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1

Activism

Active engagement and intervention (by voting or otherwise) by investors with the companies in which they have holdings, in order to monitor or influence the management of such companies.

2

Actuarial risk

The risk of not being able to meet liabilities as they fall due (ie mismatching
assets and liabilities).

3

Alpha

A measure of a stock’s, or fund’s, outperformance, adjusted for the level of risk taken.
So, for a comparison with the market, alpha is given by:
(r - rf ) - b (rm - rf )
Where r is the stock’s/ fund’s rate of return, rf is the risk free rate and rm is the
market rate of return. The risk adjustment is the same as in the CAPM model.

4

Alpha fund

A label used by fund managers to describe funds that are more aggressive in trying to outperform the market.

5

American option

An option that can be exercised on any date before its expiry.

6

Amortisation

The writing-down of the value of intangible assets (such as goodwill, advertising and R and D) over time.

7

Anomaly switch

A technique used in the active management of a bond portfolio. Anomaly switching involves moving between stocks with similar volatility, thereby taking advantage of temporary anomalies in price.

8

Arbitrage

The simultaneous buying and selling of two economically equivalent but differently priced portfolios so as to make a risk-free profit.
Recall that derivative pricing is based on the assumption that markets are arbitrage-free and so there are no arbitrage opportunities.

9

Arithmetic index

An index constructed as the arithmetic average of the prices of the constituent investments. The prices are often weighted and the average is usually multiplied by a factor chosen to give a convenient starting value for the index. The factor is periodically altered so as to maintain a continuous index value when it is necessary to alter the constituents or the weights.
Recall from Chapter 14 that such indices cannot be used for valid performance measurement.

10

Backfill

To add an investment fund's past history into a performance database. Since only successful funds will seek to be added to the database, this will tend to improve the reported returns (“backfill bias”).

11

Beta value

A measure of a stock’s volatility relative to movements in the whole market. Usually defined as the covariance of the return on the stock with the return on the market, divided by the variance of the market return.
Recall that beta measures the systematic risk of a security or a portfolio.

12

Chain-linking

Adjusting an investment index so that it reflects the investment performance of its constituents (and not injections or withdrawals of funds into or out of the market itself).

13

Close out

The process of establishing an equal and opposite derivative or asset position in order to neutralize or offset the risk of an existing position.

14

Collateral

Assets that are given as security for a loan as a fall-back measure to be used in the event of default. By taking collateral, the creditor has an additional source of repayment should its counterparty be unable to perform on its obligations.

15

Contingent liability

A liability dependent on other events.

16

Credit spread

A measure of the difference between the yield on a risky and a risk-free security. It is a measure of the risk premium a credit-risky corporate or sovereign entity must pay to attract capital. Credit spreads are used widely as references for credit derivatives.

17

Cyclical company

A company whose fortunes are very closely linked to the state of the economy. The share price, relative to the rest of the market, will therefore depend on the current state of the economy and any (discounted) expected future changes in the economy.

18

Defensive company

A company whose fortunes are reasonably immune to the state of the economy. Any security that exhibits less volatility than the market as a whole (ie its beta is less than 1.0), providing lower, but more stable, returns.

19

Deflators

Stochastic discount factors which can be applied to a series of cash flows under a set of realistic scenarios to produce market-consistent valuations of assets and liabilities. Sometimes referred to as “state-price deflators”.

20

Dividend cover

The number of times that the dividend payments are covered by earnings for the relevant period. Defined as:
earnings per share dividend per share
It is the inverse of the payout ratio. Care needs to be taken that the tax treatment of the earnings and dividend figures are consistent.

21

Downside risk

The risk that something bad will happen and a loss will occur. The risk of something going wrong. A risk whose outcome is adverse.

22

Economic good

A consumable item that is useful to people but is scarce in relation to its demand, so that human effort is required to obtain it.

23

Enterprise value

The combined total market capitalisation of a firm's debt and equity. This may also be computed as the sum of expected future net cash flows, discounted at a firm-specific discount rate.

24

Equitable

Characterised by fairness. Thus an ownership interest in assets that is conveyed via title and which is considered fair and just by the courts, but which may not represent a strict legal right (eg the interests of a beneficiary in a trust) are of an equitable nature.

25

Eurobond

An international bond issued by a company or government, often in a currency other than the currency of the borrower. The bonds are traded internationally through banks, and not in the traditional bond markets.

26

Event risk

The risk of loss due to single events that are unlikely but may have serious consequences if they do occur. The events are either largely or entirely outside the control of the organisation. Such losses do not follow traditional stochastic processes.

