I’ve done some searching online, but so far failed to find any glossary of frequently used macro-finance term. So I started to put together my own. In my experience, a good way to memorize concepts is to write them down in my own words; as I revisit my glossary, I edit definitions, correct my previous misconceptions, and try to condens the text. It’s not only a good way to retain the meaning of the terms, but also a chance to practice my writing and reading skills. Enjoy! 🙂
Abnormal returns — Difference between an asset’s return and its expected return. A coarse estimate is to take the realized return of the asset and subtract the return of a benchmark index such as the S&P 500. More sophisticated is to use the method of MacKinley, 1997 (Event Studies in Economics and Finance).
Bankruptcy — “a legal finding that imposes court supervision over the financial affairs of those who are insolvent or in default.”
Capital — The interpretation of capital depends on the context. In macro, it usually refers to some good that together with labor is used to produce output (e.g., capital can include tractors, computers, and houses). These goods can be refered to as capital assets. However, in finance, just capital often means the amount of financial assets held (e.g., cash, bonds, liquid stocks) or investments raised. It may be expanded to include a company’s capital assets.
Capital Asset Pricing Model — the CAPM. The model can be derived from several representative agent models, and boils down to that the expected return of an asset is
where is the risk-free rate, is asset ‘s “beta”, and is the expected return of the market.
The coefficient reflects how the asset correlates with the overall market and how much risk it adds to the portfolio. If is positive, the asset has a higher expected return when the overall market’s expected return increases. Assets with negative react in the opposite direction of markets; in a recession when markets are falling, negative- assets increase in value because they are expected to yield higher returns.
You can read more about the CAPM at https://www.investopedia.com/terms/c/capm.asp or https://en.wikipedia.org/wiki/Capital_asset_pricing_model.
Capital requirement — A set of rules of financial regulators how much capital a bank should hold relative to their risky assets. E.g., in Basel III banks have to hold 6% worth of Tier 1 capital in relation to risk-weighted assets.
Carry trade — this trade starts with borrowing at a low-interest rate to invest in an asset with a higher return. Often, the loan is denominated in a different currency than the asset. This adds risk to the investment.
Certificate of deposit (CD) — bank and credit unions issue certificates of deposits to raise funds. A depositor leaves money with the bank for a pre-determined time at a higher deposit rate they would receive in a checking account. Terms vary and often allow the depositor to do a limited number of withdrawals or at a fixed cost.
When a bigger investor in the money market “deposits” money in a bank, we say that they buy a certificate of deposit.
Chapter 7 bankruptcy (US) — A firm that files for Chapter 7 will be liquidated under the rules of Chapter 7 of Title 11.
Chapter 11 bankruptcy protection (US) — If a business is unable to service its outstanding credit (and risk bankruptcy), they can file for file for protection to a federal bankruptcy court. This allows for a business to continue operations and owners to remain in control. The process will either end in a reorganization, a conversion to Chapter 7 bankruptcy (liquidation), or a dismissal by the court. See https://en.wikipedia.org/wiki/Chapter_11,_Title_11,_United_States_Code#Chapter_11_overview.
Corporate paper — Refers often to short-term bonds issued by firms to finance short-term liabilities such as payroll, accounts payable and inventories.
Debt restructuring — An agent (a company, country, or individual) that holds debt they cannot repay given foreseeable future cash flows can enter debt restructuring. They renegotiate the delinquent debt, creditors remit some, and the agent continues some form of operations (at some reduced level).
Default — a debtor has passed the payment deadline on a debt they were due to pay.
“[…] for example when a home buyer fails to make a mortgage payment, or when a corporation or government fails to pay a bond which has reached maturity. A national or sovereign default is the failure or refusal of a government to repay its national debt. The biggest private default in history is Lehman Brothers with over $600 billion when it filed for bankruptcy in 2008 and the biggest sovereign default is Greece with $138 billion in March 2012.”
Delinquent — commonly refers to a situation where a borrower is late or overdue on a payment, such as income taxes, a mortgage, an automobile loan, or a credit card bill.
Equity fund — (Or, stock fund.) An equity fund is a mutual fund that invests mainly in stocks. It can be actively or passively (index fund) managed.
