Oct
07
2023
What is Volatility Skew and How Can You Trade It?

What Is Volatility Skew and How Can You Trade It?

By | Growing Wealth, invest, Investing | Comments Off on What Is Volatility Skew and How Can You Trade It?

What Is Volatility Skew?

Volatility skew, also known as Option Skew, is an options trading concept that refers to the difference in volatility between at-the-money options, in-the-money options, and out-of-the-money options. These terms in options trading refer to the relationship between the market price and the strike price of the contract.

Options contracts for the same underlying asset with the same expiration date but different strike prices have a range of implied volatility. In other words, it’s a graph plot of implied volatility points representing different strike prices or expiration dates for options contracts.

Each asset type looks different on a graph, but they tend to resemble a smile or a smirk. The volatility skewness is the slope of the implied volatility on that graph. A balanced curve is called a “volatility smile,” and if it is unbalanced to one side it is called a “volatility smirk.”

What Is Implied Volatility (IV)?

Implied volatility, denoted by the sigma symbol (σ), is an estimate of the volatility that a particular underlying asset will have between the current moment and the time when the options contract for the asset expires. It’s basically the uncertainty that investors have about an underlying stock and how likely traders think the stock will reach a particular price on a particular date.

The volatility of an underlying asset changes constantly. The more the price of the asset changes, the more volatility it has. But implied volatility doesn’t necessarily follow the same pattern because it depends on how investors view the asset and whether they predict it will have volatility. Implied volatility is usually shown using standard deviations and percentages over a particular period of time.

Option pricing assumes that options for the same asset that have the same expiration have the same implied volatility, even if they have different strike prices. But investors are actually willing to overpay for downside-striked stock options because they think there is more volatility to the downside than the upside.

Different types of options contracts have different levels of volatility, and it’s important for traders to understand this when determining their options trading strategy.


💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

What Does Volatility Skew Mean for Investors?

Volatility depends on supply and demand as well as investor sentiment about the options. The volatility skew helps investors understand the market and decide whether to buy or sell particular contracts. It’s an important indicator for investors who trade options.

Stocks that are decreasing in price tend to have more volatility. If there is implied volatility of an underlying entity, the price of an option increases, resulting in a downside equity skew.

If a skew has higher implied volatility, this means prices will be higher. So investors can look at volatility skews to find low- and high-priced contracts to decide whether to buy or sell.

There are two types of volatility skew. Vertical skew shows the volatility skew of different strike prices of options contracts that have the same expiration date. This is more commonly used by individual traders. Horizontal skew shows the volatility skew of expiration dates of options contracts that have the same strike price.

How Do You Measure Volatility Skew?

Investors measure volatility skew by plotting graph points of different implied volatility of strike prices or expiration dates. For example, a trader could look at a list of bid/ask prices for options contracts for a particular asset that expire on the same date. They take the midpoint implied volatility points from the bid/ask prices and chart them out.

The tilt of the skew changes over time as market sentiment changes. Observing these changes can give investors additional insights into the direction the market is heading, which they can use in skew trading. For instance, if the stock price increases in value significantly, traders might think it is overbought and therefore that it will decrease in value in the future. This will change the skew so its curve increases, showing more pressure for on-the-money or downside put options.

There are five factors that influence the price of options:

• Underlying stock or asset market price

• Strike price

• Time to expiry

• Interest rate

• Implied volatility

Investors can calculate the volatility at different strike prices and graph those out to see the volatility skew.

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How Do You Trade With Volatility Skew?

As mentioned above, the two types of volatility skew are horizontal and vertical. These can both be used in trading.

Horizontal Skew

There are many factors that drive changes in horizontal skew, such as product announcements, earnings reports, and global events. For instance, if traders are uncertain about the short-term future of a stock because of an upcoming earnings report, the implied volatility may increase and the horizontal skew could flatten.

Traders look for opportunities by using calendar spreads to look at the differences between option expiration implied volatility. Where there is implied volatility in a horizontal skew, there may be inefficient pricing that traders can take advantage of.

If the implied volatility is higher than expected in the front month, the option contract will be relatively more expensive, which is referred to as positive horizontal skew.

On the other hand, if the implied volatility of the back month is higher than expected this is known as negative horizontal skew or “reverse calendar spread.” In this situation traders would sell the back month and buy the front month because they can profit when the price of the underlying asset increases before the back month contract expires.

For example, a trader might look at the market for a stock and find that there is a horizontal skew in the option calls, meaning traders are putting in buy and sell orders with the prediction that it’s more likely the stock will increase a lot in the long term than in the short term.

If the trader doesn’t think the current market predictions are correct, they can use a reverse calendar call spread, similar to shorting a stock and predicting it will go down. If the price of the stock plummets, both the long- and short-term contracts will decrease in value and the trader can buy them back at a lower price than they sold them for.

In this case the trader can also profit if the implied volatility of the options decreases. They chose to sell when the implied volatility was high during the front month, so if the implied volatility decreases they can buy back at a lower price.

Although this has the potential to be a profitable way to trade, it is also risky because it’s a short call that requires a lot of margin. Stock exchanges require traders to have significant funds in their account if they want to do this type of trade.


💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.

