at your current employer you set up the sepp arrangement through a financial advisor or directly with an institution at the outset you must choose among three internal revenue service irs approved methods for calculating your distributions from a sepp each will result in a different calculated annual distribution the amount you withdraw will be pre determined and unchanged every year at least with two of the three options 3the irs advises individuals to select the method that best supports their financial situations you re permitted to change the method you use once within the lifetime of the plan 3 should you cancel the plan before the minimum holding period expires you will have to pay the irs all penalties it waived on the plan s distributions plus interest 4 | |
how to calculate substantially equal periodic payment sepp plan withdrawals | as noted above there are three different methods approved by the irs to determine withdrawals from your sepp plan we discuss them below in a little more detail under the amortization method for calculating the sepp plan s withdrawals the annual payment is the same for each year of the program it s determined by using the life expectancy of the taxpayer and his or her beneficiary if applicable and a chosen interest rate of not more than 120 of the federal mid term rate according to the irs 3as with the amortization method the distribution you must take under the annuitization method is also the same each year the amount is determined by using an annuity based on the taxpayer s age and the age of their beneficiary if applicable and a chosen interest rate with the same irs guidelines as with amortization the annuity factor is derived using an irs provided mortality table 3using the rmd method the annual payment for each year is determined by dividing the account balance by the life expectancy factor of the taxpayer and their beneficiary if applicable under this method the annual amount must be recalculated annually and as a result will change from year to year 3 it also generally results in lower annual withdrawals than the other methods early withdrawals under substantially equal periodic payments are made possible under irs rule 72 t the rule allows individual taxpayers with early access to their retirement accounts without incurring any penalties advantages and disadvantages of substantially equal periodic payment sepp plansusing a sepp plan can be a boon to those who wish or need to tap into retirement funds early the plan can allow you a steady stream of income penalty free in your 40s or 50s to help tide you over between the end of a career and a regular paycheck and the arrival of other retirement income at 59 you can withdraw additional funds from your retirement accounts without penalty by your late 60s you ll qualify for full benefits from social security and perhaps a defined benefit pension 56the restrictions for sepp stay in place until the end of the payment term which is the latter of five years or the ira owner reaching age 59 so for example an ira owner that began sepps at age 40 would have to abide by the restrictions for almost 20 years on the other hand an ira owner who begins sepps at age 58 would only have to continue until age 63 importantly this five year time period is measured from the date of the first distribution and ends exactly five years from that date it does not end after the fifth distribution is made 7one of the drawbacks of the sepp program is that it is relatively inflexible once you begin a sepp plan you must stay with it for the duration which can potentially be decades if you begin the plan in your 30s or 40s during that time you have little to no leeway to alter the amount you can withdraw from the fund each year and quitting the plan is hardly an option given the fact it imposes on you all the penalties you saved from launching it plus interest the same sanction may also apply should you miscalculate and fail to make the necessary withdrawals within any one year 4starting a sepp also has implications for your financial security later in retirement once you start a sepp you ll have to stop contributing to the plan it is tapping into meaning its balance will not grow through further contributions and by withdrawing funds early you re also essentially foregoing the earnings they ll make later along with the tax you ll save on those gains which will compound tax free within the account provides steady stream of income before retirementwithdrawals are penalty free at 59 five year period ends five years after the first distributionplan holders must stay within the plan until the duration which makes them inflexiblethe amount withdrawn can t be alteredquitting the plan isn t an optionaccount balance doesn t grow through further contributions | |
what is a substantially equal periodic payment program | a substantially equal periodic payment program allows individual taxpayers to withdraw from their retirement accounts before they turn 59 without facing any penalties withdrawals can be made from individual retirement accounts or employer sponsored plans like a 401 k as long as you are no longer employed with the company payments or distributions are made from the account either for five years or until you turn 59 whichever comes later | |
