Glossary of Financial Terms

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CAC 40

A widely watched French stock market index. It is a capitalization-weighted or value-weighted average of stock prices of the 40 largest companies traded on the Paris Bourse. “Value-weighted” implies that the larger the company in market capitalization, the higher the weight its stock enjoys in the index calculation. CAC is the acronym of Cotation Assistée en Continu, the Paris Bourse’s early version of the automated trading system.

Call Option

A call option is a derivative security that derives its value from an underlying asset. It is an investment instrument that is highly leveraged. Suppose you own a call option on Company ABC’s stock that is trading at $80 per share now. The call option is the right for you to purchase a share at a specific price (say $80) on a specific future date (say six months from now). Six months later, if the ABC share is trading at a price below $80, then you would throw away the call option because you do not want to buy something for $80 which is worth less than $80. But if the price is higher than $80, you would exercise your right: buy the share at $80. Suppose the share is trading at $120, then you make a $40 profit. The purchase price of this option is perhaps only $6. Therefore, your return over the three-month period is a whooping (40 – 6)/6 = 566%! In contrast, the return on the stock is only (120 – 80)/80 = 50%.

Callable Bond

A bond that can be called back by the issuer beyond an initial period from the time of issuance, also known as redeemable bond. The initial period (e.g., two years) is to ensure that buyers can at least hold the bond for some time without worrying about potentially losing it. Beyond this initial period, if the market interest rate is much lower than previously, then the issuer could call back the bond and issue new ones with a lower coupon to save financing cost. Being able to call back the bond is obviously a good option for the issuer, and investors are aware of this. So the issuer will have to pay for this option somehow. The issuer either offers a higher-than-otherwise coupon rate or offer a premium at the time of call (e.g., if an otherwise identical bond is trading at $850 then the issuer may offer $1,000 to buy it back). A callable bond is the opposite of an extendable bond wherein its maturity can be extended at the choice of the bondholder.

Also see “Bond,” “Extendable Bond” and “Convertible Bond.”

Canada Mortgage and Housing Corporation (CMHC)

A Canadian Crown corporation of the Government of Canada created in 1946. As a housing agency, CMHC’s original mandate was to assist returning World War II veterans in establishing home ownership via low-cost financing. The mandate has evolved and expanded, over the years. Today, CMHC provides insurance to mortgage lenders and provides financing for cost-effective housing projects and other urban renewal endeavors.

The insurance function is especially crucial since banks and other lenders won’t hesitate too much in providing mortgages to those who are unable to make a sizeable down payment. Specifically, if the down payment is lower than 20% of the purchase price, then mortgage insurance is mandatory in which case the home owner will pay an annual insurance premium to the bank (which in turn passes it on to CMHC). Suppose Justin takes out a mortgage of $800,000 on a house worth

$1,000,000 - i.e., he makes a down payment of only $200,000. For the sake of illustration, suppose the house price drops to $700,000 due to a sharp correction in the real estate market. Further suppose that Justin loses his job and declares a personal bankruptcy. In this case, the bank seizes the house, and loses $100,000 if there is no mortgage insurance. Knowing this possibility, the bank will hesitate a great deal before making the loan happen. However, once the mortgage is ensured, the bank will not hesitate anymore, even if the down payment is zero, since CMHC will step in and make up any losses if default occurs. CMHC is slightly similar to Fannie Mae, Ginnie Mae and Freddie Mac in the U.S.

See “Crown Corporations.” Also see “Fannie Mae,” “Ginnie Mae” and “Freddie Mac.”

Canada Pension Plan (CPP)

See “Pension Fund/Plan” and “Canada Pension Plan Investment Board.”

Canada Pension Plan Investment Board (CPPIB)

Established in 1997 by the Canadian Parliament, CPPIB is an organization that manages, at arm’s length from governments, the investment of the fund in the Canada Pension Plan (CPP). Previously, CPP was supervised by provincial and federal finance ministers and invested most of its fund in government bonds, with virtually no equity investments. Currently, CPPIB, armed with almost 1,000 employees, manages the pension fund in a sophisticated manner with investments covering the entire spectrum of assets: from conventional vehicles such as fixed-income securities and equities to alternative investments such as real estates, infrastructures (e.g., tolled highways), private equities and hedge funds. The asset pool is worth around $170 billion, making CPPIB the 10th largest pension fund in the world.

