Dec
28
2022
What Is Cash Settlement in Options?

What Is Cash Settlement in Options?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is Cash Settlement in Options?

Cash settlement in options is a method where the buyer of an option contract can exercise their right to receive the underlying asset, such as a stock or commodity, in the form of cash rather than the physical delivery of the asset. This means that instead of receiving the stock or commodity, the option holder will receive an amount of cash equal to the value of the underlying asset when the option is exercised.

Cash settlement may be used in options trading because it allows traders to speculate on the price movement of securities without actually having to own or hold the underlying assets. This can be particularly useful for traders looking to hedge their positions or who want to avoid the risks associated with holding the underlying assets.

What Is Cash settlement?

As noted above, cash settlement refers to a settlement method where the buyer of an option contract receives the cash difference between the strike price and the current market price of the underlying security. This is in contrast to the more traditional method of physical settlement, where the buyer of the option contract would receive the underlying security upon exercise.

When trading options, there are two primary methods for settling the contract: physical delivery and cash settlement. In physical delivery, the buyer of the option receives the underlying asset, such as a stock or commodity, when the option is exercised. Most listed equity options contracts are settled with the actual delivery of shares.

On the other hand, cash settlement allows the buyer of an option to receive the value of the underlying asset in the form of cash when the option is exercised. This means that the buyer does not receive the stock or commodity but receives an amount of cash equal to the value of the underlying asset when the option is exercised. Often, equity index and binary options are cash-settled.

💡 Recommended: Options Trading 101: An Introduction to Stock Options

How Does Cash Settlement Work?

The cash settlement process in options works like this:

When an options contract is exercised, the buyer has the right — but not always the obligation — to buy or sell the underlying security at the agreed-upon price (called the strike price). In a cash settlement, the buyer of the option is not required to purchase or sell the underlying security. Instead, they receive a cash payout based on the difference between the strike price and the current market price of the underlying security.

💡 Recommended: 10 Options Trading Strategies for Beginners

Example of Cash Settlement

Suppose an investor buys a call option on stock ABC with a strike price of $50. This means that the investor has the right to buy the stock at $50 per share at any time before the option expires if the stock’s price is above the strike price. If the stock’s market price rises above $50, the option becomes “in the money,” and the investor can exercise their right to buy the stock at $50, even if the market price is higher.

Suppose that, when the option expires, the stock’s market price is $55 per share. If the option is cash-settled, the investor can exercise their right to buy the stock at $50 per share and receive a cash payment of $5 per share (the difference between the strike price and the market price) multiplied by the number of options contracts that are exercised. This means the investor would receive a total cash payment of $500 (assuming they exercised a standard options contract of 100 shares).

Alternatively, if the stock’s market price is below $50 when the option expires, the option becomes “out of the money,” and the investor will not exercise their right to buy the stock. In this case, the option would expire worthless, and the investor would not receive any cash payment.

💡 Recommended: In the Money vs Out of the Money Options

Pros and Cons of Cash Settlement

Pros

 Cons
Improves liquidity across derivatives markets Prices have a risk of manipulation
Does not require cumbersome delivery coordination and costs in commodities markets or delivery of shares in options trading Only available on European-style options
Allows parties to hedge and speculate financially on products that cannot be physically delivered Commodities producers and consumers might prefer physical delivery when the product is needed for use

Advantages of Cash Settlement

There are several advantages to using cash settlement in options trading. First, it can be more convenient for the buyer, as they do not have to worry about physically receiving and storing the underlying asset. Cash settlement can be beneficial for traders who cannot hold the underlying asset, such as those who are trading options on futures contracts of commodities.

Another advantage of cash settlement is that it can be more cost-effective. Since the buyer does not have to take possession of the underlying asset, they do not have to pay any additional fees or expenses associated with holding an asset like gold, oil, wheat, or other commodities. This can help to reduce the overall cost of trading options and make them more accessible to a broader range of investors.

In addition to these advantages, cash settlement can provide greater flexibility for options traders. With physical delivery, the buyer must take possession of the underlying asset when the option is exercised, which can limit their ability to trade the asset in the future. With cash settlement, the buyer can use the funds received from the option to buy or sell the underlying asset in the market, allowing them to take advantage of changing market conditions.

Furthermore, cash settlement allows for a more efficient transaction in the overall derivatives markets — which includes options — adding to its liquidity.