Vertical Skew

Many investors prefer trading with vertical skew because it is simpler than horizontal skew and requires less margin and, therefore, less risk. Also referred to as volatility skew and option skew, vertical skew looks at the differences between the implied volatility of different stock strike prices that have the same expiration date. Using vertical skew, traders can find opportunities to trade debit spreads and credit spreads, finding the best strike prices to buy or sell.

For example, a trader might find a stock they believe will increase in value before its option contract expires. So they want to find a bull put spread to buy to get profits when the price increases. They will have many strikes to choose from, so they can use vertical skew to identify which are the best trades, meaning those that are low or high priced. The trader can identify one with a good price to buy, wait until it increases and sell it for a profit.

The Takeaway

Options trading is popular with many investors, and volatility skew is one way for options traders to evaluate the price of options contracts. Traders might look at either horizontal or vertical skew to make a decision about whether an options contract purchase makes sense for their investing strategy.

However, options trading is risky. It’s generally best for experienced investors and not for beginners. If you’re interested in options, it’s wise to talk to a financial professional before you do anything else.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Oct
07
2023
colorful chart

What Are Emerging Markets?

By | Financial Independence, Growing Wealth, invest, Investing, Terminology | Comments Off on What Are Emerging Markets?

Emerging markets or emerging market economies (EMEs) are in the process of achieving the building blocks of developed nations: they’re establishing regulatory bodies, creating infrastructure, fostering political stability, and supporting mature financial markets. But many emerging markets still face challenges that developed market countries have overcome, and that contributes to potential instability.

To further answer the question, “What are emerging markets?”, it helps to understand developed markets.

Developed economies have higher standards of living and per-capita income, strong infrastructure, stable political systems, and mature capital markets. The U.S., Europe, U.K, and Japan are among the biggest developed nations.

Because these economies wield so much power globally, many investors don’t realize that, in truth, emerging markets make up the majority of the global economy.

India, China, and Brazil are a few of the larger countries that fall into the emerging markets category. Some emerging market economies, like these three, are also key global players — and investors may benefit by understanding the opportunities emerging markets present.

What is an Emerging Market?

In essence, an emerging market refers to an economy that can become a developed, advanced economy soon. And because an emerging market may be a rapidly growing one, it may offer investment potential in certain sectors.

Internationally focused investors tend to see these countries as potential sources of growth because their economies can resemble an established yet still-young startup company. The infrastructure and blueprint for success have been laid out, but things need to evolve before the economy can truly take off and ultimately mature. At the same time, owing to the challenges emerging market economies often face, there are also potential risks when investing in emerging markets.

Investors might bear the brunt of political turmoil, local infrastructure hurdles, a volatile home currency and illiquid capital markets (if certain enterprises are state-run or otherwise privately held, for example).


💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

Emerging Market Examples

What constitutes an emerging market economy is somewhat fluid, and the list can vary depending on the source. Morgan Stanley Capital International (MSCI) classifies 24 countries as emerging; Dow Jones also classifies 24 as emerging. There is some overlap between lists, and some countries may be added or removed as their status changes. Greece, for example, is no longer considered a developed market but an emerging one.

India is one of the world’s biggest emerging economies. Increasingly, though, some investors see India as pushing the bounds of its emerging market status.

China

China is the second-largest economy globally by gross domestic product (GDP). It has a large manufacturing base, plenty of technological innovation, and the largest population of any country in the world.

Yet China still has a few characteristics typical of an emerging market. For example, the gross national income per capita falls below the threshold established by the World Bank for a developed country: about $12,600 per year versus the higher standard of above $13,200 per year. With its Communist-led political system, China has embraced many aspects of capitalism in its economy but investors may experience some turbulence related to government laws and policy changes. The Renminbi, China’s official currency, has a history of volatility. And finally, post-Covid, China’s economy has lagged.

India

India is another big global economy, and it’s considered among the top 10 richest countries in the world, yet India still has a low per-capita income that is typical of an emerging market and poverty is widespread.

At the same time, India was ranked as being among the more advanced emerging markets, thanks to its robust financial system, growing foreign investment, and strong industrials, especially in telecommunication and technology.

Characteristics of an Emerging Market Economy

As noted above, there isn’t a single definition of an emerging market, but there are some markers that distinguish these economies from developed nations.

Fast-Paced Growth

An emerging market economy is often in a state of rapid expansion. There is perhaps no better time to be invested in the growth of a country than when it enters this phase.

At this point, an emerging market has laid much of the groundwork necessary for becoming a developed nation. Capital markets and regulatory bodies have been established, personal incomes are rising, innovation is flourishing, and GDP is climbing.

Lower Per-Capita Income

The World Bank keeps a record of the gross national income (GNI) of many countries. For the fiscal year of 2022, lower-middle-income economies are defined as having GNI per capita of between $1,136 and $4,465 per year. At the same time, upper-middle-income economies are defined as having GNI per capita between $4,466 and $13,845. (By way of contrast, the U.S. is considered a high-income economy, with a GNI of $76,370.)

The vast majority of countries that are considered emerging markets fall into the lower-middle and upper-middle-income ranges. For example, India, Pakistan, and the Philippines are lower-middle-income, while China, Brazil, and Mexico are upper-middle-income. Thus, all these countries are referred to as emerging markets despite the considerable differences in their economic progression.

Political and Economic Instability

For most EMEs, volatility is par for the course. Risk and volatility tend to go hand in hand, and both are common among emerging market investments.

