FIN 221 Module 2 Key Terms

capital allocation

process of channeling money from those who have it (savers) to those who need it (users of capital)

savers

individuals and institutions with excess funds to invest

users of capital

those who need funds for investment

financial markets

markets where savers can invest directly in securities issues by users of capital

financial intermediaries

institutions that collect money from savers and invest on their behalf

security

a tradable financial claim, such as a stock or bond

private (closely held) company

a company whose stock is not publicly traded; ownership is limited to founders, employees, and select investors

public company

a company whose stock trades on public exchange and can be purchased by anyone

IPO (Initial Public Offering)

the first sale of stock by a company to the public; the process of ‘going public’

primary market

market where NEW securities are issued; the company receives the proceeds from the sale

secondary market

market where EXISTING securities trade between investors; the company receives nothing

stock market

market for trading ownership shares in corporations

bond market

market for trading debt securities issued by corporations and governments

money market

market for short-term debt instruments (less than one year maturity)

capital markets

markets for long-term financing instruments (stocks or bonds)

spot market

market where assets are bought and sold for immediate delivery

futures market

market where contracts are made to buy/sell assets at a predetermined price on a future date

futures contract

agreement to buy or sell an asset at a set price on a future date; used to hedge price risk

mutual fund

investment company that pools money from many investors to buy a diversified portfolio of securities

index fund

mutual fund that racks a market index rather than trying to beat it; typically low fees

pension fund

fund that invests retirement contributions and pays benefits to retirees

defined-contribution plan

retirement plan (like 401K) where the employee bears investment risk; benefits depend on investment performance

defined-benefit plan

traditional pension where the employer promises specific retirement payments; employer bears investment risk

commercial bank

financial institution that takes deposits and makes loans; deposits are FDIC insured

investment bank

financial institution that helps companies issue securities, advises on mergers, and trades; does NOT take deposits

insurance company

institution that collects premiums and pays claims; invests premiums in the meantime

hedge fund

private investment fund using complex strategies; available only to wealthy/institutional investors

bid price

the highest price a buyer is currently willing to pay for a security

ask (offer) price

the lowest price a seller is currently willing to accept for a security

bid-ask spread

the difference between the bid and ask prices; represents transaction cost and market maker profit

market maker

firm that stands ready to buy and sell a security at any time, providing liquidity to the market

liquidity

the ability to buy or sell an asset quickly without significantly affecting its price

market order

order to buy or sell immediately at the best available price; guarantees execution, not price

limit order

order to buy or sell only at a specified price or better; guarantees price, not execution

stop order

order that becomes a market order when the price reaches a specified level; used to limit losses

stock exchange

organized marketplace where securities are traded

Electronic Communication Network (ECN)

electronic trading system that matches buy and sell orders; alternative to traditional exchanges

dark pool

private exchange where large institutional trades occur anonymously to avoid moving the market

time value of money

the concept that money available today is worth more than the same amount in the future

risk transfer

moving risk from those who don’t want it to those willing to bear it (via insurance, hedging, diversification)

diversification

spreading investments across many assets to reduce risk; ‘don’t pull all your eggs in one basket’

hedging

using financial instruments (like futures) to reduce or eliminate price risk

payment system

infrastructure enabling transfer of funds between parties (checks, wire transfers, credit cards)

price discovery

the process by which markets determine the price of an asset through supply and demand

cost of capital

the minimum return a company must earn to satisfy its investors; set by financial markets

hurdle rate

the minimum acceptable rate of return for an investment; same concept as cost of capital

Efficient Market Hypothesis (EMH)

theory that security prices fully reflect all available information at any given time

weak-form efficiency

prices reflect all past price and trading data; technical analysis cannot beat the market

semi-strong form efficiency

prices reflect all publicly available information; fundamental analysis cannot beat the market

strong-form efficiency

prices reflect ALL information, including private insider information

random walk

theory that stock price changes are unpredictable because prices already reflect known information

technical analysis

studying past price patterns and charts to predict future prices (ineffective if markets are weak-form efficient)

fundamental analysis

analyzing financial statements and business conditions to find mispriced stocks

behavioral finance

study of how psychological biases affect financial decisions and market outcomes

overconfidence bias

tendency to overestimate one’s own abilities and knowledge; leads to excessive trading

loss aversion

tendency to feel losses more strongly than equivalent gains; leads to holding losers too long

herding

following the crown in investment decisions; can create bubbles and crashes

anchoring

fixating on irrelevant reference points (like purchase price) when making decisions

recency bias

overweighting recent events when predicting the future

confirmation bias

seeking information that confirms existing beliefs while ignoring contradictory evidence

bubble

situation where asset prices rise far above fundamental value, driven by speculation and herd behavior

subprime mortgage

mortgage loan to borrowers with poor credit; higher risk of default

mortgage-backed security (MBS)

security created by pooling many mortgages investors receive payments from the underlying mortgages

securitization

process of pooling loans and selling securities backed by those loans to investors

credit rating agency

firm that assesses the creditworthiness of debt securities

leverage

use of borrowed money to amplify returns; also amplifies losses and increases risk of failure

systemic risk

risk that failure of one institution could trigger widespread failure throughout the financial system

too big to fall

concept that come institutions are so long that their failure would devastate the economy, requiring government rescue