Fin management materials / 11 P4AFM-Session17_j08

SESSION 17 – GLOSSARY

Accounting Rate of Return (ARR) – the average annual operating profit generated by a project expressed as a percentage of initial or average investment.

Adjusted Present Value (APV) - an approach to appraising a project whose financing would change the firm’s capital structure i.e. financial risk

Agency Costs – the reduction in shareholders’ returns below the maximum possible level due to company managers following personal objectives not in the best interests of shareholders

Alpha – a measure of abnormal return from a security i.e. where the forecast return is higher or lower than expected by CAPM

American/US style options – can be exercised by the holder at any time until the expiry date

Arbitrage Pricing Theory - a multi-index model where the required return on an investment is determined by a variety of factors such as return on the market, industrial growth rates etc

Asymmetry of information – the fact that potential investors know less about a company than its managers and may therefore over-estimate the risk of providing finance. This can be a particular problem for SME’s

Basis – the difference between the price of a futures contract and the spot price of the underlying asset

Basis risk – (i) the risk that interest rates on assets and liabilities are referenced to a different benchmark (ii) the risk of an unexpected change in the level of basis in a futures contract

Beta factors – a measure of the sensitivity of a security’s returns to systematic risk

Bird in the Hand theory – suggest that shareholders may prefer the certainty of a cash dividend today rather than reinvestment of profits to create an uncertain capital gain in the future

Black-Scholes Model - Fischer Black and Mryon Scholes’ 1973 model for calculating the theoretical price of a European call option.

Bonus issue – issue of new shares to existing shareholders, without any subscription of new funds. Also referred to as a scrip issue

Business Risk – the volatility of operating profits, caused by the volatility of revenues and the level of operational gearing

Call option – gives the holder the right to buy the underlying asset.

CAPM – Capital Asset Pricing Model. A model that relates the systematic risk of an investment to the required return

Cap – an agreement that fixes a maximum rate of interest. An interest rate cap is an agreement by the seller of the cap to pay the buyer the excess of the reference interest rate over the agreed cap rate, based on a notional principal amount.

Capital Market Line – shows different possible combinations of holding a risk-free asset and the Market Portfolio

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SESSION 17 – GLOSSARY

Capital Rationing – where insufficient finance is available to undertake all available positive NPV projects

Certificate of deposit – a tradable security issued by banks to investors who deposit a fixed amount for a fixed period

Clientele Theory – suggest that a company’s historical dividend pattern may have attracted particular investors. Changing the pattern in future may cause this “clientele” to sell their holdings and lead to a fall in share price

Collar – an agreement that keeps either a borrowing or lending rate between specified upper and lower limits. A low-cost cap is a combination of a purchased cap and a written/sold floor agreement. It protects against rising interest rates but limits participation in falling rates

Corporate governance – controls and procedures implemented to reduce agency costs to an acceptable level. Corporate governance is defined as “the system by which companies are directed and controlled”.

Corporate Social Responsibility (CSR) – a model which suggests that company managers should take into account the objectives of a wide range of stakeholders and not just the shareholders

Currency Futures Contracts – a standard contract between buyer and seller, in which the buyer has a binding obligation to buy a fixed amount (the contract size), at a fixed exchange rate (the futures price), on a fixed date (the delivery date), of an underlying currency via a recognised exchange

Currency Swaps – A currency swap is a formal agreement between two parties to exchange principal and interest payments in different currencies over a stated time period

Delta – Delta is the change in price of an option for a small change in the price of the underlying asset. It is calculated as N(d1) from the Black Scholes Model. Also referred to as “the hedge ratio”

Delta hedging - setting up an options position as dictated by the hedge ratio to create a deltaneutral i.e. risk-free portfolio

Divestment – the withdrawal of investment in an activity

Dividend Valuation Model – states that the value of a share is the present value of future expected dividends, discounted at the investors’ required return

Duration - measures the time over which half of a project’s returns are recovered in present value terms

Economic risk – the risk that long-term changes in exchange rates affects a company’s cash flows

Economic Value Added (EVA) - measures the surplus profit being generated by a firm above the minimum level required by its providers of long-term finance

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SESSION 17 – GLOSSARY

Efficient Markets Hypothesis (EHM) – a theory which asks what information is reflected in share prices

Environmental Management Accounting (EMA) – attempts to measure the full environmental impact of a company’s operations e.g. the cost of inefficient energy usage due to poor insulation of buildings

Eurobond Market – Eurobonds are long term debt securities denominated in a currency outside of its country of origin

Eurocredit market – medium to long-term international bank loans given by banks located outside the country which issued the currency

Eurocurrency market – Eurocurrency is currency deposited outside of its country of issue

Euromarkets – banking and financial markets which are located outside the country which issued the currency

Euronote market – variety of short to medium-term debt instruments issued in the Euromarkets

European option – can be exercised on its expiry date, but not before

FX swaps – where there is a swap of currencies between counterparties but no swap of interest

Financial gearing/leverage – the proportion of debt in the capital structure

Financial risk – the increased volatility of returns to ordinary shareholders due to interest on debt being a fixed committed cost

Financial distress risk – the risk of bankruptcy caused by dangerously high levels of financial gearing

Floor – an agreement that fixes a minimum rate of interest. An interest rate floor is an agreement by the seller of the floor to pay the buyer the excess of the agreed floor rate over the reference interest rate based upon a notional principal amount

Forward contract – a legally binding contract between a company and a bank to buy or sell a fixed amount of foreign currency at a fixed exchange rate on a fixed date in the future

Forward Rate Agreements – contracts which allow companies in advance to fix future borrowing or lending rates, based on a notional principal over a given period

Free Cash Flow to Equity - the surplus cash flow generated for shareholders i.e. the potential dividend

Free Cash Flow to the Firm – the cash flow available to all of the company’s investors, both equity investors and debt investors

Futures contract – a traded forward contract

Gamma – measures the rate of change of delta as the price of the underlying asset changes.