Drawbacks of Cash Settlement

However, there are some drawbacks to cash settlement compared to physical settlement. For example, some investors may prefer the security and control that comes with physically owning and holding the underlying asset rather than receiving a cash payment. This is because cash can be more easily lost, stolen, or subject to inflation, whereas physical assets may provide a more tangible form of wealth. Also, physical settlement is not usually subject to manipulation by either party involved in the options contract because the activity is monitored by the broker and clearing exchange.

Other cash settlement drawbacks include that it is usually only available to European-style options, where the option holder can only exercise the contract at expiration rather than early like American-style options. Also, physical settlement may be preferred by traders who need the underlying asset for use.

Cash Settlement vs Physical Settlement

There are several important differences between cash settlement and physical settlement.

Definitional Differences

Cash settlement of options is a financial reconciliation. Physical settlement reconciles a contract with the underlying asset. A common physical delivery example is a commodity, but it can also be shares of an underlying financial asset such as stock.

Mode of Payment

Option cash settlement payments are made instantly by parties. It is a straightforward financial account transfer of the difference between the underlying asset’s spot price and the options contract or strike price.

Physical settlement’s mode of payment is a full payment of the underlying asset — the option contract’s underlying asset is physically delivered to the buyer.

Level of Liquidity

Liquidity is better in markets with a cash settlement option versus those with physical settlement only. More market traders — hedgers and speculators — can participate in cash-settled derivative markets since there can be lower capital requirements. Options traders also can engage in rolling options instead of exercising them.

Time Taken

Option cash settlement can be done with instantaneous financial transactions. Physical delivery involves potentially lengthy delivery times of an underlying commodity.

Level of Risk

Another upshot in markets with a cash settlement option is market risks are lower. Physical settlement often involves transfer certificates and other documents that could be susceptible to manipulation, loss, and theft.

Convenience

It is hard to argue with the convenience of cash settlement. Two parties square up using straightforward price differences rather than figuring out the logistics of the physical delivery of an asset. With equity index options, taking delivery of all the shares of a stock index can also be unwanted by the buyer. There can also be fewer fees with cash settlement, resulting in fewer trades.

Practicality, costs, and simplicity make cash settlement easier than physical settlement.

Practicality

Due to lower costs and quick payments, option cash settlement is more practical than physical settlement.

Costs Involved

Trades with cash settlements have low or even zero cost until settlement when the buyer and seller reconcile with a payment. With physical delivery, there are several costs, such as transportation costs, delivery expenses, and broker fees.

Simplicity

A final aspect that makes cash settlement advantageous versus physical settlement is the pure simplicity of cash settlement. Cash settlement is a netted payment from one party to the other.

Popularity

Cash Settlement

 Physical Settlement
Popular with retail traders who might not want to take large physical deliveries Popular with commodities firms that use the underlying asset
Popular with exchanges since more traders can transact, leading to more commissions and better liquidity Popular with large exchanges since a single exchange can become the primary exchange for a certain asset
Popular with large traders since they can quickly settle contracts with low cost Popular with listed stock options traders if they want to take delivery of shares

The Takeaway

Cash settlement in options trading may provide a convenient and cost-effective way for buyers of options contracts to exercise their rights to the underlying asset. By receiving the asset’s value in cash, traders can avoid the costs and complications associated with physical delivery while still maintaining the flexibility to trade the underlying asset in the market. However, investors should be aware that most equity options are not cash-settled but are settled with the delivery of underlying shares of stock.

If you’re ready to try your hand at options trading, SoFi can help. You can trade options from the SoFi mobile app or through the web platform. And if you have any questions come up along the way, SoFi offers educational resources about options to learn more.

Trade options with low fees through SoFi.

FAQ

What is the difference between a physical and cash settlement?

Cash settlement is a financial payment for the value of a stock or commodity underlying an options or futures contract when the holder exercises. Physical settlement entails the actual delivery of the underlying asset. In commodities markets, that means the commodity is delivered to the buyer. With equity options, physical delivery happens when the buyer receives shares of the underlying asset specified in the options contract.

Can you trade with unsettled cash?

Yes. You can use the proceeds from a sale to make another purchase in a cash account while your funds remain unsettled. Unsettled cash from a day trade cannot be used for another purchase until the settlement date

Which futures are cash settled?

According to the CME Group, equity indexes and interest rate futures are the most common cash-settled markets. Some precious metals and foreign exchange markets also settle in cash, along with agricultural products. In the options market, cash-settled options include digital options, binary options, and plain-vanilla index options.

