Definition of Interest-only strip (IO)

Interest-only strip (IO)

A security based solely on the interest payments form a pool of mortgages, Treasury
bonds, or other bonds. Once the principal on the mortgages or bonds has been repaid, interest payments stop
and the value of the io falls to zero.

fractional interest discount

the combined discounts for lack of control and marketability. g the constant growth rate in cash flows or net income used in the ADF, Gordon model, or present value factor.

PPF (periodic perpetuity factor)

a generalization formula invented by Abrams that is the present value of regular but noncontiguous cash flows that have constant growth to perpetuity.

Abandonment option

The option of terminating an investment earlier than originally planned.

Absolute priority

Rule in bankruptcy proceedings whereby senior creditors are required to be paid in full
before junior creditors receive any payment.

Accelerated depreciation

Any depreciation method that produces larger deductions for depreciation in the
early years of a project's life. Accelerated cost recovery system (ACRS), which is a depreciation schedule
allowed for tax purposes, is one such example.

Accretion (of a discount)

In portfolio accounting, a straight-line accumulation of capital gains on discount
bond in anticipation of receipt of par at maturity.

Accrued interest

The accumulated coupon interest earned but not yet paid to the seller of a bond by the
buyer (unless the bond is in default).

Accumulated Benefit Obligation (ABO)

An approximate measure of the liability of a plan in the event of a
termination at the date the calculation is performed. Related: projected benefit obligation.

Acid-test ratio

Also called the quick ratio, the ratio of current assets minus inventories, accruals, and prepaid
items to current liabilities.

Acquisition of assets

A merger or consolidation in which an acquirer purchases the selling firm's assets.

Acquisition of stock

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

Active portfolio strategy

A strategy that uses available information and forecasting techniques to seek a
better performance than a portfolio that is simply diversified broadly. Related: passive portfolio strategy

Additional hedge

A protection against borrower fallout risk in the mortgage pipeline.

Adverse selection

A situation in which market participation is a negative signal.

Aggregation

Process in corporate financial planning whereby the smaller investment proposals of each of the
firm's operational units are added up and in effect treated as a big picture.

Alpha equation

The alpha of a fund is determined as follows:
[ (sum of y) -((b)(sum of x)) ] / n
where:
n =number of observations (36 months)
b = beta of the fund
x = rate of return for the S&P 500
y = rate of return for the fund

American option

An option that may be exercised at any time up to and including the expiration date.
Related: European option

American-style option

An option contract that can be exercised at any time between the date of purchase and
the expiration date. Most exchange-traded options are American style.

Amortization

The repayment of a loan by installments.

Amortization factor

The pool factor implied by the scheduled amortization assuming no prepayemts.

Amortizing interest rate swap

Swap in which the principal or national amount rises (falls) as interest rates
rise (decline).

Annualized holding period return

The annual rate of return that when compounded t times, would have
given the same t-period holding return as actually occurred from period 1 to period t.

Anticipation

Arrangements whereby customers who pay before the final date may be entitled to deduct a
normal rate of interest.

Appraisal ratio

The signal-to-noise ratio of an analyst's forecasts. The ratio of alpha to residual standard
deviation.

Appropriation request

Formal request for funds for capital investment project.

Arbitrage-free option-pricing models

Yield curve option-pricing models.

Articles of incorporation

Legal document establishing a corporation and its structure and purpose.

Asian option

Option based on the average price of the asset during the life of the option.

Asset/equity ratio

The ratio of total assets to stockholder equity.

Asset activity ratios

Ratios that measure how effectively the firm is managing its assets.

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.

Asset substitution

A firm's investing in assets that are riskier than those that the debtholders expected.

Asset substitution problem

Arises when the stockholders substitute riskier assets for the firm's existing
assets and expropriate value from the debtholders.

Asymmetric information

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

Auction markets

Markets in which the prevailing price is determined through the free interaction of
prospective buyers and sellers, as on the floor of the stock exchange.

Auction rate preferred stock (ARPS)

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

Autocorrelation

The correlation of a variable with itself over successive time intervals.

Average collection period, or days' receivables

The ratio of accounts receivables to sales, or the total
amount of credit extended per dollar of daily sales (average AR/sales * 365).

Backwardation

A market condition in which futures prices are lower in the distant delivery months than in
the nearest delivery month. This situation may occur in when the costs of storing the product until eventual
delivery are effectively subtracted from the price today. The opposite of contango.

BAN (Bank anticipation notes)

Notes issued by states and municipalities to obtain interim financing for
projects that will eventually be funded long term through the sale of a bond issue.

Bank collection float

The time that elapses between when a check is deposited into a bank account and when the funds are available to the depositor, during which period the bank is collecting payment from the payer's bank.

Bank for International Settlements (BIS)

An international bank headquartered in Basel, Switzerland, which
serves as a forum for monetary cooperation among several European central banks, the Bank of Japan, and the
U.S. Federal Reserve System. Founded in 1930 to handle the German payment of World War I reparations, it
now monitors and collects data on international banking activity and promulgates rules concerning
international bank regulation.

Bargain-purchase-price option

Gives the lessee the option to purchase the asset at a price below fair market
value when the lease expires.

Barrier options

Contracts with trigger points that, when crossed, automatically generate buying or selling of
other options. These are very exotic options.

Base interest rate

Related: Benchmark interest rate.