See “Equity,” “Fixed-income Securities,” “Private Equity” and “Hedge Fund.”

Canadian Deposit Insurance Corporation (CDIC)

A Canadian federal Crown Corporation created by parliament in 1967. It was established to provide deposit insurance and contribute to the stability of Canadian financial systems. CDIC insures eligible deposits at member institutions for up to $100,000 per depositor and reimburses depositors for the amount of their insured deposits should the member institution fails or go bankrupt. Note that the $100,000 coverage is per institution, not per branch. For instance, if CIBC goes bankrupt and you have deposits at three CIBC branches (one each in Toronto, Montreal and Vancouver) totaling $125,000, then you will only get back $100,000.

Capital Asset Pricing Model (CAPM)

A theory developed by William Sharpe, Stanford University finance professor. CAPM states that the expected return on a financial asset is the sum of two components: the risk-free interest rate and a risk premium. Risk premium, also called “equity premium” is the product of the asset’s beta and the differential between the expected return on the market portfolio and the risk-free rate. Beta is a measure of the volatility and the systematic risk of the asset. Hence, CAPM implies that only the systematic risk is priced.

Professor Sharpe, the author of CAPM, was awarded the Nobel Prize (The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, to be precise) in 1990 for this model and his other contributions to financial theories.

Capital Gain

A value or price appreciation on capital assets. For example, you purchased a share of Company XYZ’s stock for $10 and subsequently sold it for $15. Then you have realized a capital gain of $5. Likewise, if you sold a house for $1,200,000 that was acquired at $800,000, then you have a capital gain of $400,000 (assuming you did not have to pay commissions to your friendly real estate agent).

Capital Loss

The profit one earns on the sale of an asset like stocks, bonds or real estate. It is the opposite of capital gain. Using the above example of stocks, if you subsequently sold the share for $7, then you will have incurred a capital loss of $3.

Capital Structure

Refers to the composition of a firm’s capital or financing package and is a combination of debt and equity. For example, a firm’s financing may consist of 30% debt and 70% common equity.

Cash Flow

The net amount of cash flowing into and out of a firm, an organization, a household, or any financial entity. For example, a firm purchases a machine for $80,000. This $80,000 is a cash outflow. After the purchase, the firm depreciates the machine at, say, 10% per year. The annual depreciation ($8,000) is not a cash flow, because it does not represent real cash. Once the machine is purchased, the total amount has been paid in full.

CDO (Collateralized Debt Obligation)

In order to better understand CDO, you need to first look up “Securitization”. In order to better understand CDO, it is essentially a particular type of asset-backed securities. Often times, CDOs are packaged out of corporate bonds. To illustrate, suppose JPMorgan Chase collected several bonds issued by companies with various credit ratings. JPMorgan Chase then organized these bonds into bunches according to their ratings. Let's say they established four tranches or bunches: AAA, BBB, B and equity (notice that the last tranche contains highly risky bonds and hence is called an equity tranche). Ultimately, JPMorgan Chase would sell units of these tranches to others. The said units are then called CDOs. Of course, the buyers of CDOs would receive a return equivalent to the rating or risk level of the tranche. JPMorgan Chase would make some profit in this process in the form of fees. Just like mortgage-backed securities, when properly constructed and marketed, CDOs can be beneficial to the buyers since they can get exposure to a specific risk level with ease (the alternative would be to purchase bonds on their own, which could be costly in terms of searching efforts and commissions fees). CDOs and mortgage-backed securities are also subject to abuse, however. A lot of people believe that securities like CDOs facilitated the formation of the 2007 financial crisis.

CDS (Credit Default Swap)

A type of credit derivative security that allows a swap, for protection against default or credit rating changes. The two parties of the swap are respectively called protection buyer and protection seller. The mechanics of a CDS are best illustrated through an example. Suppose Canada Pension Plan Investment Board (CPPIB) enters into a 5-year CDS with JPMorgan Chase whereby CPPIB purchases protection from JPMorgan Chase against possible default of a bond issued by IBM. Further suppose that the purchased protection is for a total principal amount of $50 million. In this deal, JPMorgan Chase will make up for any loss to CPPIB in the event that IBM defaults on its bond. Say, the post-default market value of the bond is $23 million, then JPMorgan Chase will pay CPPIB $27 million to make up for the loss. In return, every six months, CPPIB will make a payment to JPMorgan Chase, similar to how we make payments to our insurance company for our house or car insurance. The periodic payments are made until the bond default or the end of the fifth year, whichever comes first. The size of the payment is based on something referred to as CDS spread. Suppose the CDS spread is 150 basis points p.a., then the payment every six months is 1.5%/2($50,000,000) = $375,000. Not surprisingly, the CDS spread is very close to the difference between the yield on the IBM bond and that on the same-maturity treasury note.

