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Definition of Frictions

Frictions Image 1

Frictions

The "stickiness" in making transactions; the total hassle including time, effort, money, and tax
effects of gathering information and making a transaction such as buying a stock or borrowing money.



Related Terms:

Acquisition of stock

A merger or consolidation in which an acquirer purchases the acquiree's stock.


Adjustable rate preferred stock (ARPS)

Publicly traded issues that may be collateralized by mortgages and MBSs.


After-tax profit margin

The ratio of net income to net sales.


After-tax real rate of return

money after-tax rate of return minus the inflation rate.


American Stock Exchange (AMEX)

The second-largest stock exchange in the United States. It trades
mostly in small-to medium-sized companies.



Asymmetric information

information that is known to some people but not to other people.


Asymmetric taxes

A situation wherein participants in a transaction have different net tax rates.


Frictions Image 1

At-the-money

An option is at-the-money if the strike price of the option is equal to the market price of the
underlying security. For example, if xyz stock is trading at 54, then the xyz 54 option is at-the-money.


Auction rate preferred stock (ARPS)

Floating rate preferred stock, the dividend on which is adjusted every
seven weeks through a Dutch auction.


Average tax rate

taxes as a fraction of income; total taxes divided by total taxable income.


Before-tax profit margin

The ratio of net income before taxes to net sales.


Best-efforts sale

A method of securities distribution/ underwriting in which the securities firm agrees to sell
as much of the offering as possible and return any unsold shares to the issuer. As opposed to a guaranteed or
fixed price sale, where the underwriter agrees to sell a specific number of shares (with the securities firm
holding any unsold shares in its own account if necessary).


Beta equation (Stocks)

The beta of a stock is determined as follows:
[(n) (sum of (xy)) ]-[(sum of x) (sum of y)]
[(n) (sum of (xx)) ]-[(sum of x) (sum of x)]
where: n = # of observations (24-60 months)
x = rate of return for the S&P 500 Index
y = rate of return for the stock


Break-even tax rate

The tax rate at which a party to a prospective transaction is indifferent between entering
into and not entering into the transaction.


Break-even time

Related: Premium payback period.


Buying the index

Purchasing the stocks in the S&P 500 in the same proportion as the index to achieve the
same return.


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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.


Cash flow after interest and taxes

Net income plus depreciation.



Cash flow time-line

Line depicting the operating activities and cash flows for a firm over a particular period.


Cash transaction

A transaction where exchange is immediate, as contrasted to a forward contract, which
calls for future delivery of an asset at an agreed-upon price.


Common stock

These are securities that represent equity ownership in a company. Common shares let an
investor vote on such matters as the election of directors. They also give the holder a share in a company's
profits via dividend payments or the capital appreciation of the security.


Common stock/other equity

Value of outstanding common shares at par, plus accumulated retained
earnings. Also called shareholders' equity.


Common stock equivalent

A convertible security that is traded like an equity issue because the optioned
common stock is trading high.


Common stock market

The market for trading equities, not including preferred stock.


Common stock ratios

Ratios that are designed to measure the relative claims of stockholders to earnings
(cash flow per share), and equity (book value per share) of a firm.


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.


Convertible exchangeable preferred stock

Convertible preferred stock that may be exchanged, at the
issuer's option, into convertible bonds that have the same conversion features as the convertible preferred
stock.


Frictions Image 3

Convertible preferred stock

Preferred stock that can be converted into common stock at the option of the holder.



Corporate tax view

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


Corporate taxable equivalent

Rate of return required on a par bond to produce the same after-tax yield to
maturity that the premium or discount bond quoted would.


Cumulative preferred stock

Preferred stock whose dividends accrue, should the issuer not make timely
dividend payments. Related: non-cumulative preferred stock.


Deferred taxes

A non-cash expense that provides a source of free cash flow. Amount allocated during the
period to cover tax liabilities that have not yet been paid.


Depreciation tax shield

The value of the tax write-off on depreciation of plant and equipment.


Direct stock-purchase programs

The purchase by investors of securities directly from the issuer.


