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how is the consumer price index cpi used | the cpi is widely used by financial market participants to gauge inflation and by the federal reserve to calibrate its monetary policy businesses and consumers also use the cpi to make informed economic decisions since cpi measures the change in consumers purchasing power it is often a key factor in pay negotiations the fed uses cpi data to determine economic policy with a target inflation rate of 2 the fed may enact expansionary monetary policy to stimulate the economy should market growth slow or enact contractionary monetary policy should the economy and therefore prices grow too quickly in response to higher than desired inflation rates via the cpi the fed adjusts the fed funds rate 11the cost of living adjustments colas based on the cpi affect federal payments to the approximately 70 million americans receiving social security and supplemental security income ssi benefits they also apply to federal pension payments school lunch subsidies and income tax brackets 27mortgage rates and other forms of long term debt are often impacted by rates set by government agencies as the cpi increases and the government enacts policy changes to slow inflation rates often increase on the other hand landlords may use cpi information to adequately assess what annual rent increases for renters should be 1213financial market prices are driven by countless factors one such factor is the cpi as reactionary fed policies directly impact economic growth corporate profits and consumer spending ability 2a higher cpi often means that a less stringent government policy is generally in place this means that debt is often easier to obtain for cheaper and that individuals have greater spending capacity on the other hand lower or decreasing cpi may indicate that the government may ease policies that help boost the economy the cpi and its components are also used as a deflator for other economic indicators including retail sales and hourly weekly earnings to separate fundamental change from that reflecting change in prices employees may turn to cpi reports when approaching their employers for a raise based on nationwide increases in labor rates as well as pricing 14be mindful that the cpi is published using national data even though employees may be more suited to using local data to better understand their specific situation in addition some workers covered by collective bargaining agreements may have their contracts and wages tied to changes in cpi the bls reports the cpi on a fixed monthly basis a schedule of prior and future releases can be found on the bls website and the cpi is always released at 8 30 a m eastern time 15consumer price index cpi vs unemploymentin the broadest sense the cpi and unemployment rates are often inversely related this is not always the case in every economy but the federal reserve often attempts to decrease one metric while balancing the other for example in response to the covid 19 pandemic the federal reserve took unprecedented supervisory and regulatory actions to stimulate the economy 16as a result the labor market strengthened and returned to pre pandemic rates by march 2022 however this stimulus has resulted in the highest cpi calculations in decades 17as a result of higher than targeted cpi calculations the federal reserve began raising interest rates and tapering certain asset purchases on the one hand these measures aim to slow economic growth make it more expensive for consumers to acquire debt and stem monetary supply growth 18on the other hand these additional expenses may burden households and make companies less profitable all else being equal when the federal reserve attempts to lower the cpi it runs the risk of unintentionally increasing unemployment rates critiques of consumer price index cpi methodologybecause the cpi index is so crucial to economic policy and decision making its methodology has long been controversial drawing claims it either understates or overstates inflation a panel of economists commissioned by congress to study the issue in 1995 concluded the cpi overstated inflation and was followed by calculation changes to better reflect substitution effects 19critics claim that adjustments for changes in product quality and features understate the cpi according to the bls the particularly controversial hedonic adjustments which use regression techniques to adjust prices for new features on a relatively small proportion of the cpi items have a net effect close to zero on the index 20as the traditional cpi u calculation only measures inflation for urban populations it remains a less than reliable source of data for individuals living in rural areas the cpi does not explicitly state how different demographics may be impacted by inflation for example soaring education costs may adversely impact younger individuals while the impact of increasing elderly care costs is felt by a different group of individuals this notion is also widely attributable to individuals with varying degrees of income for example lower income individuals who contribute more gross income towards necessities of shelter and food will skew differently than households with larger disposable income for this reason the cpi may not adequately reflect each individual s experience about costs and changes over time | |
what is the current cpi | in may 2024 the cpi rose 3 3 over the last 12 months before seasonal adjustment the index remained unchanged in may on a seasonally adjusted basis from the 0 3 increase in april 2024 6 | |
how is the consumer price index used | the cpi index is an inflation indicator closely watched by policymakers and financial markets a related cpi measure is used to calculate cost of living adjustments for federal benefit payments | |
how is the cpi calculated | the bureau of labor statistics samples 80 000 prices monthly to calculate the cpi weighing the index for each product or service in proportion to its share of recent consumer spending to calculate the overall change in prices the calculation also factors in the substitution effect as consumers shift spending away from the products rising in price on a relative basis the cpi also adjusts for changes in product quality and features the numbers are provided with and without seasonal adjustments 21 | |
what are some criticisms of the cpi | over the years the cpi has frequently drawn criticism that it has either understated or overstated inflation because the cpi is based on consumer spending it doesn t track third party reimbursements for healthcare and significantly underweights healthcare relative to its proportion in the gdp as a result on the other hand criticism concerning the quality adjustments used in the cpi has been widely discounted by economists the bottom linethe consumer price index is an important economic metric it measures the average change in prices paid by consumers over a period of time for a basket of goods and services the index is calculated and published monthly by the bureau of labor statistics it is among the most common measures of inflation indicating the health and direction of the economy it also serves in other capacities notably to help make adjustments to certain income payments such as social security and pensions for federal civil service retirees | |
what is consumer surplus | consumer surplus is an economic measurement of consumer benefits resulting from market competition a consumer surplus happens when the price that consumers pay for a product or service is less than the price they re willing to pay it s a measure of the additional benefit that consumers receive because they re paying less for something than what they were willing to pay consumer surplus may be compared with producer surplus investopedia crea taylorunderstanding consumer surplusthe concept of consumer surplus was developed in 1844 to measure the social benefits of public goods such as national highways canals and bridges it has been an important tool in the field of welfare economics and the formulation of tax policies by governments consumer surplus is based on the economic theory of marginal utility which is the additional satisfaction a consumer gains from one more unit of a good or service the utility a good or service provides varies from individual to individual based on personal preference typically the more of a good or service that consumers have the less they re willing to spend for more of it due to the diminishing marginal utility or additional benefit they receive a consumer surplus occurs when the consumer is willing to pay more for a given product than the current market price many producers are influenced by consumer surplus when they set their prices the formula for consumer surpluseconomists define consumer surplus with the following equation | |
where | measuring consumer surplusthe demand curve is a graphic representation used to calculate consumer surplus it shows the relationship between the price of a product and the quantity of the product demanded at that price with the price drawn on the y axis of the graph and the quantity demanded drawn on the x axis because of the law of diminishing marginal utility the demand curve is downward sloping consumer surplus is measured as the area below the downward sloping demand curve or the amount a consumer is willing to spend for given quantities of a good and above the actual market price of the good depicted with a horizontal line drawn between the y axis and demand curve consumer surplus can be calculated on either an individual or aggregate basis depending on if the demand curve is individual or aggregated consumer surplus always increases as the price of a good falls and decreases as the price of a good rises for example suppose consumers are willing to pay 50 for the first unit of product a and 20 for the 50th unit if 50 of the units are sold at 20 each then 49 of the units were sold at a consumer surplus assuming the demand curve is constant consumer surplus is zero when the demand for a good is perfectly elastic but demand is perfectly inelastic when consumer surplus is infinite economic welfare is also called community surplus or the total of consumer and producer surplus example of consumer surplusconsumer surplus is the benefit or good feeling of getting a good deal for example let s say that you bought an airline ticket for a flight to disney world during school vacation week for 100 but you were expecting and willing to pay 300 for one ticket the 200 represents your consumer surplus however businesses know how to turn consumer surplus into producer surplus in our example let s say the airline realizes your surplus and as the calendar draws near to school vacation week raises its ticket prices to 600 each the airline knows there will be a spike in demand for travel to disney world during school vacation week and that consumers will be willing to pay higher prices so by raising the ticket prices the airlines are taking potential consumer surplus and turning it into producer surplus or additional profits | |
is a high consumer surplus good | a high consumer surplus means that goods are priced quite a bit lower in the market than where consumers would ultimately be willing to pay this is often the result of a high degree of competition technological progress and producer efficiency in general all of these things are considered to be good for promoting economic growth and prosperity | |
what is producer surplus | similar to consumer surplus producer surplus is the economic benefit to producers of goods measured by the difference in market price and where the producer would be willing to sell a producer surplus thus exists if the market price of a good is higher than the price the producer is willing to sell | |
what is total economic surplus | total economic surplus is equal to the producer surplus plus the consumer surplus it describes the total net benefit to society from free markets in goods or services the bottom linein free markets producers compete with one another to be the low cost producer and grab market share from other companies in their space the result is more quantity and lower prices for consumers often lower than where they would be willing to pay for it this difference between the market price as determined by supply and demand and the willingness to pay is the consumer surplus a consumer surplus is seen as a benefit to the economy | |
what are consumer staples | the term consumer staples refers to a set of essential products used by consumers this category includes things like foods and beverages household goods and hygiene products as well as alcohol and tobacco these goods are those products that people are unable or unwilling to cut out of their budgets regardless of their financial situation consumer staples are considered to be non cyclical meaning that they are always in demand year round no matter how well the economy is or is not performing as such consumer staples are impervious to business cycles also people tend to demand consumer staples at a relatively constant level regardless of their price the basics of consumer staplescomprising nearly 70 of the nation s gross national product gnp consumer spending holds a lot of sway over the economy economic growth and decline are typically led by consumer spending which is cyclical cyclical means there are ebbs and flows or times when the consumer spends more and periods when they have more conservative spending habits however spending on goods produced and sold by the consumer staples sector tends to be far less cyclical due to the lessened price elasticity of demand price elasticity is an economic concept that describes the change in consumer quantity demand as prices change the demand for consumer staples goods remains fairly constant regardless of the state of the economy or the cost of the product the makeup of the consumer staples sectorcompanies that sell pharmaceutical drugs like drugstores are included in the sector as are companies that produce and grow crops within the s p 500 index consumer staples are broken down into six industries although there are no substitutes for consumer staples goods consumers have a lot of options when shopping for the cheapest products that makes the competition among suppliers very challenging in an environment where commodity prices are rising to compete on price consumer staples producers must be able to keep their costs down by adopting new technologies and processes or they must differentiate by introducing innovative products consumer staples financial performancethe consumer staples sector has outperformed all but one sector since 1962 according to the s p dow jones indices for most of the 10 years ending april 26 2021 the consumer staples sector returned 8 20 annually 1 compare this to the 11 86 return of the s p 500 over the same period 2 but the two generally move in line with one another more importantly the consumer staples sector has outperformed the s p 500 during the last three recessionary periods or periods of negative growth in the gross domestic product gdp due to their low volatility consumer staples stocks are considered to play a key role in defensive strategies investing in consumer staplesbuoyed by the persistent demand of their products consumer staples companies generate consistent revenues even in recessionary periods as a result consumer staples stocks decline far less during bear markets than stocks in other sectors with some products such as food alcohol and tobacco demand sometimes actually increases during economic downturns the consumer staples sector also often lures investors with its components rich dividend yields which tend to be larger than those generated in other sectors because of their slow and steady nature consumer staples stocks can also not only continue to pay dividends through recessionary periods but often continue to increase their payouts according to dividend com the annual dividend rate increased 8 over the 20 years ended in 2015 as stocks rise in price dividend yields will fall if the size of the dividend does not increase as well conversely if stocks fall in price and if the dividend payout does not change then the dividend yield increases for example when stock prices fell dramatically in the wake of the 2020 economic crisis and lockdown the yield for state street s consumer staples sector index etf xlp rose from 2 74 to 3 00 due primarily to the lower priced shares producing the same dividend amount further consumer staples are important for portfolio diversification also because these stocks tend to perform in a way counter to the consumer discretionary sector in market recessions they can help bring balance to a portfolio they tend to bring in consistent earnings that support their dividend yields unlike the boom and bust cycles of riskier high growth stocks though more growth is available for consumer staples as they expand globally steady dividends earningslittle volatilitylow risksafe haven in recessionary timesslow growthlimited highsunderperformers when interest rates riseconsumer staples stocks can be a good option for investors seeking steady growth solid dividends and low volatility one can invest in consumer staples by purchasing the stocks of the individual consumer staples companies industry leaders include procter gamble p g b g foods bgs kimberly clark kmb and phillip morris pm or by purchasing mutual funds or exchange traded funds etfs that specialize in the sector real world example of consumer staplesmany of the major investment companies offer some consumer staples play vanguard for example offers vdc a consumer staples etf and a consumer staples index mutual fund invesco has pbj its dynamic food beverage etf along with a more general s p smallcap consumer staples etf further if you want to try investing internationally after all people need staples the world over the wisdomtree emerging markets consumer growth etf emcg and the ishares global consumer staples etf kxi are two options | |
what is consumerism | consumerism is the idea that increasing the consumption of goods and services purchased in the market is always a desirable goal and that a person s well being and happiness depend fundamentally on obtaining consumer goods and material possessions consumerism is related to the predominantly keynesian idea that consumer spending is the key driver of the economy and that encouraging consumers to spend is a major policy goal from this point of view consumerism is a positive phenomenon that fuels economic growth others view the drive to obtain more material possessions as problematic causing individual anxiety and eroding the social fabric investopedia matthew collinsunderstanding consumerismin common use consumerism refers to the tendency of people living in a capitalist economy to engage in a lifestyle of excessive materialism that revolves around reflexive wasteful or conspicuous overconsumption in this sense consumerism is widely understood to contribute to the destruction of traditional values and ways of life consumer exploitation by big business environmental degradation and negative psychological effects thorstein veblen for example was a 19th century economist and sociologist best known for coining the term conspicuous consumption in his book the theory of the leisure class 1899 conspicuous consumption is a means to show one s social status especially when publicly displayed goods and services are too expensive for other members of the same class this type of consumption is typically associated with the wealthy but can also apply to any economic class following the great depression consumerism was largely derided however with the u s economy kickstarted by world war ii and the prosperity that followed at the end of the war the use of the term in the mid 20th century began to have a positive connotation during this time consumerism emphasized the benefits that capitalism had to offer in terms of improving standards of living and an economic policy that prioritized the interests of consumers these largely nostalgic meanings have since fallen out of general use as consumers spend economists presume that consumers benefit from the utility of the consumer goods that they purchase but businesses also benefit from increased sales revenue and profit for example if car sales increase auto manufacturers see a boost in profits additionally the companies that make steel tires and upholstery for cars also see increased sales in other words spending by the consumer can benefit the economy and the business sector in particular some economists view increasing levels of consumer spending as a critical goal in building and maintaining a strong economy irrespective of the benefit to the consumer or society as a whole others however have grown quite concerned about the negative societal effects of hyper consumerism 1the economic impact of consumerismaccording to keynesian macroeconomics boosting consumer spending through fiscal and monetary policy is a primary target for economic policymakers consumer spending makes up the lion s share of aggregate demand and gross domestic product gdp so boosting consumer spending is seen as the most effective way to steer the economy toward growth consumerism views the consumer as the target of economic policy and a cash cow for the business sector with the sole belief that increasing consumption benefits the economy saving can even be seen as harmful to the economy because it comes at the expense of immediate consumption spending consumerism also helps shape some business practices planned obsolescence of consumer goods can displace competition among producers to make more durable products marketing and advertising can become focused on creating consumer demand for new products rather than informing consumers conspicuous consumptionas standards of living rose after the industrial revolution conspicuous consumption grew high rates of conspicuous consumption can be a wasteful zero sum or even negative sum activity as real resources are used up to produce goods that are not valued for their use but rather for the image they portray in the form of conspicuous consumption consumerism can impose enormous real costs on an economy consuming real resources in zero or negative sum competition for social status can offset the gains from commerce in a modern industrial economy and lead to destructive creation in markets for consumers and other goods sociologists view consumerism as symbolic consumption that may not maximize individual utility instead it can serve as a signal to others and help establish one s identity when it comes to being a consumer social actors e g peer pressure in groups advertisers limit your free choice | |
