Topic 3. Theoretical basis investment analysis
Investment analysis- this is a financial analysis of an investment project, it is a set of techniques and methods for evaluating the effectiveness of a project over the entire period of its life in conjunction with the activities of the enterprise - the object of investment.
Investment analysis includes:
Ø studying the development and implementation of investment policy;
Ø analysis and evaluation of the effectiveness of specific investment projects using discounted and accounting methods of evaluation;
Ø analysis and evaluation of the portfolio (budget) of investments.
Investment analysis is an independent area of economic analysis, the implementation of which depends on the need to justify management decisions on specific options for capital and financial investments.
Purpose of investment analysis- an objective assessment of the feasibility of short- and long-term investments, as well as the development of basic guidelines for the investment policy of the enterprise.
Tasks investment analysis:
1) comprehensive assessment needs and availability of required investment conditions;
2) reasonable choice of funding sources and their prices;
3) identification of factors (objective and subjective, internal and external) that affect the deviation of actual investment results from previously planned ones;
4) optimal investment decisions that strengthen competitive advantages firms and consistent with its tactical and strategic goals;
5) risk and return parameters acceptable for the investor;
6) post-investment monitoring and development of recommendations for improving the qualitative and quantitative results of investment.
The basis of the analytical substantiation of the process of making managerial decisions of an investment nature is the assessment and comparison of the volume of proposed investments and future cash receipts. The essence of analysis and evaluation is to compare the amount of required investment with projected returns. Since the compared indicators refer to different points in time, the problem of their comparability becomes key.
Highlights in the process of evaluating an investment project:
ü Forecasting the volume of production and sales, taking into account the possible demand for products;
ü Estimation of inflow Money on years;
ü assessment of the availability of required funding sources;
ü assessment of the acceptable value of the cost of capital;
ü Forecasting and estimating the costs of production and sales of products.
Features of investment projects analyzed in the capital budgeting process:
1. Each investment project has a cash flow associated with it, the elements of which represent either net cash inflows or net cash outflows. Under net cash outflow in the analyzed period is understood as the excess of the current cash costs of the project over the current cash receipts. In the reverse relation, there is net cash inflow. In investment analysis, it is precisely the focus on cash flows, and not on profit, that is taken. By using cash flows reflected real movement values, costs and financial results are evaluated. Any investment project can be represented as a cash flow consisting of two parts: the first is an investment, that is, a net outflow; the second is the subsequent return flow, that is, a series of income (net inflows) distributed over time that allows you to recoup the original investment.
2. Investment analysis is carried out, as a rule, by years. However, the analysis can be carried out for equal base periods of any duration (month, quarter, year, etc.). It is only necessary to link the amount of cash flow, interest rates and the length of the time period
3. All investments are considered to be made at the end of the year (postnumerando) preceding the first year of cash inflows generated by the project, although investments can be made over a number of years. Similarly, it is assumed that the inflow (outflow) of funds takes place at the end of the next period.
4. The main criteria for evaluating projects involve taking into account the time factor. This is done with the help of well-known algorithms used in financial mathematics to streamline the elements of a time-long cash flow (compounding - accumulation and discounting). Competent investment analysis allows you to evaluate:
Ø the cost of the investment project;
Ø future cash flows by periods life cycle projects and their current (present) value;
Ø the structure and volume of funding sources;
Ø degree of influence of inflation on the main parameters of the project;
Ø economic feasibility of the project implementation based on the calculation of basic performance indicators (NPV, PI, IRR, DPP);
Ø possible term project implementation;
Ø level of project discount rate of the project;
Ø the level of its riskiness.
Management decisions regarding the feasibility of investments are strategic decisions and require detailed analytical justification.
Factors complicating investment decision making:
§ any investment requires concentration of a large volume financial resources, despite the fact that any company experiences a limitation financial resources for investment;
§ As a rule, investments do not give momentary returns, as a result of which there is an effect of immobilization of equity capital, when funds are frozen in assets that will begin to make a profit only after some time. Therefore, the enterprise must have accumulated a certain financial "fat" that allows it to carry out investment costs;
§ Most often, investments are made with borrowed capital, and therefore it is necessary to substantiate the structure of sources, assess the cost of their maintenance and formulate arguments to attract potential investors;
§ the plurality of available (alternative or mutually exclusive) options for investing capital, which requires a comparison of projects and their selection according to some criteria;
§ there is a risk associated with the adoption of a particular investment decision. Investment activity is always carried out in conditions of uncertainty, the degree of which can vary significantly.
