Investments

Cover......Page 1
Investments......Page 2
About the Authors......Page 6
Contents......Page 9
Preface......Page 17
Distinctive Features......Page 20
Supplements......Page 25
Acknowledgments......Page 27
Chapter 1 The Investment Environment......Page 30
1.1 Real Assets versus Financial Assets......Page 31
1.2 Financial Assets......Page 32
Consumption Timing......Page 34
Separation of Ownership and Management......Page 35
1.4 The Investment Process......Page 37
The Risk–Return Trade-Off......Page 38
Efficient Markets......Page 39
Financial Intermediaries......Page 40
Investment Bankers......Page 42
Venture Capital and Private Equity......Page 43
Antecedents of the Crisis......Page 44
Changes in Housing Finance......Page 46
Mortgage Derivatives......Page 48
The Rise of Systemic Risk......Page 49
The Shoe Drops......Page 50
The Dodd-Frank Reform Act......Page 51
End of Chapter Material......Page 52
2.1 The Money Market......Page 56
Treasury Bills......Page 57
Commercial Paper......Page 58
Repos and Reverses......Page 59
Yields on Money Market Instruments......Page 60
2.2 The Bond Market......Page 62
Treasury Notes and Bonds......Page 63
Municipal Bonds......Page 64
Corporate Bonds......Page 67
Mortgages and Mortgage-Backed Securities......Page 68
Common Stock as Ownership Shares......Page 69
Stock Market Listings......Page 70
Preferred Stock......Page 71
Dow Jones Industrial Average......Page 72
The Standard & Poor’s 500 Index......Page 76
Foreign and International Stock Market Indexes......Page 77
Bond Market Indicators......Page 78
Options......Page 79
Futures Contracts......Page 80
End of Chapter Material......Page 81
3.1 How Firms Issue Securities......Page 86
Publicly Traded Companies......Page 87
Shelf Registration......Page 88
Initial Public Offerings......Page 89
Brokered Markets......Page 91
Market Orders......Page 92
Trading Mechanisms......Page 93
Dealer Markets......Page 94
3.3 The Rise of Electronic Trading......Page 95
NASDAQ......Page 97
The New York Stock Exchange......Page 98
Algorithmic Trading......Page 99
High-Frequency Trading......Page 100
Dark Pools......Page 101
3.6 Globalization of Stock Markets......Page 102
3.7 Trading Costs......Page 103
3.8 Buying on Margin......Page 104
3.9 Short Sales......Page 107
3.10 Regulation of Securities Markets......Page 111
The Sarbanes-Oxley Act......Page 112
Insider Trading......Page 114
End of Chapter Material......Page 115
4.1 Investment Companies......Page 120
4.2 Types of Investment Companies......Page 121
Managed Investment Companies......Page 122
Commingled Funds......Page 123
Investment Policies......Page 124
International Funds......Page 125
How Funds Are Sold......Page 126
Operating Expenses......Page 127
12b-1 Charges......Page 128
Fees and Mutual Fund Returns......Page 129
4.5 Taxation of Mutual Fund Income......Page 131
4.6 Exchange-Traded Funds......Page 132
4.7 Mutual Fund Investment Performance: A First Look......Page 135
4.8 Information on Mutual Funds......Page 138
End of Chapter Material......Page 141
Chapter 5 Risk, Return, and the Historical Record......Page 146
Real and Nominal Rates of Interest......Page 147
The Equilibrium Real Rate of Interest......Page 148
The Equilibrium Nominal Rate of Interest......Page 149
5.2 Comparing Rates of Return for Different Holding Periods......Page 150
Continuous Compounding......Page 152
5.3 Bills and Inflation, 1926–2015......Page 153
Expected Return and Standard Deviation......Page 155
Excess Returns and Risk Premiums......Page 157
The Geometric (Time-Weighted) Average Return......Page 158
Variance and Standard Deviation......Page 160
Mean and Standard Deviation Estimates from Higher-Frequency Observations......Page 161
The Reward-to-Volatility (Sharpe) Ratio......Page 162
5.6 The Normal Distribution......Page 163
5.7 Deviations from Normality and Alternative Risk Measures......Page 165
Expected Shortfall......Page 167
Relative Frequency of Large, Negative 3-Sigma Returns......Page 168
5.8 Historic Returns on Risky Portfolios......Page 169
A Global View of the Historical Record......Page 175
5.9 Normality and Long-Term Investments......Page 176
Short-Run versus Long-Run Risk......Page 177
End of Chapter Material......Page 180
Chapter 6 Capital Allocation to Risky Assets......Page 186
Risk, Speculation, and Gambling......Page 187