what is the consumption function | the consumption function is an economic formula that represents the relationship between total consumption and gross national income gni it was first introduced by british economist john maynard keynes who argued that the function could be used to predict total aggregate consumption expenditure the consumption function is a valuable tool for understanding the economic cycle and guiding economists and policymakers as they make key decisions about investments as well as monetary and fiscal policy investopedia sydney saporitounderstanding the consumption functionas noted above the consumption function is an economic formula introduced by john maynard keynes who tracked the connection between income and spending also called the keynesian consumption function it tracks the proportion of income used to purchase goods and services put simply it can be used to estimate and predict spending in the future the classic consumption function suggests consumer spending is wholly determined by income and the changes in income if true aggregate savings should increase proportionally as the gross domestic product gdp grows over time the idea is to create a mathematical relationship between disposable income and consumer spending but only on aggregate levels based in part on keynes psychological law of consumption theory the stability of the consumption function is a cornerstone of keynesian macroeconomic theory this is especially true when it is contrasted with the volatility of an investment most post keynesians admit the consumption function is not stable in the long run since consumption patterns change as income rises the consumption function uses gross national income as a component which is the total amount of income earned by all participants in a nation s economy this includes individuals and businesses in and outside its borders calculating the consumption functionthe consumption function is represented as c a mdwhere c consumer spendinga autonomous consumptionm marginal propensity to consumed real disposable income begin aligned c a md textbf where c text consumer spending a text autonomous consumption m text marginal propensity to consume d text real disposable income end aligned c a mdwhere c consumer spendinga autonomous consumptionm marginal propensity to consumed real disposable income assumptions and implicationsmuch of the keynesian doctrine centers around the frequency with which a given population spends or saves new income the multiplier the consumption function and the marginal propensity to consume are each crucial to keynes focus on spending and aggregate demand the consumption function is assumed stable and static where all expenditures are passively determined by the level of national income the same is not true of savings or government spending both of which keynes referred to as investments for the model to be valid the consumption function and independent investment must remain constant long enough for gross national income to reach equilibrium at equilibrium the expectations of businesses and consumers match up one potential problem is that the consumption function cannot handle changes in the distribution of income and wealth when these change so too might autonomous consumption and the marginal propensity to consume keynes was a proponent of government spending to curb economic downturns economists like milton friedman challenged these notions saying government spending and federal debt could lead to inflation 1other versionsover time other economists have made adjustments to the keynesian consumption function variables such as employment uncertainty borrowing limits or even life expectancy can be incorporated to modify the older cruder function for example many standard models stem from the so called life cycle theory of consumer behavior as pioneered by franco modigliani his model made adjustments based on how income and liquid cash balances affect an individual s marginal propensity to consume this hypothesis stipulated that poorer individuals likely spend new income at a higher rate than wealthy individuals milton friedman offered his own simple version of the consumption function which he called the permanent income hypothesis notably the friedman model distinguished between permanent and temporary income it also extended modigliani s use of life expectancy to infinity more sophisticated functions may even substitute disposable income which takes into account taxes transfers and other sources of income still most empirical tests fail to match up with the consumption function s predictions statistics show frequent and sometimes dramatic adjustments in the consumption function | |
how do you calculate the consumption function | the consumption function can be calculated using a simple formula c a md where c is the consumer spending a is autonomous consumption spending regardless of income levels m is the marginal propensity to consume the amount of additional income needed to spend on goods and services rather than saving it and d is the amount of real disposable income required who introduced the consumption function the consumption function was introduced by economist john maynard keynes he is known as the father of modern macroeconomics and the founder of keynesian economics this branch of economics suggests that governments should be actively involved in their economies rather than let their economies fall under the free market keynes said government spending can be used as a tool to cut back on weakness in the economy | |
what shifts the consumption function forward | the consumption function shifts forward or upward when disposable income or accumulated wealth also increases the inverse is true for a downward shift in the consumption function in this case it drops or shifts downward when income or wealth drops | |
why is the consumption function important | there are multiple reasons why the consumption function is important to economics it is a macroeconomic tool that can help economists understand the economy including how business cycles work and the function of the money supply among others economists and decision makers can use it and the formula to make investment decisions and shape monetary and fiscal policy to direct the economy the bottom linejohn maynard keynes introduced the idea of the consumption function which explains the relationship between a country s income and spending according to the theory spending is sensitive to the level of income so spending will increase when income does economists and leaders can use this theory to help make predictions about future spending and important economic and investment decisions for the future | |
what is contango | contango is a situation where the futures price of a commodity is higher than the spot price contango usually occurs when an asset s price is expected to rise over time that results in an upward sloping forward curve understanding contangofutures contract supply and demand affect their price at each available expiration contracts represent a specified amount of a commodity to be delivered at a certain date called the expiration date and other specifications for example one crude oil futures contract is for 1 000 barrels and defines when trading stops how the contract is settled the minimum price fluctuations and more 1commodities traders buy and sell these contracts on commodities exchanges buyers place bids to purchase the contracts some of which will take physical possession of the commodities sellers sell derivatives of the contracts or the actual commodities these contracts represent commodities that will be delivered in the future so their price is what traders believe the contracts will be worth when they reach their expiration date spot prices on the other hand are what a commodity would sell for if you were to buy it right now and take immediate delivery so if futures prices are higher than spot prices it means traders expect prices to rise this is usually represented by a rising curve on a graph | |
when prices are in contango investors are willing to pay more for a commodity that will be delivered in the future the difference between the spot and future prices is referred to as a premium | the premium usually includes the cost of carry which is a term that refers to the costs of holding an asset for a certain period the cost of carry for commodities generally includes storage insurance or depreciation due to spoiling or rotting if the commodity is an agricultural or meat product in all futures market scenarios the futures prices will usually converge toward the spot prices as the contracts approach expiration expiry that happens because the expiry date is drawing closer and is more reflective of the actual value of the commodity contract traders are going to pay closer and closer to the spot market values additionally because there is a large number of buyers and sellers the market becomes more efficient and eliminates large arbitrage opportunities that said a market in contango will see gradual decreases in the price to meet the spot price at expiration another important factor is that most futures traders and investors won t want to take possession of the underlying commodities they will close their positions long before expiry to reduce the risk of needing to store say 1 000 barrels of crude oil overall futures markets involve a substantial amount of speculation when contracts are further away from expiration they are more speculative but there are several reasons a trader would want to lock in a higher futures price as mentioned the cost of carry is one common reason for buying commodities futures producers have other reasons to pay more for futures than the spot price producers make commodity purchases as needed based on their inventory how they manage their inventory may be influenced by the spot price vs the futures price however they will generally follow the spot and futures prices while seeking to achieve the best cost efficiency some producers may believe that the spot price will rise rather than fall over time therefore they hedge by offering slightly higher prices for future contracts to try and influence contango causes of contangodifferent markets are affected by various factors for instance crops can be affected by weather and oil can be affected by geopolitical instabilities these instabilities or uncertainties can cause investors and traders to anticipate price drops or increases and to respond accordingly for the most part contango is caused by example of contangoone of the most common markets that see contango is the crude oil futures market it experienced contango in 2020 the organization of the petroleum exporting countries opec called it super contango meaning that the difference between futures and spot prices was very pronounced 2on feb 2023 brent crude front month contracts spot price settled at 83 16 front month april while future months settled at 3this is not an example of contango but if the prices had been reversed to this the market would have been in contango overtime arbitrage buying and selling an asset simultaneously in different markets to take advantage of price differences opportunities are reduced because futures prices and spot prices converge the effects of contango on investmentsgenerally contango causes investors to believe that prices are going to continue rising it indicates that demand is higher than supply in the short term causing futures prices to rise futures prices rise above spot prices because investors become comfortable paying more for the future assets however commodity and volatility funds are structured to buy short term futures as a result contango can eat away at these funds value because it can reduce the capital a fund holds for purchases for the next period contango vs backwardationcontango sometimes referred to as forwardation is the opposite of backwardation in the futures markets the forward curve can be in contango or backwardation a market is in backwardation when the futures price is below the spot price for a particular asset in general backwardation can be the result of current supply and demand factors it may be signaling that investors are expecting asset prices to fall over time because investors base their futures bids on how they foresee the market turning out sentiment plays a significant part in backwardation investors might anticipate a declining market and begin to sell short futures contracts with strike prices below the current spot price and buy the contracts for a profit a market in backwardation has a forward curve that is downward sloping as shown below advantages and disadvantages of contangoarbitrage opportunitiesinflation protectionshort selling opportunitiesfutures contracts can be rolled forwardhigh risk when attempting to profitone way to benefit from contango is through arbitrage strategies for example an arbitrageur might buy a commodity at the spot price and then immediately sell it at a higher futures price as futures contracts near expiration this type of arbitrage increases the spot and futures prices actually converge as expiration approaches due to arbitrage there is also another approach to profiting from contango futures prices above the spot price can signal higher prices in the future particularly when inflation is high speculators may buy more of the commodity experiencing contango in an attempt to profit from higher expected prices in the future they might be able to make even more money by buying futures contracts however that strategy only works if actual prices in the future exceed futures prices as mentioned previously traders can profit from short selling opportunities created by contango the most significant disadvantage of contango comes from automatically rolling forward contracts which is a common strategy for commodity etfs investors who buy commodity contracts when markets are in contango tend to lose some money when the futures contracts expire higher than the spot price fortunately the loss caused by contango is limited to commodity etfs that use futures contracts such as oil etfs gold etfs and other etfs that hold actual commodities for investors do not suffer from contango the risks of trading in a contango market are increased when you re seeking profits because trades are being made at a premium there is always the possibility that the market will fall to levels far below the price you ve agreed to pay causing losses | |
what are the causes of contago | contango can be caused by several factors including inflation expectations expected future supply disruptions and the carrying costs of the commodity in question some investors will seek to profit from contango by exploiting arbitrage opportunities between the futures and spot prices | |
what is the difference between contango and backwardation | the opposite of contango is known as backwardation when the market is in backwardation the futures prices for the commodity follow a downward sloping curve in which futures prices are below spot prices although backwardation is relatively rare it occasionally occurs in several commodity markets causes of backwardation include anticipated declines in demand for the commodity expectations of deflation and a short term shortage in the commodity s supply | |
how does contango affect commodity exchange traded funds etfs | investors in exchange traded funds etfs must understand how contango can affect certain commodity based etfs specifically if a commodity etf invests in commodity futures contracts as opposed to physically holding the commodity in question that etf may be forced to replace or continuously roll over its futures contracts as its older contracts expire if the commodity in question is subject to contango then this would lead to a steady rise in the prices being paid for these futures contracts over the long run this can significantly increase the costs borne by the etf placing a downward drag on the returns earned by its investors the bottom linecontango is a futures market occurrence marked by futures contract prices rising above spot prices it means that traders and investors anticipate an increase in prices in the coming months the opposite of contango is backwardation when futures prices are lower than spot prices futures contracts are inherently speculative but contango and backwardation are standard market conditions because investors have different views about the future the significant difference for investors then is how to trade during these conditions | |
what is a contingency | a contingency is a potential occurrence of a negative event in the future such as an economic recession natural disaster fraudulent activity terrorist attack or a pandemic although contingencies can be prepared for the nature and scope of such negative events are typically unknowable in advance companies and investors plan for various contingencies through analysis and implementing protective measures in finance managers often attempt to identify and plan using predictive models for possible contingencies that they believe may occur financial managers tend to err on the conservative side to mitigate risk assuming slightly worse than expected outcomes a contingency plan might include arranging a company s affairs so that it can weather negative outcomes with the least distress possible | |
how a contingency works | to plan for contingencies financial managers may often also recommend setting aside significant reserves of cash so that the company has strong liquidity even if it meets with a period of poor sales or unexpected expenses managers may seek to proactively open credit lines while a company is in a strong financial position to ensure access to borrowing in less favorable times for example pending litigation would be considered a contingent liability contingency plans typically include insurance policies that cover losses that may arise during and after a negative event however insurance policies may not cover all of the costs or every scenario for example business interruption insurance doesn t usually cover pandemics which many businesses suffered through as a result of the coronavirus pandemic the federal government had to step in and pass the coronavirus aid relief and economic security cares act which provided financial relief to businesses families and local governments to stem the economic hardship caused by the pandemic in particular the paycheck protection program ppp offered 349 billion in aid to small businesses to help them maintain their payroll and expenses 1insurance companies might also limit coverage or put exclusions in place for an act of god which is an exogenous event meaning outside of human control such as a flood or an earthquake also insurance can t replace the customers that were lost to competitors due to an event particularly if it was an internal systems issue such as a data breach as a result businesses need to have contingency plans established to help minimize the lost revenue and increased costs that are involved when business operations have been disrupted typically business consultants are hired to ensure contingency plans consider a large number of possible scenarios and provide advice on how to best execute the plan types of contingency planscontingency plans are utilized by corporations governments investors and central banks such as the fed contingencies can involve real estate transactions commodities investments currency exchange rates and geopolitical risks contingencies might also include contingent assets which are benefits rather than losses that accrue to a company or individual given the resolution of some uncertain event in the future a favorable ruling in a lawsuit or an inheritance would be an example of contingent assets contingency plans might involve purchasing insurance policies that pay cash or a benefit if a particular contingency occurs for example property insurance might be purchased to protect against fire or wind damage investors protect themselves from contingencies that could lead to financial losses related to investing investors might employ various hedging strategies such as stop loss orders which exit a position at a specific price level hedging can also involve using options strategies which is akin to buying insurance whereby the strategies earn money as an investment position loses money from a negative event the money earned from the options strategy completely or partially offsets the losses from the investment however these strategies come at a cost usually in the form of a premium which is an upfront cash payment investors also employ asset diversification which is the process of investing in various types of investments asset diversification helps to minimize risk if one asset class such as stocks declines in value contingent immunization is a type of contingency plan used in fixed income investing it involves the fund manager switching to a defensive position if the portfolio drops below a predetermined value as part of a contingency plan for disasters such as a pandemic companies need to plan ahead to ensure that the business can operate during and after an event this type of contingency plan is often called a business continuity plan bcp or a business recovery plan typically a business continuity team is formed to plan for any possible contingencies and manage the continuity and recovery plan during a disruption businesses need to identify their critical business functions and perform an analysis of how an event might impact the company s operations and processes the contingency plan would include implementing the recovery of critical business functions such as systems production and employee access to technology such as computers for example a contingency plan for a pandemic would include developing a remote work strategy to help prevent the spread of disease and provide employees with secure access to their work as a result companies would need to invest in technology which could include providing laptops and video conferencing access to employees creating cloud based data storage and facilitating access to company wide communications such as email and internal data with any type of disaster cybercriminals often try to take advantage of a crisis to hack into a company s systems and steal data or disrupt business operations contingency plans are used to outline the procedures for cybersecurity teams to protect an organization from threats and malicious attacks special considerationsa contingency plan should also prepare for the loss of intellectual property through theft or destruction as a result backups of critical files and computer programs as well as key company patents should be maintained in a secure off site location contingency plans need to prepare for the possibility of operational mishaps theft and fraud a company should have an emergency public relations response relating to possible events that have the ability to severely damage the company s reputation and its ability to conduct business | |
