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Instructions: This handout comprises a compilation of certain basic financial, accounting

and economic terms. This is only a representation and students are requested not to limit
their learning to this handout only.

Finance

Stock- A type of security that signifies ownership in a corporation and represents a claim on
part of the corporation's assets and earnings. There are two main types of stock: common and
preferred. Common stock usually entitles the owner to vote at shareholders' meetings and to
receive dividends. Preferred stock generally does not have voting rights, but has a higher claim
on assets and earnings than the common shares. For example, owners of preferred stock
receive dividends before common shareholders and have priority in the event that a company
goes bankrupt and is liquidated. Also known as "shares" or "equity". A holder of stock (a
shareholder) has a claim to a part of the corporation's assets and earnings. In other words, a
shareholder is an owner of a company. Ownership is determined by the number of shares a
person owns relative to the number of outstanding shares. For example, if a company has 1,000
shares of stock outstanding and one person owns 100 shares, that person would own and have
claim to 10% of the company's assets. Stocks are the foundation of nearly every portfolio.
Historically, they have outperformed most other investments over the long run.

Bonds- A Company needs funds to expand into new markets, while governments need money
for everything from infrastructure to social programs. The problem large organizations run into
is that they typically need far more money than the average bank can provide. The solution is
to raise money by issuing bonds (or other debt instruments) to a public market. Thousands of
investors then each lend a portion of the capital needed. Really, a bond is nothing more than a
loan for which you are the lender. The organization that sells a bond is known as the issuer.
You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).

Of course, nobody would loan his or her hard-earned money for nothing. The issuer of a bond
must pay the investor something extra for the privilege of using his or her money. This "extra"
comes in the form of interest payments, which are made at a predetermined rate and
schedule. The interest rate is often referred to as the coupon. The date on which the issuer has
to repay the amount borrowed (known as face value) is called the maturity date. Bonds are
known as fixed-income securities because you know the exact amount of cash you'll get back if
you hold the security until maturity.

For example, say you buy a bond with a face value of $1,000, a coupon of 8%, and a maturity of
10 years. This means you'll receive a total of $80 ($1,000*8%) of interest per year for the next
10 years. Actually, because most bonds pay interest semi-annually, you'll receive two payments
of $40 a year for 10 years. When the bond matures after a decade, you'll get your $1,000 back.

Municipal bond- Represents borrowing by state or local governments to pay for special projects
such as highways or sewers. The interest that investors receive is exempt from some income
axes.

Debt Versus Equity - Bonds are debt, whereas stocks are equity. This is the important
distinction between the two securities. By purchasing equity (stock) an investor becomes an
owner in a corporation. Ownership comes with voting rights and the right to share in any future
profits. By purchasing debt (bonds) an investor becomes a creditor to the corporation (or
government). The primary advantage of being a creditor is that you have a higher claim on
assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid
before a shareholder. However, the bondholder does not share in the profits if a company does
well - he or she is entitled only to the principal plus interest.

To sum up, there is generally less risk in owning bonds than in owning stocks, but this comes at
the cost of a lower return.
Stock Market- The market in which shares are issued and traded either through exchanges
or over-the-counter markets. Also known as the equity market, it is one of the most vital areas
of a market economy as it provides companies with access to capital and investors with a slice
of ownership in the company and the potential of gains based on the company's future
performance. This market can be split into two main sections: the primary and secondary
market. The primary market is where new issues are first offered, with any subsequent trading
going on in the secondary market. There are two main types of stocks: common stock and
preferred stock.

Common Stock - Common stock is, well, common. When people talk about stocks they
are usually referring to this type. In fact, the majority of stock is issued is in this form. We
basically went over features of common stock in the last section. Common shares represent
ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote
per share to elect the board members, who oversee the major decisions made by management.

Over the long term, common stock, by means of capital growth, yields higher returns than
almost every other investment. This higher return comes at a cost since common stocks entail
the most risk. If a company goes bankrupt and liquidates, the common shareholders will not
receive money until the creditors, bondholders and preferred shareholders are paid.

Preferred Stock - Preferred stock represents some degree of ownership in a company but
usually doesn't come with the same voting rights. (This may vary depending on the company.)
With preferred shares, investors are usually guaranteed a fixed dividend forever. This is
different than common stock, which has variable dividends that are never guaranteed. Another
advantage is that in the event of liquidation, preferred shareholders are paid off before the
common shareholder (but still after debt holders). Preferred stock may also be callable,
meaning that the company has the option to purchase the shares from shareholders at anytime
for any reason (usually for a premium).

Some people consider preferred stock to be more like debt than equity. A good way to think of
these kinds of shares is to see them as being in between bonds and common shares.

Different Classes of Stock - Common and preferred are the two main forms of stock; however,
it's also possible for companies to customize different classes of stock in any way they want.
The most common reason for this is the company wanting the voting power to remain with a
certain group; therefore, different classes of shares are given different voting rights. For
example, one class of shares would be held by a select group who are given ten votes per share
while a second class would be issued to the majority of investors who are given one vote per
share. When there is more than one class of stock, the classes are traditionally designated
as Class A and Class B.

Cyclical stocks- The earnings on these stocks are tied very closely to the overall business cycle
and economic state. Examples include the housing industry and industrial equipment
companies.

Defensive stocks- These remain stable in any economic conditions, such as food companies,
drug manufacturers or utilities. These are stocks in companies that manufacture the necessities
that people will need in any economy.

Growth stocks- As the name might suggest, these stocks have strong growth potential. These
are typically companies that are newer, busily doing research and developing products and
services in hopes of achieving growth. Much of the profits are fed back into the companies
themselves.
Income stocks - These pay higher-than-average dividends over a sustained period. They are
typically long-established companies with stable earnings or utilities such as phone companies.

Net worth- Total assets minus total liabilities of an individual or company. For a company,
also called owner's equity or shareholders' equity or net assets.

Speculative stocks - These are stocks in emerging companies that are speculating on their
future earnings and revenue. These are risky investments since the company may or may not
reach their intended future goals.

Value stocks- These are stocks in companies that, for one of many reasons, are undervalued.
They are stocks that are selling at a low price, but when analyzing the company's sales,
earnings and looking at other factors, give indications that they should be selling for a higher
per share price.

The Bulls, The Bears And The Farm- On Wall Street, the bulls and bears are in a constant
struggle. If you haven't heard of these terms already, you undoubtedly will as you begin to
invest.

The Bulls - A financial market of a certain group of securities in which prices are rising or are
expected to rise. The term "bull market" is most often used in respect to the stock market, but
really can be applied to anything that is traded, such as bonds, currencies, commodities, etc.

A bull market is when everything in the economy is great, people are finding jobs, gross
domestic product (GDP) is growing, and stocks are rising. Things are just plain rosy! Picking
stocks during a bull market is easier because everything is going up. Bull markets cannot last
forever though, and sometimes they can lead to dangerous situations if stocks become
overvalued. If a person is optimistic and believes that stocks will go up, he or she is called a
"bull" and is said to have a "bullish outlook".

Bull markets are characterized by optimism, investor confidence and expectations that strong
results will continue. Of course, no bull market can last forever, and sooner or later a bear
market (in which prices fall) will come. It's tough if not impossible to predict consistently when
the trends in the market will change. Part of the difficulty is that psychological effects and
speculation can sometimes play a large (if not dominant) role in the markets. The extreme
on the high end is a stock-market bubble, and on the low end a crash.

The use of "bull" and "bear" to describe markets comes from the way in which each animal
attacks its opponents. That is, a bull thrusts its horns up into the air, and a bear swipes
its paws down. These actions are metaphors for the movement of a market: if the trend is up,
it is considered a bull market. And if the trend is down, it is considered a bear market.

The Bears - A market condition in which the prices of securities are falling or are expected to
fall. Although figures can vary, a downturn of 15-20% or more in multiple indexes (Dow or S&P
500) is considered an entry into a bear market.

When you see a bear what do you do? Tuck in your arms and play dead! Fighting back can be
extremely dangerous. It is quite difficult for an investor to make stellar gains during a bear
market, unless he or she is a short seller. A bear market is when the economy is bad, recession
is looming and stock prices are falling. Bear markets make it tough for investors to pick
profitable stocks. One solution to this is to make money when stocks are falling using a
technique called short selling. Another strategy is to wait on the sidelines until you feel that
the bear market is nearing its end, only starting to buy in anticipation of a bull market. If a
person is pessimistic, believing that stocks are going to drop, he or she is called a "bear" and
said to have a "bearish outlook".
The Other Animals on the Farm - Chickens and Pigs -Chickens are afraid to lose anything.
Their fear overrides their need to make profits and so they turn only to money-market
securities or get out of the markets entirely. While it's true that you should never invest in
something over which you lose sleep, you are also guaranteed never to see any return if you
avoid the market completely and never take any risk,

Pigs are high-risk investors looking for the one big score in a short period of time. Pigs buy on
hot tips and invest in companies without doing their due diligence. They get impatient, greedy,
and emotional about their investments, and they are drawn to high-risk securities without
putting in the proper time or money to learn about these investment vehicles. Professional
traders love the pigs, as it's often from their losses that the bulls and bears reap their profits.

"Bulls make money, bears make money, but pigs just get slaughtered!"

Yield- In stocks and bonds, the amount of money returned to investors on their investments.
Also known as rate of return. The annual income from a SECURITY, expressed as a percentage
of the current market PRICE of the security. The yield on a SHARE is its DIVIDEND divided by its
price. A BOND yield is also known as its INTEREST RATE: the annual coupon divided by the
market price.

Yield curve- Shorthand for comparisons of the INTEREST RATE on GOVERNMENT BONDS of
different maturity. If investors think it is riskier to buy a bond with 15 years until it matures
than a bond with five years of life, they will demand a higher interest rate (YIELD) on the
longer-dated bond. If so, the yield curve will slope upwards from left (the shorter maturities)
to right. It is normal for the yield curve to be positive (upward sloping, left to right) simply
because investors normally demand compensation for the added RISK of holding longer-term
SECURITIES. Historically, a downward-sloping (or inverted) yield curve has been an indicator of
RECESSION on the horizon, or, at least, that investors expect the CENTRAL BANK to cut short-
term interest rates in the near future. A flat yield curve means that investors are indifferent to
maturity risk, but this is unusual. When the yield curve as a whole moves higher, it means that
investors are more worried that INFLATION will rise for the foreseeable future and therefore
that higher interest rates will be needed. When the whole curve moves lower, it means that
investors have a rosier inflationary outlook.

Even if the direction (up or down) of a yield curve is unchanged, useful information can be
gleaned from changes in the SPREADS between yields on bonds of different maturities and on
different sorts of bonds with the same maturity (such as government bonds versus corporate
bonds, or thinly traded bonds versus highly liquid bonds).

Yield gap- A way of comparing the performance of BONDS and SHARES. The gap is defined as
the AVERAGE YIELD on equities minus the average yield on bonds. Because shares are usually
riskier investments than bonds, you might expect them to have a higher yield. In practice, the
yield gap is often negative, with bonds yielding more than equities. This is not because
investors regard equities as safer than bonds (see EQUITY RISK PREMIUM). Rather, it is that they
expect most of the benefit from buying shares to come from an increase in their PRICE
(CAPITAL appreciation) rather than from DIVIDEND payments. Bond investors usually expect
more of their gains to come from coupon payments. They also worry that INFLATION will erode
the REAL VALUE of future coupons, making them value current payments more highly than
those due in years to come. Moreover, the usefulness of the dividend yield as a guide to the
performance of shares has declined since the early 1990s, as increasingly companies have
chosen to return cash to shareholders by buying back their own shares rather than paying out
bigger dividends.

Capital asset pricing model (CAPM)- An economic theory that describes the relationship
between risk and expected return, and serves as a model for the pricing of risky securities. The
CAPM asserts that the only risk that is priced by rational investors is systematic risk, because
that risk cannot be eliminated by diversification. The CAPM says that the expected return of a
security or a portfolio is equal to the rate on a risk-free security plus a risk premium multiplied
by the assets systematic risk. Theory was invented by William Sharpe (1964) and John Lintner
(1965).

The rationale of the CAPM can be simplified as follows. Investors can eliminate some sorts of
RISK, known as RESIDUAL RISK or alpha, by holding a diversified portfolio of assets (see MODERN
PORTFOLIO THEORY). These alpha risks are specific to an individual asset, for example, the risk
that a company’s managers will turn out to be no good. Some risks, such as that of a global
RECESSION, cannot be eliminated through diversification. So even a basket of all of the SHARES
in a stockmarket will still be risky. People must be rewarded for investing in such a risky basket
by earning returns on AVERAGE above those that they can get on safer assets, such as
TREASURY BILLS. Assuming investors diversify away alpha risks, how an investor values any
particular asset should depend crucially on how much the asset’s PRICE is affected by the risk
of the market as a whole. The market’s risk contribution is captured by a measure of relative
volatility, BETA, which indicates how much an asset’s price is expected to change when the
overall market changes.

Safe investments have a beta close to zero: economists call these assets risk free. Riskier
investments, such as a share, should earn a premium over the risk-free rate. How much is
calculated by the average premium for all assets of that type, multiplied by the particular
asset’s beta.

But does the CAPM work? It all comes down to beta, which some economists have found of
dubious use. They think the CAPM may be an elegant theory that is no good in practice. Yet it
is probably the best and certainly the most widely used method for calculating the cost of
capital.

Capital controls- government-imposed restrictions on the ability of CAPITAL to move in or out


of a country. Examples include limits on foreign INVESTMENT in a country’s FINANCIAL
MARKETS, on direct investment by foreigners in businesses or property, and on domestic
residents’ investments abroad. Until the 20th century capital controls were uncommon, but
many countries then imposed them. Following the end of the Second World War only
Switzerland, Canada and the United States adopted open capital regimes. Other rich countries
maintained strict controls and many made them tougher during the 1960s and 1970s. This
changed in the 1980s and early 1990s, when most developed countries scrapped their capital
controls. The pattern was more mixed in developing countries. Latin American countries
imposed lots of them during the debt crisis of the 1980s then scrapped most of them from the
late 1980s onwards. Asian countries began to loosen their widespread capital controls in the
1980s and did so more rapidly during the 1990s.

In developed countries, there were two main reasons why capital controls were lifted: free
markets became more fashionable and financiers became adept at finding ways around the
controls. Developing countries later discovered that foreign capital could play a part in
financing domestic investment, from roads in Thailand to telecoms systems in Mexico, and,
furthermore, that financial capital often brought with it valuable HUMAN CAPITAL. They also
found that capital controls did not work and had unwanted side-effects. Latin America’s
controls in the 1980s failed to keep much money at home and also deterred foreign
investment.

The Asian economic crisis and CAPITAL FLIGHT of the late 1990s revived interest in capital
controls, as some Asian governments wondered whether lifting the controls had left them
vulnerable to the whims of international speculators, whose money could flow out of a country
as fast as it once flowed in. There was also discussion of a “Tobin tax” on short-term capital
movements, proposed by James TOBIN, a winner of the NOBEL PRIZE FOR ECONOMICS. Even so,
they mostly considered only limited controls on short-term capital movements, particularly
movements out of a country, and did not reverse the broader 20-year-old process of global
financial and economic LIBERALISATION.

Mutual Fund- A portfolio of stocks, bonds, or other securities administered by a team of one or
more managers from an investment company who make buy and sell decisions on component
securities. Capital is contributed by smaller investors who buy shares in the mutual fund rather
than the individual stocks and bonds in its portfolio. The return on the fund's holdings is
distributed back to its contributors, or shareholders, minus various fees and commissions. This
system allows small investors to participate in the reduced risk of a large and diverse portfolio
that they could not otherwise build themselves. They also have the benefit of professional
managers overseeing their money who have the time and expertise to analyze and pick
securities. There are two types of mutual funds, open and closed-ended. Units in closed-end
funds, some of which are listed on Stock Exchanges, are readily transferable in the open
market and are bought and sold, like other stock. These funds do not accept new contributions
from investors, but only reinvest the return on the existing portfolio.

Open-end funds sell their own new shares to investors, stand ready to buy back their old
shares, and are not normally listed on exchanges. Open-end funds are so called because their
capitalization is not fixed; they issue more units as people want them. Many open-ended funds
allow contributors extra perks, such as the ability to write cheques against their units. Also
there are several open ended mutual funds which are insurance linked. It is basically marketing
with added benefits.

Mutual Funds: Different Types of Funds- each mutual fund has different risks and rewards. In
general, the higher the potential return, the higher the risk of loss. Although some funds are
less risky than others, all funds have some level of risk - it's never possible to diversify away all
risk. This is a fact for all investments. Each fund has a predetermined investment objective
that tailors the fund's assets, regions of investments and investment strategies. At the
fundamental level, there are three varieties of mutual funds:
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds

All mutual funds are variations of these three asset classes. For example, while equity funds
that invest in fast-growing companies are known as growth funds, equity funds that invest only
in companies of the same sector or region are known as specialty funds.

Other funds-

Money Market Funds - The money market consists of short-term debt instruments, mostly
Treasury bills. This is a safe place to park your money. You won't get great returns, but you
won't have to worry about losing your principal. A typical return is twice the amount you would
earn in a regular checking/savings account and a little less than the average certificate of
deposit (CD).

Bond/Income Funds - Income funds are named appropriately: their purpose is to provide
current income on a steady basis. When referring to mutual funds, the terms "fixed-income,"
"bond," and "income" are synonymous. These terms denote funds that invest primarily in
government and corporate debt. While fund holdings may appreciate in value, the primary
objective of these funds is to provide a steady cash flow to investors. As such, the audience for
these funds consists of conservative investors and retirees.

Bond funds are likely to pay higher returns than certificates of deposit and money market
investments, but bond funds aren't without risk. Because there are many different types of
bonds, bond funds can vary dramatically depending on where they invest. For example, a fund
specializing in high-yield junk bonds is much more risky than a fund that invests in government
securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means
that if rates go up the value of the fund goes down.

Balanced Funds - The objective of these funds is to provide a balanced mixture of safety,
income and capital appreciation. The strategy of balanced funds is to invest in a combination
of fixed income and equities. A typical balanced fund might have a weighting of 60% equity and
40% fixed income. The weighting might also be restricted to a specified maximum or minimum
for each asset class.

A similar type of fund is known as an asset allocation fund. Objectives are similar to those of a
balanced fund, but these kinds of funds typically do not have to hold a specified percentage of
any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset
classes as the economy moves through the business cycle.

Equity Funds - Funds that invest in stocks represent the largest category of mutual funds.
Generally, the investment objective of this class of funds is long-term capital growth with some
income. There are, however, many different types of equity funds because there are many
different types of equities.

The idea is to classify funds based on both the size of the companies invested in and the
investment style of the manager. The term value refers to a style of investing that looks for
high quality companies that are out of favor with the market. These companies are
characterized by low P/E and price-to-book ratios and high dividend yields. The opposite of
value is growth, which refers to companies that have had (and are expected to continue to
have) strong growth in earnings, sales and cash flow. A compromise between value and growth
is blend, which simply refers to companies that are neither value nor growth stocks and are
classified as being somewhere in the middle. For example, a mutual fund that invests in large-
cap companies that are in strong financial shape but have recently seen their share prices fall
would be placed in the upper left quadrant of the style box (large and value). The opposite of
this would be a fund that invests in startup technology companies with excellent growth
prospects. Such a mutual fund would reside in the bottom right quadrant (small and growth).

Global/International Funds - An international fund (or foreign fund) invests only outside your
home country. Global funds invest anywhere around the world, including your home country.

It's tough to classify these funds as either riskier or safer than domestic investments. They
do tend to be more volatile and have unique country and/or political risks. But, on the flip
side, they can, as part of a well-balanced portfolio, actually reduce risk by increasing
diversification. Although the world's economies are becoming more inter-related, it is likely
that another economy somewhere is outperforming the economy of your home country.

Specialty Funds - This classification of mutual funds is more of an all-encompassing category


that consists of funds that have proved to be popular but don't necessarily belong to the
categories we've described so far. This type of mutual fund forgoes broad diversification to
concentrate on a certain segment of the economy. Sector funds are targeted at specific sectors
of the economy such as financial, technology, health, etc. Sector funds are extremely volatile.
There is a greater possibility of big gains, but you have to accept that your sector may tank.

Regional funds make it easier to focus on a specific area of the world. This may mean focusing
on a region (say Latin America) or an individual country (for example, only Brazil). An
advantage of these funds is that they make it easier to buy stock in foreign countries, which is
otherwise difficult and expensive. Just like for sector funds, you have to accept the high risk of
loss, which occurs if the region goes into a bad recession.

Socially-responsible funds (or ethical funds) invest only in companies that meet the criteria of
certain guidelines or beliefs. Most socially responsible funds don't invest in industries such as
tobacco, alcoholic beverages, weapons or nuclear power. The idea is to get a competitive
performance while still maintaining a healthy conscience.

