CHATER 1
ContentsPART ONEELEMENTS OF INVESTMENTS 1
CHAPTER 2
Investments:Background and Issues 2
CHAPTER 3
1.1 Real Assets versus Financial Assets 3
1.2 A Taxonomy of Financial Assets 4
CHAPTER 4
1.3 Financial Markets and the Economy 5
CHAPTER 5
CHAPTER 6
CHAPTER 7
Consumption Timing 7
Allocation of Risk 7
Separation of Ownership andManagement 7
1.4 The Investment Process 8
1.5 Markets Are Competitive 8
The Risk-Return Trade-Off 8
CHAPTER 8
Efficient Markets 9
CHAPER 9
CHAPTER 10
1.6 The Players 10
Financial Intermediaries 10
CHAPTER 11
CHAPTER 12
1.7 Markets and Market Structure 12
Investment Bankers 12
Auction Markets 13
Brokered Markets 13
Direct Search Markets 13
CHAPTER 13
Dealer Markets 13
Globalization 14
1.8 Recent Trends 14
CHAPTER 14
Securitization 14
CHAPTER 15
CHAPTER 16
CHAPTER 17
Financial Engineering 17
1.9 Outline of the Text 18
CHAPTER 18
Summary 19
CHAPTER 19
CHAPTER 20
CHAPTER 21
Financial Markets and Instruments 23
2.1 The Money Market 23
Treasury Bills 24
Bank Discount Yields 24
Commercial Paper 28
Bankers Acceptances 28
Certifcates of Deposit 28
Brokers Calls 29
Repos and Reverses 29
Eurodollars 29
The LIBOR Market 30
Federal Funds 30
Yields on Money Market Instruments 30
2.2 The Fixed-Income Capital Market 31
Treasury Notes and Bonds 31
Federal Agency Debt 32
Municipal Bands 33
Mortgages and Mortage-BackedSecurities 36
Corporate Bonds 36
Common Stock as Ownership Shares 38
2.3 Equity Securities 38
Stock Market Listings 39
Characteristics of Common Stock 39
Preferred Stock 40
Stock Market Indexes 41
2.4 Stock and Bond Market Indexes 41
Dow Jones Averages 44
Standard Poor s Indexes 45
Other Market Value Indexes 46
Foreign and International Stock MarketIndexes 48
Equally Weighted Indexes 48
Bond Market Indicators 49
2.5 Derivative Markets 49
Options 49
Futures Contracts 51
Summary 52
3.1 How Firms Issue Securities 57
How Securities Are Traded 57
Investment Banking 58
Shelf Registration 59
Initial Public Offerings 59
The Secondary Markets 61
3.2 Where Securities Are Traded 61
The Third and Fourth Markets 64
The Over-the-Counter Market 64
The Participants 65
3.3 Trading on Exchanges 65
The National Market System 65
Types of Orders 66
Specialists and the Execution of Trades 67
Block Sales 69
The DOT System 69
Settlement 69
3.4 Trading on the OTC Market 70
Market Structure in Other Countries 71
3.5 Trading Costs 72
3.6 Buying on Margin 74
3.7 Short Sales 76
3.8 Regulation of Securities Markets 77
Self-Regulation and Circuit Breakers 78
Insider Trading 80
Summary 82
Mutual Funds and Other InvestmentComPanies 88
4.1 Investment Companies 89
4.2 Types of Investment Companies 89
Unit Investment Trusts 90
Managed Investment Companies 90
Other Investment Organizations 92
4.3 Mutual Funds 93
Investment Policies 93
How Funds Are Sold 94
Fee Structure 95
4.4 Costs of Investing in Mutual Funds 95
Fees and Mutual Fund Returns 97
4.5 Taxation of Mutual Fund Income 99
4.6 Mutual Fund Investment Performance:AFirst Look 101
4.7 Information on Mutual Funds 104
Summary 108
Investors and the Investment Process 112
5.1 Investors and Objectives 113
Professional Investors 115
Individual lnvestors 115
Pension Funds 116
Nonlife lnsurance Companies 117
Banks 117
Life Insurance Companies 117
5.2 Investor Constraints 118
Endowment Funds 118
Liquidity 119
Investment Horizon 119
Regulations 119
The Considerations 120
Unique Needs 120