Emerging economies can be rife with internal conflicts, political turmoil, and economic upheaval. Some of these countries might see revolutions, political coups, or become targets of sanctions by more powerful developed nations.

Any one of these factors can have an immediate impact on financial markets and the performance of various sectors. Investors need to know the lay of the land when considering which EMEs to invest in.

Infrastructure and Climate

While some EMEs have well-developed infrastructure, many are a mix of sophisticated cities and rural regions that lack technology, services and basic amenities like reliable transportation. This lack of infrastructure can leave emerging markets especially vulnerable to any kind of crisis, whether political or from a natural disaster.

For example, if a country relies on agricultural exports for a significant portion of its trade, a tsunami, hurricane, or earthquake could derail related commerce.

On the other hand, climate challenges may also present investment opportunities that are worth considering.

Recommended: 27 Potential Ways to Invest in a Carbon-free Future

Currency Crises

The value of a country’s currency is an important factor to keep in mind when investing in emerging markets.

Sometimes it can look like stock prices are soaring, but that might not be the case if the currency is declining.

If a stock goes up by 50% in a month, but the national currency declines by 90% during the same period, investors could see a net loss, although they might not recognize it as such until converting gains to their own native currency.

Heavy Reliance on Exports

Emerging market economies tend to rely heavily on exports. That means their economies depend in large part on selling goods and services to other countries.

A developed nation might house all the needs of production within its own shores while also being home to a population with the income necessary to purchase those goods and services. Developing countries, however, must export the bulk of what they create.

Emerging Economies’ Impact on Local Politics vs. Global Economy

Emerging economies play a significant role in the growth of the global economy, accounting for about 50% of the world’s economic growth. Moreover, it’s predicted that by 2050 three countries will have the biggest economies: the U.S., China, and India, with only one currently being a developed economy.

But, while emerging markets help fuel global growth, some of those with higher growth opportunities also come with turbulent political situations.

As an investor, the political climate of emerging market investments can pose serious risks. Although there is potential for higher returns, especially in EMEs that are in a growth phase, investors need to consider the potential downside. For example, Thailand and South Korea are emerging economies with high growth potential, but there is also a lot of political unrest in these regions.


💡 Quick Tip: Are self directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

Pros and Cons of Investing in Emerging Markets

Let’s recap some of the pros and cons associated with EME investments.

Pros

•  High-profit potential: Selecting the right investments in EMEs at the right time may result in returns that might be greater than most other investments. Rapidly growing economies could provide ample opportunity for profits. But as noted above, it’s impossible to guarantee the timing of any investment.

•  Global diversification: Investing in EMEs provides a chance to hold assets that go beyond the borders of an investor’s home country. So even if an unforeseen event should happen that contributes to slower domestic growth, it’s possible that investments elsewhere could perform well and provide some balance.

Cons

•  High volatility: As a general rule, investments with higher liquidity and market capitalization tend to be less volatile because it takes significant capital inflows or outflows to move their prices.

EMEs tend to have smaller capital markets combined with ongoing challenges, making them vulnerable to volatility.

•  High risk: With high volatility and uncertainty comes higher risk. What’s more, that risk can’t always be quantified. A situation might be even more unpredictable than it seems if factors coincide (e.g. a drought plus political instability).

All investments carry risk, but EMEs bring with them a host of fresh variables that can twist and turn in unexpected ways.

•  Low accessibility: While liquid capital markets are a characteristic of emerging markets, that liquidity still doesn’t match up to that of developed economies.

It may be necessary to consult with an investment advisor or pursue other means of deploying capital that may be undesirable to some investors.

Why Invest in Emerging Markets?

Emerging markets are generally thought of as high-risk, high-reward investments.

They are also yet another way to diversify an investment portfolio. Having all of your portfolio invested in the assets of a single country puts you at the mercy of that country’s circumstances. If something goes wrong, like social unrest, a currency crisis, or widespread natural disasters, that might impact your investments.

Being invested in multiple countries can help mitigate the risk of something unexpected happening to any single economy.

The returns from emerging markets might also exceed those found elsewhere. If investors can capitalize on the high rate of growth in an emerging market at the right time and avoid any of the potential mishaps, they could stand to profit. Of course timing any market, let alone a more complex and potentially volatile emerging market, may not be a winning strategy.

Recommended: Pros & Cons of Global Investments

The Takeaway

While developed nations like the U.S. and Europe and Japan regularly make headlines as global powerhouses, emerging market countries actually make up the majority of the world’s economy — and possibly, some very exciting opportunities for investors.

China and India are two of the biggest emerging markets, and not because of their vast populations. They both have maturing financial markets and strong industrial sectors and a great deal of foreign investment. And like other emerging markets, these countries have seen rapid growth in certain sectors (e.g. technology).

Despite their economic stature, though, both countries still face challenges common to many emerging economies, including political turbulence, currency fluctuations and low per-capita income.

It’s factors like these that can contribute to the risks of investing in emerging markets. And yet, emerging markets may also present unique investment opportunities owing to the fact that they are growing rapidly.

