FISCHER BLA(X'S GLOSSARY FOR FINANCE
JANUARY 1983
100% reserves
A simple way to regulate banks is to require that deposits be backed at all
times with government securities of equal value. A similar method can be used
for other financial institutions.
The banks can issue stock and bonds to raise the money for loans.
Accounts payable
A firm's accounts payable are the amounts due in the near future to its
suppliers and other creditors. One firm's account payable is another firm's
account receivable.
Accounts receivable
A firm's accounts receivable are the amounts due from its customers and other
amounts due in the near future. The market value of its accounts receivable
may be less than the stated value, because some customers may refuse to pay.
For example, some customers may have the right to return goods that are
recorded as sold, and other customers may demand refunds because the goods or
services were of low quality.
Agency costs
Agency costs are management costs: the cost of inducing others to act in your
interests.
Managers are agents for stockholders and bondholders. Employees are agents
for supervisors, and supervisors are agents for employees. Majority
shareholders are agents for minority shareholders.
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Pinerican option
An Pinerican option is one that can be exercised at any time before maturity,
while a European option can be exercised only at maturity. In the Lhited
States, most simple options are Pinerican. But Pinerican options are common in
Europe, and European options can be found in the Lhi ted States. Cne reason
that Pinerican options are so common is that the ability to exercise at any
time makes the option seem less like simply a way of creating leverage.
Asked price
An asked price is the price at which a specialist or market maker is willing
to sell a security, either for his own account or for the account of a
customer. A bid price is the price at which a specialist or market maker is
willing to buy a security. When a specialist or market maker handles an order
for a customer, it is usually a limit order that has been brought in by a
retail broker. Limit orders may also be handled by exchange employees, or by
board brokers. The price on a limit order to sell handled in this way is an
asked price too.
Asset
An asset is anything of value in the economy. Assets may be tangible, like a
file cabinet, or intangible, like the knowledge of a brand name among
customers and potential customers. Assets may be real, like a building, or
financial, like a bank deposit. A port folio of assets is also an asset.
Assets may be held by individuals or businesses or governments, but all assets
are ultimately held for the benefit of individuals, either living Dr yet to be
born.
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Available information
Information is available if it is widely enough known and unoerstood that
further disclosure would not affect the prices of any assets. Most of the
time, it seems that telling something to a few people makes it available. For
example, more often than not information a firm feels is significant will
already have been discounted by the time the firm announces it publicly.
Bankruptcy
Bankruptcy occurs when a firm is unable to make payments speci fied in its
contracts, or when it violates the terms of those contracts in some other wa~
and cannot work out an agreement with the other party. For example, a debt
contract may require that the firm maintain a certain level of workin~
capital. When bankruptcy occurs, it may pay to liquidate the firm, but more
often it pays to sell or recapitalize the entire firm as a going concern. The
holders of the old liabilities of the firm are then paid off in order of their
priority. The largest costs of bankruptcy are usually caused by the
disruption to the firm's normal activities while it works out its legal
problems. Lawyers' fees can be large, too, but are usually modest compared to
the costs caused by disruption of the business.
Bets are positions taken by investors that will show profits or losses from
changes in things like expected commodity prices, expected interest rates,
expected total risk or volatility, and expected exchange rates. Investors may
also bet on less basic things that they care about. Investors want to make
these bets because they di ffer in their feelings about these changes. For
example, some people are more sensitive to changes in the rate of inflation
than others, so they may be willing to pay to take a position that eliminates
some of their risk. others who are less sensitive may be happy to take more
of the risk in exchange for the payment.
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An asset's beta is a measure of its sensitivity to changes in asset values
generally. A beta of 0.5 means that a 1% increase (or decrease) in the market
in the short run implies a 0.5% increase (or decrease) in the value of the
asset. Choosing a different market portfolio gives a different value for
beta, so there is always considerable uncertainty about what the beta of an
asset really is.
For a given market portfolio and an asset with daily prices available, we can
use daily data to give accurate estimates of what the asset's beta has been.
We may need to make adjustments if the asset trades infrequently.
Bid price
A bid price is the price at which a specialist or market maker is willing to
buy a security, either for his own account or for the account of a customer.
An asked price is the price at which a specialist or market maker is willing
to sell a security. When a specialist or market maker handles an order for a
customer, it is usually a limit order that has been brought in by a retail
broker. Limi t orders may also be handled by exchange employees, or by board
brokers. The price on a limit order to buy handled in this way is a bid price
too.
Bid-asked spread
Suppose an investor enters a market order to buy a stock followed immediately
by a market order to sell the same amount of the same stock. (Or a market
order to sell followed by a market order to buy.) The buy price minus the sell
price is
bid-asked
the bid-asked spread for that amount of stock. Sometimes
spread is called the dealer spread or the specialist's quote.
the
The
bid-asked spread accounts for part of the cost of trading. It is a part that
is not as easy to measure or control as the commission.
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Call option
A call option is an option to buy the underlying asset by paying the exercise
price, while a put option is an option to sell the underlying asset for the
exercise price. A can option goes up when the under lying asset goes up.
Buying a call option is a substitute, in the short run, for borrowing to buy
the under lying asset. Mixing call options with lending is a substitute, in
the short run, for buying the underlying asset. An exchange traded American
call option should generally be exercised early only just before a substantial
dividend on the underlying asset.
Call price
The call price for a bond is the price at which the issuer can redeem the bond
prior to maturity. For example, the issuer may be allowed to call a bond with
a face value of $1000 at $1100 when the bond will mature in 20 years. The
call price normally declines as the bond approaches maturity.
Capi tal
The capital in the economy includes both physical capital and human capital;
both tangible assets and intangible assets. The capital stock changes because
of consumption and new investment, but the most important reason for changes
in the capital stock is changes in the value of existing capital. There are
also events like war and expropriation that can cause dramatic changes in a
country's capital stock.
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Capital asset pricing model
The capital asset pricing model says that the expected excess return on an
asset is its beta times the expected excess return on the market port folio.
The interval over which the returns are measured can in principle be any
length, but the model makes more sense if the interval is taken as very
short. The model assumes that all assets are marketable, and that everyone
can borrow or lend freely at a single riskless interest rate, so we don't
expect it to be strictly true. It also ignores premiums on bets on such
things as future commodity prices and future interest rates. It's very hard
to test the model on actual securities, because expected returns are not
observable, because the composition of the market portfolio is not known, and
because foreign assets should be partly in and partly out of the market
port folio.
Capital gain
The capital gain on an asset is the price at which you sell it (or could sell
it) minus the price at which you buy it (or could buy it). If you have bought
it and sold it, the gain is realized. If you have bought it but haven't sold
it (or if you have sold it but haven't bought it), the gain is unrealized.
The capital gain on an asset is only part of its return.
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Capital structure
A firm's capital structure may be defined narrowly as the values of its
various liabilities, or broadly as the values of its various liabilities and
financial assets. The values may be given at market value or at book value.
For most firms, common stock and debt in the form of bonds or loans are the
main elements of a firm's capital structure. In that case, the market or book
debt/equity ratio tells much about the firm's capital structure.
Sometimes assets and liabilities not on a firm's balance sheet may be included
in describing its capital structure. For some purposes, both pension
liabilities and pension assets may be included, when the firm has a defined
benefit pension plan.
Cash dividend
One way for a firm to give something of value to its shareholders is to pay a
cash dividend. It is sometimes said that the value of a stock is the
discounted value of its future dividends. But there are other, equally good
ways for a firm to give something of value to its shareholders. For example,
a firm can buy back its stock in the open market, or it can make a tender
offer for its stock. A single owner of a firm can take an exceptionally high
salary, or can cause the firm to buy goods or services at inflated prices. A
firm's stock will have value even when there is no plan to pay a cash
dividend, if only because there is always the potential for future dividend
payments. A stock's yield is a measure of the rate at which it is currently
paying cash dividends.
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Cash flow
A cash flow for an asset is a payment made to the owner of the asset (which
normally reduces the value of the asset by about the amount of the payment),
or an investment in the asset by the owner (which normally increases the value
of the asset at the time the investment is made by about the amount of the
investment). Cash flows for a firm or individual are the raw data from which
smoothed figures such as earnings are calculated. The cash flows from a
common stock include the purchase price, the dividends, and the sale price.
They may also include the tax changes resulting from the dividends and the
sale of the stock.
Certain return
A certain return for a given period is the return at the riskless interest
rate for the period. For example, if lending $100 for two years to a borrower
who is sure to repay the loan gives an interest rate of 10% per year (when
both principal and interest are repaid when the loan matures), the certain
return on the loan for the two year period is 21%. Of course, no loans are
really riskless, including loans to governments, and so no returns are really
certain.
Claim
A claim on a firm is a liability of the firm. Claims include common stock,
preferred stock, long term bonds, commercial paper, bank loans, and judgments
awarded by the courts to people claiming that the firm injured them. Claims
can also include potential liabilities such as payments to lawyers which are
made only if the firm becomes bankrupt.
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Closed end investment company
The liabilities of a closed end investment company can be worth more or less
than its assets, but normally they are worth less. The reasons for this
discount are not known. These companies rarely issue new shares unless the
discounts have become premiums, at least for the time being. Buying shares of
a closed end fund at a discount seems better than buying shares of an open end
fund at net asset value, if the size, expenses, and other characteristics of
the two funds are the same. A closed end fund at a discount can eliminate the
discount immediately by converting to an open end fund. They often do not do
that because the managers of the fund fear that total assets and thus total
management fees will decline if the fund starts redeeming its shares
continuously. They may also fear the loss of control that merger with a large
open end fund would bring.
