Posted on March 29, 2021 @ 03:37:00 PM by Paul Meagher
In today's blog I want to define some terms used in finance and investing that I think are worth knowing. I hope to make a habit of devoting future blogs to defining useful business terms. Some terms in finance and investing are "mind tools" that can help us think more clearly about certain business problems. Just like farmers have invented tools to make farming easier, academic and practicing business people have created business terms that make thinking about business problems easier. Here are some terms to start with.
Loan To Value (LTV): Loan to value is a ratio (L / V). It is the ratio of the amount of loan L used to acquire an asset to the assessed value of an asset V. Lenders may specify an LTV of say 70% meaning they will only loan up to 70 percent of the value of the asset. So, for a house assessed at $100,000, the maximum loan the lender will provide is $70,000. The portion the buyer is expected to pay is sometimes called "the haircut" (in this example 30% or $30,000) . The higher the LTV value on a loan, the riskier the loan is. Different lenders may offer different LTV rates and some may originate riskier loans. One of the factors that led to the economic crisis of 2008 was that mortgage originators were offering loans with high LTV's. In Investopedia's article The Fuel That Fed The Subprime Meltdown they describe what happened to LTV rates:
As a result of this activity, it became very profitable to originate mortgages—even risky ones. It wasn't long before even basic requirements like proof of income and a down payment were being overlooked by mortgage lenders; 125% loan-to-value mortgages were being underwritten and given to prospective homeowners. The logic being that with real estate prices rising so fast (median home prices were rising as much as 14% annually by 2005), a 125% LTV mortgage would be above water in less than two years.
Time Under Water: Measures how long it takes for some measure of business performance to return after it goes down in value. If you made, say, 50,000 in February of 2020 but your revenues took a hit as a result of COVID, then you could measure how long it takes to get back to making 50k a month again. The time under water would be the number of months it takes to get back to making 50k a month again. The time under water could be measured in days or years depending on the context. Many small businesses are continuing to spend time under water as a result of the pandemic. If you were making, say, 50k per month before the pandemic and then your revenue dropped to 10k per month, that drop of 40k would be the drawdown amount. If it was the largest drop in revenue you have ever experienced, then it would be the maximum drawdown, and your recovery back to making 50k a month again would be time spent deep underwater. When assessing the risk associated with different stock market investments, you might measure the average time under water and maximum drawdown of different stocks to create a risk profile for them.
Source: Optimal Portfolios with Traditional and Alternative Investments: An Empirical Investigation
It might be worth noting that if you are in the situation of having a mortgage loan where the value of the loan is greater then the value of the house, then your loan is said to be under water.
Arbitrage: An arbitrage opportunity arises when there is the possibility of buying something for a low price in one market and selling it for a higher price in another market. A stock that is priced lower in one stock exchange, for example, can be exploited by quickly buying up stock on the lower priced exchange and selling it on the higher priced exchange. Hedge funds will often use leverage to buy large quantities of shares to make it worth their while to make these arbitrage trades. The difference in price between the two markets is the gross profit. There are transaction costs in executing a trade which may wipe out the profits if you are not careful. Retail arbitrage involves buying items in one retail environment at a low price and selling it in another retail environment at a higher price. Some Amazon sellers, for example, use retail arbitrage to make money on the items they buy on clearance at Walmart and sell on Amazon. An example of arbitrage in rural areas might involve a store owner buying retail items in a larger big box store and selling them at a higher price in a rural general store.