Weighted average rating factor calculates and communicates the overall risk of an investment portfolio, commonly used in collateralized debt obligations. It assigns a risk factor to each asset and averages them using weighting to match their proportions in the portfolio. The final figure varies depending on the rating system used.
A weighted average rating factor is a method of calculating and communicating the overall risk of an investment portfolio. It is most commonly associated with collateralized debt obligations. The weighted average rating factor takes into account each individual asset in the portfolio, but gives emphasis based on the relative proportion of the portfolio made up of each asset.
The primary use of a weighted average rating factor is with collateralized debt obligations. These are financial products where the rights to the proceeds of multiple loans and credit offers have been purchased and packaged together. Investors then buy bonds in the CDO, with repayments and interest on the bonds ultimately coming from the proceeds of the original loans. There are two main benefits to this system: tying multiple loans together limits the damage caused by a single borrower defaulting; and the bonds can be issued in such a way that investors can choose a particular balance between earning a higher interest rate or having a claim of priority in the event that defaults mean there is not enough money to pay all bondholders .
With so many loans bundled together, it can be difficult to assess the overall default risk of a particular CDO and its range of bonds. The Weighted Average Rating Factor is a relatively simple way to accomplish this. It involves first assigning a risk factor to each individual asset: in effect, an attempt to predict the statistical probability of default of the relevant borrower.
These risk factor numbers are averaged using weighting. This means adjusting the figures to match the proportions that each asset contributes to the overall portfolio. As an extremely simplified example, if 60% of the portfolio is made up of income from Mortgage A and 40% is made up of income from Mortgage B, then the overall risk factor is simply the risk factor of Mortgage A times times 0.4, plus the risk factor for mortgage B multiplied by 0.6.
What exactly the final weighted average rating factor figure represents can vary depending on who produces the ratings. One system, operated by the ratings agency Moody’s, uses ratings where a score of 100 represents a 1% probability of default over 10 years, a score of 150 represents a 1.5% probability, and so on. Investors should check carefully to see exactly which system is being used, particularly when comparing investment options from different providers.
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