Investment in derivative markets

Bulletin board

2009-04-23T03:18:00.001-07:00

A website where investors post gossip, fact and opinion about stocks and markets. Bulletin boards are immensely popular, but - given their virtual anonymity and their lack of regulation -they can be traps for unwary investors.

Bulletin board

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Bull

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An optimist; someone who assumes that prices will rise. The origin is unknown, although it probably evolved because it contrasts strongly with bear. As the quote from Alexander Pope shows, it was in common usage in London by the early 18th century.

Come fill the South Sea goblet full;
The Gods shall of our stock take care:
Europa pleased accepts the bull,
And Jove with joy puts off the bear.
Alexander Pope, inscription on a punch bowl, 1720
(the year of the South Sea Bubble)

Warren Buffett

2009-04-23T03:12:00.000-07:00

Arguably the best-known investor on the planet. Buffett is known for the world-class returns he has produced for over 30 years from his investment conglomerate, Berkshire Hathaway, and for his witty and insightful chairman's letter in Berkshire's annual report. Adding in the investment record of Buffett's partnership, which he ran from 1956 to 1968 before sinking his capital into Berkshire, then his record from 1956 to 2001 showed an annual compound growth rate of 24.5%, enough to turn $1,000 into $i9m. Over the same period, the pre-tax return from the S&P 500 index was 10.1% a year.

Buffett is characterised as an exponent of value investing and he learned his trade from Benjamin Graham, who first espoused that particular cause. In many respects, however, Buffett's investment style is far removed from Graham's. It focuses on the "business franchise", the idea that there is a small cadre of exceptional businesses whose advantages mean that they are protected from everyday economics. Brand-name corporations, or those which can grow on the back of bigger corporations - "gross royalty businesses" such as advertising agencies - are good examples.

Brady bond

2009-04-23T03:11:00.000-07:00

Named after Nicholas Brady, an American Treasury secretary, who in 1989 came up with the Brady Plan to ease the debt burden that was crushing too many developing-country economies. Brady bonds are issued by indebted governments as part of a refinancing of their bank debt following the introduction of an agreed schedule between them and their creditors. This would be likely to include the adoption of responsible monetary policies by the governments concerned and some debt write-off by their bank lenders. Even so, Brady bonds, which are traded on over-the counter markets, are high-risk investments.

Book value

2009-04-23T03:09:00.002-07:00

That part of a company's assets which belongs to its shareholders; in the UK these are generally known as shareholders' funds or, simply, net assets. It is an accounting valuation arrived at by taking the gross assets of the business as shown in its balance sheet and subtracting all the prior claims on the business, such as bank debt, payables, allowances for future claims, and so on. Alternatively, it is the sum of the shares outstanding, additional paid-in capital and retained earnings. Book value is usually expressed in per share terms so as to make an easy comparison with the market price of the shares (see Price to book ratio).

Bottom fishing

2009-04-23T03:09:00.001-07:00

What value-seeking investors do after a stock market has fallen heavily, exposing good value in shares which fair-weather investors are still too shell-shocked to take.

Book value

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Bond rating

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The chances that bonds of all types might go into default - that is, the borrower will fail to pay the interest and/or the capital due on a bond - is rated by several credit organizations, the best known of which are Moody's and Standard & Poor's (s&p). Both organizations use a similar system to rate the safety of a bond, primarily based on a detailed examination of the credit-worthiness of the borrower and the terms of the bond. For S&P the credit rankings range from AAA (the best) to D, meaning that the bond is already in default. The Moody's ratings go from Aaa to D. However, only bonds with a rating of BBB or better (Baa in the case of Moody's) are considered "investment grade", that is, good enough for institutional investors. Bonds below these grades are colloquially termed junk bonds.

Both S&P'S and Moody's bond ratings are monitored closely by investors and therefore any change in an issuer's ratings will be matched by a corresponding movement in the market price of its debt

Bond rating

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Bond rating

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Bond rating

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Bond

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Generic name for a tradable, long-term debt security raised by a borrower who agrees to make specific payments, usually regular payments of interest and repayment of principal on maturity. (See also treasury bond, euro bond, gilt-edged stock.)

Bollinger bands

2009-04-23T02:57:00.001-07:00

Used in technical analysis to determine areas of support for and resistance to price changes. On a chart these plot the standard deviation of the moving average of a price. So when they are plotted above and below the moving average, the bands widen and narrow according to the underlying volatility of the average. The longer the period of low volatility, the closer together the lines become and the greater is the likelihood that there will be a break-out from the established price pattern.

