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| Glossary |
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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.
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).
ß-coefficient An index which relates the amount of market risk in an asset to the risk in a whole market portfolio.
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.
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).
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.
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.
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.
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.
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.
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.
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.
Operational efficiency The speed and cost at which a market enables transactions to be carried out.
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.
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.
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.
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.
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.
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.
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