Investments (8th edition): Part 1

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(BQ) Investments (8th edition) - Zvi Bodie, Alex Kane, Alan J. Marcus, is intended primarily as a textbook for courses in investment analysis. This text will introduce you to major issues currently of concern to all investors. It can give you the skills to conduct a sophisticated assessment of current issues and debates covered by both the popular media as well as more-specialized finance journals. Whether you plan to become an investment professional, or simply a sophisticated individual investor, you will find these skills essential.

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Confirming Pages INVESTMENTS bod8237x_FM_i-xxviii.indd i 5/5/08 5:07:19 PM
Confirming Pages The McGraw-Hill/Irwin Series in Finance, Insurance and Real Estate Stephen A. Ross, Franco Modigliani Professor of Finance and Economics, Sloan School of Management, Massachusetts Institute of Technology, Consulting Editor Financial Management Ross, Westerfield, and Jaffe Saunders and Cornett Corporate Finance Financial Institutions Management: A Risk Adair Eighth Edition Management Approach Excel Applications for Corporate Finance Sixth Edition First Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles Saunders and Cornett Block, Hirt, and Danielsen and Applications Financial Markets and Institutions: An Foundations of Financial Management Second Edition Introduction to the Risk Management Thirteenth Edition Approach Ross, Westerfield, and Jordan Brealey, Myers, and Allen Fourth Edition Essentials of Corporate Finance Principles of Corporate Finance Sixth Edition Ninth Edition International Finance Ross, Westerfield and Jordan Brealey, Myers, and Allen Fundamentals of Corporate Finance Eun and Resnick Principles of Corporate Finance, Concise Edition Eighth Edition International Financial Management First Edition Fifth Edition Shefrin Brealey, Myers, and Marcus Behavioral Corporate Finance: Decisions Kuemmerle Fundamentals of Corporate Finance that Create Value Case Studies in International Sixth Edition First Edition Entrepreneurship: Managing and Financing Ventures Brooks White in the Global Economy FinGame Online 5.0 Financial Analysis with an Electronic First Edition Calculator Bruner Sixth Edition Case Studies in Finance: Managing for Real Estate Corporate Value Creation Investments Fifth Edition Brueggeman and Fisher Bodie, Kane, and Marcus Real Estate Finance and Investments Chew Essentials of Investments Thirteenth Edition The New Corporate Finance: Where Theory Seventh Edition Meets Practice Ling and Archer Third Edition Bodie, Kane, and Marcus Real Estate Principles: A Value Approach Investments Second Edition Cornett, Adair, and Nofsinger Eighth Edition Finance: Applications and Theory Financial Planning and Insurance First Edition Hirt and Block Fundamentals of Investment Allen, Melone, Rosenbloom, and Mahoney DeMello Management Retirement Plans: 401(k)s, IRAs, Cases in Finance Ninth Edition and Other Deferred Compensation Second Edition Approaches Hirschey and Nofsinger Grinblatt (editor) Investments: Analysis and Behavior Tenth Edition Stephen A. Ross, Mentor: Influence through First Edition Altfest Generations Personal Financial Planning Jordan and Miller Grinblatt and Titman Fundamentals of Investments: Valuation First Edition Financial Markets and Corporate Strategy and Management Harrington and Niehaus Second Edition Fifth Edition Risk Management and Insurance Higgins Financial Institutions and Markets Second Edition Analysis for Financial Management Rose and Hudgins Kapoor, Dlabay, and Hughes Ninth Edition Bank Management and Financial Services Focus on Personal Finance: An Active Kellison Seventh Edition Approach to Help You Develop Successful Theory of Interest Financial Skills Third Edition Rose and Marquis Second Edition Money and Capital Markets: Financial Kester, Ruback, and Tufano Institutions and Instruments in a Global Kapoor, Dlabay, and Hughes Case Problems in Finance Marketplace Personal Finance Twelfth Edition Tenth Edition Ninth Edition bod8237x_FM_i-xxviii.indd ii 5/5/08 5:07:20 PM
Confirming Pages INVESTMENTS E I G H T H E D I T I O N ZVI BODIE Boston University ALEX KANE University of California, San Diego ALAN J. MARCUS Boston College Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto bod8237x_FM_i-xxviii.indd iii 5/5/08 5:07:21 PM
Confirming Pages To our families with love and gratitude. INVESTMENTS Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2009, 2008, 2005, 2002, 1999, 1996, 1993, 1989 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOW/DOW 0 9 8 ISBN 978-0-07-338237-1 MHID 0-07-338237-X Executive editor: Michele Janicek Senior developmental editor: Christina Kouvelis Marketing manager: Ashley Smith Managing editor: Lori Koetters Lead production supervisor: Michael R. McCormick Lead designer: Matthew Baldwin Senior media project manager: Lynn M. Bluhm Cover designer: Jillian Lindner Cover image: © Veer Images Typeface: 10/12 Times Roman Compositor: Laserwords Private Limited Printer: R. R. Donnelley Library of Congress Cataloging-in-Publication Data Bodie, Zvi. Investments / Zvi Bodie, Alex Kane, Alan J. Marcus.—8th ed. p. cm.—(The McGraw-Hill/Irwin series in finance, insurance and real estate) Includes index. ISBN-13: 978-0-07-338237-1 (alk. paper) ISBN-10: 0-07-338237-X (alk. paper) 1. Investments. 2. Portfolio management. I. Kane, Alex. II. Marcus, Alan J. III. Title. HG4521.B564 2009 332.6—dc22 2008009854 www.mhhe.com bod8237x_FM_i-xxviii.indd iv 5/5/08 5:07:22 PM