Black scholes option pricing model

2009-04-23T02:57:00.000-07:00

A pricing model that ranks among the most influential. It was devised by Fischer Black and Myron Scholes, two Chicago academics, in 1973, the year that formalized options trading began on the Chicago board of trade. The Black-Scholes model, or adaptations of it, has gained universal acceptance for pricing options because its results are almost as good as those achieved by other options pricing models without the complexity.

Behind the model is the assumption that asset prices must adjust to prevent arbitrage between various combinations of options and cash on the one hand and the actual asset on the other. Additionally, there are specific minimum and maximum values for an option which are easily observable. Assuming, for example, that it is a call option then its maximum value must be the share price. Even if the exercise price is zero, no one will pay more than the share price simply to acquire the right to buy the shares. The minimum value, meanwhile, will be the difference between the share's price and the option's exercise price adjusted to its present value.

The model puts these fairly easy assumptions into a formula and then adjusts it to account for other relevant factors.

The cost of money, because buying an option instead of the underlying stock saves money and, therefore, makes the option increasingly valuable the higher interest rates go.
The time until the option expires, because the longer the period, the more valuable the option becomes since the option holder has more time in which to make a profit.
The volatility of the underlying share price, because the more it is likely to bounce around, the greater chance the option holder has to make a profit.

Of these, volatility, as measured by the standard deviation of share returns, is the most significant factor. Yet it was the factor over which Black and Scholes struggled because it is not intuitively obvious that greater volatility should equal greater value. That it is so is because of the peculiar nature of options: they peg losses to the amount paid for the option, yet they offer unlimited potential for profit.

Note that the basic Black-Scholes model is for pricing a call option, but it can be readily adapted for pricing a put option. It also ignores the effect on the price of the option of any dividends that are paid on the shares during the period until the option expires. This is remedied either by deducting the likely present value of any dividend from the share price that is input into the model, or by using a refinement of the Black-Scholes model which writes off the effect of the dividend evenly over the period until it is paid.

Black monday

2009-04-23T02:46:00.000-07:00

Monday October 19th 1987 when Wall Street had its worst day since 1914. The Dow Jones Industrial Average fell 508 points from 2,247 to 1,738, or 22.6%. This triggered panic selling in equity markets around the world and, for example, on the same day the UK's all-share index fell 9-7% from 1,190 to 1,075, then dropped a further 11% the following day. Until that point 1987 had been a great year for equities. From the start of the year until its mid-August peak, the Dow rose 44%. However, rising interest rates caused investors to worry and the German Bundesbank's decision to increase its rates on October 16th was the cue for them to dash for the exit.

The Dow bounced back rapidly from its low. On October 26th alone it put on 10%. The UK index, however, continued to fall and did not bottom out until December 3rd, when it closed at 750, 39% below its mid-year peak.

Binomial option pricing model

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The basic principle behind this and other option pricing models is that an option to buy or sell a specific stock can be replicated by holding a combination of the underlying stock and cash borrowed or lent. The idea is that the cash and security combined can be fairly accurately estimated and their combined value must equal the value of the option. This has to be so, otherwise there would be the opportunity to make risk-free profits by switching between the two.

Take a simple example, the aim of which is to find the value today of a call option on a common stock that expires in one year's time. The current stock price is $100, as is the call's exercise price. To maintain clarity and avoid the complicating effect of an option's delta on the arithmetic involved, imagine that an investor holds just half of this stock (that is, $50-worth) in his portfolio. The portfolio's only other component is a short position in a zero-coupon bond currently worth $42.45, which has to be repaid at $45 in a year's time.

Next assume that the value of the stock in a year's time will be either $110 or $90. From these two postulated outcomes several conclusions arise. First, we can value the call option in a year's time. It will be either $10 or zero. Second, we can value the portfolio. It too will be either $10 or zero. This must be so, since the value of the portfolio is the stock's value minus the debt on the zero-coupon bond. So it is either $55 minus $45, or $45 minus $45. The future value of the stock may be uncertain, but the value of the debt on the bond is not. Third, the alternative values for both the call option and the portfolio at the year end are the same. If this is so, then their start value must be the same as well. The start value for the portfolio can be easily calculated. It is $50 minus $42.45; that is, $7.55. So this must also be the present value of the call option.

