Jesper Böjeryd

My macro-finance glossary | Jesper Bojeryd

# My macro-finance glossary

13 August 2020

I’ve done some searching online, but so far failed to find any glossary of frequently used macro-finance terms. So I started to put together my own. In my experience, a good way to memorize concepts is to write them down in my own words; as I revisit my glossary, I edit definitions, correct my previous misconceptions, and try to condense the text. It’s not only a good way to retain the meaning of the terms, but also a chance to practice my writing and reading skills. Enjoy! 😊

Abnormal returns – Difference between an asset’s return and its expected return. A coarse estimate is to take the realized return of the asset and subtract the return of a benchmark index such as the S&P 500. More sophisticated is to use the method of MacKinley, 1997 (Event Studies in Economics and Finance).

Backus–Smith puzzle – In theory, consumption should increase with the real exchange rate (making it cheaper to buy from abroad, leading to rising consumption). However, in data, the correlation is either zero or negative, which creates a puzzle.

Bankruptcy – “legal finding that imposes court supervision over the financial affairs of those who are insolvent or in default.”

Capital – The interpretation of capital depends on the context. In macro, it usually refers to some good that together with labor is used to produce output (e.g., capital can include tractors, computers, and houses). These goods can be referred to as capital assets. However, in finance, just capital often means the amount of financial assets held (e.g., cash, bonds, liquid stocks) or investments raised. It may be expanded to include a company’s capital assets.

Capital Asset Pricing Model – the CAPM. The model can be derived from several representative agent models and boils down to that the expected return $E[R_i]$ of an asset $i$ is

$E[R_i] = R_f + \beta_i(E[R_M] - R_f),$

where $R_f$ is the risk-free rate, $\beta_i$ is asset $i$’s “beta”, and $E[R_M]$ is the expected return of the market.

The coefficient $\beta_i$ reflects how the asset correlates with the overall market and how much risk it adds to the portfolio. If $\beta$ is positive, the asset has a higher expected return when the overall market’s expected return increases. Assets with negative $\beta$ react in the opposite direction of markets; in a recession when markets are falling, negative-$\beta$ assets rise in value because they are expected to yield higher returns.

Capital requirement – A set of rules of financial regulators on how much capital a bank should hold relative to their risky assets. E.g., in Basel III banks have to hold 6% worth of Tier 1 capital in relation to risk-weighted assets.

Carry trade – This trade starts with borrowing at a low interest rate to invest in an asset with a higher return. Often, the loan is denominated in a different currency than the asset. This adds risk to the investment.

Certificate of deposit (CD) – Bank and credit unions issue certificates of deposits to raise funds. A depositor leaves money with the bank for a pre-determined time at a higher deposit rate they would receive in a checking account. Terms vary and often allow the depositor to do a limited number of withdrawals or at a fixed cost.

When a bigger investor in the money market “deposits” money in a bank, we say that they buy a certificate of deposit.

Chapter 7 bankruptcy (US) – A firm that files for Chapter 7 will be liquidated under the rules of Chapter 7 of Title 11.

Chapter 11 bankruptcy protection (US) – If a business is unable to service its outstanding credit (and risk bankruptcy), it can file for protection to a federal bankruptcy court. This allows for a business to continue operations and owners to remain in control. The process will either end in a reorganization, a conversion to Chapter 7 bankruptcy (liquidation), or a dismissal by the court. See https://en.wikipedia.org/wiki/Chapter_11,_Title_11,_United_States_Code#Chapter_11_overview.

Corporate paper – Refers often to short-term bonds issued by firms to finance short-term liabilities such as payroll, accounts payable and inventories.

Cost-push inflation – Rising consumer prices caused by increases in the cost of production – i.e., cost of labor and raw materials. The concept is different from demand-driven inflation, where firms raise prices because consumers have higher willingness to pay.

Current account – A country’s current account represents its net transactions with the rest of the world over some period of time, often per year. It is the sum of exports of goods and services, minus imports, and the net earnings from international investments. Net transfers are also included.

Debt restructuring – An agent (a company, country, or individual) that holds debt they cannot repay given foreseeable future cash flows can enter debt restructuring. They renegotiate the delinquent debt, creditors remit some, and the agent continues some form of operations (at some reduced level).

Default – a debtor has passed the payment deadline on a debt they were due to pay.