By investment (Latin "investio" - I dress) is meant, in the most general definition, long term investment capital into the economy or a temporary refusal of an economic entity from the consumption of its own resources (capital) and their use in order to increase its own capital.
In economics, it is customary to distinguish between two types of investments:
real investments;
financial (portfolio) investments.
Real investments are capital investments in the development of the material and technical base of an economic entity. It should be noted that in the case of real investments, the condition for achieving the predicted events, as a rule, is the use of non-current assets for the production of the product and its sale.
Under the financial (portfolio) investments understand, as a rule, capital investment in financial assets (securities). To the main types financial assets can include bonds, stocks, bills.
The opposite concept of investment is "disinvestment", which involves the process of releasing funds as a result of the sale of long-term assets. Disinvestment can be in case of unprofitable use (exploitation) of assets.
If the object of investment turns out to be significant for an economic entity, the planning or design stage, which is the stage of developing an investment project, should precede the adoption of managerial decisions. V.V. Kovalev understands an investment project as “the totality of investments and the income they generate. Thus, in an investment project there is always an investment (capital outflow) with subsequent receipts (inflow of funds).
Investments are usually strategic decisions and require detailed analytical justification. Therefore, when analyzing investment projects, a financial manager must take into account:
riskiness of investment projects;
the time value of money;
attractiveness of investment projects.
The main method for achieving the projected goals is the mathematical modeling of the relevant decisions and their consequences on the performance of an economic entity.
During the simulation, the investment project is considered in the time of its action and is divided into several equal intervals - design intervals. For each planning interval, budgets are compiled - estimates of receipts and payments, reflecting the results of all operations in a specific period of time. The balance of such a budget - the difference between receipts and payments - is the cash flow of the investment project.
In a broad sense, the cash flow of an investment project consists of the following main elements:
investment costs;
sales proceeds;
total costs;
taxes and payments.
At the initial stage of the investment period, cash flows, as a rule, turn out to be negative, there is an outflow of resources in connection with the acquisition of fixed assets and the formation of net working capital. After completion of the initial stage of the investment project, the cash flow stabilizes and becomes positive.
The analysis of sales proceeds, as well as the analysis of costs incurred during the implementation of the project, can be evaluated both positively and negatively. The financial manager must analyze the riskiness of projects and control them in a timely manner from the point of maximizing income and property of shareholders.
In investment analysis, the concepts of profit and cash flow play an important role.
It should be noted that in the theory of investment analysis, the concept of "profit" does not coincide with its accounting definition. AT investment activity the fact of making a profit is preceded by the reimbursement of the initial investment, which corresponds to the concept of "amortization" (English "amortisation" - repayment). In case of investment in fixed assets This function is performed by depreciation deductions. Thus, the justification of the investment project is based on the calculation of the amounts of depreciation and profit within the time interval of the study.
The indicators used in investment analysis can be divided into two groups based on:
discounted estimates taken into account the time factor;
accounting estimates that do not take into account the time factor.
Indicators based on discounted valuations have advantages in investment analysis. In the theory of investment analysis, the concept of "discounting" (English "discounting" - cost reduction, markdown) is one of the key ones. Discounting - the calculation of the present (modern) value ("present value") of monetary amounts relating to future periods of time. The present or present value of a sum of money is determined by the formula: \r\n(5.1)
P = F / (1 + r) n, \r\nwhere
P is the real (modern) value of the amount of money; F is the future value of the amount of money; r- interest rate(in decimal) n is the number of interest periods.
The operation opposite to discounting - the calculation of the future value ("future value") of a monetary amount is called accumulation or compounding and is determined by the formula: \r\n(5.2)
F \u003d P x (1 + r) n, \r\nThe key criterion characterizing the effectiveness of investments is the net present value (Net Present Value - NPV). In the textbook V.V. Kovalyov NPV, this indicator is interpreted as "net present value". Net present (modern) value is the sum of all cash flows (receipts and payments) arising during the period under study. There are several algorithms for calculating NPV in the economic literature. To adjust cash flows for inflation and discount based on the weighted average cost of capital, in the tutorial we use the universal formula for calculating the net present value of the project: \r\nt
t \r\nn x(l-T)+DtT \r\nNW = X
Io, (5.3) \r\nt= 1
1 (1 + k)11 \r\nwhere
Rt - nominal revenue of the t-th year in basic prices (for a non-inflationary situation; \r\ni r - income inflation rate of the r-th year;
Ct - nominal cash costs of the t-th year in basic prices;
i\" r - inflation rates of costs of the r-th year;
T - profit tax rate;
Io - initial costs for the acquisition of fixed assets;
K - weighted average cost of capital, including inflation premium;
D t - depreciation deductions of the t-th year
Provided that i r and i \" r (inflation rates of income and costs) are the same, the calculation of the net present value of the project (NPV) is greatly simplified.
