Financial Investments Vocabulary

Chapter 1 – Investment Background and Issues

1. Investment – commitment of current resources in the expectation of deriving greater

resources in the future
2. Real assets – assets used to produce goods and services
3. Financial assets – claims on assets or the income generated by them
4. Fixed income securities – pay a specified cash flow over a specific period
5. Equity – ownership share in a corporation
6. Derivative securities – securities providing payoffs tha depend on the values of other
assets
7.
8. Asset allocation – allocation of an investment portfolio across broad asset classes
9. Security selection – choice of specific securities within each asset class
10. Security analysis – analysis of the value of securities
11. Risk return tradeoff – assets with higher expected returns have greater risk
12. Passive management – buying and holding a diversified portfolio without attempting to
identify mispriced securities
13. Active management – attempting to identify mispriced securities or to forecast broad
market trends
14. Financial intermediaries – institutions that connect borrowers and lenders by accepting
funds from lenders and loaning funds to borrowers.
15. Investment companies – firms managing funds for investors. An investment company
may manage several mutual funds
16. Investment bankers – firms specializing in the sale of new securities to the public,
typically by underwriting the issue
17. Primary market- a market in which new issues of securities are offered to the public
18. Dealing markets – markets in which traders specializing the particular assests buy and
sell for their own accounts
19. Secondary markets – already existing securities are bought and sold on the exchanges or
in the OTC market
20. Auction market – a market where all traders in a good meet at one place to buy or sell
an asset
21. Globalization – tendency toward a worldwide investment environment, and the
integration of national capital markets
22. Pass through securities – pools of loans (such as home mortgage loans) sold in one
package. Owners of pass through receive all the principle and interest payments made by
the borrowers.
23. Securitization – pooling loans into standardized securities backed by those loans, which
can then be traded like any other security
24. Bundling and Unbundling – creation of new securities either by combining primitive
and derivative securities into one composite hybrid or by separating returns on an asset
into classes (One person gets principle, other gets interest, etc)
25. Financial Engineering – the process of creating and designing securities with custom-
tailored characteristics
Chapter 2 – Financial Markets and Instruments
1. Money markets – includes short term, highly liquid, and relatively low risk debt
instruments.
2. Capital markets – includes longer term, relatively riskier securities.
3. Treasury bills – short term government securities issued at a discount from face value
and returning the face amount at maturity.
4. Effective annual rate – annualized interest rate on a security computed using compound
interest techniques
5. Bank discount method – an annualized interest rate assuming simple interest, a 360 day
year, and using the face value of the security rather than the purchase price to compute
return per dollar invested.
6. Bond equivalent yield – bond yield calculated using simple rather than compound
interest. Treasury bills use this yield.
7. Annual percentage rate – rate is annualized assuming simple interest
8. CD – a bank time deposit
9. Commercial paper – short term unsecured debt issued by large corporations
10. Bankers’ acceptance – ann order to a bank by a customer to pay a sum of money at a
future date
11. Eurodollars – dollar denominated deposits at foreign banks or foreign branches of
American banks
12. Repos – short term sales of government securities with an agreement to repurchase the
securities at a higher price.
13. Federal funds – funds in the accounts of commercial banks at the Federal Reserve Bank
14. LIBOR – lending rate amount bands in the London Market
15. Treasury notes or bonds – debt obligations of the federal government that make
semiannual payments and are sold at or near par value in denominations of $1000 or
more.
16. Municipal bonds – tax-exempt bonds issued by state and local governments
17. Corporate bonds – long term debt issued by private corporations typically paying
semiannual coupons and returning the face value of the bond at maturity
18. Common stocks – ownership shares in a publicly held corporation. Shareholders have
voting rights and may receive dividends.
19. Preferred stock – nonvoting shares in a corporation, usually paying a fixed stream of
dividends.
20. Price weighted average – an average computed by adding the prices of the stocks and
dividing by some constant divisor. Used to compute dow jones average, though divisor
keeps changing
21. Market value weighted index – computed by calculating a weighted average of the
returns of each security in the index, with weights proportional to outstanding market
value (market cap)
22. Equally weighted index – an index computed from a simple average of returns
23. Derivative asset or contingent claim – a security with a payoff that depends on the
prices of other securities.
24. Call option – the right to buy an asset at a specified price on or before a specified
expiration date.
 25. Put option – the right to sell an asset at a specified exercise price on or before a specified
expiration date.
26. Futures contract – obliges traders to purchase or sell an asset at an agreed upon price at
a specified future date.