Dividend yield (Stocks)

Indicated yield represents annual dividends divided by current stock price.


Double-tax agreement

Agreement between two countries that taxes paid abroad can be offset against
domestic taxes levied on foreign dividends.


Earnings before interest and taxes (EBIT)

A financial measure defined as revenues less cost of goods sold
and selling, general, and administrative expenses. In other words, operating and non-operating profit before
the deduction of interest and income taxes.


Employee stock fund

A firm-sponsored program that enables employees to purchase shares of the firm's
common stock on a preferential basis.


Employee stock ownership plan (ESOP)

A company contributes to a trust fund that buys stock on behalf of
employees.


Equivalent taxable yield

The yield that must be offered on a taxable bond issue to give the same after-tax
yield as a tax-exempt issue.


Exchange of stock

Acquisition of another company by purchase of its stock in exchange for cash or shares.


Expected value of perfect information

The expected value if the future uncertain outcomes could be known
minus the expected value with no additional information.


Foreign tax credit

Home country credit against domestic income tax for foreign taxes paid on foreign
derived earnings.


Going-private transactions

Publicly owned stock in a firm is replaced with complete equity ownership by a
private group. The shares are delisted from stock exchanges and can no longer be purchased in the open
markets.


Growth stock

Common stock of a company that has an opportunity to invest money and earn more than the
opportunity cost of capital.


Highly leveraged transaction (HLT)

Bank loan to a highly leveraged firm.


Hot money

money that moves across country borders in response to interest rate differences and that moves
away when the interest rate differential disappears.


Imputation tax system

Arrangement by which investors who receive a dividend also receive a tax credit for
corporate taxes that the firm has paid.


Income stock

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


Information asymmetry

A situation involving information that is known to some, but not all, participants.


Information Coefficient (IC)

The correlation between predicted and actual stock returns, sometimes used to
measure the value of a financial analyst. An IC of 1.0 indicates a perfect linear relationship between predicted
and actual returns, while an IC of 0.0 indicates no linear relationship.


Information costs

transaction costs that include the assessment of the investment merits of a financial asset.
Related: search costs.


Information services

Organizations that furnish investment and other types of information, such as
information that helps a firm monitor its cash position.


Information-content effect

The rise in the stock price following the dividend signal.


Informational efficiency

The speed and accuracy with which prices reflect new information.


Informationless trades

Trades that are the result of either a reallocation of wealth or an implementation of an
investment strategy that only utilizes existing information.


Information-motivated trades

Trades in which an investor believes he or she possesses pertinent
information not currently reflected in the stock's price.


Insider information

Relevant information about a company that has not yet been made public. It is illegal for
holders of this information to make trades based on it, however received.


Intercompany transaction

transaction carried out between two units of the same corporation.


Interest equalization tax

tax on foreign investment by residents of the U.S. which was abolished in 1974.


Interest tax shield

The reduction in income taxes that results from the tax-deductibility of interest payments.


In-the-money

A put option that has a strike price higher than the underlying futures price, or a call option
with a strike price lower than the underlying futures price. For example, if the March COMEX silver futures
contract is trading at $6 an ounce, a March call with a strike price of $5.50 would be considered in-the-money
by $0.50 an ounce.
Related: put.


Investment tax credit

Proportion of new capital investment that can be used to reduce a company's tax bill
(abolished in 1986).


Just-in-time inventory systems

Systems that schedule materials/inventory to arrive exactly as they are
needed in the production process.


Letter stock

Privately placed common stock, so-called because the SEC requires a letter from the purchaser
stating that the stock is not intended for resale.


Limitation on subsidiary borrowing

A bond covenant that restricts in some way a firm's ability to borrow at
the subsidiary level.


Limited-tax general obligation bond

A general obligation bond that is limited as to revenue sources.


Listed stocks

stocks that are traded on an exchange.


Listed stocks

stocks that are traded on an exchange.


Making delivery

Refers to the seller's actually turning over to the buyer the asset agreed upon in a forward contract.


