Glossary of Financial Terms
Alpha
Modern portfolio theory includes five risk ratios: alpha, beta, standard deviation, R-squared and the Sharpe ratio. These ratios are calculated to help investors ascertain the risk-reward profile of a security or fund. Alpha, perhaps the most commonly cited risk ratio, is a measure of the residual risk of an investment relative to the market, i.e., alpha is a measure of an investment's risk-adjusted performance. In many cases, the market-based return is defined as a benchmark such as the Barclays Capital U.S. Aggregate Index1 or the S&P 500 Index.
A positive alpha of 1.0 suggests that the investment outperformed the market (or benchmark) by 1.0%. Conversely, a negative alpha of -1.0 suggests that an investment has underperformed the market (benchmark) by 1.0%.
Asset-backed security (ABS)
An asset-backed security is backed by a pool of similar assets. For all intents and purposes, an ABS is the same thing as a mortgage-backed security, except that the securities backing an ABS are assets such as auto loans, leases, credit card debt, a company's receivables, royalties and mortgages. Asset-backed securities allow firms to liquefy their receivables and reduce the amount of capital they would otherwise have to maintain to meet banking regulation standards. For investors, pools of loans make otherwise uneconomical investments available to a broader bench of buyers.
Barclays Capital U.S. Aggregate Index1
The Barclays Capital U.S. Aggregate Index is used by many bond fund managers as a benchmark to measure their relative performance. The index includes government securities (including Agencies), mortgage-backed securities, asset-backed securities and corporate securities to replicate the universe of bonds in the market. The maturities of the bonds in the index are longer than one year. An investor cannot invest directly in an index.
Bear market
A bear market is any market in which investment prices are in a sustained decline. However, a bear market differs from a market correction. While estimates may vary, conventional wisdom holds that a market decline of 20% or more in multiple benchmark indexes is considered to be the point where a correction becomes a bear market.
Benchmark
A benchmark is a predetermined standard against which the performance of a security, index, or investor can be measured. Typically, benchmarks are widely available published market indexes. For example, most fixed income managers use the Barclays Capital U.S. Aggregate Index1 as a benchmark of U.S. debt securities, or the S&P 500 Index as a benchmark of U.S. equities. For the purposes of calculating the alpha of a credit or portfolio, the benchmark may substitute for the overall market. Benchmarks may be customized to suit a particular portfolio. An investor cannot invest directly in an index.
Beta
Modern portfolio theory includes five risk ratios: alpha, beta, standard deviation, R-squared and the Sharpe ratio. These ratios are calculated to help investors ascertain the risk-reward profile of a security or fund. Beta, also known as the "beta coefficient," is a measure of a security's or a portfolio's volatility or risk in relation to the market. Beta may also be thought of as the tendency of a security's or portfolio's returns to respond to movements in the overall market.
A beta of 1.0 suggests that a security's or portfolio's price will move exactly in line with the market. A beta less than 1.0 suggests that a security's or portfolio's price will not fluctuate as much as the overall market, i.e., the security or portfolio is less volatile than the market as a whole. A beta of 0.8 means the security's total return is likely to be 80% of the market's change.
A beta greater than 1.0 suggests that a security's or portfolio's price will fluctuate more than the overall market, i.e., the security or portfolio is more volatile than the market as a whole. For example, a beta of 1.2 suggests the security's total return is likely to be 120% of the market's change.
Bubble
A bubble is an economic and/or price cycle characterized by a rapid acceleration in growth, or a surge in prices, that some market participants believe to be unfounded by underlying fundamentals. Eventually, prices will reach a point at which they "pop" and go into freefall until resources that were allocated to the inflated asset or industry have been transferred back to more productive areas over the long-run.
Bull market
A bull market is any market in which investment prices are in a sustained advance. A bull market gets its name from the way a bull attacks; by thrusting its horns up into its opponent. Likewise, a bear market gets its name from the way a bear attacks; by swiping its paws downward knocking its prey to the ground.
Commercial Mortgage-Backed Security
A Commercial Mortgage-Backed Security (CMBS) is a bond secured by the loan on a commercial property. A CMBS can provide liquidity to real estate investors and to commercial lenders. As with other types of MBS, the increased use of CMBS can be attributable to the rapid rise in real estate prices over the years.
CPI, or Consumer Price Index
The Consumer Price Index is an inflationary indicator published by the U.S. Bureau of Labor Statistics that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation. The core CPI excludes food and energy prices in the analysis, in an effort to remove the volatility typically seen in food and energy prices. The CPI has come under fire in recent years as a backward-looking measure of inflationary pressures. Some economists prefer the Personal Consumption Expenditure Index or the Employment Cost Index as alternative measures of price behavior at the consumer level of the economy.