Equity premium puzzle — the puzzle is the inability of standard economic models to predict a high enough premium for investors to hold diversified portfolios of stocks. Or put in other words: given the volatility in the data, investors with “reasonable” risk aversion want the return on stocks to be 1 percentage unit higher than the risk-free rate, but in the data the return is 6 percentage units higher. This indicates that risk aversion should be higher, which leads to other puzzles.
Excess return — The difference in return earned by an asset and the risk-free rate.
Financial accelerator — a mechanism of macroeconomics that exacerbates shocks through frictions in financial markets. E.g., if a firm usually borrows using its current net worth as collateral, a shock that lowers its value decreases the firm’s ability to raise credit to invest with. This further depresses its net worth, which in return depresses it even further; the mechanism is an acceleration.
Reference: Bernanke, Gertler, and Gilchrist (1996).
Forward price — A contracted price of a specific future transaction.
Fractional reserve banking — a banking system that allows banks to only hold a fraction of deposits as cash. E.g., before March 2021, the common requirement was to hold 10% of deposits as cash. The remaining 90% could be lent. In April 2021, the Federal Reserve reduced the requirement to zero percent.
Haircut — A measure of how much discount a creditor does on the collateral value for a loan. Often used in repo markets. An example: a borrower wants to make an overnight loan, using a 1-year T-bill currently traded at $100 as collateral. The bank (creditor) says they will accept it as collateral worth $80. The haircut is then 20%.
High-yield bond — a bond with a lower credit grade than an investment-grade bond. The yield is therefore higher. Also known as junk bond, or non-investment bond.
Illiquidity — a debtor has insufficient cash (or other “liquefiable” assets) to pay his or her debts.
“A liquidity issue occurs when a firm has a temporary cash-flow problem. Its assets are greater than its debts, but some assets are illiquid. Therefore, although in theory assets are greater than debts, it can’t meet its current payment requirements.”
Insolvency — A solvency crisis occurs when a country/firm/household has debts that it can’t service by selling its assets. I.e. even if it could sell all its wealth, it would still be unable to pay what they owe their debtors.
Investment-grade bond — This is a safer bond, with a rating Baa (by Moody’s) or BBB (by S&P and Fitch) or above. Also known as a high-grade bond. Yields are lower because so is the risk of default.
IPO — Abbrev.: Initial public offering.
Kaldor’s v — see Tobin’s Q.
Leaning against the wind — (Or, leaning into the wind.) The term refers to a countercyclical monetary policy where central banks take action to dampen rising inflation or to slow down growth even when the economy is declining.
From LEO Svensson: “Leaning against the wind’ (LAW), that is, tighter monetary policy for financial-stability purposes, has costs in terms of a weaker economy with higher unemployment and lower inflation and possible benefits from a lower probability or magnitude of a (financial) crisis.”
Money market — A decentralized market of banks, credit unions (who sell CD’s), companies (who issue short-term corporate bonds), the government (who issues short-term treasuries) and investors such as money market funds and insurance companies that exchange short-term liabilities for money. The duration of securities are often less than 1 year. A big share of the money market consists of interbank lending, that banks lend each other reserves in exchange for, for example, repos.
Also MBS’s and ABS’s are sold in the money market.
Money market fund — They invest in short-term debt securities such as US Treasury bills and commercial paper. Money market funds provide liquidity to other financial intermediaries by taking on their short-term securities in exchange for reserves/money.
Mutual fund — A mutual fund pools money from many investors and invest it in a mix of stocks, bonds, and other financial instruments. Returns less a management fee are kept by the original investors.
Open market operations (OMOs) — To achieve the Fed funds target, the SOMA at the New York Federal Reserve Bank buys or sells government securities of short maturity until the overnight lending rate between banks is within a target range.
OMOs also contain repurchasing agreements (see Repo rate). The main point is to influence the amount of money in the banking system, making money scarcer if the Fed wants to increase rates, or adding more if they want to decrease.
You can find more details at the New York Fed’s webpage.