Basket options

Packages that involve the exchange of more than two currencies against a base currency at
expiration. The basket option buyer purchases the right, but not the obligation, to receive designated
currencies in exchange for a base currency, either at the prevailing spot market rate or at a prearranged rate of
exchange. A basket option is generally used by multinational corporations with multicurrency cash flows
since it is generally cheaper to buy an option on a basket of currencies than to buy individual options on each
of the currencies that make up the basket.

Beggar-thy-neighbor devaluation

A devaluation that is designed to cheapen a nation's currency and thereby
increase its exports at other countries' expense and reduce imports. Such devaluations often lead to trade wars.

Benchmark interest rate

Also called the base interest rate, it is the minimum interest rate investors will
demand for investing in a non-Treasury security. It is also tied to the yield to maturity offered on a
comparable-maturity Treasury security that was most recently issued ("on-the-run").

Best-interests-of-creditors test

The requirement that a claim holder voting against a plan of reorganization
must receive at least as much as he would have if the debtor were liquidated.

Beta equation (Mutual Funds)

The beta of a fund 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 (36 months)
x = rate of return for the S&P 500 Index
y = rate of return for the fund

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

Biased expectations theories

Related: pure expectations theory.

Binomial option pricing model

An option pricing model in which the underlying asset can take on only two
possible, discrete values in the next time period for each value that it can take on in the preceding time period.

Black-Scholes option-pricing model

A model for pricing call options based on arbitrage arguments that uses
the stock price, the exercise price, the risk-free interest rate, the time to expiration, and the standard deviation
of the stock return.

Call an option

To exercise a call option.

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 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 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.

Capital allocation

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

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 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.

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 interest

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

Cash conversion cycle

The length of time between a firm's purchase of inventory and the receipt of cash
from accounts receivable.

Cash flow after interest and taxes

Net income plus depreciation.

Cash flow coverage ratio

The number of times that financial obligations (for interest, principal payments,
preferred stock dividends, and rental payments) are covered by earnings before interest, taxes, rental
payments, and depreciation.

Cash flow from operations

A firm's net cash inflow resulting directly from its regular operations
(disregarding extraordinary items such as the sale of fixed assets or transaction costs associated with issuing
securities), calculated as the sum of net income plus non-cash expenses that were deducted in calculating net
income.

Cash ratio

The proportion of a firm's assets held as cash.

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.

Changes in Financial Position

Sources of funds internally provided from operations that alter a company's
cash flow position: depreciation, deferred taxes, other sources, and capital expenditures.

Claim dilution

A reduction in the likelihood one or more of the firm's claimants will be fully repaid,
including time value of money considerations.

Clean opinion

An auditor's opinion reflecting an unqualified acceptance of a company's financial statements.

Clear a position

To eliminate a long or short position, leaving no ownership or obligation.

Coefficient of determination

A measure of the goodness of fit of the relationship between the dependent and
independent variables in a regression analysis; for instance, the percentage of variation in the return of an
asset explained by the market portfolio return.

Collateralized mortgage obligation (CMO)

A security backed by a pool of pass-throughs , structured so that
there are several classes of bondholders with varying maturities, called tranches. The principal payments from
the underlying pool of pass-through securities are used to retire the bonds on a priority basis as specified in
the prospectus.
Related: mortgage pass-through security

Collection float

The negative float that is created between the time when you deposit a check in your account
and the time when funds are made available.

Collection fractions

The percentage of a given month's sales collected during the month of sale and each
month following the month of sale.

Collection policy

Procedures followed by a firm in attempting to collect accounts receivables.

Combination matching

Also called horizon matching, a variation of multiperiod immunization and cash
flow matching in which a portfolio is created that is always duration matched and also cash-matched in the
first few years.

Combination strategy

A strategy in which a put and with the same strike price and expiration are either both
bought or both sold. Related: Straddle

Commission

The fee paid to a broker to execute a trade, based on number of shares, bonds, options, and/or
their dollar value. In 1975, deregulation led to the creation of discount brokers, who charge lower
commissions than full service brokers. Full service brokers offer advice and usually have a full staff of
analysts who follow specific industries. Discount brokers simply execute a client's order -- and usually do not
offer an opinion on a stock. Also known as a round-turn.

Commission broker

A broker on the floor of an exchange acts as agent for a particular brokerage house and
who buys and sells stocks for the brokerage house on a commission basis.

Commission house

A firm which buys and sells future contracts for customer accounts. Related: futures
commission merchant, omnibus account.

Committee, AIMR Performance Presentation Standards Implementation Committee

The Association for Investment Management and Research (AIMR)'s Performance Presentation Standards Implementation
Committee is charged with the responsibility to interpret, revise and update the AIMR Performance
Presentation Standards (AIMR-PPS(TM)) for portfolio performance presentations.

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.

Competition

Intra- or intermarket rivalry between businesses trying to obtain a larger piece of the same
market share.

Complete portfolio

The entire portfolio, including risky and risk-free assets.

Completion bonding

Insurance that a construction contract will be successfully completed.

Completion risk

The risk that a project will not be brought into operation successfully.

Completion undertaking

An undertaking either (1) to complete a project such that it meets certain specified
performance criteria on or before a certain specified date or (2) to repay project debt if the completion test
cannot be met.

Composition

Voluntary arrangement to restructure a firm's debt, under which payment is reduced.

Compound interest

interest paid on previously earned interest as well as on the principal.

Compound option

Option on an option.

Compounding period

The length of the time period (for example, a quarter in the case of quarterly
compounding) that elapses before interest compounds.

Comprehensive due diligence investigation

The investigation of a firm's business in conjunction with a
securities offering to determine whether the firm's business and financial situation and its prospects are
adequately disclosed in the prospectus for the offering.

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