Index Funds - The last but certainly not the least important are index funds. This type of
mutual fund replicates the performance of a broad market index such as the S&P 500 or Dow
Jones Industrial Average (DJIA). An investor in an index fund figures that most managers can't
beat the market. An index fund merely replicates the market return and benefits investors in
the form of low fees.

Load Fund- Mutual Fund that is sold for a sales charge by a brokerage firm or other sales
representative. Such funds may be stock, bond or commodity funds, with conservative or
aggressive objectives.

Technical Analysis: The methods used to analyze securities and make investment decisions fall
into two very broad categories: fundamental analysis and technical analysis. Fundamental
analysis involves analyzing the characteristics of a company in order to estimate its value.
Technical analysis takes a completely different approach; it doesn't care one bit about the
"value" of a company or a commodity. Technicians (sometimes called chartists) are only
interested in the price movements in the market. Despite all the fancy and exotic tools it
employs, technical analysis really just studies supply and demand in a market in an attempt
to determine what direction, or trend, will continue in the future. In other words, technical
analysis attempts to understand the emotions in the market by studying the market itself, as
opposed to its components.

Fundamental Analysis: Fundamental analysis is the cornerstone of investing. In fact, some


would say that you aren't really investing if you aren't performing fundamental analysis.
Because the subject is so broad, however, it's tough to know where to start. There are an
endless number of investment strategies that are very different from each other, yet almost all
use the fundamentals. The biggest part of fundamental analysis involves delving into the
financial statements. Also known as quantitative analysis, this involves looking at revenue,
expenses, assets, liabilities and all the other financial aspects of a company. Fundamental
analysts look at this information to gain insight on a company's future performance. But there
is more than just number crunching when it comes to analyzing a company. This is where
qualitative analysis comes in - the breakdown of all the intangible, difficult-to-measure aspects
of a company.

Ratio Analysis: Fundamental Analysis has a very broad scope. One aspect looks at the general
(qualitative) factors of a company. The other side considers tangible and measurable factors
(quantitative). This means crunching and analyzing numbers from the financial statements. If
used in conjunction with other methods, quantitative analysis can produce excellent results.

Ratio analysis isn't just comparing different numbers from the balance sheet, income
statement, and cash flow statement. It's comparing the number against previous years, other
companies, the industry, or even the economy in general. Ratios look at the relationships
between individual values and relate them to how a company has performed in the past, and
might perform in the future.

For example current assets alone don't tell us a whole lot, but when we divide them by current
liabilities we are able to determine whether the company has enough money to cover short
term debts.

Futures Fundamentals: What we know as the futures market of today came from some humble
beginnings. Trading in futures originated in Japan during the eighteenth century and was
primarily used for the trading of rice and silk. It wasn't until the 1850s that the U.S. started
using futures markets to buy and sell commodities such as cotton, corn and wheat.
Futures Contract (Futures) - A futures contract is a legally binding agreement to buy or sell
commodities or financial securities at a fixed time in the future at a price agreed upon today.
The delivery period, quantity and quality of a futures contract is standardized and specified
while the price is set at the time a contract is opened and is negotiated between buyers and
sellers. Futures are traded either electronically or via open outcry on a trading floor on the
Exchange offering the particular contract. It is a type of derivative instrument, or financial
contract, in which two parties agree to transact a set of financial instruments or physical
commodities for future delivery at a particular price. If you buy a futures contract, you are
basically agreeing to buy something that a seller has not yet produced for a set price. But
participating in the futures market does not necessarily mean that you will be responsible for
receiving or delivering large inventories of physical commodities - remember, buyers and
sellers in the futures market primarily enter into futures contracts to hedge risk or speculate
rather than to exchange physical goods (which is the primary activity of the cash/spot market).
That is why futures are used as financial instruments by not only producers and consumers but
also speculators. The bottom line is that there is no one way to pick stocks. Better to think of
every stock strategy as nothing more than an application of a theory - a "best guess" of how to
invest. And sometimes two seemingly opposed theories can be successful at the same time.
Perhaps just as important as considering theory, is determining how well an investment
strategy fits your personal outlook, time frame, risk tolerance and the amount of time you
want to devote to investing and picking stocks.

At this point, you may be asking yourself why stock-picking is so important. Why worry so much
about it? Why spend hours doing it? The answer is simple: wealth. If you become a good stock-
picker, you can increase your personal wealth exponentially. Take Microsoft, for example. Had
you invested in Bill Gates' brainchild at its IPO back in 1986 and simply held that investment,
your return would have been somewhere in the neighborhood of 35,000% by spring of 2004. In
other words, over an 18-year period, a $10,000 investment would have turned itself into a cool
$3.5 million! (In fact, had you had this foresight in the bull market of the late '90s, your return
could have been even greater.) With returns like this, it's no wonder that investors continue to
hunt for "the next Microsoft".

Derivatives- Financial ASSETS that “derive” their value from other assets. For example, an
option to buy a SHARE is derived from the share. Some politicians and others responsible for
financial REGULATION blame the growing use of derivatives for increasing VOLATILITY in asset
PRICES, and for being a source of danger to their users. Economists mostly regard derivatives as
a good thing, allowing more precise pricing of financial RISK and better RISK MANAGEMENT.
However, they concede that when derivatives are misused the LEVERAGE that is often an
integral part of them can have devastating consequences. So they come with an economists’
health warning: if you don’t understand it, don’t use it. The world of derivatives is riddled with
jargon. Here are translations of the most important bits.

• A forward contract commits the user to buying or selling an asset at a specific price on a
specific date in the future.

• A future is a forward contract that is traded on an exchange.

• A swap is a contract by which two parties exchange the cashflow linked to a liability or an
asset. For example, two companies, one with a loan on a fixed INTEREST RATE over ten years
and the other with a similar loan on a floating interest rate over the same period, may agree to
take over each other’s obligations, so that the first pays the floating rate and the second the
fixed rate.

• An option is a contract that gives the buyer the right, but not the obligation, to sell or buy a
particular asset at a particular price, on or before a specified date.
• An over-the-counter is a derivative that is not traded on an exchange but is purchased from,
say, an investment BANK.

• Exotics are derivatives that are complex or are available in emerging economies.

• Plain-vanilla derivatives, in contrast to exotics, are typically exchange-traded, relate to


developed economies and are comparatively uncomplicated.

These underlying assets may be foreign exchange, bonds, equities or commodities. Derivatives
traded at exchanges are standardized contracts that have standard delivery dates and trading
units. OTC derivatives are customized contracts that enable the parties to select the trading
units and delivery dates to suit their requirements.

Market Open/Close Price - It is the last price a particular stock sold for the previous day.

Market Price - It is the price a particular stock is currently selling for during the operating
hours of the stock market.

Moving Average- A rolling set of averages calculated over a time series of values. A Moving
Average represents data in a manner that smoothens fluctuations and highlights possible trends

Intrinsic Value – can be explained as-

1. The value of a company or an asset based on an underlying perception of the value.


2. For call options, this is the difference between the underlying stock's price and the
strike price. For put options, it is the difference between the strike price and the
underlying stock's price. In the case of both puts and calls, if the difference between
the underlying stock's price and the strike price is negative, the value is given as zero.
3. Intrinsic value includes hidden things like the value of a brand name, which is difficult
to calculate.
4. Intrinsic value in options is the in-the-money portion of the option's premium

Doing basic fundamental valuation is quite straightforward; all it takes is a little time and
energy. The goal of analyzing a company's fundamentals is to find a stock's intrinsic value, a
fancy term for what you believe a stock is really worth - as opposed to the value at which it is
being traded in the marketplace. If the intrinsic value is more than the current share price,
your analysis is showing that the stock is worth more than its price and that it makes sense to
buy the stock.

Although there are many different methods of finding the intrinsic value, the premise behind
all the strategies is the same: a company is worth the sum of its discounted cash flows. In plain
English, this means that a company is worth all of its future profits added together. And these
future profits must be discounted to account for the time value of money, that is, the force by
which the $1 you receive in a year's time is worth less than $1 you receive today.

The idea behind intrinsic value equaling future profits makes sense if you think about how a
business provides value for its owner(s). If you have a small business, its worth is the money
you can take from the company year after year (not the growth of the stock). And you can take
something out of the company only if you have something left over after you pay for supplies
and salaries, reinvest in new equipment, and so on. A business is all about profits, plain old
revenue minus expenses - the basis of intrinsic value.

Greater Fool Theory - One of the assumptions of the discounted cash flow theory is that
people are rational, that nobody would buy a business for more than its future discounted cash
flows. Since a stock represents ownership in a company, this assumption applies to the stock
market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a
stock's price to fluctuate so much when the intrinsic value isn't changing by the minute.

The fact is that many people do not view stocks as a representation of discounted cash flows,
but as trading vehicles. Who cares what the cash flows are if you can sell the stock to
somebody else for more than what you paid for it? Cynics of this approach have labeled it the
greater fool theory, since the profit on a trade is not determined by a company's value, but
about speculating whether you can sell to some other investor (the fool). On the other hand, a
trader would say that investors relying solely on fundamentals are leaving themselves at the
mercy of the market instead of observing its trends and tendencies.

Dividend Discount Model – DDM- is the procedure for valuing the price of a stock by using
predicted dividends and discounting them back to present value. The idea is that if the value
obtained from the DDM is higher than what the shares are currently trading at, then the stock
is undervalued.

This procedure has many variations, and it doesn't work for companies that don't pay out
dividends.

Risk Return Tradeoff- The principle that potential return rises with an increase in risk. Low
levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of
uncertainty (high risk) are associated with high potential returns. In other words, the risk-
return tradeoff says that invested money can render higher profits only if it is subject to the
possibility of being lost. Because of the risk-return tradeoff, you must be aware of your
personal risk tolerance when choosing investments for your portfolio. Taking on some risk is the
price of achieving returns; therefore, if you want to make money, you can't cut out all risk.
The goal instead is to find an appropriate balance - one that generates some profit, but still
allows you to sleep at night.

Money Market: The money market is better known as a place for large institutions and
government to manage their short-term cash needs.

Money Market: Repos- Repo is short for repurchase agreement. Repos are classified as a
money-market instrument. They are usually used to raise short-term capital. Those who deal in
government securities use repos as a form of overnight borrowing. A dealer or other holder of
government securities (usually T-bills) sells the securities to a lender and agrees to repurchase
them at an agreed future date at an agreed price. They are usually very short-term, from
overnight to 30 days or more. This short-term maturity and government backing means repos
provide lenders with extremely low risk. Repos are popular because they can virtually
eliminate credit problems. Unfortunately, a number of significant losses over the years from
fraudulent dealers suggest that lenders in this market have not always checked
their collateralization closely enough. There are also variations on standard repos:

• Reverse Repo - The reverse repo is the complete opposite of a repo. In this case, a
dealer buys government securities from an investor and then sells them back at a later
date for a higher price
• Term Repo - exactly the same as a repo except the term of the loan is greater than 30
days.

ADR- Introduced to the financial markets in 1927, an American depositary receipt (ADR) is a
stock that trades in the United States but represents a specified number of shares in a foreign
corporation. ADRs are bought and sold on American markets just like regular stocks, and are
issued/sponsored in the U.S. by a bank or brokerage.

ADRs were introduced as a result of the complexities involved in buying shares in foreign
countries and the difficulties associated with trading at different prices and currency values.
For this reason, U.S. banks simply purchase a bulk lot of shares from the company, bundle the
shares into groups, and reissues them on the New York Stock Exchange (NYSE), American Stock
Exchange (AMEX) or the NASDAQ. In return, the foreign company must provide detailed
financial information to the sponsor bank. The depositary bank sets the ratio of U.S. ADRs per
home-country share. This ratio can be anything less than or greater than 1. This is done
because the banks wish to price an ADR high enough to show substantial value, yet low
enough to make it affordable for individual investors. There are three different types of ADR
issues:

Level 1 - This is the most basic type of ADR where foreign companies either don't qualify or
don't wish to have their ADR listed on an exchange. Level 1 ADRs are found on the over-the-
counter market and are an easy and inexpensive way to gauge interest for its securities in
North America. Level 1 ADRs also have the loosest requirements from the Securities and
Exchange Commission (SEC).

Level 2 - This type of ADR is listed on an exchange or quoted on NASDAQ. Level 2 ADRs have
slightly more requirements from the SEC, but they also get higher visibility trading volume.

Level 3 - The most prestigious of the three, this is when an issuer floats a public offering of
ADRs on a U.S. exchange. Level 3 ADRs are able to raise capital and gain substantial visibility in
the U.S. financial markets. The advantages of ADRs are twofold. For individuals, ADRs are an
easy and cost-effective way to buy shares in a foreign company. They save money by reducing
administration costs and avoiding foreign taxes on each transaction. Foreign entities like ADRs
because they get more U.S. exposure, allowing them to tap into the wealthy North American
equities markets.

Preferred/Preferential stock - Stock that receives preferential treatment over common stock
with respect both to dividends and claims on assets in the event that the corporation goes out
of business.

Mostly this type of stock that pays a fixed dividend regardless of corporate earnings, and which
has priority over common stock in the payment of dividends. However, it carries no voting
rights, and should earnings rise significantly the preferred holder is stuck with the same fixed
dividend while common holders collect more. The fixed income stream of preferred stock
makes it similar in many ways to bonds.

NASDAQ Composite Index - The NASDAQ Composite Index measures all NASDAQ domestic and
non-U.S. based common stocks listed on The NASDAQ Stock Market. The Index is market value
weighted. This means that each company's security affects the Index in proportion to it's
market value. The market value, the last sale price multiplied by total shares outstanding, is
calculated throughout the trading day, and is related to the total value of the Index. Today the
NASDAQ Composite includes over 5,000 companies, more than most other stock market
indexes. Because it is so broad-based, the Composite is one of the most widely followed and
quoted major market indexes.

Short Position- Stock options, or futures contracts sold short and not covered as of a
particular date. On the NYSE, tabulation is issued once a month listing all issues on the
Exchange in which there was a short position of 5,000 or more shares and issues in which the
short position had changed by 2,000 or more shares in the preceding month. Short position also
means the total amount of stock an individual has sold short and has not covered, as of a
particular date. Most stock exchanges have rigid rules regarding short selling. The reader
should ascertain these rules from a registered broker of the exchange.

Stag - An investor, who buys and sells stocks rapidly, usually to make profits quickly.

Selling short - The reverse of the usual stock market technique, short selling is based on the
anticipation that a particular security price will go down. The practice of short selling involves
borrowing shares of a security from your broker and immediately selling them at the current
price. Then, as the price of that security declines, you buy back an equal number of shares on
the open market and use them to cover the shares you borrowed from your broker, and make a
profit. For instance, if you sell short 100 shares of XYZ Corporation at 50.00 a share and the
price of the stock drops to 35.00, your profit is 15.00 a share, or 1500.00. Short sellers lose
when the price of the stock ascends rather than descends. Theoretically, there is more risk
involved with short selling because a stock price could continue to rise forever. A stock
purchased at 10.00 a share can only fall to zero. A stock sold short at 10.00 could go to 20.00,
30.00, 40.00, etc.

Stock Split - An increase in the number of outstanding shares in a corporation. This is usually
brought about by the division of existing shares. For example, a two-for-one split means that
shareholders will receive two new shares for each old share, making a total of three.
Alternately, a reverse stock split brings about the decrease in the numbers of shares in a
corporation.

Stock symbol- A unique lettering system assigned to a particular stock or mutual fund. For U.S.
securities, one, two and three letter symbols indicate that the security is listed and trades on
an exchange. NASDAQ traded securities have a four or five letters assigned to them. If a fifth
letter appears on a NASDAQ security, it identifies the issue as other than a single issue of
common stock or capital stock. Stock symbols are used so people can easily and quickly identify
stocks without having to look or write sometimes long or similar company names. The Bombay
Stock Exchange has numeric stock codes whereas the National Stock Exchange has only
alphabetical codes.

Stop Order -An order to buy or sell a security conditioned on a specific price. This order is very
often referred to as a "stop loss" order, because it prevents the security from falling below a
certain price.

Scrip- A holding in securities

Ticker- A ticker is a trading screen information display showing the current price, volume, etc.
of a particular stock, option, future, etc.

Ticker symbol - A ticker symbol represents a particular security (company, option, etc.) on the
exchange it is trading on and is used to retrieve information about that security from that
exchange. For example: the symbol "f" on the New York Stock Exchange (USA) will bring you
information about Ford Motor Company. “ONGC” will show you the information of the Oil and
Natural Gas Commission on the National Stock Exchange of India. Ticker symbols can be used to
retrieve information from a financial publication such as your daily paper's business section.
Today, ticker symbols can be submitted to an electronic ticker quote retrieval system to find
information about a particular security instantly.

Capital adequacy ratio- The ratio of a BANK’s CAPITAL to its total ASSETS, required by
regulators to be above a minimum (“adequate”) level so that there is little RISK of the bank
going bust. How high this minimum level is may vary according to how risky a bank’s activities
are.

Automated Pit Trading (APT)- Introduced in 1989, APT is the LIFFE screen-based trading
system that replicates the open outcry method of trading on screen. A.P.T. is used to extend
the trading day for the major futures contracts as well as to provide a daytime trading
environment for non-floor trading products.

Average Daily Share Volume- The number of shares traded per day, averaged over a period of
time, usually one year.

BSE Sensex- A stock index (one of many) commonly used as an indicator of changes in the
general level of the stock market or stock prices in India. In this index, there are 30 diversified
stocks thought to be representative of the market in general.

Commodities- Articles of commerce or products that can be used for commerce. In a narrow
sense, products traded on an authorized commodity exchange. Types of commodities include
agricultural products, metals, petroleum, foreign currencies, financial instruments and indexes
to name a few.

Debt to Equity Ratio- Long-term debt divided by shareholders' equity, showing relationship
between long-term funds provided by creditors and funds provided by shareholders; high ratio
may indicate high risk, low ratio may indicate low risk

Forex- An abbreviated name for foreign currency.

Capital market line (CML)- The line defined by every combination of the risk-free asset and
the market portfolio. The line represents the risk premium you earn for taking on extra risk.
Defined by the capital asset pricing model.

Hedging -A practice of taking one market position to offset potential loses in another. For
example using a futures contract to reduce the impact of price fluctuations in a cash or
physical market.

Hot stock- A stock whose price rises quickly the day it goes public.

Long Term Gain- A gain on the sale of a capital asset where the holding period was twelve
months or more and the profit was subject to the long-term capital gains tax. The legal
definition of short term and long term capital gains vary from country to country. So are
taxation based on those classifications.

Liquidity- Depth of market to absorb buy and sell interest of even large orders at prices
appropriate to supply and demand. The market must also adapt quickly to new information and
incorporate that information into the stock's price. Liquidity is one of the most important
characteristics of a good market.
401k plan- A tax-deferred investment device for employees. 401k plans allow employees to
invest pre-tax dollars into individual retirement plan accounts. Employers may also match
employee investments in the 401k.

Vesting- The period of time an employee must work at a firm before gaining access to
employer-contributed pension income. For 401k plans, employee contributions are immediately
vested, but employer contributions may be vested over a period of several years.

Adviser - An organization or person employed by a mutual fund to give professional advice on


the fund's investments and asset management practices (also called the investment adviser).

Automatic Reinvestment- A fund service giving shareholders the option to purchase additional
shares using dividend and capital gain distributions.

Average Portfolio Maturity- The average maturity of all the bonds in a bond fund's portfolio.
What drives up a price of a share? Any investor worth his or her salt will quote ratios like EPS-
earning per share or the PE-the price earning ratio-and possibly they will be right. After all,
earnings are the bottom line and how much profit a company earns, is what separates the
winners from the losers. It all comes down to earnings. More than any other figure in a
financial report, earnings -- and the prospect of higher earnings in the future -- determines
whether investors will continue to bid up share prices. Earnings are the bottom line that show
how much money a company can use to reinvest in business growth or to pay dividends to
shareholders. Earnings are usually summed up as earnings per share -- the company's net
earnings divided by the number of common-stock shares outstanding. Earnings per share, or
EPS, offers a handy way to compare past earnings to spot upward or downward trends. Some
investors measure stocks almost entirely by how much profits grow from quarter to quarter and
year to year. EPS, however, only gives a starting point to evaluate stocks. It does not take into
account the stock's current price.

