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Saturday, August 23, 2008

Financial Glossary

Someone asked me for a glossary of standard financial terms.

401(k) plan - A 401(k) plan allows employees to save money before taxes, and not pay taxes until they withdraw the money. No tax is paid on the investment returns until the money is withdrawn.

If you assume a life expectancy of 50 years, the tax deduction for a 401(k) or IRA is incredibly valuable. Assume that you make 10%/year on your investments, all of the return is taxable, and your marginal tax rate is 20%. In that case, the 401(k) or IRA allows you to grow your investments at a rate of 10%/year instead of 8%/year.

If your expected tax rate in retirement is lower than your tax rate now, that's a further advantage for the 401(k) plan.

If you expect that the US government may collapse in the next 20-50 years, then a 401(k) seems much less attractive. In that case, you would be better off investing in physical gold. As a hedge, keep some of your savings in a 401(k) and some of your savings in physical gold or silver.

401(k) plans have an interesting history. Corporations started offering deferred-income investment plans to their employees, to help them defer taxes and save for retirement. It was not clear if this practice was legal or not, but it was very common. The law was amended to make 401(k) plans clearly legal.

Recently, the law was changed to allow "Roth 401(k) plans". Similar to a Roth IRA, the contributions are taxable, but the income is not taxable when you withdraw it. You may have a Roth 401(k) only if your employer amends their plan to allow you to do it.

Social Security and Medicare taxes must still be paid on 401(k) contributions.

American-style option - In an American style option, the option holder may exercise his option on or before the expiration date. For stocks that pay a substantial dividend, or a deep in-the-money put, this right can be valuable. As the name suggests, most individual stock options in the USA are American-style. Index options in the USA tend to be European-style cash-settled, but you should read the contract details before trading.

call option - A call option is the right, but not the obligation, to buy something at a specific price at a specific time in the future.

cash-settled option or future - Normally, when you exercise a stock option, you are buying or selling the actual stock when you exercise. Normally, when you hold a futures contract to maturity, you are buying or selling the actual physical commodity. With a cash-settled option or future, you merely exchange money based on the fair market value at expiration. For example, S&P 500 index options in the USA are cash-settled; you pay or collect money based on the price of the S&P 500 index when the option expires.

clearing - The process by which money exchanges hands and actual shares of stock or commodities change hands.

clearing firm - A clearing firm is a big financial institution, typically with a new worth of $10B or more. They assume responsibility for all trades. For example, if you sell 100 shares of stock for $10,000 on the NYSE, your clearing firm guarantees that you will get $10,000, even if the other party to the trade defaults. Clearing firms are responsible for checking the creditworthiness of traders and enforcing margin rules. In practice, clearing firms will receive a Federal Reserve bailout in the event of a serious problem. JP Morgan Chase was Bear Stearns' clearing firm and was responsible for verifying Bear Stearns' creditworthiness; the Federal Reserve bailout meant that JP Morgan Chase suffered no ill effects for giving Bear Stearns too many margin loans. Without a Federal Reserve bailout, JP Morgan Chase would have had to take responsibility for most of Bear Stearns' debts.

clearing firm default - A clearing firm default is one of the biggest financial disasters that could theoretically occur. All big financial firms mutually guarantee each others' trades via the clearing process. If one of them were forced into bankruptcy, it could cause cascading bankruptcies in other big financial firms. Due to derivatives and extensive use of leverage, the notional value of their positions is far greater than their actual market value. In practice, the central bank will always intervene to prevent a clearing firm default. The Federal Reserve will always print new money to prevent a bankruptcy by a large financial institution. The Federal Reserve has an infinite budget, so it can always do this. In a free market, a bankruptcy at one business does not threaten the solvency of its competitors, if they are prudently managed.

closed-end mutual fund - A closed end mutual fund is a mutual fund that does not sell new shares, nor does it redeem shares for the net asset value. The fund shares trade on an exchange. Since shares cannot be redeemed or created, the closed-end mutual fund can trade for a substantial premium or discount to its net asset value.

