Alan and marcus go forth and multiply

Discussion

Investments

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Investments

ZVI BODIE Boston University

ALEX KANE University of California, San Diego

ALAN J. MARCUS Boston College

T E N T H E D I T I O N

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INVESTMENTS, TENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2014 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2011, 2009, and 2008. 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 McGraw-Hill Education, 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.

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ISBN 978-0-07-786167-4 MHID 0-07-786167-1

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Library of Congress Cataloging-in-Publication Data

Bodie, Zvi. Investments / Zvi Bodie, Boston University, Alex Kane, University of California, San Diego, Alan J. Marcus, Boston College.—10th Edition. pages cm.—(The McGraw-Hill/Irwin series in finance, insurance and real estate) Includes index. ISBN-13: 978-0-07-786167-4 (alk. paper) ISBN-10: 0-07-786167-1 (alk. paper) 1. Investments. 2. Portfolio management. I. Kane, Alex. II. Marcus, Alan J. III. Title. HG4521.B564 2014 332.6—dc23 2013016066

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

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v

ZVI BODIE Boston University

Zvi Bodie is the Norman and Adele Barron Professor of Management at Boston University. He holds a PhD from the Massachusetts Institute of Technology and has served on the finance fac- ulty at the Harvard Business School and MIT’s Sloan School of Management. Professor Bodie has published widely on pension finance and investment strategy in leading professional jour- nals. In cooperation with the Research Foundation of the CFA Institute, he has recently produced a series of Webcasts and a monograph entitled The Future of Life Cycle Saving and Investing.

ALEX KANE University of California, San Diego

Alex Kane is professor of finance and economics at the Graduate School of International Relations and Pacific Studies at the University of California, San Diego. He has been visit- ing professor at the Faculty of Economics, University of Tokyo; Graduate School of Business, Harvard; Kennedy School of Government, Harvard; and research associ- ate, National Bureau of Economic Research. An author of many articles in finance and management journals, Professor Kane’s research is mainly in corporate finance, portfolio management, and capital markets, most recently in the measurement of market volatility and pricing of options.

ALAN J. MARCUS Boston College

Alan Marcus is the Mario J. Gabelli Professor of Finance in the Carroll School of Management at Boston College. He received his PhD in economics from MIT. Professor Marcus has been a visiting professor at the Athens Laboratory of Business Administration and at MIT’s Sloan School of Management and has served as a research associate at the National Bureau of Economic Research. Professor Marcus has published widely in the fields of capital markets and portfolio management. His consulting work has ranged from new-product develop- ment to provision of expert testimony in utility rate proceedings. He also spent 2 years at the Federal Home Loan Mortgage Corporation (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.

About the Authors

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vi

Preface xvi

PART I

Introduction 1 1

The Investment Environment 1

2 Asset Classes and Financial

Instruments 28

3 How Securities Are Traded 59

4 Mutual Funds and Other Investment

Companies 92

PART II

Portfolio Theory and Practice 117

5 Risk, Return, and the Historical

Record 117

6 Capital Allocation to Risky Assets 168

7 Optimal Risky Portfolios 205

8 Index Models 256

Brief Contents

PART III

Equilibrium in Capital Markets 291

9 The Capital Asset Pricing Model 291

10 Arbitrage Pricing Theory and Multifactor

Models of Risk and Return 324

11 The Efficient Market Hypothesis 349

12 Behavioral Finance and Technical

Analysis 388

13 Empirical Evidence on Security Returns 414

PART IV

Fixed-Income Securities 445

14 Bond Prices and Yields 445

15 The Term Structure of Interest Rates 487

16 Managing Bond Portfolios 515

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vii

PART VII

Applied Portfolio Management 835

24 Portfolio Performance Evaluation 835

25 International Diversification 882

26 Hedge Funds 926

27 The Theory of Active Portfolio

Management 951

28 Investment Policy and the Framework of the

CFA Institute 977

REFERENCES TO CFA PROBLEMS 1015

GLOSSARY G-1

NAME INDEX I-1

SUBJECT INDEX I-4

PART V

Security Analysis 557 17

Macroeconomic and Industry Analysis 557

18 Equity Valuation Models 591

19 Financial Statement Analysis 635

PART VI

Options, Futures, and Other Derivatives 678

20 Options Markets: Introduction 678

21 Option Valuation 722

22 Futures Markets 770

23 Futures, Swaps, and Risk Management 799

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Reverses / Federal Funds / Brokers’ Calls / The LIBOR Market / Yields on Money Market Instruments

