Sunday, 21 December 2008

Finance for Engineers - The Basic Jargon

I hardly need to explain: trading desks, stock exchanges, papers flying, phones ringing, mice clicking. Its a crazy industry you have to be deranged to understand it. Well, not really. Except if you are Alistair Darling and you just issued the British Government annual budget, but had to review it after the credit mess. Being an engineer, a few "keywords" can help in debugging some terms:

The Basics

  • Buy Side: People that buy stocks (securities) in order to make a profit, either from dividends or returns. Ex: All kinds of funds: pension funds, holding companies, corporations.
  • Sell Side: People that advise the buy side on what to buy, by doing research, expert analysis and coming up with investment ideas. They effectively don't buy the stocks/securities, but rather advise the buy side on what to buy, charging a fee for service, and/or a percentage of the profit. (usually measured in basis points) Ex: Investment banks and brokerage firms.
  • Hedge Funds: An institution that holds a bulk of money for very wealthy individuals and/or companies, that allows them to create large scale investments that can yield higher return than individual investments. Hedge funds, unlike mutual funds, are exempt from a number of regulations that allow them to apply more aggressive (yet riskier) investment deals.
  • Mutual Funds: An institution that has shareholders, who invest money in that fund, which is run by an investment company. This money is then used to buy or sell shares, bonds or assets (businesses, equity, technology, etc..), according to a set objective, which is the reason the shareholders have invested. Mutual funds, unlike Hedge funds, are governed by rules and regulations against things like monopolies, unfair advantage, business disruption, etc., but on the flip side, are more liquid and shareholders can opt out at any time.<>
  • Commercial Banks: A bank in the usual sense where everyone can have an account deposit money and do transactions. Many of the commercial banks (UBS, Chase,Citi), due to immense wealth, create their own Investment banking arm, as well as their own internal funds (because they can!)
  • Investment Banks: An investment bank is everything a commercial bank is not. Fewer employees, different operations, and, in most cases, less money. (yep, amazingly so). Investment banks are underwriters, or agents for businesses and corporations issuing securities and stock. i.e. if a company wants to go public, it hires an investment bank to handle it's IPO. Investment banks employee loads of analysts that do alot of market research, to which then the associates and higher ranked employees, advise the investors (funds, corporations, businesses, and in some cases, rich individuals). The investment banks extend their functionality to so many other different areas, such as trading, with trading desks as big as football fields!
  • Traders : People who do the actual buying and selling of stocks on behalf of clients. Traders that work on the stock market are required to have a securities trading license (these are the people that throw papers and smoke outside the stock exchange and are constantly on the phone). Traders usually buy and sell in short periods of time to make profit on changing stock prices.
  • Brokers: Brokers are intermediaries between buyers and sellers. They also are sales people who would talk to clients and advise them (based on their own, or market research) on what securities to buy and sell, and charging comission.
  • Equity: Equity is the value of the securities in a given investor's account assuming that the account is liquidated at the current price. An account can have multiple stocks across industries.
  • M&A : Mergers and Acquisitions. Investment banks usually offer companies with advice on whether or not to acquire other companies and/or merge with them. Briefly, and acquisition is when a company buys-out another (usually smaller) company and incorporates its products into its own. The bottom line of an acquisition is that the bought-out company seizes to exist. Employees either become employees of the acquiring company, or are laid off. As for a merger, is when two (or more) companies merge to form a new company, with both businesses remaining servicing their primary business, but with new money, new management and refactoring. The main difference between a merger and acquisition is strategy, that mergers usually introduce strategy changes to the merging parties, while an acquisiton, is because the parent company thought that buying the acquired company fits into its strategy and growth! Merger example: Reuter-Thomson.
  • Public Companies: Companies traded on the stock exchange, in which any member of the public can buy shares in that company. The one important issue about public companies is that they are required to release financial and business details to the general public.
  • Private Companies: Privately held companies, that do not issue public stock. This frees them from the obligation to release details about the business, beyond what is general information. This makes them like a black box, and to some extent, a competitive advantage. Ex: Bloomberg
  • Portfolios: The combination of bonds, stocks , equities etc... held by a person and/or company. A portfolio usually is diversified over a number of industries, and combinations, to minimize risk. (i.e. don't put all your eggs in one basket).
  • Revenue: The total return the company made from its operations throughout a fiscal year. i.e. before deduction of tax, expenses, salaries etc...
  • Profit: What is left of the revenue after what needs to be paid is paid.
  • Dividends: The return of a given stock. The profits of a company are divided on the number of stocks, and paid out to the shareholders, either in cash, or otherwise (goes beyond my scope :))
  • Market Cap: The product of the value of an individual share by the total number of shares.
  • Income Statement: An income statement is a document that analyzes a company's revenue (not profit) and expenses over a given period of time. In the US, this is usually done on a quarterly basis (i.e. every 3 months).
  • Balance Sheet: An overview of a company's financial situation. i.e. what is in red and what is in green. What does the company has in assets (green) and what it has in liabilities (red). The gold equation of a company situation is : Assets = Liabilities + Equity
  • News: Anything released by companies to the press - this is directly related to what classifies as public information and private and confidential information- related to insider trading.
  • Price to Earnings: a measure of value of a stock. i.e. how much a stock costs compared to its return.
  • Estimates: An estimation of the potential earnings of a current investment.
  • Stocks - Outstanding/Common: Common stocks issued by the company held by the public and give holders the right to vote and claim to dividends (although the dividends are dependent on the performance of the company).
  • Stocks - Preferred : Stocks that do not give the holders voting right, and pay a fixed dividend (if any), regardless of the company performance. (not quite, but this is the general idea)
  • Bonds : A bond is basically an "I owe You" document that a government issues to raise money from the people. i.e. Someone can purchase a bond for a certain amount of money, and the government or bond issuer (not always, but usually) promises to pay back the money with interest, either at one specific date, or at set period (frequency) of time. These bonds are themselves tradeable, in which bond holders can sell these bonds before they are due. This is when a bond is sold at a premium. Government bonds are important, because, supposedly, it is zero risk and governments usually pay back the money. i.e. guaranteed money back - an alternative way of investing. (unless the government defaults on it bonds , which happens rarely, but can happen. ex: Russian government defaulted on its bonds in the 90s).
  • Analyst: The lower chain of the finance echelon. Analysts (ref. investment banks) are the people who do the grind work of research on companies and businesses.
  • Associate: Usually post-MBA employees who are the people that make the investment/brokerage decision based on research done by the analysts.
  • Rating Agency: Such as S&P that rate bonds' likelihood of default. (as in bond issuers not paying back the bond).

Oh yeah, and these are entirely my notes.....or my fault!

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