AAA Rating

The highest credit rating for a bond or company – the risk of default (or non–payment) is negligible.

Abitrage

The simultaneous sale (or purchase) of a financial instrument and the taking of an equal and opposite position in a similar instrument to provide a profit, i.e. exploiting pricing differences (anomalies) across markets. True arbitrage is risk free.

Advances

Bank loans to their customers. These may be unsecured loans, eg overdrafts, or policies held with the bank for the customer, ie life assurance.

AIM - Alternative Investment Market

The junior market, established in 1995, by the London Stock Exchange providing trading facilities for shares of smaller companies.

Amortisation

The gradual reduction over time (depreciation) of the principal of a bond or mortgage. Also applies to the repayment of debt by a series of instalments. A fund which is built up over a period of time to replace a productive asset, or to pay off a loan. If the fund is to repay a loan, then interest rates need to be considered, and if the fund is to replace an asset, then interest rates, expected lifetime of the asset, and cost of replacement also need to be considered.

Arbitrage

The simultaneous sale (or purchase) of a financial instrument and the taking of an equal and opposite position in a similar instrument to provide a profit, i.e. exploiting pricing differences (anomalies) across markets. True arbitrage is risk free.

Arbitrage Pricing Model

An extension of the Capital Asset pricing Model (CAPM) to include more than one factor (hence, an example of a multi-factor model) used to explain the returns on securities. Each factor has its own Beta coefficient.

Arbitrage Pricing Theory

A type of multi-factor model which relates return on securities to various non-diversable risk factors. The expected return on any risk security is a linear combination of these factors.

Arithmetic Mean

The average of a population equals the sum of the observations divided by the number of observations.

ARROW

Advanced Risk Responsive Operating Framework; the framework and methodology used by the Financial Services Authority to make risk-based regulation operational.

Asset-Backed Securities

See Securitisation

Top

Bad Debt

Debts that are unlikely to be paid.

Balloon Repayment on a Loan

The majority of the repayment of a loan is made at or near the maturity date, with the final payment substantially larger than the earlier payments.

Bankruptcy

Bankruptcy is a legal proceeding where an insolvent person can be relieved of of financial obligations, but looses control over bank accounts, and future financial options. Bankruptcy is a last resort for those with debt problems, and although while it may wipe the slate clean (to some extent) in terms of debt, it is extremely harmful to your credit rating, and will no doubt effect the way you are handled by financial organisations in the future.

Base Rate

The rate of interest used as a basis by UK banks to make loans to their customers.

Basel II

A framework to promote the convergence of international capital management and capital standards. It is implemented in the European Economic Area (EAA) through the European Commission’s Capital Requirements Directive (CRD), and regulated in the UK by the Financial Services Authority. The Basel framework is based upon three pillars. Pillar 1 relates to the determination of eligible capital and minimum capital requirements in relation to credit risk, operational risk and market risk. Pillar 2 is the supervisory review process designed to ensure that other risks are taken into account. Pillar 3 concerns market discipline.

Basis Point (bp)

A measure which is mainly used in the statement of interest rates. One hundredth of 1% – 25 basis points is equal to 0.25%.

Basis Risk

The risk that the price of a derivative instrument will vary from that of the underlying commodity

Basis Swap

An interest rate swap where the interest payments that are exchanged between each party are based on different indexes.

Bayesian Theory

A technique for estimating the conditional probability of a cause given that a particular event has occurred. The theorem states that the probability of cause Bj given the observation of event A is equal to the joint probability of A and Bj divided by the sum of the joint probabilities of A with B1 through Bn. The theorem is named after Thomas Bayes, an 18th century English clergyman who was interested in mathematics. The Bayesian approach provides a unified and intuitively appealing approach to the problem of drawing inferences from observations. In Bayesian probability theory, probability is a measure of subjective belief as opposed to frequentist statistics where probability is interpreted as the relative frequency of occurrences in an infinite sequence of trials. Bayesians view statistical inference as a problem in belief dynamics, or use of evidence about a phenomenon to revise and update our knowledge about it. Bayesian statistics is a scientifically justifiable way to integrate informed expert judgment with empirical data.

Benchmarking

In the credit risk context, benchmarking compares the model under investigation with a variety of popular credit risk models. It is a broad analysis using an extensive comprehensive data set and a consistent methodology based on the information content of the models.

Beta

A measure of how much a stock will move in relation to an index. It is a measure of its volatility and therefore its risk.

Beta Coefficients

Beta Coefficients relate the responsiveness of the returns on individual securities to variations in the return on the overall market portfolio.

Beta Geared

The Beta attaching to the ordinary shares of a geared firm. These bear a risk higher than the firms basic activity.

Beta Ungeared

The geared Beta stripped of the effect of gearing. Corresponds to the activity Beta in an equivalent ungeared firm.

Bid

The rate at which the market or a particular trader is willing to buy.

Bid Basis

A fund is said to be on a bid basis if it is priced on the basis of the minimum bid price required by regulations laid down by the Financial Services Authority.

Bid Offer Spread

The difference between the bid price (at which the holder can sell shares) and the offer price (at which the holder can buy shares). On occasion this can be quite large and depends on the equitys underlying price, liquidity, volatility and a number of other factors. Many unit trusts also have a bid-offer spread and effectively this amounts to an extra exit charge when the investor sells.

Bobl

German government security issued with a 5 year maturity (Bundesobligationen).

Bond

An alternative name for fixed interest securities. Normally a single premium life assurance policy, either guaranteed or unit–linked.Normally a non–qualifying policy.

Book-to-Market Equity Ratio

The ratio of a firms balance sheet value to the total market value of its shares.

Bootstrapping

Bootstrapping is the activity of applying estimators to each of many subsamples of a data sample, in the hope that the distribution of the estimator applied to these subsamples is similar to the distribution of the estimator when applied to the distribution that generated the sample. more details

Bottom

A market bottom is an area where prices in a decline encountered heavy support, were unable to progress any lower, and either reversed (i.e. went into a bull trend) or consolidated (traded sideways).

Break-Even Analysis

Analysing the level of sales at which a project, division or business produced a zero profit (accounting emphasis).

Top

Call Option

A call option bestows the right to buy an underlying asset at a given price. The short seller (also known as the writer) has an obligation to sell shares to the holder, if the option is exercised.

