Shared Flashcard Set

Details

CFA Corp Fin, Port Man, Eq. Invest
N/A
379
Accounting
Professional
07/14/2013

Additional Accounting Flashcards

 


 

Cards

Term
Capital Budgeting Process
Definition
Process of identifying and evaluating capital projects where the cash flow to the firm will be received over a period longer than a year (ex: decision to replace a delivery truck) -- 4 administrative steps (1) Idea generation (2) Analyzing project proposals; this includes cash flow forecast (3) Create firm-wide capital budget; prioritizing timing of cash flows, resources and strategic plan (4) Monitoring decision and conducting a post-audit; comparison of actual to projected results and identify systematic forecasting errors in process
Term
Capital Budgeting Project Categories
Definition
(1) Replacement projects to maintain business (2) Replacement proj. for cost reductions (3) Expansion projects to grow business (4)New product or mkt development (5) Mandatory project by govt; usually around safety (6) Other projects; high risk endeavors that are hard to analyze
Term
Capital Budget Key Principles
Definition
(1) Decision based on CF, not accounting income -- incremental cash flows (2) Cash flows are based on opportunity costs (3) The timing of cash flows is important; early flows worth more than later flows (4) Cash flows are analyzed on an after-tax basis (5) Financing costs are reflected in the project's required rate of return; discount rate used in analysis takes into acct. firms cost of capital; projects returning more than cost of capital inc. value of firm
Term
Incremental Cash Flows
Definition
The changes in cash flows that will occur if the project is undertaken
Term
Sunk Costs
Definition
Costs that cannot be avoided, even if project is not undertaken; should not be included in the analysis since these are not affected by accept/rject decision (ex: consulting fee to research firm to estimate demand for product)
Term
Externalities
Definition
The effects the accept of a project may have on other firm cash flows
Term
Cannibalization
Definition
A negative externality which happens when a new project takes sales from an existing product (Ex: soft drink company introduces diet soda that takes sales of existing beverage)
Term
Conventional Cash Flow Pattern
Definition
If the sign on cash flows changes only once, with one or more cash outflows followed by one or more cash inflows. For projects with conventional cash flow patterns, the NPV and IRR methods produce the same accept/reject decision.
Term
Unconventional Cash Flow Pattern
Definition
Sign on the cash flows has more than one sign change (ex: initial investment outflow, series of inflows, and cash outflow for retirement of asset). These patterns can produce multiple IRRs or even no IRRs (mathematically)
Term
Opportunity costs
Definition
Cash flows that firm will lose by undertaking the project under analysis (ex: building a plant and firm owns land, cost of land should be charged because it could be sold if not used)
Term
Independent Projects
Definition
Projects that are unrelated to each other all for a project to be evaluated based on its own profitability (Ex: A & B profitable, then firm accept both)
Term
Mutually exclusive
Definition
Only one project in a set of possible projects can be accepted and projects compete with each other (Ex: accept A or B, but not both)
Term
Project Sequencing
Definition
Projects taken in certain order so investing creates opportunity to invest other projects in the future
Term
Capital Rationing
Definition
Prioritizing capital expenditures to achieve maximum increase in value for shareholders given available capital
Term
Net Present Value (NPV)
Definition
The sum of the present values of all the expected incremental cash flows if a project is undertaken. + NPV increases shareholder wealth, - NPV decrease shareholder wealth, 0 NPV project has no effect on shareholder wealth
Term
Internal Rate of Return (IRR)
Definition
The discount rate that makes the present value of the expected incremental after-tax cash inflows just equal to the initial cost of the project. PV(Inflows) = PV(Outflows). IRR > Required Rate of Return, accept. IRR < Required Rate of Return, reject. IRR is discount rate that results in an NPV of zero.
Term
Payback Period (PBP)
Definition
The number of years it takes to recover the initial cost of an investment. PBP is measure of liquidity, so for a firm with liquidity concerns, teh shorter a project's payback period, the better. Drawbacks to PBP are that it doesn ot take into account time value of money or cash flows beyond the payback period (terminal or salvage value isn't considered), so useless as a measure of profitability
Term
Discounted Payback Period
Definition
Uses the present values of the projects estimated cash flows, and must be greater than the payback period without discounting. Addresses PBP drawback by using discounting, but still doesn't consider salvage or terminal value of set.
Term
Profitability Index (PI)
Definition
The present value of a project's future cash flows divided by the initial cash outlay
Term
Profitability Index Formula
Definition
PI = PV of future cash flows/CF0 = 1+NPV/CF0. If PI > 1, accept the project, if PI < 1, reject the project
Term
NPV Profile
Definition
A graph that shows a project's NPV for different discount rates. Discount rates are on the X-axis, and NPV are on y-axis
Term
Crossover Rate
Definition
The rate at which NPVs are equal is the crossover rate (on NPV Profile graph)
Term
A Key Advantage of NPV
Definition
It is a direct measure of the expected increase in the value of the firm; main weakness is that it does not include consideration of the size of project. NPV of $100 is great for project costing $100, but for one costing $1 mil.
Term
A Key Advantage of IRR
Definition
Measures profitability as a percentage, showing the return on each dollar invested. Provides information on margin of safety that NPV does not, b/c can tell how much below IRR the actual return can fall before it becomes uneconomic (negative NPV)
Term
NPV vs. IRR
Definition
NPV & IRR can give difference indications between 2 separate projects. NPV is only acceptable criterion when ranking projects. Can't rank projects cash flows by IRR, because that assumes that you can reinvest project cash flows at the IRR -- this is not correct because then this should be the rate used to discount project cash flows. NPV also produces theoretically correct decisions for projects with unconventional cash flows; sometimes there is no disc. rate that results in zero NPV, so there is mathematically no IRR.
Term
A Key Advantage of NPV
Definition
It is a direct measure of the expected increase in the value of the firm; main weakness is that it does not include consideration of the size of project. NPV of $100 is great for project costing $100, but for one costing $1 mil.
Term
A Key Advantage of IRR
Definition
Measures profitability as a percentage, showing the return on each dollar invested. Provides information on margin of safety that NPV does not, b/c can tell how much below IRR the actual return can fall before it becomes uneconomic (negative NPV)
Term
NPV vs. IRR
Definition
NPV & IRR can give difference indications between 2 separate projects. NPV is only acceptable criterion when ranking projects. Can't rank projects cash flows by IRR, because that assumes that you can reinvest project cash flows at the IRR -- this is not correct because then this should be the rate used to discount project cash flows. NPV also produces theoretically correct decisions for projects with unconventional cash flows; sometimes there is no disc. rate that results in zero NPV, so there is mathematically no IRR.
Term
Capital Budgeting Method Choice Criteria
Definition
(1) Location; European countries use PBP as much or more than NPV/IRR (2) Size of company; larger company is more likely to use NPV or IRR methods. (3) Public vs. Private; private companes use PBP more often than public, Public prefer disc. cash flow method (5) Mgmt Education; Higher education means more likely to use NPV or IRR method.
Term
NPV and Stock Price Changes
Definition
NPV is a measure of expected change in company value from undertaking a project; the firm's stock price can be affected to extent that engaging in project with NPV was previously unanticipated by investors.
Term
Weighted Average Cost of Capital (WACC)
Definition
The firm's discount rate, also known as Marginal Cost of Capital (MCC). Each investment decision assumes WACC is based on long-run target weights. Also known as the cost to finance firm assets. WACC should be adjusted upward for projects with greater than avg. risk, and downward for projects with lower than avg. risk.
Term
Kd (Cost of debt; Before-tax component cost of debt)
Definition
The rate at which the firm can issue new debt. This is the yield to maturity on existing debt and called the before-tax component cost of debt.
Term
Kd(1-t) (After-tax component cost of debt)
Definition
After-tax cost of debt, where t is the firm's marginal tax rate. This rate is used to calculate the WACC, because the interest paid on corporate debt is considered tax deductible. Overall, the number is the interest rate at which firms can issue new debt (Kd) net of tax savings from the deductibility of interest. Cost of debt is the YTM on new marginal debt, not the coupon rate on existing debt.
Term
Kps (preferred stock)
Definition
Cost of preferred stock. Not tax deductible. Kps = Dps/P, where Dps is preferred dividends and P is market price of preferred stock.
Term
Kce (common equity)
Definition
The cost of common equity, it is the required rate of return on common stock and generally pretty difficult to estimate. Not tax deductible. Kce = RFR + Beta[E(Rm)-RFR]
Term
WACC formula
Definition
WACC = (Wd)(Kd(1-t)+(Wps)*(Kps)+(Wce)*(Kce), where Wd is percentage of debt in cap. structure, Wps % of pref. stock and Wce is % of common. stock
Term
Margin Cost of Capital Curve
Definition
Marginal cost of capital, the cost of raising additional capital, can increase larger amts. are invested in new projects
Term
Investment Opportunity Schedule
Definition
An ordering of the expenditures on additional projects from highest to lowest IRR.