Confirming Pages ABOUT THE AUTHORS ZVI BODIE ALEX KANE ALAN J. MARCUS Boston University University of California, Boston College San Diego Zvi Bodie is the Norman Alan Marcus is professor and Adele Barron Professor Alex Kane is professor of of finance in the Wallace E. of Management at Boston finance and economics at the Carroll School of Management University. He holds a PhD Graduate School of Interna- at Boston College. He received from the Massachusetts Insti- tional Relations and Pacific his PhD in economics from tute of Technology and has Studies at the University of MIT. Professor Marcus has served on the finance faculty at California, San Diego. He been a visiting professor at the the Harvard Business School has been visiting professor at Athens Laboratory of Business and MIT’s Sloan School of the Faculty of Economics, Administration and at MIT’s Management. Professor Bodie University of Tokyo; Sloan School of Management has published widely on pen- Graduate School of Business, and has served as a research sion finance and investment Harvard; Kennedy School of associate at the National strategy in leading professional Government, Harvard; and Bureau of Economic Research. journals. In cooperation with research associate, National Professor Marcus has published the Research Foundation of the Bureau of Economic Research. widely in the fields of capital CFA Institute, he has recently An author of many articles markets and portfolio manage- produced a series of Webcasts in finance and management ment. His consulting work and a monograph entitled The journals, Professor Kane’s has ranged from new product Future of Life Cycle Saving research is mainly in corporate development to provision of and Investing. finance, portfolio manage- expert testimony in utility rate ment, and capital markets, most proceedings. He also spent recently in the measurement of 2 years at the Federal Home market volatility and pricing of Loan Mortgage Corporation options. (Freddie Mac), where he developed models of mortgage pricing and credit risk. He cur- rently serves on the Research Foundation Advisory Board of the CFA Institute. v bod8237x_FM_i-xxviii.indd v 5/5/08 5:07:25 PM
Confirming Pages BRIEF CONTENTS Part I Part III INTRODUCTION 1 EQUILIBRIUM IN CAPITAL 1 The Investment Environment 1 MARKETS 279 9 2 The Capital Asset Pricing Model 279 Asset Classes and Financial Instruments 23 10 3 Arbitrage Pricing Theory and Multifactor Models How Securities Are Traded 54 of Risk and Return 319 4 11 Mutual Funds and Other Investment The Efficient Market Hypothesis 344 Companies 88 12 Behavioral Finance and Technical Analysis 384 Part II 13 PORTFOLIO THEORY AND Empirical Evidence on Security Returns 410 PRACTICE 113 Part IV 5 Learning about Return and Risk from FIXED-INCOME the Historical Record 113 SECURITIES 445 6 Risk Aversion and Capital Allocation 14 to Risky Assets 156 Bond Prices and Yields 445 7 15 Optimal Risky Portfolios 194 The Term Structure of Interest Rates 484 8 16 Index Models 244 Managing Bond Portfolios 512 vi bod8237x_FM_i-xxviii.indd vi 5/5/08 5:07:25 PM
Confirming Pages BRIEF CONTENTS Part V Part VII SECURITY APPLIED PORTFOLIO ANALYSIS 553 MANAGEMENT 823 17 24 Macroeconomic and Industry Analysis 553 Portfolio Performance Evaluation 823 18 25 Equity Valuation Models 586 International Diversification 867 19 26 Financial Statement Analysis 631 Hedge Funds 902 27 Part VI The Theory of Active Portfolio Management 924 OPTIONS, FUTURES, 28 AND OTHER Investment Policy and the Framework of the CFA Institute 950 DERIVATIVES 671 REFERENCES TO CFA PROBLEMS 989 20 Options Markets: Introduction 671 GLOSSARY G-1 21 NAME INDEX IND-1 Option Valuation 715 22 SUBJECT INDEX IND-4 Futures Markets 759 23 Futures, Swaps, and Risk Management 788 vii bod8237x_FM_i-xxviii.indd vii 5/5/08 5:07:28 PM
Confirming Pages CONTENTS Part I Municipal Bonds / Corporate Bonds / Mortgages and Mortgage-Backed Securities INTRODUCTION 1 2.3 Equity Securities 35 Chapter 1 Common Stock as Ownership Shares / Characteristics of Common Stock / Stock Market Listings / Preferred Stock / The Investment Environment 1 Depository Receipts 1.1 Real Assets versus Financial Assets 2 2.4 Stock and Bond Market Indexes 38 1.2 A Taxonomy of Financial Assets 4 Stock Market Indexes / Dow Jones Averages / Standard 1.3 Financial Markets and the Economy 5 & Poor’s Indexes / Other U.S. Market-Value Indexes / The Informational Role of Financial Markets / Equally Weighted Indexes / Foreign and International Consumption Timing / Allocation of Risk / Separation Stock Market Indexes / Bond Market Indicators of Ownership and Management / Corporate Governance 2.5 Derivative Markets 46 and Corporate Ethics Options / Futures Contracts 1.4 The Investment Process 9 End of Chapter Material 49–53 Saving, Investing, and Safe Investing Chapter 3 1.5 Markets Are Competitive 10 How Securities Are Traded 54 The Risk–Return Trade-Off / Efficient Markets 3.1 How Firms Issue Securities 54 1.6 The Players 11 Investment Banking / Shelf Registration / Private Financial Intermediaries / Investment Bankers Placements / Initial Public Offerings 1.7 Recent Trends 15 3.2 How Securities Are Traded 58 Globalization / Securitization / Financial Engineering / Types of Markets Computer Networks Direct Search Markets / Brokered Markets / Dealer 1.8 Outline of the Text 18 Markets / Auction Markets End of Chapter Material 19–22 Types of Orders Chapter 2 Market Orders / Price-Contingent Orders Asset Classes and Financial Instruments 23 Trading Mechanisms 2.1 The Money Market 24 Dealer Markets / Electronic Communication Networks (ECNs) / Specialist Markets Treasury Bills / Certificates of Deposit / Commercial Paper / Bankers’ Acceptances / Eurodollars / Repos and 3.3 U.S. Securities Markets 63 Reverses / Federal Funds / Brokers’ Calls / The LIBOR NASDAQ / The New York Stock Exchange Market / Yields on Money Market Instruments Block Sales / SuperDot and Electronic Trading 2.2 The Bond Market 28 on the NYSE / Settlement Treasury Notes and Bonds / Inflation-Protected Treasury Electronic Communication Networks / The National Bonds / Federal Agency Debt / International Bonds / Market System / Bond Trading viii bod8237x_FM_i-xxviii.indd viii 5/5/08 5:07:28 PM
