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Moral hazard

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Definition of Moral hazard

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Moral hazard

The risk that the existence of a contract will change the behavior of one or both parties to the
contract, e.g. an insured firm will take fewer fire precautions.



Related Terms:

Accounting change

An alteration in the accounting methodology or estimates used in
the reporting of financial statements, usually requiring discussion in a footnote
attached to the financial statements.


Affirmative covenant

A bond covenant that specifies certain actions the firm must take.


All or none

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


All-or-none underwriting

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


American Stock Exchange (AMEX)

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



Asset-specific Risk

The amount of total risk that can be eliminated by diversification by
creating a portfolio. Also known as company-specific risk or
unsystematic risk.


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.


Moral Hazard Image 1

Bankruptcy risk

The risk that a firm will be unable to meet its debt obligations. Also referred to as default or insolvency risk.


Basis risk

The uncertainty about the basis at the time a hedge may be lifted. Hedging substitutes basis risk for
price risk.


Beta risk

risk of a firm measured from the standpoint of an investor who holds a highly diversified portfolio.


Bill of exchange

General term for a document demanding payment.


Bullet contract

A guaranteed investment contract purchased with a single (one-shot) premium. Related:
Window contract.


Business risk

The risk that the cash flow of an issuer will be impaired because of adverse economic
conditions, making it difficult for the issuer to meet its operating expenses.


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 risk

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


Cash settlement contracts

Futures contracts, such as stock index futures, that settle for cash, not involving
the delivery of the underlying.


Moral Hazard Image 2

Change in Accounting Estimate

A change in accounting that occurs as the result of new information
or as additional experience is acquired—for example, a change in the residual values
or useful lives of fixed assets. A change in accounting estimate is accounted for prospectively,
over the current and future accounting periods affected by the change.


Change in Accounting Estimate

A change in the implementation of an existing accounting
policy. A common example would be extending the useful life or changing the expected residual
value of a fixed asset. Another would be making any necessary adjustments to allowances for
uncollectible accounts, warranty obligations, and reserves for inventory obsolescense.



Change in Accounting Principle

A change from one generally accepted accounting principle to another generally accepted accounting principle—for example, a change from capitalizing expenditures
to expensing them. A change in accounting principle is accounted for in most instances
as a cumulative-effect–type adjustment.


Change in Reporting Entity

A change in the scope of the entities included in a set of, typically, consolidated financial statements.


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.


Chicago Mercantile Exchange (CME)

A not-for-profit corporation owned by its members. Its primary
functions are to provide a location for trading futures and options, collect and disseminate market information,
maintain a clearing mechanism and enforce trading rules.


Commercial risk

The risk that a foreign debtor will be unable to pay its debts because of business events,
such as bankruptcy.


Commodities Exchange Center (CEC)

The location of five New York futures exchanges: Commodity
Exchange, Inc. (COMEX), the New York Mercantile exchange (NYMEX), the New York Cotton Exchange,
the Coffee, Sugar and Cocoa exchange (CSC), and the New York futures exchange (NYFE). common size
statement A statement in which all items are expressed as a percentage of a base figure, useful for purposes of
analyzing trends and the changing relationship between financial statement items. For example, all items in
each year's income statement could be presented as a percentage of net sales.


Company-specific risk

Related: Unsystematic risk


Companyspecific Risk

See asset-specific risk


Completed-Contract Method

A contract accounting method that recognizes contract revenue
only when the contract is completed. All contract costs are accumulated and reported as expense
when the contract revenue is recognized.


Moral Hazard Image 3

Completion risk

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



Component

Raw materials or subassemblies used to make either finished goods
or higher levels of subassembly.


Conditional sales contracts

Similar to equipment trust certificates except that the lender is either the
equipment manufacturer or a bank or finance company to whom the manufacturer has sold the conditional
sales contract.


Confirmation

he written statement that follows any "trade" in the securities markets. Confirmation is issued
immediately after a trade is executed. It spells out settlement date, terms, commission, etc.


Contract

A term of reference describing a unit of trading for a financial or commodity future. Also, the actual
bilateral agreement between the buyer and seller of a transaction as defined by an exchange.


