CFA Foundations Exam Ch. 1 - Ch. 20

Subordinated debt

A bond contract may also specify that an unsecured bond has a lower priority in the event of default than other unsecured bonds

A buyer chooses whether to exercise an option based on the underlying price compared with the exercise price

A buyer will exercise the option only when doing so is advantageous compared with trading in the market, which puts the seller at a disadvantage

At the money (call)

A call option is "at the money" if the market price and exercise price are the same

Callable bonds

A call provision gives the issuer the right to buy back the bond issue prior to the maturity date (The call price typically represents the par value of the bond plus an amount referred to as the call premium)

Limit order

A ceiling price for a buy order and floor price for a sell order

Income effect

A change in demand for a product from a change in purchasing power is called the income effect

Common stock

A common share represents an ownership interest in a company

Public offerings

A company that sells securities to the public for the first time makes an initial public offering (IPO), sometimes also called a placing or placement

A risk management process provides a framework for identifying and prioritising risks; assessing their likelihood and potential severity; taking preventive or mitigating actions, if necessary; and constantly monitoring and making adjustments

A company's risk management process is not always consistently planned; it often evolves in response to crises, incorporating the lessons learned and the new regulatory requirements that sometimes follow these crises

Convertible bonds

A conversion provision gives the bondholder the right to exchange the bond for shares of the issuing company's stock prior to the bond's maturity date

Current account deficit

A country spends more than it earns and makes up the difference by borrowing or receiving investments from other countries

Floating rate

A country's central bank does not intervene and lets the market determine the value of the currency

Carried interest

A form of incentive fee that general partners deduct before distributing to the limited partners the profit made on investments (carried interest is designed to ensure that general partners' interests are aligned with limited partners' interests)

Listed closed-end funds are actively managed and generally trade at prices different from their NAV

A fund is said to trade at a discount if the trading price is lower than the fund's NAV or at a premium if the trading price is greater than its NAV

Futures

A futures contract is similar to a forward contract in that it is an agreement that obligates the seller, at a specified future date, to deliver to the buyer a specified underlying in exchange for the specified futures price (The buyers and sellers do not necessarily know who is on the other side of the contract)

Risk taking should also be considered in the structure of compensation, for example when defining bonus payments for employees

A good compensation system should take into account the level of risk undertaken for a given level of return and should reward those who achieve returns without taking excessive risks

Performance bond

A guarantee, usually provided by a third party, such as an insurance company, to ensure payment in case a party fails to fulfill its contractual obligations (defaults)

As a result of inflation

A lender's purchasing power may decline even if the money is repaid as promised (The greater the expected inflation → the higher the level of interest demanded by the lender)

Flows of money into and out of funds over time can be accounted for by dividing the measurement period into shorter holding periods

A new holding period starts each time a cash flow occurs—that is, each time money flows into or out of a fund (In practice, client cash inflows and outflows may occur on a daily basis, in which case an annual holding-period return is divided into daily holding-period returns)

Indices

A number of organisations produce financial market indices that allow investors to compare the holding-period return achieved by their fund manager with that generated by the wider market

Deflation

A persistent and pronounced decrease in prices across most products and services in an economy

Document

A piece of written, printed, or electronic matter that provides information or evidence or that serves as an official record

Stop price

A price that triggers the conversion of a stop order into a market order

Family office

A private company that manages the financial affairs of one or more members of a family or of multiple families

Venture capital

A private equity investment strategy that consists of financing the early stage of companies that have an innovative business idea

Putable bonds

A put provision gives the bondholder the right to sell the bond back to the issuer prior to the maturity date (Consequently, the coupon rate on a putable bond will generally be lower than the coupon rate on a comparable bond without an embedded put provision )

Annual percentage rate (APR)

A simple interest rate that does not involve compounding

Skill

A skilful fund manager is able to add value to a portfolio over and above changes to the portfolio's value that are driven by market movements and that could have been produced by a passive fund manager

Stock split

A stock split is when a company replaces one existing common share with a specified number of common shares

Reporting

A valuation (if a market price is available) or an appraisal (that is, an estimation if no market price is available) of each asset held is sent to the client on a regular basis

Back office

Accounting, human resources, payroll, and operations

Brokers

Act as agents and do not trade directly with investors but help buyers and sellers find and trade with each other

Depositories

Act not only as custodians but also as monitors

Front running

Act of placing an order ahead of a customer's order to take advantage of the price impact that the customer's order will have

Active approaches require a more detailed analysis of each relevant investment or asset class, which is costly because investment firms need skilled employees and/or expensive technology

Active management typically also has higher transaction costs because of more frequent trading in the portfolio

Much academic and practitioner research has shown that most active managers do not consistently outperform the market over long time periods

After accounting for fees and expenses

Collusion

Agreements between competitors to raise prices

External documents

Aim to articulate business relationships and obligations undertaken by the parties involved and are often legally binding

Expiration date

All derivatives have a finite life; each contract specifies a date on which the contract ends, called the expiration date

Orders

All orders specify what security to trade, whether to buy or sell, and how much should be bought or sold

Prospectus

All pooled investment vehicles disclose their investment policies, deposit and redemption procedures, fees and expenses, and past performance statistics in an official offering

Interest rate swap

Allows companies to swap their interest rate obligations (usually a fixed rate for a floating rate) to manage interest rate risk, to better match their streams of cash inflows and outflows, or to lower their borrowing costs

Price elasticity of demand

Allows for comparison of the responsiveness of quantity demanded with changes in price

It may also contain performance information, measured by the change in value over various periods of time—a quarter, a year, or perhaps a longer period

Along with valuation and performance statements, clients may receive a range of other documents, such as investment reports, annual financial statements, and risk management reports

An important distinction between exchanges and alternative trading venues is the regulatory authority that exchanges exert over users of their trading systems

Alternative trading venues only control the conduct of subscribers who use their trading systems

Tactical asset allocation

Although the chosen strategic asset allocation is expected to meet the investor's objectives over the long term, there are times when shorter-term fluctuations in asset class returns can be exploited to potentially increase portfolio returns (A short-term adjustment among asset classes)

Investment control problems

Although the majority of investment managers work faithfully to serve their clients, some are not always careful, conscientious, or honest, which can lead to investment losses from poor research, missed opportunities, self-serving advice, or outright fraud

Hedge

An action that reduces uncertainty or risk

Forward contract

An agreement between the two parties in which one party agrees to buy from the seller an underlying at a later date for a price established at the start of the contract

Appraisal

An assessment or estimation of the value of an asset and is subject to certain assumptions, which may not always be realistic

Capitalism

An economic system that promotes private ownership as the means of production and markets as the means of allocating scarce resources

Crossing network

An electronic trading system that matches buyers and sellers who are willing to trade at prices obtained from exchanges or other alternative trading venues (Crossing networks are popular with investors who want to trade large blocks of securities without risking moving the price of those securities by submitting an order to an exchange)

Document creation

An important aspect of document creation relates to the production style—for instance, the use of a standardised template (Any changes reflected in a policy document need to be similarly reflected in all associated procedure and process document)

Performance measurement

An important part of performance evaluation

The services offered by investment firms and the investments available will typically vary by the amount of money the client has to invest

An investment firm that focuses on retail investors has to service the needs of a large number of relatively small accounts (Often, this means consolidating the retail investors' assets into a smaller number of funds and having automated processes for the administration of client fund holdings)

Buy the physical commodity

An investor could buy a barrel of oil or a head of cattle or a bushel of wheat (transportation and storage difficulties associated with purchasing a physical commodity means that it is rare for investors to gain access to commodities this way)

Call option

An investor who buys a call option has the right (but not the obligation) to buy or call the underlying from the option seller at the exercise price until the option expires

Put option

An investor who buys a put option has the right (but not the obligation) to sell or put the underlying to the option seller at the exercise price until expiration

Risk management

An iterative process used by organisations to support the identification and management of risk (or uncertainty) and reduce the changes and/or effects of adverse events while enhancing the realisation of opportunities and the ability to achieve company objectives

Stop order

An order for which a trader has specified a stop price

Current yield

Annual coupon payment / current market price

Execution instructions

Another document is often attached giving instructions about order execution, exposure, and time-in-force

Anti-money-laundering

Anti-money-laundering legislation is a set of rules to prevent money derived from criminal activities from entering the financial system and acquiring the appearance of being from legitimate sources (These rules require companies in the financial services industry, including those in the investment industry, to obtain sufficient original or certified documentation to perform a formal risk assessment on each client and counterparty; the procedures of such an assessment are called know-your-customer procedures)

For active management to be successful

Any mispricing of investments has to be substantial enough to cover the costs of exploiting this mispricing

Effect of fixed costs on profitability

As production rises, costs are spread over more units and variable costs will increase as a result of additional inputs to the steel making process

Public consultation

Ask for public comment on proposed regulations

Depending on the nature of the fund, the performance itself might come from the following sources:

Asset allocation, sector selection, stock selection or currency exposure

Investment vehicles

Assets offered by the investment industry to help investors move money from the present to the future, with the hope of increasing the value of their money

Redemption

At some stage, a client may want to redeem or sell an investment

Making to market

At the end of each day, the exchange establishes a settlement price based on the closing trades and determines the difference between the current settlement price and the previous day's settlement price

Active managers

Attempt to add value to a portfolio by selecting investments that are expected, on the basis of analysis, to outperform a specified benchmark

Risk appetite

Attitude toward risk and on its risk culture

Thanks to the advent of straight-through processing (STP), also referred to as straight-through exception processing (STeP), the need for manual intervention has been removed

Automated processes also help reduce errors

Managing systems

Automated processes can reduce the frequency and severity of operational errors, but they are not infallible (One source of risk is the behaviour of employees who do not follow internal policies and, for instance, download unauthorised applications for personal or business use)

Major factors that affect the value of currency

Balance of payments, level of inflation, level of interest rates, level of government debt, political and economic environment and reserve currency

Professional standards

Based on fundamental ethical principles to guide practice

Basic earning power

Basic earning power = operating income / total assets (The income generated from a company's assets excluding how those assets are financed)***********************(operating income / revenues) x (revenues / total assets)

Examples of external documents in the investment industry are a contract between a buyer and a seller of an asset, an investment management agreement between a firm and a client, and a "know-your-client" (some people call it KYC) document for a new client

Because contracts and other legally binding documents are governed by law and are enforceable, parties are usually motivated to comply with them

Treasury Inflation-Protected Securities (TIPS)

Because of the inflation protection offered by inflation-linked bonds, the coupon rate on an inflation-linked bond is lower than the coupon rate on a similar fixed-rate bond

Option premium

Because of the unilateral future obligation (only the seller has an obligation), options have positive value for the buyer at the inception of the contract--the option buyer pays this value, or option premium, to the option seller at the time of the initial contract

Reduce risk by obtaining diversification benefits

Because there is a relatively low correlation between different types of alternative investments and also between alternative investments and other asset classes, adding private equity, real estate, and commodities to portfolios helps investors reduce risk

Prospectus

Before a public offering, the issuer typically provides detailed information about its business and inherent risks as well as the proposed uses for the money it hopes to raise

Confirmation

Before a trade can be settled, the buyer and seller must confirm that they traded and the exact terms of their trade

Benchmarks and the calculation of relative returns

Benchmarks can be used to assess the quality and/or quantity of a company's performance by comparing its performance with that of its peers and competitors

Bid-ask spreads

Bid-ask spreads tend to be wider in opaque markets because finding the best available price is harder for dealers in such markets

Convertible bonds

Bond issued by a company that offers the bondholder the right to convert the bond into a pre-specified number of common shares

Sovereign/government bonds

Bonds issued by central governments

Corporate bonds

Bonds issued by companies

Treasuries

Bonds issued by the US government

Aggressive accounting methods

Boost reported earnings

Economic profit

Both explicit and implicit costs are considered

For an investment management company, measuring and understanding fund manager performance is vital to managing and improving the investment process

Both investors and investment management companies will want to know how fund managers have performed relative to familiar and relevant financial market benchmarks (e.g., a stock index, such as the S&P 500 Index in the United States or the Hang Seng Index in Hong Kong SAR) and relative to their peers

Asset class

Broad grouping of similar types of investments, such as shares, bonds, real estate, and commodities

Investment industry participants

Brokers and dealers, clearing houses, settlement agents and analysts

Proxy voting rules

Brokers are required to distribute voting materials to their customers, gather voting instructions and submit them for inclusion in the counting of votes

Brokers

Brokers find sellers for their clients who want to buy and buyers for their clients who want to sell (For complex trades, such as real estate transactions, for which effective negotiation is essential to successful investment, brokers often serve as professional negotiators)

The commissions compensate brokers for the resources they use to fill orders

Brokers must maintain order routing systems, market data systems, accounting systems, exchange memberships, office space, and personnel to manage the trading process