Capital

Strictly, this is the funds invested in a firm by shareholders when they purchase ordinary shares, but often used to indicate all forms of equity, and often to refer to any form of finance, whether equity or debt.

Capital Adequacy

Requirement for firms conducting investment business to have sufficient funds.

Capital Asset

Any investment that offers a prospective return, with or without risk. However, in finance, the term is usually applied to securities and ordinary shares in particular.

Capital Asset Pricing Model

An asset pricing theory which assumes that financial assets, in equilibrium, will be priced to produce rates of return which compensate investors for systematic risk as measured by the covariance of the assets return with the market portfolio return.

Capital Employed

The total of fixed assets plus current assets less current liabilities. It also means the shareholders’ funds plus borrowing.

Capital Gearing

The mixture of debt and equity in a firms capital structure, which influences variations in shareholders profits in response to sales and EBIT variations.

Capital Markets

The means by which large amounts of money (capital) are raised by companies, governments and other organisations for long term use and the subsequent trade of the instruments issued in recognition of such capital. New money is raised in the Primary market by issuing shares or bonds to investors who can then trade them on the relevant Secondary market.

Capital Repayment

A corporate action in which the company partly repays the capital in issue by paying the holders a proportion of the paid–up capital of the security.

Capital Weighted Average IRR

The average IRR weighted by fund or investment size (each fund or investment contributes to the average in proportion to its size).

Capitalisation

The value of a company in terms of issued share capital. It is the number of shares x price quotation.

Carry

The cost of holding an inventory or portfolio of securities after deducting the funding costs from the interest received.

Cash Settlement

Many derivatives are cash settled, meaning that they underlying is not delivered but a cash payment is made, calculated as the difference between the exercise price and the price of the underlying at expiry.

Cash-Conversion Cycle

The stock-conversion period plus the debtor-conversion period minus the credit period granted by suppliers. It focuses on the length of time between the companys outlay on inputs and the receipt of money from the sale of goods.

Central Bank

The bank that provides financial and banking services to the government of a country and its commercial banking system and which implements the government’s monetary policy.

Certificate of Deposit

A deposit is made at a bank and the certificate that a deposit has been made is given in return to the lender. This is normally a bearer security. The Certificate of Deposit can then be sold in the secondary market whenever a firm needs cash.

Chicago Mercantile Exchange

An exchange which trades a wide range of currency futures and options, interest rate futures and options, commodity futures and options, and share index futures and options.

Churn

The conscious or unconscious over-trading by a stockbroker in a customers account. Since stockbrokers are generally compensated by the number of transactions made on a customers behalf, there is a temptation to trade for the sake of it. This is currently illegal in the UK, although difficult to prove.

Clause 2A

An alternative basis of mortgage indemnity claims settlement to “Normal Loss”, sometimes used by insurers during the early 1990s to reduce the payments made.

Coefficient of Determination

For single, linear regression, this is the proportion of variation in the dependant variable that is related to the variation in the independant variable

Coefficient of R Squared

Co-efficient of determination ( R squared); this measures the degree of linear association between the variable which we wish to explain and the set of drivers used to explain it. The scale used is between 1 and 0.When the coefficient is 1, there is a precise linear relationship without any noise. When the coefficient is zero, there is no linear association at all and the variables are said to be uncorrelated in this case, i.e. the drivers are uncorrelated with the variable which we seek to explain.

Collateral

A borrower will pledge collateral (securities, property etc) in order to demonstrate their ability to meet their obligations to repay monies loaned.

Collateralised Debt Obligation

An investment-grade security backed by a pool of bonds, loans and other assets. CDOs represent different types of debt and credit risk, each of which has a different maturity and risk associated with it.

Co-Movement / Co-Variation

The tendency of two variables, e.g. the returns from two investments, to move in parallel. It can be measured using either: (i) The Correlation Coefficient: a relative measure of co-movement that locates assets on a scale between -1 and +1. Where returns move exactly in unison, perfect correlation exists, and where exactly opposite movements occur, perfect negative correlation exists. Most investments fall in between, generally, with positive correlation. (ii) The Covariance: an absolute measure of co-movement with no upper or lower limits.

Correlation Coefficient

A measure of the extent to which two variables show a relationship, expressed on a scale of -1 to +1.

Cost of Capital

The rates of return that a company has to offer finance providers to induce them to buy and hold a financial security.

Cost of Debt

The yield a firm would have to offer if undertaking further borrowing at current market rates.

Cost of Equity

The minimum rate of return a firm must offer owners to compensate for waiting for their returns, and for bearing risk.

Cost-Benefit Analysis

Analysis of the stream of costs and benefits of an action.

Counterparty

One of the parties to a specific transaction – may be the buyer or the seller.

Coupon

The nominal interest rate on a fixed-interest security (bond), or a warrant which is detatched from a bearer bond or bearer share certificate to be used to claim interest.

Covariance

The extent to which two variables move together.

Covered Warrant

A covered warrant is an option issued by a third party, usually a finance house. The warrants can be issued on any number of underlying securities, including single equities, a basket of shares, or even a market index. The issuer of the warrant hedges their position using derivatives, such as traded options, and underlying shares; hence the term covered.

Credit Default Swap

A financial product designed to transfer between parties fixed-income products' exposure to credit risk. The buyer of a credit swap receives credit protection, whereas the seller guarantees the credit-worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed-income security to the seller of the swap.

Credit Derivative

Whereas derivatives' most common underlying assets include stocks, bonds, commodities and currencies, a credit derivative's price is driven by the credit risk of either private investors or governments.

Credit Period

The average length of time between the purchase of inputs and the payment for them. Equal to the average level of creditors divided by the purchases on credit per day.

Credit Rating

An estimate of the quality of a debt from the lender viewpoint in terms of the likelihood of interest and capital not being paid and of the extent to which the lender is protected in the event of default. An individual, a firm or a government with a good credit rating can borrow money from financial institutions more easily and cheaply than those who have a bad credit rating.

Credit Risk

The risk that a counterparty to a financial transaction will fail to fulfil their obligation.

Cross Price Elasticity of Demand

The Cross Price Elasticity of Demand for good i with respect to changes in the price of good j is the percentage change in the quantity of good i demanded, divided by the corresponding percentage change in the price of good j.

