Financial Terms Glossary
A comprehensive reference of key financial terms and concepts.
A
Agency Problem
Definition: Conflict of interest between shareholders (principals) and managers (agents) who may pursue personal goals rather than maximizing shareholder value.
Solutions: Stock options, takeover threats, board oversight, analyst monitoring.
Annuity
Definition: A series of equal payments made at regular intervals.
Types: Ordinary annuity (payments at end of period), Annuity due (payments at beginning).
Annuity Due
Definition: Annuity where payments are made at the beginning of each period.
Absolute Priority Rule (APR)
Definition: In bankruptcy, claims are paid in strict order of seniority: senior debt first, then junior debt, then equity.
B
Bankruptcy
Definition: Legal proceeding when a company cannot meet debt obligations.
Types: Chapter 11 (reorganization), Chapter 7 (liquidation).
Bonds
Definition: Debt securities representing a loan from investors to issuers, with mandatory interest and principal payments.
Types: Corporate bonds, government bonds, senior bonds, junior bonds.
Broker
Definition: Financial intermediary who connects buyers and sellers, earning commission without taking ownership.
C
Call Option
Definition: Financial contract giving the right (but not obligation) to buy an asset at a specified price.
Relation to Equity: Equity can be viewed as a call option on firm's assets.
Capital Budgeting
Definition: Process of evaluating and selecting long-term investment projects.
Criteria: NPV, IRR, payback period.
Capital Structure
Definition: Mix of debt and equity used to finance a company's operations and growth.
Decision: Optimal balance between debt (cheaper but risky) and equity (expensive but safe).
Commercial Bank
Definition: Financial institution that accepts deposits and makes loans to individuals and businesses.
Compound Interest
Definition: Interest calculated on principal plus previously earned interest ("interest on interest").
Corporation
Definition: Separate legal entity with limited liability, unlimited life, and easy ownership transfer.
Advantages: Limited liability, perpetual existence, easy capital raising.
Disadvantages: Double taxation, agency problems.
Coupon Rate
Definition: Annual interest rate paid on a bond's face value.
D
Dealer
Definition: Financial intermediary who owns inventory and takes risk, earning profit from bid-ask spread.
Debt
Definition: Money borrowed that must be repaid with interest.
Types: Senior debt, junior/subordinated debt, bonds, loans.
Discount Rate
Definition: Interest rate used to calculate present value of future cash flows.
Components: Real rate + expected inflation + risk premium.
Dividend
Definition: Distribution of company profits to shareholders.
Types: Cash dividends, stock dividends.
Dividend Discount Model (DDM)
Definition: Stock valuation method based on present value of future dividends.
E
Equity
Definition: Ownership interest in a company, represented by shares of stock.
Characteristics: Residual claim, voting rights, unlimited upside, limited downside.
ESG (Environmental, Social, Governance)
Definition: Framework for evaluating company's impact beyond financial metrics.
Components: Environmental (climate), Social (employee treatment), Governance (ethics).
F
Face Value
Definition: Principal amount of a bond that must be repaid at maturity.
Financial Assets
Definition: Claims on real assets or other financial assets (stocks, bonds, cash).
Key: Represent ownership/claims, don't directly produce goods.
Future Value (FV)
Definition: Value of money at a future date, calculated using compounding.
G
Geometric Brownian Motion
Definition: Stochastic process modeling asset price movements with drift and volatility.
Gordon Growth Model
Definition: Stock valuation model assuming constant dividend growth forever.
Formula:
Growing Annuity
Definition: Series of payments that increase at a constant rate over a fixed period.
Growing Perpetuity
Definition: Series of payments that grow at a constant rate forever.
Application: Foundation of stock valuation models.
H
Holding Period Return (HPR)
Definition: Total return on an investment over a specific holding period.
I
Initial Public Offering (IPO)
Definition: First sale of company stock to the public in the primary market.
Interest Rate
Definition: Cost of borrowing money or return on investment, expressed as a percentage.