Term
Optimal Capital Budget
Definition
The intersection of the marginal cost of capital curve and investment opportunity schedule; the point where the firm undertakes all projects with an IRR greater than the cost of capital.
Term
Dividend Discount Model Approach (Kce)
Definition
Known as dividend growth model; P0 = (D1/Kce-g), where D1 = next year's dividend, Kce = required rate of return on common equity, and G = firm's expected growth rate
Term
Formula to Estimate Firm's Sustainable Growth Rate (Div. Disc. Model)
Definition
g = (retention rate)(return on equity) = (1 - payout rate)(return on equity)
Term
Bond Yield Plus Risk Premium Approach (Kce)
Definition
Kce = bond yield + risk premium
Term
CAPM [Capital Asset Pricing Model] (Kce)
Definition
Kce = RFR + Beta[E(Rm)- RFR)], where RFR is based on treasury notes close to useful life of project, Beta = risk measure of stock, and E(Rm) = expected rate of return on the market
Term
Project Beta
Definition
Measure of a project's systematic risk
Term
Pure-Play Method (Beta)
Definition
Estimation of beta which uses the beta of a company engaged in a business similar to that of the project and comparable to the project. Can't use the beta of a conglomerate because that beta would be based on many diff. lines of business
Term
Unlevering to get Asset Beta for Pure Play Method
Definition
Basset = Bequity[1/1+((1-t)D/E)], where D/E = comparable company's debt to equity ratio and t is its marginal tax rate.
Term
Relevering Asset Beta to get Project Beta for Pure Play Method
Definition
Bproject = Basset(1+((1-t)D/E)), where t is subject firm's tax rate and D/E ratio
Term
Country Risk Premium
Definition
Country Risk Premium is added to CAPM model to reflect the increased risk with investing in a developing country. This number is added to the market risk premium.
Term
CAPM with Country Risk Premium
Definition
Kce = RFR + Beta[E(Rm)- RFR + CRP], where CRP = country risk premium
Term
Country Risk Premium
Definition
CRP = sovereign yield spread * (annualized st dev. of equity index of developing country/annualized st dev of sovereign bond market in terms of developed market currency), where sovereign yield spread = difference between the yields of government bonds in the developing country and treasury bonds of similar maturities.
Term
Marginal Cost of Capital
Definition
Cost of the last new dollar of capital a firm raises; raising addl. capital results in an increase in WACC.
Term
Marginal Cost of Capital Schedule
Definition
Shows WACC for different amts of financing, has an upward slope since different financing becomes more expensive as firm raises more capital
Term
Break Point
Definition
Occurs any time cost of one component of company's WACC changes
Term
Break Point Formula
Definition
Amount of capital at which the component's cost of capital changes/weight of the component in the capital structure
Term
Flotation Costs
Definition
Fees charged by investment bankers when company raises external equity capital (can be substantial, 2 to 7% of amt. of equity capital raised)
Term
Incorrect vs. Correct Flotation Costs
Definition
The correct way to account for flotation costs is to adjust the initial project cost, rather than subtracting them from the cost of equity. This is because doing so assumes that flotation costs will be a factor through the duration of the project because future cash flows are discounted at a higher WACC to determine NPV.
Term
Leverage
Definition
Refers to the amount of fixed costs a firm has (building, interest payments on debt)
Term
Business Risk
Definition
Risk associated with firm's operating income and is result of uncertainty about firm's revenues and expenditures necessary to produce the revenues
Term
Sales Risk
Definition
Uncertainty about a firm's sales
Term
Operating Risk
Definition
Additional uncertainty about operating earnings caused by fixed operating costs (the more proportion of fixed to variable costs you have, the more uncertainty)
Term
Financial Risk
Definition
Additional risk that firm's common stockholders bear when firm uses fixed cost (debt) financing
Term
Degree of Operating Leverage (DOL)
Definition
% change in operating income (EBIT) from given % change in sales
Term
Degree of Operating Leverage Formulas
Definition
DOL = % change in EBIT/% change in sales = (Change EBIT/EBIT)/(Change Q/Q)
Term
Degree of Operating Leverage Formulas for level of unit sales
Definition
DOL = (Q(P-V))/Q(P-V)-F, where Q = quantity of units sold, P = price per unit, V = variable cost per unit, F = fixed costs OR...

DOL = (S - TVC)/S-TVC-F, where S = sales, TVC = total variable costs, F = fixed costs
Term
Interpreting Degree of Operating Leverage
Definition
If DOL = 2.5, then a 10% increase in sales leads to a 25% increase in EBIT
Term
Degree of Financial Leverage (DFL)
Definition
Ratio of the % change in net income (or EPS) to % change in EBIT
Term
Degree of Financial Leverage (DFL) Formulas
Definition
DFL = % change in EPS/% change in EBIT
Term
Degree of Financial Leverage for particular level of operating earnins
Definition
DFL = EBIT/(EBIT-interest)
Term
Degree of Total Leverage (DTL)
Definition
Combines DOL and DFL, DTL measures sensitivity of EPS to changes in sales
Term
Degree of Total Leverage Formulas
Definition
DTL = DOL * DFL = (% change in EBIT/% change in sales)*(%change in EPS/%change in EBIT) = % change in EPS/% change in sales
Term
Breakeven Quantity of Sales
Definition
The quantity of sales for which revenues equal total costs, so net income is zero
Term
Contribution Margin
Definition
Difference between price and variable cost per unit that helps cover fixed costs
Term
Breakeven Quantity of Sales Formula
Definition
Qbe=(fixed operating costs + fixed financing costs)/(price - variable cost per unit)
Term
Operating Breakeven Quantity of Sales
Definition
Consider only fixed operating costs and ignore fixed financing costs
Term
Operating Breakeven Quantity of Sales
Definition
Qobe = (fixed operating costs)/(price-variable cost per unit)
Term
Debt versus Equity mix
Definition
Using more debt and less equity in firm's capital structure reduces net income through addl. interest expense, but also reduces net equity. Net effect is an increase or decrease in ROE
Term
Cash Dividends
Definition
Payments made to shareholders in cash
Term
Regular Dividends
Definition
When company pays out a portion of profits on consistent schedule (long term stable dividends is viewed as sign of company's financial stability
Term
Special Dividends
Definition
When favorable circumstances allow the firm to make a one-time cash payment to shareholders (AKA extra dividend or irregular dividend)
Term
Liquidating Dividends
Definition
Occurs when a company goes out of business and distributes the proceeds to shareholders (for tax purposes, treated as return of capital and amts over investor tax basis are treated as capital gains)
Term
Dividend Characteristics
Definition
Transfer of cash from company to shareholders, immediately reduces corp. assets and mkt. value of equity, so price of stock should drop right after.
Term
Stock Dividends
Definition
Dividends paid out in new shares of stock rather than cash (20% stock dividend means each shareholder gets 20% more stock). More shares, but each worth less so there is no change in owner's wealth.
Term
Stock Splits
Definition
Divided each existing share into multiple shares, creating more shares. More common than stock dividends. Some firms use stock splits or stock dividends to keep stocks within an optimal trading range of $20 to $80. Stock splits create more shares but don't increase shareholder value.
Term
Reverse Stock Splits
Definition
The opposite of stock splits, after a reverse split there are fewer shares outstanding, but a higher stock price. A company in financial distress with a low stock price might use this to increase stock price.
Term
Cash Dividend Effects on Financial Ratios
Definition
Paying cash dividend decreases assets (cash) and shareholder equity (retained earnings). Decrease in cash decreases company liquidity ratios and increases debt to asset ratios., while decrease in shareholders equity will increase its debt to equity ratio.
Term
Non-cash dividends and splits effects on financial ratios
Definition
Stock dividends, stock splits, and reverse stock splits have no effect on leverage or liquidity ratios; they only change the number of equity shares.
Term
Declaration Date (Div. Payment Chronology)
Definition
The date the board of directors approves payment of the dividend
Term
Ex-dividend Date
Definition
The first day a share of stock trades without the dividend (also the cutoff date for receiving the dividend and occurs two biz days before holder of record date. If you buy on or after ex-dividend date, you will not receive dividend. Stock prices should fall by amount of after-tax value of dividend on this date.
Term
Holder of Record Date
Definition
The date on which shareholders of record are designated to receive the dividend. This date is 2 business days after the ex-dividend date because the settlement date for stocks is three biz days after the trade date (t+3).
Term
Payment Date
Definition
The date the dividend checks are mailed out or when the payment is electronically transferred to shareholder accounts.
Term
Share Repurchase
Definition
When a company buys back shares of its own common stock
Term
Share Repurchase Methods
Definition
(1) Buy in the open market at market price; gives company flexibility of timing transaction (2) Buy a fixed numbers of shares at a fixed price by making a tender offer for specific shares at a specific price premium to market, possibly pro-rata if shareholders tender too many (3) Repurchase by direct negotiation; negotiate directly with a large shareholder to buy back a block of shares at premium to market leading to decrease in wealth of shareholders)
Term
Share repurchase depending on after-tax cost of debt
Definition
Share repurchase using borrowed funds will increase EPS if the after tax cost of debt used to buy back shares is less than the earnings yield of the shares before the repurchase. It will decrease EPS if the cost of debt is greater than the earnings yield, and will not change EPS if the two are equal.