27

Exchange traded funds

An exchange traded fund (ETF) is a collective investment vehicle that is traded on a securities exchange at a price that is closely related to its net asset value and is quoted in real time. It combines the valuation feature of a unit trust with the tradability of an investment trust. ETFs are generally managed as index- tracker funds and, not being shares, do not incur stamp duty on purchases.

28

Fiduciary

Proceeding from trust or confidence. Also, an individual, corporation or association to whom certain property is given to hold in trust. The property is to be utilised or invested for the benefit of the property owner, to the best ability of the fiduciary.

29

Floating rate note (FRN)

A Eurobond with a variable rate of interest. FRNs are usually medium-term bonds.

30

Forward Rate Agreement (FRA)

A forward contract where the parties agree that a certain interest rate will apply to a certain principal amount during a specified future time period.

31

Geometric index

A geometric index is based on the geometric mean of the ratio of the share prices.
Recall from Chapter 14 that such indices cannot be used for valid performance measurement.

32

Interest cover

A calculation made for loans issued by companies. The interest cover is the number of times that the profit of the company (before interest payable and tax) covers the interest on the loan (including the interest on prior ranking loans).

33

In-the-money

An option with a positive intrinsic value is in-the-money.

34

Infrastructure

The basic facilities, services and installations needed for the functioning of a community or society.

35

Intermediate goods (and services)

Goods and services used up in the course of production of 'final' goods and services.

36

Intrinsic value

For a call option, the greater of zero and the amount by which the market price of the underlying asset exceeds the exercise price.
ie max[ST -K,0]
For a put option, the greater of zero and the amount by which the exercise price
exceeds the market price of the underlying asset.
ie max [K - ST , 0]

37

Investment grade bond

A bond rated at least Baa (by Moody’s) or BBB (by Standard and Poor’s).

38

Investment trust

Investment trusts are public companies whose function is to manage shares and investments. They have a capital structure in the same way as other public companies and can raise both loan and equity capital. Most have quoted shares allowing small investors to gain exposure to the portfolio held by the investment trust.
These are described more fully in Subjects A103 and A301.

39

ISDA

The International Swaps and Derivatives Association, representing the interests of the over-the-counter derivatives marketplace, which has produced a number of Master Agreements regarding terminology, settlement procedures, counterparty risk management, etc.

40

Mandate

The terms of a commission or order.

41

Marking to market

The practice of revaluing an instrument to reflect the current values of the relevant market variables.

42

Net asset value per share

The book value of the shareholders’ interests in a company, usually excluding intangibles such as goodwill divided by the number of shares in issue.

43

Non-recourse

A loan, the servicing or repayment of which is dependent solely on the profitability of the underlying project and not on any other funds potentially in the possession of the borrower.

44

Notional portfolio

A portfolio which is created only notionally to serve as a benchmark for investment performance appraisal. Typically, such a portfolio will have weights set to closely mirror the fund's objectives.

45

Notional principal

The principal used to calculate payments in an interest rate swap. The principal is “notional” because it is neither paid nor received (although for currency swaps the full notional is typically exchanged on trade date and at final maturity).

46

Open ended investment company (OEIC)

An investment vehicle very similar to an investment trust but with the open
ended characteristics of a unit trust.
These are described more fully in Subject A301.

47

Out-of-the-money

An option with no intrinsic value is described as being out-of-the-money.

48

Par yield curve

A plot of coupon value on the y-axis against term to redemption on the x-axis. For each term, the coupon that would be required for a fixed interest bond of that term to be issued at par is plotted.

49

Payout ratio

Dividends divided by earnings per share. The inverse of dividend cover.

50

Price earnings ratio

The ratio of a share’s price to its net earnings.
PER = ordinary share price earnings per share
The earnings per share used can be historic or prospective.

51

Principal-agent problems

Where people (principals), as a result of lack of knowledge, cannot ensure that their best interests are served by their agents.

52

Rack-rented

Rent that would be received for a property if it were subject to immediate open- market rental review.

53

Redemption yield

The gross redemption yield (the word gross is often omitted), or yield to maturity, is the rate of return at which the discounted value of all future payments of interest and capital is equal to the “dirty” price of the bond. The net redemption yield allows for taxation of the amounts received by the investor.
Recall that this is also referred to as the bond yield in Chapter 11.

54

Relationship banks

A model of banking where a financial institution attempts to provide its clients with a full range of products and services, and to engage in a continuous and detailed dialogue about business requirements, in order to create a long-term business relationship.

55

Remuneration

Payment to a person for work done.

56

Return on capital employed (ROCE)

Profit before interest and tax divided by capital employed, expressed as a percentage. An indicator of a company’s efficiency in generating profit from its asset base.