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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.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Dec
28
2022
Organization of the Petroleum Exporting Countries (OPEC)

Organization of the Petroleum Exporting Countries (OPEC)

By | Growing Wealth, invest, Investing | Comments Off on Organization of the Petroleum Exporting Countries (OPEC)

OPEC is the Organization of the Petroleum Exporting Countries, an intergovernmental organization of 13 nations focused on coordinating and unifying the oil production policies of its member countries. The organization was founded in 1960 and is headquartered in Vienna, Austria.

OPEC’s primary goal is to regulate the supply of oil to stabilize the market and ensure that member countries receive an ideal price for their oil. To achieve this, the organization holds regular meetings where member countries discuss current market conditions and decide on production levels for each country. By controlling the oil supply, OPEC can influence the price of oil on the global market, which affects the global economy and, thus, investors.

What Is OPEC?

The Organization of the Petroleum Exporting Countries (OPEC) is a cartel of oil-producing countries founded in 1960 in Baghdad, Iraq. The founding members of OPEC were Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. Since then, the group has expanded to include 13 current member countries, including Nigeria, United Arab Emirates, and Libya.

As noted above, the main function of OPEC is to regulate the oil supply that its member countries produce to manage the price of the global oil market. The organization achieves this by setting production levels, conducting research, and promoting cooperation among member countries.

Despite its power, OPEC has faced criticism in recent years for its production policies. Some critics claim that OPEC’s decisions to limit oil production have led to higher oil prices that benefit member countries while harming the global economy and consumers. Others argue that the cartel’s power has diminished in recent years due to increased competition from non-OPEC countries such as the United States and Canada.

Which Countries Are Members of OPEC?

OPEC currently has 13 member countries. At its height, OPEC had 16 member countries, but Qatar, Ecuador, and Indonesia withdrew membership in recent years.

The current member countries of OPEC are:

•   Algeria

•   Angola

•   Condo

•   Equatorial Guinea

•   Gabon

•   Iran

•   Iraq

•   Kuwait

•   Libya

•   Nigeria

•   Saudi Arabia

•   United Arab Emirates

•   Venezuela

These countries are major producers and exporters of oil, and they play a significant role in the global oil market. Together, they account for about 80% of the world’s crude oil reserves and produce about 40% of the world’s oil. This makes OPEC a major player in the global energy market and allows it to wield significant power in setting the price of oil.

However, several large oil-producing countries that are not a part of OPEC, including:

•   The United States is the world’s largest oil producer and consumer.

•   Canada is the world’s fourth-largest oil producer.

•   China is the world’s fifth-largest oil producer and the second-largest oil-consuming country.

•   Brazil is the eighth-largest oil-producing country.

The decisions of oil producers in these countries may counteract OPEC policies.

OPEC vs OPEC Plus

OPEC Plus (commonly written as OPEC+) is an extension of OPEC that includes a number of non-OPEC countries that have significant oil industries. These countries have joined forces with OPEC in an effort to collectively manage the global oil market and stabilize oil prices. OPEC+ was formed in 2016 and currently includes Azerbaijan, Bahrain, Brunei, Equatorial Guinea, Kazakhstan, Russia, Mexico, Malaysia, Oman, South Sudan, and Sudan.

The main difference between OPEC and OPEC+ is that the latter is a broader group that includes both OPEC and non-OPEC countries, and was formed more recently in response to changing market conditions. Both groups have the same goal of regulating the supply of oil to stabilize the global oil market.

What Is the Purpose of OPEC?

The main purpose of OPEC is to coordinate and unify the oil, gas, and energy policies of its member countries. This is done to stabilize the international oil market and secure fair and stable prices for energy producers in the member countries. By working together, OPEC member countries can ensure that they are able to influence the supply of oil in the global market, which in turn can help to maintain stable prices.

Pros and Cons of OPEC

The pros of OPEC include:

•   Stabilizing the market: By regulating the supply of oil, OPEC can help to stabilize the global oil market and prevent prices from fluctuating wildly. This can provide a degree of predictability and reliability for both producers and consumers.

•   Ensuring fair prices: OPEC’s goal is to ensure that member countries receive fair prices for their oil. By controlling the supply of oil, the organization can influence the price of oil on the global market and help to ensure that member countries are not exploited by outside parties.

•   Providing economic benefits: The oil industry is a major source of revenue for many of the member countries of OPEC. By controlling the supply of oil, OPEC can help to maximize the economic benefits for its member countries.

