Monday, November 25, 2013

Financial Terminology

Some of the financial terms you may encounter:

Basis point One hundred basis points make up a percentage point, so an interest rate cut of 25 basis points might take the rate, for example, from 3% to 2.75%.

Bear market In a bear market, prices are falling and investors, fearing losses, tend to sell. This can create a self-sustaining downward spiral. vs
Bull market A bull market is one in which prices are generally rising and investor confidence is high.

Bill A debt security- or more simply an IOU. It is very similar to a bond, but has a maturity of less than one year when first issued.

Bond A debt security, or more simply, an IOU. The bond states when a loan must be repaid and what interest the borrower (issuer) must pay to the holder. They can be issued by companies, banks or governments to raise money. Banks and investors buy and trade bonds.  

Capital For investors, it refers to their stock of wealth, which can be put to work in order to earn income. For companies, it typically refers to sources of financing such as newly issued shares.

For Banks, it refers to their ability to absorb losses in their accounts. Banks normally obtain capital either by issuing new shares, or by keeping hold of profits instead of paying them out as dividends. If a bank writes off a loss on one of its assets - for example, if it makes a loan that is not repaid - then the bank must also write off a corresponding amount of its capital. If a bank runs out of capital, then it is insolvent, meaning it does not have enough assets to repay its debts.

Capital adequacy ratio A measure of a bank's ability to absorb losses. It is defined as the value of its capital divided by the value of risk-weighted assets (ie taking into account how risky they are). A low capital adequacy ratio suggests that a bank has a limited ability to absorb losses, given the amount and the riskiness of the loans it has made.
A banking regulator - typically the central bank - sets a minimum capital adequacy ratio for the banks in each country, and an international minimum standard is set by the BIS. A bank that fails to meet this minimum standard must be recapitalised, for example by issuing new shares.

Carry trade Typically, the borrowing of currency with a low interest rate, converting it into currency with a high interest rate and then lending it. The most common carry trade currency used to be the yen, with traders seeking to benefit from Japan's low interest rates. Now the dollar, euro and pound can also serve the same purpose. The element of risk is in the fluctuations in the currency market.

Collateralised debt obligations (CDOs) A financial structure that groups individual loans, bonds or other assets in a portfolio, which can then be traded. In theory, CDOs attract a stronger credit rating than individual assets due to the risk being more diversified. But as the performance of many assets fell during the financial crisis, the value of many CDOs was also reduced.

Commercial paper Unsecured, short-term loans taken out by companies. The funds are typically used for working capital, rather than fixed assets such as a new building. The loans take the form of IOUs that can be bought and traded by banks and investors, similar to bonds.

Commodities Commodities are products that, in their basic form, are all the same so it makes little difference from whom you buy them. That means that they can have a common market price. You would be unlikely to pay more for iron ore just because it came from a particular mine, for example.
Contracts to buy and sell commodities usually specify minimum common standards, such as the form and purity of the product, and where and when it must be delivered.
The commodities markets range from soft commodities such as sugar, cotton and pork bellies to industrial metals such as iron and zinc.

Core inflation A measure of CPI inflation that strips out more volatile items (typically food and energy prices). The core inflation rate is watched closely by central bankers, as it tends to give a clearer indication of long-term inflation trends.

CPI The Consumer Prices Index is a measure of the price of a bundle of goods and services from across the economy. It is the most common measure used to identify inflation in a country. CPI is used as the target measure of inflation by the Reserve Bank.

Credit default swap (CDS) A financial contract that provides insurance-like protection against the risk of a third-party borrower defaulting on its debts. For example, a bank that has made a loan to Greece may choose to hedge the loan by buying CDS protection on Greece. The bank makes periodic payments to the CDS seller. If Greece defaultson its debts, the CDS seller must buy the loans from the bank at their full face value. CDSs are not just used for hedging - they are used by investors to speculate on whether a borrower such as Greece will default.

Deficit The amount by which spending exceeds income over the course of a year.
In the case of trade, it refers to exports minus imports. In the case of the government budget, it equals the amount the government needs to borrow during the year to fund its spending. The government's "primary" deficit means the amount it needs to borrow to cover general government expenditure, excluding interest payments on debts. The primary deficit therefore indicates whether a government will run out of cash if it is no longer able to borrow and decides to stop repaying its debts.

Deleveraging A process whereby borrowers reduce their debt loads. Primarily this occurs by repaying debts. It can also occur by bankruptcies and debt defaults, or by the borrowers increasing their incomes, meaning that their existing debt loads become more manageable. Western economies are experiencing widespread deleveraging, a process associated with weak economic growth that is expected to last years. Households are deleveraging by repaying mortgage and credit card debts. Banks are deleveraging by cutting back on lending. Governments are also beginning to deleverage via austerity programmes - cutting spending and increasing taxation.

Derivative A financial contract which provides a way of investing in a particular product without having to own it directly. For example, a stock market futures contract allows investors to make bets on the value of a stock market index such as the FTSE 100 without having to buy or sell any shares. The value of a derivative can depend on anything from the price of coffee to interest rates or what the weather is like. Credit derivatives such as credit default swaps depend on the ability of a borrower to repay its debts. Derivatives allow investors and banks to hedge their risks, or to speculate on markets. Futures, forwards, swaps and options are all types of derivatives.