Closing out a short position
An investor closes out a short position when he delivers an asset just like
the one he sold when he created the short position. If it's a short position
in a stock, he closes it by delivering identical stock to the person who lent
him the stock. If it's a short position in an exchange traded option, he can
buy an identical option in the market and the clearing corporation will cancel
his long and short positions. The exercise of an option will also cause the
writer to close out his short position, but in this case he does it by
delivering the underlying asset (if it's a call option) or by accepting
delivery of the underlying asset and paying for it (if it's a put option).
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Commission
The commission on a trade is part of the total trading cost. The other part,
which is less obvious, is related to the bid-asked spread. The bid-asked
spread for a trade depends in part on the price effects of the trade, which
depend in turn on the size of the trade, the typical volatility and trading
volume of the stock, and the likelihood that the trader has information that
will affect the price of the stock when it has been discounted. In many cases
the commission is less than half the total trading cost.
Commodi ty option 1
A commodity option may be an option to buy the underlying commodity, but more
often it is an option to enter into a futures contract and receive a payment
equal to the futures price minus the exercise price. If it were a put option,
it would be the exercise price minus the futures price. The futures contract
specified by the option contract will, of course, have a longer maturity than
the option. An investor must put up collateral to write a commodity option,
but not to buy one. If he deals in futures contracts, though, he must put up
collateral on either side of the contract. A commodity option gives one way
to bet on changes in the expected future price of a commodity.
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Commodity price bet
A comrrodi ty price bet shows gains or losses when there are changes in the
expected price of the good or service that is the basis for the bet. It's
easier to make bets on the future prices of goods than on the future prices of
services, because part of the bet must be a definition of exactly what good or
service is being priced. One way to bet on commodity prices is to take a long
or short position in a futures market. Another is to buy or sell a commodity
option. A third way is to enter into a contract to buy or sell a speci fied
amount of the commodity at a specified price on a specified date. If one
person must pay to take one side of a commodity price bet, then it's not
neutral. We say there is a premium on the bet, because one person gains and
the other loses even if the actual future commodity price turns out to be
equal to the currently expected price. There can be a whole term structure of
commodity price bets, since there can be a bet on the expected price on each
of many future dates.
Competitor
Polaroid and Eastman Kodak are competitors in instant photography. Each is
trying to take sales away from the other, and would be pleased if the other
were to stop competing in that field. I\\;vertheless, the returns on their
common stocks are highly correlated. Developments favorable to instant
photography or to photography as a whole will cause both their stocks to go
up, and unfavorable developments will cause both to go down. Developments of
that kind are much more common than developments that imply good things for
one firm and bad things for the other.
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Consumer goods and services
Consumer goods and services are those that are used up in the current period.
The others are investment goods and services. Consumer goods and services
include both things that consumers use directly and things that the government
uses for the benefit of consumers. For example, a car is
but the service provided by a car is a consumer service.
an investment good,
The fl ow output 0 f
the economy can be divided roughly between consumer goods and services and
investment goods and services.
Continuity
A securities market has continuity if successive trade prices don I t differ
very much. For example, many trades might be at the same price as the
preceding trade, and most might be priced within an eighth or a quarter of the
preceding trade. Continuity is affected most by the frequency of trades and
by the underlying volatility of the stock, which depends on the rate at which
information affecting that stock arrives in the market. Continuity may also
be affected by the organization of a market and by the behavior of the
specialist or market makers in the market. It is not in itself a desirable
trait of a market, since a market that responds rapidly to new information may
show a lack of continuity.
Continuous market
A continuous market is one in which an investor can almost always find a buyer
or seller, at least while the market is open. This may not do him much good,
though, if the price at which he can buy is far above the price at which he
can sell. Sometimes, a continuous market means one where an investor can
almost always find a buyer or seller at a price close to the price of the last
trade.
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Convertible bond
A convertible bond is like a straight bond with one added feature. The
bondholder can exchange his bond at any time for a given amount of common
stock. When the issuer of a convertible bond exercises his option to call the
bond, the holder of the bond may exercise his option to convert it to common
stock. He will normally do this only when the value of the common stock is
greater than the call price. A convertible bond is less risky than stock, but
more risky than a comparable straight bond. A convertible bond will always be
worth more than an otherwise identical straight bond, but that doesn't mean
that there is a solid floor for the convertible's price. If conditions were
bad enough, the straight bond (and the convertible bond) might be worth
nothing at all.
Corporate bond
A corporate bond is a liability for the issuer. The corporation promises to
pay interest and principal to the bondholders at specified future times. The
corporation may have the right to buy the bond back and avoid further
payments. The bondholder may have the right to exchange his bond for a
certain amount of the corporation's common stock. If the corporation fails,
the bondholders are generally paid for their bonds before the stockholders
receive anything. The corporation is not allowed to do certain things (such
as paying a large dividend) that would help the stockholders and hurt the
bondholders.
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Correlation
The correlation between the return on firm A's stock and the return on firm
8's stock indicates how closely related the two firms are. Two firms in the
same business are closely related and will have a high correlation, even
though they compete for customers, workers, and machines. The correlation is
defined as the covariance between the return on stock A and the return on
stock 8, divided by the standard deviation of the return on stock A and
the standard deviation of the return on stock 8. Past correlation can be
estimated accurately using daily data, if we take account of the effects of
infrequent trading.
Cost of capital
The cost of capital for a proposed investment is the expected return on the
investment starting from its initial value. The initial value of the
investment may be greater than or less than the cost of the investment, and
it's important not to use cost in this calculation. A firm does not have a
cost of capital: only an existing or proposed investment does.
Unfortunately, the cost of capital for a proposed investment is not
observable, and is very hard to estimate. It's even hard to estimate the
expected return on an existing security. So rather than trying to derive a
cost of capital to use in discounting the cash flows of a project, it may make
sense to move more directly to an estimate of the value of the project and
then to compare the value with the cost.
?
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Dealer
A dealer buys and sells the assets he specializes in continuously. The
difference between his buying price and his selling price is the dealer spread
or bid-asked spread. In some cases he also charges a commission. One kind of
dealer is a specialist, who is chosen by an exchange to make a market in a
security. Another kind is a market maker who competes with other market
makers either on or a ff an exchange floor.
Deal er sprea d
The dealer spread is the same as the bid-asked spread. It is the di fference
between the price at which a dealer will sell a security and the price at
which he will buy. The dealer spread depends on size: it will normally be
larger for 1,000 shares than for 100 shares, and it may not even exist for
100,000 shares. The dealer spread represents part of the total cost of
executing a trade.
Debt
From a legal point of view, a firm's debt includes liabilities such as
straight bonds, convertible bonds, and bank loans. Interest payments on
liabilities like these are deductible in computing taxable income. Equity
includes liabilities such as common stock and preferred stock. Oi vidends on
liabilities are not deductible. From a financial point of view, debt includes
any liability where promised payments that are likely to be made give the
liability most of its value. This includes most preferred stock, but omits
very risky bonds such as convertibles selling well above face value.
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Demand loan
A demand loan is one where the lender can demand payment in full at any time.
Normally the lender will give plenty of notice before he actually demands
payment of the principal of the loan, because he knows it may take time for
the borrower to find a new lender or to raise the money in some other way.
However, the lender will not hesitate to change the interest rate charged on
the loan, either because interest rates generally have changed, or because the
risk of default has changed. The interest rate on a riskless demand loan is
the shortest of short term rates.
Depth
An asset market has depth if it is possible to buy or sell a large amount of
the asset without affecting the price very much. A market with lots of
trading is likely to have depth. It's possible for a specialist or market
maker to give a market depth, even when there isn't much trading, if he is
willing to carry a large position for a long time. But if large buyers and
sellers are typically trading on information that is not yet reflected in the
market price, it makes sense for the trade to affect the price.
Disclosure
Forced disclosure hurts a firm, because it helps the firm's rivals. It
discourages investment in information that will have to be disclosed.
Forced disclosure of existing information helps society, by allowing others to
use the information without cost. But this gain is elusive, because a policy
of forced disclosure will cause much information not to be produced at all.
Society gains when information is disclosed that helps in valuing the stocks
of different firms. The accounting system, when it works well, allows the
release of this kind of information without the release of specific
information that is most helpful to rivals.
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Discounting of cash flows
Discounting of future cash flows is dangerous because the future amounts are
usually so uncertain and because the right discounting procedure may be hard
to find. If the future cash flows are certain and their tax status is the
same as the tax status of cash flows from bonds, then we may be able to use
the prices of traded bonds to discount the cash flows. If the cash flow
projections are made under the assumption that the equilibrium expected return
on every asset similarly taxed is the short term interest rate, then we may be
able to take the expected future cash flows and discount the expected values
as if they were certain.
More generally, we can take the cash flows that we would expect if the return
on the market were equal to interest in each period prior to the cash flows,
and discount them at the interest rate. We will assume the return on the
market is at the after-tax interest rate, and we will discount after-tax cash
fl ows at the a fter-tax interest rate.
Discounting of information
When asset prices fully reflect a piece of information, we say that the
information has been discounted. If the information were widely known and
understood, the prices of all assets would be the same as they are today. In
an efficient market, all available information is fully discounted.
Diversifiable risk
An asset's diversifiable risk is that part of its total risk that become
unimportant when the asset is held as part of a large port folio. If a very
large number of assets having only diversifiable risk were put together into a
portfolio, the return on the portfolio would be nearly certain. The
diversifiable risk of an asset does not affect its expected return, because
investors do not have to be paid to bear it. That part of an asset's risk
that is not diversifiable is called systematic risk.