If NPV > 0, the project should be accepted;
NPV NPV = 0, the project is neither profitable nor unprofitable.
When calculating NPV, as a rule, a constant discount rate is used, however, individual coefficients for the years of the investment project can also be applied. A qualitative assessment of the effectiveness of an investment project largely depends on the choice of the discount rate. There are various methods that allow you to justify the use of a particular rate and differ in the degree of risk.
The main goal of evaluating an investment project is to justify its commercial viability, which implies the fulfillment of two conditions:
full recovery (recoupment) of invested funds;
profit, indicating the correct choice of method of use
Other criteria are also used to evaluate investment projects, the calculation methodology of which can be considered in more detail in the course "Investments".
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The financial instruments constructed in the course of securitization transactions - especially mortgage-backed securities (MBS) backed by loans to individuals - present unique requirements for investment analysis. These securities present investors with challenges that are not known in other markets and which are both a source of new opportunities and a source of serious difficulties. The main problem stems from the combination of the complexity of structuring a deal with the unpredictability of human behavior.
From a purely academic point of view, the coverage can be considered as a pool of loans, each of which includes a certain set of embedded options. The market value and repayment dynamics of these loans can be calculated based on the assumption of optimal exercise of the embedded options. Further, the results of calculations for individual loans can be summed up in order to estimate the market value and other basic characteristics of the issued securities. Estimating the value of a security would only require examining the documentation of the loans underlying the transaction (constituting the cover) in order to determine the contractual obligations of each individual borrower.
Unfortunately, this procedure does not work in practice. The behavior of the borrower is the result of the interaction of many factors, some of which are not so easy to describe. Mortgage loans backed by real estate, and for many borrowers, that real estate is the primary residence and the most valuable piece of property. The borrower's decision on when and in what form he can exercise his option (on early repayment credit) 1 is determined by many factors, not just pure mathematics. That is why, in many cases, securities issued during securitization are marked by a human factor (warm-blooded securities), when the dynamics of human life is intertwined with the mechanisms of financial markets.
For many years, participants in the securities market have unsuccessfully tried to find a perfect model that would allow absolutely all investment decisions to be analyzed. They hoped to find a universal method, using which one could simply enter data on all securities circulating on the market into a computer and get the optimal solution on the monitor screen. Such a model somehow had to take into account all possible risks and likely outcomes of the market behavior of the securities. Further this ideal model was to analyze the current state of the securities portfolios of all investors, the desired financial results and find those papers in which investments would bring the best result. The model had to take into account historical information and predict the future. The consequence of applying such a perfect model would be the formation of an optimal investment portfolio.
For better or worse, there is no such model. It's not that analysts haven't tried to build it. Some thought that a method based on computer simulation of the price calculated taking into account the value of embedded options (option-adjusted spread, OAS) might be ideal. Since the OAS model considers hundreds of future scenarios, analysts believed that this method could give an unambiguous answer to the question of which particular security to buy. However, even the OAS model, with its powerful ability to model future behavior, is not able to provide investors with clear investment recommendations (without the use of other models). An analysis based on it - if it is done skillfully - can answer the question of which securities are currently undervalued by the market, but it cannot tell which ones are most suitable for a particular investor's portfolio.
Some participants in the securities market turned to classical optimization methods, but as a result they found a “black box”. Optimization methods involve setting a certain objective function and a set of restrictions, on the basis of which the characteristics of such a security are calculated, which maximizes the objective function. Although the use of optimization methods often leads to good results in solving simple problems of optimizing an investment portfolio, however, in more complex tasks, it indicates the fallacy of the initial assumptions and assumptions rather than gives realistic recommendations for investors.
Given the complexity of finding optimal investment decisions and the many existing methods of analysis, it is not easy for an investor to determine which of these methods should be used. Our answer may seem unsatisfactory if you're looking for an immediate solution, but it's nonetheless: choose the analysis method that suits your goals and the degree of complexity of the tools you intend to invest in. A few examples will help clarify our point of view.
