AF4036 Principles and Theories of Finance Flashcards

A comprehensive vocabulary set covering the financial system, markets, investment theory, interest rates, foreign exchange, and green finance based on the AF4036 lecture notes.

Lender (surplus unit)

Someone with surplus funds who generally wants high return, liquidity, certainty and minimal risk (examples: mortgage providers, credit-card companies, households, institutions).

Borrower (deficit unit)

Someone who needs funds and generally wants low cost and cash for a preferred period (examples: individuals, governments, businesses).

Financial market

A physical or virtual place where financial claims are issued or traded.

Financial institution

A business that deals with borrowers and savers and often offers financial advice.

Money market

Market for short-term (original maturity < $1$ year) financial claims.

Capital market

Market for long-term (original maturity > $1$ year) financial claims.

Deposit-taking institutions (DTIs)

Retail banks, investment banks, and building societies.

Non-deposit-taking institutions (NDTIs)

Insurance companies, pension funds, unit trusts, and investment trusts.

Retail / commercial bank

Manages deposits and withdrawals and supplies short-term loans to individuals and small businesses.

Investment bank

Provides underwriting, corporate reorganisation and other services mainly to institutional clients.

Building society

Member-owned institution providing banking and other financial services to members.

Credit union

Member-owned financial co-operative where profits are shared among members.

Insurance company

Provides coverage (compensation for loss) in exchange for a premium.

Unit / investment trust

Allows individuals to invest in a diversified portfolio of assets.

Credit-rating agency

Independent agency that gives an opinion on the financial strength of other institutions.

Financial liability

A financial obligation owed to somebody else (debt).

Financial asset

A claim that somebody owes you, or a product you hold.

Risk

The probability of financial loss or gain; the possibility that future events do not turn out as expected.

Maturity

The time until a financial product pays back in full or ends.

Liquidity

How easily an asset can be turned into cash.

Debt

Product usually sold with fixed maturity where the issuer pays interest.

Equity (ownership)

Issuer sells certain rights; may pay dividends; no fixed maturity.

Primary market

Where new issues of debt or equity are sold; includes IPOs.

Secondary market

Where existing debt or equity is traded.

OTC (over-the-counter)

Trade conducted directly between buyer and seller.

Exchange

Physical or virtual location where buyers and sellers meet to trade.

Treasury bill (T-bill)

Short-term government debt issued at a discount and redeemed at face value, with typical maturities of $28$, $63$, $91$, or $182$ days.

Commercial paper

Short-term unsecured debt issued by large high-reputation companies.

Certificate of deposit (CD)

Bank deposit with fixed term where interest is paid at maturity; often negotiable.

Bankers’ acceptance

Trade-finance instrument between banks that becomes a tradable instrument after acceptance.

Repurchase agreement (repo)

Sale of securities (often T-bills) with an agreement to repurchase at a higher price; used for liquidity as a product of last resort.

Ordinary shares

Ownership stake with voting rights and no maturity; price is driven by supply and demand, and dividends may be received.

Preference shares

Shares with a preferred dividend and priority in liquidation, usually without voting rights.

Bond (or gilt in the UK)

Negotiable instrument that generally pays a fixed coupon, has a par/redemption value, and usually a fixed maturity date.

Saving (finance definition)

Personal disposable income minus personal consumption expenditure ($\text{income} - \text{spending}$).

Savings

A stock of assets, usually in the form of deposits.

Investment

Any vehicle into which funds are placed with the expectation of positive income, preservation, or increase in value; the sacrifice of current consumption for future gain.

Utility

Satisfaction, pleasure, or fulfilment derived from consuming a good or service.

Diminishing marginal utility

The principle that the more we have of something, the less additional utility each extra unit brings.

Prospect Theory (Kahneman & Tversky)

Theory stating that utility carriers are changes in wealth relative to a reference point; losses loom larger than gains, leading to risk aversion for gains and risk-seeking for losses.

Homo economicus

Decison-maker who searches for complete information, is risk-sensitive, and makes unbiased decisions.

Return

Reward for investment consisting of periodic cash income (interest/dividend) and capital gain/loss.