how a company is reorganized after a negative event should be included in a contingency plan it should have procedures outlining what needs to be done to return the company to normal operations and limit any further damage from the event | for example financial services firm cantor fitzgerald was able to resume operation in just days after being crippled by the 9 11 terrorist attacks due to having a comprehensive contingency plan in place benefits of a contingency plana thorough contingency plan minimizes loss and damage caused by an unforeseen negative event for example a brokerage company may have a backup power generator to ensure that trades can be executed in the event of a power failure preventing possible financial loss a contingency plan can also reduce the risk of a public relations disaster a company that effectively communicates how negative events are to be navigated and responded to is less likely to suffer reputation damage a contingency plan often allows a company affected by a negative event to keep operating for example a company may have a provision in place for possible industrial action such as a strike so obligations to customers are not compromised companies that have a contingency plan in place may obtain better insurance rates and credit availability because they are seen to have reduced business risks banks and contingenciesas a result of the financial crisis of 2008 and the great recession regulations were implemented requiring bank stress tests to be performed to test how a bank might handle various negative contingencies the stress tests project how much a bank would lose if a negative economic event occurred to determine if the bank has enough capital or funds set aside to survive the event banks are required to have a specific percentage of capital reserves on hand depending on the total risk weighted assets rwas these assets which are typically loans have various risk weightings applied to them for example a bank s mortgage portfolio might receive a 50 weighting meaning the bank in a negative scenario should have enough capital that s valued at 50 of the outstanding mortgage loans the capital called tier 1 capital can include equity shares or shareholders equity and retained earnings which are accumulated savings of prior years profits although there are various components that go into the tier capital ratio requirement the ratio has to be at least 6 of the total risk weighted assets 2let s say as an example bank xyz has 3 million in retained earnings and 4 million in shareholders equity meaning the total tier 1 capital is 7 million bank xyz has risk weighted assets of 70 million as a result the bank s tier 1 capital ratio is 10 7 million 70 million since the capital requirement is 6 the bank is considered well capitalized when compared to the minimum requirement of course we won t know if the banking sector s contingency plan will be adequate until another recession occurs which is a limitation of these plans since it s difficult to plan for every contingency | |
why is an environmental contingency plan important | businesses that are at risk for environmental accidents particularly spills of hazardous materials should always have a plan in place detailing their response actions being prepared can help minimize the total damage done to the environment minimize accident related costs and limit liability | |
what is contingency theory | contingency theory is an approach to management that suggests the best way to run an organization is dependent or contingent on that particular situation in other words a specific management style can work well in one company and fail completely in another one | |
what are the steps in creating a contingency plan | to create a contingency plan first identify the key risks to your business and order them in regard to the likelihood of occurring and severity next conduct a business impact analysis bia from there start shaping your plan which should include preventive controls an incidence response plan a disaster recovery plan and a business continuity plan make sure to provide training to employees frequent testing and updating of your plan the bottom linea contingency is a potentially negative future event or circumstance such as a global pandemic natural disaster or terrorist attack by designing plans that take contingencies into account companies governments and individuals are able to limit the damage done by such events | |
what is a contingent asset | a contingent asset is a potential economic benefit that is dependent on some future event s largely out of a company s control a contingent asset is thus also known as a potential asset not knowing for certain whether these gains will materialize or being able to determine their precise economic value means these assets cannot be recorded on the balance sheet however they can be reported in the accompanying footnotes of financial statements provided that certain conditions are met understanding contingent assetsa contingent asset becomes a realized asset recordable on the balance sheet when the realization of cash flows associated with it becomes relatively certain in this case the asset is recognized in the period when the change in status occurs contingent assets may arise due to the economic value being unknown alternatively they might occur due to uncertainty relating to the outcome of an event in which an asset may be created a contingent asset appears because of previous events but the entirety of all asset information will not be collected until future events happen there also exists contingent or potential liabilities unlike contingent assets they refer to a potential loss that may be incurred depending on how a certain future event unfolds examples of contingent assetsa company involved in a lawsuit that expects to receive compensation has a contingent asset because the outcome of the case is not yet known and the dollar amount is yet to be determined let s say company abc has filed a lawsuit against company xyz for infringing a patent if there is a decent chance that company abc will win the case it has a contingent asset this potential asset will generally be disclosed in its financial statement but not recorded as an asset until the lawsuit is settled based on this same example company xyz would need to disclose a potential contingent liability in its notes and then later record it in its accounts should it lose the lawsuit and be ordered to pay damages contingent assets also crop up when companies expect to receive money through the use of a warranty other examples include benefits to be received from an estate or other court settlement anticipated mergers and acquisitions are to be disclosed in the financial statements reporting requirementsboth generally accepted accounting principles gaap and international financial reporting standards ifrs require companies to disclose contingent assets if there is a decent possibility that these potential gains will eventually be realized for u s gaap there generally needs to be a 70 likelihood that the gain occurs ifrs on the other hand is slightly more lenient and generally permits companies to make reference to potential gains if there is at least a 50 likelihood that they will occur 1international accounting standard 37 ias 37 applicable to ifrs states the following contingent assets are not recognized but they are disclosed when it is more likely than not that an inflow of benefits will occur however when the inflow of benefits is virtually certain an asset is recognized in the statement of financial position because that asset is no longer considered to be contingent 2contingent asset accounting policies for gaap meanwhile are mainly outlined in the financial accounting standards board s fasb accounting standards codification asc topic 450 3special considerationscompanies must reevaluate the potential asset continually when a contingent asset becomes likely firms must report it in financial statements by estimating the income to be collected the estimate is generated using a range of possible outcomes the associated risks and experience with similar potential contingent assets contingent assets are ruled under the conservatism principle which is an accounting practice that states that uncertain events and outcomes should be reported in a manner that results in the lowest potential profit in other words companies are discouraged from inflating expectations and are generally advised to utilize the lowest estimated asset valuation 1in addition no gain may be recorded from a contingent asset until it actually occurs the conservatism principle supersedes the matching principle of accrual accounting meaning the asset may not be reported until a period after associated costs were incurred | |
what is a contingent asset | a contingent asset is a potential economic benefit that is dependent on some future event s largely out of a company s control a contingent asset is thus also known as a potential asset not knowing for certain whether these gains will materialize or being able to determine their precise economic value means these assets cannot be recorded on the balance sheet however they can be reported in the accompanying footnotes of financial statements provided that certain conditions are met understanding contingent assetsa contingent asset becomes a realized asset recordable on the balance sheet when the realization of cash flows associated with it becomes relatively certain in this case the asset is recognized in the period when the change in status occurs contingent assets may arise due to the economic value being unknown alternatively they might occur due to uncertainty relating to the outcome of an event in which an asset may be created a contingent asset appears because of previous events but the entirety of all asset information will not be collected until future events happen there also exists contingent or potential liabilities unlike contingent assets they refer to a potential loss that may be incurred depending on how a certain future event unfolds examples of contingent assetsa company involved in a lawsuit that expects to receive compensation has a contingent asset because the outcome of the case is not yet known and the dollar amount is yet to be determined let s say company abc has filed a lawsuit against company xyz for infringing a patent if there is a decent chance that company abc will win the case it has a contingent asset this potential asset will generally be disclosed in its financial statement but not recorded as an asset until the lawsuit is settled based on this same example company xyz would need to disclose a potential contingent liability in its notes and then later record it in its accounts should it lose the lawsuit and be ordered to pay damages contingent assets also crop up when companies expect to receive money through the use of a warranty other examples include benefits to be received from an estate or other court settlement anticipated mergers and acquisitions are to be disclosed in the financial statements reporting requirementsboth generally accepted accounting principles gaap and international financial reporting standards ifrs require companies to disclose contingent assets if there is a decent possibility that these potential gains will eventually be realized for u s gaap there generally needs to be a 70 likelihood that the gain occurs ifrs on the other hand is slightly more lenient and generally permits companies to make reference to potential gains if there is at least a 50 likelihood that they will occur 1international accounting standard 37 ias 37 applicable to ifrs states the following contingent assets are not recognized but they are disclosed when it is more likely than not that an inflow of benefits will occur however when the inflow of benefits is virtually certain an asset is recognized in the statement of financial position because that asset is no longer considered to be contingent 2contingent asset accounting policies for gaap meanwhile are mainly outlined in the financial accounting standards board s fasb accounting standards codification asc topic 450 3special considerationscompanies must reevaluate the potential asset continually when a contingent asset becomes likely firms must report it in financial statements by estimating the income to be collected the estimate is generated using a range of possible outcomes the associated risks and experience with similar potential contingent assets contingent assets are ruled under the conservatism principle which is an accounting practice that states that uncertain events and outcomes should be reported in a manner that results in the lowest potential profit in other words companies are discouraged from inflating expectations and are generally advised to utilize the lowest estimated asset valuation 1in addition no gain may be recorded from a contingent asset until it actually occurs the conservatism principle supersedes the matching principle of accrual accounting meaning the asset may not be reported until a period after associated costs were incurred | |
what are contingent convertibles cocos | contingent convertibles cocos are debt instruments primarily issued by european financial institutions these securities work in a fashion similar to traditional convertible bonds they have a specific strike price that once breached allows the conversion of the bond into equity or stock cocos also known as at1 bonds are high yield high risk products a coco is also referred to as an enhanced capital note ecn the importance of this hybrid debt security is that it carries specialized options that help the issuing financial institution absorb a capital loss cocos can help to shore up a bank s balance sheets by allowing it to convert its debt to stock if specific unfavorable capital conditions arise they were created after the 2007 2008 global financial crisis to help undercapitalized banks and to reduce the potential for taxpayer funded bailouts understanding contingent convertibles cocos cocos are designed to automatically cover bank losses and aid them in satisfying additional tier 1 at1 and tier 2 t2 regulatory capital requirements imposed by basel iii there is a significant difference between bank issued contingent convertibles bonds and standard convertible bonds convertible bonds have bond like characteristics they pay a regular rate of interest and have seniority in the case of the underlying business defaulting these debt securities also allow the bondholder to convert the debt security into the issuer s common stock shares at a specified strike price this gives investors the potential for share price appreciation the strike price is a specific stock price that needs to be reached for the conversion to occur investors can benefit from convertible bonds since the bonds can be converted to stock when the company s stock price is appreciating the convertible feature allows investors to enjoy both the benefits of bonds with their fixed interest rate and the potential for capital appreciation from a rising stock price contingent convertibles expand on the concept of convertible bonds by modifying the conversion terms as with the convertible bond investors receive periodic fixed interest payments during the life of the bond but cocos automatically create a loss for investors if the issuer s capital drops under a specific level reaching these points of normally 7 or 5 125 of total risk weighted assets can cause three potential results for investors broadly the trigger can take several forms including the price of the underlying shares the bank s need to meet regulatory capital requirements or the demand of a managerial or supervisory authority the use of cocos has not yet been introduced in the u s banking industry background of cocoscontingent convertibles became popular as an aid to financial institutions in meeting basel iii capital requirements basel iii is a regulatory accord outlining a set of minimum standards for the banking industry its goal was to improve the supervision risk management and the regulatory framework for the critical financial sector as part of the standards a bank must maintain enough capital to be able to withstand a financial crisis and absorb unexpected losses from loans and investments the basel iii framework tightened banks capital requirements by limiting the kind of capital that they could include in their various capital tiers and structures one type of bank capital is tier 1 capital the highest rated capital available to offset bad loans on the institution s balance sheet tier 1 capital includes retained earnings an accumulated account of profits as well as common stock shares banks issue shares to investors to raise funding for their operations and to offset bad debt losses cocos act as additional tier 1 capital at1 helping european banks to meet the basel iii requirements they allow a bank to absorb the loss of underwriting bad loans or other financial industry stress | |
how banks use contingent convertibles | banks use contingent convertibles differently from the way corporations use convertible bonds banks have their own set of parameters that warrant the bond s conversion to stock the triggering event for cocos can be the bank s value of tier 1 capital the judgment of supervisory authority or the value of the bank s underlying stock shares banks absorb financial loss through coco bonds instead of converting bonds to common shares based solely on stock price appreciation investors in cocos agree to take equity in exchange for the regular income from the debt when the bank s capital ratio falls below regulatory standards importantly the stock price might be lower than desired when a conversion is triggered if the bank is having financial difficulty and needs capital this is reflected in the value of its shares as a result cocos can convert to equity while the stock s price is declining this puts investors at risk for losses 1 contingent convertible bonds are an ideal product for undercapitalized banks in markets around the globe since they come with an embedded option that allows banks to meet capital requirements and limit capital distributions at the same time 2 the issuing bank benefits from the coco by raising capital from the bond issue however if the bank has underwritten many bad loans it may fall below its basel tier 1 capital requirements in this case the coco carries a stipulation that the bank doesn t have to pay periodic interest payments and it may even write down the full debt to satisfy tier 1 requirements 3 when the bank converts the coco to shares it may remove the value of the debt from the liability side of its balance sheet this bookkeeping change allows the bank to underwrite additional loans 4 the security has no end date at which time the principal must return to investors if the bank experiences financial hardship it can postpone the payment of interest force a conversion to equity or in dire situations write the debt down to zero u s banks issue preferred stocks instead of cocos to meet at1 capital requirements benefits and risks of cocos for investorseuropean banks can raise tier 1 capital by issuing coco bonds if necessary the bank can postpone interest payment or may write down the debt to zero investors receive periodic high yield interest payments if a coco conversion is triggered by a higher stock price investors receive share appreciation investors bear the risks and have little control if the bonds are converted to stock cocos converted to stock can result in investors receiving shares as the stock price is declining investors may have difficulty selling their position in cocos if regulators do not allow the sale banks that issue cocos have to pay a higher interest rate than that for traditional bonds examples of a contingent convertiblelet s say deutsche bank issued contingent convertibles with a trigger set to core tier 1 capital instead of a strike price if tier 1 capital falls below 5 the convertibles automatically convert to equity and the bank improves its capital ratios by removing the bond debt from its balance sheet if an investor owns a coco with a 1 000 face value that pays 8 per year in interest then the bondholder receives 80 per year the stock trades at 100 per share when the bank reports widespread loan losses the bank s tier 1 capital falls below the 5 level which triggers the cocos to be converted to stock the conversion ratio allows the investor to receive 25 shares of the bank s stock for the 1 000 investment in the coco however the stock has steadily declined from 100 to 40 over the past several weeks the 25 shares are worth 1 000 at 40 per share the investor decides to hold the stock and the next day the price declines to 30 per share the 25 shares are now worth 750 and the investor has lost 25 it s important that investors who hold coco bonds weigh the risk that they ll need to act quickly if the bond is converted otherwise they may experience significant losses as stated earlier when a coco trigger occurs it may not be an ideal time to purchase the stock in 2023 credit suisse group ag s contingent convertible securities suffered a historic 17 billion loss after ubs group ag agreed to buy the bank the swiss government brokered the deal to contain a spreading crisis of confidence in global financial markets the deal triggered a total write down of cocos which provoked an angry reaction from some bondholders credit suisse had 13 coco issues outstanding worth a combined 16 billion swiss francs however cocos were designed for crisis points like this and their risks were known coco bonds of other european lenders also plunged with deutsche bank s 650 million 792 million 7 125 note suffering its biggest ever one day decline cocos are a popular way for european banks to raise capital while providing additional loss absorbing capacity in times of stress however credit suisse s experience raised concerns about the future of the coco market and at1 bonds while european regulators reiterated that equities should absorb losses before bondholders the decision to write down the bank s riskiest debt sparked a furious response from some creditors it should be noted that most other banks in europe and the united kingdom have more protections for their at1 bonds credit suisse and ubs had language in the terms of their deal that allowed for a permanent write down | |