COMEX - COMEX is the most popular exchange for metal commodities, such as gold or silver. If you buy a gold future on the COMEX, hold it to maturity, and pay the full purchase price, you will get a COMEX warehouse receipt. A COMEX warehouse receipt for gold is a specifically numbered bar of gold that belongs to you. You can exchange your warehouse receipt for actual physical gold, or hold onto it for sale later. The advantage of holding a COMEX warehouse receipt is that it is a very liquid investment, the gold is assayed and of a guaranteed quality, and is stored in a secure location. The disadvantages of holding a COMEX warehouse receipt are that you are charged a storage fee, and any sales are automatically reported to the IRS for taxation. In a SHTF scenario, a COMEX warehouse receipt is probably worthless.

defined-benefit pension plan - A defined-benefit pension plan pays the beneficiary a fixed amount per year. A CPI-based inflation adjustment may or may not be included. Defined-benefit pension plans place a lot of risk on the employer. The liability is uncertain, because you don't know how long someone is going to live, and you don't know what rate of return the employer will make on their pension savings pool.

The formula for a defined-benefit pension plan is typically something like 3% of salary per year of service, multiplied by your last years' salary (or average over the last 3-5 years). This formula means that most of the benefit is accrued in the last years working. An older worker benefits more than a younger worker, because they're closer to retirement. Some employers have "frozen" their pension plans, which means that workers receive the benefit they've earned, but accrue no new benefits. Such a pension freeze really screws over older workers; if you have 20 years of credit, the ability to earn another 5 years of credit plus pay raises would have been very valuable. Defined-benefit pension plans also discriminate against workers who switch jobs frequently, which is the norm in the modern economy.

If you have a defined-benefit pension and there is inflation, then the value of your pension is substantially eroded.

defined-contribution pension plan - In a defined-contribution pension plan, such as a 401(k) plan, the employer makes a fixed contribution per year. All the investment risk is passed on to the employee. Defined-contribution pension plans favor younger workers and workers who frequently switch jobs.

discount broker - A discount broker is a broker that executes your trades at a cheap price. They do not offer any advice. The Internet allows discount brokers to operate at a very low cost. I use Vanguard as my discount broker for stock trading, and Schwab as my discount broker for option trading.

European-style option - In a European-style option, the option holder may only exercise the option at expiration. The value of a European-style option is always strictly less than the value of an equivalent America-style option. As the name suggests, European-style options are common in Europe.

ex-dividend date - If you buy a stock after the ex-dividend date, you will not get the dividend. The ex-dividend date is typically 3 business days before the record date, due to T+3 settlement. The concept of "ex-dividend date" was invented by brokers to facilitate stock trading. With the ex-dividend date, it's easier to determine who's eligible to receive a dividend.

exchange traded fund - An exchange traded fund is an index fund that lists its shares on a stock market. You may only purchase or redeem shares of a mutual fund once per day. You can trade an exchange traded fund whenever you want; an ETF trades exactly the same as a stock. A natural arbitrage process guarantees that the market value is close to the net asset value. The market makers hedge their position with the stocks held by the ETF. At the end of the day, the market makers purchase/redeem shares of the ETF, exchanging their basket of stocks for shares in the ETF. Recently, actively managed ETFs have started, rather than ETFs that track a specific index. You pay a commission whenever you buy or sell an ETF, but the management fee is typically lower than a comparable index mutual fund. Some mutual funds have both ETF shares and regular mutual fund shares, and fund shareholders may pay a fee and convert one type of share to the other.

exotic option - An exotic option is a derivative contract that has more complicated terms than a call or put. If you can imagine it, you can actually buy it as an option. Exotic options tend to be "level 3 assets", which means that the traders can value the position at whatever price they choose. Typically, both parties to an exotic option trade will claim immediate "mark-to-model" profits on the trade.

failure to deliver - A failure to deliver is when someone short sells but fails to deliver actual shares. See "naked short selling" below for more details. A failure to deliver is like ordering a new sofa, they don't deliver the sofa, but still charge the full price of the sofa to your credit card. In any business other than stock trading, a failure to deliver is treated as a crime. The stock clearing system treats failure to delivers as equivalent to actual shares, making the failure to deliver transparent to customers. A failure to deliver is, literally, counterfeiting.

full service broker - A full service broker doesn't just execute trades; a full service broker also offers investment advice. A full service broker charges much higher fees than a discount broker. A full service broker may manage your account for you, charging a management fee, typically 1%/year. The rise of discount brokers has squeezed full service brokers out of the market. Before the Internet, the only way to trade stock was via a full service broker.