The cons of OPEC include:

•   Harming the global economy: Critics argue that OPEC’s decisions to limit oil production can lead to higher oil prices, which can harm the global economy and consumers. High oil prices can lead to inflation and reduce the purchasing power of consumers, which can slow economic growth.

•   Diminishing power: Some argue that the power of OPEC has diminished in recent years as a result of increased competition from non-OPEC countries such as the United States and Canada. This has led to a more fragmented and complex global oil market, which has reduced OPEC’s ability to influence the price of oil.

•   Facilitating corruption: Because OPEC is a cartel of oil-producing countries, it has been criticized for facilitating corruption and non-transparent practices. This can lead to abuses of power and mismanagement of oil revenues, which can have negative consequences for both the member countries and the global market.

How Does OPEC Affect Oil Prices?

OPEC’s decisions about production levels can have a significant impact on the price of oil. If OPEC decides to reduce production levels, it can lead to a decrease in the global supply of oil, which can cause the price of oil to increase. On the other hand, if OPEC decides to raise production levels, it can increase the global supply of oil, which can cause the price of oil to decrease.

Therefore, OPEC’s decisions about production levels can significantly impact the price of oil on the global market, as well as global investments. By controlling the oil supply, the organization can influence the price of oil and help ensure that member countries receive fair prices for their oil.

However, OPEC’s influence on oil prices has arguably waned in recent years, largely because the United States has become the world’s largest producer and one of the largest exporters of oil. Because the U.S. has grown its oil-production market share, it has lessened the influence of OPEC on the markets.

OPEC is also facing challenges to its oil hegemony because of the rise of renewable energy sources, like solar energy, which may lessen the demand for oil in the future.

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Does OPEC Affect Investing in the Oil Sector?

The decisions made by the Organization of the Petroleum Exporting Countries (OPEC) may affect investors. Because OPEC members control a large portion of the world’s oil supply, its decisions about production levels can affect the global supply of oil and, ultimately, the price of oil on the market.

If OPEC decides to reduce production levels, it can lead to a decrease in the global supply of oil, which can cause the price of oil to increase. This can be beneficial for investors who have invested in energy stocks or oil-related assets, as they may see an increase in the value of their investments. However, higher oil prices could also harm the global economy, which may be a drag on an investor’s overall portfolio.

On the other hand, if OPEC decides to boost production levels, it can increase the global oil supply, which can cause the price of oil to decrease. This can be detrimental for investors who have invested in oil companies or oil-related assets, as they may see a decrease in the value of their investments.

Therefore, it is essential for investors to monitor OPEC’s decisions and how they may affect the global oil market. By understanding the organization and its role in the market, investors can make more informed decisions about their investments in the oil industry.

💡 Recommended: How and Why to Invest in Oil

The Takeaway

OPEC is a major player in the global oil market and economy. When the organization meets and makes production decisions, it can ultimately affect consumers at the gas pump and investors’ portfolios. Thus, staying up to speed with OPEC and its decisions can help you understand how the organization affects your wallet.

If you’re interested in investing in the energy sector, SoFi can help. With a SoFi Invest® online brokerage account, you can trade energy-related stocks and exchange-traded funds (ETF), along with IPOs and more, with no commissions for as little as $5. All you need to do is open an account.

Build your portfolio with SoFi Active Investing.

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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.

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Dec
15
2022
Guide to Leverage in Options Trading

Guide to Leverage in Options Trading

By | Growing Wealth, invest, Investing | Comments Off on Guide to Leverage in Options Trading

Options leverage is a core concept of options trading. For a given capital outlay, investing in options will increase your potential returns compared with investing in the underlying stock. However, options leverage works both ways by also increasing the potential losses.

Options leverage is inherent to options trading and allows you to use call or put options to earn the returns on a specific amount of stock (usually 100 shares per contract) with less money than purchasing the stock outright.

What Is Leverage?

Leverage applies to a variety of different financial products. The leverage example most familiar to people is the purchase of a home.

If you’re looking to buy a new home valued at $400,000, one approach would be to pay $400,000 upfront in cash. A more common approach would be to put 20% down ($80,000) and get a mortgage for the $320,000 balance.

Continuing with our house example, let’s say your house appreciates in value to $500,000. If you paid all cash, you get a return of $100,000 or 25% of your initial investment of $400,000. But through the use of a mortgage, you get the same return of $100,000 but on a lower initial investment of $80,000, a return of 125%.

