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Black Swan Events

black swan events

The “mythical” black swan

You may have heard the term “Black Swan Event“, particularly recently.  But what exactly is a black swan event and what can, and should, we learn from them?

The notion of black swan events was first set forth by Nassim Nicholas Taleb. Taleb, a finance professor and former Wall Street trader, wrote about this concept in his 2001 book Fooled by Randomness which concerned financial events. In a later work, The Black Swan, Taleb extends the metaphor to events outside the financial markets.  He defines three attributes that are common to all black swan events:

  1. The event is unpredictable (to the observer)
  2. The event has widespread ramifications
  3. After the event has occurred, people will assert that it was indeed explainable and predictable (hindsight bias).

Where did the term “Black Swan” come from?

The origin of the use of the term “black swan” to characterize such events is interesting.  Prior to 1697, any Western civilization has not observed any black swan. This gave rise to the notion that such creatures didn’t exist.  Hence, the term became used to describe situations of impossibility.  After a black swan was finally observed in western Australia in 1697, the notion was disproved.  Since then, “black swan” describes situations where perceived impossibilities have been disproven and paradigms have been shattered.

What are some examples of Black Swan events?

Examples Taleb gives of black swan events include the rise of the Internet, the personal computer, World War I, the dissolution of the Soviet Union and the September 11, 2001 terrorist attacks.  He underscores the point that the black swan event depends upon the observer.  The Thanksgiving turkey sees his demise as a black swan, but the butcher does not.

Isn’t a Black Swan just another way to define a crisis?

It’s important to draw the distinction between a black swan event and a crisis.  Not all black swan events are crises, any lottery winner will attest to that.  And not all crises are black swan events.  Terrorist attacks are an almost daily occurrence worldwide, but the terrorist attacks of September 11, 2001 were of unprecedented magnitude and unpredictability, hence their characterization as a black swan.

How can we deal with Black Swan events?

How can we avoid becoming the Thanksgiving turkey?  According to Taleb, not by attempting to predict the unpredictable.  Rather, he says our time would be better spent preparing for the impact of negative black swans that occur. In addition, he advises that we position ourselves to be able to exploit the positive ones.

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black swan events

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Put Option

See Also:
Call Option
Synthetic Stock
Future Value
Intrinsic Value – Stock Options
Purchase Option

Put Option Definition

A put option is the right for an investor to sell an asset at a pre-determined exercise price on a certain date known as the put option expiration.

Put Option Explained

A put option gives a holder or investor the ability to make an essentially risk free profit if the market fluctuates correctly. The holder of an option can simply look into the market without taking any real part in it. The benefit for a put option holder comes if the stock price does not exceed the put option price. Therefore, the lower the better for the put option holder because he is selling into the market. A put is exercised only if the holder can deliver an asset that is worth less than the exercise price.

Put Option Example

Jim has received a put option with the right to sell 100 shares of Wawadoo Inc. at a price of $35 by December. The current month is January, and the current stock price is $32. Jim could exercise the put now, but he believes that the market will drive the Wawadoo stock further down. By November, the stock has dropped to $28. Jim exercises his option and makes a profit of $700 (($35*100) – ($28*100)). If the price had increased throughout the year and went above the put option exercise price then Jim would have simply let his option expire. By doing this Jim has not gained anything or lost anything, except the potential where he could have exercised the put at the beginning of the year.

put option definition

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Histogram Definition

Histogram Definition

The histogram definition is a graphical representation of the density or frequencies over a certain data set. Many usually use histograms graphs in finance for market analysis.

Histograms Explanation

A histogram exposure is related to a data set usually in finance. The data set is usually the entire existence of the market and where prices are set. For example, the histogram might use a data set from the S&P 500 on expected returns. Thus for each frequency that the market hit that return it will show up as part of a bar graph. The higher the bar graph the more frequent the market hits that particular return.

The histogram can also show the density amount or find data that provides somewhat of a percentage range of where the stock or market index is likely to hit. Returns are not the only use for the histogram within the market. In fact, you can use histogram graphs for just about any aspect of a stock, bond, or market index. Some of these factors may include the standard deviation or covariance in measuring risk, or returns in different stocks or markets.

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histogram definition

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histogram definition

See Also:

Financial Instruments
Finance Beta Definition
Efficient Market Theory
Required Rate of Return
Covariance

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Baby Bonds

See Also:
Coupon Rate Bond
Non-Investment Grade Bonds (Unsecured Debentures)
Par Value of a Bond
What is a Bond?
Yield to Maturity of a Bond

Baby Bonds Definition

The baby bonds definition is completely the same as a normal bond except for the fact that the face values are less than $1,000. They typically come in denominations of $500 or $25.

Baby Bonds Meaning

A baby bond has two special purposes. First, a baby bond are able to bring smaller investors into the market allowing companies to benefit from another source of cash. The second purpose is to provide funding for smaller companies who do not have access to the larger institutionalized markets.

Baby Bonds Example

Look at the following baby bonds example. Sarah has $600 that she would like to invest in debt instruments. However, the amount is not enough for her to invest in a bond with a $1,000 face value. She hears about baby bonds from a friend and decides to invest in one $500 face value bond and four $25 face value bonds. Both of them pay the same interest rate at 5%, semi-annually. This is much more beneficial to Sarah because she can get a higher interest rate through a baby bond than she can when she is investing in a certificate of deposit or savings account.

baby bonds, Baby Bonds Definition, Baby Bonds Example

baby bonds, Baby Bonds Definition, Baby Bonds Example

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Buyer Bargaining Power (one of Porter’s Five Forces)

See also:
Porter’s Five Forces of Competition
Threat of New Entrants
Intensity of Rivalry
Threat of Substitutes
Supplier Power
Supplier Power Analysis

Buyer Power Definition

Porter’s Five Forces of buyer bargaining power refers to the pressure consumers can exert on businesses to get them to provide higher quality products, better customer service, and lower prices. When analyzing the bargaining power of buyers, conduct the industry analysis from the perspective of the seller. According to Porter’s 5 forces industry analysis framework, buyer power is one of the forces that shape the competitive structure of an industry.