5.3 Objectives and Constraints of VariousInvestors 121
Objectives 121
Constraints 122
5.4 Investment Policies 123
Top-Down Policies for InstitutionalInvestors 124
Active versus Passive Policies 125
Tax-Shelter Options 127
5.5 Taxes and Investment Strategy 127
5.6 Monitoring and Revising InvestmentPortfolios 129
Summary 130
PARTTWOPORTFOLIO THEORY 136
Measuring Investment Returns over MultiplePeriods 137
6.1 Rates of Retum 137
Risk and Return:Past and Prologue 137
Conventions for Quoting Rates ofReturn 140
Scenario Analysis and ProbabilityDistributions 141
6.2 Risk and Risk Premiums 141
Bills,Bonds,and Stocks,1926-1996 145
6.3 The Historical Record 145
6.4 Inflation and Real Rates of Return 146
The Equilibrium Nominal Rate ofInterest 150
6.5 Asset Allocation Across Risky and Risk-FreePortfolios 151
The Risky Asset 151
The Risk-Free Asset 152
Portfolio Expected Return and Risk 153
The Capital Allocation Line 155
Risk Tolerance and Asset Allocation 156
6.6 Passive Strategies and the Capital MarketLine 157
Historical Evidence on the Capital MarketLine 159
Summary 160
Costs and Benefits of Passive Investing 160
Efficient Diversification 166
7.1 Diversification and Portfolio Risk 167
7.2 Asset Allocation with Two RiskyAssets 168
Covariance and Correlation 168
The Three Rules of Two-Risky-AssetPortfolios 171
The Risk-Return Trade-Off with TWo-Risky-Asset Portfolios 172
Mean-Variance Criteria 173
Using Historical Data 176
7.3 The Optimal Risky Portfolio with a Risk-Free Asset 177
The Efficient Frontier of Risky Assets 180
7 4 Edducient Diversification with Many RiskyAssets 180
Choosing the Optimal Risky Portfolio 181
7.5 A Single-Factor Asset Market 182
The Preferred Complete Portfolio and theSeparation Property 182
Specification of a Single-Index Model ofSecurity Returns 183
Statistical and Graphical Representation ofthe Single-Index Model 184
Summary 188
Diversification in a Single-Factor SecurityMarket 188
Appendix:The Fallacy of TimeDiversification 196
Capital Asset Pricing and Arbitrage PricingTheory 198
8.1 The Capital Asset Pricing Model 199
Why All Investors Would Hold the MarketPortfolio 200
The Risk Premium of the MarketPortfolio 201
The Passive Strategy Is Efficient 201
Expected Returns on IndividualSecurities 202
The Security Market Line 204
Applications of the CAPM 205
8.2 The CAPM and Index Models 206
The Index Model,Realized Returns,and theExpected Return-Beta Relationship 206
Estimating the Index Model 207
The CAPM and the Index Model 209
Predicting Betas 213
8.3 The CAPM and the Real World 215
8.4 Arbitrage Pricing Theory 217
Arbitrage Opportunities and Profits 217
Well-Diversified Portfolios and the ArbitragePricing Theory 219
Multifactor Generalization of the APT andCAPM 222
The APT and the CAPM 222
Summary 224
The Efficient Market Hypothesis 231
9.1 Random Walks and the Efficient MarketHypothesis 232
Competition as the Source of Efficiency 232
Versions of the Efficient MarketHypothesis 233
Technical Analysis 234
9.2 Implications of the EMH for InvestmentPolicy 234
Active versus Passive PortfolioManagement 235
Fundamental Analysis 235
The Role of Portfolio Management in anEfficient Market 236
The Issues 237
9.3 Are Markets Efficient? 237
Tests of Predictability in Stock MarketReturns 239
Predictors of Broad Market Movements 240
Portfolio Strategies and MarketAnomalies 240
Scientific and Computing Power in Search ofAbnormal Returns 251