Term
Share repurchase effects on Book value per share
Definition
BVPS will decrease if the repurchase price is greater than the original BVPS and increase if the repurchase price is less than the original BVPS
Term
Share repurchase and effects on shareholder wealth
Definition
If shares are repurchased using own company's cash, a repurchase can be considered alternative to ac ash dividend as way of distributing earnings to shareholders (assuming tax treatment is the same)
Term
Company's Primary Source of Liquidity
Definition
Cash used in normal day to day operations (Cash balances from selling goods, investments; short term funding like lines of credit; cash flow management of collections and payments). Liquidity position improves if cash flows in more quickly and out more slowly.
Term
Company's Secondary Sources of Liquidity
Definition
Liquidating short-term or long-lived assets, re-negotiating debt agreements or re-organizing comp/filing for bankruptcy. Tapping these resources can indicate financial position is deteriorating.
Term
Drags on Liquidity
Definition
Delay or reduce cash inflows or increase borrowing costs (uncollected receivables and bad debts or obsolete inventory)
Term
Pulls on Liquidity
Definition
These pulls accelerate cash outflows (paying vendors sooner than is optimal or changes in credit terms that require repay of outstanding balances)
Term
Current Ratio Formula
Definition
Current Ratio = Current Assets/Current Liabilities; the higher, the more likely company will be able to repay its short-term bills; if less than 1, prob facing liquidity crisis
Term
Quick Ratio (Acid Test Ratio) Formula
Definition
Quick Ratio = (Cash + Short-term marketable securities + receivables)/(current liabilities); this does not include inventories or other assets that might not be as liquid
Term
Receivables Turnover Formula
Definition
Receivables Turnover = Credit Sales/Average Receivables; measure of accounts receivable liquidity, desirable to have a turnover figure close to industry average
Term
Number of Days of Receivables Formula
Definition
Number of Days of Receivables = 365/receivables turnover = average receivables/average day's credit sales; if too high, customers may be too slow paying bills; if too low, credit policy could be too rigorous and hamper sales
Term
Inventory Turnover Formula
Definition
Inventory Turnover = Cost of Goods Sold/Average Inventory
Term
Number of Days of Inventory Formula
Definition
365/Inventory Turnover = Average Inventory/Average Day's COGS; close to industry average is good; if too high, could mean inventory is obsolete; if too low, could mean firm has inadequate stock on hand and hurt sales
Term
Payables Turnover Ratio
Definition
Purchases/Average Trade Payables
Term
Number of Days of Payables Formula (AKA Payable Payment Period)
Definition
Number of days of payables = 365/payables turnover ratio = average payables/average day's purchases
Term
Operating Cycle
Definition
Average number of days that it takes to turn raw materials into cash proceeds from sales
Term
Operating Cycle Formula
Definition
Days of Inventory + Days of Receivables
Term
Cash Conversion Cycle
Definition
Average Days of receivables + average days of inventory - average days of payables; high conversion cycles considered undesirable, meaning too much tied up in working capital
Term
Daily Cash Position
Definition
Refers to uninvested balances firm has available to make routine purchases and pay expenses as they come due
Term
Short Term Securities that Firms Invest In (List of 9)
Definition
(1)U.S. Treasury Bills (2) Short-term federal agency securities (3) bank certificates of deposit (4) Banker's acceptances (5) Time deposits (6) Repurchase agreements (7) Commercial Paper (8) Money Market Mutual Funds (9) Adjustable rate preferred stock
Term
Discount from Face Value Formula for Short Term Securities
Definition
% discount = (face value - price/face value)
Term
Discount-Basis Yield Formula (Bank Discount Yield) for Short-Term Securities
Definition
discount basis yield = % discount * (360/days)
Term
Money Market Yield Formula
Definition
money market yield = (face value - price/price)*(360/days) = holding period yield * (360/days), where days = days to maturity and price = purchase price of security
Term
Bond Equivalent Yield Formula
Definition
BEY = (face value - price/price)(365/days to maturity) = holding period yield * (365/days). Return on firm's short term securities should be stated in BEY, but return on portfolio should be expressed as weighted average of these yields
Term
Cash Management Investment Policy
Definition
(1) Begins with statement of purpose and objective of investment portfolio (2) general guidelines about strategy employed to achieve objectives and securities to be used (3) Specific info on who is allowed to purchase securities and responsible for complying with company guidelines and what steps taken if investment guidelines are not followed (4) Includes limitations on the specific types of securities permitted for investment of short-term funds (5) limitations on credit ratings of portfolio securities (6) limitations on proportions of total short term securities portfolio that can be invested in the various types of securities (7) evaluated on how well policy can expect to satisfy goals and purpose of short-term investments
Term
Account Receivables Aging Schedule
Definition
Schedule which gives detail about accounts receivable performance (days outstanding on left, month across the top and receivables in the grid. Can be shown as percentage as well).
Term
Weighted Average Collection Period
Definition
Days outstanding on left side (less than 31, great than 31 less than 60, etc.) and average collection days across top, relative weights of the days, and then the average collection period. is the sum of Days * weight
Term
Term Structure on Accounts Payable
Definition
Ex: 2/10 net 60, meaning 2% discount if paid within 10 days, otherwise do 60 days from invoice date.
Term
Cost of Trade Credit Formula
Definition
Cost of not taking discount for early payment; cost of trade credit = ((1 + %discount/1-%discount)^(365/days past discount))-1, where days past discount is number of days after the end of the discount period
Term
Number of Days of Payables (Formula)
Definition
Number of days of payables = accounts payable/average day's purchases, where average days' purchases = annual purchases/365
Term
Lines of Credit (Sources of Short Term Funding)
Definition
Used by large, financially sound companies (1) Uncommitted line of credit; bank extends line of credit for certain amount but won't lend if circumstances change (2) Committed line of credit; offer of credit that is committed to by bank, loans are less than year charged at LIBOR (3) Revolving Line of Credit; more reliable source of shot-term financing, usually for longer terms like years and can be listed on fin statements as source of liquidity. If company with weak credit, bank can have blanket lien which allows claim to all current and future assets; if firm assigns acct. receivables, it must still service receivables if bank gets them.
Term
Banker's acceptances
Definition
Used by firms that export goods; guarantee from bank of firm ordering goods stating that payment made upon receipt of goods. Exporting company must sell at discount to get immediate funds.
Term
Factoring
Definition
Sale of receivables at discount from face value; the factor (buyer of receivables) is responsible for collecting receivables and credit risk of receivables portfolio
Term
Commercial Paper
Definition
large companies can sell directly to investors and interest costs are usually less than what you can get at bank. Lowest cost relative to other short-term funding sources
Term
Short Term Funding Sources in order of Dec. firm creditworthiness and increasing cost
Definition
(1) Commercial Paper (2) Bank Lines of Credit (3) Collateralized borrowing (4) Non-bank financing (5) Factoring
Term
Corporate Governance
Definition
The set of internal controls, processes and procedures by which firms are managed. These practices ensure board of directors is independent of mgmt, and firm and managers act lawfully, ethically and in interest of shareholders
Term
General Board Duties
Definition
(1) Majority must be independent (2) meet outside presence of mgmt. (3) not be former chairman or CEO (4) not have any conflict of interests (5) should have experience and knowledge to advise management (6) should be able to hire outside consultants without management approval
Term
Board Independence
Definition
Board is considered independent if decisions are not controlled or biased by management of the firm. The board must work to protect long-term interests of shareholders
Term
Board Member Experience
Definition
Should have experience with (1) Products or services firm produces (2) financial operations, accounting, and auditing (3) legal issues (4) strategies and planning (5) the firm's business and financial risks. Also, board members who serve for long time may not be considered independent b/c too close to mgmt.
Term
Board Audit Committee Requirements
Definition
Resonsible for providing fin information to shareholders. Audit Committee should (1) follow proper acct. and auditing procedures (2) appoint an external auditor that is free from mgmt influence. (3) resolve conflicts b/w auditor and mgmt in way that favors shareholders (4) Approve or reject any non-audit engagements with external auditor (5) Have no restrictions on communications with firm's internal auditors (6) control audit budget
Term
Board Compensation Committee Requirements
Definition
Responsible for setting comp of firm executives Committee should (1) determine whether exec. comp is appropriate and linked to LT profitability (2) Provide shareholders details about exec. comp in public document (3) Require firm and board to seek shareholder approval for any share-based compensation plans
Term
Nomination Committee Requirements
Definition
Responsible for recruiting new, qualified, and independent board members. Also should (1) review performance, independence and skills of existing board members (2) Create nomination procedures and policies (3) Prepare succession plan for senior management
Term
Firm Code of Ethics
Definition
Sets standard for basic principles of integrity, trust, and honesty; having one can be mitigating factor if breach occurs. Strong code should (1) comply with standards of home country and stock exchange (2) prohibit advantages to insiders that aren't available to shareholders (3) discourage payments to board members of consultant fees or finder's fees for acquisitions (4) designate person responsible for corp. governance
Term
Share Blocking
Definition
Mechanism that prevents investors who wish to vote their shares from trading their shares during a period prior to the annual meeting.