Confirming Pages CONTENTS 3.4 Market Structure in Other Countries 68 5.2 Comparing Rates of Return for Different Holding London / Euronext / Tokyo / Globalization Periods 118 and Consolidation of Stock Markets Annual Percentage Rates / Continuous Compounding 3.5 Trading Costs 70 5.3 Bills and Inflation, 1926–2005 121 3.6 Buying on Margin 71 5.4 Risk and Risk Premiums 124 3.7 Short Sales 74 Holding-Period Returns / Expected Return and 3.8 Regulation of Securities Markets 77 Standard Deviation / Excess Returns and Risk Self-Regulation / Regulatory Responses to Recent Premiums Scandals / Circuit Breakers / Insider Trading 5.5 Time Series Analysis of Past Rates of Return 126 End of Chapter Material 82–87 Time Series versus Scenario Analysis / Expected Returns and the Arithmetic Average / The Geometric Chapter 4 (Time-Weighted) Average Return / Variance and Mutual Funds and Other Investment Standard Deviation / The Reward-to-Volatility Companies 88 (Sharpe) Ratio 4.1 Investment Companies 88 5.6 The Normal Distribution 130 4.2 Types of Investment Companies 89 5.7 Deviations from Normality 132 Unit Investment Trusts / Managed Investment 5.8 The Historical Record of Returns on Equities Companies / Other Investment Organizations and Long-Term Bonds 134 Commingled Funds / Real Estate Investment Average Returns and Standard Deviations / Other Trusts (REITS) / Hedge Funds Statistics of the Risky Portfolios / Sharpe Ratios / Serial Correlation / Skewness and Kurtosis / Estimates 4.3 Mutual Funds 92 of Historical Risk Premiums / A Global View of the Investment Policies Historical Record Money Market Funds / Equity Funds / Sector Funds / 5.9 Long-Term Investments 141 Bond Funds / International Funds / Balanced Funds / Risk in the Long Run and the Lognormal Distribution / Asset Allocation and Flexible Funds / Index Funds The Sharpe Ratio Revisited / Simulation of Long-Term How Funds Are Sold Future Rates of Return / Forecasts for the Long Haul 4.4 Costs of Investing in Mutual Funds 95 5.10 Measurement of Risk with Non-Normal Fee Structure Distributions 148 Operating Expenses / Front-End Load / Back-End Value at Risk (VaR) / Conditional Tail Expectation Load / 12b-1 Charges (CTE) / Lower Partial Standard Deviation (LPSD) Fees and Mutual Fund Returns / Late Trading and End of Chapter Material 150–155 Market Timing Chapter 6 4.5 Taxation of Mutual Fund Income 100 4.6 Exchange-Traded Funds 100 Risk Aversion and Capital Allocation to Risky Assets 156 4.7 Mutual Fund Investment Performance: A First Look 102 4.8 Information on Mutual Funds 105 6.1 Risk and Risk Aversion 157 End of Chapter Material 108–112 Risk, Speculation, and Gambling / Risk Aversion and Utility Values / Estimating Risk Aversion Part II 6.2 Capital Allocation across Risky and Risk-Free Portfolios 165 PORTFOLIO THEORY AND 6.3 The Risk-Free Asset 167 PRACTICE 113 6.4 Portfolios of One Risky Asset and a Risk-Free Asset 168 Chapter 5 6.5 Risk Tolerance and Asset Allocation 171 Learning about Return and Risk from 6.6 Passive Strategies: The Capital Market Line 176 the Historical Record 113 End of Chapter Material 180–193 5.1 Determinants of the Level of Interest Rates 114 Appendix A: Risk Aversion, Expected Utility, and the Real and Nominal Rates of Interest / The Equilibrium St. Petersburg Paradox 188 Real Rate of Interest / The Equilibrium Nominal Rate Appendix B: Utility Functions and Equilibrium of Interest / Taxes and the Real Rate of Interest Prices of Insurance Contracts 192 ix bod8237x_FM_i-xxviii.indd ix 5/5/08 5:07:29 PM
Confirming Pages CONTENTS Chapter 7 Part III Optimal Risky Portfolios 194 EQUILIBRIUM IN CAPITAL 7.1 7.2 Diversification and Portfolio Risk 195 Portfolios of Two Risky Assets 197 MARKETS 279 7.3 Asset Allocation with Stocks, Bonds, and Bills 204 Chapter 9 The Optimal Risky Portfolio with Two Risky Assets The Capital Asset Pricing Model 279 and a Risk-Free Asset 9.1 The Capital Asset Pricing Model 279 7.4 The Markowitz Portfolio Selection Model 209 Why Do All Investors Hold the Market Portfolio? / The Security Selection / Capital Allocation and the Separation Passive Strategy Is Efficient / The Risk Premium of Property / The Power of Diversification / Asset Allocation the Market Portfolio / Expected Returns on Individual and Security Selection Securities / The Security Market Line 7.5 Risk Pooling, Risk Sharing, and Risk in the Long 9.2 The CAPM and the Index Model 292 Run 218 Actual Returns versus Expected Returns / The Index Risk Pooling and the Insurance Principle / Risk Sharing Model and Realized Returns / The Index Model and the End of Chapter Material 221–243 Expected Return–Beta Relationship Appendix A: A Spreadsheet Model for Efficient 9.3 Is the CAPM Practical? 295 Diversification 231 Is the CAPM Testable? / The CAPM Fails Empirical Appendix B: Review of Portfolio Statistics 236 Tests / The Economy and the Validity of the CAPM / The Investments Industry and the Validity of the CAPM Chapter 8 9.4 Econometrics and the Expected Return–Beta Index Models 244 Relationship 299 9.5 Extensions of the CAPM 300 8.1 A Single-Factor Security Market 245 The Zero-Beta Model / Labor Income and Nontraded The Input List of the Markowitz Model / Normality Assets / A Multiperiod Model and Hedge Portfolios / A of Returns and Systematic Risk Consumption-Based CAPM 8.2 The Single-Index Model 247 9.6 Liquidity and the CAPM 305 The Regression Equation of the Single-Index Model / End of Chapter Material 311–318 The Expected Return–Beta Relationship / Risk and Covariance in the Single-Index Model / The Set of Chapter 10 Estimates Needed for the Single-Index Model / The Arbitrage Pricing Theory and Multifactor Models Index Model and Diversification of Risk and Return 319 8.3 Estimating the Single-Index Model 252 10.1 Multifactor Models: An Overview 320 The Security Characteristic Line for Hewlett-Packard / Factor Models of Security Returns / A Multifactor The Explanatory Power of the SCL for HP / Analysis of Security Market Line Variance / The Estimate of Alpha / The Estimate of Beta / Firm-Specific Risk / Correlation and Covariance Matrix 10.2 Arbitrage Pricing Theory 324 8.4 Portfolio Construction and the Single-Index Arbitrage, Risk Arbitrage, and Equilibrium / Well- Model 259 Diversified Portfolios / Betas and Expected Returns / The One-Factor Security Market Line Alpha and Security Analysis / The Index Portfolio as an 10.3 Individual Assets and the APT 331 Investment Asset / The Single-Index-Model Input List / The Optimal Risky Portfolio of the Single-Index Model / The APT and the CAPM The Information Ratio / Summary of Optimization 10.4 A Multifactor APT 332 Procedure / An Example 10.5 Where Should We Look for Factors? 334 Risk Premium Forecasts / The Optimal Risky Portfolio The Fama-French (FF) Three-Factor Model 8.5 Practical Aspects of Portfolio Management 10.6 A Multifactor CAPM and the APT 337 with the Index Model 266 End of Chapter Material 337–343 Is the Index Model Inferior to the Full-Covariance Chapter 11 Model? / The Industry Version of the Index Model / Predicting Betas / Index Models and Tracking The Efficient Market Hypothesis 344 Portfolios 11.1 Random Walks and the Efficient Market End of Chapter Material 273–278 Hypothesis 345 x bod8237x_FM_i-xxviii.indd x 5/5/08 5:07:30 PM