2.2 The Bond Market 34

Treasury Notes and Bonds / Inflation-Protected Treasury Bonds / Federal Agency Debt / International Bonds / Municipal Bonds / Corporate Bonds / Mortgages and Mortgage-Backed Securities

2.3 Equity Securities 41

Common Stock as Ownership Shares / Characteristics of Common Stock / Stock Market Listings / Preferred Stock / Depository Receipts

2.4 Stock and Bond Market Indexes 44

Stock Market Indexes / Dow Jones Averages / Standard & Poor’s Indexes / Other U.S. Market-Value Indexes / Equally Weighted Indexes / Foreign and International Stock Market Indexes / Bond Market Indicators

2.5 Derivative Markets 51

Options / Futures Contracts

End of Chapter Material 54–58

CHAPTER 3

How Securities Are Traded 59

3.1 How Firms Issue Securities 59

Privately Held Firms / Publicly Traded Companies / Shelf Registration / Initial Public Offerings

3.2 How Securities Are Traded 63

Types of Markets

Direct Search Markets / Brokered Markets / Dealer Markets / Auction Markets

Types of Orders

Market Orders / Price-Contingent Orders

Trading Mechanisms

Dealer Markets / Electronic Communication Networks (ECNs) / Specialist Markets

Preface xvi

PART I

Introduction 1 CHAPTER 1

The Investment Environment 1

1.1 Real Assets versus Financial Assets 2

1.2 Financial Assets 3

1.3 Financial Markets and the Economy 5

The Informational Role of Financial Markets / Consumption Timing / Allocation of Risk / Separation of Ownership and Management / Corporate Governance and Corporate Ethics

1.4 The Investment Process 8

1.5 Markets Are Competitive 9

The Risk–Return Trade-Off / Efficient Markets

1.6 The Players 11

Financial Intermediaries / Investment Bankers / Venture Capital and Private Equity

1.7 The Financial Crisis of 2008 15

Antecedents of the Crisis / Changes in Housing Finance / Mortgage Derivatives / Credit Default Swaps / The Rise of Systemic Risk / The Shoe Drops / The Dodd-Frank Reform Act

1.8 Outline of the Text 23

End of Chapter Material 24–27

CHAPTER 2

Asset Classes and Financial Instruments 28

2.1 The Money Market 29

Treasury Bills / Certificates of Deposit / Commercial Paper / Bankers’ Acceptances / Eurodollars / Repos and

Contents

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5.1 Determinants of the Level of Interest Rates 118

Real and Nominal Rates of Interest / The Equilibrium Real Rate of Interest / The Equilibrium Nominal Rate of Interest / Taxes and the Real Rate of Interest

5.2 Comparing Rates of Return for Different Holding Periods 122

Annual Percentage Rates / Continuous Compounding

5.3 Bills and Inflation, 1926–2012 125

5.4 Risk and Risk Premiums 127

Holding-Period Returns / Expected Return and Standard Deviation / Excess Returns and Risk Premiums

5.5 Time Series Analysis of Past Rates of Return 130

Time Series versus Scenario Analysis / Expected Returns and the Arithmetic Average / The Geometric (Time- Weighted) Average Return / Variance and Standard Deviation / Mean and Standard Deviation Estimates from Higher-Frequency Observations / The Reward-to- Volatility (Sharpe) Ratio

5.6 The Normal Distribution 135

5.7 Deviations from Normality and Risk Measures 137

Value at Risk / Expected Shortfall / Lower Partial Standard Deviation and the Sortino Ratio / Relative Frequency of Large, Negative 3-Sigma Returns

5.8 Historic Returns on Risky Portfolios 141

Portfolio Returns / A Global View of the Historical Record

5.9 Long-Term Investments 152

Normal and Lognormal Returns / Simulation of Long- Term Future Rates of Return / The Risk-Free Rate Revisited / Where Is Research on Rates of Return Headed? / Forecasts for the Long Haul

End of Chapter Material 161–167

CHAPTER 6

Capital Allocation to Risky Assets 168

6.1 Risk and Risk Aversion 168

Risk, Speculation, and Gambling / Risk Aversion and Utility Values / Estimating Risk Aversion

