Financial Dictionary


oldbooksbest (1)In conjunction with the Chartered Alternative Investment Analyst (CAIA) Association and the Women and Financial Independence program of the Smith College Center for Financial Education, the Institute has developed an online, publicly-accessible financial dictionary.

Click on the letters below to see appropriate words:

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1 and 20:  A “1 and 20” fee structure consists of a 1% management fee and a 20% incentive fee — the incentive fee is a percentage of the profits taken.

 

1031 exchange:  also known as a like kind exchange, an IRS provision that allows gains and losses from a sale to be deferred under conditions including that the proceeds are reinvested in similar assets.

 

12b-1 charges: used by mutual funds to pay for distribution costs such as advertising and annual reports, and for commissions paid to brokers who sell the funds; may be used in addition to, or instead of, front-end loads to cover brokers’ commissions; limited to 1% of the fund’s average annual net assets, are not billed directly to investors but are subtracted from the fund’s assets.

 

15-client threshold: part of rule, 203(b)(3)-2, if an investment advisor manages one or more hedge funds that had in the aggregate 15 or more investors in the last 12 months then the investment advisor must register.

 

Abnormal return: a return above or below the typical return that would be commensurate with the same level of risk.

 

Account representative: in hedge fund management, the account representative handles performance issues, withdrawals, distributions, meetings, and increased investments.

 

Accrued interest: interest that is due the lender but has not been distributed.

 

Acquis Communautaire: used in European Union law to refer to the total body of EU law.
Active risk: the standard deviation of excess returns of the hedge fund.

 

Additional compensation: includes incentive fees, referral fees, and other arrangements with the employer that may conflict with clients’ interests.

 

Adjusted historical loss ratio (AHLR): in Litzenberger et al. they adjust the historical loss ratios (ratios of insured catastrophic losses as a proportion of previously received premiums) for the effects of population density so that historic ratio analysis is not biased by the tendencies for the larger growth and insurance penetration in areas of higher catastrophe probability (e.g., Florida and California).

 

Adjusted rate on line: the idea of the rate on line (premium divided by the amount at risk) applied using the capitalized premium rather than the uncapitalized premium in the numerator.

 

Administrative review: in hedge funds, the administrative review encompasses examining civil, criminal, and regulatory actions against a hedge fund manager or its principals over a given time period.  The review also examines the personnel employed at the firm, identifies the primary contact person (the account representative), and reviews the “disaster plan.”

 

Advance rates: the percentage of a particular asset’s (e.g., portfolio’s) value that can be applied as collateral to back a particular level of rated debt.

 

Advisory committee: in hedge funds, a group of limited partners who advise the hedge fund manager.  The presence of an advisory committee generally depends on the proportion of public market investments relative to the private investments.

 

Agency costs: in entrepreneurial firms, two related types exist: 1. entrepreneurs may wish to invest in projects with high personal returns but low returns to shareholders; 2. continuation of negative NPV projects due to financial incentives to pursue high variance projects.

 

Alpha engines: generally strategies perceived to consistently generate excess returns.

 

Alpha seekers: investors seeking a rate of return above the average rate of return of investments with similar risk.

 

Alpha: the difference between the fair and actual expected rate of return where the expected rate of return is found by using the security market line suggested by the Capital Asset Pricing Model.

 

Alternative hypothesis:  the other claim in the hypothesis test, stated against the null; denoted by H1.

 

American option: option that gives its holder the right to exercise the option at any time on or before the expiration date – most traded options do so, exceptions include foreign currency options and CBOE stock index options.

 

Amortization schedule:  a predetermined listing of the declining principal of a loan.

 

Amortization: the schedule for repayment of debt (i.e., the decline in the remaining principal).  Types of amortization include: zero amortization in which only interest is paid until the final payment, with principal remaining constant until final payment at which point the original principal is returned; positive amortization in which the principal is paid back along with interest during the life of the loan; and negative (accrual) amortization, in which the amount borrowed grows over time.

 

Annuity: generally, a stream of regular payments (e.g., annual).

 

Appraisal ratio: measures abnormal return per unit of risk that in principle could be diversified away by holding a market index portfolio; a risk-adjusted performance measure that divides the alpha of the portfolio by its non-systematic risk.
 
Appraisal-based indices: somewhat simplistic real estate price indices based on appraisals (analysts’ judgments) which are typically performed less often than the index is reported and which typically generate smoothed or “stale” values.

 

Arbitrage: in the hedge fund industry the term ‘arbitrage’ is used differently than in the traditional meaning, in which it refers to a truly risk free trade attempting to capitalize on a temporary pricing discrepancy between two otherwise identical instruments.   The current use with hedge funds is less strict. It means any trade with the attempt to earn superior returns in which one instrument is sold and another similar instrument is bought with a small degree of expected risk when compared to a directional trade.

 

Arithmetic return: returns calculated using an arithmetic average, such as that used in the calculation of a time-weighted return; that is, totaling the returns and dividing by the number of returns.

 

Asian hedge: a journal with related databases, indices and forums that focuses on the Asia hedge fund industry.

 

Asian options: options whose payoffs depend on the average price of the underlying asset during some portion of the life of the option; e.g., it may have a payoff equal to the average stock price over the last three months minus the strike price, if the difference is positive, and zero otherwise.
 
Asset allocation decisions: the overall decision of which broad categories to invest in and with what weights.

 

Asset allocation funds: mutual funds that hold both equity and fixed income securities in varying proportions, depending on the fund manager’s prediction of each sector’s relative performance; these funds undertake market timing and are not considered low risk investments.

 

Asset-backed bonds: structured such that the income from a specific set of securities or other assets is used to pay for the debt, an example of which includes “David Bowie bonds” (backed by his music royalties).
 
At the money: when an option’s exercise price equals the market value of the underlying asset.

 

Autocorrelation: where past returns are correlated with current returns: in the context of the CAIA keyword, we note that markets with lower liquidity such as real estate are more likely to demonstrate positive return autocorrelation than markets such as S&P 500 futures.

 

Aversion: a preference to avoid – as in a dislike for losses or for risk.

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Back-end load: fees incurred when shares of mutual funds are sold; the charges typically begin at 5% or 6% and decrease by 1% for each year the investment remains; also known as contingent deferred sales charges.

 

Backfilling: when a successful hedge fund finally chooses to report their returns to the database provider, they will immediately report the entire track record of the fund –which can be a source of bias in the dataset.

 

Balanced funds: mutual funds that hold both equity and fixed income securities in fairly constant proportions.

 

Barrier options: options with payoffs that depend not only on some asset price at option expiration but also on whether the underlying asset price has crossed some predefined level.

 

Barrier options: options with payoffs that depend not only on some asset price at option expiration but also on whether the underlying asset price has crossed some predefined level.
 
Base correlation: in the pricing of CDO tranches it is the correlation of default probabilities of bonds within the portfolio associated with CDO tranch prices much like equity volatilities are associated with option prices in the case of simple options on equities.  A “base” correlation is distinguished from a “compound” correlation in that the base correlation (like a spot rate in a zero coupon curve) is associated with a hypothetical CDO that is a single option on a single loss interval. (e.g., see McGinty et al.)

 

Basis risk: the possibility that the difference between the futures price and the spot price will change or will differ from zero at the time the hedger wants to liquidate her position.

 

Basis: the difference between the futures price and the spot price.

 

Bavar: adjusts the beta of competing investments to be equivalent – and allows appropriate comparisons of fund returns when the funds have different correlations to the market.

 

Benchmarking: the comparison or targeting of an investments performance to the performance of an index or other alternative with a similar risk level.

 

Bernardo-Ledoit gain-loss ratio: the ratio of the expectation, under a benchmark risk-adjusted probability measure, of the positive part of the portfolio’s excess payoff to the negative part of the portfolio’s excess payoff.

 

Best execution: optimal security transaction regarding price and the full range and quality of a broker’s services, including the value of research provided, execution capabilities, commission rate, financial responsibility, and responsiveness.
 
Beta: the measure of systematic risk; for an asset i, covariance between i’s returns and that of the market’s, divided by the variance of the market returns; factor by which risk-averse investors demand a risk premium above the risk-free rate of return.

 

Bid-ask spread: the difference between the price at which the dealer purchases and sells from the inventory of their account; represents the dealer’s profit margin.

 

Binary options: options that provide a fixed payoff depending on whether or not a condition is satisfied or not; e.g. or a put, it may provide a payoff of $50 given that the stock price at option expiration is below the exercise price; also called bet options.

 

Binomial model: a method for pricing options and other derivatives; its framework is based on the assumption that at the end of the next period there are only two possible outcomes (an up movement and a down movement) to an underlying value such as a stock price; computes the value of a derivative on this underlying security at the beginning of a period using restrictive assumptions and a few parameters.

 

Black box: a type of investment process wherein the trade signals are generated by a system that is proprietary and opaque.

 

Blackout/restricted periods: to prevent front-running, periods prior to trades for clients whereby managers cannot take advantage of their knowledge of client activity.

 

Black-Scholes option pricing model: the classic formula (with five inputs: the strike price, the price of the underlying asset, the volatility of the underlying asset, the constant risk free rate and the time to expiration) for pricing European options on non-dividend paying assets whose returns are lognormally distributed.

 

Blanket subordination: prevents any repayment to mezzanine investors until other creditors (senior debt) is fully repaid.

 

Block trades: large trading order of 10,000 shares of a given stock or that with a market value of at least $200,000.

 

Block transactions: involve the trading of several thousands of shares of stock at a time, typically carried out by institutional investors.

 

Block-allocation: concerning the distribution of new issues and secondary financings to clients on an equitable basis; firm policies should be consulted.

 

Bond credit ratings: evaluations (usually assigned a letter grade) designed to indicate the probability that a particular debt obligation will be paid in full.

 

Bond indenture: the contract between the firm issuing the bond and the bondholder; it generally includes provisions such as the basic terms of the bond, the total amount of bonds issued, repayment arrangements, call provisions, collateral provided, and details of protective covenants.

 

Book value: a company’s or other asset’s net worth as it appears on an accounting statement such as the balance sheet – for a firm that is the firm’s total assets less liabilities.

 

Book-to-market: the ratio of the accounting value of an asset such as a stock to the value observed in the market.

 

Bottom up analysis: portfolio selection driven from analysis of individual securities and the search for superior individual positions.

 

Boxplot: an alternative graphical representation of data most useful for depicting the dispersion of the data values; the data are typically presented vertically, where a box is drawn to represent the interquartile range, a horizontal broken line drawn in the box to represent the median, and vertical lines extending from the top and bottom of the box drawn to represent the range of values.

 

Breakeven rate on line: the rate of line such that the present value of premiums forecasted to be received is equal to the present value of the losses expected to be paid.

 

Bridge CRB Index: a naïve commodity index in that each commodity within the index is equally weighted. The index comprises 17 physical commodities and no consideration is given to production or liquidity in the weighting scheme of the index.

 

Broad fundamental model: in Alexander and Dimitriu it is one of four factor models that they used to explain hedge fund returns — this one using numerous equity indices, bond indices and others (foreign exchange rates and commodity prices).

 

Brokerage: the business of making sales and purchases for a commission.

 

Budgeting: risk budgeting is the process of determining and quantifying an investor’s tolerance for risk and then deciding how to allocate that risk across a diversified portfolio.

 

Buy and build: also known as a “leveraged build-up”, this is sort of the reverse of streamlining conglomerates. It is based on the idea of synergies behind mergers.

 

Buy-and-hold: a portfolio strategy in which there is no rebalancing even when market prices move.

 

Buy-side: institutional clients that may have stocks in their portfolios that members or candidates are covering, may have incentives to pressure analysts to not downgrade such stocks.

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Calendar spread: a combination of two or more options on the same underlying asset with different times to expiration.

 

Call option: gives its holder the right to buy an asset for a specified price, called the exercise or strike price, on or before a certain date in the future, called the expiration date; the purchase price of an option, called the premium, is paid to the seller of the option, referred to as the option writer, who assumes a liability to the option holder.
 
Call provisions: terms in a bond or other contract allowing the issuer to repurchase the security under predetermined conditions; e.g., the bond from the bondholder prior to maturity at a specific price.

 

Callable bonds: a bond that allows its issuer to retire the bond at some time before maturity at a specified price; can be viewed as a combination of a straight bond and the sale of a call option on the bond to the issuer.

 

Cap ex: short for capital expenditures, in real estate the outlays for the purpose of acquiring or upgrading physical assets.

