Definition of Consumption Function

Consumption Function

The relationship between consumption demand and disposable income. More generally, it refers to the relationship between consumption demand and all factors that affect this demand.

Probability density function

The probability function for a continuous random variable.

Probability function

A function that assigns a probability to each and every possible outcome.

Utility function

A mathematical expression that assigns a value to all possible choices. In portfolio theory the
utility function expresses the preferences of economic entities with respect to perceived risk and expected return.

functional classification

a separation of costs into groups based on the similar reason for their incurrence; it includes
cost of goods sold and detailed selling and administrative
expenses

objective function

the linear mathematical equation that
states the purpose of a linear programming problem

Aggregate Production Function

An equation determining aggregate output as a function of aggregate inputs such as labor and capital.

Capital Consumption Allowance

See depreciation.

Base probability of loss

The probability of not achieving a portfolio expected return.

Cumulative probability distribution

A function that shows the probability that the random variable will
attain a value less than or equal to each value that the random variable can take on.

Normal probability distribution

A probability distribution for a continuous random variable that is forms a
symmetrical bell-shaped curve around the mean.

Probability

The relative likelihood of a particular outcome among all possible outcomes.

Probability distribution

Also called a probability function, a function that describes all the values that the random variable can
take and the probability associated with each.

Probability Distribution

A list of all possible outcomes and the chance of each outcome
occurring

probability distribution

a range of possible values for which each value has an assigned likelihood of occurrence

All equity rate

The discount rate that reflects only the business risks of a project and abstracts from the
effects of financing.

All or none

Requirement that none of an order be executed unless all of it can be executed at the specified price.

All-in cost

Total costs, explicit and implicit.

All-or-none underwriting

An arrangement whereby a security issue is canceled if the underwriter is unable
to re-sell the entire issue.

Asset allocation decision

The decision regarding how an institution's funds should be distributed among the
major classes of assets in which it may invest.

Balloon maturity

Any large principal payment due at maturity for a bond or loan with or without a a sinking
fund requirement.

Borrower fallout

In the mortgage pipeline, the risk that prospective borrowers of loans committed to be
closed will elect to withdraw from the contract.

Call

An option that gives the right to buy the underlying futures contract.

Call an option

To exercise a call option.

Call date

A date before maturity, specified at issuance, when the issuer of a bond may retire part of the bond
for a specified call price.

Call money rate

Also called the broker loan rate , the interest rate that banks charge brokers to finance
margin loans to investors. The broker charges the investor the call money rate plus a service charge.

Call option

An option contract that gives its holder the right (but not the obligation) to purchase a specified
number of shares of the underlying stock at the given strike price, on or before the expiration date of the
contract.
Call premium
Premium in price above the par value of a bond or share of preferred stock that must be paid to
holders to redeem the bond or share of preferred stock before its scheduled maturity date.

Call price

The price, specified at issuance, at which the issuer of a bond may retire part of the bond at a
specified call date.

Call price

The price for which a bond can be repaid before maturity under a call provision.

Call protection

A feature of some callable bonds that establishes an initial period when the bonds may not be
called.

Call provision

An embedded option granting a bond issuer the right to buy back all or part of the issue prior
to maturity.

Call risk

The combination of cash flow uncertainty and reinvestment risk introduced by a call provision.

Call swaption

A swaption in which the buyer has the right to enter into a swap as a fixed-rate payer. The
writer therefore becomes the fixed-rate receiver/floating rate payer.

Callable

A financial security such as a bond with a call option attached to it, i.e., the issuer has the right to
call the security.

Capital allocation

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

Chinese wall

Communication barrier between financiers (investment bankers) and traders. this barrier is
erected to prevent the sharing of inside information that bankers are likely to have.

Conflict between bondholders and stockholders

These two groups may have interests in a corporation that
conflict. Sources of conflict include dividends, distortion of investment, and underinvestment. Protective
covenants work to resolve these conflicts.

Continuous compounding

The process of accumulating the time value of money forward in time on a
continuous, or instantaneous, basis. Interest is earned continuously, and at each instant, the interest that
accrues immediately begins earning interest on itself.

Continuous random variable

A random value that can take any fractional value within specified ranges, as
contrasted with a discrete variable.

Conversion factors

Rules set by the Chicago Board of Trade for determining the invoice price of each
acceptable deliverable Treasury issue against the Treasury Bond futures contract.

Covered call

A short call option position in which the writer owns the number of shares of the underlying
stock represented by the option contracts. Covered calls generally limit the risk the writer takes because the
stock does not have to be bought at the market price, if the holder of that option decides to exercise it.