Term
Cumulative Voting
Definition
Generally favorable for shareholders, when shareholders can cast the cumulative votes allotted to their shares for one or limited number of board nominees. Can work against most shareholders if the cumulative voters have significant minority interests.
Term
Takeover Defenses
Definition
Provisions designed to make a company less attractive to a hostile bidder (1) golden parachutes, rich severance packages for top managers who lose their jobs (2) poison pill, provisions granting rights to existing shareholders in the event a certain percentage of company shares are acquired (3) greenmail, use of corporate funds to buy back share sof a hostile acquirer at a premium to their market value. All of these decrease share value
Term
Portfolio Perspective
Definition
Refers to evaluating individual investments by their contribution to the risk and return of an investor's portfolio
Term
Diversification Ratio
Definition
A measure of the benefits of diversification, calculated as the ratio of the risk of an equally weighted portfolio of n securities measured via std dev. returns versus the risk of single security selected at random from n securities (ex: if st dev of returns for n stocks is 25% and std dev of returns for equal weighted portfolio of n stock is 18%, diversification ratio is 18/25 = 0.72. Diversification is best when fin markets are operating normally, but provides less reduction in market turmoil (credit contagion of 08). Correlations increase in these times, and reduce benefits of diversification.
Term
Defined Contribution (DC) Pension Plans
Definition
Popular vehicles for individual investors to invest for retirement and defer any taxes on investment income and gains until funds are withdrawn. The individual makes the investment decisions and takes on the investment risk, but there is no guarantee of specific future pension payments
Term
Defined Benefit(DB) Pension Plans
Definition
Funded by company contributions and have an obligation to provide specific benefits to retirees, such as lifetime income based on employee earnings. Very long time horizon and select investments that meet goal of providing benefits to retirees.
Term
Endowment
Definition
Fund that is dedicate to providing financial support on an ongoing basis for a specific purpose (universities)
Term
Foundation
Definition
Fund established for charitable purposes to support specific types of activities or to fund research related to a particular disease. Goal to fund activities w/o decreasing real (inflation adjusted) value of portfolio assets. Long investment horizon, high risk tolerance and little need for addl. liquidity.
Term
Bank
Definition
Goal to earn more on bank's loans and investments than the bank pays for deposits on various types. Banks keep risk low and need adequate liquidity to meet investor withdrawals.
Term
Insurance Companies
Definition
Invest customer premiums with the objective of funding customer claims as they occur. Have long-term investment horizon, but property and casualty insurers have shorter investment horizon b/c claims come sooner than for life insurers
Term
Investment Companies
Definition
They manage pools of funds for many investors with different styles (index vs. growth) and subcategories (small-cap, energy stocks)
Term
Sovereign Wealth Funds
Definition
Pools of assets owned by government. Abu Dhabi Investment Authority funded by government surplus, manage $627 billion
Term
Characteristics of Different Investors (Individuals)
Definition
(1) Risk Tolerance, depends on indiv. (2) Investment Horizon, depends on indiv. (3) Liquidity Needs, depends on indiv. (4) Income Needs, depends on indiv.
Term
Characteristics of Different Investors (DB Pension)
Definition
(1) Risk Tolerance, high. (2) Investment Horizon, long. (3) Liquidity Needs, low. (4) Income Needs, depends on age.
Term
Characteristics of Different Investors (Banks)
Definition
(1) Risk Tolerance, Low. (2) Investment Horizon, Short. (3) Liquidity Needs, high. (4) Income Needs, pay interest.
Term
Characteristics of Different Investors (Endowments)
Definition
(1) Risk Tolerance, high. (2) Investment Horizon, long. (3) Liquidity Needs, low. (4) Income Needs, spending level.
Term
Characteristics of Different Investors (Insurance)
Definition
(1) Risk Tolerance, low. (2) Investment Horizon, long for life, short for P&C. (3) Liquidity Needs, high. (4) Income Needs, low.
Term
Characteristics of Different Investors (Mutual Funds)
Definition
(1) Risk Tolerance, depends on fund. (2) Investment Horizon, depends on fund. (3) Liquidity Needs, high. (4) Income Needs, depends on fund.
Term
Steps in Portfolio Management Process
Definition
(1) Planning Step (2) Execution Step (3) Feedback Step
Term
Steps in Portfolio Management Process (Planning Step)
Definition
Analysis of investor's risk tolerance, return objectives, time horizon, tax exposure, liquidity needs, income needs, and unique circumstance or investor prefs.
Term
Steps in Portfolio Management Process (Executing Step)
Definition
Analysis of risk and return characteristics of asset classes to determine how funds allocated to various types. Use top-down, macro analysis and diversify across various asset classes.
Term
Steps in Portfolio Management Process (Feedback Step)
Definition
Last step, rebalance portfolio in response to changes of asset classes (risk and return characteristics) or investor circumstances. Also view performance relative to benchmark
Term
Mutual Funds
Definition
Form of pooled investments (single portfolio that contains investment funds from multiple investors). Each investor owns shares representing ownership of portion of overall portfolio.
Term
NAV (Net Asset Value) per share
Definition
Total Net value of assets in the fund divided by number of such shares issued
Term
Open-End Fund Characteristics
Definition
Investors can buy newly issued shares at their NAV in this type. Investors can also redeem their shares (sell back to fund) at NAV as well. All funds charge fees for ongoing mgmt of portfolio asset, and this is percentage of NAV of fund.
Term
Open End - No Load Fund Characteristics
Definition
They do not charge additional fees for purchasing shares (up-front fees) or for redeeming shares (redemption fees)
Term
Open End - Load Fund Characteristics
Definition
Charge up-front feess, redemption feeds, or both
Term
Closed-End Funds
Definition
Managed pools of money that do not take new investments into fund or redeem investor shares. These shares trade like equity shares on exchange or OTC. They also charge on-going mgmt fees.
Term
Money Market Funds
Definition
Invest in short-term debt securities and provide interest income with very low risk of changes in share value. Fund NAV is set to one currency, and differentiator is type of MM securities and maturities
Term
Bond Mutual Funds
Definition
Invest in fixed-income securities. Differentiated by bond maturities, credit ratings, issuers,types (govt bond funds, high yield corporate bond funds).
Term
Stock Mutual Funds - Passively Managed
Definition
This is portfolio constructed to match performance of specific index (S&P 500)
Term
Stock Mutual Funds - Actively Managed
Definition
Where mgmt selects individual securities with goal of producing returns higher than benchmark indices. Higher mgmt in active management because of higher turnover of securities in portfolio. Also greater tax liabilities than in passive mgmt.
Term
Exchange Traded Funds
Definition
Similar to closed-end funds, where purchases/sales are made in market than with fund. However, closed-end is managed, where ETF is invested to match particular index (passive). Closed-end can also have diff between NAV and market price, whereas ETF has provisions to keep market price near NAV. ETFS traded like stocks, and investors pay brokerage, view spreads and receive div income on portfolio stocks in cash. Open-end funds offer reinvestment of div into addl. fund shares.
Term
Separately Managed Account
Definition
Portfolio owned by a single investor and managed according to investor's needs and prefs.
Term
Hedge Funds
Definition
Pools of investor funds that are not regulated to the extent that mutual funds are (1)Long/short funds (2) Equity market-neutral funds; neutral with respect to market moves, but make money as long as longs outperform shorts over time (3) Bias; long bias or short bias (4) Event-driven funds; corporate events like M&A (5) Fixed-income arbitrage funds; long and short in debt (6)Convertible bond arbitrage funds; attempt to profit off mispricing between convertible bonds and equity (7) Global macro funds (speculate on changes in interest rates, exchange rates, and use lots of leverage)
Term
Buyout Funds (private equity)
Definition
Buy entire public companies and take them private (usually reorg firm, pay down debt with cash flow and sell parts)
Term
Venture Capital Funds
Definition
Invest in companies in start-up phase, with intent to grow into valuable companies.
Term
Holding Period Return
Definition
% Increase in value of an investment over a given time period. (HPR = End of period value/beginning of period value)-1 = (Pt + Divt)/P0 - 1 = (Pt-P0+Divt)/P0
Term
Arithmetic Mean Return
Definition
Simple average of a series of period returns. ARM = (R1+R2+R3...RN)/n
Term
Geometric Mean Return
Definition
Compound Annual Return. GMR = sqrtN((1+R1)*(1+R2)*...(1+RN)) - 1
Term
Money Weighted Rate of Return
Definition
The Internal rate of return on a portfolio based on all of its cash inflows and outflows. Use the shortest period between significant cash flows into and out of the account when setting up the IRR calculation.