 

Cap rate:  an “interest rate like” value in real estate used to price real estate.  In the “cap rate” approach the stabilized cash flow is divided by the cap rate (like valuing a perpetuity).

 

Capacity: the amount of assets that can be invested in a type of strategy before that strategy underperforms.

 

Capital allocation line: the straight line relating the expected return on a portfolio to its standard deviation and a risk premium on the risky asset over the risk-free rate.

 

Capital asset pricing model: a theory that the expected return of an asset should depend only on the responsiveness of the asset to overall market fluctuations (beta).

 

Capital assets: assets such as stocks and bonds that provide a claim on an ongoing stream of cash flows.

 

Capital structure of collateralized debt obligations: the various claims (i.e., tranches) to the entity’s assets (cash flows) – differing typically in timing and seniority.

 

Carried interest: profit sharing provisions used by corporations to compensate their venture managers; reluctance to use has been a cause of failed corporate venture programs.

 

Cash delivery: when a futures contract is settled through actual delivery, the seller delivers the physical asset to the buyer in return for cash payment in the amount of the futures price.

 

Cash flow: actual cash value received or paid as distinguished from accounting numbers such as depreciation.

 

Cash substitute: a low risk investment.

 

Cash waterfall: how fund proceeds are distributed between fund investors and the sponsor.
Catastrophe bias: the idea that a data set of returns contains less than a representative proportion of extremely negative outcomes due to failure of such losses to be reported.

 

Catastrophe bonds: bonds structured such that payments are dependent upon a catastrophe such as an earthquake not occurring; investors are offered higher coupon rates to compensate them for taking on this “catastrophe risk”.

 

Catastrophe: a sudden, large, unanticipated and destructive event.

 

Certainty equivalent: an amount of money received with certainty that is equally valuable as a given risky cash flow.

 

Certificates of deposit: an interest-bearing time deposit with a bank, which requires the depositor to keep the money invested for a fixed time period; the bank pays the depositor principal and interest at the end of the term of the instrument and withdrawals cannot be made prior to the maturity of the instrument; however, for those issued in denominations greater than $100,000, terms are generally negotiable in that they can be sold to other investors.

 

Characteristic lines: the relationship between a particular security’s return and the return of the overall market portfolio.

 

Chicago Board of Trade (CBOT): organized futures trading in the United States began with the foundation of the Chicago Board of Trade (CBOT) in 1848.  Initially, it was a cash market for grain traders.  Grain producers and buyers subsequently founded this commodity futures exchange in order to hedge the price risk associated with the harvest and sale of crops.

 

Chicago Mercantile Exchange (CME): a futures exchange founded after the CBOT, offers futures contracts on, among other things, livestock.

 

Clawback provision: provisions common in the private equity world, but rare in the hedge fund world that enable investors to “clawback” incentive fees previously paid to the fund manager if the manager is not able to meet a predetermined hurdle rate.

 

Clearinghouse: acts as a middleman between the parties to a derivative and assumes all counterparty risks both for the buyers and sellers.

 

Closed-end funds: in contrast to open-end funds, they do not issue or buy back shares.  Investors in these funds who want to redeem their shares sell them on organized exchanges to other investors.  Consequently, their share prices can differ from net asset value.

 

Closed-end funds: in contrast to open-end funds, they do not issue or buy back shares.  Investors in these funds who want to redeem their shares sell them on organized exchanges to other investors.  Consequently, their share prices can differ from net asset value.

 

Coefficient of variation: the ratio of the standard deviation, s, to the expected return, E(r); like variance and standard deviation is a measure of dispersion.

 

Collateral yield: the interest rate or yield received on collateral by the entity that posted it.

 

Collateral: assets providing security against default such as real estate backing a mortgage loan.

 

Collateralized debt obligations (CDOs): a cost efficient special purpose vehicle that allows the assembly of securities (especially debt securities), derivatives and financial guarantees into a portfolio that can then be partitioned, if desirable, into various ownership classes or tranches.

 

Collateralized fund obligations (CFOs): the application of the CDO concept to investing in hedge funds and private equity.

 

Collateralized loans: loans that require collateral as guarantee of that the loan will be paid back; in case of default, the lender takes possession of the collateral; this arrangement provides the borrower with an implicit call option on the collateral; the borrower has the option to wait until loan maturity and see if the value of the collateral is above the loan amount, in which case the loan is repaid, or below the loan amount, in which case the borrower may default on the loan.

 

Commercial mortgage backed security (CMBS): each issue is created by an originator with a portfolio of commercial loans; portfolios can vary in their total size, by the number of loans in the portfolio and the number of properties securing the loan; the loans themselves can differ by size; often the loans share similar aspects such as maturity, type (fixed vs. variable), coupon, credit quality, coverage ratios; and perhaps property type and/or geographic location; all of these potentially similar or diverse loan aspects of the portfolio of loans are key characteristics of the pool.

 

Commercial paper: a short-term unsecured debt note issued by a large, well-known company in need of short-term financing; it is sold at a discount and typically backed by a bank line of credit that enables the borrower to access cash in case funds are needed to repay the debt at maturity; the notes are generally issued in denominations of $100,000; thus, small investors can only indirectly invest in commercial paper, that being through investment in money market mutual funds.

 

Commercial timberland: generally comprised of many small lots by large industrial owners, usually integrated forest products companies.

 

Commissions: broker’s fee for buying or selling securities.

 

Commodities Futures Trading Commission (CFTC): the primary Federal regulator of futures and futures trading.

 

Commodity Exchange Act: established the Commodity Futures Trading Commission to regulate the futures industry and it created disclosure and related rules for commodity pool operators (CPOs), which are a type of hedge fund.

 

Commodity futures: standardized contracts for the deferred purchase or sale of a commodity.
 
Commodity indices: averages of commodity futures prices that are constructed to be long-only and unleveraged.

 

Commodity linked notes: intermediate debt instruments, the value of which at maturity is a function of the value of an underlying commodity futures contract or basket of commodity futures contracts.

 

Commodity pool operator (CPO): a subset of the hedge fund industry. They are vehicles that indirectly or directly use futures contracts in their investment activity. Section 1.3(cc) of the Commodity Exchange Act (CEA) defines them, generally speaking, as any ‘person’ who gathers money from others for the purpose of using commodity futures markets.
 
Commodity pool: skill-based, active investment funds that pool the funds of several investors for the purpose of investing in commodity futures markets.  They are similar in structure to hedge funds and are considered a subset of the hedge fund universe. A commodity pool is managed by a general partner, who typically must register as a Commodity Pool Operator (CPO) with the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

 

Commodity price shocks: large price changes that occur in the commodity markets usually related to decreased supplies of a commodity.  Examples of this are crop freezes and political instability.

 

Comparative valuation ratios: ratio used to assess the value of one firm compared to another; e.g., price-to-earnings ratio, price-to-book ratio, price-to-cash flow ratio, price-to-sales ratio, etc.

 

Comparison universe: the group of all investment managers or investment alternatives with similar strategies or levels of risk.

 

Composites: an average or index.

 

Compound correlation: in McGinty et al. and the pricing of CDO tranches it is the correlation of default probabilities of bonds within the portfolio associated with CDO tranch prices much like equity volatilities are associated with option prices in the case of simple options on equities.  A “base” correlation is distinguished from a “compound” correlation in that the compound correlation (like a yield in a yield curve of coupon bonds) is associated with an actual CDO price (and which is comprised of two simpler option positions).

 

Concave payoff curves: in the context of the Perold and Sharpe study refers to the tendency of a strategy to decrease equity exposure (risk) as the equity market rises.

 

Conditional correlation: how closely related to variables are, assuming that some other event has already occurred: Lo contrasts the unconditional correlation of two variables (close to zero) with the correlation conditioned on a catastrophic event (close to one) in phase-locking.

 

Conditional value at risk: corresponds to the expected loss conditional on the loss being greater than or equal to VaR (the maximum loss for a given confidence interval) and therefore accounts for asymmetrical return distributions.
 
Conduit loan: a small loan pooled by intermediaries that are designed to be placed in CMBS issues.

 

Confidence interval: an interval of values within which one expects the true value of the population parameter to be contained.

 

Constant growth: an assumed rate at which a firm is expected to grow forever.

 

Constant mix: a portfolio rebalancing strategy wherein there is periodic rebalancing such that the portfolio is returned to being a specified percentage mix of securities or security classes.

 

Constant-proportion portfolio insurance: a portfolio reallocation strategy wherein the investor sets a floor value at which all risky investing terminates.  Further, the investor increases risky assets holding when the market rises and decreases risky asset holdings when the market falls.

 

Consumable assets: commodities that can be consumed directly. For example, corn, which is a consumable asset, can be used as either feedstock or food stock. Transformable commodities, on the other hand, are used to produce other goods. Such commodities include crude oil and industrial metals.
 
Contango: the situation where the expected spot price is less than the futures price.  In contango, the term structure of futures prices is upward sloping, that is, contracts with longer maturities have higher prices than contracts with shorter maturities.  The opposite of (normal) backwardization.

 

Continuous distributions: probability distributions that are “uncountable” in that the range of outcomes are infinite, and must be described by formulae.

 

Convenience yield: the benefits obtained from owning a physical commodity that are not obtained from owning a futures contract. This may relate to the ability to profit from temporary or local demand and supply imbalances or to maintain production.  In the case of precious metals, this may include a lease rate.

 

Convergence property: the idea that the futures and spot prices will tend towards equality (a zero basis) as the delivery date approaches.
 
Convertible bond arbitrage: typically found in discussion of hedge funds strategies such strategies generally attempt to buy underpriced convertible bonds and then generally sell a corresponding number of shares or options on the underlying company to hedge the equity exposure.

 

Convertible bonds: bonds with option provisions which give the bondholder the option to convert each bond into a specific number of stocks.

 

Convex payoff curves: in the context of the Perold and Sharpe study refers to the tendency of a strategy to increase equity exposure (risk) as the equity market rises.

 

Convexity: a measure of the rate of change of the slope of the bond price-yield curve, expressed as a fraction of the bond price; a measure of the curvature of the price-yield curve.

 

Copulas: the most general way of modeling dependence between random variables; may accommodate a wide range of dependence structures; allows marginal behavior of individual risk factors to be separated from their dependence structure.

 

Corporate bonds: debt securities issued by private companies as a means of raising funds; similar to Treasury instruments in that they return the face value of the instrument to the holder at maturity, and make semi-annual coupon payments; they differ from Treasuries in that they are not free of default risk.

 

Corporate governance: system for suppliers of finance to direct and control corporations.

 

Correlation coefficient: a scaled form of the covariance term, is a number between –1 and 1, inclusive, and measures the linear association between the assets.

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Data risk: the risk of suboptimal performance due to portfolio allocation decisions based on faulty or biased data.

 

Deal opportunities: refers to the emergence of private equity funding needs caused by, for example, the privatization of stated owned enterprises in Eastern Europe.

 

Death spirals: securities structured with a floating conversion rate that are potentially “poisonous” to a company and can result in a “death spiral.”  With the floating conversion rate, the amount of shares that an investor receives increases as the price of the stock declines.  Stock price declines can force the company to issue more equity (to keep up with the conversion rate), resulting in more dilution, further driving the stock price down.  Can involve unscrupulous private equity investors providing cash at an agreed upon floating conversion rate, shorting the company stock, and then covering their shorts with newly issued equity from the floating conversion rate agreement.

 

Debenture: unsecured bond with no collateral.

 

Debt service coverage ratio (DSCR): calculated by dividing a property’s net operating income (NOI) by the loan’s annual interest payment.  It is similar to the interest coverage ratio, but in the case of an amortized loan takes into account repayment of the loan’s principal as opposed to only interest payments. Typical values are at least 1.2 for first mortgages. 
Dedication: the concept of devoting the proceeds (cash flows) of assets to match and fund a liability stream.
 
Delta hedge: holding offsetting positions in (hedging) a derivative and its underlier based on the estimated current responsiveness of the derivative to changes in the value of the underlier (the delta).

 

Delta hedging: an attempt to offset the risks of two (or more) positions with opposite risk exposures based on the delta of the derivative security, which is the change in the price of an option or option related security for a $1 increase in the stock price, e.g., generally, an options strategy for reducing the risk associated with price movements in the underlying asset by offsetting long and short positions.
 
Delta: in AIMR’s Code of Ethics and Standards of Professional Conduct it is the idea that members should “maintain knowledge of and comply with all applicable laws, rules, and regulations (including ) of any government, governmental agency, regulatory organization, licensing agency, or professional association governing the members’ professional activities”.

