Essentials of investments

Cover......Page 1
Essentials of Investments......Page 2
About the Authors......Page 6
Brief Contents......Page 7
Contents......Page 8
A Note from the Authors . . .......Page 16
Organization of the Tenth Edition......Page 17
Pedagogical Features......Page 19
Excel Integration......Page 21
End-of-Chapter Features......Page 22
Supplements......Page 23
Acknowledgments......Page 26
Part One Elements of Investments......Page 28
1 Investments: Background and Issues......Page 29
1.1  Real Assets Versus Financial Assets......Page 30
1.2  Financial Assets......Page 32
Consumption Timing......Page 33
Separation of Ownership and Management......Page 34
Corporate Governance and Corporate Ethics......Page 35
1.4 The Investment Process......Page 36
The Risk-Return Trade-Off......Page 37
1.6 The Players......Page 38
Financial Intermediaries......Page 39
Investment Bankers......Page 41
Antecedents of the Crisis......Page 42
Changes in Housing Finance......Page 44
Credit Default Swaps......Page 46
The Shoe Drops......Page 47
The Dodd-Frank Reform Act......Page 48
End of Chapter Material......Page 49
2 Asset Classes and Financial Instruments......Page 53
Treasury Bills......Page 54
Commercial Paper......Page 55
Federal Funds......Page 56
Yields on Money Market Instruments......Page 57
Treasury Notes and Bonds......Page 59
International Bonds......Page 60
Municipal Bonds......Page 61
Mortgages and Mortgage-Backed Securities......Page 63
Common Stock as Ownership Shares......Page 65
Stock Market Listings......Page 66
Dow Jones Averages......Page 67
Standard & Poor’s Indexes......Page 69
Equally Weighted Indexes......Page 71
Bond Market Indicators......Page 72
Options......Page 73
Futures Contracts 47......Page 74
End of Chapter Material......Page 75
3 Securities Markets......Page 81
Privately Held Firms......Page 82
Shelf Registration......Page 83
3.2 How Securities are Traded......Page 84
Types of Markets......Page 85
Types of Orders......Page 86
Trading Mechanisms......Page 88
3.3 The Rise of Electronic Trading......Page 89
NASDAQ......Page 91
3.5 New Trading Strategies......Page 92
High-Frequency Trading......Page 93
Dark Pools......Page 94
3.6 Globalization of Stock Markets......Page 95
3.7 Trading Costs......Page 96
3.8 Buying on Margin......Page 97
3.9 Short Sales......Page 99
3.1 0Regulation of Securities Markets......Page 102
Self-Regulation......Page 103
The Sarbanes-Oxley Act......Page 104
End of Chapter Material......Page 105
4 Mutual Funds and Other Investment Companies......Page 111
4.2 Types of Investment Companies......Page 112
Managed Investment Companies......Page 113
Other Investment Organizations......Page 114
Investment Policies......Page 115
How Funds Are Sold......Page 117
Fee Structures......Page 118
Fees and Mutual Fund Returns......Page 120
4.5 Taxation of Mutual Fund Income......Page 121
4.6 Exchange-Traded Funds......Page 122
4.7 Mutual Fund Investment Performance: a First Look......Page 125
4.8 Information on Mutual Funds......Page 128
End of Chapter Material......Page 130
Part TWO Portfolio Theory......Page 136
5 Risk and Return: Past and Prologue......Page 137
Measuring Investment Returns over Multiple Periods......Page 138
Conventions for Annualizing Rates of Return......Page 140
5.2 Inflation and the Real Rate of Interest......Page 141
The Equilibrium Nominal Rate of Interest......Page 142
Scenario Analysis and Probability Distributions......Page 143
The Normal Distribution......Page 145
Normality over Time......Page 147
Deviation from Normality and Value at Risk......Page 148
Using Time Series of Return......Page 149
Risk Premiums and Risk Aversion......Page 150
History of U.S. Interest Rates, Inflation, and Real Interest Rates......Page 152
World and U.S. Risky Stock and Bond Portfolios......Page 154
The Risk-Free Asset......Page 160
Portfolio Expected Return and Risk......Page 161
The Capital Allocation Line......Page 162
Risk Aversion and Capital Allocation......Page 163
Historical Evidence on the Capital Market Line......Page 164