Margin account (Stocks)

A leverageable account in which stocks can be purchased for a combination of
cash and a loan. The loan in the margin account is collateralized by the stock and, if the value of the stock
drops sufficiently, the owner will be asked to either put in more cash, or sell a portion of the stock. Margin
rules are federally regulated, but margin requirements and interest may vary among broker/dealers.


Marginal tax rate

The tax rate that would have to be paid on any additional dollars of taxable income earned.


Market timer

A money manager who assumes he or she can forecast when the stock market will go up and down.


Money base

Composed of currency and coins outside the banking system plus liabilities to the deposit money banks.


Money center banks

Banks that raise most of their funds from the domestic and international money markets, relying less on depositors for funds.


Money management

Related: Investment management.


Money manager

Related: Investment manager.


Money market

money markets are for borrowing and lending money for three years or less. The securities in
a money market can be U.S.government bonds, treasury bills and commercial paper from banks and
companies.


Money market demand account

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


Money market fund

A mutual fund that invests only in short term securities, such as bankers' acceptances,
commercial paper, repurchase agreements and government bills. The net asset value per share is maintained at
$1. 00. such funds are not federally insured, although the portfolio may consist of guaranteed securities
and/or the fund may have private insurance protection.


Money market hedge

The use of borrowing and lending transactions in foreign currencies to lock in the
home currency value of a foreign currency transaction.


Money market notes

Publicly traded issues that may be collateralized by mortgages and MBSs.


Money purchase plan

A defined benefit contribution plan in which the participant contributes some part and
the firm contributes at the same or a different rate. Also called and individual account plan.


Money rate of return

Annual money return as a percentage of asset value.


Money supply

M1-A: Currency plus demand deposits
M1-B: M1-A plus other checkable deposits.
M2: M1-B plus overnight repos, money market funds, savings, and small (less than $100M) time deposits.
M3: M-2 plus large time deposits and term repos.
L: M-3 plus other liquid assets.


New York Stock Exchange (NYSE)

Also known as the Big Board or The Exhange. More than 2,00 common
and preferred stocks are traded. The exchange is the older in the United States, founded in 1792, and the
largest. It is lcoated on Wall Street in New York City


New money

In a Treasury auction, the amount by which the par value of the securities offered exceeds that of
those maturing.


Non-cumulative preferred stock

Preferred stock whose holders must forgo dividend payments when the
company misses a dividend payment.
Related: Cumulative preferred stock


Out-of-the-money option

A call option is out-of-the-money if the strike price is greater than the market price
of the underlying security. A put option is out-of-the-money if the strike price is less than the market price of
the underlying security.


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.


Philadelphia Stock Exchange (PHLX)

A securities exchange where American and European foreign
currency options on spot exchange rates are traded.


Precautionary demand (for money)

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


Preferred equity redemption stock (PERC)

Preferred stock that converts automatically into equity at a
stated date. A limit is placed on the value of the shares the investor receives.


Preference stock

A security that ranks junior to preferred stock but senior to common stock in the right to
receive payments from the firm; essentially junior preferred stock.


Preferred stock

A security that shows ownership in a corporation and gives the holder a claim, prior to the
claim of common stockholders, on earnings and also generally on assets in the event of liquidation. Most
preferred stock pays a fixed dividend that is paid prior to the common stock dividend, stated in a dollar
amount or as a percentage of par value. This stock does not usually carry voting rights. The stock shares
characteristics of both common stock and debt.


Preferred stock agreement

A contract for preferred stock.


Progressive tax system

A tax system wherein the average tax rate increases for some increases in income but
never decreases with an increase in income.


Protective put buying strategy

A strategy that involves buying a put option on the underlying security that is
held in a portfolio. Related: Hedge option strategies


Real time

A real time stock or bond quote is one that states a security's most recent offer to sell or bid (buy).
A delayed quote shows the same bid and ask prices 15 minutes and sometimes 20 minutes after a trade takes place.


Repurchase of stock

Device to pay cash to firm's shareholders that provides more preferable tax treatment
for shareholders than dividends. Treasury stock is the name given to previously issued stock that has been
repurchased by the firm. A repurchase is achieved through either a dutch auction, open market, or tender offer.



 

 

 

 

 

 

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