how do cocos differ from convertible bonds | contingent convertibles cocos and convertible bonds both have a price point that triggers the conversion of the bond into equity or stock however cocos have several triggers while traditional convertible bonds have only one cocos pay higher interest rates than convertible bonds due to their risks they have special options that help banks absorb a capital loss moreover convertible bondholders have priority should the underlying business default cocos are secondary debts issued by banks cocos are used mainly by banks to improve their financial position while corporations use convertible bonds to raise capital | |
are contingent convertibles regulated | yes cocos are regulated in the european union under the basel iii regulatory framework the framework sets minimum standards for the banking industry to improve supervision risk management and capital requirements | |
what happens to contingent convertibles during a financial crisis | during a period of financial stress or uncertainty for banks the value of cocos can significantly decrease as they are high risk instruments if a bank is struggling and needs additional capital the value of its shares may decrease putting coco investors at risk for losses if a bank fails to meet its capital requirements it may postpone the payment of interest or convert the bond into equity at a lower price to meet the regulatory standards in dire situations the bank may write down the value of cocos to zero the bottom linecontingent convertibles or cocos are a type of debt instrument issued by european financial institutions they are similar to traditional convertible bonds in that they can be converted into common stock at a particular strike price cocos are used in the banking industry to shore up banks tier 1 balance sheets allowing them to absorb a capital loss because of this cocos are high yield higher risk products and investors need to weigh the benefits and risks of investing in cocos carefully | |
what is a contingent liability | a contingent liability is a liability that may occur depending on the outcome of an uncertain future event contingent liabilities are recorded if the contingency is likely and the amount of the liability can be reasonably estimated the liability may be disclosed in a footnote on the financial statements unless both conditions are not met investopedia nono flores | |
how contingent liabilities work | pending lawsuits and product warranties are common contingent liability examples because their outcomes are uncertain the accounting rules for reporting a contingent liability differ depending on the estimated dollar amount of the liability and the likelihood of the event occurring the accounting rules ensure that financial statement readers receive sufficient information a probable contingent liability that can be reasonably estimated is entered into the accounts even if the precise amount cannot be known | |
when do i need to be aware of contingent liability | if you run a business or oversee the accounts of one you need to be aware of the contingent liabilities that you have taken on you ll also need to record them both gaap generally accepted accounting principles and ifrs international financial reporting standards require companies to record contingent liabilities in accordance with the three accounting principles full disclosure materiality and prudence 12a contingent liability has to be recorded if the contingency is likely and the amount of the liability can be reasonably estimated gaap recognizes three categories of contingent liabilities probable possible and remote | |
what is important to know about contingent liability | contingent liabilities adversely impact a company s assets and net profitability as a result knowledge of both contingencies and commitments is extremely important to users of financial statements because they represent the encumbrance of potentially material amounts of resources during future periods and thus affect the future cash flows available to creditors and investors contingent liabilities are also important for potential lenders to a company who will take these liabilities into account when deciding on their lending terms business leaders should also be aware of contingent liabilities because they should be considered when making strategic decisions about a company s future example of a contingent liabilityassume that a company is facing a lawsuit from a rival firm for patent infringement the company s legal department thinks that the rival firm has a strong case and the business estimates a 2 million loss if the firm loses the case because the liability is both probable and easy to estimate the firm posts an accounting entry on the balance sheet to debit increase legal expenses for 2 million and to credit increase accrued expense for 2 million the accrual account permits the firm to immediately post an expense without the need for an immediate cash payment if the lawsuit results in a loss a debit is applied to the accrued account deduction and cash is credited reduced by 2 million now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be 2 million under these circumstances the company discloses the contingent liability in the footnotes of the financial statements if the firm determines that the likelihood of the liability occurring is remote the company does not need to disclose the potential liability a warranty is another common contingent liability because the number of products returned under a warranty is unknown assume for example that a bike manufacturer offers a three year warranty on bicycle seats which cost 50 each if the firm manufactures 1 000 bicycle seats in a year and offers a warranty per seat the firm needs to estimate the number of seats that may be returned under warranty each year if for example the company forecasts that 200 seats must be replaced under warranty for 50 the firm posts a debit increase to warranty expense for 10 000 and a credit increase to accrued warranty liability for 10 000 at the end of the year the accounts are adjusted for the actual warranty expense incurred | |
what is a contingent liability | a contingent liability is a liability that may occur depending on the outcome of an uncertain future event a contingent liability has to be recorded if the contingency is likely and the amount of the liability can be reasonably estimated both generally accepted accounting principles gaap and international financial reporting standards ifrs require companies to record contingent liabilities 12 | |
what are the 3 types of contingent liabilities | gaap recognizes three categories of contingent liabilities probable possible and remote probable contingent liabilities can be reasonably estimated and must be reflected within financial statements possible contingent liabilities are as likely to occur as not and need only be disclosed in the financial statement footnotes remote contingent liabilities are extremely unlikely to occur and do not need to be included in financial statements at all | |
what are examples of contingent liability | pending lawsuits and warranties are common contingent liabilities pending lawsuits are considered contingent because the outcome is unknown a warranty is considered contingent because the number of products that will be returned under a warranty is unknown | |
is contingent liability an actual liability | yes when they are probable even though they are only estimates due to their high probability contingent liabilities classified as probable are considered real this is why they need to be reported via accounting procedures and why they are regarded as real liabilities the bottom linea contingent liability is a potential liability that may occur in the future such as pending lawsuits or honoring product warranties if the liability is likely to occur and the amount can be reasonably estimated the liability should be recorded in the accounting records of a firm contingent liabilities are recorded to ensure that the financial statements are accurate and meet gaap or ifrs requirements gaap recognizes three categories of contingent liabilities probable possible and remote | |
what is a contingent value right cvr | the term contingent value right cvr refers to a right often granted to shareholders of a company facing restructuring or a buyout these rights ensure that the shareholders get certain benefits if a specific event occurs usually within a specified time frame these rights are similar to options because they frequently have an expiration date beyond which the rights to the additional benefits will not apply cvrs are usually related to the performance of a company s stock understanding contingent value rights cvrs a contingent value right is tied to a theorized future event such as an acquisition cvrs are created when the two companies in an acquisition come to different conclusions about the value of the target the acquirer may feel that the current value of the target is limited with the potential for a higher value the target on the other hand may value itself higher for any number of reasons including a new product or technology cvrs help bridge the gap between this difference in valuation an acquiring company can pay less upfront for the acquired company but if the acquired company hits certain performance targets in the future its shareholders will receive additional benefits shareholders who are given a cvr are granted the benefit only if the triggering event takes place in the given time frame if not the cvr becomes worthless and expires these benefits give shareholders additional shares of the acquiring company or they may provide a cash payment this is often linked if the acquired company s share price drops below a certain price by a predetermined date cvrs come with some risks that s because their real value is not discernible when they are issued the risk shareholders face remains unknown because these rights are based entirely on the anticipated price of the stock or some unforeseeable occurrence when cvrs are issued a portion of the acquirer s risk is transferred to the target company s shareholders this could have an adverse effect on any existing shareholders depending on the price paid to acquire the company types of cvrsthere are two ways that a contingent value right may be offered they may be traded on a stock exchange or may be non transferable cvrs that trade on a stock exchange can be bought by anyone which means they do not have to be current shareholders of the acquired company an investor can buy a cvr on an exchange up until it expires non transferable cvrs on the other hand apply only to current shareholders of the acquired company and are distributed at the time of the merger companies prefer non transferable cvrs as transferable cvrs listed on an exchange require regulatory work and incur higher costs cvrs as unsecured obligationsthe new york stock exchange nyse listed company manual refers to cvrs as unsecured obligations of the issuer an unsecured obligation also known as unsecured debt carries no collateral or backing by an underlying asset shareholders do not have a guaranteed right that the reward will be granted to them 1while they hold an obligation from a company investors who receive cvrs are more akin to options holders than to say bondholders unlike the latter they have no guarantee to be paid and they have no claim on the company s assets should their payment not materialize just like options all cvrs have an expiration date no additional benefit is paid to the shareholder other than the stock itself if the cvr expires example of a cvrin feb 2023 the pharmaceutical company astrazeneca purchased the pharmaceutical company cincor as part of the deal shareholders of cincor received non tradeable contingent value rights which are payable when the regulatory submission of a baxdrostat product is submitted by a specified time the value of the cvrs is 1 8 billion 2 | |
when are contingent value rights used | cvrs are issued at the time that one company acquires another it represents the difference in the two companies valuation of the target and provides a benefit to its shareholders these investors receive the benefit when the acquired company achieves a certain performance achievement | |
are contingent value rights guaranteed | contingent value rights are not guaranteed the acquired company must meet certain performance metrics and or targets for shareholders to receive the benefit if the cvr expires before this happens no benefit is granted | |
how can a shareholder profit from contingent value rights | to profit from a cvr investors must hold stock in the acquired company before it is delisted from the stock exchange companies tend to prefer non transferable cvrs because it doesn t require listing the shares on an exchange this costs less money and regulatory hurdles the bottom linein an acquisition the goal of cvrs is to bridge the gap between what the acquirer values the company at and what the company being acquired values itself at as the acquirer believes the value is limited with upside potential in the future it will provide shareholders with cvrs which will provide a monetary benefit to shareholders if certain value potentials are reached | |
what is continuous compounding | continuous compounding is the mathematical limit that compound interest can reach if it s calculated and reinvested into an account s balance over a theoretically infinite number of periods while this is not possible in practice the concept of continuously compounded interest is important in finance it is an extreme case of compounding as most interest is compounded on a monthly quarterly or semiannual basis formula and calculation of continuous compoundinginstead of calculating interest on a finite number of periods such as yearly or monthly continuous compounding calculates interest assuming constant compounding over an infinite number of periods the formula for compound interest over finite periods of time takes into account four variables the formula for continuous compounding is derived from the formula for the future value of an interest bearing investment future value fv pv x 1 i n n x t calculating the limit of this formula as n approaches infinity per the definition of continuous compounding results in the formula for continuously compounded interest fv pv x e i x t where e is the mathematical constant approximated as 2 7183 | |
what continuous compounding can tell you | in theory continuously compounded interest means that an account balance is constantly earning interest as well as refeeding that interest back into the balance so that it too earns interest continuous compounding calculates interest under the assumption that interest will be compounding over an infinite number of periods although continuous compounding is an essential concept it s not possible in the real world to have an infinite number of periods for interest to be calculated and paid as a result interest is typically compounded based on a fixed term such as monthly quarterly or annually even with very large investment amounts the difference in the total interest earned through continuous compounding is not very high when compared to traditional compounding periods example of how to use continuous compoundingas an example assume a 10 000 investment earns 15 interest over the next year the following examples show the ending value of the investment when the interest is compounded annually semiannually quarterly monthly daily and continuously with daily compounding the total interest earned is 1 617 98 while with continuous compounding the total interest earned is 1 618 34 a marginal difference | |
what is compound interest | compound interest is interest earned on interest you ve received when interest compounds each subsequent interest payment will get larger because it is calculated using a new higher balance more frequent compounding means you ll earn more interest overall | |
how does annual percentage yield apy relate to continuous compounding | annual percentage yield apy is the real rate of return on an investment taking compounding interest into account the apy of an account with more frequent or continuous compounding will be higher than the apy of an account that has infrequent compounding assuming they both have the same interest rate | |
what are the most common compounding periods | depending on the situation interest is typically compounded monthly quarterly semi annually or annually some accounts may even offer daily compounding though compounding more frequently than that is incredibly unusual | |
what is discrete compounding | discrete compounding is the opposite of continuous compounding instead of interest compounding constantly it compounds at set intervals such as daily or monthly the bottom linecontinuous compounding may be a theoretical concept that can t be achieved in reality but it has real value for savers and investors it allows savers to see the maximum amount they could earn in interest for a given period and can be useful when comparing to the actual yield of the account | |
what is a contra account | a contra account is used in a general ledger to reduce the value of a related account when the two are netted together a contra account s natural balance is the opposite of the associated account if a debit is the natural balance recorded in the related account the contra account records a credit for example the contra account for a fixed asset is accumulated depreciation investopedia madelyn goodnightunderstanding a contra accountcontra accounts are reported on the same financial statement as the associated account for example a contra account to accounts receivable often called allowance for doubtful accounts is a contra asset account this type of account could be called the allowance for doubtful accounts or a bad debt reserve the balance in the allowance for doubtful accounts represents the dollar amount of the current accounts receivable balance that is expected to be uncollectible the amount is reported on the balance sheet in the asset section immediately below accounts receivable the net of these two figures is typically reported on a third line accountants use contra accounts rather than reduce the value of the original account directly to keep financial accounting records clean if a contra account is not used it can be difficult to determine historical costs which can make tax preparation more difficult and time consuming by keeping the original dollar amount intact in the original account and reducing the figure in a separate account the financial information is more transparent for financial reporting purposes for example if a piece of heavy machinery is purchased for 10 000 that 10 000 figure is maintained on the general ledger even as the asset s depreciation is recorded separately contra accounts provide more detail to accounting figures and improve transparency in financial reporting types of contra accountsthere are four key types of contra accounts contra asset contra liability contra equity and contra revenue contra asset accounts include allowance for doubtful accounts and accumulated depreciation contra asset accounts are recorded with a credit balance that decreases the balance of an asset a key example of contra liabilities includes discounts on notes or bonds payable contra liabilities hold a debit balance contra liability accounts are not as popular as contra asset accounts a contra liability is an account in which activity is recorded as a debit balance and is used to decrease the balance of a liability the balance of a contra liability account is a debit balance this account decreases the value of the liability contra liability a c is not used as frequently as contra asset accounts it is not classified as a liability since it does not represent a future obligation the third contra type is contra equity these contras reduce the equity account and carry a debit balance contra equity reduces the total number of outstanding shares on the balance sheet the key example of a contra equity account is treasury stock which represents the amount paid to buyback stock last for contra revenue accounts there are sales discounts sales allowances or sales returns contra revenue reduced gross revenue resulting in net revenue these contra revenue accounts tend to have a debit balance and are used to calculate net sales | |