Costs and Benefits of Passive Investing......Page 165
End of Chapter Material......Page 166
6 Efficient Diversification......Page 174
6.1 Diversification and Portfolio Risk......Page 175
6.2 Asset Allocation with Two Risky Assets......Page 176
Covariance and Correlation......Page 177
Using Historical Data......Page 180
The Three Rules of Two-Risky-Assets Portfolios......Page 181
The Risk-Return Trade-Off with Two-Risky-Assets Portfolios......Page 182
The Mean-Variance Criterion......Page 184
6.3 The Optimal Risky Portfolio with a Risk-Free Asset......Page 186
The Efficient Frontier of Risky Assets......Page 190
The Preferred Complete Portfolio and a Separation Property......Page 192
Constructing the Optimal Risky Portfolio: An Illustration......Page 193
6.5 A Single-Index Stock Market......Page 195
Statistical and Graphical Representation of the Single-Index Model......Page 197
Diversification in a Single-Index Security Market......Page 199
Using Security Analysis with the Index Model......Page 201
Risk and Return with Alternative Long-Term Investments......Page 203
End of Chapter Material......Page 206
7 Capital Asset Pricing and Arbitrage Pricing Theory......Page 219
The Model: Assumptions and Implications......Page 220
Why All Investors Would Hold the Market Portfolio......Page 221
The Passive Strategy Is Efficient......Page 222
The Risk Premium of the Market Portfolio......Page 223
Expected Returns on Individual Securities......Page 224
The Security Market Line......Page 225
Applications of the CAPM......Page 226
7.2 The Capm and Index Models......Page 227
Estimating the Index Model......Page 228
7.3 The Capm and the Real World......Page 235
7.4 Multifactor Models and the Capm......Page 237
The Fama-French Three-Factor Model......Page 238
7.5 Arbitrage Pricing Theory......Page 241
Well-Diversified Portfolios and the APT......Page 242
Multifactor Generalization of the APT and CAPM......Page 245
End of Chapter Material......Page 247
8 The Efficient Market Hypothesis......Page 259
8.1 Random Walks and the Efficient Market Hypothesis......Page 260
Competition as the Source of Efficiency......Page 262
Versions of the Efficient Market Hypothesis......Page 263
Technical Analysis......Page 264
Fundamental Analysis......Page 265
Active versus Passive Portfolio Management......Page 266
Resource Allocation......Page 267
The Issues......Page 268
Weak-Form Tests: Patterns in Stock Returns......Page 270
Semistrong Tests: Market Anomalies......Page 271
Interpreting the Anomalies......Page 276
Mutual Fund Managers......Page 279
End of Chapter Material......Page 283
9 Behavioral Finance and Technical Analysis......Page 291
9.1 The Behavioral Critique......Page 292
Information Processing......Page 293
Behavioral Biases......Page 294
Limits to Arbitrage......Page 296
Limits to Arbitrage and the Law of One Price......Page 297
Bubbles and Behavioral Economics......Page 299
Evaluating the Behavioral Critique......Page 300
Trends and Corrections......Page 301
Sentiment Indicators......Page 306
A Warning......Page 307
End of Chapter Material......Page 308
Part three Debt Securities......Page 316
10 Bond Prices and Yields......Page 317
Treasury Bonds and Notes......Page 318
Corporate Bonds......Page 320
Preferred Stock......Page 321
Innovation in the Bond Market......Page 322
10.2 Bond Pricing......Page 324
Bond Pricing between Coupon Dates......Page 327
Bond Pricing in Excel......Page 328
Yield to Maturity......Page 329
Yield to Call......Page 331
Realized Compound Return versus Yield to Maturity......Page 333
10.4 Bond Prices over Time......Page 335
Yield to Maturity versus Holding-Period Return......Page 336
After-Tax Returns......Page 337
Determinants of Bond Safety......Page 339
Bond Indentures......Page 341
Yield to Maturity and Default Risk......Page 342
Credit Default Swaps......Page 344
The Expectations Theory......Page 346
The Liquidity Preference Theory......Page 349
A Synthesis......Page 350
End of Chapter Material......Page 351
11 Managing Bond Portfolios......Page 361
Interest Rate Sensitivity......Page 362
