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 secured debt obligations. The weighted average rating factor takes into account each individual asset in the portfolio, but emphasizes it based on the relative proportion of the portfolio comprised of each asset.
The primary use of a weighted average rating factor is with secured debt obligations. These are financial products in which rights to income from various loans and credit offers have been acquired and pooled. Investors then buy bonds at the CDO, with repayments and interest on the bonds coming from the original loan proceeds. There are two main benefits to this system: tying multiple loans limits the damage done by a single borrower defaulting; and bonds can be issued in such a way that investors can choose a specific balance between getting a higher interest rate or having a priority claim in the event that a default means there is not enough cash to pay all bondholders.
With so many loans bundled together, it can be difficult to assess the overall default risk of a specific CDO and its range of securities. The weighted average rating factor is a relatively simple way to do this. It involves first assigning a risk factor to each individual asset: in effect, an attempt to predict the statistical probability of default for the relevant borrower.
These risk factor numbers are calculated using weighting. This means adjusting the numbers 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 multiplied by 0.4, plus mortgage risk factor B multiplied by 0.6.
Exactly what the final weighted average rating factor value represents can vary depending on who produces the ratings. One system, operated by ratings agency Moodys, uses ratings where a score of 100 represents a 1% chance of default in 10 years, a score of 150 represents a 1.5% chance of default, and so on. Investors should carefully check to see exactly which system is being used, particularly when comparing investment options from different providers.