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Diversi fication
Diversification means adjusting a portfolio so that it has less specific
risk. The more securities a portfolio has, and the less they have in common
with one another, the more diversified the port folio is likely to be. If a
market port folio were available, it would be a fully diversified port folio.
Perhaps the hardest parts of diversification are dealing with the specific
risk of human capital and the risk in foreign assets. Diversi fication
eliminates risk that investors are not paid to bear, and leaves risk that they
are paid to bear. It may also leave risks that individuals are willing to pay
to bear, such as bets on future commodity prices and interest rates.
Diversification includes both asset diversification and time diversification.
While diversification has direct benefits for an individual, its benefits for
a corporation are indirect. The holders of a corporation's stock will usually
hold it as part of a pert folio of stocks, so they can have diversified
portfolios even though the corporation's assets are not diversified. But a
better diversified corporate portfolio of assets will allow more debt or
reduced costs of possible bankruptcy, and will thus reduce the firm's cost of
capital.
Dividend
A dividend is an amount of cash or other assets paid to a firm's
stockholders. A dividend that is not a cash dividend is a stock dividend or a
distribution of assets. When a dividend is paid, the price of the stock drops
by about the amount of the dividend, so the dividend does not in itself make a
stockholder better off. Larger cash dividends may cause the stock price to go
up by signalling that the firm's officers and directors feel that the firm's
future cash flows will be large and stable enough to support the dividend. ~l
the other hand, larger cash dividends cause higher taxes for many
stockholders. A firm with risky debt outstanding may be able to increase its
stock price by increasing its dividend, because it is shifting its assets in
part from the lenders to the stockholders.
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Dollar return
The cbllar return on an asset is the change in its price or value over a
specified period plus the value of any distributions, such as dividends or
interest, paid to holders of the asset during the period. The dollar return
may be a f more interest on an asset such as an option than the return
expressed as a fraction or percentage, because the price of the asset can be
small and can change very rapidly. J en a forward or futures contract, me
dollar return must be used, because the initial price of the contract is
zero. And it must be used for a short position because the investment in a
short position is negative (ignoring collateral and margin requirements).
Earnings
The earnings of a firm are figured from verifiable data such as past cash
flows of the firm. The accounting rules for figuring earnings seem designed
to give a figure that can be multiplied by a price-earnings ratio to give an
estimate of the value of the firm. Thus the earnings figure is designed to be
proportional to the value of a firm, rather than to measure the actual or
expected change in the firm's value.
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Efficient market
An efficient market is a market in which asset prices reflect all available
information. N:J market is fully efficient: the more available a piece of
information is, the more efficient markets will be with respect to that
information. In an efficient market, it is not possible to make trading
profits using available information.
It's hard for an investor to make trading profits using available information,
but it's also hard for him to lose money trading on no information, at least
gross of expenses. So he can choose securities for reasons other than the
attempt to use trading profits. Similarly, it's hard for a corporation to
issue stock at the wrong time, if the information it has is available to
others. If it has a good investment opportunity, issuing stock to finance it
will pay.
It is sometimes possible to infer available information from market prices in
an efficient market. For example, a firm's stock price may tell us something
about how attractive its opportunities are, and the volatility of its stock
price may tell us something about how risky they are. Normally, however,
there is no way to test whether a market is efficient. We can hope to prove
that a market is inefficient by showing a way of earning a consistent return
greater than the short term interest rate. But we can never prove a market
efficient: the best we can do is to keep ruling out proposed inefficiencies.
Even though we can't prove that any market is efficient, theory suggests that
the efforts of traders to take advantage of any profit opportunities they see
will tend to make markets efficient. Such traders can make trading profits,
though, only if someone is willing to make trading losses, so market
efficiency depends on the existence of fools, gamblers, and liquidity traders
along with rational information traders.
The more efficient markets are, the better the investment decisions made by
firms will be. So it may pay to encourage efficiency, even when that involves
complex government regulations designed to force disclosure of important
information.
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Efficient port folio
An efficient portfolio is a diversified portfolio. It's sometimes called an
efficiently diversifed portfolio. It is a portfolio with no unnecessary
risk. If an individual cares only about the expected return and total risk of
a portfolio of securities, then an efficient portfolio for him is a portfolio
that has the highest expected return of all portfolios with the same total
risk, and the lowest total risk of all portfolios with the
return. There can be many efficient portfolios in this sense:
risk and low expected return, and some wth high risk and
return. When an individual has assets he can 't sell such as
and when he cares about things like future commodity prices
rates, it becomes harder to define an efficient portfolio.
Endowment fund policy
same
some
high
human
and
expected
with low
expected
capital,
interest
So long as an endowment fund is receiving sizable gifts, the most important
factor in investment policy is attracting more and larger gi fts. While ~
? factors would nprmally imply that the fund be invested entirely in bonds, the
• gift factor will normally suggest at least some investments in common stock.
Few donors would consider an all bond portfolio appropriate.
Egually weighted market index
An equally weighted market index is based on a portfolio where every stock has
an equal dollar investment. The percentage change in the index is the average
of the percentage change in each of the component stocks.
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European option
A European option can be exercised only at maturity, while an American option
can be exercised at any time before maturity. It is not clear how these
options got their names. In the U1ited States, most simple options are
American, but there is no obvious economic reason for that. European options
wouldserve as well in almost all uses for options, and the use of European
options would avoid the disruptions that occur when an American option must be
exercised early.
Excess return
The excess return on an asset is the return on the asset minus interest at the
riskless rate for the period. In other words, it's the difference between
what a holder of the asset received and what he would have received had he
lent his money instead atthe riskless interest rate. The excess return can be
either positive or negative.
Exchange
An exchange is a focal point for trading in any security listed on it. Buyers
and sellers can find one another through the eXChange floor, or through
electronic systems tied to the exchange floor. M exchange normally provides
continuous trading in each of its securities while it is open, and reports the
prices of all trades that make use of the exchange. It provides other
services too, such as the storage and execution of limit orders.
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Exchange floor
An exchange floor is a place where investors and their agents meet to trade
securities in person. Often it provides a focus for trading in a security so
that buyers andsellers can easily find one another. Person-to -person trading
di ffers from electronic trading in many of the ways that the use of currency
differs from the use of credit cards: no matter how fancy the systems for
electronic trading become, there will always be a place for person-to-person
trading.
Exchange rate bet
One way to bet on changes in expected future exchange rates is to hold foreign
currency. The trouble with that way is that currency does not bear interest.
Another is to take a position in a forward or futures market for the
currency. Betting on exchange rates is one way to bet on the di fferences
between foreign and domestic inflation, since exchange rates areclosely
related to the ratio of domestic prices to foreign prices of similar goods.
It's not known whether there are generally any premiums on exchange rate
bets. It may be that the expected changes in an exchange rate futures price
is generally near zero. It's possible to bet on exchange rates as of many
future da tes.
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Exchange traded option
With an exchange traded option, the writer has a contract with an options
clearing corporation, and the clearing corporation has a contract with the
buyer. This means that the buyer can sell without disturbing the writer' 5
position, and the writer can buy in without disburbing the buyer's position.
To make this possible, options are standardized by maturity date and exercise
price, and there is a continuous market (during trading hours) in each
standardized option. Because the exercise price is standardized, there is
normally no adjustment for cash dividends. The terms of the options are
adjusted, however, for substantial stock dividends. When a buyer decides to
exercise an exchange traded option, the clearing corporation assigns an
exercise notice randomly to one of its members, and a writer is eventually
chosen to deliver the underlying asset. Exchange traded options don't exist
on all listed securities, in part because of the cost of maintaining
continuous markets in a security's options. Even when they do exist, an
investor may not be able to take a large position because of position limits
set by the exchanges and the government.
Exercise
An option is exercised when the holder of the option buys the underlying asset
at the exercise price or strike price specified in the option contract. It
usually pays to exercise a call option before maturity only when the
underlying asset is about to decline in value (as it does when a large
dividend is paid). It may pay to exercise a put option early whenever the
price of the underlying asset falls far enough below the exercise pr,ice.
Selling an option can be a good substitute for exercising it, and the writer
of an option may buy it back to avoid receiving an exercise notice.
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Expected excess return
The expected excess return on an asset is the expected return on the asset
minus interest at the riskless interest rate for the period. It's also the
expected or average value of the excess return. In the capital asset pricing
model, the expected excess return on an asset is the asset's beta times the
expected excess return on the market.
Expected return
The expected return on an asset is the expected terminal value of the asset,
plus any expected cash flows on the asset, minus the initial value of the
asset, expressed as a fraction of the initial value of the asset. While the
promised return on a security depends on the total risk of the issuer, the
expected return depends mostly on that part of the risk that can't be
diversified away. Since investors don't have to bear that part of the risk,
they don't have to be paid for bearing it unless the asset is sensitive to a
non-rnarket risk that bears a risk premium. (Interest rate risk may be an
example of such a non-market risk.) Expected return can be divided into
interest and risk premium. The interest is what investors would receive if
they lent a comparable amount of money. The risk premium is what investors
must be paid to bear the relevant part of the asset's risk.
Face value
The face value of a bond is the amount that the bondholder receives when the
bond matures. It is also his claim on the issuer in the event of bankruptcy.
Finally, the prices at which the issuer can redeem the bond before maturity
are set in relation to the face value of the bond.
