Glossary of Financial Terms

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Daily Compounding

Please see “Compounding Frequency.”

DAX

It is a widely watched stock market index in Germany. Similar to Dow Jones Industrial Average in the U.S., DAX is based on only 30 major stocks listed on the Frankfurt Stock Exchange. As a result, just like the Dow, DAX provides a general indication of the German market, but doesn’t necessarily represent the entire German equity market. Unlike the Dow which is a price-weighted average, DAX is essentially an average of market capitalization of the component stocks. The name DAX comes from Deutscher Aktien Index which simply means German stock index.

Day Order

A trading request submitted by a customer to either buy or sell stocks that is good until the end of the trading day. By the end of the day, if the order is not canceled or still not executed, then it automatically expires. All orders are day orders unless otherwise specified.

Debenture

A type of borrowing by corporations or a debt instrument. They are bonds not secured by any collateral.

Decimalization

A system where security prices are quoted using a decimal format instead of fractions. It also refers to the quoting of stock prices accurate to the penny. The term decimalization is spoken mostly with respect to the history of the U.S. stock markets. Since the emergence of the NYSE in 1792, stock prices had been quoted in 1/8th of a dollar (e.g., $23 3/8). Specifically, the smallest possible price change was $0.125. The 1/8th quoting practice was in turn adopted from the old Spanish way of dividing currencies: 2’s, 4’s and 8’s. The quoting based on 1/8th continued until 1997 when the American Stock Exchange first abolished the 1/8th and adopted 1/16th on March 13, 1997. Then NASDAQ followed suit on March 25. Under tremendous pressure from the regulators, the NYSE eventually adopted 1/16th quoting on June 24, 1997. The change from 1/8th to 1/16th open the way for the eventual decimalization. By April 9, 2001, the SEC decreed that all U.S. exchanges must quote prices in decimals (i.e., to the penny, e.g., $37.59). So April 9, 2001 marked the official start of the decimal quoting era. However, most of the exchanges has earlier adopted penny quoting before this deadline.

See “NYSE,” “NASDAQ” and “SEC.”

Default

Failure to fulfill a contract or an obligation, typically in financial terms. For instance, a company may default on its bonds by not paying interest. In such a case, the company will be put under court protection, enabling it to undergo restructuring.

Depreciation

It is the annual charge against accounting income that reflects the cost of capital equipment used up in production. For reporting purposes, a firm can choose its preferred method of depreciation (e.g., straight-line method); but for tax purposes, the firm is required to use the Capital Cost Allowance (CCA) schedule to calculate the allowable amount. It is important to stress that depreciation is an accounting number instead of a cash flow. The firm already pays up the total price of the equipment when it acquires it; the firm no longer has to incur additional annual expenses (i.e., depreciation) later on. The easiest way to understand the concept of depreciation is from the tax perspective. In general, firms are allowed to deduct production costs from revenue when calculating taxable income. Investments in plants and equipment are of inevitably part of the production costs. But since their economic life is much longer than a tax cycle (usually one year), the tax authorities do not allow firms to claim the entire capital investment as production costs in merely a year. They expect firms to spread the costs over the years during which the equipment in question are in service. This is why depreciation appears in income statements.

Derivative Securities

A general term for a specific class of financial instruments. A derivative security is a financial instrument that derives its value from a fundamental security such as a bond or a stock. For example, you can sell a piece of paper to an individual, which obliges you to sell one share of Air Canada’s stock at $4 three months from now. This piece of paper is of course a contract between you and the other party. For the other party, the contract is equivalent to some money, because after three months, the Air Canada stock may be trading at $6, in which case the other party will have a net profit of $2. The present value of the contract obviously depends on the future performance of the stock. In other words, its value is derived from the Air Canada stock value. This specific type of contract is actually called a “Call Option.”

See “Call Option,” and “Put Option.”

Dirty Price

The price of a bond including the interest accrued since the last coupon payment. It is also described as the combination of the bond’s “clean price” and the accrued interest. This is the price that a buyer pays when he/she buys the bond. To illustrate, suppose you are acquiring a particular bond that pays semi-annual coupons with an annual coupon rate of 8%. Two months have gone by since the last coupon payment, and suppose the clean price is $928. Since you will receive the next coupon but you only earn it for four months, so to speak, so you should also pay for the two months that have passed. The accrued interest in this example is, [8%($1,000)/2](2/6) = $13.33. In this case, the dirty price is $928 + $13.33 = $941.33.

