Key terms for CFA Level I
156 words that more than one topic assumes you already know, in plain English. Start a topic, meet an unfamiliar word, and look it up here instead of going into another topic.
- Key terms: money, time and returns
- Key terms: risk and return
- Key terms: markets and private investments
- Key terms: the financial statements
- Key terms: companies, the economy and ethics
- Key terms: fixed income
- Key terms: derivatives
1. Key terms: money, time and returns
Interest, discounting and the ways a return is measured. Almost every topic assumes these.
What the lesson covers
- Annualising
- Restating a return earned over one period as the equivalent rate per year, by compounding rather than multiplying, so returns over different horizons can be compared. It magnifies noise as much as return.
- Annuity
- A level payment made every period for a fixed number of periods, in its ordinary form at the end of each. Its value is a perpetuity less the perpetuity that would have begun after the final payment.
- Annuity factor
- The sum of the discount factors for a series of payment dates: the present value of one unit paid on each. It turns a difference in rates into the value of a swap or swaption.
- Basis point
- A hundredth of a percentage point. A rate moving from 4.00% to 4.25% has moved 25 of them.
- Compounding
- Interest being added to the balance so that it earns interest itself in later periods. It makes growth exponential rather than linear, and more frequent compounding raises the effective annual rate.
- Discount factor
- The present value of one unit paid on a given date: 1 ÷ (1 + spot rate) raised to the number of periods. Multiplying a cash flow by it discounts that cash flow.
- Discount rate
- The rate a future amount is shrunk by to express it in today's money. It is the return available elsewhere on something equally risky.
- Economic profit
- Revenue less all costs, including the opportunity cost of the owners' capital. Zero means a normal return: enough to stay in the industry, not enough to attract entrants.
- Expected value
- The probability-weighted average of all possible outcomes: what would be averaged over many repetitions, not necessarily a value that can occur. Two prospects sharing it can carry very different downside.
- Face value
- The amount repaid at maturity, and the figure the coupon rate is applied to. Almost never the price actually paid.
- Geometric mean
- The average that compounds correctly over time. For a series of returns it is the right summary; the arithmetic mean always overstates once returns vary.
- Gross return
- Return before management fees, custody and other administrative costs are deducted, though after trading costs. It measures the manager's investing, not what the investor received.
- Hurdle rate
- A return a fund must clear before any incentive fee is earned.
- Internal rate of return
- The discount rate at which a project's net present value is zero. It says at what rate the project pays, not how much value it adds.
- Money-weighted return
- The internal rate of return on a portfolio's actual cash flows, so it reflects when money was added or withdrawn. The fair measure when the manager, such as a private equity general partner, controls that timing.
- Net present value
- The value a project adds, in money, once every cash flow has been discounted and the outlay subtracted. Denominated in what shareholders actually receive.
- Net return
- Return after management and administrative fees have come off the gross figure. Closer to what the investor actually received, though still before tax and inflation.
- Opportunity cost
- The value of the best alternative given up by a choice. For a country, it is the other goods its resources could have produced instead, and it is what comparative advantage compares.
- Perpetuity
- A level payment that continues forever. Its present value is simply the payment divided by the discount rate, because payments far enough away are worth almost nothing today.
- Present value
- What an amount arriving later is worth today, once the cost of waiting is taken off.
- Real return
- Return with inflation taken out, so it measures the change in purchasing power. Roughly the nominal return less inflation; exactly, one plus nominal over one plus inflation, less one.
- Required return
- The minimum return investors demand for holding an asset, given its risk. It is the discount rate in a valuation, so every value rests on this estimate.
- Terminal value
- The value, at the end of an explicit forecast, of everything that follows - usually from a constant growth formula. It often supplies most of the total, so its growth assumption deserves the most scrutiny.
- Time-weighted return
- The compound growth of one unit over the period, linking returns between external cash flows so their timing and size have no effect. The standard measure for a manager who does not control the flows.
- Weighted average cost
- An inventory method that gives every unit sold and every unit left the same average cost of the goods available. Its profit and inventory figures fall between those of FIFO and LIFO.
