Financial Glossary

Jargon busterFinancial terminology

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Jargon buster

Financialglossary

Speaking the language of finance with confidence is often a deal-breaker. If you need to brush up on your financial terminology, take a look at our AtoZ guide.

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Active return

Return on an investment relative to a benchmark. For example, if a portfolio has a benchmark return of 5% but the actual return is 8%, then the active return is 3% (actual return minus the benchmark return). Active returns can be positive or negative depending on whether the actual return outperforms the benchmark or not.


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Arbitrage

Exploiting usually small differences in the price of securities, currencies, commodities, or other assets to make a profit. Arbitrage can only happen in an inefficient market.


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The total market value of financial assets an investment company manages on behalf of its clients.

Assets under management (AUM)


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A graphical model for valuing options. It is one of two major methods for pricing options. The other being Black-Scholes.

Binomial tree


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The formula that made it possible to create prices in the derivatives market. The formula is named after its creators: Fischer Black and Myron Scholes.

Black-Scholes


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A certificate issued by a government, company or other organisation promising to repay borrowed money at a fixed rate of interest at a specified time.

Bond


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The value that a convertible bond would have if it was no longer convertible. The bond value represents the market value of the bond less the value of the conversion option.

Bond value


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Organisations that buy investment services. These include private equity funds, mutual funds, life insurance companies, unit trusts, hedge funds and pension funds.

Buy-side


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For investors, it refers to their stock of wealth, which can be put to work in order to earn income.For companies, it typically refers to sources of financing such as newly issued shares.For banks, it refers to their ability to absorb losses in their accounts. Banks normally obtain capital either by issuing new shares, or by keeping hold of profits instead of paying them out as dividends. If a bank writes off a loss on one of its assets – for example, if it makes a loan that is not repaid – then the bank must also write off a corresponding amount of its capital. If a bank runs out of capital, then it is insolvent, meaning it does not have enough assets to repay its debts.

Capital


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The part of a financial system concerned with raising capital by dealing in shares, bonds and other long-term investments.

Capital markets


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The composition of a company’s mixture of debt and equity financing. A company’s debt-equity ratio is often referred to as its gearing.

Capital structure


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A small company created from a larger one. A company undertaking a carve-out is not selling a business unit outright, and may instead sell an equity stake in that business or spin the business off on its own while retaining an equity stake itself.

Carve-outs


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A measure of a company’s financial performance based on the cash flow a company produces with its invested capital.

Cash return on gross investment (CROGI)


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A bond that uses a variety of high-yield junk bonds as collateral. These bonds are separated, or pooled, into tranches with higher and lower levels of risk.

Collateralised bond obligations (CBO)


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A tradable derivative. A number of loans or debt securities payable by various companies are put into a pool, and new securities are issued which pay out according to the pool’s collective performance.

Collateralised debt obligation (CDO)


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Convexity

A measure of the way that bond duration and prices change when interest rates fluctuate as shown in the curve of the price to yield relationship. The shape of the typical curve is convex.


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How a company is managed, in terms of the institutional systems and protocols meant to ensure accountability and sound ethics. The concept encompasses a variety of issues, including disclosure of information to shareholders and board members, senior executive pay, potential conflicts of interest among managers and directors, supervisory structures, etc.

Corporate governance


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Derivatives that investors use to protect against, or bet on, an entity being unable to repay its debts. The credit default swaps market is believed to have played a big part in the 2008 financial crisis.

Credit default swap (CDS)


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The risk that a borrower will default on any type of debt by failing to make required payments.

Credit risk


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A financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, but it may include notes, bills, and so on.

Debt market


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A financial contract which provides a way of investing in a particular product without having to own it directly. For example, a stock market futures contract allows investors to make bets on the value of a stock market index such as the FTSE 100 without having to buy or sell any shares. The value of a derivative can depend on anything from the price of coffee to interest rates or what the weather is like. Credit derivatives such as credit default swaps depend on the ability of a borrower to repay its debts. Derivatives allow investors and banks to hedge their risks, or to speculate on markets. Futures, forwards, swaps and options are all types of derivatives.

