Words and expressions

Absolute return

Often used as a way to describe portfolios or funds which are not measured against any particular index, but rather aims to generate a positive return now matter the market direction. Hedgefunds are sometimes labelled as absolute return funds.

Equity Index

Shows the development over time of all, or part of, the stocks quoted on a particular stock exchange, with a rebased to a specific year, often with value 100. Important equity indexes in Sweden are Generlaindex (SGX) which contains all the quoted shares and OMX30 which is made up of the 30 largest companies by market capitalisation. International index of importance is Dow Jones Industrial Average (DJIA) and NASDAQ in New Your, FTSE 100 in London and Nikkei 225 in Tokyo. One of most used World Index is MSCI. Many asset managers compare themselves with this particular index.

Portfolio theory

Harry Markowitz at Chicago university showed 1952 the relationship between risk and return in a famous article. His doctor thesis “Portfolio Selection” got a lot of attention and he was later rewarded with the Nobel Prise together with William Sharpe and Merton Miller. Sharpe and Miller had developed Markowitz’s ideas and formed the well known Capital Asset Pricing Model, or CAPM. A cornerstone in portfolio theory is that an investor cannot expect to get a higher return than the short interest rate if he or she is not prepared to take on some risk. The risk is measured by what mathematicians call Variance or Standard deviation. If the price of a financial instrument is moving a lot, it is deemed to be a high risk investment.

Within the financial community there is a strong consensus that risk and return is linked together. The definition of risk may vary though. One type of risk, specific risk, is possible to avoid by diversifying the portfolio. Market risk however is always present everywhere in all portfolios and investments, even in a bank account.

Active Risk

Is used within asset management to describe the risk originating from active allocation in funds and portfolios.  Also known as tracking error or TE which is measured as allocation divergence relative ti a benchmark.

Active management

Active allocation or selection of securities to invest in. Opposite to passive management or index tracking.

Alpha

An often used expression in asset management.  Alpha describes the added value a manager creates relative to the risk. This measure is also called Jensen’s Alpha after an article written by Michael Jensen 1968. A negative Alpha mean that the return of an investment is lower than would be expected by it’d Beta. Beta is a sensitivity measure.

Allemansfond

Prior to 1996 a Swedish tax efficient mutual fund type, which still have significant assets under management.

Alemansdepå

A draft legislation regarding an account that would be much like a capital insurance. It is suggested that a flat tax is paid on the amount yearly instead of capital gain tax. Which instruments that would be in scope and level of the flat tax is still not decided.

Arbitrage

Simultaneously buying or selling the same good at different prices, whereby a risk free profit is achieved.

Asian Crisis

The financial crisis late 1997 and 1998. Unrealistic fixed currency regimes was broken starting with the Thai Bath. Other Asian currencies followed. This led to a high level of uncertainty on the world financial markets with high volatility as a result.

Bank Guarantee

A guarantee that shields deposits in banks in the event of a bank default. The Bank Guarantee was turned into a State Guarantee for deposits in late -95 which guarantee deposits up to  250k SEK. During the financial crisis in 2008 this was hiked to 500k SEK.

Basbelopp

A fixed amount that is decided by the government each year and that serves as a reference amount when calculating pensions, health insurance, and many other welfare programmes. The amount is regulated by the CPI index which mirrors a broad picture of the cost of living. Basbeloppet was first defined in 1960 and was then set to 4200 SEK. For the year 2010 it is set to 42400 SEK.

Bear Market

The exact definition varies, but in general a Bear Market is an expression used to describe a falling or negative market. The length and depth of the fall that is required to qualify as a Bear Market varies,  but for the stock market -20% is normally used as a benchmark.

Black & Scholes

A pricing model for options introduced in 1973 by Fischer Black and Myron Scholes. The model calculates the theoretical value of an option with 5 parameters as input. These are; the current price of the underlying instrument, the strike price, risk free interest rate, the volatility of the underlying instrument and time to expiry. Of these only the future volatility is unknown.

Bull Market

The opposite of a Bear Market. A market that is rising or producing positive returns for investors being long that particular market.

