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Adverse selection

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Definition of Adverse selection

Adverse Selection Image 1

Adverse selection

A situation in which market participation is a negative signal.



Related Terms:

Pecking-order view (of capital structure)

The argument that external financing transaction costs, especially
those associated with the problem of adverse selection, create a dynamic environment in which firms have a
preference, or pecking-order of preferred sources of financing, when all else is equal. Internally generated
funds are the most preferred, new debt is next, debt-equity hybrids are next, and new equity is the least
preferred source.


Country selection

A type of active international management that measures the contribution to performance
attributable to investing in the better-performing stock markets of the world.


Currency selection

Asset allocation in which the investor chooses among investments denominated in
different currencies.


Security selection decision

Choosing the particular securities to include in a portfolio.


Self-selection

Consequence of a contract that induces only one group (e.g. low risk individuals) to participate.



Stock selection

An active portfolio management technique that focuses on advantageous selection of
particular stocks rather than on broad asset allocation choices.


Agency cost view

The argument that specifies that the various agency costs create a complex environment in
which total agency costs are at a minimum with some, but less than 100%, debt financing.


Adverse Selection Image 1

Average cost of capital

A firm's required payout to the bondholders and to the stockholders expressed as a
percentage of capital contributed to the firm. Average cost of capital is computed by dividing the total
required cost of capital by the total amount of contributed capital.


Bankruptcy cost view

The argument that expected indirect and direct bankruptcy costs offset the other
benefits from leverage so that the optimal amount of leverage is less than 100% debt finaning.


Bankruptcy view

The argument that expected bankruptcy costs preclude firms from being financed entirely
with debt.


Buy limit order

A conditional trading order that indicates a security may be purchased only at the designated
price or lower.
Related: Sell limit order.


Capital

Money invested in a firm.


Capital account

Net result of public and private international investment and lending activities.


Capital allocation

decision Allocation of invested funds between risk-free assets versus the risky portfolio.


Capital asset pricing model (CAPM)

An economic theory that describes the relationship between risk and
expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk
that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification.
The CAPM says that the expected return of a security or a portfolio is equal to the rate on a risk-free security
plus a risk premium.


Capital budget

A firm's set of planned capital expenditures.


Adverse Selection Image 2

Capital budgeting

The process of choosing the firm's long-term capital assets.


Capital expenditures

Amount used during a particular period to acquire or improve long-term assets such as
property, plant or equipment.



Capital flight

The transfer of capital abroad in response to fears of political risk.


Capital gain

When a stock is sold for a profit, it's the difference between the net sales price of securities and
their net cost, or original basis. If a stock is sold below cost, the difference is a capital loss.


Capital gains yield

The price change portion of a stock's return.


Capital lease

A lease obligation that has to be capitalized on the balance sheet.


Capital loss

The difference between the net cost of a security and the net sale price, if that security is sold at a loss.


Capital market

The market for trading long-term debt instruments (those that mature in more than one year).


Capital market efficiency

Reflects the relative amount of wealth wasted in making transactions. An efficient
capital market allows the transfer of assets with little wealth loss. See: efficient market hypothesis.


Capital market imperfections view

The view that issuing debt is generally valuable but that the firm's
optimal choice of capital structure is a dynamic process that involves the other views of capital structure (net
corporate/personal tax, agency cost, bankruptcy cost, and pecking order), which result from considerations of
asymmetric information, asymmetric taxes, and transaction costs.


Capital market line (CML)

The line defined by every combination of the risk-free asset and the market portfolio.


Adverse Selection Image 3

Capital rationing

Placing one or more limits on the amount of new investment undertaken by a firm, either
by using a higher cost of capital, or by setting a maximum on parts of, and/or the entirety of, the capital
budget.



Capital structure

The makeup of the liabilities and stockholders' equity side of the balance sheet, especially
the ratio of debt to equity and the mixture of short and long maturities.


Capital surplus

Amounts of directly contributed equity capital in excess of the par value.


Capitalization

The debt and/or equity mix that fund a firm's assets.


Capitalization method

A method of constructing a replicating portfolio in which the manager purchases a
number of the largest-capitalized names in the index stock in proportion to their capitalization.


Capitalization ratios

Also called financial leverage ratios, these ratios compare debt to total capitalization
and thus reflect the extent to which a corporation is trading on its equity. capitalization ratios can be
interpreted only in the context of the stability of industry and company earnings and cash flow.


