Glossary of Financial Terms

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Fannie Mae

A nickname coined from Federal National Mortgage Association (FNMA). If you try to pronounce FNMA, it sounds very much like Fannie Mae. It’s obviously an easy name to pronounce and remember.

Fannie Mae was launched in 1938 by the U.S. government to help ordinary Americans acquire home ownership in the Great Depression era.  As a government agency, Fannie Mae basically operated as a secondary mortgage market. What is a secondary mortgage market and how did that gave way to home ownership? Fannie Mae’s main activity is to purchase mortgages from banks, savings and loans associations (similar to credit unions) and other mortgage providers, and securitize them as something called mortgage-backed securities. These mortgage-backed securities are thereafter sold to the public. This process helped banks, savings and loans associations as well as other mortgage providers free up the funds tied up with the original mortgages so that they could make additional mortgages available to more home buyers.

Fannie Mae was converted into a public company in 1968, with shares listed on the NYSE. Nevertheless, the core business stayed the same: operating in the secondary mortgage market. To maintain the governmental support to home ownership, part of the original Fannie Mae didn’t go public and stayed as a government agency, which is know today as Government National Mortgage Association (GNMA), nicked named “Ginnie Mae.”

Shortly after privatizing Fannie Mae in 1968, the U.S. government created another public company to carry out exactly the same business as Fannie Mae for the sake of competition. That public company was named Federal Home Loan Mortgage Corporation (FHLMC), nicknamed “Freddie Mac.” Eventually, the two public companies were of comparable size in terms of total assets, though Freddie Mac was a bit smaller.

Due to their heavy exposures to subprime mortgages, both companies were in deep trouble in the 2007 financial crisis. Because they were both quite large (too big to fail) and their downfall would shake the already shattered confidence in the housing market, the U.S. government quickly nationalized the two companies in September 2008 (i.e. they were put into the so-called conservatorship).  As soon as June 2010, the stocks of both companies were delisted from the NYSE. To everyone’s relief, both companies recuperated subsequently. In 2013 alone, Fannie Mae paid almost $100- billion dividends to the U.S. Treasury.

See also “Securitization,” “Mortgage-backed Securities,” “Financial Crisis of 2007,”
“NYSE.” Also see “Canada Mortgage and Housing Corporation (CMHC).”

Federal Deposit Insurance Corporation (FDIC)

It is the U.S. counterpart of CDIC. The insurance coverage is $250,000U.S. per depositor.

See “CDIC.”

Federal Reserve System

Often referred to as the Federal Reserve, it is the monetary authority and central bank of the United States of America. The system includes 12 Federal Reserve Banks representing twelve geographic regions of the U.S. “The Fed” (as it is sometimes referred to) has the authority to regulate monetary policy in the U.S. as well as supervise the commercial and savings banks of the entire country. It is also responsible for setting the so-called “discount rate” which is the U.S. counterpart of the “bank rate” set by the Bank of Canada.

See “Bank of Canada,” “Bank Rate,” and “Central Bank.”

 Financial Crisis (of 2007)

The crisis that occurred in the financial sector of the U.S. and its ripple effects throughout the world. Approximately, it started in 2007 and ended in 2009. It is regarded to be one of the worst financial crises in modern history. The pathology of the crisis is complex one. To summarize, it was a result of an overheated housing market in the U.S. and the overuse and abuse of credit derivatives.

The U.S. housing market took an extraordinary bull run leading up to 2006, thanks to easy credit in the form of subprime loans. To compete for businesses, banks and other financial institutions allowed mortgages to customers without stable income and almost zero wealth (what we call subprime loans). Things were good for everyone as the housing market continued to reach new highs: borrowers can use their houses as collateral and easily acquire loans; banks can earn substantial interest on their mortgage loans without worrying about default since they can always take over the house should the buyer fail to pay obligations. As long as the housing price keeps going up, everything is fine. As soon as the housing price took a nose-down, all hell broke loose. Generally, it was actually in the interest of house owners to turn in the keys and declare bankruptcy since their mortgages were much more than the house values.