Efficient portfolio

Highest return for a given level of risk, or lowest risk for a given return.

Portfolio diversification principle

Spreading risk across and within asset classes, sectors, and regions to avoid putting all eggs in one basket.

Unsystematic risk

Unique or firm-specific risk that can be diversified away.

Systematic risk

Market risk that cannot be diversified away, arising from economy-wide factors.

Capital Asset Pricing Model (CAPM)

Equilibrium model linking risk and return assuming only systematic risk is priced: $\text{required return} = r_f + \beta \times (r_m - r_f)$.

Beta ($\beta$)

Measure of non-diversifiable / market risk; sensitivity of a security’s return to market return; market $\beta = 1$.

Interest rate

The price of time and risk; the rate of return paid by a borrower to a lender.

Expectation theory

Theory that long-term rates are determined by expected future short-term rates.

Liquidity-preference theory

Theory that investors prefer short-term bonds and require a liquidity premium for longer bonds.

Market-segmentation theory

Theory that markets for different maturities are completely segmented and rates in one do not affect others.

Spot exchange rate

Exchange rate for immediate delivery.

Forward exchange rate

Exchange rate agreed now for delivery at a future date.

Direct quotation

Units of home currency per unit of foreign currency.

Indirect quotation

Units of foreign currency per unit of home currency; the standard UK quotation for sterling.

Spread

Difference between bid and offer rates; reflects risk and covers costs/profit.

Impossible trinity

Economic theory that a country cannot simultaneously have free capital movement, a fixed exchange rate, and an independent monetary policy.

Purchasing-power parity (PPP)

Exchange rate that equalises the cost of the same basket of goods in two different countries.

LIBOR

London Interbank Offered Rate; trimmed mean of bank rates used as a global reference until its end in $2022$.

SOFR

Secured Overnight Financing Rate; the USD replacement for LIBOR.

SONIA

Sterling Overnight Index Average; the GBP replacement for LIBOR.

Day-count convention (UK/Japan)

$\text{Actual} / 365$ days per year.

Treasury-bill discount yield formula

$$dy = \frac{FV - P}{FV} \times \frac{360}{t} \times 100$$

Gilt

A UK government bond traded on the London Stock Exchange by authorised market-makers (GEMMs).

Bond indenture

Legal contract containing restrictive covenants, subordination, and other terms between the issuer and bondholder.

Eurobond

Bond denominated in a currency other than that of the country of issue and underwritten by an international syndicate.

Strips

Individual coupon and principal cash-flows of a bond traded separately as zero-coupon instruments.

Clean price

Bond price excluding accrued interest.

Dirty price

Bond price including accrued interest ($\text{Clean Price} + \text{Accrued Interest}$).

Rights issue

New shares offered to existing shareholders, usually at a discount, to raise capital while preserving proportional ownership.

Bonus / scrip / capitalisation issue

Free shares issued to existing shareholders, reducing the market price proportionally.

Stock split

Increase in the number of shares with a proportional reduction in nominal and market price.

AIM (Alternative Investment Market)

London Stock Exchange market with less stringent requirements for smaller, younger companies.

Arbitrage

Risk-free profit gained from the simultaneous buying and selling of the same asset in different markets.

Pound-cost averaging

Investing fixed amounts at regular intervals to buy more units when prices are low and fewer when high, smoothing market timing risk.

Greenwashing

Misleading environmental claims used for marketing purposes.

ESG

Environmental, Social, and Governance factors used to direct and control businesses.

Negative screening

SRI strategy of excluding 'sin stocks' such as alcohol, tobacco, and gambling.

Green bond

Debt instrument whose proceeds are used exclusively for eligible green projects like renewable energy or pollution prevention.

Kyoto Protocol ($1997$)

Climate agreement where $37$ industrialised countries aimed to reduce $\text{CO}_2\text{e}$ by 5\text{ %} below $1990$ levels.

Paris Agreement ($2015$)

Global agreement with $195$ signatories to keep temperature rise well below $2^\text{ o}\text{C}$.

EU ETS

EU Emissions Trading System; a capped compliance market covering electricity, heat, energy-intensive industry, and aviation.