Using a mortgage leverages your cash to potentially get higher returns.

How Leverage Works in Options Trading

Using options leverage works much the same way. No matter which strategies for trading options you use, you may increase the leverage of your investment by using options.

💡 Recommended: How to Trade Options

Example of Leverage in Options

For example; an investor wants to invest in stock ABC currently trading at $50 per share. There is also an at-the-money option with a strike price of $50 trading at $5. They can choose to buy 100 shares at $50 each for a capital outlay of $5,000. Or, using options leverage, they can purchase an options contract at $500 ($5 times 100 shares per option contract).

Some time later the ABC stock trades at $60 per share. If you purchased 100 shares, your shares would now be worth $6,000, an increase of $1,000 and a 20% return on your initial outlay of $5,000.

An investor in the options strategy could see their options triple in price to $15. The options contract would now be worth $1,500, also an increase of $1,000 but on the much smaller initial outlay of $500 for a return of 200%.

In addition, the options investor would still have the opportunity to invest the $4,500 from the original capital as they saw fit. That includes investing the additional capital in ABC stock, buying more ABC options, or pursuing other investments entirely.

Pros and Cons of Leverage in Options

Here are a few of the pros and cons of using leverage in options trading:

Pros

 Cons
Potentially higher percentage of return Risk of losing your entire investment
Options can allow you to hedge an existing position against unfavorable movement You can lose money if you are wrong on any one of the direction, timing or magnitude of the stock’s move, even if you are right on the other two
Flexibility to make money with a variety of different strategies Options typically have less liquidity than stocks

Calculating Leverage

The options leverage example above presents the options price movement from $5 to $15 without explaining what drove the price change. Generally, the price of an option is driven by asset volatility, time to expiration, and asset price. Those factors drive the delta Greek of an option which tells an investor how much the option price will change relative to a change in the underlying stock price.

One way to calculate the amount of leverage that you get with a particular option is to take the option’s delta value, multiply it by the stock’s price and divide it by the price of the option. This calculation is usually represented by the Greek letter lambda.

The Takeaway

Options can be a way to increase your returns, but with those higher potential returns comes higher potential risk. Before trading options, make sure you understand the risks and rewards of your position, and set up an exit plan.

If you’re ready to try your hand at options trading, SoFi can help. You can trade options from the SoFi mobile app or through the web platform. And if you have any questions come up along the way, SoFi offers educational resources about options to learn more.

Trade options with low fees through SoFi.

FAQ

How much leverage can you get with options?

In theory you can have nearly unlimited leverage with options, if you buy an option with a very low cost. However, the cheaper the option contract that you purchase, the higher the risk that it will expire worthless.

How is option leverage calculated?

To calculate the amount of leverage that you will get with a particular option contract, first determine the option’s delta value. Then multiply that by the stock’s price and divide it by the price of the option to get the leverage or lambda of the option.

Do call options use leverage?

Yes, using call options is one way to use leverage to invest in the stock market. When you buy a call option, you can control 100 shares of stock for a much lower price than purchasing those 100 shares outright.

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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.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
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New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.

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Green Bonds, Explained

Green Bonds, Explained

By | Growing Wealth, invest, Investing, Terminology | Comments Off on Green Bonds, Explained

Green bonds are debt instruments used to raise money for new and existing environmental and sustainability projects while providing investors with steady returns, similar to ordinary bonds. Green bonds may help fund climate change mitigation and adaptation, renewable energy, conservation, waste management, transportation, and more.

To qualify as actual green bonds, these investments have to be certified by a third party, like the Climate Bonds Standard and Certification Scheme. Green bonds may offer investors certain tax benefits versus other kinds of bonds.

What Is a Green Bond?

A green bond is a type of fixed-income security that pension funds or institutional investors can buy. Individual investors can add green bonds to their portfolio by purchasing ETFs or mutual funds that include green bonds. They are issued by corporations, governments, and financial institutions to raise money for specific sustainability and environmental projects. The World Bank is one of the largest green bond issuers.

A green bond is similar to other types of bonds, but the money borrowed through their sale goes towards vetted projects that fit into pre-determined frameworks to meet sustainability standards.

Most green bonds are asset-linked bonds or “use of proceeds” bonds, where the money raised from the sale of the bonds is earmarked for green projects and backed by the issuer’s balance sheet. For example, “use of proceeds” revenue bonds use the issuer’s revenue as collateral; green project bonds rely on the assets and balance sheet of the particular project as collateral; and green securitized bonds where a group of projects are collateral.

