A clearing house stands between two clearing firms, typically big banks, in a trade. Clearing firms must follow a strict set of rules and regulations in order to engage in transactions and have the clearing house as the intermediary. The…
Potential Future Exposure estimates the most you can win in a trade within a given timeframe and with a given confidence level. By extension, it tells you the most your counterparty can end up owing you, exposing you to the…
In Europe, investment funds are typically structured under the UCITS directive (Undertakings for Collective Investment in Transferable Securities) or as an Alternative Investment Fund (AIF) under the Alternative Investment Fund Manager Directive (AIFMD). Funds that follow the UCITS directive can…
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AuM is the total market value of the assets an asset manager oversees on behalf of its investors. It includes stocks, bonds, and cash within the funds the asset manager manages. AuM doesn’t subtract unpaid expenses. NAV on the other…
Delivery risk (also called settlement risk) is when the settlement process of a trade involves one party paying out cash or securities before it receives the countervalue from its counterparty. The risk is that the counterparty may default in the…
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A SICAV is an investment company, while an FCP is a fund. Both are common legal fund structures offered in Europe. A SICAV has its own legal identity and is usually an umbrella structure, meaning it has many sub-funds under…
In derivatives trading, initial margin is collateral exchanged at the beginning of the contract to protect a party from the possibility of default of its counterparty. Variation margin is another type of collateral, paid every day throughout the life of…
To calculate the exposure of a UCITS fund, the commitment approach estimates the leverage caused by all the derivatives in the portfolio. In contrast, the VaR approach measures the maximum potential loss within a specified time period due to market…
Both credit risk and counterparty credit risk refer to the same thing—that the firm on the other side of a transaction defaults and is no longer able to repay its obligations. Credit risk usually refers to the potential loss that…
A negative sum of discounted FCFF is rare. Usually, forecasts are positive and on top of that, there’s the terminal value. A negative forecasted cash flow in some years of your projection window shouldn’t stop you from using the DCF…
The second derivative of a utility function is negative to reflect risk aversion and decreasing marginal utility. A negative second derivative implies a concave function, which illustrates that the more money you have, the less satisfaction you get from additional…
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Equity beta is the overall business risk of the company, including both operational and financial risk. Asset beta on the other hand, excludes the effects of leverage on the capital structure, thus assuming the business is funded by equity only.…
You’re calculating the unlevered beta of a company and need the debt beta, but don’t know how to find it? Then this is for you. You can extract the implied debt beta from the CAPM formula by equating the formula…
Asset-intensive industries are industries that require big investments in fixed assets such as property, plant, and equipment (PP&E) to produce the goods or services they sell. Companies will have a high assets-to-sales ratio. Depreciation has a big impact on the…
The present value index tells you how promising an investment project is. You calculate it by dividing the present value of a project’s future expected cash flows by its initial investment cost. The higher the result the better. Financial analysts…
The difference is MOIC takes into account the value of both realized and unrealized gains and compares it to the invested capital. Thus, it is a gross measure of return that doesn’t take into account fund fees. Meanwhile, DPI compares…
RVPI in private equity compares the estimated remaining fair value of the fund’s investments that have not yet been exited, to all the capital the fund has received from investors. It gives you perspective on the performance of the fund’s…
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Both TVPI and DPI are widely used in private equity to evaluate fund performance. TVPI compares the total value of a private equity fund (realized and unrealized gains and losses) to the capital the fund has received from its investors.…
The key difference between MOIC and ROIC is in the purpose of each metric. MOIC is mostly used in private equity to assess fund performance. In contrast, analysts use ROIC to evaluate how well a company allocates money from its…
To calculate the WACC you need the cost of equity, cost of debt, the proportions of equity and debt in the total value of the company, and the corporate tax rate. But what if you’re given the debt-to-equity ratio only,…
Working capital items such as accounts receivable, inventory, and accounts payable don’t go directly to the cash flow statement. However, the variation in the value of these items from the previous year to the current one is indeed included in…
Both paid-in capital and invested capital are used in private equity. Paid-in capital is the cumulative amount of committed capital that has been drawn down. In other words, the money that limited partners have actually transferred to the fund. On…