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Earnings retention ratio: percentage of earnings not paid to shareholders as dividends; also known as the plowback ratio.

 

EBITDA: stands for earnings before interest and taxes plus depreciation and amortization. This quantity represents the free cash flow from operations that is available for shareholders and creditors.

 

Economic exposure: in futures contracts refers to the amount of price risk in a commodity futures position and is magnified by leverage, that is, the price risk the investor assumes is a multiple of the actual cash invested in a futures position.

 

Efficient frontier: the relationship, usually depicted graphically, between risk and return of all investment opportunities with the maximum return achievable for any given level of portfolio volatility or, equivalently, the minimum volatility portfolio associated with any given target rate of return.
Efficient frontier: the relationship, usually depicted graphically, between risk and return of all investment opportunities with the maximum return achievable for any given level of portfolio volatility or, equivalently, the minimum volatility portfolio associated with any given target rate of return.

 

Elasticity: the percentage price change in an option relative to a percentage price change in the underlying asset.

 

Employee turnover: in context, high employee turnover can be problematic because a fund’s employees are its most valuable resource.  High turnover can cost money, emotions, and time for recruiting and training new employees.  It may also be indicative of a volatile CEO.

 

Enhanced diversification: in the context of the cited reading, enhanced diversification may be generated through having a greater amount of total assets — and is one reason for using leverage in a real estate portfolio.

 

Equity commitment: provisions in private equity funds and other funds such as traditional private equity funds that require investors to provide additional capital (draws) through time (e.g., 2-4 years) if requested.

 

Equity long/short: typically found in discussion of hedge funds strategies such strategies generally have long and short positions with a net long exposure to equity markets. This exposure tends to be concentrated in a relatively few positions.
 
European option: gives its holder the right to exercise the option only on the expiration date.

 

European Venture Capital Association (EVCA): the EVCA is a not-for-profit trade association “representing the European private equity industry since 1983” and active in promoting and protecting the interests of the private equity and venture capital industry.

 

Event driven: typically found in discussion of hedge funds strategies such strategies generally seek to exploit mispricings arising from capital market activity.  There is a variety of sub-strategies that fall under this general heading. They include: mergers and acquisitions, spin-offs, reorganizations, bankruptcies, and buy backs.
 
Event risk: the exposure of particular hedge fund strategies to extreme market events.  For example, a merger arbitrage fund takes the risk that a merger will fail to be consummated, fixed income arbitrage funds can take the risk that spreads might widen dramatically during times of global market turmoil. In the context of Till and Gunzberg, trend-following CTAs earn premiums on event risk rather than illiquidity risk, or other risk premia — since events “drive trends toward their final conclusion”.

 

Event study: a technique that enables an individual to assess the impact on a firm of a particular event such as changes to dividend payments; typically estimates the abnormal return of the security around the time of the release of the new information, and any abnormal performance is attributed to the new information.

 

Event: the exposure of particular hedge fund strategies to extreme market events.  For example, a merger arbitrage fund takes the risk that a merger will fail to be consummated, fixed income arbitrage funds can take the risk that spreads might widen dramatically during times of global market turmoil.

 

Excess kurtosis: is the “peakedness” of a distribution, with a higher measure indicating the distribution’s center peak more sharply and causes fatter tails, indicating higher probabilities of extreme outcomes than exists in the normal distribution; and a lower measurement.

 

Excess return: the return earned above and beyond a normal return that would be commensurate with the given risk level.

 

Exchange-traded funds: derivatives of mutual funds that enable investors to trade index portfolios in the same way they trade stocks; the first was known as spider, a pseudonym for Standard & Poor’s Depository Receipt (SPDR).

 

Execution of orders: should be on first-in first-out basis.

 

Exercise price: the price at which the holder of a call (put) option can choose to buy (sell) the underlying asset.

 

Exit plan: the anticipated method that venture capitalists will end participation in a deal, including selling the company to a competitor, selling the company to the public (IPO), doing another LBO, and refinancing with debt and paying cash to equity owners.

 

Expectations hypothesis: asserts that (implied) forward rates are equal to expected future short interest rates. In other words, only interest rate expectations, and in particular not risk aversion, cause interest rates with differing maturities to differ.

 

Expected holding period return: the average total return anticipated over a specified time interval.

 

Expected return: mean or average return, for a two-asset portfolio it is the weighted average of the expected rates of return of each asset in the portfolio, where the weights are given by the portfolio proportions using market values.

 

Expected shortfall: Expected shortfall (ES), also known as conditional VaR or tail VaR, is designed to capture the expected loss that will occur given that the loss exceeds the threshold identified by the VaR.

 

Exposure diagram: in the context of the article by Period and Sharpe, is a graph of the relationship between desired stock position (amount of risk) on the vertical axis and total portfolio value on the horizontal axis. Simply put, it tells the investor the risk exposure of the portfolio in relationship to the total portfolio’s cumulative performance.

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Face value: the original principal or indebtedness (not including interest) on an obligation, usually due at maturity.

 

Factor model: tools for identifying the financial variables that drive the movement of stock (or other security) prices, the key being the attempt to reduce a potentially very large system of explanatory variables into a reduced and manageable set.

 

Factor pricing model: model (of various forms – linear and nonlinear) of the dependence of a security’s price on specific risk factor.

 

Fair dealing: not favoring one client over another with respect to investment recommendations and actions.

 

Fair swap price: a price to enter a swap contract that is equal to the price of entering all of the forward contracts (i.e., a series through time) that, when combined” would be identical to the swap.

 

Federal agency debt: constitutes securities issued by government agencies to finance their transactions; this form of debt is considered extremely safe and offers a yield slightly higher than that on Treasury securities; most is issued to support farm credit and home mortgages.

 

Federal funds: non-interest-bearing reserves required to be maintained by depository institutions, such as commercial banks, in the form of deposits at their district Federal Reserve Bank.

 

Fee recapture: provisions (also known as clawback provisions) common in the private equity world, but rare in the hedge fund world that enable investors to “clawback” incentive fees previously paid to the fund manager if the manager is not able to meet a predetermined hurdle rate.

 

Fees: include management fees as a percentage of the fund assets and incentive fees as a percentage of the profits.

 

Filtering information: processing information; one of two types of information-based skills (the other being gathering information); all successful hedge fund strategies rely on superior skills at one or both of these information-based skills; example of strategies relying on this type of information-based skill are relative value and merger arbitrage.

 

Financial engineering: used to transform the risk and other characteristics towards desired levels.  An example is the inverse floater bond that pays a lower coupon rate when a reference interest rate rises.  Such a bond can be created synthetically by allocating the cash flows from a fixed income security into two derivative securities.  That is, the payments from a straight bond can be split and sold as a floating-rate note and an inverse floater.

 

Financial futures: standardized contracts for the deferred purchase or sale of a financial security or a cash flow based on financial values such as interest rates or index levels.

 

Fire walls: are designed to prevent conflicts of interest; a key element is separate reporting structures for personnel within the investment banking and research areas of the same firm.

 

Fixed charges ratio: calculated by dividing a property’s net operating income (NOI) by the amount of annual fixed charges, such as debt service payments, ground lease payments, operating leases, and payments on unsecured debt; is indicative of how much of an income cushion a borrower has before being unable to make repayment of the loan’s principal, interest payments, and other fixed charges such as lease payments and payments for unsecured debt.

 

Fixed income arbitrage: typically found in discussion of hedge funds strategies such strategies generally involves numerous positions often consisting of pairs involving buying one fixed income instrument and selling another one with enough similar properties to minimize the risk.

 

Fixed rate fusion pool: refers to the overall pool having a fixed rate (since all of the loans are fixed rate) and refers to the pool being comprised of several categories of loans (e.g., conduits and large loans).

 

Flash report: a method of communicating new or changed investment recommendations.

 

Floating rate bond: make interest payments based on rates that are linked to another market rate and adjusted periodically at a specified amount over that rate.

 

Floor: in the context of the Perold and Sharpe study refers to a total portfolio value which if reached via a decline in portfolio value causes a portfolio reallocation such as the termination of investment in risky assets.

 

Forced diversification: most funds of funds have restrictions contained in the fund’s structure such as maximum exposures to single funds, single managers, single strategies, single sub-strategies, and, in the case of private equity: industries, vintages and geography.

 

Foreign currency options: offers the right to exchange a quantity of one currency for another currency.
Foreign currency: currency of another nation or group of nations.

 

Foreign exchange swap: a stream of foreign exchange forwards contracts in a single contract.

 

Forward contract: an agreement in which exchange takes place at a (pre-specified) point in time in the future, but not standardized and exchange traded like a futures contract.

 

Forward rates: interest rates, exchange rates or other rates agreed to today (or implied by spot prices) for a period that begins in the future.

 

Fourth market: the direct trading between investors in exchange-listed securities, without the use of a broker; an example is the electronic communication network (ECN) in which members may post buy or sell orders in the system to be matched by other orders.

 

Fraud: deceit; in the context of Standard I(D), personal bankruptcy may be over-looked as misconduct, with the exception of when deceit is involved.

 

Front-end load: commissions or sales charges that are paid when shares of mutual funds are purchased and are used primarily to pay the brokers who sell the funds; the charges may not exceed 8.5% of invested funds.

 

Front-running: trading activity taken in advance a known pending transaction by his/her brokerage that will move the security’s price in a predictable fashion.

 

Fundamental analysis: an attempt to determine the present discounted value of all payments received from a share of stock, using expected future interest rates, a firm’s earnings and dividend prospects, and the firm’s risk evaluation.

 

Funds from operations: the free cash flow from operations that is available for shareholders and creditors.

 

Futures options: offers the holder the right to enter a futures contract at the exercise price of the option (i.e., the payoff to the option holder upon exercise is equal to the difference between the current futures price on the specified asset and the exercise price of the option).

 

Futures price: the price level at which participants in a futures contract initially agree to transact (with exchange occurring on a deferred basis).

 

Futures price: the price level at which participants in a futures contract initially agree to transact (with exchange occurring on a deferred basis).

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Gathering information: having a proprietary information set; one of two types of information-based skills (the other being filtering information); all successful hedge fund strategies rely on superior skills at one or both of these information-based skills; an example of a strategy relying on this type of information-based skill are long-short equity.

 

Geometric return: rate of return based on the principle of compounding.
 
Global macro: typically found in discussion of hedge funds strategies and the broadest mandate of all strategies. They can generally trade in any market globally and use any kind of instruments they choose to. They can utilize stocks, bonds, currencies, or commodities.   These managers evaluate global macroeconomic factors to identify possible price trends. They are top-down managers, unlike the fundamental long/short managers.

 

Goldman Sachs Commodity Index: a tradable, investable, long-only commodity futures index designed as a benchmark for commodity market investment and performance over time.  The GSCI is comprised of 26 physical commodities futures and holds the first nearby futures contract in each commodity.  The index is production-weighted, using a 5-year average of a particular commodity’s contribution to world production.
 
Group of Five Hedge Funds: a group of large, well-respected hedge funds convened to produce a document that addressed various concerns within the industry.
 
Guarantees: refers to commitments made by a borrower, such as completion of construction, guaranteed by the borrower’s personal or other assets;  recourse to these assets is no longer allowed once the commitments are fulfilled.

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Hedge fund classification: the grouping of hedge funds based on underlying investment strategies.

 

Hedge fund management company: an asset management company that acquires ownership in several hedge fund managers; in return for their equity stake, it oversees the regulatory, marketing and operational issues for hedge fund managers.

 

Hedge fund of funds: designed to reduce idiosyncratic risk among individual managers through diversification into a single entity (fund).

 

Hedge ratio: an option’s hedge ratio is the change in the price of an option for a $1 increase in the stock price.  A call option has a positive hedge ratio and a put option has a negative hedge ratio.  The hedge ratio is also called the option’s delta and reflects the relative holdings that hedge against changes in the price of the underlying asset.

 

Hedging: generally, offsetting positions in correlated securities, in the case of a convertible bond may be viewed as a combination of a long position in the convertible bond and a short position in the common stock of the same firm.
 
HFR model: in Alexander and Dimitriu it is one of four factor models that they used to explain hedge fund returns — this one using hedge fund return indices from HFR – Hedge Fund Research.

 

High watermark: the largest previous cumulative total return level.  A high watermark indicates that incentive fees cannot be collected by a hedge fund manager until the fund has exceeded its highest previous net asset value.
Histogram: a graphical representation of a data set in the form of a bar chart; it is constructed by first dividing the range of random variable values into intervals then drawing a rectangle over each interval.

