Tag Archives | investment

What is a Bond?

what is a bondWhat is a bondIt is a corporate or government debt instrument. It represents a loan to the company from the investing public. In this case, the company is the borrower and the investor is the lender. Companies issue bonds to raise money for business investments.

What is a Bond?

A bond has a par value, a maturity date, and a coupon rate. The maturity date is the date the company must repay the investor an amount equal to the par value. The par value is the amount the lender will receive at the maturity date. The coupon rate is the interest rate on the bond. A coupon is typically semi-annually. So if the bond has a coupon rate of 8%, the investor will receive two payments per year, each equal to 4% of the bond’s par value.

Rating agencies rate the creditworthiness of bonds. High quality bonds are considered investment grade. Low quality bonds are considered noninvestment grade, or junk bonds.

what is a bond

See Also:
Non-Investment Grade Bonds
Yield to Maturity of a Bond
Zero Coupon Bonds
Sukuk
Baby Bonds

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Yield Curves

See Also:
What is a Bond?
Yield to Maturity
Coupon Rate Bond
Par Value of a Bond
Zero Coupon Bonds

Yield Curves Definition

In the field of finance, yield curves represent the relationship between the yields on bonds of similar credit quality that have differing maturity dates. Many commonly use the yield curve plotting U.S. Treasury bonds of differing maturities (3-month, 2-year, 5-year, and 30-year) as a reference for interest rates on other financial instruments. Also, consider the U.S. Treasury bond yield curve an indicator of macroeconomic conditions.

Types of Yield Curves

A yield curve can be normal, flat, or inverted. In a normal yield curve, investments with longer maturities have higher yields than investments with shorter maturities. Whereas, in a flat yield curve, investments with long maturities and investments with short maturities have similar yields. In an inverted yield curve, investments with shorter maturities have higher yields than investments with longer maturities.

Consider a normal yield curve a sign of a healthy economy. However, if long-term yields are significantly higher than short-term yields, it may be a sign of inflation. A flat yield curve is considered a sign of a transitional period in an economy. An inverted yield curve is considered a sign of a troubled economy, or even a recession.

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Trade Finance

See Also:
Trade Credit
Trade Account
Exchange Traded Funds
Currency Exchange Rates
Currency Swap

Trade Finance Definition

Trade Finance is the movement of assets, transactions, or investments overseas into other markets. To ensure the safety of a purchaser or seller trade finance, banks often provide a needed service to make the transactions as meaningful and as safe as possible.

Trade Finance Meaning

Many transactions among a buyer and a seller result in a prepayment or purchase on credit. This, of course, depends on the terms of the sale. These activities are often more risky for a buyer (importer) or a seller (exporter) because of the international arena in which they operate.

Finance methods often include a bank in transactions to reduce the risk. For example, if a buyer purchases goods on credit, then the seller may want to reduce its overall risk in the receipt of payment by using a trade finance bank. The bank would take part in the transaction by putting up a contract. Whereas, the bank will pay the seller and leave the buyer to pay the bank for the transaction of the goods. If a prepayment occurs, banks can assist in the documentation of the goods to be shipped. This ensures that the buyer is actually purchasing the goods it has paid for.

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Term Deposit

See Also:
Loan Term
5 C’s of Credit (5 C’s of Banking)
How to manage your banking relationship
Bank Charge
Financial Instruments

Term Deposit Definition

A term deposit, also referred to as a time deposit or a certificate of deposit (CD), is an amount of money invested into a financial institution for a set amount of time or term period. Interest and withdrawal terms are sometimes negotiable because there are at times penalties with early withdrawals.

Term Deposits Explained

Term deposits are often short-term investments individuals make into a bank or other financial institution. Because of there short-term nature, consider time deposits one of the safest investments in the marketplace. Another advantage for an investor is the ability to invest at a higher interest rate than a normal savings account.