Confirming Pages CONTENTS Competition as the Source of Efficiency / Versions of the Dow Theory / Moving Averages / Breadth Efficient Market Hypothesis Sentiment Indicators 11.2 Implications of the EMH 349 Trin Statistic / Confidence Index / Put/Call Ratio Technical Analysis / Fundamental Analysis / Active versus A Warning Passive Portfolio Management / The Role of Portfolio End of Chapter Material 403–409 Management in an Efficient Market / Resource Allocation 11.3 Event Studies 353 Chapter 13 11.4 Are Markets Efficient? 357 Empirical Evidence on Security Returns 410 The Issues 13.1 The Index Model and the Single-Factor APT 411 The Magnitude Issue / The Selection Bias Issue / The Expected Return–Beta Relationship The Lucky Event Issue Setting Up the Sample Data / Estimating the SCL / Weak-Form Tests: Patterns in Stock Returns Estimating the SML Returns over Short Horizons / Returns over Long Tests of the CAPM / The Market Index / Measurement Horizons Error in Beta / The EMH and the CAPM / Accounting Predictors of Broad Market Returns / Semistrong Tests: for Human Capital and Cyclical Variations in Asset Market Anomalies Betas / Accounting for Nontraded Business The Small-Firm-in-January Effect / The Neglected- 13.2 Tests of Multifactor CAPM and APT 422 Firm Effect and Liquidity Effects / Book-to-Market A Macro Factor Model Ratios / Post–Earnings-Announcement Price Drift 13.3 The Fama-French Three-Factor Model 423 Strong-Form Tests: Inside Information / Interpreting Risk-Based Interpretations / Behavioral the Evidence Explanations Risk Premiums or Inefficiencies? / Anomalies or 13.4 Liquidity and Asset Pricing 429 Data Mining? 13.5 Time-Varying Volatility 433 The “Noisy Market Hypothesis” and Fundamental Indexing 13.6 Consumption-Based Asset Pricing and the Equity Premium Puzzle 434 11.5 Mutual Fund and Analyst Performance 369 Consumption Growth and Market Rates of Return / Stock Market Analysts / Mutual Fund Managers / Expected versus Realized Returns / Survivorship Bias / Survivorship Bias in Mutual Fund Studies / So, Are Extensions to the CAPM May Resolve the Equity Markets Efficient? Premium Puzzle / Behavioral Explanations of the End of Chapter Material 376–383 Equity Premium Puzzle Chapter 12 End of Chapter Material 441–444 Behavioral Finance and Technical Analysis 384 Part IV 12.1 The Behavioral Critique 385 Information Processing FIXED-INCOME Forecasting Errors / Overconfidence / Conservatism / Sample Size Neglect and SECURITIES 445 Representativeness CHAPTER 14 Behavioral Biases BOND PRICES AND YIELDS 445 Framing / Mental Accounting / Regret Avoidance / 14.1 Bond Characteristics 446 Prospect Theory Treasury Bonds and Notes Limits to Arbitrage Accrued Interest and Quoted Bond Prices Fundamental Risk / Implementation Costs /Model Risk Corporate Bonds Limits to Arbitrage and the Law of One Price Call Provisions on Corporate Bonds / “Siamese Twin” Companies / Equity Carve-outs / Convertible Bonds / Puttable Bonds / Closed-End Funds Floating-Rate Bonds Bubbles and Behavioral Economics / Evaluating the Preferred Stock / Other Issuers / International Bonds / Behavioral Critique Innovation in the Bond Market 12.2 Technical Analysis and Behavioral Finance 395 Inverse Floaters / Asset-Backed Bonds / Catastrophe Trends and Corrections Bonds / Indexed Bonds xi bod8237x_FM_i-xxviii.indd xi 5/5/08 5:07:31 PM
Confirming Pages CONTENTS 14.2 Bond Pricing 452 16.4 Active Bond Management 539 Bond Pricing between Coupon Dates Sources of Potential Profit / Horizon Analysis / 14.3 Bond Yields 456 Contingent Immunization Yield to Maturity / Yield to Call / Realized Compound End of Chapter Material 543–552 Return versus Yield to Maturity 14.4 Bond Prices over Time 462 Part V Yield to Maturity versus Holding-Period Return / Zero-Coupon Bonds and Treasury Strips / After-Tax SECURITY ANALYSIS 553 Returns Chapter 17 14.5 Default Risk and Bond Pricing 467 Macroeconomic and Industry Analysis 553 Junk Bonds / Determinants of Bond Safety / Bond 17.1 The Global Economy 554 Indentures 17.2 The Domestic Macroeconomy 556 Sinking Funds / Subordination of Further Debt / 17.3 Demand and Supply Shocks 558 Dividend Restrictions / Collateral 17.4 Federal Government Policy 559 Yield to Maturity and Default Risk Fiscal Policy / Monetary Policy / Supply-Side Policies Credit Risk and Collateralized Debt Obligations 17.5 Business Cycles 561 End of Chapter Material 477–483 The Business Cycle / Economic Indicators / Other Indicators Chapter 15 17.6 Industry Analysis 566 The Term Structure of Interest Rates 484 Defining an Industry / Sensitivity to the Business Cycle / 15.1 The Yield Curve 484 Sector Rotation / Industry Life Cycles Bond Pricing Start-Up Stage / Consolidation Stage / Maturity Stage / Relative Decline 15.2 The Yield Curve and Future Interest Rates 487 Industry Structure and Performance The Yield Curve under Certainty / Holding-Period Returns / Forward Rates Threat of Entry / Rivalry between Existing Competitors / Pressure from Substitute Products / 15.3 Interest Rate Uncertainty and Forward Rates 492 Bargaining Power of Buyers / Bargaining Power 15.4 Theories of the Term Structure 494 of Suppliers The Expectations Hypothesis / Liquidity Preference End of Chapter Material 578–585 15.5 Interpreting the Term Structure 498 Chapter 18 15.6 Forward Rates as Forward Contracts 501 End of Chapter Material 504–511 Equity Valuation Models 586 18.1 Valuation by Comparables 586 Chapter 16 Limitations of Book Value Managing Bond Portfolios 512 18.2 Intrinsic Value versus Market Price 589 16.1 Interest Rate Risk 513 18.3 Dividend Discount Models 590 Interest Rate Sensitivity / Duration / What Determines The Constant-Growth DDM / Convergence of Price Duration? to Intrinsic Value / Stock Prices and Investment Rule 1 for Duration / Rule 2 for Duration / Rule 3 Opportunities / Life Cycles and Multistage Growth for Duration / Rule 4 for Duration / Rule 5 for Models / Multistage Growth Models Duration 18.4 Price–Earnings Ratio 604 16.2 Convexity 522 The Price–Earnings Ratio and Growth Opportunities / Why Do Investors Like Convexity? / Duration and P/E Ratios and Stock Risk / Pitfalls in P/E Analysis / Convexity of Callable Bonds / Duration and Convexity Combining P/E Analysis and the DDM / Other of Mortgage-Backed Securities Comparative Valuation Ratios 16.3 Passive Bond Management 530 Price-to-Book Ratio / Price-to-Cash-Flow Ratio / Bond-Index Funds / Immunization / Cash Flow Matching Price-to-Sales Ratio and Dedication / Other Problems with Conventional 18.5 Free Cash Flow Valuation Approaches 611 Immunization Comparing the Valuation Models xii bod8237x_FM_i-xxviii.indd xii 5/5/08 5:07:32 PM