- Weighted average cost of capital
- The blended return a firm must earn to satisfy everyone who funded it. A single rate, and using it for everything subsidises the risky projects.
- Zero-coupon bond
- A bond paying nothing until maturity. With nothing to reinvest its promised yield is actually realised, and its duration equals its maturity exactly.
2. Key terms: risk and return
How risk is measured, what diversification does, and how return is judged against risk.
What the lesson covers
- Beta
- How much an asset moves when the market moves. One means with it, above one amplifies it, below one damps it - and it is the only risk the market pays you to hold.
- Capital asset pricing model
- The model in which expected return is the risk-free rate plus beta times the market risk premium. Only market risk is paid for, since other risk can be diversified away.
- Correlation
- Covariance rescaled to run from minus one to plus one, so co-movement can be compared across pairs. Anything below plus one pulls portfolio risk beneath the weighted average of the parts.
- Covariance
- A measure of whether two variables move together: positive if they rise and fall in step, negative if they offset. Its size carries the units of both, so it cannot be compared across pairs.
- Diversification
- Holding things that do not move together, so their independent disappointments cancel. It lowers risk without lowering expected return, which nothing else does.
- Dividend yield
- Annual dividends per share divided by the share price. In derivatives pricing it is often treated as a continuous yield, δ, which lowers the forward price and the value of a call on the share.
- Efficient frontier
- The portfolios with the highest expected return for each level of risk: the upper part of the minimum-variance frontier. Anything beneath it is beaten by something on it.
- Equal-weighted
- Giving every constituent of an index or portfolio the same weight. It tilts towards smaller companies and must be traded back after every move, so its published return overstates what a fund nets.
- Fat tails
- A distribution putting more probability on extreme outcomes than the normal does, which is positive excess kurtosis. Risk measures that assume normality then understate how often large losses occur.
- Market-capitalisation-weighted
- Weighting each constituent by the market value of its shares. Weights move with prices on their own, so trading is needed only when shares outstanding change, giving the lowest turnover.
- Minimum-variance portfolio
- The combination of risky assets with the lowest possible variance: the leftmost point on the curve of possible portfolios, and where the efficient frontier begins.
- Negative skew
- A return distribution with a long left tail: many small gains and occasional large losses. Standard deviation treats both sides alike, so it understates the risk that matters.
- Price-weighted
- An index that adds share prices, so a high-priced company sways it regardless of size - and a share split changes the answer with no economics behind it.
- Rho
- The change in an option's value for a change in the risk-free rate. Positive for calls and negative for puts, because a higher rate lowers the present value of the strike.
- Risk aversion
- Preferring less uncertainty for the same expected return, and accepting a lower expected return to get it. Its degree differs between investors, and it decides how much risk each chooses to hold.
- Risk-free rate
- The return on an investment with no default risk over the horizon, usually proxied by short-term government bills. Every risky return is measured against it, and option models discount the exercise price at it.
- Scenario analysis
- Changing a coherent set of inputs together to describe a recognisable state of the world, such as a recession. It captures risks arriving together, which one-at-a-time testing misses.
- Sharpe ratio
- Return in excess of the risk-free rate per unit of total volatility: the slope of the line from the risk-free asset to a portfolio. It penalises upside and downside alike, so it flatters negatively skewed strategies.
- Skewness
- A measure of a distribution's asymmetry. Negative skew means a long tail of losses, with the mean dragged below the median - typical of asset returns, and unwelcome.
- Standard deviation
- The square root of variance, and so in the same units as the data. The usual measure of dispersion and of investment risk, though it counts pleasant surprises as risk too.
- Survivorship bias
- The upward tilt from studying only the funds or firms that still exist, because the failures have dropped out of the database. It flatters average performance and understates risk.
- Systematic risk
- Risk that cannot be diversified away because it moves the whole market. The only kind anyone is compensated for holding.
- Value at risk
- The minimum loss expected over a set period with a given probability: a 5% one-day figure of $1m means a loss at least that large one day in twenty. It says nothing about how bad the tail gets.
- Variance
- The probability-weighted average of squared deviations from the mean, measuring dispersion. Its units are squared, which is why its square root, the standard deviation, is the figure usually quoted.