Discount Bond

A bond that does not pay coupons and trades for less than its par or face value . Investors purchase the bond at a “discount” and receive the par or face value at the end of the investment period. To illustrate, Jack purchases a Government of Canada discount bond for $863.84. The bond matures four years from now, at which point he will get $1000 (par value) back. No coupon payments are made between now and its maturity. In a sense, a discount bond is nearly the same as a T-bill, except that a discount bond normally has a longer maturity. A discount bond is very similar to a GIC except that a GIC is guaranteed by the CDIC (Canadian Deposit Insurance Corporation) while a discount bond is not.

In this case, the word “discount” has nothing to do with lowering prices to attract customers.

Discount Rate

The rate of return used to determine the today’s value of future cash flows. It basically measures the worth of tomorrow’s money in today’s terms. To illustrate, if $1 one year from now is worth $0.83333 today, then the discount rate is 20%: $1/(1 + 0.2) = $0.83333. Of course, knowing the discount rate and future cash flows, we can also find their present value or today’s value. For instance, with a discount rate of 10% per year, $100 one year from now plus $150 two years from now will be worth, $100/(1 + 0.1) + $150/(1 + 0.1)2 = $214.88 today.

Discount Rate is not to be confused with the percentage markdown in a merchandise or service sale.

Discounted Payback Period

Please see “Payback Period.”

Discounting

The process of finding the present value of a series of cash flows. It is the reverse process of compounding. For example, if you are scheduled to receive $2,000 one year from now and $3,500 two years from now, and the interest rate is 10% p.a., then we discount the two payments to get the present value: 2000/(1+0.1) + 3500/(1+0.1)2 = $4,710.74.

Please see “Compounding.”

Diversifiable Risk

The synonym of “nonsystematic risk.”

Diversification

An equivalent of the saying, “don’t put all your eggs in one basket.” If you invest all your money on a single stock, then your fortune will depend on the performance of this stock. If the stock takes off, you become wealthy; if the stock tanks, you become poor. However, if you spread your money over several stocks, typically called a portfolio, then your fortune will not take wild swings. This is because, although the individual stocks within the portfolio may still fluctuate (some shooting up, while some other dropping like flies), the overall combined return will be stable thanks to the cancellation effect. In other words, by holding more stocks in one portfolio, we can hope for the idiosyncratic movements to cancel each other and are left with the stable growth that is the market-wide return. The canceling of the idiosyncratic movements among individual stocks is referred to as diversification. As a rule of thumb, holding 10 to 15 unrelated stocks will accomplish an almost complete diversification.

Please see “Portfolio.”

Dividend

An income received from common stock investments. Just as interest is received by holding bonds, dividends are received by holding stocks. Dividends are paid by companies to shareholders. They are normally paid quarterly. Dividend yield is said to be generally lower than the yield from investing in bonds.

See “Dividend Yield”, “Bond” and “Shareholder.”

Dividend Reinvestment Plan (DRP or DRIP)

A plan that enables shareholders to automatically reinvest their cash dividends in additional shares. Several Canadian companies have DRP’s or DRIP’s. Examples of which include BCE and Canadian Tire. The main benefit of DRP’s is the ability to acquire more shares without incurring commission fees. Even so, since shareholders in effect receive cash dividends first and then purchase company shares, they still have to pay taxes on the dividend amount.

Dividend Yield

It is a financial ratio that shows the total amount of per-share dividends received during the year divided by the share price. The numerator is well defined while the denominator is related to certain choices. The beginning-of-the-year price may be used or some average of the stock prices during the year. For example, suppose the total per-share dividends amount to $2.5 for a particular year, and the year-start and year-end stock prices are $95 and $105 respectively. Therefore, the dividend yield is 2.5/95 = 2.63% using the year- start price and 2.5/100 = 2.5% using the average price. If the investor bought shares at the beginning of the year and held them until the year end, then 2.63% would be a more appropriate measure of dividend yield.

Dodd-Frank Act

It is the shorthand name for “Dodd–Frank Wall Street Reform and Consumer Protection Act” passed as a law by President Obama in July 2010. It was named after two members of Congress, Chris Dodd and Barney Frank, as a result of their active involvements in the formation and presentation of the Act.

The Dodd-Frank Act was created in response to the fallouts of the 2007 Financial Crisis and the ensuing recession. It is a comprehensive and far-reaching legislation that covers almost every main aspect of the financial industry. Many rules were changed and/or introduced and many new regulatory bodies were established.

One of the most obvious changes had to do with hedge funds. Previously, hedge funds were hugely unregulated. Under the Dodd-Frank Act, hedge funds with assets more than $100 million must register with the Securities and Exchange Commission (SEC) and report their trading activities accordingly. Another is the so-called Volcker Rule which prohibits deposit-taking institutions such as banks from engaging in proprietary trading. To ensure better management of counter-party credit risks, the Dodd-Frank Act also requires that standardized over-the-counter (OTC) products such as CDS be cleared by a central clearing party or an exchange.