CUM

If a share is quoted CUM divident or CUM rights issue, it means that it still bears the entitlement and this is reflected in the price. CUM is latin for with.

Cumulative Accuracy Profile

One method of evaluating the accuracy of a rating model is to draw a cumulative accuracy profile (CAP) curve (also called the Gini curve, power curve, or Lorenz curve) and to calculate the accuracy ratio (AR), a statistical value that quantifies the performance of a model. In this method, accuracy of the model in detecting default is evaluated by arranging borrowers in an order by their creditworthiness that is expressed in scores and comparing the number of defaulted borrowers. illustration

Cumulative PD Scales

The reliability of ratings as predictors of absolute credit risks can be evaluated by examining the default rates associated with different ratings over time, particularly if the time horizon is long enough to incorporate both ends of the business cycle.

Current Ratio

The ratio of current liabilities to the current assets of a business.

Credibility Theory

Credibility theory is a branch of insurance mathematics that explored model-based principles for construction of such formulas. The development of the theory brought it far beyond the original scope so that in today’s usage credibility covers more broadly linear estimation and prediction in latent variable models. The term credibility was originally attached to experience rating formulas that were convex combinations (weighted averages) of individual and class estimates of the individual risk premium.

Top

Debt Capacity

The Debt Capacity of an investment or a whole firm is the maximum amount of debt finance, and hence interest payments that it can support without incurring financial distress.

Default

A failure to make agreed payments of interest or principal.

Delta

The amount by which an options price will move for a given movement in the underlying asset. Also known as the hedge ratio.

Depreciation

Depreciation is the drop in value of an asset due to wear and tear, age and obsolescence (going out of date) as recorded in an organisations financial records.

Derivative

A financial product whose price is dependent upon - or derived from - underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset.

Derivative Market

The Market on which futures, such as derivatives are sold. Sales are made on the basis of a guaranteed future sale at a current price, which is known as the "underlying". The terms "contracts" or "products" are often applied to denote the traded instrument.

Differentiation Strategy

The unique nature of the product/service offered allows for a premium price to be charged

Disintermediation

Borrowing firms bypassing financial institutions and obtaining debt finance directly from the market.

Distressed Debt

Corporate bonds of companies that have either filed for bankruptcy or appear likely to do so in the near future. The strategy of distressed debt firms involves first becoming a major creditor of the target company by snapping up the companys bonds at a low price. This gives them the leverage they need to call most of the shots during either the reorganisation or the liquidation of the company. In the event of a liquidation, distressed debt firms, by standing ahead of the equity holders in line to be repaid, often recover all of their money, if not a healthy return on their investment.

DMI

Domestic Mortgage Indemnity (also known as Mortgage Guarantee Insurance); a contract of insurance taken out by a lender to cover against losses in the event of default and loss following the possession and sale of a property. The contract was a prudential requirement for lenders on loans provided in excess of the prudent amount (normal loan) expressed as a ratio (LTV) to the property value. This ratio was usually between 70 and 80%. The amount of the guarantee, upon which the premium was levied, was the amount by which the loan exceeded this ratio. In the UK, a variation of DMI was a “pool indemnity”, where cover was provided upon a group or pool of loans, rather than upon a single loan. This was usually in support of a securitisation.

Drawdown Arrangement

A loan facility is established and the borrower uses it (takes the money available) in stages as the funds are required.

Drawdowns

The process by which the general partner of a fund requests the capital committed by the limited partners for investments. Most general partners today call down capital only as they require it, rather than in pre-set amounts according to a rigid timetable.

Due Diligence

The investigation and evaluation of a management teams characteristics, invesment philosophy, and terms and conditions prior to committing capital to the fund.

Top

EBIT

Earnings (i.e. profits) before Interest and Taxation.

Econometrics

The branch of economics devoted to measuring relationships using economic data.

Economic Book Value

A term used by Stern Stewart and Co. It is based on the balance sheet capital employed figure subject to a number of adjustments.

Elastic Demand

Where the price elasticity is more negative that -1.

Elasticities

The elasticity of y with respect to x means the percentage change caused in y by a one per cent change in x.

EMIR

Effective Mortgage Interest Rate; the rate of mortgage interest after tax reduction.

Endogenous Growth

Growth which occurs in models in which the steady-stage growth can be affected by economic behaviour and economic policy.

Equities

Physical investments. Often used instead of the more accurate term - Equity shares - to describe the risk capital of a company (shares).

Equivalent Loan

The loan than would involve the same schedule of interest and loan replayments as the profile of rentals required by an equipment lessor.

ERM.

Exchange Rate Mechanism; a system established in 1979 to control exchange rates within the European Monetary System (EMS) of the European Union (EU), intended to prepare the way for a single currency. The member currencies within the ERM were fixed against each other within a narrow band based on a central European Currency Unit (ECU) rate, but floating against non-member countries. If a currency deviated significantly from the central ECU rate, the European Monetary Cooperation Fund and the central banks concerned stepped in to stabilize the currency. The ERM was revised from 1st January 1999, with the launch of the single European currency.

Euribor

A rate used for Euro interest rate fixings based upon trading activity in the markets of Euro zone.

European Central Bank

The main institution in the European Monetry Union, or EMU. The ECB, which has its offices in Frankfurt, has powers to change interest rates and issue Euro coins and notes.

Expectations Hypothesis of the Term Structure of Interest Rates (Yield Curve)

Long-term interest rates reflect the market consesnsus on the changes in short-term interest rates.

Expected Return

The mean or average outcome calculated by weighting each of the possible outcomes by the probability of occurence and then summing the result.

Expert Judgment Model

This is a procedure whereby models were built by experts who provided the key parameters and weight based on their expertise. The analysis of the information to yield forecasts was rather subjective. It was carried out by people who had had a significant amount of experience in the industry and who also had much data at their disposal.

Extrapolative Expectation

The assumption that the future will be similar to the recent past.

Top

Factor Model

A model which relates the returns on a security to that securitys sensitivity to the movements of various factors (e.g. GDP growth, inflation, etc.) common to all shares.

Financial Distress

Obligations to creditors are not met or are met with difficulty.