Brokered markets

Brokers organize markets for assets that are unique and thus of interest as potential investments to only a limited number of investors (Brokers who are organizing markets in unique assets try to know everyone who might now or in the future be willing to trade such assets)

Endowment funds are usually intended to exist in perpetuity and, as such, are regarded as very long-term investors

But they are also typically required to spend annually on the charitable or philanthropic purpose for their existence, so money needs to be drawn from their funds

Retail investors

Buy and sell relatively small amounts of securities and assets for their personal accounts (They also may invest indirectly by buying pooled investment products, such as mutual fund shares or insurance contracts)

Analysts

Buy side analysts are hired by institutional investors to review potential investors

Leveraged buyouts

Buyouts for which the financing of the transaction involves a high proportion of debt

Existing shareholders who do not want to exercise their rights will be "diluted"—that is, their proportional ownership will decrease because they will hold the same number of shares in a company that now has more shares outstanding

By selling their rights to others who will exercise them, they receive compensation for the decrease in their proportional ownership (Shareholders generally dislike rights offerings because they must provide additional capital to avoid dilution or sell their rights and experience dilution of ownership)

Expenses divided into different categories

COGS, SG&A, depreciation, interest expense and income tax expense

Net book value decreases each year

Calculated as the gross value of the asset minus accumulated depreciation

Net asset value (NAV)

Calculated by dividing the total net value of the fund (the value of all assets minus the value of all liabilities) by the fund's current total number of shares outstanding (Managers compute the fund's NAV each day following the normal close of exchange market trading)

Downside deviation

Calculated in almost exactly the same way as standard deviation, but instead of using all the deviations from the mean—positive and negative— downside deviation is calculated using only negative deviations (downside deviation may also be calculated by focussing on outcomes that are less than a specified return target; this target does not have to be the mean)

Immediate or cancel orders

Can be executed only on immediate receipt by the broker or trading venue

Good-until-cancelled orders

Can be executed until they are cancelled (Some brokers or trading venues may set a maximum number of days before the order is automatically cancelled)

Risk matrix

Can be used to prioritise risks and to select the appropriate risk response for each risk identified

To avoid the risk of recruiting the wrong people, companies typically take various precautions, such as the following:

Carrying out background checks, such as checking criminal records and disciplinary records with regulators for new hires, verifying credentials and previous work experience, performing personality assessment tests and getting character references to confirm suitability

Revenue is considered earned when a sales transaction is identified by certain conditions

Cash flow from the transaction usually occurs later (On the income statement, profits are measured on an accrual basis)

Cash flow rights

Cash flow rights are the rights of shareholders to distributions, such as dividends, made by the company

Cash flows from financing activities

Cash inflows resulting from raising new capital (an increase in borrowing and/or issuance of shares) and cash outflows for payment of dividends, repayment of debt, or repurchase of shares (also known as share buybacks

Margins

Cash or securities that are pledged as collateral

Cash flow statement

Cash received and spent during the period

Current assets

Cash, inventories and accounts receivable (assets converted to cash in 1 year)

Monetary policy

Central bank activities that are directed toward influencing the money supply

Managed floating rate

Central bank intervenes to stabilize its country's currency

Primary dealers

Central banks sell bonds to primary dealers to decrease the money supply → the primary dealers then sell the bonds to their clients

Effect of changes in general tastes and preferences on demand

Changes in consumers' general tastes and preferences may also affect a product's demand curve

Contingent claims

Claims are dependent on future conditions ( If the buyer decides to use (exercise) the option, the seller is obligated to satisfy the option buyer's claim) and if the buyer decides not to exercise the option, it expires without any action by the seller

Clearing houses and settlement agents

Clearing houses and settlement agents settle trades after they have been arranged

Front office

Client-facing activities that provide direct revenue generation

Banks

Collect deposits from savers and transform them into loans or borrowers

Financial institutions

Collect money from savers and to invest it in financial assets

Commodities

Commodities, such as precious and base metals, energy products, and agricultural products, tend to rise in price with inflation

Types of equity securities

Common stock, preferred stock, convertible bonds, warrants

Disposal

Companies have a responsibility to discard or destroy documentation after the retention period

Sweeteners

Companies may attach warrants to a bond issue or a preferred stock issue in an effort to make the bond or preferred stock more attractive (Allows the issuer to offer a lower coupon rate (interest rate) on a bond issue or a lower annual fixed dividend on a preferred stock issue)

Long-term investments are usually managed under the direction of the chief financial officer or the chief investment officer, if the company has one

Companies often invest long-term to finance future research, investments, and acquisitions of companies and products

Private placements

Companies sell securities directly to a small group of investors, usually with the assistance of an investment bank that helps identify potential investors and set the price of the securities (Investors in private placements are expected to have sufficient knowledge and experience to recognise the risks that they assume, so most countries require less disclosure for private placements than for public offerings)

Corporate policies

Companies set and enforce rules for their employees to ensure compliance with regulation and to guide employees with matters outside the scope of regulation

Shelf registration

Companies sometimes sell new issues of seasoned securities directly to the public over time via shelf registrations (In contrast to a seasoned offering in which all the shares are sold in a single transaction, a shelf registration allows the company to sell the shares directly to investors over a longer period of time)

SEC

Companies that go public have to comply with certain rules and regulations

Access

Companies usually have a centralised repository that is often electronic: a read-only drive, document database, or documentation management system capable of storing internal and external documents relevant to the company's business activities

Balance sheet

Company's financial position at a specific point in time, such as the end of the fiscal year or the end of the quarter (assets, liabilities and shareholders equity)

The typical KYC process requires the client to

Complete a questionnaire and provide personal background information, including documentary proof of identity (for instance a passport), addresses, and other personal details, be screened against various global databases to ascertain whether he or she is known or wanted by local or international law enforcement agencies, submit to anti-money-laundering checks at on-boarding and thereafter to identify any potential suspicious transactions that the company would be obligated to report to a regulator and provide proof of the source of funds to verify that the money does not originate from an illegal or criminal source

Comparing simple interest and compound interest

Compound interest is extremely powerful for savers; reinvesting the interest earned on investments is a way of growing savings

Investment industry

Comprises all the participants that are instrumental in helping savers invest their money and helping spenders raise capital in financial markets

Clearing houses and settlement agents

Confirm and sell trades after they have been agreed upon

Analysis

Consider all different regulatory approaches to achieve a desired outcome

Accounting profit

Considers only the explicit costs

Settlement

Consists of the final exchange of cash for securities

Sales practice rules

Consumers seeking financial advice find it difficult to assess the quality of the advice they are receiving

Derivatives

Contracts that derive their value from the performance of an underlying asset, event, or outcome

Communicates

Conveys ideas, concepts, or information

Economies of scale

Cost savings arising from a significant increase in output without a comparable rise in fixed costs

Selling general and administrative (SG&A)

Costs not associated with operations

Fixed costs

Costs that do not fluctuate with the level of output

Variable costs

Costs that fluctuate with the level of output by the company

Speculator

Counter party that is not hedging risk but is instead taking on risk in anticipation of earning a return

Counterparty risk

Counterparty risk is potentially very high in forward contracts but the presence of an exchange or a clearing house as the intermediary for all buyers and all sellers helps reduce counterparty risk for futures

Property insurers

Cover assets such as homes, cars and businesses

Money laundering

Criminals using companies in the financial services industry to transfer money from illegal operations into other legal activities

Liabilities (short term)

Current liabilities must be repaid in the next year and include operating debt such as accounts payable

Current ratio

Current ratio = current assets / current liabilities (Measures the current assets available to cover one unit of current liabilities)

Valuation of fixed rate and zero coupon bonds

Current value of the bond = (The bonds cash flows + par value)/(1 + discount rate)^(number of periods until maturity)

Business continuity planning rules

Customer records need to be backed up and companies have plans to recover in the event of a natural disaster

Conservative accounting

Dampen reported earnings

Dark pools

Dark pools do not display orders from clients to other market participants (Large institutional investors may transact in dark pools because market prices often move to their disadvantage when other traders know about their large orders)

Quote driven markets

Dealer markets or price-driven markets are markets in which investors trade with dealers (These markets take their name from the fact that investors trade with dealers at the prices quoted by the dealers)

Depending on the trading venue, these quotation sizes may or may not be exposed to other traders or dealers in that market

Dealers are said to quote a market when they expose their bids and offers (The highest bid in the market is the best bid and the lowest ask in the market is the best ask)

Notes

Debt securities with maturities from 1 to 10 years

Bonds

Debt securities with maturities longer than 10 years

Bills

Debt securities with maturities of one year or less

Debt to equity ratio

Debt-to-equity ratio = debt / equity

Technology

Decreased trade processing costs and increased trade processing capacity

Internal risk limits

Defining limits and then controlling and monitoring those limits allows firms to implement risk response strategies

Inferior goods

Demand for inferior goods decreases when income increases

Unrelated products

Demand is affected by prices of other products that are not substitute or complementary

Shares, units, or partnership interests

Depending on the form of the organization, ownership shares

Underlying

Derivatives can be created on any asset, event, or outcome, which is called the underlying

Swaps

Derivatives in which two parties exchange (swap) cash flows or other financial instruments over multiple periods (months or years) for mutual benefit, usually to manage risk

Performance attribution

Determining how much of performance is the result of the selection of asset classes, sectors, individual securities, and currencies

Spread

Difference between the bid and the offer

Real estate

Direct or indirect investments in land and buildings

Distressed

Distressed investing focuses on purchasing the debt of troubled companies that may have defaulted or are on the brink of defaulting (If the company can survive and prosper, the value of its debt will increase and the investor will realize significant value)

People invest in financial products and instruments because they expect to get future benefits in the form of future cash flows

Dividends and interest

Expect two types of cash flows

Dividends, proceeds from selling their shares

No-load funds

Do not charge deposit or redemption fees, set the same price for deposits and redemptions on any given day

Adverse opinion

Do not comply with the accounting standards

Fee-only professionals

Do not have incentives to generate commissions by recommending specific products or excessive trades

Trading

Documentation is important in trading—to provide a record of which assets were ordered and traded, in what quantity and at what price

Direction

Documents "flow" in different directions (Typically, documents associated with policies and procedures "flow down" through a company) ( In contrast, documents associated with reporting usually "flow up")

Calculate the geometric mean

Does consider compounding and is usually the preferred approach

Calculate the arithmetic mean by adding the two six-month returns

Does not consider compounding

If necessary, the underwriter provides price support for a limited period of time, typically about a month

During that time, if the price of the securities falls below a certain threshold, the underwriter will buy securities to stop or limit the price fall

EBITDA

EBITDA = EBIT (or operating income) + Depreciation and Amortisation

Earnings before taxes

Earnings before taxes = EBIT (or operating income) - Interest expense

Allocationally efficient economies

Economies that put resources to use where they are most valuable

Documentation in the context of the investment industry does the following:

Educates, communicates, authorizes, formalizes and organizes

Currency swap

Enables borrowers to exchange debt service obligations denominated in one currency for equivalent debt service obligations denominated in another currency

Organizes

Ensures thoroughness and consistency of action, allowing the company to function more efficiently and effectively

Compliance risk

Ensuring compliance with rules and regulations has often been viewed as a rather mundane chore, but the rapidly changing regulatory environment has recently brought compliance to the forefront of business priorities

Equity book value per share

Equity book value per share = equity reported on the balance sheet / number of shares outstanding

Total shareholders' equity

Equity reflects the residual value of the company's shares

Warrants

Equity-like security that entitles the holder to buy a pre-specified amount of common stock of the issuing company at a pre-specified per share price (called the exercise price or strike price) prior to a pre-specified expiration date

Formalises

Establishes roles, deliverables, and obligations

Discounted cash flow

Estimates the value of a security as the present value of all future cash flows that the investor expects to receive from the security

Asset-based valuation

Estimates the value of common stock by calculating the difference between the value of a company's total assets and its outstanding liabilities

Framework for legal and regulatory compliance

Every company has to follow a set of rules, beginning with the statutory laws and other regulations imposed by regulatory bodies and many investment firms must follow guidelines from regulators, stock exchanges, and industry associations that have been given powers to oversee members

Misappropriation

Excessive claims on expense reports and using company assets for personal purposes

International trade

Exchange of products, services and capital between countries

To respond to regulatory requirements, all trading venues offer post-trade transparency, although the speed at which it happens varies among trading venues

Exchanges are pre-trade transparent, but many alternative trading venues are not (Many investors value transparency because it allows them to better manage their trading, understand market prices, and estimate their transaction costs but dealers often prefer to trade in opaque markets because, as frequent traders, they have an informational advantage over those who trade less frequently)

Phases of the economic cycle

Expansion, peak, contraction, trough, recovery

Rules based

Explicit regulations that offer clarity and legal certainty to investment industry participants