Capitalization table

A table showing the capitalization of a firm, which typically includes the amount of
capital obtained from each source - long-term debt and common equity - and the respective capitalization
ratios.


Capitalized

Recorded in asset accounts and then depreciated or amortized, as is appropriate for expenditures
for items with useful lives greater than one year.


Capitalized interest

Interest that is not immediately expensed, but rather is considered as an asset and is then
amortized through the income statement over time.


Complete capital market

A market in which there is a distinct marketable security for each and every
possible outcome.


Corporate tax view

The argument that double (corporate and individual) taxation of equity returns makes
debt a cheaper financing method.


Cost of capital

The required return for a capital budgeting project.


Cost of limited partner capital

The discount rate that equates the after-tax inflows with outflows for capital
raised from limited partners.


Country beta

Covariance of a national economy's rate of return and the rate of return the world economy
divided by the variance of the world economy.


Country financial risk

The ability of the national economy to generate enough foreign exchange to meet
payments of interest and principal on its foreign debt.


Country risk General

Level of political and economic uncertainty in a country affecting the value of loans or
investments in that country.


Cross-border risk

Refers to the volatility of returns on international investments caused by events associated
with a particular country as opposed to events associated solely with a particular economic or financial agent.


Day order

An order to buy or sell stock that automatically expires if it can't be executed on the day it is entered.


Dedicated capital

Total par value (number of shares issued, multiplied by the par value of each share). Also
called dedicated value.


Economic order quantity (EOQ)

The order quantity that minimizes total inventory costs.


Efficient capital market

A market in which new information is very quickly reflected accurately in share
prices.


Fill or kill order

A trading order that is canceled unless executed within a designated time period.
Related: open order.


Hard capital rationing

capital rationing that under no circumstances can be violated.


Human capital

The unique capabilities and expertise of individuals.


Issued share capital

Total amount of shares that are in issue. Related: outstanding shares.


Legal capital

Value at which a company's shares are recorded in its books.


Limit order

An order to buy a stock at or below a specified price or to sell a stock at or above a specified
price. For instance, you could tell a broker "Buy me 100 shares of XYZ Corp at $8 or less" or to "sell 100
shares of XYZ at $10 or better." The customer specifies a price and the order can be executed only if the
market reaches or betters that price. A conditional trading order designed to avoid the danger of adverse
unexpected price changes.


Limit order book

A record of unexecuted limit orders that is maintained by the specialist. These orders are
treated equally with other orders in terms of priority of execution.


Liquidity theory of the term structure

A biased expectations theory that asserts that the implied forward
rates will not be a pure estimate of the market's expectations of future interest rates because they embody a
liquidity premium.


Long-term debt/capitalization

Indicator of financial leverage. Shows long-term debt as a proportion of the
capital available. Determined by dividing long-term debt by the sum of long-term debt, preferred stock and
common stockholder equity.


Market capitalization

The total dollar value of all outstanding shares. Computed as shares times current
market price. It is a measure of corporate size.


Market capitalization rate

Expected return on a security. The market-consensus estimate of the appropriate
discount rate for a firm's cash flows.


Market order

This is an order to immediately buy or sell a security at the current trading price.


Negotiable order of withdrawal (NOW)

Demand deposits that pay interest.


Net working capital

Current assets minus current liabilities. Often simply referred to as working capital.


Nondiversifiability of human capital

The difficulty of diversifying one's human capital (the unique
capabilities and expertise of individuals) and employment effort.


Open (good-til-cancelled) order

An individual investor can place an order to buy or sell a security. That
open order stays active until it is completed or the investor cancels it.


Opportunity cost of capital

Expected return that is foregone by investing in a project rather than in
comparable financial securities.


Other capital

In the balance of payments, other capital is a residual category that groups all the capital
transactions that have not been included in direct investment, portfolio investment, and reserves categories. It
is divided into long-term capital and short-term capital and, because of its residual status, can differ from
country to country. Generally speaking, other long-term capital includes most non-negotiable instruments of a
year or more like bank loans and mortgages. Other short-term capital includes financial assets of less than a
year such as currency, deposits, and bills.


Outstanding share capital

Issued share capital less the par value of shares that are held in the company's treasury.


Perfect capital market

A market in which there are never any arbitrage opportunities.


Perfect market view (of capital structure)

Analysis of a firm's capital structure decision, which shows the
irrelevance of capital structure in a perfect capital market.


