2 THE BLACKWELL ENCYCLOPEDIA OF MANAGEMENT EDITED BY CARY L. COOPER AND CHRIS ARGYRIS Blackwell Encyclopedic Dictionary of Accounting Edited by A. Rashad Abdel-khalik Blackwell Encyclopedic Dictionary of Strategic Management Edited by Derek F. Channon Blackwell Encyclopedic Dictionary of Management Information Systems Edited by Gordon B. Davis Blackwell Encyclopedic Dictionary of Marketing Edited by Barbara R. Lewis and Dale Littler Blackwell Encyclopedic Dictionary of Managerial Economics Edited by Robert McAuliffe Blackwell Encyclopedic Dictionary of Organizational Behavior Edited by Nigel Nicholson Blackwell Encyclopedic Dictionary of International Management Edited by John J. O'Connell Blackwell Encyclopedic Dictionary of Finance Edited by Dean Paxson and Douglas Wood Blackwell Encyclopedic Dictionary of Human Resource Management Edited by Lawrence H. Peters, Charles R. Greer, and Stuart A. Youngblood Blackwell Encyclopedic Dictionary of Operations Management Edited by Nigel Slack Blackwell Encyclopedic Dictionary of Business Ethics Edited by Patricia H. Werhane, and R. Edward Freeman 3 The Blackwell Encyclopedic Dictionary of Finance Edited by Dean Paxson and Douglas Wood Manchester Business School 4 Disclaimer: Some images in the original version of this book are not available for inclusion in the netLibrary eBook. Copyright © Blackwell Publishers Ltd, 1997, 1998 Editorial Organization © Dean Paxson and Douglas Wood, 1997, 1998 First published 1997 First published in paperback 1998 2 4 6 8 10 9 7 5 3 1 Blackwell Publishers Inc. 350 Main Street Malden, Massachusetts 02148 USA Blackwell Publishers Ltd 108 Cowley Road Oxford OX4 1JF UK All rights reserved. Except for the quotation of short passages for the purposes of criticism and review, no part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher. Except in the United States of America, this book is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, resold, hired out, or otherwise circulated without the publisher's prior consent in any form of binding or cover other than that in which it is published and without a similar condition including this condition being imposed on the subsequent purchaser. Library of Congress Cataloging-in-Publication Data The Blackwell encyclopedic dictionary of finance / edited by Dean Paxson and Douglas Wood. p. cm Originally published as a volume in The Blackwell encyclopedia of management, 1997 Includes bibliographical references and index. ISBN 1–55786–912–X (alk. paper) ISBN 0–631–21188–8 (pbk. : alk. paper) 1. Finance– – Dictionaries. I. Paxson, Dean. II. Wood, Douglas. 5 HG151.B49 1998 98–26082 332'.03—dc21 CIP British Library Cataloguing in Publication Data A CIP catalogue record for this book is available from the British Library. Typeset in 9 1/2 on 11pt Ehrhardt by Page Brothers, Norwich Printed in Great Britain by T. J. International Ltd, Padstow, Cornwall This book is printed on acid-free paper 6 CONTENTS Preface 9 A .18 Agency Theory .18 Artificial Neural Networks .21 Asset Allocation 24 Asset Pricing .26 B 34 Bankruptcy 34 Banks as Barrier Options 38 Bid–Ask Spread 41 Black–Scholes .43 C 45 Capital Adequacy 45 Capital Structure .51 Catastrophe Futures and Options 55 Commodity Futures Volatility 57 Conditional Performance Evaluation 60 Consolidation 64 Contagion 68 Contingent Claims 70 Convenience Yields 72 Convertibles 78 Corporate Governance 81 Corporate Takeover Language 85 Cost of Capital 88 D .91 Debt Swaps .91 Deposit Insurance .95 Discounted Cash Flow Models .100 Disinvestment Decisions .103 Dividend Growth Model .106 Dividend Policy 109 E 113 Electronic Banking .113 Electronic Payments Systems .120 Embedded Inflation .124 Ethics in Finance .127 Eurocredit Markets .133 Event Studies 137 Exotic Options 141 Expectations 146 7 Experimental Asset Markets .149 F 152 Fat Tails in Finance .152 Financial Distress 161 Foreign Exchange Management .165 Foreign Exchange Markets .168 Futures and Forwards 176 Fuzzy Logic 178 G .180 Game Theory in Finance .180 Growth by Acquisition 187 H .191 Hedging .191 I .194 Initial Public Offerings (IPOS) .194 Insider Trading Law (US) .198 Insurance .200 Insurance Derivatives 206 International Initial Public Offerings 212 Investment Banking 216 Iowa Electronic Market .219 L 223 Leasing 223 Log Exponential Option Models .226 M .229 Market Efficiency .229 Mergers and Acquisitions .234 Mutual Funds 245 N .247 Noise Trader .247 Note Issuance Facilities 251 P 254 Persistence of Performance .254 Portfolio Management 259 Portfolio Performance Measurement 266 Price/Earnings Ratio .275 Privatization