6.2 Capital Allocation across Risky and Risk-Free Portfolios 175

6.3 The Risk-Free Asset 177

6.4 Portfolios of One Risky Asset and a Risk-Free Asset 178

6.5 Risk Tolerance and Asset Allocation 182

Nonnormal Returns

6.6 Passive Strategies: The Capital Market Line 187

End of Chapter Material 190–199

Appendix A: Risk Aversion, Expected Utility, and the St. Petersburg Paradox 199

3.3 The Rise of Electronic Trading 68

3.4 U.S. Markets 69

NASDAQ / The New York Stock Exchange / ECNs

3.5 New Trading Strategies 71

Algorithmic Trading / High-Frequency Trading / Dark Pools / Bond Trading

3.6 Globalization of Stock Markets 74

3.7 Trading Costs 76

3.8 Buying on Margin 76

3.9 Short Sales 80

3.10 Regulation of Securities Markets 83

Self-Regulation / The Sarbanes-Oxley Act / Insider Trading

End of Chapter Material 87–91

CHAPTER 4

Mutual Funds and Other Investment Companies 92

4.1 Investment Companies 92

4.2 Types of Investment Companies 93

Unit Investment Trusts / Managed Investment Companies / Other Investment Organizations

Commingled Funds / Real Estate Investment Trusts (REITs) / Hedge Funds

4.3 Mutual Funds 96

Investment Policies

Money Market Funds / Equity Funds / Sector Funds / Bond Funds / International Funds / Balanced Funds / Asset Allocation and Flexible Funds / Index Funds

How Funds Are Sold

4.4 Costs of Investing in Mutual Funds 99

Fee Structure

Operating Expenses / Front-End Load / Back-End Load / 12b-1 Charges

Fees and Mutual Fund Returns

4.5 Taxation of Mutual Fund Income 103

4.6 Exchange-Traded Funds 103

4.7 Mutual Fund Investment Performance: A First Look 107

4.8 Information on Mutual Funds 110

End of Chapter Material 112–116

PART II

Portfolio Theory and Practice 117

CHAPTER 5

Risk, Return, and the Historical Record 117

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Appendix B: Utility Functions and Equilibrium Prices of Insurance Contracts 203

Appendix C: The Kelly Criterion 203

CHAPTER 7

Optimal Risky Portfolios 205

7.1 Diversification and Portfolio Risk 206

7.2 Portfolios of Two Risky Assets 208

7.3 Asset Allocation with Stocks, Bonds, and Bills 215

Asset Allocation with Two Risky Asset Classes

7.4 The Markowitz Portfolio Optimization Model 220

Security Selection / Capital Allocation and the Separation Property / The Power of Diversification / Asset Allocation and Security Selection / Optimal Portfolios and Nonnormal Returns

7.5 Risk Pooling, Risk Sharing, and the Risk of Long- Term Investments 230

Risk Pooling and the Insurance Principle / Risk Sharing / Investment for the Long Run

End of Chapter Material 234–244

Appendix A: A Spreadsheet Model for Efficient Diversification 244

Appendix B: Review of Portfolio Statistics 249

CHAPTER 8

Index Models 256

8.1 A Single-Factor Security Market 257

The Input List of the Markowitz Model / Normality of Returns and Systematic Risk

8.2 The Single-Index Model 259

The Regression Equation of the Single-Index Model / The Expected Return–Beta Relationship / Risk and Covariance in the Single-Index Model / The Set of Estimates Needed for the Single-Index Model / The Index Model and Diversification

8.3 Estimating the Single-Index Model 264

The Security Characteristic Line for Hewlett-Packard / The Explanatory Power of the SCL for HP / Analysis of Variance / The Estimate of Alpha / The Estimate of Beta / Firm-Specific Risk / Correlation and Covariance Matrix

8.4 Portfolio Construction and the Single-Index Model 271

Alpha and Security Analysis / The Index Portfolio as an Investment Asset / The Single-Index-Model Input List / The Optimal Risky Portfolio in the Single-Index Model / The Information Ratio / Summary of Optimization Procedure / An Example

Risk Premium Forecasts / The Optimal Risky Portfolio

8.5 Practical Aspects of Portfolio Management with the Index Model 278

Is the Index Model Inferior to the Full-Covariance Model? / The Industry Version of the Index Model / Predicting Betas / Index Models and Tracking Portfolios

End of Chapter Material 284–290

PART III

Equilibrium in Capital Markets 291

CHAPTER 9

The Capital Asset Pricing Model 291

9.1 The Capital Asset Pricing Model 291

Why Do All Investors Hold the Market Portfolio? / The Passive Strategy Is Efficient / The Risk Premium of the Market Portfolio / Expected Returns on Individual Securities / The Security Market Line / The CAPM and the Single-Index Market