This is where the price-earnings ratio comes in. The price-earnings ratio, or P/E, is the price of
a company's stock divided by its EPS. It is one of the most widely used tools in sizing up stocks.
Simply put, it is how much investors are willing to pay for a rupee of the company's earnings.
You may also hear it referred to as a "multiple." Theoretically when you calculate a P/E based
on the past year's earnings, the P/E is called "trailing, or historical." When you're considering
historical P/Es, a lower ratio is often more attractive because investors may be getting a
bargain. But things start to get a bit fuzzy when future projections come in to play, so here the
market tries to determine the forward PE based on the future earnings projections. This is the
"forward" P/E (also referred to as the "anticipated" P/E). Now mostly in real life scenario what
we see quoted as the PE is a measure which is a mixture of both. The PE ratio has already
incorporated into the price of the scrip any news –good or bad and projected earnings of the
company for the coming year. This is exactly what the term "discounted the news and earnings"
means. But how does one evaluate a company's growth? One common method is to look at the
price/earnings growth ratio. The price/earnings growth, or PEG, ratio is the P/E divided by the
projected earnings growth rate. First, determine the projected growth rate using current EPS
and next year's estimated EPS. (est. EPS - current EPS) / current EPS = growth rate

Company A: ( 5.00 - 2.50 ) / 2.50 = 1 = 100%

Company B: ( 1.25 - 1.00 ) / 1.00 = 0.25 = 25%

Company A's earnings are expected to grow 100% over the next year, while Company B's should
grow 25%. Next, plug in the forward P/E, since the idea is to look at the company's future
prospects. The PEG calculation would look like this: forward P/E / growth rate = PEG

A: 21 / 100 = 0.21
B: 28.8 / 25 = 1.152

Theoretically a PEG ratio of 1 is considered standard -- in other words, its growth rate is
already incorporated into the price of its stock. Anything higher than 1 means that the stock
is trading at a premium to its growth rate. A PEG ratio lower than 1 shows that a stock may
be undervalued. Company A, with a PEG of 0.21, may look like a good buy, with good
potential for growth. Company B's stock price has already been bid up to incorporate its
potential growth over the next year. Investors would do well to keep an eye out for unusually
high P/Es. The higher the P/E, the greater investors' expectations. The greater the
expectations, the faster the stock can plummet if those expectations aren't met.

Price-Earnings Ratio - P/E Ratio-A valuation ratio of a company's current share price compared
to its per-share earnings. Calculated as:

For example, if a company is currently trading at $43 a share and earnings over the last 12
months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).
EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the
estimates of earnings expected in the next four quarters (projected or forward P/E). A third
variation uses the sum of the last two actual quarters and the estimates of the next two
quarters.

Also sometimes known as "price multiple" or "earnings multiple". In general, a high


P/E suggests that investors are expecting higher earnings growth in the future compared to
companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself.
It's usually more useful to compare the P/E ratios of one company to other companies in the
same industry, to the market in general or against the company's own historical P/E. It would
not be useful for investors using the P/E ratio as a basis for their investment to compare the
P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has
much different growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are
willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of
20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.

It is important that investors note an important problem that arises with the P/E measure, and
to avoid basing a decision on this measure alone. The denominator (earnings) is based on an
accounting measure of earnings that is susceptible to forms of manipulation, making
the quality of the P/E only as good as the quality of the underlying earnings number.

Price-To-Book Ratio - P/B Ratio- A ratio used to compare a stock's market value to its book
value. It is calculated by dividing the current closing price of the stock by the latest quarter's
book value per share. Also known as the "price-equity ratio". Calculated as:

A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that
something is fundamentally wrong with the company. As with most ratios, be aware this
varies by industry. This ratio also gives some idea of whether you're paying too much for what
would be left if the company went bankrupt immediately.

What PE ratios reveal -- and what they don't.


Financial ratios scare off lots of people, so it's an irony that one of the most easily
misinterpreted -- and abused -- ratios is one that even investment toddlers tout. The price-
earnings (PE) ratio, also known as the PE multiple, is computed by dividing the current market
price of one share of a company by its earnings per share (EPS) during the most recent
accounting period. The EPS is a company's profit after tax divided by the number of shares it
has issued to its shareholders. What it is supposed to do is give you some idea of the value
(essentially the potential for appreciation) in the investment you seek. Unfortunately, its
looseness of definition (both high and low PEs can be good investments) and its susceptibility to
creative accounting by companies (the bottom line is routinely manipulated by dodgy
companies) make it more of a trap than a useful tool.

There's little argument about the need to estimate value. Buy a company's shares, and you are
effectively taking a stake in its business. If you expect this investment to appreciate, you need
to believe that the intrinsic value of this business is not fully reflected in the price you pay for
the stock. Successful investing is all about getting a fix on this intrinsic value, and acting on it
whenever a gap exists between it and the market price.

In general, if the market expects a company to grow and have higher future earnings, it will
have a higher PE than a company in decline. Investors in Indian Shaving Products or Hindustan
Lever pay a large multiple of these companies' current earnings for their shares because they
expect their sales and profits to grow quickly, compared to other companies.

If the PE is too high, however, it means that the share price has already anticipated the future
growth. That's why investors often look out for low PE stocks with the potential for growth. The
low PE should, in theory, imply that the price has not yet risen to reflect the stock's potential.

But don't rush out and pick stocks purely on PEs. It is simple and useful, but it also has
limitations that can really mislead investors. For instance, most low-PE stocks are poor
performers. Even when they are undervalued, they will never give you the long-term return
you would get from a great stock that is undervalued, because these are in businesses that will
grow faster than the market for years -- the classic case for stocks like Lever. However high a
stock's PE is, if it does not fully reflect the earnings growth potential, it is still worth
considering for investment.

Moreover, the further you get from the end of the financial period for which earnings figures
are available, the more out-of-date the ratio gets. For instance, because several Indian
companies still have not declared their 1997-98 results, PE ratios for most would at this time
be calculated on earnings for the year ending March 31, 1997. The developments in the
intervening 15 months can make the ratio quite meaningless.

Trailing PE. One way to get a PE ratio more up to date is to use a trailing PE, which takes the
earnings for the most recent accounting periods that add up to 12 months. In developed
markets, where companies declare results every three months, a 12-month trailing PE can be
much closer to reality than a figure based on the last annual results. However, in India few
firms declare results more than twice a year, so a trailing PE is not as finely tuned. In any case,
PEs are based on past performance, which is no guarantee of future goodies; certainly, its
predictive power declines the further ahead one looks. And when price movements anticipate
future performance, as is often the case, a PE ratio is no help. There are two ways of getting
around this.

Leading PE. A leading PE is based on the current price and the earnings projected for the
coming 12 months.

PE-growth (PEG) ratio- The PEG is the current PE divided by the estimated growth rate in EPS.
This shows whether a stock is cheap relative to its future EPS growth prospects. The weakness
of both methods lies in their dependence on analysts' estimates. Estimating future earnings is
usually a highly subjective process. Usually we have little basis for judging the accuracy of
estimates until the results are actually declared -- which is generally too late. Ultimately, a PE
ratio is only a tool -- one of several that investors can use. It's how one uses it that matters;
not simply the fact that one has it.

Relationship between PE Ratio and Earnings Yield- Reverse the PE ratio and we get earnings
yield. So double-digit growth in earnings is necessary to enhance yields for investments made
now.

Carrying Value- An accounting measure of value, where the value of an asset or a company is
based on the figures in the company's balance sheet. For assets, the value is based on the
original cost of the asset less any depreciation, amortization or impairment costs made against
the asset. For a company, carrying value is a company's total assets minus intangible assets and
liabilities such as debt.

Also known as "book value"- This is different from market value, as it can be higher or lower
depending on the circumstances, the asset in question and the accounting practices that affect
them. In many cases, the carrying value of an asset and its market value will differ greatly.
This is because, in accordance with accounting rules, the assets are held based on original
costs. If a company holds land that was purchased 100 years ago, it holds it at the cost paid.
Over time, however, this real estate has likely gained considerably in value.

Banker’s Acceptance- It refers to a short-term credit investment created by a non-financial


intermediary and guaranteed by a bank. Acceptances are traded at discounts from their face
value in the secondary market.

Beta- A measure of a security or managed investment’s fluctuation in relation to that of the


market. A security or fund with a beta higher than 1 is expected to move up or down more than
the market. A beta below 1 indicates a security or fund that usually moves to a lesser extent
than that of the market.

Residual risk- When you buy an ASSET you become exposed to a bundle of different RISKs.
Many of these risks are not unique to the asset you own but reflect broader possibilities, such
as that the stock market average will rise or fall, that INTEREST rates will be cut or increased,
or that the GROWTH rate will change in an entire economy or industry. Residual risk, also
known as alpha, is what is left after you take out all the other shared risk exposures. Exposure
to this risk can be reduced by DIVERSIFICATION. Contrast with SYSTEMATIC RISK.

Bid/ Bid Price- It is the uppermost price a buyer is willing to pay for a security.

Buy-back- It is related to managed investments, whereby the investment manager is required


to repurchase units from unit-holders seeking to redeem part or all of their investment. When
in the case of a company, the company buys back and cancels its securities.

Buyer’s Market- his pinpoints a market condition whereby there is an abundance of goods and
services available and buyers can buy at a lower price than usual.

Capital Adequacy- In relations to banks, whereby a set minimal level of shareholders’ equity
must be sustained to maintain the lending and investing activities of a bank.

Capital Gain- The increase between the price at which an investment was purchased, and the
price for which it was sold.
Capital Gains Tax- A tax on the appreciation of the capital value of investments, not including
value increases that are due to inflation, i.e., the cost base is usually indexed along with
movements in the consumer price index.

Certificate Of Deposit (CD)- This is a negotiable interest-bearing debt instrument of specific


maturity issued by banks. A CD represents the title to a time deposit with a bank, but is a
liquid instrument since it can be traded in the Secondary Market. It is a Money Market
instrument with a maturity of less than one year and is issued at a discount from the face
value.

Collateral- A promise of some form of security by a borrower to secure payment of a loan.


Also- It means an asset that is pledged against a loan.

Commercial Paper (CP)- It is an instrument by which blue chip companies raise funds from the
market. The company should have a minimum net worth of Rs four crore and a minimum
working capital requirement of Rs. four crore. Normally, the rate on commercial paper ranges
from 8.50 to 10.75 per cent depending on the period, which is cheaper when compared to
finance from the bank.

Counter-Cyclical- An investment style where trading is performed in anticipation of a turn in


the business cycle.

Current yield- The ratio of interest to the actual market price of the bond, stated as a
percentage or t he coupon rate divided by the market price of the bond.

Dividend Yield (Stocks)- Annual dividends divided by present stock price.

Dividend Yield (Funds)- A depiction of the return on a share of a mutual fund held over the
past year.

Cushion bonds- Bonds with high coupon rate. These bonds provide a cushion in a falling
market.

Delivery Points- It refers to physical points at futures exchanges at which the physical
commodity signified in a futures contract may be delivered in fulfillment of such a contract.

Dow Theory- A belief that major trends in the stock market are confirmed by more than one
index. Only if a new high or low is recorded in two or more indexes can it be safely said that
the market is headed in a certain direction.

Earnings Yield- It is calculated by dividing the Earnings Per Share (EPS) by the company’s
current share price and multiplying the result by 100

Equity Risk Premium- The rate of return differential between low risk assets such as
government bonds, and higher risk assets such as shares.

Exercise- When an option is converted to its underlying asset.

Exercise (Option)- When the holder of a long option position purchases (if calls are owned) or
sells (if puts are owned) the underlying security at the exercise (strike) price. The exercise is
accomplished when the customer holding the long position gives his broker instructions to
exercise his position. This must be done in accordance with the rules pertaining to timing
established by the exchanges and individual brokerage firms.
Exercise Price- It is the price at which the underlying asset will be bought or sold if the holder
exercises the option, i.e. the strike price.

Exit Fee- A redemption fee charged in relation to the withdrawal of units in a unit trust.

Expected Rate of Return- The calculated average of the probability distribution of possible
returns on an asset or portfolio.

Expected Value- The anticipated value of a future variable.

Expense Ratio- The percentage of the expenses incurred, such as fees, overhead costs,
advertising and distribution costs in order to run a mutual fund (as of the last annual
statement).

Extrinsic Value- An option’s price minus its intrinsic value (its value should it expire
immediately).

Asset Allocation -The process of repositioning assets within a portfolio to maximize return for
a given level of risk. This process is usually done using the historical performance of the asset
classes within sophisticated mathematical models.

Zero-Coupon Bond- This type of bond makes no periodic interest payments but instead is sold
at a steep discount from its face value. Bondholders receive the face value of their bonds when
they mature.

Capital Adequacy Ratio – CAR- A measure of a bank's capital. It is expressed as a percentage of


a bank's risk weighted credit exposures.

Also known as "Capital to Risk Weighted Assets Ratio (CRAR)."This ratio is used to protect
depositors and promote the stability and efficiency of financial systems around the world.

Two types of capital are measured: tier one capital, which can absorb losses without a bank
being required to cease trading, and tier two capital, which can absorb losses in the event of a
winding-up and so provides a lesser degree of protection to depositors.

Cash Reserve Ratio (CRR)- Maintenance of CRR- Consequent upon the amendment to sub-
section (1) of Section 42 of the RBI Act 1934,effective from June 22, 2006 the Reserve Bank
having regard to the needs of securing monetary stability in the country, can prescribe the
Cash Reserve Ratio (CRR) for Scheduled Commercial Banks without any floor rate or ceiling
rate. The statutory minimum CRR requirement of 3 per cent of total demand and time
liabilities no longer exists with effect from June 22, 2006, RBI has decided to continue with the
status quo on the rate of CRR required to be maintained by Scheduled Commercial Banks at the
rate of 5 per cent of the demand and time liabilities subject to the exemptions as indicated in
para 2.3.7 of this circular.

Computation of Demand and Time Liabilities- Liabilities of a bank may be in the form of
demand or time deposits or borrowings or other miscellaneous items of liabilities. Liabilities of
the banks may be towards banking system (as defined under Section 42 of RBI Act, 1934) or
towards others in the form of Demand and Time deposits or borrowings or other miscellaneous
items of liabilities. Reserve Bank of India has been authorized in terms of Section 42 (1C) of the
RBI. Act, 1934 to classify any particular liability and hence for any doubt regarding
classification of a particular liability, the banks are advised to approach RBI for necessary
clarification.

Demand Liabilities- 'Demand Liabilities' include all liabilities which are payable on demand and
they include current deposits, demand liabilities portion of savings bank deposits, margins held
against letters of credit/guarantees, balances in overdue fixed deposits, cash certificates and
cumulative/recurring deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs),
Demand Drafts (DDs), unclaimed deposits, credit balances in the Cash Credit account and
deposits held as security for advances which are payable on demand. Money at Call and Short
Notice from outside the Banking System should be shown against liability to others.

Time Liabilities- Time Liabilities are those which are payable otherwise than on demand and
they include fixed deposits, cash certificates, cumulative and recurring deposits, time
liabilities portion of savings bank deposits, staff security deposits, margin held against letters
of credit if not payable on demand, deposits held as securities for advances which are not
payable on demand and Gold Deposits.

Assets with the Banking System- Assets with banking system include balances with banks in
current accounts, balances with banks and notified financial institutions in other accounts,
funds made available to banking system by way of loans or deposits repayable at call or short
notice of a fortnight or less and loans other than money at call and short notice made available
to the Banking System. Any other amounts due from banking system which cannot be classified
under any of the above items are also to be taken as assets with the banking system.

Procedure for calculation of CRR- In order to improve the cash management by banks, as a
measure of simplification, a lag of one fortnight in the maintenance of stipulated CRR by banks
has been introduced with effect from the fortnight beginning 6th November 1999. Thus, all
Scheduled Commercial Banks are required to maintain the prescribed Cash Reserve Ratio
(which is currently @ 5% per cent with effect from the fortnight beginning October 02, 2004 )
based on their NDTL as on the last Friday of the second preceding fortnight.

Maintenance of CRR on daily basis - With a view to providing flexibility to banks in choosing an
optimum strategy of holding reserves depending upon their intra period cash flows, all
Scheduled Commercial Banks, are required to maintain minimum CRR balances upto 70 per
cent of the total CRR requirement on all days of the fortnight with effect from the fortnight
beginning December 28, 2002.

Statutory Liquidity Ratio (SLR)- In terms of Section 24 (2-A) of the B.R. Act, 1949 all
Scheduled Commercial Banks, in addition to the average daily balance which they are required
to maintain under Section 42 of the RBI, Act, 1934, are required to maintain in India,

a) in cash, or
b) in gold valued at a price not exceeding the current market price,
c) in unencumbered approved securities valued at a price as specified by the RBI from
time to time.

an amount which shall not, at the close of the business on any day, be less than 25 per cent or
such other percentage not exceeding 40 per cent as the RBI may from time to time, by
notification in gazette of India, specify, of the total of its demand and time liabilities in India
as on the last Friday of the second preceding fortnight,

At present, all SCBs are required to maintain a uniform SLR of 25 per cent of the total of their
demand and time liabilities in India as on the last Friday of the second preceding fortnight
which is stipulated under section 24 of the B.R. Act, 1949.
Procedure for computation of demand and time liabilities for SLR- The procedure to
compute total net demand and time liabilities for the purpose of SLR under Section 24 (2) (B)
of B.R. Act 1949 is similar to the procedure followed for CRR purpose. However, it is clarified
that Scheduled Commercial Banks are required to include inter-bank term deposits / term
borrowing liabilities of original maturities of 15 days and above and up to one year in 'Liabilities
to the Banking System'. Similarly banks should include their inter-bank assets of term deposits
and term lending of original maturity of 15 days and above and up to one year in 'Assets with
the Banking System' for the purpose of maintenance of SLR. However, both the above liabilities
and assets are not to be included in the liabilities to /assets with the banking system for
computation of DTL/NDTL for the purpose of CRR as mentioned in para 2.3.7 above.

Floating Exchange rate- It is the exchange rate of a currency that is allowed to float, either
within a narrow specified band around a reference rate or freely according to market forces.
These forces of demand and supply are influenced by factors, such as, a nation's economic
health, trade performance and balance of payments position, interest rates and inflation.

Option- A contract that gives a holder the right to buy (Call Option) or sell (Put Option) a
certain number of shares of a company at a specified price is known as the 'Striking Price' or
'Exercise Price'.

Forex Open Position- A corporate/financial institution, which deals in buying and selling of
foreign exchange, may keep their position either at 'overbought or 'oversold' which is exposed
to exchange risk. Keeping their position as either 'overbought' or 'oversold' is known as Open
Position.

VAR- Value at Risk- The new complexities of financial instruments makes the assessment of
risk of the exposed positions inadequate. VAR is a simple and attractive model to compute
portfolio risk by assigning probabilities of value-chain (asset-price data) quantified by a
measurement of their standard deviations.

Liquidity Risk - Measuring and managing liquidity is vital for effective operations in commercial
banks. The bank’s asset and liability as on a particular day can be put on various residual
maturity periods called 'time buckets' varying from 1 – 14 days, 15 – 28 days and so on. All the
liability figures are outflows while the asset figures are inflows. The bank can find out the net
outflow or inflow in different periods and make their strategies so as to meet the mismatches
in outflows. By assuring a bank’s ability to meet its liabilities as they become due, liquidity
management can reduce the probability of an adverse situation arising.

Interest Rate Risk- The phased deregulation of interest rates and the operational flexibility
given to banks in pricing most of the assets and liabilities imply the need for the banking
system to hedge the Interest-Rate Risk. Interest Rate Risk is the risk where changes in market
interest rates might adversely affect the Bank’s Net Interest Income. The gap report should be
generated by grouping interest rate sensitive liabilities, assets and off balance sheet positions
into time buckets according to residual maturity or next re-pricing period, whichever is earlier.
Interest rates on term deposits are fixed during their currency while the advance interest rates
are floating rates. The gaps on the assets and liabilities are to be identified on different time
buckets from 1–28 days, 29 days up to 3 months and so on. The interest changes should be
studied vis-à-vis the impact on profitability on different time buckets to assess the interest
rate risk.

Rate Sensitive Assets and Liabilities- An asset or liability is normally classified as rate
sensitive, if:

• Within the time interval under consideration, there is a cash flow,


• The interest rate resets/re prices contractually during the interval,
• RBI changes interest rates (i.e. interest rates on Savings Bank Deposits, DRI advances,
Export Credit, Refinance, CRR balance, etc.) in cases where rates are administered
and,
• It is contractually pre-payable or withdrawal before the stated maturities.

Certain assets and liabilities receive/pay rates that vary with a reference rate. These assets
and liabilities are re priced at pre-determined intervals and are rate sensitive at the time of re
pricing.

Asset and Liability Management System- ALM is concerned with risk management and provides
a comprehensive and dynamic framework for measuring, monitoring and managing liquidity
interest rate, foreign exchange and equity and commodity price risks of a bank that needs to
be closely integrated with the banks’ business strategy. ALM involves assessment of various
types of risks and altering asset-liability portfolio in a dynamic way in order to manage risks.

Gap Analysis- The various items of rate sensitive assets and liabilities and off-balance sheet
items are to be classified in the various time buckets such as 1-28 days, 29 days and upto 3
months etc. and items non-sensitive to interest based on the probable date for change in
interest.

The gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities
(RSL) in various time buckets. The positive gap indicates that it has more RSAS than RSLS
whereas the negative gap indicates that it has more RSLS. The gap reports indicate whether
the institution is in a position to benefit from rising interest rates by having a Positive Gap (RSA
> RSL) or whether it is a position to benefit from declining interest rate by a negative Gap (RSL
> RSA).

Internal Rate of Return- IRR is the discount rate that makes the Net Present Value (NPV) of a
project equal to zero. This rate becomes the cut off rate to borrow money to finance the
project. If the cost of funds is above this rate, the project is financially not viable.