Confirming Pages CONTENTS 18.6 The Aggregate Stock Market 616 20.6 Financial Engineering 700 Explaining Past Behavior / Forecasting the Stock Market 20.7 Exotic Options 701 End of Chapter Material 618–630 Asian Options / Barrier Options / Lookback Options / Currency-Translated Options / Digital Options Chapter 19 End of Chapter Material 704–714 Financial Statement Analysis 631 Chapter 21 19.1 The Major Financial Statements 631 Option Valuation 715 The Income Statement / The Balance Sheet / The Statement of Cash Flows 21.1 Option Valuation: Introduction 715 19.2 Accounting versus Economic Earnings 636 Intrinsic and Time Values / Determinants of Option Values 19.3 Profitability Measures 636 21.2 Restrictions on Option Values 718 Past versus Future ROE / Financial Leverage and ROE Restrictions on the Value of a Call Option / Early 19.4 Ratio Analysis 639 Exercise and Dividends / Early Exercise of American Puts Decomposition of ROE / Turnover and Other Asset 21.3 Binomial Option Pricing 722 Utilization Ratios / Liquidity Ratios / Market Price Two-State Option Pricing / Generalizing the Two-State Ratios: Growth versus Value / Choosing a Benchmark Approach 19.5 Economic Value Added 649 21.4 Black-Scholes Option Valuation 729 19.6 An Illustration of Financial Statement Analysis 650 The Black-Scholes Formula / Dividends and Call Option 19.7 Comparability Problems 652 Valuation / Put Option Valuation / Dividends and Put Option Valuation Inventory Valuation / Depreciation / Inflation and Interest Expense / Fair Value Accounting / Quality of Earnings / 21.5 Using the Black-Scholes Formula 737 International Accounting Conventions Hedge Ratios and the Black-Scholes Formula / Portfolio 19.8 Value Investing: The Graham Technique 658 Insurance / Hedging Bets on Mispriced Options End of Chapter Material 659–670 21.6 Empirical Evidence on Option Pricing 747 End of Chapter Material 749–758 Part VI Chapter 22 OPTIONS, FUTURES, AND Futures Markets 759 OTHER DERIVATIVES 671 22.1 The Futures Contract 760 The Basics of Futures Contracts / Existing Contracts Chapter 20 22.2 Mechanics of Trading in Futures Markets 765 Options Markets: Introduction 671 The Clearinghouse and Open Interest / The Margin 20.1 The Option Contract 672 Account and Marking to Market / Cash versus Actual Options Trading / American and European Options / Delivery / Regulations / Taxation Adjustments in Option Contract Terms / The Options 22.3 Futures Markets Strategies 770 Clearing Corporation / Other Listed Options Hedging and Speculation / Basis Risk and Hedging Index Options / Futures Options / Foreign Currency 22.4 The Determination of Futures Prices 774 Options / Interest Rate Options The Spot-Futures Parity Theorem / Spreads / Forward 20.2 Values of Options at Expiration 678 versus Futures Pricing Call Options / Put Options / Option versus Stock 22.5 Futures Prices versus Expected Spot Prices 780 Investments Expectation Hypothesis / Normal Backwardation / 20.3 Option Strategies 682 Contango / Modern Portfolio Theory Protective Put / Covered Calls / Straddle / Spreads / End of Chapter Material 782–787 Collars Chapter 23 20.4 The Put-Call Parity Relationship 690 20.5 Option-like Securities 693 Futures, Swaps, and Risk Management 788 Callable Bonds / Convertible Securities / 23.1 Foreign Exchange Futures 788 Warrants / Collateralized Loans / Levered Equity The Markets / Interest Rate Parity / Direct versus Indirect and Risky Debt Quotes / Using Futures to Manage Exchange Rate Risk xiii bod8237x_FM_i-xxviii.indd xiii 5/5/08 5:07:33 PM
Confirming Pages CONTENTS 23.2 Stock-Index Futures 795 24.8 Performance Attribution Procedures 850 The Contracts / Creating Synthetic Stock Positions: An Asset Allocation Decisions / Sector and Security Selection Asset Allocation Tool / Index Arbitrage / Using Index Decisions / Summing Up Component Contributions Futures to Hedge Market Risk End of Chapter Material 856–866 23.3 Interest Rate Futures 802 Chapter 25 Hedging Interest Rate Risk 23.4 Swaps 804 International Diversification 867 Swaps and Balance Sheet Restructuring / The Swap 25.1 Global Markets for Equities 868 Dealer / Other Interest Rate Contracts / Swap Pricing / Developed Countries / Emerging Markets / Market Credit Risk in the Swap Market / Credit Default Swaps Capitalization and GDP / Home-Country Bias 23.5 Commodity Futures Pricing 811 25.2 Risk Factors in International Investing 872 Pricing with Storage Costs / Discounted Cash Flow Exchange Rate Risk / Country-Specific Risk Analysis for Commodity Futures 25.3 International Investing: Risk, Return, and Benefits End of Chapter Material 814–822 from Diversification 878 Risk and Return: Summary Statistics / Are Investments Part VII in Emerging Markets Riskier? / Are Average Returns in Emerging Markets Greater? / Benefits from APPLIED PORTFOLIO International Diversification / Misleading Representation MANAGEMENT 823 of Diversification Benefits / Realistic Benefits from International Diversification / Are Benefits from Chapter 24 International Diversification Preserved in Bear Markets? Portfolio Performance Evaluation 823 25.4 Assessing the Potential of International Diversification 888 24.1 The Conventional Theory of Performance The Home Bias / The Pursuit of Efficient Diversification / Evaluation 823 Diversification Benefits over Time / Active Investors Average Rates of Return / Time-Weighted Returns versus 25.5 International Investing and Performance Dollar-Weighted Returns / Adjusting