From this basic building block of the binomial model comes the formula that the value of a call will be the current value of the stock in question multiplied by the option's delta (which, in effect, was 0.5 in our example) minus the borrowing needed to replicate the option. Using our example, the linear representation would be:

Call value = ($100 x 0.5) - $42.45 = $7.55

This is the single-period binomial model, so called because the starting point is to take two permitted outcomes for the stock price and then work back to find what this means for the present value of the option.

In the real world, however, a single-period model is not practical, hence the development of the multi-period binomial model where each period used to estimate the price of the option can be as short as computer power will allow. As the number of price outcomes rises by 2 to the power of the number of periods under review, the model is computer-intensive; a model using 20 periods, for example, would need over 1m calculations. Additionally, rather than using arbitrary stock-price outcomes from which to estimate the value of the option, the model takes advantage of the fact that, given an estimate of the rate at which a stock price will change, future stock prices can be estimated within a reasonable band of certainty using mathematical distribution tables.

The result is a model which produces options prices that closely mirror market prices. Furthermore, because the binomial model splits its calculations into tiny time portions, it can easily cope with the effect of dividends on stock prices and, hence, option values. This is an important factor with which the more widely used black-scholes option pricing model copes less capably.

Big bang

2009-04-23T02:39:00.001-07:00

The event that took place on October 27th 1986 and transformed the way in which the London Stock Exchange operated. It resulted from a deal between the government and the stock exchange in which the government dropped moves to challenge the exchange's restrictive practices in return for various liberalization measures.

The exchange scrapped the obligations that its members had to be either wholesalers of shares (jobbers) or brokers who dealt directly with investors.
Brokers became free to supply clients with shares held in their own account and they could, if they wished, become market makers in shares.
Restrictions on ownership of exchange member firms were first relaxed and then dropped, unleashing a flood of money into London as various financial conglomerates bought London jobbing and broking firms.
A screen-based system of trading stocks (Stock Exchange Automated Quotations - SEAO) closely modeled on the NASDAQ system was introduced, leading to the demise of floor trading on the exchange.

The abolition of exchange controls by the UK government in 1979 made these moves almost inevitable. The London market had to adapt to the globalization of share trading or it would have become a backwater.

Bid price

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The price that a dealer will pay for securities in the market. Thus it is the lower of the two prices that the dealer will quote for any security. For a mutual fund, it is the price at which the fund management company will buy in units from investors. (See also offer price and spread.)

Beta

2009-04-23T02:31:00.000-07:00

A widely used statistic which measures the sensitivity of the price of an investment to movements in an underlying market. In other words, beta measures an investment's price volatility, which is a substitute for its risk. The important point is that beta is a relative, not an absolute, measure of risk. In stock market terms, it defines the relationship between the returns on a share relative to the market's returns (the most commonly used absolute measure of risk is standard deviation). But in so far as much of portfolio theory says that a share's returns will be driven by its sensitivity to market returns, then beta is a key determinant of value in price models for share or portfolio returns.

An investment's beta is expressed as a ratio of the market's beta, which is always 1.0. Therefore a share with a beta of 1.5 would be expected to rise 15% when the market goes up 10% and fall 15% when the market drops 10%. In technical terms, beta is calculated using a least-squared regression equation and it is the coefficient that defines the slope of the regression line on a chart measuring, say, the relative returns of a share and its underlying market. However, the beta values derived from the regression calculation can vary tremendously depending on the data used. A share's beta generated from weekly returns over, say, one year might be very different from the beta produced from monthly returns over five years.

This highlights a major weakness of beta: that it is not good at predicting future price volatility based on past performance. This is certainly true of individual shares. For portfolios of shares beta works far better, basically because the effects of erratically changing betas on individual shares generally cancel each other out in a portfolio. Also, to the extent that portfolio theory is all about reducing risk through aggregating investments, beta remains a useful tool in price modeling.

Bellwether stock

2009-04-23T02:29:00.001-07:00

Just as the bellwether sheep is the one in the flock that all the others follow, so a bellwether stock is the one that is supposed to lead a market. It follows, therefore, that such stocks will be the ones with a big capitalization, which can also reflect signs of which way the economies in which they trade are heading. In the UK Vodafone and BP fulfill this role as do, for example, Microsoft, General Motors and General Electric in the United States and Mitsubishi and Nippon Steel in Japan.