Chapter 5 – Investors and the Investment Process

1. Risk tolerance – the investor’s willingness to accept higher risk to attain higher expected
returns
2. Risk aversion – the investor’s reluctance to accept risk
3. Personal trust – an interest is an asset held by a trustee for the benefit of another person
4. Mutual fund – a firm pooling and managing funds of investors
5. Endowment funds – portfolios operated for the benefit of a non-profit entity
6. Liquidity – liquidity refers to the speed and ease which an asset can be converted into
cash
7. Investment horizon – the planned liquidation date
8. Prudent Man Law – the fiduciary responsibility of a professional investor (must be able
to defend decisions in court)
9. Asset universe – approved list of assets in which a portfolio manager may invest

Chapter 6 – Risk and Return

1. Holding period return – rate of return over a given investment period
2. Capital Gains – (ending price – beginning price) / beginning price
3. Dividend Yield – total dividend paid / beginning security price
4. Arithmetic average – the sum of returns in each period divided by the number of periods
5. Geometric average – the single per period return that gives the same cumulative
performance as the sequence of actual returns
6. Dollar-weighted average return – the internal rate of return on an investment. Discount
each cash flow according to its time.
7. Scenario analysis – process of devising a list of possible economic scenarios and
specifying the likelihood of each one, as well as the HPR that will be realized in each
case
8. Probability distribution – list of possible outcomes with associated probabilities
9. Expected return – the reward from an investment (expected)
10. Mean Return – same as expected return
11. Variance – the expected value of the squared deviation from the mean
12. Standard Deviation – the square root of the variance
13. Risk free rate – the rate of return that can be earned with certainty
14. Risk premium – an expected return in excess of that on risk free securities
15. Inflation rate – the rate at which prices are rising, measured as the rate of increase of the
CPI
16. Nominal interest rate – the interest rate in terms of nominal (not adjusted for purchasing
power) dollars
17. Real rate interest – the excess of the interest rate over the inflation rate. The growth rate
of purchases power derived from an investment.
18. Complete Portfolio – the entire portfolio including risky and risk free assets
 19. Capital Allocation Line – plot of risk/return combinations available by varying portfolio
allocation between a risk free asset and a risky (often optimal) portfolio.
20. Reward to variability ratio – ratio of risk premium to standard deviation
21. Passive strategy – investment policy that avoids security analysis
22. Capital market line – the capital allocation line using the market index portfolio as the
risky asset

Chapter 7 – Efficient Diversification

1. Market risk – risk that remains even after diversification.
2. Systematic Risk – Same as market risk
3. Nondiversifiable Risk – same as market risk
4. Unique Risk – risk that can be related with diversification
5. Firm specific risks – same as unique risk
6. Nonsystematic risk – same as unique risk
7. Diversifiable risk – same as unique risk
8. Investment Opportunity Set – set of available portfolio risk/return combinations
9. Optimal risky portfolio – the best combination of risky assets to be mixed with safe
assets to form the complete port folio
10. Efficient frontier – graph representing a set of portfolios that maximizes expected return
at each level of portfolio risk
11. Separation property – the property that implies portfolio choice can be separated into
two independent tasks – determination of the optimal risky portfolio and the personal
choice of the best mix of the risky portfolio and the risk-free asset.
12. Factor model – statistical model to measure the firm specific versus systematic risk of a
stock’s rate of return (two components of risk).
13. Excess return – rate of return in excess of the risk free rate
14. Beta – the sensitivity of a security’s returns ot the systematic or market factor
15. Index model – a model of stock returns using a market index such as the S/P 500 to
represent common or systematic risk factors
16. Security characteristic line – plot of a security’s excess return as a function of the
excess return of the market