Similar swaps can also be structured as a protection against bond rating changes (e.g., going from A to BBB).

During the financial crisis, many financial institutions lost a sizeable amount of money from CDS bets. AIG (American International Group) lost so much money on their CDS bets that it would have gone bankrupt had the U.S. government not bailed it out. Insofar as CDS are zero-sum games just like other derivative securities, numerous winners were also created during or after the financial crisis. John Paulson, a well- known hedge fund manager in the U.S., made billions of dollars through CDS bets when he predicted the demise of the subprime loan market.

Also, see “Derivative Securities,” “Financial Crisis,” “Default,” “Swap,” “Bond Rating” and “Basis Points.”

Central Bank

A country’s bank of banks or financial authority. It is a financial institution given privileged control over the production and distribution of money. Its operations are usually (or at least supposedly) independent of its government. A central bank’s main responsibility is to promote the country’s economic and financial welfare. Specifically, a central bank normally makes the country’s monetary policy, managing the currency circulation, and overseeing the financial system. Most countries’ central banks are named after the country. For instance, Bank of Canada, Bank of Italy, Bank of Japan, to name a few. There are exceptions though. For instance, the central bank of the U.S. is the Federal Reserve System, and that of China is The People’s Bank of China. Bank of China is actually a commercial bank and came into operation after existence of The People’s Bank of China.

Please see “Bank of Canada” and “Federal Reserve System.”

Circuit Breaker

A trading halt triggered by precipitous falls of the market. Different countries have slightly varied rules governing the temporary trading halts, but almost of them were installed after the so-called Black Monday on October 19, 1987 when the Dow plunged 23% on that day.

In the U.S., the trading halts are to be triggered by sharp declines in the S&P 500 index. After the most recent update in April 2013, the rules (Rule 80B, to be precise) more or less work in the following way.

First, the three levels of market declines are defined: Level 1: 7%, Level 2: 13%, and Level 3: 20%. These are percentage movements of the S&P 500 index relative to the close of the previous trading day. Second, if at any time between 9:30am and 3:25pm, the index experiences a Level 1 or a Level 2 decline, then the entire market will be shut down for at least 15 minutes. In the event of a Level 3 decline, the market will be shut down for the rest of the day. Third, trading halts will not transpire after 3:25pm if Level 1 or Level 2 declines occur (since the market is about to close anyway and investors will have a whole night to collect themselves).

Evidently, the first two levels more or less have the same consequence as far as triggering trading halts is concerned. In any case, the whole point of having a halting mechanism is to prevent market freefalls due to snowballing effects. The halt enables investors to digest the event and cool themselves down.

See “Dow Jones Industrial Average” and “S&P 500.”

Classified Board

See “Board of Directors.”

Clean Price

The price of a bond that is not inclusive of the interest accrued since the last coupon payment. This is the price typically published in the financial press. When the bond is being purchased or sold or when calculating the yield to maturity, the accrued interest needs to be added to the clean price. The adjusted price is referred to as “dirty price.”

Closed-end Fund

More legally known as “closed-end company.” The company issues these shares like any other corporation and the shares are traded just like stocks on major exchanges such as the NYSE. The money raised is used to buy stocks of other companies, similar to how a mutual fund operates. However, here is a key difference: closed-end fund shares usually are not redeemable; once the fund is created, it is “closed.” The fund itself does not issue new shares or redeem existing ones like an open-end fund or regular mutual fund normally does.

In addition, unlike mutual fund units, the market price of a closed-end fund’s shares is determined by demand and supply therefore may be different from its net asset value (NAV).