Depository services- A Depository holds securities of investors in electronic form and renders
services related to transactions in securities. The purpose of establishing depository are to
reduce paper work, to eliminate risks attached to physical form of certificates, to reduce
transaction cost and to facilitate pledging of securities. Presently we have 2 depositories
functioning in India:

(a) National Securities Depository Ltd (NSDL) promoted by IDBI, UTI, NSE and SBI;
(b) Central Depository Services Ltd. promoted by BSE, Bank of India, Bank of Baroda, SBI
and HDFC Bank.

Depository Participants (DP)- A Depository interfaces with investors through agents known as
Depository participants. Institutions which are eligible to function as D.P. are Scheduled
Commercial Bank, Bank approved by RBI, Public Financial Institutions, State Financial
Corporation, Clearing Corporations, NBFC, SEBI registered brokers and SEBI registered
custodians. The institution must have a minimum net worth of Rupees one crore. The
concerned depository has the right to choose D.P. subject to approval of SEBI. A D.P. opens
accounts of the investors.

Yield to maturity- It is an annualized rate of return on investment. It indicates return earned


by an investor on a debenture or bond held till maturity. It is a discount rate which equates the
present value of a security’s inflows to its purchase price. It is assumed that the periodic
inflows are reinvested at the rate equal to the yield to maturity.
Primary dealers and satellite dealers- Primary Dealers are those corporations like Discount &
Finance House of India Ltd., which are active in government securities market. Minimum net
owned funds for them is Rs.50 crores. They have a double code i.e. of sales and purchases.
They have to commit a minimum bidding per year. They take part in primary as well secondary
market. At present, there are 13 primary dealers. Satellite dealers act on behalf of primary
dealers and render services in any part of the country. The minimum net owned funds are
prescribed as Rs.5 crores.

Accounting Terms-

Paid-in capital – Capital received from investors in exchange for stock, but not stock from
capital generated from earnings or donated. This account includes capital stock and
contributions of stockholders credited to accounts other than capital stock. It would also
include surplus resulting from recapitalization.

Accumulation- In the context of corporate finance refers to profits that are added to the
capital base of the company rather than paid out as dividends. In the context of investments,
refers to the purchase by an institutional broker of a large number of shares over a period of
time in order to avoid pushing the price of that share up. In the context of mutual funds, refers
to the regular investing of a fixed amount while reinvesting dividends and capital gains.

Accumulation area- A price range in which a buyer accumulates shares of a stock

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

Cost of goods sold - The amount which the retailer has paid for goods actually resold. It
includes the invoice cost, discounts, rebates, shrinkage and freight charges. Formula: opening
stock (at cost) plus purchases (at cost) less closing stock (at cost).

Cost price - An amount which the retailer pays to the supplier/vendor for goods

Accrual Accounting- This is an accounting practice that takes into account all the revenues
earned but not yet received, and expensed incurred but not yet paid, as well as any cash
transactions.

Accrual- Bond- These are bonds in which interest is accumulated and paid at the time of
redeeming the bonds along with the redeemable value

Actuary- An actuary is a qualified expert who makes valuations and calculations related to
investment funds.

Amortization- This involves the pay off of an interest bearing liability through a series of
installments, which includes interest along with the principal in each installment. An example
is the typical home loan, or a mortgage.

Arbitrage- It represents the profit made from the price differences in different markets, i.e.
the purchase of an asset for a low price in one market and its sale for a higher price in another.

Articles of Association- These are the rules regarding the operations of a company, as spelled
out in a formal document.
Asset- It represents any tangible or intangible resources or items of value that an individual or
a corporation owns. E.g. Property, Equipment, Cash, Long-term and Short investments.

Asset Backing- It means the company’s asset value when divided by its issued shares.

Asset Value- It shows the worth of the assets underpinning a security.

Collateral- An ASSET pledged by a borrower that may be seized by a lender to recover the
value of a loan if the borrower fails to meet the required INTEREST charges or repayments.

Economics

Inflation: Inflation is defined as a sustained increase in the general level of prices for goods
and services. It is measured as an annual percentage increase. As inflation rises, every dollar
you own buys a smaller percentage of a good or service.

Deflation- is when the general level of prices is falling. This is the opposite of inflation. Since
1930 it has been the norm in most developed countries for AVERAGE PRICES to rise year after
year. However, before 1930 deflation (falling prices) was as likely as INFLATION. On the eve of
the first world war, for example, prices in the UK, overall, were almost exactly the same as
they had been at the time of the great fire of London in 1666. Deflation is a persistent fall in
the general price level of goods and SERVICES. It is not to be confused with a decline in prices
in one economic sector or with a fall in the INFLATION rate (which is known as DISINFLATION).

Sometimes deflation can be harmless, perhaps even a good thing, if lower prices lift real
INCOME and hence spending power. In the last 30 years of the 19th century, for example,
consumer prices fell by almost half in the United States, as the expansion of railways and
advances in industrial technology brought cheaper ways to make everything. Yet annual real
GDP GROWTH over the period averaged more than 4%.

Deflation is dangerous, however, more so even than inflation, when it reflects a sharp slump in
DEMAND, excess CAPACITY and a shrinking MONEY SUPPLY, as in the Great DEPRESSION of the
early 1930s. In the four years to 1933, American consumer prices fell by 25% and real GDP by
30%. Runaway deflation of this sort can be much more damaging than runaway inflation,
because it creates a vicious spiral that is hard to escape. The expectation that prices will be
lower tomorrow may encourage consumers to delay purchases, depressing demand and forcing
FIRMS to cut prices by even more. Falling prices also inflate the real burden of DEBT (that is,
increase real INTEREST rates) causing BANKRUPTCY and BANK failure. This makes deflation
particularly dangerous for economies that have large amounts of corporate debt. Most serious
of all, deflation can make MONETARY POLICY ineffective: nominal interest rates cannot be
negative, so real rates can get stuck too high.

Hyperinflation- is unusually rapid inflation. In extreme cases, this can lead to the breakdown
of a nation's monetary system. One of the most notable examples of hyperinflation occurred in
Germany in 1923, when prices rose 2,500% in one month!

Stagflation- is the combination of high unemployment and economic stagnation with inflation.
This happened in industrialized countries during the 1970s, when a bad economy was combined
with OPEC raising oil prices.

Causes of Inflation

Demand-Pull Inflation - This theory can be summarized as "too much money chasing too few
goods". In other words, if demand is growing faster than supply, prices will increase. This
usually occurs in growing economies.

Cost-Push Inflation - When companies' costs go up, they need to increase prices to maintain
their profit margins. Increased costs can include things such as wages, taxes, or increased costs
of imports.

Consumer Price Index (CPI)- It is an index measuring the changing prices of household goods
and services bought by ordinary consumers. It is used as a measure of inflation and the relative
cost of living.

RBI Re-Finance / Rediscount Facilities- Refinance is the system under which a Bank/F.I
borrows from apex banking institutions or other such specific institutions. It is a measure which
is used by apex bank in a short-term period to control/regulate call money rates. Rediscounting
implies discounting of a debt instrument such as a Bill of Exchange by a Bank/F.I. which had
earlier discounted it.

Weak Bank- Narasimham Committee-II- A ‘Weak Bank’ has been defined by the committee as
follows:

• Where a total of accumulated losses of the bank and net NPA amount, exceeds the net
worth of the bank.
• Alternatively, where operating profit minus income from recapitalization bonds results
in a negative position, for the last three consecutive years.

Selective Credit Control- With the view to discourage hoarding and black-marketing of certain
essential commodities by traders, RBI has been controlling margins, sanctioning powers and
rate of interest charged by banks to borrowers dealing in such sensitive commodities. The list
of items under selective credit control is revised from time to time as per market forces.

Sweat Equity- Sweat Equity is the equity issued by the company to employees or director’s at a
discount for consideration other than cash for providing the know-how or making available
rights in the nature of intellectual property rights or value addition. It is issued by a corporate
to retain the human assets. SEBI is formulating a policy whereby it will mandate a three year
lock in period from the date of allotment of shares issued under the Sweat Equity Plan.

G.N.P- Gross National Product is the aggregate market value of all final goods and services
produced during a given year in a country.

G.D.P- Gross Domestic Product is the sum total of values of output of goods and services in the
country without adding net factor incomes received from abroad. Gross domestic product, a
measure of economic activity in a country. It is calculated by adding the total value of a
country's annual output of goods and services. GDP = private consumption + investment + public
spending + the change in inventories + (exports - imports). It is usually valued at market prices;
by subtracting indirect tax and adding any government subsidy, however, GDP can be
calculated at factor cost. This measure more accurately reveals the income paid to factors of
production. Adding income earned by domestic residents from their investments abroad, and
subtracting income paid from the country to investors abroad, gives the country's gross national
product (GNP).

The effect of inflation can be eliminated by measuring GDP growth in constant real prices.
However, some economists argue that hitting a nominal gdp target should be the main goal of
macroeconomic policy. This is because it would remind policymakers to take into account the
effect of their decisions on inflation, as well as on growth. GDP can be calculated in three
ways. The income method adds the income of residents (individuals and firms) derived from
the production of goods and services. The output method adds the value of output from the
different sectors of the economy. The expenditure method totals spending on goods and
services produced by residents, before allowing for depreciation and capital consumption. As
one person's output is another person's income, which in turn becomes expenditure, these
three measures ought to be identical. They rarely are because of statistical imperfections.
Furthermore, the output and income measures exclude unreported economic activity that
takes place in the black economy but that may be captured by the expenditure measure.

GDP is disliked as an objective of economic policy by some because it is not a perfect measure
of welfare. It does not include aspects of the good life such as some leisure activities. Nor does
it include economically valuable activities that are not paid for, such as parents teaching their
children to read. But it does include some things that lower the quality of life, such as
activities that damage the environment.

N.N.P- Net National Product is the value of the net output of the economy during a year. It is
arrived at by deducting the value of depreciation or replacement allowance of the capital
assets from G.N.P.

Gross NPA- Gross Non Performing assets is the total outstanding of all the borrowers classified
as non-performing assets (viz, substandard, doubtful and loss asset).

Net NPA- Net Non Performing assets is the Gross NPA minus gross provision made, unrealized
interest and unadjusted credit balances with regard to various NPA accounts.

Yield Curve- It is a graphical representation of the pattern of yields on a specific date for
government securities with varying maturities. Yield curve can take different shapes depending
upon the prevailing conditions at any point of time. Yield curve reflects the broad expectations
about interest rates.

Time Buckets in ALM- The assets and liabilities of a bank’s balance sheet are nothing but
future cash inflows or outflows. To measure the liquidity and interest rate risk, the use of
maturity ladder and calculation of cumulative surplus or deficit of funds in different time slots
on the basis of statutory reserve cycle of 14 days are termed as time buckets. As per RBI
guidelines, commercial banks have to distribute the outflows/inflows in different residual
maturity period known as time buckets, varying from 1–14 days, 15–28 days, 29 days up to 3
months and so on.

Capital- Tier I and Tier II- Capital structure of banks is made up of 2 tiers.

Tier I refers to core capital consisting of Capital, Statutory Reserve, Revenue and other
reserves, Capital Reserve (excluding Revaluation Reserves) and unallocated surplus/profit but
excluding accumulated losses, investments in subsidiaries and other intangible assets.

Tier II is comprised of Property Revaluation Reserve, Undisclosed Reserves, Hybrid Capital,


Subordinated Term Debt and General Provisions. This is Supplementary Capital.

Capital adequacy is determined as a ratio of capital funds to total Risk Weighted Assets of the
bank.

Bank Rate- Bank Rate is the rate at which RBI allows finance to commercial banks. Normally,
different types of refinance facilities by RBI to banks are linked to a Bank Rate. Bank Rate is a
tool which RBI uses for short-term purposes. Any revision in Bank Rate by RBI is a signal to
banks to revise deposit rates as well as Prime Lending Rate. For greater effectiveness, this tool
is used together with other measures like Cash Reserve Ratio and Repo Rate. At present, the
bank rate is 6.5% p.a.
Categorization and valuation of Bank’s investments - The entire investment portfolio of the
banks(including SLR and NON-SLR securities) will be classified under three categories, viz, 'Held
to Maturity', 'Available for Sale' and 'Held for Trading'. The securities acquired by the banks
with the intension to hold them up to maturity will be classified under Held to Maturity. The
securities acquired by the banks with the intension to trade by taking advantage of the short-
term price/interest rate movements will be classified under Held for Trading. The securities
which do not fall within the above two categories will be classified under Available for Sale.

Market Value- The 'market value' for the purpose of periodical valuation of investments
included in the Available for Sale and Held for Trading categories would be the market price of
the scrip as available from the trades/quotes on the stock exchanges, price of SGL
transactions, price list of RBI.

Commercial paper (CP)- It is an instrument by which blue chip companies raise funds from the
market. The company should have a minimum NET WORTH of rupees four crores and having a
sanctioned working capital limit from a bank/FI. Normally, the rate on commercial paper
ranges from 8.50 to 10.75% depending on the period, which is cheaper when compared to
finance from the bank. Once the company repays commercial paper, the working capital limits
hitherto availed from the bank is restored.

Ways and Means Advances-WMA- RBI has granted the facility of overdraft to the Central
Government as well to State Governments. These government borrowings result in high
increase in interest payments on public debt. This enlarged borrowing program of the
government has brought pressure on absorptive capacity of the market. With a view to check
the adverse impact of government’s large borrowing program on interest rates, RBI announced
in June '98, its intention to accept private placement of government securities from time to
time. In any case, fiscal deficit of government and its borrowing requirements are to be kept
within reasonable limits.

Disclosure Norms- With a view to bring in transparency in banking transactions and for the
benefit of investors, depositors and general public, RBI has stipulated disclosure norms to be
observed by banks. These are as follows:

• Capital adequacy ratio.


• Per employee business.
• Per branch profit.
• Maturity profile of the rate sensitive assets and liabilities.
• Average cost of funds and return on assets.
• Movements of NPAs, quantum-wise gross and net NDA, opening balance and closing
balance.
• Maturity pattern of deposits, loans, investments, borrowings foreign currency assets-
liabilities as per buckets prescribed under Asset-Liability Management guidelines.

Balance of payments on current account- That part of the balance of payments recording
current, i.e. non-capital transactions.

Budget Deficit- When government expenditure exceeds government income. Deficit- In the red
– when more MONEY goes out than comes in. A BUDGET deficit occurs when PUBLIC SPENDING
exceeds GOVERNMENT revenue. A current account deficit occurs when EXPORTS and inflows
from private and official TRANSFERS are worth less than IMPORTS and transfer outflows (see
BALANCE OF PAYMENTS).
Budget surplus- When government income exceeds government expenditure. The budget
surplus in the UK used to be called the Public Sector Debt Repayment. It is now termed as a
negative Public Sector Net Cash Requirement.

Public Sector Borrowing Requirement (PSBR)- The difference between government income
and expenditure which is financed by borrowing. The PSBR is now known as the Public Sector
Net Cash Requirement and can be either positive or negative.

Public Sector Net Cash Requirement (PSNCR)- This used to be called the Public Sector
Borrowing Requirement (PSBR) and is the amount of money the government need to borrow to
meet their spending plans. In other words it the amount that their spending exceeds their tax
revenue by.

Economies of Scale- A reduction in long run unit costs which arise from an increase in
production. Economies of scale occur when larger firms are able to lower their unit costs. This
may happen for a variety of reasons. A larger firm may be able to buy in bulk, it may be able to
organize production more efficiently, it may be able to raise capital cheaper and more
efficiently. All of these represent economies of scale.

Buying economies of scale- The ability of large firms to purchase their inputs at a larger
discount than small firms.

Diseconomies of Scale- Increases in long run costs which occur from an increase in the scale of
production.

Financial economies of scale- The ability of large firms to borrow money on more favorable
terms than small firms.

Marketing economies of scale- The lower unit cost of advertising and promotion that is
enjoyed by a large firm and which is unavailable to smaller companies

Black economy- Unrecorded production. The Black economy results from activity that has not
been recorded through the tax system or other conventional means of recording.

Parallel economy- The production that takes place outside of the declared and formal circular
flow of income.

Long run average cost curve- Shows the minimum unit cost of producing each level of output,
allowing the size of plant to vary.

Long Run Average Cost (Envelope) Curve- The long run average cost curve is derived from a
series of short run average cost curves and so is often described as the envelope curve. If a
firm is producing in the most efficient way possible in the long run, but they then want to
expand, they will have to expand along a short run average cost curve as they will be limited
by their fixed factors. However, in the long run they can get more of the fixed factors and so
will move back down to the long run average cost curve. This is why the LRAC is made up of a
series of SRAC curves
Constant Returns to Scale- When a firm experiences constant returns to scale, the long run
average cost curve is horizontal

Constant Returns to Scale

Base Year- The year in which calculations, usually indexes, commence and with which other
years are compared.

Base Rate- The rate of interest on which financial institutions base their lending rates. It is
used to set all their other interest rates. Their loan rates will be a certain percentage above
the base rate, and their savings rates below. When they change their base rate, this will then
automatically change all their other rates.

Real rate of interest- The rate of interest adjusted for inflation

Nominal rate of interest- The annual return form lending money expressed as a percentage,
without having taken account of the rate of inflation.
Bank Multiplier- Shows by how much total liabilities can increase as a result of a rise in liquid
assets

Money Multiplier- Shows by how much total liabilities can increase as a result of a rise in liquid
assets

Credit Creation multiplier- Shows by how much total liabilities can increase as a result of a
rise in liquid assets

Credit Creation- The ability of the banking sector to create money by giving advances

Informal Sector- the sector of the economy, often comprising of small businesses and
individuals, which is unregistered with the tax authorities.

Backward sloping supply curve- A curve showing that as the price of a good or service rises, so
the quantity offered for sale falls. For example a worker may use an increase in wage rates to
work fewer hours and enjoy more leisure time.

Backward bending supply of Labor- In some circumstances it may be possible for the labor
supply curve to become backward-bending as people become less willing to work at higher
wage levels

Backward-bending Supply of Labour

Average Revenue Curve- A curve which plots average revenue. It is equivalent to the demand
curve. The shape of the average revenue curve will depend on the situation the firm is in. If
the firm has price setting power then the average revenue curve (demand curve) will be
downward-sloping. If the firm is a price-taker then the average revenue curve will be
horizontal and the same as the marginal revenue curve. Average revenue and marginal
revenue- Average revenue is the level of total revenue divided by output. Marginal revenue is
the revenue that the firm receives for the next unit of output. Revenue Curves for a Price
Setter- A price setter is a firm that is powerful enough to set the price that they will charge in
the market. They will therefore face a downward sloping demand curve for their product.

Revenue Curves for a Price Setter


Average Propensity to Consume- The proportion of disposable income spent: APC = C/Y. For
example, if a person spends £4,000 of a £10,000 income, then the APC is 0.4.

Average Propensity to save- The proportion of disposable income saved, APS = S/Y. For
example, if a person spends £4,000 of a £10,000 income, then they have saved £6,000. The APS
is therefore 0.6.

Marginal Propensity to save- The proportion of each extra pound of disposable income not
spent

Average Cost pricing- Setting price equal to average cost

Abnormal loss- An abnormal loss is where total revenue does not cover total cost. It is a
situation where a firm is making below normal profits. If abnormal losses persist in an industry
firms will tend to leave, prices will rise and normal profits will be restored.

Pure Monopoly- Only one producer who can therefore determine the market price on its own.

Monopolist- Loss- If the level of average cost is above the average revenue, then the firm will
make a loss (or below normal profit if normal profit is included in the cost curves).

Abnormal profits- Profits exceed the amount a firm must receive to carry on production. Also
known as supernormal profit. If abnormal profits persist in an industry this will tend to attract
new firms in, supply will increase, prices will fall and normal profits will be restored. If there
are barriers to entry then abnormal profits may persist in the long-run.

Monopolist- Supernormal profit- If the level of average revenue is above the average cost,
then the firm will make a supernormal profit.

Monopolist -Supernormal Profit

Absorption pricing- A means by which the fixed costs are shared between all the products that
are sold. The fixed costs are said to be absorbed into the price of the goods, as the price
charged reflects the variable costs of each item plus a share of the fixed costs

Arbitrage- Buying an asset in one market and simultaneously selling an identical asset in
another market at a higher price. Sometimes these will be identical assets in different
markets, for instance, shares in a company listed on both the London Stock Exchange and New
York Stock Exchange. Often the assets being arbitraged will be identical in a more complicated
way, for example, they will be different sorts of financial securities that are each exposed to
identical risks. Some kinds of arbitrage are completely risk-free—this is pure arbitrage. For
instance, if EUROS are available more cheaply in dollars in London than in New York,
arbitrageurs (also known as arbs) can make a risk-free PROFIT by buying euros in London and
selling an identical amount of them in New York. Opportunities for pure arbitrage have become
rare in recent years, partly because of the GLOBALISATION of FINANCIAL MARKETS. Today, a lot
of so called arbitrage, much of it done by hedge funds, involves assets that have some
similarities but are not identical. This is not pure arbitrage and can be far from risk free.

