Financial Management Terms
Accounting rate of return
The ratio of the average operating profit generated by a project (net operating flows less depreciation) to the average capital employed.
Alternative Investment Market (AIM)
A UK market (similar ones in other countries) which exist for the issue and trading in equity of small and intermediate size companies. The AIM has lower admission costs and regulatory requirements than the full market.
American option
An option that can be exercised at any time up until the exercise date.
Asset beta
Measures the sensitivity of the underlying business to market risk. It is the beta we would expect to observe if the firm was financed solely from equity.
Basis point
is equal to 1/100th of a percentage point.
E.g. a change in interest rates of 0.10% is equivalent to a change of 10 basis points.
Basis risk
The variability in the prices of two related securities in the hedging arrangement. For example, if changes in the price of a currency future do not perfectly match the change in the price of the underlying security then a profit (or loss) may occur on the hedged position. This potential variability in the outcome of a hedge is basis risk.
Bills
Money market securities issued by the government and others. They are normally offered to the market at a discount and do not carry interest, but are repaid at par.
Call option
An option to purchase the underlying asset at a stated price on or before a given date from another party, the option ‘writer’.
Capital market
The market for the purchase and sale of securities which have longer than one year to maturity.
Certificates of Deposit (CD)
In exchange for a deposit of funds the issuer writes a receipt (the CD) offering a one-off interest payment plus repayment of the face value of the deposit at maturity. The CDs are negotiable and can be traded.
Commercial paper
Corporate ‘IOUs’ against borrowed funds. They are issued at a discount and repaid at their face value and no extra interest is paid. They are the short term equivalent of corporate bonds and can be asset backed or ‘credit backed’ where the issuing firm has a weak credit rating but can obtain credit support from another company. A CP is not normally traded but is usually held until maturity once issued.
Coupon
The fixed rate of interest paid on a bond at regular (usually annual or semi-annual) intervals.
Credit risk (or default risk)
The risk borne by a lender that the borrower will default either on interest payments, the repayment of the borrowing at the due date, or both.
Derivative security
A security whose value is derived from the value of some other security such as a share, bond, money market bill or foreign exchange.
Discounted payback
The time taken for a firm to recover with its discounted cash flows the initial capital investment on a capital project.
Disintermediarisation
The removal of intermediaries such as banks and other financial institutions in the borrowing and lending process whereby borrowers issue securities in exchange for loan finance directly with investors.
Dividend cover
The ratio of earnings per share to dividend per share
Dividend yield
The ratio of dividend per share to price per share
Dynamic Delta hedging
The continuous adjustment of the balance between options and shares so as to ensure the maintenance of a risk neutral position.
Efficient markets hypothesis
The hypothesis that share prices respond instantly and without bias to new information such that an investor with access to that information cannot expect to make a systematic return greater than that offered by the market for the level of risk to which they are exposed. The EMH is traditionally presented in three forms: weak form (the information in past share prices), semi-strong form (publicly available information), and strong form (private information).
Eurobonds
Debt denominated in any currency (dollars, yen, euros etc) which are traded on the international capital markets.
European option
An option that can be exercised only on the exercise date.
Financial risk
The alteration in the volatility of the residual earnings to the equity investor caused by an alteration in the firm’s gearing.
Fisher effect
The proposition that real rates of interest are constant between countries which implies that there is a direct relationship between changes in nominal interest rates and inflation rates in different countries.
FOREX
Foreign exchange
Free cash flow to equity
Operating cash flow less interest and tax paid. The free cash flow to equity is potentially distributable to shareholders as dividend or can be retained in the form of net capital investment.
Future
An exchange traded forward agreements to buy or sell some underlying security at some future date for a currently agreed price.
Gilts (gilt edged security)
Bonds issued by the UK Government (also known as Treasury Bonds)
Hedging
Taking positions in two or more securities which by their nature are designed to create perfectly counter varying returns. A short sale in a futures contract, for example, can offset the risk associated with a long position on an underlying asset. A perfect hedge is one where all chance of loss is eliminated.
Hostile bid
A bid to acquire another company that is opposed by the company’s directors.
Initial margin
A deposit of cash or securities required by an exchange by parties to derivative agreements to underwrite any early losses that may be made on the position. Initial margin is about 20% of the value of the position in the underlying.