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FIFO
FIFO means first in, first out inventory accounting. When an item is sold
from inventory, the cost assigned to that item is the cost of the first
similar item bought for inventory. When the cost
FIFO will normally give a lower cost than LIFO.
income for accounting or tax purposes.
Financial leverage
of similar items is rising,
Thus it will give higher
A firm has high financial leverage if it has lots of debt in its capital
structure. The debt can come in the form of long term bonds and bank loans,
or in less obvious forms such as long term leases or purchase commitments. As
a first approximation, the amount of financial leverage a firm has is more a
matter of form than a matter of substance. Changes in the financial leverage
of the firm can be made in a way that leaves both the value of the firm and
the per-share value of cash of the claims on the firm roughly unchanged.
Flow output
The flow output of the economy is like dividends on common stock. Some modes
of production cause high current output but deplete the capital stock so that
future output is lower than it might otherwise be. other modes of production
cause low current output but preserve the existing capital stock. Unexpected
changes in the value of the existing capital stock probably say more about how
the economy is doing than variations in the level of flow output. However,
changes in the value of the existing capital stock and changes in the level of
flow output will be correlated.
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Forward contract
When two people enter into a forward contract for a commodity, one agrees to
buy the commodity from the other at a specified price on a future date. The
description, location, and amount of the commodity are made part of the
contract, but need not be standardized, because there is no continuous
secondary market for the contract. The initial value of the contract is zero,
but it can have either a positive or negative value later on. Each person may
put up collateral to guarantee that he can do what the contract says he will
do. jib money changes hands until the commodity is delivered at maturity.
With a futures contract, on the other hand, the contract price is changed each
day to the then current futures price, and the loser for the day pays the
winner. They start even with each new day.
Frictions
Frictions include trading costs, taxes, selling costs, information costs and
management costs.
In a world without frictions, investors would mix holdings of index funds with
borrowing or lending, at least as a first approximation. As a second
approximation, they might bet on changes in interest rates or on changes in
the volatility of the market.
In a world without frictions, all borrowing and lending would be on a demand
basis through banks. Bank deposits would be close to riskless. Debits and
credits would be applied to positive or negative bank acounts. Some debits
would make a positive account negative, and some credits would make a negative
account positive.
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Fully efficient market
A fully efficient market is a market in which everyone has all available
information, and prices reflect that information. A different concept of
"available information" will give a different definition of "fully efficient
market." In a fully efficient market, there can be no trading profits.
M::lreover, market prices will not tell any person something that person does
not already know.
Fund
A fund is an investment company, a pension fund, an endowment fund or some
other large portfolio managed for the benefit of a number of people. A closed
end fund is a closed end investment company, and an open end fund is an open
end investment company or mutual fund.
Futures contract
When two people enter into a futures contract for a commodity, one makes a
tentative agreement to buy the commodity from the other at a specified price
on a future date. The description and location and amount of the commodity
are standardized. The initial value of the contract is zero, but each person
must generally put up collateral to make it likely that he can cover any
losses. 01 the next trading day, the speci fied price in the contract is
changed to the last price at which a new position was opened on that day. If
the price ha gone up, the person on the short side of the contract pays the
person on the long side the difference between the two prices. If the price
has gone down, the payment goes the other way. The two people are always
even. Either one can terminate his risk by going into the market and taking
the other side of a new contract with a third person. In effect, the third
person takes his place in the original contract. In a forward contract, on
the other hand, there is no day-by -day settlement. The original contract
price is not changed, and no ITOney changes hands until the commodity is
delivered at maturity.
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Futures market
Futures contracts are opened and closed in a futures market. Futures
contracts can't exist without a futures market, because it's the closing price
in the futures market that determines how much the loser in a futures contract
will pay the winner each day. The closing price is the price specified in the
last futures contract opened during the day. Futures market rules frequently
limit the amount by which the futures price can move during a single day.
It's not known what the real reason for this is, but it does limit the amount
that the loser has to come up with the next day. It also stops most trading
when the price at which people would like to trade is beyond the day's limit.
This costs the exchange money, at least in the short run, because total
trading is reduced.
I1Jman capital
Human capital is what gives a person earning power. It gives him the ability
to work at a variety of jobs, where the job that pays him the highest wage at
any time will depend on the circumstances at that time. Individuals invest in
human capital by going to school and by taking jobs that provide valuable
experience even if the pay is low. I1Jman capital can't be sold, because that
would greatly change an individual's incentives to work. Since there is no
market for human capital, it is hard to estimate its value. It's even hard to
define the value 0 f human capital, because its characteristics would change if
it were marketable.. fJn individual making investments in human capital looks
at both the level of his wages and the changes that occur in the risk
associated with his future wages.
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Income
Income from and asset can be defined as (l) the return on the asset over a
given past interval, including both realized and unrealized capital gains; (2)
the expected return on the asset over some future interval; or (3) the cash
flows from the asset over a given interval. For example, the income from a
common stock might be defined as the actual return on thestock, the expected
return on the stock, or the dividends on the stock. other definitions are
possible too, such as defining the income or earnings of a firm by smoothing
out the firm's cash flows using accounting rules. The past return on an asset
can be observed when the asset's value is known at the start and the end of
the interval. The cash flows from an asset can usually be observed too. But
the expected return on a risky asset cannot be observed, so it that definition
is chosen, we can have at best very poor estimates of the income from the
asset.
Index fund
An index fund is a portfolio managed so that its return will almost always be
close to the return on a market index, such as the Standard & Poor's 500 Stock
Index. Ole way to match an index is to hold all the stocks in the index,
weighting them the same way they are weighted in the index. Mother is to
hold all the stocks in the index except a few that are thought to be in danger
of bankruptcy. A third way is to use complex statistical rules for selecting
a smaller group of stocks that is likely to actthe same as all the stocks in
an index. The advantages of an index fund are wide diversification and low
turnover. There is no reason to believe, however, that an index fund is
better than other port folios with wide diversification and low turnover. It
seems to have marketing advantage, though, among customers familiar with the
index being matched.
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Inflation
The rate of inflation is the average rate at which the prices of consumer
goods and services are increasing. When the rate is negative, we have
deflation. There are many ways to take the average, each of which will give a
different rate of inflation. For many goods and services it is difficult to
measure the prices, because both prices and the non-price terms of a sale may
be changing rapidly. Thus measured rates of inflation should not be taken too
seriously. Changes in short term interest rates may give more information
than changes in the measured rate of inflation about changes in the average
price of consumer goods and services.
Information
When information arrives in a market, asset prices change. Information
includes facts, like the resignation of a key officer in a firm, and new
interpretations of previously known facts, like an analysis of the impact of
declining rates of population growth on sales of running shoes. The rate of
arrival of information on a stock determines the volatility of the stock.
Information most often affects the general level of the market or the prices
of a whole group of stocks, but can sometimes be specific to a single firm.
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Information trading
Information trading is the attempt to make trading profits. Trading that is
not information trading is liquidity trading. An information trader is acting
on information that he believes the market has not yet discounted, while a
liquidity trader is trading because of changes in his wealth, changes in the
risks and expected returns from various investment opportunities, and changes
in his tastes for the various risks he can take on. Information trading
should change prices of risky assets, while liquidity trading, if it is known
not to be motivated by information, should not. If markets are effiCient,
information trading will not pay. Information traders are more likely to use
market orders than liquidity traders, because they want to trade before their
information is discounted. Uquidity traders are more likely to use limit
orders.
Inside information
Inside information is information that is not yet available: information that
has not had its full effect on market prices. The officers and employees of a
firm and their relatives and friends are the most likely to have inside
information about the firm, but customers, competitors, and suppliers may also
have such information. Ulder certain circumstances, trading on inside
information is illegal. Even when it is not illegal, trying to trade on
inside information may be unwise, because it's hard to tell inside information
from information that has already been discounted.
Interest rate
Riskless ·lending earns dollars at the interest rate. The amount of interest
earned depends on the time the money is lent as well as the interest rates
that apply while the loan is outstanding. The interest rate is nominal; when
adjusted for inflation it is called the real interest rate.
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Interest rate bet
An interest rate bet shows gains or losses when there are changes in expected
future interest rates. Che way to bet on interest rates is to buy or sell
bonds or notes. Pnother is to deal in futures or options on bonds or bills.
Betting on interest rates is one way to bet on future rates inflation, since
interest rates depend heavily on expected rates of inflation. It's generally
believed that people who buy long term bonds are paid for taking that side of
an interest rate bet: the side that gains when expected interest rates go
down and loses when expected interest rates go up. The resulting premium on
long term bonds tend to be higher than expected returns on short term bonds,
even when the risk in a long term bond can all be diversified away. There is
a term structure of interest rate bets that corresponds to the term structure
of yields on bonds with various maturities.
Investment
For an individual, an investment is an asset he holds primarily because of the
dollar return it provides. A washing machine would not normally be considered
an investment. A house and a car, however, might be considered investments
even though they provide returns mainly in the form of services. Stocks,
bonds, and savings deposits are clearly investments. For a firm, an
investment is an asset it uses in its business, and any outly it makes hoping
to increase its profits. Firms make investments in such things as real
estate, advertising, equipment, research, and training for employees.
Investment company
An investment company issues securities and uses the money that comes in to
buy the shares of other firms. Or it may buy bonds or lend some of the
money.
market:
The shares of a closed end investment company trade in a secondary
the market value 0 f its liabilities may differ from the market value
of its assets. The shares of an open end investment company or mutual fund
are normally issued and redeemed by the company ata price that makes the
market value of its liabilities equal to the market value of its assets.