when accounting for assets the difference between the asset s account balance and the contra account balance is referred to as the book value there are two major methods of determining what should be booked into a contra account | the allowance method of accounting allows a company to estimate what amount is reasonable to book into the contra account the percentage of sales method assumes that the company cannot collect payment for a fixed percentage of goods or services that it has sold both methods result in an adjustment to book value for example a company has 40 000 worth of accounts receivable at september month end it estimates 10 of its accounts receivable will be uncollectible and proceeds to create a credit entry of 10 x 40 000 4 000 in the contra account allowance for doubtful accounts a debit will be made to the bad debt expense for 4 000 to balance the journal entry although the accounts receivable is not due in september the company still has to report credit losses of 4 000 as bad debts expense in its income statement for the month if accounts receivable is 40 000 and allowance for doubtful accounts is 4 000 the net book value reported on the balance sheet will be 36 000 those who are struggling with recording contra accounts may benefit from utilizing some of the best accounting software currently available the difference between an asset s account balance and the contra account balance is known as the book value example of a contra accounta major example of a contra account is an allowance for doubtful accounts this contra asset reduces the balance of gross accounts receivable by an estimate of how many receivables will go uncollected notice on amazon s balance sheet that the balance of accounts receivable is noted as being a net amount amazon sheds more light on that net balance in the notes to the financial statements the balance of the contra asset is composed of the estimate mentioned below | |
what is the benefit of using a contra account | contra accounts are used to reduce the value of the original account directly to keep financial accounting records clean if a contra account is not used it can be difficult to determine historical costs which can make tax preparation more difficult and time consuming | |
what are the different types of contra accounts | there are four key types of contra accounts contra asset contra liability contra equity and contra revenue contra assets decrease the balance of a fixed or capital asset carrying a credit balance contra liabilities reduce liability accounts and carry a debit balance contra equity accounts carry a debit balance and reduce equity accounts contra revenue accounts reduce revenue accounts and have a debit balance | |
what are examples of a contra asset account | key examples of contra asset accounts include allowance for doubtful accounts and accumulated depreciation allowance for doubtful accounts reduces accounts receivable accumulated depreciation reflects the reduction in value of a fixed asset | |
is a contra balance negative or positive | depending on how you view the account balance a contra account balance can be negative or positive on one hand a contra asset represents a true positive amount of something in the amazon example above the company estimated roughly 1 4 billion of accounts receivable were uncollectable and that uncollectable amount is positive however that 1 4 billion is used to reduce the balance of gross accounts receivable therefore contra accounts though they represent a positive amount are used to net reduce a gross amount for this reason contra accounts are primarily seen as having negative balances because they are used to reduce the balance of another account | |
do contra accounts have debit or credit balances | contra assets have natural credit balances whereas assets normally have positive debit balances contra assets though still reported along with other assets have an opposite type of natural balance contra liability equity and revenue accounts have natural debit balances these three types of contra accounts are used to reduce liabilities equity and revenue which all have natural credit balances therefore for these three the debit balance actually represents a negative amount the bottom linecontra accounts are used to reduce the original account directly keeping financial accounting records clean this allows for the easy determination of historical costs this is particularly important for contra asset accounts the difference between an asset s balance and the contra account asset balance is the book value | |
what is a contract for difference cfd | a contract for difference cfd is an arrangement made in financial derivatives trading where the differences in the settlement between the open and closing trade prices are cash settled there s no delivery of physical goods or securities with cfds contracts for difference are an advanced trading strategy used by experienced traders and they re not allowed in the united states 1investopedia julie bangunderstanding contracts for difference cfd cfds allow traders to trade in the price movement of securities and derivatives the financial investments that are derived from an underlying asset cfds are essentially used by investors to make price bets as to whether the price of the underlying asset or security will rise or fall cfd traders can bet on the price moving up or down traders who expect an upward movement in price will buy the cfd those who see the opposite downward movement will sell an opening position the buyer will offer their holding for sale should the buyer of a cfd see the asset s price rise the difference between the purchase price and the sale price are netted together the net difference representing the gain or loss from the trades is settled through the investor s brokerage account an opening sell position can be placed if a trader believes that a security s price will decline they must purchase an offsetting trade to close the position again the net difference of the gain or loss is cash settled through their account transacting in cfdscontracts for difference can be used to trade many assets and securities including exchange traded funds etfs traders will also use these products to speculate on the price moves in commodity futures contracts such as those for crude oil and corn futures contracts are standardized agreements or contracts with obligations to buy or sell a particular asset at a preset price with a future expiration date cfds allow investors to trade the price movements of futures but they re not futures contracts by themselves cfds don t have expiration dates containing preset prices they trade like other securities with buy and sell prices cfds trade over the counter otc through a network of brokers that organize the market demand and supply for cfds and make prices accordingly they re not traded on major exchanges such as the new york stock exchange nyse the cfd is a tradable contract between a client and their broker they re exchanging the difference in the initial price of the trade and its value when the trade is unwound or reversed cfds allow investors to trade the price movement of assets including etfs stock indices and commodity futures cfds provide investors with all of the benefits and risks of owning a security without actually owning it cfds use leverage allowing investors to put up a small percentage of the trade amount with a broker cfds allow investors to easily take a long or short position or a buy and sell position leverage can amplify gains with cfds but leverage can also magnify losses extreme price volatility or fluctuations can lead to wide spreads between the bid buy and ask sell prices from a broker the cfd industry isn t highly regulated and it s not allowed in the u s traders are reliant on a broker s credibility and reputation investors holding a losing position can get a margin call from their broker requiring the deposit of additional funds advantages of a cfdcfds provide traders with all the benefits and risks of owning a security without actually owning it or having to take any physical delivery of the asset cfds are traded on margin the broker allows investors to borrow money to increase leverage or the size of the position brokers will require traders to maintain specific account balances before they allow this type of transaction trading on margin cfds typically provides higher leverage than traditional trading standard leverage in the cfd market can be as low as a 10 margin requirement and as high as a 50 margin but it can vary significantly by broker lower margin requirements mean less capital outlay and greater potential returns for the trader 2fewer rules and regulations surround the cfd market as compared to standard exchanges as a result cfds can have lower capital requirements or cash required in a brokerage account as a result traders can often open an account with a broker for as little as 1 000 a cfd owner can also receive cash dividends increasing the trader s return on investment because cfds mirror corporate actions taking place most cfd brokers offer products in all major markets worldwide traders have easy access to any market that s open from the broker s platform cfds allow investors to easily take a long or short position or a buy and sell position the cfd market typically doesn t have short selling rules an instrument may be shorted at any time there s no borrowing or shorting cost because there s no ownership of the underlying asset few or no fees are charged for trading a cfd brokers make money from the trader paying the spread the trader pays the ask price when buying and takes the bid price when selling or shorting the brokers take a piece or spread on each bid and ask price that they quote disadvantages of a cfdthe spread on the bid and ask prices can be significant if the underlying asset experiences extreme volatility or price fluctuations paying a large spread on entries and exits prevents profiting from small moves in cfds decreasing the number of winning trades and increasing losses the cfd industry isn t highly regulated so the broker s credibility is based on its reputation and financial viability cfds are not available in the united states as a result cfds trade using leverage so investors holding a losing position can get a margin call from their broker this requires that additional funds be deposited to balance out the losing position leverage can amplify gains with cfds but leverage can also magnify losses traders are at risk of losing 100 of their investment the trader will also be charged a daily interest rate amount if money is borrowed from a broker to trade example of a cfdan investor wants to buy a cfd on the spdr s p 500 spy an exchange traded fund that tracks the s p 500 index the broker requires 5 down for the trade the investor buys 100 shares of the spy for 250 per share for a 25 000 position from which only 5 or 1 250 is paid initially to the broker two months later the spy is trading at 300 per share and the trader exits the position with a profit of 50 per share or 5 000 in total the cfd is cash settled the initial position of 25 000 and the closing position of 30 000 300 100 shares are netted out and the gain of 5 000 is credited to the investor s account | |
what is one difference between a contract for differences cf and a futures contract | futures contracts have an expiration date at which time there s an obligation to buy or sell the asset at a preset price cfds are different in that there is no expiration date and you never own the underlying asset can u s citizens buy cfds cfds are not allowed by the u s securities and exchange commission 1 these over the counter otc products are unregulated and pose a large risk of losses in what countries are cfds legal cfds are allowed in several countries with listed otc markets they include belgium canada denmark france germany italy the netherlands new zealand norway singapore south africa spain sweden switzerland thailand and the united kingdom 3the bottom lineinvesting in cfds allows you to trade the price movements of stock indices etfs and commodity futures you get all the benefits and risks of owning a security without actually owning it using leverage allows investors to put up only a small percentage of the trade amount with a broker the drawback is that such leverage can lead to significant losses due to extreme price volatility and the limited regulation of the cfd market means u s residents cannot trade them 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 a contractionary policy | a contractionary policy is a monetary measure to reduce government spending or the rate of monetary expansion by a central bank it is a macroeconomic tool used to combat rising inflation the main contractionary policies employed by the united states government include raising interest rates increasing bank reserve requirements and selling government securities understanding contractionary policiescontractionary policies aim to hinder potential distortions to the capital markets distortions include high inflation from an expanding money supply unreasonable asset prices or crowding out effects where a spike in interest rates leads to a reduction in private investment spending such that it dampens the initial increase of total investment spending while the initial effect of the contractionary policy is to reduce nominal gross domestic product gdp which is defined as the gross domestic product gdp evaluated at current market prices it often ultimately results in sustainable economic growth and smoother business cycles contractionary policy notably occurred in the early 1980s when the then federal reserve chair paul volcker finally ended the soaring inflation of the 1970s at their peak in 1981 target federal fund interest rates neared 20 1 measured inflation levels declined from nearly 14 in 1980 to 3 2 in 1983 2tools used for contractionary policiesboth monetary and fiscal policies implement strategies to combat rising inflation and help to contract economic growth contractionary policy is often connected to monetary policy with central banks such as the u s federal reserve able to enact the policy by raising interest rates real world examplethe covid 19 pandemic affected businesses ability to produce and consumers ability to consume many governments resorted to large fiscal stimuli which boosted consumption leading to supply chain bottlenecks and price tensions the government support throughout the crisis supported a strong economic rebound with both gdp and employment recovering at a remarkable pace through 2021 3however in 2022 with growing signs of inflation and to achieve maximum employment and keep the inflation at the rate of 2 percent over the long run the federal reserve decided to raise the target range for the federal funds rate the fed views ongoing increases in the target range as appropriate to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time 4contractionary policy vs expansionary policya contractionary policy attempts to slow the economy by reducing the money supply and fending off inflation an expansionary policy is an effort that central banks use to stimulate an economy by boosting demand through monetary and fiscal stimulus expansionary policy is intended to prevent or moderate economic downturns and recessions | |
what are the effects of contractionary policy | a contractionary policy often results in the tightening of credit through increased interest rates increased unemployment reduced business investment and reduced consumer spending there is commonly an overall reduction in the gross domestic product gdp | |
what is the main goal of contractionary policy | the purpose of a contractionary policy is to slow growth to a healthy economic level typically between 2 to 3 a year for the gdp an economy that grows more than 3 creates negative consequences including inflation | |
why is contractionary policy unpopular | contractionary policies require elected officials to increase taxes and reduce government spending like social and welfare programs both unpopular with voters the bottom linea contractionary policy is a tool used to reduce government spending or the rate of monetary expansion by a central bank to combat rising inflation the main contractionary policies employed by the united states include raising interest rates increasing bank reserve requirements and selling government securities contractionary policies are often difficult to implement as they may also include increases in tax rates higher rates of unemployment and a decrease in government programs and subsidies | |
what is a contrarian | contrarian investing is an investment style in which investors purposefully go against prevailing market trends by selling when others are buying and buying when most investors are selling berkshire hathaway chair and chief executive officer ceo warren buffett is a famous contrarian investor contrarian investors believe that people who say the market is going up do so only when they are fully invested and have no further purchasing power at this point the market is at a peak so when people predict a downturn they have already sold out and the market can only go up at this point understanding contrarian strategycontrarian investing is as the name implies a strategy that involves going against the grain of investor sentiment at a given time the principles behind contrarian investing can be applied to individual stocks an industry as a whole or even entire markets a contrarian investor enters the market when others are feeling negative about it the contrarian believes the value of the market or stock is below its intrinsic value and thus represents an opportunity in essence an abundance of pessimism among other investors has pushed the price of the stock below what it should be and the contrarian investor will buy that before the broader sentiment returns and the share prices rebound according to david dreman contrarian investor and author of contrarian investment strategies the next generation investors overreact to news developments and overprice hot stocks and underestimate the earnings of distressed stocks this overreaction results in limited upward price movement and steep falls for stocks that are hot and leaves room for the contrarian investor to choose underpriced stocks special considerationscontrarian investors often target distressed stocks and then sell them once the share price has recovered and other investors begin targeting the company as well contrarian investing is built around the idea that the herd instinct that can take control of market direction doesn t make for a good investing strategy however this sentiment can lead to missing out on gains if broad bullish sentiment in the markets proves true leading to market gains even as contrarians have already sold their positions similarly an undervalued stock targeted by contrarians as an investment opportunity may remain undervalued if the market sentiment remains bearish contrarian investing vs value investingcontrarian investing is similar to value investing because both value and contrarian investors look for stocks whose share price is lower than the intrinsic value of the company value investors generally believe that the market overreacts to good and bad news so they believe that stock price movements in the short term don t correspond to a company s long term fundamentals many value investors hold that there is a fine line between value investing and contrarian investing since both strategies look for undervalued securities to turn a profit based on their reading of the current market sentiment examples of contrarian investorsthe most prominent example of a contrarian investor is warren buffett be fearful when others are greedy and greedy when others are fearful is one of his most famous quotes and sums up his approach to contrarian investing 1at the height of the 2008 financial crisis when markets were tumbling amidst a wave of bankruptcy filings buffett counseled investors to buy american stocks as an example he purchased equities for american companies including investment bank goldman sachs group inc gs 2 ten years later his advice proved to be correct from 2008 to 2018 goldman s stock had jumped by approximately 239 3michael burry a california based neurologist turned hedge fund owner is another example of a contrarian investor through his research in 2005 burry determined that the subprime market was mispriced and overheated his hedge fund scion capital shorted the riskiest parts of the subprime mortgage market and profited from them his story was written up into a book the big short by michael lewis and has been made into a movie of the same name sir john templeton was a noted contrarian investor and founded the templeton growth fund in 1954 with dividends reinvested a 10 000 investment in the fund at inception was worth 2 million by 1992 4limitations of contrarian investinginvestors interested in employing a contrarian investing strategy should be aware of some of the strategy s drawbacks it can be challenging to find undervalued stocks and contrarians typically spend a great deal of time researching stocks and various industries to find potential investment opportunities it will not be enough to rely on simply doing the opposite of the prevailing market sentiment it s important for contrarians to develop their skills in fundamental analysis to accurately measure a security s intrinsic value contrarians may have periods where their portfolios underperform it may take a significant amount of time before an undervalued stock begins to show gains in the meantime the contrarian investor may have to endure paper losses on their investments | |