9.2 Assumptions and Extensions of the CAPM 302

Assumptions of the CAPM / Challenges and Extensions to the CAPM / The Zero-Beta Model / Labor Income and Nontraded Assets / A Multiperiod Model and Hedge Portfolios / A Consumption-Based CAPM / Liquidity and the CAPM

9.3 The CAPM and the Academic World 313

9.4 The CAPM and the Investment Industry 315

End of Chapter Material 316–323

CHAPTER 10

Arbitrage Pricing Theory and Multifactor Models of Risk

and Return 324

10.1 Multifactor Models: An Overview 325

Factor Models of Security Returns

10.2 Arbitrage Pricing Theory 327

Arbitrage, Risk Arbitrage, and Equilibrium / Well- Diversified Portfolios / Diversification and Residual Risk in Practice / Executing Arbitrage / The No-Arbitrage Equation of the APT

10.3 The APT, the CAPM, and the Index Model 334

The APT and the CAPM / The APT and Portfolio Optimization in a Single-Index Market

10.4 A Multifactor APT 338

10.5 The Fama-French (FF) Three-Factor Model 340

End of Chapter Material 342–348

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CHAPTER 11

The Efficient Market Hypothesis 349

11.1 Random Walks and the Efficient Market Hypothesis 350

Competition as the Source of Efficiency / Versions of the Efficient Market Hypothesis

11.2 Implications of the EMH 354

Technical Analysis / Fundamental Analysis / Active versus Passive Portfolio Management / The Role of Portfolio Management in an Efficient Market / Resource Allocation

11.3 Event Studies 359

11.4 Are Markets Efficient? 362

The Issues

The Magnitude Issue / The Selection Bias Issue / The Lucky Event Issue

Weak-Form Tests: Patterns in Stock Returns

Returns over Short Horizons / Returns over Long Horizons

Predictors of Broad Market Returns / Semistrong Tests: Market Anomalies

The Small-Firm-in-January Effect / The Neglected- Firm Effect and Liquidity Effects / Book-to-Market Ratios / Post–Earnings-Announcement Price Drift

Strong-Form Tests: Inside Information / Interpreting the Anomalies

Risk Premiums or Inefficiencies? / Anomalies or Data Mining? / Anomalies over Time

Bubbles and Market Efficiency

11.5 Mutual Fund and Analyst Performance 375

Stock Market Analysts / Mutual Fund Managers / So, Are Markets Efficient?

End of Chapter Material 380–387

CHAPTER 12

Behavioral Finance and Technical Analysis 388

12.1 The Behavioral Critique 389

Information Processing

Forecasting Errors / Overconfidence / Conservatism / Sample Size Neglect and Representativeness

Behavioral Biases

Framing / Mental Accounting / Regret Avoidance

Affect

Prospect Theory

Limits to Arbitrage

Fundamental Risk / Implementation Costs / Model Risk

Limits to Arbitrage and the Law of One Price

“Siamese Twin” Companies / Equity Carve-Outs / Closed-End Funds

Bubbles and Behavioral Economics / Evaluating the Behavioral Critique

12.2 Technical Analysis and Behavioral Finance 400

Trends and Corrections

Momentum and Moving Averages / Relative Strength / Breadth

Sentiment Indicators

Trin Statistic / Confidence Index / Put/Call Ratio

A Warning

End of Chapter Material 407–413

CHAPTER 13

Empirical Evidence on Security Returns 414

13.1 The Index Model and the Single-Factor APT 415

The Expected Return–Beta Relationship

Setting Up the Sample Data / Estimating the SCL / Estimating the SML

Tests of the CAPM / The Market Index / Measurement Error in Beta

13.2 Tests of the Multifactor CAPM and APT 421

Labor Income / Private (Nontraded) Business / Early Versions of the Multifactor CAPM and APT / A Macro Factor Model

13.3 Fama-French-Type Factor Models 426

Size and B/M as Risk Factors / Behavioral Explanations / Momentum: A Fourth Factor

13.4 Liquidity and Asset Pricing 433

13.5 Consumption-Based Asset Pricing and the Equity Premium Puzzle 435

Consumption Growth and Market Rates of Return / Expected versus Realized Returns / Survivorship Bias / Extensions to the CAPM May Resolve the Equity Premium Puzzle / Liquidity and the Equity Premium Puzzle / Behavioral Explanations of the Equity Premium Puzzle /

