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Finance & Economics Terms

Absolute Advantage
This is the simplest yardstick of economic performance. If one person, firm or country can produce more of something with the same amount of effort and resources, they have an absolute advantage over other producers. Being the best at something does not mean that doing that thing is the best way to use your scarce economic resources. The question of what to specialize in, and how to maximize the benefits from international trade--is best decided according to comparative advantage. Both absolute and comparative advantage may change significantly over time. Economist Investopedia

Comparative Advantage
A situation in which a country, individual, company or region can produce a good at a lower opportunity cost than a competitor. Economist Investopedia

Opportunity Cost
The true cost of something is what you give up to get it. This includes not only the money spent in buying (or doing) the something, but also the economic benefits (utility) that you did without because you bought (or did) that particular something and thus can no longer buy (or do) something else. Economist Investopedia

Diminishing Marginal Utility

Underlying most economic theory is the assumption that people do things because doing so gives them utility. People want as much utility as they can get. However, the more they have, the less difference an additional unit of utility will make there is diminishing marginal utility. OR A law of economics stating that as a person increases consumption of a product - while keeping consumption of other products constant - there is a decline in the marginal utility that person derives from consuming each additional unit of that product. Economist Investopedia

Capital Structure
A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.

Finance & Economics Terms

Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure. Economist Investopedia

Cost of Capital
The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. OR The amount a firm must pay the owners of capital for the privilege of using it. This includes interest payments on corporate debt, as well as the dividends generated for shareholders. In deciding whether to proceed with a project, firms should calculate whether the project is likely to generate sufficient revenue to cover all the costs incurred, including the cost of capital. Economist Investopedia

Debt Financing
When a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid. Investopedia

Cost of Debt
The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; however, because interest expense is deductible, the after-tax cost is seen most often. This is one part of the company's capital structure, which also includes the cost of equity. After tax cost of debt = cost of debt before tax (1 tax rate) Investopedia

Bonds
A bond is an interest-bearing security issued by governments, companies and some other organizations. Bonds are an alternative way for the issuer to raise capital to selling shares or taking out a bank loan. Economist Investopedia

Finance & Economics Terms

Common Equity
A security that represents ownership in a corporation. Holders of common stock exercise control by electing a board of directors and voting on corporate policy. Common stockholders are on the bottom of the priority ladder for ownership structure. In the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debtholders have been paid in full. Investopedia

Preferred Equity
A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights. The precise details as to the structure of preferred stock is specific to each corporation. However, the best way to think of preferred stock is as a financial instrument that has characteristics of both debt (fixed dividends) and equity (potential appreciation). Also known as "preferred shares". Investopedia

Cost of Equity
The return that stockholders require for a company. The traditional formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. Investopedia

Return on Equity
The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

Finance & Economics Terms

ROE is expressed as a percentage and calculated as: Return on Equity = Net Income/Shareholder's Equity Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares. Investopedia

Beta
A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns. Economist Investopedia

Derivative
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Economist Investopedia

Option
A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date). Options can be prices using Black-Scholes model. Call options give the option to buy at certain price, so the buyer would want the stock to go up. Put options give the option to sell at a certain price, so the buyer would want the stock to go down. Investopedia

Call
An option contract giving the owner the right (but not the obligation) to buy a specified amount of an underlying security at a specified price within a specified time. Investopedia

Finance & Economics Terms

Put
An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of a put option estimates that the underlying asset will drop below the exercise price before the expiration date. The possible payoff for a holder of a put option contract is illustrated by the following diagram:

Investopedia

Forward
A cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. Investopedia

Future
Financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets. Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long or short using futures. Investopedia

Finance & Economics Terms

Swap
Traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps. Investopedia

Price-to-Earnings ratio (P/E)

A crude method of judging whether shares are cheap or expensive; the ratio of the market price of a share to the companys earnings (profit) per share. The higher the price/earnings (P/E) ratio, the more investors are buying a companys shares in the expectation that it will make larger profits in future than now. In other words, the higher the P/E ratio, the more optimistic investors are being. Economist Investopedia

Price-to-Book ratio (P/B)

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:

Investopedia

Price/Earnings to Growth ratio (PEG)

A ratio used to determine a stock's value while taking into account earnings growth. The calculation is as follows:

Investopedia