Contract

A formal written statement of the rights and obligations of each party to a transaction.


Contract Accounting

Method of accounting for sales or service agreements where completion
requires an extended period.


contract manufacturer

an external party that has been granted an outsourcing contract to produce a part or component for an entity


Contract month

The month in which futures contracts may be satisfied by making or accepting a delivery.
Also called value managers, those who assemble portfolios with relatively lower betas, lower price-book and
P/E ratios and higher dividend yields, seeing value where others do not.


contract vendor

an external party that has been granted an
outsourcing contract to provide a service activity for an entity


Contract Work Hours and Safety Standards Act

A federal Act requiring federal contractors to pay overtime for hours worked exceeding 40 per week.


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.


cost-plus contract

a contract in which the customer agrees
to reimburse the producer for the cost of the job plus a
specified profit margin over cost


Counterparties

The parties to an interest rate swap.


Counterparty risk

The risk that the other party to an agreement will default. In an options contract, the risk
to the option buyer that the option writer will not buy or sell the underlying as agreed.
Country economic risk Developments in a national economy that can affect the outcome of an international
financial transaction.


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.


Credit risk

The risk that an issuer of debt securities or a borrower may default on his obligations, or that the
payment may not be made on a negotiable instrument. Related: Default risk


Credit Risk

Financial and moral risk that an obligation will not be paid and a loss will result.


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.


Cumulative Effect of a Change in Accounting Principle

The change in earnings of previous years
based on the assumption that a newly adopted accounting principle had previously been in use.


Cumulative Effect of Accounting Change

The change in earnings of previous years assuming
that the newly adopted accounting principle had previously been in use.


Currency risk

Related: Exchange rate risk


Currency risk sharing

An agreement by the parties to a transaction to share the currency risk associated with
the transaction. The arrangement involves a customized hedge contract embedded in the underlying
transaction.


Default risk

Also referred to as credit risk (as gauged by commercial rating companies), the risk that an
issuer of a bond may be unable to make timely principal and interest payments.


Diversifiable risk

Related: unsystematic risk.


Dow Jones industrial average

This is the best known U.S.index of stocks. It contains 30 stocks that trade on
the New York Stock Exchange. The Dow, as it is called, is a barometer of how shares of the largest
U.S.companies are performing. There are thousands of investment indexes around the world for stocks,
bonds, currencies and commodities.


Dow Jones Industrial Average

Index of the investment performance of a portfolio of 30 “blue-chip” stocks.


economic components model

Abrams’ model for calculating DLOM based on the interaction of discounts from four economic components.
This model consists of four components: the measure of the economic impact of the delay-to-sale, monopsony power to buyers, and incremental transactions costs to both buyers and sellers.


Economic risk

In project financing, the risk that the project's output will not be salable at a price that will
cover the project's operating and maintenance costs and its debt service requirements.


Effective Exchange Rate

The weighted average of several exchange rates, where the weights are determined by the extent of our trade done with each country.


Electronic data interchange (EDI)

The exchange of information electronically, directly from one firm's
computer to another firm's computer, in a structured format.


electronic data interchange (EDI)

the computer-to-computer transfer of information in virtual real time using standardized formats developed by the American National Standards Institute


Embodied Technical Change

Technical change that can be used only when new capital embodying this technical change is produced.


Engineering change

A change to a product’s specifications as issued by the engineering
department.


engineering change order (ECO)

a business mandate that changes the way in which a product is manufactured or a
service is performed by modifying the design, parts,
process, or even quality of the product or service


Equation of Exchange

The quantity theory equation Mv = PQ.


Equilibrium market price of risk

The slope of the capital market line (CML). Since the CML represents the
return offered to compensate for a perceived level of risk, each point on the line is a balanced market
condition, or equilibrium. The slope of the line determines the additional return needed to compensate for a
unit change in risk.


European Monetary System (EMS)

An exchange arrangement formed in 1979 that involves the currencies
of European Union member countries.