End of Chapter Material 442–444

PART IV

Fixed-Income Securities 445 CHAPTER 14

Bond Prices and Yields 445

14.1 Bond Characteristics 446

Treasury Bonds and Notes

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Accrued Interest and Quoted Bond Prices

Corporate Bonds

Call Provisions on Corporate Bonds / Convertible Bonds / Puttable Bonds / Floating-Rate Bonds

Preferred Stock / Other Domestic Issuers / International Bonds / Innovation in the Bond Market

Inverse Floaters / Asset-Backed Bonds / Catastrophe Bonds / Indexed Bonds

14.2 Bond Pricing 452

Bond Pricing between Coupon Dates

14.3 Bond Yields 458

Yield to Maturity / Yield to Call / Realized Compound Return versus Yield to Maturity

14.4 Bond Prices over Time 463

Yield to Maturity versus Holding-Period Return / Zero- Coupon Bonds and Treasury Strips / After-Tax Returns

14.5 Default Risk and Bond Pricing 468

Junk Bonds / Determinants of Bond Safety / Bond Indentures

Sinking Funds / Subordination of Further Debt / Dividend Restrictions / Collateral

Yield to Maturity and Default Risk / Credit Default Swaps / Credit Risk and Collateralized Debt Obligations

End of Chapter Material 479–486

CHAPTER 15

The Term Structure of Interest Rates 487

15.1 The Yield Curve 487

Bond Pricing

15.2 The Yield Curve and Future Interest Rates 490

The Yield Curve under Certainty / Holding-Period Returns / Forward Rates

15.3 Interest Rate Uncertainty and Forward Rates 495

15.4 Theories of the Term Structure 497

The Expectations Hypothesis / Liquidity Preference

15.5 Interpreting the Term Structure 501

15.6 Forward Rates as Forward Contracts 504

End of Chapter Material 506–514

CHAPTER 16

Managing Bond Portfolios 515

16.1 Interest Rate Risk 516

Interest Rate Sensitivity / Duration / What Determines Duration?

Rule 1 for Duration / Rule 2 for Duration / Rule 3 for Duration / Rule 4 for Duration / Rule 5 for Duration

16.2 Convexity 525

Why Do Investors Like Convexity? / Duration and Convexity of Callable Bonds / Duration and Convexity of Mortgage-Backed Securities

16.3 Passive Bond Management 533

Bond-Index Funds / Immunization / Cash Flow Matching and Dedication / Other Problems with Conventional Immunization

16.4 Active Bond Management 543

Sources of Potential Profit / Horizon Analysis

End of Chapter Material 545–556

PART V

Security Analysis 557 CHAPTER 17

Macroeconomic and Industry Analysis 557

17.1 The Global Economy 558

17.2 The Domestic Macroeconomy 560

17.3 Demand and Supply Shocks 562

17.4 Federal Government Policy 563

Fiscal Policy / Monetary Policy / Supply-Side Policies

17.5 Business Cycles 566

The Business Cycle / Economic Indicators / Other Indicators

17.6 Industry Analysis 571

Defining an Industry / Sensitivity to the Business Cycle /

Sector Rotation / Industry Life Cycles

Start-Up Stage / Consolidation Stage / Maturity Stage / Relative Decline

Industry Structure and Performance

Threat of Entry / Rivalry between Existing Competi- tors / Pressure from Substitute Products / Bargaining Power of Buyers / Bargaining Power of Suppliers

End of Chapter Material 582–590

CHAPTER 18

Equity Valuation Models 591

18.1 Valuation by Comparables 591

Limitations of Book Value

18.2 Intrinsic Value versus Market Price 593

18.3 Dividend Discount Models 595

The Constant-Growth DDM / Convergence of Price to Intrinsic Value / Stock Prices and Investment Opportunities / Life Cycles and Multistage Growth Models / Multistage Growth Models

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18.4 Price–Earnings Ratio 609

The Price–Earnings Ratio and Growth Opportunities / P/E Ratios and Stock Risk / Pitfalls in P/E Analysis / Combining P/E Analysis and the DDM / Other Comparative Valuation Ratios

Price-to-Book Ratio / Price-to-Cash-Flow Ratio / Price-to-Sales Ratio

18.5 Free Cash Flow Valuation Approaches 617

Comparing the Valuation Models / The Problem with DCF Models

18.6 The Aggregate Stock Market 622

End of Chapter Material 623–634

CHAPTER 19

Financial Statement Analysis 635

19.1 The Major Financial Statements 635

The Income Statement / The Balance Sheet / The Statement of Cash Flows

19.2 Measuring Firm Performance 640

19.3 Profitability Measures 641

Return on Assets, ROA / Return on Capital, ROC / Return on Equity, ROE / Financial Leverage and ROE / Economic Value Added