The cost of equity is the return equity investors demand in order to be willing to risk their money in the company. The Return on Equity is the profitability of that money. When the cost of equity is lower than…
A quadratic utility function is a type of utility function used in economics and finance to describe a person’s preferences over different outcomes. In other words, how people make choices under uncertainty. The quadratic utility has special importance in finance…
It depends. If you want to evaluate the company’s ability to meet short-term obligations, you calculate working capital as the difference between total current assets and current liabilities. Current assets include cash and cash equivalents. If you want to compute…
Excess cash is cash balance beyond what a business requires to fulfill its daily operational money needs. Usually, analysts consider 2% of the revenues of a company as the cash it really needs to function properly. Thus, the remaining cash…
The geometric average monthly return tells you the average monthly return of an investment, assuming you reinvest the profits every month. Meaning, it takes into account the compounding effect. You calculate it by multiplying all the month’s growth factors together…
If you, as a shareholder, choose to do nothing or not subscribe to a rights issue, the company sells them in the market, and you receive the net proceeds. Your existing shareholdings will be worth less money (at least in…
Working cash is the cash balance a company has on hand to cover its day-to-day expenses and cash needs. In contrast, excess cash and marketable securities are non-operating assets the company does not employ in its business (having or not…
Yes. Private companies pay dividends either from net income, retained earnings, or newly issued debt, just like public companies do. The only significant difference is more regulation in public companies. That’s the gist of it. For a more comprehensive look…
This post is a brief and somewhat incomplete look at Arrow-Debreu pricing theory, based on my lecture notes. Hope it helps! What is an Arrow-Debreu Security Arrow-Debreu securities (or state-contingent claims, or simply state claims) are financial instruments that pay…
The certainty equivalent of a lottery is the amount you would accept to receive to pass on the possibility of playing said lottery. In other words, it’s the maximum amount a person is willing to pay for a gamble. You…
Both TVPI and MOIC measure fund performance using the total value (realized plus unrealized) of private equity investments. The difference is in the denominator. MOIC divides the total value of the investment or fund by the total invested capital, whereas…
When a company goes public, its existing shareholders will see their shares lose controlling power in the company. However, this equity dilution only happens when the company issues new shares to raise capital. If the shares sold to the public…
If a SPAC fails to merge with a target company within the specified time frame (typically 2 years), it is liquidated and the funds raised in its IPO are returned. This means investors get their money back—minus any fees or…
Real options increase the expected returns of an investment opportunity by allowing adjustments to the investment strategy in response to changing market conditions or new information. In other words, having more flexibility in investment and disinvestment increases the value of…
Depreciation should not exceed capital expenditures in the terminal year of a DCF model unless you want to assume the value of the company’s assets will go to zero. When estimating the Enterprise Value of a firm through a DCF…
If maintenance/repair costs are capitalized into a fixed asset, inflation results in an increase in depreciation. Still confused? Keep reading for a more comprehensive answer: Depreciation is the non-cash expense that accounts for the decline in value of an asset…
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Return on Invested Capital. Return on Investment. Wondering how the hell are these two things different? Then this is for you. The ROIC measures how efficiently a company employs the capital it received from its investors (both equity and debt…
Low coupon bonds are more volatile because the face value received at the maturity date as a lump sum is a big chunk of the total bond’s value. Interest payments along the way are not as significant. This means changes…
The difference between the Return on Invested Capital and the Return on Equity is that the ROIC measures how effective is the company’s employment of all sources of capital at increasing the operating income, while the ROE compares the capital…
A price to book below 1 indicates the stock is undervalued. It means the market values the company below its accounting net worth. This could be an investment opportunity, or a sign the business lacks future growth opportunities. Here’s a…
Here’s a table showing you the equivalent ratings between the big three credit rating agencies: S&P Moody’s Fitch AAA Aaa AAA AA+ Aa1 AA+ AA Aa2 AA AA- Aa3 AA- A+ A1 A+ A A2 A A- A3 A- BBB+…
To calculate the cost of equity using the CAPM, you need the beta of the company. The problem is that beta is a volatility measure based on the stock market. What if the company you’re evaluating isn’t publicly traded? The…
The fundamental difference between ROIC and ROA lies in the difference between invested capital and total assets. The Return on Invested Capital compares operating income to money shareholders and lenders have put into the company, which tells you its ability…