Term deposit disadvantages include the fact that a company or individual cannot touch or withdraw the fixed amount until the term is up without suffering a penalty. Smaller denominations under $100,000 usually contain contracts that are pre-established, with a certain amount of penalties if the deposit is withdrawn, interest rates are non-negotiable, and the amount of time in which the individual or company wishes to invest. Larger denominations or deposits above $100,000 are often negotiable. This means that the company or individual will negotiate the penalties for withdrawal, rate at which the money will be invested and the term or time period that the investor wants to pursue in his/her/its investment strategy.

Term Deposit Example

Company X has just received $1 million cash in its receivables from a customer. Company X also owes Company Y $800,000 in accounts payable for supplies that X used to manufacture its products. However, the payables are not due for another 3 months to Y. Therefore X has decided to put the $800,000 aside into a certificate of deposit (CD) for 3 months at a rate 5% which is higher than the savings account rate of 3.5%. Thus by the end of the 3 months X will have a profit of $10,000 (3/12 * 5% * $800,000). By holding the cash owed to Y and investing in a term deposit X has earned an extra $10,000.

term deposit

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Tax Efficiency

See Also:
Federal Unemployment Tax Act (FUTA)
Tax Brackets
Prepaid Income Tax
Marginal Tax Rate
Cash Flow After Tax
Ad Valorem Tax

Tax Efficiency Definition

Tax efficiency, defined as the process of organizing an investment so that it receives the least possible taxation, is as important in general investment as it is in business. Business, commercial investments, and even private investment vehicles can experience tax efficiency through planning. Any time a person has caused a change which avoids a higher tax rate they are experiencing the benefits of a change in their tax efficiency rating.


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Tax Efficiency Meaning

Tax efficiency means paying less to the government due to some changes in the structure of an investment. This can have relatively minor or an extremely profound effect on net profit depending on the scale of the investment in question.

For public market investments, achieve an increased tax efficiency ratio through a variety of means. Tax free bonds and money market accounts, stocks which are held over one year, and tax efficiency of etfs other than this can be utilized for an income which is greater than their taxed counterpart.

For businesses, tax efficiency can be gained through other means. The structure of the legal entity that is the business can effect tax efficiency: LLC’s do not experience double-taxation like corporations do. Additionally, moving finances from account to account inside the business can also leave less to be taxed. Reinvesting profits into research and development rather than taking company profits is one option: the business experiences less capital gains than if it kept the income.

In personal finances, other investment tools can increase tax efficiency. For example, a Roth IRA has increased tax efficiency over some other tools. For proper planning it is important to consult with a financial planner and find out which tool is best for each circumstance.

Tax accountants are the experts in creating tax efficiency. For those who have a large amount of funds tied up in investments a tax accountant is a necessity. These trained professionals can inform the business owner on the proper structuring of business, investment, and personal finances.

Example

Dom is a business owner who is experiencing new success. His business is taking off like never before and has provided a lot of extra income as it does this. Dom has no need to reinvest this money into the business as it already has enough free cash flow. Dom has decided to diversify his holdings by investing in other places. He now needs to bring it together to increase his tax efficiency of index funds and business dealings alike.

Dom arranges a meeting with both his financial advisor and his tax accountant. He knows these two will not see eye-to-eye on everything but wants to bring his investments to work together.

His meeting goes quite well. Dom has received advice that will benefit him immensely. From his tax accountant, he received advice on restructuring his business entity as well as accounting methods. From his financial advisor, he was informed about places to invest which hold value steady and will increase tax efficiency of mutual funds. Dom leaves with a good attitude that tomorrow will be better than today.

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tax efficiency

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Sunk Costs

See Also:
Sunk costs: How should they affect your future business decisions?
Variable vs Fixed Cost
Replacement Costs
Joint Costs
Service Department Costs
Ten In-House Secrets for Reducing Your Company’s Legal Costs
Capital Budgeting Methods

Sunk Cost Definition

What is sunk cost? A sunk cost is a cost that has been incurred and cannot be recovered. The money is spent. In accounting, a sunk cost is a type of irrelevant cost. When facing a potential project or investment, a manager must only consider relevant costs and ignore all irrelevant costs.