Duration......Page 364
What Determines Duration?......Page 368
Immunization......Page 370
Cash Flow Matching and Dedication......Page 376
11.3 Convexity......Page 377
Why Do Investors Like Convexity?......Page 379
Sources of Potential Profit......Page 381
An Example of a Fixed-Income Investment Strategy......Page 382
End of Chapter Material......Page 383
Part four Security Analysis......Page 396
12 Macroeconomic and Industry Analysis......Page 397
12.1 The Global Economy......Page 398
12.2 The Domestic Macroeconomy......Page 400
Sentiment......Page 401
12.3 Interest Rates......Page 402
12.4 Demand and Supply Shocks......Page 403
Monetary Policy......Page 404
Supply-Side Policies......Page 405
The Business Cycle......Page 406
Economic Indicators......Page 408
12.7 Industry Analysis......Page 411
Defining an Industry......Page 412
Sensitivity to the Business Cycle......Page 414
Sector Rotation......Page 415
Industry Life Cycles......Page 416
Industry Structure and Performance......Page 419
End of Chapter Material......Page 420
13 Equity Valuation......Page 429
13.1 Valuation by Comparables......Page 430
13.2 Intrinsic Value Versus Market Price......Page 431
13.3 Dividend Discount Models......Page 433
The Constant-Growth DDM......Page 434
Stock Prices and Investment Opportunities......Page 436
Life Cycles and Multistage Growth Models......Page 439
Multistage Growth Models......Page 443
The Price–Earnings Ratio and Growth Opportunities......Page 444
Pitfalls in P/E Analysis......Page 448
Other Comparative Valuation Ratios......Page 451
13.5 Free Cash Flow Valuation Approaches......Page 452
Comparing the Valuation Models......Page 455
13.6 The Aggregate Stock Market......Page 456
End of Chapter Material......Page 458
14 Financial Statement Analysis......Page 470
The Income Statement......Page 471
The Statement of Cash Flows......Page 472
14.3 Profitability Measures......Page 475
Financial Leverage and ROE......Page 476
Economic Value Added......Page 478
Decomposition of ROE......Page 479
Turnover and Asset Utilization......Page 481
Liquidity Ratios......Page 484
Market Price Ratios......Page 485
Choosing a Benchmark......Page 486
14.5 An Illustration of Financial Statement Analysis......Page 487
14.6 Comparability Problems......Page 490
Depreciation......Page 491
Fair Value Accounting......Page 492
Quality of Earnings and Accounting Practices......Page 493
International Accounting Conventions......Page 495
14.7 Value Investing: The Graham Technique......Page 496
End of Chapter Material......Page 497
Part five Derivative Markets......Page 510
15 Options Markets......Page 511
15.1 The Option Contract......Page 512
Options Trading......Page 513
American and European Options......Page 514
Other Listed Options......Page 515
Call Options......Page 516
Put Options......Page 517
Options versus Stock Investments......Page 519
Option Strategies......Page 521
Callable Bonds......Page 529
Convertible Securities......Page 530
Warrants......Page 532
Leveraged Equity and Risky Debt......Page 533
15.4 Exotic Options......Page 534
End of Chapter Material......Page 535
16 Option Valuation......Page 546
Determinants of Option Values......Page 547
Two-State Option Pricing......Page 549
Generalizing the Two-State Approach......Page 552
Making the Valuation Model Practical......Page 553
16.3 Black-Scholes Option Valuation......Page 556
The Black-Scholes Formula......Page 557
The Put-Call Parity Relationship......Page 563
Hedge Ratios and the Black-Scholes Formula......Page 566
Portfolio Insurance......Page 568
Option Pricing and the Crisis of 2008–2009......Page 571
16.5 Empirical Evidence......Page 572
End of Chapter Material......Page 573
17Futures Markets and Risk Management......Page 584
The Basics of Futures Contracts......Page 585
Existing Contracts......Page 588
The Clearinghouse and Open Interest......Page 590
Marking to Market and the Margin Account......Page 592
Taxation......Page 594
Hedging and Speculation......Page 595
Basis Risk and Hedging......Page 597
Spot-Futures Parity......Page 598
