Glossary of Financial Terms

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Accrued Expenses

Accrued expenses are an interest-free source of short-term financing. They are costs that are incurred in the current period but not paid for until the next period. Some examples include unpaid taxes, wages and interest. When individuals charge their groceries on a credit card, the cost of the groceries can be considered an accrued expense until the time of receiving the credit card bill.

Accrued Taxes

Taxes owed and not yet paid.

Please see “Accrued Expenses.”

Algorithmic Trading

Algorithm trading is essentially a computer-automated trading designed for a specific purpose. It is completely conducted by computers. For example, a huge pension fund may employ algorithmic trading to offload a large position on a stock rather than submitting the massive order at once, which can largely depress the price, ultimately resulting to a loss in the sale. The pension fund may program its computers such that they watch the price movements and squeeze in many small sell orders when the value is on an uptick. The computers can accomplish offloading the entire holding gradually at good prices. Or, a hedge fund may program its computers to carry out automated trades on the spot and futures markets to take advantage of certain arbitrage conditions.

Algorithmic trading is a relatively new phenomenon given that it requires a good deal of computing power. It may be a good or a bad thing. It is estimated that at least half or more of the trading on major exchanges is performed through algorithmic trading. It is said that certain types of algorithmic trading might be beyond the comprehension of the average individual.

As an example, please see “High Frequency Trading”.

Also see “Arbitrage,” “Futures Contract,” “Hedge Fund” and “NYSE.”

All Ordinaries

A widely watched stock market index in Australia. It is the oldest share index in Australia and commonly referred to as the 'All Ords'. It tracks the performance of the top 500 companies listed on the ASX (Australian Securities Exchange), based upon their market capitalization. It is likewise known as All Ordinaries Index. It is a value-weighted average of stock prices of the 500 largest companies traded on the ASX. “Value- weighted” is best describes as, the larger the company in market capitalization, the higher the weight its stock enjoys in the index calculation. When first established in 1980, the index contained almost all ordinary or common shares thus the name “All Ordinaries.” In 2000, the index was restructured to include only the top 500 stocks by market capitalization.

Also see “CAC 40,” “CSI 300,” “DAX,” “Dow Jones Industrial Average,” “Euro Stoxx 50,” “FTSE 100,” “Hang Seng Index,”
“Nasdaq Composite,” “Nikkei 225,” “Russell 2000,” “S&P/TSX,” “S&P 500” and “Shanghai Composite.”

American Depositary Receipt (ADR)

A negotiable certificate issued by a U.S. depository bank representing a specified number of shares of a foreign company's stock. The ADR trades on U.S. stock markets in U.S. dollars and may be bought or sold rather like domestic shares. ADR’s are traded on a U.S. stock exchange (e.g., the NYSE) The foreign shares are usually held by the bank’s branch or its correspondent in the foreign country.  Therefore, ADR’s are a convenient way for U.S. investors to invest in foreign shares.

American Option

A version of an options contract that allows holders to exercise the option rights at any time on or before the day of expiration. Suppose you have a call option on a stock that matures on September 8, and it is now May 25. Then, between now and on September 8, you may exercise your right and purchase the stock at your will according to the contract option. American options outline the timeframe when the option holder can exercise the option contract rights. Because an American option gives you more freedom, it is typically worth more than an otherwise identical European option. An American option can be a call or a put option.

The word “American” here does not convey any geographical connotation, although it might be intended to signify the option-exercising flexibility in that the United States of America is usually considered as the dreamland of freedom. You will notice that the counterparty of an American option is called “European option.”

See also “Options,” “Call Option,” “Put Option,” “ASIAN Option,” “European Option,” and “Exercise Price,” or “Strike Price.”

Amortization

An accounting technique utilized to periodically lower the book value of a loan or intangible asset over a set period of time. It is the process of amortizing a loan. In reference to a loan, amortization is concerned with spreading out loan payments over time. When applied to an asset, amortization is like depreciation. Provided the total loan amount, the interest rate, and the term (i.e., the number of years of borrowing), amortization is finding out the equal amount of payment per period and its breakdown between the interest and the principal repayment.

Please see “Amortized Loan” and “Amortization Schedule.”

Amortization Schedule 

A table showing the exact breakdown between the interest and principal of each periodic payment for an amortized loan. Each periodic payment includes some interest and some principal because an amortized loan is repaid in equal amounts. There is a need to know the precise breakdown for tax purposes, since for most businesses, the interest payments are tax deductible.

The process of making the amortization schedule is not arduous. Here is an example:

Suppose you take out a loan of $5,000, which is to be repaid annually in three equal amounts. The interest rate is 5% p.a. First we need to find the annual payment, denoted by X. Since we will make three payments of X dollars each, their present value must be equal to the loan amount today. The equation will be as follows:

5,000 = X/(1+0.05) + X/(1 + 0.05)2 + X/(1 + 0.05)3.

We can easily solve for X as $1,836. To create the schedule, we start with year one. For the first year, we carry the full amount of the loan, so the interest amount is simply $5,000  0.05 = $250. The principal repayment is then, $1,836  $250 = $1,586. Therefore, at the end of the first year, the remaining principal is $5,000  $1,586 = $3,414. This process is repeated each year until the end of the loan. The loan is completely paid off as soon as you make the last payment and the balance is finally zero. It is a huge celebration, for owners with mortgaged houses!  Prior to this time the house is owned by the bank. 