futures contract - A futures contract is an agreement to buy a commodity at a future date at a predetermined price. For example, if you buy a January gold future for $1000/ounce, you are agreeing to buy gold at $1000/ounce in January. Futures contracts typically allow very high leverage, with collateral as little as 5%-10% of the value of the commodity. This allows people to bet on inflation. Futures are risky, because if the price of the commodity goes down, you will be faced with margin calls and may lose your entire investment. In extreme circumstances, your loss may be greater than your initial investment, if your broker can't sell fast enough as the price declines.

futures option - An option to buy a futures contract. Bond and commodity options are typically futures options, rather than an option to outright buy a bond or the commodity. This increases the amount of leverage.

hedge fund - A hedge fund is a loosely regulated investment pool. An investor must be "qualified" and have a sufficiently high net worth. Hedge funds extensively use leverage. They profit from negative real interest rates. Due to their large capital base, hedge funds borrow at slightly more than the Fed Funds Rate, and invest in assets that increase in value in line with the true inflation rate of 15%-30%. Hedge fund managers charge very high fees, typically quoted as 2/20, where "2" is a flat 2% fee of all assets and "20" means 20% of the profit, either the gross profit or profit in excess of a benchmark such as the S&P 500.

Hedge fund managers take their management fee in the form of additional shares of their hedge fund. This allows them to exploit a tax loophole. Their income is treated as capital gains instead of ordinary income. Hedge fund managers are merely exploiting defects in the financial system for their personal benefit; they don't actually produce anything of tangible economic value. Technically, by using extensive leverage, hedge fund managers are printing new money that the rest of the economy uses to trade. Even though tje mainstream media touts hedge fund managers as brilliant risk takers, they really are parasites. Part of the wealth the State steals from you via taxes and inflation winds up in the pockets of hedge fund managers.

incentive stock option - Incentive stock options are a form of compensation that management of large corporations give themselves. Some technology companies give incentive stock options to all employees. An incentive stock option is a call option. The strike equals the market value of the stock when the option is issued. The term is very long, typically 10 years. If the employee changes jobs, the incentive stock option must be immediately exercised or forfeited. There is a vesting period, typically 3-5 years at an equal rate per year.

Recently, there was a regulation passed that corporations must charge their incentive stock options as an expense. However, they are priced on the assumption that the stock price will increase at the risk-free interest rate, whereas stocks typically increase at a rate of 15%+ per year. This causes the expense to be dramatically understated.

If the stock price dramatically tanks after stock options are issued, the management can "re-price" their options. They give up their old options and receive new ones with a lower strike, based on the current market value. In this manner, corporate management benefits from both declines and gains in the stock market.

Most gain in the stock market is due to money supply inflation, rather than a corporation's specific performance. Incentive stock options reward corporate management for inflation, more than the performance of their individual corporation.

index fund - An index fund is a mutual fund that tries to track the performance of a specific index minus its management fee. The S&P 500 is the most popular index for an index fund. The operation of an index fund is nearly 100% transparent. The fund manager makes no decisions, except how to best track the index's performance. Index funds charge very low fees, typically 0.1%-0.5%. Index funds buy and sell shares infrequently, which lowers costs for shareholders and generates less capital gains income.

inflation - Inflation is the process by which unbacked paper money loses its purchasing power. As more paper money is printed, the existing paper loses its value. The CPI is falsely touted as an accurate measure of inflation. I consider M2, M3, or the price of gold to be more accurate measures of inflation.

interest rate swap - Large banks offer their institutional customers interest rate swaps, which let them hedge the risk that interest rates change. For example, you can offer to pay the 1 year Treasury yield + a small fee (0.10%) and collect the Fed Funds Rate. Large banks can then hedge this trade by buying or short-selling the appropriate bond and borrowing/lending at the Fed Funds Rate. For this reason, the 1 year Treasury bond yield is always approximately equal to the expected average Fed Funds Rate over the next year.

IRA (regular) - In a regular IRA, you save money in a special trust and receive a tax deduction. You owe tax on the money when you withdraw it when you retire. A regular IRA is logically equivalent to a 401(k) plan. When you switch jobs, you can and should "roll over" your 401(k) plan to an IRA. If the transaction is processed correctly, it is not taxable. If the transaction is processed incorrectly, you may face mandatory withholding and huge taxes.

An IRA is always held with a trustee. I use Vanguard as my trustee for my IRA.