Similar to the housing market boom, the trading of credit derivatives such as CDOs and CDS also reached historical levels. In several cases, deals were struck purely for the purpose of betting (facilitated by things like CDS and CDOs). Since there were just a handful of big players out there (e.g., Lehman Brothers and Bear Stearns), the deals inevitably created a web which precariously linked everyone’s wellbeing. When a bank coughed, all the other banks sneezed. Eventually, Wall Street icons such as Lehman Brothers, Bear Stearns, and Merrill Lynch all fell to their knees.

The financial crisis spread to other parts of the world as well, especially Europe (although the prolonged financial woes in Europe were largely the European’s own making).

See “CDS,” “Subprime Loans” and “CDO.”

Financial Engineering

A process in which financial securities are designed and packaged with innovative features with the use of mathematical techniques. Typically, financial engineering involves developing certain types of derivative securities. House construction is to civil engineering while security packaging is to financial engineering. They both involve combining raw materials to come up with something for a particular purpose. The purpose is usually to create a tool to solve financial problems.

Fixed-income Securities

Securities that have a fixed claim on the company’s revenue or income. Bonds and preferred shares are some examples of fixed-income securities. Bondholders receive fixed income in the form of coupon payments while holders of preferred shares receive fixed income in the form of dividends. On the contrary, common shareholders receive variable income since dividends on common shares are not guaranteed and can vary over time depending on the performance of the firm.

It should be noted that in general, “fixed-income securities” refer to debt securities, and the income can definitely vary on some types of debt securities. For instance, a bond may have a variable coupon rate linked to, say, the inflation rate. 

See also “Bond” and “Preferred Shares.”

Fixed-rate Mortgage

A mortgage wherein the rate is fixed. Usually, the rate is renegotiated every five years, meaning that every five years, the rate is fixed according to the market condition. Once the rate is fixed, the monthly payment will stay the same over the five-year period.

See “Mortgage” and “Variable-rate Mortgage” for related information.

Forward Contract

An agreement to purchase or sell an asset or commodity at a pre- specified price on a future date. For example, a farmer can enter a forward contract in July to sell his wheat in October. Suppose the contract is for 100,000 bushels at a price of $8 per bushel. Then in October, the farmer must deliver 100,000 bushels of wheat, and he will get 100,000*8 = $800,000, no matter what the prevailing market price of wheat is in October. If the prevailing price is lower than $8, then the contract will turn out to be beneficial. But if the price is higher than $8, the contract will have an adverse effect on the farmer’s total profit, since he could have sold the wheat at a higher price that month. Utilizing a forward contract to lock into a fixed price is called “hedging.”

Evidently, a forward contract has two parties, both of which must honor the contract. Forward contracts are not officially traded on exchanges.

See also “Hedging.”

Forward Interest Rates

To properly understand this term, you first need to look up “Spot Interest Rates.” Forward interest rates are rates that are applicable to future periods. For instance, the one-year, two-year and three-year spot rates are 2.50% p.a., 2.75% p.a. and 3.00% p.a., respectively. Those are the applicable rates if you want to deposit money right now. Suppose you would like to arrange a two-year deposit one year from now, and you would like to fix the rate now. Therefore, this rate is an example of forward rates. How do we arrive at the proper forward rate? Let the said forward rate be R. Subsequently, we can compare two investment alternatives: 1) invest $1 today for three years at 3.00% p.a. to end up with $1(1+0.03)3, and 2) invest $1 today for one year at 2.50% p.a. and roll it over for the next two years at R to end up with $1(1+0.025)(1+R)2. Since both investments are for $1 and a three-year period, they must lead to the same ending return as long as R is properly set. Strictly saying, we must have (1+0.03)3 = (1+0.025)(1+R)2. We then can solve R as R = 3.25%. We can employ similar methods to solve for other forward rates.