Bellwether stock

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Behavioral finance

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An increasingly fashionable field of study to explain how financial markets work. Essentially, behavioral finance tries to put people back into the equation. Much of the influential academic work of the 1950s and 1960s assumed that market prices were determined by profit-seeking individuals acting rationally. However, this work, which generated portfolio theory and the efficient market hypothesis, could not explain many of the pricing anomalies that regularly crop up (for example, see calendar effect and small cap stock). Behavioral finance tackles these issues by applying the methods of behavioral psychology to investors' behavior. In particular, it takes the rules of thumb that people use in everyday life to make judgments under conditions of uncertainty and examines their shortcomings from the point of view of probability theory. Such rules of thumb fall into three main categories.

Representativeness. People make consistently poor predictions when they think that an instance is representative of a wider category. For example, the more favorable the description of a company, the more likely it is that investment analysts will forecast good profits growth and a high price for its shares because favorable descriptions imply success. They ignore the point that a forecast does not become more accurate as the description on which it is based becomes more favorable.

Availability. People draw conclusions faster and more confidently the more readily they can recall similar instances. For example, they believe that the chance of a stock market crash is much greater than statistically likely if there has been a recent crash that springs to mind.

Anchoring and adjustment. People make predictions by adjusting an initial calculation, but too often they make insufficient adjustment. For example, when estimating the likelihood that a company can bring a new product to market, analysts are often too optimistic. They underestimate the sequence of events that must be successfully negotiated. Even if the probability of success at each stage of the process is high, the overall probability of success will be lower and will decline the more stages that have to be passed.

Bearer security

2009-04-23T02:22:00.000-07:00

A security for which evidence of ownership is provided by possession of the security's certificate. The issuer keeps no record of ownership. A euro bond is generally issued in bearer form. It was common for the US Treasury and municipal authorities to issue bearer bonds too. However, in order to combat money \ laundering this was made illegal in 1983.

Bear squeeze

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If too many speculators simultaneously sell stock they do not own in the hope of buying it back more cheaply later for a profit, they risk getting caught in a bear squeeze. The dealers from whom they must eventually buy stock to settle their obligations raise prices against them. When the bears scramble for stock to limit their losses they push up prices still further.

Bear

2009-04-23T02:20:00.000-07:00

Someone who acts on the assumption that the price of a security in which he deals will fall. The origin is unknown, although it was common in London by the time of the south sea bubble (1720). It probably derives from the occupation of a bear-skin jobber, about whom the saying went: "He's sold the bear's skin before he's caught the bear."

Basis point

2009-04-23T02:18:00.000-07:00

One hundredth of a percentage point. Basis points are used in currency and bond markets where the sizes of trades mean that large amounts of money can change hands on small price movements. Thus if the yield on a treasury bill rose from 5.25% to 5.33%, the change would have been eight basis points.

Basis

2009-04-23T02:15:00.000-07:00

In a futures market, basis is defined as the cash price (or spot price) of whatever is being traded minus its futures price for the contract in question. It is important because changes in the relationship between cash and futures prices affect the value of using futures as a hedge. A hedge, however, will always reduce risk as long as the volatility of the basis is less than the volatility of the price of whatever is being hedged.

Bargain issue

2009-04-23T02:11:00.000-07:00

The Holy Grail for followers of value investing. The term has a general meaning indicating good value in an ordinary share. However, through the writing of Benjamin Graham, it also has a specific meaning which was successfully applied by Graham and continues to be used by orthodox value investors, although usually with some modifications. These allow for the fact that stock markets are now generally more highly valued than when Graham was working from the 1930s to the 1970s.

The specific meaning of a bargain issue is when a company's ordinary shares sell in the market for less than the per share book value of current assets after deducting all other claims on the business. In other words, take a company's current assets (inventories, debtors, cash) and deduct not only the current liabilities (creditors, short-term borrowings) but also the long-term borrowings and any other allowances. The net result is that the shares of such companies sell for less than the value of net current assets with any fixed assets thrown in for nothing. Graham found that buying a selection of such shares across a variety of industries invariably produced good investment returns.