Carry trade

A long term fixed income strategy that involves borrowing at a low interest rate and investing at a higher interest rate. Typically risks like credit risk, FX risk, liquidity risk and interest rate risk are imbedded in this strategy. A popular carry trade before the US subprime crisis in 2008 was to borrow in JPY and buy NZD bonds.

Courtage

A transaction fee that is paid to the broker of financial instruments and products.

Credit risk

Credit risk is defined as the risk that the creditor is not able to fulfil its obligations. This could for example be a company not able to pay promised coupons on a corporate bond, or a counterpart not able to honour its part of a OTC derivative transaction. Rating institutes such as Fitch and Moody’s rates corporate bonds to help investors quantify, among other things, credit risk.

Cycles

A theory within technical analysis that believes that markets moves in cycles. One advocate for this theory is the Elliott Wave theory.

Day trader

A private person that is involved in high frequency trading. Normally trades are executed on the basis of different technical analysis, rather than on fundamental indicators.

Deflation

The opposite of Inflation. A term in economics that describes falling prices in an economy.  It is difficult to stimulate an economy that is in a deflationary state as economical agents has incentive to save any marginal increase in income as the real value, and thereby the purchasing power, of cash is rising every day. Hence there are incentives to postpone all consumption and investments. Japan has struggled with this problem during the last decade.

Dividend yield

A term used in the equity markets which describes the dividend of a particular stock in relation th the price of that stock.

Devaluing

A decision possible in a fixed exchange rate regime to value the currency of a country lower towards other currencies.  The purchasing power of the county declines, but exporters are helped as they are able to sell their goods cheaper. One problem that might occur when a country is devaluing is that the country will import inflation as imports suddenly are more expensive.

Duration

A measure of risk in fixed income securities. It express the average time to maturity taking the coupon payments into account. It could be described as a sensitivity measure of a bond to changes in the interest rate level, and thus related to the Delta of an option. Basically the first derivative of the price subject to a change in interest rates, i.e. a linear approximation to the price-yield relationship. For a better fit, especially when the interest rate volatility is high, the second derivative or Convexity should also be taken into account.

Efficient market hypothesis

A non-arbitrage theory advocated by among other Eugene Fama. In essence there are 3 levels of market efficiency. In the most efficient state, strong market efficiency, all investor has access to the same information and the financial markets at all times only price known information. Hence, for the market to move, new information must be added. When it is, an instantaneous reaction shifts the market price to the new level taking the new information into account.

Financial bubble

A phenomenon occurring when the pricing of financial assets no longer is based on realistic assumptions about future cash flow.

Finansinspektionen

The Swedish financial authority, supervising the financial markets and financial institutions. Finansinspektionen is also involved in consumer protection when it comes to financial products.

Fund Insurance

An insurance with a supply of mutual funds. This could for example be a pension insurance or capital insurance.

Fundamental Analysis

A term usually used in stock valuation. The fundamental analysis is based on the financial statements of a company and the analyst is then trying to estimate the present value of future cash flow.

GDP

A measure used in economics to quantify the value of produced goods and services.

Inflation

The word comes from the Latin “inflatio” which mean expand or inflate. In economics the term is used to describe an economy with rising price levels. The result of inflation is that the real value of money is decreasing.  Hence there are strong incentives in the economy to use the money as soon as possible, since it will be worth less tomorrow. This is why inflation often leads to overheating in the economy as the wheels turns faster and faster if nothing is done to bring inflation back down. Today it is the job of the Central Banks to keep inflation in check.

ISIN

A unique identification code that all financial instruments have.

Investor protection

The investor protection applies to financial instrument such as stocks, bonds and derivatives that is bought, sold or deposited in a financial institute. Tea maximum amount is 250k SEK.

Long Yield

The yield of a long government bond, typically with longer maturity than 10 years.

Market risk premium

In portfolio theory a term that measures the difference between the non-diversifiable market risk and the risk free interest rate.

Morningstar

An institute that rates mutual funds.  Morningstar has been in operation in Sweden since March 17 1999. The mother company is Citygate. The institute supplies independent and unbiased information on mutual funds.

