- Adverse selection
- Adverse selection refers generally to a situation in which sellers have information that buyers do not have, or vice versa, about some aspect of product quality—in other words, it is a case where asymmetric information is exploited. Asymmetric information, also called information failure, happens when one party to a transaction has greater material knowledge than the other party.
- In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to purchase products like life insurance. In these cases, it is the buyer who actually has more knowledge (e.g., about their health). To fight adverse selection, insurance companies reduce exposure to large claims by limiting coverage or raising premiums.
- Amortization is an accounting technique used to periodically lower the book value of a loanor intangible asset over a set period of time. The term “amortization” can refer to two situations.
- First, amortization is used in the process of paying off debtthrough regular principal and interest payments over time. An amortization schedule is used to reduce the current balance on a loan, for example a mortgage or car loan, through installment
- Second, amortization can also refer to the spreading out of capital expensesrelated to intangible assets over a specific duration – usually over the asset’s useful life – for accounting and tax purposes.
- A bond is a fixed income instrumentthat represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an O.U. (An IOU is a document that acknowledges a debt owed) between the lender and borrower that includes the details of the loan and its payments.
- Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer. Bond details include the end date when the principalof the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments made by the borrower.
Characteristics of Bonds
- Face value is the money amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium $1,090 and another investor buys the same bond later when it is trading at a discount for $980. When the bond matures, both investors will receive the $1,000 face value of the bond.
- The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. For example, a 5% coupon rate means that bondholders will receive 5% x $1000 face value = $50 every year.
- Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made in any interval, but the standard is semiannual payments.
- The maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
- The issue price is the price at which the bond issuer originally sells the bonds.
- Bracket Creep
- A bracket creep is a situation wherein inflation pushes income into higher tax brackets. The result is an increase in income taxes but no increase in real purchasing power
- Bracket creep can occur on an ongoing basis if the overall economy grows yet taxpayers do not see substantial increases to their income. In other words, they are charged more taxes without realizing any real improvement on their actual income. This can create a financial drag on the economy as taxpayers spend more money on taxes though they have not reaped any benefits of a tangibly higher salary rate.
- A bubble is an economic cycle characterized by the rapid escalation of asset prices followed by a contraction. It is created by a surge in asset prices unwarranted by the fundamentalsof the asset and driven by exuberant market behavior. When no more investors are willing to buy at the elevated price, a massive sell-off occurs, causing the bubble to deflate.
- Bubbles form in economies, securities, stock markets and business sectors because of a change in investor behavior. This can be a real change — as seen in the bubble economy of Japan in the 1980s when banks were partially deregulated, or a paradigm shift— which took place during the dot-com boom in the late 1990s and early 2000s.
- During the boom, people bought tech stocks at high prices, believing they could sell them at a higher price until confidence was lost and a large market correction, or crash, occurred. Bubbles in equities markets and economies cause resources to be transferred to areas of rapid growth. At the end of a bubble, resources are moved again, causing prices to deflate.
The Five Steps of a Bubble
- Displacement: This stage takes place when investors start to notice a new paradigm, like a new product or technology, or historically low interest rates — basically anything that gets their attention.
- Boom: Prices start to rise at first, then get momentum as more investors enter the market. This sets up the stage for the boom. There is an overall sense of failing to jump in, causing even more people to start buying assets.
- Euphoria: When euphoria hits and assetprices skyrocket, caution is thrown out the window.
- Profit taking: Figuring out when the bubble will burst isn’t easy; once a bubble has burst, it will not inflate again. But anyone who looks at the warning signs will make money by selling off positions.
- Panic: Asset prices change course and drop as quickly as they rose. Investors and others want to liquidate them at any price. Asset prices decline as supply outshines demand.
- Capital Adequacy Ratio
- The capital adequacy ratio (CAR) is a measurement of a bank’s available capital expressed as a percentage of a bank’s risk-weighted credit exposures. The capital adequacy ratio, also known as capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and promote the stability and efficiency of financial systems around the world.
- Two types of capital are measured: tier-1 capital, which can absorb losses without a bank being required to cease trading, and tier-2 capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
- Tier-1 capital, or core capital, consists of equity capital, ordinary share capital, intangible assets and audited revenue reserves. Tier-1 capital is used to absorb losses and does not require a bank to cease operations. Tier-1 capital is the capital that is permanently and easily available to cushion losses suffered by a bank without it being required to stop operating. A good example of a bank’s tier one capital is its ordinary share capital.
- Tier-2 capital comprises unaudited retained earnings, unaudited reserves and general loss reserves. This capital absorbs losses in the event of a company winding up or liquidating. Tier-2 capital is the one that cushions losses in case the bank is winding up, so it provides a lesser degree of protection to depositors and creditors. It is used to absorb losses if a bank loses all its Tier-1 capital.
- Risk-weighted assets are used to determine the minimum amount of capital that must be held by banks and other institutions to reduce the risk of insolvency. The capital requirement is based on a risk assessment for each type of bank asset. For example, a loan that is secured by a letter of credit is considered to be riskier and requires more capital than a mortgage loan that is secured with collateral.
- Capital Output Ratio
- Capital output ratio is the amount of capital needed to produce one unit of output. For example, suppose that investment in an economy, investment is 32% (of GDP), and the economic growth corresponding to this level of investment is 8%.
- Here, a Rs 32 investment produces an output of Rs 8. Capital output ratio is 32/8 or 4. In other words, to produce one unit of output, 4 unit of capital is needed. But don’t forget that the Rs 32 invested in the form of machineries will remain there for around ten or twelve years. Such machinery will be giving Rs 1 output in every year.
- Capital output ratio thus explain the relationship between level of investment and the corresponding economic growth. There is a simple equation in economics that shows the relationship between investment, capital output ratio and economic growth.
G = S/V
Here, G is economic growth, S is saving as a percentage of GDP and V is capital output ratio.
- A lower capital output ratio shows that only low level of investment is needed to produce a given growth rate in the economy. This is considered as a desirable situation. Lower capital output ratio shows that capital is very productive or efficient.
- Crony Capitalism
- Crony capitalismis an economic system in which businesses thrive not as a result of risk, but rather as a return on money amassed through a nexus between a business class and the political class.
This is often achieved by using state power rather than competition in managing permits, government grants, tax breaks, or other forms of state intervention over resources where the state exercises monopolist control over public goods, for example, mining concessions for primary commodities