Options 277 Program Trading .282 Project Financing 284 R 287 Real Options .287 Regulation of US Equity Markets .294 Restructuring and Turnaround 297 Retail Banking 301 8 Risk Analysis 306 Rollover Risk 308 S 311 Scrip Dividend 311 Securitization 313 Share Repurchases 317 Short-Termism 319 Sovereign Risk 325 Speculation 328 Stability of Returns .331 State-Contingent Bank Regulation .334 Stochastic Processes .337 Stock Market Indices 340 Syndicated Euroloans .343 T 346 Tactical Asset Allocation 346 Term Structure Models .348 Time Series Analysis 357 Transaction Costs 359 Transition Economies .361 V .366 Valuing Flexibility 366 Venture Capital .370 Volatility .376 Volatility Risk Pricing 381 Volatility Smile .384 W 387 Warrants 387 9 Preface Although the basic purposes of finance, and the nature of the core instruments used in attaining them, are relatively constant, recent years have seen an explosion in complexity of both products and techniques. A number of forces are driving this explosion. The first is internationalization encompassing a dramatic growth in the number of countries with stock markets, convertible currencies and a positive regime for foreign investors. For a number of years the more adventurous institutional and private investors have been increasing the proportion of their investments in foreign markets in general and emerging markets in particular in search of growth, higher returns and better diversification. Reflecting this, finance has begun the long process of overhauling the traditionally domestic measurement of risk and return. In the new world order in which the next generation is likely to see an unprecedented transfer of economic power and influence from slow growing developed economies to the high growth tigers in Asia and the Pacific Rim, the ability of financial markets to recognize and accommodate the changes will be a priority. The second change has come from dramatic falls in the costs of both information and transaction processing. More information is available and it is available more quickly in more places. Improved databases allow sophisticated analysis that would have been impossible a few years ago and data intensive artificial intelligence techniques allow a much richer array of market structures to be considered. The switch to electronic systems of transactions and trading has dramatically lowered costs, allowing increased arbitrage and stimulating the widespread use of complex new derivative products and products offering potentially an infinity of combinations of underlying products. It is no exaggeration to claim that these new techniques and instruments can be used to provide a proxy for any underlying traded instrument. This power is increasingly used in the marketplace to provide the financial community with new choices, including performance guarantees and indexed products. The development of traded instruments provides an ability to pinpoint exposures precisely and this has lead to a new science of risk management, where the net exposures of a portfolio of risky assets such as securities or bank loans can be estimated and, where required, selectively or completely hedged by buying opposite exposures in the marketplace. Not surprisingly, this encyclopedic dictionary reflects these new techniques which are inexorably creating a world in which financial assets are priced in a seamless global marketplace. New technology has helped in selecting entries for the dictionary. A word count of titles in finance and business journals was used to identify the frequency with which particular terms appeared and this was used as a primary guide to the priority and length of entries. To accommodate new topics such as real options that are only just emerging into the literature, we also included some entries where interest was growing rapidly towards the end of the search period. 10 In compiling the dictionary we have been privileged in the support we have received from a wide range of distinguished contributors who have taken the time from a busy programme of research and publication to summarize the often voluminous literature in their specialist areas into an accessible form. Inevitably the technical content of some of the entries reflects the rocket science development in the areas covered, but all entries provide an initial definition and bibliographic references for the less expert. Finally, we would like to thank Joanne Simpson and Catherine Dowie for their support for this project. The demands of monitoring and recording the progress of contributions as they passed from commissioning through each stage of the editing process to final completion provided an essential foundation to the project. DEAN PAXSON DOUGLAS WOOD [...]