Glossary of Terms and Ideas

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Security

A security represents financial value and is broken down into three categories:

Debt

Equity

Derivative contracts

Debt is banknotes or bonds, equity is stocks and shares and derivatives are slightly more complicated and come in the form of forwards, futures, options and swaps.

Equities

Equities might be referred to as capital stock or simply stock of a business. It represents the initial investment (or in time subsequent investments). If for example $10,000 is invested equally by four investors (individuals or groups, it makes no difference) into setting up a company for use buying inventory or machinery for example, each investor now has 25% of the capital stock of the company. If 4 shares were created then each investor has 1 each at a value of $2,500 each, if 100,000 were created then each investor therefore has 25,000 shares at a value of $0.1.

You effectively own a fraction of the company depending on what percentage of the total stock you own.

As time goes by the way the company performs will change the value of your stock and therefore the value of the company.

Therefore we can draw the conclusion that value of the company (in simple or “market capitalisation” terms) is number of shares * value of share.

Bonds

This is the same as equity in many ways; instead of owning part of the company you own part of its debt and are paid a fixed rate of return. 

A bond in simple terms is an agreement to borrow money off of an “investor” for the borrower to repay this debt plus interest (a coupon). It differs from a conventional loan where you pay the loan back over time, also known as an amortizing loan, as at maturity the bond is paid off in full (at par = 100).

The cash flows for a 5-year 10% bond are:   10+10+10+10+110

Bonds can be bought in anything from governments to small companies the interest rate or the coupon depends on the “likelihood of being paid back”, therefore the rate the UK government have to pay is less than your local convenience store. Until recently government or sovereign debt of developed countries was considered risk free. 

They are slightly different to commercial paper that is issued on a short-term basis to meet cash flow problems and does not have collateral.

A "Position"

This is simply getting into a binding commitment to buy or sell a given amount of a security. You can either have a long or a short. 

For a long position in options, if you buy the (relevant) option that has not yet been written, this is considered opening the long position. If you then sell the (relevant) option that is not owned by you, this is considered closing the long position. 

For a short position, if you sell or write the (relevant) option that you do not already own, this is considered opening the long position. If you then buy the (relevant) option that is already sold, this is considered closing the short position. 

The profit or loss depends on whether you are going short (hoping for a drop in value) or long (hoping for an increase in value).

Long

A long position is created when the speculator (investor) believes that the underlying security (eg stock or bond) is going to increase in value, creating profit for the investor if the value of the security increases.


To "go long" you can buy a security.

One way an investor “goes long” if you incorporate options would be to buy call options or “write” (selling) put options on that security.

Short

A short position is created when the speculator (investor) believes that the underlying security (eg stock or bond) is going to decrease in value, creating profit for the investor if the value of the security decreases.  


To "go short" you would sell stock that you borrow on the assumption the value will lower

One way an investor “goes short” if you incorporate options would be to sell ("write") call options or buy put options on that security.

Put Option

A put option is a contract to sell an amount of a stock at a predetermined price (strike price) within (normally) a specific time range. 

The idea behind this is that if own one put option with a $10 strike price, and the value of the underlying stock drops to say $5 you have the right to sell the stock at $10 but can buy the stock in the open market meaning the difference between the two prices is profit. (Ignoring the premium to obtain a put option).

This is ideal if you think the value of a stock is going to decrease.

Call Option

A call option is a contract to buy an amount of a stock at a predetermined price (strike price) within (normally) a specific time range. 

The idea behind this is that if own one call option with a $10 strike price, and the value of the underlying stock increases to say $20 you have the right to sell the stock at $20 but can buy the stock in the open market meaning the difference between the two prices is profit. (Ignoring the premium to obtain a put option).

This is ideal if you think the value of a stock is going to increase.

Credit

This is the trust put in somebody by an investor that they will pay back the investor in an agreed time period. The person who is entrusted with the credit can use the credit (normally financial/money) to pay for goods and services paying back the money with a coupon at the agreed time. 