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Investment decision
An investment decision can be a choice among traded securities. ~re often,
it means the decision by an individual or firm to create a new asset, in the
hope that it will be worth more than it costs. A firm can make investment
decisions by imitating what its competitors are doing, by observing the prices
at which similar assets are sold and comparing those prices with the cost of
producing it, by figuring what the asset will contribute to earnings and
multiplying by a price-earnings ratio specific to tyhe asset, or by projecting
cash flows from the asset and discounting them to the present to get a value
that can be compared with the cost of the asset. These complex methods seem
less practical than the simple ones like imitating competitors.
Investment goods and services
Investment goods and services are those that are not used up in the current
period. They include machines, inventories, skills, knowledge, consumer
habits, real estate, weapons, and consumer durables such as cars. The flow
output of the economy can be divided roughly between consumer goods and
services and investment goods and services.
Leverage
A claim on an investment has leverage if the percentage chang
of the claim tend to be greater than the percentage changes in the value
the investment, and are highly correlated with the
value of the investment. An equity claim on an investment that is financed in
part by debt will have leverage. An option will have leverage, where the
investment is the underlying asset. These kinds of leverage are financial.
We also speak of operating leverage, referring to a business with a high
proportion of fixed costs. The profits of the business will be very sensitive
to its sales.
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LIFO means last in, first out inventory accounting. When an item is sold from
inventory, the cost assigned to that item is the cost of the similar item most
recently bought for inventory. When the cost of similar items is rising, LIFO
will normally give a higher cost, and thus lower income for accounting or tax
purposes, than FIFO.
Limit order
A limit order is one that can be executed only at the specified price or
better. A buy limit order at 550 can be executed only at 550 or below. A
sell limit order at $50 can be executed only at $50 or above. A liquidity
trader may gain by using a limit order, because a limit order signals to the
market that he does not have significant perishable information. He will
probably trade at a better price than if he used a market order, but he's not
sure how long he'll have to wait to trade. A limit order will often be at the
same price as one side of the specialist's quote, so the specialist is (in a
sense) sharing his profits with the users of limit orders. It's possible,
though, that the specialist's trades for his own account are more pro fi table
than his trades on behalf of limit orders.
Liquidity
A liquid asset is one that can be sold or redeemed quickly and easily at a
known price. Sometimes an asset is considered liquid only if it can also be
bought an immediately sold for a low total trading cost. All government bonds
are liquid in this sense, but short term government bonds are sometimes
considered more liquid than long term government bonds, because the price of a
short term bond fluctuates less than the price of a long term bond. Sometimes
a less liquid asset will have a higher expected return than a more liquid
asset, and this difference is called a liquidity premium or term premium. One
of the most liquid assets is currency, which has a zero nominal return so long
as it is accepted in payment. A market in which a liquid asset trades is a
liquid market, though the asset may be liquid only because the market exists.
Liquidity trading
Liquidity trading is trading that would occur even if all investors had the
same information and the same beliefs about investment opportunities. It is
trading that would result from changes in these shared beliefs, anci from
changes in an investor's tastes. For example, it may result from changes in
an investor's overall tolerance for risk, or from changes in his preferences
for risks of changes in the prices of goods and services. These changes may
in turn be associated with ,changes in the investor's wealth. Small cash flows
may not result in liquidity trading, because they can just change the amount
on which the investor is earning or paying the short term interest rate.
Large cash flows, though, 0 ften mean a change in the inves tor's wealth and
thus lead to liquidity trading. If a liquidity trader can arrange to trade
only with other liquidity traders, he can reduce the price effects of his
trades; but it is difficult to convince others that you are a liquidity
trader. Information traders like to pretend to be liquidity traders.
Liquidi ty traders use limit orders more than information traders, and market
orders less. Offering to buy or sell a whole portfolio is one way to suggest
that you aren't trading on information, and buying or selling over a long
period of time is another. Yet another is offering to trade at future market
prices. If information traders make money as a group, they make it at the
expense of liquidity traders.
A loan is an asset for the lender, and a liability for the borrower. The
terms of a loan include promised payments, restrictions on the borrower's use
of his assets, and the lender's rights in case the borrower fails to live up
to the other terms of the loan. The yield or annual percentage rate is only
the promised return or maximum return on the loan. The expected return is
lower becaue of possible default, and may be reduced further by the costs of
administering the loan. The promised return depends on the total risk
associated wi th the borrower and his assets while the expected return may
depend mostly on the part of the risk that can't be diversifed away.
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Long position
When an investor has a long position in an asset, he gains when the price of
the asset goes up, and loses when the price of the asset goes down, other
things being equal. An investor can have a long position by owning the asset
or by having a contract whose value depends in part on the price of the
asset. Buying a call option on the asset or selling a put option on the asset
will give him a long position. Buying the bonds of a firm close to bankruptcy
will give him a long position in the firm. A person who takes a contract to
buy in a forward or futures market also has a long position.
t>'aking a market
A dealer makes a market in the securities he speCializes in. He buys and
sells the securities continuously. When an underwriter brings a new issue to
the market for the first time, he will often make a market in the issue so
that it will be traded continuously.
t>'anipulation
Manipulation of a stock means causing it to sell at a price that is not
justified by the issuing firm's prospects. The Price may be either too low or
too high. Anyone with enough money can manipulate the price of a stock: he
can buy and force the price up; and he can sell short (if not subject to the
uptick rule) and force the price down. What's not clear is why he would want
to do that. If he buys to force the price up, he will force the price down
when he sells again, and his average selling price will normally be lower than
his average buying price. He will expect to lose money, unless he combines
this activity with issuing false information that the market believes. So
instead of having rules against manipulation, perhaps we should rely on rules
against issuing false information.
- 38 -
Market index
A market index is constructed by plotting the changes in price for a
diversified port folio of common stocks. An equally weighted market index is
based on a portfolio that always has the same dollar investment in each of its
stocks. A value weighted market index is based on a port folio where each
stock is weighted in proportion to the total outstanding dollar amount of that
stock. Another kind of market index is based on a port folio that always has
just one share of each of its stocks. There are also indexes, sometimes
called market indexes, where the change in the index is a geometric average of
the changes in the individual stock prices. An index like this does not show
the change in price of any actual portfolio.
Market information
Market information causes the prices of assets generally to change. It is
usually information about the prospects for the economy, ei ther near term or
long term. Sometimes, though, it is information about government actions such
as price controls that will affect the share of output going to owners of
physical assets compared to the share going to owners of human capital.
Market maker
A market maker is a dealer. He buys and sells the assets he speCializes in
continuously. Normally there is more than one market for a securit y and then
we refer to competing market makers. When an underwriter brings 8 firm 's
common stock to the market for the first time, he will 0 ften act as a market
maker in the stock afterward to help ensure a continuous market.
- 39 -
Market order
A market order to buy or sell a security is one that is to be executed
immediately at the best price available. A market order to buy is executed at
the asked price, and a market order to sell is executed at the bid price. On
an exchange floor, a market order is usually filled by the specialist, ei ther
for his own account or for a customer who has left a limit order with him.
Earning the dealer spread on market orders is one of the specialist's main
sources of income.
Market portfolio
If the world were simple, the market portfolio would be a portfolio of all
assets taken together. In practice, we usually choose a port folio containing
traded securities of the largest domestic firms. We ignore privately held
firms, real estate, human capital, and foreign assets.
Market value balance sheet
A market value balance sheet is a statement of a firm's (or individual's)
assets and liabilities, where an attempt is made to use market values for both
assets and liabilities. When the asset market values cannot be observed
directly, and almost all liabilities are publicly traded, we can start by
figuring the total market value of all the liabilities. We subtract from this
the total market value of the assets whose market value are known, and the
result is an estimate of the total market value of the assets whose market
values are not known. The figures in the market value balance sheet change
every day.
- 40 -
Maturity
The maturity of a bond is the time between now and the final payment to the
bondholder, or the time between original issue and final payment. The
maturity of an option is the length of the period during which the option can
be exercised, or the time between now and the last time at which the option
can be exercised.
Maturity date
The maturity date for an option is the date on which the option expires: the
last date (or the only date) on which it can be exercised. The maturity date
for a bond is date of the last required payment of interest or principal.
Money market fund
A money market fund is a mutual fund that buys short term interest-bearing
securities. However, a money market fund normally does not allow its price
per share to fluctuate with the value of the securities it holds. Reserves
are used to absorb the normally small asset value fluctuations. As a result,
the interest rates on these funds may differ somewhat from market rates,
causing substantial flows of money into or out of the funds at times.
Money market funds grew up at a time when bank deposit interest rate ceilings
were especially onerous. If rate ceilings were removed for both demand and
time deposits, and if reserve requirements were applied evenly to all forms of
lending, including lending through money market funds, these funds would
probably cease to exist.
- 41 -
M.Jtual fund
A mutual fund redeems its shares continuously at net asset value per share.
It usually sells its shares continuously at net asset value per share, too,
which means that its price cannot deviate from net asset value. Occasionally
there is a redemption fee paid into the fund, which helps prevent traders from
taking advantage of quirks in the method for finding net asset value. Often
there is a sales charge or load paid to the selling organization. Since the
price of the fund shares are fixed by the fund at the value of its assets per
share, fluctuations in demand for the shares result in flows of money into or
out of the fund.
News
News is information: anything that causes asset prices to change. World news
causes prices all over the world to change, usually in the same direction.