Summary 253
So,Are Markets Efficient? 253
PAR THREEFIXED-INCOME SECURITIES 258
Bond Prices and Yields 259
10.1 Bond Characteristics 260
Treasury Bonds and Notes 260
Corporate Bonds 262
Preferred Stock 264
International Bonds 265
Other Domestic Issuers 265
Innovation in the Bond Market 265
10.2 Default Risk 266
Junk Bonds 267
Determinants of Bond Safety 268
Bond Indentures 269
10.3 Bond Pricing 270
Yield to Matmity 273
10.4 Bond Yields 273
Yield to Call 275
Yield to Maturity and Default Risk 277
Realized Compound Yield versus Yield toMaturity 278
Yield to Maturity versus Holding-PeriodReturn 279
10.5 Bond Prices over Time 280
Zero-Coupon Bonds 281
After-Tax Recturns 282
The Expectations Theory 283
10.6 The Yield Curve 283
The Liquidity Preference Theory 285
Market Segmentation Theory 286
A Synthesis 286
Summary 288
Managing Fixed-Income Investments 296
11.1 Interest Rate Risk 297
Interest Rate Sensitivity 297
Duration 299
What Determines Duration? 301
11.2 Passive Bond Management 303
Target Date Immunization 304
Net worth Immunization 304
Cash Flow Matching and Dedication 309
11.3 Convexity 310
Sources of Potential Profit 313
11.4 Active Bond Management 313
Contingent Immunization 315
Horizon Analysis 315
An Example of a Fixed-Income ImestmentStrategy 316
11.5 Interest Rate Swaps 318
Summary 320
PARTFOURSECURITY ANALYSIS 327
Macroeconomic and Industry Analysis 328
12.1 The Global Economy 329
12.2 The Domestic Macroeconomy 329
Inflation 331
Employment 331
Gross Domestic Product 331
Budget Deficit 332
12.3 Interest Rates 332
Interest Rates 332
Sentiment 332
12.4 Demand and Supply Shocks 334
12.5 Federal Govemment Policy 334
Fiscal Policy 335
Monetary Policy 336
Supply-Side Policies 336
The Business Cycle 337
12.6 Business Cycles 337
Economic Indicators 340
Defining an Industry 341
12.7 Industry Analysis 341
Sensitivity to the Business Cycle 344
Industry Life Cycles 346
Industry Structure and Performance 349
Summary 350
Equity Valuation 355
13.1 Balance Sheet Valuation Methods 355
13.2 Intrinsic Value versus Market Price 356
13.3 Dividend Discount Models 358
The Constant Growth DDM 359
Stock Prices and InvestmentOpportunities 362
Life Cycles and Multistage GrowthModels 364
13.4 Price/Earnings Ratios 368
The Price/Earnings Ratio and GrowthOpportunities 368
P/E Ratios and Stock Risk 371
Pitfalls in P/E Analysis 371
13.5 The Aggregate Stock Market 374
Combining P/E Analysis and the DDM 374
Summary 377
Financial Statement Analysis 383
The Balance Sheet 384
The Income Statement 384
14.1 The Major Financial Statements 384
The Statement of Cash Flows 385
14.2 Accounting versus Economic Earnings 387
14.3 Return on Equity 388
Financial Leverage attd ROE 388
Past versus Future ROE 388
Decomposition of ROE 390
14.4 Ratio Analysis 390
Turnover and Other Asset UtilizationRatios 392
Liquidity and Coverage Ratios 393
Market Pric e Ratios 394
14.5 An Illustration of Financial StatementAnalysis 396
14.6 Comparability Problems 398
Inventory Valuation 398
Depreciation 400
Inflation and Interest Expense 401
International Accunting Conventions 401
Inflation Accounting 402
14.7 Value Investing:The GrahamTechnique 404
Summary 404
Technical Analysis 413
15.1 Technical Analysis 413
15.2 Charting 414
The Dow Theory 414
Other Charring Techniques 417
A Warning 418
15.3 Technical Indicators 421
Sentiment Indicators 422
Market Structure 424
Flow of Funds 424
