Glossary of Financial Terms
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Payback Period
It is a metric used to assess a capital investment project. It is the number of years necessary for recovering the initial investment. Suppose that a three-year project needs an initial investment of $1.5 million, and it is supposed to generate the following cash flows for the three years: $0.6 million, $0.8 million, and $2.0 million. Obviously, after the first two years, you recover only $1.4 million of the investment; you still need to recover $0.1 million, which will take only a fraction of the third year: ($0.1 million /$2.0 million)(1 year) = 0.05 years. Thus, the total payback period for this project is 2 + 0.05 = 2.05 years.
To reflect the time value of money, people would sometimes calculate the so-called “discounted payback period.” What needs to be done is to discount the future cash flows first to get their present values, and then go through the same procedure as earlier done. To continue the earlier illustration, suppose the discount rate is 12% p.a., then the present values of the three future cash flows are, $0.6/(1+0.12) = $0.5357 million, $0.8/(1+0.12)2 = $0.6378 million, and $2.0/(1+0.12)3 = $1.4236 million. Therefore, the discounted payback period is 2.229 years. The complete calculation is as follows:
2 + (1.5 0.5357 0.6378)/1.4236 = 2.229.
See also “Discount Rate” and “Discounting.”
Pension Fund/Plan
A pool of money used to pay for the pensions of retirees. The employer and the employee contributes to the pool of money. The amount of contribution is different from fund to fund. Usually, employers and employees make equal contributions as a percentage (say 8%) of the employee’s annual salary. Typically, there is also a cap on pensionable earnings, meaning that the percentage contribution is only applied to the annual salary to a certain level (e.g., $140,000). Salaries that are beyond this threshold are not subject to pension-contribution deductions. It’s not all good news! As a matter of fact, the capping of deduction only means the pension payment upon retirement is also capped (e.g., at $80,000). This is specifically true for the so-called “defined benefit” (DB) pension plans which guarantee a pension amount based on years of service and salary level. In contrast, in the so-called “defined contribution” (DC) plans, no such guarantee is present. How much pension the employee gets entirely depends on the investment performance of the pension fund. In the heydays of the stock market (e.g., before the bursting of the dotcom bubble in the late 1990s), many employees converted their DB plans into DC plans. Not a smart move at all, judging by the general low returns that pension funds make.
Interestingly enough, Canada Pension Plan (CPP) is different from usual pension plans in that it is a mandatory social insurance (or social security) program. Any Canadian resident aged 18 or above must pay a small percentage of their earnings (up to a cap) to the CPP. As soon as they retire, they will automatically receive an annual pension from the government. This pension, however, is typically much smaller in amount than the workplace pension. As earlier mentioned, even workplace pensions have a cap. Therefore, to continue a comfortable lifestyle after retirement (e.g., going to the fancy restaurants weekly and replacing your luxury car every few years), an individual must also save for his retirement through other means such as the RRSP.
See “Registered Retirement Savings Plan” (RRSP).
Poison Pill
On the mention of this term, people usually think of a malicious, murderous act. In finance, this term also talks about a poisonous act of some sort, but a perfectly legal one though. Simply speaking, it is an anti-takeover defense or device. It is stated in the corporate charter/bylaw and works in the following way. If/when a shareholder, aiming to take control of the company, has acquired shares more than a threshold level (e.g., holding more than 25% of the company’s shares), the company will issue new shares to other shareholders at a deep discount. This is therefore poisonous to the shareholder attempting to take over the company since his holdings will then be diluted after the new share issuance. Thus, anyone contemplating a hostile takeover will have to think twice. At times, the poison pill provision allows the shareholders to purchase the shares of the merged company at a deep discount. It will also achieve the same purpose: discourage a hostile takeover by dilution.
See “Hostile Takeover.”
Ponzi Scheme
A fraudulent scheme whereby the fraudster makes use of the money from new investors to pay off existing investors. The fraudster attracts victims by committing to pay investment returns at a much higher rate than what the market can offer. In irony, this kind of scheme is usually being exposed on its own. The reason is rather simple: the scheme collapses the moment new money stops coming in. Many “adverse” conditions can lead to the demise of a Ponzi scheme. One is the slow pace of new money coming in, causing existing investors to be alarmed when the inflow of their high investment income is being interrupted or when they are unable to get their initial investments back; the other is a market crash which immediately limits the ability for the fraudster to keep up with the promised payments. The “successful” fraudsters are of course, those who manage to disappear with the investors’ money before the scheme is exposed. Of course, most Ponzi schemes are eventually exposed. It is only a matter of how much (if any) the victims could still recover from the fraudster.