Explicit trading costs

Explicit trading costs represent the direct costs associated with trading (Brokerage commissions are the largest explicit trading cost)

CAPM

Factor models, such as the CAPM, separate a fund's performance into return from market performance (beta), from luck or randomness, or from the investment skills of the fund manager (alpha)

Real assets

Factors of production like land, buildings, machinery, cattle and gold

Support economic stability

Failure of the entire financial system, including loss of access to credit and collapse of financial markets

Front-end sales loads

Fees that investors may have to pay when they buy shares in a fund

Back-end sales loads

Fees that investors may have to pay when they sell shares in a fund that they have not held for more than some pre-specified period, typically a year or more

Management fees

Fees that limited partners must pay general partners to compensate them for managing the private equity investments

Two trends that have promoted international trade

Fewer trade barriers, international trade barriers have reduced and better transportation and communications

Securities

Financial assets that can be traded

Non-current assets

Financial assets, such as shares or bonds issued by another company, tangible assets, such as land, buildings, machinery, and equipment, and intangible assets, such as patents (Tangible assets are often grouped together on the balance sheet as property, plant, and equipment)

Co-operative and mutual banks

Financial institutions that their members own and sometimes run (Provide mortgages and commerical bank services but depositors earn a return without having to locate borrowers)

Investment banks

Financial intermediaries that have expertise in assisting companies and governments raise capital

Equity multiplier ratio

Financial leverage = equity multiplier / total assets equity (The amount of total assets supported by one monetary unit of equity)

Financial market integrity

Financial markets that are ethical and transparent and provide investor protection

Institutional and individual investor services

Financial planning, investment management, investment information, trading and custodial

10k

Financial statements, MD&A, results of operations, quantitative and quantitative disclosures about the risks the company faces

Private equity

Firms invest in private companies that are not publicly traded on the stock exchange

Buy side firms

Firms that manage portfolios for clients and/or themselves

There are at least two reasons why investors care about historical variability (the standard deviation of past returns)

First, past variability of returns might be indicative of how variable returns may be in the future and second, the variability of returns may affect an investor's objectives

Keynesian

Fiscal policy can have a powerful effect on aggregate demand, output and employment

Monetarists

Fiscal policy only has temporary effects

Capital gains and losses

Fluctuations in the prices and values of investments reflect the risk of investing

Growth equity

Focuses on financing companies with proven business models, good customer bases, and positive cash flows or profits (By providing additional money in return for equity of the company, growth equity investors help these companies expand and become more established)

Depreciation

For a capitalised, long-term asset, the company allocates the cost of that asset over the asset's estimated useful life

Fundamental analysis

For equity investors, this process means conducting a thorough analysis of a company's business model, its prospects, and its financial situation

These complementary techniques include scenario analysis and stress testing, which focus on the effect of more extreme situations that would not be fully captured or evaluated with VaR

For example, an asset management firm may perform a scenario analysis by identifying different scenarios for the economy (strong growth, moderate growth, slow growth, no growth, mild recession, and severe recession) and then determining how each scenario would affect the value of a portfolio and the firm's earnings and equity capital

After receiving the money, the company initiates the investment transaction and sends a formal confirmation to the client

For example, the documentation associated with the investment transaction could be a share certificate or confirmation of an investment in a mutual fund (Service providers may provide transaction, safekeeping, or administrative services to the client or the company, and external documentation would also be used to record activities related to these activities)

Likewise, the pension plans, foundations, and other institutional investors want to monitor the performance of their investments to ensure that the assets will be sufficient to meet their needs

For retail investors, the performance of their investments may determine whether they will enjoy a comfortable retirement, whether they will have enough money to send their children to university, or whether they can afford their dream holiday

Passive management of equity portfolios is a well-established discipline and replicating an equity market index is quite straightforward

For some markets, such as real estate, in which all properties are unique and trading is done in private transactions rather than on a public stock exchange, it is less clear how a passive approach can be used

Settlement risk

Form of counterparty risk in which one of the parties fails to honour their obligation between the time a trade is negotiated and the time the trade is settled (The shorter the settlement period, the fewer extreme price changes can occur before final settlement)

Adoption

Formally adopted by regulator

Bilateral contracts

Forward and futures contracts are sometimes termed forward commitments or bilateral contracts because both parties have a commitment in the future

Timing of cash flows

Forward contracts have no cash flows except at maturity while futures contracts are marked to market daily

Settlement

Forward contracts may settle with physical delivery or cash settlement and futures contracts are typically settled with cash

Liquidity

Forward contracts trade in the over-the-counter market and are illiquid but futures contracts are relatively liquid; they trade on exchanges and can be bought and sold at times other than initiation

Trading and flexibility of terms

Forward contracts transact in the over-the-counter market and terms are customized according to the contracting parties' needs where futures contracts trade on exchanges

Four types of derivatives contracts

Forwards, futures, options, swaps

Complements

Frequently consumed together

Employees/managers

Front-line employees and managers, through their daily responsibilities, form the first line of defence

Alpha

Fund manager skill

Benchmarks

Fund managers may not only use a benchmark for assessment, but some, such as index fund managers, may also manage their portfolios to a benchmark

Calculating a funds holding period is complex

Funds may consist of hundreds of individual investments that pay income at different times throughout the holding period and clients may make additional investments (cash inflows) in and withdrawals (cash outflows) from a fund throughout the holding period

Futures contracts trade on exchanges

Futures contracts are standardized regardless of buyers' and sellers' specific needs

Expenditure approach

G + C + I + (X - I)

GDP per capita

GDP / population

In 1999, a set of voluntary investment performance standards—the Global Investment Performance Standards (GIPS)—was proposed for this purpose

GIPS requires the use of the time-weighted rates of return method because this measure is not distorted by cash inflows and outflows

Law of diminishing returns

Gain in output will increase at a decreasing rate even if the fixed inputs of production remain unchanged

GAAP

Generally Accepted Accounting Principles

Internal documents

Generally administrative and formulate policies, procedures, and processes (They help reduce risk by preventing errors and unethical behaviour)

Companies can mitigate operational risks through education, by clearly communicating policies and procedures and by having efficient and effective internal controls

Good human resource management processes are also critical; hiring the right people and motivating them with the right incentives are well-known ingredients for success

Gatekeeping rules

Govern who is allowed to operate as an investment professional as well as if and how products can be marketed

Bond

Governed by a legal contract between the bond issuer and the bondholders

Parties that can be involved in external documents include the following:

Governments, legislators, and regulators, groups that help organise the market, such as stock exchanges, clearing houses, and depositories, market participants active in facilitating investments or transactions, such as banks, brokers, and asset managers, professional firms and individuals serving the needs of the industry, including credit rating agencies, auditors, lawyers, consultants, and trustees and investors, including retail clients and institutional investors

Sovereign wealth funds

Govts accumulate surpluses by collecting taxes in excess of current spending (Invest a government surpluses)

Foundations

Grant making institutions funded by financial gifts and by the investment income that they produce

Foundations

Grant-making institutions funded by gifts and by the investment income that they produce (They fund organisations that provide services in areas such as the arts or charities)

Gross profit

Gross profit = Revenues - cost of sales

Cartel

Group joins to control supply and pricing of products from the group

Economic growth

Growth in labor force, productivity gains and growth in availability of capital

Closed-end funds

Have a fixed number of shares; they do not issue or redeem shares on demand (They may issue additional shares in secondary offerings or through rights offerings or they may repurchase shares, but these events are uncommon)

Operationally efficient markets

Have low transaction costs and they can absorb large orders without substantial price impacts

Insurance companies

Help individuals and companies offset the risks they face, protect them from potential loss by providing payments in the event that losses occur

Block brokers

Help investors who want to trade large blocks of securities (Large block trades are hard to arrange because finding a counter party willing to buy or sell a large number of securities is often quite difficult)

Financial planners

Help their clients understand their current and future financial needs, the risks they face when investing, their ability to tolerate investment risks, and their preferences for capital preservation versus capital growth

Enterprise risk management

Helps a company manage all its risks together in an integrated way rather than managing each risk separately (The advantage of this approach is that it aligns risk management with objectives at all levels of the company, from the corporate level to the business unit level to the project level)

Financial system

Helps link savers who have money to invest and spenders who need money

High net worth individual

Higher amounts of investable assets

Preferred stock

Higher claim on the company's assets compared with common shareholders if the company ceases operations

VaR primarily relies on historical data to forecast future expected losses

History is not helpful in forecasting events that have far-reaching effects, but are unforeseen or considered impossible—that is, black swan events

Pension plan

Hold and manage investment assets for the benefit of the future and already retired people, called beneficiaries

Pension plans

Hold investment portfolios—pension funds—for the benefit of future and current retired members, who are called beneficiaries

Custodians and depositories

Hold money and securities on behalf of clients

Investors can reduce specific risk

Holding a number of different securities in their portfolios

Hotels

Hotels include branded short-term stay facilities and longer-stay facilities catering to contract workers in remote locations, as well as boutique and independent facilities

Current account

How much the country consumes and invests compared with how much it receives

Tracking error

How the performance of the investment fund deviates from the performance of its benchmark

Elasticity

How the quantity demanded or supplied changes in response to small changes in a related factor, such as price, income, or the price of a substitute or complementary product

Managing people

Human failures range from unintentional errors to fraudulent activities

Income statement

Identifies the profit or loss generated by the company during the period covered by the financial statements

Enforcement

Identify and punish lawbreakers

The clearing members guarantee settlement of the trades that their clearing clients present to them, and clearing houses guarantee settlement of all trades presented to them by their clearing members

If a clearing member fails to settle a trade, the clearing house settles the trade using its own capital or capital pledged by the other members of the clearing house

Bankruptcy

If a company files for bankruptcy or undergoes a reorganisation, the client may be affected, depending on the nature of the underlying transaction or investment

Merger and acquisition activity

If a company merges with, spins off from, or acquires another company, its business and operations may change, affecting the client's investment

Goodwill

If a company purchased another company, but paid more than the fair value of the net assets of the company it purchased (The additional value reflected in goodwill is created by other items not listed on the balance sheet)

Inelastic

If a product has no immediate substitutes

Elastic

If a product is easy to substitute because similar products exist, then own price elasticity will be large and negative

Normal goods

If income increases, demand increases too

Time horizon

If investors have a long time horizon, they have more scope to adjust their circumstances to cope with losses by saving more or waiting for markets to recover, although recovery and its timing cannot be guaranteed

Assets

If investors have far more assets than liabilities, any losses that result from risk taking may not alter their lifestyle

Effect of the expected future price of a product on demand

If people expect that price will rise → demand will increase

An informationally efficient market is one in which the prices of investments reflect available information about the fundamental values and return prospects of the assets they represent

If stock markets are believed to be informationally efficient, the investor will believe there is little point to actively managing stock market investments because share prices already reflect the potential of the underlying companies

Default

If the bond issuer fails to make the promised payments

In a defined benefit plan, the employer bears the risk—in this case, that the investments made by the pension fund fail to perform as expected

If the investments fail to perform as expected, the employer may be required to make additional contributions to the fund

An investor may set the strategic asset allocation and simply hold a portfolio for the life of the investment

If the investor does so, the proportions of the portfolio will likely depart from the original weights chosen as the different asset classes provide different rates of return over time and their values thus increase or decrease by different amounts

At the money (put)

If the market price and exercise price are the same. In this case

In the money (call)

If the market price is greater than the exercise price

Out of the money (put)

If the market price is greater than the exercise price

In the money (put)

If the market price is less than the exercise price

Out of the money (call)

If the market price is less than the exercise price

Pre-trade transparent

If the trading venue publishes real-time data about quotes and orders

Post-trade transparent

If the trading venue publishes trade prices and sizes soon after trades occur

Undersubscribed

If there are not enough buyers for all the securities that are for sale

Oversubscribed

If there is more demand than securities for sale

Implementation

Implemented by regulator and complied with by those who are affected by them

Implicit trading costs

Implicit trading costs are the indirect costs associated with trading

Key risk measures

Important for the risk management function to be proactive and predictive, key risk measures should provide a warning when risk levels are rising, they require the collection and compilation of data from various internal and external sources and the types of key risk measures vary among industries and companies, and they need to be reviewed regularly to ensure that the measures are still relevant and sensitive to risk events

Reinvestment risk

In a period of falling interest rates, the coupon payments received during the life of a bond and/or the principal payment received from a bond that is called early must be reinvested at a lower interest rate than the bond's original coupon rate

Rights offerings

In a rights offering, a company allows existing shareholders to buy shares at a fixed price (called the exercise price) in proportion to their holdings (The rights that existing shareholders receive are often known as pre-emptive rights because existing shareholders have the right of first refusal on any new equity offerings)

As mentioned earlier, a clear separation needs to exist between front and back offices

In accounting departments, there should also be a clear separation between those who enter items into the accounts and those who reconcile the bank statements with the cash balances in the accounting system

