Glossary

A | B | C | D | E | F | G | H | I | J | K | L | M | N | O | P | Q | R | S | T | U | V | W | X | Y | Z

A

Accrued interest  The interest that accrues to the seller of a bond between the last coupon payment date and the date of sale. It is paid to the seller by the buyer and makes the difference between the clean price and the dirty price.

Adaptive expectations  Expectations formed on the basis of the average values of past events.

Adverse selection  The situation where the demand for insurance comes mainly from those most likely to produce the outcomes insured against.

Agency capture  The situation where a regulatory process is 'captured' by those it is supposed to regulate and turned to their advantage.

Allocative efficiency  The best economic use of scarce resources that use of resources which maximizes consumer utility. In the case of financial markets, this requires that funds go to their most productive use.

American option  The option to buy or sell an asset at a pre-determined price at any time within the period of the option contract.

Asymmetric information  The situation where one party in a bargain has information which is superior to that of the other.

Back to the top

B

Backwardation  The state of a futures contract in which the price of the future is below the cash price of the underlying asset. The price of the future will be rising towards the cash price as the delivery date approaches.

Basis point  One one-hundredth of a percentage point (i.e. 1% = 100 bp).

-coefficient  An index which relates the amount of market risk in an asset to the risk in a whole market portfolio.

Back to the top

C

Call option  An option which gives the buyer an opportunity to purchase an asset within the time specified in the contract.

Capital risk  The risk that the capital value of an asset at the time of disposal may differ from the value expected.

Cash and carry strategy  The process of arbitrage between the futures market and the cash market that establishes the boundaries within which the futures price must lie.

Clean price  The price (usually of a bond) excluding any accrued interest.

Competitive laxity  Competition for customers by financial centres in the form of relaxing the rules by which financial institutions must abide, resulting in the weakening of the regulation of the financial system.

Compliance costs  The costs of complying with regulation for those being regulated.

Contango  The state of a futures contract in which the price of the future is above the cash price of the underlying asset. The price of the future will be falling towards the cash price as the delivery date approaches.

Correlation coefficient of return  The extent to which the returns on two assets are correlated. The more closely the returns move together, the closer the correlation coefficient is to unity.

Coupon  The fixed, periodic, payment on a bond.

Coupon rate  The coupon payment on a bond, expressed as a percentage of its par value.

Covariance  A measure of the extent to which two (or more) asset prices vary together from their average values.

Covered call  A call option (q.v.) where the underlying asset is owned by the writer (seller) of the option.

Covered interest arbitrage  The act of moving funds from one country to another to gain from higher interest rates while protecting oneself in the forward foreign exchange market against spot exchange rate changes.

Credibility  The likelihood, as judged by market agents, of an announced economic policy or existing fixed exchange rate being maintained by the government.

Currency substitution  The use of or holding of a foreign currency by domestic residents, usually as a protection against expected depreciation of the domestic currency.

Currency swap  The exchange between two borrowers of the interest payments of different types of loans e.g. fixed and floating interest rate loans, loans in different currencies or loans using different basis rates.

Back to the top

D

Default risk  The probability that a borrower may fail to make payments of interest or repayment of principal at the scheduled time.

Direct quotation  The practice of quoting the exchange value of a currency by saying how many units of that currency is required to buy a single unit of another currency.

Dirty price  The price of a bond including any portion of the next coupon payment that may have accrued to the seller between the last coupon payment and the date of sale.

Discount basis  The rate of return on an asset quoted as a rate of discount on the principal plus the interest payment.

Disintermediation  The switching of lending/borrowing away from banks and other financial institutions to direct lending/borrowing or lending/borrowing via financial markets.

Dividend yield  The dividend payment on a share expressed as a percentage of the share's price.

Divisia  A measurement of the total stock of money which weights each component of the money stock according to its liquidity characteristics.

Duration  The average length of time taken to receive a series of income payments (usually from a bond).

Back to the top

E

Efficient market hypothesis  The proposition that prices of financial assets adjust instantaneously to all relevant news.

European option  The option to buy or sell an asset at a pre-determined price on a date specified in the contract.

Exchange agio  The sum payable for the convenience of exchanging one type of money for another, e.g. spot dollars for forward dollars hence, in this case, the forward premium or discount on a currency.