Spreads......Page 602
Stock-Index Futures......Page 603
Index Arbitrage......Page 604
Interest Rate Futures......Page 605
17.6 Swaps......Page 608
The Swap Dealer......Page 609
End of Chapter Material......Page 610
Part six Active Investment Management......Page 618
18Portfolio Performance Evaluation......Page 619
Comparison Groups......Page 620
Basic Performance-Evaluation Statistics......Page 621
Performance Evaluation of Entire-Wealth Portfolios Using the Sharpe Ratio and M-Square......Page 622
Performance Evaluation of Fund of Funds Using the Treynor Measure......Page 624
The Relation of Alpha to Performance Measures......Page 625
Performance Evaluation with a Multi-Index Model......Page 627
18.2 Style Analysis......Page 628
18.3 Morningstar’s Risk-Adjusted Rating......Page 630
18.4 Risk Adjustments with Changing Portfolio Composition......Page 632
18.5 Performance Attribution Procedures......Page 633
Asset Allocation Decisions......Page 635
Sector and Security Selection Decisions......Page 636
Summing Up Component Contributions......Page 637
18.6 Market Timing......Page 639
Valuing Market Timing as an Option......Page 640
The Value of Imperfect Forecasting......Page 641
Measurement of Market-Timing Performance......Page 642
End of Chapter Material......Page 643
19 Globalization and International Investing......Page 652
Emerging Markets......Page 653
Market Capitalization and GDP......Page 656
Exchange Rate Risk......Page 657
Political Risk......Page 662
Risk and Return: Summary Statistics......Page 666
Are Investments in Emerging Markets Riskier?......Page 669
Are Average Returns Higher in Emerging Markets?......Page 671
Is Exchange Rate Risk Important in International Portfolios?......Page 672
Benefits from International Diversification......Page 674
Realistic Benefits from International Diversification......Page 676
Are Benefits from International Diversification Preserved in Bear Markets?......Page 677
Active Management and International Diversification......Page 678
Performance Attribution......Page 680
End of Chapter Material......Page 683
20 Hedge Funds......Page 688
20.1 Hedge Funds Versus Mutual Funds......Page 689
Directional and Nondirectional Strategies......Page 690
20.3 Portable Alpha......Page 692
An Example of a Pure Play......Page 693
20.4 Style Analysis for Hedge Funds......Page 695
20.5 Performance Measurement for Hedge Funds......Page 696
Liquidity and Hedge Fund Performance......Page 697
Hedge Fund Performance and Survivorship Bias......Page 699
Hedge Fund Performance and Changing Factor Loadings......Page 700
Tail Events and Hedge Fund Performance......Page 701
20.6 Fee Structure in Hedge Funds......Page 703
End of Chapter Material......Page 706
21 Taxes, Inflation, and Investment Strategy......Page 711
The Retirement Annuity......Page 712
A Real Savings Plan......Page 713
An Alternative Savings Plan......Page 715
21.3 Accounting for Taxes......Page 716
21.4 The Economics of Tax Shelters......Page 717
A Benchmark Tax Shelter......Page 718
The Effect of the Progressive Nature of the Tax Code......Page 719
Employee Defined Contribution Plans......Page 721
Roth Accounts with the Progressive Tax Code......Page 722
Sheltered versus Unsheltered Savings......Page 724
21.6 Social Security......Page 726
21.7 Large Purchases......Page 727
21.9 Uncertain Longevity and Other Contingencies......Page 728
21.1 0Matrimony, Bequest, and Intergenerational Transfers......Page 729
End of Chapter Material......Page 730
22 Investors and the Investment Process......Page 733
22.1 The Investment Management Process......Page 734
Individual Investors......Page 736
Professional Investors......Page 737
Life Insurance Companies......Page 739
Endowment Funds......Page 740
Liquidity......Page 741
Unique Needs......Page 742
22.4 Investment Policies......Page 744
Top-Down Policies for Institutional Investors......Page 745
Active versus Passive Policies......Page 746
End of Chapter Material......Page 748
A References......Page 755
B References to CFA Questions......Page 761
Index......Page 764