Risk Aversion and Utility Values......Page 188
6.2 Capital Allocation across Risky and Risk-Free Portfolios......Page 193
6.3 The Risk-Free Asset......Page 195
6.4 Portfolios of One Risky Asset and a Risk-Free Asset......Page 196
6.5 Risk Tolerance and Asset Allocation......Page 199
Non-Normal Returns......Page 204
6.6 Passive Strategies: The Capital Market Line......Page 205
End of Chapter Material......Page 207
Appendix A: Risk Aversion, Expected Utility, and the St. Petersburg Paradox......Page 216
Appendix B: Utility Functions and Risk Premiums......Page 220
Chapter 7 Optimal Risky Portfolios......Page 222
7.1 Diversification and Portfolio Risk......Page 223
7.2 Portfolios of Two Risky Assets......Page 224
Asset Allocation with Two Risky Asset Classes......Page 232
Security Selection......Page 237
Capital Allocation and the Separation Property......Page 240
The Power of Diversification......Page 243
Asset Allocation and Security Selection......Page 245
7.5 Risk Pooling, Risk Sharing, and the Risk of Long-Term Investments......Page 246
Risk Pooling and the Insurance Principle......Page 247
Risk Sharing......Page 248
Time Diversification and the Investment Horizon......Page 249
End of Chapter Material......Page 251
Appendix A: A Spreadsheet Model for Efficient Diversification......Page 261
Appendix B: Review of Portfolio Statistics......Page 266
Chapter 8 Index Models......Page 274
The Input List of the Markowitz Model......Page 275
Systematic versus Firm-Specific Risk......Page 276
The Regression Equation of the Single-Index Model......Page 277
Risk and Covariance in the Single-Index Model......Page 279
The Set of Estimates Needed for the Single-Index Model......Page 280
The Index Model and Diversification......Page 282
The Explanatory Power of Ford’s SCL......Page 284
The Estimate of Alpha......Page 285
Typical Results from Index Model Regressions......Page 286
8.4 The Industry Version of the Index Model......Page 288
Predicting Betas......Page 289
Alpha and Security Analysis......Page 291
The Index Portfolio as an Investment Asset......Page 292
The Optimal Risky Portfolio in the Single-Index Model......Page 293
The Information Ratio......Page 294
Correlation and Covariance Matrix......Page 296
The Optimal Risky Portfolio......Page 298
End of Chapter Material......Page 300
9.1 The Capital Asset Pricing Model......Page 306
Why Do All Investors Hold the Market Portfolio?......Page 308
The Risk Premium of the Market Portfolio......Page 309
Expected Returns on Individual Securities......Page 311
The Security Market Line......Page 314
The CAPM and the Single-Index Market......Page 316
Identical Input Lists......Page 317
Risk-Free Borrowing and the Zero-Beta Model......Page 318
Labor Income and Nontraded Assets......Page 319
A Multiperiod Model and Hedge Portfolios......Page 320
A Consumption-Based CAPM......Page 322
Liquidity and the CAPM......Page 323
9.3 The CAPM and the Academic World......Page 327
9.4 The CAPM and the Investment Industry......Page 328
End of Chapter Material......Page 329
Chapter 10 Arbitrage Pricing Theory and Multifactor Models of Risk and Return......Page 338
Factor Models of Security Returns......Page 339
10.2 Arbitrage Pricing Theory......Page 341
Well-Diversified Portfolios......Page 342
The Security Market Line of the APT......Page 344
Well-Diversified Portfolios in Practice......Page 347
The APT and the CAPM......Page 348
The APT and Portfolio Optimization in a Single-Index Market......Page 349
10.4 A Multifactor APT......Page 350
10.5 The Fama-French (FF) Three-Factor Model......Page 353
End of Chapter Material......Page 355
Chapter 11 The Efficient Market Hypothesis......Page 362
11.1 Random Walks and the Efficient Market Hypothesis......Page 363
Competition as the Source of Efficiency......Page 364
Versions of the Efficient Market Hypothesis......Page 366
Technical Analysis......Page 368
Fundamental Analysis......Page 369
Active versus Passive Portfolio Management......Page 370
The Role of Portfolio Management in an Efficient Market......Page 371
11.3 Event Studies......Page 372
The Lucky Event Issue......Page 376
Returns over Long Horizons......Page 378
Predictors of Broad Market Returns......Page 379
Semistrong Tests: Market Anomalies......Page 380
The Small-Firm Effect......Page 381