Obviously, investment goals are important in determining the depth of analysis. For example, if you have determined the desired level of return and the average term, then it is these characteristics of a potential investment instrument that should determine the minimum requirements for your analysis. The complexity of the requirements for analysis can increase significantly if you, as a portfolio manager, are required to evaluate an investment instrument based on the frequency of income received and market value investment portfolio. In addition, managers are increasingly required to manage their portfolio in such a way as to achieve the most accurate correspondence between the risk structure of assets and liabilities. For example, many insurance instruments contain embedded options, and investment portfolios should be structured in such a way as to compensate for the risks associated with these options.
Asset complexity also affects the depth of analysis. Suppose you are analyzing two corporate bonds that are rated AA. Both of them have a maturity of 5 years, are non-puttable instruments with par value at maturity. In order to determine which one is cheaper, you should calculate their yield, and also make sure that both bonds have the same credit quality. If both bonds have the same coupon, it's easy enough to compare their prices. The total revenue scenario analysis or the OAS model will not be able to change the results of the analysis.
However, if you try to compare a callable agency bond with a CMO-type mortgage-backed security, looking at the performance of these securities alone will not give you complete information about their relative market price. Making a fair comparison of the market behavior of these two types of securities would require some form of option analysis. Moreover, option analysis can be quite complicated, since the methods used to evaluate certificates issued by agencies with the right to early redemption and for CMOs, as a rule, are not the same and are not always compatible. Table 3.1 provides several examples of progressively more complex comparative analysis of different types of securities.
In addition, even if it is possible to determine that the security issued by the agency is cheaper than the CMO, the investor can still decide in favor of buying the CMO, since the behavior of this security under certain circumstances is more in line with his investment preferences. For example, he may be interested in obtaining the maximum yield if interest rates are stable or if early returns (prepayments) compensate for the risks associated with other securities in the portfolio.
| Security (bond) | Compared to another security (bond) | Comparison Features |
| Corporate bond with a high credit rating without the right to early redemption | Same market, lump sum redemption, same maturity, same coupon rates | |
| Corporate bond with a high credit rating without the right to early redemption | Corporate bond with a high credit rating without the right to early redemption | Various maturities, coupon rates, issuers' areas of activity |
| MBS pass-through | MBS pass-through | |
| Puttable corporate bond | MBS pass-through | The right of early repayment, i.e. early return (prepayments), the same markets |
| CMO inverse floater (with inverse variable rate) | MBS pass-through | Availability of leverage (leveraged inverse floater), identical markets |
| ARM+IO (mortgage-backed securities that provide the right to receive interest payments generated by a cover consisting of mortgage loans with variable interest rate) | Perpetual floater (perpetual securities with a variable interest rate) | Availability of leverage (leveraged), various markets |
It may seem that the most reliable is to use the most sophisticated type of analysis in order to take into account all the risks associated with specific securities and ensure that the goals and directions of investment are consistent. This approach looks tempting, but there are serious dangers hidden in it. The more complex the analysis, the more preconditions and assumptions have to be made. When it comes to the results of such an analysis, many assumptions remain unknown to decision makers. Therefore, it is practically impossible to assess how changes in assumptions may affect the final result. The slightest adjustment of the assumptions used in the analysis may necessitate significant changes in investment decision. Therefore, we recommend using the simplest analytical models whenever possible, provided that they take into account all the risks that arise.
The consequence of the rule of correspondence between the depth of analysis to the goals of investment and the complexity of the tools used is the following circumstance. Manager's judgment always plays an important role in the investment process. In this book, we do not provide recipes for avoiding the need for such judgments. On the contrary, we would like to alert managers to the importance of this issue and offer them a number of ways to help them make these difficult decisions.
There are many different types of investors, each with specific investment preferences and goals. However, all of them can be grouped into three main categories according to the criterion of investment purpose: speculation-arbitrage(trading), receiving interest margin(net interest spread) or receiving total income (total return). Investors can assess risks using various methods and types of investment analysis. In practice, most investors cannot be classified into any one specific category: when making investments, they simultaneously pursue many goals.