Contraction
A contraction is the phase of the business cycle when the aggregate economy is in decline. Contractions occur after an expansionary phase. A recession is a prolonged contraction, typically lasting at least two or more quarters.
Convexity
Both convexity and duration measure a bond's sensitivity to changes in interest rates. Convexity, however, refers to the degree to which a bond's price-yield relationship departs from a linear relationship. Positive convexity corresponds to curvature that opens upward. Negative convexity corresponds to curvature that opens downward.
Correlation
Correlation refers to a statistical measure of how two securities move in relation to each other. Correlations are often used in portfolio management to evaluate the relative performance of securities, portfolios or market indices. Correlation ranges from -1.0 to +1.0. A correlation of zero suggests that the relationship between the two variables is random. When the correlation is negative, it means that the asset classes move in opposite directions over a given period, when the correlation is positive is suggests that the asset classes move in similar directions over a given period.
Credit Risk
Credit risk is the possibility that an issuer of a bond will default by failing to repay principal and/or interest in a timely manner.
Credit spread
In fixed-income markets, a credit spread represents the spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating.
Cyclical stocks and industry groups
A cyclical stock tends to rise quickly when economic growth is strong and fall rapidly when growth slows. A cyclical industry is one that is sensitive to the business cycle and price changes. Many cyclical industries tend to produce durable goods such as raw materials and heavy equipment.
Default
Default is the failure of a borrower to make payment of interest or principal on a debt security when it is due, or comply with the provisions of a bond indenture. In most cases, when a borrower defaults, the lenders may renegotiate the terms of the debt or force them to into bankruptcy.
Deflation
Deflation refers to the general downward aggregate price movement of goods and services in an economy. It is usually measured by the Consumer Price Index or the Personal Consumption Expenditure Index. At the wholesale level, deflation is typically measured by the Producer Price Index.
Depression
A depression is a severe and prolonged recession characterized by inefficient economic productivity, very high unemployment and falling price levels.
Diversification
Diversification is a portfolio risk-management strategy designed to combine a variety of investments and sectors that are unlikely to all move in the same direction at the same time. Diversification attempts to smooth out unsystematic risk in a portfolio, allowing the positive performance of some holdings to neutralize the negative performance of other exposures. It is important to note that the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.
Diversification cannot ensure an investment against market loss or assure a profit.
Dow Jones Industrial Average (DJIA)
The DJIA is perhaps the most popular measure of the stock market. The average, which was created by Charles Dow in 1896, is comprised of 30 common stocks of leading companies in major industries. Unlike the S&P 500, which is weighted by market capitalization, the DJIA is a price-weighted index — an arithmetic mean of current prices. An investor cannot invest directly in an index.
Duration
Duration represents the change in the value (price) of a fixed income security that will result from a 1% change in interest rates. Duration is a complicated calculation that takes into account present value, yield, coupon, final maturity and any call features of a bond. Duration is quantified in years and is a weighted measure of the length of time the bond will pay out.
Duration is a key measure of the interest rate risk that can affect the value of a security. A bond with a higher duration carries a greater interest rate risk and typically a greater potential reward. Duration is considered a more sophisticated measure of interest-rate sensitivity than average maturity.
Emerging Markets
An emerging market is the financial market of a developing economy. Emerging markets generally do not have the level of market efficiency and strict standards in accounting and securities regulation to be on par with advanced economies (such as the United States, Europe Union and Japan), but emerging markets will typically have a physical financial infrastructure including banks, exchanges, and a unified currency.
Expansionary period
An expansionary period is the phase of the business cycle when the aggregate economy, as measured by GDP, moves above its previous peak. Recovery defines the period of growth from a trough to the previous peak, and usually leads to an expansionary period. Therefore, the business cycle moves from contraction, to trough, to recovery, to expansion, to peak and back to contraction.
Federal Reserve System (Fed)
The Federal Reserve is the central bank of the U.S. It was established in 1913 and is governed by the Federal Reserve Board, which is headquartered in Washington, D.C. The system is comprised of the Board and 12 Federal Reserve Banks that are scattered around the country. The Fed is authorized to regulate monetary policy in the U.S. as well as to supervise Federal Reserve member banks, bank holding companies, international operations of American banks, and American operations of foreign banks.