Extrapolative expectations  The belief that the value of a variable, which has just changed, will go on changing in the same direction, e.g. that rising equity prices will go on rising.

Back to the top

F

Fair game model  A model of an efficient market in which all errors are random and hence there is no relationship between an investor's estimate of the deviation from the required or equilibrium rate of return and the actual deviation from that rate of return.

Financial deficit  The situation where planned consumption plus real investment spending exceed income.

Financial surplus  The situation where income exceeds planned consumption plus real investment.

Fisher effect  The assumption that in equilibrium real interest rates will be the same everywhere and hence that differences in nominal interest rates on different currencies will reflect only the differences in inflation rates in the respective countries.

Forward premium/discount  The difference between the spot and forward exchange rate.

Functional integration  The development of financial conglomerates, with mergers and takeovers leading to single firms being engaged in many financial functions, e.g. banking, insurance and securities business.

Back to the top

G

Back to the top

H

Hoarding  Saving. Usually associated with the idea of people holding money despite the loss of interest involved because of the fear of the prices of financial instruments falling.

Back to the top

I

Income risk  The probability that the rate of return from an asset will differ from what was expected.

Indirect quotation  The practice of quoting the exchange value of a currency by saying how many units of another currency can be bought with one unit.

Inflation premium  That part of the nominal interest rate which compensates for (strictly speaking expected) inflation.

Informational efficiency  The speed with which relevant information is incorporated into prices.

Initial margin  The percentage of the value of a futures contract that an investor must lodge with the clearing house at the beginning of a futures contract, against the possibility that the futures contract will experience losses.

Interest rate parity  Equality of interest rates in different countries, making allowances for expected changes in exchange rates (uncovered interest rate parity) or for the forward premium/discount of a currency (covered interest rate parity).

Interest rate swap  The exchange of interest rates on two loans one a fixed interest rate loan, the other a floating interest rate loan.

Interest yield  The coupon payment on a bond divided by the market price of the bond.

Intermediation  Lending/borrowing carried out via a bank or other financial institution.

Back to the top

J

Back to the top

K

Back to the top

L

Law of Large Numbers  The Law of Large Numbers says that in repeated, independent, trials with the same probability p of success in each trial, the chance that the percentage of successes differs from the probability p by more than a fixed positive amount converges to zero as the number of trials becomes very large.

Lender of last resort  The sole supplier of bank reserves in the event of a system-wide shortage.

Liability management  Attempts by a financial institution to control the volume and type of its liabilities by varying the terms offered to holders of those liabilities.

Liquidity  The extent to which an asset can be converted to money, quickly, cheaply and for a known capital sum.

Liquidity preference theory  The theory that the rate of interest is determined by the demand for money (liquidity preference) and the supply of money.

Liquidity premium  The price people are prepared to pay (usually in the form of a lower return) for a liquid asset compared with an illiquid one.

Loanable funds theory  The theory that the rate of interest is determined by people's willingness to save and the demand for funds to invest in real capital assets.

Back to the top

M

Marked to market  The process by which margins are adjusted on the basis of daily price changes in the markets for assets underlying futures contracts. Investors must either pay additional margin to the clearing house or may draw funds from their margin accounts depending on the direction in which prices have moved in the cash markets.

Market efficiency  Usually refers to 'informational efficiency' (q.v.) but could refer to allocative (q.v.) or operational (q.v.) efficiency, or all three.

Market risk  The extent to which returns on assets vary because of events which affect the whole market portfolio of risky assets.

Market segmentation  The formal or informal division of markets into smaller segments influenced by different supply and demand conditions.

Maturity transformation  The difference between the average maturity of a financial institution's liabilities and its assets.

Monetary base  Notes and coin outside the central bank plus banks' deposits with the central bank.

Money illusion  Mistaking changes in nominal values for changes in real values; failing to allow for inflation.

Money's own rate  The rate of return on money. Usually calculated as the average rate of return on all deposits in the money stock, weighted by their respective proportion of the total money stock.

Monitoring  The process by which financial intermediaries attempt to ensure that loans are being used for the intended purpose and in an effective way and hence are likely to be repaid on time.

Moral hazard  The tendency of agents who are insured to behave more recklessly because of their insurance cover.

Back to the top

N

NAIRU  The 'non-accelerating inflation rate of unemployment'. (That rate of unemployment at which aggregate demand pressure is consistent with a constant rate of inflation.)