Term
Gross Return
Definition
Total return on a security portfolio before deducting fees for the management and admin of investment account
Term
Net Return
Definition
Return after management and admin fees have been deducted.
Term
Pretax Nominal Return
Definition
Return prior to paying taxes. Div income, interest income, short-term capital gains, and LT cap gains can all be taxed at diff rates.
Term
After-tax nominal return
Definition
Return after tax liability is deducted
Term
Real Return
Definition
Nominal return adjusted for inflation (Ex: investor earns nominal of 7%, inflation is 2%, so real return is 5%. Or 1.07/1.02 = 4.9%
Term
Leveraged Return
Definition
Return to an investor that is a multiple of the return on an underlying asset. Calc'd as gain or loss on investment as % of investor's cash investment (real estate)
Term
Population Variance
Definition
(stdev)^2 = Summation(Rt - mean value of distribution)^2/T, where Rt is the return for each period, and T = number of periods
Term
Sample Variance
Definition
s^2 = Summation(Rt - sample mean)^2/(T-1)
Term
Covariance
Definition
Measures extent to which two variables move together over time. Positive means variables move together, negative means variables move oppositely. zero covariance means no linear relationships between variables..
Term
Covariance Formula
Definition
Covariance = SummationN((Rt1-Rmean1)*(Rt2-Rmean2))^2/(N-1), where Rt1 is return on asset 1, Rmean1 is mean return on asset 1, Rt2 is return on asset 2, Rmean2 is mean return on asset 2, and n is number of periods
Term
Correlation
Definition
Standardization of covariance of returns of two securities. Correlation of 1 means deviations from mean or expected return are always proportional in same direction. Correlation of - 1 means deviations from mean, or expected reurn are proportional in opposite direction. Correlation coefficient of zero means no linear relationship between two stock returns.
Term
Correlation Formula
Definition
Covariance between 1,2/(st dev1)*(st dev2)
Term
Returns of Major Asset Classes over Time
Definition
From 1926 to 2008, small-cap stocks had highest risk and highest avg. returns. T-bills had lowest avg returns and lowest risk. Evaluating investments using expected return and variance is simplification, b/c returns don't follow normal dist. Dist are negative skewed with greater kurtosis (fat tails) than norm dist. Liquidity is also important to consider when choose investment; hard to trade securities in emerging markets frequently, such as low-quality corporate bonds.
Term
Risk-Averse Investor
Definition
Dislikes risk (prefers less risk to more risk). 2 investments with equal return, investors chooses one with less risk. However, will hold risky portfolio if extra return is adequate comp for extra risk.
Term
Risk-Seeking Investor
Definition
Prefers more risk to less, and will choose more risky investment
Term
Risk-neutral investor
Definition
Has no preference regarding risk and is indifferent between two investments
Term
Variance of Returns for Portfolio of 2 risk assets Formula
Definition
VarPortfolio = (w1^2)*(stdev1^2)+(w2^2)*(stdev2^2)+2(w1)(w2)(stdev1)(stdev2)(correlation1&2)
Term
StDev of Returns for Portfolio of 2 risk assets Formula
Definition
StDevPortfolio = SQRT((w1^2)*(stdev1^2)+(w2^2)*(stdev2^2)+2(w1)(w2)(stdev1)(stdev2)(correlation1&2))
Term
Minimum Variance Portfolios
Definition
Portfolios that have the lowest standard deviation of all portfolios with given expected return
Term
Minimum Variance Frontier
Definition
All portfolios that have the lowest standard deviation of all portfolios with given expected return. Absolute farthest left portfolio is known as global minimum-variance portfolio
Term
Efficient Frontier
Definition
All Portfolios that have greatest expected return for each level of risk (stdev)
Term
Utility Function
Definition
Represents the investor's preferences in terms of risk and return
Term
Indifference Curve
Definition
A tool from economics that plots combinations of risk (st dev) and expected return among which an investor is indifferent. Investor's expected utility is the same for all points along a single indifference curve. A more risk averse investor will have steeper indifference curve because needs more return to be compensated for risk. Flatter for more risk-seeking investors.
Term
Stdev of Portfolio with 1 Risky Asset and 1 Risk Free Asset
Definition
StdevPortfolio = WeightA*stdevA
Term
Two Fund Separation Theorem
Definition
All investors optimum portfolios will be made up of some combination of an optimal portfolio of risky assets and risk free asset.
Term
Capital Allocation Line (CAL)
Definition
Line representing the possible combinations of risk-free asset and the optimal risky assets portfolio. Return on y-axis, risk on x axis. Starts from Rf return point. Plotting Indifference Curves on the CAL shows optimal portfolio for investors that are available in the market.
Term
Market Portfolio
Definition
The same risky portfolio that every investor uses under the assumption of homogeneous risk/return expectations when determining the optimal risky portfolio and optimal CAL. Investors can choose different weights between risk-free and risky portfolio, however.
Term
Capital Market Line
Definition
Under assumption of homogeneous expectations, optimal CAL for all investors is called the capital market line (CML). This line is where the riisky asset is the market portfolios, so combinations of the risky asset and risk-free asset form the CML.
Term
Capital Market Line (Formula)
Definition
E(Rp) = RFR + [(E(Rm)-RFR/stdevM]*stdevP
Term
Passive Investment Strategy
Definition
For investors who believe mkt prices are informally efficient (invest in index of risky assets as proxy of market portfolio and rest in risk free asset.
Term
Active Portfolio Management
Definition
Investors who invest more than market weights into securities they believe are undervalued or less in overvalued.
Term
Unsystematic Risk
Definition
Risk that is eliminated by diversification (unique, or firm-specific risk). Takes approximately 30 securities to diversify away most unsystematic risk. Unsystematic risk is not compensated in equilibrium because it can be eliminated for free through diversification.
Term
Systematic Risk
Definition
Risk that cannot be diversified away (market risk or undiversifiable risk) in a portfolio. Securities can have high systematic risk as well (very responsive to the market changes), like luxury goods. Expected equilibrium return on individual security will depend on its systematic risk, according to capital market theory.
Term
Total Risk
Definition
Systematic Risk + Unsystematic Risk
Term
Return Generating Models
Definition
Used to estimate the expected returns on risky securities based on specific factors (macro, fundamental and statistical)
Term
Multifactor Models
Definition
Most commonly use macroecnomic factors such as GDP growth, or inflation along with fundamental factors such as earnings, earnings growth, etc.
Term
Multifactor Model Formula
Definition
E(Ri)-RFR = Beta1*Factor1+Beta2*Factor2+Beta3*Factor3

Expected return is sum of each factor sensitivity or factor loading (the betas) times expected value of that factor.
Term
Single-Index Model Formula
Definition
E(Ri) - Rf = Beta*[(E(Rm)-Rf)]. This has return on the market as it's only risk factor.
Term
Market Model
Definition
Used to estimate a security or portfolio's beta and estimate securities return above expected return based on actual market return.
Term
Market Model Formula
Definition
Ri = Alphai + Betai*Rm + ei, where Ri = return on asset i, alphai = intercept, betai = slope coefficient, Rm = market return, and ei = abnormal return on asset i
Term
Beta
Definition
Sensitivity of an asset's return to return on market index (in context of market model. Standardized measure of covariance of asset's return with market return.
Term
Beta Formula
Definition
Betai = covariance of Asset i's return with the market return/variance of the market return = Covariance(i,m)/variance(m) = correlation(i,m)*stdev(i)/stdev(m)
Term
Security Characteristic Line
Definition
Regression line that is, in practice, how beta is calculated. Uses leas squares regression line that minimizes sum of squared distances of points plotted. The slope of security characteristic line is Covariance(i,m)/variance(m). If beta is greater than one, intrepreation is that returns on asset i are more variable in response to systematic risk factors than is overall market which has beta of 1.
Term
Security Market Line
Definition
Relationship between risk and return for individual assets using Cov(i,mkt) as measure of systematic risk.
Term
Security Market Line Formula
Definition
E(Ri) = RFR + E(Rmkt)-RFR*(Cov(i,mkt)/variance(mkt))... last term is defined as beta
Term
Capital Asset Pricing Model (CAPM)
Definition
Relation between beta (systematic risk) and expected return
Term
Difference between Capital Market Line and Security Market Line
Definition
CML uses total risk = stdev(p) on x-axis, so only efficient portfolios will plot on CML. SML uses beta (systematic risk), so all properly priced securities and portfolios of securities will plot on SML.
Term
Mispriced Securities Relative to SML
Definition
If estimated return (dividends, enxt years price) plots higher than the SML (which uses CAPM model), then the stock is undervalued. If it plots lower than the SML, the stock is overvalued.
Term
Sharpe Ratio
Definition
Risk adjusted return measure that evalutes relative performance of a portfolio with different risk from a benchmark.