19.4 Ratio Analysis 645

Decomposition of ROE / Turnover and Other Asset Utilization Ratios / Liquidity Ratios / Market Price Ratios: Growth versus Value / Choosing a Benchmark

19.5 An Illustration of Financial Statement Analysis 655

19.6 Comparability Problems 658

Inventory Valuation / Depreciation / Inflation and Interest Expense / Fair Value Accounting / Quality of Earnings and Accounting Practices / International Accounting Conventions

19.7 Value Investing: The Graham Technique 665

End of Chapter Material 665–677

PART VI

Options, Futures, and Other Derivatives 678

CHAPTER 20

Options Markets: Introduction 678

20.1 The Option Contract 679

Options Trading / American and European Options / Adjustments in Option Contract Terms / The Options Clearing Corporation / Other Listed Options

Index Options / Futures Options / Foreign Currency Options / Interest Rate Options

20.2 Values of Options at Expiration 685

Call Options / Put Options / Option versus Stock Investments

20.3 Option Strategies 689

Protective Put / Covered Calls / Straddle / Spreads / Collars

20.4 The Put-Call Parity Relationship 698

20.5 Option-Like Securities 701

Callable Bonds / Convertible Securities / Warrants / Collateralized Loans / Levered Equity and Risky Debt

20.6 Financial Engineering 707

20.7 Exotic Options 709

Asian Options / Barrier Options / Lookback Options / Currency-Translated Options / Digital Options

End of Chapter Material 710–721

CHAPTER 21

Option Valuation 722

21.1 Option Valuation: Introduction 722

Intrinsic and Time Values / Determinants of Option Values

21.2 Restrictions on Option Values 725

Restrictions on the Value of a Call Option / Early Exercise and Dividends / Early Exercise of American Puts

21.3 Binomial Option Pricing 729

Two-State Option Pricing / Generalizing the Two-State Approach / Making the Valuation Model Practical

21.4 Black-Scholes Option Valuation 737

The Black-Scholes Formula / Dividends and Call Option Valuation / Put Option Valuation / Dividends and Put Option Valuation

21.5 Using the Black-Scholes Formula 746

Hedge Ratios and the Black-Scholes Formula / Portfolio Insurance / Option Pricing and the Crisis of 2008–2009 / Option Pricing and Portfolio Theory / Hedging Bets on Mispriced Options

21.6 Empirical Evidence on Option Pricing 758

End of Chapter Material 759–769

CHAPTER 22

Futures Markets 770

22.1 The Futures Contract 771

The Basics of Futures Contracts / Existing Contracts

22.2 Trading Mechanics 775

The Clearinghouse and Open Interest / The Margin Account and Marking to Market / Cash versus Actual Delivery / Regulations / Taxation

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22.3 Futures Markets Strategies 781

Hedging and Speculation / Basis Risk and Hedging

22.4 Futures Prices 785

The Spot-Futures Parity Theorem / Spreads / Forward versus Futures Pricing

22.5 Futures Prices versus Expected Spot Prices 791

Expectations Hypothesis / Normal Backwardation / Contango / Modern Portfolio Theory

End of Chapter Material 793–798

CHAPTER 23

Futures, Swaps, and Risk Management 799

23.1 Foreign Exchange Futures 799

The Markets / Interest Rate Parity / Direct versus Indirect Quotes / Using Futures to Manage Exchange Rate Risk

23.2 Stock-Index Futures 806

The Contracts / Creating Synthetic Stock Positions: An Asset Allocation Tool / Index Arbitrage / Using Index Futures to Hedge Market Risk

23.3 Interest Rate Futures 813

Hedging Interest Rate Risk

23.4 Swaps 815

Swaps and Balance Sheet Restructuring / The Swap Dealer / Other Interest Rate Contracts / Swap Pricing / Credit Risk in the Swap Market / Credit Default Swaps

23.5 Commodity Futures Pricing 822

Pricing with Storage Costs / Discounted Cash Flow Analysis for Commodity Futures

End of Chapter Material 825–834

PART VII

Applied Portfolio Management 835

CHAPTER 24

Portfolio Performance Evaluation 835

24.1 The Conventional Theory of Performance Evaluation 835

Average Rates of Return / Time-Weighted Returns versus Dollar-Weighted Returns / Dollar-Weighted Return and Investment Performance / Adjusting Returns for Risk / The M2 Measure of Performance / Sharpe’s Ratio Is the Criterion for Overall Portfolios / Appropriate Performance Measures in Two Scenarios

