Glossary of Financial Terms
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Rate of Return
A number used to measure investment performance in span of a fixed period. For example, you spent $6,000 purchasing some stocks three months ago. You sell the stocks for $6,600 today. Then the rate of return of your investment is (6600 6000)/6000 = 0.1 = 10%. If you sell the stocks for $5250, then the rate of return is (5250 6000)/6000 = 0.125 = 12.5% (needless to say, in this case, you also lose the right to brag).
Real Interest Rate
A part of the nominal interest rate.
Please see “Nominal Interest Rate” for further details.
Real Options
It refers to the managerial flexibility in a capital budgeting situation. This concept is best explained through an illustration. Suppose there are two projects (Y and Z) that are identical in every aspect, except that Project Z can be terminated and sold back to the government for a pre-set price one year later. In this situation, we say that Project Z has a real option in it, and it is an abandonment option. The choice of abandoning the project one year later is very similar to a put option (and the pre-set price is the exercise price). Therefore, it can be said that real options add value to a capital project. In this example, a year later, if the prospect is not very bright for the remaining life of the project, to avoid further loss it is best to get out. This is where the value can be seen. Project Y doesn’t have this option.
The word “real” in this case is used to indicate that the options involve real assets rather than financial assets. If a teacher uses the best three of four assignments to evaluate students’ performance, then in effect the students also have a real option here. The only thing is, it is difficult to attach a dollar value to this option.
See also “Option.”
Registered Retirement Savings Plan (RRSP)
A retirement savings plan that is available to Canadians and Canadian permanent residents. A plan holder makes tax-deductible contributions under his/her own name or in the name of his/her spouse or that of a common-law partner. The income earned within the plan is exempt from any taxes as long as the funds remain in the plan. The funds in the plan can be withdrawn at any point, and the withdrawal is subject to regular taxation. In the case of spousal or common-law RRSP, the tax is levied at the rate that is applicable to the spouse or the common-law partner. There are three advantages of the RRSP. One, it defers taxation. Another is that earnings within the plan are tax-free until the time of withdrawal. The third one is that it reduces taxes since the marginal tax rate after retirement is typically lower. RRSP is quite similar to the 401(k) plan in the U.S.
See also “Tax-Free Savings Account (TFSA).”
Repo (Repurchase Agreement)
An agreement wherein the seller of a security, such as a T-Bill, commits to buy it back on a particular date for a specified price. A repo or repurchase agreement is basically a collateralized short-term loan.
See also “Reverse Repo.”
Required Rate of Return
The rate of return one requires on a specific investment. It is primarily affected by the riskiness of the investment. For example, if someone borrows money from you to set up a corner grocery store, then you may require 10% interest rate. But if the money is used for gold mining, then you may charge an interest rate of 20%.
Retail Banking
Please see “Commercial Banking.”
Retained Earnings
The sum of net earnings accumulated by a firm, through time. “Net earnings” refers to the net profits which is: revenues after all operating expenses, interest payments, and taxes.
Return on Assets (ROA)
First look up “Net Income.” ROA is the net income divided by total assets. In the example under the entry “Net Income,” the net income is $400,000. Assume the total amount of assets is $8,000,000. Then ROA = $400,000/$8,000,000 = 5%. ROA measures how efficiently the assets are being used in generating profits.
Of course, the higher the ROA, the better. It must be noted that different industries tend to have different ROA levels. Therefore, it only makes sense to compare returns on assets within the same industry, or compare the company’s ROA with its own previous ROAs. Even within the same industry, a higher ROA doesn’t always mean a better bottom line for shareholders. What also should be considered is the leverage.
Please see “Return on Equity (ROE)” for details.
Return on Equity (ROE)
First look up “Net Income.” ROE is the net income divided by the book value of equity. It depicts a firm’s overall financial performance. For instance, Canadian banks’ ROE is typically between 10% and 20%. It must be noted that ROE is only an accounting metric because both the net income and book value of equity are accounting numbers. The real return an investor makes of course depends on the stock price and dividend payments.
Note that a higher ROA doesn’t necessarily lead to a higher ROE (please look up ROA before reading on). How much debt financing the firm implements will affect the bottom line a lot. To continue the example in “Net Income” and “ROA,” suppose, out of the $8,000,000 total assets (remember: total assets is equal to the total liability plus equity), $6,000,000 is debt and $2,000,000 is equity. Then the ROE is $400,000/$2,000,000 = 20%. Recall the ROA is 5% in this case.
Now, let’s modify the situation a little bit. Suppose the firm is fully equity financed so that equity is equal to $8,000,000. The interest expense is zero in this case.
Therefore, the before-tax income is $1,200,000 $500,000 = $700,000. With a tax rate of 20%, the net income is therefore 700,000(1 0.2) = $560,000. For this equity-financed firm, the ROA is $560,000/$8,000,000 = 7%, higher than the ROA of the leveraged firm, 5%. However, its ROE is also 7% (since total equity is equal to total assets in this case), much lower than the 20% ROE of the leveraged firm. Generally, other things being equal, leverage enhances ROE.
Reverse Repo
A reverse repo is simply a repo viewed from the buyer’s perspective. The buyer of the security is primarily the provider of the loan.
See also “Repo (Repurchase Agreement).”
Risk Aversion
It refers to people’s dislike or avoidance of risk. When we make decisions, especially financial ones, we have the tendency to avoid uncertainty. When we couldn’t evade it in the end, we tend to require a fair amount of compensation for bearing the uncertainty. This risk-shunning inclination or behavior is referred to as risk aversion.
The concept can be easily understood with the following example. If we are asked to choose between a) receiving $1,000 for sure and, b) receiving either $500 or $1,600 with equal probability, most of us would prefer to receive $1,000 for sure, even if the expected amount in choice b) is actually $1,050 (i.e., $500(1/2) + $1,600(1/2) = $1,050). We would rather forgo the expected extra $50 just to steer clear the chance of receiving only $500.
Also see “Loss Aversion” and “Prospect Theory.”
Russell 2000
It is an extensively watched stock market index in the U.S. It is a value-weighted or capitalization-weighted average of stock prices of the 2,000 smallest companies included in the Russell 3000 index. “Value-weighted” indicates that the larger the company in market capitalization, the higher the weight its stock enjoys in the index calculation. The index is reviewed and amended each year so that companies that have grown in size are replaced by smaller ones. Generally, the total market capitalization of the 2,000 stocks accounts for less than 10% of the total capitalization of the Russell 3000 index.
Also see “All Ordinaries,” “CAC 40,” “CSI 300,” “DAX,” “Dow Jones Industrial Average,” “Euro Stoxx 50,” “FTSE 100,”
“Hang Seng Index,” “Nasdaq Composite,” “Nikkei 225,” “Russell 3000,” “S&P/TSX,” “S&P 500” and “Shanghai Composite.”
Russell 3000
A stock market index in the U.S. It is a value-weighted or capitalization-weighted average of stock prices of the 3,000 largest listed companies in the U.S. “Value- weighted” indicates that the larger the company in market capitalization, the higher the weight its stock enjoys in the index calculation. Its coverage is so vast that the index represents around 98% of the total U.S. equity market capitalization. Although, it is not as well known as S&P 500 which is considered as the barometer of the U.S. equity market. Interestingly, Russell 3000’s small cousin, Russell 2000, is more widely followed, primarily because it represents a particular sector (i.e., the small-cap) of the market.