3. Key terms: markets and private investments
How securities are issued and traded, and the words private funds use.
What the lesson covers
- Appraisal
- Valuing an asset by expert estimate, usually from comparable transactions, rather than by an observed trade. Appraised values lag and smooth the true series, so volatility and correlation are understated.
- Cumulative voting
- Letting shareholders cast all their votes - one per share for each seat - for a single director candidate. It helps a minority elect some of the board, which straight voting would prevent.
- Custody
- Safekeeping of assets on an owner's behalf. For digital assets it means control of the private keys, so a lost key or a hacked custodian can mean a permanent loss with no one to recover it from.
- Enterprise value
- The value of the whole firm to all its capital providers: equity market value plus debt and preferred stock, less cash and investments. Set against pre-interest measures such as EBITDA, it compares firms financed differently.
- General partner
- In a limited partnership, the partner that runs the business and bears general-partner liability, often through a limited-liability entity. In a private fund it is the manager: it finds, runs and exits the investments and calls capital.
- Initial public offering
- A company's first sale of shares to the public, usually through underwriters who gauge demand and set the price. It creates the listing on which later secondary trading depends.
- J-curve
- The dip in a private equity fund's reported return in its early years. Fees are charged from day one and value takes years, so it is negative by construction.
- Leveraged buyout
- The purchase of a company funded largely with debt secured on its own assets and cash flows. The borrowing magnifies the equity return on any improvement in the business, and the loss on any decline.
- Limited partner
- A partner whose liability is capped at what it contributed, in return for no part in management. In a private fund it is the investor, committing capital it can rarely get back before the fund ends.
- Liquidity
- How quickly something can be turned into cash without moving its price. Scarce exactly when it is most wanted.
- Lock-up
- A period during which capital cannot be withdrawn from a fund, or shares held by insiders cannot be sold. For a fund investor it is the constraint an illiquidity premium is meant to compensate.
- Management fee
- A fee charged as a percentage of committed or invested capital, or of assets, whatever the returns. It pays for running the fund, and a large one can reward gathering assets more than performing.
- Marked to market
- Revalued at the current market price, with a futures position's gain or loss settled in cash each day. Credit exposure then never grows beyond a single day's move.
- Momentum
- Recent winners continuing to outperform, and recent losers to lag, over the following months. A persistent anomaly, explained either as underreaction and herding or as a risk not yet identified.
- Net asset value
- Assets less liabilities, per share or unit. Open-end funds deal at it; shares traded on an exchange, such as a closed-end fund's, can sit at a premium or discount to it.
- Price discovery
- The process by which trading reveals what the market thinks something is worth. Derivatives often lead it, being cheaper to trade and open when the underlying is not.
- Primary market
- Where a company sells newly issued securities and receives the cash. The only point at which dealing in its shares raises money for the business.
- Reconstitution
- Changing which securities belong to an index, adding and removing members under its rules. The dates are known in advance, so others trade ahead of them and index funds pay for it.
- Residual claim
- The right to whatever is left of earnings and assets after every prior claim has been met. It carries all the upside, and is paid last and only if something remains.
- Secondary market
- Where investors trade existing securities among themselves, the issuer receiving nothing. Its liquidity is what makes new issues saleable, so it lowers the cost of raising capital.
- Short selling
- Borrowing a security, selling it and later buying it back to return, so as to profit from a fall. The possible loss is unlimited, and the seller must pay the lender any dividends meanwhile.
- Token
- The unit a language model reads and writes: a word or a piece of one. The model generates text by estimating probabilities for the next token, picking one and repeating.
- Underwriter
- A bank that manages a new issue, gauges demand and sets the price, often guaranteeing the proceeds by buying the securities itself and reselling them.
- Waterfall
- The order in which cash is paid out or losses absorbed. In a private fund: capital back first, then a preferred return, a catch-up and the profit split; in a securitisation, senior tranches are paid first.
4. Key terms: the financial statements
The profit ladder, leverage, liquidity and cash flow: the vocabulary of the financial statements.
What the lesson covers
- Cash conversion cycle
- Days of inventory plus days of receivables less days of payables: how long cash is tied up between paying suppliers and being paid by customers.