Credit also refers to corporate bonds, as said above these can be traded, by credit traders. There are different levels of quality associated with credit. This is based on the quality of the borrower, the more risky the higher the interest rate associated with the debt is. The most common “grades” of credit are as follows: investment grade (AAA rating to BAA (see ratings agencies)), High Yeild (BA to B) and Junk (CAA to C)

Debt also has a “credit spread” this is the difference in yields between two different bonds. The spread between a US treasury and a UK sov bond is much smaller than between a US treasury and a Thomas Cook corporate debt bond. 

Bull/Bear

This is the direction of the market trend and can be due to the level of consumer confidence, a bullish (bearish) market will have an upwards (downwards) trend and could be due to an increase (decrease) in consumer confidence. It is important to point out you can have a rally or a sell off in either a bullish or bearish market.

Yield

The rate of return of a security, taking into account future cash-flows and capital appreciation by net-present-valuing.

Rates 

This is nothing more than the government sovereign debt interest rate, i.e. the yield on a "govvie" (government bond), typically with a 10 year maturity.

Inflation/Deflation

This is the increase (decrease) of prices as time goes on, if bread costs £1 in 2011 and £1.1 (£0.9) in 2012 there has been a 10% increase (decrease) in prices therefore inflation (deflation) has been 10% (-10%).

Central banks aim for 2% of inflation because if you aim for 0% you might slip into deflation, this is detrimental because if you slip into deflation people will put off purchases waiting for lower prices and therefore GDP/growth falters.

Appreciation/Depreciation

This is the increase (decrease) in the market value (MTM) of an asset or, more regularly,  the price of one currency, expressed in another currency, increasing (decreasing).

Currency Cross (EURJPY)

Currency was normally (or historically) traded through the dollar, so if you wanted AUD from GBP you would have had to go GBP  USD  AUD. A currency cross is the trading of foreign exchange (Forex, FX etc) currency without going through the USD. 

EUR/JPY 100, would mean that 1 Euro is worth 100 Japanese Yen, a change to 105 would mean the JPY has depreciated and the EUR has appreciated. Euro is the base and JPY the variable.

"Safe Haven"

This was often seen as a triple A rated country or organisation, with US bonds (treasuries) being seen as a risk free asset. This is somewhere where you can put value or wealth and you hope not to see a drop in its value, the go to asset for investors during times of crisis, due to its unwavering value or its liquidity as an asset.

Often gold becomes popular at times of strife and is often see as a safe haven, due to its some what counter-cyclical valuation pattern, but recently this has even come into contention. People may see Germany as a safe haven in the Euro zone and potentially the UK in Europe. As times get more uncertain safe havens become few and far between, but if you’re in for the long haul gold, treasuries and UK bonds are still viewed as safe. 

Risk Assets

These are assets that move in a cyclical nature or with the market; this is the opposite of a “safe haven” asset that moves differently to the market. Most assets move in a cyclical or pro-cyclical nature, where as gold or sov debt might not be considered in the same way.

More recently, and in times of market volatility, more assets move in sync with the market and become risk assets.

Support/Resistance

This is price level that the price of a security might bounce off when it is falling (support level) or rising (resistance level). Given enough noise, very short run volatility in security price, the security will push through the level and often move until another S/R level is found. 

Support (resistance) exists when there is a group of buy (sell) limit orders clustered around some level. Predicting these levels forms the art/science of technical analysis or TA.

Stop (Loss)

This is a simple tool that investors use so that their positions don’t have maximum exposure, or limitless loses. The idea is that you aren’t watching your stocks at all times and this feature allows you to limit your loses. If you buy a stock at £10 you might put a stop loss at 10% loss, so if the value of the security drops below £9 the system sells the security at the current price, limiting your loses.

Take (Profit)

This is a simple tool that investors use so that their positions don’t have maximum exposure, or limitless loses. The idea is that you aren’t watching your stocks at all times and this feature allows you to limit your loses. If you buy a stock at £10 you might put a stop loss at 10% loss, so if the value of the security drops below £9 the system sells the security at the current price, limiting your loses.