Commercial Banking

One of the main business activities performed by banks and other financial institutions. Commercial banking involves taking deposits and making loans. Commercial banking activities are generally further classified into retail banking and wholesale banking, with the former dealing with individual customers like you and me and the latter dealing with corporations, various levels of governments, and other institutions and agencies (e.g., universities, charity organizations, etc.). Banks and other financial institutions offering the service of commercial banking make their profit from the interest rate spread: the difference between the rate they charge on loans and the rate paid on deposits. Usually, the spread is larger from retail banking, but the volume is lower per account. The opposite is what happens in wholesale banking.

Commercial banking is in contrast with investment banking which has nothing to do with deposit-taking and loan-making.

See “Investment Banking” for details.

Commercial Paper

A commercial paper is a short-term promissory note issued under the general credit of a corporation. The note is frequently backed by the unused portion of a line of credit (from a bank) and/or a grantee of a parent corporation. It is used by corporations to raise short-term funds to finance items such as accounts receivable and inventories.

“Commercial Papers” are not to be confused with the ghost-penned articles on sale from those “term paper services” agents.

Commodity Swap

Please first look up “Swap.” It is a swap that involves a certain type of commodity, used by either a commodity producer or a commodity user to manage the price risk. As an example, let’s look at an airline company. Since the jet fuel price fluctuates almost on a daily basis yet the airline is not able to constantly adjust its ticket price, the airline must manage the price risk of jet fuel to have a stable profit. One way of achieving this is for the airline company to enter into commodity swaps with a counterparty. In the swap, the airline company would pay to the swap counterparty a fixed price for jet fuel for a specified quantity per period over a specific duration (e.g., $x per liter for 200 million liters per year for five years) and, in return, get the market price of jet fuel for the same quantity and duration. In that manner, the variable payments received from the swap counterparty will exactly cover the purchasing costs charged by the jet fuel supplier, and the airline company will end up paying a fixed jet-fuel price in net.

A commodity producer (e.g., a gold mining company) may also enter into a commodity swap to manage the price risk, except that, in this case, the producer would agree to receive a fixed price.

An acute reader would now realize that a commodity swap is basically a series of forward contracts on the underlying commodity.

See “Forward Contract.” Also see “Equity Swap,” “CDS (Credit Default Swap),” “Asset Swap” and “Total Return Swap.”

Common Shares

Shares issued by corporations that come with voting rights and represents ownership. Typically, one share comes with one vote. Suppose that a total of 500,000 shares of firm ABC is held by 150 different investors. Assume you are one of the 150 investors, and you hold 100,000 shares. Then, when shareholders meet and elect a new director, you can cast 100,000 votes. Anyone who owns more than 50% of the shares has absolute control.

Just as bonds, common shares are issued by companies to raise capital. In contrast to bonds, common shares carry ownership with them. To create an analogy, you may borrow $10,000 from the bank and, together with your own savings of $25,000, set up a printing shop. Therefore, you are the owner of the shop. The $10,000 is like bonds and the $25,000 represent common shares. As a shareholder, you are entitled to the entire net earnings after interests and taxes. Naturally, you also bear the loss in case your company fails to produce a profit.

Compound Interest

Interest paid not only on the principal amount, but also on the interest earned so far. For instance, for a deposit of $1,000 with a compound interest rate of 5% p.a., the balance at the end of the first year is $1,050, out of which $50 is interest earnings. In the case of compound interest, the $50 interest will likewise earn interest in the second year. Thus, the total balance at the end of the second year will be, $1,000(1 + 0.05) + $50(1 + 0.05) = $1,102.5, or simply, $1,000(1+ 0.05)2 = $1,102.50. In contrast, if we have simple interest, then the balance at the end of the first year is still $1,050; however, at the end of the second year the amount will be only $1,100, since we simply earn another $50 in the second year. In other words, if the interest is specified as simple interest instead of compound interest, then we earn interest only on the principal. Obviously, we prefer compound interest as far as deposits are concerned.

Also see “Compounding” and “Compounding Frequency.”

Compounding

The arithmetic process of finding the future value of a series of cash flows as long as the interest rate is specified as compound interest rate. For example, with a compound interest rate of 10% p.a., the future value (at the end of year two) of $100 one year from now and $300 two years from now is 100(1+0.1) + 300 = $410. The reverse process (i.e., finding the present value of a series of cash flows) is referred to as “discounting.”