Speculator-arbitrator (trader) has a relatively simple goal: to buy investment instruments at a low price and sell them at a higher price. This type of investor seeks to conduct purchase and sale transactions in short periods of time. The longer the speculator's trading position remains open, the higher the risks, so he tries to minimize the time period between buying and selling. Arbitrage speculators have two main sources of income. First, they benefit from their status as a regular trader (“market maker”) by earning on spreads. The price at which a company is willing to buy a security is called bid price (bid). The price at which it is ready to sell (offer for sale) a security - offer price (ask). The difference between them is called the difference between the bid and ask price (bid-ask spread). This difference (spread), multiplied by the volume of transactions made by the company, forms the profit of the company as a market maker.
Speculators-arbitrageurs seek to benefit from the deviation of market prices for investment instruments from the optimal (fair) value. They buy those securities for which, in their opinion, the rest of the market participants will be willing to pay a higher price. Arbitrage speculators use their position as active participants in many markets to identify and take advantage of these opportunities. Securitization is one of the tools that these companies can use to profit from price differences. From time to time, arbitrage speculators find that structuring certain assets and securitizing them allows them to fetch a higher price for those assets.
In addition, arbitrage speculators seek to reduce risk through hedging. The ideal hedging, from a trader's point of view, is a simple sale of a position that eliminates all risks. But not all positions can be closed immediately at the best price. The trader needs to evaluate whether hedging will actually reduce the risk of a particular position. Most speculators (traders) in the fixed income market hedge the risks associated with possible changes in profitability levels, i.e. with the risk of changing the duration (duration risk) of their position. Traders may also seek to mitigate the sector risks of an investment portfolio by short selling the instruments in their portfolio.
Traders call arbitration a strategy where certain assets are acquired at a low price and then sold at a higher price, or structured after the acquisition and resold at a profit. Although the term has several meanings in economic and financial theory, traders use it in its broadest sense to refer to any opportunity to make a profit. Often, speculators-arbitrageurs cannot quickly implement all elements of the hedging strategy, lacking the necessary tools. Such situations are hardly true arbitrage, and in many cases they have resulted in significant losses for investors, especially when market conditions have changed rapidly.
Companies operating on Wall Street and having large trading divisions that conduct brokerage and dealer operations are typical arbitrage speculators (traders). However, there are many other companies that can also work as traders. Mortgage banks, which issue loans primarily with a view to their subsequent resale in the secondary market, in essence, are traders: they provide loans to individual borrowers and then sell them in the form of securities. Some investment institutions, such as hedge funds, that seek to increase asset turnover and take advantage of short-term opportunities associated with the relative price movement of investment instruments can also be classified as traders.
Earning-oriented investors interest margin, seek to achieve a stable source of income in the form of the difference between the income that their assets bring and the costs associated with paying off obligations. The size of the resulting difference should be sufficient to ensure an acceptable return on equity in accordance with the chosen strategy. Banks and other depository institutions are typical representatives of this category of investors.
A typical bank uses the funds placed on its deposits (deposits) to provide loans to various categories of borrowers. The difference between the interest on loans paid by borrowers and the costs associated with interest payments to depositors is called the interest margin. Supervisory authorities require the bank to maintain a certain amount of equity capital, corresponding to the total risk level of the assets it holds. In general, banks evaluate the profitability of investment strategies based on the calculation of return on assets, which is equal to the ratio of interest margin to total assets, or return on equity, which is equal to the ratio of interest margin to equity. An important element investment management is to ensure a balance between the risks of a particular strategy and the amount of own (share) capital. Decreasing the share of equity and increasing the share of borrowed funds not only increases the return on equity, but also leads to an increase in the risk of losses.
While banks are the most common interest-margin investor, theoretically any investor who borrows to acquire assets and maintains open positions over a sufficiently long period, implements a similar strategy. Therefore, he must carefully evaluate the amount of leverage and the level of risk. Securities such as collateralized-bond obligations (CBO) or collateralized-debt obligations (CDO) are essentially instruments that have become the result of the activities of investors who adhere to this strategy.
Managers with an acquisition strategy total income, strive to surpass a set of some comparative (reference) indicators (benchmarks) in terms of the amount of annual return on invested capital. In general, the indicator of comprehensive income reflects the total income and changes in the market value of investment instruments for a certain period. The classic total return investor is the manager pension fund. Many mutual investment funds also proceed from the strategy of maximizing total income. It is believed that investment companies focused on total return usually do not use "leverage" because they do not resort to borrowing in the implementation of their investment strategy.