IRA (Roth) - In a Roth IRA, the contributions are taxable income, but the withdrawals are not taxable. If your marginal income tax rate is the same now as it is when you retire, then a regular IRA and Roth IRA are logically equivalent. There is one advantage of a Roth IRA; your effective contribution is higher. Suppose your marginal tax rate is 35%. If you contribute $1k to an IRA, it's like contributing $650 after taxes. If you contribute $1k to a Roth IRA, it's already post-tax, and it's like contributing $1538 to a regular IRA. The contribution to a Roth IRA is effectively bigger. This matters to me, because the IRA contribution I would like to make is larger than the maximum legal contribution.

level 3 assets - Level 3 assets are bank assets that do not need to be "marked to market". A bank carries level 3 assets on its books at the purchase price or whatever price it chooses. This is a valuable perk, because the level 3 assets can be used as collateral for further borrowing. During an economic bust, a large bank is technically insolvent; if it were forced to sell its level 3 assets at whatever price it could get, it would be unable to pay off its loans from the Federal Reserve. By carrying assets on its books at an arbitrary price, banks exploit flaws in the economic system. Even if a level 3 asset is overvalued, inflation means these assets will be profitable eventually.

long position - A long position is where you own something. This is a bet that its price would increase. If you are unleveraged, your worst-case loss is 100%, if the asset becomes worthless. If you are leveraged, a loss greater than 100% is possible. A leveraged long position is a bet *IN FAVOR* of inflation. This makes leveraged long positions very lucrative. This is the opposite of "short position".

mutual fund - A mutual fund is an investment pool available to small retail customers. Before discount brokers were popular, a mutual fund was the best investment vehicle for small investors. Typically, all the investment options in a 401(k) plan are mutual funds; individual stock investing in a 401(k) is legal, but not typically supported by plans.

Mutual funds are required to pass on their dividends and capital gains to shareholders, so they can pay taxes on them. Mutual funds aren't allowed to use extensive leverage like hedge funds. Mutual funds typically invest only in stocks or bonds, but sometimes they invest in commodities or other things.

With cheap discount brokers, an individual can get better returns picking individual stocks than by investing in an index fund. If you have more than $25k to invest, purchasing individual stocks is superior to a mutual fund or index fund.

naked short position - The "naked short" problem typically is cited in the case of stock trading. Normally, to short sell stock, you need to borrow shares from someone else and sell them. If the person you borrowed them from wants to sell, you must find someone else to borrow from or buy and cover your short sale. Sometimes, a lot of people want to short sell the same stock. This can occur after an IPO when a lot of shares are under "lock-up agreements". This can occur when a lot of people want to short sell a stock, typically due to lack of confidence in management or market conditions.

A naked short can occur accidentally, if there is a miscommunication regarding borrowing shares. Some hedge funds try to game the system by *INTENTIONALLY* naked short selling; this is sometimes called "strategic naked short selling". They short sell, and they never have any intention of borrowing shares. This allows them to avoid paying stock loan fees. If it's difficult or impossible to borrow shares, strategic naked short selling allows traders to circumvent the rules.

The stock clearing system treats a "failure to deliver" (see above) as equivalent to actual shares. If someone naked short sells you shares of stock, you'll see the shares credited to your account as if you actually owned them. There are two differences. Dividends are treated as ordinary income, instead of the preferred 15% taxation rate. If the company holds its annual meeting, you can't vote your shares. There have been occasions where there were so many "failure to delivers" in a stock that they couldn't figure out who actually owned the shares to vote in the meeting!

Via naked short selling, an unscrupulous trader can manipulate a stock price downward. The naked short seller is literally printing new shares of stock and selling them. The corporation that's a victim is unable to raise money. Due to an artificially depressed stock price; they can't raise capital by selling more shares or convertible bonds. Their bond rating could suffer, because stock price is viewed as an indicator of a corporation's health. Seeing a declining stock price, other shareholders may decide to sell. The naked short seller can then cover his short or buy out the corporation at an artificially low price.

According to the SEC, naked short selling is illegal. However, there is no penalty for naked short selling. Further, SEC confidentiality rules prevent them from actually publishing who is naked short selling and how many shares! If the SEC were serious about cracking down on naked short selling, they should publish a list of violators and impose a fine of $1 per share per day. Financial industry insiders are the primary beneficiaries of naked short selling, and they want to make sure the rules are lax! Making a regulation without any penalty for violating it is pointless!