 

Holding period return: the rate of return over a specific investment period.

 

Holding period: a specific investment time period.

 

Homogeneous expectations: a description of investors’ analysis of securities and their economic perspectives as being the same.

 

Horizon analysis: a form of interest rate forecasting in which the analyst selects a particular holding period and predicts the yield curve at the end of that period; using the predicted yield curve, the end-of-period bond price can be predicted; the total return of the bond over the holding period can then be determined by adding the coupon income and the predicted capital gains over the period.

 

Hot issue securities: securities from a public offering trading at a premium in the secondary market.

 

Hurdle rate: a return below which is deemed inadequate and may result in consequences such as elimination of incentive fees.

 

Hypothesis testing: a statistical inference procedure, based on constructing a statistic from a random sample that enables the analyst to determine the likelihood of the sample data being generated by a hypothesized population.

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Idea generation: the source of investment ideas is related to the firm’s competitive advantage (e.g., a research team).

 

Idiosyncratic risk: risk that can be eliminated through the use of a large portfolio, also known as unique, diversifiable and nonsystematic.
 
Illiquidity: the inability to liquidate assets at market value quickly, due to for example, lock-up periods.  In essence, being in illiquid assets is being short real options, since the flexibility to liquidate is limited and analogous to selling insurance. In the context of private equity, their values are often set by an appraisal method because there are no observable market prices.  Because of asymmetries in information, secondary markets may offer poor sales opportunities.

 

Immunization: attempts to shield portfolios from interest rate risk; is generally achieved by properly adjusting the maturity structure or duration of bond portfolios.

 

Implicit reinsurance premium (IRP): in the context of Litzenberger et al. it is the present value of the difference between the return promised by a catastrophe linked bond and the return offered by an otherwise identical risk free bond.

 

Implied volatility: volatility computed from the prices of options found as the number that, when used in the Black-Scholes option pricing model, would result in the observed market prices of existing options.

 

In the money: an option is said to be in the money if in the case of a call the exercise is below the market price of the underlying asset, and in the case of a put option if the exercise price is above the market price of the underlying asset.

 

Incentive fee: the portion of the management fee that depends on the level of profits in the fund. Performance fee.
 
Indenture: the contract between the firm issuing the bond and the bondholder generally including provisions such as the basic terms of the bond, the total amount of bonds issued, repayment arrangements, call provisions, collateral provided, and details of protective covenants.

 

Independent variable: variable that helps to describe the behavior of a dependent variable.

 

Index arbitrage: a strategy that exploits a violation of the spot-futures parity relationship and mispricing of contracts; if the futures price is too high, buy the stocks in the index and short the futures contracts; on the other hand, if the futures price is too low, short the stocks in the index and go long in futures contracts.

 

Index funds: a mutual fund that attempts to match the performance of a market index; the fund purchases shares in securities that are included in a specific index in proportion to the representation of each security in the index; these funds provide a means for investors to engage in a passive investment strategy that is of low cost.

 

Index options: an option whose underlying asset is a market index such as the S&P 500 or the NASDAQ 100.

 

Indexed bonds: make payments linked to a general price index or the price a specific commodity; e.g., Treasury Inflation Protected Securities (TIPS).

 

Indifference curve: a plot in the expected return-standard deviation plane that connects all combinations of expected return and standard deviation that have a given level of expected utility, that is, all combinations to which an investor is indifferent.

 

Indirect real estate investments: non-listed real estate funds and other indirect real estate investments allowing real estate ownership without the management burden of direct real estate ownership.  Other potential advantages can include increased tax efficiency and price behavior that mirrors the diversification benefits of the underlying real estate.

 

Individually managed account: in addition to pooled investments such as limited partnerships, managers can run individually managed accounts for an investor.    Such accounts do not provide the advantage of financial firewalls but may protect the investor from withdrawals by other investors, facilitate management for taxes, etc.

 

Inflation protection: offering acceptable or even positive real returns during periods of high, unexpected inflation.  In contrast to most financial assets, such as stocks or bonds, which often provide little or no inflation protection, real assets such as commodities have an underlying physical presence and tend to increase with inflation.  Therefore, in an inflationary environment, real assets can hedge the decline in value of stocks and bonds.

 

Initial margin: when a futures position is opened, only a fraction of the value of the underlying commodity, called the initial margin, is deposited with the exchange as security.

 

Initial public offering: a firm’s first offering of stock to the public; typically managed by investment bankers and are often underpriced compared to their market price; these issuances tend to have impressive initial performances, however, are not typically good long-term investments.

 

Initial sale of securities: the initial issuing of securities to raise capital regulated primarily by the Securities Act of 1933.

 

Inside information: private information held by directors, officers, or others that is not available to the public.
 
Insider trading: taking unfair advantage over the investing public using information obtained with special access. The use of private information by directors, officers, or major stockholders to make profits prior to the information being available to the public; this practice is illegal.

 

Instant history bias: when funds entering the database are allowed to include “back fill” results from previous time periods.

 

Insurance principle: the idea that as a sample becomes larger the average characteristics of the sample will approach the average characteristics of the population.
 
Insurance: a contract purchased to hedge against the risk of financial loss.

 

Integration of economic regions: the integration of economic regions refers to developments such as the establishment of the EU (European Union) which facilitates flows between countries and causes the real estate prices of member nations of the region to behave more similarly in terms of pricing and return correlation.  Other regions offer similar but less powerful integration (e.g., NAFTA and ASEAN), but in all cases the real estate is still less integrated than the markets for traditional financial assets.

 

Intercept: expected value of a dependent variable, assuming all independent variables in the function have a value of zero.

 

Inter-creditor agreement: in mezzanine financing, it generally requires: Subordination of the mezzanine debt: Springing subordination – allows for repayment and interest payments while senior debt is outstanding but it “springs” up to stop payments in the case of any default.

 

Interest coverage ratio: calculated by dividing a measure of income or revenue by interest payments.  An indicator of default probability with low values signaling lower credit worthiness.

 

Interest coverage trigger: a benchmark interest coverage ratio which — if not reached — signifies a failed test.

 

Interest rate options: options on interest rates, fixed income securities or fixed income futures contracts including options on Treasury notes, Treasury bills, certificates of deposit, GNMA pass-through securities, yields on Treasury and Eurodollar securities of various maturities, and futures contracts such as Treasury notes, municipal bonds, LIBOR, Euribor, Eurodollar and German government bonds.

 

Interest rate parity theorem: states that the relationship between the spot and forward exchange rates between two currencies depends on the differential in the risk-free interest rates between the two countries.

 

Interest rate swap: a contract specifying an exchange of two streams of cash flows based on two different interest rates (e.g., receive fixed and pay variable).

 

Interest rate: the percentage value, often expressed as an annual proportion, used in computing future and present values.

 

Internal rate of return (IRR): the discount rate at which the total discounted value of future cash flows expected from an investment equals the cost of making the investment; the discount rate which results in a zero net present value of the investment.

 

Interquartile range: the difference between the lower and upper quartiles, that is, IQR = 75th percentile – 25th percentile; the 25th percentile is the data point at which 25% of the data set lies below that value; similarly, the 75th percentile is the data point at which 75% of the data set lies below that value, that is, 25% of the data set lies above that value.

 

Intrinsic value: the present value of the firm’s expected future cash payments to an investor in the firm, which includes dividend payments and the final sale price of the stock, discounted by the appropriate required rate of return.

 

Investable commodity index: a commodity index that can be replicated with an actual investment strategy.

 

Investment Advisers Act of 1940: the Federal law governing investment advisors.

 

Investment banker: underwriter.

 

Investment Company Act of 1940: the Federal legislation intended to regulate investment pools like mutual funds.

 

Investment markets: the markets in which a particular fund invests.

 

Investment objective: the general purpose to an investment program.

 

Investment opportunity set: the universe of all available investment alternatives.

 

Investment process: the process by which investment managers make trading decisions.

 

Investment securities: the securities in which a particular fund invests.

 

Investment style: the hedge fund’s basic strategy classification such as relative value, as well as further clarification such as whether the relative value strategy is a stat arb or an economic arb.

 

Issuer: in mortgage backed securities, the originator creates a pool of loans (assembling the loans and designing the legal structure).  The CMBS pool is sold by an issuer.

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Joint venture: joint venture between a hedge fund and an institutional investor can provide benefits to the institutional investor such as reduced fees and potentially an equity stake in the manager’s revenues.

 

Junk bonds: corporate bonds rated below investment grade; classified as speculative grade; also referred to as high-yield bonds.

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Kurtosis: the “peakedness” or fourth moment of a distribution.

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Large company stocks: typically the largest (perhaps) 200 US stocks or stocks in excess of perhaps $5 Billion or $10 billion in total equity market value.

 

Large pool Gaussian Copula model: a model of bond default probability correlation that is commonly used to price default correlation derivatives.  Specifically, the model assumes that bond default is the result of declines in asset values below a barrier, that the portfolio’s value is driven by a common market factor that is normally distributed, and that there is a very large number of homogeneous credits within the portfolio.

 

Lease analysis: involves understanding the details and implications of the specific terms of a lease such as dividing operating costs into reimbursable and non-reimbursable expenses. Reimbursable expenses depend on the terms of the lease and often include common area maintenance and property taxes.  The expenses are initially paid by the owner and then are due for reimbursement from the tenant.  Often, reimbursements may be incomplete due to vacancies.  Non-reimbursable expenses are directly and ultimately borne by the owner/landlord and may include insurance, utilities, and management.

 

Leases: contract for use or occupation of property over a pre-specified period in exchange for a pre-specified payment.

 

Leptokurtosis: the relatively high probability of extreme events compared to that which would be predicted by the normal distribution, also called “fat tails”.

 

Leverage: the use of borrowed capital or other financial devices (e.g., derivatives) to magnify risk and potential return.

 

Leveraged build-up: also known as a “buy and build”, this is sort of the reverse of streamlining conglomerates. It is based on the idea of synergies behind mergers.

 

Leveraged buyout: public companies repurchase all of their outstanding shares (using debt) and are converted into private companies.

 

Levered cash flow: cash flow to equity subject to interest expenses (and perhaps other expenses such as loan points) from debt financing; the reduced cash flow available to equity is offset by the fact that less equity is required due to debt financing; however, interest expense can also affect cash flows through tax reduction.

 

Limit order: orders that specify the prices at which the investors are willing to buy or sell the securities; the trade is to be executed if the stock price falls below a limit on a buy order or above a limit on a sell order.

 

Limited partnership: organizational form whereby investors can monitor a fund’s progress without getting actively involved in the management of the fund.

 

Liquidation value: the estimated amount of money that could be realized by quickly selling off the firm, paying off the debts, and distributing the remains to the shareholders.

 

Liquidation: termination and distribution of a fund.

 

Liquidity facilities: arrangements for the provision of liquidity under certain conditions such as a guarantee by a bank to a CDO to fund emergency redemptions.

 

Liquidity preference theory: asserts that forward rates exceed expected future short rates, where the excess, referred to as the liquidity premium, is expected to be positive.

 

Liquidity: the ability of an entity to meet required cash expenditures or the speed with which an asset can be converted into cash with little or no loss of value.

 

Load: front-end: commissions or sales charges that are paid when shares of mutual funds are purchased and are used primarily to pay the brokers who sell the funds; the charges may not exceed 8.5% of invested funds; back-end: fees incurred when shares of mutual funds are sold; the charges typically begin at 5% or 6% and decrease by 1% for each year the investment remains; also known as contingent deferred sales charges.

 

Loan-to-value (LTV): calculated by dividing the principal amount of the loan by the estimate of the collateral value; reflects how much the collateral can fall in value before the lender risks not recovering the principal of the loan; typical values are 50-70%.

 

Lock-up period: per rule 203(b)(3)-2, if an investment advisor allows withdrawals within 2 years of an investor’s investment, then the investment advisor is required to register with the SEC. Period of time when the investors’ capital is committed to the fund and cannot be withdrawn.
 
Lognormal distribution: distribution which describes a random variable which grows continuously by a rate that is a normal random variable.

 

London Interbank Offered Rate: rate that London banks loan money to each other at.

 

Long position: owning or holding an asset or otherwise having a positive position.

 

Long Term Capital Management (LTCM): Long Term Capital Management, the hedge fund run by highly credentialed experts that used a large amount of leverage to attempt to capture profits from perceived small price discrepancies.  In 1998 after numerous highly successful years the firm rapidly collapsed in value sending huge financial shocks through the entire financial world.