Companies pursuing this strategy usually compare the results of their activities with the results of other players who set themselves similar goals. investment goals, or with indices certain set of securities. investment banks Lehman Brothers, Salomon Brothers (now part of Citigroup) and Merrill Lynch are the main providers of information on fixed income indexes (Dow Jones, Standard & Poor's and Nasdaq are the main indicators describing the state of affairs in the US stock market). Lipper Analytical Services, currently owned by Reuters, is the main source of comparative data on the levels of return shown by various managers. Morningstar is considered the market leader in mutual fund performance information.
Since the results of management in the securities market, calculated on the basis of the criterion of total income, are usually compared with the returns on other assets, the level of risk of such investments is assessed by comparing the structure of the existing investment portfolio with the structure of the index, which is considered a benchmark for this investment company. Managers are trying to find such instruments that allow them to show better results compared to the benchmark, and try not to take on excessive risks associated with the possibility of a decrease in the profitability of the acquired investment instruments below the benchmark index.
Many portfolios of insurance companies are valued in terms of total return, although Insurance companies in general, should stick to an interest margin strategy to a greater extent. However, the wide range of liabilities and the uncertainty associated with insurance policy payments make it cumbersome to analyze the dynamics of interest rate spreads for such companies. Since the analysis of total income includes an assessment of the impact of changes in both returns and prices of the corresponding financial instruments, then it is widely used for complex investment analysis.
There are many methods for analyzing securities issued in the process of securitization and structuring. Each type of securities and portfolio strategy requires its own analytical method. In this book, we take an approach that allows us to consider various methods. This approach consists of four steps, which are summarized in Table 1. 3.2.
The four stages under consideration involve research methodology, coverage (security), structure and investment result. At the stage of studying the methodology, a set of possible market conditions as a whole is considered that can influence the results of the analysis. In other words, we create many possible scenarios. The coverage (collateral) analysis stage looks at the characteristics of a particular pool of assets, especially in terms of early returns, losses and other aspects that can affect the flow of payments. When considering the structure, the amount of payments for securities is calculated for each scenario, taking into account early returns, losses and other estimated indicators, including the peculiarities of the structures used in the issuance of specific types of securities, as well as other significant factors. Finally, when evaluating the result, the calculations necessary to summarize the payment flow data are carried out.
Differences in methods of analysis reflect differences in the choice of options at each of these four stages. A relatively simple method of analysis, the calculation of the MBS return, is described in Chapter 8. A more complex analysis that takes into account the cost of embedded options (OAS) for MBS is contained in Chapter 13. Both analytical methods (as well as in other cases discussed in the book) include the four steps listed above. Although the analysis process is divided into four stages for clarity, they are all closely related. For example, the choice of methodology depends on what the possible set of results looks like. Coverage analysis assumes knowledge of the results obtained in the methodology specification phase and in turn identifies some key building blocks.
At the stage of defining the methodology, the basic parameters of the future analysis are set. The types of risks to be considered are determined. This stage is the most important, and at the same time its importance is often underestimated. The main goal is to determine a set of factors that reflect the results of the market behavior of securities, which must be included in the analysis. The importance of this stage lies in the fact that it sets the boundaries of the analysis. Factors not considered here are not included in the analysis at a later stage.
Due to the complexity of the securitization and structuring processes, the analysis of securities requires consideration of many factors. Unfortunately, too often the methods that are acceptable for the analysis of certain financial instruments and processes are blindly transferred to all other instruments and processes without taking into account the characteristics of the latter. Thus, the results of the market behavior of MBS should be correlated with the situation in the housing market; the fate of a debt instrument secured by the right to commercial real estate, may depend on the volume of retail sales, and the results of behavior in the securities market, secured by receipts on credit cards, - from the number of bankruptcies individuals. Underestimating the impact of changing economic conditions may result in the analysis not taking into account potential investment risks.
The most important component of the economic environment that affects most fixed income investments is the interest rate. Interest rate ratios have a direct impact on the results and the level of risk of investing in non-puttable securities with a high rating. Puttable securities, such as MBS and other structured instruments, are indirectly affected by the interest rate through the dependence of the flow of payments on securities on changes in the interest rate. Determining the market value of an investment instrument and the associated risks in this case is a complex process.
When analyzing the dynamics of interest rates, various assumptions are possible - from the simplest, when it is assumed that the interest rate will remain unchanged throughout the analyzed period, to dynamic models, when it is assumed that the interest rate changes linearly over 12 months, and the nature of each change is calculated in in accordance with the probability determined by the current volatility of interest rates; and, finally, to the most complex ones, when interest rates are determined within the framework of a two-factor model of a stochastic process, in which the distribution of interest rate values is log-normal, has the ability to "return to the average value" and meets the condition of no arbitrage (two factor, log-normal, mean-reverting process which satisfies a no-arbitrage condition), and the variance and covariance values used in the simulation are based on empirical data.