Emerging market exchange-traded funds (ETFs) might invest in different assets within a single country or spread their investments throughout multiple countries. Bonds can also play a role in an emerging market portfolio. Many countries with developing economies have used the issuance of new debt to borrow money to build out their infrastructure. That means some emerging economies could offer bonds with attractive yields. But investors need to carefully weigh the potential risks.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


Invest with as little as $5 with a SoFi Active Investing account.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SOIN0723054

Read more
Oct
06
2023
Introduction To Weighted Average Cost of Capital (WACC)

Introduction to Weighted Average Cost of Capital (WACC)

By | Financial Independence, Growing Wealth, invest, Investing, Terminology | Comments Off on Introduction to Weighted Average Cost of Capital (WACC)

Properly formulated, the weighted average cost of capital, or WACC, merges a business’s cost of capital across financial components. Once weighted for proportional balance, WACC bundles all company financial sources (with an emphasis on equity and debt) and adds them together. The final figures represent the current value of a company, or a project or initiative undertaken by a company.

Understanding the weighted average cost of capital, or the cost of capital, is both a business calculus and an economic term. It’s a term to describe the relationship between two key economic components – equity and debt, as a financial ratio.

What Is WACC?

The WACC is the rate that a company must pay, on average, to finance its operations. It’s a figure that business leaders use to make strategic decisions, and a data point used by investors as part of their fundamental analysis of a company.

In general, a low weighted average cost of capital shows that a business is in good financial health and can more efficiently and economically pay for company operations, either through debt financing or equity financing. Earnings are robust enough to curb company debt loads and offer solid investment returns to market investors, which should increase capital to the company.

Recommended: How to Know When to Sell a Stock

A higher weighted average cost of capital suggests the opposite outcome. The firm is likely paying more to handle their debt and paying more to raise capital for company projects. That scenario can lead to a business with a lower valuation with less demand from investors to buy company stock or invest in its bond issues, as returns on those investments would likely be lower.

Who Uses Weighted Average Cost of Capital?

The weighted average cost of capital formula can be used by a number of people in or around a business. That can include company management, who can use it to guide decisions about the direction of the company, along with investors and investment analysts, who are keeping tabs from the outside.

High vs Low WACC Calculations

Investors can use the results of WACC calculations to help guide their investment decisions. In general, a high WACC may be a turn-off for some investors, as it indicates that the company isn’t as likely to provide investors with a high rate of return. The opposite is also true – a low WACC may be a bullish sign for investors.


💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

What is the WACC Formula?

The calculation used for WACC includes cost of equity and cost of debt, along with additional economic components commonly used by businesses.

Here is how those components are broken down in a WACC formula.

• E = Market value of the business’s equity

• V = Total value of capital (equity + debt)

• Re = Cost of equity

• D = Market value of the business’s debt

• Rd = Cost of debt

• T = Tax rate

Once you have those numbers, here’s how to calculate WACC:

How to Calculate WACC

Calculating WACC looks like this:

WACC = (E/V x Re) + ((D/V x Rd) x (1-T))

To use the WACC formula, you need to first multiply the costs of each financial component and include that component’s proportional rate. Once you’ve arrived at those figures, multiply them by the company’s corporate tax rate. The resulting figure gives you the company’s weighted average cost of capital.

Difficulties With Using WACC

There’s a caveat to be mindful of when calculating the weighted average cost of capital: The formula heavily relies on the cost of equity in its equation, which is largely unknown, since that value can vary. A company’s share capital depends on what the market (i.e., investors) are willing to pay to invest in the company, as exhibited by the company’s stock price.

Given that unknown, companies must evaluate the expected return of their stock, through an investor’s eyes. That represents the value of the company’s equity and any effort to hide or diminish that value could put a damper on a company’s share price.

That’s why companies factor the estimated cost of equity into the WACC equation – they view the cost of equity as the amount of capital a company needs to spend to maintain a stock price that’s largely acceptable to market investors.

An Example of the WACC at Work

As an example of the WACC at work, let’s look at a company’s weighted average cost of capital – let’s say ABC Company has an annual return of 15% and an average cost of 5% annually to pay for operations. That dynamic represents a 10% profit on its investment in the company.

From an investor’s viewpoint, that same profit scenario represents 10 cents of every dollar invested in the company. That’s 10 cents of capital a business can use to either invest back into the company or can be used to pay down company debt.

On the other end of the equation, if XYZ Company generates an annual investment return of 10% yet owns an average annual cost of capital of 15%, that company is down 5 cents on each dollar invested in the company.

In that scenario, XYZ Co. is in a bind that no company wants to find itself in – its costs of doing business exceed its investment returns. That translates into fewer investors until the firm realigns its financing picture, cuts debt, and gives investors a good reason to buy its stocks and bonds.

Why the Need for Weighted Average Cost of Capital?

The weighted average cost of capital breaks down a firm’s cost of doing business by weighing the debt (including bonds and other long-term debt) and equity structure (including the cost of both common and preferred stock) of the company.

Primarily, companies need to finance their operations in three ways:

1. Debt financing

2. Equity financing

3. A combination of debt and equity

No matter which option a company chooses, sources of capital come with a financial cost.

The WACC seeks to find the “true cost of money” in operating a business by comparing the cost of borrowing of capital to run a company versus raising capital through equity to pay for common business needs like property and equipment, research and development, human capital (i.e., employees), and business expansion, among other costs.

When company executives know the WACC, they can leverage that financial ratio to decide on funding the firm through debt or equity financing. The cost of equity will depend on the value of the company’s stock, while the cost of debt will reflect interest rates.