Arbitrage pricing theory- This is one of two influential economic theories of how assets are
priced in the financial markets. The other is the capital asset pricing model. The arbitrage
pricing theory says that the price of a financial asset reflects a few key risk factors, such as the
expected rate of interest, and how the price of the asset changes relative to the price of a
portfolio of assets. If the price of an asset happens to diverge from what the theory says it
should be, arbitrage by investors should bring it back into line.

Asian crisis- During 1997-98, many of the East Asian tiger economies suffered a severe financial
and economic crisis. This had big consequences for the global financial markets, which had
become increasingly exposed to the promise that Asia had seemed to offer. The crisis
destroyed wealth on a massive scale and sent absolute poverty shooting up. In the banking
system alone, corporate loans equivalent to around half of one year's GDP went bad - a
destruction of savings on a scale more usually associated with a full-scale war. The precise
cause of the crisis remains a matter of debate. Fingers have been pointed at the currency peg
adopted by some countries, and a reduction of capital controls in the years before the crisis.
Some blamed economic contagion. The crisis brought an end to a then widespread belief that
there was a distinct "Asian way" of capitalism that might prove just as successful as capitalism
in America or Europe. Instead, critics turned their fire on Asian cronyism, ill-disciplined
banking and lack of transparency. In the years following the crisis, most of the countries
involved have introduced reforms designed to increase transparency and improve the health of
the banking system, although some (such as South Korea) went much further than others (such
as Indonesia).

Monopolistic competition-Somewhere between PERFECT COMPETITION and MONOPOLY, also


known as imperfect competition. It describes many real-world markets. Perfectly competitive
markets are extremely rare, and few FIRMS enjoy a pure monopoly; OLIGOPOLY is more
common. In monopolistic competition, there are fewer firms than in a perfectly competitive
market and each can differentiate its products from the rest somewhat, perhaps by
ADVERTISING or through small differences in design. These small differences form BARRIERS TO
ENTRY. As a result, firms can earn some excess profits, although not as much as a pure
monopoly, without a new entrant being able to reduce PRICES through COMPETITION. Prices
are higher and OUTPUT lower than under perfect competition.

Trickle-down economics- an assumption that the benefits of economic growth will eventually
trickle-down to the poorest sectors of a society. History has shown that this does not actually
happen. Economic growth does not benefit all members of a society equally but rather
increases the wealth of the richest while increasing the poverty of the poorest.

Ceteris paribus- Other things being equal. Economists use this Latin phrase to cover their
backs. For example, they might say that “higher interest rates will lead to lower inflation,
ceteris paribus”, which means that they will stand by their prediction about INFLATION only if
nothing else changes apart from the rise in the INTEREST RATE.

Closed economy- An economy that does not take part in international trade; the opposite of
an OPEN ECONOMY. At the turn of the century about the only notable example left of a closed
economy is North Korea (see AUTARKY).

Competition- The more competition there is, the more likely are FIRMS to be efficient and
PRICES to be low. Economists have identified several different sorts of competition. PERFECT
COMPETITION is the most competitive market imaginable in which everybody is a price taker.
Firms earn only normal profits, the bare minimum PROFIT necessary to keep them in business.
If firms earn more than this (excess profits) other firms will enter the market and drive the
price level down until there are only normal profits to be made. Most markets exhibit some
form of imperfect or MONOPOLISTIC COMPETITION. There are fewer firms than in a perfectly
competitive market and each can to some degree create BARRIERS TO ENTRY. Thus firms can
earn some excess profits without a new entrant being able to compete to bring prices down.

The least competitive market is a MONOPOLY, dominated by a single firm that can earn
substantial excess profits by controlling either the amount of OUTPUT in the market or the
price (but not both). In this sense it is a price setter. When there are few firms in a market
(OLIGOPOLY) they have the opportunity to behave as a monopolist through some form of
collusion (see CARTEL). A market dominated by a single firm does not necessarily have
monopoly power if it is a CONTESTABLE MARKET. In such a market, a single firm can dominate
only if it produces as efficiently as possible and does not earn excess profits. If it becomes
inefficient or earns excess profits, another more efficient or less profitable firm will enter the
market and dominate it instead.
Contagion- The domino effect, such as when economic problems in one country spread to
another.

Deposit insurance- Protection for your SAVINGS, in case your BANK goes Bust. Arrangements
vary around the world, but in most countries deposit insurance is required by the GOVERNMENT
and paid for by banks (and, ultimately, their customers), which contribute a small slice of their
ASSETS to a central, usually government-run, insurance fund. If a bank defaults, this fund
guarantees its customers’ deposits, at least up to a certain amount. By reassuring banks’
customers that their cash is protected, deposit insurance aims to prevent them from panicking
and causing a bank run, and thereby reduces SYSTEMIC RISK. The United States introduced it in
1933, after a massive bank panic led to widespread BANKRUPTCY, deepening its DEPRESSION.

The downside of deposit insurance is that it creates a MORAL HAZARD. By insulating depositors
from defaults, deposit insurance reduces their incentive to monitor banks closely. Also banks
can take greater risks, safe in the knowledge that there is a state-financed safety net to catch
them if they fall. There are no easy solutions to this moral hazard. One approach is to monitor
what banks do very closely. This is easier said than done, not least because of the high cost.
Another is to ensure CAPITAL adequacy by requiring banks to set aside, just in case, specified
amounts of capital when they take on different amounts of RISK.

Alternatively, the state safety net could be shrunk, by splitting banks into two types: super-
safe, government-insured “narrow banks” that stick to traditional business and invest only in
secure assets; and uninsured institutions, “broad banks”, that could range more widely under a
much lighter regulatory system. Savers who invested in a broad bank would probably earn much
higher RETURNS because it could invest in riskier assets; but they would also lose their shirts if
it went bust.

Yet another possible answer is to require every bank to finance a small proportion of its assets
by selling subordinated DEBT to other institutions, with the stipulation that the YIELD on this
debt must not be more than so many (say 50) basis points higher than the rate on a
corresponding risk-free instrument. Subordinated debt (uninsured certificates of deposit) is
simply junior debt. Its holders are at the back of the queue for their MONEY if the bank gets
into trouble and they have no safety net. Investors will buy subordinated debt at a yield quite
close to the risk-free INTEREST RATE only if they are sure the bank is low risk. To sell its debt,
the bank will have to persuade informed investors of this. If it cannot convince them it cannot
operate. This exploits the fact that bankers know more about banking than do their
supervisors. It asks banks not to be good citizens but to look only to their profits. Unlike the
present regime, it exploits all the available INFORMATION and properly aligns everybody’s
incentives. This ingenious idea was first tried in Argentina, where it became a victim of the
country's economic, banking and political crisis of 2001-02 before it really had a chance to
prove itself.

Depression- A bad, depressingly prolonged RECESSION in economic activity. The textbook


definition of a recession is two consecutive quarters of declining OUTPUT. A slump is where
output falls by at least 10%; a depression is an even deeper and more prolonged slump.

The most famous example is the Great Depression of the 1930s. After growing strongly during
the “roaring 20s”, the American economy (among others) went into prolonged recession.
Output fell by 30%. UNEMPLOYMENT soared and stayed high: in 1939 the jobless rate was still
17% of the workforce. Roughly half of the 25,000 BANKS in the United States failed. An attempt
to stimulate growth, the New Deal, was the most far-reaching example of active FISCAL POLICY
then seen and greatly extended the role of the state in the American economy. However, the
depression only ended with the onset of preparations to enter the second world war.
Why did the Great Depression happen? It is not entirely clear, but forget the popular
explanation: that it all went wrong with the Wall Street stockmarket crash of October 1929;
that the slump persisted because policymakers just sat there; and that it took the New Deal to
put things right. As early as 1928 the Federal Reserve, worried about financial SPECULATION
and inflated STOCK PRICES, began raising interest rates. In the spring of 1929, industrial
production started to slow; the recession started in the summer, well before the stockmarket
lost half of its value between October 24th and mid-November. Coming on top of a recession
that had already begun, the crash set the scene for a severe contraction but not for the
decade-long slump that ensued.

So why did a bad downturn keep getting worse, year after year, not just in the United States
but also around the globe? In 1929 most of the world was on the GOLD STANDARD, which should
have helped stabilise the American economy. As DEMAND in the United States slowed its
IMPORTS fell, its BALANCE OF PAYMENTS moved further into surplus and gold should have
flowed into the country, expanding the MONEY SUPPLY and boosting the economy. But the Fed,
which was still worried about easy CREDIT and speculation, dampened the impact of this
adjustment mechanism, and instead the money supply got tighter. Governments everywhere,
hit by falling demand, tried to reduce imports through TARIFFS, causing international trade to
collapse. Then American banks started to fail, and the Fed let them. As the crisis of confidence
spread more banks failed, and as people rushed to turn bank deposits into cash the money
supply collapsed.

Bad MONETARY POLICY was abetted by bad fiscal policy. Taxes were raised in 1932 to help
balance the budget and restore confidence. The New Deal brought DEPOSIT INSURANCE and
boosted GOVERNMENT spending, but it also piled taxes on business and sought to prevent
excessive COMPETITION. Price controls were brought in, along with other anti-business
regulations. None of this stopped – and indeed may well have contributed to – the economy
falling into recession again in 1937–38, after a brief recovery starting in 1935.

Deregulation- Cutting red tape. The process of removing legal or quasi-legal restrictions on the
amount of COMPETITION, the sorts of business done, or the PRICES charged within a particular
industry. During the last two decades of the 20th century, many governments committed to the
free market pursued policies of LIBERALISATION based on substantial amounts of deregulation
hand-in-hand with the PRIVATISATION of industries owned by the state. The aim was to
decrease the role of GOVERNMENT in the economy and to increase competition. Even so, red
tape is alive and well. In the United States, with some 60 federal agencies issuing more than
1,800 rules a year, in 1998 the Code of Federal Regulations was more than 130,000 pages thick.
However, not all REGULATION is necessarily bad. According to estimates by the American
Office of Management and Budget, the annual cost of these rules was $289 billion, but the
annual benefits were $298 billion.

Devaluation- A sudden fall in the value of a currency against other currencies. Strictly,
devaluation refers only to sharp falls in a currency within a fixed EXCHANGE RATE system. Also
it usually refers to a deliberate act of GOVERNMENT policy, although in recent years reluctant
devaluers have blamed financial SPECULATION. Most studies of devaluation suggest that its
beneficial effects on COMPETITIVENESS are only temporary; over time they are eroded by
higher PRICES (see J-CURVE).

Diminishing returns- The more you have, the smaller is the extra benefit you get from having
even more; also known as diseconomies of scale (see ECONOMIES OF SCALE). For instance,
when workers have a lot of CAPITAL giving them a little more may not increase their
PRODUCTIVITY anywhere near as much as would giving the same amount to workers who
currently have little or no capital. This underpins the CATCH-UP EFFECT, whereby there is
(supposedly) convergence between the rates of GROWTH of DEVELOPING COUNTRIES and
developed ones. In the NEW ECONOMY, some economists argue, capital may not suffer from
diminishing returns, or at least the amount of diminishing will be much smaller. There may
even be ever increasing returns.

Mergers and acquisitions- When two businesses join together, either by merging or by one
company taking over the other. There are three sorts of mergers between FIRMS: HORIZONTAL
INTEGRATION, in which two similar firms tie the knot; VERTICAL INTEGRATION, in which two
firms at different stages in the SUPPLY chain get together; and DIVERSIFICATION, when two
companies with nothing in common jump into bed. These can be a voluntary marriage of
equals; a voluntary takeover of one firm by another; or a hostile takeover, in which the
management of the target firm resists the advances of the buyer but is eventually forced to
accept a deal by its current owners. For reasons that are not at all clear, merger activity
generally happens in waves. One possible explanation is that when SHARE PRICES are low, many
firms have a MARKET CAPITALISATION that is low relative to the value of their ASSETS. This
makes them attractive to buyers (see TOBIN). In theory, the different sorts of mergers have
different sorts of potential benefits. However, the damning lesson of merger waves stretching
back over the past 50 years is that, with one big ex ception – the spate of LEVERAGED BUY-
OUTS in the United States during the 1980s – they have often failed to deliver benefits that
justify the costs.

Leveraged buy-out- Buying a company using borrowed MONEY to pay most of the purchase
PRICE. The DEBT is secured against the ASSETS of the company being acquired. The INTEREST
will be paid out of the company’s future cashflow. Leveraged buy-outs (LBOs) became popular
in the United States during the 1980s, as public DEBT markets grew rapidly and opened up to
borrowers that would not previously have been able to raise loans worth millions of dollars to
pursue what was often an unwilling target. Although some LBOs ended up with the borrower
going bust, in most cases the need to meet demanding interest bills drove the new managers to
run the firm more efficiently than their predecessors. For this reason, some economists see
LBOs as a way of tackling AGENCY COSTS associated with corporate governance.

Modern portfolio theory- One of the most important and influential economic theories about
finance and INVESTMENT. Modern portfolio theory is based upon the simple idea that
DIVERSIFICATION can produce the same TOTAL RETURNS for less RISK. Combining many
financial ASSETS in a portfolio is less risky than putting all your investment eggs in one basket.
The theory has four basic premises-
• Investors are RISK AVERSE.
• SECURITIES are traded in efficient markets.
• Risk should be analyzed in terms of an investor’s overall portfolio, rather than by looking at
individual assets.
• For every level of risk, there is an optimal portfolio of assets that will have the highest
EXPECTED RETURNS.

Money illusion- When people are misled by INFLATION into thinking that they are getting
richer, when in fact the value of MONEY is declining. Whether, and how much, people are
fooled by inflation is much debated by economists. Money illusion, a phrase coined by KEYNES,
is used by some economists to argue that a small amount of inflation may not be a bad thing
and could even be beneficial, helping to “grease the wheels” of the economy. Because of
money illusion, workers like to see their nominal WAGES rise, giving them the illusion that their
circumstances are improving, even though in real (inflation-adjusted) terms they may be no
better off. During periods of high inflation double-digit pay rises (as well as, say, big increases
in the value of their homes) can make people feel richer even if they are not really better off.
When inflation is low, GROWTH in real incomes may hardly register.
Treasury bills- A form of short-term GOVERNMENT DEBT. Treasury bills usually mature after
three months. They are used for managing fluctuations in the government’s short-run cash
needs. Most government borrowing takes the form of longer-term BONDS.

Econometrics- Mathematics and sophisticated computing applied to ECONOMICS.


Econometricians crunch data in search of economic relationships that have STATISTICAL
SIGNIFICANCE. Sometimes this is done to test a theory; at other times the computers churn the
numbers until they come up with an interesting result. Some economists are fierce critics of
theory-free econometrics.

Economic indicator- A statistic used for judging the health of an economy, such as GDP per
head, the rate of UNEMPLOYMENT or the rate of INFLATION. Such statistics are often subject to
huge revisions in the months and years after they are first published, thus causing difficulties
and embarrassment for the economic policymakers who rely on them

Elasticity- A measure of the responsiveness of one variable to changes in another. Economists


have identified four main types.

• Price Elasticity measures how much the quantity of SUPPLY of a good, or DEMAND for it,
changes if its PRICE changes. If the percentage change in quantity is more than the percentage
change in price, the good is price elastic; if it is less, the good is INELASTIC.

• Income Elasticity of demand measures how the quantity demanded changes when income
increases.

• Cross-elasticity shows how the demand for one good (say, coffee) changes when the price of
another good (say, tea) changes. If they are SUBSTITUTE GOODS (tea and coffee) the cross-
elasticity will be positive: an increase in the price of tea will increase demand for coffee. If
they are COMPLEMENTARY GOODS (tea and teapots) the cross-elasticity will be negative. If
they are unrelated (tea and oil) the cross-elasticity will be zero.

• Elasticity of substitution describes how easily one input in the production process, such as
LABOUR, can be substituted for another, such as machinery

Engel's law- People generally spend a smaller share of their BUDGET on food as their INCOME
rises. Ernst Engel, a Russian statistician, first made this observation in 1857. The reason is that
food is a necessity, which poor people have to buy. As people get richer they can afford better-
quality food, so their food spending may increase, but they can also afford LUXURIES beyond
the budgets of poor people. Hence the share of food in total spending falls as incomes grow.

Enron- Until late 2001, Enron, an energy company turned financial powerhouse based in
Houston, Texas, had been one of the most admired firms in the United States and the world. It
was praised for everything from pioneering energy trading via the internet to its innovative
corporate culture and its system of employment evaluation by peer review, which resulted in
those that were not rated by their peers being fired. However, revelations of accounting fraud
by the firm led to its bankruptcy, prompting what was widely described as a crisis of
confidence in American capitalism. This, as well as further scandals involving accounting fraud
(WorldCom) and other dubious practices (many by Wall Street firms), resulted in efforts to
reform corporate governance, the legal liability of company bosses, accounting, Wall Street
research and regulation.

Federal reserve system- America's central bank. Set up in 1913, and popularly known as the
Fed, the system divides the United States into 12 Federal Reserve districts, each with its own
regional Federal Reserve bank. These are overseen by the Federal Reserve Board, consisting of
seven governors based in Washington, DC. monetary policy is decided by its Federal Open
Market Committee.

Financial system- The firms and institutions that together make it possible for money to make
the world go round. This includes financial markets, securities exchanges, banks, pension
funds, mutual funds, insurers, national regulators, such as the Securities and Exchange
Commission (SEC) in the United States, central banks, governments and multinational
institutions, such as the imf and world bank.

Foreign direct investment- Investing directly in production in another country, either by


buying a company there or establishing new operations of an existing business. This is done
mostly by companies as opposed to financial institutions, which prefer indirect investment
abroad such as buying small parcels of a country's supply of shares or bonds. Foreign direct
investment (FDI) grew rapidly during the 1990s before slowing a bit, along with the global
economy, in the early years of the 21st century. Most of this investment went from one oecd
country to another, but the share going to developing countries, especially in Asia, increased
steadily.

There was a time when economists considered FDI as a substitute for trade. Building factories
in foreign countries was one way of jumping tariff barriers. Now economists typically regard
FDI and trade as complementary. For example, a firm can use a factory in one country to
supply neighboring markets. Some investments, especially in services industries, are essential
prerequisites for selling to foreigners. Who would buy a Big Mac in London if it had to be sent
from New York? Governments used to be highly suspicious of FDI, often regarding it as
corporate imperialism. Nowadays they are more likely to court it. They hope that investors will
create jobs, and bring expertise and technology that will be passed on to local firms and
workers, helping to sharpen up their whole economy. Furthermore, unlike financial investors,
multinationals generally invest directly in plant and equipment. Mergers and Acquisitions are a
significant form of FDI. For instance, in 1997, more than 90% of FDI into the United States took
the form of mergers rather than of setting up new subsidiaries and opening factories.

Giffen goods- Named after Robert Giffen (1837-1910), a good for which demand increases as its
price rises. But such goods may not exist in the real world.

Gilts- Shorthand for gilt-edged securities, meaning a safe bet, at least as far as receiving
interest and avoiding default goes. The price of gilts can vary considerably over time, however,
creating a degree of risk for investors. Usually the term is applied only to government bonds.

Gini coefficient- An inequality indicator. The Gini coefficient measures the inequality of
income distribution within a country. It varies from zero, which indicates perfect equality, with
every household earning exactly the same, to one, which implies absolute inequality, with a
single household earning a country's entire income. Latin America is the world's most unequal
region, with a Gini coefficient of around 0.5; in rich countries the figure is closer to 0.3.

Hawala- An ancient system of moving money based on trust. It predates western bank
practices. Although it is now more associated with the Middle East, a version of hawala existed
in China in the second half of the Tang dynasty (618-907), known as fei qian, or flying money.
In hawala, no money moves physically between locations; nowadays it is transferred by means
of a telephone call or fax between dealers in different countries. No legal contracts are
involved, and recipients are given only a code number or simple token, such as a low-value
banknote torn in half, to prove that money is due. Over time, transactions in opposite
directions cancel each other out, so physical movement is minimised. Trust is the only capital
that the dealers have. With it, the users of hawala have a worldwide money-transmission
service that is cheap, fast and free of bureaucracy.

From a government's point of view, however, informal money networks are threatening, since
they lie outside official channels that are regulated and taxed. They fear they are used by
criminals, including terrorists. Although this is probably true, by far the main users of hawala
networks are overseas workers, who do not trust official money transfer methods or cannot
afford them, remitting earnings to their families.

Hedge- Reducing your risks. Hedging involves deliberately taking on a new RISK that offsets an
existing one, such as your exposure to an adverse change in an EXCHANGE RATE, INTEREST
RATE or COMMODITY PRICE. Imagine, for example, that you are British and you are to be paid
$1m in three months’ time. You are worried that the dollar may have fallen in value by then,
thus reducing the number of pounds you will be able to convert the $1m into. You can hedge
away that currency risk by buying $1m of pounds at the current exchange rate (in effect) in the
futures market. Hedging is most often done by commodity producers and traders, financial
institutions and, increasingly, by non-financial FIRMS.