National news causes prices of assets within a country to change. Local news
causes the prices of local assets to change.
flbn-voting stock
Occasionally a firm will issue two classes of common stock that are identical
except that one class has voting rights and the other does not. The state in
which the firm is incorporated may not allow this, however, because the voting
stockholders may cause the firm to do things that help them and hurt the
non-voting stockholders. For example, the voting shareholders may cause the
firm to buy goods and services at inflated prices from other firms in which
they have an interest. flbn-voting stock is also created by a short sale. The
lender of the stock receives the equivalent of non-voting stock, issued by the
borrower who is selling the voting stock short.
- 42 -
cperating leverage
A business has high operating leverage if its fixed costs are a large part of
its total costs. The fixed costs include such things as interest out of debt,
the cost of owning or renting plant and equipment, and the salaries of
permanent employees. The division of total costs makes sense only for the
short run. In the long run, almost all costs are variable, because debt can
be repaid, plant and equipment can be used up or sold, and employees can be
fired or allowed to leave voluntarily.
cption
An option is the right to buy (or sell) an asset at a specified price for a
specified period. An option to buy is a call option, while an option to sell
is a put option. An American option can be exercised throughout the specified
period, while a European option can be exercised only at the end of the
period. J An over-the-counter option is a contract between 8 buyer ana a
writer, while an exchange traded option puts a clearing corporation between
the buyer and the writer .J The corporate liability closest to a simple option
is the warrant, but all corporate liabilities have some option features:
sometimes the issuer has the option, and sometimes the holder of the security
has the option. For example, the issuer of a straight bond sometimes has the
right to buy it back at a specified price. The value of an option depends on
such things as the terms of the option, the volatility of the price of the
underlying asset, the current price of the underlying asset, the likely
dividends or other distributions on the asset, and current interest rates.
- 43 -
The output of the economy is the same as total income, so we have the same
choices in defining output that we have in defining income. The past output
of the economy can be defined as the change in the value of the existing
capital stock plus the flow output of the economy. Expected future output can
be defined as the expected change in the value of the existing capital stock
plus flow output. The more usual definition of output focuses only on flow
output, but this seems incomplete. The value of the existing capital stock is
not easy to define or measure, but it seems plausible that changes in the
value of the capital stock are highly correlated with changes in the level of
stock prices generally.
Over-the-counter option
With an over-the-counter option, the writer has a contract directly with the
buyer, and the terms 0 f the option can be arranged to suit the two parties.
In particular, there is no limit on the size or number of contracts the writer
or buyer may have. Since the exercise price of an over-the-counter option is
not standardized, it can be adjusted for cash dividends. With an exchange
traded option, on the other hand, the writer has a contract with the options
clearing corporation, and the clearing corporation has a contract with the
buyer. The terms of the option are standardized so that either party can
close out his position without affecting the other. If the buyer chooses to
exercise his option, a given writer has only a small chance of being chosen to
deliver the underlying asset.
- 44 -
Pass i ve port fol io
A passive portfolio is a portfolio managed for broad diversification, low
trading costs, and low taxes. Information trading is not done. Even cash
inflows or outflows may not cause any portfolio turnover, because they will
ini tially jus t increase or decrease the cash balance or loan balance. (The
cash balance or loan balance is a positive or negative balance growing at the
appropriate short term interest rate.) Trading will be done to change the
overall risk of the portfolio, to handle large cash flows, to improve
diversification, and for reasons like responding to attractive tender offers.
Trades may involve many stocks at once, or may cover an extended period, to
help reduce trading costs. When taxes are involved, a stock may be sold
partly because the sale will create a realized capital loss. A passive
portfolio may also involve consistent exposure to the risk of changes in
interest rates, volatilities, or the prices of certain goods and services.
Performance
The performance of a portfolio is usually measured relative to the performance
of a standard such as a market portfolio. The usual method is ot construct a
mixture of the market portfolio with borrowing or lending that has the same
systematic risk as the portfolio we're looking at. The measure of performance
is hte average di fference between the returns on these two port folios. It is
very rare for a portfolio to show up as consistently superior to the market by
this test. But the test would show only relatively large differences in
expected return. A portfolio may have an expected return that is consistentlY
higher by 1% per year and it won't show up, by this or any other empirical ?
test of performance.
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Portfolio
A portfolio is usually a collection of securities. Sometimes other assets are
included. A port folio may contain short positions as well as long positions.
The return on a port folio is the sum 0 f the returns on the assets in the
portfolio, where each return is weighted by the amount of the asset in the
port folio. If the port folio contains a short position in any asset, the
weight on that asset will be negative. Large portfolios where every asset has
a positive weight tend to have highly correlated returns, even when each
portfolio contains assets from a different country.
Preferred stock
A preferred stock is like a bond with indefinite maturity, except that missing
a dividend on preferred stock does not force a firm into bankruptcy, while
missing a payment of interest or principal on a bond generally does. Also,
preferred stock dividends are not deductibel for tax purposes, while bond
interest payments are deductible. Convertible preferred stock is like a
convertible bond. Both straight preferreds and convertibles are normally
£allable, meaning that the issuer has the option of buying the issue back at
speci fied prices. When a convertible preferred is called, the holder can
accept the speci fied price, or he can exchange his preferred stock for common
stock.
Premiums on bets
Suppose that the expected price of a certain commodity three months from now
is $3.00. Two people can bet on the future commodity price by agreeing that
one will pay the other a certain multiple difference between the commodity
price and $3.00. If that's all they do, there is no premium on the bet. But
if one must pay the other to induce him to make the agreement, or if the $3.00
must be changed to a different figure to make the agreement possible, there is
a premium on the bet. The dollar premium is the amount that one person will
pay the other if the future commodity price is exactly $3.00.
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Present value
The present value of an asset is the same as its value. The phrase present
value implies that the value is estimated by estimating the asset I s future
cash flows and discounting them to the present. If the cash flows are
certain, then the discounting can be done using current riskless interest
rates on bonds of different maturities.
Price
The price of an asset is the price at which it trades in an organized market,
or the price someone is willing to payor take at a particular time. The
asset will be a good buy if its price is less than your estimate of its value,
and a good sell if its price is more than your estimate of its value.
Price effect
The price effect of a trade is the effect that the trade has on the price of
the security. A large buyer may force the price higher than the last trade
price, while a large seller may force the price lower. Some price effects are
permanent, because the buyer or seller is trading on information that becomes
available and thus changes the value of the security. ether price effects are
temporary, and represent part of the total cost of making a trade.
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Price-earnings ratio
The price-earnings ratio for a firm is the ratio of the price or value of its
common stock to its past or estimated future earnings. Accounting rules seem
desigled so that price-earnings ratios are as close to constant to possible
(or perhaps as close as possible to the inverse of the short term interest
rate). Price-earnings ratios should be relatively constant over time and
across firms. The more similar two firms are, the closer their price-earnings
ratios should be. A firm that expects higher earnings in the near future
should have a higher price-earnings ratio than an otherwise similar firm that
expects lower earnings in the near future.
Pro fit opportunities
Profi t opportunities allow an investor to do better by buying and selling
securities and other assets than he could do by holding a fixed port folio. At
least they allow him to expect to do better. In an uncertain world, a
strategy that has a higher expected return and lower risk than a second
strategy may still give worse results in the end than the second strategy.
Before the fact, the first strategy was better. It involved profit
opportunities. After the fact, though, the first strategy was worse. The
only sure profit opportunity is one that allows a consistent return higher
than the short term interest rate.
Pro.iect
A project is a proposed investment. Cne way to evaluate a project is to see
whether similar firms have made the same investment and are happy with the
results. If similar ongoing projects are sometimes sold, see what they sell
for. Or estimate the contribution that the project will make to earnings in a
typical year, and multiply by a price-earnings ratio. The price-earnings
ratio should depend on· the project, though, and not on the firm making the
proposed investment.
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Promised return
The promised return on a secuerity is the amountthe contract requires the
issuer to pay if it can, expressed as a percentage of the initial price of the
security. A common stock has no promised return. A preferred stock doesn't
have a promised return unless the issuer is in liquidation, because only the
dividend is promised. Promised return is clearest with a short term bond,
where the issuer promises to pay both interest and principal in the near
future. These promises, however, are not always kept. Promised return and
expected return are not the same. The riskier the issuer is, the more likely
it is that the promised payments will not be made, and the higher the promised
return must be to induce investors to hold the security.
Put option
A put option is an option to sell the underlying asset for the exercise price,
while a call option is an option to buy the underlying asset by paying the
exercise price. A put option goes up when the under lying asset goes down.
Buying a put option is a substitute for selling the underlying asset short.
An Pmerican put opti80n should sometimes be exercised early after the stock
price has fallen well below the exercise price.
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Random walk hypothesis
The random walk hypothesis says that it's not possible to predict future
returns on a risky asset. The weak form of the random walk hypothesis says
that it's impossible to predict future returns from past returns. The strong
form of the random walk hypothesis says that it's impossible to predict future
returns using any data at all, including data about the company and data about
the economy. In an efficient market both forms of the random walk hypothesis
may be roughly true, but neither form can be strictly true. The interest
portion of the return on an asset is predictable, so almost all the return on
a very low risk asset will be predictable. Assets such as options have
changes in risk that are accompanied by price changes, so these changes in
risk and the changes in expected return that go with them can easily be
identi fied. More generally, changes in the risk of assets generally can be
observed and predicted, even in an efficent market, and these changes in risk
go along with changes in the expected return on assets generally.
Real interest rate
The real interest rate is the interest rate minus the expected inflation
rate. Since the expected inflation rate depends on the price index being
used, so does the real interest rate. For a given price index, the real
interest rate is not observable, because the expected inflation rate is not
observable. It is dangerous to rely too heavily on past actual inflation in
forming impressions about expected future inflation.
