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A weighted average rating factor is a method of calculating and communicating the overall risk of a portfolio of investments. 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 by each asset.
The main use of a weighted average rating factor is with collateralized debt obligations. These are financial products where the rights to income from multiple loans and credit deals have been bought up and packaged together. Investors then buy bonds in the CDO, with the repayments and interest from the bonds ultimately coming from the income from 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 a way such that investors can choose a particular balance between getting a higher rate of interest or having a priority claim in the event that defaults mean there isn't enough money to pay all bondholders.
With so many loans packaged together, it can be difficult to assess the overall risk of default on a particular CDO and its range of bonds. The weighted average rating factor is a relatively simple way of achieving this. It involves first assigning a risk factor to each individual asset: in effect, an attempt to predict the statistical likelihood of the relevant borrower defaulting.
These risk factor figures are then averaged using weighting. This means adjusting the figures to match the proportions 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 multiplied by 0.4, plus the risk factor of mortgage B multiplied by 0.6.
Exactly what the final weighted average rating factor figure represents may vary depending on who produces the ratings. One system, operated by ratings agency Moody's, uses ratings by which a score of 100 represents a 1% chance of default during 10 years, a score of 150 represents a 1.5% chance, and so on. Investors should check carefully to see exactly what system is being used, particularly when comparing investment options from different providers.
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