The interest rate is not the only factor influencing the results of the market behavior of securities. As human securities, these complex financial instruments are subject to all the circumstances that influence the behavior of end borrowers. Changes in personal life (marriage, divorce, birth of children, death of loved ones) affect the ownership of housing and affect the solvency of the borrower. Because a securitization transaction involves many individual loans, the behavior of one individual borrower cannot significantly influence the decisions of investors. However, taken as a whole, the actions of individual borrowers will determine the market behavior of securities. That is why analysts specializing in the analysis of such securities scrutinize economic data related to the labor and real estate markets, as well as other economic and demographic statistics.
One of the main difficulties of this analysis is that these "volatile" characteristics related to the coverage and market behavior of securities must be considered in the context of assumptions about the dynamics of interest rates. It is not enough to conclude that an increase in unemployment leads to a decrease in the frequency of early returns. It is also necessary to determine how exactly the unemployment rate changes with a given change in the interest rate.
The choice of methodology also provides for the choice of a financial-theoretical model. As a rule, the analysis of fixed income securities is carried out within the framework of a comparative analytical method and involves comparing the market prices of two or more types of securities. Some analytical tools are more suitable for comparative analysis of securities with different investment characteristics. There is a developed theory that links the dynamics of interest rates with the frequency of option exercise (frequency of early repayments). Various methods of analysis have a greater or lesser degree of compatibility with the provisions of this theory. But even in cases where analysts have determined the theory to be applied, they may choose different methods of applying it, which may differ in both the mechanisms of analysis and the results. The financial theory of interest rates is discussed in more detail in Chapters 7 and 12.
Having decided on a specific approach and initial assumptions (assumptions) regarding general economic scenarios, investors are able to predict the characteristics and expected behavior of coverage (collateral). The purpose of the analysis is to identify factors that affect the flow of payments that generates coverage, as well as the fulfillment of obligations on issued securities. Such factors (assumptions) usually take the form of specific indicators that characterize the market behavior of assets (for example, the annual interest rate), or in the form of complete models that allow, based on coverage data and economic indicators build a monthly forecast of the behavior of the security. In such an analysis, the emphasis is usually on early repayments and credit conditions.
Early repayments occur when the borrower decides to exercise his right (option) to early repay the loan. Majority contract terms loan products give borrowers the right to make early repayment of the principal debt at any time; others, on the contrary, provide for penalties in case of early repayment of the debt or other restrictions established in loan agreements. Unlike corporate bonds, time schedules for early repayments on consumer loans are usually predicted based on the analysis of statistical data obtained over a long period, and not on the basis of optimizing the timing of payment obligations, since borrowers often face unforeseen expenses, the timing and amount of which cannot be estimated theoretically.
Credit assessment is, first of all, an assessment of the probability of its delay in repayment or default (default), as well as the amount of losses arising from this. Typically, loans that are in arrears are considered overdue(delinquent). The quality of arrears is measured by the number of days that have passed since the due date. Arrears with a maturity of more than 60 or 90 days are considered dubious(seriously delinquent). For some credit products, arrears with this maturity are recognized borrower default. The fact of default means the beginning of the procedure for indemnification. The service company (servicer) may try to recover losses by entering into a new agreement or by foreclosing the debtor's property (foreclosure). The difference between the amount of outstanding debt and the amount of compensation (minus court costs) is called size of losses (severity of the loss).
Assumptions regarding the frequency of early repayments and their timing, as well as the fulfillment of loan obligations are usually based on statistical analysis historical data. Testing and evaluating the reliability of such assumptions is a key element in choosing (designing) a securitization structure and predicting the market behavior of issued securities. Each type of coverage (collateral) requires an independent and comprehensive analysis of these characteristics.
The design phase is the core of the analytical process. In this case, the flow of payments for securities is calculated. The calculation is based on assumptions made regarding the future economic situation (methodology), estimates obtained at the stage of analysis of coverage (collateral), as well as features loan agreements included in the coverage, and legal registration securitization transactions. The results obtained at the next stage are usually a generalization of all the characteristics of the payment flows, carried out in one way or another. Calculating the flow of payments from a theoretical point of view is a rather trivial task, but in many cases it is also the most laborious.