Many leading investment banks, such as Barclays Capital and Goldman Sachs, produce bond indices for different types of issuers located in developed or emerging countries

In addition to aggregate bond indices that are designed to cover the market as a whole, many index providers offer bond indices classified by maturity, credit rating, currency, and industrial category

Order driven markets

In contrast to most bonds, currencies, and spot commodities that trade in quote-driven markets, many shares, futures contracts, and most standard options contracts trade on exchanges and alternative trading venues that use order-driven trading systems (Arrange trades using rules to match buy orders with sell orders)

Public market investments

In contrast to real estate limited partnerships and real estate equity funds that are private investments, real estate investment trusts (REITs) are investments through public markets

Investors choose when to buy or sell their direct investments to minimise their tax liabilities

In contrast, although the managers of indirect investments often try to minimize the collective tax liabilities of their investors, they cannot simultaneously best serve all investors when those investors have diverse tax circumstances

Trading venues that are call markets have the potential to be very liquid when they are called, but they are completely illiquid between calls

In contrast, traders can arrange and execute their trades at any time in continuous trading markets

In defined contribution plans, the member (or employee) bears the risk that the pension account's investments fail to perform as expected

In defined contribution plans, the employer has no obligation to make additional contributions if the investments perform poorly

Deposit taking institutions

In exchange for using the depositors' money, banks offer transaction services, such as check writing and check cashing and may pay interest on a deposit

One role of the board of directors is to ensure that the company works within the law and, in doing so, protects and represents the interests of all stakeholders

In general, regulation concentrates on outward-facing documentation, such as product disclosures and other client-focused material Many companies look externally to identify standards that should be followed

Other segments

In many developed markets, senior housing designed for people aged 55+ and student housing for post-secondary education have both received considerable investments

Leveraged positions

In many markets, investors can buy securities on margin—that is, by borrowing some of the purchase price

Money market funds are vulnerable to a run on assets

In particular, if investors expect the value of their money market funds will decline in the near future, they may rush to redeem their shares before the NAV falls

Bid prices

In quote-driven markets, the prices at which dealers are willing to buy from investors or other dealers

Factors that affect option premiums

In summary, an option's premium depends on the current spot price of the underlying, exercise price, time to expiration, and volatility of the underlying

Seniority ranking

In the event that the company is liquidated, assets are distributed following a priority of claims

Private market investments

In the private market, the primary way of investing in real estate is through real estate limited partnerships and real estate equity funds

Investment companies

Include mutual funds, hedge funds, and private equity funds (These companies exist solely to hold investments on behalf of their shareholders, partners, or unitholders)

Alternatively, an investor may distinguish

Income and capital gains, seeking income for current spending and capital gains for long-term needs

Dividends and interest

Income may also differ from what was expected

Three statements

Income statement, cash flow statement and the balance sheet

Commercial real estate

Income-generating real estate

Improve society

Increasing availability of credit financing to a specific group, encouraging home ownership or increasing national savings rates

Fundamental/intrinsic value

Indicates the price that investors would pay for the investment if they had a complete understanding of the investment's characteristics

Asset allocation

Indicates the proportion of a portfolio that should be invested in various asset classes to help meet financial goals (Cash, equity and debt securities, and alternative investments)

Less regulated and less transparent than traditional investments

Individual investors are less likely to invest in them

Savers

Individuals (households), companies, and governments that have money to invest

Inflation

Inflation is a general rise in prices for products and services

Inflation linked bonds

Inflation-linked bonds contain a provision that adjusts the bond's par value for inflation and thus protects the investor from inflation (The par value—not the coupon rate—of the bond is adjusted at each payment date to reflect changes in inflation (which is usually measured via a consumer price index))

Ensure fairness

Information asymmetries can deter investors from investing

Information technology

Information technology (IT) has greatly enhanced our ability to collect, collate, manage, and distribute documents

Educates

Informs or provides instruction

Institutional investors

Institutional investors are organisations that hold and manage portfolios of assets for themselves or others

Orders

Instructions that investors who want to trade give trading service providers, such as brokers and dealers

Market order

Instructs the broker or trading venue to obtain the best price immediately available when filling the order

Insurance companies

Insurance companies collect premiums from the individuals and companies they insure

Regulators often set requirements to restrict the types of investments insurance companies can hold

Insurance companies profit from income that they can earn on the float, which is the amount of money they have available to use after receiving premiums and before paying claims

Compound interest

Interest is assumed to be reinvested so future interest is earned on principal and reinvested interest, not just on the original principal

Internal audit

Internal auditors follow risk-based internal audit programmes, delving into the details of business processes and ensuring that information technology and accounting systems accurately reflect transactions

IASB

International Accounting Standards Board

IFRS

International Financial Reporting Standards

Sovereign wealth funds

Invest these surpluses for the benefit of current and future generations of their citizens

To help clients meet their objectives, a benchmark should meet certain criteria:

Investability, compatibility, clarity and pre-specification

Willingness to take risk

Investing experiences, attitude toward risk and investment knowledge

Pension funds invest to generate the returns necessary to pay their beneficiaries, insurance companies invest to generate returns to meet the claims on their policies, and individuals invest because they usually have a future expenditure in mind

Investing in a portfolio or fund whose returns vary significantly over time could potentially disrupt investors' plans

Investment analysis

Investment analysis involves estimating the fundamental value of potential investments and identifying attractive securities and assets

Companies generally contract with investment banks to help them sell their securities to the public

Investment banks play an important role in identifying potential investors and setting the offering price—that is, the price at which the securities are sold

Financial companies

Investment companies, banks and other lenders, and insurance companies

Institutional investors that invest to provide financial services to their clients

Investment companies, banks, and insurance companies

Endowment funds and foundations typically have a charitable or philanthropic purpose and receive gifts from donors interested in supporting their activities

Investment income and capital gains that these organisations receive from investing these funds may also be tax-exempt

Soft money agreement

Investment managers use arrangements in which broker commissions are used to pay for external research

Churning

Investment managers who receive commissions on trades that they recommend may execute too many trades

Standard deviation

Investment risk is often measured using some measure of variability (or volatility) of returns, and a common measure of variability is the standard deviation

Financial account

Investments domestic entities make in foreign entities and the investments foreign entities make in domestic entities

Commodities

Investments in physical products, such as precious and base metals (e.g., gold, copper), energy products (e.g., oil), and agricultural products that are typically consumed (e.g., corn, cattle, wheat) or used in the manufacture of goods (e.g., lumber, cotton, sugar)

Private equity

Investments in private companies—that is, companies that are not listed on a stock exchange

Separately managed accounts

Investor assets may still be invested in funds, but some high-net-worth investors will prefer their own segregated accounts

Reward to risk ratios

Investors are interested in maximising the return on their investments while simultaneously trying to minimise the risks

Buy commodity derivatives

Investors can buy derivatives in which the underlying asset is a commodity or a commodity index

Buy shares of natural resources or commodity-related companies

Investors can buy shares of companies that have a major portion of their operations in the exploration, recovery, production, and processing of commodities

Credit spreads

Investors commonly refer to the difference between a risky bond's yield to maturity and the yield to maturity on a government bond with the same maturity as the risky bond's credit spread

Management accountability

Investors in indirect investment vehicles cannot choose who will manage their investments

Pooled investment vehicles

Investors in these companies pool their money for common management

Globalization

Investors look outside their domestic markets to diversify their investments and generate higher returns

Investment research providers

Investors may also purchase reports directly from independent research firms, or they may obtain reports from research firms that issuers pay to produce reports about their securities

Credit rating

Investors may be able to assess the credit risk of a bond by reviewing its credit rating

Some funds also charge purchase or redemption fees

Investors pay these fees to the fund as opposed to paying them to the distributor as in a front-end or back-end sales load (Purchase and redemption fees help compensate existing shareholders for costs imposed on the fund when other shareholders buy and sell their shares)

Pooled investments

Investors pool their money together to gain the advantages of being part of a large group

Investors can choose not to invest directly in certain securities

Investors who are wealthy can often obtain high-quality investment advice at a lower cost when investing directly rather than indirectly

Limited partners

Investors who contribute capital to the partnership

How to invest in real estate?

Investors who have sufficient funds can buy real estate directly or gain exposure to real estate through either the private or public market

Investors exercise more control over direct investments than over indirect investments

Investors who hold indirect investments generally must accept all decisions made by the investment managers, and they can rarely provide input into those decisions

Investors are more concerned about the accountability of managers of actively managed open-end mutual funds and ETFs

Investors will withdraw their money from these funds if they are unhappy with the management, thus reducing the manager's assets under management and the fee paid to the manager

Investors may also have specific needs in relation to liquidity, tax considerations, regulatory requirement, consistency with particular religious or ethical standards, or other unique circumstances

Investors' circumstances and needs change over time, so it is important to re-evaluate their needs at least annually

The investment manager or adviser has to be comfortable that the investor's desired rate of return is achievable within the related constraints

Investors, particularly individual investors, will usually adjust the proportion they invest in different kinds of assets over time as they age and their circumstances change.

Hyperinflation

Involved price increases so large and rapid that consumers find it hard to afford many products and services

Fiscal policy

Involved the use of govt spending and tax policies

Secondaries

Involves buying or selling existing private equity investments that are organized in funds managed by partnerships

Rebalancing

Involves selling some of the holdings that have increased as a proportion of the portfolio and investing the proceeds into the holdings that have decreased as a proportion of the portfolio

Annuity

Involves the initial payment of an amount, usually to an insurance company, in exchange for a fixed number of future payments of a certain amount

Risk

It can be defined as the effect of uncertain future events on a company or on the outcomes the company achieves (Events that have or could have a negative effect, leading to losses or negative rates of return, tend to be emphasised in discussions of risk)

With many profit-motivated investors digesting corporate information

It is a challenge to interpret the information faster and better than the aggregate market view

VaR offers several advantages:

It is a standard metric that can be applied across different investments, portfolios, business units, companies, and markets

General partnership

It is responsible for raising capital, finding suitable investments, and making decisions (General partners have unlimited personal liability for all the debts of the partnership)

Note that the issuer only receives additional capital when it issues new securities in the primary market

It will not receive any new capital from the trading of its securities in the secondary market

Covenants

Legal agreements that describe actions the issuer must perform or is prohibited from performing

Non-investment grade

Less creditworthy and have a greater probability of default

Ad hoc documents

Letters, memos, and e-mails, are typically informal (The free-form nature of ad hoc documents means that they carry additional risk for the company, particularly if the records are subpoenaed in a legal dispute; consequently, companies may implement policies and procedures to impose a process of peer review for ad hoc communication--peer review should be documented and auditable)

Obstacles

Licenses, brand loyalty or control of natural resources

Casualty insurers

Life insurers that pay out a sum of money upon death or serious injury of the person insured

Ability to risk

Liquidity, assets and time horizon

Debt

Loans with interest payments

Endowment fund

Long term funds not for profit institutions

Endowment funds

Long-term funds of non-profit institutions, such as universities, colleges, schools, museums, theatres, opera companies, hospitals, and clinics (These organisations use their endowment funds to provide some services to their students, patrons, and patients)

Strategic asset allocation

Long-term mix of assets that is expected to meet the investor's objectives

Devaluation

Make a country's central bank decrease the value of the domestic currency relative to other countries, an action that many governments are reluctant to take

Dealers

Make it possible for their clients to trade without having to wait to find a counter party (Dealers thus participate in their clients' trades, in contrast to brokers who do not trade with their clients but only arrange trades on behalf of their clients)

Life insurance companies

Make payments to the policyholder's beneficiaries in the event the policyholder dies while the insurance coverage is in force (Life insurers have longer- term time horizons and more predictable payouts and, therefore, have more latitude to invest in riskier assets)

Companies must also make sure that all employees receive adequate training regarding existing procedures and processes, and that they are kept informed when changes are made

Making changes is never easy, so it is advisable to make processes modular—that is, they should be made up of separate elements that can be reviewed and replaced independently of each other

Passive managers

Manage a portfolio designed to match the performance of a specified benchmark

Select a risk response

Management must select an appropriate response and develop actions to align the company's risk profile with its risk tolerance

Technical and behavioral analysis

Managers using technical analysis study market information, including price patterns and trading volumes, whereas managers using behavioural analysis focus on indicators of market sentiment, such as manufacturers' new orders or indices of consumer expectations

Competition

Manifests through innovative investment product and service offerings, pricing and performance

Industrial properties

Manufacturing facilities, research and development space, and warehouse/distribution space

Monopolistic competition

Many buyers and sellers who are able to differentiate products

Strategic investments

Many companies invest directly in the shares and bonds of their suppliers and in the shares of potential merger partners to strengthen their relationships with them

Data vendors

Many data vendors provide such data, including historical data and real-time data

Life

Many equity securities are issued with an infinite life

The investment industry provides mostly standardised services to retail investors because they generate the least revenue per investor for investment firms