Bar chart

2009-04-23T01:42:00.000-07:00

The most common type of price chart used to identify patterns that may give clues to future price movements in the investment under scrutiny. Price is plotted vertically and time horizontally. The price change for each unit of time - day, week, month, and so on - is plotted by a vertical bar, the top and bottom representing the high and low respectively for each period. Usually there will be a horizontal tick attached to the bar, representing the closing price. On the bottom of the chart more bars sometimes plot the volume of business transacted, scaled to the right-hand axis. This helps correlate price changes to volume of business done, which may be significant. For B example, a surge in the price of a share to new highs based on little volume could be a sign of impending weakness or, alternatively, a sign of strength if the buying has been done by informed insiders.

An open-high-low-close chart (also OHLC chart, or simply bar chart) is a type of chart typically used to illustrate movements in the price of a financial instrument over time. Each vertical line on the chart shows the price range (the highest and lowest prices) over one unit of time, e.g. one day or one hour. Tick marks project from each side of the line indicating the opening price (e.g. for a daily bar chart this would be the starting price for that day) on the left, and the closing price for that time period on the right. The bars may be shown in different hues depending on whether prices rose or fell in that period.

This type of chart is often used by technical analysts to spot trends and view stock movements, particularly on a shorter term basis.

Backwardation

2009-04-23T01:39:00.002-07:00

In a furures market the price of a contract for future delivery of, say, a commodity usually trades above the spot price because the notional interest received from holding cash rather than the underlying commodity is added to the cost of the contract. Sometimes, however, demand for the commodity pushes the spot price above the futures price. This is a backwardation, also known as an inverted market.

Balance sheet

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The financial statement of what a company owns and what it owes at a particular date, known as the statement of financial position in the United States. Traditionally, the left-hand side of the balance sheet is a schedule of the company's assets (land, buildings, plant and equipment, cash and inventories); the right-hand side is a statement of the liabilities, either real or potential. Real liabilities comprise the debts the company must pay - that is, creditors - plus its loans. Potential liabilities are the allowances that are likely to be paid: deferred taxes and, increasingly, post-retirement benefits for employees. The remaining item on the right-hand side is the shareholders' interest in the business. This is technically not a liability at all, but a statement of the risk capital subscribed to the business adjusted by the aggregate of retained earnings and (possibly) revaluation of some assets.

Balanced fund

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A mutual fund that invests in a combination of ordinary share and bonds (including government debt). As such, it has a wide spread of assets and could be considered medium risk, in contrast to funds that are invested wholly in equities (high risk) and wholly in bonds (low risk). The consequence of this should be that the investment return of a balanced fund will be pedestrian compared with an equity fund during a bull market, but will do well during a bear market.

Annuity

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An annual sum paid in perpetuity, usually for a fixed amount, although it can be linked to an index.

Annual report

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All companies whose owners have a limited liability to the financial obligations of their company must publish an annual report, which is sent to the owners and lodged with a central authority for public inspection. For companies whose shares are listed on a recognised stock exchange, the annual report will almost certainly contain a mix of statutory information and information given voluntarily by the management. The statutory information includes a profit and loss account (income statement in the United States), balance sheet (statement of financial position in the United States) and cash flow statement, together with explanatory notes to these.

Amortization

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US terminology for depreciation. In the UK amortization generally refers to writing off the cost of intangible assets.

American Stock Exchange (Amex)

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New York's other stock market, the American Stock Exchange Stock Exchange (Amex) is similar to the much bigger New York Stock Exchange (NYSE) in its organisation and trading arrangements. However, Amex's presence in the equity markets has been squeezed by both the NYSE and NASDAQ. Indeed, it was taken over by NASDAQ in 1998, although it continues to run independently. Its origins date back to street trading in the late 19th century, and it was not until 1921 that it moved to a permanent building in Trinity Place in New York's financial district, where it is still based. By the mid-1960s the volume of stocks traded on Amex reached half the level of business done on the NYSE. Since then its relative importance has declined, so that at the end of 2002 the aggregate market value of domestic companies whose shares were listed on Amex was below $100 billion, compared with over $9,000 billion for the NYSE. However, Amex has been successful in derivatives trading, especially in exchange traded funds, which it launched in 1993 and whose trading it dominates, with US market share of over 90%.

Arithmetic mean

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The full term for what non-mathematicians intuitively call the average and which is generally shortened simply to the mean. It is calculated by taking the sum of a series of values and dividing that number by the number of values. So if 12 values add up to 96, the average is eight. It should not be confused with the geometric mean, under which heading there is a fuller discussion of the circumstances in which it is more appropriate to use one or the other.