The calculation process begins with the valuation of the underlying assets, i.e. coverage. Based on it, the amount of payments on securities that will be issued upon securitization of the selected credit pool is determined. Pass-through securities payouts correspond to the flow of payments that generates a pool of loans. The cash flow generated by structured securities is formed on the basis of the cash flow from pass-through securities. The portfolio's cash flow is defined as the sum of the cash flows for each security. The process of distributing the cash flow generated by coverage among different classes of securities is sometimes referred to as waterfall, because it describes how a single payment stream is divided among different instruments.
The greatest difficulty at this stage is the choice of appropriate indicators that describe the behavior of securities. Each loan granted has unique characteristics that determine the dynamics of payments, and each security is subject to a complex set of rules that determine the distribution of incoming payments between different classes of securities. Another important consideration related to this stage of the analysis concerns the level of detail required. In some cases, complete information about each loan is not available, so the analysis must be based on weighted averages. In other cases, more information is available. In this case, the analyst must find the right balance between striving for maximum accuracy of estimates and additional costs associated with the increasing amount of calculations.
The final stage is the analysis of the obtained results. At this stage, generalized indicators are determined based on the calculation of cash flows and theoretical approaches (methodology). The purpose of defining generic indicators is to help companies in the investment process. Analytical results usually provide a fairly complete picture of returns, costs, and risks.
The income estimate gives an idea of the time schedule of the future flow of payments and the amount of receipts. Determining the value allows you to answer the question, which of the securities are valued by the market at a high price, and which are cheap? Although higher quality valuation parameters provide more reliable predictions of the future behavior of securities, all valuations made have their own strengths and weaknesses. weak sides. A quantitative risk assessment makes it possible to draw a conclusion about the effectiveness of an investment, as well as to compare the results of the market behavior of various investment instruments with each other (Table 3.3).
|
Options |
Static |
scenario |
Including Options |
|
Yield |
Total income (yield) |
Yield with value of embedded options (OA-yield) (rarely used parameter) |
|
|
Market price |
Yield spread |
Income Profile |
Option Value Spread (OAS) |
|
Weighted average maturity Payment flow duration |
Effective duration |
Duration including embedded options (OA-duration) Convexity with Embedded Options (OA-convexity) |
For securities exposed to the risk of loss due to non-fulfillment of obligations included in the coverage, there are indicators that help assess credit risk. Part of this risk is determined during the structuring process, when each class of securities is assigned a credit rating. However, to evaluate credit risk from an investor's point of view, additional analysis may be required.
The accuracy and usefulness of these indicators depends on how complex the analytical process is. At the final stage, only those factors are taken into account that were included in the analysis at the very beginning, i.e., at the stage of choosing a methodology, then put into a specific form when studying the coverage, applied to a specific structure, and, finally, summarized in the form of generalized indicators when obtaining result.
The variety of coverage types, securitization structures and investment strategies calls for a variety of analysis tools. Dissimilar problems require the use of different methods and depth of analysis. Despite the fact that analytical tools vary significantly in the degree of complexity of the calculations performed, in terms of input data requirements and technical complexity, most of them include the same four stages of analysis related to methodology, coverage, structure and results.
The choice made at each stage determines the effectiveness of the tools used to solve specific problems. Each stage is closely related to the others. Good analytical tools have comparable levels of sophistication across all four steps. Complex metrics based on simple assumptions or simplistic assumptions can give a false impression of accuracy, while using primitive metrics based on complex assumptions is a waste of time and effort. Good analysis requires full compliance with the method of solving the degree of complexity of the task.
Exercise 3.1a. What is the short-term and long-term impact of increasing the spread on the investment portfolio of three types of investors: the arbitrage speculator, the interest margin investor, and the total return investor? Assume that an increase in the spread on those securities that are in investors' portfolios affects the cost of hedging instruments for an arbitrage speculator, the size of obligations for an interest-oriented investor, and changes in the benchmark index for a market participant with a strategy maximizing total income.
Exercise 3.1b. If a company has additional funds to invest in some instrument, what are the short and long term effects of increasing the spread?
Exercise 3.2. Consider the differences between different types of investors. What are the comparative advantages and disadvantages for each type of the two following methods of reflection in financial statements financial instruments: market value accounting, cost of acquisition accounting?
1 In the terminology of the options market, a synonym for the term "credit repayment" is the term "exercise of the option". - Note. scientific ed.
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