Compounding Frequency

The frequency at which the interest on a loan or deposit is compounded. In the example of “compound interest,” we illustrated that, with an annual interest of 5% and an initial balance of $1,000, the balance at the end of year two will be $1,102.50. As shown, the interest is compounded annually, meaning that we tally up the balance every 12 months and roll over the total balance. However, if the interest is more frequently compounded, then the balance would be higher. If the said interest is compounded semi- annually, i.e., we tally up the balance every 6 months. In this particular case, with a 5% annual rate, after 6 months, the total balance will be 1000(1+0.05/2) = $1,025. In the second half of the first year, we would earn interest on the $25 interest earlier earned during the first half of the year. Thus, the balance at the end of year one will be 1025(1+0.05/2) = $1,050.625. Compared with annual compounding, the amount of $0.625 is the extra interest earned during the second half of the year due to more frequent compounding that has occurred.

Basically, if the specified annual interest rate is r and the compounding frequency is m per year (e.g., m = 2 with semi-annual compounding), then the future value of $1 today n years from now is,

To continue the above example, the future value of $1,000 six years from now will then be

Evidently, the higher the compounding frequency, the higher the future value. More frequent compounding covers quarterly compounding, monthly compounding, weekly compounding, and daily compounding. There is even continuous compounding where the interest is compounded so often that the frequency m in the above formula is set to infinity! Don’t get too excited though, since the extra gain is surprisingly not that much. It appears that when we set m to infinity, the above formula becomes ern. Hence, with continuous compounding, the ending balance after six years will be 1000e0.056 = $1,349.86. The extra interest in comparison with the semi-annual compounding is only $1,349.86  $1,344.89 = $4.97, just enough to buy a Big Mac at MacDonald’s.

Contingent Claims

A term interchangeably used with “Derivative Securities.”

Please see “Derivative Securities”

Continuous Compounding

Please see “Compounding Frequency.”

Convertible Bond

A bond that can be converted into common shares at a predetermined conversion ratio. Conversion ratio is basically the number of shares each bond can exchange into. When the firm’s stock is doing well, convertible bonds are likely to get converted. Obviously, a convertible bond is more desirable than an otherwise identical straight bond, therefore it tends to carry a lower coupon rate. Firms issue convertible bonds to be able to save financing cost (i.e., lower coupons) and signal their confidence about its own future (i.e., higher stock prices). In this sense, the conversion feature is like the warrants attached to regular bond issues.

Please see “Bond” and “Warrant.”

Coupon Payments

See “Bond.”

Credit Derivatives

A particular class of derivative securities that allows parties to minimize exposure to credit risks. Particularly, they are securities whose payoff depends on the credit standing of one or more identities such as a bond, a company or even a country. CDOs and CDS are some examples of credit derivatives. Credit derivatives can be utilized to either manage or speculate on credit risk. The market of credit derivatives first appeared in the late 90s and has undergone rapid growth ever since. The ongoing market size is dozens of trillions of dollars. Credit derivatives played a critical role in the 2007 financial crisis.

See “Derivative Securities,” “CDO,” “CDS” and “Financial Crisis.”

Credit Rating

Usually pertains to the credit quality of a debt issuer.

Please see “Bond Rating.”

Crown Corporations

Corporations regulated and owned by a government. For example, Canada Post is a crown corporation established and owned by the Canadian federal government. The government may choose to privatize the crown, in which case we say the corporation has gone public or is undertaking an initial public offering (IPO). An example of such is Canadian National (CN), which was privatized in November 1995.

See “IPO.”

CSI 300 Index

Also referred to as Hushen 300 or 沪深 300 in Chinese. It is a value-weighted or capitalization-weighted average of stock prices of 300 A-shares traded on the Shanghai Stock Exchange as well as the Shenzhen Stock Exchange (A-shares are those owned and traded by Chinese residents, while B-shares are owned by foreigners). “Value-weighted” denotes that the larger the company in market capitalization, the higher the weight its stock enjoys in the index calculation. Around 3/5 of the shares are traded on the Shanghai Stock Exchange and 2/5 on the Shenzhen Stock Exchange. In total, they cover about 60% of the entire A-shares markets.