Jane’s Portfolio Represents Her Entire Risky Invest- ment Fund / Jane’s Choice Portfolio Is One of Many Portfolios Combined into a Large Investment Fund

The Role of Alpha in Performance Measures / Actual Performance Measurement: An Example / Performance Manipulation and the Morningstar Risk-Adjusted Rating / Realized Returns versus Expected Returns

24.2 Performance Measurement for Hedge Funds 851

24.3 Performance Measurement with Changing Portfolio Composition 854

24.4 Market Timing 855

The Potential Value of Market Timing / Valuing Market Timing as a Call Option / The Value of Imperfect Forecasting

24.5 Style Analysis 861

Style Analysis and Multifactor Benchmarks / Style Analysis in Excel

24.6 Performance Attribution Procedures 864

Asset Allocation Decisions / Sector and Security Selection Decisions / Summing Up Component Contributions

End of Chapter Material 870–881

CHAPTER 25

International Diversification 882

25.1 Global Markets for Equities 883

Developed Countries / Emerging Markets / Market Capitalization and GDP / Home-Country Bias

25.2 Risk Factors in International Investing 887

Exchange Rate Risk / Political Risk

25.3 International Investing: Risk, Return, and Benefits from Diversification 895

Risk and Return: Summary Statistics / Are Investments in Emerging Markets Riskier? / Are Average Returns Higher in Emerging Markets? / Is Exchange Rate Risk Important in International Portfolios? / Benefits from International Diversification / Misleading Representation of Diversification Benefits / Realistic Benefits from International Diversification / Are Benefits from International Diversification Preserved in Bear Markets?

25.4 Assessing the Potential of International Diversification 911

25.5 International Investing and Performance Attribution 916

Constructing a Benchmark Portfolio of Foreign Assets / Performance Attribution

End of Chapter Material 920–925

CHAPTER 26

Hedge Funds 926

26.1 Hedge Funds versus Mutual Funds 927

26.2 Hedge Fund Strategies 928

Directional and Nondirectional Strategies / Statistical Arbitrage

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Contents

xv

CHAPTER 28

Investment Policy and the Framework of the CFA Institute 977

28.1 The Investment Management Process 978

Objectives / Individual Investors / Personal Trusts / Mutual Funds / Pension Funds / Endowment Funds / Life Insurance Companies / Non–Life Insurance Companies / Banks

28.2 Constraints 983

Liquidity / Investment Horizon / Regulations / Tax Considerations / Unique Needs

28.3 Policy Statements 985

Sample Policy Statements for Individual Investors

28.4 Asset Allocation 992

Taxes and Asset Allocation

28.5 Managing Portfolios of Individual Investors 994

Human Capital and Insurance / Investment in Residence / Saving for Retirement and the Assumption of Risk / Retirement Planning Models / Manage Your Own Portfolio or Rely on Others? / Tax Sheltering

The Tax-Deferral Option / Tax-Deferred Retirement Plans / Deferred Annuities / Variable and Universal Life Insurance

28.6 Pension Funds 1000

Defined Contribution Plans / Defined Benefit Plans / Pension Investment Strategies

Investing in Equities / Wrong Reasons to Invest in Equities

28.7 Investments for the Long Run 1003

Target Investing and the Term Structure of Bonds / Making Simple Investment Choices / Inflation Risk and Long-Term Investors

End of Chapter Material 1004–1014

REFERENCES TO CFA PROBLEMS 1015

GLOSSARY G-1

NAME INDEX I-1

SUBJECT INDEX I-4

26.3 Portable Alpha 931

An Example of a Pure Play

26.4 Style Analysis for Hedge Funds 933

26.5 Performance Measurement for Hedge Funds 935

Liquidity and Hedge Fund Performance / Hedge Fund Performance and Survivorship Bias / Hedge Fund Performance and Changing Factor Loadings / Tail Events and Hedge Fund Performance

26.6 Fee Structure in Hedge Funds 943

End of Chapter Material 946–950

CHAPTER 27

The Theory of Active Portfolio Management 951

27.1 Optimal Portfolios and Alpha Values 951

Forecasts of Alpha Values and Extreme Portfolio Weights / Restriction of Benchmark Risk

27.2 The Treynor-Black Model and Forecast Precision 958

Adjusting Forecasts for the Precision of Alpha / Distribution of Alpha Values / Organizational Structure and Performance

27.3 The Black-Litterman Model 962

Black-Litterman Asset Allocation Decision / Step 1: The Covariance Matrix from Historical Data / Step 2: Determination of a Baseline Forecast / Step 3: Integrating the Manager’s Private Views / Step 4: Revised (Posterior) Expectations / Step 5: Portfolio Optimization

27.4 Treynor-Black versus Black-Litterman: Complements, Not Substitutes 968

The BL Model as Icing on the TB Cake / Why Not Replace the Entire TB Cake with the BL Icing?