 Futures A futures contract is an agreement to buy or sell a commodity at a predetermined date and price. It could be used to hedge or to speculate on the price of the commodity. Futures contracts are a type of derivative, and are traded on an exchange. 

GDP Gross domestic product. A measure of economic activity in a country, namely of all the services and goods produced in a year. 
  • Output measure: This is the value of the goods and services produced by all sectors of the economy; agriculture, manufacturing, energy, construction, the service sector and government
  • Expenditure measure: This is the value of the goods and services purchased by households and by government, investment in machinery and buildings. It also includes the value of exports minus imports
  • Income measure: The value of the income generated mostly in terms of profits and wages.
Hedge fund A private investment fund which uses a range of sophisticated strategies to maximise returns including hedging, leveraging and derivatives trading. Around the world mainly deregulated.

Hedging Making an investment to reduce the risk of price fluctuations to the value of an asset. Airlines often hedge against rising oil prices by agreeing in advance to to buy their fuel at a set price. In this case, a rise in price would not harm them - but nor would they benefit from any falls.

 Junk bond A bond with a credit rating of BB+ or lower. These debts are considered very risky by the ratings agencies. Typically the bonds are traded in markets at a price that offers a very high yield(return to investors) as compensation for the higher risk of default.

Keynesian economics The economic theories of John Maynard Keynes. In modern political parlance, the belief that the state can directly stimulate demand in a stagnating economy, for instance, by borrowing money to spend on public works projects such as roads, schools and hospitals.

Leverage Leverage, or gearing, means using debt to supplement investment. The more you borrow on top of the funds (or equity) you already have, the more highly leveraged you are. Leverage can increase both gains and losses. Deleveraging means reducing the amount you are borrowing.

Liquidity How easy something is to convert into cash. Your current account, for example, is more liquid than your house. If you needed to sell your house quickly to pay bills you would have to drop the price substantially to get a sale.

Liquidity crisis A situation in which it suddenly becomes much more difficult for banks to obtain cash due to a general loss of confidence in the financial system. Investors (and, in the case of a bank run, even ordinary depositors) may withdraw their cash from banks, while banks may stop lending to each other, if they fear that some banks could go bust. Because most of a bank's money is tied up in loans, even a healthy bank can run out of cash and collapse in a liquidity crisis. Central banks usually respond to a liquidity crisis by acting as "lender of last resort" and providing emergency cash loans to the banks.

Liquidity trap A situation described by economist John Maynard Keynes in which nervousness about the economy leads everybody to cut back on their spending and to hold cash, even if the cash earns no interest. The widespread fall in spending undermines the economy, which in turn makes households, banks and companies even more nervous about spending and investing their money. The problem becomes particularly intractable when - as in Japan over the last 20 years - the weak spending leads to falling prices, which creates a stronger incentive for people to hold onto their cash, and also makes debts more difficult to repay. In a liquidity trap, monetary policy can become useless, and Keynes said that the onus is on governments to increase their spending

Loans-to-deposit ratio For financial institutions, the sum of their loans divided by the sum of their deposits. It is used as a way of measuring a bank's vulnerability to the loss of confidence in a liquidity crisis. Deposits are typically guaranteed by the bank's government and are therefore considered a safer source of funding for the bank. Before the 2008 financial crisis, many banks became reliant on other sources of funding - meaning they had very high loan-to-deposit ratios. When these other sources of funding suddenly evaporated, the banks were left critically short of cash.

Monoline insurance Monolines were set up in the 1970s to insure against the risk that a bondwill default. Companies and public institutions issue bonds to raise money. If they pay a fee to a monoline to insure their debt, the guarantee helps to raise the credit rating of the bond, which in turn means the borrower can raise the money more cheaply.

Mortgage-backed securities (MBS) Banks repackage debts from a number of mortgages into MBS, which can be bought and traded by investors. By selling off their mortgages in the form of MBS, it frees the banks up to lend to more homeowners.

Naked short selling A version of short selling, illegal or restricted in some jurisdictions, where the trader does not first establish that he is able to borrow the relevant asset before selling it on. The aim with short selling is to buy back the asset at a lower price than you sold it for, pocketing the difference.

Negative equity Refers to a situation in which the value of your house is less than the amount of the mortgage that still has to be paid off.

Options A type of derivative that gives an investor the right to buy (or to sell) something - anything from a share to a barrel of oil - at an agreed price and at an agreed time in the future. Options become much more valuable when markets are volatile, as they can be an insurance against price swings.

Ponzi scheme Similar to a pyramid scheme, an enterprise where funds from new investors - instead of genuine profits - are used to pay high returns to current investors. Named after the Italian fraudster Charles Ponzi, such schemes are destined to collapse as soon as new investment tails off or significant numbers of investors simultaneously wish to withdraw funds.

