Bottom fishing

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.

Black scholes option pricing model

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.

Beta

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

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

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.

Bear squeeze

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.

Bargain issue

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.

American depositary receipt(ADRS)

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.

Alpha

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

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.