# Financial Terms- a Glossary

Glossary of Key Financial Terms in

## A

agent
• see principal-agent theory. (see step 4.9)
aggressive stock
• A stock with a beta value greater than one. (see step 2.17)
American option
• An option that can be exercised at any time during its life. (see step 3.11)
asset
• Resource with market value; a unit of wealth capable of earning an income. (see step 1.1)
asset price bubble
• An asset price which continues to rise to a high level until it collapses. (see step 4.2)
asset-backed security (ABS)
• Security created from a portfolio of loans, bonds, credit card receivables, or other assets. (see steps 1.13 and 4.2)
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## B

backwardation
• In commodity markets, it is the amount by which a spot price and the cost of carrying a commodity over time exceeds the forward price. (see step 3.10)
bank run
• The simultaneous demands of the deposit-holders of a retail bank for their deposits to be paid. (see step 1.17)
beta
• A measure of the systematic risk of an asset. (see step 2.16)
Black-Scholes model
• A model for pricing European options on stocks, developed by Fischer Black, Myron Scholes and Robert Merton. (see step 3.13)
bond
• A fixed interest security issued by a government, corporation or company. (see step 1.13)
bond yield
• See yield to maturity (see step 1.13)
broker
• Financial intermediary who acts on behalf of others. (see step 1.8)
building society
• A British financial institution primarily concerned with raising deposits from members, and making loans to them secured on land and buildings for residential use. (see steps 1.7 and 1.16)
• Theory relating banking crises to fluctuations in economic activity. (see step 4.2)
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## C

call option
• An option to buy an asset at a certain price by a certain date. (see step 3.11)
capital asset pricing model (CAPM)
• A model relating the expected return on an asset to its beta. (see step 2.16)
capital gain, capital loss
• Increase (or decrease) in the capital value of an asset between its purchase and its sale. (see step 1.11)
capital market
• A market for raising long-term capital for industry by the issue of securities. (see step 1.7)
cash flow
• The cash payments associated with a bond: the coupons and the repayment of the bond’s principal value on maturity. (see step 1.13)
clearance house
• A firm that guarantees the performance of the parties in a derivatives transaction. (see step 3.5)
collateralised debt obligations
• A way of packaging credit risk. Several classes of securities (known as tranches) are created from a portfolio of bonds and there are rules for determining how principal repayments are channelled to the classes. (see step 1.10)
commodity
• A raw material or primary product. (see step 3.4)
compound interest
• Cumulative interest which is paid on both the original amount lent and subsequent interest which is added to the principal. See also continuous compounding. (see step 3.13)
contagion
• A shock to one firm (or market or sector) spreading to other firms (or markets or sectors). (see step 4.2)
contango
• A situation where the futures price is above the current spot price. (see step 3.10)
continuous compounding
• A way of quoting interest rates. It is the limit as the assumed compounding interval is made smaller and smaller. (see step 3.13)
convenience yield
• A measure of the benefits from ownership of an asset that are not obtained by the holder of a long futures contract on the asset. (see step 3.10)
correlation coefficient
• A measure of the interrelatedness of two variables. A value of −1 indicates a perfect negative relationship, and a value of +1 indicates a perfect positive relationship. (see step 2.12)
cost-of-carry
• The storage cost plus the cost of financing an asset minus the income earned on the asset. (see step 3.10)
coupons
• Interest payments made on a bond. (see step 1.11)
covariance
• A measure of how two variables vary together, with a potential range of minus infinity to plus infinity. (see step 2.12)
credit
• A loan, or an agreement to lend money, which will be repaid at a later date. (see step 1.3)
credit default swap (CDS)
• An instrument that gives the holder the right to sell a bond for its face value in the event of a default by the issuer. (see step 3.3)
credit rating
• A measure of the creditworthiness of a bond issue. (see step 1.3)
current yield
• see flat yield (see step 1.13)
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## D