Hedge

This is an operation that shields you from losses from another investment; the hedge can be constructed across many products and instruments, and does not only exist in financial betting. It is a way of mitigating risk. Normally you might hedge industry risk when betting on a single stock. This reduces your risk because if the whole industry drops you should be protected by the hedge. 

The classic example of a hedge is as follows, if you thought British Airways was about to increase in value due to some unexpected profit reports you would want to bet on BA, right? Well in short yes, if right you would capture the profit. However if the whole industry reduced in value due to future fuel concerns the gain on BA would be lost and there would be an overall lose. 

So you would long BA (locking in the profit of the increase in value of BA, relative to the wider market) and short the industry (stopping your loses if the industry drops in value). So effectively you are betting on the relative increase in BA verses the market. 

If both BA and the industry go up it will reduce your gains and if both drop it will reduce your losses. If however the market moves against BA then the investor will make money on the short and on the long of BA, and if both tank then the money lost on the investment will be remade on the short.

Tail Risk

This is the 1 in 1000 risk, or the risk of the unlikely event, the event is unexpected but rationalised with hindsight. The phrase comes from the binomial distribution.

The concept of fat tails refers to the observation that real-world financial markets have far larger price swings than would be expected in a traditional normal distribution.

Rally/Sell-Off

A rally (sell-off) is a fast increase (decrease) in security prices, this is linked to a rapid increase (decrease) in demand. It often occurs when the market is perceived to, or is undervalued (overvalued). This should not be confused with a bullish (bearish) market.

Expected Value

This is often written E(x) or simply E(.). This effectively is what some people might refer to as the mean or average. In a lottery where you can win £100 or £50 from the toss of the coin the expected return (outcome) is £75. This is of course not a physically attainable sum.

E(.)= [(1/2)*100] + [(1/2)*50]=75

Risk weighted

This is a way of valuing assets. If you have an asset that has a large potential to default you cannot value that asset at full value. Treasury bonds normally come in at 100% and therefore can be listed at full value but subprime mortgages come in a lot lower. Basel I and II put together a list of how you should/can account for various assets. 

Trading Range

This is the difference between high and low prices during a predetermined period of time. 

Often markets will be said to be "range trading", over any time-frame, when no particular trend can be identified.

Collateral

This is the asset that you are using to guarantee a loan, or the deposit you are putting down to give the lender confidence in you that you will not default on them.

e.g. A house is the collateral for a mortgage.

Secured/Unsecured

This term is commonly used when describing personal loans. If you take out a secured (unsecured) loan there is (not) an asset that is used as collateral, this means that if you default on the loan the bank will (not) reclaim the asset from you to finance the amount of the defaulted loan. A credit card is unsecured and a mortgage is secured.

Margin

The margin is the percentage of the value of an asset that an investor needs to put down as a deposit to cover the credit risk of the lender for the purchase of the asset. This risk occurs when the rest of the value of the underlying asset (100%-margin) is financed through borrowing, or sold financial assets short.

S&P/Moody's/Fitch (Ratings Agencies)

These are the ratings agencies that rate financial products and organisations based on their strength and resilience to financial strife or volatility. It was commonplace for developed countries to have the highest possible rating. Products that get a rating are normally in the following categories: issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities.

The reason for the rating is for investors in debt or securities of an organization to see how strong the company is. However large volumes of controversy exists around rating agencies and their scores. This is due to conflict of interests and partly to moral hazard, as they are no exposed to any of the risk of actually investing in the products they rate.

The conflict of interest occurs because the owner of the product has to pay for a rating to be made as otherwise no body would buy the asset, however the credit rating companies own this therefore they have a motive to give a good rating so as to retain the customer. If they said all the SPVs (Special purpose vehicle) 

LTRO (Long Term Refinancing Operation) 

These are 3 year secured loans offered at low interest rates to banks and sovereign countries. Sovereign debt is deemed acceptable as an asset to secure the debt, therefore banks have been borrowing money at low rates and buying riskier PIIGS country debt and taking the credit spread in a carry trade fashion.