Naked call  A call option (q.v.) where the underlying asset is not owned by the writer (seller) of the option.

Natural rate of unemployment  The percentage of the labour force that is recorded as unemployed when the labour market is in equilibrium.

Netting agreements  The accounting practice of offsetting profits and losses on different contracts or in different currencies in the attempt to lower the overall level of risk.

Back to the top

O

Operational efficiency  The speed and cost at which a market enables transactions to be carried out.

Back to the top

P

Payout ratio  The fraction of a firm's earnings which it pays as a dividend to shareholders (= 1 the retention ratio).

Portfolio choice  The decision to hold one's wealth in a variety of different assets.

Portfolio equilibrium  The situation where the distribution of wealth across a range of assets shows no tendency to change.

Portfolio theory  The principles involved in making the decision on how to hold one's wealth in a variety of different assets.

Price/earnings (P/E) ratio  The price of a company share divided by the earnings per share. A measure of the price that has to be paid for a share of a firm's profits.

Purchasing power parity  The situation where the exchange rate between two currencies represents the difference between the price levels in the two countries.

Put option  The option to sell an asset at a pre-determined price at some time in future.

Back to the top

Q

Back to the top

R

Random walk  A time series in which the change from one period to the next in the value of the variable in question (e.g. an asset price) is purely random.

Rate of discount  The rate of return implied by the difference between the price paid for the asset and the amount the holder will receive when the asset matures.

Rational expectations  Expectations that would be formed by agents making the best use of available information.

Real interest rate  The nominal rate of interest minus the expected rate of inflation (strictly) but in practice often the nominal rate minus the actual rate of inflation.

Redemption yield  The rate of return on an asset (usually a bond) held to redemption, taking account of the reinvestment of coupon income and any difference in current price and redemption price.

Reinvestment risk  The risk that when a bond matures and the holder wishes to reinvest the proceeds interest rates will have fallen.

Reputation  The view taken by the market of the long-term policy performance of governments or central banks based on past performance and the constitutional constraints imposed on the authority in question.

Retention ratio  The fraction of its earnings retained by a firm for reinvestment in the business (= 1 the payout ratio).

Return  The cashflow generated by an asset (usually expressed as a rate).

Risk  The probability that an outcome differs from what was expected.

Risk premium  The additional rate of return, over and above the return on a risk-free asset, required to persuade investors to hold a risky asset.

Back to the top

S

Search costs  The costs, in money and time, of finding an opportunity to trade.

Securitization  The transformation of a non-tradable asset/liability into one which can be bought and sold between third parties.

Serial correlation  A time series in which the change from one period to the next in the value of the variable in question (e.g. an asset price) is correlated with past values of the variable.

Specific risk  The variability in an asset's return caused by events specific to that particular asset.

Strike price  In an auction, the situation where all bidders pay the (same) minimum price necessary to clear the market. In an option, the price of the underlying asset at which it becomes profitable to exercise the option.

Synthetic call option  The combination of being long in the underlying cash market and, at the same time, holding a put option.

Back to the top

T

Term premium  The additional rate of return, over and above the rate on a short-dated asset, required to persuade investors to hold assets with a long period to maturity.

Term structure  The pattern of returns available on assets differentiated solely by their term to maturity.

Time inconsistency  The failure to maintain an announced policy because the original policy brings about changes in circumstances that then require policy authorities to alter the policy in order to maximize its welfare.

Total risk  The combination of specific risk, which relates to a particular type of asset, and market risk, which derives from events that effect all types of asset. Total risk is measured by the standard deviation of returns from the mean.

Transaction costs  Administrative costs of buying and selling in a market, including commissions and taxes.

Back to the top

U

Back to the top

V

Variation margin  The proportion of the value of a futures contract that must be held with the clearing house against the possibility of losses arising on the contract. Often the variation margin is the same proportion of the value as the initial margin.

Velocity  Total output at current market prices, divided by the stock of money in circulation.

Back to the top

W

Back to the top

X

Back to the top

Y

Yield basis  The rate of return on an asset calculated, like a conventional rate of interest, on the basis of the sum laid out in order to earn the return.

Back to the top

Z

Back to the top


A | B | C | D | E | F | G | H | I | J | K | L | M | N | O | P | Q | R | S | T | U | V | W | X | Y | Z

Copyright © 1995-2005 by Pearson Education