Financial Gearing

A term used to describe the relationship between the Companys debt and equity shareholders funds. Gearing is usually expressed as a percentage and is calculated by dividing the Companys debt by its equity. A highly geared company is one where there is a high proportion of debt to equity, and can be considered a risky investment as there is a higher likelihood of the company being unable to pay its large debts.

Financial Services Authority

The government agency that regulates investment business as required by Financial Services Act 1986. Used to be the Securities and Investments Board (SIB).

Fiscal Drag

The increase in real tax revenue when inflation raises nominal income and pushes people into higher tax brackets in a progressive income tax system.

Fishers Equation

The money rate of return m is related to the real rate of return h and the expected inflation rate i through the following equation: (1 + m) = (1 + h) (1 + i).

Fixed-Interest Securities

Securities such as bonds on which the holder received a predetermined interest pattern on the par value (e.g. gilts, corporate bonds, eurobonds).

Floor

An agreement whereby, if interest rates fall below an agreed level, the seller (floor writer) makes compensatory payments to the floor buyer

Force Majeure

A supplier usually has a clause in delivery contracts allowing him to break the contract when there is a force majeure - a major external event such as a strike or major catastrophe.

Frequency Function

The organisation of data to show the probabilities of certain values occuring.

Fundamental Analysis

The assessment of the value of a share on a companys actual earnings, assets and dividends. Individuals that try to estimate a shares true value, based on future returns to the company.

Futures

The right to buy or sell a financial instrument at an agreed price at some future time.

Top

Gearing

The proportion of assets that were funded from borrowing and the proportion funded by shareholders. A common metric is the debt/equity ratio: Profit x 100% / Shareholders’ Funds

General Inflation

The process of steadily rising prices resulting in the diminishing purchasing power of a given nominal sum of money. Measured by an over-all price index which follows the price changes of a basket of goods and services through time.

General Insurance

Insurance against specific contingencies, e.g. fire, theft and accident.

Geometric Mean

The geometric mean of a set of n positive numbers is the nth root of their product. The compound rate of return.

Gini Coefficient

The Gini coefficient is a measure of inequality developed by the Italian statistician Corrado Gini and published in his 1912 paper "Variabilità e mutabilità". It is usually used to measure income inequality, but can be used to measure any form of uneven distribution. The Gini coefficient is calculated as a ratio of the areas on the Lorenz curve diagram. If the area between the line of perfect equality and Lorenz curve is A, and the area underneath the Lorenz curve is B, then the Gini coefficient is A/(A+B). This ratio is expressed as a percentage or as the numerical equivalent of that percentage, which is always a number between 0 and 1. more details

GNMA

Government National Mortgage Association. A US government-owned agency which buys mortgages from lending institutions, securitizes them, and then sells them to investors. Because the payments to investors are guaranteed by the full faith and credit of the US Government, they return slightly less interest than other mortgage-backed securities.

Gross Domestic Product

A measure of the total flow of goods and services produced by an economy over a specified time period, normally a year. In other words, the total market value of all the goods produced by a specific country over a period of time, usually a year. When looking at GDP figures, analysts are often looking for a year-on-year rise, to show that the economy of the country is developing.

Top

Hazard Rate

Measures the probability of an event, given that it has not happened before; thus a constant hazard tells us that the past does not matter whilst an increasing hazard means that the longer the time until default, the higher the risk of default

Hedge

Use of investments to manage commercial risk, or to minimise a potential loss to an existing position or known commitment. By using two counterbalancing investment stragies, any losses caused by price fluctuations are minimised. For example, a trader in commodities buys an amount of one particular item. At the same time he also makes a contract to sell an amount of a similar item at a later date. Thus if the price of the item he has bought falls, he can still recover money by selling the similar item at the earlier, higher price.

Hedge Fund

Is a type of investment fund often used by corporate institutions or very high net worth individuals and private partnerships that use derivatives for directional investing and/or are allowed to go short and/or use significant leverage through borrowing. Depending on the jurisdiction these techniques may not be allowed in a typical mutual investment fund.

High-Yield Debt

See Mezzanine Finance .

HPI

House Price Index.

Hybrid

A security that embodies features of both equity and debt, and is thus difficult to classify under either category.

Top

IBEL

Interest Bearing Eligible Security

Income Distribution

The Income Distribution (in a country or the world) tells us how income is divided between different groups of individuals.

Income Elasticity of Demand

The Income Elasticity of Demand for a good is the percentage change in quantity demanded divided by the corresponding percentage change in income.

Income Gearing

The proportion of the annual income streams (i.e. pre-interest profits) devoted to the prior claims of debt holders. The reciprocal of income gearing is the interest cover.

Inelastic Demand

Where the price elasticity lies between -1 and 0.

Inflation

A rise in prices and wages in an economy. It is measured by calculating the proportional changes of a relevant index.

Inflation Rate

The annual rate of change of the price index.

Inland Revenue

The principal tax-collecting authority in the UK.

Institutional Funds

The large, managed investment funds, including pension funds, insurance funds, unit and investment trusts are known as institutional funds and are the major players in the stock market.

Interbank Rates

FX rates large international banks quote other large international banks. The difference between the buy and sell rate, (the spread) can be around 0.07%. Normally the public and and other businesses do not have access to these rates.

Interest

The amount that you pay when you borrow money from someone for a certain length of time, or the amount of money that someone will pay you for borrowing their money.

Interest Cover

The number of times the income of a business exceeds the interest payments made to service its loan capital.

Interest Rate Parity

This asserts that the difference between the spot and forward exchanges is equal to the difference between interest rates prevailing in the money markets for lending/borrowing in the respective currencies.

Interest Rate Spread

The gap between the interest rate a bank pays on deposits and the higher rate it charges for loans.

IRB

Internal Ratings Based approach (the IRB approach) to capital requirements for credit risk. The Basel Committee for Banking Supervision (BCBS) believes that such an approach, which relies heavily upon a bank’s internal assessment of its counterparties and exposures, can secure two key objectives consistent with those which support the wider review of The New Basel Capital Accord. The first is additional risk sensitivity, in that a capital requirement based on internal ratings can prove to be more sensitive to the causes of credit risk and economic loss in a bank’s portfolio. The second is incentive compatibility, in that an appropriately structured IRB approach can provide a framework which encourages banks to continue to improve their internal risk management practices.