Preference shares A class of shares that usually do not offer voting rights, but do offer a superior type of dividend, paid ahead of dividends to ordinary shareholders. Preference shareholders often also have somewhat better protection when a company is liquidated.

Prime rate A term used primarily in North America to describe the standard lending rate of banks to most customers. The prime rate is usually the same across all banks, and higher rates are often described as "x percentage points above prime".

 Quantitative easing Central banks increase the supply of money by "printing" more. In practice, this may mean purchasing government bonds or other categories of assets, using the new money. Rather than physically printing more notes, the new money is typically issued in the form of a deposit at the central bank. The idea is to add more money into the system, which depresses the value of the currency, and to push up the value of the assets being bought and to lower longer-term interest rates, which encourages more borrowing and investment. Some economists fear that quantitative easing can lead to very high inflation in the long term.

Rating The assessment given to debts and borrowers by a ratings agency according to their safety from an investment standpoint - based on their creditworthiness, or the ability of the company or government that is borrowing to repay. Ratings range from AAA, the safest, down to D, a company that has already defaulted. Ratings of BBB- or higher are considered "investment grade". Below that level, they are considered "speculative grade" or more colloquially as junk.

Recession A period of negative economic growth. In most parts of the world a recession is technically defined as two consecutive quarters of negative growth - when economic output falls. In the United States, a larger number of factors are taken into account, such as job creation and manufacturing activity. However, this means that a US recession can usually only be defined when it is already over.

Reserve currency A currency that is widely held by foreign central banks around the world in their reserves. The US dollar is the pre-eminent reserve currency, but the euro, pound, yen and Swiss franc are also popular.

Securities lending When one broker or dealer lends a security (such as a bond or a share) to another for a fee. This is the process that allows short selling.

Securitisation Turning something into a security. For example, taking the debt from a number of mortgages and combining them to make a financial product, which can then be traded (see mortgage backed securities). Investors who buy these securities receive income when the original home-buyers make their mortgage payments.

Security A contract that can be assigned a value and traded. It could be a share, a bond or a mortgage-backed security.
Separately, the term "security" is also used to mean something that is pledged by a borrower when taking out a loan. For example, mortgages in the UK are usually secured on the borrower's home. This means that if the borrower cannot repay, the lender can seize the security - the home - and sell it in order to help repay the outstanding debt.

Shadow banking A global financial system - including investment banks, securitisation, SPVs, CDOs and monoline insurers - that provides a similar borrowing-and-lending function to banks, but is not regulated like banks. Prior to the financial crisis, the shadow banking system had grown to play as big a role as the banks in providing loans. However, much of shadow banking system collapsed during the credit crunch that began in 2007, and in the 2008 financial crisis.

Short selling A technique used by investors who think the price of an asset, such as shares or oil contracts, will fall. They borrow the asset from another investor and then sell it in the relevant market. The aim is to buy back the asset at a lower price and return it to its owner, pocketing the difference. Also known as shorting.

SPV A Special Purpose Vehicle (also Special Purpose Entity or Company) is a company created by a bank or investment bank solely for the purpose of owning a particular set of loans or other investments, and distributing the risk to investors. Before the financial crisis, SPVs were regularly used by banks to offload loans that they owned, freeing the banks up to lend more. SPVs were a major part of the shadow banking system, and were used in securitisation and CDOs.

Stimulus Monetary policy or fiscal policy aimed at encouraging higher growth and/or inflation. This can include interest rate cuts, quantitative easing, tax cuts and spending increases.

Sub-prime mortgages These carry a higher risk to the lender (and therefore tend to be at higher interest rates) because they are offered to people who have had financial problems or who have low or unpredictable incomes.

Swap A derivative that involves an exchange of cash flows between two parties. For example, a bank may swap out of a fixed long-term interest rate into a variable short-term interest rate, or a company may swap a flow of income out of a foreign currency into their own currency.

Tobin Tax A 0.5% tax on financial transactions, originally proposed in 1972 by economist James Tobin as a levy on share, bond and currency conversions. The tax is intended to discourage currency market speculators by making their marginal activities uneconomic, and in this way, to increase stability in financial markets. 
More recently it has been formally proposed by the European Commission, with some suggesting the revenue could be used to tackle the financial crisis. It is opposed by the US & UK governments, which argues that to be effective, the tax would need to be applied globally - not just in the EU - as most financial activities could quite easily be relocated to another country in order to avoid the tax, and that examples of the model have failed ( eg: Sweden 1984 ) however Hong Kong, Mumbai, Seoul, Johannesburg and Tapei all have current Tobin Tax-like levies.

Yield The return to an investor from buying a bond implied by the bond's current market price. It also indicates the current cost of borrowing in the market for the bond issuer. As a bond's market price falls, its yield goes up, and vice versa. Yields can increase for a number of reasons. Yields for all bonds in a particular currency will rise if markets think that the central bank in that currency will raise short-term interest rates due to stronger growth or higher inflation. Yields for a particular borrower's bonds will rise if markets think there is a greater risk that the borrower will default.

Definitions - BBC News Financial Glossary 13 October 2011

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