Term
Sharpe Ratio Formula
Definition
Sharpe Ratio = (Rp - RFR)/stdev(p). Sharpe ratio is excess return per unit of total portfolio risk and higher Sharpe ratios indicate better risk-adjusted portfolio performance. Uses total risk, instead of systematic risk, so accounts for any unsystematic risk portfolio manager has taken. Only useful to compare with sharpe ratio of another portfolio.
Term
Sharpe Ratios as Slopes
Definition
Sharpe Ratio is slope of the CAL for portfolio and can be compared to slope of the CML, which is sharpe ratio for any portfolio along CML.
Term
M-squared (M^2)
Definition
Measure which produces same portfolio rankings as Sharpe ratio but stated in percentage terms
Term
M-squared (M^2) Formula
Definition
(Rp-Rf)(stdev(m)/stdev(p) - (Rm-Rf). The first term is the ecess return on a portfolio constructed by taking a leverage position in the portfolio so that it has the same total risk as the market portfolio.
Term
Treynor Measure
Definition
Measure of risk-adjusted return based on systematic risk (beta) rather than total risk. Based on slope.
Term
Treynor Measure Formula
Definition
Rp-Rf/Beta(p), interpreted as excess returns per unit of systematic risk and represented as a slope of a line.
Term
Jenson's Alpha
Definition
Calculated as alpha(p) = Rp - [Rf + Beta(p)(Rm-Rf)], and is percentage of portfolio return above that of a portfolio with same beta as portfolio that lines on SML.
Term
Sharpe Ratio/M^2 vs. Treynor/Jenson's Alpha
Definition
If single manager is used and risk adjustment based on total risk, then use Sharpe and M^2 measures. If fund uses multiple managers where non-systematic risk is diversified out, then use Treynor or Jensen's Alpha b/c those based only on systematic (beta) risk.
Term
Investment Policy Statement Components
Definition
(1) Description of Client circumstances, situation, investment obj. (2) Statement of Purpose (3) Statement of Duties and Responsibilities of investment manager (4) Procedures to update IPS (5) Investment Objectives (6) Constraints (7) Guidelines, asset types permitted an leverage to be used. (8) Evaluation of Performance using benchmark portfolio (9) Appendicies containing asset allocation and how/when portfolio should be rebalanced
Term
Risk Objectives of IPS
Definition
Absolute Risk Objective - "portfolio not decrease in value by more than 2% at any point of 12 month period." or Relative Risk Objective - "Returns not less than 12 month euro LIBOR over any 12 month period"
Term
Ability to bear risk
Definition
Depends on financial circumstances (long investment horizon, greater asset v/ liabilities, secure job all suggest greater ability to bear risk)
Term
Willingness to bear risk
Definition
Based on investor's attitudes and beliefs about investments (risk aversion or tolerance). If willingness to bear risk is high, but ability is low, then manager will take low risk.
Term
Investment Contraints
Definition
Investor's liquidity needs, time horizon, tax considerations, legal and regulatory constraints, and unique needs and preferences.
Term
Investment Contraints (Liquidity)
Definition
Refers to ability to turn investment assets into spendable cash in short period of time without having to make significant price concessions to do so.
Term
Investment Contraints (Time Horizon)
Definition
Longer an investor's time horizon, more risk and less liquidity the investor can accept in a portfolio.
Term
Investment Contraints (Tax Situation)
Definition
Tax treatment of various types of accts. also a consideration in portfolio construction (investors with higher tax rate might take tax-free bonds)
Term
Investment Contraints (Legal and Regulatory)
Definition
Legal and regulartory constraints may apply (corporate officers facing legal restrictions on trading securities of their firms)
Term
Unique Circumstances
Definition
Each investors has specific preferences on which securities may be purchased (people who won't invest in securities issued by tobacco commons)
Term
Strategic Asset Allocation
Definition
Specifies percentage allocations to included asset classes (low correlations between asset classes leads to diversification). Can be equities in emerging or developing markets, bonds into maturities or foreign or domestic, or even hedge funds, commodities, etc.
Term
Tactical Asset Allocation
Definition
Variation of strategic asset allocation to take advantage of perceived short term opportunities.
Term
Security selection
Definition
Deviations from index weights on individual securities within asset class.
Term
Risk Budgeting
Definition
Sets an overall risk limit for portfoflio and allocates a portion of permitted risk to systematic risk of strategic asset allocation, tactical asset allocation, and security selection.
Term
Core-Satellite Approach
Definition
Invests majority of portfolio into passively managed indexes and smaller into actively managed strategies. Reduces likelihood of excessive trading or offsetting active positions by multiple managers.
Term
Three Functions of Financial System
Definition
(1) Allow entities to save and borrow money, raise equity capital, manage risks, trade assets, and trade based on estimates of asset values. (2) Determine returns that equate total supply of saving with total demand for borrowing (3) Allocate capital to msot efficient uses
Term
Equilibrium Interest Rate (Determines Return that equates supply of savings with demand for borrowing)
Definition
The rate at which the amount of individuals, business, and governments desire to borrow is equal to amount that individuals, businesses and governments desire to lend.
Term
Financial Assets
Definition
Securities (stocks and bonds), derivative contracts and other currencies
Term
Real Assets
Definition
Real Estate, equipment, commodities, and other physical assets
Term
Debt securities
Definition
Promises to repay borrowed funds
Term
Equity securities
Definition
Represent ownership positions and include common, preferred stock and warrants.
Term
Publicly traded securities
Definition
Traded on exchanges/through security dealers and subject to regulatory oversight.
Term
Private Securities
Definition
Not traded in public markets, often illiquid and not subject to regulation
Term
Derivative Contracts
Definition
Have values that depend on values of other assets
Term
Financial derivatives contract
Definition
Based on equities, equity indexes, debt, debt indexes or other financial contracts
Term
Physical Derivative contract
Definition
Derive values from values of physical assets such as gold, oil, and wheat
Term
Spot Markets
Definition
Markets for immediate delivery
Term
Primary market
Definition
Market for newly issued securities
Term
Secondary Market
Definition
Subsequent sales of securities issued in primary market happen in secondary market
Term
Money Markets
Definition
Markets for debt securities with maturities of one year or less
Term
Capital Markets
Definition
Markets for longer-term debt securities and equity securities that have no specific maturity date.
Term
Traditional Investment Markets
Definition
Markets for debt and equity
Term
Alternative Markets
Definition
Markets for hedge funds, commodities, real estate, gemstones, collectibles. These often sell at discount because more difficult to value, illiquid and require due diligence.
Term
Issue
Definition
The initial sale of a security when security is sold to the public
Term
Fixed income securites
Definition
Refer to debt securities that are promises to repay borrowed moeny in the future; short term < 1 or 2 years, long term > 5 or 10 years, mid term is in between. Bonds considered long-term, notes are intermediate term, commercial paper is short term issued by firms. Govts. issue bills, banks issue certificates of deposit
Term
Repurchase Agreement
Definition
Borrower sells high-quality asset and has right and obligation to repurchase at higher price in future. Can be for as short as one day.
Term
Convertible Debt
Definition
Debt that investor can exchange for a specified number of equity shares of issuing firm.
Term
Common Stock
Definition
Residual claim on firm's assets, dividends paid only after interest paid to debt holders and dividends paid to preferred stockholders. If firm liquidation, debt holder and preferred paid before common stock holder.
Term
Preferred Stock
Definition
Equity security with scheduled dividends that do not change over security's life and paid before any dividends on common stock may be paid.
Term
Warrants
Definition
Similar to option b/c they give holder right to buy a firm's equity shares (usually common stock) and fixed exercise price prior to warrant expiry.
Term
Pooled investment vehicles
Definition
Mutual funds, depositories, hedge funds (ownership referred to as shares, units, depository receipts, etc.)
Term
Mutual Funds
Definition
Pooled investment vehicles where investors can purchase shares from fund itself (open-end funds) or secondary market (closed-end funds)
Term
Exchange-traded funds and Exchange traded Notes
Definition
Trade like closed-end funds, but have special provision allowing conversion into individual portfolio securities or exchange of portfolio shares for ETF. Keeps market price close to value of proportional interest in overall portfolio.
Term
Asset-backed securities
Definition
Claim to a portion of a pool of financial assets such as mortgages, car loans, or credit card debt. Different classes of claims (tranches) have different risk levels.
Term
Hedge Funds
Definition
Limited partners with investors as limited partners and fund manager as general partner. Use leverage, restricted to investors with substantial wealth and investment knowledge.
Term
Currencies
Definition
Issued by a government's central bank. Some are referred to as reserve currencies (dollar/euro held by governments or central banks worldwide).
Term
Contracts
Definition
Agreements between two parties that require some action in future, such as exchange an asset for cash. (futures, forwards, options, swaps).