Basically, companies require an accurate weighted cost of capital to properly weigh expenses and provide fair cost of analysis on projects in the pipeline. Additionally, companies can leverage their WACC to evaluate their capital structure and weigh the myriad financial sources needed to fund operations, proportioned accurately.

Using one form of capital to fund a company’s operations makes the cost of capital formula fairly simple. However, when companies use multiple forms of capital the formula becomes more complicated and requires financial modeling.

The Takeaway

The weighted average cost of capital is not exactly a precise measurement of a company’s financial health, but it can be a highly useful one, especially for investors. If you’re looking at potentially investing in a company, it can be one piece of information that provides more detail into the company’s relative strength.

The data is easily found in a publicly-traded company’s balance sheets, which are made available to investors on a regular basis. Just visit the company’s web site, locate its financial information page, and look for the relevant data.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

How can you calculate WACC for a private company?

Calculating WACC for a private company is more or less the same process as calculating WACC for a public company, but the calculation will need to be done using estimates of the company’s value, perhaps through cash flow analysis.

What is the difference between WACC and Required Rate of Return (RRR)?

While WACC and RRR are similar, the two are distinct from one another. In fact, WACC can be a tool used to determine RRR, but the two produce different values that can be important for investors for different reasons.

How does WACC influence sensitivity analysis?

WACC calculations can change in different scenarios, and sensitivity analysis can help determine how and what those changes are. Effectively, by experimenting with different values, you can get a sense of how sensitive a WACC calculation is, which can be important for investors.

Photo credit: iStock/fizkes

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN0723168

Read more
Oct
06
2023
What Is a Financial Instrument? Types & Asset Classes Explained

What Is a Financial Instrument? Types & Asset Classes Explained

By | Growing Wealth, invest, Investing | Comments Off on What Is a Financial Instrument? Types & Asset Classes Explained

A financial instrument is simply a contract between entities that represents the exchange of money for a certain asset. Financial instruments include most types of investments: cash, stocks, bonds, mutual funds, exchange-traded funds (ETFs), certificates of deposit (CDs), loans, derivatives, and more.

Financial instruments facilitate the movement of capital through the markets and the broader economic system. While this may take different forms, the flow of capital remains a central feature.

What Is a Financial Instrument?

Generally Accepted Accounting Principles (GAAP) defines a financial instrument as cash; evidence of an ownership interest in a company or other entity; or a contract. A financial instrument confers either a right or an obligation to the holder of the instrument, and is an asset that can be created, modified, traded, or settled.

Investors can trade financial instruments on a public exchange. The New York Stock Exchange (NYSE) is an example of a spot market in which investors can trade equity instruments for immediate delivery.


💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

Financial Instrument vs Security

A security is a type of financial instrument with a fluctuating monetary value that carries a certain amount of risk for the individual or entity that holds it. Investors can trade securities through a public exchange or over-the-counter market.

The federal government regulates securities and the securities industry under a series of laws, including the Securities Act of 1933, the Securities Exchange Act of 1934, and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

All securities are financial instruments but not all financial instruments are securities.

Like financial instruments, securities fall into different groups or categories. The four types of securities include:

•   Equities. Equities represent an ownership interest in a company. Stocks and mutual funds are examples of equity securities.

•   Debt. Debt refers to money lent by investors to corporate or government entities. Corporate and municipal bonds are two examples of debt securities.

•   Derivatives. Derivatives are financial contracts whose value is tied to an underlying asset. Futures and stock options are derivative instruments.

•   Hybrid. Hybrid securities combine aspects of debt and equity. Convertible bonds are a type of hybrid instrument.

Recommended: Bonds vs. Stocks: Understanding the Difference

Types of Financial Instruments

Financial instruments are not all alike. There are different types of financial instruments in different asset classes. Certain financial instruments are more complex in nature than others, meaning they may require more knowledge or expertise to handle or trade.

1. Cash Instruments

Cash instruments are financial instruments whose value fluctuates based on changing market conditions. Cash instruments can be securities traded on an exchange, such as stocks, or other types of financial contracts.

For example, a certificate of deposit account (CD) is a type of cash instrument. Loans also fall under the cash instrument heading as they represent an agreement or contract between two parties where money is exchanged.

2. Derivative Instruments

Derivative instruments or derivatives draw their value from an underlying asset, and fluctuate based on the changing value of the underlying security or benchmark.

As mentioned, options are a type of derivative instrument, as are futures contracts, forwards, and swaps.

3. Foreign Exchange Instruments

Foreign exchange instruments are financial instruments associated with international markets. For example, in forex trading investors trade currencies from different currencies through global exchanges.

Asset Classes of Financial Instruments

Financial instruments can also be broken down by asset class.

4. Debt-Based Financial Instruments

Companies use debt-based financial instruments as a means of raising capital. For example, say a municipal government wants to launch a road improvement project but lacks the funding to do so. They may issue one or more municipal bonds to raise the money they need.

Investors buy these bonds, contributing the capital needed for the road project. The municipal government then pays the investors back their principal at a later date, along with interest.

5. Equity-Based Financial Instruments

Equity-based financial instruments convey some form of ownership of an entity. If you buy 100 shares of stock in XYZ company, for example, you’re purchasing an equity-based instrument.