what is contrarian investing | contrarian investing refers to an investing strategy that looks for profit opportunities in trades that go against current market sentiment for example if the market is bullish the contrarian investor is bearish and will look for opportunities to sell conversely if the market is bearish the contrarian is bullish and will look for opportunities to buy who are some famous contrarian investors berkshire hathaway s warren buffett and charlie munger are two of the most well known contrarian investors david dreman investment company founder and author of several books on contrarian investing is another prominent contrarian ray dalio sir john templeton michael burry and george soros are all investors who have made a name for themselves as contrarians | |
how have billionaire contrarians used deep value to beat the market | deep value investing is a term often used in conjunction with billionaire contrarians who pick their stock investments based on their analysis that a particular company is trading at many multiples below intrinsic or book value these billionaires look for companies with share prices that have been unfairly and significantly discounted by the market they will then acquire large stakes in these companies with the anticipation that over time they will profit from the share price increase investopedia does not provide tax investment or financial services and advice the information is presented without consideration of the investment objectives risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors investing involves risk including the possible loss of principal | |
what is contributed capital | contributed capital also known as paid in capital is the cash and other assets that shareholders have given a company in exchange for stock investors make capital contributions when a company issues equity shares based on a price that shareholders are willing to pay for them the total amount of contributed capital or paid in capital represents their stake or ownership in the company contributed capital is part of stockholders equity shown on the balance sheet it comprises common stock and additional paid in capital also known as contributed surplus if the company has issued preferred stocks this line item is also shown in this section of the balance sheet and is part of contributed capital investopedia xiaojie liuunderstanding contributed capitalcontributed capital is the total value of the stock that shareholders have bought directly from the issuing company it includes the money from initial public offerings ipos direct listings direct public offerings and secondary offerings including issues of preferred stock it also includes the receipt of fixed assets in exchange for stock and the reduction of a liability in exchange for stock common stock can be compared with additional paid in capital and the difference between the two values will equal the premium paid by investors over and above the par value of the company s shares common stock is recorded at a nominal amount called the par value the par value is merely an accounting value of each of the shares to be offered and is not equivalent to the market value that investors are willing to pay it s important to distinguish that capital contributions which are an injection of cash into a company can come in other forms besides the sale of equity shares for example an owner might take out a loan and use the proceeds to make a capital contribution to the company businesses can also receive capital contributions in the form of non cash assets such as buildings and equipment these scenarios are all types of capital contributions and increase owners equity however the term contributed capital is typically reserved for the amount of money received from issuing shares and not other forms of capital contributions | |
when companies repurchase shares and return capital to shareholders the shares bought back are listed at their repurchase price which reduces shareholders equity | calculating contributed capitalcontributed capital is reported in the shareholder s equity section of the balance sheet and usually split into two different accounts common stock and additional paid in capital account in other words contributed capital includes the par value or nominal value of the stock found in the common stock account and the amount of money over and above the par value that shareholders were willing to pay for their shares the share premium found in the additional paid in capital account the common stock account is also known as share capital account and the additional paid in capital account is also known as the share premium account example of contributed capitalfor example a company issues 5 000 1 par value shares to investors the investors pay 10 a share so the company raises 50 000 in equity capital as a result the company records 5 000 to the common stock account and 45 000 to the paid in capital in excess of par both of these accounts added together equal the total amount stockholders were willing to pay for their shares in other words the contributed capital equals 50 000 | |
what is contribution margin | the contribution margin can be stated on a gross or per unit basis it represents the incremental money generated for each product unit sold after deducting the variable portion of the firm s costs the contribution margin is computed as the selling price per unit minus the variable cost per unit also known as dollar contribution per unit the measure indicates how a particular product contributes to the overall profit of the company it provides one way to show the profit potential of a particular product offered by a company and shows the portion of sales that helps to cover the company s fixed costs any remaining revenue left after covering fixed costs is the profit generated formula and calculation of contribution marginthe contribution margin is computed as the difference between the sale price of a product and the variable costs associated with its production and sales process this is expressed through the following formula c r v begin aligned textbf c textbf r textbf v end aligned c r v | |
where c is the contribution margin r is the total revenue and v represents variable costs | it may also be useful to express the contribution margin as a fraction of total revenue in this case the contribution margin ratio cr is expressed as the contribution margin divided by total revenues in the same time period cr r v r begin aligned textbf cr frac textbf r textbf v textbf r end aligned cr r r v | |
what contribution margin can tell you | the contribution margin is the foundation for break even analysis used in the overall cost and sales price planning for products the contribution margin helps to separate out the fixed cost and profit components coming from product sales and can be used to determine the selling price range of a product the profit levels that can be expected from the sales and structure sales commissions paid to sales team members distributors or commission agents fixed cost vs variable costfixed cost are costs that are incurred independent of how much is sold or produced the business pays them to establish itself and exist buying items such as machinery are a typical example of a fixed cost specifically a one time fixed cost regardless of how much it is used and how many units are sold its costs remains the same however these fixed costs become a smaller percentage of each unit s cost as the number of units sold increases another common example of a fixed cost is the rent paid for a business space a store owner will pay a fixed monthly cost for the store space regardless of how much goods are sold on the other hand variable costs are costs they depend on the amount of goods and services a business produces for example a factory needs raw materials to produce products the more it produces in a given month the more raw materials it requires those raw materials are therefore a variable cost likewise a cafe owner needs things like coffee and pastries to sell to visitors the more customers she serves the more food and beverages she must buy their cost is variable these costs would be included when calculating the contribution margin fixed costs are often considered sunk costs that once spent cannot be recovered these cost components should not be considered while taking decisions about cost analysis or profitability measures contribution margin vs gross profit marginthe contribution margin is different from the gross profit margin the difference between sales revenue and the cost of goods sold while contribution margins only count the variable costs the gross profit margin includes all of the costs that a company incurs in order to make sales the contribution margin shows how much additional revenue is generated by making each additional unit product after the company has reached the breakeven point in other words it measures how much money each additional sale contributes to the company s total profits example of contribution marginsay a machine for manufacturing ink pens comes at a cost of 10 000 manufacturing one ink pen requires 0 2 worth of raw materials like plastic ink and nib another 0 1 goes towards the electricity charges for running the machine to produce one ink pen and 0 3 is the labor charge to manufacture one ink pen these three components constitute the variable cost per unit the total variable cost of manufacturing an ink pen comes to 0 2 0 1 0 3 0 6 per unit if a total of 100 ink pens are manufactured the total variable cost will come to 0 6 100 units 60 while manufacturing 10 000 ink pens will lead to a total variable cost of 0 6 10 000 units 6 000 such total variable cost increases in direct proportion to the number of units of the product getting manufactured however ink pen production will be impossible without the manufacturing machine which comes at a fixed cost of 10 000 this cost of the machine represents a fixed cost and not a variable cost as its charges do not increase based on the units produced such fixed costs are not considered in the contribution margin calculations if a total of 10 000 ink pens are manufactured using the machine at a variable cost of 6 000 and at a fixed cost of 10 000 the total manufacturing cost comes to 16 000 the per unit cost will then be computed as 16 000 10 000 1 6 per unit if each ink pen is sold at a price of 2 per unit the profit per unit comes to sp tc 2 0 1 6 0 4 per unit where sp sales price tc total costs begin aligned text sp text tc 2 0 1 6 0 4 text per unit textbf where text sp text sales price text tc text total costs end aligned sp tc 2 0 1 6 0 4 per unitwhere sp sales pricetc total costs however the contribution margin does not account for fixed cost components and considers only the variable cost components the incremental profit earned for each unit sold as represented by contribution margin will be sp tvc 2 0 0 6 1 4 per unit where sp sales price tvc total variable costs begin aligned text sp text tvc 2 0 0 6 1 4 text per unit textbf where text sp text sales price text tvc text total variable costs end aligned sp tvc 2 0 0 6 1 4 per unitwhere sp sales pricetvc total variable costs a key characteristic of the contribution margin is that it remains fixed on a per unit basis irrespective of the number of units manufactured or sold on the other hand the net profit per unit may increase decrease non linearly with the number of units sold as it includes the fixed costs uses of contribution marginthe contribution margin can help company management select from among several possible products that compete to use the same set of manufacturing resources say that a company has a pen manufacturing machine that is capable of producing both ink pens and ball point pens and management must make a choice to produce only one of them if the contribution margin for an ink pen is higher than that of a ball pen the former will be given production preference owing to its higher profitability potential such decision making is common to companies that manufacture a diversified portfolio of products and management must allocate available resources in the most efficient manner to products with the highest profit potential investors and analysts may also attempt to calculate the contribution margin figure for a company s blockbuster products for instance a beverage company may have 15 different products but the bulk of its profits may come from one specific beverage along with the company management vigilant investors may keep a close eye on the contribution margin of a high performing product relative to other products in order to assess the company s dependence on its star performer the company steering its focus away from investing or expanding the manufacturing of the star product or the emergence of a competitor product may indicate that the profitability of the company and eventually its share price may get impacted | |
how to improve contribution margin | based on the contribution margin formula there are two ways for a company to increase its contribution margins they can find ways to increase revenues or they can reduce their variable costs variable costs tend to represent expenses such as materials shipping and marketing companies can reduce these costs by identifying alternatives such as using cheaper materials or alternative shipping providers alternatively the company can also try finding ways to improve revenues for example they can simply increase the price of their products however this strategy could ultimately backfire and hurt profits if customers are unwilling to pay the higher price | |
when to use contribution margin analysis | investors examine contribution margins to determine if a company is using its revenue effectively a high contribution margin indicates that a company tends to bring in more money than it spends very low or negative contribution margin values indicate economically nonviable products whose manufacturing and sales eat up a large portion of the revenues low values of contribution margins can be observed in the labor intensive industry sectors like manufacturing as the variable costs are higher while high values of contribution margins are prevalent in the capital intensive sectors the concept of contribution margin is applicable at various levels of manufacturing business segments and products the figure can be computed for an entire corporation for a particular subsidiary for a particular business division or unit for a particular center or facility for distribution or sales channel for a product line or for individual products | |
how do you calculate contribution margin | contribution margin is calculated as revenue variable costs the contribution margin ratio is calculated as revenue variable costs revenue | |
what is a good contribution margin | the best contribution margin is 100 so the closer the contribution margin is to 100 the better the higher the number the better a company is at covering its overhead costs with money on hand | |
what is the difference between contribution margin and profit margin | profit margin is calculated using all expenses that directly go into producing the product contribution margin only takes into account variable costs the bottom linethe contribution margin represents the revenue that a company gains by selling each additional unit of a product or good this is one of several metrics that companies and investors use to make data driven decisions about their business as with other figures it is important to consider contribution margins in relation to other metrics rather than in isolation | |
what is a controller | a controller is an individual who has responsibility for all accounting related activities including high level accounting managerial accounting and finance activities within a company the duties of a controller include assisting with the preparation of the operating budgets overseeing financial reports and performing essential duties relating to payroll across all of the duties a controller often works most with the collection analysis and consolidation of financial data although the controller doesn t always maintain the annual budget the controller position monitors variances summarizes trends and investigates budget deficiencies the controller may report material budgeting variances or expenditure variances to upper management understanding financial controllerscontroller functions vary across companies owing to the size and complexity of the business and the industry smaller companies demand more versatility of the controller while larger companies are able to disperse the following job responsibilities across other employees including the chief financial officer and treasurer financial controllers are often the head financial position in charge of overseeing that historical actual financial transactions are being reported properly this may range across all finance departments including accounts payable purchasing vendor management treasury financial reporting and financial planning the controller of an organization may partake in staff recruitment selection and training since the controller often has several finance or accounting managers reporting directly to them the position requires appraising job results leading employees and performing disciplinary actions as necessary roles of financial controllersa joint publication by the institute of management accountants and deloitte development llc outlined the four primary roles a controller takes 1 these four roles include in terms of job opportunities the bureau of labor statistics bls projects a 10 year growth outlook from 2022 2032 for financial managers controllers of 16 which is much faster than average 2duties of financial controllersthe role of the controller will be different across every company for many the controller will take on at least some of the following tasks according to glassdoor a controller makes a median of roughly 143 000 per year this includes an average of 114 000 per year of base pay and about 30 000 in additional forms of compensation 3skillset of financial controllersto become a financial controller finance professionals must often have achieved proficiency in three aspects of their career education experience and licensure regarding education becoming a financial controller almost always requires at least a bachelor s degree in accounting finance business administration or a similar field in most situations a master s degree is preferred with many companies now making a master s degree a requirement though there is no industry wide requirement on the amount of work experience a controller must have most financial professionals must obtain at least five to ten years of professional experience to be considered for a controller role again a controller at a smaller company may have much smaller requirements than a large public corporation that will seek 20 years of experience in a related relevant industry companies may require that a controller candidate have public accounting experience last it is not an industry requirement to obtain a certified public accountant cpa certified management accountant cma chartered financial analyst cfa or any other type of licensure for many these licensures will help and may be a preferred requirement for the role for larger public companies controllers will often be required to have at least a cpa license career path of controllersas every company will require different qualifications there is no single career path to becoming a controller however many controllers get their start by working in the accounting field often in public accounting for finance professionals most serious about achieving controller roles they must often seek out big four positions and earn escalating responsibilities over several years after moving to the corporate or private sector a controller may continue to develop skills as an accountant booking transactions or manager overseeing the operations of a specific finance department this includes developing gaps related to receivables reporting payroll quarterly financial reporting or internal controls last controllers often transition into the role of assistant controller before making the jump to a full controller role an assistant controller is simply a more junior position that may perform many of the same tasks as a controller however the junior controller may not take full ownership of responsibility for outcomes as this may transition to a controller also a company may employ a junior status to candidates that must first demonstrate proficiency in the role before getting promoted accounting vs controllinga controller is engrained in a company s financial accounting process however the controller may not do direct accounting themselves and there is a difference between accounting and controlling in financial