Some of the established new regulatory bodies include: The Bureau of Financial Protection, the Federal Insurance Office, the Financial Stability Oversight Council, the Office of Credit Ratings, and the Office of Financial Research.

Dollar Cost Averaging

An investment strategy where the money is invested in installments at equal intervals. Suppose you would like to invest $12,000 annually in the stock market. You could either make the entire investment once, or spread over, say, 12 months by investing $1,000 monthly. The spreading strategy is known as dollar cost averaging. The advantage of this particular strategy is the avoidance of the negative effect of major market swings. To further explain, because you are buying over a period of time, for a fixed investment amount (e.g., $1,000) you will acquire more shares when the market is low and fewer shares when the market is high, enabling you to average out the overall purchase cost.

Dotcom Bubble

Otherwise known as the “tech bubble” or “internet bubble.” It refers to the internet- venture frenzy in from 1997 to 2000. The talk of business revolutions due to the emergence of internets began in the early 1990s. Various e-commerce ventures started to grow, here and there. By the mid 1990s, large-scale ventures emerged which captured the attention of people from all walks of life, many of whom later on became investors in the dotcom stocks (a well known example is eBay, founded in 1995). By 1997, the party had truly started. Many ventures were initiated and almost all were embraced by investors with a great deal of enthusiasm. Any new firm with a name prefixed by “e-” or involving “.com” would fly (needless to say, the moniker “dotcom” came from “.com”).

In January of 1997, the Nasdaq composite (dominated by technology stocks) stood at 1,300. On March 10, 2000, thanks to unbridled optimism and speculative trading, the index was propelled to its peak at 5,048.62. In the course of time, many ordinary folks got quite rich which in turn inspired their neighbors, colleagues, friends and relatives. Almost everybody was scrambling for a seat in the express train with rich- paradise being its destination. Unfortunately, the train rudely jerked everyone onboard afterwards. By December 20, 2000, the Nasdaq composite plummeted to less than half of its peak at 2,332.78. The train went on to travel to the wrong destination with its devastated passengers until October 9, 2002 when the Nasdaq composite plummeted to 1,114.11, about 1/5 of its peak. Some of the recently minted rich quickly turned into paupers. In fact, quite a few were severely devastated that they ended their own lives.

Obviously, not all e-commerce ventures went bust after the bubble had burst. Some emerged from the wreckage and are now thriving (hello, Amozon.com, eBay). Even a few of the dead died with legacy (e.g., pets.com).

In any speculative bubbles, most players consider themselves rational, though rarely admitting being greedy. They are very much aware that the price is not sustainable and will fall eventually. But they can’t bear seeing people around them getting rich while they themselves are being left behind. They rush in and purchase the stock (or tulip bulb, or whatever is being speculated on) and wait to sell it to the next unknowing victim.

See “Nasdaq Composite.” Also see “South Sea Bubble” and “Tulipmania.”

Dow Jones Industrial Average (Dow)

A widely watched U.S. stock market index that is calculated out of the stock prices of the 30 largest U.S. companies. Thus it is sometimes also referred to as the Dow 30 or simply the Dow. The index was first created at the end of the 19th century. As you might have guessed, “Dow” and “Jones” are two surnames involved: Charles Dow and Edward Jones, co-founders of Dow Jones & Company which owned the iconic Wall Street Journal. Believe or not, there was even a third, equal co-founder named Charles Bergerstresser. Initially, they tossed around a few names including “Dow, Jones, and Bergerstresser” and “Berger, Dow and Jones,” and didn’t like any of those. In the end, they settled with Dow Jones & Company and dropped Bergerstresser’s surname.

Incidentally, although widely watched, the Dow is rather unique from other stock market indices such as S&P/TSX or S&P 500 in terms of construction. Instead of valued-weighted, the index is price-weighted, which means that the higher the stock price, the bigger weight it enjoys in calculating the index.

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

Draft

A draft is also referred to as a “bill of exchange.” It is a document signed by one party to request a sum of money from another party. It is used more frequently by importers and exporters. As soon as the draft is accepted or guaranteed by a bank or a company, it becomes a “Bankers’ Acceptance.”

Duration

It is the average, effective maturity of a coupon bond. We can describe a coupon bond as a series of discount bonds. Each coupon (and the par) can be considered as a single discount bond. The current value of the bond is simply the sum of the present values of all the future coupons and the par (i.e., all the “discount bonds”). Therefore, dividing the present value of each “discount bond” by the current value of the bond gives us the weight of each discount bond. The weighted average of the discount bond maturities is said to be the duration. Apparently, the duration also measures a bond’s interest rate sensitivity. For insance, if a 10-year bond’s duration is 5.8 years, then for a one-percent change in interest rate, the bond price will change by 5.8 percent.