when can i start making withdrawals from a sepp plan | you can begin making withdrawals from a sepp plan before you turn 59 keep in mind though that you must take these payments in accordance with one of the three calculations set up by the irs these are the amortization annuitization and required minimum distribution methods each method leaves you with a different annual distribution the method you choose should suit your own financial situation can i take sepp withdrawals from my 401 k yes and no you can use make withdrawals from your 401 k through a sepp program if you are no longer employed with the company as such you cannot take any money from your account if you still work for the employer that sponsors the plan | |
are there any penalties associated with sepp plans | there are generally no penalties associated with sepp plans but you will be on the hook for penalties and interest if you decide to cancel the plan before you reach the minimum five year holding period or before you turn 59 whichever comes later 4the bottom linethere are rules in place to protect your retirement nest egg until you need it the most as such you can t make early withdrawals from your accounts without incurring penalties but there are exceptions substantially equal periodic payment programs allow you to use your retirement accounts if an exceptional circumstance arises such as an illness but there are certain rules you must follow the irs has certain calculation methods you must use to determine your distributions and you must take these payments for a certain length of time if you re unsure of how the program works or if it s right for your situation be sure to consult a financial or retirement specialist | |
what is a substitute | a substitute or substitutable good in economics and consumer theory refers to a product or service that consumers see as essentially the same or similar enough to another product put simply a substitute is a good that can be used in place of another substitutes play an important part in the marketplace and are considered a benefit for consumers they provide more choices for consumers who are then better able to satisfy their needs bills of materials often include alternate parts that can replace the standard part if it s destroyed 1investopedia xiaojie liuunderstanding substitutes | |
when consumers make buying decisions substitutes provide them with alternatives substitutes occur when there are at least two products that can be used for the same purpose such as an iphone vs an android phone for a product to be a substitute for another it must share a particular relationship with that good those relationships can be close like one brand of coffee with another or somewhat further apart such as coffee and tea | giving consumers more choice helps generate competition in the market and lower prices as a result while that may be good for consumers it may have the opposite effect on companies bottom line alternative products can cut into companies profitability as consumers may end up choosing one more over another or see market share diluted | |
when you examine the relationship between the demand schedules of substitute products if the price of a product goes up the demand for a substitute will tend to increase this is because people will prefer to lower cost substitute to the higher cost one if for example the price of coffee increases the demand for tea may also increase as consumers switch from coffee to tea to maintain their budgets | conversely when a good s price decreases the demand for its substitute may also decrease in formal economic language x and y are substitutes if demand for x increases when the price of y increases or if there is positive cross elasticity of demand the availability of substitutes are one of porter s 5 forces the others being competition new entrants into the industry the power of suppliers and the power of customers 2examples of substitute goodssubstitute goods are all around us as mentioned above they are generally used for the same purpose or are able to satisfy similar needs for consumers here are just a few examples of substitute goods there is one thing to keep in mind when it comes to substitutes the degree to which a good is a substitute for another can and often will differ 3perfect vs less perfect substitutesclassifying a product or service as a substitute is not always straightforward there are different degrees to which products or services can be defined as substitutes a substitute can be perfect or imperfect depending on whether the substitute completely or partially satisfies the consumer a perfect substitute can be used in exactly the same way as the good or service it replaces this is where the utility of the product or service is pretty much identical for example a one dollar bill is a perfect substitute for another dollar bill and butter from two different producers are also considered perfect substitutes the producer may be different but their purpose and usage are the same a bike and a car are far from perfect substitutes but they are similar enough for people to use them to get from point a to point b there is also some measurable relationship in the demand schedule although an imperfect substitute may be replaceable it may have a degree of difference that can be easily perceived by consumers so some consumers may choose to stick with one product over the other consider coke versus pepsi a consumer may choose coke over pepsi perhaps because of taste even if the price of coke goes up if a consumer perceives a difference between soda brands she may see pepsi as an imperfect substitute for coke even if economists consider them perfect substitutes less perfect substitutes are sometimes classified as gross substitutes or net substitutes by factoring in utility a