 

Long-option-like strategies: examples such as Global Macro and Managed Futures (CTAs) can have payoff profiles that resemble straddles (long call + long put) which benefit from “event risk.”

 

Lookback options: an option whose payoff depends on the maximum and minimum levels achieved by the underlying asset over a reference period.  For example, a lookback call option might provide a payoff equal to the difference between the maximum stock price over the life of the option and the option exercise price.  A lookback put option might provide a payoff equal to the difference between the exercise price and the minimum stock price over the life of the option.

 

“Look through Provisions”: the part of Rule 203(b)(3)-2 that requires investment advisors to count the number of investors in a fund, rather than just the fund itself, as a client for purposes of determining whether the investment adviser must register.

 

Loss harvesting: selectively disposing of depreciated securities in order to  achieve some end, often tax savings, by using the recognized losses to offset similar-type income gains.

 

Lucky event issue: superior performance by certain managers or investors does not necessarily contradict market efficiency, since this performance may be a result of luck or the law of averages.

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Maintenance margin: at all points in time after the initiation of a transaction, it is the minimum amount of equity that a futures margin account may have. Whenever the current or variation margin falls to or below the level of the maintenance margin, the investor receives a margin call from the exchange clearinghouse, which is a demand for additional cash to be deposited in the margin account to bring the equity up above the maintenance margin.
 
Managed futures: the process of or returns that can be earned from the active investment style of a Commodity Trading Advisor (CTA) or a Commodity Pool Operator (CPO) potentially including leverage.

 

Management buyout: leveraged buyouts executed by a team of the company’s existing managers.

 

Management fee: managed futures funds, similar to hedge funds, charge both a management fee, which is based on asset size, and a performance-based incentive fee.  The standard is referred to as “1 and 20”, that is, 1% management fee and 20% incentive fee.  However, management fees may range from 0% to 3% and incentive fees from 10% to 35%.
 
Mapping risk: the risk that different hedge funds use different definitions to calculate and report investment risk, which makes it difficult for the investor to understand and compare the investment risks incurred by hedge funds.

 

Margin call: in the case of a futures position, only a fraction of the value of the underlying commodity, called the initial margin, is deposited with the exchange.  Whenever changes in market prices cause the variation margin to falls below the level of the maintenance margin, the investor receives a margin call from the exchange clearinghouse, which is a demand for additional cash to be deposited in the margin account to bring the equity up above the maintenance margin.

 

Margin of safety: In Calandro’s article on catastrophe investments, it is the idea of requiring a premium or price for bearing risk that more than compensates the bearer for expected outcomes.

 

Margin: involves the investor purchasing a portion of the stock with funds borrowed from the broker; the initial requirement is 50%, which means that a minimum of 50% of the purchase must be made in cash; to protect themselves against decreases in stock prices, brokers set a maintenance that specifies that if the account falls below a maintenance level, the investor will receive a call requiring funds to be added.

 

Market anomalies: observed consistent abnormal performance unexplained by risk differentials often argued to exist in, for example, P/E effects, small firm effects, neglected firm effects, and book-to-market effects.

 

Market capitalization rate: the interest rate reflected in market prices that is used to discount future cash flows.

 

Market frictions: transactions costs, borrowing constraints, costs of gathering and processing information, institutional restrictions on short sales, illiquidity; serial correlation (s.c) may be arise from these, in particular from illiquidity, and therefore s.c. may be view.

 

Market manipulation: practices that deceptively impact trading volume or prices.

 

Market neutral: typically found in discussion of hedge funds strategies; such strategies generally have long and short positions with no net long or short exposure to equity markets. (Topic 14)

 

Market order: buy or sell orders to be executed at once at current market prices.

 

Market portfolio: the entire wealth of the economy, that is, all assets, where the proportion of each asset in the portfolio equals the market value of the asset divided by the total market value of all assets.

 

Market price of risk: the risk premium required in the marketplace for a particular type of risk, typically the expected return of the overall market portfolio above and beyond the risk free rate.
 
Market risk: market risk is systematic risk and is associated with the movement of a market or market segment as opposed to distinct elements of risk associated with a specific security or firm.  Systematic risk cannot be diversified away.

 

Market timers: those who attempt to create superior risk adjusted performance primarily through alternating overall exposure to a particular market (e.g., switching between a market index and a cash position).

 

Market value: the value of an asset indicated through competitive transactions.

 

Market: market risk is systematic risk and is associated with the movement of a market or market segment as opposed to distinct elements of risk associated with a specific security or firm.  Systematic risk cannot be diversified away.

 

Market: market risk is systematic risk and is associated with the movement of a market or market segment as opposed to distinct elements of risk associated with a specific security or firm.  Systematic risk cannot be diversified away.

 

Marking to market: the practice of not waiting until the expiration date for the buyer and the seller to settle their positions, but rather where the clearinghouse makes both parties settle their profits and losses on a daily basis; the difference between yesterday’s future price and the current future price is withdrawn from the margin account of the losing side and credited to the margin account of the profiting side.

 

Master servicer: maintains loans during the life of the CMBS pool; involves servicing the loans and tranches, ensuring there are no problems with the loans, collecting loan payments, keeping the books, sending disbursements to the tranch owners, filing reports and so forth.

 

Master trust: in terms of hedge fund organization, the fund may be on-shore or have an off-shore master trust account to cater to the different tax residences of hedge fund investors.  The purpose of the master trust is to invest the assets of on-shore and off-shore funds so that they both profit from the fund manager’s perception. Master trusts, which provide a means of neutralizing taxes, are generally set up in tax-neutral locations such as Bermuda.

 

Material changes: in prior investment advice arising from subsequent research, and needs to be communicated to all clients.

 

Material nonpublic information: information that has not been released to the general marketplace and if done so, would likely impact the market price of a security.

 

Maximum premium level: in Calandro’s article on catastrophe investments, it is the sum of the premium (at a given confidence interval) and the capitalized premium: Maximum Premium Level  = Premium + Capitalized Premium.  In effect it may be viewed as an upper bound on premiums.

 

Measurement: the attempt to quantify risk or return performance.

 

Mental accounting: apparently irrational behavior in which, for example, investors categorize money spent or lost in manners that influence future behavior without clear economic reasoning such as a refusal to buy a needed replacement item when the original item was lost.

 

Merchant banking: the practice of buying non-financial companies by financial institutions — similar to leveraged buyouts.

 

Merger arbitrage: typically found in discussion of hedge funds strategies such strategies generally involve buying the stock of a company that is the target of an acquisition and selling the stock of the acquiring company.  The objective of the arbitrageur is to profit from the narrowing of the spread between the stock of the companies as the merger approaches, and possibly achieves, completion.

 

Merton framework: applying market values, estimated volatility and the options pricing model to the capital structure of the firm to imply, for example, bond default probabilities and correlations.

 

Mezzanine debt: a hybrid of private debt and equity financing.

 

Mezzanine financing: a hybrid of private debt and equity financing.

 

Minimum variance portfolio: a risky portfolio with the lowest variance of all risky portfolios; for a portfolio of two assets, it has a variance smaller than that of either of the individual assets in the portfolio – this feature reflects the results of diversification; its exact composition depends on the correlation between the component assets.
 
MLM Index: the Mount Lucas Management Index — a passive, trend-following index using a 12-month look-back window to identify trends in futures prices.  Specifically, the index takes a long position in a futures market if the current unit asset value is higher than the average unit asset value over the look-back window. Otherwise, the index takes a short position in the futures market.  This is carried out once a month, on the day prior to the last trading day.

 

Modified value at risk: a statistical method proposed by Signer and Favar for adjusting VaR to incorporate skewness and kurtosis.

 

Money market funds: mutual funds that invest in money market securities; they typically offer check-writing features and their net asset value is fixed at $1 per share.

 

Monte Carlo simulations: a full valuation method to compute risk measures (e.g., VaR and ES) based on replicating the behavior of risk factors through large numbers of draws produced by a random generator and using these with pricing functions to calculate a number portfolio position.

 

Morningstar ratings: their set of Risk Adjusted Ratings (RARs) are among the most widely used performance measures;  RARs are based on fund returns relative to a peer group and used to award each fund one to five stars based on the rank of its RAR.

 

Mosaic theory: maintains that significant conclusions that may be the same as that based on inside information communicated directly to an analyst from a company, yet are instead based on a collection of public and nonmaterial nonpublic information may be used without risking violation.

 

M-square measure: like the Sharpe ratio, focuses on total volatility as a measure of risk; a performance measure of the difference between the expected return on the market index, rm, and the expected return on a managed portfolio, adjusted to have the same standard deviation as the market index, rp* , that is, M2 measure = rp* – rm.

 

Multi-period sampling bias: when the database includes only those funds with a specified minimum history of available results.

 

Multiple regression: regression with several explanatory (independent) variables.

 

Multiplier: within a portfolio reallocation strategy such as “constant proportion portfolio insurance,” it is the parameter that indicates how much an investor increases risky assets holding when the market rises and decreases risky asset holdings when the market falls.  A multiplier of 2 would indicate holding $2 of additional risky assets for each $1 rise in portfolio value.

 

Multistage growth models: formulae for pricing, typically, firms that allow assumptions that the firm will grow by different rates during different intervals of time.

 

Municipal bonds: debt securities issued by state and local governments; similar to Treasury and corporate debt securities; one difference is that their interest income is exempt from taxation at the federal level, and at the state and local levels in the issuing state; however, capital gains must be paid at the bond’s maturity date or if the bond is sold prior to maturity for more than its purchase price.

 

Mutual fund theorem: the idea that all investors preferences can be met by investing in two parts: a mutual fund and a risk-free asset, in propositions that depends on their level of risk aversion.

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Naïve trend following strategy: used in the construction of the MLMI, it is a mechanical and transparent rule for trading based on price trends.  The purpose of its construction is to provide a benchmark for returns available due to pricing trends in the underlying commodities.

 

NAREIT: The National Association of Real Estate Investment Trust, an industry trade association that, among other things, compiles the NAREIT index of the returns of publicly traded REITs (as opposed to returns on private real estate, as the NCREIF does).

 

National Council of Real Estate Investment Fiduciaries Property Index (NCREIF): the NCREIF index reports quarterly private real estate returns.  However, the returns are determined by appraisers, which makes the index vulnerable to manipulation (when owners attempt to overstate earnings), and to lag (since appraisal is often only annual).  Return series for sub-indices are available based on geographic location and property type.  In all cases returns are value weighted and are broken into income and capital appreciation.

 

National Futures Association (NFA): the futures industry’s self-regulatory body.

 

Natural resource companies: corporations whose primary business line is sale of natural resources such as oil.

 

NCREIF: The National Council of Real Estate Investment Fiduciaries, which compiles the NCREIF index.

 

Negative loan covenant: in loan agreements, dictates what the borrower must not do; examples include prepayment penalties, restrictions on dividends, operating restrictions such as minimum occupancy levels or minimum tenant credit quality, and restrictions on receiving additional financing.

 

Neglected firm effect: due to the scarcity of public information on small firms, investors require a risk premium.

 

Net absorption: the process in which vacant real estate supply is being leased, for example due to strong economic growth and population growth.

 

Net asset value (NAV): (market value of assets – liabilities) / number of shares outstanding.
 
Net asset value: the total net assets (assets minus all liabilities) of an entity such as a mutual fund, divided by the number of shares.

 

Net credit lease property: refers to high-LTV loans made to entities with high-credit tenants.
 
Net operating income (NOI): the earnings from the assets prior to interest expense and taxes.
 
Net present value: the discounted value of all future cash flows associated with a project minus the cost of the initial investment.

 

New York Mercantile Exchange (NYMEX): a futures exchange that lists, among other things, contracts on energy.  The Commodity Exchange of New York (COMEX), a division of NYMEX, lists futures contracts on precious metals and industrial metals.

 

Nonlinearity: generally the idea that the responsiveness of an asset to another asset (or a factor) changes is different at different levels – more specifically it is the idea that correlations for extreme market movements differ from correlations during minor market movements.

 

Non-negativity constraint: in Alexander and Dimitriu it is when in their simulated portfolio construction models they disallowed short selling – not allowing portfolio weights to be negative.

 

Non-recourse terms: in the case of a default, allows the lender access only to the collateral and not the borrower’s other assets.

 

Nonsynchronous returns: in the context of private equity, values are often set by an appraisal method and are often non-synchronous given the market movements (i.e., the appraisal values change with a time lag relative to market prices of public equity).

 

Nonsystematic risk: diversifiable, unique or idiosyncratic risk that can be diversified away.