Federal funds rate
The federal funds rate is the interest rate at which banks lend their excess reserves to banks that need to borrow overnight in order to meet their reserve requirements. The federal funds rate is a benchmark for U.S. interest rates and is targeted by the Federal Reserve's Open Market Committee. The Federal Reserve cannot set the federal funds rate since it is determined by the open market. However, the Fed conducts open market operations nearly every business day in an effort to keep the funds rate on target.
Flight to Quality
A flight to quality is the action of investors moving their capital from riskier investments to the safest possible investment vehicles, typically U.S. Treasuries. A flight to quality is usually triggered by uncertainty in the domestic and/or international financial markets, or political arena. A possible indication of a flight to quality may be dramatic fall in the yield on government securities as a result of a sudden increase in demand.
Fiscal policy
Fiscal policy represents decisions by the President and Congress, usually relating to taxation and government spending, that impact macroeconomic conditions such as employment, price stability and economic growth.
Federal Open Market Committee (FOMC)
The FOMC is the 12-member committee that establishes credit and interest rate policies for the Federal Reserve System. The committee consists of all seven members of the Fed's Board of Governors and five of the 12 Federal Reserve Bank Presidents. Of the five, the President of the Federal Reserve Bank of New York always retains his/her voting rights. The remaining four seats rotate annually among the eleven other regional Federal Reserve Banks, although the President of the Federal Reserve Bank of Chicago retains voting rights every other year.
The FOMC meets eight times each year and reports to Congress twice annually. The FOMC sets the Fed's key interest rates, such as the federal funds rate target and the discount rate.
Gross Domestic Product (GDP)
GDP is the aggregate market value of all final goods and services produced in a country in a given year. GDP is equal to the sum of consumer spending, investment spending, government spending, as well as the value of exports minus the value of imports:
GDP = C + G + I + (X-M)
Where:
C represents all private consumption, or consumer spending, in a nation's economy
G is the sum of government spending
I is the sum of all the country's capital investment
X represents the nation's total exports
M is the nations total imports
Hybrid security
A hybrid security combines two or more instruments, usually debt and equity. Convertible bonds are the most common form of hybrids, whose price movements tend to follow the equity prices of the stock into which it is convertible.
Inflation
Inflation refers to the general upward price movement of goods and services in the aggregate economy. It is usually measured by the Consumer Price Index and/or the Personal Consumption Expenditure Index. At the wholesale level, inflation is typically measured by the Producer Price Index.
Interest Rate Risk
Interest rate is the risk that a security's value changes due to a change in interest rates. Interest rate risk impacts the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall, reducing the value of a bond portfolio or fund's share price.
Inverted market
An inverted market refers to a futures market in which nearby monthly contracts are selling at premiums to deferred months. Inverted markets typically occur when a commodity is in short supply.
The exception is for interest rate futures markets, which are inverted when nearby months sell at a discount to deferred months.
Macroeconomics
Macroeconomics studies the behavior of an economy at the aggregate level, examining the causes and effects of unemployment, price behavior and national income.
Market capitalization
Market capitalization represents the market price of an entire company and is computed by multiplying the number of shares outstanding by the price per share. For example, if a company was trading at $10 per share and had 1 million shares outstanding, then its market capitalization would be $10 million ($10 x 1 million shares).
Stocks are often categorized by the market capitalization into three groups: large capitalization or large-cap stocks; mid-capitalization or mid-cap stocks; and small capitalization, or small-cap stocks. Although the exact break point between each grouping is inexact, and varies among similar products and strategies, market capitalizations typically fall into the following ranges:
Large Cap: more than $10 billion
Mid Cap: $3 billion to $10 billion
Small Cap: Less than $3 billion.
Maturity
The maturity of a bond is the length of time until its principal amount must be repaid to the bondholder or lender. Maturity is the end of the life of a security.
Microeconomics
Microeconomics studies the behavior of an economy at the household and company level. Microeconomics focuses on supply and demand and price determination for both goods and labor by examining the interaction between and choices made by both buyers and sellers in individual markets.
Monetary policy
Monetary policy refers to the management of the money supply and (by extension) interest rates by a central bank, such as the Federal Reserve Board. Monetary policy is said to be accommodative when it is designed to stimulate economic growth by increasing the level of bank reserves and boosting the money supply. That, in turn, should lower short-term interest rates, and reduce the cost of borrowing and investment. In contrast, monetary policy is said to be restrictive or tight when the central bank reduces bank reserves and shrinks the money supply. That should raise short-term interest rates, and increase the cost of borrowing and investment. The central bank manages monetary policy through daily open market operations.
Mortgage-backed Securities (MBS)
Mortgage-backed Securities are a type of bond that is secured by a mortgage or pool of mortgages. MBS payments are typically broken down into different classes of securities, depending on the riskiness of different mortgages as they are classified under the MBS.