- Cost of goods sold
- The cost of the goods a company actually sold in the period - materials, labour and production overheads attached to them. It is matched to the revenue those sales produced, not to what was bought.
- Current ratio
- Current assets over current liabilities. It counts inventory, which is the current asset least likely to turn into cash when it is needed.
- Ebitda
- Profit before interest, taxes, depreciation and amortisation: a rough proxy for operating cash earnings before capital spending. Buyout prices and debt capacity are usually quoted as multiples of it.
- Fair value
- The price something would fetch in an orderly transaction today, ranked by how observable the inputs are - from a quoted price down to a firm's own model.
- Financial leverage
- Fixed financing costs, chiefly interest, magnifying what a change in operating profit does to net income - in both directions.
- Free cash flow
- Cash from operations after the investment needed to keep the business going. What is genuinely available to the people who funded it.
- Free cash flow to equity
- Cash flow from operations less investment in fixed capital, plus net borrowing: what is left for shareholders after operating needs, investment and payments to lenders. Discounted at the cost of equity.
- Free cash flow to the firm
- Cash available to all capital providers after operating expenses, taxes and investment in fixed and working capital. Discounted at the WACC it values the whole firm; debt is then deducted to reach equity.
- Goodwill
- The premium paid over the identifiable net assets of a business acquired. Not amortised, tested for impairment, and writing it down concedes the price was too high.
- Gross margin
- Gross profit over revenue. It answers a question about the product - pricing power and what it costs to make - and nothing about overheads.
- Gross profit
- Revenue less the cost of the goods or services sold. It measures what the product earns before any overheads, and divided by revenue it gives the gross margin.
- Operating cash flow
- Cash generated by the trading that produces net income. Far harder to manage than profit, which is why the two coming apart is worth explaining.
- Operating leverage
- Fixed operating costs magnifying what a change in sales does to operating profit. A company with no debt at all can be dangerously leveraged.
- Operating margin
- Operating profit over revenue. It stops above interest, so two identical businesses financed differently share it - which is what makes it comparable.
- Operating profit
- Profit from the business's operations after operating expenses but before interest and tax. Financing choices do not reach it, which is why it is the line to compare across firms.
- Quick ratio
- Liquidity counting only what could become cash quickly - inventory excluded. Two firms with the same current ratio can differ sharply here.
- Return on equity
- Profit as a share of what shareholders put in. Two firms reaching the same figure through margin and through borrowing are not the same proposition.
- Stock dividend
- A dividend paid in new shares rather than cash. Every holder keeps the same proportion of the company, so the price per share falls and nothing of value changes hands.
- Working capital
- The current assets and current liabilities a business runs on. Profitable firms still fail when the gap between paying and being paid is not funded.
5. Key terms: companies, the economy and ethics
Industry structure, the economy, company funding, pensions, portfolio policy and ethics terms.
What the lesson covers
- Bargaining power
- How far suppliers or buyers can push prices in their own favour. Greater when they are concentrated, or when they can switch easily and the other side cannot.
- Barriers to entry
- Anything that stops new firms entering a profitable market, such as scale, patents, licences or control of distribution. They decide how much pricing power incumbents keep, more than concentration does.
- Business cycle
- The swing of output around its trend through expansion, peak, contraction and trough. It describes the fluctuation, not the growth underneath it.
- Capital structure
- The mix of debt and equity funding a firm. It changes who is owed what, and can change the cost of capital, without changing the business.
- Concentration ratio
- The combined market share of an industry's largest firms. Simple, but blind to how that share is split among them and to how easily new firms can enter.
- Conflict of interest
- An interest or relationship that could reasonably be expected to impair independence or interfere with duties to clients or employer. It must be avoided or fully and fairly disclosed, and avoiding it is preferred where reasonably possible.
- Current account
- The part of the balance of payments recording trade in goods and services, investment income and transfers. A deficit means the country spends more abroad than it earns and must borrow or sell assets to pay.
- Defined benefit
- A pension promising a specified payment, so the employer carries the investment and longevity risk rather than the employee.