 

Normal backwardation: or simply backwardation, refers to the situation where the expected spot price is greater than the futures price. In normal backwardation, the term structure of futures prices is downward sloping, that is, contracts with longer maturities have lower prices than those with shorter maturities; the opposite of contango.
 
Normal distribution: the density function of a continuous random variable that has the following properties: the expected value (i.e., the mean), median, and mode have the same value; the graph of the density function is symmetric about the expected value; the density function is completely characterized by its expected value and its standard deviation; any weighted sum of such distributed random variables results in a variable distributed with the same properties; also referred to as a Gaussian distribution.

 

Notice period: the length of time limited partners of a hedge fund must give the fund manager (e.g., 30 to 90 days) regarding their intent to withdraw funds (advance notice) to enable the fund manager to position the fund’s portfolio in such a way as to honor the request without damaging the fund’s performance.

 

Null hypothesis: stated claim that is to be tested in a hypothesis test; denoted by H0.

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Open end funds: a types of managed corporation.; the board of directors of the corporation hires a management company to manage the portfolio for an annual fee that typically ranges from 0.2% to 1.5% of total assets; issue or buy back shares at their net asset value (NAV).

 

Open interest: the value or number of all outstanding derivative contracts on a given date.

 

Operating restrictions: operating restrictions are often included as a negative covenant; examples include minimum occupancy levels and minimum tenant credit quality.

 

Option-based portfolio insurance: a portfolio reallocation strategy wherein the investor sets a floor value at which all risky investing terminates and increases risky asset holdings at values above that floor value such that the ultimate risk exposure of the strategy mirrors that of a portfolio comprised of risk free bills and call options on a risky asset.

 

Originator: creates a pool of loans (assembling the loans and designing the legal structure); the pool is sold by an issuer.

 

Out of the money: an option is said to be out of the money if in the case of a call the exercise is above the market price of the underlying asset, and in the case of a put option if the exercise price is below the market price of the underlying asset.

 

Outside service providers: includes auditors who can provide information on the hedge fund manager’s accounting system, prime brokers who can provide information on the manager’s trading positions, and legal counsel who can provide information on the manager’s regulatory registration and any disciplinary actions outstanding against the manager.

 

Over the counter market: informal exchanges on secondary markets, in which brokers register with the Securities and Exchange Commission (SEC) as dealers;  the dealers provide quotes of prices at which they are willing to purchase or sell securities.

 

Overage: rental income leases (especially in the retail sector) can contain overage/percentage rent wherein the tenant is obligated to pay additional rent if sales exceed a pre-specified threshold.

 

Overcollateralization trigger: a benchmark collateralization ratio which — if not reached — signifies a failed test.

 

Overconfidence: apparently irrational behavior in which people overestimate their abilities such as when relatively uninformed investors wrongly believe they can consistently pick winning stocks.
Oversubscribed issue: should be prorated to all subscribers.

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Par value tests: also known as over-collateralization tests, they are procedures for monitoring whether, for example, a CDO, has sufficient collateral.

 

Passive index: commodity indices that reflect only long positions, are unleveraged, do not include financial futures, and the returns thereof do not depend on manager skill.
 

Passive investment strategy: avoids any direct or indirect security analysis.

 
Passive securities benchmark: the use of the returns of a target such as an index with a buy and hold emphasis evaluate relative performance.

 

Payout ratio: the percentage of earnings paid to shareholders as dividends.

 

PCA factor model: in Alexander and Dimitriu it is one of four factor models that they used to explain hedge fund returns — this one using the statistically derived return components from a principle components analysis – PCA.

 

Performance attribution: the procedure of trying to explain difference in returns such as between a managed portfolio and a selected benchmark portfolio with factors such as risk differentials and skill.

 

Performance benchmarks: in global real estate, performance benchmarks are now available in a large number of countries.  Starting with an index for UK property, the indices now cover most large countries, facilitating institutional investment analysis and monitoring through the transparency that they offer real estate investments and the ability to perform comparisons.

 

Performance fees: compensation tied to capital appreciation.

 

Performance history: historic returns – can be useful, but should not be the sole factor when selecting a hedge fund manager.

 

Performance measurement: the attempt to quantify return performance on a risk adjusted basis.

 

Performance persistence: the extent to which past returns are similar to future returns, especially with respect to abnormal return levels.

 

Persistence: a continued consistent abnormal return.

 

Phase-locking component: term in a model of asset prices or returns to represent otherwise uncorrelated movements suddenly becoming synchronized.

 

PIPEs: increasingly common instances in which offerings are made by public enterprises and other non-venture type issuers; SEC examinations may focus on trading in the issuer of the PIPE, including any abnormal trading, unusual short interest, and trading in proprietary accounts or employee accounts.
 
Platykurtosis: the relatively low probability of extreme events compared to that which would be predicted by the normal distribution, also called “thin tails”.

 

Plowback ratio: percentage of earnings not paid to shareholders as dividends; also known as the earnings retention ratio.

 

Portable alpha: alpha is the average excess return. A portable alpha strategy attempts to “transport” an alpha from its original investment strategy to a portfolio with a different investment strategy using derivatives or other risk transfer techniques.

 

Portfolio concentration: the extent to which a portfolio has high investment levels in particular securities, types of securities or other attributes.

 

Portfolio insurance: limiting the worst-case scenario rate of return to some acceptable level; a simple example is the protective put strategy, whereby a put option is held in conjunction with the underlying asset, which allows the portfolio manager to set a maximum loss level for the portfolio in case of a sharp reduction in the value of the underlying asset.

 

Portfolio opportunity set: the entire spectrum of possible investment portfolios.

 

Portfolio snapshot: detail regarding a portfolio at a particular point in time.

 

Portfolio: a collection of one or (typically) more assets.

 

Positive loan covenant:  commonly incorporated covenants into loan agreements.  Positive covenants dictate what the borrower must do, including required deposits; the maintenance of minimum EBIT, Cash flow, or NOI; and the provision of new leases to the lender prior to execution.

 

Preferred stock: an equity investment with features that are similar to both equity and debt; as an equity investment, may or may not receive dividends, the decision of payment remaining with the firm; most dividends declared are cumulative, that is, in the event that the firm does not pay the dividends, they accumulate and must be paid in full before any dividends are paid to common stockholders.

 

Premium: the amount of money paid to an insurer to bear a risk.

 

Prepayment penalty: a type of negative covenant providing for pre-specified charges in certain situations of extra payments (prepayments).

 

Present value of growth opportunities  (PVGO): the extra value assigned to, typically, a firm for superior earnings above and beyond current earnings and normal earnings growth through reinvestment.

 

Present value: the current worth of a future value found by discounting at an appropriate interest rate.
Price-to-book ratio: the ratio of price per share to book value per share; is used an indicator of how aggressively the firm is valued by the market; is one comparative valuation ratio used to assess the value of one firm compared to another.

 

Price-to-earnings ratio: the ratio of price per share to earnings per share; also referred to as the P/E ratio.

 

Price-to-sales ratio: one comparative valuation ratio used to assess the value of one firm compared to another; the ratio of price per share to annual sales per share; is often used for start-up firms that have no earnings.

 

Prime broker: an outside service provider for hedge fund managers.  Their responsibilities include executing the manager’s trades, providing leverage in the form of short-term financing, and loaning assets to be shorted.

 

Private commodity pools: sold to sophisticated investors, that is, high net worth individuals and institutions, to enable the pools to avoid registration requirements with the Securities and Exchange Commission (SEC) and the reporting requirements of the Commodity Futures Trading Commission (CFTC).  Compared to public commodity pools, advantages of private commodity pools are typically lower brokerage commissions and higher flexibility to implement investment strategies.  Private commodity pools typically have high minimum investment requirements and are less liquid.

 

Private investment in public equities (PIPE): PIPE’s are increasingly common instances in which offerings are made by public enterprises and other non-venture type issuers; SEC examinations may focus on trading in the issuer of the PIPE, including any abnormal trading, unusual short interest, and trade.

 

Private placement: involves the sale of primary share offerings to small groups of institutional or wealthy investors rather than to the general public; tend to be cheaper than public offerings, due to the lower requirement of registration paperwork; they are less liquid than public offerings since they do not trade in secondary markets.

 

Process risk:  the risk that any area of the investment process is not transparent to the investor or is subject to change by the management of the hedge fund.  This may also be called manager risk, which is uncorrelated to any type of market risk, credit risk or leverage risk.  The only way to overcome process risk is to diversify across hedge fund managers, and be comprehensive in your due diligence before sending funds to any manager.

 

Program trading: trading generated by objective, quantitative and/or computer based signals — often when performed simultaneously by numerous participants.

 

Promote: the portion of the waterfall (cash flow) that the sponsor receives.

 

Protective put: a combination of a stock and a put option on the stock; allows the holder to limit losses on the stock position to a certain level; whatever happens to the stock price, the investor is guaranteed a payoff equal to the put option’s exercise price.

 

Public commodity pools: open to the general public and similar to mutual funds.  They must register with the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).   They must also register with the Securities and Exchange Commission (SEC) before distributing shares to the public. Public commodity pools offer the advantage of a low minimum investment requirement and high liquidity.

 

Public offering: the initial sale of securities to the public; regulated under the 1933 Act.  There are two ways in which hedge funds avoid the requirement to register with the SEC.  If a hedge fund operates ‘off-shore’, meaning outside the jurisdiction of the United States, it will not fall under this requirement.  Additionally, it a hedge fund does not offer its units for sale through a ‘public offering’, but through an unadvertised ‘private offering’, it will not need to register.

 

Pump and dump: pushing prices upward through information-based manipulation with, for example, misleading overly positive projections, and then selling.

 

Put bonds: bonds which allow the bondholder to sell the bond back to the issuing firm prior to maturity at a specific price.

 

Put option: a security or agreement allowing the holder to sell a specified asset at a specified price within a specified time frame.

 

Put option: gives its holder the right to sell an asset for a specified (exercise or strike) price on or before the expiration date.

 

Put-call parity theorem: the proper relationship between European put prices and call prices (given the present value of the exercise price and the price of the underlying asset).  Specifically, that a portfolio consisting of a call option and a zero-coupon risk-free bond with the same maturity date as the expiration date of the call option and face value equal to the option strike price has the same payoff and combined value as a portfolio consisting of a share of the underlying stock and a put option on the stock with the same strike price and expiration date as the call option.

 

Puts: gives its holder the right to sell an asset for a specified (exercise or strike) price on or before the expiration date.  The purchase price of an option, called the premium, is paid to the seller of the option, referred to as the option writer, who assumes a liability to the option holder.

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Q-statistic: a statistic that measures the statistical significance of the autocorrelation of a series was proposed by Box and Ljung; will be zero for an independent series of returns of a presumably liquid security and will be positive for a series of autocorrelated.

 

Qualified client: generally include individuals with $5 million in investable assets and entities with $25 million in investable assets.  Section 12(g)(1) of the securities and exchange Act of 1934 effectively limits the number of qualified purchases a fund can have before registration is required to 500.

 

Qualified purchaser: Rule 3(c)(7) defines a qualified purchaser as a person who owns at least $5,000,000 in investments; a company owning at least $5,000,000 in investments and itself owned by two or more persons not related as siblings or spouse; a trust that is not a company in the previous sense and was not formed specifically to purchase the securities in question; a person who is a discretionary investor and who acts for its own account or in behalf of others and who has at least $25,000,000 in investments.

 

Quality tests: procedures for monitoring whether, for example, a CDO, has sufficient diversification and/or credit quality in the collateral portfolio.

 

Quantitative equity long/short: typically found in discussion of hedge funds strategies such strategies generally tend not to be specialized but rather to trade a wide variety of markets.  They do so, not based on an analysis of market and company fundamentals, but based on their quantitative models.

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Random variable: in the context of a decision or experiment, the value of the decision outcome.

 

Random walk: changes in stock prices are believed to be random and unpredictable.

 

Range: difference between the maximum and minimum values of a random variable.

 

Rate on line: simply the premium received divided by the potential loss exposure.

 

Ratings agencies: entities (such as Standard & Poors and Moody’s) whose goal is to determine the probabilities and extent that a given debt security will default and to associate that risk with a rating.

 

Real assets: assets that have an underlying tangible nature, such as oil, soybeans, silver, and commodity futures.  In contrast to a financial asset, such as a stock or a bond, which is represented by a piece of paper, a real asset has an underlying physical presence.  In further contrast to stocks and bonds, the value of real assets tends to increase with inflation.