The real interest rate is affected by both tastes and technology: by
preferences for spending now or spending later; by the degree of aversion to
risk that people have; and by the expected productivity of capital at
different levels of risk. Changes in any of these factors and in other
factors will cause changes in the real interest rate, so we cannot assume that
the real interest rate is constant. Still, the past behavior of interest
rates and inflation suggests that a constant before-tax real interest rate is
a good first approximation.
Recapitalization
When a firm recapi talizes,
all of its old securities.
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it issues new securities in exchange for some or
For example, a firm that cannot repay a debt issue
might issue new common stock and give all of it to the old debtholders,
leaving the old stockholders with nothing. It is usually possible to set the
terms of the recapitalization so that the holders of each of the firm I s
liabilities ends up with new securities worth about what the claims he gave up
were worth just before the recapitalization.
Restricted borrowing
The government can restrict borrowing by putting limits on how much
individuals can borrow, as with margin requirements, or by forcing lenders to
put on such limits. It can restrict borrowing by outlawing the use of certain
kinds of collateral, like assets in a pension plan, to secure a loan. It can
restrict both borrowing and lending with tax policy that makes the after-tax
borrowing rate significantly higher than the after-tax lending rate even when
default risk is minimal.
Borrowing restrictions affect the amounts that people spend and save; the
degree to which more risk averse people transfer risk to less risk averse
peopl ej and the interest rate. These restrictions also a ffect the kinds of
investments that firms make.
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Restricted lending
The government can restrict lending by putting limits on how much individuals
can lend or by making certain kinds of lending unattractive, as with interest
rate ceilings on deposits at financial institutions. It can restrict both
borrowing and lending with tax policy.
Lending restrictions and borrowing restrictions affect the same things,
including the total amount of credit in the economy. (enerally, both will
reduce the gross volume of credit, but lending restrictions will increase the
interest rate, while borrowing restrictions will reduce the interest rate.
Return
The return on an asset is the change in its price or value over a speci fied
period plus any distributions paid to holders of the asset during the period.
The distributions on a stock are called dividends, while the distributions on
a bond are called interest payments. The return on an asset is generally
expressed as a fraction or percentage of its price at the start of the period;
it is not converted to an annual rate, because the returns in two successive
periods are usually almost independent. When the return is not expressed as a
fraction or percentage, it is called the dollar return.
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Rights
A right is an option to buy a security such as comnun stock. Ri ghts are
generally issued bny a firm as part of a plan to issue new stock. If the
exercise price is set low enough, the firm can be sure that almost all the
rights will be exercised and the new stock will be sold. The full price of
the new stock is the exercise price of the rights plus the price of the rights
just before they expire, so a low exercise price does not imply a bargain sale
of stock. When rights are distributed to stockholders, the value of the stock
falls by about the value of the rights being distributed, so rights don't
represent a special bonus for stockholders, either. The biggest part of the
cost of issuing stock through a distribution of rights is the decline in the
stock price needed to expand the market for the stock. If an underwriter is
involved, it's a smaller decline in the stock price plus the underwriter's
fee. The total cost may be lower if an underwriter is involved, but it's hard
to tell because it's very hard to estimate the decline in the stock price
caused by the new issue of.stock, either before te fact or after the fact.
An asset is risky because its future return is uncertain. Lricertainty that is
independent of the uncertainty about asset returns generally is called
speci fiec risk, or risk that can be diversified away. The uncertainty that
assets have in common is called systematic risk, or risk that can't be
diversified away. Ole measure of systematic risk is the asset's beta. Ole
measure of total risk, the sum of systematic and specific risk, is the asset's
volatility. Any measure of risk will also be a measure of the likely losses
if the price of the asset goes down.
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Risk premium
The risk premium on an asset is the difference between the expected return on
the asset and interest on the price of the asset at the riskless rate. It is
also called the expected excess return. The risk premium is what's being
offered to investors who bear the risk of an asset. It depends on that part
of the asset's risk that cannot be diversifed away. In the capital asset
pricing model, beta measures the risk tha can't be diversified away, and the
risk premium is proportional to beta. Bets on things like future commodity
prices and future interest rates may have risk premiums too. The risk premium
on a futures contracts may have to be expressed in dollar terms rather than in
percentage terms, because the initial value of such a contract may be zero.
Round lot
A round lot is a standard unit of trading. For most common stocks, a round
lot is 100 shares. Any smaller amount of stock is an odd lot. In exchange
trading, odd lot orders are handled automatically at the price of the next
roung lot trade. The price may be adjusted by a form of commission called the
odd lot differential.
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Security
A security is a corporate or government liability that can be transferred from
one investor to another. It includes common and preferred stock, striaght and
convertible bonds, and warrants. t-brmally it does not include bank loans or
obligations created by such contracts as long term leases of plant or
equipment.
Short position
A short position is the other side of a long position. When a long position
moves, a short position moves in the opposite direction. An inves tor with a
short position in an asset gains when the asset goes down, ana loses when the
asset goes up. Selling the asset short gives a short position, but
maintaining this position may involve loss of interest on the collateral given
to the buyer or the lender of the asset. Thus it may be better to take a
short position in an asset by writing a call option or buying a put option.
Exchange traded options can't be used to create large short positions, though,
because of position limits imposed by the exchanges and the government. A
person who takes a contract to sell in a forward or futures market also has a
short position. The cost of maintaining a short position can be defined as
the losses that would be incurred if a short position and a long position were
held at the same time. In principle, losses on a short position are
unlimited, while losses on a long position are limited. In practice, though,
an investor can limit his losses on a short position by closing out the
position, in part or in full, as his losses become large.
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Short sale
When an investor owns an asset, he can sell it short by agreeing with the
buyer on a price but deferring delivery of the asset until a later time. When
he does not own the asset, he can sell a contract to deliver the asset, and
can later ei ther buy the contract back or buy the asset and end the contract
by delivering the asset. Or he may borrow the asset, sell it, and close out
his position later by returning the asset to the lender. When an investor
sells short a stock he does not own, and buys the stock that he must deliver
later at a lower price, he comes out ahead. An investor with a short position
in an asset gains when the asset goes down in price, and loses when the asset
goes up. In U. S. markets, selling an option short is called writing a naked
option, and no borrowing is involved. But selling a stock short means the
seller must get a stock loan from a third party, and often must put up cash
collateral for the loan on which he receives less than the market interest
rate. A person with a short position in a security normally matches any
dividends or other distributions that the issuer of the security pays. If a
person has a long position and a short position in the same asset
simultaneously, and does not lose interest on any of his collateral, his gains
on one position will just offset his losses on the other. Selling short is a
natural response to unfavorable information on an asset the investor doesn't
own. Selling short is no more a sign of manipulation than buying. But the
non-voting shares created when a stock is sold short may set up the potential
for manipulation. It IS not possible to figure a meaningful percentage return
on a short position, since the investment in the position is negative
(ignoring collateral and margin requirements).
Simple option
A simple option is an over-the-counter option or an exchange traded option.
It can be either a call option or a put option; either an American option or a
European option. A simple option generally has a maturity less than a year.
A warrant is not a simple option; a firm that issues warrants will issue and
deliver its own stock if the warrants are exercised.
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Specialist
A specialist is designated by an exchange to make a continuous market in one
or more securities. He normally operates as part of a firm that handles a
number of securities. He stands ready to buy or sell at least one round lot
of his security at any time during trading hours, unless trading has been
suspended. He also handles limit orders that have been left with him: when
the price reaches or crosses the limit, the limit order is executed. He does
other things too, such as helping to bring together large guyers and selers of
a security. He charges a commission for handling a limit order and he tries
to make money through the bid-asked spread when buying and selling for his own
account. He also tries to put continuity, depth, and liquidity into the
market for his securities.
Specific information
Speci fic information affects the value of a single firm, but has a negligible
impact on the values of other firms. There isn't much of it around, since
what affects one firm is likely to affects its competitors, either positively
or negatively. Most information affects an even larger group of firms.
Stock dividend
A stock dividend is an added number of shares sent to every stockholder of a
firm. The stock price falls when a stock dividend is paid, so stockholders do
not benefit directly. A stock dividend is something like exchanging 20
nickels for 10 dimes. A large stock dividend is called a stock split. A
small stock dividend may have an indirect effect on the stock price because it
may imply a change in the terms of outstanding warrants, convertible bonds, or
risky straight debt.
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Stock loan
A stock loan is just what it says. The lender gives the stock to the
borrower, and the borrower agrees to return identical stock to repay the
loan. The lender maintains his financial interest in the stock, but he should
lose his voting rights. (If the lender is a broker using customer stock, the
customer may be allowed to continue to vote.) A lender normally requires that
the borrower pay the lender any dividends on the stock, and maintain cash
collateral at least equal to the value of the stock at all times. The lender
may pay the borrower some interest on his cash collateral, but the reason he
is willing to lend the stock is that market interest rates exceed the rate he
pays on the borrower's collateral. There is a significant risk of de fault on
this kind of stock loan, because the collateral may be insufficient if there
is a sharp rise in the stock price. The lender could protect himself, though,
by insisting that the borrower maintain collateral worth substantially more
than the stock he borrowed. But this may involve risk to the borrower that
the lender will have financial problems and won't return all of the
collateral.
lends his
Sometimes a lender requires no collateral at
stock to a brokerage firm that uses it to
all, as
satisfy
when he
capital
requirements. He must then be compensated in some other way for bearing the
risk that the collateral will not be returned.