When a manager is considering a particular decision, relevant costs are the costs that are incurred if the decision is made and irrelevant costs are the costs that are incurred whether or not the decision is made. A sunk cost is not a relevant cost for decision making.

Whether a cost is relevant or irrelevant depends on the decision at hand. A cost may be relevant to one decision and that same cost may be irrelevant to another decision. A sunk cost, however, is always an irrelevant cost.

Sunk Costs Fallacy

The sunk cost fallacy is when someone considers a sunk cost in a decision and subsequently makes a poor decision.

An example of the sunk cost fallacy is paying for a movie ticket, finding out the movie is terrible, and staying to watch anyway just to get your money’s worth. When you find out the movie is terrible, you should make a decision whether to sit through the bad movie or to do something more meaningful with your time – the price you paid for the ticket should not affect your decision. The ticket price is a sunk cost.

Another example of the sunk cost fallacy is paying for an all-you-can-eat buffet, eating until you’re full, and then going back for more just to get your money’s worth. When you are full, you should decide whether you want to eat more or to stop eating – the fact that you paid for unlimited food should not affect your decision. The price of the buffet is a sunk cost.

Sunk Costs Examples

Let’s say a company spent $5 million building an airplane. Before the plane is complete, the managers learn that it is obsolete and no airline will buy it. The market has evolved and now the airlines want a different type of plane.

The company can finish the obsolete plane for another $1 million, or it can start over and build the new type of plane for $3 million. What should the managers decide? Should they spend that last $1 million to finish up the plane that’s almost done, or should they spend the $3 million to build the new plane?

At first glance, you may think the company should just finish the old plane. It’s only another million bucks and they already spent $5 million. But in reality, the five million is irrelevant. It is a sunk cost. The only relevant cost is the $3 million dollars. The managers should consider whether or not to spend $3 million on the new plane, and nothing regarding the old plane should affect the decision.

sunk costs

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Sharpe Ratio

See Also:
Efficient Market Theory
Effective Rate of Interest Calculation
Coupon Rate Bond
Discount Rate
Federal Funds Rate Definition

Sharpe Ratio Definition

The sharpe ratio definition is the excess return or risk premium of a well diversified portfolio or investment per unit of risk. Measure sharpe ratio using standard deviation. You may also know this ratio as the reward to variability ratio or the reward to volatility ratio.

Sharpe Ratio Explained

The sharpe ratio is a good measure for investors because it allows them to distinguish the amount of reward needed per unit of risk. This allows for risk averse investors to stay away from low reward high risk situation that they are uncomfortable with. The higher the ratio the better for an investor. It is also useful in establishing the ratio efficient frontier in which an investor can build a model for several different investments and build a portfolio that is exactly equal to the desired ratio. These efficient frontier models can distinguish down to the specific weights what an investor needs to do to build the desired portfolio.

Sharpe Ratio Formula

Use the following sharpe ratio formula:

SR = E(R-Rf)
       σ

Where:

R = asset return
Rf = Risk free return
E(R-Rf) = Expected return of the risk premium
σ = standard deviation of the risk premium

Example

Tim is looking to invest in a stock that has an expected return of 12%. The risk free rate is 4%, and the standard deviation of the risk premium is 10%. Thus, the calculation is as follows:
Sharpe = (.12-.04)/.10 = .8

The .8 can be interpreted as meaning that for every unit of risk that you accept as an investor you will be taking on an additional one and a quarter amount of risk.

sharpe ratio, Sharpe Ratio Definition, Sharpe Ratio Formula

sharpe ratio, Sharpe Ratio Definition, Sharpe Ratio Formula

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