Glossary of financial terms

Credit default swaps

A type of insurance against loss on loans in case of default. For example: If an investor buys $10 million in bonds backed by mortgage-backed securities, that investor, to limit his risk, might buy a $10 million CDS from AIG for a certain premium. In return for the premium, which changes daily and is based on changing risk factors, AIG agrees to pay the investor $10 million should the issuer of the bonds default. To make sure the CDS seller can make good on its promise, it has to post a certain amount of collateral based on the value of the company selling the insurance. If the company’s credit rating is downgraded, which is what happened to AIG when its stock price dropped, it has to post more collateral. “What put AIG on the brink was that it had to post $14 billion overnight, which of course it didn’t have lying around. Next week, the looming downgrades might have forced it to come up with $250 billion,” said a Sept. 18 Time magazine article.

Hedge fund

As the name implies, hedge funds often seek to offset losses by hedging their investments using a variety of methods, most notably short selling. Originally, this practice limited both losses and gains by bringing down risk. However, the term “hedge fund” has come to be applied to many funds using short selling and other “hedging” methods to increase rather than reduce risk, with the expectation of increasing return, according to Wikipedia, the free online encyclopedia. Some hedge funds use leverage, which means investing borrowed money, to boost returns. Because of the substantial risks associated with hedge funds, securities laws limit participation to individuals with incomes of at least $200,000 a year ($300,000 for couples) or those who have a net worth of at least $1 million, according to the Dictionary of Financial Terms.

Short selling

Profit is made when an investor borrows shares — the price of which he expects to decline in the short term — from a long-term investor, sells them at the higher price, buys them back at the lower price and pockets the difference before returning the shares to the owner. Investors often use short selling to allow them to profit on trading in stocks that they believe are overvalued. Naked shorting is the practice of trading on the decline of stocks the investor has not made arrangements to borrow. Short sellers have been blamed, in part, for manipulating the stock prices of firms like Lehman Brothers and AIG with rumors that frightened investors and caused a sell-off. Britain has said it will ban all short selling of financial stocks until January, and the SEC last week tightened rules against “naked” shorting.

Derivatives

Financial instruments with no intrinsic value of their own, whose value is derived from the changing values of underlying assets. Typically, derivatives are used to limit risk (hedge) or to create profit from periods of decline. Common types of derivatives are futures, forwards, options and swaps. A derivative can be something as simple as a futures contract between a wheat grower and a flour producer, or as complex as a short sale of stocks borrowed from an owner who purchased them with borrowed funds. A credit default swap (see above) is a derivative.

— Source: Wire services, staff research