Stop order
A stop order is one that is not to be executed until the security trades at or
beyond the limit price. When that happens, the stop order becomes a market
order, so that it may be executed at a price worse than the limit. For
example, a stop order to buy a stock at S50 will be executed after the stock
trades at $50 or below. The stock might trade at $50, and the execution of
the stop order might give a trade at S50.SQ.
- 58 -
straight debt
A straight debt issue is one that is not convertible into any other securities
at the option of the lender. The borrower will often have the option of
redeeming the debt at prices at or above the face value of the debt.
Systematic risk
An asset's systematic risk is that part of its total risk that cannot be
diversified away. The systematic risk of a portfoliO can be obtained by
summing the systematic risk of each asset in the portfolio, weighting each
asset's systematic risk by the amount of the asset in the port folio. It is
systematic risk that influences the expected return on an asset. In the
capi tal asset pricing model, an asset's beta is a measure of its systematic
risk. In a more general model, systematic risk would include the uncertainty
in future commodity prices, future interest rates, and the future volatility
of various assets.
Time diversi fication
An individual diversifies over time by changing the amount of market risk he
is bearing smoothly over time, and by changing it in resonse to changes in his
wealth and age and taste for risk. If an individual shifts in and out of the
market because he mistakenly thinks he can forecast market movements, he will
have poor time diversification. f-'e will be bearing too much total risk for
the expected return offered by his portfolio. An individual who bears a lot
of risk in one period of his life but very little in other periods is in the
same kind of trouble as an individual who has a lot of his money in one
asset. Time diversification may help reduce risk even more than asset
diversi fication, because portfoliO returns in successive periods are roughly
independent.
- 59 -
Trade
A trade happens when one investor buys an asset from another. Cne or both
investors may be dealers. If one is a dealer, then the trade price may
reflect the dealer spread. Sometimes a dealer buys from one investor and
immediately resells, usually at a higher price, to another investor. In this
case the dealer spread is the difference between the two prices. Also, such a
pair of trades might be considered just a single trade if the trade is to be
reported publicly.
Trading pro fi ts
Trading profits are profits that depend on the use of information that the
market doesn't have. They are profits (or losses) from information trading.
Interest earned on a savings account or short term note would not be part of
trading profits. I'€ither would the returns to an investor holding a passive
portfolio. Thus trading profits are profits over and above both interest and
the amounts that investors must be paid for bearing the risks in the market,
including the risk of changes in interest rates, volatilities, or commodity
prices. Trading profits for investors as a group must be zero, so some
investors can have positive trading profits only if others have negative
trading profits. If investors realize this, and if all investors are
concerned only about increasing expected return and reducing risk, then some
investors can have positive expected trading profits only if other investors
have negative trading profits. If no investor could tolerate negative
expected trading profits, there would be no information trading, and no force
to keep markets efficient. For markets to be efficient, at least some
investors must be willing to trade even if their trading reduces expected
return or increases risk or both.
- 60 -
Turnover
The turnover in a port folio is the dollar amount of trading in a year as a
fraction of the value of the port folio. The amount of trading may be, for
different purposes, one of the following: purchases, sales, the average of
purchases and sales, the maximum of purchases and sales, and the minimum of
purchases and sales. The value of the portfolio may be the initial value, the
final value, or an average value for the year. The costs of high turnover
include commissions, the price effects of purchases and sales, and taxes that
result from realizing capital gains. Markets seem efficient enough that in
most cases, these costs are not offset by expected gains from trading. For
some investors, with special access to information that has not been
discounted, the expected gains from trading may offset the turnover costs.
Uncertain return
All returns are uncertain, because all assets are risky. Thus an uncertain
return is the return on any real or financial asset. Even governments that
seem very stable sometimes default on their promises to pay, especially when
those promises are made to specific individuals rather than to the bearer of a
financial asset. Individuals and firms are normally even more likely to
default on their promises to pay. And many assets, such as common stock,
don't involve any promises to pay. The returns on these assets are uncertain
even if all contracts are fulfilled. The return on an asset is uncertain
because it depends on information that is not yet known.
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Underlying asset
The underlying asset for a call option is the asset that the holder of the
option has a right to buy by paying the exercise price. The underlying asset
for a put option is the asset that the holder of the option has the right to
sell at the exercise price. With a warrant, the underlying asset is created
only when the warrant is exercised. With a commodity option, there is
normally no underlying asset as such: when the option is exercised, a futures
contract is created between the buyer and the writer, and the writer must put
up cash at least equal to the difference between the exercise price and the
futures price at the time of exercise.
Underwriting
Underwri ters expand the market for a security through their selling efforts.
They may essentially create the market for a security that has only been held
by the officers of the issuing firm. The firm may help the process by setting
a relatively low price on its securities, but some underwriting effort is
usually necessary. Even if a firm gives rights to existing shareholders, many
of the rights will be sold to brokers who then act like underwriters selling
the shares created by exercising the rights.
- 62 -
Uptick rule
The uptick rule says that a short sale of stock can be made only at a higher
price than the last different trade price. It was designed to keep a person
from driving the price of a stock down by repeatedly selling large amounts of
stock short. It seems unnecessary, because a person who drives the price down
by selling short will drive the price back up when he buys. He will expect to
lose money by the time he has closed out his short position, unless he
combines this activity with releasing false information that the market takes
to be true. So it seems more appropriate to focus regulation on ensuring the
release of true information. If the rule really reduces the amount 0 f short
selling, then it may reduce individual losses from speculation, but it also
creates economic losses because prices don't more fully reflect negative
information about a firm or the economy. Ol stocks that have exchange traded
options, the uptick rule may be ineffective, because an investor can take a
short position by writing call options or buying put options.
Value
The value of an asset is the same as its present value. It is an estimate of
the price at whiCh you would be indifferent to buying it or selling it. Ole
way to estimate value is to assume that it will be broken into pieces, and to
add up the prices for the pieces that will be sold. A second way to estimate
value is to look at the prices of assets that seem very similar and that have
traded recently. A third way is to find out whether sophisticated people are
buying or selling at current prices. A fourth way is to estimate the asset's
future cash flows and discount them to the present.
- 63 -
Value weighted market index
A value weighted market index is based on a portfolio where every stock has a
dollar investment proportional to the total dollar value of that stock's
outstanding shares. The percentage change in the index is the weighted
average of the percentage change in each of the component stocks, where the
weight on a stock is the ratio of the dollars in that stock to the dollars in
the whole portfolio.
Volatility
The volatility of an asset measures the extent to which its price fluctuates
over time. The figure usually used for volatility is the standard deviation
of the asset's return over a specified interval. The standard deviation can
be divided by the square root of the length of the specified interval (in
years) to convert it to an annual standard deviation. As a first
approximation, a single volatility figure measures the day -to -day,
week-to-week, month-to-month, or year-to-year variability in the price of the
asset. The volatility of an asset changes over time, and may change with such
factors as the price of the asset or the average volatility over all assets.
- 64 -
Volatili ty bet
Volatility bets are positions that show profits or losses if there are changes
in expected volatility, for individual assets or for the economy as a whole.
Buying or selling options normally means making such bets, because option
prices go up when volatility estimates go up, and down when volatility
estimates go down. A person may care about a change in the overall risk of
the economy because it affects his weI fare directly, and because it may be
asociated with a change in the expected return on assets generally. The
person who takes one side of the bet will gain if expected volatility goes up,
and lose if expected volatility goes down. The person who takes the other
side will gain if expected volatility goes down, and lose if expected
volatility goes up. If both break even when there is no change in expected
volatili ty, it is a neutral bet. otherwise, there is a premium on such bets,
and one person is paying the other for taking the unfavorable side of the
bet. There can be a whole term structure of such bets, because there can be a
different bet for the expected volatility at each future time.
Voting stock
The owners of a corporation's voting stock are entitled to elect the directors
(and to vote on certain other matters). In theory, electing the directors
means controlling the corporation, but if no one owns a large percentage of
the voting stock, the officers may control the corporation. Most firms issue
only voting stock, partly because of state laws restricting the issue of
non-voting stock. But non-voting stock is created, at least in principle,
whenever an investor sells voting stock short. The person who lends stock for
a short sale should lose his voting rights, though he will continue to have
gains and losses when the stock goes up and down. In practice, a person whose
broker lends the stocks in his margin account will almost always be allowed to
vote.
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Warrant
A warrant is an option issued by a corporation. When a warrant is exercised,
the underlying shares are created by the corporation for delivery to the
warrantholder in exchange for the exercise price. The typical warrant has a
maturity of five years or more at the time it is issued, while the typical
over-the-counter option or exchange-traded option has a maturity of less than
a year when it is issued. Some warrants are perpetual. Warrants are
frequently issued along with straight bonds. When a warrant expires without
being exercised, the price initially received for the warrant may be counted
as taxable income for the issuer. Warrantholders may bear a substantial
amount of the risk of a corporation, but they have no votes. For these and
other reasons, corporations do not often issue warrants to raise money.
Writing an option
Writing an option means selling the option short. The writer puts up
collateral as a guarantee that he can buy the option back, and then sells the
option in the open market. If he puts up collateral in cash, he may lose the
interest that he might otherwise have earned on the cash, but if he puts up
collateral in securities, he has no such losses. Writing an option is
inherently less costly than selling stock short, because the option need not
be borrowed before it is sold. An option writer does, however, have the risk
that the holder of the option will exercise it, which would force him to
deliver the underlying security. An option writer must also be prepared to
close out his position be fore the option expires. Often, however, option
writing gives a position that behaves like a short position in the underlying
stock.