ISMI

Income Support for Mortgage Interest.

Investment Grade Debt

Debt with a sufficiently high credit rating to be regarded as safe enough for some institutional investors.

IPO

Initial Public Offering - the share offer when a company first decides to change to public status.

IRB

Internal ratings based approach (the IRB approach) to capital requirements for credit risk.The Basel Committee for Banking Supervision (BCBS) believes that such an approach, which relies heavily upon a bank’s internal assessment of its counterparties and exposures, can secure two key objectives consistent with those which support the wider review of The New Basel Capital Accord. The first is additional risk sensitivity, in that a capital requirement based on internal ratings can prove to be more sensitive to the drivers of credit risk and economic loss in a bank’s portfolio. The second is incentive compatibility, in that an appropriately structured IRB approach can provide a framework which encourages banks to continue to improve their internal risk management practices.

ISIN

International Securites Identification Number. An ISO coding system to create a single global code for indentifying a security.

Top

Knock-Down American Call

Also called a “knockout option”; so-called because exercise of the call occurs if the holder buys or sells. Typically this would occur when the holder is “in the money”, because a threshold has been reached or a barrier crossed e.g. since the price of the underlying asset has dropped. For a full explanation of the term and subdivisions, readers are referred to F Arditti on Derivatives (pages 110-111, Harvard Business School Press, 1996).

Kondratiev Wave

A theoretical economic cycle lasting approximately 60 years.

KS Statistic

Kolmogorov-Smirnov (KS) statistic that is used to assess risk discrimination in the context of default. The KS statistic measures the maximum difference between the cumulative proportions of defaulters and nondefaulters below a particular score as this score varies. The K-S statistic and the Gini coefficient are common measures of a model’s ability to separate risk. more details

Top

Laffer Curve

This shows how much tax is revenue is raised at each possible tax rate.

Large Cap

The current market price value of a company’s entire issued securities. This figure includes every security type issued.

Lender of Last Resort

The lender who is ready to lend to banks and other financil institutions when financil panic threatens the financial system

Leasing

The owner of an asset (lessor) grants the use of the asset to another party (lessee) for a specific period in return for regular rental payments. The asset does not become the property of the lessee at the end of the specified period.

LGD

Loss Given Default: “the amount of loss which firms might expect in the event that default occurs and which typically varies with economic cycle” (FSA CP189: 3.259). “In estimating losses given default firms should supplement inadequate data with conservative assessments that reflect the different outcomes that are likely to occur in times of economic downturn.” (Ibid. 3.259)

Liabilities

Liabilities are long-term loans of the type used to finance the business and short-term debts or money owing as a result of trading activities to date.

LIBOR

Is short for "The London Interbank Offered Rate". The interest rate used when one bank borrows from another. Also used as a benchmark to price derivative or capital market transactions.

Linear Probability Model (LPM)

In this technique, one or more independent variables are used to predict a single dependent variable. Linear probability models accommodate all types of independent variables (metric and non-metric) and do not require the assumption of multivariate normality. The mathematical structure is that the left hand side is the probabilities, thus forecasts can be less than zero or greater than one.

Y = a + BX + e where

• Y is a dummy dependent variable, =1 if event happens, =0 if event doesn't happen,
• a is the coefficient on the constant term,
• B is the coefficient(s) on the independent variable(s),
• X is the independent variable(s), and
• e is the error term.

Logit Analysis

Logit analysis is a special form of regression in which the criterion variable is a non-metric, dichotomous (binary) variable. more details

Loan Guarantee Scheme

A facility whereby banks are able to lend to firms that would not otherwise qualify for bank finance due to lack of track record, the loan being guaranteed by the Department of Trade and Industry.

LTV

Loan to Value; the ratio of the loan to the valuation or the price paid, whichever is the lower.

Top

M3

A measure of money supply. There are various measures as follows: M0 - A narrow measure of money which consists of notes, coins and retail banks` balances at the Bank of England M1 - one measure of the money supply that includes all coins, currency held by the public, travellers’ cheques, checking account balances, new accounts, automatic transfer service accounts, and balances in credit unions. see also M2, M3 M2 - one measure of the money supply that includes M1, plus savings and small time deposits, overnight repos at commercial banks, and non-institutional money market accounts. A key economic indicator used to forecast inflation. see also M3 M3 - one measure of the money supply that includes M2, plus large time deposits, repos of maturity greater than one day at commercial banks, and institutional money market accounts. see also M1 M4 - A broad measure of money which consists of notes, coins and all deposits with banks and building societies denominated in sterling

Macroeconomics

Emphasizing the interactions in the economy as a whole. It deliberately simplifies the individual building blocks of the analysis in order to retain a manageable analysis of the complete interaction of the economy.

Mark to Market

Revaluation of an OTC product. Defined as the difference between the previous days close against the current closing price.

Market

A shorthand expression for the process by which households decisions about consumption of alternative goods, firms decisions about what and how to produce, and workers decisions about how much and for whom to work are all reconciled by adjustment of prices.

Market Capitalisation

The total value at market prices of the shares in issue for a company (or a stock market, or a sector of the stock market). It is calculated by multiplying the share price with the total number of shares in issue, effectively giving the total value of all the shares currently in issue. For companies wishing to be listed on the London Stocjk Exchange (LSE), there is a minimum level of market capitalisation required. For listing on the Alternative investment market (AIM), there is no minimum level of market capitalisation required.

Market Index

A sample of shares is used to represent a share (or other) markets level and movements

Market Portfolio

A portfolio which contains all assets. Each asset is held in proportion to the assets share of the total market value of all the assets. A proxy for this is often employed, e.g. the FTSE 100 index.

Market Share

This is the amount of total sales of an item or group or products by a company in a particular market. It is often shown as a percentage, and is a good indicator of performance compared to competitors in the same market sector.

Market to Book Ratio

Simply put, the market value of a firm divided by capital invested. Market to Book Ratio seeks to show the value of a company, by comparing the book value and market value. Book value is calculated from the companys historical cost, or accounting value, and market value is calculated from its market capitalisation.

Median

The mid-point of a distribution, with half of the samples less than or equal to the median, and half of the samples greater than or equal to the median.