Nominal long-term interest rate
Nominal long-term interest rate is the stated interest rate on a bond, unadjusted for inflation.
Pass-Throughs
Pass-throughs are vehicles comprised of pools of fixed-income securities backed by a package of assets. A pass-though is created when one or more holders of loans form a pool of securities and sell shares in the resulting pool. Once a loan is included in such a pool, it is said to be securitized.
Mortgage-backed securities are the most common type of pass-through. In an MBS pass-through, the homeowners' payments pass from the original lender through an intermediary to the investors. The servicing intermediary collects the monthly payments from issuers (borrowers) and, after deducting a fee, remits or passes them through to the holders (lenders) of the pass-through security.
Another common type of pass-through are agency pass-throughs, which are mortgage-backed securities whose principal and interest payments are guaranteed by government agencies, such as the Government National Mortgage Association (" Ginnie Mae "), Federal Home Loan Mortgage Corporation (" Freddie Mac") and Federal National Mortgage Association (" Fannie Mae").
Personal Consumption Expenditure Index (PCE)
The PCE is a measure of price changes in consumer goods and services. It consists of the actual and imputed expenditures of households and includes data pertaining to the consumption of durable goods, non-durables, and services. The PCE is released monthly as part of the personal income and consumption report.
Many economists prefer the PCE over the CPI as a measure of consumer prices. The PCI is a chain-type price index, which accounts for changes in consumer tastes. The weight assigned to each good and service change as consumer behavior changes. In contrast, the CPI is computed using a fixed basket of goods whose weights are only updated every few years.
Prepayment
Prepayment involves the payment of the principle or interest of a debt obligation before it is due.
Prepayment Risk
Prepayment risk is associated with the early and unscheduled return of principal on a fixed-income security. Some fixed-income securities, such as mortgage-backed securities, have embedded call options which may be exercised by the borrower. For example, if a homeowner adds additional principal to his/her monthly payment or refinances his/her mortgage, the risk of that occurring to the lender is the prepayment risk associated with the loan.
Prepayment risk leaves the yield-to-maturity of such securities uncertain at the time of purchase because the cash flows are unknown. When principal is returned early, future interest payments will not be paid on that part of the principal. If the bond was purchased at a premium (a price greater than 100), the bond's yield will be less than what was estimated at the time of purchase.
Price-to-book ratio
The price-to-book ratio is computed by dividing a stock's capitalization by its book value. This ratio compares the market's valuation of a company to the value indicated on its financial statements. The higher the ratio, the higher the premium the market is willing to pay for the company above its hard assets.
Price-to-earnings ratio
The price-to-earnings ratio, or P/E ratio, measures the price paid for a stock relative to the firm's income. The P/E ratio is computed by dividing a stock's market capitalization by its after-tax earnings over a 12-month period, usually the trailing period but sometimes uses the forward period, or expected earnings.
Price-to-sales ratio
The price-to-sales ratio is computed by dividing a stock's capitalization by its sales for the trailing 12 months. The price-to-sales ratio varies substantially across industries; therefore, it's useful mainly when comparing companies within the same industry.
R-Squared
Modern portfolio theory includes five risk ratios: alpha, beta, standard deviation, R-squared, and the Sharpe ratio. These ratios are calculated to help investors ascertain the risk-reward profile of a security or fund. R-squared is derived through regression analysis and is the square of the correlation coefficient proportion of the variability explained by the linear regression model.
In portfolio analysis, R-squared measures how closely a portfolio's performance correlates with the performance of a benchmark. It measures the portion of a security's or portfolio's performance that can be explained by the performance of the overall market or benchmark. R-squared ranges in value from 0 to 1, where zero indicates no correlation and 1 indicates perfect correlation.
R-squared is typically used in conjunction with beta analysis. A higher R-squared usually adds more confidence to the beta value of a security or portfolio.
Real long-term interest rates
Real long-term interest rates are adjusted to remove the effect of inflation, thereby allowing the borrower and lender to see their real cost and their real yield respectively. The real rate of interest is approximated by taking the nominal interest rate and subtracting inflation. By correcting for inflation, the real interest rate is the growth rate of purchasing power derived from an investment.
Recession
A recession is a prolonged economic contraction, typically lasting at least two or more quarters.
Relative valuation
Relative valuation refers to the process of determining the attractiveness of an asset or company by measuring it against the value of another similar asset or company. Attractiveness is typically measured in terms of risk, liquidity and return of one instrument relative to another, or for a given instrument, of one maturity relative to another.