Equity-based instruments can help companies raise capital, but the company does not have to pay anything back to investors. Instead, investors may receive dividends from the stock shares they own, or realize profits if they’re able to sell those shares for a capital gain.

Are Commodities Financial Instruments?

Commodities such as oil or gas, precious metals, agricultural products and other raw materials are not considered financial instruments. A commodity itself, such as pork or copper, doesn’t direct the flow of capital.

That said, there are certain instruments whereby commodities are traded, including stocks, exchange-traded funds, and futures contracts.

A futures contract represents an agreement to buy or sell a certain commodity at a specific price at a future date. So, for example, an orange grower might sell a futures contract agreeing to sell a certain amount of their crop for a set price. An orange juice company could then buy a contract to purchase oranges at X price.

For the everyday investor, futures trading in commodities typically doesn’t mean you plan to take delivery of two tons of coffee beans or 4,000 bushels of corn. Instead, you buy a futures contract with the intention of selling it before it expires.


💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.

Uses of Financial Instruments

Investors and businesses may use financial instrument for the following purposes:

1. As a Means of Payment

You already use financial instruments in your everyday life. When you write a check to pay a bill or use cash to buy groceries, you’re exchanging a financial instrument for goods and services.

Likewise, business entities may charge purchases to a business credit card. They’re borrowing money from the credit card company and paying it back at a later date, often with interest.

2. Risk Transfer

Investors use financial instruments to transfer risk when trading options and other derivative instruments, such as interest rate swaps. With options, for example, an investor has the option to buy or sell an underlying asset at a specified price on or before a predetermined date. A contract exists between the individual who writes the option and the individual who buys it. This type of financial instrument allows an investor to speculate about which way prices for a particular security may move in the future.

3. To Store Value

Businesses often use financial instruments in this way. For example, say you default on a credit card balance. Your credit card company can write off the amount as a bad debt and sell it to a debt collector. Meanwhile, businesses with outstanding invoices they’re awaiting payment on can use factoring or accounts receivables financing to borrow against their value.

4. To Raise Capital

Companies may issue stocks or bonds in order to get access to capital that they can invest in their business. In this case, the financial instruments could be a means of raising capital for one party and a store of value for the other.

Importance of Financial Instruments

Financial instruments are central to not only the stock market, but also the financial and economic system as a whole. They provide structures and legal obligations that facilitate the regulated exchange of capital via investing, lending and borrowing, speculation and growth.

In short, financial instruments keep the financial markets moving, and they also help businesses to keep their doors open and allow consumers to manage their finances, plan for the future, and invest with the hope of future gains.

For example, you may also have a savings account that you use to hold your emergency fund, an Individual Retirement Account (IRA) that you use to save for retirement and a taxable brokerage account for trading stocks. Your checking account is one of the basic tools you might use to pay bills or make purchases.

You might be paying down a mortgage or student loans while occasionally using credit cards to spend. All of these financial instruments allow you to direct the flow of money from one place to another.

The Takeaway

Financial instruments are integral to every aspect of the financial world, and they also play a significant part in business transactions and day-to-day financial management. If you trade stocks, invest in an IRA, or write checks to your landlord, then you’re contributing to the movement of capital with various financial instruments. Understanding the different types of financial instruments is the first step in becoming a steward of your own money.

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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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2023
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Can You Pay Off Student Loans with Your 401(k)?

By | Debt Payoff, Fresh Out of School, Investing, Student Loans, student_loan | No Comments

If you’re one of the 44 million Americans who currently hold a portion of the country’s more than $1.7 trillion student debt—and are perhaps now back to making payments after a three-year pause—chances are you’re looking for solutions to get rid of that debt ASAP. After all, the average student who borrowed money to pay for school graduates with just over $37,000 in federal student loan debt alone.

Paying off that much debt is an impressive feat which takes discipline and commitment. If you’re currently living under the heavy weight of your student loans, you may have considered using your 401(k) for student loans. But should you really cash out your 401(k) for student loans?

It probably goes without saying that figuring out how you’re going to pay off your student loans is overwhelming—and there isn’t one definitive solution. And while it’s certainly tempting to just take the cash from your 401(k) and pay off a high-interest loan, there are some serious drawbacks to consider before running with that plan.

Key Points

•   Using a 401(k) to pay off student loans can eliminate debt quickly but has significant drawbacks, including penalties and lost investment growth.

•   Early withdrawal from a 401(k) before age 59½ incurs a 10% penalty and is subject to income tax.

•   Alternatives like income-driven repayment plans or loan forgiveness programs offer safer ways to manage student loan debt without risking retirement savings.

•   Refinancing student loans might lower interest rates and monthly payments, providing a financial breather without tapping into retirement funds.

•   Borrowing from a 401(k) or taking a hardship withdrawal are options, but they compromise future financial stability and retirement planning.

The Downsides of Using Your 401(k) to Pay Off Your Student Loans

A potential benefit of using your 401(k) to pay off student loans is that you can eliminate your debt in one fell swoop. However, withdrawing money from your 401(k) should be considered a last resort option—or maybe not an option at all. That’s because there are several major downsides to doing so:

•   Early withdrawal penalty: If you’re under the age of 59½, you’ll generally have to pay a 10% early withdrawal penalty on the amount you take out. The amount you withdraw will also be considered taxable income, which means you could owe a hefty tax bill for that year.

