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A plain man’s glossary of finance market terms

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Thursday, 23 October 2008 21:34 by Ad astra

To understand what parliamentarians are talking about in Question Time on the current financial upheaval, what the finance experts are saying in the business media, or even what the news bulletins mean, a working knowledge of financial terms is handy.  So this a compilation of terms that until now have not had much airplay, but now are in common use on TV, radio, in the newspapers and online.  It is of necessity incomplete; there are literally thousands of terms that adorn the world of finance.  As it is assumed the meaning of words in common usage, such as ‘mortgage’, ‘interest’, ‘asset’ and ‘term’ is well known, they are not included here.

Acknowledgement is made of the value of Investopedia http://www.investopedia.com and Wikipedia in compiling this small lexicon.  For any terms not included here, go to Investopedia and use the search function.

If you feel this glossary is incomplete and that an additional widely-used term would enhance it, or that reordering of the terms would be desirable, please indicate via the Comments facility.

Shares and stock - In financial markets, a share is a unit of account for various financial instruments including stocks, mutual funds, limited partnerships, and Real Estate Investment Trusts. In British English, use of the word ‘shares’ in the plural to refer to stock is so common that it almost replaces the word ‘stock’ itself. In American English, the plural ‘stocks’ is widely used instead of shares, in other words to refer to the stock (or perhaps originally stock certificates) of even a single company. Traditionalist demands that the plural stocks be used only when referring to stock of more than one company are rarely heard nowadays.

The income received from shares is called a dividend, and a person owning shares is called a shareholder.

Stock option -  A privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date.  In the U.K., it is known as a "share option".  American options can be exercised anytime between the date of purchase and the expiration date. European options may only be redeemed at the expiration date. Most exchange-traded stock options are American.

Security - A security is a negotiable instrument representing financial value. Securities are broadly categorized into debt securities (such as bank notes, bonds and debentures), and equity securities, e.g., common stocks.  Securities may be represented by a certificate or, more typically, by an electronic book entry.

Derivative – A derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.   Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Derivatives are generally used to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using American dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into euros. 

Debenture -  A type of debt instrument that is not secured by physical asset or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of bond in order to secure capital. Like other types of bonds, debentures are documented in an indenture. 

Debentures have no collateral. Bond buyers generally purchase debentures based on the belief that the bond issuer is unlikely to default on the repayment. An example of a government debenture would be any government-issued Treasury bond (T-bond) or Treasury bill (T-bill). T-bonds and T-bills are generally considered risk free because governments, at worst, can print off more money or raise taxes to pay these type of debts.

Bond - A bond is a debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity.  A bond is simply a loan in the form of a security with different terminology: The issuer is equivalent to the borrower, the bond holder to the lender, and the coupon to the interest. Bonds enable the issuer to finance long-term investments with external funds. Note that certificates of deposit (CDs) or commercial paper are considered to be money market instruments and not bonds.  Bonds and stocks are both securities, but the major difference between the two is that stock-holders are the owners of the company (i.e., they have an equity stake), whereas bond-holders are lenders to the issuing company. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely.

Deposit-taking institutions – Banks, building societies, credit unions and other organisations which accept customers' funds, either at call or for fixed periods, and pay interest on the amounts are deposit-taking institutions.  They are identified with 'savings' and differ in purpose from investment institutions which actively manage their customers' funds in the pursuit of profits, or from corporations which 'borrow' money from the public by issuing debentures or bonds.

Government guarantee -  Is where government announces that it would guarantee all bank and other lender deposits.

Commodity

 1. A basic good used in commerce that is interchangeable with other commodities of the same type. Commodities are most often used as inputs in the production of other goods or services. The quality of a given commodity may differ slightly, but it is essentially uniform across producers. When they are traded on an exchange, commodities must also meet specified minimum standards, also known as a basis grade.

2. Any good exchanged during commerce, which includes goods traded on a commodity exchange. 

The basic idea is that there is little differentiation between a commodity coming from one producer and the same commodity from another producer - a barrel of oil is basically the same product, regardless of the producer. Compare this to, say, electronics, where the quality and features of a given product will be completely different depending on the producer. Some traditional examples of commodities include grains, gold, beef, oil and natural gas. More recently, the definition has expanded to include financial products such as foreign currencies and indexes. Technological advances have also led to new types of commodities being exchanged in the marketplace: for example, cell phone minutes and bandwidth.

The sale and purchase of commodities is usually carried out through futures contracts on exchanges that standardize the quantity and minimum quality of the commodity

Futures – A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.

Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long or short using futures. 

 The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract. In real life, the actual delivery rate of the underlying goods specified in futures contracts is very low. This is a result of the fact that the hedging or speculating benefits of the contracts can be had largely without actually holding the contract until expiry and delivering the good(s). For example, if you were long in a futures contract, you could go short the same type of contract to offset your position. This serves to exit your position, much like selling a stock in the equity markets would close a trade.

Equity 
1. A stock or any other security representing an ownership interest.

2. On a company's balance sheet, the amount of the funds contributed by the owners (the stockholders) plus the retained earnings (or losses). Also referred to as "shareholders' equity".

3. In the context of margin trading, the value of securities in a margin account minus what has been borrowed from the brokerage.

4. In the context of real estate, the difference between the current market value of the property and the amount the owner still owes on the mortgage. It is the amount that the owner would receive after selling a property and paying off the mortgage.