Returns for Risk / Attribution 892 The M2 Measure of Performance / Sharpe’s Measure as the Criterion for Overall Portfolios / Appropriate Constructing a Benchmark Portfolio of Foreign Assets / Performance Measures in Two Scenarios Performance Attribution Jane’s Portfolio Represents Her Entire Risky Investment End of Chapter Material 896–901 Fund / Jane’s Choice Portfolio Is One of Many Chapter 26 Portfolios Combined into a Large Investment Fund Hedge Funds 902 The Role of Alpha in Performance Measures / Actual Performance Measurement: An Example / Realized 26.1 Hedge Funds versus Mutual Funds 903 Returns versus Expected Returns 26.2 Hedge Fund Strategies 904 24.2 Performance Measurement for Hedge Funds 834 Directional and Nondirectional Strategies / Statistical 24.3 Performance Measurement with Changing Portfolio Arbitrage Composition 836 26.3 Portable Alpha 907 24.4 Market Timing 837 An Example of a Pure Play The Potential Value of Market Timing / Valuing Market 26.4 Style Analysis for Hedge Funds 910 Timing as a Call Option / The Value of Imperfect 26.5 Performance Measurement for Hedge Funds 912 Forecasting Liquidity and Hedge Fund Performance / Hedge Fund 24.5 Style Analysis 844 Performance and Survivorship Bias / Hedge Fund Style Analysis and Multifactor Benchmarks/Style Performance and Changing Factor Loadings / Tail Risk Analysis in Excel and Hedge Fund Performance 24.6 Morningstar’s Risk-Adjusted Rating 848 26.6 Fee Structure in Hedge Funds 919 24.7 Evaluating Performance Evaluation 849 End of Chapter Material 920–923 xiv bod8237x_FM_i-xxviii.indd xiv 5/5/08 5:07:34 PM
Confirming Pages CONTENTS Chapter 27 Life Insurance Companies / Non–Life Insurance Companies / Banks The Theory of Active Portfolio Management 924 28.2 Constraints 955 27.1 Optimal Portfolios and Alpha Values 924 Liquidity / Investment Horizon / Regulations / Tax Forecasts of Alpha Values and Extreme Portfolio Weights / Considerations / Unique Needs Restriction of Benchmark Risk 28.3 Asset Allocation 957 27.2 The Treynor-Black Model and Forecast Policy Statements / Taxes and Asset Allocation Precision 931 28.4 Managing Portfolios of Individual Investors 960 Adjusting Forecasts for the Precision of Alpha / Human Capital and Insurance / Investment in Residence / Distribution of Alpha Values / Organizational Structure Saving for Retirement and the Assumption of Risk / and Performance Retirement Planning Models / Manage Your Own 27.3 The Black-Litterman Model 935 Portfolio or Rely on Others? / Tax Sheltering A Simple Asset Allocation Decision / Step 1: The The Tax-Deferral Option / Tax-Deferred Retirement Covariance Matrix from Historical Data / Step 2: Plans / Deferred Annuities / Variable and Universal Determination of a Baseline Forecast / Step 3: Integrating Life Insurance the Manager’s Private Views / Step 4: Revised (Posterior) 28.5 Pension Funds 965 Expectations / Step 5: Portfolio Optimization Defined Contribution Plans / Defined Benefit Plans / 27.4 Treynor-Black versus Black-Litterman: Alternative Perspectives on Defined Benefit Pension Complements, Not Substitutes 941 Obligations / Pension Investment Strategies The BL Model as Icing on the TB Cake / Why Not Investing in Equities / Wrong Reasons to Invest Replace the Entire TB Cake with the BL Icing? in Equities 27.5 The Value of Active Management 943 28.6 Investments for the Long Run 970 A Model for the Estimation of Potential Fees / Results Advice from the Mutual Fund Industry / Target Investing from the Distribution of Actual Information Ratios / and the Term Structure of Bonds / Making Simple Results from Distribution of Actual Forecasts / Results Investment Choices / Inflation Risk and Long-Term with Reasonable Forecasting Records Investors 27.6 Concluding Remarks 946 End of Chapter Material 972–988 End of Chapter Material 947–949 Appendix: A Spreadsheet Model for Long-Term Appendix A: Forecasts and Realizations Investing 982 of Alpha 948 Appendix B: The General Black-Litterman REFERENCES TO CFA PROBLEMS 989 Model 948 GLOSSARY G-1 Chapter 28 NAME INDEX IND-1 SUBJECT INDEX IND-4 Investment Policy and the Framework of the CFA Institute 950 28.1 The Investment Management Process 951 Objectives / Individual Investors / Personal Trusts / Mutual Funds / Pension Funds / Endowment Funds / xv bod8237x_FM_i-xxviii.indd xv 5/5/08 5:07:35 PM
Confirming Pages PREFACE We wrote the first edition of this textbook two decades of financial economics and find virtually all of the ago. The intervening years have been a period of rapid, material in this book to be of great intellectual interest. profound, and ongoing change in the investments indus- Fortunately, we think, there is no contradiction in the field try. This is due in part to an abundance of newly designed of investments between the pursuit of truth and the pursuit securities, in part to the creation of new trading strate- of money. Quite the opposite. The capital asset pricing gies that would have been impossible without concurrent model, the arbitrage pricing model, the efficient markets advances in computer technology, and in part to rapid hypothesis, the option-pricing model, and the other cen- advances in the theory of investments that have come out terpieces of modern financial research are as much intel- of the academic community. In no other field, perhaps, lectually satisfying subjects of scientific inquiry as they is the transmission of theory to real-world practice as are of immense practical importance for the sophisticated rapid as is now commonplace in the financial industry. investor. These developments place new burdens on practitioners In our effort to link theory to practice, we also have and teachers of investments far beyond what was required attempted to make our approach consistent with that of the only a short while ago. Of necessity, our text has evolved CFA Institute. In addition to fostering research in finance, along with financial markets. the CFA Institute administers an education and certifi- Investments, Eighth Edition, is intended primarily as a cation program to candidates seeking the designation of textbook for courses in investment analysis. Our guiding Chartered Financial Analyst (CFA). The CFA curriculum principle has been to