 

Real estate cycles: prolonged periods of imbalance between real estate supply and demand.  Due to the nature of real estate, these imbalances can be acute and can last a number of years.  This is primarily because increasing the supply of real estate (i.e., completing building programs) takes a long time.  Nevertheless, cycles are difficult to predict.

 

Real estate private equity funds: private equity funds with real estate as underlying assets, started in 1988 and took off in the 1990’s growing to over $100 billion by 2000.  Investors include pension funds, endowments, foundations and high net worth individuals.  The funds typically utilize leverage.

 

Real estate: land and/or natural resources or improvements (e.g., buildings) associated with it.
 
Real interest rate: the rate of return anticipated (typically risk free) after the effects of inflation have been removed.

 

Realized compound yield: the compounded growth rate of invested funds, assuming that all coupon payments are reinvested; this yield is computed after the investment period ends and is larger than the yield to maturity of the bond if the reinvestment rate is larger than the yield to maturity.

 

Receivables: in real estate refers to the right of a lender to claim the debts of tenants to the landlord in the event of non-payment.

 

Recourse: refers to the right of the lender to seize a borrower’s personal or other assets, in addition to the property’s assets in the event of non-payment.  If the terms of the loan deny the lender this opportunity, the loan is a non-recourse loan.

 

Redemptions: withdrawals — can have a negative effect on the performance of a hedge fund if positions have to be liquidated unexpectedly.

 

Reference checks: part of the due diligence process in which existing clients and service providers, such as auditors, prime brokers, and legal counsel are contacted for feedback.

 

Referral fees: compensation for the recommendation of services.

 

Regression: an example of a univariate model is given by: Ri,t = ai + bi RM,t + ei,t where Ri t represents the return on asset i at time t and RM,t represents the return on the market index at time t; Ri,t is referred to as the dependent variable, RM,t the independent (explanatory) variable, ei,t the disturbance term, and aj and bj the regression coefficients; the right side of equation (1) consists of two parts: ai + bi RM,t is the explained (by the relationship) component of the dependent variable i, and ej,t is the unexplained (by the relationship) component of the dependent variable;  the disturbance term, ei,t, is assumed to be uncorrelated with the explanatory variable, RM,t, and to have an expected value of zero; the disturbance term is also called a noise variable because it contributes to the variance but not to the expected value of the dependent variable, Ri,t.

 

Regret avoidance: apparently irrationally intense dislike for making mistakes and the feelings that follow.

 

Regulation D: under the Securities Act of 1933, a company that offers securities exempt from SEC registration, often requiring the company to sell its securities only to “accredited investors”.

 

Regulatory registration: hedge fund managers may be registered with the Securities and Exchange Commission (SEC) as an Investment Adviser.  Or, the manager may be registered with National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC) either as a Commodity Trading Advisor (CTA) or as a commodity pool operator (CPO).  Further, the hedge fund manager may be registered with the NFA as an introducing broker or a futures commission merchant.

 

Relative returns: measuring the difference between a return and a target or benchmark in order to adjust for risk and market performance.

 

Replacement cost: the estimated amount of money that would be necessary to create additional identical assets or to return harmed assets to their original condition.

 

Repos and reverses: a repurchase agreement, often referred to as a repo, is a debt security of very short-term, typically overnight, often used by dealers in government securities; the transaction involves the sale of government securities with an agreement to repurchase the securities the following day at a slightly higher price – in effect, the transaction amounts to a one-day loan, with government securities serving as collateral; an alternative is a term repo, which differs from a repo in that the repurchase date may be 30 days or more; a reverse repo is the opposite of a repo in that the dealer purchases government securities from a holder of the securities, with an agreement to sell them back at a future date at a slightly higher price.

 

Required rate of return: the minimum expected rate of return that would be demanded by one or more investors to hold a given asset or bear a given level of risk.

 

Residential properties: housing real estate.

 

Residuals: estimates of disturbances; i.e., difference between observed values and predicted values.

 

Resistance levels: used in technical analysis, a level of prices above which prices are not anticipated to rise.

 

Restricted list: contains names of those companies the firm is unwilling to put in a negative light, and thus should not be covered by an analyst in order to prevent biased reporting and conflicts of interest; also, list of stocks that employees may not trade on due to the company having related material nonpublic information.

 

Return distributions: the relationship between various return levels and their probabilities.

 

Return persistence: the extent to which past returns are similar to future returns, especially with respect to abnormal return levels.

 

Return to capital: of the three primary inputs to economic production (labor, capital, and raw materials) the return to capital is the compensation paid to the providers of capital for time and risk.

 

Reversal effect: previously winning investments perform poorly and previously losing investments perform well; suggests inefficiencies in that markets overreact to information.

 

Reversion value: the terminal value of a property is the estimated value of a property at some future point in time.   The reversion value is estimated by summing the present values of all future cash flows beyond a chosen date.  It is typically based on the assumption that cash flows will grow forever at a consistent rate from the net operating income in the year for which the terminal value is estimated.  This estimation is made because the farther into the future cash flows are predicted, the more uncertain they become.

 

Risk aggregation: the process of constructing the total risk of a portfolio from the risks of the constituent positions.

 

Risk aversion: a dislike for risk such that one must be provided with extra compensation for bearing risk.
 
Risk budgeting: the process of determining and quantifying an investor’s tolerance for risk and then deciding how to allocate that risk across a diversified portfolio.

 

Risk factor mapping: to condense the myriad of potential determinants of security price changes in an economy into a manageable set of variables to use in risk management.

 

Risk lover: a preference to bear risks even without additional compensation or with lower expected compensation.

 

Risk management: the processes and procedures for understanding, measuring and controlling risk.

 

Risk measurement: the attempt to quantify risk.

 

Risk measures: formulas and/or values that attempt to quantify various aspects of risk.

 

Risk neutral: indifference towards risk such that risk is no priced — and investments are selected based only on expected return.

 

Risk premia: strategies based on earning risk premia may experience large but infrequent losses yet earn enough frequent small gains for bearing risk to make the strategy profitable on average.

 

Risk premium: the reward received or anticipated for holding a risky investment as opposed to a risk-free investment.

 

Roll yield: the return due to replacing contracts close to expiration with contracts that have expiration dates further away in time.  Thus, roll yield depends on the term structure of commodity futures prices.  In an upward sloping term structure, roll yield is negative because more expensive contracts need to be purchased to replace expiring ones.  The reverse is true when the term structure of futures prices is downward sloping.

 

Rollover provision: allows private equity managers to rollover cash into new private equity investments when those in the portfolio come to fruition before the lock-up period ends.

 

Round-lot: order for more than 100 shares, in contrast to an odd lot.

 

Rule 23(c)(3): provides a safe haven for funds, allowing them certain exemptions from securities laws provided that the interval fund fulfills the requirements of the rule, namely: Redemption policy – “Repurchase Offers” by the interval fund are limited to between 5% and 25% of the outstanding shares at any interval date which may be no more frequent than quarterly; Fundamental policy – the redemption policy of an interval fund must be stated in its prospectus; Redemption price – the redemption prices must be set at the net asset value at a date that is within seven days of the repurchase date; Fees – a repurchase fee to cover expenses related to the repurchase  (transactions costs and administrative expenses) must not be above 2% of the proceeds from the repurchase; Notification – shareholders must be notified of the number of shares being offered 21 to 42 days before the Repurchase Request Deadline and the SEC must be notified within 3 days of the shareholder notification; and Cancellation of Repurchase – the repurchase offer can only be cancelled by a majority vote by the fund’s directors.

 

Rule of one alpha: what market neutral managers follow in portfolio construction to isolate and maximize a single source of returns while attempting to eliminate exposure to all other market movements and sector relationships.

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Scenario analysis: analysis that entails assigning probabilities to various events and corresponding outcomes.

 

Secondary market: where the purchase and sale thereof takes place after securities have been issued to the public; these markets consist of national and local securities exchanges, the over-the-counter market, and direct trading between two parties.

 

Secondary offerings: public offering of securities by a firm, occurring subsequent to an initial public offering.

 

Secondary research: in contrast to third party research, this is research conducted internally by others.

 

Section 3(c)(1) of the Investment Company Act of 1940: exempts for the definition of investment company for purposes of the Investment Company Act of 1940 any issuer whose securities, other than short term paper, are beneficially owned by not more than 100 persons and that is not making or proposing to make a public offering.

 

Section 3(c)(7) of the Investment Company Act of 1940: exempts from the definition of investment company for purposes of the Investment Company Act of 1940 any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers and that is not making or proposing to make a public offering of securities.

 

Sector analysis: an analysis of a portfolio’s attributes or returns in the context of market sectors such as (in the case of stocks) healthcare, telecommunications, energy, etc.

 

Sector funds: mutual funds that focus on a specific industry, such as utilities or precious metals.

 

Secured: refers to loans in which the lender can foreclose on a property, its improvements, the land, and/or the leases, to ensure repayment of the loan.

 

Securities Act of 1933: the primary Federal legislative act regarding the initial issue of securities.

 

Securities and Exchange Commission (SEC): the primary US governing body over the securities industry.

 

Securities Exchange Act of 1934: the primary Federal legislative act regarding the secondary trading of securities.

 

Security market line: the expected return-beta relationship; plotted in two-dimensional space with expected return and beta on the vertical and horizontal axes, respectively; intercepts the vertical axis at the risk-free rate of return and has a slope equal to the market risk premium, that is, E (rM) – rf.
 
Security selection: the process of identifying which securities should be in a portfolio and in what proportion.

 

Selection (self-reporting) bias: when the funds included in the database are not representative of the full population due to the hedge funds’ decisions not to report or the decision of the database compiler not to include funds.

 

Selection bias: unrepresentative sampling in an index or database.  For example, hedge funds with a poor track record may choose more often to not contribute their track record to hedge fund databases compared with other funds.  Because these hedge funds have not been selected to be included in the databases, this bias can cause the historic track record to be overstated.
 
Selection: in index and database construction, it is the process of sampling from the population.

 

Self selection bias: the potential historical performance bias introduced into a return data set when managers decide whether or not to report their returns to the data collector with the potential result that better returns will be reported with a higher probability than inferior returns.
 
Self-dealing: “appropriating for one’s own property a business opportunity or information belonging to one’s employer.”

 

Sell-side: investment banking.
Semi-strong form efficiency: market prices reflect all publicly available information.

 

Separate accounts: in addition to pooled investments such as limited partnerships, managers can run separate accounts for an investor. Separate accounts do not provide the advantage of financial firewalls but may protect the investor from withdrawals by other investors, facilitate management for taxes, etc.

 

Separation property: portfolio choice can be separated into two independent tasks: the first task is the determination of the optimal risky portfolio, which depends on security analysis and is generally determined by the portfolio manager – the optimal risky portfolio maximizes the reward-to-variability ratio and is independent of the degree of risk aversion of the clients; the second task is the allocation of the entire portfolio between the risk-free asset and the risky portfolio – this task depends entirely on the clients’ risk preferences.

 

Servicer: the company responsible for making sure borrowers are paying as agreed, and taking action if they are not.

 

Sharpe ratio: measures the reward per unit of total risk; a risk-adjusted performance measure that divides a portfolio’s average return in excess of the risk-free return by its standard deviation.

 

Short position: owing and being obligated to deliver an asset or otherwise having a negative position.

 

Short sales: involve an investor borrowing stock from a broker, selling it in the market, and then re-purchasing it at a later date to return to the broker.

 

Short strategy: the use of short, bearish or negative positions.

 

Short volatility bias: the tendency to have a net exposure to loses from reduced volatility — typically caused by short options positions.

 

Short volatility risk: having a net exposure to losses from reduced volatility — typically caused by short options positions.

 

Short volatility strategy: having a net exposure to losses from reduced volatility — typically caused by short options positions.

 

Short-option-like strategies: examples such as some fixed income and equity arbitrage strategies that have payoff profiles that resemble being short puts, which is like selling insurance (frequent small profits and infrequent large losses). A source of short put option risk is illiquidity costs.

 

Side letters: these used to cut deals outside of the constitutional or contractual arrangements of a hedge fund with specific investors.  These side deals encompass anything from waivers of fees to variations or modifications of generally applying redemption provisions for the hedge fund.  They can be concluded between an investor and the hedge fund directly, or by an investment adviser or management company on behalf of and with authority from the hedge fund.

 

Significance level: the probability that the null hypothesis is rejected when it is true; denoted by α.

 

Simple regression: regression with only one explanatory (independent) variable.