- Deflation
- A sustained fall in the general price level. It raises the real burden of debt, can hold back spending and, with rates near zero, limits what conventional monetary policy can do.
- Esg
- Environmental, social and governance: factors outside the usual financial statements, such as emissions, labour practices and board structure, that can affect a company's risk, cash flows or cost of capital.
- Five forces
- Porter's framework for industry profitability: the threat of entrants, the threat of substitutes, buyer power, supplier power and rivalry. The weaker they are, the more of the value it creates an industry keeps.
- Funded status
- Pension plan assets minus the pension obligation. A deficit is shown as a net liability and a surplus as a net asset, though the asset recognised may be capped.
- Investment policy statement
- The document setting objectives and constraints before anyone manages anything. Its real job is to be read during a drawdown, by someone no longer thinking clearly.
- Life cycle
- The phases an industry passes through - embryonic, growth, shakeout, mature and declining - each with typical growth, competition and profitability. A guide to what tends to happen, not a timetable.
- Line of credit
- A bank facility a borrower can draw on up to a limit as needed. A committed line obliges the bank to lend, for a fee; an uncommitted one can be withdrawn at the bank's discretion.
- Longevity risk
- The risk of living longer than planned and so outliving one's assets or, for a pension plan or insurer, paying benefits for longer than expected. A lifetime annuity transfers it to an insurer.
- Mandate
- The stated strategy, benchmark and constraints a manager has agreed to run money to. Others build their allocations on it, so departing from it, even for a better idea, breaks the agreement.
- Materiality
- Whether an item is large or relevant enough to change a decision or a valuation. In ESG analysis, which issues are likely to affect a company's cash flows, risk or cost of capital in its particular industry.
- Monetary policy
- A central bank's management of interest rates and the money supply to steer inflation and output. A country with a fixed exchange rate and open capital markets cannot run one of its own.
- Negative screening
- Excluding sectors, companies or practices that fail set ESG or ethical criteria, such as tobacco or weapons. The simplest ESG approach, and the one that says least about value.
- Net borrowing
- New debt raised less debt repaid in a period. Added in FCFE because borrowed cash is available to shareholders, which also means borrowing can flatter FCFE.
- Overconfidence
- Rating one's own knowledge, judgement or virtue higher than the evidence supports. It narrows forecast ranges, encourages over-trading and, in ethics, makes people think themselves more principled than their peers.
- Pricing power
- The ability to raise prices without losing much volume. It comes from concentration, differentiation or switching costs, and shows up as margins that hold when costs rise.
- Proxy voting
- Voting the shares held for a client at company meetings. Under the Standards it is part of the duty of loyalty, and not voting needs a reasoned case that the cost to the client outweighs the benefit.
- Rebalancing
- Trading back to target weights - a portfolio's policy weights or an index's weighting scheme - after prices have pulled holdings away. Because it sells what has risen, it is contrarian by construction.
- Return objective
- What a portfolio must achieve, stated so it can be checked - often a real return tied to spending needs, inflation or a liability. It has to be consistent with the client's risk tolerance.
- Synergies
- Cost savings or extra revenue from combining businesses that neither could achieve alone. A buyer creates value only if its standalone value plus synergies exceeds the price it pays.
- Target price
- The price an analyst expects a share to reach, usually within twelve months. Typically forecast earnings times a chosen multiple, so it inherits the uncertainty of both.
- Tolerance band
- The range around a target weight within which drift is allowed. A breach triggers rebalancing, which avoids both constant trading and unlimited drift.
6. Key terms: fixed income
Yields, rates, covenants, credit risk and the instruments built on them.
What the lesson covers
- Affirmative covenant
- A promise in the loan agreement about what the borrower will do - pay on time, insure the assets, deliver audited accounts.
- Bond ladder
- A bond portfolio with roughly equal amounts maturing at regular intervals. Maturing bonds provide cash or are reinvested at the long end, spreading reinvestment risk, though the portfolio still carries duration.
- Commercial paper
- Unsecured short-term debt sold directly to investors by large, highly rated issuers, usually maturing within months. Cheaper than bank borrowing, but it depends on investors continuing to roll it over.