•   Opportunity cost: By using your 401(k) money to pay off student loans, you are potentially losing out on an overall higher return from your investments. For example, if your loan has an interest rate of 6% and your 401(k) returns an average of 8% per year, you essentially lose 2% a year by liquidating those funds to pay off your loans.

•   Difficulty catching up: With your stunted 401(k) balance, you’ll need to make much larger contributions going forward to make up for it, which could strain your budget. Plus, there is a cap on the total amount you can contribute to a 401(k) each year. You may never be able to fully make up for the growth you would have experienced if that money stayed invested.

When deciding whether or not to withdraw money from your retirement savings, it’s important to note that while you borrow loans for other expenses in life, there’s no such thing as a “retirement loan.” You’re responsible for ensuring you have enough money to live on in retirement.

While it can feel like student loans are preventing you from living your life or meeting your financial goals today, saving for retirement can be a valuable investment in your future.


💡 Quick Tip: Get flexible terms and competitive rates when you refinance your student loan with SoFi.

Alternatives to Help Control Your Student Loan Debt

If you’re struggling with student loan payments, there are alternatives to taking money out of your 401(k) that can help you get your student loan debt under control while keeping your retirement savings intact. Here are a few examples:

Applying for Income-Driven Repayment

One option is applying for an income-driven repayment (IDR) plan. These plans reduce your payments to a small percentage of your discretionary income. The term length also gets extended out to 20 or 25 years, depending on the specific program. At the end of the repayment term, any remaining debt is forgiven. The exception is the newest plan, Saving on a Valuable Education (SAVE), which awards forgiveness for some borrowers with smaller balances within as few as 10 years.

Keep in mind that extending your repayment term usually means paying more in interest over the life of the loan. Any canceled IDR debt may also be taxed as income. Still, if your payments are far too high to afford on the Standard Repayment Plan, income-driven repayment could provide much-needed relief. In fact, if your income is below a certain threshold, you could qualify for $0 payments.

Pursuing Loan Forgiveness

There are also many programs that forgive student loans after you’ve worked in a qualifying profession and made a certain number of payments. On the national level, Public Service Loan Forgiveness (PSLF) is one example. If you work for a qualifying employer in the public service sector, such as the government or a non-profit, you can have your loans forgiven after 120 payments. Other similar programs include Teacher Loan Forgiveness and National Defense Student Loan Discharge.

In addition to federal forgiveness programs, there are also hundreds of programs offered through states, schools, and other organizations.

Refinancing Your Student Loans

When you refinance your student loans, you take out a brand new loan from a private lender, who will review your credit history and other financial factors to determine how much they will lend to you and at what rate. You then use those funds to pay off your existing loan(s).

With a solid financial picture and credit history, you could qualify for a lower interest rate. This could result in lower monthly payments, as well as reducing the amount of money you spend in interest over the life of the loan (depending on the loan term, of course).

You could also lower your monthly payments by extending the length of the loan term. This results in paying more money in interest over the life of the loan, but could help free up some cash flow more immediately.

It’s important to note that refinancing federal student loans with a private lender means you’ll permanently lose access to federal loan benefits including income-driven repayment plans, forbearance, and deferment.

To help you decide if refinancing is a good idea, take a look at SoFi’s student loan payoff calculator to see when you might pay off your current loans. Then compare that with a potential new loan—you may be surprised at how much of a difference refinancing can make. And with more wiggle room in your budget, you could make headway toward student loan repayment and save for a retirement you’ll be able to enjoy.

Take control of your student loans.
Ditch student loan debt for good.



💡 Quick Tip: When refinancing a student loan, you may shorten or extend the loan term. Shortening your loan term may result in higher monthly payments but significantly less total interest paid. A longer loan term typically results in lower monthly payments but more total interest paid.

Options for Using Your 401(k) to Pay Off Debt

If you decide to pursue using 401(k) funds to pay off student loans despite the many risks and drawbacks, there are a few ways to go about it. First, you’ll need to determine how much you are eligible to withdraw from your 401(k), and what penalties and taxes you would encounter. In most cases, you would be responsible for a 10% penalty and regular income taxes on a withdrawal from your 401(k) prior to age 59 ½.

There are a few exceptions to this rule. For instance, if you were laid off, you may be able to withdraw money penalty-free as long as certain requirements are met.

And depending on the exact terms of your 401(k) plan, you may be able to withdraw the money from your plan without penalty in certain hardship situations—like to cover tuition or medical expenses.

If you already attended college and are trying to use your 401(k) to pay back student loans, that doesn’t qualify for a hardship withdrawal. If you’re not sure what the exact rules of your plan entail, it’s worth contacting your HR representative or the financial firm that handles your company’s 401(k) program.

Again, using money from your 401(k) to pay off debt can be a risky proposition. While on the bright side it would potentially allow you to eliminate your student debt, it also puts your retirement savings at risk. You’ll not only potentially have to pay a penalty and taxes on the withdrawn amount, but you’ll also lose out on years of compounding returns on money you take out.

Still, depending on your circumstances, you might be considering cashing out your entire 401(k). Alternatively, however, you could borrow against your 401(k) by taking out a 401(k) loan. Here’s a bit more info about those two options.