Book-to-Market Ratios......Page 382
Post–Earnings-Announcement Price Drift......Page 383
Strong-Form Tests: Inside Information......Page 384
Risk Premiums or Inefficiencies?......Page 385
Anomalies or Data Mining?......Page 386
Bubbles and Market Efficiency......Page 387
11.5 Mutual Fund and Analyst Performance......Page 388
Mutual Fund Managers......Page 389
So, Are Markets Efficient?......Page 393
End of Chapter Material......Page 394
Chapter 12 Behavioral Finance and Technical Analysis......Page 402
Information Processing......Page 403
Conservatism......Page 404
Mental Accounting......Page 405
Regret Avoidance......Page 406
Prospect Theory......Page 407
Fundamental Risk......Page 408
Equity Carve-Outs......Page 409
Closed-End Funds......Page 410
Bubbles and Behavioral Economics......Page 411
Evaluating the Behavioral Critique......Page 412
12.2 Technical Analysis and Behavioral Finance......Page 413
Momentum and Moving Averages......Page 414
Breadth......Page 416
Confidence Index......Page 417
A Warning......Page 418
End of Chapter Material......Page 420
Chapter 13 Empirical Evidence on Security Returns......Page 426
Estimating the SCL......Page 427
Tests of the CAPM......Page 428
The Market Index......Page 429
Measurement Error in Beta......Page 430
13.2 Tests of the Multifactor Models......Page 432
Labor Income......Page 433
Private (Nontraded) Business......Page 434
A Macro Factor Model......Page 435
13.3 Fama-French-Type Factor Models......Page 436
Size and B/M as Risk Factors......Page 438
Behavioral Explanations......Page 440
Momentum: A Fourth Factor......Page 442
13.4 Liquidity and Asset Pricing......Page 443
13.5 Consumption-Based Asset Pricing and the Equity Premium Puzzle......Page 445
Expected versus Realized Returns......Page 447
Survivorship Bias......Page 448
Extensions to the CAPM May Resolve the Equity Premium Puzzle......Page 449
Behavioral Explanations of the Equity Premium Puzzle......Page 450
End of Chapter Material......Page 451
Chapter 14 Bond Prices and Yields......Page 454
Treasury Bonds and Notes......Page 455
Corporate Bonds......Page 456
Call Provisions on Corporate Bonds......Page 457
Preferred Stock......Page 458
International Bonds......Page 459
Indexed Bonds......Page 460
14.2 Bond Pricing......Page 461
Bond Pricing between Coupon Dates......Page 465
Yield to Maturity......Page 467
Yield to Call......Page 469
Realized Compound Return versus Yield to Maturity......Page 471
14.4 Bond Prices over Time......Page 473
Yield to Maturity versus Holding-Period Return......Page 475
After-Tax Returns......Page 476
Junk Bonds......Page 478
Determinants of Bond Safety......Page 480
Bond Indentures......Page 481
Subordination of Further Debt......Page 482
Yield to Maturity and Default Risk......Page 483
Credit Default Swaps......Page 485
Credit Risk and Collateralized Debt Obligations......Page 487
End of Chapter Material......Page 489
15.1 The Yield Curve......Page 496
Bond Pricing......Page 497
The Yield Curve under Certainty......Page 499
Holding-Period Returns......Page 501
Forward Rates......Page 502
15.3 Interest Rate Uncertainty and Forward Rates......Page 504
The Expectations Hypothesis......Page 506
Liquidity Preference Theory......Page 507
15.5 Interpreting the Term Structure......Page 509
15.6 Forward Rates as Forward Contracts......Page 513
End of Chapter Material......Page 515
Chapter 16 Managing Bond Portfolios......Page 524
Interest Rate Sensitivity......Page 525
Duration......Page 528
Rule 2 for Duration......Page 531
Rule 4 for Duration......Page 532
Rule 5 for Duration......Page 533
16.2 Convexity......Page 534
Duration and Convexity of Callable Bonds......Page 537
Duration and Convexity of Mortgage-Backed Securities......Page 539
Bond-Index Funds......Page 542
Immunization......Page 544
Cash Flow Matching and Dedication......Page 550
Sources of Potential Profit......Page 551
Horizon Analysis......Page 553
End of Chapter Material......Page 554
17.1 The Global Economy......Page 566
17.2 The Domestic Macroeconomy......Page 569
Sentiment......Page 570
17.4 Federal Government Policy......Page 571
Monetary Policy......Page 572
Supply-Side Policies......Page 573
The Business Cycle......Page 574
Economic Indicators......Page 575
Other Indicators......Page 578
17.6 Industry Analysis......Page 579
Defining an Industry......Page 580