Ponzi scheme fraudsters love two types of people: the financially illiterate (who don’t ask sharp questions before investing) and the downright greedy. Lack of financial knowledge will not get people in much trouble as long as they are not greedy; greed be blinding to people even when they are financially literate. The moment you hear someone say he can guarantee a return higher than the GIC rate, be alert and, more advisably, stay away from him.
The name Ponzi came from, the infamous Carlo Pietro Giovanni Guglielmo Tebaldo Ponzi or simply Charles Ponzi. An Italian, Charles Ponzi pursued his fraudster career in the U.S. and Canada at the early part of the 20th century. He of course was not the inventor of the scheme, smart scoundrels were already taking advantage of investors’ greed way back in history. Charles Ponzi acquired the honor only because he made it big by the standard back then (of as much as $20 million). Arguably, Bernard L. Madoff is quite an equal competitor for the crown since he was able to amass a total loss of more than $17 billion for his “aspiring” investors.
See “GIC.”
Portfolio
A basket of securities which means a group of shares or other securities, including, but not limited to, one or more exchange-traded funds or securities. For example, you may invest $8,000 in government bonds, $5,000 in stocks, and $7,000 in T-bills. The total investment in all these securities is called a portfolio.
See also “Diversification.”
Portfolio Insurance
It refers to the hedging of downsize risk of a portfolio. There are several techniques available for portfolio insurance. If the portfolio is said to be a well diversified equity portfolio, then one may purchase put options on a stock market index (e.g., S&P 500). Taking a short position on index futures will also suffice. Hedging can be achieved since your diversified equity portfolio usually moves in tandem with the market so that losses (if any) will be made up by gains from the put options or futures. In the so-called synthetic portfolio insurance, one can sell a portion of the portfolio and put it in T-bills and perform this adjustment constantly in response to market movements. In this case, you would switch more equity to T-bills if the market continues to slide, and transfer money back into equity if the market goes up. Insurance or hedging is achieved through this continues adjustment. Theoretically, it is equivalent to insuring via put options.
See “S&P 500,” “Futures Contract,” “Short” and “Put Option.”
Precious Metals
Metals that are rare, slow to react (chemically), shiny and easy to manipulate. Notice that the mentioned properties must be present simultaneously in order for the metal in question to be called a precious metal. The term “precious” here mostly indicates that the metals are also used for investment purposes aside from their usual industrial applications. Frequently, “precious metals” include gold, silver, platinum and palladium. Technically, platinum and palladium are actually members of a larger group: ruthenium, rhodium, palladium, osmium, iridium and platinum. But they are the two widely traded ones.
Formerly, gold was not the most precious/expensive. In 2013, gold stands around $1,300/oz while platinum trades at a higher value around $1,400/oz. Currently, gold trades at 1, 700/oz. and platinum trades for lower at 1,100/oz. The reality is there are even more expensive metals. What is the most precious of all? Rhodium takes the honor. Although it only stands at around $28,500/oz at the time of writing, its historical price has topped that of gold many times over. The highest gold price to date is around $2067/oz. reached in August 2020. The record high of rhodium is $29,800/oz in March 2021. Why so? Because rhodium is much more difficult to come by than gold or platinum.
Preferred Shares
Shares issued by companies that guarantee relatively stable dividends but is not accompanied by voting rights. These shares are “preferred” since they enjoy a higher priority (relative to common shares) in reference to dividend payments.
Price Earnings Ratio (P/E ratio)
Refers to the ratio of stock price over the recent annual earnings per share. To illustrate, if Stock Bre-X is trading at $10 now and its earnings per share in the past year is $0.5, then the P/E ratio is 10/0.5 = 20. This is what we call “trailing P/E ratio.” In turn, one could divide the current stock price by the forecasted earnings for the next year. In this case, we speak of “forward P/E ratio.” To continue the example, suppose the forecasted earnings for the next 12 months is $0.6 per share, then the forward P/E ratio is 10/0.6 = 16.67.
Similar ratios can likewise be calculated for a stock market index. Typically, P/E ratio for a stock market index can be anywhere between 15 and 60, however the normal range is around 20 or so. Stable stocks has the tendency to have low P/E ratios, and fast growing stocks usually have high P/E ratios. For example, in January 1999, the stock of Ebay had a P/E ratio around 2,000. That is quite high by any standard! It showcases the mad bidding on that company’s stock.
Prime Rate
The rate a commercial bank (Royal Bank, e.g.) would charge its most credit-worthy corporate customers (BCE, e.g.) for short-term loans. It is even lower than the bank loan rates charged on small businesses or individual borrowers. Prime rates may vary across banks, but they tend to be very close due to competitions among banks.