Chapter 8 – CAPM
1. CAPM – model that relates the required rate of return for a security to its risk as
measured by beta. K = rf + B(rm – rf)
2. Market portfolio –the portfolio for which each security is held in proportion to its
market value
3. Mutual fund theorem – states that all investors desire the same portfolio of risky assets
and can be satisfied by a single mutual fund composed of that portfolio.
4. Arbitrage – creation of riskless profits made possible by relative mispricing among
securities
5. Zero investment portfolio – a portfolio of zero net value, established by buying and
shorting component securities usually in the context of an arbitrage strategy
6. APT – a theory of risk return relationships derived from no arbitrage considerations in
large capital markets
 7. Well diversified portfolio – a portfolio sufficiently diversified that nonsystematic risk is
negligible
8. Factor portfolio – a well diversified portfolio constructed to have a beta of 1.0 on one
factor and a beta of 0 on any other factor
9. Technical Analysis – research on recurrent and predictable stock price patterns and on
proxies for buy or sell pressure in the market
10. Fundamental analysis – research on determinants of stock value, such as earnings and
dividends prospects, expectations for future interest rates, and risks of the firm.
11. Passive Investment strategy – buying a well diversified portfolio without attempting to
search out mispriced securities.
12. Index fund – a mutual fund holding shares in proportion to their representation in a
market index such as the S/P 500
13. P/E Effect – portfolios of low P/E stocks have exhibited higher average risk adjusted
returns than high P/E stocks
14. Small firm effect – stocks of small firms have earned abnormal returns, primarily in the
month of January
15. Neglected firm effect – the tendency of investments in stock of less well known firms to
generate abnormal returns
16. Book to market effect – the tendency for investments in shares of firms with high ratios
of book value to market value to generate abnormal returns
17. Reversal effect – the tendency of poorly performing stocks and well performing stocks
in one period to experience reversals in the following period

Chapter 10 – Bonds
1. Fixed income security – a security such as a bond that pays a specified cash flow over a
specific period.
2. Bond – a security that obligates the issuer to make specified payments to the holder over
a period of time
3. Face value, par value – the payment to the bondholder at the maturity of the bond.
4. Coupon rate – the bond’s annual interest payment per dollar of par value
5. Zero coupon bond – a bond paying no coupons that sells at a discount and provides only
a payment of par value at maturity
6. Callable bonds – bonds that may be repurchased by the issuer at a specified call price
during the call period.
7. Convertible bond – a bond with an option allowing the bond holder to exchange the
bond for a specified number of shares of common stock in the firm
8. Put bond – a bond that the holder may choose either to exchange for par value at some
date or to extend for a given number of years
9. Floating rate bonds – bonds with coupon rates periodically reset according to a
specified market rate
10. Investment grade bond – a bond rated BBB and above by the S/P, or Baa and above by
Moody’s
11. Speculative grade or Junk Bond – a bond rated BB or lower by S/P, Ba or lower by
Moody’s, or an unrated bond. By Drexel Burnham Lambert, Michael Milken.
12. Indenture – the document defining the contract between the bond issuer and the
bondholder
 13. Sinking fund – a bond indenture that calls for the issuer to periodically repurchase some
partition of the outstanding bonds prior to maturity.
14. Subordination clauses – restrictions on additional borrowing that stipulate that senior
bondholders will be paid first in the vent of bankruptcy.
15. Collateral – a specified assets pledged against possible default on a bond
16. Debenture – a bond not backed by specific collateral
17. YTM – discount rate that makes the present value of a bond’s payments equal to its
price. Assumes reinvestment rate is YTM.
18. Current yield – annual coupon divided by bond price
19. Default premium – the increment to promised yield that compensates the investor for
default risk
20. Realized Compound Yield – different from YTM if the reinvestment rate isn’t the same
as the YTM.

Chapter 11 – Fixed Income Investments

1. Duration – a measure of the effective maturity of a bond defined as the weighted average
of the times until each payments, with weights proportional to the present value of the
payment. Discount the payments, divide by the total present value of all payments,
multiply by times, add.
2. DelP / P = -D * (Del(1+y)/(1+y)) = -D* * DelY. D* = D/(1+y)
3. Bond prices and yields are inversely related. Interest rates and yields are directly related
4. An increase in a bond’s YTM results in a smaller price decline than the price gain
associated with a decrease of equal magnitude in yield.
5. Prices of long term bonds tend to be more sensitive to interest rate changes than prices of
short term bonds
6. The sensitivity of bond prices to changes in yields increases as a decreasing rate as
maturity incases. In other words, interest rate risk is less than proportional to bond
maturity
7. Interest rate risk is inversely related to the bond’s coupon rate. Prices of high coupon
bonds are less sensitive to changes in interest rates than prices of low coupon bonds
8. The sensitivity of a bond’s price to a change in its yield is inversely related to the YTM at
which the bond is currently selling.
9. Known as Malkiel’s bond pricing relationships.

