Like technology, finance is an area replete with cool sounding words that no one outside finance understands. The dirty secret – they rarely mean anything complicated. So here’s a simple glossary of terms to help you understand what the hell finance people are talking about.
- Debt: Money that you owe to someone.
- Equity: Money that belongs to the owners of the company.
- Risk: The chance that you’ll make money or not. Risk has value – a risky pound is worth less than a riskless pound. For example – if you bet on a dog winning at the track, you don’t put down the value of what you might win to bet, but a much smaller figure, because winning is risky.
- Security: A security is an investment of any sort, and it’s a word that’s really just meant to confuse non-finance people. For example, if a bank lends money to a someone for a mortgage, they have made an investment in that person. That investment is a mortgage backed security. See?
- Amortisation: This just means payments spread over a certain amount of time. For example, if you are paying for a sofa you just bought, you could make one large payment up front, or make smaller payments over time, i.e. amortise the payments.
- Bond: If you’re a company and you need to borrow money, you can issue a bond. That bond is a promise to pay the bond holder the value that’s on the face of the bond by a certain date.
- Coupon rate: If you decide to issue a bond, you can either pay back your bond holders at the end of a set time (the bond duration), or you could pay back a percentage of the total every so often (say, every month). That percentage is the coupon rate.
- Discount rate: If you put money in the bank in year one, you’ll get that money back with interest in year two. This means that a pound today is more valuable than a pound tomorrow. That rate which determines the time value of money – which in this case is the interest rate – is more generally called a discount rate.
- Stock or Share: If you buy a share, you buy a small part of the company. For small companies, this might mean buying out a founder’s capital investment in part or in total. For a large company, this might be buying a share from an investment market – but essentially both are the same thing.
- Option: An option is, literally, the option (but not the requirement) to buy a share at a predetermined price. You can exercise this option at a future date, or any any time until that future date (depending on the option type).
- Future: A future is an obligation (or contract) to buy at a specific price, at a specific future date. Pretty much the same as an option, but this time there is an obligation to buy.
- Beta: Indicates how well a company does versus the economy. See below!
There are some concepts here that bear a little bit of further explanation.
Let’s say the value of one share of Yahoo is $10 right now, and you buy an option on this at a strike price of $10 which you can exercise in a year. This means that in one year, you can buy a share at the preset strike price ($10) and sell it at whatever the current market rates, or you can choose to just let the option go. So, if the stock price next year is $12 you would exercise your option and make $2, but if the stock price next year is $8 you would choose to let the option go. Of course, if the market believes the price is going to go up, then it will cost you something to buy that option.
I won’t go into a discussion on the CAPM – but sound off in the comments if you want me to change this. Instead, here’s the simple version. Beta indicates how you might expect a company’s returns to vary with respect to the market. If:
- beta = 1.5, it will return 1.5x the market
- beta = 1, it follows the market
- beta = 0.5, it is positive when the market is positive but half as big
- beta = negative, it is positive when the market is negative
So, you can expect the price of large beta stocks to be up when the market is up, and low or negative stocks to be up when the market is in trouble.
How do you determine the beta? By examining historical share prices. By examining the betas of other similar firms. But best of all, by considering consumer behaviour. For example, a firm that manufactures and packages own-brand economy label food might be a negative beta firm, as more people buy economy brand food when times are tough.
Debt & Equity
Debt and equity are weirdly interchangeable.
Usually, equity holders are the owners of the company, they ultimately call the shots, and profit comes back to them. Debt holders just lend money and get paid back.
But it’s not so simple. If you own one share of GE, you’re not calling any shots. Tax shield effects mean that company profits are going to interest payments for debt holders. And those debt holders might have lent GE so much money that they are calling the shots on what happens with that cash.
There are also these things called hybrid securities which are, literally, a hybrid between debt and equity. Oddly, pure debt and pure equity are both extremes of a scale.