- Conversion value
- The value of the shares a convertible bond can be exchanged for: the conversion ratio times the share price. A convertible is worth at least the higher of this and its straight value.
- Convertible bond
- A bond the holder can exchange for a set number of the issuer's shares. Worth at least the higher of its straight value and its conversion value, it offers equity upside with a bond's downside protection.
- Covenant
- A term written into a loan agreement constraining the borrower afterwards. It is what stops value being moved to shareholders once the money is lent.
- Credit default swap
- A contract in which the protection buyer pays a periodic premium and the protection seller pays out if the reference entity suffers a credit event. It transfers credit risk without trading the bonds.
- Credit spread
- The extra yield a borrower pays over a government benchmark. It covers far more than expected default losses - liquidity and the risk of the spread itself widening take a share.
- Expected loss
- The chance of default multiplied by the share not recovered. Both are averages, and they worsen together in a recession, so it understates the tail.
- Forward rate
- The rate at which locking money away for longer ties exactly with rolling a shorter position. A breakeven computed from today's prices, not a prediction.
- Negative covenant
- A restriction on what a borrower may not do - borrow past a ratio, pledge assets elsewhere, pay large dividends. The covenants that actually protect recovery.
- Recovery rate
- The share of an exposure recovered after a default. It falls in the same conditions that cause defaults, which is what makes losses cluster.
- Spot rate
- The yield on a single payment at one future date. Pricing each of a bond's cash flows at its own is the arbitrage-free answer.
- Tranche
- A slice of a securitisation with its own place in the queue for losses or for principal. Subordination is what lets ordinary loans support a high rating.
- Yield to maturity
- The single rate equating a bond's price with its cash flows. A promised return, realised only if it is held, paid, and every coupon reinvested at that same rate.
7. Key terms: derivatives
Forwards, options, swaps and the words that go with them.
What the lesson covers
- American option
- An option that can be exercised at any time up to expiry. Worth at least as much as the equivalent European option; in a binomial tree it is valued with a check for exercise at each node.
- Arbitrage
- Buying and selling equivalent things at different prices for a profit that carries no risk. Its existence is what forces prices into line.
- Backwardation
- A futures curve sloping down, with contracts for later delivery cheaper than the spot price. Rolling a long position forward then earns money.
- Call option
- The right, but not the obligation, to buy the underlying at the exercise price. The buyer can lose no more than the premium; the writer's loss has no ceiling as the underlying rises.
- Contango
- A futures curve sloping up, with later delivery dearer than spot. Rolling a long position forward then costs money, whatever the commodity does.
- Convenience yield
- The benefit of holding the physical commodity rather than a futures contract, such as keeping production running through a shortage. It lowers futures prices relative to spot and is largest when inventories are tight.
- European option
- An option that can be exercised only at expiry, so its value depends only on the payoff at that date. Never worth more than the equivalent American option, and the kind most pricing formulas value directly.
- Exercise price
- The price at which an option's holder may buy the underlying (a call) or sell it (a put). Where the underlying stands relative to it decides whether exercising is worth anything.
- Forward price
- The price agreed today for delivery at a future date, set so the contract is worth nothing at the start. It follows from the cost of carrying the asset to delivery and is not a forecast of the spot price.
- Interest rate swap
- An agreement to exchange fixed-rate for floating-rate interest payments on a notional amount that itself never changes hands. It converts debt from one type to the other without refinancing it.
- Participation rate
- The share of the working-age population in the labour force. A fall can flatter the unemployment rate, because people who give up looking stop being counted as unemployed.
- Protective put
- Owning the underlying and buying a put on it, so losses below the exercise price are covered. Insurance, with the premium as its cost, paid whatever happens.
- Put option
- The right, but not the obligation, to sell the underlying at the exercise price. The holder's gain is capped at the exercise price less the premium, because the underlying cannot fall below zero.
- Reference rate
- The published rate a floating coupon resets to, before the fixed margin is added.
- Swap rate
- The fixed rate on an interest rate swap that makes it worth zero at the start. It is the par yield implied by the swap's discount factors, and the curve of these rates is a market benchmark.
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