“[…] for example when a home buyer fails to make a mortgage payment, or when a corporation or government fails to pay a bond which has reached maturity. A national or sovereign default is the failure or refusal of a government to repay its national debt. The biggest private default in history is Lehman Brothers with over \$600 billion when it filed for bankruptcy in 2008 and the biggest sovereign default is Greece with \$138 billion in March 2012.”

Delinquent – commonly refers to a situation where a borrower is late or overdue on a payment, such as income taxes, a mortgage, an automobile loan, or a credit card bill.

Dowish (monetary policy) – see Hawkish vs dowish (monetary policy) below.

Equity fund – (Or, stock fund.) An equity fund is a mutual fund that invests mainly in stocks. It can be actively or passively (index fund) managed.

Equity premium puzzle – the puzzle is the inability of standard economic models to predict a high enough premium for investors to hold diversified portfolios of stocks. Or put in other words: given the volatility in the data, investors with “reasonable” risk aversion want the return on stocks to be 1 percentage unit higher than the risk-free rate, but in the data the return is 6 percentage units higher. This indicates that risk aversion should be higher, which leads to other puzzles.

Excess return – The difference in return earned by an asset and the risk-free rate.

Fannie Mae – or, The Federal National Mortgage Association (FNMA), is a company funded by the U.S. Congress in 1938 which went public in 1968. Its purpose is to facilitate credit provision to owners of real estate by buying loans from loan originators. So, a bank can make out a mortgage to a home owner, then they turn around and sell it to Fannie Mae, which has to buy the loan as long as the mortgage fulfills certain criteria, at any market condition (the last is because it is a so-called Government-Sponsored Enterprise). Fannie Mae can then bundle the mortgage with others, into a so-called MBS (Mortgage-backed security) which they sell to e.g. a pension fund. Fannie Mae takes on the credit risk; if a loan defaults, they guarantee the buyer of the MBS the cashflow. However, it is not in law that the GSE is backed my the U.S. government, while there seems to be an implicit backing.

During the turmoil of the Financial crisis of 2007–2008, the U.S. government took back control of Fannie Mae (and Freddie Mac). As of late 2022, it is still under government charter.

Financial accelerator – a mechanism of macroeconomics that exacerbates shocks through frictions in financial markets. E.g., if a firm usually borrows using its current net worth as collateral, a shock that lowers its value decreases the firm’s ability to raise credit to invest with. This further depresses its net worth, which in return depresses it even further; the mechanism is an acceleration.

Reference: Bernanke, Gertler, and Gilchrist (1996).

Fiscal theory of the price level (FTPL) – The theory emphasizes that inflation (the price level) is mostly determined by government fiscal policy. I.e., how governments spend and finance that spending (which they do through a combination of taxes and borrowing at different horizons). Inflation can here be explained as a decision of the government to “inflate away” their debt. However, this has to surprise the market who else will require compensation (through higher treasury rates).

FIMA Repo Facility (Foreign and International Monetary Authorities) – A Fed facility where e.g. foreign central banks can buy repos on U.S. treasuries for USDs. This provides foreign financial markets with access to dollars. (If a country is in need of dollars, that country’s central bank can exchange a U.S. treasury for dollars, and lend the dollars to whoever needs it locally.)

Fiscal dominance – In this regime, the government chooses its level of debt, and in consequence, the rate of inflation (fiscal policy plays an active role). Monetary policy is passive and adjusts the cost of borrowing in accordance.

Forward price – A contracted price of a specific future transaction.

Fractional reserve banking – a banking system that allows banks to only hold a fraction of deposits as cash. E.g., before March 2021, the common requirement was to hold 10% of deposits as cash. The remaining 90% could be lent. In April 2021, the Federal Reserve reduced the requirement to zero percent.

Freddie Mac – (The Federal Home Loan Mortgage Corporation, FHLMC) is as Fannie Mae (see above) a government-sponsored enterprise but created in 1970, with the same role to provide liquidity to mortgage lendors in the U.S. mortgage market. The major difference is that Freddie Mac buys mortgage loans from smaller banks while Fannie Mae buys from larger, commercial banks. They also differ in downpayment requirements, and the income cap of eligibility.

Gilts – refers to treasuries issued in countries of the Commonwealth.

Ginnie Mae – (The Government National Mortgage Association, GNMA). The company is owned by the U.S. government (unlike Fannie Mae and Freddie Mac) and guarantees the payments of mortgage-backed securities that are issued by other government agencies (government agency-backed mortgage loans). They do not create nor sell MBSs, they guarantee their payments. Ginnie Mae is explicitly backed by the U.S. government.

