Glossary of Financial Terms

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Idiosyncratic Risk

It is the synonym of “nonsystematic risk.”

In-the-money

A term used to show the relative magnitude between the current underlying asset price and the exercise price of an option. An option is said to be “in-the-money” if the immediate exercise value is positive. Thus, a call option is “in-the-money” when the current underlying asset price is higher than the exercise price; a put option is “in- the-money” when the current underlying asset price is lower than the exercise price.

Please see “Call Option,” “Put Option,” “Exercise Price,” “At-the-money,” and “Out-of- the-money.”

Income Trust

It is a legal entity holding an underlying asset or a group of assets. Most of the time, the assets are from a subdivision of a firm. The income generated from such assets is distributed to unit-holders tax-free.

One can consider an income trust as a representative of shareholders having entitlement to the income of a designated group of assets. The trust offers units to the public much like an IPO and then uses the proceeds to acquire the equity and debt of the operating entity such as a subdivision of a firm. It is this structure that allows for the tax exemption of the income.

The first income trust emerged in the 1980s in the form of royalty trust (on gas and oil sectors) and REIT (real estate investment trust). Income trust formerly represent a significant proportion of total listings on most exchanges in North America. Some exchanges even created a sector index for it. However, starting 2007, the popularity of income trusts in Canada faded a great deal. In October 31 of 2006, Jim Flaherty (Finance Minister) announced a new 34% tax on income trust distributions in a bid to close a loophole that the Bay Street had been taking advantage of. Since then, the conversion of regular companies into income trusts literally stopped (except for REIT which continued to enjoy the tax-exemption treatment). Due to the timing coincidence, the announcement was subsequently dubbed as “Halloween Massacre.”

Index-linked GIC

As the name suggests, the payoff of this kind of GIC is linked to stock market indexes such as the S&P/TSX 60. Here is how a typical index-linked GIC functions. Bank customers deposit money for a specified maturity, say three years, at a specified annual rate, say 1.5%. Suppose the GIC is linked to the S&P/TSX 60 whose current level is 750. At maturity, if the index is lower than 784.26 (which is 750 compounded at 1.5% per year for three years), then, the customer will simply receive the 1.5% annual return as promised. But if the index at maturity is above 784.26, say 868.22, then the customer will receive the actual index return, in this case it is 5% per year which is higher than the promised 1.5% per year.

Evidently, the good thing about an index-linked GIC is its unlimited upward potential. But there is no free lunch! The “price” a customer has to pay is the possibility of a much lower promised annual rate. If the stock market stays flat or declines, the customer will then get a return much lower than that on an ordinary GIC.

In many cases, the banks merely guarantee the principal, i.e., offer a zero guaranteed return. In addition, some banks use the monthly average of the market index in the last year of the GIC contract to calculate the index return, which basically has the effect of lowering the return they pay on the index-linked GIC. Furthermore, some banks put a cap on the index return when calculating GIC returns. For instance, if the cap is 15% p.a., then even if the market returns 20% that year, the return on the GIC is still 15%.

Index Option

An option whose value depends on a stock index such as the S&P/TSX 60, unlike a stock option that depends on a particular stock. Because a stock index normally consists of several individual stocks, it is difficult to buy or sell the basket of stocks. Consequently, most index options are settled in cash.

See “Option.”

Initial Public Offering (IPO)

Initial Public Offering refers to the first-time common shares are issued by a corporation. In this case, we say the firm or corporation is going public to be able to access the capital markets for funds. The corporation may be a privately owned firm initially such as a small family owned technology firm or a crown corporation such as Canada Post.

As an illustration, Canadian National (CN), established in 1919 as a crown corporation, was privatized in November 1995 through Canada’s largest and most successful IPO to that date. 83.8 million shares were put into the market, which produced a total proceed of $2.2 billion. Since then, CN became a public corporation.

Inside Information (Trading)

“Trading on inside information” means transactions based on privileged information. It is illegal and is the common target of crackdown by securities commissions such as the SEC in the U.S. and the Ontario Securities Commission in Canada. Stock exchanges (or any exchange for that matter) are built and operated on the premise that all players and participants are on equal footings.

Any person acting on privileged information has an unfair advantage and therefore should not be permitted. Trading based on inside information is a crime and the perpetrator shall be prosecuted and punished (if caught, that is). Examples of profiting from inside information are far too many to enumerate. A CEO could tip off his brother about a pending takeover deal, and both will be prosecuted if the brother is caught profiting from transactions related to the takeover announcement; a chief geologist of a gold mining company could tip off his uncle about a major find of gold deposit and both will be prosecuted if the uncle buys the company stock before the formal announcement and is caught; and so on and so forth.

Obviously, trading on inside information is a white-collar crime. Consequently (and perhaps unfairly), the punishment is usually rather light: short sentences coupled with fines.

To have a better picture the high drama of such kind of trading, watch the Oscar-winning 1987 film Wall Street. Charlie Sheen, in a desperate bid to impress Michael Douglas, tipped him off with some really valuable inside information. And of course, Michael Douglas made good use of it.

See “SEC” and “Ontario Securities Commission.”