management controlling is the act of ensuring data is recorded accurately and on time this is a broader function of accounting as the controlling function may go behind recording transactions for example a controller may oversee the accounts payable department responsible for 1099 reporting though this process is unrelated to internal accounting transactions the controller may be a stakeholder in the process and give feedback on process improvement implementations whereas an accounts payable clerk is responsible for the accounting of liabilities tied to invoices a controller may be more concerned with the overall accurate and timeliness in which invoices are being processes and payments remit for larger companies controllers report up to a cfo or other executive the controller is usually not part of the executive leadership team controller vs other financial rolesdepending on the size and organizational layout of a company the controller may hold more than one title or be responsible for multiple aspects of finance in general especially for larger companies there are differences between controllers and other high ranking financial positions although both the controller and cfo of a company are leaders in finance they are often two separate positions responsible for different tasks a controller is more likely to be entangled in general ledgers trial balances and financial reports being delivered to more senior management meanwhile a cfo utilizes these reports to focus on more broad big picture company positioning in general cfos often take a greater presence in external facing tasks including mergers acquisitions or involvement with investors meanwhile financial controllers own more of the internal reporting process including implementing internal controls managing the month end close schedule and ensuring financial accuracy in many situations a company s vice president of finance mimics the traditional role of cfo a vice president is often tasked with the highest level of financial and accounting oversight while a controller s role is more limited to the financial preparation and management of the financial reporting process for companies with both a controller and vice president of finance the controller would most likely report directly to the vice president financial controllers are in charge of the past they review historical transactions and ensure reporting is done correctly these reports may then be delivered to a financial planning and analysis fp a leader this fp a director relies on their team to build budgets forecasts and long term plans based on the future of the company a controller s role is heavily if not exclusively rooted in dealing with actual transactions overseeing both revenue and expense reporting a controller often does not deal in theory meanwhile an fp a director leverages historical data to devise future plans that may or may not materialize these plans may rotate on a quarterly basis if the company decides to reforecast any projections a variation of the controller position is called a comptroller a comptroller is typically a more senior position that is more commonly found in government or nonprofit organizations a controller and comptroller simply have similar roles in different industries who reports to the controller a controller often oversees the department leads within finance for each respective department tied to financial reporting this may include the accounts payable lead procurement lead purchasing lead financial reporting manager or payroll manager | |
is a controller the same as cfo or vp of finance | a controller is not the same as a cfo or vp of finance a cfo or vp of finance are often higher level positions that are on the executive team meanwhile a controller is usually a lower level position that is less involved in strategic planning or external affairs and mostly involved in internal reporting | |
what qualifications does a controller need | a controller must often have around at least 10 years of professional experience though larger public companies will often require more though an accounting or finance license is not always required a controller may need to carry a cpa license a controller usually needs to have at least some sort of higher education as well | |
why is a controller important | controllers are important to finance because they control the risk and reporting aspects of the company a controller is the point person for making sure the financial reporting is done correctly they are also the person to understand why inaccuracies may exist what changes must be put in place and how those changes will impact future reports the bottom linea financial controller is a higher level finance officer who is responsible for the financial reporting process not quite an executive level position at most companies a controller oversees many of the processes that come together to deliver financial statements a controller also works with the external audit team assists internal managers will budget preparation and identifies areas of opportunity to mitigate risk and employ cost savings | |
what is a conventional mortgage or loan | a conventional mortgage is a homebuyer s loan made through a private lender compared to a federal housing administration fha loan a conventional loan often requires a higher credit score to qualify 1conventional loans are not offered or secured by a government entity instead these mortgages are available through private lenders such as banks credit unions and mortgage companies however some conventional mortgages can be guaranteed by the two government sponsored enterprises gses the federal national mortgage association fannie mae and the federal home loan mortgage corp freddie mac 2understanding conventional mortgages and loansconventional mortgages can have a fixed or variable interest rate conventional mortgages or loans are not guaranteed by the federal government and as a result typically have stricter lending requirements by banks and creditors there are a few government agencies that secure mortgages for banks such as the federal housing administration fha which offers low down payments and no closing costs 3 two other agencies are the u s department of veterans affairs va and the u s department of agriculture s usda s rural housing service neither of which requires a down payment 45 however there are requirements that borrowers must meet to qualify for these programs upfront fees on fannie mae and freddie mac home loans changed in may 2023 fees were increased for homebuyers with higher credit scores such as 740 or higher while they were decreased for homebuyers with lower credit scores such as those below 640 another change your down payment will influence what your fee is the higher your down payment the lower your fees though it will still depend on your credit score fannie mae provides the loan level price adjustments on its website 6example of conventional mortgageif you meet the relatively strict requirements to qualify for a conventional mortgage this can be an inexpensive way to borrow money to buy property if for example you took out a conventional mortgage to buy a home worth 500 000 had a 100 000 down payment that s 20 and a good credit score of 650 you might be able to get a conventional mortgage with a locked in rate of 5 50 this would equate to a monthly payment of around 2 271 on a 30 year loan just for the principal and interest payments conventional mortgage vs fha mortgagethe primary difference between conventional and fha mortgages is that fha loans are designed to make homeownership possible and easier for low to moderate income borrowers who may not otherwise be able to get financing because of a lack of or a poor credit history or because they have limited savings those who qualify for an fha loan require a lower down payment and the credit requirements aren t nearly as strict as other mortgage loans even those with credit scores below 580 may get financing these loans are not granted by the fha itself instead they are advanced by fha approved lenders in contrast to qualify for a conventional loan consumers typically must have stellar credit reports with no significant blemishes and credit scores of at least 620 conventional loan interest rates vary depending on the amount of the down payment the consumer s choice of mortgage product and current market conditions conventional vs conformingconventional loans are often erroneously referred to as conforming mortgages or loans while there is overlap the two are distinct categories a conforming mortgage is one whose underlying terms and conditions meet the funding criteria of fannie mae and freddie mac chief among those is a dollar limit set annually by the federal housing finance agency fhfa in most of the continental united states a loan must not exceed 766 550 in 2024 up from 726 200 in 2023 7so while all conforming loans are conventional not all conventional loans qualify as conforming for example a jumbo mortgage of 800 000 is a conventional mortgage but not a conforming mortgage because it surpasses the amount that would allow it to be backed by fannie mae or freddie mac at the end of fiscal year 2023 there were 7 5 million homeowners with fha insured mortgages 8 the secondary market for conventional mortgages is extremely large and liquid most conventional mortgages are packaged into pass through mortgage backed securities mbs which trade in a well established forward market known as the mortgage to be announced tba market many of these conventional pass through securities are further securitized into collateralized mortgage obligations cmos types of conventional mortgagesthere are several types of conventional mortgages and the terms used to refer to them can be confusing here are the most common types required documentation for a conventional mortgagein the years since the subprime mortgage meltdown in 2007 lenders have tightened the qualifications for loans but overall most of the basic requirements haven t changed 9 potential borrowers need to complete an official mortgage application and usually pay an application fee and then supply the lender with the necessary documents to perform an extensive check on their background credit history and current credit score no property is ever 100 financed in checking your assets and liabilities a lender is not only looking to see if you can afford your monthly mortgage payments which usually shouldn t exceed 35 of your gross income 10 the lender is also looking to see if you can handle a down payment on the property and if so how much along with other up front costs such as loan origination or underwriting fees broker fees and settlement or closing costs all of which can significantly drive up the cost of a mortgage among the items required are these documents will include but may not be limited to borrowers also need to be prepared with proof of any additional income such as alimony or bonuses you will need to present bank statements and investment account statements to prove that you have funds for the down payment and closing costs on the residence as well as cash reserves if you receive money from a friend or relative to assist with the down payment you will need gift letters which certify that these are not loans and have no required or obligatory repayment lenders today want to make sure they are loaning only to borrowers with a stable income your lender will want to see your pay stubs self employed borrowers will need to provide significant additional paperwork concerning their business and income your lender will need to copy your driver s license or state id card and will need your social security number and your signature allowing the lender to pull your credit report interest rates for conventional mortgagesconventional loan interest rates may be higher than those of government backed mortgages such as fha loans although these loans which usually mandate that borrowers pay mortgage insurance premiums may work out to be just as costly in the long run 11the interest rate carried by a conventional mortgage depends on several factors including the terms of the loan its length its size and whether the interest rate is fixed or adjustable as well as current economic or financial market conditions mortgage lenders set interest rates based on their expectations for future inflation the supply of and demand for mortgage backed securities also influences the rates a mortgage calculator can show you the impact of different rates on your monthly payment | |
when the federal reserve makes it more expensive for banks to borrow by targeting a higher federal funds rate the banks in turn pass on the higher costs to their customers and consumer loan rates including those for mortgages tend to go up | typically linked to the interest rate are points or fees paid to the lender or broker the more points you pay the lower your interest rate one point costs 1 of the loan amount and reduces your interest rate by about 0 25 12the final factor in determining the interest rate is the individual borrower s financial profile personal assets creditworthiness and the size of the down payment that they can make on the residence to be financed a buyer who plans on living in a home for 10 or more years should consider paying for points to keep interest rates lower for the life of the mortgage special considerations for a conventional mortgage or loanthese types of loans are not for everyone here s a look at who is likely to qualify for a conventional mortgage and who is not people with established credit and stellar credit reports who are on a solid financial footing usually qualify for conventional mortgages more specifically the ideal candidate should have generally speaking those just starting out in life those with a little more debt than normal and those with a modest credit rating often have trouble qualifying for conventional loans more specifically these mortgages may be tough for those who have however if you re turned down for the mortgage be sure to ask for the reasons in writing you may qualify for other programs that could help you get approved for a mortgage for example if you have no credit history and are a first time homebuyer you may qualify for an fha loan fha loans are tailored specifically for first time homebuyers as a result fha loans have different qualifications and credit requirements including a lower down payment | |
what s the difference between a federal housing administration fha loan and a conventional loan | fha loans are designed to make homeownership possible and easier for low to moderate income borrowers with poor credit history or limited savings conventional loan interest rates may be higher than government backed mortgages such as fha loans and you will need a higher credit score and down payment to qualify | |
is it better to go fha or conventional | a conventional loan is often better if you have good or excellent credit because your mortgage rate and private mortgage insurance pmi costs will decrease but an fha loan can be perfect if your credit score is in the high 500s or low 600s for lower credit borrowers fha is often the cheaper option however it s worth checking both options because the best way to borrow can depend on many factors | |
what credit score do i need for a conventional loan | fannie mae says conventional loans typically require a minimum credit score of 620 but it can vary by lender banks may be more willing to lend to people with a significant down payment the bottom linea conventional mortgage or conventional loan is a homebuyer s loan that is not offered or secured by a government entity they are often compared to fha loans which are designed to allow low income families or those with low credit scores or little savings to access mortgage loans conventional mortgages are available via private lenders or the two government sponsored enterprises gses fannie mae and freddie mac potential borrowers need to complete an official mortgage application and supply the required documents credit history and current credit score conventional loan interest rates tend to be higher than those of government backed mortgages such as fha loans unless you have an excellent credit rating | |
what is a convertible bond | a convertible bond is a fixed income corporate debt security that yields interest payments but can be converted into a predetermined number of common stock or equity shares the conversion from the bond to stock can be done at certain times during the bond s life and is usually at the discretion of the bondholder as a hybrid security the price of a convertible bond is especially sensitive to changes in interest rates the price of the underlying stock and the issuer s credit rating investopedia ryan oakleyunderstanding convertible bondsconvertible bonds are a flexible financing option for companies a convertible bond offers investors a type of hybrid security which has features of a bond such as interest payments while also providing the opportunity of owning the stock this bond s conversion ratio determines how many shares of stock you can get from converting one bond for example a 5 1 ratio means that one bond would convert to five shares of common stock the conversion price is the price per share at which a convertible security such as corporate bonds or preferred shares can be converted into common stock the conversion price is set when the conversion ratio is decided for a convertible security the conversion price and ratio can be found in the bond indenture for convertible bonds or the security prospectus for convertible preferred shares we ll discuss how the conversion ratio is calculated more later in this article bond issuers might also force or exercise their right to call the bond if interest rates are favorable with a forced conversion the investor does not have a say in holding or converting their bond one version of convertible bonds is known as death spiral debt with this version the bond is converted into a fixed dollar value paid in shares investors holding this convertible will jump in to convert their holdings if the stock price declines substantially this action can further dilute shares and drive the price even further downward you do not have to convert a convertible bond you can simply let it ride to maturity and let it act like a regular bond convertible bonds vs regular bondsconvertible bonds and regular bonds are very similar in many ways but they do differ in addition to the conversion feature there s a few other points worth mentioning on the difference between convertible bonds and regular bonds first convertible bondholders have the option to participate in the company s equity while a regular bond is simply a debt instrument a convertible bond gives investors the opportunity to benefit from capital appreciation if the company s stock price increases second convertible bonds typically offer lower interest rates compared to regular bonds because of the added potential for equity participation through conversion regular bonds on the other hand offer higher interest rates to compensate investors for the absence of equity upside convertible bonds are also often traded on secondary markets meaning investors can choose to buy or sell them before maturity with regular bonds you can do this as well however the liquidity of each of these types of bonds may be dramatically different depending on the issuer s credit rating and prevailing market conditions for example a single company could issue both types of bonds depending on that company investors may have a higher appetite and therefore drive higher liquidity for one type over the other last convertible bonds could theoretically be used as a rebalancing tool for portfolio management if an investor realizes they ve become overweight in debt instruments they could convert their bond instead of having to sell a position this flexibility just isn t present with regular bonds features of convertible bondslet s run though the general features of convertible bonds much of this information is sprinkled throughout this article here s a comprehensive list of features you can usually expect when dealing with convertible bonds convertible bond arbitrage is a trading strategy that aims to capitalize on mispricing between a convertible bond and its underlying stock varieties of convertible bondsa vanilla convertible bond provides the investor with the choice to hold the bond until maturity or convert it to stock if the stock price has decreased since the bond s issue date the investor can hold the bond until maturity and get paid the face value if the stock price increases significantly the investor can convert the bond to stock and either hold or sell the stock at their discretion ideally an investor wants to convert the bond to stock when the gain from the stock sale exceeds the face value of the bond plus the total amount of remaining interest payments mandatory convertible bonds are required to be converted by the investor at a particular conversion ratio and price level on the other hand a reversible convertible bond gives the company the right to convert the bond to equity shares or keep the bond as a fixed income investment until maturity if the bond is converted it is done so at a preset price and conversion ratio calculating the conversion price of convertible bondstypically the conversion price is set at a premium to the current market price of the stock at the time of issuance this premium is designed to provide an incentive for investors to convert their bonds into equity as it ensures that they can acquire shares at a lower price than what they would pay if they were to purchase them on the open market the calculation of the conversion price is relatively straightforward it is calculated by dividing the bond s face value by the conversion ratio the conversion ratio specifies