Derivative


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A way of estimating the attractiveness of an investment. DCF analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Discounted cashflow (DCF)


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The process of selling subsidiary business interests or investments. Not to be confused with disinvestment, which is a reduction in a company’s capital goods.

Divestment


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An income payment by a company to its shareholders usually linked to its profits.

Dividend


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Dual-listed company

A merger between two companies, in which they agree to combine their operations and cash flows, and make similar dividend payments to shareholders in both companies, while retaining separate shareholder registries and identities. In most cases, the two companies are listed in different countries.


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The value of a business or investment after subtracting any debts owed by it. The equity in a company is the value of all its shares.

Equity


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Same as stock market. Not to be confused with the physical place where shares are traded. That’s called a stock exchange.

Equity market


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A condition where a company cannot meet, or has difficulty paying off its financial obligations to its creditors. The chance of financial distress increases when a firm has high fixed costs, illiquid assets, or revenues that are sensitive to economic downturns.

Financial distress


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The organisation responsible for regulating the financial services industry in the UK.

Financial ServicesAuthority (FSA)


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Fixed income

Any type of investment, such as bonds and other debt instruments, that produces regular or fixed returns.


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Foreign exchange.

Forex (FX)


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The qualitative and quantitative information that contributes to the economic well-being and the subsequent financial valuation of a company, security or currency. Analysts and investors analyse these fundamentals to develop an estimate as to whether the underlying asset is considered a worthwhile investment. For businesses, information such as revenue, earnings, assets, liabilities and growth are considered some of the fundamentals.

Fundamentals


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A futures contract is an agreement to buy or sell a commodity at a predetermined date and price. It could be used to hedge or to speculate on the price of the commodity. Futures contracts are a type of derivative and are traded on an exchange.

Futures


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Same as leverage. The extent to which a company’s operations are funded by lenders versus shareholders. A company with a high proportion of debt to equity is highly geared and is more vulnerable to fluctuations in business activity. It presents a higher risk for shareholders.

Gearing


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A private investment fund which uses a range of sophisticated strategies to maximise returns including leveraging and derivatives trading. Despite its name, hedging is rarely used.

Hedge fund


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A strategy to minimise risk. It involves deliberately taking on a new risk that offsets the existing one. For example, an importer of a commodity may sell futures contracts to offset losses if prices fall.

Hedging


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The first sale of stock by a company to the public. A company can raise money by issuing either debt or equity. If the company has never issued equity to the public, it’s known as an IPO.

Initial public offering (IPO)


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A financial instrument based on an underlying financial security whose value is affected by changes in interest rates. Interest-rate derivatives are hedges used by institutional investors such as banks to combat the changes in market interest rates.

Interest-rate derivatives


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Need for intermediation occurs due to the imperfect nature of markets and everyday situations where the complete (‘perfect’) knowledge about providers and seekers (and about what they seek) is not available to everyone.

Intermediation


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Agreement between two or more companies to cooperate on a particular project or a business that serves their mutual interests. In most cases, the agreement involves the parties taking a share in the capital of a joint venture company, and sharing costs and earnings in proportion to that share.

Joint venture


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The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition.

Leveraged buy-out


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Holding a security such as a stock, commodity or currency, with the expectation that the price will rise.

Long (or ‘long position’)


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The branch of economics concerned with large-scale or general economic factors, such as interest rates and national productivity.

Macroeconomics


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A transaction where a company’s management team purchases the assets and operations of the business they manage.

Managementbuy-out (MBO)


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When two businesses join together, either by merging or by one company taking over the other.

Mergers and acquisitions (M&A)


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Modern portfolio theory is based on the simple idea that diversification can produce the same total returns for less risk. Combining many financial assets in a portfolio is less risky than putting all your investment eggs in one basket. Harry Markowitz was awarded a Nobel Prize in Economics for developing this theory. However, when it came to investing his own money, Markowitz didn’t use MPT, but chose a simpler rule which allocates money equally across a number of funds under consideration.

