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Economics in Pills

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The Yield Curve

The Yield Curve risk is the risk of experiencing an adverse shift in market interest rates associated with investing in a fixed income instrument. When market yields change, this will impact the price of a fixed-income instrument. When market interest rates, or yields, increase, the price of a bond will decrease, and vice versa.

Intrinsic Value

Intrinsic Value is the perceived or calculated value of an asset, an investment, or a company. The term finds use in fundamental analysis to estimate the value of a company and its cash flows. Another use of intrinsic value is in the amount of profit that exists in an options contract.

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Preferred Stock

Cumulative preferred stock is a type of preferred stock with a provision that stipulates that if any dividend payments have been missed in the past, the dividends owed must be paid out to cumulative preferred shareholders first. This is before other classes of preferred stock shareholders and common shareholders can receive dividend payments. Cumulative preferred stock is also called cumulative preferred shares.

Annuity

An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income stream for retirees.

Annuities are created and sold by financial institutions, which accept and invest funds from individuals and then, upon annuitization, issue a stream of payments at a later point in time. The period of time when an annuity is being funded and before payouts begin is referred to as the accumulation phase. Once payments commence, the contract is in the annuitization phase.

Depreciation

Accelerated Depreciation is any method of depreciation used for accounting or income tax purposes that allows greater deductions in the earlier years of the life of an asset. While the straight-line depreciation method spreads the cost evenly over the life of an asset, an accelerated depreciation method allows the deduction of higher expenses in the first years after purchase and lower expenses as the depreciated item ages.

Standard Deviation

The Standard Deviation is a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance.

It is calculated as the square root of variance by determining the variation between each data point relative to the mean. If the data points are further from the mean, there is a higher deviation within the data set; thus, the more spread out the data, the higher the standard deviation.

Bull market

A Bull Market is the condition of a financial market of a group of securities in which prices are rising or are expected to rise.

The term “bull market” is most often used to refer to the stock market but can be applied to anything that is traded, such as bonds, real estate, currencies and commodities. Because prices of securities rise and fall essentially continuously during trading, the term “bull market” is typically reserved for extended periods in which a large portion of security prices are rising. Bull markets tend to last for months or even years.

Call Options

Call Options are an agreement that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset.

Systematic Risk

Systematic Risk is the risk inherent to the entire market or market segment. Systematic risk, also known as “undiversifiable risk,” volatility” or “market risk,” affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy.

Moving Average

A Moving Aaverage (MA) is a widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random short-term price fluctuations. It is a trend-following, or lagging, indicator because it is based on past prices

Compound Interest

Compound Interest (or compounding interest) is interest calculated on the initial principal, which also includes all of the accumulated interest of previous periods of a deposit or loan. Thought to have originated in 17th century Italy, compound interest can be thought of as “interest on interest” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount. The rate at which compound interest accrues depends on the frequency of compounding, such that the higher the number of compounding periods, the greater the compound interest. Compound interest is calculated by multiplying the initial principal amount by one plus the annual interest rate raised to the number of compound periods minus one.

The total initial amount of the loan is then subtracted from the resulting value. The formula for calculating compound interest is: Compound Interest = Total amount of Principal and Interest in future (or Future Value) less Principal amount at present (or Present Value) = [P (1 + i)n] – P = P [(1 + i)n – 1] (Where P = Principal, i = nominal annual interest rate in percentage terms, and n = number of compounding periods.)

Take a three-year loan of $10,000 at an interest rate of 5% that compounds annually. What would be the amount of interest? In this case, it would be: $10,000 [(1 + 0.05)3 – 1] = $10,000 [1.157625 – 1] = $1,576.25.

Coverage Ratio

A Coverage Ratio, broadly, is a group of measures of a company’s ability to service its debt and meet its financial obligations such as interests payments or dividends. The higher the coverage ratio, the easier it should be to make interest payments on its debt or pay dividends. The trend of coverage ratios over time is also studied by analysts and investors to ascertain the change in a company’s financial position.

Coverage ratios come in several forms and can be used to help identify companies in a potentially troubled financial situation, though low ratios are not necessarily an indication that a company is in financial difficulty. Many factors go into determining these ratios and a deeper dive into a company’s financial statements is often recommended to ascertain a business’s health.

Enterprise value

Enterprise value (EV) is a measure of a company’s total value, often used as a more comprehensive alternative to equity market capitalization. EV includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company’s balance sheet.

Enterprise value is a popular metric used to value a company for a potential takeover. Calculate the market capitalization if not readily available by multiplying the number of outstanding shares by the current stock price. Total all debt on the company’s balance sheet including both short-term and long-term debt. Add the market capitalization to the total debt and subtract any cash and cash equivalents from the result

Futures Contract

A Futures Contract is a legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is taking on the obligation to buy the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide the underlying asset at the expiration date.

Futures contracts are used by two categories of market participants: hedgers and speculators. Producers or purchasers of an underlying asset hedge or guarantee the price at which the commodity is sold or purchased, while portfolio managers and traders may also make a bet on the price movements of an underlying asset using futures.

Futures are available on many different types of assets. There are futures contracts on stock exchange indexes, commodities, and currencies.

 

Exchange-Traded Fund

We start with ETF, or exchange-traded fund, is a marketable security that tracks a stock index, a commodity, bonds, or a basket of assets. Although similar in many ways, ETFs differ from mutual funds because of shares trade like a common stock on an exchange.

The price of an ETF’s shares will change throughout the day as they are bought and sold. The largest ETFs typically have higher average daily volume and lower fees than mutual fund shares which makes them an attractive alternative for individual investors. While most ETF’s track stock indexes, there are also ETFs that invest in commodity markets, currencies, bonds, and other asset classes.

Many ETFs also have options available for investors to use income, speculation, or hedging strategies.

 

Stock Option

A Stock Option gives an investor the right, but not the obligation, to buy or sell a stock at an agreed upon price and date. There are two types of options: puts, which is a bet that a stock will fall, or calls, which is a bet that a stock will rise. Options give a trader the right to buy or sell a stock at an agreed-upon price and date. There are two types of options: Calls and Puts. One contract represents 100 shares of the underlying stock

Real World Example of Stock Options:

 

In the example below, a trader believes Nvidia Corp’s (NVDA) stock is going to rise in the future to over $170. They decide to buy 10 January $170 Calls which trade at a price of $16.10 per contract. It would result in the trader spending $16,100 to purchase the calls. However, for the trader to earn a profit, the stock would need to rise above the strike price and the cost of the calls, or $186.10. Should the stock not rise above $170, the options would expire worthless, and the trader would lose the entire premium.

Additionally, if the trader wants to bet that Nvidia will fall in the future, they could buy 10 January $120 Puts for $11.70 per contract. It would cost the trader a total of $11,700. For the trader to earn a profit the stock would need to fall below $108.30. Should the stock close above $120 the options would expire worthless, resulting in loss of the premium.