... examined – the economic theory of agency and the financial theory of agency The economic theory of agency examines the relationship between a single principal who provides capital and an agent (manager) whose efforts are required to produce some good or service The principal receives a claim on the firm's end -of- period value Agents are compensated for their efforts by a dollar wage, a claim on the end -of- period... method Weights are adjusted in the direction that reduces the value of the error function after each presentation of the input records ANNs sometimes share the problem of local minima and the problem of overtraining Because of the non-linearity involved, the algorithm may not always reach a global minimum Overtraining refers to the situation where the network literally memorizes the inputs and cannot generalize... example of ANN is the multilayer perceptron The middle sets of units are called hidden layers and the other two input and output layers The transfer functions in the input and output layers can be identities, and those of the hidden layer are usually sigmoid or hyperbolic tangent functions These functions map the sum of weighted inputs to the range between zero and one or between minus one and plus one The. .. are used to predict the performance of equities relative to bonds or real estate relative to equities Dependent on the outcome of these forecasts, the investor will switch into or out of the asset being forecasted Models are used to derive frequent forecasts of one asset against another and to move the portfolio day by day depending on the outcome of the forecasting model This type of model is sometimes... Pricing The modern theory of asset prices has its foundations in the portfolio selection theory initiated by Markowitz (1952) In a one-period framework Markowitz assumed that agents' utilities, and hence the price they will pay, depend only on the means and variances of returns This mean-variance model can be justified either on the grounds of quadratic utility (for arbitrary distributions of the asset... beta, measures the covariance of the asset's return with the market return Black (1972) derived the CAPM for an economy without a riskless asset (the zero-beta CAPM) The CAPM has been extensively tested Black et al (1972) and Fama and MacBeth (1973) originated the two frameworks in which most of the tests were done However, the unsatisfactory empirical performance of the CAPM, as well as the problems... (1977) related to the unobserved nature of the market portfolio, are the reasons why the single-period, single-beta relation had to be relaxed Historically, the first direction was to place the individual decision making in an intertemporal set-up in which agents maximized utility, thus leading to the intertemporal CAPM (ICAPM) of Merton (1973) The other is the arbitrage pricing theory (APT) of Ross (1976)... production) that proxy for the economy–wide factors Shanken (1982, 1985) questions the possibility of testing the APT; Dybvig and Ross (1983) present the counter-argument The works of Ross (1976), Cox and Ross (1976), Harrison and Kreps (1979), and Ross (1978) contain what has come to be known as the fundamental theorem of asset pricing: the absence of arbitrage is equivalent to the existence of a positive linear... Misspecification of capital asset pricing Journal of Financial Economics, 9, 19–46 Roll, R (1977) A critique of the asset pricing theory's tests Part I: On past and potential testability of theory Journal of Financial Economics, 4, 129–76 Roll, R & Ross, S (1980) An empirical investigation of the arbitrage pricing theory Journal of Finance, 35, 1073–1103 Roll, R (1981) A possible explanation of the small... under the assumptions of many identical agents with homogeneous expectations and market clearing, derived the ICAPM The asset prices in Merton's model follow a diffusion process If the investment opportunity set, namely the drift and diffusion parameters, and the instantaneous correlations between the returns of the different assets, do not change over time, then a continuous time version of the static . relationship examined – the economic theory of agency and the financial theory of agency. The economic theory of agency examines the relationship between a single. recording or otherwise, without the prior permission of the publisher. Except in the United States of America, this book is sold subject to the condition