Insider Trading

The term “insider trading” can mean different things in different contexts. To a great extent, it means trading of stocks, options, bonds and the like by insiders. The confusion stems from the definition of “insider.” In the context of trading on inside information illustrated in the previous entry, the insider is one who possesses privileged information and acts on it at the expense of others. In this case, the insider trading also like trading on inside information and is therefore illegal. This is how the term is typically understood by most people. However, in some other contexts, insider trading is in fact legal. Who are the insiders in those particular cases? They are actually the CEOs and other executives of a company. As discussed under “Executive Stock Options,” CEOs and other executives are usually given company’s stock and options for incentive purposes. They of course are permitted to sell, e.g., their incentive stocks (after the usual vesting period). When to sell them is up to the executives themselves, as long as they don’t do it prior to a major announcement of negative news. Another condition is, CEOs and other company executives must file with appropriate authorities (usually local securities commissions) within a period of time (no more than a month after their transactions). As long as they don’t act on privileged information and report their trades in a timely fashion, then their trades are considered legal, although we still call it insider trading.

In other words, don’t treat all insider trading as bad. Study the context and ensure that you know what the term means.

Interest Rate Parity

It refers to the relationship between two countries’ interest rates and the exchange rates. Let’s set the U.S. and Japan as an example. Let r$ be the U.S. and r¥ be the Japanese interest rates respectively, and S$¥ and F$¥ be the spot and forward exchange rates in terms of dollars per Japanese yen. The interest rate parity is then expressed as

How do we arrive at this relationship? It is quite simple to illustrate. For instance, you have one dollar to invest. If you invest in the U.S., then your gross return is $(1 + r$ ). What about investing that in Japan? First, you need to convert the one dollar into Japanese yen, which is 1/ S$¥ . Then we invest the yen to get a gross return of (1/ S$¥ )(1 + r¥ ). If we convert this yen amount to dollar at the future market exchange rate, we have no knowledge how many dollars we will get back.

By entering into a contract to sell yen forward we eliminate this exchange rate risk. Since the forward exchange rate is F$¥ , we will be able to lock into F$¥ (1/ S$¥ )(1 + r¥ ) dollars. In well-functioning markets, investing in the U.S. and investing in Japan must lead to the same return, i.e., (1 + r$ ) = (1/ S$¥ )(1 + r¥ ), which is exactly the interest rate parity. So, obviously, many seemingly formidable theories are based on nothing but common sense.

Interest Rate Swap

See “Swap.”

Internal Rate of Return (IRR)

It is an implied return from an investment. To illustrate, if you put in $100 today and get $120 back one year from now, then the internal rate of return or IRR is 20% per year. Likewise, if you purchase a 12-month T-bill with a face value of $1000 for

$909.09 today, then the actual return you will earn is 10% ($1000 discounted at 10% gives you $909.09 today). In this example the IRR is 10%. In general, IRR is the discount rate that makes the net present value (NPV) of an investment equivalent to zero. In the T- bill illustration, initial investment is $909.09, dollar return is $1000, and NPV = 1000/(1 + r)  909.09. When you set NPV to zero and solve for the discount rate r, you will get IRR = 10%. When the investment involves multiple cash flows over many years, the IRR is difficult to be solved by hand. Several spreadsheets such as Excel have built-in functions to solve for IRR. For instance, if you put in $100 today, and get back $80 one year later and $140 two years later, then the IRR is 64.90%.

IRR is typically used to gauge the profitability of an investment. For example, if your minimum acceptable return is 12%, and a project offers an IRR of 14%, then this is an attractive project.

The word “internal” translates to the word implied or intrinsic. It not related to the cheating practice where a firm reports one return internally while another externally.

See “Net Present Value.”

International Monetary Fund (IMF)

The International Monetary Fund, along with the World Bank, was created by the victorious countries of the World War II. The two financial institutions, both headquartered in Washington D.C., were designed to help rebuild the post-war economies of the allied countries. Today, the primary mandate of the IMF includes promoting international monetary cooperation, balanced expansion of world trade, stability of exchange rates, the avoidance of competitive currency devaluations, and the orderly correction of a country’s balance of payments problems. The IMF has almost 200 member countries.

Investment Banker

Synonym of “investment dealer.”

Investment Banking

One of the main business activities performed by large banks. Unlike commercial banking which involves accepting deposits and making loans, investment banking mostly involves assisting companies in their financing and other related financial decisions. The generally known activities include underwriting securities and advising companies on mergers and acquisitions (M&As). When firms are in need of capital, investment banks assist them in issuing new debt or equity. When a private company goes public the first time, investment banks help them execute the so- called “initial public offering (IPO).” In the case of M&As, investment banks conduct such activities as valuation and due diligence checks. While banks make money from the interest rate spread in commercial banking, the profit in investment banking comes from charging service fees. The proceeds from investment banking usually accounts for a large portion of the bank’s total revenue.

Incidentally, there are also independent financial firms that engage exclusively in investment banking.

Investment Dealer

Financial firms which specialize in selling securities on behalf of other companies. In the U.S., they are referred to as investment bankers. Major investment dealers in Canada include RBC Dominion Securities, CIBC Capital Markets, and BMO Nesbitt Burns.

Investment Grade Bonds

Bonds rated above and including BBB. Many institutional investors are not permitted (by law) to hold bonds rated below BBB, or junk bonds. Therefore, bonds rated above and including BBB are called investment grade bonds.

Please see “Bond Rating.”

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