Graham King

Solvitas perambulum

Financial Glossary

finance
Summary
Commodities are physical goods like sugar and wheat, while financial ones include gold and energy. LIBOR, the London Interbank Offered Rate, is the interest rate at which banks lend to each other and serves as a benchmark for other loans. Liquidity measures how quickly assets convert to cash, with government bonds being highly liquid and exotic options less so. Banks profit from bid/offer spreads, fees, and the time value of money. Financial instruments trade either OTC, directly between parties, or on exchanges through central locations, with traditional open outcry replaced by computer networks. "Vanilla" refers to simple, common financial instruments as opposed to "exotic" ones.

Commodities

Commodities are anything that you can take physical delivery of, such as sugar, coffee, wheat, etc. Many have heard the story of the trader who bought a pork belly future, intending to sell the contract at a profit. He forgot about it and when the contract expired a lorry full of pigs arrived at the bank to deliver the pork bellies he had agreed to buy !

Financial commodities are bullion (gold) and energy.

LIBOR

London Interbank Offered Rate. The rate at which banks lend / borrow from each other. The rate depends on how long the loan is for, so it is usually quoted as 3m LIBOR (if borrowing for 3 months), 6m LIBOR, etc. If the currency is not sterling then it is quoted as well – for example 3m $ LIBOR or 6m EUR LIBOR. Investments typically have to pay more than LIBOR because otherwise we could simply lend the money to another bank at LIBOR. Hence LIBOR is a reference rate.

Liquidity

How easy it is to convert an asset into cash. Government bonds and equity in large companies are very liquid because there are many buyers and sellers constantly active in the market. An option on the currency of a small country or a very exotic, highly structured, bond would be illiquid because it would be hard to find someone to buy them from you.

Making Money

Banks make money from:

  • The bid / offer spread: The difference between what they buy something at and what they sell it for. This is the same as the buy / sell on high street foreign exchange boards.
  • Fees: Most investments made through a bank incur a fee – the bank makes money whether the investment does or not.
  • Time value of money

Over The Counter (OTC) / Exchange traded

An instrument traded OTC is negotiated directly between buyer and seller. An exchange traded instrument is bought and sold in a specific physical location where buyers and sellers meet. Most financial business used to be conducted in exchanges by open outcry (buyers and sellers stand in a circle and shout out what they are selling and buying). The traditional image of a trader in a colorful jacket shouting and waving his arms is open outcry. Nowadays computer networks mean buyers and sellers do not have to be in the same physical location, and most business is OTC.

Vanilla

The most popular and ‘ordinary’ flavor of ice-cream. Used to mean the simplest most common type of a financial instrument. The opposite of ‘exotic’.