Green Bonds vs Climate Bonds vs Blue Bonds

Green bonds can be structured in different ways and generally fall into the category of impact investing.

•   For example, the term green bond can cover a broad spectrum of projects, from renewable energy to waste management to climate change.

•   There are also climate bonds that put money specifically towards climate change projects such as reducing emissions or adapting infrastructure to changing climate conditions.

•   Blue bonds specifically fund water-related projects, such as cleaning up plastic from the oceans, marine ecosystem restoration and conservation, sustainable fisheries, and wastewater treatment projects.

How Do Green Bonds Work?

Green bonds work much the same as other types of bonds. They’re issued by an entity and pay a certain interest rate, with the main difference being that institutional investors are usually buying the bonds, not retail investors.

Who Issues Green Bonds?

When a company, government, or financial institution wants to raise money for a sustainability project, they might choose to issue green bonds, which can be purchased by individual or institutional investors. Generally green bond issuers are large municipalities or public corporations, because a strong credit rating provides the issuer with a better borrowing rate.

The difference between investing in a green bond and buying a traditional bond is the issuer publicly discloses their plans for how the money will be spent. Uses of the money must be considered ‘green’ for it to be marketed as a green bond. The issuer generally releases a pre-issuance report describing the projects the funds will be used for and their expected impact.

Certifying Green Bonds

Issuers don’t have to follow specific requirements to call their bond green, but many follow voluntary frameworks such as the Climate Bonds Standard (CBS) or the Green Bond Principals (BGPs). By following those frameworks the bond will have a higher rating and investors will be more likely to buy it.

The guidelines outline the types of projects funds are recommended to be used for, how to select green projects, and how to report on the use of funds and results of the bond issuance.

Third-party firms work with the issuer as underwriters, certifiers, and auditors to ensure the money is going towards quality projects and used in the ways the borrower claimed it would be.

The Importance of Pre-Issuance Reports

Many issuers also work with third parties to prepare pre-issuance reports. Those parties help validate the quality of the bond to the extent the issuer chooses. There are four levels of validation a third-party can provide:

1.    An external opinion about the quality of the bond

2.    Verification that the bond aligns with certain environmental and business goals and criteria

3.    Certification with a particular standard such as CBS or BGPs

4.    A bond rating or score

If an issuer plans to issue multiple bonds, they might develop their own green bond framework to outline their particular criteria, goals, and impact. Issuers can either sell directly to investors or go through an exchange that works with green bonds, like the Luxembourg Stock Exchange (LuxSE).

Since the process of creating and tracking a green bond is costly and time consuming, they tend to be issued for large-scale projects.

Once the bond is issued and money raised, the issuer puts the money towards the projects stated in the pre-issuance report. The project could either be directly funded and internally run, or the money could go towards a service company like an energy provider.

The green bond issuer then puts out regular public post-issuance reports to investors, usually on an annual basis. The reports describe the way money has been used, progress, and results of the projects.

Green Bond Principles

In 2014, a group of investment banks established four “Green Bond Principles” to help investors understand green bonds. The principles are:

1.    Use of Proceeds: How money is spent and what types of projects are included

2.    Process for Project Evaluation and Selection: How projects are chosen and vetted

3.    Management of Proceeds: How the money raised by the bond is managed

4.    Reporting: How project progress and impact is shared

Issuers

Issuers of green bonds can include federal, state or city governments, financial institutions, or corporations.

Some reasons a company, government, or financial institution might issue a green bond include:

•   The desire to promote one’s sustainability efforts and image

•   Attracting new investors looking specifically for ESG investment products

•   There can be tax benefits and incentives for issuing green bonds

•   Issuing green bonds can be a good way to raise low-cost capital

•   The issuer is looking to raise millions of dollars or more for particular sustainability projects

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Examples of Green Bonds

One example of a green bond is the World Bank Green Bond, which was developed in collaboration with Skandinaviska Enskilda Banken (SEB) and launched in 2008. SEB and the World Bank saw that there was a demand for a triple-A-rated fixed income product that supports climate change projects, so they developed the World Bank Green Bond in response.

Sale of the bonds raises money from investors looking for a fixed-income asset, and the money goes towards projects vetted by the World Bank that focus on mitigating and adapting to climate change.