Term
Forward Contract
Definition
Agreement to buy or sell an asset in the future at a price specified in the contract at its inception. (Buy 100 oz of gold 90 days from now for $1000 is a forward). Not traded on exchange or dealer markets.
Term
Futures Contract
Definition
Similar to forwards, except standardized to amount, asset characteristics, and delivery time. Traded on exchange so they are liquid investments.
Term
Swap Contract
Definition
Term
Swap Contract
Definition
Two parties make payments that are equivalent to one asset being traded for another. (Interest rate swap is trading floating rate payment for fixed-rate payment) (Currency swap involves loan in one currency for loan of another currency) (equity swap involves exchange of return on equity index for port interest payment on debt instrument).
Term
Option Contract
Definition
Gives owner right to buy or sell an asset at a specific exercise price at some specified time in the future
Term
Call option
Definition
Gives option buyer the right(but not obligation) to buy an asset
Term
Put Option
Definition
Gives option buyer the right (but not obligation) to sell an asset
Term
Sellers of Call (Put) Options
Definition
Receive a payment referred to as option premium when they sell options but incur obligation to sell (buy) asset at specified price if owner chooses to exercise.
Term
Insurance Contract
Definition
Pays a cash amount if a future event occurs (life, liability, and automobile insurance), can be traded and often have tax-advantaged payouts.
Term
Credit Default Swaps
Definition
Form of insurance that makes payment if issuer defaults on its bonds (used by bond investors to hedge default risk or speculators who think issuer will have more or less financial trouble than expected).
Term
Where Commodities Trade
Definition
Trade in spot, forward, and futures markets (metals, ags, energy products, carbon credits). Futures and forwards allow hedgers/speculators to participate without buying physical and storing it.
Term
Real Assets
Definition
Real estate, equipment, and machinery (held for use in production, but can be held by institutional investors). Illiquid because specialization results in limited pool of investors.
Term
Real Estate Investment Trust (REIT)
Definition
Investor can choose to buy real assets indirectly instead of directly. Indirect ownership interest usually more liquid than direct ownership of asset itself. Can also buy stock of company that owns lots of real assets.
Term
Financial Intermediaries
Definition
This group stands between buyers and sellers and facilitate exchange of capital, risk, and assets. Allow for greater effieincy, includes brokers, exchanges, securitizers, depository institutions, insurance companies, arbitrageurs, and clearinghouses.
Term
Brokers (Financial Intermediary)
Definition
Help clients buy and sell securities by finding counterparties to trades in a cost efficient manner (work for brokerage firms, banks or exchanges)
Term
Investment Banks (Financial Intermediary)
Definition
Help corporations sells common stock, preferred stock, and debt securities to investors. Also provide advice (M&A and capital raising)
Term
Exchanges (Financial Intermediary)
Definition
Provide a venue where traders can meet; exchanges promote shareholder democratization and acquire regulatory power through member agreement or government.
Term
Alternative Trading Systems (ATS) (Financial Intermediary)
Definition
Serve same trading function as exchanges but have no regulatory functino, also known as electronic communication networks (ECNs or multilateral trading facilities (MTFs). ATS that do not reveal client orders are dark pools.
Term
Dealers
Definition
Facilitate trading by buying for or selling from their own inventory. They provide liquidity and profit from bid-ask spread.
Term
Broker-Dealers
Definition
Dealers who also act as brokers. They have an inherent conflict of interest because brokers are supposed to look for best price for trader, but dealers are looking to profit off the bid-ask spread. Traders place limits on how orders are filled when transacting with broker-dealers.
Term
Primary Dealers
Definition
Dealers that trade with central banks buy or sell government securities to affect money supply
Term
Securitizers
Definition
Pool large amounts of securities or assets and then sell interest in the pool to other investors. They create diversified pool of assets with more predictable cash flows; this creates liquidity in assets because assets in ownership interest are valued more easily. Assets securitized are mortgages, car loans, credit card receivables, bank loans, and equipment leases. Primary benefit of securitization is to decrease teh funding costs for the assets in the pool. Senior tranches provide most certain cash flows, junior tranches have more risk.
Term
Depository Institutions
Definition
Banks, Credit Unions, and Savings and Loans. Pay interest on customer deposit and provide transaction services like checking accounts. They also make loans with funds.
Term
Prime Brokers
Definition
securities brokers who provide loans to investors who purchase securities on margin. When it is to hedge funds and other institutions, they are called prime brokers.
Term
Insurance Companies
Definition
Collect insurance premiums in return for providing risk reduction to the insured. Can do this because it has diversified pool of policyholders whose risks of loss are typically uncorrelated, so more predictable losses and cash flows compare to single contract (just like bank loans.)
Term
Moral Hazard
Definition
Occurs because the insured may take more risks once he is protected against losses.
Term
Adverse Selection
Definition
Occurs when those most likely to experience losses are the predominant buyers of insurance.
Term
Fraud
Definition
Insured person purposely causes damage or claims fictitious losses so he can collect on his policy.
Term
Arbitrage
Definition
Refers to buying an asset in one market and reselling it in another at a higher price. Provides liquidity by buying in one market and selling it in another.
Term
Clearinghouses
Definition
Act as intermediaries between buyers and sellers in financial markets and provide (1) Escrow services; transferring cash and assets to the respective parties (2) Guarantees of contract completion (3) Assurance that margin traders have adequate capital (4) Limits on the aggregate net order quantity of members (buy minus sell orders).
Term
Counterparty Risk
Definition
Clearinghouses limit this risk that the other party to a transaction will not fulfill its obligation.
Term
Custodians
Definition
Improve market integrity by holding client securities and preventing loss due to fraud or other events that affect the broker or investment manager.
Term
Long Position
Definition
Investor who owns an asset or has right or obligation under contract to purchase an asset has this.
Term
Short Position
Definition
Results from borrowing an asset and selling it, with the obligation o replace the asset in the future (a short sale)
Term
Hedgers
Definition
Use short positions in one asset to hedge an existing risk from a long position in another asset that has returns that are strongly correlated with the returns of the asset shorted. Hedgers must do in the futures market what they must do in the future, so if the farmer has to sell wheat in the future, he can reduce price risk should sell wheat futures.
Term
Short Sale
Definition
Seller (1) simultaneously borrows and sells securities through a broker (2) returns the securities at the request of the lender or when the short sale is closed out (3) must keep a portion of the proceeds of the short sale on deposit with the broker. Repayment of the borrowed asset is referred to as covering the short position.
Term
Payments-in-lieu of dividends or interest
Definition
Where short seller who simultaneously borrowed and sold security must cover dividends or interest that the lender would have received. Short seller must also deposit the proceeds from the borrow & sale with the broker as collateral for eventual repurchase of the security. The broker earns interest on the collateral and may return a portion of interest to seller at short rebate rate.
Term
Short Rebate Rate
Definition
Interest earned on collateral funds deposited with broker and the portion returned to short seller is short rebate rate.
Term
Leveraged Position
Definition
The use of borrowed funds to purchase an asset; investor is using "leverage"
Term
Margin
Definition
Investors buy on this when they borrow funds from brokers. The borrowed funds are called a margin loan.
Term
Call Money Rate
Definition
The interest paid on funds in a margin loan from a broker. Generally hgigher than government bill rate.
Term
Initial Margin Requirement
Definition
At time of new margin purchase, investors are required to put down a minimum amount of equity. (set by government, exchange, clearinghouse, or broker).
Term
Financial Leverage
Definition
Additional risk from use of borrowed funds
Term
Leverage Ratio
Definition
Value of the asset divided by the value of the equity position in a margin investment. (EX: investor who satisfies initial marg. req. of 50% equity has 2 to 1 leverage ratio so 10% inc in price results in 20% increase in investor's equity amt.
Term
Maintenance Margin Requirement
Definition
To ensure that margin loan is covered by the value of asset, an investor must maintain a minimum equity percentage, called the maintenance margin requirement. Minimum is usually 25%. If % of equity in margin account falls below maintenance margin req, investor receives a margin call, which is request to bring equity percentage in account back up to maintemance margin percentage.
Term
Margin Call
Definition
If % of equity in margin account falls below maintenance margin req, investor receives a margin call, which is request to bring equity percentage in account back up to maintenance margin percentage, investor receives margin call. If happens with short position, investor must deposit initial margin equal to % of value of shares sold short to protect broker in case price increases. Increase in price can generate margin call.
Term
Margin Call Formula (Finding the Stock Price)
Definition
Margin Call Price = P0(1-initial margin/1-maintenance margin), where P0 = initial purchase price.
Term
Bid Price
Definition
Price at which dealer will buy a security
Term
Offer (Ask) Price
Definition
Price at which dealer will sell a security.