Risk
Risk is the possibility that an investment's actual return will be different than the expected return. Risk is typically measured by calculating the standard deviation of the historical returns or average returns of a specific investment. The relationship between risk and return is fundamental to understanding finance. The greater the risk to an investor, the potential return to that investor must be greater as well. Otherwise the investor would not be rewarded for taking on the additional risk.
Risk-free rate
The risk-free rate is the theoretical interest rate returned on an investment that is completely free of risk. In practice, the three-month U.S Treasury bill is a close approximation to the risk-free rate and is typically used in financial modeling. The three-month bill is widely considered to be risk-free because the U.S. Government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity.
S&P 500 Index
The Standard and Poor's 500 index is a common measure of the stock market, representing 500 of the largest capitalization stocks trading on U.S. exchanges. The index represents a broad swathe of the industries that comprise the U.S. economy. Unlike the Dow Jones Industrial Average, the S&P 500 is float-weighted by market capitalization. An investor cannot invest directly in an index.
Sharpe ratio
Modern portfolio theory includes five risk ratios: alpha, beta, standard deviation, R-squared, and the Sharpe ratio. The Sharpe ratio is computed by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.
The ratio is calculated to help investors ascertain the risk-reward profile of a security or fund. A higher Sharpe ratio suggests that a portfolio's returns may have been derived from sounder investment decisions, not just increased risk. This can be useful since a portfolio manager is only better than his/her peers if their returns are not accompanied by excessive risk.
Sortino Ratio
The Sortino ratio was developed to differentiate between the effects of upward and downward price movements on the Sharpe ratio. The Sortino ratio is computed by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of only the negative portfolio returns.
Standard deviation
Standard deviation is a measure of dispersion of a set of data from its mean. In finance, it represents a statistical measure of an investment's range of performance. When a security or portfolio has a high standard deviation, the range of performance is very wide, suggesting there is a greater potential for volatility. Standard deviation is calculated as the square root of variance. Investors use standard deviation as a gauge of a security's or portfolio's expected volatility.
Systematic risk
Systematic risk refers to the risk inherent in the entire market. It is the minimum level of risk that cannot be addressed through diversification or hedging.
Treasury Inflation-Protected Securities (TIPS)
TIPS are U.S. Treasury notes and bonds that have a fixed coupon rate and mature on a fixed date. However, the coupon payments and underlying principal are automatically increased to compensate for inflation as measured by the Consumer Price Index (CPI).
Tracking error
Tracking error measures the difference between the price behavior of a holding or portfolio and the price behavior of a benchmark. The tracking error is the divergence between the return you received and that of the benchmark you were trying to match or outperform.
Unsystematic risk or residual risk
Unsystematic risk refers to the risk of price change due to events or circumstances surrounding a specific security, rather than the aggregate market.
Variance
A measure of dispersion of a set of data points around their mean value, the mathematical expectation of the squared deviations from the mean. Variance measures the volatility from an average. The square root of the variance is the standard deviation.
Weighted average life
The average number of years for which each dollar of unpaid principal remains outstanding. In other words, the weighted average life computes the how many years it takes to pay off half of the principal of a bond. The time weightings are based on principal paydowns. For example, principal paydowns for a mortgage are weighted heavily toward to latter years of the life of the loan, so the weighted average life of a mortgage will likely fall well after the midpoint of the life of the loan.
Whole Loan
A term used to distinguish between an original mortgage loan and a pass-through. Whole loans are usually larger in size than the maximum amount allowed within GNMA, FNMA and, FHLMC's standards.
Yield
A yield represents the income return on an investment expressed as a percentage, usually on an annual basis.
Yield curve
A yield curve plots the static relationship between yields and maturity dates for a set of similar bonds, usually Treasuries, with different maturities. In general, the yield of longer-term bonds will exceed the yield of shorter-term bonds.
The shape of the yield curve is a closely watched leading indicator of economic activity. There are three main types of yield curve shapes: normal, inverted and flat. A normal yield curve is positively sloped - longer maturity bonds have a higher yield than shorter-term bonds. This is considered a normal yield curve because the longer maturities introduce an increased amount of risk. An inverted yield curve is negatively sloped - shorter-term bonds have a higher yield than longer-term bonds. This may be interpreted as leading indicator of slower aggregate economic activity. A flat yield curve is one in which the spread between shorter-term and longer-term yields is very tight. The slope of the yield curve is also closely watched: the steeper the slope, the wider the spread between short- and long-term rates.
All investments are subject to risk including possible loss of principal.1 Prior to November 3, 2008, this index was known as the Lehman Brothers U.S. Aggregate Index.
