News | Wednesday, 25 February 2009

Economic downturn terms defined

At a time when media reports feature all sorts of economic jargon, Business Today this week picks a set of commonly used financial terms and provides their definition

AAA-rating: The best credit rating that can be given to a corporation’s bonds, effectively indicating that the risk of default is negligible.

Assets: Things that have earning power or some other value to their owner.
Fixed assets (also known as long-term assets) are things that have a useful life of more than one year, for example buildings and machinery; there are also intangible fixed assets, like the good reputation of a company or brand.
Current assets are the things that can easily be turned into cash and are expected to be sold or used up in the near future.

Basis point: One hundred basis points make up a percentage point, so an interest rate cut of 25 basis points might take the rate, for example, from 3 per cent to 2.75 per cent.

Bear market: In a bear market, prices are falling and investors, anticipating losses, tend to sell. This can create a self-sustaining downward spiral.

Bond: A debt security - or more simply an IOU. The bond states when a loan must be repaid and what interest the borrower (issuer) must pay to the holder. Banks and investors buy and trade bonds.

Bull market: A bull market is one in which prices are generally rising and investor confidence is high.

Capitulation: Used of the stock markets, the point when a flurry of panic selling induces a bottoming out of prices.

Carry trade (currency): Typically, the borrowing of currency with a low interest rate, converting it into currency with a high interest rate and then lending it. One common carry trade currency is the yen, as traders seek to benefit from Japan’s low interest rates. The element of risk is in the fluctuations in the currency market.

Chapter 11: The term for bankruptcy protection in the US. It postpones a company’s obligations to its creditors, giving it time to reorganise its debts or sell parts of the business, for example.

Collateralised debt obligations (CDOs): A collateralised debt obligation is a financial structure that groups individual loans, bonds or assets in a portfolio, which can then be traded.
In theory, CDOs attract a stronger credit rating than individual assets due to the risk being more diversified. But as the performance of some assets has fallen, the value of many CDOs have also been reduced.

Commercial paper: Unsecured, short-term loans issued by companies. The funds are typically used for working capital, rather than fixed assets such as a new building.

Commodities: Commodities are products that, in their basic form, are all the same so it makes little difference from whom you buy them.
That means that they have a market price. You would be unlikely to pay more for iron ore from a particular mine, for example.

Correction: A short-term drop in stock market prices. The term comes from the notion that, when this happens, overpriced stocks are returning back to their “correct” values.

Credit crunch: The situation created when banks hugely reduced their lending to each other because they were uncertain about how much money they had.
This in turn resulted in more expensive loans and mortgages for ordinary people.

Credit default swap: A swap designed to transfer credit risk, in effect a form of financial insurance. The buyer of the swap makes periodic payments to the seller in return for protection in the event of a default on a loan. Currency peg A commitment by a government to maintain its currency at a fixed value in relation to another currency. Typically this is done by the government buying its own currency to force the value up, or selling its own currency to lower the value. One example of a peg was the fixing of the exchange rate of the Chinese yuan against the dollar.
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Dead cat bounce: A phrase long used on trading floors to describe a short-lived recovery of share prices in a falling stock market.

Deflation: The downward price movement of goods and services.

Derivatives: Derivatives are a way of investing in a particular product or security without having to own it. The value can depend on anything from the price of coffee to interest rates or what the weather is like.
Derivatives can be used as insurance to limit the risk of a particular investment.
Credit derivatives are based on the risk of borrowers defaulting on their loans, such as mortgages.

Equity: In a business, equity is how much all of the shares put together are worth.
In a house, your equity is the amount your house is worth minus the amount of mortgage debt that is outstanding on it.

Fundamentals: Fundamentals determine a company, currency or security’s value. A company’s fundamentals include its assets, debt, revenue, earnings and growth.

Futures: A futures contract is an agreement to buy or sell a commodity at a predetermined date and price. It could be used to hedge or to speculate on the price of the commodity.

Hedge fund: A private investment fund with a large, unregulated pool of capital and very experienced investors.
Hedge funds use a range of sophisticated strategies to maximise returns - including hedging, leveraging and derivatives trading.

Hedging: Making an investment to reduce the risk of price fluctuations to the value of an asset.
For example, if you owned a stock and then sold a futures contract agreeing to sell your stock on a particular date at a set price. A fall in price would not harm you - but nor would you benefit from any rise.

Investment bank: Investment banks provide financial services for governments, companies or extremely rich individuals. They differ from commercial banks where you have your savings or your mortgage.

Junk bond: A bond (or loan to a company) with a high interest rate to reward the lender for a high risk of default.

Keynesian economics: The economics of John Maynard Keynes. In modern political parlance, the belief that the state can directly stimulate demand in a stagnating economy. For instance, by borrowing money to spend on public works projects like roads, schools and hospitals.

Leveraging: Leveraging, or gearing, means using debt to supplement investment.
The more you borrow on top of the funds (or equity) you already have, the more highly leveraged you are. Leveraging can maximise both gains and losses.
Deleveraging means reducing the amount you are borrowing.

Liquidity: The liquidity of something is how easy it is to convert it into cash. Your current account, for example, is more liquid than your house.
If you needed to sell your house quickly to pay bills you would have drop the price substantially to get a sale.

Loans to deposit ratio: For financial institutions, the sum of their loans divided by the sum of their deposits.
Currently important because using other sources to fund lending is getting more expensive.