Prime rate is periodically reset according to the movement of bank rate. In general, prime rate is 1% to 1.5% above the bank rate. It is very typical that an individual obtains a loan from a bank at the prime rate or even prime rate minus some basis points. One example is when the loan is fully guaranteed by, say, a fixed term GIC. Another scenario would be when you are super rich but still need a loan. For an obvious reason, banks tend to have more confidence in super rich individuals than, say, university professors.
See also “Bank Rate,” “GIC” and “Basis Point.”
Private Equity
First, look up “Equity.” The term “private equity” often refers to a particular class of investments − investments in a company that are not publicly traded on a stock exchange. Since the investment objects are not publicly traded, individual investors typically don’t have direct access to private equity investing. The investing is often done by private equity firms. These firms are organized as partnerships which consist of general partners (those who contribute more money and perform all investment and management decisions) and limited partners (those who contribute less money and are not exactly responsible for management decisions). The general partners are very much like hedge fund owners in that they also follow the usual 2/20 fee and profit sharing scheme. The companies that private equity firms invest in are often small- to medium-sized firms originated from a family business. But there are some quite large companies as well that are controlled by private equity firms. In fact, some publicly listed companies are sometimes taken private. In other words, private equity firms purchase all the shares of the public companies and delist them from stock exchanges. (After a period of restructuring under private management, the companies are taken public again via IPOs at a much higher value − this is how private equity firms make their money.)
Nevertheless, private equity firms can, and almost always do, borrow money to leverage up the general and limited partners’ equity investments.
It is generally believed, and usually true, that returns from private equity investments are on average higher than returns from public equity investments (i.e., investing in stocks traded on exchanges). But the risk is also higher since some companies fail even before they can successfully grow.
Incidentally, it is not completely unseen for retail investors to invest in private equities. Apart from the fact that their pension funds might have already got exposure to private equities, investors can actually buy shares of companies that specialize in private equity investments − private equity firms that are publicly traded. Examples include Onex (in Canada) as well as Blackstone (in the U.S.).
See also “Hedge Fund,” “IPO” and “Venture Capital.”
Prospect Theory
A theory proposed by Nobel Prize Laureate, Daniel Kahneman together with his colleague Amos Tversky (see “Behavioral Finance” for more details about Daniel Kahneman). It is said to be the theoretical foundation for behavioral economics/finance. In contrast to the classic economic theories assuming that people make decisions with a cool mind, prospect theory embraces psychology and emotions as factors that have effects on decision making. For instance, the theory builds on loss aversion, something not permitted in the classic economic theories.
See “Loss Aversion.”
Put Option
A put option is a derivative security wherein the value depends on a particular underlying asset. It is a investment instrument that is of high-leverage. Suppose you own a put option on Company Z’s stock that is trading at $42 per share now. The put option is the right for you to sell a share at a specific price (say $44) on a specific future date (say three months from now). Three months later, if the ABC share is trading at a price above $44, then you would throw away the put option because you do not want to sell something for $44 which is worth more than $44. But if the price is lower than $44, then you would exercise your right − sell the share at $44. Suppose the share is trading at $37, then you make a $7 profit. The purchase price of this option is perhaps only $1. Therefore, your return over the three-month period is (7 1)/1 = 600%! (How does one estimate the value of an option? See “Black-Scholes Option Pricing Model/Formula.”)
A put option holder tends to have worries about market crashes.
See also “Call Option,” “European Option,” “American Option,” “Asian Option,”
“Index Option” and “Exercise Price” or “Strike Price.”
Put-Call Parity
It refers to the relationship between the value of a European call and that of a European put written on the same stock , the same exercise price and the same time to maturity. More precisely, the parity says: the sum of the put value and the stock price is equal to the sum of the call value and the present value of the exercise price. This relationship is independent of any pricing model.
It is actually not too difficult to understand the parity. To prove it, all that is necessary is the no-arbitrage principle: if two portfolios have the same value at a future time, then they must have the same value today to prevent arbitrage. The arguments are outlined below.
As described above, the put-call parity essentially involves two portfolios, one consisting of a share and a put (let’s call this portfolio A), while the other consisting of a call and a T-bill whose par value is the exercise price of the options (let’s call this portfolio B). Let’s look at the value of the portfolios at the options’ maturity. First let’s examine the case where the stock price is above the exercise price. In this case, portfolio A will just have a stock in it since the put is worthless; portfolio B will likewise have a share in it since we will render the T-bill (whose value is exactly equal to the exercise price) to acquire a share in exercising the call option. The two portfolios have equal value. Using the same logic, we can show that the value of both portfolios will be the same as the exercise price or the par value of the T-bill when the stock price is lower than the exercise price. Hence, no matter whether the stock price is above or below the exercise price, the two portfolios will always have the same exact value at the options’ maturity. Therefore, they must have the same value today.
Thus, the put-call parity. Obviously, some seemingly intimidating things are actually not that difficulty to understand.