Definition of trade-off theory

Trade-off Theory Image 1

trade-off theory

Debt levels are chosen to balance interest tax shields against the costs of financial distress.

Related Terms:

Agency theory

The analysis of principal-agent relationships, wherein one person, an agent, acts on behalf of
anther person, a principal.

Arbitrage Pricing Theory (APT)

An alternative model to the capital asset pricing model developed by
Stephen Ross and based purely on arbitrage arguments.

Balance of trade

Net flow of goods (exports minus imports) between countries.

Block trade

A large trading order, defined on the New York Stock Exchange as an order that consists of
10,000 shares of a given stock or a total market value of $200,000 or more.

Bubble theory

Security prices sometimes move wildly above their true values.

Counter trade

The exchange of goods for other goods rather than for cash; barter.

1) A bond in default trades flat; that is, the price quoted covers both principal and unpaid,
accrued interest.
2) Any security that trades without accrued interest or at a price that includes accrued
interest is said to trade flat.

Floor trader

A member who generally trades only for his own account, for an account controlled by him or
who has such a trade made for him. Also referred to as a "local".

Forward trade

A transaction in which the settlement will occur on a specified date in the future at a price
agreed upon the trade date.

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.

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.

Local expectations theory

A form of the pure expectations theory which suggests that the returns on bonds
of different maturities will be the same over a short-term investment horizon.

Market segmentation theory or preferred habitat theory

A biased expectations theory that asserts that the
shape of the yield curve is determined by the supply of and demand for securities within each maturity sector.

Modern portfolio theory

Principles underlying the analysis and evaluation of rational portfolio choices
based on risk-return trade-offs and efficient diversification.

Normal backwardation theory

Holds that the futures price will be bid down to a level below the expected
spot price.

Posttrade benchmarks

Prices after the decision to trade.

Preferred habitat theory

A biased expectations theory that believes the term structure reflects the
expectation of the future path of interest rates as well as risk premium. However, the theory rejects the
assertion that the risk premium must rise uniformly with maturity. Instead, to the extent that the demand for
and supply of funds does not match for a given maturity range, some participants will shift to maturities
showing the opposite imbalances. As long as such investors are compensated by an appropriate risk premium
whose magnitude will reflect the extent of aversion to either price or reinvestment risk.

Pre-trade benchmarks

Prices occurring before or at the decision to trade.

Program trades

Also called basket trades, orders requiring the execution of trades in a large number of
different stocks at as near the same time as possible. Related: block trade

Publicly traded assets

Assets that can be traded in a public market, such as the stock market.

Pure expectations theory

A theory that asserts that the forward rates exclusively represent the expected
future rates. In other words, the entire term structure reflects the markets expectations of future short-term
rates. For example, an increasing sloping term structure implies increasing short-term interest rates. Related:
biased expectations theories

Registered trader

A member of the exchange who executes frequent trades for his or her own account.

Reversing trade

Entering the opposite side of a currently held futures position to close out the position.

Spot trade

The purchase and sale of a foreign currency, commodity, or other item for immediate delivery.

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.

Terms of trade

The weighted average of a nation's export prices relative to its import prices.

Thinly traded

Infrequently traded.

Trade

A verbal (or electronic) transaction involving one party buying a security from another party. Once a
trade is consummated, it is considered "done" or final. Settlement occurs 1-5 business days later.

Trade acceptance

Written demand that has been accepted by an industrial company to pay a given sum at a future date.
Related: banker's acceptance.

Trade credit

Credit granted by a firm to another firm for the purchase of goods or services.

Trade date

In an interest rate swap, the date that the counterparties commit to the swap. Also, the date on
which a trade occurs. trades generally settle (are paid for) 1-5 business days after a trade date. With stocks,
settlement is generally 3 business days after the trade.

Trade debt

Accounts payable.

Trade draft

A draft addressed to a commercial enterprise. See:draft.

Trade on top of

trade at a narrow or no spread in basis points relative to some other bond yield, usually
Treasury bonds.

Trade house

A firm which deals in actual commodities.

Traders

Persons who take positions in securities and their derivatives with the objective of making profits.
traders can make markets by trading the flow. When they do that, their objective is to earn the bid/ask spread.
traders can also be of the sort who take proprietary positions whereby they seek to profit from the directional
movement of prices or spread positions.

Uptick trade

Related:Tick-test rules

North American Free Trade Agreement (NAFTA)

an agreement among Canada, Mexico, and the United States establishing the North American Free trade Zone, with a resulting reduction in trade barriers

theory of constraints (TOC)

a method of analyzing the bottlenecks
(constraints) that keep a system from achieving
higher performance; it states that production cannot take
place at a rate faster than the slowest machine or person
in the process

World Trade Organization (WTO)

the arbiter of global trade that was created in 1995 under the General Agreement on Tariffs and trade; each signatory country has one
vote in trade disputes

expectations theory of exchange rates

theory that expected spot exchange rate equals the forward rate.

pecking order theory

Firms prefer to issue debt rather than equity if internal finance is insufficient.

random walk theory

Security prices change randomly, with no predictable trends or patterns.

Balance of Merchandise Trade

The difference between exports and imports of goods.

Balance of Trade

See balance of merchandise trade.

Free Trade

The absence of any government restrictions, such as tariffs or quotas, on imports or exports.

Quantity Theory of Money

theory that velocity is constant, and so a change in money supply will change nominal income by the same percentage. Formalized by the equation Mv = PQ.

Real Business Cycle Theory

Belief that business cycles arise from real shocks to the economy, such as technology advances and natural resource discoveries, and have little to do with monetary policy.

Terms of Trade

The quantity of imports that can be obtained for a unit of exports, measured by the ratio of an export price index to an import price index.

Trade Deficit

Deficit on the balance of merchandise trade.

Trade Loading

A term used for channel stuffing in the domestic tobacco industry.

J-curve

theory that says a country's trade deficit will initially worsen after its currency depreciates because
higher prices on foreign imports will more than offset the reduced volume of imports in the short-run.

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