 

Sinking funds: an account managed by a bond trustee for the purpose of repaying the bonds; where the firm makes payments to the trustee who subsequently uses the funds to retire portions of the debt.

 

Skewness: is the third moment of a distribution such as a return distribution.  It indicates the extent, if any, to which the sides of a distribution differ.  Negative skew is the tendency of the distribution to have a higher probability of outcomes far below average compared with far above average.
 
Skill based investment process: an investment process requiring skilled managers with the “process risk” that there is a concentration of decision making authority.

 

Slope: given two points on a line, the ratio of the vertical distance (rise) to the horizontal distance (run).

 

Small company stocks: typically all but the largest (perhaps) 1,000 US stocks, also typically stocks smaller than $1 Billion in total equity market value.

 

Small firm effect: small firms have consistently higher average annual returns.

 

Soft commissions: synonym for soft dollars.
 
Soft dollars: products or services other than execution of securities transactions provided to an adviser by a broker-dealer in return for client brokerage transactions being directed to broker-dealer.

 

Special servicer: the company responsible for seeking payments from borrowers in the case of defaulted loans.

 

Speculating: the attempt to earn excess profits through abnormal price movements (as opposed to long term risk bearing).

 

Spot futures parity theorem: the relationship, also referred to as the cost-of-carry relationship, specifying the theoretically correct relationship between spot and futures prices based on the incremental costs and or benefits of holding a cash security relative to holding a position in a futures contract.

 

Spot price: the current market price for immediate delivery (as opposed to a futures or forward price with deferred delivery).

 

Spot rate: an interest rate, exchange rate or other rate for a transaction that begins immediately.

 

Spreads: a combination of two or more call options (or two or more put options) on the same stock with different strike prices or times to expiration – some options are bought while other sold.

 

Springing subordination: allows for repayment and interest payments while senior debt is outstanding but it “springs” up to stop payments in the case of any default.

 

Stale pricing: refers to the problem in which, for example, private equity investments’ book values are “old” and do not reflect the latest information, such as that of recent stock market movements.

 

Standard deviation: a measure of dispersion equal to the square root of variance.

 

Standard error: sample standard deviation divided by the square root of the # of observations is referred to as the standard error of the sample statistic.

 

State-owned enterprise (SOE): SOEs refers to state-owned enterprises, most of which were privatized and formed a major source of private equity deal opportunities in Eastern Europe in the last 1900’s.

 

Stock index arbitrage: the attempt to earn very low risk short term profits through disparities between futures, index and spot values in stocks.

 

Stop-loss tool: based on an order placed with a broker to buy or sell once the security reaches a certain price, in the context of the reading, non-recourse debt serves the same purpose in that it limits the borrower’s loss in the specified property to the equity investment.

 

Storage cost: costs associated with purchasing a physical commodity and storing it until the time it is consumed or sold. Storage costs can be viewed as negative income and must be factored into the futures pricing equation.

 

Straddle: is established by purchasing both a call and a put on the same stock, each with the same strike price and expiration date; is profitable when a stock price moves sharply from its current level either up or down; if the stock price remains unchanged, the investor incurs losses equal to the premiums paid for the call and the put; therefore, straddle positions are bets on volatility; the higher the volatility of the stock price, the more profitable the position will be.

 

Strike price: the price at which the holder of a call (put) option can choose to buy (sell) the underlying asset.

 

Strong form efficiency: market prices reflect all information, both public and private.

 

Structured pipes: “pipes” stands for “private investment in public equity”.  Structured pipes are pipes that offer conversion prices that are reset or variable.

 

Stutzer index: a risk measure that penalizes negative skewness and high kurtosis and rewards a lower likelihood of underperforming a benchmark.
 
Style analysis: introduced by William Sharpe (1992), the technique typically uses empirical analysis to estimate factors amongst investment opportunities (e.g., funds) and associating the funds with the factors or styles with which they are measured to be most correlated.

 

Style drift: the departure, through time, of a fund’s investment strategy (style) from its original or stated strategy.

 

Subordination: the idea that (relative to other obligations such as more senior debt) an obligation has lower priority for receiving limited distributions such as interest and principal repayment.

 

Subscription amount: quantity of funds necessary to meet fund’s minimum investment requirement.

 

Supply disruptions: unexpected reductions in the supply of commodity – a major cause of commodity price shocks.

 

Support levels: used in technical analysis, a level of prices below which prices are not anticipated to fall.

 

Survivorship bias: when a database or an index contains only those observations (e.g., hedge funds) that have continued to operate through to the end of the time period being reported.
 
Swaps: an agreement to exchange a series of cash flows.
 
Swaption: an option allowing the holder to enter a swap.

 

Sweep: refers to the right of a lender to take all cash flows until the loan is repaid, often to prevent a borrower from diverting the cash flows in preparation for default.

 

Systematic risk: nondiversifiable risk due to a correlation with the overall market.

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Tail risk: the risk of loss caused by extraordinarily large events of small probability.

 

Takeout provisions: mezzanine investors have rights to take out the senior debt and convert to equity becoming a large shareholder, perhaps the largest.

 

Target return: also known as the benchmark return, but the returns of private real estate equity funds are difficult to compare due to the disparate range of investment strategies.

 

Technical analysis: the pursuit of periodic and predictable patterns in stock prices.

 

Tenant improvements: costs of adapting leased space to the specific needs of a tenant, such as light fixtures and carpeting; depending on the condition of the market and the specifics of a lease agreement, some or all of these costs may be borne by the landlord; these costs generally correlate with turnover and vacancy.

 

Term structure: a relationship between a variable (typically interest rates such as bond yields) and its longevity.

 

Thinly traded security: a security with relatively low trading activity whereby legitimate (not manipulative) trades could impact the price.

 

Third market: the trading of exchange-listed securities on the over-the-counter (OTC) market.
 
Timber investment management organizations: institutional ownership and management of large tracts of land purchased from forest products companies.

 

Timberland Property Index: an index of EBITDDA return, capital return, and total return for U.S. commercial timberland reported by NCREIF (National Council of Real Estate Investment Fiduciaries and is widely used to benchmark timber investments.

 

Time value of money: the concept that cash flows received in the present are more valuable than equal sized cash flows received in the future.

 

Time varying volatility: when the volatility of asset prices changes over time such as due to the arrival rate of information varying due to market and economic factors.

 

Track record: a performance history.

 

Tranching: pool involves breaking up the cash flows from securities into tranches, each of which has claims of a different priority in terms of cash flow receipts.  Thus, some senior most tranches are unlikely to lose money unless virtually all loans default; other tranches are the first to absorb losses.  Various tranches will typically be assigned credit ratings that differ from the credit rating of the underlying CMBS or pool.  In addition to differentiating the tranches by credit quality, the tranches typically differ by anticipated maturity (life) and yield.  Tranches allow various investors to receive cash flow streams with the expected lives (maturities) and credit risk that they prefer.

 

Transactions based index: an index of real estate prices based on transaction prices rather than appraisals.

 

Transformable assets: are used to produce other goods. Such commodities include crude oil and industrial metals.  Commodities are generally either consumable or transformable assets. Consumable assets are commodities that can be consumed directly.

 

Transparency: the extent to which the current positions or risks of a fund are clear to investors on an ongoing basis.

 

Treasury bill: short-term, discounted securities issued by the U.S. government; they have a maturity of one year or less and at maturity return the face value of the bill to the holder; are highly liquid, sell at low transaction costs, and do not have much price risk; distinct from most other money market securities in that the income earned is exempt from all state and local taxes, and they sell in minimum denominations of $10,000, whereas most other money market securities sell in minimum denominations of $100,000.

 

Treasury bonds and notes: Treasury notes (original maturities between one and ten years) and bonds (original maturities between ten and thirty years) are debt instruments issued by the U.S. government.

 

Triple-witching hour: when three major sets of contracts expire on the same day (S&P 500 futures, S&P 100 options and options on individual stocks) potentially causing volatility.

 

Turnover: fraction of dollar value of portfolio securities sold for the purpose of purchasing different securities relative to dollar value of the portfolio.

 

Two tailed test: a test is carried out if the alternative hypothesis is formulated such that the variable of interest is not equal to a specific value, that is, H1: E(r) ¹ x.

 

Type I error: a situation in which the null hypothesis is rejected when it is true; the probability of this error corresponds to the significance level.

 

Type II error: a situation in which the null hypothesis is not rejected when it is false; one minus the probability of this error is called the power of the test.

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Underwriters: involves the marketing of public offerings of stocks and bonds.

 

Unique risk: diversifiable, nonsystematic or idiosyncratic risk that can be diversified away.

 

Unit investment trusts: pools of money invested in a portfolio, the composition of which remains fixed for the entire life of the portfolio; once established, require little active management and, hence, are referred to as unmanaged.

 

Unleveraged index: some commodity indices are constructed to be long-only and unleveraged, that is, the face value of the futures contracts are fully supported (collateralized) by cash or Treasury bills.  Futures contracts are purchased to provide economic exposure to commodities equal to the amount of cash invested in the index.  The result is that every dollar of exposure to a commodity futures index represents one dollar of commodity price risk.

 

Upper bound: in Alexander and Dimitriu it is when in their simulated portfolio construction models they set an upper limit on the proportion of the portfolio invested in any one particular fund – not allowing any portfolio weights to dominate massively the portfolio.
 
Utility: an economic term used to denote satisfaction derived from, for example, wealth.

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Vacancy rates: the percentage of unleased space within a given real estate category such as office buildings. An 8% vacancy rate for office buildings is a reasonably normal market in which supply roughly equals demand.

 

Vacancy: unleased space within a given real estate category such as office buildings.  Usually exists even in very strong real estate markets due to, for example, turnover.

 

Value at risk (VaR): VaR is a single measure of risk that indicates the level of loss which can be expected to be met or exceeded with a specified probability over a specified time interval.
Variance: a measure of dispersion, also the second moment, it is the expected squared deviations of the rates of return about the average return.

 

Variation margin: in a futures position, on a daily basis, the margin account fluctuates with fluctuations in the value of futures contracts. This is called the variation margin. The minimum amount of equity a futures margin account may have is called the maintenance margin and is usually set below the initial margin. Whenever the variation margin falls to or below the level of the maintenance margin, the investor receives a margin call from the exchange clearinghouse, which is a demand for additional cash to be deposited in the margin account to bring the equity up above the maintenance margin.

 

Venture capital: according to Gompers and Lerner, starts with the raising of funds; then investing in, monitoring of, and adding value to firms; continuing with exits of successful deals with return of capital to the investors; and renewing the cycle by raising additional funds.

 

Volatility arbitrage: typically found in discussion of hedge funds strategies such strategies generally rely on the use of options and warrants.  It is a twofold strategy. One approach involves comparing the volatilities implicit in the prices of various options and attempting to arbitrage differentials.  The second approach involves comparing the implied volatility with the historical volatility of the underlying stock. 
Volatility event: an event extremely different than the typical return behavior of a market.  For example, a return that is 2 standard deviations above or below the mean return may be classified as some market participants as an extreme event or a volatility event.

 

Volatility persistence: the extent to which past volatility is similar to future volatility.

 

Vultures: distressed debt investors who often pay a fraction of the face value of the debt and are called “vultures” for picking the bones of troubled companies.

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Wash sale rules: described in section 1091 or the Internal Revenue Code, deny capital losses when an asset is repurchased within one year of its sale.

 

Watch list: similar to a restricted list.

 

Waterfall: the distribution of cash flows (in the cited reading from a Collateralized Debt Obligation).  The waterfall (after payment of deal expenses and other obligations) is distributed based on the prioritization (i.e., seniority) of the various classes of security holders.

 

Weak form efficiency: market prices reflect all historical information.

 

Whisper number: projected earnings per share.
 
Withdrawals: liquidation of investment in hedge funds – can have a negative effect on the performance of a hedge fund if positions have to be liquidated unexpectedly.

 

Working international institutional framework: The establishment of a working international institutional framework refers to increased international consultants, increased service providers and harmonization of the legal framework for capital flows.  These advances facilitate the flow of information between the market and the investors, and make cross-border investment easier.

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Yield curve: the relationship, typically expressed graphically, between bond yields and their maturity.

 

Yield to call: return that would be realized on a callable bond in the event that the bond were redeemed by the issuer on the next available call date.

 

Yield to maturity: the interest rate that makes the present value of a bond’s payments equal to its price (i.e., internal rate of return).

Zero coupon bonds: pay no coupons but promise to pay the face value of the bond at maturity; are initially priced at a deep discount; e.g., a U. S. Treasury bill.