15.4 The Value Line System 427
Self-Desnucting Patterns 429
15.5 Can Technical Analysis Work in EfficientMarkets? 429
A New View of Technical Analysis 430
Summary 43lPART FIVEDERIVATIVE ASSETS:OPTIONSAND FUTURES 436
OPtions Markets 437
16.1 The Option Contract 438
Options Trading 439
The Option Clearing Corporation 441
American and European Options 441
Other Listed Options 442
16.2 Values of Options at Expiration 445
Call Options 445
Put Options 446
Options versus Stock Investments 448
The Put-Call Pariy Relationship 450
Option Strategies 453
16.3 Option-Like Securities 459
Callable Bonds 460
Convertible Securities 461
Warrants 463
Collateralized Loans 463
Levered Equity and Risky Debt 464
16.4 Exotic Options 464
Asian Options 465
Binary Options 466
Summary 466
Currency-Translated Options 466
Lookback Options 466
Barrier Options 466
17.1 Option Valuation:Introduction 474
Intrinsic and Time Values 474
Dererminants of Option Values 474
Option Valuation 474
17.2 Binomial Option Pricing 477
TWo-State Option Pricing 477
Generalizing the Two-State Approach 480
17.3 Black-Scholes Option Valuation 482
The Black-Scholes Foemula 482
Put Option Valuation 486
17.4 Using the Black-Scholes Formula 487
Hedge Ratios and the Black-ScholesFormula 487
Portfolio Insurance 488
17.5 Empirical Evidence 492
Summary 493
Futures Markets 498
18.1 The Futures Contract 499
The Basics of Futures Contracts 500
Existing Contracts 500
18.2 Mechanics of Trading in FuturesMarkets 501
The Clearinghouse and Open Interest 501
Marking to Market and the MarginAccount 505
Cash versus Actual Delivery 507
Hedging and Speculation 508
Basis Risk and Hedging 508
18.3 Futures Market Strategies 508
Regulations 508
Taxation 508
18.4 The Determination of Futures Prices 511
The Spot-Futures Parity Theorem 511
Spreads 513
18.5 Financial Futures 514
Stock Index Futures 514
Creating Synthetic Stock Positions 515
Index Arbitrage and the Triple-WitchingHour 516
Foreign Exchange Futures 518
Interest Rate Futures 519
Summary 521
PART SIXACTIVE INVESTMNT MANAGEMENT 526
Performance Evaluation 527
19.1 Risk-Adjusted Returns 527
Comparison Groups 527
Risk Adjustments 529
Risk Adjustments with Changing PortfolioComposition 532
19.2 Market Timing 534
19.3 Performance Attribution Procedures 535
Asset Allocation Decisions 536
Sector and Security Selection Decisions 537
Summing Up Component Contributions 538
Summary 539
International Diversification 544
20.1 Intemational Investments 545
The World Market Portfolio 545
International Diversification 545
Exchange Rate Risk 550
Passive and Active InternationalInvesting 554
Factor Models and InternationalInvesting 555
Equilibrium in International CapitalMarkets 557
Summary 558
Appendix A Investments in Nontraditional AssetGroups 562
Real Estate 562
Precious Metals 562
Other Nontraditional Assets 564
Active Portfolio Management 565
21.1 The Lure of Active Management 565
21.2 Objectives of Active Portfolios 567
21.3 Market Timing 570
The Value of Imperfect Forecasting 572
Valuing Market Timing as an Option 572
21.4 Security Selection:The Treynor-BlackModel 573
Overview of the Treynor-Black Model 573
Portfolio Construction 575
21.5 Multifactor Models and Active PortfolioManagement 577
Summary 578
APPENDIXESA Sources of Financial and EconomicInformation 581
B References 590
C Mathematical Tables 594
D References to CFA Questions 599
NAME INDEX 602
SUBJECT INDEX 604