daily settlement
• See mark-to-market (see step 3.5)
Dax
• Stock market index for the Frankfurt exchange. (see step 1.14)
debt securities
• Securities used by a firm, government or household to borrow. In contrast to equity instruments, which represent ownership. (see step 1.10)
defensive stock
• A stock with a beta value less than one. (see step 2.17)
deficit
• An excess of expenses over income (or liabilities over assets). (see step 1.3)
demutualisation
• Change of ownership of an institution from member ownership to shareholdings. (see step 1.16)
derivative
• An instrument whose price depends on, or is derived from, the price of another asset. (see step 3.2)
diversify, diversification
• The spreading of investments over a range of assets with different degrees of risk in a portfolio. (see step 2.1)
dividend
• A cash payment made to the owner of a stock. (see step 1.1)
Dow Jones Industrial Average, “The Dow”
• The leading US index of stock market prices, which is an average of the thirty industrial shares most widely quoted in the USA. (see step 1.14)
downward multiplier
• Cumulative and self-reinforcing contractionary effect of many firms cutting production and employment. (see step 1.16)
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## E

efficient market hypothesis
• A hypothesis that asset prices reflect relevant information. (see step 2.19)
equity, equity securities
• A share in the capital or net assets of a company. (see step 1.10)
European option
• An option that can be exercised only at the end of its life. (see step 3.11)
exchange rate
• The price of a currency in terms of another. (see step 1.4)
exercise price
• The price at which the underlying asset may be bought or sold in an option contract (also called the strike price). (see step 3.11)
expiration date
• The end of life of a contract. (see step 3.5)
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## F

fallacy of aggregation
• The mistake of analysing the behaviour of the aggregate (a market, or sector, or the economy) as if it was an individual (a firm, or household). (see step 1.16)
flat yield
• The annual coupon payment on a bond divided by the market price (also known as current yield or interest yield). (see step 1.13)
forwards, forward contract
• A contract that obligates the holder to buy or sell an asset for a predetermined delivery price at a predetermined future time. (see step 3.4)
FTSE 100, FTSE 250
• A price index of the shares of the 100 largest companies traded on the international stock exchange of London. The FTSE 250 is an index relating to the next 250 largest companies (the 101st to the 350th). (see step 1.14)
futures contract
• A contract that obligates the holder to buy or sell an asset at a predetermined delivery price during a specified future time period. The contract is settled daily. (see step 3.5)
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## G

Glass Steagall Act
• Banking Act 1933 (USA) which separated investment banking from deposit-taking banking with the aim of discouraging speculation and conflicts of interest. (see step 1.16)
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## H

Hang Seng Index
• The index of stock market securities traded on the Hong Kong Stock Exchange. (see step 1.14)
hedge, hedging
• A trade designed to reduce risk. (see step 3.2)
heuristics
• Shortcuts or ‘rules of thumb’ intended to assist decision making. (see step 2.20)
historical data approach
• A non-parametric approach to estimating Value at Risk, by collecting information on past stock returns and ranking the returns by size. (see step 4.4)
holding period return (HPR)
• The change in the price of an asset, plus any income received, expressed relative to the initial price of the asset. (see step 1.11)
home bias
• A tendency to overinvest in the financial assets of someone’s home country. (see step 2.19)
hot hand fallacy
• A misperception of the probability distribution of returns after a success. (see step 2.19)
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## I

index
• A number showing variation in the prices of stocks or other assets, and also the risk associated with assets. See, for example, Dow Jones, Hang Seng, but also the VIX index. (see step 1.14)
insurance
• A method of sharing risks. (see step 1.7)
interest yield
• See flat yield. (see step 1.13)
investment
• The purchase of a financial asset. (see step 1.2)
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## L

liabilities
• Debts or financial obligations of a firm, household or government. (see step 1.3)
liquidation
• The process of winding up a company and allocating its assets. (see step 1.11)
liquidity
• The characteristic of assets which are immediately available for the discharge of financial obligations. (see step 4.2)
liquidity risk
• Risk that it will not be possible to sell a holding of a particular instrument at its theoretical price. Also, the risk that a company will not be able to borrow money to fund its assets. (see step 4.2)
loan
• A sum of money lent, and subsequently returned, usually with interest. (see step 1.8)
log returns
• The natural logarithm of the price of an asset in one period minus the natural logarithm of the price of the asset in the previous period. (see step 3.13)
lognormal distribution
• A variable has a lognormal distribution when the natural logarithm of the variable has a normal distribution. (see step 3.13)
long call
• Purchasing a call option. (see step 3.15)
long position
• A position involving the purchase of an asset. See also short position. (see step 3.5)
long put
• Purchasing a put option. (see step 3.15)
loss
• Selling an asset at a price that is less than was paid for it. Also a negative return. (see step 2.3)
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## M