Covered call writing strategy

A strategy that involves writing a call option on securities that the investor
owns in his or her portfolio. See covered or hedge option strategies.

Deferred call

A provision that prohibits the company from calling the bond before a certain date. During this
period the bond is said to be call protected.

Demand deposits

Checking accounts that pay no interest and can be withdrawn upon demand.

Demand line of credit

A bank line of credit that enables a customer to borrow on a daily or on-demand basis.

Demand master notes

Short-term securities that are repayable immediately upon the holder's demand.

Demand shock

An event that affects the demand for goods in services in the economy.

Discrete random variable

A random variable that can take only a certain specified set of discrete possible
values - for example, the positive integers 1, 2, 3, . . .

Dynamic asset allocation

An asset allocation strategy in which the asset mix is mechanistically shifted in
response to -changing market conditions, as in a portfolio insurance strategy, for example.

Economic income

Cash flow plus change in present value.

Effective call price

The strike price in an optional redemption provision plus the accrued interest to the
redemption date.

Endogenous variable

A value determined within the context of a model.

Exogenous variable

A variable whose value is determined outside the model in which it is used. Also called
a parameter.

Expected return-beta relationship

Implication of the CAPM that security risk premiums will be
proportional to beta.

Fallout risk

A type of mortgage pipeline risk that is generally created when the terms of the loan to be
originated are set at the same time as the sale terms are set. The risk is that either of the two parties, borrower
or investor, fails to close and the loan "falls out" of the pipeline.

Federally related institutions

Arms of the federal government that are exempt from SEC registration and
whose securities are backed by the full faith and credit of the U.S. government (with the exception of the
Tennessee Valley Authority).

First-call

With CMOs, the start of the cash flow cycle for the cash flow window.

Fixed-income equivalent

Also called a busted convertible, a convertible security that is trading like a straight
security because the optioned common stock is trading low.

Fixed-income instruments

Assets that pay a fixed-dollar amount, such as bonds and preferred stock.

Fixed-income market

The market for trading bonds and preferred stock.

Generally Accepted Accounting Principals (GAAP)

A technical accounting term that encompasses the
conventions, rules, and procedures necessary to define accepted accounting practice at a particular time.

Glass-Steagall Act

A 1933 act in which Congress forbade commercial banks to own, underwrite, or deal in
corporate stock and corporate bonds.

Hedging demands

demands for securities to hedge particular sources of consumption risk, beyond the usual
mean-variance diversification motivation.

Implied call

The right of the homeowner to prepay, or call, the mortgage at any time.

Income beneficiary

One who receives income from a trust.

Income bond

A bond on which the payment of interest is contingent on sufficient earnings. These bonds are
commonly used during the reorganization of a failed or failing business.

Income fund

A mutual fund providing for liberal current income from investments.

Income statement (statement of operations)

A statement showing the revenues, expenses, and income (the
difference between revenues and expenses) of a corporation over some period of time.

Income stock

Common stock with a high dividend yield and few profitable investment opportunities.

Installment sale

The sale of an asset in exchange for a specified series of payments (the installments).

Internally efficient market

Operationally efficient market.

Investment income

The revenue from a portfolio of invested assets.
Investment management Also called portfolio management and money management, the process of
managing money.

Investor fallout

In the mortgage pipeline, risk that occurs when the originator commits loan terms to the
borrowers and gets commitments from investors at the time of application, or if both sets of terms are made at closing.

Irrational call option

The implied call imbedded in the MBS. Identified as irrational because the call is
sometimes not exercised when it is in the money (interest rates are below the threshold to refinance).
Sometimes exercised when not in the money (home sold without regard to the relative level of interest rates).

Margin call

A demand for additional funds because of adverse price movement. Maintenance margin
requirement, security deposit maintenance
Margin of safety With respect to working capital management, the difference between 1) the amount of longterm
financing, and 2) the sum of fixed assets and the permanent component of current assets.

Money market demand account

An account that pays interest based on short-term interest rates.

Monthly income preferred security (MIP)

Preferred stock issued by a subsidiary located in a tax haven.
The subsidiary relends the money to the parent.

Mutually exclusive investment decisions

Investment decisions in which the acceptance of a project
precludes the acceptance of one or More alternative projects.

Net income

The company's total earnings, reflecting revenues adjusted for costs of doing business,
depreciation, interest, taxes and other expenses.

Non-parallel shift in the yield curve

A shift in the yield curve in which yields do not change by the same
number of basis points for every maturity. Related: Parallel shift in the yield curve.

Normal random variable

A random variable that has a normal probability distribution.

Operationally efficient market

Also called an internally efficient market, one in which investors can obtain
transactions services that reflect the true costs associated with furnishing those services.