Many retail investment services are delivered over the internet or through customer service representatives working at call centres

Oligopoly

Market dominated by a small number of large companies

Systematic risk

Market or non-diversifiable risk

Disclosure rules

Market participants require information, including information about companies and governments raising funds, information about the specific financial instruments being sold and traded, and information about the markets for those instruments

Market risk

Market risk, which arises from price movements in financial markets, can be classified into the risks associated with the underlying market instruments: equity price risk, interest rate risk (for debt securities), foreign exchange rate risk, and commodity price risk

They often implement an approach called risk budgeting to determine how risk should be allocated among different business units, portfolios, or individuals

Market risks that cannot be tolerated must be mitigated, and companies have different alternatives available (One of them is to hedge unwanted risks by using derivative instruments)

Typical client interaction cycle

Marketing, client on-boarding, funding, ongoing reporting, investment events and redemption

Although directors and senior managers are in charge of setting the appropriate level of risk to support the corporate strategy, risk management should involve all employees

Markets are increasingly interdependent, and media and the internet can spread the news of a mistake or scandal across the globe in a matter of minutes

Primary markets

Markets in which companies and governments sell their securities to investors

MR = MC

Maximises profit

Operations rules

May dictate some aspects of how a company operates

Anti-money-laundering rules

May require companies to confirm and record the identity of their clients, report payments (such as dividends) to tax authorities and report other activities like large transactions

The performance evaluation process includes four discrete but related components:

Measure absolute returns, adjust returns for risk, measure relative returns and attribute performance

Reward to risk ratio

Measure of portfolio return / measure of portfolio risk (The higher the value of the reward-to-risk ratio, the better the risk-adjusted return— that is, the higher the return per unit of risk)

Utility

Measure of relative satisfaction

Economic indicators

Measures that offer insight regarding economic activity and are reported with greater frequency than GDP

Producer price index

Measures the average selling price of products in the economy

By measuring relative returns investors can determine whether they could have made more money in other investments

Measuring relative returns allows them to assess their opportunity cost and determine whether their investments are generating appropriate returns

Liabilities (long term)

Money borrowed from banks or other lenders that is to be repaid over periods greater than one year

Accounts receivable

Money owed to the company by customers who purchase on credit, sometimes called debtors

Debt

Money that has been borrowed and must be repaid at some future date

Monitoring

Monitor companies and individuals to assess whether they are complying with regulation

Income elasticity of demand

Most products have positive income elasticities As a person's income increases → they buy more of a product

Transfer agent

Most transfer agents are banks or trust companies, but sometimes companies keep their own records and act as their own transfer agents

Mutual funds pool the assets of many investors into a single investment vehicle, which is professionally managed and benefits from economies of scale

Mutual funds are typically categorised by their investment(s)

Sources of comparative advantage

Natural, human and capital

Dispute resolution

Need for a fast, fair and efficient dispute resolution system to improve market's reputation for integrity

Value at Risk (VaR)

Need to estimate the potential loss on an investment if their forecasts for the asset or security turn out to be inaccurate

Return on Equity (ROE)

Net income / equity (How much return, as measured by net income, is available to a monetary unit of equity)**************(net income / equity) = (net income / revenues) x (revenues / total assets) x (total assets / equity)

Net income

Net income = EBIT (or operating income) - Interest expense - Tax expense = Earnings before taxes - Tax expense

Net profit margin

Net profit margin = net income / revenues

Monopoly

No competition

Fixed rate

No fluctuations of currencies

Assess and prioritise risks

No matter what form risk takes, two elements of it are typically considered, in particular for undesirable events: the expected frequency of the event and the expected severity of its consequences

Real GDP

Nominal GDP adjusted for changes in price levels

Open-end mutual funds

Not exchange traded

Retention

Not only for business reasons but also often for legal or regulatory reasons, that all documents are retained until the risk associated with the action described in the document no longer exists

Endowment funds

Not-for-profit institutions with long term investment objectives

Size and price

Note that the price specified in the contract is not the current or spot price for the underlying but a price that is good for future delivery

A common format for an IPS is to split it into sections covering objectives and constraints

Objectives and constraints

Fixed rate bonds

Offers a coupon rate that does not change over the life of the bond

Financial services industry

Offers a range of products and services to savers and spenders and helps channel funds between them

The consequences of not doing so can be severe and can include financial penalties, loss of business licenses, lawsuits by clients, and in serious cases, prison terms

Often the greatest consequences are the damage to the company's reputation and the loss of existing and potential business opportunities

Many endowment funds and foundations establish spending rules; for example, they may set spending goals of a percentage range of their assets

Often, their challenge lies in balancing long-term growth with shorter-term income or cash flow requirements

Limit orders do not execute if the limit price on a buy order is too low or if the limit price on a sell order is too high

On average, limit orders trade at better prices than market orders when they trade, but they often do not trade

Funding

Once the client on-boarding process is complete and the relationship has been initiated and approved by the compliance department, the next stage is the cash transfer and the investment of the money

Investments in private equity partnerships tend to be illiquid

Once the limited partners have committed capital to the partnership, it is difficult, if not impossible, for them to exit the investment before the end of the commitment term

Basis points

One hundred basis points = 1%

Credit default swaps (CDS)

One party buys a CDS to protect itself against a loss of value in a debt security or index of debt securities (The premium compensates the seller for the risk of the contract)

Security

Only authorised staff should be able to access restricted documents, such as compensation data or confidential client information

Operating profit margin

Operating income / revenues

Operating income (EBIT)

Operating income = Gross profit - Other operating expenses

Operational risk

Operational risk is the risk of losses from inadequate or failed people, systems, and internal policies and procedures, as well as from external events that are beyond the control of the company but that affect its operations

Interest is determined by two factors

Opportunity cost and risk

Trading

Order document, execution instructions, submitted for dealing note, confirmation note, contract note and otification to issuer's transfer agent

Order exposure instructions

Order exposure instructions indicate whether, how, and sometimes, by whom an order should be seen

Institutional

Organizations that invest either for themselves or to advance their missions or on behalf of others Pension plans, endowments, foundations and sovereign wealth funds)

Origin

Origin relates to the source of the document (Original documents, derived documents, associated documents)

Underlying

Originally, all derivatives were based only on tangible assets, but now some contracts are based on outcomes

The consequences of inadequate risk management include investment losses and even bankruptcy

Other costly consequences are also possible, such as sanctions for the breach of regulations, loss of licenses to provide financial services, and damage to the company's reputation and the reputations of its employees

For asset management firms, the marketing documentation also contains information about the managers, including their investment strategy and competitive advantages

Other features include past performance, risk analytics, and characteristics of the product, such as liquidity, distributed income, and fees that will be borne by the client

Investment events

Over the life of the investment, numerous events may take place that affect the client or require the client to take action

Brokers and agents

Paid commissions on the trades and contracts they recommend

Continuous trading markets

Participants can arrange and execute trades any time the market is open

Call market

Participants can arrange trades only when the market is called, which is usually once a day

Interest

Payment for the use of borrowed money

Defined benefit pension funds, particularly those of government-sponsored plans, are among the largest institutional investors

Pension funds may invest in equity securities, debt securities, and alternative investments because they typically have relatively long time horizons

Institutional investors that invest to advance their missions

Pension plans, endowment funds and foundations, trusts, governments and sovereign wealth funds, and non- financial companies

Stagflation

Periods of little or no economic growth (high inflation, high unemployment and stagnant demand)

Discretionary relationships

Permit the service provider to act on behalf of the client— for example, as an investment manager with a specific mandate or as a trustee of a trust

Non-discretionary relationship

Permits the service provider to undertake only specific tasks that are authorised by the client on a per task basis

Financial market

Places where buyers and sellers trade securities are known as securities makers or financial markets

Complying with internal policies and procedures

Policies and procedures should explicitly set out the delegation of authority and define clear responsibilities and accountability (The segregation of duties is an important principle that international companies and regulators and other authorities in many countries require and recommend)

Documents that are clearly presented in a style that most people are familiar with help individuals read and understand these documents

Policies, procedures, and processes are living documents and should be subject to a regular review and confirmation process as a function of good governance

Policy documentation

Policy documents often describe the company's mission, values, and objectives (These documents should be consistent with the company's documents and bylaws, which summarise the legal identity, purpose, and activities of the company)

Identification of perceived need

Political pressure, anticipation of future need, in response to a scandal

The directors appoint a professional investment management firm, which is almost always an affiliate of the sponsor

Pooled investment vehicles are overseen by a board of directors, a board of trustees, a general partner, or a single trustee; the governance structure depends on the form of legal organization

Exchange traded funds

Pooled investment vehicles that are typically passively managed to track a particular index or sector, although an increasing number of ETFs are actively managed

Short positions

Positions that increase in value when prices fall (To take short positions, investors must sell assets or securities that they do not own, a process that involves borrowing the assets or securities, selling them, and repurchasing them later to return them to their owner)

Intangible assets

Ppatents, trademarks, copyrights, franchises, and goodwill

Standardized documents

Pre-established (They are crafted for a range of specific purposes; some standard contracts are tailored by negotiation, but their form, content, and purpose are still pre-established)

Unqualified or clean opinion

Prepared in accordance with the applicable accounting standards

Marketing documentation for a company in the investment industry typically includes the following:

Presentation materials that provide background on the company, its products, and/or its services, offering documentation, such as a prospectus or term sheet, which are legal documents that contain detailed information about the terms and conditions of the investment opportunity, highlight various risks, and make other required disclosures and fact sheets about the company's products that provide short summaries of the investments and typically detail historical performance

Records

Preserves learning within the company (also known as institutional memory)

External documents may also be used to inform the public or other external parties about a company's activities or changes in its business

Press release announcing the appointment of a new chief executive officer, a marketing presentation for a new investment product, or a statement about the launch of a new website

Price to book ratio

Price-to-book ratio = market price per share / equity book value per share

Price to earnings ratio (P/E)

Price-to-earnings ratio = market price per share / earnings per share

Accurately predicting mispricing is difficult

Prices generally should already reflect most publicly available information about fundamental values

Sell side firms

Primarily provide investment products and services; they are typically investment banks, brokers, and dealers

Ethical standards

Principles that support and promote desired values or behaviors

Buyouts

Private equity investment strategy that consists of financing established companies that require money to restructure and facilitate a change of ownership

Policies broadly set the rules, procedures help apply policies, and processes divide procedures into manageable actions

Procedure and process documents communicate how best to undertake an activity while taking into account internal and external constraints

Non financial companies

Produce goods and non- financial services for their customers

Substitute

Product that could take the place for another product

Imports

Products and services that are produced outside a country's borders and then brought into the country

Exports

Products and services that are produced within a country's borders and then transported to another country

Comparative advantage

Products and services that countries can produce relatively better than other countries

Three components of current account

Products and services, income and current transfers

Indirect investments are professionally managed

Professional management is particularly important when direct investments are hard to find and must be managed

Actuaries

Professionals who specialize in assessing insurance risks using statistical models

Defined benefit plans

Promise a defined annual amount to their retired members

From a legal perspective, documents also establish proof

Proof of existence, authority, activity, and obligation

Property and casualty insurance companies

Protect their policyholders from the financial loss caused by such incidents as accidents and theft (Property and casualty insurers have short-term horizons and relatively unpredictable payouts; therefore, they prefer shorter-term investments that are more conservative and liquid)

Commerical banks

Provide a wide range of products and services to companies and other financial institutions

Retail banks

Provide banking products to individuals and small businesses

Brokerage services

Provided to clients who want to buy and sell securities; they include not only execution services (that is, processing orders on behalf of clients) but also investment advice and research

Measures

Provides a benchmark for measurement and audit

Protects

Provides assurance of a system to safeguard interests and manage risks

Authorises

Provides the basis, and often the authority, for action

PRA

Prudential Regulation Authority (UK)

Open market operations

Purchase and sale of government notes and bonds, sell instruments to commercial banks, the central bank creates a shortage or surplus of money

Quantitative easing

Purchase of instruments and other short term government instruments

Difficult to value

Purchases and sales of start-up companies, land, or buildings are infrequent, so valuation is challenging and is often based on an appraisal

Cross price elasticity

Quantity demanded of a product as a result of a price change in price of another product

Quick ratio

Quick ratio = current assets - inventories / current liabilities (Excludes inventories, which are the least liquid current asset)

Return on assets (ROA)

ROA = net income / total assets ********* (net income / total assets) = (net income / revenues) x (revenues / total assets)

Assets

Real assets and financial assets

Capital and financial account

Records the ownership of assets like investments by domestic entities in foreign entities and investments by foreign entities in domestic entities

Primer brokerage

Refers to a bundle of services that brokers provide to some of their clients, usually investment professionals engaged in trading

