October 23, 2005

Finance basics

Posted in Finance at 17:18 by graham

A loose collection of definitions and information concerning the financial world. Accuracy not guaranteed.

Securities

A security is anything that guarantees a loan. Your house is the security in your mortgage agreement. It offers security to the lender because if you don’t pay back the money they can take the house. In agreements between large financial institutions long term securities are bonds, shares (also called equity), floating rate notes, medium term notes, etc.

Bonds

A bond is a way in which governments and companies raise money. The issuer of the bond borrows money from the entity that buys the bond. A bond has a value ($10 000), a coupon (5%), and a maturity date (in 10 years). The person lending the money buys the bond (pays $10 000 to the issuer), receives the value of the coupon each year (5% of $10 000) and the value of the bond back at maturity (after 10 years).

The entity that bought the bond can sell it on to anyone at any time before it matures. There is an active market in bonds.

Government issued bonds are often used as a reference bond, and bonds issued by companies are priced in terms of these. Government bonds are very low risk (the government can always print more money), easily traded, but offer the lowest interest rates. Corporate issued bonds are issued at the rate of government bonds plus a bit, as they are more risky (the company might go bankrupt and not pay back the bond when it matures). Government bonds in the U.K. are called Gilts.

Convertible Bonds are bonds which allow the owner to convert the bond into a fixed amount of shares in the company that issued it. If the value of the shares goes above the value of the bond, the owner can convert and make a profit. If the values of the shares goes down the owner holds on to the bond and has not lost any money, and still receives the coupon.

Repo’s

Re-purchase Agreements (repos) are contracts for the sale and future re-purchase or a security. The securities are almost always government issued bills or bonds (‘bills’ covers a range of other ways money can be borrowed by large institutions, usually for a period of time shorter than a bond).

Repo’s are almost always between banks, so they are an inter-bank loan backed by a security. If the security is shares it is called a sell and buy back.

Time value of money

Money has a time value because:

  • Inflation means prices go up: £10 a hundred years ago was a lot of money !
  • Lenders need an incentive to take the risk of lending (the risk being that the borrower won’t pay back the money).

Compounding: To calculate the future value of money by working forward from the present value. FV = PV * (1 + InterestRate / 100) ^ N where N is the number of periods, i.e. years if the interest rate is yearly.

Discounting: To calculate the present value by working back from a future value. PV = FV / (1 + InterestRate / 100)^N

Ratings

Ratings agencies give opinions on the ability of companies to pay back their debt. The two main ratings agencies are Moodys and Standard and Poors.

The ratings vary by agency, but typically they are letters and go, from lowest to highest risk, AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Debt between AAA and BBB is considered investment grade – beyond BBB is speculative or ‘junk’ debt. A D rating implies the company has already defaulted on that debt.

Foreign Exchange

Foreign Exchange (FX) is the selling of one currency and buying of another. Dollar, Sterling, Euro and Yen are the currencies traded the most.

Many international transactions (a UK company buying a US bond) involve an FX deal (the UK company has to turn its pounds into dollars). For this reason the money markets are amongst the most active of any financial market, and large companies (that otherwise have no banking interests) maintain a money market trading desk.

3 Comments »

  1. Zack said,

    October 17, 2009 at 17:48

    A very good post, thanks. It’s suggested that you explain more on how to determine a bond price, whether it is sold at premium or at discount.

    Please visit this link in your spare time:  http://www.best-way-2-invest.com/things-you-should-know-about-investing-in-bonds

  2. http://www.1juta.com said,

    January 8, 2008 at 15:00

    Yes but the post is a bit old and I think a lot has changed over the years thought the basics still remains the same.

  3. Manju said,

    December 22, 2007 at 15:05

    Very well written post.Thank you so much for sharing.I too come across few terms I was unware of them.

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