Mark-to-market: Recording the value of an asset on a daily basis according to current market prices.
So for a futures contract, what it would be worth if realised today rather than at the specified future date. Also marked-to-market.

Money markets: Global markets dealing in borrowing and lending on a short-term basis.

Monoline insurance: Monolines were set up in the 1970s to insure against the risk that a bond will default. Companies and public institutions issue bonds to raise money. If they pay a fee to a monoline to insure their debt that in turn helps to raise the credit rating of the bond which in turn means the institutions can raise the money more cheaply.

Mortgage-backed securities: These are securities made up of mortgage debt or a collection of mortgages. Banks repackage debt from a number of mortgages which can be traded. Selling mortgages off frees up funds to lend to more homeowners. See securities.

Naked short selling: A version of short selling, illegal or restricted in some jurisdictions, where the trader does not first establish that he is able to borrow the relevant asset.

Nationalisation: The act of bringing an industry or assets like land and property under state control.

Negative equity: Refers to a situation in which the value of your house is below the amount of the mortgage that still has to be paid off.

Ponzi scheme: Similar to a pyramid scheme, an enterprise where - instead of genuine profits - funds from new investors are used to pay high returns to current investors. Named after the Italian fraudster Charles Ponzi, such schemes are destined to collapse as soon as new investment tails off or significant numbers of investors simultaneously wish to withdraw funds.

Preference shares: A class of shares that usually do not offer voting rights, but do offer a superior type of dividend, paid ahead of dividends to ordinary shareholders. Preference shareholders often also have superior status in the event of a liquidation.

Prime rate: A term used primarily in North America to describe the standard lending rate of banks to most customers. The prime rate is usually the same across all banks, and higher rates are often described as “x percentage points above prime”.

Profit warning: When a company issues a statement indicating that its profits will not be as high as it had expected. Also profits warning.

Quantitative easing: Central banks flood the economy with money by printing new notes, in order to increase the supply of money. The idea is to add more money into the system to avert deflation and encourage banks/people to borrow and spend.
One of the dangers of this tactic is hyperinflation.

Rating: Bonds are rated according to their safety from an investment standpoint - based on the ability of the company or government that has issued it to repay.
Ratings range from AAA, the safest, down to D, a company that has already defaulted.

Recapitalisation: To inject fresh money into a firm, thus reducing the debts of a company.
For example, when a government intervenes to recapitalise a bank, it might give cash in exchange for some form of guarantee, such as a stake in the company. Taxpayers can then benefit if the bank recovers.

Recession: A period of negative economic growth.
In most parts of the world a recession is technically defined as two consecutive quarters of negative economic growth - when real output falls.
In the United States, a larger number of factors are taken into account, like job creation and manufacturing activity. However, this means that a US recession can usually only be defined when it is already over.

Retained earnings: Money not paid out as dividend and held awaiting investment in the company.

Rights issue: When a public company issues new shares to raise cash. The company might do this for a number or reasons - because it is running short of cash, or because it wants to make an expensive investment. By putting more shares on the market, a company dilutes the value of its existing shares.

Securities lending: Security lending is when one broker or dealer lends a security to another for a fee. This is the process that allows short selling.

Securitisation: Turning something into a security. For example, taking the debt from a number of mortgages and combining them to make a financial product which can then be traded.
Banks who buy these securities receive income when the original home-buyers make their mortgage payments.

Security: Essentially, a contract that can be assigned a value and traded. It could be a stock, bond or mortgage debt, for example.

Short selling: A technique used by investors who think the price of an asset, such as shares, currencies or oil contracts, will fall. They borrow the asset from another investor and then sell it in the relevant market.
The aim is to buy back the asset at a lower price and return it to its owner, pocketing the difference. Also shorting.

Spiv: A term popularised in World War II for flashily-dressed chancers involved in black market dealings. A fictional spiv is ladies’ man Private Joe Walker in Dad’s Army.
Newspaper headline writers use “spiv” as shorthand for traders who play for high stakes.

Stagflation: The dreaded combination of inflation and stagnation - an economy that is not growing while prices continue to rise.

Sub-prime mortgages: These carry a higher risk to the lender (and therefore tend to be at higher interest rates) because they are offered to people who have had financial problems or who have low or unpredictable incomes.

Swap: An exchange of securities between two parties. For example, if a firm in one country has a lower fixed interest rate and one in another country has a lower floating interest rate, an interest rate swap could be mutually beneficial.

Tier 1 capital: A calculation of the strength of a bank in terms of its capital, defined by the Basel Accords, typically comprising ordinary shares, disclosed reserves, retained earnings and some preference shares.

Toxic debts: Debts that are very unlikely to be recovered from borrowers. Most lenders expect that some customers cannot repay; toxic debt describes a whole package of loans where it is now unlikely that it will be repaid.

Underwriters: When used of a rights issue, the institution pledging to purchase a certain number of shares if not bought by the public.

Unwind: To unwind a deal is to reverse it - to sell something that you have previously bought, or vice versa.
When administrators are called in to a bank, they must do the unwinding before creditors can get any money back.

Warrants: A document entitling the bearer to receive shares, usually at a stated price.

Write-down: Reducing the book value of an asset to reflect a fall in its market value. For example, the write-down of a company’s value after a big fall in share prices.

Yield spread: The difference in the rate of return in two different investments. If Bond A earns a return of 10 per cent and Bond B 7 per cent, the yield spread would be three percentage points.

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