Modern portfolio theory (MPT)


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An investment fund that gathers capital from a number of investors to create a pool of money that is then re-invested into stocks, bonds and other assets. Mutual funds are known as unit trusts in the UK.

Mutual fund


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A value that helps people decide whether to go ahead with an investment or project. It is the current value of the investment plus the present value of future cash flows, minus the initial cost of the investment plus the present value of any future cost.

Net present value (NPV)


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A type of derivative that gives an investor the right to buy (or to sell) something at an agreed price and at an agreed time in the future. Options become much more valuable when markets are volatile, as they can be an insurance against price swings.

Options


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Greeks – the quantities representing the sensitivity of the price of derivatives such as options to a change in underlying parameters on which the value of an instrumentor portfolio of financial instruments is dependent.Exotics – Exotics are derivatives that are complex or are available in emerging economies.

Options: Greeks,Exotics


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Deciding on the weights of securities so that they best suit the goal of the portfolio, such as: ‘maximise return for a given risk’.

Portfoliooptimisation


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A simple way of judging whether shares are cheap or expensive. It is the ratio of the market price of a share to the company’s earnings (profit) per share.

Price-earning ratio


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A firm that specialises in buying up troubled or undervalued companies, taking them private with the aim of running them better and later taking them public or selling them at a profit.

Private equity firm


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In the UK, a way of creating public-private partnerships by funding public infrastructure projects with private capital.

Private finance initiative (PFI)


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A financial ratio that measures a company’s profitability and the efficiency with which its capital is employed.

Return on capitalemployed (ROCE)


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The profit on an investment in relation to the amount invested.

Return on investment (ROI)


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An accounting principle under generally accepted recognition accounting principles (GAAP) that determines the specific conditions under which income becomes realised as revenue. Generally, revenue is recognised only when a pecific critical event has occurred and the amount of revenue is measurable.

Revenue


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The process of managing the risk you want to bear, and minimising your exposure to the risk you do not want. Some of the ways that companies manage risk include hedging, diversification, buying insurance and, simply, avoidance.

Risk management


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The part of the financial industry involved with the creation, promotion, analysis and sale of securities. Sell-side individuals and firms work to create and service stock products that will be made available to the buy-side of the financial industry.

Sell-side


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The sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value. Strategic asset The practice of realigning a portfolio’s asset composition in allocation order to accommodate changes in market.

Shorting


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An exchange of securities between two parties. For example, if a firm in one country has a lower fixed interest rate and one in another country has a lower floating interest rate, an interest rate swap could be mutually beneficial.

Swap


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Determining the value of an asset or a company.

Valuation


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The strategy of selecting stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued.

Value investing


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Private equity to help new companies grow. An alternative source of finance for entrepreneurs who might otherwise have to rely on a bank loan.

Venture capital


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A graph of the relationship between the yields and maturities of different bonds of similar quality, currency denomination and risk (usually government bonds).

Yield curve


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Masters in Finance – MiF

Masters in Financial Analysis – MFA

Beyond the jargon: finance programmes at LBS


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Executive Education Programmes

■■ Corporate Finance Portfolio:■■ Accounting and Financial Analysis■■ Valuation■■ Financial Strategies for Value Creation■■ Advanced Corporate Finance

■■ Financing the Entrepreneurial Business■■ Financial Seminar for Senior Managers

■■ Investment Management Programmes:■■ Equity Portfolio Management■■ Fixed Income Markets and Bond Portfolio

Management

■■ Masterclass in Private Equity■■ Mergers and Acquisitions■■ Project and Infrastructure Finance■■ Strategic Investment Management

Beyond the jargon: finance programmes at LBS

Financial Glossary

Business

financial system

active return return

benchmark return

actual return

bond value

capital markets

convertible bond

mutual funds