The index debuted on April 8, 2005 and was established by China Securities Index Company Ltd. (hence the name CSI 300 Index). Futures contracts are available on this index. The fact is, China Securities Index Company Ltd. also maintains 10 sector indices (e.g., CSI 300 Energy Index, CSI 300 Financial Index, CSI 300 Utilities Index). Whereas the Shanghai Composite reflects the overall strength of the Shanghai market (both A-shares and B-shares), the CSI 300 Index reflects the overall strength of the A-shares markets in China.

Currency Appreciation

A change in exchange rate. Particularly, it is the increase in one currency’s value against that of another currency due to market conditions. For instance, if one Canadian dollar was worth 95 cents U.S. yesterday and it is worth 95.5 cents U.S. today, then we can say that the Canadian dollar has appreciated against the U.S. dollar. We speak of currency appreciation or depreciation whenever the currency in question is free to respond to market conditions.

Currency Depreciation

A change in exchange rate. More specifically, it is the decrease in one currency’s value against that of another currency due to market conditions. For instance, if one Canadian dollar was worth 95 cents U.S. yesterday and it is worth 94.3 cents U.S. today, then we can say that the Canadian dollar has depreciated against the U.S. dollar. We speak of currency depreciation or appreciation whenever the currency in question is free to respond to market conditions.

Currency Devaluation

An adjustment in a controlled or government stipulated exchange rate. It is specifically, the downward adjustment in one currency’s value against that of the counterparty currency. For instance, the Chinese yuan was formerly pegged to the U.S. dollars at 8.26 yuan per U.S. dollar. If the Chinese government adjusted the rate to 9.38 yuan per U.S. dollar, then we can say the Chinese yuan had been devalued against the U.S. dollar. We talk about currency devaluation or revaluation when the exchange rate in question is officially controlled by the government. The Chinese yuan has incidentally become semi-free floating these days, i.e., it is now subject as well to market forces.

Currency Option

An option written on a foreign currency. It is a contract that gives the buyer the right to buy or sell a certain amount of foreign currency at a fixed change rate.

Please see “Option.”

Currency Revaluation

An adjustment in a controlled or government stipulated exchange rate. More specifically, it is the upward adjustment in one currency’s value against that of the counterparty currency. For instance, the Chinese yuan used to be pegged to the U.S. dollars at 8.26 yuan per U.S. dollar. If the Chinese government adjusted the rate to 7.56 yuan per U.S. dollar, we then say the Chinese yuan had been revalued against the U.S. dollar. We speak of currency revaluation or devaluation whenever the exchange rate in question is officially controlled by the government. The Chinese yuan incidentally has become semi-free floating these days, i.e., it is now subject as well to market forces.

Currency Swap

See “Swap.”

Current Assets

A firm’s investment in short-term assets such as cash, marketable securities, inventory, pre-paid liabilities and accounts receivable. In this case, “current” means “ease of converting into cash.” It doesn’t necessarily mean that the firm also has “old” or “past” assets. The amount of current assets is dependent on the firm’s policy on working capital management.

Current Liabilities

A firm’s sources of short-term financing. They usually include accounts payable, short-term loans, maturing long-term loans, accrued taxes and other accrued expenses such as wages. The amount of current liabilities is dependent on the firm’s policy on working capital management.

Current Ratio

The ratio of current assets over current liabilities. It measures a firm’s ability to satisfy the claims of short-term creditors using exclusively current assets like cash and marketable securities.

Current Yield

This is a concept referring to coupon paying bonds. It is an investment’s annual income. The annual interest payment divided by the current price of the bond is the current yield. For instance, if a 9% coupon bond is selling for $968.32, then the current yield is 90/968.32 = 9.29%. Although frequently quoted by traders and brokers, current yield can be misleading if one is not fully aware of the nature of bonds. As the name implies, it only measures the current return from the bond. Eventually, this number will change even if the interest rate remains constant. To continue the earlier example, the bond price will gradually revert to the par $1,000 as the maturity approaches. Hence, the current yield on the bond will decline over time. But this will be offset by a capital gain as a result of the price appreciation. The opposite is true for a bond selling above par: the current yield will gradually increase, accompanied by a capital loss due to the price reverting to par. Regardless of the bond price, in net, the total return (i.e., the sum of current yield and the capital gain/loss) on the bond will be simply the market interest rate, and this return is more or less similar across different bonds.