Components: Real rate + inflation + risk premium.
Investment Bank
Definition: Financial institution that helps companies raise capital by underwriting and selling securities.
Services: IPO underwriting, M&A advisory, market making.
J
Junior Debt (Subordinated Debt)
Definition: Debt with lower priority than senior debt in bankruptcy proceedings.
Risk: Higher risk than senior debt, higher return.
L
Leverage
Definition: Use of debt to amplify returns (and risks) on equity investment.
Effect: Equity returns become more sensitive to asset value changes.
Limited Liability
Definition: Shareholders' losses limited to their initial investment; personal assets protected.
Liquidation
Definition: Process of selling off company assets and distributing proceeds to creditors.
M
Market Maker
Definition: Dealer who provides liquidity by continuously buying and selling securities.
Profit: Bid-ask spread.
Merton's Model
Definition: Nobel Prize-winning framework analyzing corporate securities as contingent claims (options).
Application: Pricing debt and equity using option theory.
Mutually Exclusive Projects
Definition: Investment projects where selecting one precludes selecting others.
Decision Rule: Choose project with highest NPV.
N
Net Present Value (NPV)
Definition: Present value of future cash flows minus initial investment.
Decision Rule: Accept if NPV > 0, reject if NPV < 0.
O
Opportunity Cost
Definition: Value of the next best alternative forgone when making a decision.
Ordinary Annuity
Definition: Annuity where payments are made at the end of each period.
P
Partnership
Definition: Business owned by two or more people with unlimited liability.
Disadvantage: Partners personally liable for business debts.
Perpetuity
Definition: Series of constant payments continuing forever.
Present Value (PV)
Definition: Current value of future cash flows, calculated using discounting.
Primary Market
Definition: Market where new securities are issued and sold to investors.
Money Flow: Goes to the issuing company.
Principal
Definition: Original amount of money invested or borrowed.
Put Option
Definition: Financial contract giving the right (but not obligation) to sell an asset at a specified price.
Relation to Debt: Credit risk can be modeled as short put option.
R
Real Assets
Definition: Assets that produce other assets or income (equipment, real estate, machinery).
Key: Directly produce goods and services.
Real Rate of Return
Definition: Return on investment after adjusting for inflation.
Required Return
Definition: Minimum return investors demand for taking on investment risk.
Components: Real rate + expected inflation + risk premium.
Residual Claimant
Definition: Party entitled to assets remaining after all obligations are paid (equity holders).
Risk-Free Rate
Definition: Return on investment with zero credit risk (e.g., US Treasury bills).
Risk Premium
Definition: Additional return required for taking on risk beyond risk-free rate.
S
Secondary Market
Definition: Market where existing securities are traded between investors.
Money Flow: Between investors, not to company.
Senior Debt
Definition: Debt with highest priority in bankruptcy proceedings.
Risk: Lowest risk among securities, capped return.
Shareholder
Definition: Owner of shares in a corporation with residual claims and typically voting rights.
Simple Interest
Definition: Interest calculated only on principal amount.
Sole Proprietorship
Definition: Business owned by single individual with unlimited liability.
Stock (Equity)
Definition: Ownership share in a corporation with residual claims.
Types: Common stock (voting rights), Preferred stock (senior to common).
T
Time Value of Money
Definition: Principle that money today is worth more than the same amount in the future.
Reasons: Opportunity cost, consumption preference, inflation risk.
Takeover
Definition: Acquisition of company by another entity, often used as discipline mechanism for poor management.
U
Uncertainty
Definition: Situation where future outcomes have known probabilities.
Contrast: Certainty (known outcomes), Ambiguity (unknown probabilities).
Underwriting
Definition: Process where investment banks help companies issue new securities, taking inventory risk.
V
Volatility
Definition: Measure of price fluctuations in an asset, represented by sigma (σ) in financial models.
W
Working Capital Management
Definition: Management of short-term assets and liabilities to ensure day-to-day operations.