Sensitivity to the Business Cycle......Page 582
Sector Rotation......Page 584
Consolidation Stage......Page 586
Relative Decline......Page 587
Rivalry between Existing Competitors......Page 588
End of Chapter Material......Page 589
18.1 Valuation by Comparables......Page 598
Limitations of Book Value......Page 599
18.2 Intrinsic Value versus Market Price......Page 600
18.3 Dividend Discount Models......Page 602
The Constant-Growth DDM......Page 603
Stock Prices and Investment Opportunities......Page 607
Life Cycles and Multistage Growth Models......Page 610
Multistage Growth Models......Page 615
The Price–Earnings Ratio and Growth Opportunities......Page 616
Pitfalls in P/E Analysis......Page 619
Other Comparative Valuation Ratios......Page 622
Price-to-Sales Ratio......Page 623
18.5 Free Cash Flow Valuation Approaches......Page 624
Comparing the Valuation Models......Page 627
18.6 The Aggregate Stock Market......Page 628
End of Chapter Material......Page 630
The Income Statement......Page 642
The Balance Sheet......Page 644
The Statement of Cash Flows......Page 646
19.2 Measuring Firm Performance......Page 647
Return on Assets, ROA......Page 648
Financial Leverage and ROE......Page 649
Economic Value Added......Page 651
Decomposition of ROE......Page 652
Turnover and Other Asset Utilization Ratios......Page 656
Liquidity Ratios......Page 658
Market Price Ratios: Growth versus Value......Page 659
Choosing a Benchmark......Page 660
19.5 An Illustration of Financial Statement Analysis......Page 662
Inventory Valuation......Page 665
Inflation and Interest Expense......Page 666
Fair Value Accounting......Page 667
Quality of Earnings and Accounting Practices......Page 668
International Accounting Conventions......Page 670
19.7 Value Investing: The Graham Technique......Page 671
End of Chapter Material......Page 672
20.1 The Option Contract......Page 686
Options Trading......Page 688
The Options Clearing Corporation......Page 690
Index Options......Page 691
Call Options......Page 692
Put Options......Page 693
Option versus Stock Investments......Page 694
Protective Put......Page 696
Covered Calls......Page 698
Straddle......Page 700
Collars......Page 702
20.4 The Put-Call Parity Relationship......Page 704
Callable Bonds......Page 707
Convertible Securities......Page 708
Collateralized Loans......Page 711
Levered Equity and Risky Debt......Page 712
20.6 Financial Engineering......Page 713
Asian Options......Page 715
End of Chapter Material......Page 716
Intrinsic and Time Values......Page 728
Determinants of Option Values......Page 729
Restrictions on the Value of a Call Option......Page 732
Early Exercise and Dividends......Page 733
Early Exercise of American Puts......Page 734
Two-State Option Pricing......Page 735
Generalizing the Two-State Approach......Page 737
Making the Valuation Model Practical......Page 739
The Black-Scholes Formula......Page 743
Put Option Valuation......Page 750
Hedge Ratios and the Black-Scholes Formula......Page 751
Portfolio Insurance......Page 754
Option Pricing and the Crisis of 2008–2009......Page 757
Option Pricing and Portfolio Theory......Page 758
Hedging Bets on Mispriced Options......Page 759
21.6 Empirical Evidence on Option Pricing......Page 763
End of Chapter Material......Page 764
22.1 The Futures Contract......Page 776
The Basics of Futures Contracts......Page 777
Existing Contracts......Page 780
The Clearinghouse and Open Interest......Page 782
The Margin Account and Marking to Market......Page 783
Cash versus Actual Delivery......Page 785
Hedging and Speculation......Page 786
Basis Risk and Hedging......Page 789
The Spot-Futures Parity Theorem......Page 790
Spreads......Page 793
Forward versus Futures Pricing......Page 795
Normal Backwardation......Page 797
Modern Portfolio Theory......Page 798
End of Chapter Material......Page 799
The Markets......Page 804
Interest Rate Parity......Page 805
Using Futures to Manage Exchange Rate Risk......Page 809
The Contracts......Page 812
Creating Synthetic Stock Positions: An Asset Allocation Tool......Page 813
Index Arbitrage......Page 814
Using Index Futures to Hedge Market Risk......Page 815
Hedging Interest Rate Risk......Page 817
23.4 Swaps......Page 819
The Swap Dealer......Page 821
Other Interest Rate Contracts......Page 822
Swap Pricing......Page 823