mark-to-market
• The practice of revaluing an instrument to reflect the current values of the relevant market variables. (see step 3.5)
materiality
• The principle that finance must be tied to real economic activity. (see step 2.22)
maturity date
• The end of the life of a contract. (see step 1.11)
mean return
• The average or expected return; a measure of the central tendency of the distribution of returns. (see step 2.6)
mean-variance approach
• An approach to portfolio analysis in which the characteristics of the return on an asset are represented by the expected return and the variance of the probability distribution of returns. (see step 2.6)
Michie-Oughton D-Index
• A measure of corporate diversity in financial services. (see step 1.16)
Monte-Carlo simulation approach
• A procedure for randomly sampling changes in market variables. Can be used to compute Value at Risk, but also to value derivatives. (see step 4.4)
moral hazard
• A situation where an economic entity (a household, firm, or bank) takes on more risk because of the existence of insurance, or other financial guarantees or support. (see step 1.17)
mortgage
• A charge over property given to a lender so that a borrower can raise finance either to purchase the property or to acquire funds for other purposes. (see step 1.8)
mortgage-backed security
• A security that entitles the owner to a share in the cash flows realised from a pool of mortgages. (see step 4.13)
mudarabah
• A contract specifying how profits and losses are to be shared between the financier and the entrepreneur. (see step 2.22)
mutual fund
• US unit trust, which purchases assets (equity, bonds, or commodities) and sells unit portions of the acquired portfolio to the general public. (see step 1.10)
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## N

NASDAQ
• National Association of Securities Dealers Automated Quotation System. A US securities market, the first to trade electronically. (see step 1.14)
Nikkei average
• The leading index of stock market prices used by the Tokyo Stock Exchange. (see step 1.14)
normal distribution
• The standard bell-shaped distribution of statistics. (see step 3.13)
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## O

off setting
• When a financial position (or a change in a variable) diminishes or neutralises the effect of an original position (or change in the variable). (see step 2.4)
opportunity cost
• The value of the alternative foregone by choosing a particular activity. (see step 1.12)
• The price of an option. (see step 3.11)
options, options contract
• The right to buy or sell an asset. (see step 3.11)
• Lenders make loans and sell them to other institutions or investors. In contrast to holding the loans to their maturity. (see step 4.13)
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## P

parametric approach
• An approach to computing measures of Value at Risk using the parameters that characterise the normal distribution (the mean and standard deviation). (see step 4.4)
payoff
• The cash realised by the holder of an option or other derivative at the end of its life. (see step 3.8)
pension
• A replacement of employment earnings for retired persons. (see step 1.7)
portfolio
• The mixture of financial assets constituting the holdings of wealth of an individual or an institution. (see step 2.3)
preferred stock (preference shares)
• Fixed interest shares which have first entitlement to a company’s earnings after the payment of interest on debentures (fixed interest loans secured on the assets of a company). (see step 1.11)
principal
• See principal-agent theory. (see step 4.9)
principal value
• The par or face value of a debt instrument. (see step 1.11)
principal-agent problem
• A theory of the firm, and other cooperative behaviour, focussing on the contractual relationship between a principal person (usually owners of a company) and others who provide services as agents (the managers). Problems include losses if the agent’s decisions fail to maximise the welfare of the principal, and the costs of monitoring the agents. (see step 4.9)
probability distribution
• A probability distribution specifies the probabilities with which a random variable will take various values. (see step 2.6)
profit
• Selling an asset at a price that is greater than was paid for it. Also a positive return. (see step 2.3)
put option
• An option to sell an asset for a certain price by a certain date. (see step 3.11)
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## R

