Thursday, 15 January 2009

Finance for Engineers - The Advanced Stuff

Some more finance terms for the engineer..... With time working in a financial software house, you learn alot about finance, although at some point you decide that you have to do your own homework, and piece things together because, the future may take you to a trading desk, and you find yourself working on the Monte Carlo algorithm....
  • Splits : Companies can "split" their stocks. i.e. If the value of 1 share is £100 and the company issues a 2:1 split, this means every share will become 2 shares, and the value of the individual share is adjusted accordingly, i.e. each share will be now valued at £50. The shareholders themselves still maintain the same stake valued at £100, but instead of owning one share, they now own two (neat!). This gives them more flexibility. Also, once a split occurs, this will affect the stock price (up/down increasing trading activity) , and there can be all kinds of splits with ratios such as 10:9 , giving leeway for financial (mathematical) modelling! Another issue is that the more a company has in number of stocks, i.e. volume, the more possible shareholders it can have, and the more shareholders it has, the more complicated hostile takeovers become.

  • S&P500, FTSE 100: The index of the top 100 or 500 companies/stocks (depending on geographic location) and their performance which is used as a benchmark for measuring market performance. (See my post about The New Barbarians, in reference to the power of these ranking institutions. They even rank countries! )

  • Dow Jones Average Basically to measure the performance of the stock market. It's measured in points, or dollar per share. Simply enough (I think) is the total number of points traded on the market that day, compared to the previous day. If greater than one, market is up, if less than one, market is down. A value of one means the stock market performed exactly the same (hardly ever the case).

  • Basis Points: 1/100 of a percent, or 0.01%, which is used either to measure the yield of (fixed income) securities, or commission some traders may be basing their deals on.

  • IPOs: When a company decides to go public, it will have an Initial Public Offering, which is when it first issues it stock to be traded on the stock exchange(s). Usually, one (or more) of the investment banks would be the advisers of the company on how to handle the IPO and how to price the stock, based on initial asking price.

  • Spreads: Stocks can be volatile i.e. have a given amount of risk. The spread is the measure of risk between investing in government bonds (risk free) to investing in stocks (risk avert).

  • Arbitrage: This is a tough one. Arbitrage is basically betting on two different trades in different industries/domains that are usually (but not necessarily) different (or in a sense arbitrage sense- opposite). Hence if one trade (or the dependent market) performs badly, means the other is performing well, and vice versa, so one will make profit, and the other won't, therefore, exploiting the difference, the trader would make a profit. Of course, the trick, is to have it pay off significantly to cancel out the loss, and make a profit. Nothing is about breaking even and its not a zero sum game. (hardly) * Volatility: The measure of how much the security price fluctuates, and how varied the fluctuations are. i.e. a highly volatile stock is a stock that can go up and down 25% on day-to-day trades.

    * Exposure: Is the risk to which a given asset is threatened by. i.e. if a company has an asset worth one billion, and its exposure is 5 billion, means that its trades are valued at 5 billion, except it only has assets worth 1 billion. The importance of exposure is that if the company goes bust, it looses its assets, but the loss is much more than the worth of the assets.

  • Bear Market : When a market is said to be a "bear market" means that its going down. When a trader is said to be "bearish" refers to him being pessimistic about the market

  • Bull Market : When a market is said to be a "bull market" means that its going up. When a trader is said to be "bullish" refers to him being optimistic about the market

  • Hedging : When a fund hedges, it makes certain investments to reduce risk on a given security.

  • Models: Usually mathematical, quants create algorithms and models to simulate and predicate market behavior and/or the future of a security or market (by quantifying market factors)

  • Trades: The transaction of selling or buying a security.

  • Hostile Takeovers: Is when a company or fund takes over another company through a majority stock buyout, against the will of the stakeholders. Splits are one way of increasing the volume of stokes and thus increasing the number of shareholders, making a hostile takeover more difficult.

  • Leveraged Buy-outs: This is a scary one. A leveraged buy-out is when a company or investor begins on issuing bonds based on the assets of the company to be taken over. Imagine! You are issuing bonds whose underlying assets are the company you "will" buy-out. i.e. if the buy out fails, those bonds are worthless- but, well, the acrobatics about this, is that you issue bonds as a way of raising enough cash to force the buy-out and make the company's assets as your own, and be able to backup your bonds! (financiers are crazy!)
  • Buy Backs: Is when a company buys back a number of its own shares, to reduce the number of shares, and giving its current shareholders a bigger stake, thus raising the value of its stock. This is opposite (not quite though) to a split. This is a positive sign that the management is optimistic about the future of the company and think its current stock price is undervalued

  • Premium: When a bond is purchased before its interest or is due.

  • Short Selling: (complicated) This is basically when someone is selling stocks he does not own.
  • Liquidity: Th ability of transforming assets into cash (liquid money) without any loss to its value. Usually the root problem for leverage and exposure

  • Overvaluation:when a stock is mis-priced, and analysts give it an estimated price that is unrealistic and higher than it actually is worth. The trick is that overvaluation only is exposed as over-valuation when the stock price goes the other way, and people end up paying more for it. (This is sometimes picked up by traders as a misprice, and they go back-to-back on the stock. Serious shit I am too young in the business to figure out)

  • Undervaluation: the inverse of overvaluation - usually a bargain for the buyer, a loss for the seller.

  • Default: When a company defaults, usually on a bond or loan, means it has declared that it cannot and will not be re-paying the holders of the bonds or debtors for the money they paid for this bond. (related to bankruptcy, but not quite).

  • FSA: Financial Services Authority. Is the governing body of the Financial industry in the UK. It's a non-governmental, independent organization whose primary function is to insure efficient, fair and good business operation in the finance industry. i.e. it regulates the operation of financial institutions and individuals and prevents illegal practices such as insider trading, fraud, unfair advantage, etc...

  • SEC US Security and Exchange Committee. The US equivalent of the FSA.

  • Black Wednesday: September 16, 1992 in the UK when the British government had to withdraw the pound from the European Exchange mechanism.

  • Black Monday: October 19,1987. When the Dow Jones dropped 508 points, with markets crashing anywhere between 20 and 45% around the world. It was the largest one day percentage decline in stock market history.

  • Russell Index : The Russell Index is a capitalization-weighted index designed to measure the performance of a market consisting of the 2,000 smallest publicly traded U.S. companies (in terms of market capitalization).

So what is actually traded?

Need not get into Economics or philosophy on currencies, market behaviors etc. The bulk of trade is commodities (money itself is a commodity), and their derivatives.

Note: These are notes I made myself, and I hold the nominal copyright. I have passed them over to work colleagues but I am the originator, just in case somebody is wondering.