Recently, the SEC made the bizarre announcement that it would be strictly enforcing the naked short sale rules, but only for certain financial stocks. Instead of enforcing the law fairly, the SEC is enforcing the law only for corporations it favors.

net asset value - The net asset value of a mutual fund the fair market value of its assets per share. Mutual funds only invest in liquid assets, so the net asset value can be fairly determined by looking at the market value. Hedge funds invest in illiquid assets, and it can be difficult to determine the net asset value for a hedge fund. Hedge funds limit the times when people can purchase or redeem shares.

notional value - The notional value of a position is the sum of the absolute value of all the amounts involved. For example, suppose you own 100 call options to buy XYZ at $100/share, with the standard 100 shares per contract. This position has a notional value of $100*100*100 = $1M. However, if XYZ's price is near $100, the actual value is probably much less, around $50k-$100k. As another example, suppose you put up $1B to buy $10B of bonds, using 10x leverage. The actual value of your position is $1B, but the notional value is $10B. With extensive use of leverage and derivative contracts, the notional value can be far greater than the actual market value. This is risky, because during an economic bust, prices can rapidly crash. Everyone is using leverage, so everyone is forced to sell during the bust at the exact same time. Large politically-connected banks profit immensely when market crashes occur, because they receive a direct or indirect bailout from the Federal Reserve.

options contract - An options contract is the right, but not the obligation, to buy or sell something at a specific price at a specific time in the future.

payable date - The payable date for a dividend is when the money is actually credited to your account. The payable date is always after the record date.

put option - A put option is the right, but not the obligation, to sell something at a specific price at a specific time in the future.

record date - The record date for a dividend is the date when the corporation determines who is eligible for a dividend. Due to T+3 settlement, the record date is usually 3 business days after the ex-dividend date. Similarly, corporations have a record date for their annual meeting. Only shareholders who owned their shares on the record date are eligible to attend the meeting and vote their shares.

shares held in street name - If you buy stock on an exchange and leave the shares with your broker, the shares are "held in street name". Technically, your broker owns the shares, and they are held in trust for you. This facilitates settlement. Since the shares are already in your broker's name, it is very easy for them to sell the shares for you. Your broker will automatically credit dividends to your account. Your broker will automatically exchange your shares when there is a split or buyout or spinoff. When it is time to vote your shares at an annual meeting, your broker will vote your shares according to your instructions. Most brokers charge a fee if you want physical delivery of your shares.

Theoretically, you are accepting a risk by leaving your shares at your broker. However, in the event of a clearing firm default, there would be a Federal Reserve sponsored bailout. The actual risk is the same as the risk of the US government collapsing.

short position - A short position is where you sold something you don't actually own. A short position is a bet that its price will decrease. For a short position, your potential loss is unlimited, if the price of the thing sold short skyrockets. This is the opposite of "long position". See also - naked short position.

stock spinoff - A stock spinoff is when a corporation splits into two or more pieces. For example, suppose stock XYZ spins off stock UVW at a rate of 0.20 shares of UVW per share of XYZ. If you owned 100 shares of XYZ pre-spinoff, you would own 100 shares of XYZ and 20 shares of UVW post-spinoff. If a corporation has two independent businesses with different growth rates, then shareholders may benefit from a spinoff; the rapidly growing business would be more valuable. If you leave your shares "in street name" at your broker, your broker will automatically process the spinoff for you.

stock split - Corporations like to keep their share price below $100, to facilitate trading in round lots of 100. When a stock price rises too much, there is a split. Splits can occur at various ratios, although 2:1 is most common. In a 2:1 split, if you owned 100 shares pre-split, you own 200 shares post-split. If you leave your shares "in street name" at your broker, your broker will automatically process the split for you.

Sometimes, a corporations' share price tanks below $1. Most big exchanges have a minimum $1/share requirement for listing. In that case, there will be a reverse split to increase the stock price.

T+3 settlement - When you buy or sell stock on an exchange in the USA, you don't actually complete the trade until 3 days later. The stock settlement process takes 3 full days. This is the reason the "ex-dividend date" differs from the "record date". With modern computers and software, the settlement delay could be decreased, but T+3 is still the standard for stock trading. Before modern computers, there were times when financial institutions were unable to keep up with the volume of trading, and settlement was sometimes delayed.

zero coupon bond - A zero coupon bond is a bond that does not make any payments until the bond matures. The interest is factored into the price of the bond. For example, for a $10,000 1 year zero coupon bond paying 5%, you will pay $10,000/1.05 = $9524 now.

This is a long list! Let me know if I missed anything.

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