Amortized Loan

A loan that is to be repaid in equal periodical amounts (e.g., monthly, quarterly, annually). Home mortgages and car loans are examples of which.

Annuity

A series of a sum of money payable for a specified number of periods. The payments are of equal amounts and occurring at fixed intervals. Examples would be mortgage payments and car loan payments. It is also a form of insurance or investment entitling the investor to a series of annual sums. 

Arbitrage/Arbitraging

Arbitraging is the process of selling overvalued and buying undervalued assets to make a profit. It is a trade that profits by taking advantage of the price differences of identical or similar financial instruments in different markets or in different forms.

If two identical items are selling at different prices at two locations of the same store (e.g., $200 at the Mall A and $250 at the Mall B), then an arbitrage opportunity exists. You could buy the item at Mall A, and return it at the Mall B, and pocket $50.

The example may sound a bit contrived, but arbitrage transactions in financial markets are real and arbitragers rarely have ethical concerns.

Take a look at the following illustration: If stock Z is cross-listed on the Toronto Stock Exchange and the New York Stock Exchange, and if, at a peculiar moment, you observe two different prices (after looking at the exchange rate), then you can buy the stock at the exchange where the price is lower and sell it at the exchange where the price is higher to make “arbitrage profits.” Another place where such opportunities are frequently explored by traders are foreign exchange markets. 

Asian Option

An option that is settled based on the average price (as opposed to the typical spot price) of the underlying asset is an Asian option. Suppose you have an Asian call option on a stock. The option matures on August 1, and it is now April 23. You simply are asked to pay the exercise price for a typical call option, and receive a share upon exercising. Instead of paying the exercise price upon exercising and obtaining a share, you simply get the cash difference between the average stock price over a certain period and the exercise price for an Asian call option. The averaging could be over the last segment of the maturity period (e.g., July to August 1 in the above example) or any other period prior to the settlement date. Since the averaging tends to eliminate extreme payoffs, an Asian option is typically worth less than its standard counterpart.

Although “Asian” does not convey any geographical connotation in this case, it may be perceived otherwise. Asian option tends to eliminate extreme payoffs, the choice of the word might be motivated by the perception that Asian people tend to eschew extremes and favor moderation.

See also “Options,” “Call Option,” “Put Option,” “American Option,” “European Option,” and “Exercise Price,” or “Strike Price.”

Ask Price

A price at which a seller is willing to sell something. If a buyer offers to pay $30 for a used bike at a garage sale, then the $30 is the bid price. If the owner counters with a price of $35, then the $35 is an ask price. Similarly, if a market maker posts a price of $12.50 to sell a stock, then the $12.50 is the ask price.

See also “Bid Price,” “Bid-Ask Spread” and “Market Maker.”

Asset-backed Securities (ABS)

See “Securitization.”

Asset Swap

Please first look up “Swap” and “Total Return Swap.” An asset swap is also usually classified under “credit derivatives” just like a total return swap. Moreover, it involves the exchange of LIBOR plus a spread with some bond returns. Consequently, the two types of swaps can be easily confused with one another. Although, an asset swap is quite different from a total return swap. First of all, it is not a financing vehicle, instead it allows one party of the swap to directly gain the yield spread of a bond. Even though an asset swap involves the exchange of floating rate and fixed rate payments as in an interest rate swap, the floating rate payments are actually determined by the credit risk of an actual asset, i.e., the bond. Therefore, the name “asset swap.”

The following example better explains the mechanics: Assuming CPPIB holds some bonds issued by Canadian Tire. The bonds pay a coupon of 7.5% per year and currently trade at $108.50 per unit, corresponding to a yield of 5.9%. Suppose a comparable government bond currently yields 4 5%. Thus the yield spread on Canadian Tire’s bonds is 5.9% - 5% = 0.9%. If CPPIB is concerned about Canadian Tire’s credit risk in the next five years, yet would still like to hold the bond in the long run, then it can enter into an asset swap to offload the credit risk. Suppose RBC accepted to be the counterparty of the swap. Then in the next five years, CPPIB will pay RBC the annual coupon of 7.5% while RBC pays CPPIB the LIBOR rate plus a spread which is simply the yield spread of 0.9%. During the five years the swap still stands even if Canadian Tire defaults. This is the reason an asset swap can protect CPPIB from default risk.

You may notice that the bond price is missing in the above swap. In reality, at the beginning of the swap, a one-time payment is made to reflect the difference between the bond price and the par. In the above example, before exchanging the agreed cash flows in the next five years, for each bond, RBC must pay CPPIB $8.50 (which is $108.50 − $100) upfront. Why? Because in the swap, CPPIB will pay RBC a coupon rate of 7.5%, much higher than market interest rate. RBC must make an upfront payment to deserve this high coupon rate.

ALSO See “CPPIB,” “Bond,” “LIBOR,”
AND “Commodity Swap,” “Interest Rate Swap,” “CDS (Credit Default Swap),” “Total Return Swap” and “Credit Derivatives.”

At-the-money

The term describes the relative magnitude between the current underlying asset price and the exercise price of an option. An option is “at-the-money” when the exercise price is identical to the current market price of the underlying asset.

Please see “Exercise Price,” “Option,” “In-the-money,” and “Out-of-the-money.