Clearing

Refers to all activities that occur from the arrangement of the trade to its settlement

Positions

Refers to the quantity of an asset or security that a person or institution owns or owes

Operational risk

Refers to the risk of losses from inadequate or failed people, systems, and internal policies and procedures, as well as from external events that are beyond the control of the company but that affect its operations

Informationally efficient prices

Reflect all available information about fundamental values

Time value of money

Reflect the principle that the timing of a cash flow affects the cash flow's value

Nominal GDP

Reflects current market value of products and services, unadjusted for price changes

Fair value

Reflects the amount the asset could be sold for in a transaction between willing and unrelated parties, called an "arm's length transaction" (only applied to a few assets like financial instruments)

Registers

Registers of the previous and next review dates should be maintained by a control function (generally, the compliance or internal audit function) and scheduled for discussion

Trading rules

Regulations are designed to set investment industry standards as well as to prevent abusive trading practices

Review

Regulations can become obsolete as technology and the investment industry change

Regulatory issues

Regulations on the holdings of insurance companies are typically extensive

Merit based

Regulators attempt to protect investors by limiting the products sold to them

Investment grade

Regulators often specify that certain investors, such as insurance companies and pension funds, must restrict their investments to or largely hold bonds with a high degree of creditworthiness

Foster capital formation and economic growth

Regulators seek to ensure healthy financial markets in order to foster economic development

Principle based

Regulators set up broad principles within the investment industry in which it is expected to operate

Identification of legal authority

Regulatory bodies need to have authority to regulate

Cash flows from operating activities

Relate to the company's profit-making activities and occur on an ongoing basis

Compliance risk

Relates to the risk that a company fails to follow all applicable rules, laws, and regulations and faces sanctions as a result

Capital account

Reports capital transfers between domestic entities and foreign entities

Liabilities and equity

Represent how the company's assets are financed

Portfolio construction

Requires investment managers to invest in the attractive securities and assets they identified through their investment analysis, taking into account the client's requirements and appropriate asset allocation

Excessive trading (churning)

Results in high trading costs to the client and reduces the client's return after transaction costs and is no in the client's best interest

Individual

Retail investors and high net worth individuals

Relative returns

Returns relative to a suitable benchmark

Coincident indicator

Reveals current economic conditions, but do not have predictive value

Profit (loss)

Revenues - expenses

Asset turnover

Revenues / total assets (How effectively the company uses its assets to generate revenues)

Accrual basis

Revenues are recorded when the revenues are earned rather than when they are received in cash

Currency risk

Risk associated with the fluctuations of exchange rates

Set objectives

Risk management enables management to identify potential events that could affect the realisation of those objectives (A company may set strategic objectives, which are typically high-level objectives connected to its mission)

Risk management functions

Risk management functions vary by company, but it is typical for companies in the investment industry to have a stand-alone risk management function with a senior head, often called the chief risk officer, who is capable of independent judgment and action

Middle office

Risk management, information technology (IT), corporate finance, portfolio management, and research are generally considered middle-office activities

Credit risk

Risk of loss if the borrower, or bond issuer, fails to make full and timely payments of interest and/or principal

Specific risk

Risk that is specific to a certain company or security is variously known as specific, idiosyncratic, non-systematic, or unsystematic risk

Regulations

Rules that set standards for conduct and that carry the force of law

Seniority ranking of debt securities

Secured debt, unsecured debt: senior unsecured debt, senior subordinated debt, junior subordinated debt

SEC

Securities and Exchange Commission (USA)

Over the counter (OTC) markets

Securities once literally traded over a counter in the dealer's office

Depositary receipts

Security representing an economic interest in a foreign company that trades like a common share on a domestic stock exchange (Depositary receipts facilitate trading of a company's stock in countries other than the country where the company is located)

Passive investment managers

Seek to match the return and risk of an appropriate benchmark

There are various approaches to managing credit risk, including the following:

Set limits on the amount of exposure to a particular counterparty or level of credit rating allowed and Require additional collateral and impose covenants

Ethics

Set of moral principles, or the principles of conduct governing an individual or a group

Settlement

Settlement describes how a contract is satisfied at expiration (Some contracts require settlement by physical delivery of the underlying and other contracts allow for or even require cash settlement)

Financial assets

Share of a stock represents ownership in a company

Managers of closed-end funds are largely insulated from their shareholders

Shareholders can sell their shares to new investors, but the assets under management remain the same

Accounts payable

Short-term borrowing and a portion of long term debt due in that period

Term structure of interest rates

Shows how interest rates on government bonds vary with maturity

Lagging indicator

Signal a change in economic activity after output has already changed

The return over the holding period usually comes from two sources: changes in the price (capital gain or loss) and income (dividends or interest)

Similarly, the holding-period returns from owning bonds result from changes in price (capital gain or loss) and receipt of interest (income)

Ethical dilemmas

Situations in which values, interests, and/or rules potentially conflict

Rogue trading

Situations wherein traders bypass management controls and place unauthorised trades, at times causing large losses for the companies they work for

These objectives may take different forms, but they are typically driven by a company's mission and strategy

So, an important objective of the risk management process is to help managers deal with this uncertainty and identify the threats and opportunities their company faces

Adjust returns for risk

So, if two investments have a holding-period return of 10% but the first investment has very little risk whereas the second one is very risky, the first investment is better than the second one on a risk-adjusted basis.

Marketing

So, most companies' documentation at the marketing stage of the cycle shares the same purpose: to promote and position the company's products and services to persuade the client to invest

The choice between internal and external management will often be driven by the size of the institutional investor, with larger institutional investors better able to afford the resources required for internal management

Some institutional investors will adopt a mixed model, managing some assets internally in which they have expertise and outsourcing more specialised investments

Unique circumstances

Some investors have social, religious, or ethical preferences that affect how their assets can be invested

The markets for such investments as real estate or private equity may not be efficient for a number of reasons

Some investors may have access to information and deals that are not available to other investors

Quantitative analysis

Some managers build statistical models to try to identify shares that are likely to outperform

Premiums are payments that insurance companies require to provide insurance coverage

Some of these premiums are put into reserve funds from which insurance companies pay out claims (The premiums in the reserve funds are invested in highly diversified portfolios of securities and assets that aim to ensure that sufficient funds are always available to satisfy all claims)

Voting rights

Some shares give their holders the right to vote on certain matters

Taxes

Some types of investors are taxed on their investment returns, and others are not

Money market funds

Special class of open-end mutual funds that investors view as uninsured interest-paying bank accounts (In particular, they may only hold money market securities—that is, generally very short-term, low-risk debt securities issued by entities with very high-quality credit)

Credit rating agencies

Specialize in providing opinions about the credit quality of bonds and their issuers

Building societies (savings and loan associations)

Specializes in financing long-term residential mortgages

Payout policies

Specify how much money can be taken from long-term funds to use for current spending

The organizer is often called the sponsor

Sponsors can organize investment vehicles as business trusts, limited partnerships, or limited liability companies

Enhance efficiency

Standardized documentation or transmission can reduce costs and increase economic efficiency

Financial statements

Statements show the monetary value of the economic resources under the company's control and how those resources have been used to create value

Equity

Stock/shares in a company

Financial capital

Synonym for money, cash, funds and capital

Control and monitor

Taking action in response to risk involves a range of controlling and monitoring activities that must be performed in a timely manner

Positive covenant

Terms for loans that specify both what a borrower must do

The "reward" part of the information ratio is the difference between the holding-period return on the portfolio and the return on an appropriate benchmark over the same period

The "risk" part of the information ratio is based on the tracking error of the fund—that is, its deviation from the performance of the benchmark (Difference in average return between portfolio and benchmark / fund tracking error)

Implicit GDP deflator

The GDP price deflator is a ratio of price levels in two different years that accounts for inflation in the prices of goods and services so that comparisons of real GDP can be made

Monetizing

The IPO provides founders and other early investors with a means of converting their investments into cash

The IPS serves as a guide to what is required and what is acceptable in the investment portfolio

The IPS helps guide asset allocation—that is, which asset classes and how much of each asset class should be included in the investor's portfolio

The heavy penalties imposed by most regulators globally help combat identity theft, criminal activity, and the flow of money from illegal sources into the financial services industry, including the investment industry

The KYC process also serves to define the client's level of knowledge and sophistication, assign associated and specific risk profiles, and assess any possible restrictions

Risk tolerance

The ability to handle risk is primarily driven by the company's financial health and depends on its level of earnings, cash flows, and equity capital

Corruption

The abuse of power for private gain (To safeguard against corruption, companies must start by establishing a tone at the top, with senior management communicating an unambiguous policy of zero tolerance for unethical business practices and bribery)

Historical cost

The actual cost of acquiring the asset minus any cost expensed to date

Depreciation expense

The amount allocated for each year

Central bank duties

The amount of money in circulation, the amount of money available for borrowing and at what cost or interest rate and macroeconomic targets

Equity

The amount received from selling stock to common shareholders and retained earnings

Auditor

The auditor issues an opinion on their correctness and presentation, which indicates to the reader how trustworthy the statements are in reflecting the financial performance of the company

Geometric mean

The average return assuming that returns are compounding

Book values

The balance sheet values are commonly known as the book values of the company's assets, liabilities, and equity

Investability

The benchmark should be composed of assets that can be bought and sold by the fund manager (For passive fund managers, it would be difficult to mimic the benchmark if it contained assets that they could not buy)

Pre-specification

The benchmark should be specified before an investment is made so that the manager is clear about the client's objectives and expectations and so the manager can construct a portfolio accordingly

Compatibility

The benchmark should have an appropriate composition and level of risk for the investor

The tracking error is measured by taking the standard deviation of the differences between the returns on the fund and the returns on its benchmark

The bigger these differences, the larger the tracking error (A passive fund manager may be expected to have a very low tracking error because the manager is seeking to replicate a benchmark)

Secondary market

The bondholders may later sell their bonds to other investors in the secondary market

Interest is all about timing: someone needs money now while someone else is willing and able to give up money now, but at a price

The borrower pays a price for not being able to wait to have money and to compensate the lender for giving up potential current consumption or other investment opportunities (Interest is paid by a borrower and earned by the lender to compensate the lender for opportunity cost and risk)

Option contract

The buyer of the option has the right, but not the obligation, to buy or sell the underlying

Skill vs. luck

The calculation and analysis of reward-to-risk ratios allow an understanding of the price fund investors have to pay in terms of units of reward for each unit of risk—the total return—generated by the fund's manager

Three elements to consider

The cash flows each investment will generate in the future, the timing of these cash flows, the risk associated with each investment, which is reflected in the discount rate

Price impact

The change in the market price when you try to trade

Pension sponsors or plan sponsors

The companies and governments that sponsor a pension plan to provide benefits to its employees

Retained earnings

The company's undistributed income (as opposed to dividends) which represents a link between the company's income statement and the balance sheet

Employees also generally contribute to their own retirement plan accounts, usually through employee payroll deductions

The contributions are then invested, normally in funds that the employee chooses from a list of eligible funds within the plan

Money from employer and/or employee contributions is set aside to provide income to plan members when they retire

The contributions must be invested until the employee retires and receives the retirement benefits

Expenses

The cost of company resources (cash, inventories and equipment)

Operating expenses/cost of goods sold (COGS)

The cost of sales

Simple interest rate

The cost to the borrower or the rate of return to the lender, per period, on the original principal

Costs

The costs incurred by pooled investment vehicles are deducted from their assets, reducing their investment performance

Coupon rate

The coupon rate is the promised interest rate on the bon

Floating rate bonds

The coupon rate of a floating-rate bond is usually linked to a reference rate (The floating rate is equal to the reference rate plus a percentage that depends on the borrower's (issuer's) creditworthiness and the bond's features *floating rate = reference rate + spread*)

Call risk

The coupon rate on a callable bond will generally be higher than a comparable bond without an embedded call provision to compensate the bondholder for the risk that the bond may be retired early

Securitization

The creation and issuance of new debt securities (asset backed securities)

Passive investment managers attempt to minimise tracking error

The deviation of the return on the portfolio from the return on the benchmark being tracked

Market bid-ask spread

The difference between the best bid and the best offer

Yield to maturity

The discount rate that equates the present value of a bond's promised cash flows to its market price

Effect of prices of other products on demand

The effect of a change in the prices of other products on a product's demand curve depends on the type of relationship between the products

Bid exchange rate

The exchange rate at which the bank or currency dealer will buy the foreign currency

Offer exchange rate

The exchange rate at which the bank or dealer will sell the foreign currency

Forward rate

The exchange rate for the transaction

The choice between the two approaches typically hinges on the relative costs of active management compared with passive management and on the investor's expectation of the success of active management

The expectation is related to the investor's beliefs about the efficiency of the markets being invested in

Operating leverage

The extent to which fixed costs are used in production

Pricing is less challenging in a seasoned offering because the issuer's securities already trade in the secondary market