It used to be fashionable for firms to hedge by following a policy of DIVERSIFICATION. More


recently, firms have hedged using financial instruments and DERIVATIVES. Another popular
strategy is to use “natural” hedges wherever possible. For example, if a company is setting up
a factory in a particular country, it might finance it by borrowing in the currency of that
country. An extension of this idea is operational hedging, for example, relocating production
facilities to get a better match of costs in a given currency to revenue.

Hedging sounds prudent, but some economists reckon that firms should not do it because it
reduces their value to shareholders. In the 1950s, two economists, Merton Miller (1923–2000)
and Franco Modigliani, argued that firms make MONEY only if they make good investments, the
kind that increase their operating cashflow. Whether these investments are financed through
DEBT, EQUITY or retained earnings is irrelevant. Different methods of financing simply
determine how a firm’s value is divided between its various sorts of investors (for example,
shareholders or bondholders), not the value itself. This surprising insight helped win each of
them a Nobel prize. If they are right, there are big implications for hedging. If methods of
financing and the character of financial risks do not matter, managing them is pointless. It
cannot add to the firm’s value; on the contrary, as hedging does not come free, doing it might
actually lower that value. Moreover, argued Messrs Miller and Modigliani, if investors want to
avoid the financial risks attached to holding SHARES in a firm, they can diversify their portfolio
of shareholdings. Firms need not manage their financial risks; investors can do it for
themselves. Few managers agree.

Hedge funds- These bogey-men of the FINANCIAL MARKETS are often blamed, usually unfairly,
when things go wrong. There is no simple definition of a hedge fund (few of them actually
HEDGE). But they all aim to maximize their absolute returns rather than relative ones; that is,
they concentrate on making as much MONEY as possible, not (like many mutual funds) simply
on outperforming an index. Although they are often accused of disrupting financial markets by
their SPECULATION, their willingness to bet against the herd of other investors may push
security prices closer to their true fundamental values, not away.
Hypothecation

Earmarking taxes for a specific purpose. It may be a clever way to get around public hostility to
paying more in TAXATION. If people are told that a specific share of their INCOME TAX will go
to some popular cause, say education or health, they may be more willing to cough up. At the
very least they may be forced to make more informed decisions about the trade-offs between
taxes and public SERVICES. There is a downside, however. Hypothecated taxes may tie the
hands of a GOVERNMENT at times when the hypothecated revenue could be spent to better
effect elsewhere in the public sector. Conversely, and perhaps more likely, hypothecated taxes
may prove to be less hypothecated than the public is led to believe. Civil servants, doubtless
under pressure from their political bosses, can usually find ways to fudge the definition of the
specific purpose for which a tax is hypothecated, letting government regain control over how
the MONEY is spent.

IMF- Short for International Monetary Fund, referee and, when the need arises, rescuer of the
world’s FINANCIAL SYSTEM. The IMF was set up in 1944 at BRETTON WOODS, along with the
WORLD BANK, to supervise the newly established fixed EXCHANGE RATE system. After this fell
apart in 1971–73, the IMF became more involved with its member countries’ economic policies,
doling out advice on FISCAL POLICY and MONETARY POLICY as well as microeconomic changes
such as PRIVATISATION, of which it became a forceful advocate. In the 1980s, it played a
leading part in sorting out the problems of DEVELOPING COUNTRIES’ mounting DEBT. More
recently, it has several times coordinated and helped to finance assistance to countries with a
currency crisis.

The Fund has been criticized for the CONDITIONALITY of its support, which is usually given only
if the recipient country promises to implement IMF-approved economic reforms. Unfortunately,
the IMF has often approved “one size fits all” policies that, not much later, turned out to be
inappropriate. It has also been accused of creating MORAL HAZARD, in effect encouraging
governments (and FIRMS, BANKS and other investors) to behave recklessly by giving them
reason to expect that if things go badly the IMF will organize a bail-out. Indeed, some
financiers have described an INVESTMENT in a financially shaky country as a “moral-hazard
play” because they were so confident that the IMF would ensure the safety of their MONEY,
one way or another. Following the economic crisis in Asia during the late 1990s, and again after
the crisis in Argentina early in this decade, some policymakers argued (to no avail) for the IMF
to be abolished, as the absence of its safety net would encourage more prudent behaviour all
round. More sympathetic folk argued that the IMF should evolve into a global LENDER OF LAST
RESORT.

Income effect- A change in the DEMAND for a good or service caused by a change in the
INCOME of consumers rather than, say, a change in consumer tastes. Contrast with
SUBSTITUTION EFFECT.

Institutional investors- The big hitters of the FINANCIAL MARKETS: pension funds, fund-
management companies, INSURANCE companies, investment BANKS, HEDGE FUNDS, charitable
endowment trusts. In the United States, around half of publicly traded SHARES are owned by
institutions and half by individual investors. In the UK, institutions own over two-thirds of listed
shares. This gives them considerable clout, including the ability to move the PRICES in financial
markets and to call company bosses to account. But because institutions mostly invest other
people’s MONEY, they are themselves prone to AGENCY COSTS, sometimes acting against the
best long-term interests of the people who trust them with their SAVINGS.
Invisible trade

EXPORTS and IMPORTS of things you cannot touch or see: SERVICES, such as banking or
advertising and other intangibles, such as copyrights. Invisible trade accounts for a growing
slice of the value of world trade.

Leveraged buy-out- Buying a company using borrowed MONEY to pay most of the purchase
PRICE. The DEBT is secured against the ASSETS of the company being acquired. The INTEREST
will be paid out of the company’s future cashflow. Leveraged buy-outs (LBOs) became popular
in the United States during the 1980s, as public DEBT markets grew rapidly and opened up to
borrowers that would not previously have been able to raise loans worth millions of dollars to
pursue what was often an unwilling target. Although some LBOs ended up with the borrower
going bust, in most cases the need to meet demanding interest bills drove the new managers to
run the firm more efficiently than their predecessors. For this reason, some economists see
LBOs as a way of tackling AGENCY COSTS associated with corporate governance.

Transfer pricing- The PRICES assumed, for the purposes of calculating tax liability, to have
been charged by one unit of a multinational company when selling to another (foreign) unit of
the same firm. FIRMS spend a fortune on advisers to help them set their transfer prices so that
they minimise their total tax bill. For instance, by charging low transfer prices from a unit
based in a high-tax country that is selling to a unit in a low-tax country, a firm can record a low
PROFIT in the first country and a high profit in the second. In theory, however, transfer prices
are supposed to be set according to the arm’s-length principle: that they should be the same as
would be charged if the sale was to a business unconnected in any way to the selling firm. But
when there is no genuinely independent market with which to compare transfer prices, what
an arm’s length price would be can be a matter of great debate and an opportunity for firms
that want to lower their tax bill.

Overheating- When an economy is growing too fast and its productive CAPACITY cannot keep
up with DEMAND. It often boils over into INFLATION.

Positional goods- Some things are bought for their intrinsic usefulness, for instance, a hammer
or a washing machine. Positional goods are bought because of what they say about the person
who buys them. They are a way for a person to establish or signal their status relative to
people who do not own them: fast cars, holidays in the most fashionable resorts, clothes from
trendy designers. By necessity, the quantity of these goods is somewhat fixed, because to
increase SUPPLY too much would mean that they were no longer positional. What would owning
a Rolls-Royce say about you if everybody owned one? Fears that the rise of positional goods
would limit GROWTH, since by definition they had to be in scarce supply, have so far proved
misplaced. Entrepreneurs have come up with ever more ingenious ways for people to buy
status, thus helping developed economies to keep growing.

Purchasing power parity- A method for calculating the correct value of a currency, which may
differ from its current market value. It is helpful when comparing living standards in different
countries, as it indicates the appropriate EXCHANGE RATE to use when expressing incomes and
PRICES in different countries in a common currency. By correct value, economists mean the
exchange rate that would bring DEMAND and SUPPLY of a currency into EQUILIBRIUM over the
long-term. The current market rate is only a short-run equilibrium. Purchasing power parity
(PPP) says that goods and SERVICES should cost the same in all countries when measured in a
common currency.

PPP is the exchange rate that equates the price of a basket of identical traded goods and
services in two countries. PPP is often very different from the current market exchange rate.
Some economists argue that once the exchange rate is pushed away from its PPP, trade and
financial flows in and out of a country can move into DISEQUILIBRIUM, resulting in potentially
substantial trade and current account deficits or surpluses. Because it is not just traded goods
that are affected, some economists argue that PPP is too narrow a measure for judging a
currency’s true value. They prefer the fundamental equilibrium exchange rate (FEER), which is
the rate consistent with a country achieving an overall balance with the outside world,
including both traded goods and services and CAPITAL flows. (See BIG MAC INDEX.)

Quantity theory of money- The foundation stone of MONETARISM. The theory says that the
quantity of MONEY available in an economy determines the value of money. Increases in the
MONEY SUPPLY are the main cause of INFLATION. This is why Milton FRIEDMAN claimed that
“inflation is always and everywhere a monetary phenomenon”.
The theory is built on the Fisher equation, MV = PT, named after Irving Fisher (1867–1947). M is
the stock of money, V is the VELOCITY OF CIRCULATION, P is the average PRICE level and T is
the number of transactions in the economy. The equation says, simply and obviously, that the
quantity of money spent equals the quantity of money used. The quantity theory, in its purest
form, assumes that V and T are both constant, at least in the short-run. Thus any change in M
leads directly to a change in P. In other words, increase the money supply and you simply cause
inflation.

In the 1930s, KEYNES challenged this theory, which was orthodoxy until then. Increases in the
money supply seemed to lead to a fall in the velocity of circulation and to increases in real
INCOME, contradicting the classical dichotomy (see MONETARY NEUTRALITY). Later,
monetarists such as Friedman conceded that V could changein response to variations in M, but
did so only in stable, predictable ways that did not challenge the thrust of the theory. Even so,
monetarist policies did not perform well when they were applied in many countries during the
1980s, as even Friedman has since conceded.

Random walk- Impossible to predict the next step. EFFICIENT MARKET THEORY says that the
PRICES of many financial ASSETS, such as SHARES, follow a random walk. In other words, there
is no way of knowing whether the next change in the price will be up or down, or by how much
it will rise or fall. The reason is that in an efficient market, all the INFORMATION that would
allow an investor to predict the next price move is already reflected in the current price. This
belief has led some economists to argue that investors cannot consistently outperform the
market. But some economists argue that asset prices are predictable (they follow a non-
random walk) and that markets are not efficient.

Rate of return- A way to measure economic success, albeit one that can be manipulated quite
easily. It is calculated by expressing the economic gain (usually PROFIT) as a percentage of the
CAPITAL used to produce it. Deciding what number to use for profit is rarely simple. Likewise,
totaling up how much capital was used can be tricky, especially if it is expanded to include
INTANGIBLE ASSETS and HUMAN CAPITAL. When FIRMS are evaluating a project to decide
whether to go ahead with it, they estimate the project’s expected rate of return and compare
it with their COST OF CAPITAL. (See NET PRESENT VALUE and DISCOUNT RATE.)

Rate of return regulation- An approach to REGULATION often used for a PUBLIC UTILITY to
stop it exploiting MONOPOLY power. A public utility is forbidden to earn above a certain RATE
OF RETURN decided by the regulator. In practice, this often encourages the utility to be
inefficient, slow to innovate and quick to spend money on such things as big offices and
executive jets, to keep down its PROFIT and thus the rate of return. Contrast with PRICE
REGULATION.

Ratings- A guide to the risk attached to the FINANCIAL INSTRUMENT provided by a ratings
agency, such as Moody’s, Standard and Poor’s and Fitch IBCA. These measures of CREDIT
quality are mostly offered on marketable GOVERNMENT and corporate DEBT. A triple-A or A++
rating represents a low risk of DEFAULT; a C or D rating an extreme risk of, or actual, default.
Debt PRICES and YIELDS often (but not always) reflect these ratings. A triple-A BOND has a low
yield. High-yielding bonds, also known as junk bonds, usually have a rating that suggests a high
risk of default. A series of financial market crises from the mid-1990s onwards led to growing
debate about the reliability of ratings, and whether they were slow to give warning of
impending trouble. After the Enron debacle, which again the ratings agencies had failed to
predict, some critics argued that the big three agencies had formed a cozy oligopoly and that
encouraging more competition was the way to improve ratings.

Real options theory- A recent theory of how to take INVESTMENT decisions when the future is
uncertain, which draws parallels between the real economy and the use and valuation of
financial options. It is becoming increasingly fashionable at business schools and even in the
boardroom. Traditional investment theory says that when a firm evaluates a proposed project,
it should calculate the project’s NET PRESENT VALUE (NPV) and if it is positive, go ahead.

Real options theory assumes that FIRMS also have some choice in when to invest. In other
words, the project is like an option: there is an opportunity, but not an obligation, to go ahead
with it. As with financial options, the interesting question is when to exercise the option:
certainly not when it is out of the money (the cost of investing exceeds the benefit). Financial
options should not necessarily be exercised as soon as they are in the money (the benefit from
exercising exceeds the cost). It may be better to wait until it is deep in the money (the benefit
is far above the cost). Likewise, companies should not necessarily invest as soon as a project
has a positive NPV. It may pay to wait.

Most firms’ investment opportunities have embedded in them many managerial options. For
instance, consider an oil company whose bosses think they have discovered an oil field, but
they are uncertain about how much oil it contains and what the PRICE of oil will be once they
start to pump. Option one: to buy or lease the land and explore? Option two: if they find oil, to
start to pump? Whether to exercise these options will depend on the oil price and what it is
likely to do in future. Because oil prices are highly volatile, it might not make sense to go
ahead with production until the oil price is far above the price at which traditional investment
theory would say that the NPV is positive and give the investment the green light.

Options on real ASSETS behave rather like financial options (a SHARE option, say). The
similarities are such that they can, at least in theory, be valued according to the same
methodology. In the case of the oil company, for instance, the cost of LAND corresponds to the
down-payment on a call (right to buy) option, and the extra investment needed to start
production to its strike price (the money that must be paid if the option is exercised). As with
financial options, the longer the option lasts before it expires and the more volatile is the price
of the underlying asset (in this case, oil) the more the option is worth. This is the theory. In
practice, pricing financial options is often tricky, and valuing real options is harder still.

Regression analysis- Number-crunching to discover the relationship between different


economic variables. The findings of this statistical technique should always be taken with a
pinch of salt. How big a pinch can vary considerably and is indicated by the degree of
STATISTICAL SIGNIFICANCE and R SQUARED. The relationship between a dependent variable
(GDP, say) and a set of explanatory variables (DEMAND, INTEREST rates, CAPITAL,
UNEMPLOYMENT, and so on) is expressed as a regression equation.

Regressive tax- A tax that takes a smaller proportion of INCOME as the taxpayer’s income
rises, for example, a fixed-rate vehicle tax that eats up a much larger slice of a poor person’s
income than a rich person’s income. This goes against the principle of VERTICAL EQUITY, which
many people think should be at the heart of any fair tax system.

Shadow price- The true economic PRICE of an activity: the OPPORTUNITY COST. Shadow prices
can be calculated for those goods and SERVICES that do not have a market price, perhaps
because they are set by GOVERNMENT. Shadow pricing is often used in COST-BENEFIT ANALYSIS,
where the whole purpose of the analysis is to capture all the variables involved in a decision,
not merely those for which market prices exist.

Sharpe ratio- A rough guide to whether the rewards from an INVESTMENT justify the RISK,
invented by Bill Sharpe, a winner of the NOBEL PRIZE FOR ECONOMICS and co-creator of the
CAPITAL ASSET PRICING MODEL. You simply divide the past RETURN on the investment (less the
RISK-FREE RATE) by its STANDARD DEVIATION, the simplest measure of risk. The higher the
Sharpe ratio is the better, that is, the greater is the return per unit of risk. However, as it is a
backward-looking measure, based on what an investment has done in the past, the Sharpe ratio
does not guarantee similar performance in future.

Soft loan- A loan provided at below the market INTEREST RATE. Soft loans are used by
international agencies to encourage economic activity in DEVELOPING COUNTRIES and to
support non-commercial activities.

Spot price- The PRICE quoted for a transaction that is to be made on the spot, that is, paid for
now for delivery now. Contrast spot markets with FORWARD CONTRACTS and futures markets,
where payment and/or delivery will be made at some future date. Also contrast with long-term
contracts, in which a price is agreed for repeated transactions over an extended time period
and which may not involve immediate payment in full.

Sticky prices- Petrol-pump PRICES do not change every time the oil price changes, and holiday
prices and standard hotel rates are fixed for months. Sticky prices are slow to change in
response to changes in SUPPLY or DEMAND. As a result there is, at least temporarily,
DISEQUILIBRIUM in the market. The causes of stickiness include MENU COSTS, inadequate
information, consumers’ dislike of frequent price changes and long-term contracts with fixed
prices. Prices change only when the cost of leaving them unchanged exceeds the expense of
adjusting them. In FINANCIAL MARKETS, prices move all the time because the cost of quoting
the wrong price can be huge. In other industries, the penalty may be much less severe. Small
disequilibria in, say, the pricing of hotel rooms will not make much difference. So hotel prices
are often sticky.

Systematic risk- The RISK that remains after DIVERSIFICATION, also known as market risk or
undiversifiable risk. It is systematic risk that determines the RETURN earned on a well-
diversified portfolio of ASSETS.

Systemic risk- The RISK of damage being done to the health of the FINANCIAL SYSTEM as a
whole. A constant concern of BANK regulators is that the collapse of a single bank could bring
down the entire financial system. This is why regulators often organize a rescue when a bank
gets into financial difficulties. However, the expectation of such a rescue may create a MORAL
HAZARD, encouraging banks to behave in ways that increase systemic risk. Another concern of
regulators is that the RISK MANAGEMENT methods used by banks are so similar that they may
increase systemic risk by creating a tendency for crowd behavior. In particular, problems in
one market may cause banks in general to liquidate positions in other markets, causing a
vicious cycle of LIQUIDITY being withdrawn from the financial system as everybody rushes for
the emergency exit at once. (See CAPITAL ASSET PRICING MODEL.)

Wage drift-The difference between basic pay and total earnings. Wage drift consists of things
such as overtime payments, bonuses, PROFIT share and performance-related pay. It usually
increases during periods of strong GROWTH and declines during an economic downturn

X-efficiency- Producing OUTPUT at the minimum possible cost. This is not enough to ensure
the best sort of economic EFFICIENCY, which maximizes society’s total CONSUMER plus
PRODUCER SURPLUS, because the quantity of output produced may not be ideal. For instance,
a MONOPOLY can be an X-efficient producer, but in order to maximize its PROFIT it may
produce a different quantity of output than there would be in a surplus-maximizing market
with PERFECT COMPETITION.
-end-
Instructions: This handout comprises a compilation of certain basic marketing concepts and
terms. This is only a representation and students are requested not to limit their learning to this
handout only.

Branding -- is a promise, a pledge of quality. It is the essence of a product, including why it is


great, and how it is better than all competing products. It is an image. It is a combination of
words and letters, symbols, and colors.

Brand - A name, term, sign, symbol, or a combination of these used to identify the products of
one seller or group of sellers and differentiate them from those of competitors.

Brand image - The total of all the impressions the consumer receives from the brand. These
include actual experience, hearsay from other consumers, its packaging, its name, the kind of
store in which it is sold, advertising, the tone and form of advertising, the media used for
advertising, and the types of people seen using, buying or recommending the brand.

Brand loyalty - The degree of consumer preference for one brand compared to close
substitutes; it is often measured statistically in consumer marketing research.
Brand Licensing- A popular branding strategy, brand licensing is an agreement in which a
company permits another organization to use its brand on other products for a license fee.
Royalties maybe as low as 2 per cent of wholesale revenues or higher than 10 per cent. Mattel,
for example, licensed Warner Bros Harry Potter brand for use on board games and toys. Warner
guaranteed royalties of $20 million from Mattel’s licensing fee of 15 percent of gross revenues
earned in these branded products.

Marketing -- the process of planning and executing the conception, pricing, promotion, and
distribution of ideas, goods, services, and people to create exchanges that will satisfy
individual and organizational goals. Marketing activities should attempt to create and maintain
satisfying relationships exchange relationships. To maintain an exchange relationship, buyers
must be satisfied with the obtained good, service, or idea and sellers must be satisfied with the
financial reward or something else of value received. A dissatisfied customer who lacks trust in
the relationship often searches instead for alternative organizations or products.

Marketing management- Is the process of planning, organizing, implementing and controlling


marketing activities to facilitate exchanges effectively and efficiently. Effectiveness is the
degree to which an exchange helps achieve an organization’s objectives. Efficiency refers to
minimizing the resources an organization must spend to achieve a specific level of desired
exchanges.