present the material in a framework represents the consensus of a committee of distinguished that is organized by a central core of consistent fundamen- scholars and practitioners regarding the core of knowledge tal principles. We make every attempt to strip away unnec- required by the investment professional. This text also essary mathematical and technical detail, and we have is used in many certification programs for the Financial concentrated on providing the intuition that may guide Planning Association and by the Society of Actuaries. students and practitioners as they confront new ideas and There are many features of this text that make it consis- challenges in their professional lives. tent with and relevant to the CFA curriculum. Questions This text will introduce you to major issues currently from past CFA exams appear at the end of nearly every of concern to all investors. It can give you the skills to chapter, and, for students who will be taking the exam, conduct a sophisticated assessment of current issues and those same questions and the exam from which they’ve debates covered by both the popular media as well as been taken, are listed at the end of the book. Chapter 3 more-specialized finance journals. Whether you plan to includes excerpts from the “Code of Ethics and Standards become an investment professional, or simply a sophis- of Professional Conduct” of the CFA Institute. Chapter 28, ticated individual investor, you will find these skills which discusses investors and the investment process, essential. presents the CFA Institute’s framework for systematically Our primary goal is to present material of practical val- relating investor objectives and constraints to ultimate ue, but all three of us are active researchers in the science investment policy. xvi bod8237x_FM_i-xxviii.indd xvi 5/5/08 5:07:35 PM
Confirming Pages PREFACE In the Eighth Edition, we have further extended our returns come only at a price: the need to bear systematic collection of Excel spreadsheets that give tools greater investment risk. However, this notion to explore concepts more deeply than was previously pos- leaves several questions unanswered. How should sible. These spreadsheets are available on the Web site for one measure the risk of an asset? What should be this text (www.mhhe.com/bkm), and provide a taste of the quantitative trade-off between risk (properly the sophisticated analytic tools available to professional measured) and expected return? The approach investors. we present to these issues is known as modern portfolio theory, which is another organizing principle of this book. Modern portfolio theory U N D E R LY I N G P H I L O S OPHY focuses on the techniques and implications of In the Eighth Edition, we address many of the changes in efficient diversification, and we devote considerable the investment environment. attention to the effect of diversification on portfolio At the same time, many basic principles remain impor- risk as well as the implications of efficient tant. We believe that attention to these few important diversification for the proper measurement of risk principles can simplify the study of otherwise difficult and the risk–return relationship. material and that fundamental principles should orga- 2. This text places greater emphasis on asset nize and motivate all study. These principles are crucial allocation than most of its competitors. We prefer to understanding the securities already traded in financial this emphasis for two important reasons. First, it markets and in understanding new securities that will be corresponds to the procedure that most individuals introduced in the future. For this reason, we have made actually follow. Typically, you start with all of your this book thematic, meaning we never offer rules of money in a bank account, only then considering thumb without reference to the central tenets of the mod- how much to invest in something riskier that might ern approach to finance. offer a higher expected return. The logical step at The common theme unifying this book is that security this point is to consider other risky asset classes, markets are nearly efficient, meaning most securities are such as stock, bonds, or real estate. This is an usually priced appropriately given their risk and return asset allocation decision. Second, in most cases, attributes. There are few free lunches found in markets as the asset allocation choice is far more important competitive as the financial market. This simple observa- in determining overall investment performance tion is, nevertheless, remarkably powerful in its implica- than is the set of security selection decisions. tions for the design of investment strategies; as a result, Asset allocation is the primary determinant of the our discussions of strategy are always guided by the risk–return profile of the investment portfolio, implications of the efficient markets hypothesis. While and so it deserves primary attention in a study of the degree of market efficiency is, and always will be, a investment policy. matter of debate (and in fact, in this edition, we devote a full chapter to the behavioral challenge to the efficient 3. This text offers a much broader and deeper market hypothesis), we hope our discussions throughout treatment of futures, options, and other derivative the book convey a good dose of healthy criticism concern- security markets than most investments texts. ing much conventional wisdom. These markets have become both crucial and integral to the financial universe and are the major Distinctive Themes sources of innovation in that universe. Your only choice is to become conversant in these markets— Investments is organized around several important themes: whether you are to be a finance professional or 1. The central theme is the near-informational- simply a sophisticated individual investor. efficiency of well-developed security markets, such as those in the United States, and the general awareness that competitive markets do not offer NEW IN THE EIGHTH EDIT ION “free lunches” to participants. The following is a guide to changes in the Eighth Edition. A second theme is the risk–return trade-off. This This is not an exhaustive road map, but instead is meant to too is a no-free-lunch notion, holding that in provide an overview of substantial additions and changes competitive security markets, higher expected to coverage from the last edition of the text. xvii bod8237x_FM_i-xxviii.indd xvii 5/5/08 5:07:41 PM