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SESSION 17 – GLOSSARY

Gap exposure – the risk that interest rates on assets and liabilities are reset at different intervals

Gordon’s growth model – states that the forecast growth rate of a company’s dividend = proportion of profits retained × return on equity

Grabbe Model - Orlin Grabbe’s modified version of the Black-Scholes Model which can be used to value currency options

Gross Redemption Yield – see Yield to Maturity

Interest Rate Futures – interest rate futures (IRF’s) are traded forward interest rate agreements

Interest Rate Swaps – an exchange between two parties of interest obligations or receipts in the same currency on an agreed amount of notional principal for an agreed period of time

Intrinsic value of an option – intrinsic value of an option is its basic or fundamental price or value. It is the profit that a purchaser could make if the option were exercised immediately

IRR – Internal Rate of Return; the discount rate where NPV equals zero

Market Portfolio – an equity portfolio containing every share listed on the stock market and hence contains zero unsystematic risk

Market Value Added – present value of EVA forecast to infinity

Merton Model - Robert Merton’s model for estimating credit spreads and the probability of default on corporate debt. Based upon the Black Scholes Model

Mezzanine finance - a form of high risk unsecured debt bordering on equity, with its exact nature depending on how it is structured

Modified Internal Rate of Return (MIRR) - the average annual % return on a project under the assumption that its cash flows are reinvested at the firm’s minimum required return

Non-deliverable forwards (NDF’s) – An NDF is a short-term, cash-settled currency forward contract between two counterparties. Also known as SAFE’s – Synthetic Agreements on Foreign Exchange.

NPV – Net Present Value; the change in shareholders’ wealth due to an investment project

Operational gearing – the proportion of fixed operating costs to variable operating costs

Option – a contract giving one party the right, but not the obligation, to buy or sell an underlying asset at a given price, on or before a specified date (expiry date)

Payback – the period of time required for the operating cash flows from a project to equal the cost of investment

Pecking Order theory – a theory which suggests that company managers have a preference for using internal finance i.e. retained earnings, rather than external finance. A key cause may be asymmetry of information

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SESSION 17 – GLOSSARY

Pre-emptive rights – the right of existing shareholders to be offered new shares before they can be offered to new investors. Also known as pre-emption rights

Put option – gives the holder the right to sell the underlying asset

Recovery period - the number of years required to recover a project’s initial investment, taking into account the time value of money

Rho – measures how much option prices change with changes in interest rates.

Rights Issue – an offer of new shares to existing shareholders who hold pre-emptive rights

Risk – An investment is defined as having a degree of risk if its returns are uncertain or variable. The amount of risk an investment has will depend upon the variability of the returns of the investment around the average return

Scrip dividend – issue of new shares to existing shareholders in lieu of a cash dividend

Scrip Issue – see bonus issue

Securities – financial instruments that can be traded e.g. shares, bonds and derivatives

Security Market Line – a graph of the CAPM formula

Security Characteristic Line – a graph of the excess returns from a particular share (above the risk-free rate) against the excess returns from the market portfolio. The gradient of the line measures the share’s beta factor.

SME’s – Small and Medium-sized Enterprises. No official definition exists but generally these are unlisted companies

Special dividend – a substantial dividend payment that is not expected to be repeated in the near future

Spin off – splitting a group into two or more independent units. Another name for a demerger

Stakeholders – groups of people who have some type of interest in an organization. Shareholders are the key stakeholder but other groups include employees, customers, suppliers and, arguably, even society as a whole

Swaptions – A swaption is an option that provides the holder with the right but not the obligation to execute an interest rate (or a currency swap) during a limited period of time and at a specified rate

Systematic risk – the relative effect on the returns of an individual security of changes in the market as a whole. Also known as market risk. It cannot be removed by diversification but can be measured using beta factors

Tax Shield – interest on debt is a tax allowable expense for a company and leads to lower corporate tax payments

Term Structure of Interest Rates – the relationship between short and long term interest rates

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SESSION 17 – GLOSSARY

Tick size – the minimum price movement recognised by the futures market

Tick value – the gain or loss on one futures contract for a one tick price change

Time value of an option – the difference between the premium and the intrinsic value.

Theta – measures how much value an option loses over time. The theta is usually expressed as the amount of loss per day

Total Shareholder Returns (TSR) – the total return to shareholders via dividend and capital gain, usually measured over a one year period

Transaction Risk – the risk that exchange rates change between the date of an import/export and the related payment/receipt of foreign currency

Translation risk – gains/losses caused by translating the financial statements of overseas subsidiaries into the reporting currency of the parent upon consolidation

Treasury Bills – virtually risk-free short-dated debt securities issued by governments

Unbundling - the process of selling off incidental businesses in order to concentrate resources on the core business

Unsystematic risk – the risk that is specific to a company and hence can be diversified away by building a portfolio of investments

Value At Risk (VAR) - gives an indication of the potential loss which is likely to occur from a project at a given level of confidence

Vega – measures how much option prices change with changes in volatility of the underlying asset

WACC – Weighted Average Cost of Capital; the average cost of long-term finance

Warrants – share options attached to debt to make the debt more attractive to investors

Yield to Maturity (YTM) – the average annualized return on a debt security, taking into account both income and capital gains

Z-Score Model - a multivariate model combining five different financial ratios to determine the likelihood of financial distress i.e. bankruptcy

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