Interest rate futures
These are notional securities traded on the futures markets whose prices depend on the prevailing interest rates. The value of the future is (100 – implied interest rate). Thus the greater the interest rate the lower the value of the future, and vice versa.
Interest rate swaps
Where two partied agree to swap their liabilities for interest rate payments on a given capital sum. This is usually, but not necessarily, a fixed for variable interest rate swap.
Internal Rate of Return
The rate of discount which gives a zero Net Present Value when applied to an investment’s cash flows. The IRR assumes that all cash flows throughout the life of the project are reinvested at the IRR.
International Fisher Effect
If the Fisher Effect holds then changes in the spot rate are directly related to changes in interest rate.
Intrinsic value (of an option)
The payoff if an option could be exercised immediately.
LIBOR
London Inter-Bank Offered Rate. The average overnight rate of interest offered by deposit accepting banks as complied on a daily basis by the British Bankers Association. A LIBOR is quoted for sterling, dollar, yen, euro and other currency deposits.
LIFFE
London International Financial Futures Exchange.
Mezzanine debt
Low grade debt issued by fast expanding businesses (often as a result of leveraged buyouts) which promises high rates of return and usually some form of equity participation through the attachment of warrants.
Money market
The market for securities which normally have less than one year to maturity.
Monte Carlo simulation
A mathematical modelling process where random numbers are drawn from assumed distributions attaching to the variables within a given model. By repeated trials using random numbers the performance of the model can be examined under different assumptions about the nature of the underlying distribution.
NOPAT
Net operating profit after tax
OTC
Over the counter – the term relating to private agreements between counterparties to by or sell a security (normally, but not always, referring to derivatives).
Pecking order hypothesis
This is the hypothesis that there is a natural progression in the way that a manager will use the capital resources with the most preferred being retained earnings followed by debt followed by new equity issue.
Perfect capital market
This is a market characterized by unrestricted access to capital at the current market rate of return, perfect certainty, zero information costs and an absence of transaction costs and taxes.
Price/earnings (P/E) ratio
The ratio of a company’s price per share divided by its earnings per share. This ratio is commonly used as a valuation metric by the multiple method.
Put option
An option to sell the underlying asset at the stated price on or before a given date to another party, the option ‘writer’.
Put call parity
A formal relationship between the value of a European call and put option in the same underlying security.
Real option
An option attaching to the future cash flows derived from an investment in a capital asset by a firm. Real options include managerial discretion to delay, expand, withdraw, or redeploy resources within an investment project.
Securitisation
The process of converting claims upon an entity such as a government or a firm, or its assets, into negotiable certificates of entitlement that can be traded between individuals and where the holder at any point in time has the same rights as were held by the person to whom they were originally issued.
Senior debt
Unsubordinated debt, i.e. debt which takes priority in the event of liquidation.
Swap
An agreement between two counterparties to swap a liability to interest payments or to swap an asset such as foreign currency.
Synergy
The concept that mergers and acquisitions can create value that would not be available to either company independently. Synergy can be either: revenue, cost, or financially induced and is often used by management to justify mergers or acquisitions.
Tick
The smallest price movement on an exchange traded derivative contact . A tick is defined as the number of basis point movement in the value of the derivative times the unit of trading multiplied by the fraction of the year that the movement has occurred over.
Treasury Bills
Government ‘IOUs’ of usually one or three months’ maturity.
Value at risk (VAR)
The value that can be attached to the downside of a value or price distribution of known standard deviation and within a given confidence level.
Value at risk and related measures give an indication of the potential loss in monetary value which is likely to occur with a given level of confidence. The setting of the confidence level is necessary because in principle, if a price distribution is normally distributed for example, the downside loss is potentially infinite.
Variation margin
Further calls of cash or other securities from traders to underwrite any losses that may have accumulated against their position in a given derivative contract.
Venture capital
High risk finance for start-ups and other business ventures which is normally achieved through equity participation in the company concerned. Providers of venture capital are commonly backed by private equity finance.
Volatility
This is the measurement of the change in security price over time. It is normally calculated as the annualised standard deviation of the change in share price taken over time intervals (t). In finance it is the most common measure of risk.
Yield curve
The relationship between the yield that investors require upon risk-free bonds and the time to maturity.
Yield (with respect to bonds and other fixed interest securities)
The discount rate which equates the present value of the future stream of coupon payments and redemption value with the current market value of the bond concerned.