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- E -

efficient market theory

This is the theory which claims that given full access to all information, the market's current price of a share is the best estimate of future returns from that share. A market is reckoned to be more efficient the more quickly share prices respond to information. The theory is part of the random walk theory of share price movements, which says that future price movements are independent of past changes - that is to say, you cannot forecast the future from past performance.

equity bonds

Equity Bonds (or Insurance bonds investing exclusively in company shares) are comparable with unit trusts, except for the taxation differences.

Equity Bonds can be just as specialist as unit trusts, putting cash into sectors such as 'Emerging Markets' or investing for 'UK Income' or 'UK Growth'. Since insurance bonds pay Capital Gains Tax (CGT) internally (within the fund), they will be less tax efficient than unit trusts for most investors.

However, insurance bonds do have their merits. For example, switching between different funds within an Insurance Bond is frequently 'free of charge' and is not counted as a disposal for CGT purposes by the taxman.

They are therefore a useful tool for those people who wish to actively manage their investments.

Eurobond

Eurobond is no relation to James Bond. In fact a Eurobond has a much less dramatic life but like James it's known in all the major capitals! A Eurobond is a medium or long-term interest-bearing bond created in the international capital markets. A Eurobond is denominated in a currency other than that of the place where it is being issued.

This means, among other things, that interest on such bonds is usually paid gross - without tax being deducted.

Eurobonds are only issued by major borrowers, such as governments, other public bodies or large multinational companies.

ex coupon-

A stock or bond sold without the right of receipt of the next due interest payment.

excession

expected excession of a percentile level:

expected recovery given default (ERGD):

Recovery, in this context, is the compliment of loss given default (LGD). This long-winded term is far less popular than simply saying, "recovery rate".

exposure:

The amount which would be lost in default given the worst possible assumption about recovery in the liquidation or bankruptcy of an obligor. For a loan or fully drawn facility, this is the full facility amount plus accrued interest; for an unused or partly used facility the prevailing practice is to still say that the full facility amount is "exposed". This is because the worst assumption is that the borrower draws the full amount and then immediately default.

• For loan and bond instruments, there is not element of statistical chance that determines the exposure. It does not make any attempt to assess the probability of loss or degrees of recovery. It only states the amount at risk.
• For market-driven instruments, (e.g., swaps, forwards, etc.) a proxy for exposure is estimated given the volatility of underlying market rates/prices.

- F -

facility

A generic term which includes loans, commitments, lines, letters of credit, etc. Any extention of credit made by a bank officer. Note that there can (and often are multiple facilities outstanding to a bank client at once.

fallen angels

Obligors that originally borrowed/issued while rated "investment grade" who have since been downgraded to "sub-investment grade".

Fannie Mae-

Federal National Mortgage Association. The largest player in the secondary mortgage market.

Federal Reserve Board

The Federal Reserve Board or the 'Fed' is the U.S. central bank, the nearest the U.S. comes to our own Bank of England.

• to control the issue of banknotes
• to manage public debt and the issuing of government bonds
• to pay a key role in carrying out monetary policy by setting interest rates and advising on policy.

The tool by which the 'Fed' controls monetary policy is via movements in the 'Fed Funds' interest rate. This is the interest rate at which banks in the U.S. lend to themselves. it's a short term (day to day) rate. It's important, but not as influential as the 'discount rate' - the equivalent of base rates in the U.K.

The sheer size of the U.S. economy traditionally means that changes in interest rates announced in Washington immediately have a knock on effect in the London financial markets as investors re-adjust to lower U.S. borrowing costs. Clearly, if U.S. interest rates are falling, it may persuade some investors and speculators to move cash out of the dollar, in favor of the Pound, Deutschemark etc.

fixed interest

The term generally refers to bonds on which the holder receives a pre-determined and unchanging rate of interest. What this offers the potential investor is a known return from holding the investment. That return contrasts with non-guaranteed variable return on equities.