Cashing Out Your 401(k)

Withdrawing money from your 401(k) can seem like a tempting idea when your student loan payments are causing you to stress at the moment and retirement feels like it’s ages away.

But making an early withdrawal comes with penalties. If you withdraw your money prior to the age of 59 ½ you’ll pay a 10% penalty on the amount you withdraw, in addition to regular income tax on the distribution itself. In addition to the taxes and the early withdrawal penalty, money that you withdraw loses valuable time to grow between now and retirement. That is why, as mentioned, simply withdrawing money from a 401(k) very rarely makes sense, when you consider the taxes, penalties, and lost growth.

To reinforce this point, let’s consider a (completely hypothetical) person who earns $68,000 per year and is a single filer, putting them in the 22% income tax bracket. (And remember, this is just an example – there are many other factors that can come into play, but this should give you a high-level glimpse into why withdrawing cash from your 401(k) might not be the best call.)

If this person cashed out $20,000 from their 401(k), they would have to pay a 10% penalty of $2,000 right off the top. Then they’d need to pay federal income taxes at the highest end of their bracket, totaling $4,400. So even though this person took out $20,000 from their account, they actually receive just $13,600. Depending on their state, they might also pay state income taxes, let’s not get bogged down on that right now.

Now let’s assume they used that money to pay off $13,600 in student loans, which have a 5% interest rate and five years left on the loan. In this scenario, they would save roughly $1,798.93 in interest.

So essentially, this person would have incurred $6,400 in penalties and taxes in order to save $1,798.93 in interest. Plus, had they let that money stay invested in their 401(k) over the next five years, that $20,000 could have grown to more than $28,000, assuming a 7% average return. That’s why cashing out a 401(k) to pay off student loan debt might not be a great idea.

Borrowing from Your 401(k)

When you borrow money from your own 401(k), you are really borrowing from yourself. You are accessing your retirement funds and then paying them back, with interest, in an attempt to replenish your savings. So these loans don’t require a formal application or credit check.

Not all companies offer 401(k) loans, so it’s important to check with your employer to confirm if the option is available to you. (And for the record, you can’t take out a loan from an employer-sponsored 401(k) if you’re no longer with that employer.)

In addition to the rules determined by your employer, the IRS sets limits on 401(k) loans as well. The current maximum loan amount as determined by the IRS is 50% of your vested balance
or $50,000, whichever is less. If you have a balance of less than $10,000, you may be able to borrow up to $10,000.

The IRS also requires that the money borrowed from your 401(k) be paid back within five years based on a payment plan that is established when you borrow the money. There is an exception; if you buy a house with the money you withdraw, you may be able to extend the repayment plan.

If you don’t pay the loan back according to the terms, it’s considered defaulted and the balance may be treated as a distribution instead. That means you’d owe penalties and taxes on that amount for that year.

Note that if you change jobs, your 401(k) plan will roll over, but not your loan. If you leave your employer with an unpaid 401(k) balance, you’ll face an accelerated payment plan.

Interest rates are usually set by your plan administrator, and are relatively low compared to other financing options. It could be a viable option for those interested in securing a lower interest rate for their debt, but don’t qualify for student loan refinancing due to their credit history or other factors.

A 401(k) loan typically offers a relatively low interest rate and doesn’t require a credit check.

You may want to crunch some numbers and compare the interest rates on your student loans with the interest rate on a 401(k) loan before you commit to this course of action.

If your student loan interest rate is lower than the potential interest rate on your 401(k) loan, it could make sense to keep your retirement savings intact.

The other factor to consider is the missed growth on the money you borrow from your 401(k), which is why 401(k) loans could make more sense for high-interest debt such as personal loans or credit cards, but are typically less ideal for low-interest debt such as student loans or mortgages.

Hardship Withdrawals

While a hardship withdrawal won’t be an option if you are looking to pay off your student loans, it could be worth considering if you are planning on attending graduate school or are assisting a family member with their college education.

To qualify for a hardship withdrawal, you must meet certain criteria. You must prove your need is immediate and heavy. Tuition for the school year usually qualifies as immediate.

Student loan repayment wouldn’t qualify because they provide a repayment plan over a set period of time. You must also prove the expense is heavy. Usually, that means things like college tuition, a down payment on a primary residence, or a qualifying medical expense that is 10% or more of your adjusted gross income.

Looking to lower your monthly student loan payment? Refinancing may be one way to do it — by extending your loan term, getting a lower interest rate than what you currently have, or both. (Please note that refinancing federal loans makes them ineligible for federal forgiveness and protections. Also, lengthening your loan term may mean paying more in interest over the life of the loan.) SoFi student loan refinancing offers flexible terms that fit your budget.


With SoFi, refinancing is fast, easy, and all online. We offer competitive fixed and variable rates.

SoFi Student Loan Refinance
SoFi Student Loans are originated by SoFi Bank, N.A. Member FDIC. NMLS #696891. (www.nmlsconsumeraccess.org). SoFi Student Loan Refinance Loans are private loans and do not have the same repayment options that the federal loan program offers, or may become available, such as Public Service Loan Forgiveness, Income-Based Repayment, Income-Contingent Repayment, PAYE or SAVE. Additional terms and conditions apply. Lowest rates reserved for the most creditworthy borrowers. For additional product-specific legal and licensing information, see SoFi.com/legal.


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SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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