Merchant Bank

A bank which works as a financial intermediary, offering such services as takeover and merger assistance, and the placing of new share and bond issues.

Mezzanine Debt

A middle layer of debt in leveraged buyouts - below the senior debt layer and above the equity layer. A typical mezzanine investment includes a loan to the borrower, in addition to the borrowers issuance of equity in the form of warrants, common stock, preferred stock, or some other equity investment. Mezzanine finance shares characteristics of both debt and equity financing.

Mezzanine Finance

Unsecured debt or preference shares offering a high return with a high risk. Ranked behind secured debt but ahead of equity. It may carry an equity kicker.

MIG

Mortgage Insurance Guarantee – see DMI (Domestic Mortgage Indemnity).

MIRAS

Mortgage Interest Relief at Source; the long standing method providing mortgage borrowers with tax relief on the interest payable on their loan. The interest was deducted from the mortgage repayment and then claimed back from the Inland Revenue by the lender.

MPPI

Mortgage Payment Protection Insurance.

Monetary Policy Committee

A body whose members are appointed by the Bank of England, responsible for setting UK interest rates at monthly meetings.

Multivariate Analysis

The expression is used rather loosely to denote the analysis of data which are multivariate in the sense that each member bears the values of p variates. The principal techniques of multivariate analysis, beyond those admitting of a straightforward generalisation, e.g. regression, correlation and variance analysis, are factor and component analysis, classification, discriminatory analysis, canonical correlation and various generalisations of homogeneity tests.

Top

National Debt

The stock of outstanding government debt.

National Income

The economys net national product. It is calculated by subtracting depreciation from GNP at basic prices.

Negative Equity

This is where the market value of an asset, for example your home, is less than the outstanding payments, ie the mortgage. This can make it difficult to move house, as the finance gained from the sale of the house would not cover the remaining mortgage. This happens where property prices crash, for example at the end of a housing-boom where prices were over-inflated, and buyers bought when the market was strong

Net Asset Value

Value of a corporation or of a corporate asset according to accounting records, which is determined by dividing the number of issued shares into a companys net assets.

Net Debt

A firms net borrowing including both long-term and also short-term debt, offset by cash holdings. Expressed either in absolute terms, or in relation to owners equity.

Net Present Value

A figure which represents the profitability of a project. It shows this by calculating the total of future cash inflows from a project, less cash outflows, inflation, and/or a required Rate of return. Present Value Net Present Value (NPV) = Present Value (PV) - Amount Invested. It is generally accepted that if the Net Present Value of a project is positive, then it should be carried forward, whereas if it is negative, then it should not.

Net Worth

The difference in monetary amounts between all the things that you have and all that you owe.

Neural Networks

A network of neurons that are connected through synapses or weights. Each neuron performs a simple calculation that is a function of the activations of the neurons that are connected to it. Through feedback mechanisms and/or the nonlinear output response of neurons, the network as a whole is capable of performing extremely complicated tasks, including universal computation and universal approximation. Three different classes of neural networks are feedforward, feedback, and recurrent neural networks, which differ in the degree and type of connectivity that they possess. The method can be used to build non-linear forecasting models

Nominal Interest Rate

This shows us how many acual pounds will be earned in interest by lending £1 for one year.

Normal Loss

The basis of claims calculation under a standard Domestic Mortgage Indemnity Policy prior to 1993 and division of the deficit between insurer and lender. This is illustrated here for a 90% (£54,000) loan on a £60,000 property with a normal lending limit of 75% LTV.

Top

Objective Probability

A probability that can be established theoretically or from historical data.

Offer Price

The price at which a marketmaker in shares will sell a share, or a dealer in other markets will sell a security or asset. The price that you can purchase a share or security from a dealer or marketmaker.

Options

The right, but not the obligation to buy or sell something at some time in the future at a given price.

Organic Growth

Growth from within the firm rather than through mergers.

Overdraft

A permit to withdraw on an account (e.g. a bank account) up to a stated limit; to take more out of a bank account than it contains.

Top

Perpetual American Put

A put option is a contract which allows the holder to sell an entity at an agreed price at some future time; the adjective “American” means that sale can be at any chosen time; the adjective “perpetual” means that the option is valid indefinitely, i.e. for all time.

Personal Disposable Income

The income households receive from firms, plus transfer payments received from the government, minus direct taxes paid to the government. It is the income that households have available for spending or saving.

Personal Loan

A loan from a financial institution, such as a bank, to an individual. These kinds of loan are commonly used for expensive purchases such as a car, or an item of furniture, and do not necessarily have to be secured, for example on an asset. Personal loans tend to carry more risk for lenders than secured loans such as mortgages, and as such tend to carry higher interest rates.

Pillar 1

Pillar 1 refers to the first pillar of the new Basel Accord for Banking Supervision, which emphasises quantitative measures of capital charge to provide a risk measurement and management framework

Political Business Cycle

The Political Business Cycle arises from cycles in policy between general elections.

Positive Economics

Deals with objective of scientific explanations of the working economy.

Premium

1) Upward difference between issue price of a share or other investment and its market value. 2) The amount paid for an insurance policy, which can be paid monthly or annually. 3) An additional amount paid to lenders above interest rates to compensate for the level of risk involved. 4) A "premium bond" is a government security issued in the UK which gives monthly "prizes" instead of interest.

Prepayment Rate

The pre-agreed percentage applied to total approved debt/invoices to give gross funding availability on your account.

Present Value

Future cash flow is discounted to time zero, ie: Present Value (PV) = Discount Factor x Future Payoff.

Price Earnings Ratio

The market price of a share divided by its earnings (e.g. profits) gives the p/e ratio, which is the most commonly used measure of the value of a share. Although this is used to show the value of a share, it is a subjective test, as, for example some investors would consider a PE ratio of 20 to be too high, and others might consider it to be just right.

Price Elasticity of Demand

The percentage change in the quantity demanded divided by the corresponding percentage change in its price.

Probability

The likelihood of a random event occuring, measured between 0 and 1. 0 means that the event will not occur, whereas 1 means it is certain to occur.

Probability of Default

Also known as PD is the likelihood of default by a counter-party over a given period of time. In estimating PD, “Firms need to take into experience over a historic period of time at least as long as the contractual maturity of an exposure” (FSA CP189: 3.243).