Credit Risk in the Swap Market......Page 825
Pricing with Storage Costs......Page 826
Discounted Cash Flow Analysis for Commodity Futures......Page 828
End of Chapter Material......Page 830
Average Rates of Return......Page 840
Time-Weighted Returns versus Dollar-Weighted Returns......Page 841
Adjusting Returns for Risk......Page 842
The Sharpe Ratio for Overall Portfolios......Page 844
The M2 Measure and the Sharpe Ratio......Page 845
The Treynor Ratio......Page 846
The Information Ratio......Page 847
Implementing Performance Measurement: An Example......Page 848
Realized Returns versus Expected Returns......Page 850
24.2 Style Analysis......Page 852
24.3 Performance Measurement with Changing Portfolio Composition......Page 855
24.4 Market Timing......Page 859
The Potential Value of Market Timing......Page 861
Valuing Market Timing as a Call Option......Page 862
The Value of Imperfect Forecasting......Page 863
24.5 Performance Attribution Procedures......Page 864
Asset Allocation Decisions......Page 866
Sector and Security Selection Decisions......Page 867
Summing Up Component Contributions......Page 869
End of Chapter Material......Page 870
25.1 Global Markets for Equities......Page 882
Developed Countries......Page 883
Emerging Markets......Page 884
Market Capitalization and GDP......Page 885
Exchange Rate Risk......Page 886
Investment Risk in International Markets......Page 890
International Diversification......Page 892
Are Benefits from International Diversification Preserved in Bear Markets?......Page 896
25.3 Political Risk......Page 897
Constructing a Benchmark Portfolio of Foreign Assets......Page 900
Performance Attribution......Page 902
End of Chapter Material......Page 904
Chapter 26 Hedge Funds......Page 910
Compensation Structure......Page 911
Directional and Nondirectional Strategies......Page 912
Statistical Arbitrage......Page 914
An Example of a Pure Play......Page 915
26.4 Style Analysis for Hedge Funds......Page 918
26.5 Performance Measurement for Hedge Funds......Page 920
Liquidity and Hedge Fund Performance......Page 921
Hedge Fund Performance and Survivorship Bias......Page 923
Hedge Fund Performance and Changing Factor Loadings......Page 924
Tail Events and Hedge Fund Performance......Page 925
26.6 Fee Structure in Hedge Funds......Page 928
End of Chapter Material......Page 931
27.1 Optimal Portfolios and Alpha Values......Page 936
Forecasts of Alpha Values and Extreme Portfolio Weights......Page 937
Restriction of Benchmark Risk......Page 941
Adjusting Forecasts for the Precision of Alpha......Page 943
Distribution of Alpha Values......Page 944
Organizational Structure and Performance......Page 945
Step 1: The Covariance Matrix from Historical Data......Page 947
Step 2: Determination of a Baseline Forecast......Page 948
Step 3: Integrating the Manager’s Private Views......Page 949
Step 4: Revised (Posterior) Expectations......Page 950
Step 5: Portfolio Optimization......Page 951
27.4 Treynor-Black versus Black-Litterman: Complements, Not Substitutes......Page 952
Why Not Replace the Entire TB Cake with the BL Icing?......Page 953
A Model for the Estimation of Potential Fees......Page 954
Results from Distribution of Actual Forecasts......Page 955
End of Chapter Material......Page 956
Appendix A: Forecasts and Realizations of Alpha......Page 957
Appendix B: The General Black-Litterman Model......Page 958
Chapter 28 Investment Policy and the Framework of the CFA Institute......Page 960
Objectives......Page 961
Pension Funds......Page 964
Banks......Page 965
Liquidity......Page 966
Unique Needs......Page 967
Sample Policy Statements for Individual Investors......Page 968
28.4 Asset Allocation......Page 972
Taxes and Asset Allocation......Page 973
Saving for Retirement and the Assumption of Risk......Page 974
Manage Your Own Portfolio or Rely on Others?......Page 975
The Tax-Deferral Option......Page 977
Tax-Protected Retirement Plans......Page 978
Deferred Annuities......Page 979
Defined Benefit Plans......Page 980
Investing in Equities......Page 982
28.7 Investments for the Long Run......Page 983
Inflation Risk and Long-Term Investors......Page 984
End of Chapter Material......Page 985
References to CFA Problems......Page 996
Glossary......Page 998
Name Index......Page 1012
Subject Index......Page 1015
formulas......Page 1038