Confirming Pages PREFACE Chapter 3 How Securities Are Traded Chapter 23 Futures, Swaps, and Risk This chapter has been largely rewritten to reflect the ongo- Management ing transformation of trading practices, the growing domi- We have added new material on credit default swaps to nance of electronic trading, the accelerating consolidation this chapter. We show how these securities are constructed, of securities markets, and continuing regulatory reform, and how they are used to transfer credit risk. in particular the response to the Sarbanes-Oxley Act. Chapter 26 Hedge Funds Chapter 7 Optimal Risky Portfolios This new chapter covers various hedge fund strategies; This chapter contains additional material on the “art” market-neutral investing and portable alpha; performance of selecting reasonable parameter values for portfolio evaluation for hedge funds with changing risk exposures; construction, and a discussion of what can go wrong selection bias in hedge fund performance; tail risk in when inputs are derived solely from recent historical hedge fund portfolios; and hedge fund fees. experience. Chapter 28 Investment Policy and the Chapter 9 The Capital Asset Pricing Model Framework of the CFA Institute We introduce new material generalizing the intuition of This chapter has been updated to reflect the CFA Insti- the simple CAPM to more sophisticated treatments of tute’s expanded rubric for constructing a statement of risk, for example, consumption risk. We have also updated investment policy. the material on liquidity and asset pricing throughout the set of chapters dealing with portfolio theory. ORGANIZATION AND CONTENT Chapter 11 The Efficient Market Hypothesis The text is composed of seven sections that are fairly We critically evaluate recent suggestions for “fundamen- independent and may be studied in a variety of sequences. tal indexing” as a response to market errors in security Because there is enough material in the book for a two- valuation. We show that these strategies are nothing more semester course, clearly a one-semester course will than variations on the value-tilted portfolio strategies dis- require the instructor to decide which parts to include. cussed earlier in the chapter. Part One is introductory and contains important insti- tutional material focusing on the financial environment. Chapter 13 Empirical Evidence on Security We discuss the major players in the financial markets, pro- Returns vide an overview of the types of securities traded in those We add considerable new material on the interpretation of markets, and explain how and where securities are traded. risk premiums. For example, we examine new evidence We also discuss in depth mutual funds and other invest- on the relation between the Fama-French risk factors and ment companies, which have become an increasingly more fundamental measures of security risk. important means of investing for individual investors. The material presented in Part One should make it Chapter 14 Bond Prices and Yields possible for instructors to assign term projects early in The chapter has new material explaining collateralized the course. These projects might require the student to debt obligations (CDOs) as well as the role of credit rat- analyze in detail a particular group of securities. Many ing agencies in the recent credit market crisis. instructors like to involve their students in some sort of investment game, and the material in these chapters will Chapter 19 Financial Statement Analysis facilitate this process. The chapter has been updated to address current issues in Parts Two and Three contain the core of modern fair value accounting. It also contains additional discus- portfolio theory. Chapter 5 is a general discussion of risk sion of the proper interpretation of market-to-book ratios. and return, making the general point that historical returns on broad asset classes are consistent with a risk–return Chapter 20 Options Markets trade-off, and examining the distribution of stock returns. We have added a discussion of options backdating to this We focus more closely in Chapter 6 on how to describe chapter. investors’ risk preferences and how they bear on asset xviii bod8237x_FM_i-xxviii.indd xviii 5/5/08 5:07:42 PM
Confirming Pages PREFACE allocation. In the next two chapters, we turn to to portfo- risk–return relationship, as well as liquidity effects on lio optimization (Chapter 7) and its implementation using asset pricing. index models (Chapter 8). Part Four is the first of three parts on security valu- After our treatment of modern portfolio theory in Part ation. This part treats fixed-income securities—bond Two, we investigate in Part Three the implications of that pricing (Chapter 14), term structure relationships (Chap- theory for the equilibrium structure of expected rates of ter 15), and interest-rate risk management (Chapter 16). return on risky assets. Chapter 9 treats the capital asset Parts Five and Six deal with equity securities and deriva- pricing model and Chapter 10 covers multifactor descrip- tive securities. For a course emphasizing security analysis tions of risk and the arbitrage pricing theory. Chapter and excluding portfolio theory, one may proceed directly 11 covers the efficient market hypothesis, including its from Part One to Part Four with no loss in continuity. rationale as well as evidence that supports the hypothesis Finally, Part Seven considers several topics important and challenges it. Chapter 12 is devoted to the behavioral for portfolio managers, including performance evalua- critique of market rationality. Finally, we conclude Part tion, international diversification, active management, and Three with Chapter 13 on empirical evidence on security practical issues in the process of portfolio management. pricing. This chapter contains evidence concerning the This part also contains a new chapter on hedge funds. xix bod8237x_FM_i-xxviii.indd xix 5/5/08 5:07:43 PM