Operation Twist — Mainstream media name for e.g. the Maturity extension program (MEP) of 2011, when the Fed announced to sell short-term government bonds to finance the purchases of long-term bonds to flatten the yield curve. This “twisting” of the yield curve does not expand the balance sheet of the Fed, unlike quantitative easing (since the purchases are financed by selling short-term bonds and not fountain pen money). Operation Twist was coined in 1961 when the Fed took similar action.
Price-to-earnings ratio (PE ratio or P/E ratio) — It is the ratio . The numerator is given by the currently traded stock price, while the denominator is either an average of previous earnings, or it is an estimate for future earnings.
Quantitative easing (QE) — QE is when the Fed buys large numbers of bonds (government, municipal, corporate, MBS) to drive down interest rates. A difference to usual open market operations is that QE aims at driving down long rates in other markets than the overnight market.
q ratio — see Tobin’s Q.
Refinancing — is the process of replacing a current loan with a new. The new loan is used to pay off the existing debt; total debt stays the same, but usually at a lower rate or conditions that better suit the debtor.
Repo rate — Short for repurchase agreement rate. A repurchasing agreement (“repo”) is a contract that states the following: A dealer sells a government security for a price . The investor commits to sell the security back at some other price after a (pre-agreed) short period. Often the security is bought back after one night (over-night repo), but there are also week-long and month-long repos.
The repo rate is then the return on the purchasing agreement, which for the investor is the annualized rate of
Retail funding — When a bank funds investment by demand deposits, usually from households, they are conducting retail funding.
Risk premium — a risk premium is a compensation/discount on an asset. The price of an asset is usually its expected payoff, but because of risk aversion, investors require some compensation if to hold a riskier asset. This lowers the price of the asset and the difference between expected payoff and actual price due to risk aversion is the risk premium. The risk premium can be divided into several sources of risk, e.g., inflation risk or default risk.
Sharpe ratio — the average return of an asset subtracted the risk-free rate, divided by its standard deviation.
An ex-ante Sharpe ratio uses expected return and predicted volatility, while the ex-post (or historic) Sharpe ratio takes realized return and estimated volatility over the period. http://web.stanford.edu/~wfsharpe/art/sr/sr.htm and https://en.wikipedia.org/wiki/Sharpe_ratio
Shiller P/E or CAPE — Cyclically adjusted price-to-earnings ratio “is defined as price divided by the average of ten years of earnings, adjusted for inflation.”
Spot price — Current market price of an immediate transaction; e.g., selling a bond here and now – on the spot – for a price . Then, is the spot price.
T-bill — U.S. treasury bond of maturity less than (but including) one year. They pay no coupons.
T-bond — U.S. treasury bond issued at maturities 20 and 30 years. Pays a coupon every six months (semi-annually).
T-note — U.S. treasury bond of medium duration. Issued at maturities 2, 3, 5, 7, and 10 years. Pays semiannual coupons.
Term structure of interest rates — another name for the yield curve. See below.
Tier 1 capital — Defined in the Basel accords. Consists of core capital which is disclosed reserves and the original value of the bank’s equity, plus accumulated net profits. The bank equity is thus not the current price on an exchange.
Tobin’s Q — also known as Kaldor’s v or q ratio. It is the ratio of market value to the replacement value of a company/asset. “One, the numerator, is the market valuation: the going price in the market for exchanging existing assets. The other, the denominator, is the replacement or reproduction cost: the price in the market for newly produced commodities. We believe that this ratio has considerable macroeconomic significance and usefulness, as the nexus between financial markets and markets for goods and services.” (page 1–2, Asset Markets and the Cost of Capital, Brainard & Tobin, 1976.)
Wholesale funding — In contrast to retail funding, wholesale funding is sourced from big investors in the money market. These are usually local governments, insurance companies, and other institutional investors.
Yield curve — it plots the annualized yield of treasury securities of different maturities along the horizontal axis. Since there is an always-present risk of inflation and the incertitude regarding it increases in duration, usually the yield curve is upward sloping (i.e., it carries a risk premium that is higher the more exposed to inflation risk it is). It is also possible to plot yield curves for other than treasury bonds. Those will also reflect default risk (as will yield curves of sovereign bonds that are not risk free).