Parallel loan

A process whereby two companies in different countries borrow each other's currency for a
specific period of time, and repay the other's currency at an agreed maturity for the purpose of reducing
foreign exchange risk. Also referred to as back-to-back loans.

Parallel shift in the yield curve

A shift in the yield curve in which the change in the yield on all maturities is
the same number of basis points. In other words, if the 3 month T-bill increases 100 basis points (one
percent), then the 6 month, 1 year, 5 year, 10 year, 20 year, and 30 year rates increase by 100 basis points as
well.
Related: Non-parallel shift in the yield curve.

Policy asset allocation

A long-term asset allocation method, in which the investor seeks to assess an
appropriate long-term "normal" asset mix that represents an ideal blend of controlled risk and enhanced
return.

Precautionary demand (for money)

The need to meet unexpected or extraordinary contingencies with a
buffer stock of cash.

Price-volume relationship

A relationship espoused by some technical analysts that signals continuing rises
and falls in security prices based on accompanying changes in volume traded.

Principal-agent relationship

A situation that can be modeled as one person, an agent, who acts on the behalf
of another person, the principal.

Provisional call feature

A feature in a convertible issue that allows the issuer to call the issue during the noncall
period if the price of the stock reaches a certain level.

Put-call parity relationship

The relationship between the price of a put and the price of a call on the same
underlying security with the same expiration date, which prevents arbitrage opportunities. Holding the stock
and buying a put will deliver the exact payoff as buying one call and investing the present value (PV) of the
exercise price. The call value equals C=S+P-PV(k).

Rally (recovery)

An upward movement of prices. Opposite of reaction.

Random variable

A function that assigns a real number to each and every possible outcome of a random experiment.

Random walk

Theory that stock price changes from day to day are at random; the changes are independent
of each other and have the same probability distribution. Many believers of the random walk theory believe
that it is impossible to outperform the market consistently without taking additional risk.

Randomized strategy

A strategy of introducing into the decision-making process a random element that is
designed to reduce the information content of the decision-maker's observed choices.

Shortfall risk

The risk of falling short of any investment target.

Small-firm effect

The tendency of small firms (in terms of total market capitalization) to outperform the
stock market (consisting of both large and small firms).

Small issues exemption

Securities issues that involve less than $1.5 million are not required to file a
registration statement with the SEC. Instead, they are governed by Regulation A, for which only a brief
offering statement is needed.

Speculative demand (for money)

The need for cash to take advantage of investment opportunities that may arise.

Spread income

Also called margin income, the difference between income and cost. For a depository
institution, the difference between the assets it invests in (loans and securities) and the cost of its funds
(deposits and other sources).

Tactical Asset Allocation (TAA)

An asset allocation strategy that allows active departures from the normal
asset mix based upon rigorous objective measures of value. Often called active management. It involves
forecasting asset returns, volatilities and correlations. The forecasted variables may be functions of
fundamental variables, economic variables or even technical variables.

Taxable income

Gross income less a set of deductions.

Transaction demand (for money)

The need to accommodate a firm's expected cash transactions.

Uncovered call

A short call option position in which the writer does not own shares of underlying stock
represented by his option contracts. Also called a "naked" call, it is much riskier for the writer than a covered
call, where the writer owns the underlying stock. If the buyer of a call exercises the option to call, the writer
would be forced to buy the stock at market price.

Underwriting income

For an insurance company, the difference between the premiums earned and the costs
of settling claims.

Utility function

A mathematical expression that assigns a value to all possible choices. In portfolio theory the
utility function expresses the preferences of economic entities with respect to perceived risk and expected return.

Variable

A value determined within the context of a model. Also called endogenous variable.

Variable annuities

Annuity contracts in which the issuer pays a periodic amount linked to the investment
performance of an underlying portfolio.

Variable cost

A cost that is directly proportional to the volume of output produced. When production is zero,
the variable cost is equal to zero.

Variable life insurance policy

A whole life insurance policy that provides a death benefit dependent on the
insured's portfolio market value at the time of death. Typically the company invests premiums in common
stocks, and hence variable life policies are referred to as equity-linked policies.

Variable price security

A security, such as stocks or bonds, that sells at a fluctuating, market-determined price.

Variable rate CDs

Short-term certificate of deposits that pay interest periodically on roll dates. On each roll
date, the coupon on the CD is adjusted to reflect current market rates.

Variable rated demand bond (VRDB)

Floating rate bond that can be sold back periodically to the issuer.

Variable rate loan

Loan made at an interest rate that fluctuates based on a base interest rate such as the
Prime Rate or LIBOR.

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