gross substitute is one in which demand for x increases when the price of y increases net substitutes are those in which demand for x increases when the price of y increases and the utility derived from the substitute remains constant 1substitute goods in perfect competition and monopolistic competitionin cases of perfect competition perfect substitutes are sometimes conceived as nearly indistinguishable goods being sold by different firms for example gasoline from a gas station on one corner may be virtually indistinguishable from gasoline sold by another gas station on the opposite corner an increase in the price at one station will result in more people choosing the cheaper option monopolistic competition presents an interesting case that present complications with the concept of substitutes in monopolistic competition companies are not price takers meaning demand is not highly sensitive to price a common example is a difference between the store brand and name branded medicine at your local pharmacy the products themselves are nearly indistinguishable chemically but they are not perfect substitutes due to the utility consumers may get or believe they get from purchasing a brand name over a generic drug believing it to be more reputable or of higher quality 4 | |
what is the substitution effect | the substitution effect is the decrease in sales for a product that can be attributed to consumers switching to cheaper alternatives when its price rises a product may lose market share for many reasons but the substitution effect is purely a reflection of frugality if a brand raises its price some consumers will select a cheaper alternative if beef prices rise many consumers will eat more chicken 1understanding the substitution effectin general when the price of a product or service increases but the buyer s income stays the same the substitution effect kicks in this is not only evident in consumer behavior for example a manufacturer faced with a price hike for an essential component from a domestic supplier may switch to a cheaper version produced by a foreign competitor 1 | |
how then does any company get away with increasing its price in addition to the substitution effect there s the income effect some of its customers may be enjoying an increase in spending power and be willing to buy a pricier product a company s success in repricing its product is determined in part by how much of the substitution effect is offset by the income effect | special considerationsas noted when a product price increases consumers tend to drop it for a cheaper alternative this can turn into an endless game of supply and demand steak prices rise so consumers substitute pork this leads to a decline in the demand for steak so its price drops and consumers return to buying steak this does not mean only that consumers chase a bargain consumers make their choices based on their overall spending power and make constant adjustments based on price changes they strive to maintain their living standards despite price fluctuations the substitution effect kicks in when a product s price increases but the consumer s spending power stays the same the substitution effect is strongest for products that are close substitutes for instance a shopper might pick a synthetic shirt when the pure cotton brand seems too pricey eventually enough shoppers may follow suit to make a measurable effect on the sales of both shirt makers elsewhere if a golf club hikes its fees some members might quit however if there is no comparable choice for them to turn to then they may just have to pay up to avoid quitting the sport completely as illogical as it seems the substitution effect may not occur when the products that increase in price are inferior in quality in fact an inferior product that rises in price may actually enjoy a sales increase products that display this phenomenon are called giffen goods after a victorian economist who first observed it sir robert giffen noted that cheap staples such as potatoes will be purchased in greater quantities if their prices rise he concluded that people on extremely limited budgets are forced to buy even more potatoes because their increasing price places other higher quality staples altogether out of their reach substitute goods may be adequate replacements or inferior goods demand for an inferior good will increase when overall consumer spending power falls | |
what is a sukuk | a sukuk is an islamic financial certificate similar to a bond in western finance that complies with islamic religious law commonly known as sharia since the traditional western interest paying bond structure is not permissible the issuer of a sukuk essentially sells an investor group a certificate and then uses the proceeds to purchase an asset that the investor group has direct partial ownership interest in the issuer must also make a contractual promise to buy back the bond at a future date at par value understanding sukukwith the rise of islamic finance sukuk have become extremely popular since 2000 when the first such products were issued in malaysia bahrain followed suit in 2001 fast forward to current times and sukuk are used by islamic corporations and state run organizations alike around the globe taking up an increasing share of the global fixed income market islamic law prohibits what s known as riba or what we understand as interest in the west therefore traditional western debt instruments cannot be used as viable investment vehicles or ways to raise capital for a business to circumvent this