Provisions

Sums set aside in accounts for anticipated loss or expenditure.

Public Sector Borrowing Requirement

The amount that the UK government has to borrow, ie when its expenditure, eg. hospitals, is more than its income, eg. taxes. The government can borrow by selling securities, or by borrowing from banks. The PSBR is considered as a good indication of the financial state of the country.

Pump Priming

The theory that it is possible to help the economy to recover from a slump by increasing purchasing power in the economy, for example by reducing prices. The name comes from an analogy with a mechanical pump, which requires an initial amount of water before they begin to work.

Top

Quartile

Segment of a sample representing a sequential quarter (25%) of a group of data.

Top

Ranking

Order of precedence for payment of obligations. Senior debt recieves annual interest and redemption payments ahead of junior (or subordinated) debt. So, if the company has insufficient resources to pay its obligation the the junior debt holders may recieve little or nothing.

Rate of Return

Calculated as profit (value now minus value at time of purchase) divided by (amount invested) value at time of purchase. For equities, we often include dividends with the value now.

Rating

A rating is issued by a rating agency assessing an issuer’s capacity to repay the debts that he is planning to issue or has issued.

Regression

Formulating a mathematical model of the relationship between a response (outcome, dependent) variable, Y, and a set of explanatory (predictor, independent, regressor) variables, X. Depending on the characteristics of the variables, the choice of model can be simple linear regression, multiple regression, logistic (binary) regression, Poisson regression, etc. In any regression problem, the key quantity is the mean value of the outcome variable, given the value of the independent variable(s). This quantity is called the conditional mean and expressed as "E (Y|x)" where Y is the response (outcome), x is the explanatory (predictor) variable. The question is whether the variable(s) in question tells us more about the outcome variable than a model that does not include that variable. In other words, whether the coefficient of the variable(s) is zero and the outcome is equal to a constant (which is the mean for Y) or not. The aim of model building is to arrive at a meaningful and parsimonious model that explains the data. The model may be linear if the parameters are linear, or nonparametric if the parameters are not linear. No matter how strong is the statistical relationship between x and Y, no cause-and-effect pattern is necessarily implied by the regression models

Relevant Risk

The component of total risk taken into account by the stock market when assessing the appropriate risk premium for determining capital asset value.

Repayment Mortgage

A form of mortgage where the monthly repayments are a combination of interest and capital, ensuring full repayment of the loan at the terms completion.

Repurchase Agreement

A financial transaction in which a dealer in effect borrows money by selling securities and simultaneously agreeing to buy them back at a higher price at a later time. The dealer invests the money paid for the securities, hoping to get a higher return than he owes on his obligation to repurchase the securities. Repurchase agreements are commonly called repos.

Research and Development

Research is the process of invention. Development makes research commercially viable.

Retail Banking

Banking for individual customers or small firms, normally for small amounts. High-volume/low-volume banking.

Retail Price Index

The monthly Index in the UK that demonstrates the movement of retail prices. It effectively shows the cost of living as it tracks the prices of UK consumer goods and services. It also includes expenditure on items such as mortgage interest, rent, and other charges which are not necessarily considered as retail. The RPI is inclusive of VAT, and other taxes, and as such can change as a result of changes in taxation levels. Similar to the Consumer Price Index (CPI) of other countries.

Revolving Credit Facility

Enabling a firm to borrow up to a pre-specified amount usually over 1-5 years. As repayments of outstanding balances are made, the loan facility is replenished.

Risk

A future return has a variety of possible values. Sometimes measured by standard deviation.

Risk Drivers

This is a term used for the explanatory variables in risk models.

Risk Grades

These country risk grades for 144 countries attempt to measure the likelihood that a country will service its external debt. They range from 1 (high) to 7 (country in default). The OECD's country risk grades sets minimum benchmarks for the sovereign risk premiums official export credit agencies, such as EFIC, can charge for medium-term insurance and finance products in different countries.

Risk Management

The selection of those risks a business should take, and those which should be avoided or mitigated, followed by action to avoid or reduce risk.

RMD Distribution

Required Minimum Distribution The minimum amount that the IRS requires must be withdrawn each year from all tax-advantaged retirement plans starting in the calendar year following the year in which the plan holder reaches age 70-1/2

ROCC (see ROC)

ROC

Receiver Operating Characteristic (Curve) more details

R-Squared / R²

See Coefficient of Determination.

Top

Scatter Diagram

A Scatter Diagram plots pairs of values simultaneously observed for two different variables.

Scenario Analysis

An analysis of the change in NPV brought about by the simultaneous change in a number of key inputs to an NPV analysis. Typically a worst case scenario, when all the changes in variables are worsening, and a best case scenario, when all the variable changes are positive, are calculated. Scenario Analysis typically refers to a wider range of parameters being varied at the same time (than would be varied in Stress Testing – see below). Scenario Analyses often examine the impact of catastrophic events on a firm’s financial position, for example simultaneous movements in a number of risk categories affecting all of a firm’s business operations – such as volumes, investment values and interest rate movements.

Securities

These are any financial instrument traded on a stock exchange, such as shares or bonds.

Securitisation

Financial payments (e.g. a claim to a number of mortgage payments) which are not tradable, and can be repackaged into other securities (e.g. a bond) and then sold. These are called asset-backed securities. The process of pooling and re-packaging illiquid financial assets with the same characteristics in terms of yield, maturity and geographical spread, into marketable securities that can be sold to investors. For example, a collection of similar commercial loans could be packaged together, and sold on to investors. The originator of the loan will still continue to collect repayments on the investors behalf, but can now use the cash originally tied up in the loans for other purposes.

Self-Certified

A loan based upon a borrower income verified by the borrower rather than by the lender. This type of loan is often used to accommodate mortgages to a self-employed individual and can be considered as a sub-prime class of lending.

Sensitivity Analysis

An analysis of the effect on project NPV of changes in the assumed values of key variables, e.g. sales level, labour costs. Variables are changed one at a time. It is a what-if analysis, e.g. what if raw material costs rise by 20 per cent?