Haircut – A measure of how much discount a creditor does on the collateral value for a loan. Often used in repo markets. An example: a borrower wants to make an overnight loan, using a 1-year T-bill currently traded at \$100 as collateral. The bank (creditor) says they will accept it as collateral worth \$80. The haircut is then 20%.

$\text{haircut} = \frac{\text{market price} - \text{value as collateral}}{\text{market price}}.$

Hawkish vs dowish (monetary policy) – A hawkish policy stance is one that focuses on keeping inflation in control or at some certain level. This is often contrasted to dowish policy, where policymakers put more weight on other variables such as unemployment.

High-yield bond – a bond with a lower credit grade than an investment-grade bond. The yield is therefore higher. Also known as junk bond, or non-investment bond.

Illiquidity – a debtor has insufficient cash (or other “liquefiable” assets) to pay his or her debts.

“A liquidity issue occurs when a firm has a temporary cash-flow problem. Its assets are greater than its debts, but some assets are illiquid. Therefore, although in theory assets are greater than debts, it can’t meet its current payment requirements.”

Insolvency – A solvency crisis occurs when a country/firm/household has debts that it can’t service by selling its assets. I.e. even if it could sell all its wealth, it would still be unable to pay what they owe their debtors.

Investment-grade bond – This is a safer bond, with a rating Baa (by Moody’s) or BBB (by S&P and Fitch) or above. Also known as a high-grade bond. Yields are lower because so is the risk of default.

IOU – Short for I owe you’’, i.e., debt.

IPO – Abbrev.: Initial public offering.

Kaldor’s v – see Tobin’s Q.

Leaning against the wind – (Or, leaning into the wind.) The term refers to a countercyclical monetary policy where central banks take action to dampen rising inflation or to slow down growth even when the economy is declining.

From LEO Svensson: “‘Leaning against the wind’ (LAW), that is, tighter monetary policy for financial-stability purposes, has costs in terms of a weaker economy with higher unemployment and lower inflation and possible benefits from a lower probability or magnitude of a (financial) crisis.”

Liquidity trap – a situation when monetary policy is ineffective because households prefer to save in liquid assets (cash, deposit accounts) and lowering interest rates does not change that. E.g., if savers anticipate rising future interest rates they will avoid bonds (rate increases is equivalent to a falling bond price).

Modigliani–Miller theorem – (Or, the capital structure irrelevance principle). This is a theoretical result that in a frictionless world (no taxes, wedges, bankruptcy costs, information asymmetry, etc.) “the enterprise value of a firm is unaffected by how that firm is financed.” I.e., any way of raising capital will be equivalent, e.g., equity issuance, short-bond or long-bond financing. The theorem generalizes from private to public debt (see Bolton and Huang’s “The capital structure of nations”, 2017).

Monetary dominance – This is a regime in which monetary policy determines inflation while fiscal policy stabilizes the debt. For the opposite case, see Fiscal dominance.

Money market – A decentralized market of banks, credit unions (who sell CDs), companies (who issue short-term corporate bonds), the government (who issue short-term treasuries), and investors such as money market funds and insurance companies that exchange short-term liabilities for money. The duration of securities are often less than 1 year. A big share of the money market consists of interbank lending, where banks lend each other reserves in exchange for, for example, repos.

Also, MBSs and ABSs are sold in the money market.

Money market fund – They invest in short-term debt securities such as US Treasury bills and commercial paper. Money market funds provide liquidity to other financial intermediaries by taking on their short-term securities in exchange for reserves/money.

Mutual fund – A mutual fund pools money from many investors and invest it in a mix of stocks, bonds, and other financial instruments. Returns less a management fee are kept by the original investors.

NBFIs – Nonbank financial institutions

Open market operations (OMOs) – To achieve the Fed funds target, the SOMA at the New York Federal Reserve Bank buys or sells government securities of short maturity until the overnight lending rate between banks is within a target range.

OMOs also contain repurchasing agreements (see Repo rate). The main point is to influence the amount of money in the banking system, making money scarcer if the Fed wants to increase rates, or adding more if they want to decrease.

You can find more details at the New York Fed’s webpage.

Operation Twist – Mainstream media name for e.g. the Maturity extension program (MEP) of 2011, when the Fed announced to sell short-term government bonds to finance the purchases of long-term bonds to flatten the yield curve. This “twisting” of the yield curve does not expand the balance sheet of the Fed, unlike quantitative easing (since the purchases are financed by selling short-term bonds and not fountain pen money). Operation Twist was coined in 1961 when the Fed took similar action.