sukuk were created in order to link the returns and cash flows of debt financing to a specific asset being purchased effectively distributing the benefits of that asset this allows investors to work around the prohibition outlined under sharia and still receive the benefits of debt financing however because of the way that sukuk are structured financing can only be raised for identifiable assets thus sukuk represent aggregate and undivided shares of ownership in a tangible asset as it relates to a specific project or a specific investment activity an investor in a sukuk therefore does not own a debt obligation owed by the bond issuer but instead owns a piece of the asset that s linked to the investment this means that sukuk holders unlike bond holders receive a portion of the earnings generated by the associated asset sukuk vs traditional bondssukuk and conventional bonds do share similar characteristics but also have important key differences both provide investors with payment streams bonds and sukuk are issued to investors and may be used to raise capital for a firm both are considered to be safer investments than equities | |
what is the sum of squares | the term sum of squares is a statistical measure used in regression analysis to determine the dispersion of data points the sum of squares can be used to find the function that best fits by varying the least from the data in a regression analysis the goal is to determine how well a data series can be fitted to a function that might help to explain how the data series was generated the sum of squares can be used in the financial world to determine the variance in asset values understanding the sum of squaresthe sum of squares measures how widely a set of datapoints is spread out from the mean it is also known as variation it is calculated by adding together the squared differences of each data point to determine the sum of squares square the distance between each data point and the line of best fit then add them together the line of best fit will minimize this value a low sum of squares indicates little variation between data sets while a higher one indicates more variation variation refers to the difference of each data set from the mean you can visualize this in a chart if the line doesn t pass through all the data points then there is some unexplained variability we go into a little more detail about this in the next section below in statistics the sum of squares is used to calculate the variance and standard deviations of a data set which are in turn used in regression analysis analysts and investors can use these techniques to make better decisions about their investments keep in mind though that using it means you re making assumptions about using past performance for instance this measure can help you determine the level of volatility in a stock s price or how the share prices of two companies compare let s say an analyst wants to know if microsoft msft share prices tend to move in tandem with those of apple aapl the analyst can list out the daily prices for both stocks for a certain period say one two or 10 years and create a linear model or a chart if the relationship between both variables i e the price of aapl and msft is not a straight line then there are variations in the data set that must be scrutinized sum of squares formulathe following is the formula for the total sum of squares for a set x of n items sum of squares i 0 n x i x 2 where x i the i t h item in the set x the mean of all items in the set x i x the deviation of each item from the mean begin aligned text for a set x text of n text items text sum of squares sum i 0 n left x i overline x right 2 textbf where x i text the i th text item in the set overline x text the mean of all items in the set left x i overline x right text the deviation of each item from the mean end aligned for a set x of n items sum of squares i 0 n xi x 2where xi the ith item in the setx the mean of all items in the set xi x the deviation of each item from the mean variation is a statistical measure that is calculated or measured by using squared differences | |
how to calculate the sum of squares | you can see why the measurement is called the sum of squared deviations or the sum of squares for short you can use the following steps to calculate the sum of squares in statistics the mean is the average of a set of numbers which is calculated by adding the values in the data set together and dividing by the number of values however knowing the mean may not be enough to understand your data and draw conclusions as such it helps to know the variation in a set of measurements how far individual values are from the mean may provide insight into how much variation exists and how well the values fit a regression line types of sum of squaresthe formula we highlighted earlier is used to calculate the total sum of squares the total sum of squares is used to arrive at other types the following are the other types of sum of squares as noted above if the line in the linear model created does not pass through all the measurements of value then some of the variability that has been observed in the share prices is unexplained the sum of squares is used to calculate whether a linear relationship exists between two variables and any unexplained variability is referred to as the residual sum of squares the rss allows you to determine the amount of error left between a regression function and the data set after the model has been run you can interpret a smaller rss figure as a regression