What counts as acceptable collateral will most likely be relaxed in the future. 

Arbitrage

This can occur when one asset is priced differently on two separate markets, the arbitrage is the profit made between the two different prices of the same assets. This could be gold sold in France and China at two different prices. It is a concept of market inefficiency, and is used as a mechanism for price differences to be rectified. 

As markets became more global this occurs less likely to occur as information becomes more perfect.  

NAV (Net Asset Value)

This is very simply: assets minus liabilities, this is the same as “book value” and is different to MTM (mark to market) valuation (see below). This is the value of the immediate sale of all assets and liabilities

This is the market value of all assets currently, if you were to liquidate all assets and liabilities immediately, hence the net asset value. MTM (below) is used to work out the NAV of a company.

Mark to Market

This is what is often known as a fair value valuation. It was brought into accounting when it was deemed that people were misreporting their financial data by keeping the book value (original value – depreciation) in their financial reports, which were often wildly incorrect and therefore gave a distorted value of the company. 

The way it works is by taking the market value of something or effectively the replacement value of an asset, i.e. a 2 yr old VW golf’s reported value would not be original price minus depreciation rather it would be the value of a similar car.

It is key to note that this is, obviously, an estimation.

EUR 

This is a currency, used in 17 out of the 27 member states of the European Union. It is the second largest currency reserve in the world, and also the second most traded. Lots of other currencies exist in their three-letter form the most common are below:

GBP: Great Briton Pound

USD: United States Dollar

JPY: Japanese Yen

AUD: Australian Dollar

NZD: New Zealand Dollar

EURX

This is the Euro currency index; much like the FTSE for equities this serves the same purpose for currencies. It is measured against a basket of 5 currencies.

“EURX calculation according to five currencies’ basket is not accident – it coincides with the information used by theECB (European Central Bank) during calculation of trade and weighted euro index regarding the currencies of the countries forming the main foreign trade turnover of European Union countries. The greatest part of foreign trade of EU members falls to USA (31.55%), after which come Great Britain (30.56%), Switzerland (11.13%), Japan (11.13%), and Sweden (7.85%) and uses this formula:

EURXt=34.38805726 x (USDt)–0,3155 x (GBPt)0, 3056 x (JPYt)– 0.1891 x (CHFt) 0.1113 x (SEKt) 0.0785”

Correlation (& typical correlations)

This is the degree of strength of a relationship between two or more variables, the most common are strong positive, positive, no, negative and strong negative. A positive correlation exists when as one variable increases the other variable increases (height and weight being an obvious example) a negative correlation occurs when as one variable increase the other decreases (number of education years and years in prison).

An interesting topic in correlation is causation; if there is a correlation there might not necessarily be causation. If you found a relationship between being tall and liking diet coke it does not mean because people are tall they like diet coke or the other way round, it also doesn’t mean its not! See this article for further discussion.

Currently in financial markets, the EURUSD and most equity indices are highly correlated as they are all considered risk assets.

ECB

European Central Bank, Frankfurt, Germany. This is the equivalent of the Bank of England or the Federal Reserve. It has one objective to maintain price stability (inflation) through control on interest rates and monetary supply.

EFSF

European Financial Stability Facility, this is a special purpose vehicle financed by members of the Euro zone to combat the sovereign debt crisis. The idea is that the facility will provide financial assistance to Euro zone countries in financial difficulty.

It sells bonds and uses the funds to recapitalise banks or buy sovereign debt, guarantees are given by the member states.

EIB

European investment bank, much like any normal investment bank deals with long term investing and lending. It uses European money to make a difference through correct investments; this includes wind farms, motorways, bridges etc across Europe and the world

Budget Deficit/Surplus

This is in the news a lot at moment in reference to sovereign debt; a country is in budget deficit (surplus) if they spend more (less) than they collect in receipts or taxes.

Current Account Deficit/Surplus

This is the difference between imports and exports, if you export are larger (smaller) than your imports then you have current account surplus (deficit)