PB ratio

A key ratio used in valuing companies. The price of the stock is put in relation to what the book value of the company is. Hence, what the owners would get if they broke up the company and sold all the assets.

PEG ratio

A key ratio used for valuation of growth companies.  It is defined as the PE ration divided by the company’s growth ratio. Hence, a company with PE of 12 and a growth rate of 6% has a PEG of 2. The lower the PEG the cheaper the company. A rule of thumb is that a company with a PEG below 1 is attractively priced.

PE ratio

A key ratio used in valuing companies. The price of the stock, P, is set in relation to the earnings, E, of the company and thus it is a measure of how expensive the profit stream of a particular company is. Historically the stocks listed at Stockholm Exchange has had an average PE between 8-15, with large individual deviations. The inverse of the PE ratio could also be used to value stocks relative to bonds, as the stock is then seen as a bond with the yearly profit as a yearly coupons.

PS ratio

A key ratio used in valuing companies. The PS ration shows how the company’s turnover or sales is valued. This measure the cash flow in the company relative to the stock price. This is especially useful for young companies not yet generating a profit. By pricing the top line growth, it will be possible to say something about the value of the company even though it is not making a profit.

Sharpe ratio

A key ratio in portfolio management developed by William Sharpe in 1966. It was designed as a measure to risk adjust returns, i.e. to make it easier to compare investment with different returns and different risks. However the risk in the Sharpe ration is defined as standard deviation and is hence path independent, which is an unrealistic assumption.

Short selling

This is a trade where an investor borrows a security from someone, and immediately sells it in the market. Later she has to buy the security back in the market in order to give it back the person she borrowed it from. Obviously, if she sold it at 100 and bought it back at 90 she made a profit of 10. Short selling is used when an investor expect the price of an overvalued security to fall.

Spread

The difference between what buyers want to pay and what sellers is asking in a financial instrument. Could also be the difference between two different instruments like a corporate bond and a government with the same maturity.

Standard deviation

A statistical measure designed to quantify the distribution of a material. In finance it is often mistaken for financial risk, but is actually a distribution and variance measure. However, if the standard deviation is high it is more difficult to foresee a future value of an instrument or portfolio, as the possible distribution is wider.

Technical analysis

This is a term for the family of analysis tools based on the historic development of prices of stocks, bonds, currencies or commodities. The aim is to try to forecast future development in priced based on previous moves and patterns. Technical analysts argue that there is little use to do any fundamental analysis as all available information and expectations are accumulated in the present price of a financial instrument. There is a vast flora of tools developed by technical analysts over the years. Most commonly used are MA, MACD, RSI, Elliot Wave, DeMark, Williams R, Bollinger Bands, Parablics and Oscillators. One of the oldest technical analysis methods is the Japanese Candlesticks developed by rice trader Homma Munehisa in the 18th century. This gave Mr Munehisa an overview of open, high, low and closing levels in the market. This method was picked up by Charles Dow around 1900 who founded the Wall Street Journal.

A recent, more scientific, branch is the Behavioural finance theories, which argues that rationality is not always present when people makes decisions but rather psychology and rules of thumb are driver of decision processes.

Value-at-Risk (VaR)

A method used in portfolio management and trading, measuring the amount of downside risk a portfolio or position has within a certain time frame. To quantify the VaR, a normal distribution is often used to assess the probability of a certain move. For example a portfolio can be structured so that it will not lose more than 4% with 95% probability during 1 trading day. A problem with this approach is that it expects the liquidity to be constant, which it rarely is.

Volatility

There are two types of volatility, Implied and historic. The implied volatility is backed out of the B&S formula and is a way to judge if an option is cheap or expensive. Historic volatility on the other hand is a modified measure for standard deviation or variance. As uncertainty of the future price of a financial instrument that follows a wiener process increases over time, the standard deviation has to be modified by time. But this is not a linear relationship, as time goes some moves cancel each other out, and the distance from initial price is less than a linear relationship would predict. Historical, or actual, volatility is therefore calculated as standard deviation times the square root of time. It is expressed in percentage.