Perfect market view (of dividend policy)

Analysis of a decision on dividend policy, in a perfect capital
market environment, that shows the irrelevance of dividend policy in a perfect capital market.


Personal tax view (of capital structure)

The argument that the difference in personal tax rates between
income from debt and income from equity eliminates the disadvantage from the double taxation (corporate
and personal) of income from equity.


Pie model of capital structure

A model of the debt/equity ratio of the firms, graphically depicted in slices of
a pie that represent the value of the firm in the capital markets.


Planned capital expenditure program

capital expenditure program as outlined in the corporate financial plan.


Pro forma capital structure analysis

A method of analyzing the impact of alternative capital structure
choices on a firm's credit statistics and reported financial results, especially to determine whether the firm will
be able to use projected tax shield benefits fully.


Progress review

A periodic review of a capital investment project to evaluate its continued economic viability.


Real capital

Wealth that can be represented in financial terms, such as savings account balances, financial
securities, and real estate.


Sell limit order

Conditional trading order that indicates that a, security may be sold at the designated price or
higher. Related: buy limit order.


Single country fund

A mutual fund that invests in individual countries outside the United States.


Signaling view (on dividend policy)

The argument that dividend changes are important signals to investors
about changes in management's expectation about future earnings.


"Soft" Capital Rationing

capital rationing that under certain circumstances can be violated or even viewed
as made up of targets rather than absolute constraints.


Static theory of capital structure

Theory that the firm's capital structure is determined by a trade-off of the
value of tax shields against the costs of bankruptcy.


Stop-loss order

An order to sell a stock when the price falls to a specified level.


Stop order (or stop)

An order to buy or sell at the market when a definite price is reached, either above (on a
buy) or below (on a sell) the price that prevailed when the order was given.


Stop-limit order

A stop order that designates a price limit. In contrast to the stop order, which becomes a
market order once the stop is reached, the stop-limit order becomes a limit order once the stop is reached.


Structured arbitrage transaction

A self-funding, self-hedged series of transactions that usually utilize
mortgage securities as the primary assets.


Structured debt

Debt that has been customized for the buyer, often by incorporating unusual options.


Structured portfolio strategy

A strategy in which a portfolio is designed to achieve the performance of some
predetermined liabilities that must be paid out in the future.


Structured settlement

An agreement in settlement of a lawsuit involving specific payments made over a
period of time. Property and casualty insurance companies often buy life insurance products to pay the costs
of such settlements.


Taking a view

A London expression for forming an opinion as to where market prices are headed and acting on it.


Tax differential view ( of dividend policy)

The view that shareholders prefer capital gains over dividends,
and hence low payout ratios, because capital gains are effectively taxed at lower rates than dividends.


Traditional view (of dividend policy)

An argument that "within reason," investors prefer large dividends to
smaller dividends because the dividend is sure but future capital gains are uncertain.


Venture capital

An investment in a start-up business that is perceived to have excellent growth prospects but
does not have access to capital markets. Type of financing sought by early-stage companies seeking to grow rapidly.


Weighted average cost of capital

Expected return on a portfolio of all the firm's securities. Used as a hurdle
rate for capital investment.


Working capital

Defined as the difference in current assets and current liabilities (excluding short-term
debt). Current assets may or may not include cash and cash equivalents, depending on the company.


Working capital management

The management of current assets and current liabilities to maximize shortterm liquidity.


Working capital ratio

Working capital expressed as a percentage of sales.


CAPITAL

The money, raised by selling stock or bonds or taking out loans, that you use to start, operate, and grow a business.


CAPITAL IN EXCESS OF PAR VALUE

What a company collected when it sold stock for more than the par value per share.


Capital

The shareholders’ investment in the business; the difference between the assets and liabilities
of a business.


Capital employed

The total of debt and equity, i.e. the total funds in the business.


Capitalize

To make a payment that might otherwise be an expense (in the Profit and Loss account) an asset
(in the Balance Sheet).


Capital market

The market in which investors buy and sell shares of companies, normally associated with a Stock Exchange.


Cost of capital

The costs incurred by an organization to fund all its investments, comprising the risk-adjusted
cost of equity and debt weighted by the mix of equity and debt.


Return on capital employed (ROCE)

The operating profit before interest and tax as a percentage of the total shareholders’ funds plus
the long-term debt of the business.



 

 

 

 

 

 

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