Market- a market could be a specific location or a geographic location, it is a group of people


who as individuals or as organizations have needs for products in a product class and have the
ability, willingness, and authority to purchase such products. In general use, the term market
sometimes refers to the total population or mass market that buys products. There are two
types of markets- Consumer markets and Business Markets.

Consumer markets- Purchasers and household members who intend to consume or benefit
from the purchased products and do not buy to make profits.

Business markets- Individuals or groups that purchase a specific kind of product for resale,
direct use in producing other products, or use in general daily operations.

Personal Selling- Paid personal communication that informs customers and persuades them to
buy products in an exchange situation.

Elements of Personal selling process- The specific activities involved in the selling process
vary among salespeople and selling situations. No two salespeople use the same selling
methods. Nonetheless, many salespeople move through a general selling process as they sell
the products. This process consists of seven steps- prospecting, pre approach, approach,
making the presentation, overcoming objections, closing the sale and following up.

4 P's vs. 4 C's

• Not PRODUCT, but CONSUMER- Understand what the consumer wants and needs.
Times have changed and you can no longer sell whatever you can make. The product
characteristics must now match what someone specifically wants to buy. And part of
what the consumer is buying is the personal "buying experience."
• Not PRICE, but COST- Understand the consumer's cost to satisfy the want or need. The
product price may be only one part of the consumer's cost structure. Often it's the cost
of time to drive somewhere, the cost of conscience of what you eat, and the cost of
guilt for not treating the kids.
• Not PLACE, but CONVENIENCE- As above, turn the standard logic around. Think
convenience of the buying experience and then relate that to a delivery mechanism.
Consider all possible definitions of "convenience" as it relates to satisfying the
consumer's wants and needs. Convenience may include aspects of the physical or
virtual location, access ease, transaction service time and hours of availability.
• Not PROMOTION, but COMMUNICATION- Communicate, communicate, communicate.
Many mediums working together to present a unified message with a feedback
mechanism to make the communication two-way. And be sure to include an
understanding of non-traditional mediums, such as word of mouth and how it can
influence your position in the consumer's mind. How many ways can a customer hear
(or see) the same message through the course of the day, each message reinforcing the
earlier images?

Micromarketing- An approach to market segmentation in which organizations focus precise


marketing efforts on very small geographic markets.

Geodemographic segmentation- Marketing segmentation that clusters people in zip code


areas and smaller neighborhood units based on lifestyle and demographic information.

Market density- the number of potential customers within a unit of land area.

Psychographic variables- Marketers sometimes use psychographic variables such as personality


characteristics, motives and lifestyles to segment markets. A psychographic dimension can be
used by itself to segment a market or combined with other types of segmentation variables.

Cooperative advertising- Sharing media costs by manufacturer and retailer for advertising the
manufacturer’s products.

Dealer Loader- A gift, often part of the display, offered to a retailer who purchases a specific
quantity of the merchandise

Premium push money- Extra compensation to sales people for pushing a line of goods.

AIDA model of communication: A communication model which aims to obtain Attention,


Interest, Desire and Action.

Advertising objective: The objective of your communication strategy. To inform of a new


development, persuade or remind.

Benefit: The gain obtained from the use of a particular product or service. Consumers
purchase product/services because of their desire to gain these built in benefits.

Benefit Segmentation: Dividing a market according to the benefit they seek from a
particular product/service.

Brand extension strategy: The process of using an existing brand name to extend on to a new
product/service e.g. The application of the brand name Virgin on a number of business
activities.

Competitive Advantage: Offering a different benefit then that of your competitors.

Competitor Analysis: Process of understanding and analysing a competitors strengths and


weaknesses, with the aim that an organisation will find a competitive positioning difference
within the market.
Concept testing: Testing the idea of a new product or service with your target audience.

Brand repositioning: An attempt to change consumer perceptions of a particular brand. For


example VW has successfully repositioned the Skoda brand.

Data mining: Application of artificial intelligence to solve marketing problems and aiding
forecasting and prediction of marketing data.

Dichotomous question: Questions which limit the responses of the respondent eg YES/NO.

Direct marketing: The process of sending promotion material to a named person within an
organisation.

Diversification: A growth strategy which involves an organisation to provide new products or


services. The new products on offer could be related or unrelated to the organisations core
activities.

Demography: A study of the population.

Demographic segmentation. Dividing the population into age, gender, income and socio-
economic groups amongst other variables..

Engels Law: Suggest that peoples spending patterns change as their income rises.

Exclusive distribution: Limiting the distribution of a product to particular retail store to create
an exclusive feel to the brand/product.

Econometric modeling: Application of regression techniques in marketing analysis

Focus Group: A simultaneous interview conducted amongst 6-8 respondents. The aim is to
obtain qualitative information on the given topic.

Geographic segmentation: Dividing the market into certain geographic regions e.g. towns,
cities or neighborhoods.

Innovator: Those consumers who are the first to adopt a product/service at the beginning of
its lifecycle. They are usually willing to pay a premium to have the benefit of being the first.

Intensive distribution: Distributing a product to as many retail outlets as possible.

Laggards: Those consumers who adopt the product/service as it reaches the end of its
lifecycle. They usually pay a competitive price for the benefit of waiting.

Lifestyle segmentation: Analyzing consumers activities, interest and opinion (AIOs) to develop
a profile on the given segment.

Market Development Strategy: Selling an existing product/service in a new and developing


market.

Mass marketing: The promotion of a product or service to all consumers.


Marketing Planning: A written document which plans the marketing activities of an
organization for a given period. The document should include an environmental analysis,
marketing mix strategies and any contingency plans should an organization not reach their
given objectives.

Market position: The perception of a product or an organization from the view of the
consumer.

Market research: Analyzing and collecting data on the environment, customers and
competitors for purposes of business decision making.

Modified Rebuy: Where an organization has to make changes to a specific buying situation.

New buy: Where an organization faces the task of purchasing a new product/service.

Niche marketing: The process of concentrating your resources and efforts on one particular
segment

Objective to task method: Setting a advertising budget based on the desired goals of the
communication campaign.

Open ended questions: Questions which encourage the respondent to provide their own
answers.

Paretos Law (80/20) : A rule which suggests that 80% of an organizations turnovers is
generated from 20% of their customers.

Perceptual map: Mapping a product/organization alongside all competitors in the hope to find
a ' positioning gap' in the given market.

Primary data: The process of organizing and collecting data for an organization.

Product Development Strategy: The development of a new product/service aimed at the


organization existing market. The aim is to increase expenditure within the segment.

Product Cannibalization: Loosing sales of a product to another similar product within the
same product line.

Public relations: The process of building good relations with the organizations various
stakeholders.

Relationship marketing: Creating a long-term relationship with existing customers. The aim is
to build strong consumer loyalty.

Sales promotion: An incentive to encourage the sale of a product/service e.g. money off
coupons, buy one, get one free.

Secondary data: Researching information which has already been published.


Segmentation: The process of dividing a market into groups that display similar behavior and
characteristics.

Straight Rebuy: Where an organization reorders without modification to the specification.

SWOT analysis: A model used to conduct a self appraisal of an organization. The model looks
at internal strengths and weaknesses and external environmental opportunities and threats.

Test marketing: Testing a new product or service within a specific region before national
launch.

Usage segmentation: Dividing you segment into non, light, medium or heavy users.

Core Competencies-Things a firm does extremely well, which sometimes gives it an advantage
over its competition

Market opportunity-A combination of circumstances and timing that permits an organization to


take action to reach a target market

Competitive advantage-The result of a company’s matching a core competency to


opportunities in the market place. Types of competition-

Brand Competitors-Firms that market products with similar features and benefits to the same
customers at similar prices.

Product competitors-Firms that compete in the same product class but have products with
different features, benefits and prices

Generic competitors-Firms that provide very different products that solve the same problem
or satisfy the same basic customer need

Total budget competitors- Firms that compete for limited financial resources of the same
customers

Discretionary income- Disposable income available for spending and saving after an individual
has purchased the basic necessities of food, clothing and shelter

Sampling- the process of selecting representative units from a total population

Probability sampling- A sampling technique in which every element in the population being
studied has a known chance of being selected for study

Random sampling – A type of probability sampling in which all units in a population have an
equal chance of appearing in the sample

Stratified sampling- A type of probability sampling in which the population is divided in sub
groups according to a common attribute and a random sample is then chosen within each
group.

Data mining technique- refers to discovery of patterns hidden in databases that have the
potential to contribute to marketers understanding of customers and their needs
Strategic Window-A temporary period of optimal fit between the key requirements of a market
and a firm’s capabilities

Customer Relationship Management- using information about customers to create marketing


strategies that develop and sustain desirable customer relationships.

Customer Value-Value is important element of managing long term customer relationships and
implementing the marketing concept. A value is a customer’s subjective assessment of benefits
relative to costs in determining the worth of the product.

Mission statement- A long term view of what the organization wants to become

Corporate strategy- A strategy that determines the means for utilizing resources in the various
functional areas to reach organization’s goals. A corporate strategy determines not only the
scope of business but also its resource deployment, competitive advantages and overall
coordination of functional areas.

BCG matrix- Boston Consulting Group approach is based on the market growth / market share
matrix and is based of the philosophy that a product’s market growth rate and its markets
hare are important considerations in determining its marketing strategy. All the firms SBUs and
products should be integrated into a single, overall matrix and evaluated to determine overall
portfolio strategies. The matrix enables the strategic planner to classify a firm’s products into
four basic types: stars, cash cows, dogs and question marks.

Stars are products with dominant share of the market and good prospects for growth. However,
they use more cash than they generate to finance growth, add capacity, and increase market
share. Example Apple’s Imac computer.

Cash Cows have a dominant share of the market but low prospects for growth typically they
generate more cash than is required to maintain market share. Bounty the best selling paper
towels in US are a cash cow for Procter & Gamble.

Dogs have a subordinate share of the market and low prospects for growth; these products are
often found in established markets. Example- Checkers a fast food chain that features twin
drive through lanes is experiencing declining profits and market share and may be considered a
dog relative to other fast food chains with different formats

Questions marks sometimes called “problem children” have a small share of the growing
market and generally require a large amount of cash to build market share. Mercedes mountain
bikes are a question mark relative to Mercedes’ automobile products. The long term health of
the organization depends on having some products that generate cash and provide acceptable
profits and others that use cash to support growth.

Intensive Growth- Growth occurs when current products and current markets have the
potential for increasing sales. Strategies for intensive growth are – Market penetration,
Product Development, Market Development

Diversified growth- Growth occurring when new products are developed to be sold in new
markets.

Michael Porter’s Five Forces Model- Michael Porter described a concept that has become
known as the "five forces model". This concept involves a relationship between competitors
within an industry, potential competitors, suppliers, buyers and alternative solutions to the
problem being addressed. We used the five-forces model as a basic structure and built on it
with concepts from the works of many other authors. The result was a model with over 5,000
relational links.

While each industry involves all of these factors, the relational strengths vary. This results in a
set of analyses, including:

• a success potential rating in eleven key areas


• a list of strategic strengths and weaknesses
• observations on strategic inconsistencies
• a written critique of your strategy
• a graphic analysis of key marketing concepts
• a written draft of a marketing plan

GATT- General Agreement on tariffs and trade (GATT)- An agreement among nations to
reduce worldwide tariffs and increase international trade. Originally signed by 23 nations in
1947, GATT provides a forum for tariff negotiations and a place where international trade
problems can be discussed and resolved. The General Agreement on Tariffs and Trade (typically
abbreviated GATT) was originally created by the Bretton Woods Conference as part of a larger
plan for economic recovery after World War II. The GATT's main purpose was to reduce barriers
to international trade. This was achieved through the reduction of tariff barriers, quantitative
restrictions and subsidies on trade through a series of different agreements. The GATT was an
agreement, not an organisation. Originally, the GATT was supposed to become a full
international organisation like the World Bank or IMF called the International Trade
Organisation. However, the agreement was not ratified, so the GATT remained simply an
agreement. The functions of the GATT have been replaced by the World Trade Organisation
which was established through the final round of negotiations in the early 1990s.

The history of the GATT can be divided into three phases: the first, from 1947 until the
Torquay round, largely concerned which commodities would be covered by the agreement and
freezing existing tariff levels. A second phase, encompassing three rounds, from 1959 to 1979,
focused on reducing tariffs. The third phase, consisting only of the Uruguay Round from 1986 to
1994, extended the agreement fully to new areas such as intellectual property, services,
capital, and agriculture. Out of this round the WTO was born. IMF describes itself as "an
organization of 184 countries, working to foster global monetary cooperation, secure financial
stability, facilitate international trade, promote high employment and sustainable economic
growth, and reduce poverty". With the exception of North Korea, Cuba, Liechtenstein, Andorra,
Monaco, Tuvalu and Nauru, all UN member states either participate directly in the IMF or are
represented by other member states.

Marketing Mix -- the blend of product, place, promotion, and pricing strategies designed to
produce satisfying exchanges with a target market.

Market Research -- the process of planning, collecting, and analyzing data relevant to
marketing decision-making. Using a combination of primary and secondary research tools to
better understand a situation.

Personal Selling -- persuasive communication between a representative of the company and


one or more prospective customers, designed to influence the person's or group's purchase
decision.

Place - the process of getting a product from the place it was manufactured into the hands of
consumers in the right location at the right time.

Positioning -- developing a specific marketing mix to influence potential customers’ overall


perceptions of a brand; to develop a specific image of the brand in the minds of consumers.

Price -- the money or other compensation or unit of value exchanged for the purchase or use of
a product, service, idea, or person.

Product -- a good, service, person, or idea consisting of a bundle of tangible and intangible
benefits that satisfies consumers’ needs and wants.

Promotion -- any type of persuasive communication between a marketer and one or more of its
stakeholder groups. Promotional tools include advertising, personal selling, publicity, and sales
promotion.

Strategic Marketing Planning -- the process of managerial and operational activities required
to create and sustain effective and efficient marketing strategies, including identifying and
evaluating opportunities, analyzing markets and selecting target markets, developing a
positioning strategy, preparing and executing the market plan, and controlling and evaluating
results.

Unique Selling Proposition (USP) -- the one thing that makes a product different than any
other. It's the one reason marketers think consumers will buy the product even though it may
seem no different from many others just like it.

Difference between Joint venture and Strategic Alliance- Joint venture is the partnership
between a domestic firm and a foreign firm or government. Joint ventures are especially
popular in industries that call for large investments. Control of the joint venture can be split
equally or one party may control decision making. These are gaining importance because with
the advent of globalization a number of inexperienced firms are entering the market and it
gives a cost advantage as well.

Strategic alliances – are partnerships formed to create competitive advantage on a worldwide


basis. Similar to joint ventures. What distinguishes strategic alliances from other business
structures is that the partners in the alliance may have traditional rivals competing for market
share in the same product class.

Ansoff Matrix- A common tool used within marketing was developed by Igor Ansoff in 1957. His
model gives organization five strategic business options. 1. Market Penetration: This involves
increasing sales of an existing product and penetrating the market further by either promoting
the product heavily or reducing prices to increase sales. 2. Product Development: The
organization develops new products to aim within their existing market, in the hope that they
will gain more custom and market share. For Example Sony launched the Play station 2 to
replace their existing model.3. Market Development: The organization here adopts a strategy
of selling existing products to new markets. This can be done either by a better understanding
of segmentation, i.e. who else can possibly purchase the product or selling the product to new
markets overseas. 4. Diversification: Moving away from what you are selling (your core
activities) to providing something new e.g. Moving over from selling foods to selling cars.5.
Consolidation: Where the organization adopts a strategy of withdrawing from particular
markets, scaling back on operations and concentrating on its existing products in existing
markets.

STP- Segmenting, Targeting and Positioning-


Segmenting- Segmenting a market helps a company target its products / solutions better to its
customers. It is a strategic approach midway between mass marketing and individual
marketing. Segmentation is based on the concept that customers in a specific segment
have similar needs, purchasing power, geographic location, etc. A market can be
segmented according to customer needs. For example, car manufacturers can segment
the car market into two broad segments: basic cars and luxury cars. They can have
separate product lines for each segment. For example, for the luxury car segment,
Toyota has the Lexus product line, Honda has Acura, and Nissan has Infiniti.

Targeting- is a process of prioritizing target segments based on the firm’s core competencies
or capabilities, and other researched factors including segmented market size, growth
potential of the segmented market, competitive dynamics, etc. Unless the target
segment is chosen based on considerable market research and careful planning, a
company’s product / solution will not be able to capture the intended market share in
the target segment. So, targeting is key, because businesses battle for market share in
these target segments.

Positioning-This involves developing a marketing mix for each targeted segment. One way to
think of a marketing mix is using the 4P’s framework. Another way to look at positioning is
articulating the value of the company’s products / solutions vis-à-vis customer needs,
competitive products, etc. Product data sheets, hot sheets, beat sheets, cheat sheets, white
papers help articulate this value tactically.

SWOT - Strengths, Weaknesses, Opportunities, Threats

Where as the strengths and weaknesses analyze the core competencies and capabilities of the
company in the context of the internal environment, the opportunities and threats are in the
context of the competitive landscape in the external marketplace. The above is a time-
honored framework to initiate any meaningful competitive analysis. It can be applied to a
company and also to its products and services.
Five C's- This is an elementary framework which can drive any strategic analysis. The five C's
stand for Company, Customers, Competition, Costs, and Channels. If one thinks through
the answers raised under each term, one can analyze a Company's business problems step
by step as a means to proposing solutions which will improve the Company's business:

• Company: What is the company size, i.e., is the company mid-sized (less than $500 M
in revenue) or larger? Is it public or private? What are its products / product lines /
services? What are its sustainable competitive advantages / core competencies? Who
are its key executives? Who are its board members?
• Customers: Are they consumers or businesses? What are their current / emerging
problems / needs? Does the company listen to its customers and solve their problems?
What is the bargaining power of these customers? Will they switch to the competition,
if the company increases its price? What are their preferences for company's product
quality / availability / reliability / performance? How can the company segment the
customer base to target its products at specific segments? If the customers are business
/ industrial houses, is it appropriate to segment them as mid-market and Fortune 500;
or does it make more sense to segment the market geographically? If these are
individual consumers, what are their demographic and psychographic patterns; what do
they crave that the company can't provide; what will they be buying over the next two
years; and what will the next generation of customers need from the company?

• Competition: Who are the biggest competitors and how much market share do they
hold in each market segment the company plays in? What are their strategic
advantages? Is it tight appropriability of their product lines to the market segment
requirements, is it complementary assets like better sales and marketing channels, or
is their speed of execution? Is any competitor gaining market share in any specific
market / market segment? Is the competitor public or private? Who are the key
executives of the competitor and what is their leadership / management style? What
are the competitor's core competencies?
• Costs: Which costs are fixed and which are variable? What is the basic split between
fixed and variable costs; are they likely to vary with volume; are they likely to vary
over time? How do the costs compare to the competitors' costs? How do these costs
compare to the industry? Is there any advantage to offshoring / outsourcing to reduce
costs?
• Channels: What are the company's distribution channels? Does it rely on a direct sales
force to deliver its products / services to customers, or does it rely on indirect sales /
channel partners? In the context of manufactured products, distributors / retailers can
have significant bargaining power if they are the dominant players in their channel
segment, e.g, Walmart. Internet is also emerging as a dominant distribution channel
with the advent of e-commerce, and examples of successful companies include
Amazon.com and Dell. Can sales and revenue grow, if the company crafts and executes
an effective Internet strategy? Also see double marginalization in our advanced
frameworks section.
Strategy, Systems, Structure, Staff, Skills, Style, Shared Values

Strategy, Systems, and Structure constitute the "hard" S's. The other four are "soft" S's. This
framework was developed by McKinsey consultants in the early 1970s, and is discussed in Tom
Peter's book "In Search of Excellence." Together, the hard and soft S's constitute a company's
competitive advantage. All these seven factors will be hard to duplicate by a competitor. So,
these key factors, if developed right, will work in synergy to create a superior company vis-a-
vis the competition.

Four P's-The four P's of marketing are Product, Price, Place, and Promotion. Together, they
constitute the classic "marketing mix." Sometimes, brand and service are additional mix
variables used in crafting a meaningful marketing strategy.

• Product: What are the company's core products / product lines / services? Are the
products and services tightly or loosely coupled and why? Does the company bundle its
products together? If the company is in the business of services as opposed to
manufacturing and distributing tangible products, the distributions channels for these
services will be different from those of the traditional manufacturing companies.
• Price: What is the demand elasticity of the product, or in other words, how sensitive
are the customers to price increases? Is the pricing cost based, or is it based on
economic fundamentals where marginal revenues equal marginal costs, or is it based
on the competitive pricing in the marketplace?
• Place: What are the distribution channels for the product (please refer to Channels
under the five C's framework)? Does the competition serve market segments which the
company can't reach?
• Promotion: What marketing campaigns does the company use to reach its customers?
How effective are these campaigns? Can the Internet be used more effectively to
improve these campaigns?