Chapter 12 – Macroeconomic and Industry Analysis

1. Business Cycles – repetitive cycles of recession and recovery
2. peak – the transition from the end of an expansion to the start of a contraction
3. Trough – the transition between recession and recovery
4. Cyclical industries – industries with above average sensitivity to the state of the
economy
5. Defensive industries – industries with below average sensitivity to the state of the
economy
6. Leading economic indicators – economic series that tend to rise or fall in advance of the
rest of the economy
7. SIC codes – classification of firms into industry groups using numerical codes to identify
industries.
 8. Degree of operating leverage – percentage change in profits given a 1% change in sales.
9. Industry Cycle life – stages through which firms typically pass as they mature
10. Slow growers – large, aging companies that will grow only slightly faster than the broad
economy
11. Stalwarts – large, well known firms, grow faster than slow growers, but not much
12. Fast growers – small and aggressive new firms with growth rates of 20 – 25%
13. Cyclicals – firms with sales and profits that regularly expand and contract along with the
business cycle
14. Turnarounds – these are firms that in bankruptcy or soon might be
15. Asset plays – these are firms that have valuable assets not currently reflected in the stock
price.
16. Threat of entry – new entrants to an industry put pressure on price and profits
17. Rivalry between existing competitors
18. Substitute products – consumers can choose to use other, similar products
19. Bargaining power of buyers – if a buyer purchases a large fraction of an indsutry’s
output, it can demand lower prices.
20. Bargaining power of suppliers – if a supplier of a key input has monopolistic control
over the product, it can demand higher prices

Chapter 13 – Stocks
1. Book value – the net worth of common equity according to a firm’s balance sheet
2. Liquidation value – net amount that can be realized by selling the assets of a firm and
paying off the debt
3. Replacement cost – cost to replace a firm’s assets. If the stock rose too high above this
value, other companies would try to replicate the firm.
4. Tobin’s q – ratio of market value of firm to replacement cost
5. Intrinsic Value – the present value of a firm’s expcted future net cash flows discounted
by the required rate of return
6. DDM – a formula for the intrinsic value of a firm equal to the present value of all
expected future dividends
7. Dividend Payout Ratio – percentage of earnings paid out as dividends
8. Plowback ratio/Earnings Retention Ratio – 1 – Div Payout ratio
9. Present Value of Growth Opoprtunities – PVGO – net present value of a firm’s future
investments
10. P/E ratio – ratio of a stock’s price to EPS
11. Riskier stocks generally will have lower P/E multiples, HOLDING ALL ELSE EQUAL

Chapter 14 – Financial Statement Analysis (aka Econ 4)

1. Income statement – a financial statement showing a firm’s revenues and expenses
during a specified period
2. Balance sheet – an accounting statement of a firm’s financial position at a point in time
3. Cash flow statement – a financial statement showing a firm’s cash receipts and cash
payments during a specified period.
4. Accounting earnings – earnings of a firm as reported on its income statement
 5. Economic earnings – real flow of cash that a firm could pay out forever in the absence
of any change in the firm’s productive capacity.
6. Return on equity – the ratio of net profits to common equity
7. Return on assets – earnings before interests and taxes divided by total assets
8. Profit Margin/return on sales (ROS) – the ratio of operating profits per dollar of sales
9. Asset turnover (ATO)– the annual sales generated by each dollar of assets
10. Leverage ratio – measure of debt to total capitalization of a firm
11. Average collection period/days receivables – the ratio of accounts receivable to daily
sales, or the total amount of credit extended per dollar of daily sales.
12. Current ratio – the ability of the firm to pay off its current liabilities by liquidating
current assets (current assets/current liabilities)
13. Quick ratio or acid test ratio – a measure of liquidity similar to the current ratio except
for exclusion of inventories
14. Interest coverage ratio or times interest earned – a financial leverage measure arrived at
by dividing earnings before interest and taxes by interest expense
15. Market to book value ratio – market price of a share divided by book value per share
16. Price/earnings ratio – the ratio of a stock’s price to its earnings per share, P/E
17. Earnings yield – ratio of earnings to price, E/P

Chapter 16 - Options
1. Call – right to buy stock at some strike price
2. Put – right to sell stock at some strike price
3. American option – can be exercised on or before its expiration
4. European option - Can be exercised only at expiration
5. Protective put – asset combined with a put option that guarantees minimum proceeds
equal to the put’s exercise price. Limits losses
6. Covered call – short a call with an asset – Caps gains, but limits losses when shorting
7. Straddle – A combination of call and a put, each with the same price and date. You win
if the market moves in either direction, worst case when market doesn’t do anything
8. Spread – combination of two or more call options or put options on the same asset with
differing prices/expirations. Limits gains/losses either way
9. Collar – brackets the value of a portfolio between two bounds.