The fees charged for a seasoned offering are lower than for an initial public offering because there is less risk

Links between the financial statements

The income statement is linked to the balance sheet through net income and retained earnings, the revenues and expenses reported on the income statement that have not been settled in cash are reflected on the balance sheet as current assets or current liabilities and cash expenditures are shown as an increase in the gross fixed assets on the balance sheet

Processes

The individual steps that the company must take, from start to finish, to achieve that desired outcome

Initial margin

The initial margin should be sufficient to protect the exchange against movements in the underlying price (The greater the underlying price volatility, the higher the margin)

Best efforts offering

The investment bank acts only as a broker and does not assume the risk associated with buying the securities

Underwritten offering

The investment bank buys the securities from the issuer at a price that is negotiated with the issuer, thus guaranteeing that the issuer gets the amount of capital it requires (The objective of the investment bank is not to become a long-term shareholder of the issuer but to be an intermediary between the issuer and the investors for a fee)

Subscribers

The investment bank identifies investors who are willing to buy the securities (These investors are known in the industry as subscribers)

Book building

The investment bank tries to build a book of orders from clients or other interested buyers to whom they can resell the securities

The investment manager works on a contractual basis in exchange for a management fee paid by the investment vehicle from its assets

The investment manager chooses the securities and other assets held by the investment vehicle

Risk tolerance

The investor's risk tolerance is a function of his or her ability and willingness to take risk

One of the main functions of risk management is to find the right balance between risk and return

The involvement of the board of directors and senior management in risk management is critical because they set corporate strategy and strategic business objectives

Bond indenture or offering circular

The legal bond contract (In the event that the issuer does not meet the contractual obligations and make the promised payments, the bondholders typically have legal recourse)

Maturity date

The life of the bond ends on its maturity date, assuming that all promised payments have been made

Retail investors

The lowest amount of investable assets

Providers, such as brokers and dealers and exchanges

The main distinction between exchanges and brokers is their regulatory operations (Most exchanges regulate their members' actions when trading on the exchange and sometimes also away from the exchange)

Trends and momentum in markets

The manager could also look at stock and bond market trends as a way of gauging investor sentiment

Market valuation measures relative to past data

The manager may then look at the level of the price-to-earnings ratio of the stock market and how it compares with recent decades as a measure of valuation or with the level of bond yields relative to historical ranges

If the share price is significantly below the estimated value

The manager will increase the weighting of the shares in the portfolio or add the shares to the portfolio

Active investment managers

The managers then act on their opinions by buying the securities and assets that they expect to outperform and selling (or simply not buying) the securities and assets that they expect to underperform

Law of diminishing marginal utility

The marginal satisfaction derived from an additional unit of a product decreases as more of the product is consumed

Primary market

The market in which new securities are issued and sold to investors

Treynor ratio

The measure of portfolio reward is the same as that used in the Sharpe ratio but the measure of portfolio risk is different (the chosen measure of portfolio risk is beta of the portfolio, a measure of the portfolio's systematic risk (also called market or non-diversifiable risk)

Principal

The money originally borrowed, which interest is calculated on

Clearing

The most important clearing activity is confirmation

Private equity strategies

The most widely used strategies are venture capital, growth equity, buyouts, and distressed... as well as secondaries

Dematerialization

The move from physical certificates to electronic bookkeeping

Other primary market transactions

The national governments of financially strong countries generally issue their debt securities in public auctions

Detect and identify events

The next step in the risk management process is to detect and identify events that may affect achieving the company's objectives

Zero coupon bonds

The only cash flow offered by a zero coupon bond is a single payment equal to the bond's par value that is paid on the bond's maturity date (Zero-coupon bonds are issued at a discount to the bond's par value)

Option premiums

The option premium represents the maximum profit that the option seller can make (option premiums are expected to compensate option sellers for their risk)

Par value

The par (principal) value is the amount that will be paid by the issuer to the bondholders at maturity to retire the bonds

Real estate limited partnerships

The partnership is often set by a real estate development firm that becomes the general partner

Passive management is typically cheaper to implement than active management because successfully replicating or tracking a benchmark requires fewer analytical resources than researching and identifying investments with superior return potential

The passive approach requires some skill, such as knowing which investments to include in the benchmark and their respective values and weights in the benchmark

Own price elasticity

The percentage change in the quantity demanded of a product as a result of the percentage price change in that products (Luxury goods have a positive own price elasticities)

Sales loads are calculated as a percentage of the sales price

The percentage is usually around 3%, but can be as high as 9%

Spread

The percentage paid above the reference rate

Holding period returns

The performance of a security, such as an equity (stock) or debt (bond) security, over a specific time period—called the holding period—is referred to as the holding-period return

Immobilisation

The placement of certificates or other documents of title evidencing ownership of financial instruments in a central securities depository to reduce the movement of physical securities in the marketplace and to facilitate book entry transfers

Sharpe ratio

The portfolio reward is measured as the portfolio's excess return, which is equal to the difference between the portfolio's holding-period return and the return on a "risk-free" investment

Present value

The present value is obtained by discounting the future cash flow by the interest rate

Net present value

The present value of future cash flows or returns minus the present value of the cost of the investment

Exercise price/strike price

The price is what the underlying will be purchased or sold for under the terms of the contract

Offer/ask prices

The prices at which they are willing to sell

Luck

The prices of financial assets held in portfolios are affected by events that cannot be foreseen by a fund manager

Client on-boarding

The process by which a company accepts a new client and inputs the client's details into its records to enable the company to conduct transactions with and on behalf of the client

Inflation risk

The promised interest payments and final principal payment from most debt securities are nominal amounts—that is, the amounts do not change with inflation

Portfolio construction

The proportion of the portfolio to invest in each asset class

Exchange rate

The rate at which one currency can be exchanged for another

Required return

The rate of return required—before and after tax—can be calculated using some goal for future wealth or portfolio value

Marketing materials are typically regulated to ensure that companies in the investment industry provide fair representations of their products

The regulation is usually more onerous as the client's level of investment sophistication decreases

Relative valuation

The relative valuation approach estimates the value of a common share as the multiple of some measures, such as earnings per share (EPS) or revenue per share

Multifamily residential dwellings

The retail segment includes such assets as shopping malls, commercial shopping centres, and other buildings designated for retail purposes

The costs of passive management are lower than the costs of active management

The return earned by the passive investor will typically be less than the index return because of costs

Positive deviation

The return is greater than the mean

Absolute returns

The returns achieved over a certain time period (absolute returns do not consider the risk of the investment or the returns achieved by similar investments)

Investment risk

The risk associated with investing that arises from the fluctuation in the value of investments

Systematic risk

The risk created by general economic conditions is known as systematic or market risk because the risk stems from the wider economic system

Credit risk

The risk for a lender that a borrower fails to honour a contract and make timely payments of interest and principal

Risk management and compliance

The risk management and compliance groups operate as a second line of defence, assisting and advising employees and managers while maintaining a certain level of independence

Risk managers assess, monitor, and report on risks, and in some cases, they may have an approval function or veto authority

The risk manager must ensure that all relevant risks are identified, but the final judgment on the business decision lies with the decision makers

Liquidity risk

The risk of being unable to sell a bond prior to the maturity date without having to accept a significant discount to market value

Political risk

The risk that a change in the ruling political party of a country will lead to changes in policies that can affect everything from monetary policy (money supply, interest rates, and credit) and fiscal policy (taxation) to investment incentives, public investments, and procurement

Sovereign risk

The risk that a government will not repay its debt because it does not have either the ability or the willingness to do so (The unique aspect of sovereign risk is that lenders have limited legal remedies available to compel the borrower to repay or to be able to recover the assets themselves)

Liquidity risk

The risk that an asset or security cannot be bought or sold quickly without a significant concession in price

Legal risk

The risk that an external party will sue the company for breach of contract or other violations

Settlement risk

The risk that counterparties will not settle their trades

Interest rate risk

The risk that interest rates will change

Call risk

The risk that the issuer will buy back (redeem or call) the bond issue prior to maturity through the exercise of a call provision

Counterparty risk

The risk that the other party to the contract will not fulfill its contractual obligations

Settlement risk (counterparty risk)

The risk that when settling a transaction, a company performs one side of the deal, such as transferring a security or money, but the counterparty does not complete its side of the deal as agreed, often because it has declared bankruptcy

The lender also bears risks, such as the risk of not getting the money back if the borrower defaults

The riskier the borrower or the less certain the borrower's ability to repay the loan → the higher the level of interest demanded by the lender

Procedure and process documentation

The role of procedure documentation is often to provide a bridge between the activities that are allowed at the policy level and what needs to happen at the process level

Clarity

The rules governing the construction of the benchmark should be clear

Arbitrage opportunity

The same product sells for different prices

Secondary, or seasoned equity offering

The selling of new shares by a publicly traded company subsequent to its IPO

Settlement

The settlement cycle refers to the timing of the procedures used to settle trades and differs across markets (The seller must deliver the security to the clearing house and the buyer must deliver cash--the settlement agent then makes the exchange in a process called delivery versus payment)

An investor may take a total-return perspective, which makes no distinction between income (for example, dividends and interest) and capital gains (that is, increases in market value)

The source of return—changes in value or income—does not matter to a total-return-oriented investor

Par value

The stated value, or face value, of the equity security

Reporting documentation usually takes the form of a statement, often provided by a third-party custodian or administrator

The statement typically contains information on the asset, including its fair value per unit and the quantity of units held at a particular point in time

Macroeconomics

The study of an economy as a whole

Economics

The study of choices in the presence of scarce resources and it is divided into two broad areas

Microeconomics

The study of how individuals and companies make decisions to allocate scarce resources

A single investment bank may not have the distribution network, capital, or risk appetite to organize a large offering, so large offerings are often organized by a syndicate that includes several investment banks

The syndicate helps the investment bank that leads the offering (known as the lead underwriter) to build the book of orders

Individual investors

The term "retail investor" can be used to refer to all individual investors, but it is common to use the term to refer to individual investors with modest resources to invest

Yield curve

The term structure is often presented in graphical form

Application of the time value of money

The time value of money concept can help to solve many common financial problems, time value of money can also help determine the value of a financial instrument,

Time weighted rate of return

The timing of each individual cash flow identifies the sub-periods to use for calculating holding-period returns (By calculating holding-period returns in this manner, client cash inflows and outflows do not distort the measurement and reporting of a fund's investment performance)

Managing the environment

The type of environment in which a company operates can add layers of uncertainty that need to be addressed

DCF

The value of a debt security is usually estimated by using a discounted cash flow (DCF) approach

Opportunity cost

The value of alternative opportunities that have been given up by the lender

Distribution

The values a variable can take and the number of observations associated with each of these values

Relative returns

The wide range of financial market indices available allows investors to set performance targets (passive or active) for their fund managers and enables them to compare the performance of their fund manager over time against an independent benchmark

Alternative trading venues

There are a number of alternative trading venues that are owned and operated by broker/dealers, exchanges, banks, and private companies (In the United States, such venues are generally referred to as alternative trading systems, whereas in Europe, they are commonly called multilateral trading facilities) (Most alternative trading venues allow institutional traders to trade directly with each other without the intermediation of dealers or brokers, which makes them lower-cost trading venues)

Insider trading

There are laws that prohibit the trading of a security when in possession of important confidential information pertaining to the security in question

Call options and put options

There are two basic types of options: options to buy the underlying, known as call options, and options to sell the underlying, known as put options

Tax reporting

There is a technical difference between "tax avoidance", which means using tax code provisions to minimise the tax that is owed, and "tax evasion", which means not paying taxes in violation of the tax law (From a risk-management perspective, tax risk should be managed in a consistent manner, incorporating the appropriate expertise at each stage of a transaction or financial reporting cycle)

Many investment firms make a distinction between their retail clients, more affluent clients with larger amounts, and high- and ultra-high-net-worth investors with the largest amounts of investable assets

There is no defined standard in the industry to classify individual investors by investable assets; each investment firm designates its own categories and values within those categories

The corporate treasurer usually manages the short- term investment assets

These assets typically include cash that the company will need soon to pay salaries and accounts payable and financial vehicles that are safe and liquid, including demand deposits (checking accounts), money market funds, and short- term debt securities issued by governments or other companies

Other documents are for external use

These documents convey information to and from the public domain and often help limit the risks that interaction with the public creates

Security lenders

These investors who lend their securities

Market return

These managers, however, are not looking to add value to the portfolios by picking securities that they believe will outperform other securities

Open-end mutual funds

These pooled investment vehicles are called open-end because they have the ability to issue or redeem (repurchase) shares on demand (When investors want to invest in a mutual fund, the fund issues new shares in exchange for cash that the investors deposit)

Dealers may also indicate the quantities that they will trade at their bid and ask prices