Freddie Mac-

Federal Home Loan Mortgage Association. The second largest player in the secondary mortgage market.

futures

A contract for the purchase and sale of a commodity, financial instrument or index at a fixed price at a fixed date in the future. Futures contracts were originally invented to allow those who regularly buy and sell goods to protect themselves against future changes in the price of those goods. In other word, the futures markets evolved to allow producers or consumers to hedge their risk.

Put another way, a producer of sugar may know he is going to deliver a consignment of the commodity in three months time at Liverpool Docks. He knows the price he might receive now but not the price that will be available to him when he delivers the goods. By using the 'futures' market, he can lock in now to a price for the goods he will deliver later.

Equally, a consumer of the sugar, let us say a large supermarket knows it will need sugar in three months time. But it does not know what the prevailing market price will be at that time. This is a nuisance, because it would like to know with certainty. The answer for the supermarket is to use the futures market to lock in to a purchase price now. Of course all players in the futures markets are producers and consumers. There are also speculators. They give liquidity to the market and try and make money by betting on the future direction of prices. Sometimes these futures traders make a fortune (and in some cases buy Porsches). In other cases, they lose fortunes and subsequently lose their jobs.

- G -

guaranteed income bond

A single premium insurance bond which pays a fixed amount of income annually and returns the original sum invested at the end of a specified period.

Beware of bonds which offer high returns but may set performance benchmarks for the return of your capital - if these targets are not met your income is effectively no more than the draw-down of your capital.

guaranteed stock market bond

The stock market has in the last couple of decades outperformed other types of investment. But the stock market can be a risky place which can suddenly lose you a chunk of your money at a moment's notice. The solution for the slightly nervous may be the 'Guaranteed Stock market Bond'.

These investments come in a variety of packages, usually from insurance companies. They all have the same basic aim - to give you a return based on rising share prices but with a guarantee that you will not lose your original capital. Most of the schemes are marketed as fixed-term policies (usually five years).

When your policy matures you are guaranteed to get back the higher of two sums, either your original investment or your investment increased in line with whatever benchmark (usually the FTSE-100) is being used.

There are also guaranteed equity bonds offering to guarantee you a high rate of income - much higher than is available in any other form.

They also aim to pay back your original capital at the end of the period, provided that the stock market has performed well enough. If not, you get less of your original investment back - effectively your high income will have been sustained partly by payments out of your capital.

If you're looking at investing in guaranteed bonds, make sure you know which type you are buying into. These products can be complicated and in some ways for that reason they may not be desirable.

guarantor

If you borrow money and suddenly find you can't pay, the lender may find they have a bad debt on his hands. And so, basically if a lender thinks you might not be able to pay back a loan being applied for, they can ask for a guarantor - a third party who'll pay your debts if you can't (or wont). So a guarantor is a third party who stands liable to cover any shortfall or default on the borrower's debt.

In the early 1990s, a number of mortgage lenders offered escape routes to 'young' people in negative equity provided their parents acted as guarantors of the excess debt. The assumption was that the parents would either own their own homes outright or have significant equity in the property to be able to provide a guarantee for their offspring to move up the property ladder from starter homes their own, younger families, might have outgrown.

- H -

hedge-

An investment made in order to reduce the risk of adverse price movements in a security. Normally, a hedge consists of a protecting position in a related security.

Herstatt risk

Definition: The risk to Counterparty A in the settlement of a foreign currency transaction with Counterparty B, that A would deliver its payment to B, but B might not pay, as agreed.  If A and B deliver their payments in different time zones, then Herstatt risk occurs regularly.  However, in 1994 a report indicated that Herstatt risk lasts more than one day in a significant portion of transactions.  The eponymous Bankhaus Herstatt defaulted on a number of currency transactions when it failed in 1974.

Example: Bank A might agree to deliver DEM in Frankfurt at 3 p.m., in exchange for Bank B's delivery of USD in New York at 3 p.m. on the same day.  Although the times appear the same, the New York delivery comes later, because of the difference in time zones.