Separation Theorem

The choice of the optimal portfolio (the market portfolio) is made by all investors and is separate from the risk/return choice which is determined by the extent to which the invester lends or borrows at the risk-free rate. Applied to the capital asset pricing model.

Sharpe Ratio

A key risk/reward ratio used by the industry, it compares the rate of reward with the risk of gaining that reward. The formula is the annualised arithmetic standard deviation.

Somers' D

Somers' D can be thought of as a version of a bivariate correlation in an ordinal world. more details

Spot Market

A market for immediate transactions (eg. spot forex market, spot interest market), as opposed to an agreement to make a transaction some time in the future (eg. forward, option, future).

Spot Rate

The rate of exchange quoted for transations involving immediate settlement. Hence, spot market.

Standard Deviation

A measure of the variation in a distribution, equal to the square root of the arithmetic mean of the squares of the deviations from the arithmetic mean, ie. the square root of the variance.

Standardised

The application of external assessments of credit exposures, risk weights and credit conversion factors specified by the Basel Committee.

Strategy

Selecting which product or market areas to enter/exit and how to ensure a good competitive position in those markets/products.

Stress Testing

Stress testing is a simple form of scenario analysis. Rather than consider the evolution of risk factors over several time steps, stress testing considers changes in risk factors over a single time step.

Subordinated Debt

A debt which ranks below another liability in order of priority for payment of interest or principal. Senior debt ranks above junior debt for payment.

Subprime Loan

A type of loan offered to individuals who do not qualify for a lender's best-available (or "prime") rate. They often do not qualify because of poor credit history. Subprime loans tend to have higher interest rates than traditional loans.

Synthetic Collateralised Debt Obligation

A CDO that invests in credit default swaps or other non-cash assets.

Systematic Risk

That element of return variability from an asset which cannot be eliminated through diversification. It is measured by beta. It comprises the risk factors common to all firms.

Top

Tau-a

Kendall's tau b A statistic measures of ordinal association. It ranges from -1 to +1 and is based on the number of concordant and discordant pairs of observations. A concordant pair is one is which the two variables (row and column) have the same relative ranking (greater than or less than). A discordant pair is one in which the two variables have the opposite ranking. Both variables must be ordinal. A correction is made for tied pairs. Kendall's tau a, tau b or tau c, Or Goodman And Kruskal's Gamma, Or Kim's d These statistics differ with respect to how they treat pairs of cases that fall in the same category on one or both of the variables. Except in extreme cases (i.e., where any of the statistics equals 0 or 1) the absolute value of Gamma will be the highest of the five statistics, tau a will be the smallest, and tau b, tau c, and Kim's d will be intermediate. This ordering is because Gamma ignores all ties (when present in the data - as is usually the case), whereas the other four statistics penalize for ties in the sense of reducing the absolute value of the statistic obtained. Unlike tau b or Kim's d, tau c can attain plus or minus 1 even if the two variables do not have the same number of categories. If there are no ties on either variable the five measures are identical. Tau-b is appropriate only when both variables lie on an ordinal scale. Refer to Kendall (1955) and Brown and Benedetti (1977).

Term Assurance

A policy that pays out only if death occurs within a certain period. There is no savings element.

Term Loan

An advance by a financial institution for a given period, which has to be repaid, with interest, at regular intervals

The Law of Diminishing Returns

Holding all factors except one, The Law of Diminishing Returns states that beyond some level of variable input, further increases in the variable input lead to a steadily decreasing marginal product of that input.

The Quantity Theory of Money

This states that changes in the nominal money supply lead to equivalent changes in the price level (and money wages) but do not have effects on ouput and employment.

Tick Value

The value of a one point movement (0.01 per cent) in the price of an exchange trade financial future or option.

Transaction

Usually refers to the order to purchase or sell a security or to receive or pay cash.

Triple-A Rating (AAA)

The highest credit rating for a bond or company where the risk of default (or non–payment) is negligible. See AAA rating.

Top

Uncertainty

Strictly (in financial terms), uncertainty is where there is more than one possible outcome to a course of action; the form of each possible outcome is known, but the probability of getting any one outcome is not known.

Underlying Asset

An asset which acts as the security upon which an option or futures contract is based.

Unemployment

A measure of the number of people registered as looking for work but without a job.

Unemployment Rate

The percentage of the labour force without a job.

Univariate Analysis

The analysis of a single variable, for purposes of description (e.g., averages, or the proportion of cases falling into a given category among the entire sample).

Unsecured

A financial claim with no collateral or an charge over assets of the borrower.

Top

Validation

A procedure assesses the validity of the credit models under investigation. Actual Losses should be captured and used together with external data (benchmarks, economic cycle indicators, competitor analysis and Obligor default rates) to provide an assessment of the overall validity of risk models and process. This information is reported to enable the market and regulators to assess the validity of credit risk systems and this ability going forward to capture and store default related information. Further, it is expected that this information will be analyzed internally to determine any potential adjustments or ‘calibration’ that is required to the underlying credit risk models to ensure the validity of future risk-based reporting.

Valuation

The determination of a fair value for a security. If you dont use some reasonable method, then you have what is technically known as a guess.

Valuation Risk

The possibility that, when a financial instrument matures or is sold in the market, the amount recieved is less that anticipated by the lender.

Top

Warrant

An equity warrant offers the holder the right to buy underlying equity at a predetermined price on specified dates, or at any time, up to the end of a predetermined time period. A warrant differs from an option in that options usually have a life of less than 1 year. Warrants are usually issued by companies or by securities houses and have a life span of more than 1 year. The exercise of a company issued warrant will result in an increase of the capital of that company.

Weighted Average Cost of Capital

The Weighted Average Cost of Capital is calculated by weighting the cost of debt and equity in proportion to their contributions to the total capital of the firm.

Top

Yield

The yield on an investment is the interest or dividend income as a percentage of the capital value. This is also known as the running yield. The yield to redemption also takes into account the annualised capital profit (or loss) on holding a fixed interest security to redemption, ie the investors have an annual average total return.

Yield Curve

A series of interest rates plotted against the time to maturity to which they apply.

Top

Zero Cost Option

A combination of option purchase and option writing. The price of the written option (premium) is the same as the price (premium) paid for the option that is purchased, so the net cost is zero.

Z-Score

A mathematically-derived critical value below which firms are associated with failure.