American depositary receipt(ADRS)

2009-04-21T23:31:00.000-07:00

Most US investors who own shares in foreign corporations do so via American depositary receipts (ADRS). There is nothing to stop them buying overseas shares directly (although they may technically infringe the 1933 Securities Act when they come to sell them). ADRS, however, are much more convenient. Basically, they are tradable receipts which say that the underlying shares represented by the ADRS are held on deposit by a bank in the corporation's home country. The depository bank collects dividends, pays local taxes and distributes them converted into dollars. Additionally, holders of ADRS usually have all the rights of shareholders who own their stock directly. The vast majority of overseas corporations that list their shares on a US exchange use ADRS; at the end of 2002 there were over 1,000 such listings. ADRS have spawned imitators and nowadays there are global depositary receipts, basically ADRS which are traded on over-the counter markets in both the United States and the euro market, and European depositary receipts, which are traded on European exchanges.

Alternative investment market (AIM)

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The London stock market's junior market for small, fast-growing companies, launched in June 1995. Its progress to date has substantially exceeded expectations and at the end of November 2002, 698 companies were quoted on the Alternative Investment Market (AIM) with a combined stock market value of £15.2 billion. The logic behind the AIM was to form a market with a minimum of regulation and spiced with tax breaks, thus creating a cheap means of raising risk capital for young companies. Since its launch, over 1,100 companies have had their shares listed on the AIM, raising over £12 billion in the process. Regulation is carried out by approved advisers rather than the exchange itself; and the information that companies have to supply is minimal as is the number of shares that have to be made available for trading.

Alpha

2009-04-21T23:22:00.000-07:00

A term borrowed from statistics which is used to show how much of the investment performance of a stock or portfolio of stocks is independent of the stock market in which they trade.

Within a simplified pricing model used to identify those portfolios of investments that deliver the best combination of risk and return, alpha is used to describe the expected return from a security or a portfolio assuming that the return from the market is zero. Thus in this model the expected return for, say, an ordinary share would be its alpha plus the market return leveraged by the share's sensitivity to market returns (its beta). Here both alpha and beta are estimated based on comparison of the historical returns of the share and the market (see also single index model).

In measuring portfolio performance, alpha is used to define to what extent a portfolio has done better or worse than it should have done, given the amount of risk it held. If it is accepted that a portfolio's performance will (simply speaking) depend on market returns times the portfolio's sensitivity to the market, then alpha quantifies the extent to which the portfolio's return varies from its expected return. Thus it measures the extent to which the manager adds or erodes value.

Advance decline line

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Also known as the breadth of market indicator, this plots the number of share prices that rise minus the number of share prices that fall over a specific period (usually a day or a week) for a given stock market average (the S&P 500 INDEX, for example). Followers of technical analysis use this to gauge the strength of a stock market. In particular, if the advance-decline line shows a negative return (that is, more shares fall than rise) yet the stock market index continues to rise, they see this as an indication that the market is weak and as a prelude to a fall in the index.

Advance corporation tax

2009-04-21T23:14:00.000-07:00

A taxation system used by the UK government to take a slice of income from the dividends that companies paid to their shareholders. However, advance corporation tax (ACT) had a penal effect on UK-based companies that made most of their profits overseas and was abolished in April 1999. Thus companies no longer have to pay the government 25% of the amount of the dividend that they paid to their shareholders. Correspondingly, shareholders no longer receive a tax credit equal to the value of the ACT paid. The exception to this rule, however, is that private investors still get a small tax credit, equal to 11% of the dividend that they receive, which they can offset against their tax liability.

Accrued interest

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The interest that has been earned on a bond since its most recent dividend was paid. The market price for bonds ignores this element; it quotes the price of bonds "clean" of accrued interest. However, a buyer would have to pay for the interest that has accrued. Imagine a bond with a 10% coupon. If it were quoted in the market at $125 120 days after the last dividend had been paid then, ignoring dealing costs, a buyer would have to pay $125 plus 120/365 of $10; that is, $128.29.

Accruals concept

2009-04-21T23:01:00.000-07:00

A basic idea on which company accounts are based: that cause and effect should be linked by matching the costs which are incurred in running a business with the resultant revenue earned (although not necessarily received in cash) in the same accounting period. The alternative would be to have a system of cataloging the cash transactions of a business and calling the net result profit or loss. But in any one year this would be likely to distort the picture of the company's performance since many cash costs would be incurred, or income received, in respect of pieces of work that span more than one accounting year.