the number of shares that a bondholder will receive upon conversion for example if a convertible bond with a face value of 1 000 has a conversion ratio of 20 the conversion price would be 50 per share 1 000 divided by 20 this means that for each bond they hold the bondholder has the right to convert it into 20 shares of the company s stock at a price of 50 per share in most cases the conversion ratio of a convertible bond remains fixed throughout the life of the bond when a convertible bond is issued the conversion ratio is established and specified in the bond s terms this ratio usually doesn t change so in the example above the investor could always exchange the bond for 20 shares regardless of share price however when the instrument is created the conversion rate may be set to be unfavorable to convert if the conversion price were set at or below the market price of the stock bondholders could potentially convert their bonds and immediately sell the shares at a profit effectively deeming the debt instrument process worthless therefore in the example above 20 shares of stock may be worth 950 in the open market an investor may simply prefer to hold equity instead of debt so they accept the conversion price that is less favorable than the market advantages and disadvantages of convertible bondsissuing convertible bonds can help companies minimize negative investor sentiment that would surround equity issuance each time a company issues additional shares or equity it adds to the number of shares outstanding and dilutes existing investor ownership the company might issue convertible bonds to avoid negative sentiment bondholders can then convert into equity shares should the company perform well issuing convertible bonds can also help provide investors with some security in the event of default a convertible bond protects investors principal on the downside but allows them to participate in the upside should the underlying company succeed a startup company for example might have a project that requires a significant amount of capital resulting in a loss in the near term revenues however the project should lead the company to profitability in the future convertible bond investors can get back some of their principal upon failure of the company while they can also benefit from capital appreciation by converting the bonds into equity if the company is successful investors can enjoy the value added component built into convertible bonds meaning they re essentially a bond with a stock option particularly a call option a call option is an agreement that gives the option buyer the right not the obligation to buy a stock bond or other instruments at a specified price within a specific period however convertible bonds tend to offer a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into common stock the lower value is known as the bond floor companies benefit since they can issue debt at lower interest rates than with traditional bond offerings however not all companies offer convertible bonds also most convertible bonds are considered to be riskier more volatile than typical fixed income instruments investors receive fixed rate interest payments with the option to convert to stock and benefit from stock price appreciation investors get some default risk security since bondholders are paid before common stockholders companies benefit by raising capital without immediately diluting their shares companies may pay lower interest rates on their debt compared to using traditional bonds due to the option to convert the bond into common stock they offer a lower coupon rate issuing companies with little or no earnings like startups create an additional risk for convertible bond investors share dilution happens if the bonds convert to stock shares which may depress the share s price and eps dynamics convertible bonds and taxesthere s a few things to keep in mind regarding taxes and convertible bonds note that if convertible bonds are held in a tax advantaged account the notes to follow may be different first convertible bonds typically pay periodic interest payments to bondholders this interest income is generally taxable as ordinary income in the year it is received 1if a convertible bond is converted into shares of the issuing company s stock and the investor subsequently sells the shares any capital gains or losses realized from the sale will likely be subject to capital gains tax when a convertible bond is converted into shares the conversion itself is not typically taxable however any subsequent capital gains or losses realized from the sale of the shares would be 2some convertible bonds may be issued at a discount to their face value resulting in an original issue discount oid oid is generally taxable as ordinary income over the life of the bond regardless of whether you hold the bond to maturity or sells it before maturity when a convertible bond is converted into shares 3last if the convertible bond is converted into shares of stock and the issuing company pays dividends on the shares any dividends received may be eligible for preferential tax treatment as qualified dividends qualified dividends are subject to lower tax rates than ordinary income tax rates for eligible investors 1example of a convertible bondas an example let s say exxon mobil corp xom issued a convertible bond with a 1 000 face value that pays 4 interest the bond has a maturity of 10 years and a convertible ratio of 100 shares for every convertible bond if the bond is held until maturity the investor will be paid 1 000 in principal plus 40 in interest for that year however the company s shares suddenly spike and are trading at 11 per share as a result the 100 shares of stock are worth 1 100 100 shares x 11 share price which exceeds the value of the bond the investor can convert the bond into stock and receive 100 shares which could be sold in the market for 1 100 in total | |
how does a convertible bond work | a convertible bond works by providing bondholders with the flexibility to convert their bonds into shares of the issuing company s stock if the bondholder chooses to convert they surrender the bond and receive shares at the predetermined conversion price if they opt not to convert they continue to receive periodic interest payments until the bond matures at which point they receive the principal amount | |
what is the conversion ratio | the conversion ratio of a convertible bond specifies the number of shares that a bondholder will receive upon conversion for example a conversion ratio of 10 1 means that one convertible bond can be converted into 10 shares of the issuing company s stock | |
how do interest payments on convertible bonds work | interest payments on convertible bonds work similarly to those on regular bonds bondholders receive periodic interest payments usually semiannually or annually based on the bond s coupon rate and face value these payments continue until the bond matures or is converted into equity | |
what happens if a convertible bond is not converted | if a convertible bond is not converted by the bondholder before its maturity date the issuing company is typically obligated to repay the principal amount of the bond to the bondholder along with any accrued interest payments | |
when can bondholders convert their bonds into shares | bondholders can usually convert their bonds into shares of the issuing company s stock at any time before the bond matures as long as the conversion conditions specified in the bond s terms are met sometimes a company may include language saying the instrument can only be converted after being held or issued for a certain amount of time i e no sooner than three month the bottom lineconvertible bonds are a type of hybrid security that offer investors the option to convert their bonds into shares of the issuing company s stock at a predetermined conversion price they provide investors with the potential for capital appreciation through equity participation while also offering downside protection through fixed interest payments | |
what is convertible preferred stock | convertible preferred stocks are preferred shares that include an option for the holder to convert them into a fixed number of common shares after a predetermined date most convertible preferred stock is exchanged at the request of the shareholder but sometimes there is a provision that allows the company or issuer to force the conversion the value of a convertible preferred stock is ultimately based on the performance of the company s common stock understanding convertible preferred stockcorporations use convertible preferred stock to raise capital these securities are especially useful as a financing medium for early stage companies as they can offer greater flexibility to investors making them an attractive option that is the investor has the promise of regular dividends and the potential for stock price growth in the future preferred stock is a class of equity capital issued by a corporation that has a higher claim on assets and earnings than common stock preferred shares typically pay steady dividends while common stock pays dividends only if and when they are approved by the board of directors based on the company s recent financial performance preferred shares do not usually come with voting rights as common shares do as such preferred stock is often thought of as a hybrid between a corporate bond and common stock convertible preferred stock is distinguished by the fact that it contains an embedded option that allows the holder to trade it for a specified number of common shares at some point in the future this conversion option provides a potential upside for the holder as the value of the common stock could increase over time meanwhile it has the benefits of preferred stock however this advantage comes at a price convertible preferred stock typically trades at a premium over regular preferred shares and may also carry a comparatively lower dividend rate convertible preferred stock termscommonly used terms when referring to convertible preferred stock are as follows example of convertible preferred stockconsider a convertible preferred stock issued by the hypothetical company abc inc at 1 000 with a conversion ratio of 10 and a fixed dividend of 5 the conversion price is thus 100 and abc s common shares need to trade above this threshold for the conversion to be worthwhile for the investor even if the common shares are trading close to 100 it may not be worth it to convert since the preferred shareholder will be giving up a fixed 5 dividend and a higher claim on company assets in the event of liquidation if the convertible preferred stock is trading at 1 000 and the abc common shares are trading at 80 then the conversion premium would be 200 i e 1 000 80 10 or 20 200 1 000 if the common shares move up to 90 the conversion premium shrinks to 100 or 10 thus the conversion premium influences the price at which the convertible preferred stock trades in the market a high conversion premium implies that the underlying common shares are trading well below the conversion price and there is little possibility of a profitable conversion in this case the convertible preferred stock will act more like a bond and will be susceptible to changes in interest rates if the conversion premium is very low implying that the common stock is trading quite close to the conversion price the convertible preferred stock will be sensitive to changes in the underlying common shares those of abc in this case and will act like straight equity as the common shares increase in price a conversion becomes more attractive if the abc common shares move to 110 the preferred shareholder gets 1 100 110 10 for each 1 000 preferred stock that s a gain of 10 if the investor converts and sells the common shares at 110 the danger in converting is that the investor then becomes a common shareholder and is at the mercy of swings in the stock price if the price of abc stock falls to 75 after conversion and the investor continues to hold the common shares they would now own 750 75 10 in common shares for each preferred stock worth 1 000 that they previously owned this represents a notional loss of 250 and the investor no longer receives the 5 preferred stock dividend or has a preferential claim on assets | |
how is a convertible preferred share different from a regular preferred share | convertible preferred shares give their holders the option of converting them into a set amount of common stock shares in the future this gives the shareholder the potential benefit of capital appreciation in addition to the guaranteed benefit of a regular dividend as a result convertible preferred shares will often trade at a relative premium and offer a lower dividend rate than ordinary preferred shares | |
how does a convertible preferred share differ from a convertible bond | both convertible preferred shares and convertible bonds can be converted into common shares but they differ in several key ways convertible bonds like any bonds are debts that gives the owners of convertible preferred bonds priority over the owners of convertible preferred shares in the event of bankruptcy or liquidation both have priority over holders of common stock convertible preferred shares typically pay a fixed cash dividend out of a company s retained earnings convertible bonds pay a coupon rate which is a periodic interest payment finally most convertible bonds have a specified maturity date while convertible preferred shares can exist as long as the company remains a going concern | |
why would investors buy convertible preferred stock | convertible preferred stock offers the investor the benefits of both preferred stock and common stock investors get the stability liquidation priority and higher dividends of preferred stock but they also have the option to convert their shares into common stock later if they believe that the price will go up this conversion feature can generate a potentially higher return on investment than investors would get with traditional preferred stock while also offering a level of flexibility that is not possible with either preferred stock or bonds the bottom linecombining features of both preferred and common stock convertible preferred shares are a hybrid security with the benefit of a steady fixed dividend and the potential for capital appreciation via conversion investors in this type of security value their flexibility the conversion price or the number of common shares that one share of convertible preferred stock is good for is determined at the time of issuance and may be adjusted subsequently by the issuer | |
what is convexity | convexity is apparent in the relationship between bond prices and bond yields convexity is the curvature in the relationship between bond prices and interest rates it reflects the rate at which the duration of a bond changes as interest rates change duration measures a bond s sensitivity to changes in interest rates it represents the expected percentage change in the price of a bond for a 1 change in interest rates investopedia joules garciaunderstanding convexityconvexity demonstrates how the duration of a bond changes as the interest rate changes portfolio managers will use convexity as a risk management tool to measure and manage the portfolio s exposure to interest rate risk in the example figure shown below bond a has a higher convexity than bond b which indicates that all else being equal bond a will always have a higher price than bond b as interest rates rise or fall as interest rates fall bond prices rise conversely rising market interest rates lead to falling bond prices the bond yield is the earnings or returns an investor can expect to make by buying and holding that particular security the bond price depends on several characteristics including the market interest rate and can change regularly if market rates rise new bond issues must also have higher rates to satisfy investor demand for lending money the price of bonds returning less than that rate will fall as there would be very little demand for them as bondholders will look to sell their existing bonds and opt for bonds with higher yields eventually the price of these bonds with the lower coupon rates will drop to a level where the rate of return is equal to the prevailing market interest rates bond durationbond duration measures the change in a bond s price when interest rates fluctuate if the duration of a bond is high it means the bond s price will move to a greater degree in the opposite direction of interest rates if rates rise by 1 a bond or bond fund with a 5 year average duration would likely lose approximately 5 of its value conversely when this figure is low the debt instrument will show less movement to the change in interest rates the higher a bond s duration the larger the change in its price when interest rates change and the greater its interest rate risk if an investor believes that interest rates are going to rise they should consider bonds with a lower duration bond duration should not be confused with its term to maturity though they both decline as the maturity date approaches the latter is simply a measure of the time during which the bondholder will receive coupon payments until the principal is paid if market rates rise by 1 a one year maturity bond price should decline by an equal 1 for bonds with long dated maturities the reaction increases as a general rule of thumb if rates rise by 1 bond prices fall by 1 for each year of maturity convexity and riskconvexity builds on the concept of duration by measuring the sensitivity of the duration of a bond as yields change convexity is a better measure of interest rate risk where duration assumes that interest rates and bond prices have a linear relationship convexity produces a slope duration can be a good measure of how bond prices may be affected due to small and sudden fluctuations in interest rates however the relationship between bond prices and yields is typically more sloped or convex therefore convexity is a better measure for assessing the impact on bond prices when there are large fluctuations in interest rates as convexity increases the systemic risk to which the portfolio is exposed increases for a fixed income portfolio as interest rates rise the existing fixed rate instruments are not as attractive as convexity decreases the exposure to market interest rates decreases and the bond portfolio can be considered hedged typically the higher the coupon rate or yield the lower the convexity or market risk of a bond example of convexitya bond issuer xyz corporation has two bonds on the market bond a and bond b both bonds have a face value of 100 000 and a coupon rate of 5 bond a however matures in 5 years while bond b matures in 10 years using the concept of duration we can calculate that bond a has a duration of 4 years while bond b has a duration of 5 5 years this means that for every 1 change in interest rates bond a s price will change by 4 while bond b s price will change by 5 5 if the interest rate increase by 2 the price of bond a should decrease by 8 while the price of bond b will decrease by 11 however using the concept of convexity we can predict that the price change for bond b will be less than expected based on its duration alone this is because bond b has a longer maturity which means it has a higher convexity the higher convexity of bond b acts as a buffer against changes in interest rates resulting in a relatively smaller price change than expected based on its duration alone negative and positive convexityif a bond s duration increases as yields increase the bond is said to have negative convexity the bond price will decline by a greater rate with a rise in yields than if yields had fallen therefore if a bond has negative convexity its duration would increase and the price would fall as interest rates rise the opposite is true if a bond s duration rises and yields fall the bond is said to have positive convexity as yields fall bond prices rise by a greater rate or duration than if yields rise positive convexity leads to increases in bond prices if a bond has positive convexity it would typically experience price increases as yields fall compared to price decreases when yields increase under normal market conditions the higher the coupon rate or yield the lower a bond s degree of convexity there s less risk to the investor when the bond has a high coupon or yield since market rates would have to increase significantly to surpass the bond s yield a portfolio of bonds with high yields would have low convexity and subsequently less risk of existing yields becoming unattractive as interest rates rise most mortgage backed securities mbs will have negative convexity because their yield is typically higher than traditional bonds as a result it would take a significant rise in yields to make an existing holder of an mbs have a lower yield or less attractive than the current market | |
what is negative and positive convexity | if a bond s duration increases as yields increase the bond is said to have negative convexity the bond price will decline by a greater rate with a rise in yields than if yields had fallen if a bond s duration rises and yields fall the bond is said to have positive convexity as yields fall bond prices rise by a greater rate or duration | |
why do interest rates and bond prices move in opposite directions | as interest rates fall bond prices rise and vice versa new bond issues must also have higher rates to satisfy investor demand for lending the issuer their money the price of bonds returning less than that rate will fall as there would be very little demand for them as bondholders will look to sell their existing bonds and opt for bonds most likely newer issues paying higher yields |
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