These quantities are called bid sizes for bids and ask sizes for offers

An alternative approach for such companies is to apply standards that suit their own specific circumstances

These standards are known as "fit for purpose", and a company using this approach has to critically assess and document its own needs and requirements

Investment firms that face a high risk of insider trading, such as investment banks, have "control rooms" to monitor information flowing between teams

They also have virtual walls or information barriers to restrict and segregate information and to manage other conflicts of interest

Illiquid

They are difficult to sell quickly without accepting a lower price

Hedge funds and private equity funds can similarly be considered institutional investors that manage private investment pools and as investment vehicles

They are distinguished by their use of strategies beyond the scope of most traditional mutual funds

Some documents are for internal use only

They are generally administrative and reflect a company's philosophy, approach, and activities

It is important to note that investors in an investment vehicle do not share ownership of the investment securities and assets held by the investment vehicle

They are the beneficial owners of the investment vehicle's securities and assets, but not their legal owners

Offices

They are usually owned by real estate investment companies that lease space to tenants in varying terms, from short-term monthly leases to longer multi year leases

Market makers

They are willing to make a market (that is, trade on demand) in specified securities at their bid and ask prices

Investors cannot diversify away systematic risk

They can do little to avoid systematic risk because all investments will be affected to some extent by systematic risk—for instance, a recession

Minimising transaction costs

They employ skilful brokers, use electronic algorithms to manage their trading, or as mentioned before, use hidden orders or dark pools so other market participants cannot see their orders and exploit them

Factors needed for active management to be successful

They have to be better than other investors at assessing the potential of investments

Active management

They may attempt to select assets that will outperform the benchmark or active managers may also try to time the market (buying when they believe the market is undervalued and selling when they believe the market is overvalued)

When active managers buy a security or investment because their analysis suggests it has good return potential

They may be buying it from another active manager who believes the prospects for the security are poor

Protect customers

They might not have the skill or information needed to determine quality

For active managers to identify outperforming securities on a consistent basis

They must either have access to better information than other investors or be able to respond and use the same information faster or with better models to process the information

The investment professionals who work in family offices generally manage these investments using the same methods and systems that institutional investors use

They pay especially close attention to personal and estate tax issues that may significantly affect the family's wealth and its ability to pass wealth on to future generations or charitable institutions

Most market participants employ brokers to trade on their behalf

They pay their brokers commissions for arranging their trades (The commissions are usually a fixed percentage of the principal value of the transaction or a fixed price per share, bond, or contract)

Dealers act as principles

They use their own accounts and their own capital to trade with buyers and sellers in proprietary trading, they "make markets" in securities by acting as buyers when investors want to sell and as sellers when investors want to buy

The return requirement, particularly for a long-term horizon, should be specified in real terms, which means adjusting for the effect of inflation

This adjustment is important because it maintains the focus on what the accumulated portfolio will provide at the end of the time horizon (An increase in value that simply matches inflation does not give a client increased spending power)

One such model is the capital asset pricing model (CAPM), from which the term alpha comes

This model includes a measure of systematic risk: beta

Seniority ranking

This priority of claims can affect the amount that an investor will receive upon liquidation

Effective annual rate (EAR)

This rate involves annualizing, through compounding, a rate that is paid more than once a year

Because individual investors are often thought of as less knowledgeable and less experienced than institutional investors, regulators in many countries try to protect them by putting restrictions on the investments that can be sold to them

This restriction is presumably based on the logic that wealthier investors are expected to have a higher level of investment knowledge or at least be better able to pay for advice and better able to bear risk

Tolerate

This strategy involves accepting the risk and its effect

Terminate

This strategy involves avoiding the risk and its effect by ceasing an activity

Transfer

This strategy involves moving the risk and its effect to a third party

Treat

This strategy involves taking action to reduce the risk and its effect

Insurance companies try to match their investments to their liabilities

This strategy of matching investment assets to liabilities, called asset/liability matching, reduces the risk that the company will fail to pay its claims

Natural disaster

This type of event may affect a real asset or even a financial asset

Multiplier effect

Those who benefit from additional spending, in turn, increase their own spending

Asset managers

Those who have such discretionary authority from their clients to trade securities and assets on their behalf

Spenders

Those who need money

Clearing houses

Thus, brokers and dealers who are not members of the clearing house must arrange to have a clearing member settle their trades at the clearing house

Limitations of fiscal policy

Time lags, unexpected responses by consumers and companies, Unintended consequences

Order time in force instructions

Time-in-force instructions indicate when an order can be filled

A manager might be given a specific mandate reflecting specific risk requirements, return targets, or style or sector preferences, such as investing in biotech companies

To beat this benchmark, the manager will have to be an active manager and to use analytical and trading skills and deliver high levels of client service to satisfy the mandate

Mortgage backed securities

To create mortgage-backed securities, a financial intermediary bundles a pool of mortgage loans from lenders and then issues debt securities against the pool of mortgages

Security lending is subject to the risk that one of the parties to the contract will fail to honor their obligation, a risk called counter party risk

To limit counter party risk, security lenders require that short sellers leave the proceeds of the short sale on deposit with them as collateral for the loan

Posting margin

To protect itself against one of the parties defaulting, the exchange typically requires that parties to the contract deposit funds as collateral (The buyer's and seller's margin accounts are adjusted to reflect the change in settlement price and whether it was to their advantage or disadvantage)

Fundamental relationship underlying the balance sheet

Total assets = Total liabilities + Total shareholders' equity

GDP

Total value of all final products and services produced in a country over a period of time

Information ratio

Tracking error can also be used to formulate another widely used reward-to-risk ratio

Balance of payments

Tracks transactions between a country and the rest of the world over a period of time, usually a year

Closed-end funds and exchange-traded funds

Trade in organized secondary markets just like common stocks

Opportunity costs

Traders who are willing to wait until other traders want to trade with them generally incur lower transaction costs on their trades (They lose the opportunity to profit if their buy orders fail to execute when prices are rising, and they lose the opportunity to avoid losses if their sell orders fail to execute when prices are falling)

Stop-loss order

Traders who want to protect their long positions often use stop orders that trigger market sell orders if prices are falling with the hope of stopping losses on positions that they have established

Insider trading

Trading while in possession of information that is not publicly available and that is likely to affect the price

Transaction costs

Transaction costs usually are embedded in forward contracts and are not easily visible to the customers. Futures contracts, however, are traded on exchanges through brokerage firms or brokers (agents authorized to trade directly with the exchange), and the transaction costs are visible

Regulation

Trend toward greater regulation of the financial services industry

Custodians

Typically banks and brokerage firms that hold money and securities for safekeeping on behalf of their clients

Cash flows from investing activities

Typically cash outflows related to purchases of long-term assets, such as equipment or buildings, as the company invests in its long-term resources

Primary markets are where securities first become available to all investors Issuers

Typically companies and governments; selling securities to investors in exchange for cash is a way for these companies and governments to raise money

Real estate equity funds

Typically hold investments in hundreds of commercial properties (real estate equity funds are often open-end funds, meaning that they issue or redeem shares when investors want to buy or sell)

The defined amount typically varies by member based on factors such as years of service and annual compensation while employed

Typically, employees do not have the right to receive benefits until they have worked for the company or government for a period specified by the pension plan

All contracts specify four things

Underlying, size and price, expiration date and settlement

An important consideration when creating or reviewing procedures is risk management—without a strong control environment, processes are at risk of error.

Understanding where inputs come from, where outputs go, and what they will be used for provides that context

Land

Undeveloped, or raw, land can be highly speculative because there are no cash inflows from tenants or occupants, only cash outflows in the form of real estate taxes and other costs of holding the land

Unilateral contract

Unilateral contracts because only one party to the contract (the seller) has a future commitment that, if broken, represents a breach of contract (The buyer of the contract will exercise the right or option if conditions are favorable or if specified conditions are met)

Accrued liabilities

Unpaid operating expenses, such as money due to workers but not yet paid

Unsecured

Unsecured debt securities are not backed by collateral

Inventories

Unsold units of production on hand called stocks in some parts of the world

Indirect finance

Use financial intermediaries that act as the middlemen between savers and spenders (no direct claims)

Consumer price index

Used to measure the change in price of a basket of goods typically purchased by a consumer or household over time

Private equity partnership

Usually includes two types of partners

Leading indicator

Usually signal changes in the economy in the future, and are considered useful for economic prediction and policy formulation

(VaR) was developed in the late 1980s and is now a widely used metric

VaR gives an estimate of the minimum loss of value that can be expected for a given period with a given level of probability

Weaknesses of VaR

VaR often underestimates the frequency and magnitude of losses, mainly because of erroneous assumptions and models

The value of a security can be viewed as the present value of all the cash flows the security will generate in the future

Value that is estimated this way is called the stock's fundamental value or intrinsic value

Ultra high net worth investors and family offices

Very wealthy individuals usually employ professionals who help them manage their investments, future estates, and legal affairs

High net worth investors

Wealthier investors generally receive more personal attention from investment personnel (They either pay directly for these services on a fee- for- service basis or indirectly through commissions and other transaction costs)

An investment firm or division within an investment firm focussing on high-networth investors may have fewer clients, but higher average account balances, than one that focuses on retail investors

Wealthy clients may have higher expectations of client service than retail customers, and usually the services that are provided to them are more personalised

Negative covenants

What a borrower is not allowed to do

Income approach

What an economy spends is another economic entity's income (factor incomes + factors of production)

Instead of full replication, passive managers may use a tracking approach and hold a subset of the market that is expected to closely track the benchmark's returns and risk

Whatever passive investment approach is used, a passive investor must be willing to accept the risk of the underlying market

Secured

When a borrower issues secured debt securities, it pledges certain specific assets as collateral to the bondholders

Occupational fraud (sometimes called internal fraud or employee fraud)

When an employee abuses his or her position for personal gain by misappropriating the company's assets or resources

Order document

When an order is placed, a document is sent to the chosen trading venue, specifying what security to trade, whether to buy or sell, and how much should be bought or sold

Diversification

When assets and/ or asset classes with different characteristics are combined in a portfolio, the overall level of risk is typically reduced

Internalisation

When brokers fill their clients' orders by acting as proprietary traders rather than as agents (When acting as dealers, however, they profit most when they sell to their clients at high prices or buy from their clients at low prices)

Fundamental analyses of economic and political conditions and their likely effects on market returns

When considering tactically altering a portfolio's asset allocation, a manager may look at the strength of the economy and likely future trends to gain a perspective on how the central bank might change interest rates and on what might happen to corporate profits

Conflict of interest

When either the employee's personal interest or the employer's interests conflict with the interests of the client

Financial contagion

When financial shocks spread from their place of origin to other locales

Direct investments

When investors buy securities issued by companies and governments and when they buy real assets, such as precious metals, art, or timber

Liquidity

When liquidity is required, the investments will need to be able to be converted to cash relatively quickly and without too much cost (keeping transaction costs and changes in price low) when the cash is needed

Moral hazard

When people are less careful about avoiding losses once they have purchased insurance

Fraud

When people deliberately cause or falsely report losses to collect insurance settlements

Objectives of documentation

When policies, procedures, and processes are undocumented or poorly documented, there is room for doubt

Indirect investments

When they buy the securities of companies, trusts, and partnerships that make direct investments

Governments receive money from collecting taxes or selling bonds

When they do not have to spend this money immediately, they usually invest it

Long position

When they own assets or securities (Long positions increase in value when prices rise)

Adverse selection

When those who are at most risk buy insurance, causing insured losses to be greater than average losses

Secondary market

When trading securities and contracts in secondary markets, investors often obtain assistance from trading services providers, such as brokers and dealers

Document classification systems

When using, developing, or reviewing a document, companies and individuals should consider three factors

Foreign exchange market

Where currencies are traded

Spot market

Where currencies are traded now and delivered immediately

Forward market

Where currencies are traded now but delivered at some future date

Direct finance

Where savers and spenders can buy and sell securities as well as have a direct claim on the users of capital (If you own shares of Nestle, you have a claim on the assets and earnings of Nestle)

Disclosure based

Whether or not an investment is appropriate for investors but only whether all material information is disclosed to investors

Asset allocation

Which asset classes are suitable (e.g., global equities, domestic government bonds, commodities, or domestic real estate investment trusts)

Day orders

Which can be executed only on the day they are submitted and are cancelled at the end of that day

Companies should have internal reporting procedures to encourage employees to come forward and report instances in which they suspect someone has violated internal policies, procedures, laws, or regulations

Whistle-blowing has become an important way for authorities to learn of violations, and provisions to protect and reward whistle-blowers have been strengthened in the wake of financial scandals

Purchasing power parity

a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries

Defined contribution pension plans

defined contribution—to an account set up for each employee

Investment policy statement

for both individual and institutional investors—serves as a guide for the investor and investment manager or adviser regarding what is required of and acceptable in the investment portfolio

Hidden order

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