Event risk

The risk that the ability of an issuer to make interest and principal payments will change because
of rare, discontinuous, and very large, unanticipated changes in the market environment such as (1) a natural
or industrial accident or some regulatory change or (2) a takeover or corporate restructuring.


Exchange

The marketplace in which shares, options and futures on stocks, bonds, commodities and indices
are traded. Principal US stock exchanges are: New York Stock Exchange (NYSE), American Stock Exchange
(AMEX) and the National Association of Securities Dealers (NASDAQ)


Exchange controls

Governmental restrictions on the purchase of foreign currencies by domestic citizens or
on the purchase of the local domestic currency by foreigners.


Exchange of assets

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


Exchange of stock

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


Exchange offer

An offer by the firm to give one security, such as a bond or preferred stock, in exchange for
another security, such as shares of common stock.


Exchange rate

The price of one country's currency expressed in another country's currency.


exchange rate

Amount of one currency needed to purchase one unit of another.


Exchange Rate Mechanism (ERM)

The methodology by which members of the EMS maintain their
currency exchange rates within an agreed upon range with respect to other member countries.


Exchange Rate, Nominal

The price of one currency in terms of another, in this book defined as number of units of foreign currency per dollar.


Exchange Rate, Real

The nominal exchange rate corrected for price level differences.


Exchange rate risk

Also called currency risk, the risk of an investment's value changing because of currency
exchange rates.


Exchange risk

The variability of a firm's value that results from unexpected exchange rate changes or the
extent to which the present value of a firm is expected to change as a result of a given currency's appreciation
or depreciation.


Exchangeable Security

Security that grants the security holder the right to exchange the security for the
common stock of a firm other than the issuer of the security.


expectations theory of exchange rates

Theory that expected spot exchange rate equals the forward rate.


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.


Fiat Money

Fiat Money is paper currency made legal tender by law or fiat. It is not backed by gold or silver and is not necessarily redeemable in coin. This practice has had widespread use for about the last 70 years. If governments produce too much of it, there is a loss of confidence. Even so, governments print it routinely when they need it. The value of fiat money is dependent upon the performance of the economy of the country which issued it. Canada's currency falls into this category.


Financial risk

The risk that the cash flow of an issuer will not be adequate to meet its financial obligations.
Also referred to as the additional risk that a firm's stockholder bears when the firm utilizes debt and equity.


financial risk

risk to shareholders resulting from the use of debt.


Firm

Refers to an order to buy or sell that can be executed without confirmation for some fixed period. Also,
a synonym for company.


Firm commitment underwriting

An undewriting in which an investment banking firm commits to buy the
entire issue and assumes all financial responsibility for any unsold shares.


Firm's net value of debt

Total firm value minus total firm debt.


Firm-specific risk

See:diversifiable risk or unsystematic risk.


Fixed-exchange rate

A country's decision to tie the value of its currency to another country's currency, gold
(or another commodity), or a basket of currencies.


Fixed Exchange Rate

An exchange rate held constant by a government promise to buy or sell dollars at the fixed rate on the foreign exchange market.


Flat price risk

Taking a position either long or short that does not involve spreading.


Flexible Exchange Rate

An exchange rate whose value is determined by the forces of supply and demand on the foreign exchange market.


Floating exchange rate

A country's decision to allow its currency value to freely change. The currency is not
constrained by central bank intervention and does not have to maintain its relationship with another currency
in a narrow band. The currency value is determined by trading in the foreign exchange market.


Floating Exchange Rate

See flexible exchange rate.


Floating-rate contract

A guaranteed investment contract where the credit rating is tied to some variable
("floating") interest rate benchmark, such as a specific-maturity Treasury yield.


Force majeure risk

The risk that there will be an interruption of operations for a prolonged period after a
project finance project has been completed due to fire, flood, storm, or some other factor beyond the control
of the project's sponsors.


Foreign exchange

Currency from another country.


Foreign Exchange

The currency of a foreign country.


Foreign exchange controls

Various forms of controls imposed by a government on the purchase/sale of
foreign currencies by residents or on the purchase/sale of local currency by nonresidents.



 

 

 

 

 

 

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