function that is well fit to the data while the opposite is true of a larger rss figure here is the formula for calculating the residual sum of squares sse i 1 n y i y i 2 where y i observed value y i value estimated by regression line begin aligned text sse sum i 1 n y i hat y i 2 textbf where y i text observed value hat y i text value estimated by regression line end aligned sse i 1 n yi y i 2where yi observed valuey i value estimated by regression line the regression sum of squares is used to denote the relationship between the modeled data and a regression model a regression model establishes whether there is a relationship between one or multiple variables having a low regression sum of squares indicates a better fit with the data a higher regression sum of squares though means the model and the data aren t a good fit together here is the formula for calculating the regression sum of squares ssr i 1 n y i y 2 where y i value estimated by regression line y mean value of a sample begin aligned text ssr sum i 1 n hat y i bar y 2 textbf where hat y i text value estimated by regression line bar y text mean value of a sample end aligned ssr i 1 n y i y 2where y i value estimated by regression liney mean value of a sample adding the sum of the deviations alone without squaring them results in a number equal to or close to zero since the negative deviations will almost perfectly offset the positive deviations to get a more realistic number the sum of deviations must be squared the sum of squares will always be a positive number because the square of any number whether positive or negative is always positive limitations of using the sum of squaresmaking an investment decision on what stock to purchase requires many more observations than the ones listed here an analyst may have to work with years of data to know with a higher certainty how high or low the variability of an asset is as more data points are added to the set the sum of squares becomes larger as the values will be more spread out the most widely used measurements of variation are the standard deviation and variance however to calculate either of the two metrics the sum of squares must first be calculated the variance is the average of the sum of squares i e the sum of squares divided by the number of observations the standard deviation is the square root of the variance there are two methods of regression analysis that use the sum of squares the least squares method refers to the fact that the regression function minimizes the sum of the squares of the variance from the actual data points in this way it is possible to draw a function which statistically provides the best fit for the data note that a regression function can either be linear a straight line or non linear a curving line example of sum of squareslet s use microsoft as an example to show how you can arrive at the sum of squares using the steps listed above we gather the data so if we re looking at the company s performance over a five year period we ll need the closing prices for that time frame now let s figure out the average price the sum of the total prices is 369 73 and the mean or average price is 369 73 5 73 95 then figure out the sum of squares we find the difference of each price from the average square the differences and add them together in the example above 1 0942 shows that the variability in the stock price of msft over five days is very low and investors looking to invest in stocks characterized by price stability and low volatility may opt for microsoft | |
how do you define the sum of squares | the sum of squares is a form of regression analysis to determine the variance from data points from the mean if there is a low sum of squares it means there s low variation a higher sum of squares indicates higher variance this can be used to help make more informed decisions by determining investment volatility or to compare groups of investments with one another | |
how do you calculate the sum of squares | in order to calculate the sum of squares gather all your data points then determine the mean or average by adding them all together and dividing that figure by the total number of data points next figure out the differences between each data point and the mean then square those differences and add them together to give you the sum of squares | |
how does the sum of squares help in finance | investors and analysts can use the sum of squares to make comparisons between different investments or make decisions about how to invest for instance you can use the sum of squares to determine stock volatility a low sum generally indicates low volatility while higher volatility is derived from a higher sum of squares the bottom lineas an investor you want to make informed decisions about where to put your money while you can certainly do so using your gut instinct there are tools at your disposal that can help you the sum of squares takes historical data to give you an indication of implied volatility use it to see whether a stock is a good fit for you or to determine an investment if you re on the fence between two different assets keep in mind though that the sum of squares uses past performance as an indicator and doesn t guarantee future performance correction may 18 2023 a previous version of this article misstated that the sum of squares is calculated by subtracting the data points from the mean it has been corrected to show that the mean should be subtracted from the data points |
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