Par value – synonymous with the face value of a bond, which most often is different from the asset’s market value.

Price-to-earnings ratio (PE ratio or P/E ratio) – It is the ratio $\frac{\text{Market value per share}}{\text{Earnings per share}}$. The numerator is given by the currently traded stock price, while the denominator is either an average of previous earnings, or it is an estimate for future earnings.

Quantitative easing (QE) – QE is when the Fed buys large numbers of bonds (government, municipal, corporate, MBS) to drive down interest rates. A difference to usual open market operations is that QE aims at driving down long rates in other markets than the overnight market.

q ratio – see Tobin’s Q.

Refinancing – is the process of replacing a current loan with a new. The new loan is used to pay off the existing debt; total debt stays the same, but usually at a lower rate or conditions that better suit the debtor.

Repo rate – Short for repurchase agreement rate. A repurchasing agreement (“repo”) is a contract that states the following: A dealer sells a government security for a price $p_1$. The investor commits to sell the security back at some other price $p_2$ after a (pre-agreed) short period. Often the security is bought back after one night (over-night repo), but there are also week-long and month-long repos.

The repo rate is then the return on the purchasing agreement, which for the investor is the annualized rate of $p_2/p_1.$

Retail funding – When a bank funds investment by demand deposits, usually from households, they are conducting retail funding.

Risk premium – a risk premium is a compensation/discount on an asset. The price of an asset is usually its expected payoff, but because of risk aversion, investors require some compensation if to hold a riskier asset. This lowers the price of the asset and the difference between expected payoff and actual price due to risk aversion is the risk premium. The risk premium can be divided into several sources of risk, e.g., inflation risk or default risk.

Sharpe ratio – the average return of an asset subtracted the risk-free rate, divided by its standard deviation.

An ex-ante Sharpe ratio uses expected return and predicted volatility, while the ex-post (or historic) Sharpe ratio takes realized return and estimated volatility over the period. http://web.stanford.edu/~wfsharpe/art/sr/sr.htm and https://en.wikipedia.org/wiki/Sharpe_ratio

Shiller P/E or CAPE – Cyclically adjusted price-to-earnings ratio “is defined as price divided by the average of ten years of earnings, adjusted for inflation.”

SIFIs – Systemically important financial institutions

Spot price – Current market price of an immediate transaction; e.g., selling a bond here and now – on the spot – for a price $q$. Then, $q$ is the spot price.

T-bill – U.S. treasury bond of maturity less than (but including) one year. They pay no coupons.

T-bond – U.S. treasury bond issued at maturities 20 and 30 years. Pays a coupon every six months (semi-annually).

Term premium – “the extra return that lenders demand to hold a longer-term bond instead of investing in a series of short-term securities (a new one-year security each year, for example). Typically, long-term yields are higher than short-term yields, implying that term premiums are usually positive (investors require extra compensation to hold longer-term bonds instead of short-term securities).” (see link)

Term structure of interest rates – another name for the yield curve. See below.

T-note – U.S. treasury bond of medium duration. Issued at maturities 2, 3, 5, 7, and 10 years. Pays semiannual coupons.

Tier 1 capital – Defined in the Basel accords. Consists of core capital which is disclosed reserves and the original value of the bank’s equity, plus accumulated net profits. The bank equity is thus not the current price on an exchange.

Tobin’s Q – also known as Kaldor’s v or q ratio. It is the ratio of market value to the replacement value of a company/asset. “One, the numerator, is the market valuation: the going price in the market for exchanging existing assets. The other, the denominator, is the replacement or reproduction cost: the price in the market for newly produced commodities. We believe that this ratio has considerable macroeconomic significance and usefulness, as the nexus between financial markets and markets for goods and services.” (page 1–2, Asset Markets and the Cost of Capital, Brainard & Tobin, 1976.)

Wholesale funding – In contrast to retail funding, wholesale funding is sourced from big investors in the money market. These are usually local governments, insurance companies, and other institutional investors.

Yield curve – it plots the annualized yield of treasury securities of different maturities along the horizontal axis. Since there is an always-present risk of inflation and the incertitude regarding it increases in duration, usually the yield curve is upward sloping (i.e., it carries a risk premium that is higher the more exposed to inflation risk it is). It is also possible to plot yield curves for other than treasury bonds. Those will also reflect default risk (as will yield curves of sovereign bonds that are not risk free).