redemption yield
• See yield to maturity. (see step 1.13)
risk
• The chance of an event occurring with a known probability. (see step 1.3)
risk aversion
• Choosing assets with little risk of either capital loss or an uncertain return. (see step 1.5)
risk lover
• A person who will gamble even when a mathematical calculation shows the odds are unfavourable. Risk lovers will accept a lower expected income in the hope of obtaining a greater capital gain. (see step 1.5)
• The difference between the higher expected return on risky assets that is required by cautious investors, and the return on risk-free assets. (see step 2.16)
risk-return ratio
• The ratio of the return an investor expects to make from their position relative to the possible losses from the position. More generally, the balance of risk an investor is prepared to take relative to the returns they would like to make. (see step 1.2)
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## S

securitisation
• The conversion of bank loans into tradable securities. (see step 4.13)
security
• A financial instrument in bearer form or registered form i.e. its owner is the bearer or a person listed in the register for that security. Securities take many forms, including bonds, stocks and shares. (see step 1.10)
share
• A portion of the financial capital of a limited company. (see step 1.4)
short call
• Selling (also known as writing) a call option. (see step 3.15)
short position
• A position involving the sale of an asset. (see step 3.5)
short put
• Selling (also known as writing) a put option. (see step 3.15)
speculation
• Buying and selling in commodity or financial markets, which are subject to many price fluctuations, in order to make a capital gain. (see step 2.4)
spot market
• A market in which currencies or commodities are traded for immediate delivery. (see step 3.2)
spot price
• The present price of an asset, currency or commodity for immediate delivery. (see step 3.2)
Standard & Poor’s 500
• A stock index representing stocks traded on the New York Stock Exchange and NASDAQ. (see step 1.14)
standard deviation
• A measure of the dispersion of values of a variable about its arithmetic mean. The square root of the variance. (see step 2.8)
stock market
• A physical and electronic market in which government bonds and the securities of companies are regularly traded. (see step 1.7)
stock option
• Option on a stock. (see step 3.11)
stock
• Equity capital of a corporation. (see step 1.10)
structured products
• Non-standard financial instruments, involving a variety of complex features. (see step 1.4)
subprime mortgage
• Mortgage granted to borrower with a poor credit history or no credit history. (see step 4.2)
sukuk
• Financial securities that are compliant with Islamic law. (see step 2.22)
sunspot theory
• The theory that some economic events (for example, bank runs) are caused by random actions (in this case, random withdrawal of deposits). (see step 4.2)
surplus
• An amount left over when requirements have been met. (see step 1.3)
swap
• An agreement to exchange cash flows in the future according to a prearranged formula. (see step 3.2)
systemic risk
• Risk that a default by one financial institution will lead to defaults by other financial institutions. (see step 1.16)
systematic risk
• Risk that cannot be diversified away. (see step 1.17)
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## T

time value of money
• Cash flows of equal size occurring at different times are not valued equally. In particular, cash flows received sooner are valued more than cash flows of equivalent size received later. (see step 1.11)
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## U

uncertainty
• A state of affairs with an unknown outcome which is not subject to a probability distribution. (see step 1.4)
unsystematic risk
• Risk that can be diversified away. Also known as idiosyncratic risk. (see step 1.17)
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## V

Value at Risk (VaR)
• A loss that will not be exceeded at some specified confidence level. (see step 4.3)
variability
• The property of being not constant, and the extent to which a variable changes over time. (see step 2.11)
variance
• A measure of variability or dispersion. The average of the sum of the squared deviations of a variable around its expected value. (see step 2.8)
VIX index
• Index of the volatility of the S&P 500. (see step 1.14)
volatility
• A measure of the uncertainty of the return realised on an asset. (see step 3.13)
volatility index
• An index of uncertainty. (see step 1.14)
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## W

writing an option
• Selling an option. (see step 3.3)
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## Y

yield
• A return provided by an instrument. (see step 1.13)
yield curve
• The relationship between interest rates and their maturities. Also known as the term structure of interest rates. (see step 4.6)
• The difference between the yields on bonds of different riskiness e.g. between corporate bonds and government bonds. Also known as risk spread. (see step 4.7)
yield to maturity
• Discount rate which, when applied to all the cash flows of a bond, causes the present value of the cash flows to equal the bond’s market price. Also known as the bond yield, or redemption yield. (see step 1.13)
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