Asset stripping

2009-04-21T22:59:00.000-07:00

A term first coined in the UK in the late 19605 to describe the practice of taking over a company, splitting it into parts and selling them for a profit. It was a derogatory label since it implied no effort on the part of the acquirer to develop the company. By the late 19805 asset stripping was more in tune with the spirit of the times, so when the practice once more swept through the corporations of the UK and the United States it was more likely to be called "financial restructuring".

Asset allocation

2009-04-21T22:56:00.000-07:00

The process of deciding in which sorts of assets to make investments and what proportion of total capital available should be allocated to each choice. The task is as relevant to private investors as it is to giant savings institutions. The latter formalize the process rather more, however, often beginning with a top-down approach, which decides both in which asset classes to make investments (shares, bonds, real estate, cash, other classes) and in which geographical areas to invest (North America, Europe, East Asia, emerging markets, for example). Estimates of the likely returns from individual investment choices compared with the target return that the institution seeks will drive the selection process. From this will follow the decision to invest an above-average or below-average proportion of funds in some markets with reference to benchmark weightings that are commercially available.

Asset

2009-04-21T22:48:00.000-07:00

For something so fundamental to investment the surprise is that the definition of an asset is so vague. The US accounting standards body has defined it as being "probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events". However, within the context of a company's balance sheet, an asset is also a deferred cost. If a company shows plant and equipment of £1m in its balance sheet, that represents past expenditures which have yet to be written off and which, according to the accruals concept of accounting, will be depreciated as the plant is used up. The test of whether the plant is ultimately an asset or a liability will be whether it generates after-tax revenue greater than its cost. For a company to survive, most plant and equipment must pass that test. But for other items which are carried forward as assets, such as the deferred cost of a pension fund, there is no suggestion that they can bring economic benefits.

More generally, the broad categories of investments within a portfolio - shares, bonds, property - are known as assets. Hence the term asset allocation.

Arbitrage pricing theory (APT)

2009-04-21T22:37:00.000-07:00

A theory which aims to estimate returns and, by implication, the correct prices of investments. Intellectually, it is an extension of the capital asset pricing model. It says that the CAP-M is inadequate because it assumes that only one factor - the market - determines the price of an investment, whereas common sense tells us that several factors will have a major impact on its price in the long term. Put those factors into a model and you are making progress.

Thus arbitrage pricing theory (APT) defines expected returns on, say, an ordinary share as the risk-free rate of return plus the sum of the share's sensitivity to various independent factors. (Here sensitivity, as with the CAP-M, is defined by the share's BETA.) The problem is to identify which factors to choose. This difficulty is compounded by academic studies which have come up with varying conclusions about the number and identity of the key factors, although benchmarks for interest rates, inflation, industrial activity and exchange rates loom large in tests.

In practice, the aim of using APT would be simultaneously to buy and sell a range of shares whose sensitivity to the chosen factors was such that a profit could be made while all exposure to the effect of the key variables and all capital outlay were canceled out. To the extent that APT assumes that markets always seek equilibrium, it says that the market would rapidly price away such arbitrage profits.

Alternatively, a portfolio could be chosen which could be expected to outperform the market if there were unexpected changes in one or more key factors used in the model, say industrial activity and interest rates. As such, however, that would be doing little more than betting on changes in industrial production and interest rates and would not have much to do with minimizing risk for a given return. Resolving problems such as these means that APT gives greater cause for thought to academics than to investors.

Arbitrage

2009-04-21T22:14:00.000-07:00

To arbitrage is to make a profit without risk and, therefore, with no net exposure of capital. In practice, it requires an arbitrager simultaneously to buy and sell the same asset - or, more likely, two bundles of assets that amount to the same - and pocket the difference. Before financial markets were truly global, arbitraging was most readily identified with selling a currency in one financial center and buying it more cheaply in another. The game has now moved on a little, but, for example, there would be the potential to make risk-free profits if dollar interest rates were sufficiently high to allow traders to swap their euros for dollars and be left with extra income after they had covered the cost of their currency insurance by selling dollars forward in the futures market. Similarly, arbitrage opportunities can be exploited by replicating the features of a portfolio of shares through a combination of equity futures and bonds then simultaneously selling the actual stocks in the market. (See risk arbitrage)