5. In terms of investment strategies, equity (stocks) is one of the principal asset classes. The other two are fixed-income (bonds) and cash/cash-equivalents. These are used in asset allocation planning to structure a desired risk and return profile for an investor's portfolio.

The term's meaning depends very much on the context. In general, you can think of equity as ownership in any asset after all debts associated with that asset are paid off. For example, a car or house with no outstanding debt is considered the owner's equity because he or she can readily sell the item for cash. Stocks are equity because they represent ownership in a company.

Leverage - (or gearing) generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity.  Loans or other borrowings (debt) are reinvested with the intent to earn a greater rate of return than the cost of interest. The reversal of the leveraging process is deleveraging.

Securitization – The process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors. The process can encompass any type of financial asset and promotes liquidity in the marketplace.   Mortgage-backed securities are a perfect example of securitization. By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage's inherent risk of default and then sell those smaller pieces to investors. The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. Using the mortgage-backed security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages.

Collateralization -  The act where a borrower pledges an asset as recourse to the lender in the event that the borrower defaults on the initial loan. Collateralization of assets gives lenders a sufficient level of reassurance against default risk, which allows loans to be issued to individuals/companies with less than optimal credit history/debt rating.   Mortgage financing allows borrowers to hold title over their own home despite acquiring it via borrowed funds. However, in the terms of the mortgage, if the borrowers default on the mortgage payments, the lender has a right to sell the property to recoup the loan amount.

Businesses can use collateralization for debt offerings. Such bonds may go into details as to the specific asset, such as equipment and/or property that is being pledged for the repayment of the bond offering in the event of default. The increased level of security offered to a bondholder typically means that the coupon rate offered on the bond will be lower as well. 

Subprime Mortgage – A type of mortgage that is normally made out to borrowers with lower credit ratings. As a result of the borrower's lowered credit rating, a conventional mortgage is not offered because the lender views the borrower as having a larger-than-average risk of defaulting on the loan. Lending institutions often charge interest on subprime mortgages at a rate that is higher than a conventional mortgage in order to compensate themselves for carrying more risk. 

Hedge fund - A hedge fund is a private investment fund open to a limited range of professional or wealthy investors which is permitted by regulators to undertake a wider range of activities than other investment funds and which pays a performance fee to its investment manager. Although each fund will have its own strategy which determines the type of investments and the methods of investment it undertakes, hedge funds as a class invest in a broad range of investments, from shares, debt and commodities to works of art.  As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term ‘hedge fund’ has come to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other ‘hedging’ methods to increase rather than reduce risk, with the expectation of increasing return.

Short selling - Short selling or ‘shorting’ is the practice of selling a financial instrument that the seller does not own at the time of the sale. Short selling is done with intent of later purchasing the financial instrument at a lower price. Short-sellers attempt to profit from an expected decline in the price of a financial instrument. Short selling or ‘going short’ is contrasted with the more conventional practice of ‘going long’ which occurs when an investment is purchased with the expectation that its price will rise.  Typically, the short-seller will ‘borrow’ or ‘rent’ the securities to be sold, and later repurchase identical securities for return to the lender. If the security price falls as expected, the short-seller profits from having sold the borrowed securities for more than he or she later pays for them but if the security price rises, the short seller loses by having to pay more for them than the price at which he or she sold them. The practice is risky in that prices may rise indefinitely, even beyond the net worth of the short seller. The act of repurchasing is known as ‘closing’ a position.

Naked short selling – The illegal practice of short selling shares that have not been affirmatively determined to exist. Ordinarily, traders must borrow a stock, or determine that it can be borrowed, before they sell it short. But due to various loopholes in the rules and discrepancies between paper and electronic trading systems, naked shorting continues to happen.

Margin – Borrowed money that is used to purchase securities. This practice is referred to as ‘buying on margin’.  Margin trading is a related term.

Margin account – A brokerage account in which the broker lends the customer cash to purchase securities. The loan in the account is collateralized by the securities and cash. If the value of the stock drops sufficiently, the account holder will be required to deposit more cash or sell a portion of the stock.   In a margin account, you are investing with your broker's money. By using leverage in such a way, you magnify both gains and losses.

Margin call – A broker's demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin.  You would receive a margin call from a broker if one or more of the securities you had bought (with borrowed money) decreased in value past a certain point. You would be forced either to deposit more money in the account or to sell off some of your assets. This is sometimes called a ‘fed call’ or ‘maintenance call’.

Credit default swaps

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.  They are a product to make some quick and easy money during boom times.  The CDS market has expanded into structured finance, such as CDOs, that contained pools of mortgages. It also exploded into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. They are a form of ‘derivatives’ – complex bank creations in which the basic idea is that you can insure an investment you want to go up by betting it will go down. The simplest form of derivative is a short sale: You can place a bet that some asset you own will go down, so that you are covered whichever way the asset moves.  Credit default swaps are the most widely traded form of credit derivative. They are bets between two parties on whether or not a company will default on its bonds.  When the economy soured and the subprime credit crunch began expanding into other credit areas over the past year, parties holding the CDS insurance after multiple trades often did not have the financial wherewithal to pay up in the event of mass defaults. The problem was lack of regulation: While banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded, or swapped, from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends – the insured and the insurer. As the derivatives are often three times the value of the debt they are created against, they can spell trouble.

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