57

Reverse yield gap

The long-dated gilt yield minus the equity yield.

58

Reversion interest

The interest of a freeholder or long term leaseholder, to whom the property will revert on expiry of a lease.

59

Rights issue

A rights issue is where a company issues further shares, at a given price, to existing shareholders in proportion to their existing shareholdings. For example, a 1-for-5 rights issue allows each shareholder to buy one new share for each five currently held. The purpose is for the issuing company to raise more money.

60

Running yield

The annual income on an investment divided by its current market value. Important examples are the flat yield on gilts, the gross dividend yield on equities and the rental yield on property.

61

Scrip issue

A scrip issue (sometimes called a capitalisation or bonus issue) is a further issue of new shares to existing equity shareholders. They receive free a number of shares in proportion to their holdings.

62

Settlement

The payment of an account. Completing a stock transaction by delivering the required stock certificates and/or funds. Closing out a brokerage account.

63

Share buy-backs

Repurchase, by a company, of its own shares in the market. Usually a tax- efficient means of returning capital to shareholders.

64

Share split

In a share split existing shares are split into two shares of half the original nominal value. No new money is raised and no reserves are capitalised.

65

Shareholder value

The present value of all expected current and future cashflows available to shareholders.

66

Short-selling

Selling, in the market, shares that have been borrowed from another investor.

67

Sovereign debt

Fixed income stock issued by a national government (in order to finance expenditure not covered by taxation). The loans outstanding of individual countries, usually negotiated by their respective governments.

68

Specific risk

The risk of holding a share which is unique to the industry or company and can be eliminated by having a suitably diversified portfolio of shares of differing types of companies. This is sometimes also referred to as alpha, unsystematic or residual risk.

69

Split-capital investment trust

An investment trust where the ordinary share capital consists of income shares and capital shares. Holders of income shares receive all or most of the distributed income while holders of capital shares receive little or no income but receive the residual value of the assets after income shares have been redeemed at a fixed value when the trust is wound up.

70

Spot interest rate

The n-year spot interest rate is the geometrical average of the interest rates that are expected to apply over the next n years. It is the redemption yield on an n year zero-coupon bond. (See zero-coupon yield curve.)
Recall from Chapter 11 that spot rates are also referred to as zero rates. Spread
The difference between a market maker’s bid and offer prices. Often referred to as bid-offer spread.

71

Strip

A bond strip is a tradable security consisting of one of the payments constituting a coupon paying bond. In effect it is a zero-coupon bond.

72

Sub-sovereigns

Fixed income stock issued by government agencies, supranationals and government guaranteed organisations.

73

Supersector

A sector comprising several lesser sectors.

74

Systematic risk

The risk of the individual share relative to the overall market which cannot be eliminated by diversification. It is measured by the beta factor. A share with a beta greater than 1 is said to be aggressive, ie the price of the share is expected to do better than the market when prices rise. Conversely, a share with a beta less than 1 is a defensive stock, ie its price will be expected to fall by less than the market when prices fall.

75

Tick size

The size of the minimum movement in a quoted price (eg 0.01 for gilts).

76

Tick value

The change in the value of a futures contract when the price changes by one tick.

77

Time deposit

A deposit that requires notice of withdrawal (or where a penalty is charged for withdrawals on demand).

78

Total return index

A performance measure that allows for coupon or dividends as well as changes in market values.
Total return indices are discussed in detail in Chapter 14.

79

Tracking error

The annual standardised deviation of the difference between portfolio return and benchmark return.

80

Trade cycle

The periodic fluctuations of national output around its long-term trend.

81

Traded options

Option contracts with standardised features actively traded on organised
exchanges.

82

Unit trust

An open-ended investment vehicle whereby investors can buy “units” in an underlying pool of assets from the trust manager. If there is demand for units, the managers can create more units for sale to investors. If there are redemptions (sales by investors), the managers will buy in units offered to them. Unit trusts are trusts in the legal sense.
These are described more fully in Subjects A103 and A301.

83

Warrant

An option issued by a company. The holder has the right to purchase shares at a specified price at specified times in the future.

84

Working capital

Current assets minus current liabilities. A measure of a company's short-term operating resources.

85

Yield curve

A plot of yield against term to redemption. Usually the yi§eld plotted is the gross redemption yield on coupon-paying bonds but other yields can be used. (See par yield curve, zero-coupon yield curve.)

86

Zero-coupon bond

A bond where the sole return is the payment of the nominal value on maturity.

87

Zero-coupon yield curve

A plot of redemption yields against term to redemption for (usually hypothetical) zero-coupon bonds.
This is discussed in more detail in Chapter 11.