Product Life Cycle- Product Life Cycle (PLC) as a concept was first introduced into
management literature by Ted Levitt in 1965. Since then, the world has changed, and Geoffrey
Moore of Silicon Valley came up with a book called “Crossing the Chasm” where he introduced
the concept of a majority of new high-tech products falling into the chasm.

PLC divides the product lifecycle into four stages based on time: introductory, growth,
maturity, and decline. On the other hand, Moore’s chasm is based on a now well-accepted
concept called technology adoption which categorizes users of technology into four categories:
early adaptors, early majority, late majority, and laggard.
It can be argued that this chasm, if it exists, will not let the product move to the growth stage
from the introductory stage, in the classic PLC diagram below, because the product will fall
into the chasm between the early adaptors and the early majority.

So, the PLC framework, if used for new product introduction strategies, should be used in
conjunction with the concept of user adoption; this specially holds true for high-tech product
cases involving technology adoption. Nevertheless, the PLC mapping is a useful framework to
adopt for product cases in general, especially for established products, because as per the PLC
curve above, the products sales will grow during the growth stage, will keep growing into the
maturity stage, and then decline with time. Before the product sales and profits enter the
decline stage, or at the beginning of the maturity stage, the company can take measures to
extend the life cycle of the maturing product by introducing new products into the product
mix, by stretching the product line vertically and horizontally, by making the product
compatible with the latest technologies, etc.

For example, enterprise software companies with maturing ERP (Enterprise Resource Planning)
and CRM (Customer Relationship Management) software products, which were on-premise
(deployable at the client’s premises) are now extending the PLC of these solutions by
introducing new ERP and CRM product lines which are on-demand (web based, need not be
deployed at client sites, client can use the product on-demand through the Internet).

Double Marginalization-Double marginalization happens when there is market power at two


channel segments. This produces a double whammy effect of lower total channel profits,
and higher retail prices. For example, let’s take a simple channel with two segments:
manufacturer, and retailer. If both the retailer and manufacturer are monopolists, there is
market power in both the segments of the channel. This is a simple case of double
marginalization. which results in lower total channel profits, and higher retail prices.

In a simple example of double marginalization below, it is illustrated that if market power


exists in both the segments of a two layer channel, the end consumer pays a higher retail
price of $10.70 as opposed to $ 7.13 in case of no double marginalization (only the
manufacturer has market power, and not the retailer). Further, it is illustrated that in case of
double marginalization, the total channel profits of $ 6625.36 are lower compared to the
profits of $ 8838.76 in case of no double marginalization.

Game Theory- A firm's business decision is often affected by the moves made by its
competitors. In other words, if the firm believes that its competitors are rational and act to
maximize their own profits, the firm has to take this into account while making its own profit-
maximizing decisions. This is what gaming and strategic decision is all about, in a nut-shell. The
major strategies in Game Theory are as follows:

Nash Equilibrium-This is a set of strategies such that each player is doing the best it can given
the action of its competitors.

Dominant Strategy-This is a strategy that is optimal for a player regardless of what its
competitors do.

Maximum Strategy-This is a strategy that maximizes the minimum gains that can be earned.

Tit-for-Tat Strategy-This is a strategy where the firm attempts to reach a cooperative


outcome through sending appropriate signals, and punishes the competitor if the
competitor fails to cooperate.

GE Portfolio Matrix- This 3 x 3 matrix is an outgrowth of a framework pioneered by General


Electric (GE) in the 1970s to assess its Strategic Business Units (SBUs) along two dimensions:
industry attractiveness, and business strength. All business units of a firm can be represented
by circles placed appropriately within the matrix. The size of the circle represents the industry
/ market size. The market share of the SBU is represented by the smaller sector within the
circle. Thus, as you can see, this is a complex framework to evaluate an SBU along four
dimensions: market attractiveness, market size, market share, and business strength.

The strength of this framework is based on the premise that to be successful, a firm should
enter attractive markets / industries for which it has the needed business strengths to succeed.
However, over-reliance on this framework may lead to undue neglect of existing businesses.
SBU owners / managers will also be susceptible to manipulate the parameters so that their
SBUs show up on the desired high or medium-high overall attractive zones. Thus, this
framework should be used with caution while crafting strategy.

Base point pricing- Is a geographic pricing policy that includes the price at factory, plus freight
charges from the base point nearest the buyer

Transfer Pricing- Prices charged in sales between organization’s units. The price is determined
by one of the following methods-

Actual full cost- calculated by dividing all fixed and variable expenses for a period into the
number of units produced.

Standard Full Cost- calculated based on what it would cost to produce the goods at full plant
capacity.

Cost plus investment- calculated at full cost, plus the cost of a portion of the selling units
assets used for internal needs

Market based cost- calculated at the market price less a small discount to reflect the lack of
sales effort and other expenses

Cost plus pricing- Assigning a specified dollar amount or percentage to the seller’s cost

Mark up pricing- Assigning to the cost of the product a pre determined percentage of the cost .

Electronic commerce- Sharing business information, maintaining business relationships and


conducting business transactions by means of telecommunications network

URL-Uniform Resource Locator is nothing but the website address

Click through rate- The percentage of ads that website visitors actually click on.

Pop Up ads- Large ads that open in a separate web browser window on top of the website
viewed

Pop Under ads- Large ads that open in a new browser window underneath the currently viewed
site

Monopsony- A market dominated by a single buyer. A monopsonist has the MARKET POWER to
set the PRICE of whatever it is buying (from raw materials to LABOUR). Under PERFECT
COMPETITION, by contrast, no individual buyer is big enough to affect the market price of
anything.
Scrambled Merchandising- The addition of unrelated products and product lines to an existing
product mix, particularly fast moving items that can be sold in volume.

Wheel of retailing- A Hypothesis holding that new retailers usually enter the market as low
status, low margin, low price operators but eventually evolve into high cost, high price
merchants.

Push and Pull channel policies- Push policy- promoting a product only to the next institution
down the marketing channel. Pull Policy- promoting a product directly to consumers to develop
strong consumer demand that pulls products through the marketing channel.

Predatory Pricing- Charging low PRICES now so you can charge much higher prices later. The
predator charges so little that it may sustain losses over a period of time, in the hope that its
rivals will be driven out of business. Clearly, this strategy makes sense only if the predatory
firm is able eventually to establish a MONOPOLY. Some advocates of anti-DUMPING policies say
that cheap IMPORTS are examples of predatory pricing. In practice, the evidence gives little
support for this view. Indeed, in general, predatory pricing is quite rare. It is certainly much
less common in practice than it might appear from the propaganda of FIRMS that are under
pricing pressure from more efficient competitors.

Price Discrimination- When a firm charges different customers different PRICES for the same
product. For producers, the perfect world would be one in which they could charge each
customer a different price: the price that each customer would be willing to pay. This would
maximize PRODUCER SURPLUS. This cannot happen, not least because sellers do not know how
much any individual would pay. Yet some price discrimination is possible if an overall market
can be segmented into somewhat separate markets and the EQUILIBRIUM price in each of these
markets is different, perhaps because of differences in consumer tastes, perhaps because in
some segments the firm enjoys some MARKET POWER. But this will work only if the market
segments can be kept apart. If it is possible and profitable to buy the product in a low-price
segment and resell it in a high-price segment, then price discrimination will not last for long.

Buying power - The ability to buy in large quantities and thereby attract special price or
discount.

Captive Brands - Exclusive merchandise assortments where the brand mark is owned by
someone other than the company selling the merchandise and the design, product development
and sourcing is either completed in house or with an external partner.

Captive market - The potential clientele of retail or service businesses located in areas where
consumers may have no reasonable alternative sources of supply.

Price Skimming- Charging the highest possible price that buyers who most desire the
product will pay. This approach provides the most flexible introductory base price.
Demand tends to be inelastic in the introductory stage of its life cycle.

Penetration pricing- Setting prices below those of competing brands to penetrate a


market and gain significant market share quickly.

Product line pricing- Establishing and adjusting prices of multiple products within a
product line.

Captive pricing- Pricing the basic product in a product line low while pricing related
items at a higher level.
Premium pricing- Pricing the highest quality or most versatile products higher than
other models in the product line

Bait Pricing- Pricing an item in the product line low with the intention of selling a higher
priced item in the line

Price lining- Setting a limited number of prices for selected groups or lines of
merchandise

Psychological pricing- Pricing that attempts to influence a customer’s perception of


price to make a product’s price more attractive.

Reference pricing- Pricing a product at a moderate level and positioning it next to a


more expensive model or brand.

Bundle pricing- Packaging together two or more complementary products and selling
them for a single price.

Multiple unit pricing- packaging together two or more identical products and selling
them for a single price.

EDLP - Everyday Low Pricing. A pricing policy based on the lowest prices everyday rather than
sale markdowns.

Odd even pricing- Ending the price with certain numbers to influence buyer’s perceptions of
the price of a product. Odd prices are marked at Rs. 99.95 as against an even price of Rs. 100.
the Odd price gives the impression that the product is low priced and great for bargain hunters.
Even prices are often used to give a product an exclusive or upscale image.

Customary pricing- Pricing on the basis of tradition

Prestige pricing- Setting prices at an artificially high level to convey prestige or a quality
image.

Comparison discounting- Setting a price at a specific level and comparing it with a higher
price.

Market leader - The company, product or brand of product that has the largest sales to the
consumer in a particular market
Market share - How much of the total market a company, product or brand of product
attracts.

Promotional advertising - Advertising intended to inform prospective customers of special


sales, new products and seasonal goods and to maintain a market for the merchandise in
regular stock.

Eye Tracking – A research method that determines what part of an advertisement consumers
look at, by tracking the pattern of their eye movements.

Ethnographic Research- uses naturalistic observation to record systematically the behavior of


research subjects in their own settings. With its origins in anthropology, the focus is on cultural
aspects of behavior. Ethnographic techniques can include the disposable camera technique, the
mystery customer technique, the video and audio recording of everyday behavior where the
recording apparatus is made as less obtrusive as possible, and even such creative and non-
mainstream techniques as "garb logy" - the analysis of garbage left out for collection by
householders. More traditional techniques can include the observation of shoppers and the way
they browse stores, identifying problems shoppers may have with locating items, labeling,
queuing, and other aspects of the shopping experience that may be impossible to detect with
traditional survey and focus group techniques. It can also identify powerful linguistic elements
too, such as phrases used by consumers in their daily lives that many not be recalled naturally
in focus groups as they are less immediate. The strength of ethnographic research is in
reducing the sources of error associated with more artificial and secondary qualitative methods
such as focus groups. Focus Groups are typically carried out in custom built focus group
facilities, and in some cases, the placing of consumers in such foreign environments affects
their responses. They still often rely on participants recalling how they make decisions and
interpreting their own motives within a different social context.

Intercepts- The term "Intercepts" defines a broad range of short interviews, usually only a few
minutes in length which are carried out "in-situe" with consumers.

Street intercepts are common and involve approaching likely research interview prospects at a
certain time and place, asking a few qualification or screening questions, then asking for
permission to deliver a questionnaire in return for a small incentive. Intercepts are also
commonly carried out in or outside shopping malls, or retail outlets - indeed any venue where
large numbers of a target group are possible. Generally, despite the few short qualification
questions, the sample should be viewed as a "convenience sample", as generally sample
selection is less strict than other methods. However, intercept surveys have great advantages
in terms of expense, speed of data collection and collecting a good range of views.

Top Line Report- The top line report is usually part of a comprehensive research report,
summarizing the key findings in a short document for top management. Usually 2 or 3 pages,
the top line report is targeted specifically at senior management, using language they are
comfortable with and avoiding market research jargon. It is a key document as it will be far
more widely read, and at higher levels, than the full market research report. For readability,
the top line report is often provided in point format, and often clients request the top line in
Powerpoint format, so it can be easily merged into their own presentations to top
management. If analysis is a part of the brief, a key section of the topline report must address
implications, and be action oriented in nature. It should clearly relate the results back to the
original management or research questions, completing the loop from management questions
to research questions to results and back. In academic or other management areas, the topline
report can be viewed as similar (though not totally analogous) to an "executive summary".

Usabililty Testing- Research focused solely on assessing the usability of a product. Usability
criteria can include "ease of use", intended vs. extended or unintended use, intuitiveness,
usage patterns (e.g. high or frequent, seasonal, periodic), and clarity of product use
instructions. Usability can be most effectively and validly assessed by observational research
techniques, where consumers are observed using the product in natural settings, preferably
where the user is unaware of the fact that they are being observed. It can also be tested less
directly in more contrived settings such as focus groups, face to face interviews or
questionnaire surveys.

The results of Usability Testing can be used for product redesign, re-packaging, branding,
converting casual users to high users, enhancing product instructions or communications aimed
at modeling various examples of product-in-use.

Hypothesis-Is an informed guess or assumption about a certain problem or a set of


circumstances. It is based on the insight and knowledge available about the problem or
circumstances from previous research studies and other sources.
Prospecting-Is the process of identifying prospective buyers of the product. The prospects are
those who have a need or will to buy and the power to pay.

Different ways to identify a prospect-

Acquaintance references- A satisfied customer can be a good source of information about the
names, addresses and phone numbers of prospects who may be among acquaintances, relatives
or family members.

Cold Calling- Also called random prospecting. Identifies the customer segment to whom the
sales person may call upon without reference but with anticipation of converting the call into
sale.

Centre of Influence Method- salesmen obtain the reference from the eminent people in the
society. Using these references the prospects are influenced into taking a buying decision since
the recommendations of eminent personalities such as politicians, actors etc are taken
seriously.

Personal Observation method- Identifying prospects on several occasions like attending


seminars, social gatherings, functions, traveling etc..

Direct Mail method- A salesmen can contact prospective buyers through a telephone call,
direct mail, brochure informing them about new products, product modifications etc.

Company Records- The salesmen can refer to the company’s records and get in touch with
several old and new contacts

Newspapers- through advertisements

Retailers- take leads for new customers, their tastes and preferences

Other Methods- participating in trade fairs and exhibitions can generate sales leads.

Buying Formula Theory- This theory emphasizes on the needs or problems of the buyer. The
salesperson assists the buyer in finding an appropriate solution to the problem. This solution
could be in terms of a product or service.

Sales Budget Vs Sales Forecast-Sales Forecasting is the art that predicts the likelihood of
economic activity on the basis of certain assumptions. The process of making certain estimates
of future events is referred to as sales forecasting.

Sales Budget- is the final forecast of the sales to be achieved in a stipulated period. The sales
budget can be prepared on the basis of division, brand, products, dealers, territory and sales
force.

CAPI - Computer Assisted Personal Interviewing is conducted face-to-face, usually employing


laptop computers. The interviewer is prompted with the question by the computer and the
appropriate response codes are keyed in directly according to the respondent's answers.
Routing procedures use these codes to determine which question appears next. Since the data
is entered directly into the computer, analyses can be produced quickly.

Multivariate analysis -A range of analysis techniques which can examine quantitative data in
more depth than can usually be obtained from a basic cross-analysis of the data by, for
example, age, sex and social grade. The essence of this range of approaches is that the
information is analyzed in a way that permits patterns to emerge from within the data itself -
i.e. based on the responses of the informants - rather than being imposed in advance, perhaps
incorrectly or simplistically, by the researcher.
Mystery shopping - The collection of information from retail outlets, showrooms etc, by
people posing as ordinary members of the public.

Observation - A non-verbal means of obtaining primary data as an alternative or complement


to questioning.

Omnibus surveys - A survey covering a number of topics, usually for different clients. The
samples tend to be nationally representative and composed of types of people for which there
is a general demand. Clients are charged by the market research agency on the basis of the
questionnaire space or the number of questions required.

Semiotics - A form of social description and analysis which, used in research, puts particular
emphasis on an understanding and exploration of the cultural context in which the work is
taking place.
Advertising and other images (including overt and implied symbolism), language, societal
assumptions, media content and style, packaging design, etc, are evaluated since they provide
the cultural framework within which, for example, purchasing patterns develop and can be
influenced.

Qualitative research - A body of research techniques which seeks insights through loosely
structured, mainly verbal data rather than measurements. Analysis is interpretative,
subjective, impressionistic and diagnostic.

Quantitative research - Research which seeks to make measurements as distinct from


qualitative research.

Analysis of Covariance (ANCOVA) An analysis of variance procedure in which the effects of one
or more metric-scaled extraneous variables (covariates) are removed from the dependent
variable data before one conducts ANOVA.

Analysis of Variance (ANOVA) is a statistical technique for examining the differences among
means for two or more populations.

Association Technique is a form of projective technique where participants are presented with
some stimulus material and they are then asked to respond with the first thing that comes to
their minds.

Atomistic Test is a test that aims to assess participants’ reactions to individual elements of a
product or concept (in contrast to a holistic test that looks at a product or concept as a whole).

Attempt is when someone tries to contact a potential research participant, whether or not
anyone is actually reached and whether or not the contact results in the potential respondent
participating in some research.

Attitude is an individual’s learned predisposition to behave in a consistent manner towards an


object or idea. There are three components of attitude: (i) a cognitive component - knowledge
and beliefs (ii) an affective component - feelings and emotions (iii) a co native component -
behavior (usually measured in terms of likelihood to buy).

Attitude Research (aka Attitude Survey) is a research study to obtain information on how
people feel about certain products, ideas or companies.

Attitude Scaling is the development of measurement criteria used to measure individuals’


attitudes.
Attribute is a word or phrase to describe a qualitative characteristic of an idea or object under
consideration, example, gender is a attribute but age is a variable.

Attribute Analysis is a technique that is designed to develop lists of characteristics, uses or


benefits relevant to a particular product category.

Audimeter see people meter. Audit has two definitions in the context of Marketing Research.
A Store Audit is a method of determining the number of product units that have been sold by
counting physical units in stores and combining that with a knowledge of the number ordered
and stock levels. A second definition is a Project Audit that involves visiting a project site to
ensure all project specifications are being met and agreed procedures are being followed.

Average is a general term that is used to represent or summarize the relevant features of a set
of values. The arithmetic mean is often used as a measure of average, but the median and the
mode can also be used to summarize a set of values.

Average Issue Readership is the average number of people who read a particular publication.

Awareness is a measure of respondents’ knowledge of an object or an idea. There are two


main measures of awareness: spontaneous (or unaided) and prompted (or aided) awareness.

Marketing research techniques are-

Interviews-
-face to face
-telephone
-postal questionnaire

B. Attitude Measurement
cognitive component (know/ believe about an act or object)

- affective component (feel about an act / object)


- co native component (behave towards an object or act)
-
C. Likert scale
- strongly agree
- agree
- neither agree nor disagree
- disagree
- strongly disagree

D. Semantic Differential Scale- differences between words example practical or impractical

E. Projective Techniques-

- sentence completion
- psychodrama (yourself as a product)
- friendly Martian (what someone else might do)

F. Group Discussion and focus group


G. Postal research questionnaire
H. Diary panels- sources of continuous data
I. In home canning- hand held light pen to scan barcodes
J. Telephone research
K. Observation- home audit and direct observation
L. In store testing
Glossary of Economic Terms and Concepts

Absolute advantage - The ability to produce something with fewer resources than other
producers would use to produce the same thing
Alternatives - Options among which to make choices.

Balance of trade - The part of a nation's balance of payments that deals with merchandise (or
visible) imports or exports.
Bank, commercial - A financial institution accepts checking deposits, holds savings, sells
traveler's checks and performs other financial services.
Barter - The direct trading of goods and services without the use of money.
Benefit - The gain received from voluntary exchange.
Bond - A certificate reflecting a firm's promise to pay the holder a periodic interest payment until
the date of maturity and a fixed sum of money on the designated maturity date.
Business (firm) - Private profit-seeking organizations that use resources to produce goods and
services.

Capital - All buildings, equipment and human skills used to produce goods and services.
Capital resources - Goods made by people and used to produce other goods and services.
Examples include buildings, equipment, and machinery.
Change in demand - see Demand decrease and Demand increase.
Change in supply - see Supply decrease and Supply increase.
Choice - What someone must make when faced with two or more alternative uses of a resource
(also called economic choice).
Circular flow of goods and services (or Circular flow of economic activity) - A model of an
economy showing the interactions between households and business firms as they exchange goods
and services and resources in markets.
Collateral - Anything of value that is acceptable to a lender to guarantee repayment of a loan.
Command economy - A mode of economic organization in which the key economic functions--
what, how, and for whom--are principally determined by government directive. Sometimes called
a "centrally planned economy."
Comparative advantage - The principle of comparative advantage states that a country will
specialize in the production of goods in which it has a lower opportunity cost than other countries.
Competition - The effort of two or more parties acting independently to secure the business of a
third party by offering the most favorable terms.
Complements - Products that are used with one another such as hamburger and hamburger buns
Consumers - People whose wants are satisfied by consuming a good or a service.
Consumption - In macroeconomics, the total spending, by individuals or a nation, on consumer
goods during a given period. Strictly speaking, consumption should apply only to those goods
totally used, enjoyed, or "eaten up" within that period. In practice, consumption expenditures
include all consumer goods bought, many of which last well beyond the period in question --e.g.,
furniture, clothing, and automobiles.