Around $18 billion in World Bank Green Bonds have been issued since 2008. There have been 200 different bonds available in 25 currencies. Investors who buy the bonds can both earn a fixed amount and know that their money is going towards climate change mitigation and adaptation projects.

Other green bonds that have been issued by corporations include:

•   Goldman Sachs Renewable Power issued a 24-year, $500 million bond, certified by Sustainalytics, to use for solar energy projects

•   PNC Financial Services Group issued a 5-year, $650 million bond, using an internal green bond framework, to use for energy projects

•   Verizon Communications Inc. issued a 10-year, $1 billion bond to use for energy generation and storage, buildings, and land use projects

When Did Green Bonds Start?

In 2008, the first green bond was issued by the World Bank and European Investment Bank (EIB). The bond was rated AAA. After that it took a few years for green bonds to take off, but since 2014 the market has grown significantly each year.

In 2013, the first USD 1 billion green bond issued by IFC sold out within just one hour after issuance. The first green bond issued by a corporation was issued in 2013 by Vasakronan.

Also in 2013, the first green muni bond was issued by Massachusetts, the first Green City bond was issued by Gothenburg, and the first solar asset-backed securities (ABS) were issued by SolarCity (now Tesla).

The Growth of the Green Bond Market

Over $1 trillion in green bond issuance has been put on the market since the first green bonds were issued in 2007.

Over the past 15 years, the green bond market has grown exponentially. In 2019, $51.3 billion in green bonds was issued in the U.S., and $257.7 billion in bonds was issued worldwide.

The largest green bond issuer is government-backed mortgage firm Fannie Mae in the United States. They issue 9% of the world’s green bonds. Green bonds have been issued by city governments and large corporations including Verizon, Pepsi, and Apple.

Although the U.S. currently has the biggest green bond market, it is projected to be overtaken by the EU in coming years. Between European companies and governments, about $300 billion has been allocated to green bond issuances over the next five years.

Investing In Green Bonds

Interest in sustainability, ESG, renewable energy, and climate change has increased significantly in recent years and is projected to keep growing. As investor interest grows, more and more green bonds are being made available with better disclosure and transparency to give investors peace of mind about the quality of the asset.

Investing in green bonds can be a good way for investors to put their money where their values are. Like other kinds of sustainable investing, ESG investing, or impact investing, green bonds are a way to both make money and make a positive difference in the world

While individuals can’t usually purchase green bonds directly, they can add them to their portfolio by purchasing certain ETFs and mutual funds.

Are Green Bonds a Good Investment?

Like other types of bonds, green bonds can be a relatively safe investment that provides fixed income without a high risk of loss. Bonds don’t tend to pay out high interest rates, but are less risky than other types of investments.

One risk of investing in green bonds is the phenomenon of greenwashing, where an issuer markets a bond as green but it doesn’t actually result in as much positive impact as advertised. A few questions an investor can explore to choose the best green bonds are:

•   Why is the bond being marketed as green?

•   What is the definition of green being used?

•   Is the issuer using a standard such as CBS and working with a third-party certifier?

•   Does the bond have an independent rating?

•   How will the use of funds and impacts be disclosed to investors?

•   Has the issuer issued green bonds in the past and what were the results and reporting standards?

Benefits Of Green Bonds

The main benefit of green bonds is they are designed help support sustainability projects (companies, new technologies) that support people and ecosystems around the world. Market demand is growing for green bonds, and they can be a good way to earn stable, low-risk interest.

Another benefit of green bonds is they can come with tax exemptions and tax credits, so investors might not have to pay income tax on the interest earned from the bond.

The Takeaway

Green bonds are an increasingly popular type of investment product that aim to help make the world a more sustainable place. When a company, government, or financial institution wants to raise money for a sustainability project, they might choose to issue green bonds.

Though green bonds work similar to other types of bonds, in that they’re a form of debt issued by an entity and pay a certain interest rate, the main difference is that institutional investors typically purchase the bonds, not retail investors.

Generally green bond issuers are large municipalities or public corporations, because a strong credit rating provides the issuer with a better borrowing rate.

Investors interested in adding green bonds to their portfolio can purchase ETFs and mutual funds that include green bonds. If you are interested in investing in green bonds through the purchase of fund shares, consider using SoFi Invest®. You can set up an Active Invest account seamlessly and security. The online investing platform lets you research and buy ETFs, stocks, and other assets right from your phone. All you need is a few dollars to get started with sustainable investing.

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

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