See “Spot Interest Rates.”

Forward Price

Please first look up the term “Forward Contract.” Forward Price is the price of a security or commodity contracted today but applicable for a future transaction. In other words, it is the price agreed upon by the two parties in a forward contract. For example, suppose today’s stock price is $90, and Mike agrees to sell Lisa the stock for $98 one year from now, then the price $98 is called the forward price of the stock. Evidently, a forward price is time and maturity specific. To put it another way, for the same current price, the forward prices are different for different future dates. Furthermore, for the same future date, the forward price changes as we march along time since the current price changes. Clearly, the current price and forward price (of any maturity) are positively related.

The concept of forward price is relevant to almost any asset (e.g., stocks, stock indices, bonds, commodities, foreign currencies, and so on).

Freddie Mac

See “Fannie Mae.”

Front Running

An illegal practice through which a stockbroker, with privileged information about the direction of potential price movements, buys or sells stocks on his own account before executing orders from his customers. Front running can take several forms. For instance, a broker receives a large order from his customer to buy Stock ABC. Knowing that the buying pressure from this large order will push the price up, the broker can purchase some shares on his own account, then execute the large buy order, and finally offload his own shares after the price has been pushed up. Similarly, if he receives a large sell order, he could short the stock first on his own account and purchase the shares back after the price is depressed. Stockbrokers can also profit from information not related to customer orders. Suppose Broker A learns from his analyst colleague B that the quarterly earnings of company XYZ will be much higher than expected. Broker A could then buy XYZ shares and wait for the price to go up (upon the earnings announcement). Offloading the shares at the higher price will obviously earn him a huge profit.

Front running is not only unethical but is outright illegal.

See also “Short/Short Selling.”

FTSE 100

A widely watched stock market index in the U.K. It is also known as a value-weighted or capitalization-weighted average of stock prices of the 100 largest companies traded on the London Stock Exchange. “Value-weighted” connotes that the larger the company in market capitalization, the higher the weight its stock enjoys in the index calculation. The acronym FTSE means Financial Times and (London) Stock Exchange. FTSE Group, which maintains the FTSE 100 index, is a joint venture between Financial Times and the London Stock Exchange, thus the name.

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

Fund of Hedge Funds

Also referred to as “fund of funds.” A fund of hedge funds is in fact a mutual fund of hedge funds. Strictly speaking, it is an investment company that invests in hedge funds (as opposed to individual securities). Although hedge funds themselves are subject to minimal regulation, funds of hedge funds must file certain reports to concerned authorities.

See also “Hedge Fund” and “Mutual Fund.”

Fundamental Analysis

A type of stock analysis which ultimate goal is to determine the intrinsic or true value of the stock. As the term suggests, the focus is on the fundamentals. One may apply either a top-down approach or a bottom-up approach. In a top-down approach, one would give attention to the fundamentals of the economy, the industry and the company in question, in that order. In a bottom-up approach, the order is reversed and the analysis of the industry and the economy is only supplementary to the company analysis. Of course, the flow of analysis is usually author-specific and it is not necessary to follow a rigid format.

The fundamental factors being analyzed usually include: overall economic state (interest rate, consumer confidence, etc.), industry state (competition, regulation, etc.), and all elements pertaining to the firm (sales, costs, earnings, etc.).

In the end, the author of a stock’s fundamental analysis will provide either a range or a point estimate of the stock price and, in reference to the current trading price, make a buy, hold or sell recommendation. Some sort of valuation models might be used to come up with the price estimate.

As opposed to “technical analysis,” fundamental analysis does not place much emphasis on things like trading patterns in price or volume.

See also “Technical Analysis.”

Futures Contract

It functions exactly like a forward contract except that a futures contract is standardized and formally traded on major exchanges such as the Winnipeg Commodity Exchange and the Chicago Mercantile Exchange.