(See the other Porter’s 5 forces of competition.)

The idea is that the bargaining power of buyers in an industry affects the competitive environment for the seller and influences the seller’s ability to achieve profitability. Strong buyers can pressure sellers to lower prices, improve product quality, and offer more and better services. All of these things represent costs to the seller. A strong buyer can make an industry more competitive and decrease profit potential for the seller. On the other hand, a weak buyer, one who is at the mercy of the seller in terms of quality and price, makes an industry less competitive and increases profit potential for the seller. The concept of buyer power Porter created has had a lasting effect in market theory.

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Buyer Power – Determining Factors

Several factors determine Porter’s Five Forces buyer bargaining power. If buyers are more concentrated than sellers – if there are few buyers and many sellers – then buyer power is high. Whereas, if switching costs – the cost of switching from one seller’s product to another seller’s product – are low, the bargain power of buyers is high. If buyers can easily backward integrate – or begin to produce the seller’s product themselves – the bargain power of customers is high. If the consumer is price sensitive and well-educated about the product, then buyer power is high. Then if the customer purchases large volumes of standardized products from the seller, buyer bargaining power is high. If substitute products are available on the market, buyer power is high.

And of course, if the opposite is true for any of these factors, buyer bargaining power is low. For example, low buyer concentration, high switching costs, no threat of backward integration, less price sensitivity, uneducated consumers, consumers that purchase specialized products, and the absence of substitute products all indicate that buyer power is low.

Buyer Power – Analysis

When analyzing a given industry, all of the aforementioned factors regarding Porter’s 5 Forces buyers power may not apply. But some, if not many, certainly will. And of the factors that do apply, some may indicate high buyer bargaining power and some may indicate low buyer bargaining power. The results will not always be straightforward. Therefore, it is necessary to consider the nuances of the analysis and the particular circumstances of the given firm and industry when using these data to evaluate the competitive structure and profit potential of a market.

Buyer Power is High/Strong if:

• Buyers are more concentrated than sellers

• Buyer switching costs are low

• Threat of backward integration is high

• Buyer is price sensitive

• Buyer is well-educated regarding the product

• Undifferentiated product

• Buyer purchases product in high volume

Substitutes are available

• Buyer purchases comprise large portion of seller sales

Buyer Power is Low/Weak if:

• Buyers are less concentrated than sellers

• Buyer switching costs are high

• Threat of backward integration is low

• Buyer is not price sensitive

• Buyer is uneducated regarding the product

• Highly differentiated product

• Buyer purchases product in low volume

• Substitutes are unavailable

• Buyer purchases comprise small portion of seller sales

Buyer Bargaining Power Interpretation

When conducting Porter’s 5 forces buyer power industry analysis, low buyer bargaining power makes an industry more attractive and increases profit potential for the seller, while high buyer bargaining power makes an industry less attractive and decreases profit potential for the seller. Buyer power is one of the factors to consider when analyzing the structural environment of an industry using Porter’s 5 forces framework. Many respect the buyer power Porter’s five forces.

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Arbitrage

See Also:
Arbitrage Pricing Theory
Market Positioning
Capitalization
Inventory to Working Capital Analysis
Mining the Balance Sheet for Working Capital

Arbitrage Definition

Arbitrage is the practice of profiting from the mispricing of an asset that trades in multiple markets. For arbitrage to be possible, an asset must trade in at least two different markets. If the same asset is trading in two different markets with two different prices, there is an arbitrage opportunity. The idea is to buy the asset where it is cheaper, sell it where it is more expensive, and pocket the difference.

Arbitrage Examples

For example, imagine you can buy an apple at the supermarket for fifty cents and sell it to tourists on the sidewalk for one dollar. This is an arbitrage opportunity. You would buy apples at the supermarket and sell them to the tourists. For each apple, you would profit 50 cents.

Similarly, if one US dollar is worth .5000 British pounds in London, and one US dollar is worth .5001 British pounds in New York, the arbitrageur might want to purchase dollars with pounds in London and then sell the dollars for pounds in New York. Depending on the volume and the transaction costs, this could be a profitable arbitrage opportunity.

Arbitrage and Market Efficiency

Due to market efficiency, arbitrage opportunities are hard to find. When they do exist, they are typically small and fleeting. Profiting significantly from arbitrage often requires timely action and large sums of money. And because of market efficiency, the very act of engaging in arbitrage serves to eliminate the arbitrage opportunity.

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Financial Ratios

Monitoring a company’s performance using ratio analysis and comparing those measures to industry benchmarks often leads to improvements in company performance. Not to mention these ratios are often part of loan covenants. The following article provides an overview of the 5 categories of financial ratios and links to their description and calculation.

Use the following Financial Ratios to measure financial performance against standards. In addition, analysts compare these ratios to industry averages (benchmarking), industry standards or rules of thumbs and against internal trends (trends analysis). Furthermore, the most useful comparison when performing financial ratio analysis is trend analysis. They are derived from the three following financial statements:

5 Categories of Financial Ratios

The five (5) major categories in the financial ratios list include the following :

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5 Categories of Financial Ratios

5 Categories of Financial Ratios

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