Key Concepts in Finance and Investment
Adverse Selection
Explains why someone might fund an investment with equity instead of debt.
Moral Hazard
Raises the question: How can I be sure this corporate entity will use my savings in the most efficient manner?
Risk-Return Tradeoff
States that the interest rate of a riskier bond is usually higher than the interest rate of a low-risk security.
Direct and Indirect Financing
Direct finance is a method of financing where borrowers borrow funds directly from the financial market without using a third-party service, such as a financial intermediary. Indirect finance is where borrowers borrow funds from the financial market through indirect means, such as through a financial intermediary.
Loanable Funds Theory
This theory states that the real interest rate is determined by the supply and demand for loans. The interest rate is the price of the loan.
Liquidity Preference Theory
The nominal interest rate is determined by the supply and demand for money. It assumes there are only two types of assets: bonds and money:
- Money can be used to buy goods and services.
- Only bonds pay interest.
Double Coincidence of Need
An important category of transaction costs that imposes severe limitations on economies lacking a medium of exchange (such as money), which have to rely on barter or other in-kind transactions.
Yield Curve
A curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
Term Premium
The compensation that investors require for bearing the risk that short-term Treasury yields do not evolve as they expected.
Classical Theory of Asset Prices
Deals with asset price fluctuations, bubbles, and crashes. It also covers measuring interest rates and rates of return.
Efficient Market Hypothesis
States that all stocks are correctly priced and display all relevant information.
Market Orders and Limit Orders
A market order is an order to buy at the best price possible. A limit order is when someone wants to buy or sell a stock for a specific price.
Indexed Funds and Actively Managed Funds
An index mutual fund is said to provide broad market exposure, low operating expenses, and low portfolio turnover.
Mutual Funds and Hedge Funds
Mutual funds are investment programs funded by shareholders that trade in diversified holdings and are professionally managed.
Bid-Ask Spread
The amount by which the ask price exceeds the bid price.
Asset Price Bubble
Occurs when there is trade in an asset at a price or price range that strongly exceeds the asset’s intrinsic value.
Statutory Reserve Requirement
An instrument used to measure a bank’s liquidity.
Primary and Secondary Reserves of a Bank
Primary reserves refer to the selling of new equities. Secondary reserves refer to existing equities.
Credit Risk
The risk that loans will not be repaid. This is reduced by screening. Write-offs reduce net worth.
Liquidity Risk
The risk that withdrawals from a bank will exceed its liquid assets. The bank may have to sell illiquid assets at a fire-sale price, losing money in the process.
Interest Rate Risk
The instability in bank profits caused by fluctuations in short-term interest rates. Bank assets often have long maturities, while liabilities have short maturities, making them rate-sensitive.
Insolvency of a Bank
Occurs when a bank’s liabilities exceed its assets/capital (corrected definition).