Term
Bid-Ask Spread
Definition
Difference between bid and ask prices, this is the source of dealer compensation. Bid and ask quoted for specific trade sizes (bid size or ask size). Traders who post bids or offers are making a market; those who trade at posted prices are taking a market
Term
Market Order
Definition
Instructs broker to execute the trade immediately at best possible price
Term
Limit Order
Definition
Places a minimum execution price on sell orders and maximum execution price on buy orders. This helps avoid price execution uncertainty, so you don't necessarily get filled at a bad price because of low liquidity. (buy order with a limit of $6 will be executed immediately as long as shares can be purchased for $6 or less). The disadvantage of limit order is that it might not be filled
Term
Standing Limit Orders
Definition
Limit orders waiting to execute are standing limit orders.
Term
Limit Order Specifics
Definition
Limit sell below best bid is said to be "marketable" or "aggressively priced" because at least part of order is likely to execute immediately. If limit price is between best bid and ask, limit order is said to be "making a new market" or "inside the market". Limit buy orders at the best bid or limit sell orders at the best ask are said to "make the market". This order may not be filled. A limit price below best bid or sell order with limit price above best ask is said to be "behind the market". A limit buy order with price a lot lower than best bid or limit sell with price way higher than best ask is called "far from the market".
Term
All or nothing orders
Definition
Execute only if whole order can be filled.
Term
Hidden orders
Definition
Those trades for which only broker or exchange knows trade size.
Term
Display Size of Trade
Definition
Traders can specify where some of the trade is visible to the market but the rest is not. Also known as iceberg orders.
Term
Day Orders
Definition
Trade orders that expire if left unfilled by the end of the trading day
Term
Good-till-cancelled
Definition
Trade orders that last until they are filled
Term
Immediate-or-cancel orders
Definition
Trade orders that are cancelled unless they can be filled immediately. Also known as fill-or-kill
Term
Good-on-close orders
Definition
Trade orders that are filled only at the end of the day.
Term
Market-on-close orders
Definition
Market trade orders are only filled at the end of the day.
Term
Good-on-open orders
Definition
Trade orders that get filled at open of the day.
Term
Stop orders
Definition
Trade orders that are not executed unless the stop price has been met. Also referred to as stop loss orders because they can prevent losses or protect profits. (Ex: Trader has stock at $50, he can put up stop sell order to sell at $45 if price falls 10%. At $45, a market order is triggered to sell, but order could be filled at a much lower price if stock continues to fall and go through the stop order.) Stop buy order is entered above stop with a stop above current mkt. price. (1) Done by traders with short positions to limit losses from inc. prices, (2) If investor thinks stock is undervalued, then puts in stop-buy to own stock when it starts to rise and rest of market believes its undervalued.
Term
Primary capital markets
Definition
Refers to the sale of newly issued securities. Newly issued shares by firms who already issued shares are called seasoned offerings or secondary issues. First time issues of shares not traded are called initial public offersing (IPOs).
Term
Secondary Financial Markets
Definition
Where securities trade after their initial issuance (ex: a buy order on the London stock exchange)
Term
Indications of Interest
Definition
Public offerings of stock (primary markets) where investment bank finds investors who agree to buy part of the issue. They aren't actual orders but are referred to as indications of interest.
Term
Book Building
Definition
The process of gathering indications of interest and adjusting the offering price of the stock upward or downward based on if interest is greater than number of shares to be offered.
Term
Book Runner
Definition
Refers to what the book builder is called in London.
Term
Accelerated Book Build
Definition
In Europe, when securities must be issued quickly.
Term
Underwritten Offering
Definition
Most common way an i-bank assist with security issuance, where they agree to purchase entire issue at a price negotiated between issuer and bank; if issue is undersubscribed, the bank has to buy the unsold portion. If IPO, the bank also makes a market for the stock for a period to provide price support. Banks have conflict of interest here, because they can set the price low with the issuer, make sure everything sells to its clients and ensure they get the benefit of the undervalued IPO. This is why IPOS are usually underpriced.
Term
Best Efforts Basis
Definition
Agreement on distribution of shares of an IPO where the bank is not obligated to buy the unsold portion if issue is undersubscribed.
Term
Private Placement
Definition
Securities are directly sold to qualified investors with assistance of i-bank. They usually have substantial wealth and investment knowledge. These securities cannot be resold in public markets, so less valuable than shares registered for public trading.
Term
Shelf Registration
Definition
Firm makes its public disclosures as in a regular offering, but issues registered securities over time when it needs capital and markets are favorable.
Term
Dividend Reinvestment Plan (DRIP)
Definition
Allows existing shareholders to use their dividends to buy new shares from the firm at a slight discount.
Term
Rights Offering
Definition
Existing shareholders are given the right to buy new shares at a discount to the current market price. They don't really like these because ownership is diluted unless they exercise rights and buy additional shares.
Term
Call Markets
Definition
Markets in which the stock is only traded at specific times. Potentially very liquid when in session b/c all traders present, but illiquid between sessions. In this market, all bids and asks are declared, and one negotiated price is set that clear the market for stock.
Term
Continuous Markets
Definition
In this market, trades occur at any time the market is open. Price is set by auction process or dealer bid-ask quotes.
Term
Quote Driven Markets
Definition
Traders Transact with dealers (market makers) who post bid and ask prices. Dealers maintain inventory of securities. Sometimes called dealer markets, price-driven markets or OTC markets. Trading takes place electronically.
Term
Order-Driven Markets
Definition
Orders are executed using trading rules because traders are anonymous. Exchanges and ATS. Two sets of rules used in these markets; order matching rules and trade pricing rules.
Term
Order Matching Rules
Definition
These establish order precedence hierarchy. Price priortiy is one criteria where trades with highest priority are highest bid and ask. If orders at same prices, then secondary precedence gives priority to non-hidden orders and earliest arriving orders.
Term
Trade Pricing Rules
Definition
After orders created using order matching rules, trade pricing rules used to determine price. Uniform Pricing Rule is where all orders trade at same price (price resulting in highest volume of trading). Discriminatory pricing rule uses Limit price of order that arrived as first trade price.
Term
Brokered Markets
Definition
Brokers find the counterparty in order to execute a trade. Valuable when trader has security that is unique or illiquid.
Term
Pre-trade transparent Market
Definition
Market where investors can obtain pre-trade information regarding quotes and orders.
Term
Post-trade transparent Market
Definition
Market where investors can obtain post-trade information regarding completed trade prices and sizes.
Term
Complete Markets (Well-functioning financial system)
Definition
Complete Markets fulfill the following (1) investors can save for future at fair rates of return (2) creditworthy borrowers can obtain funds (3) Hedgers can manage their risks (4) traders can obtain currencies, commodities and other assets they need.
Term
Operationally Efficient Market
Definition
Market can perform functions of complete markets at low trading costs (commissions, bid-ask spreads, and price impacts)
Term
Informationally Efficient Market
Definition
Security prices reflect all information associated with fundamental value in a timely fashion. These markets are also allocationally efficient if capital is allocated to its most productive use.
Term
Problems if no Market Regulation
Definition
Without Market Regulation potential for (1) Fraud and theft; investment managers taking adv. of investors (2) Insider trading; insiders using info to advantage (3) Costly information; info is expensive and markets not informationally efficient (4) Defaults; parties don't honor obligations
Term
Duties of Market Regulation
Definition
(1) Protect unsophisticated investors so trust in markets is preserved (2) Make it easier for investors to evaluate performance (3) prevent insiders from exploiting others (4) Require common financial reporting requirements (5) Require minimum levels of capital so participants can honor long-term commitments.
Term
Security Market Index
Definition
Represents the perfromance of an asset class, security market, or segment of a market. Created as portfolios of individual securities called "constituent securities".
Term
Constituent Securities
Definition
Securities that create an index that represents the performance of an asset class, security market, or segment of a market.
Term
Price Index
Definition
A way to calculate an index return, uses only prices of constituent securities in the return calculation. A rate of return that is calculated based on a price index is referred to as a price return.
Term
Return Index
Definition
Includes both prices and income from constituent securities. Rate of return that is calculated based on a return index is called total return. If assets in index produce interim cash flows like such as dividends or interest payments, then total return will be greater than price return.
Term
Calculating Return of an Index
Definition
Rp = (1+Rs1)(1+Rs2)(1+Rsk)-1, where Rp = portfolio return during measurement period, K = total number of subperiods, Rsk = portfolio return during subperiod K
Term
Index Construction and Management
Definition
Index providers must determine: (1) What is the target market (stocks in US, small-cap value stocks in US, etc.) the index is intended to measure (2) Which securities from target market should be included (3) How should securities be weighted in the index? (4) How often should index be rebalanced (5) When should selection and weighting of securities be re-examined?
Term
Price-weighted index
Definition
An arithmetic average of the prices of the securities included in the index. Divsior adjusted for stock splits and change in comp when securities are added or deleted. Advantage: Easy computation Disadvantage: given percentage change in higher priced stock has greater impact on index's value than does equal percentage change in price of lower price stock. Example of this type is DJIA, which is price weighted off 30 stocks, and Nikkei Dow based off 225 stocks on Tokyo Stock Exchange.
Term
Equal-weighted index
Definition
Calculated as the arithmetic average return of the index stocks
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