27.5 The Value of Active Management 970

A Model for the Estimation of Potential Fees / Results from the Distribution of Actual Information Ratios / Results from Distribution of Actual Forecasts / Results with Reasonable Forecasting Records

27.6 Concluding Remarks on Active Management 972

End of Chapter Material 973–974

Appendix A: Forecasts and Realizations of Alpha 974

Appendix B: The General Black-Litterman Model 975

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xvi

become an investment professional, or simply a sophisti- cated individual investor, you will find these skills essen- tial, especially in today’s rapidly evolving environment.

Our primary goal is to present material of practical value, but all three of us are active researchers in finan- cial economics and find virtually all of the material in this book to be of great intellectual interest. Fortunately, we think, there is no contradiction in the field of investments between the pursuit of truth and the pursuit of money. Quite the opposite. The capital asset pricing model, the arbitrage pricing model, the efficient markets hypothesis, the option-pricing model, and the other centerpieces of modern financial research are as much intellectually satis- fying subjects of scientific inquiry as they are of immense practical importance for the sophisticated investor.

In our effort to link theory to practice, we also have attempted to make our approach consistent with that of the CFA Institute. In addition to fostering research in finance, the CFA Institute administers an education and certifi- cation program to candidates seeking designation as a Chartered Financial Analyst (CFA). The CFA curriculum represents the consensus of a committee of distinguished scholars and practitioners regarding the core of knowledge required by the investment professional.

Many features of this text make it consistent with and relevant to the CFA curriculum. Questions from past CFA exams appear at the end of nearly every chapter, and, for students who will be taking the exam, those same ques- tions and the exam from which they’ve been taken are listed at the end of the book. Chapter 3 includes excerpts from the “Code of Ethics and Standards of Professional Conduct” of the CFA Institute. Chapter 28, which dis- cusses investors and the investment process, presents the

W e’ve just ended three decades of rapid and pro-found change in the investments industry as well as a financial crisis of historic magnitude. The vast expansion of financial markets during this period was due in part to innovations in securitization and credit enhancement that gave birth to new trading strategies. These strategies were in turn made feasible by develop- ments in communication and information technology, as well as by advances in the theory of investments.

Yet the financial crisis also was rooted in the cracks of these developments. Many of the innovations in secu- rity design facilitated high leverage and an exaggerated notion of the efficacy of risk transfer strategies. This engendered complacency about risk that was coupled with relaxation of regulation as well as reduced trans- parency, masking the precarious condition of many big players in the system. Of necessity, our text has evolved along with financial markets and their influence on world events.

Investments, Tenth Edition, is intended primarily as a textbook for courses in investment analysis. Our guiding principle has been to present the material in a framework that is organized by a central core of consistent fundamen- tal principles. We attempt to strip away unnecessary math- ematical and technical detail, and we have concentrated on providing the intuition that may guide students and practitioners as they confront new ideas and challenges in their professional lives.

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 watershed current issues and debates covered by the popular media as well as more-specialized finance journals. Whether you plan to

Preface

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Preface

xvii

CFA Institute’s framework for systematically relating investor objectives and constraints to ultimate investment policy. End-of-chapter problems also include questions from test-prep leader Kaplan Schweser.

In the Tenth Edition, we have continued our systematic collection of Excel spreadsheets that give tools to explore concepts more deeply than was previously possible. These spreadsheets, available on the Web site for this text ( www. mhhe.com/bkm ), provide a taste of the sophisticated ana- lytic tools available to professional investors.

UNDERLYING PHILOSOPHY

In the Tenth Edition, we address many of the changes in the investment environment, including the unprecedented events surrounding the financial crisis.

At the same time, many basic principles remain impor- tant. We believe that attention to these few important principles can simplify the study of otherwise difficult material and that fundamental principles should orga- nize and motivate all study. These principles are crucial to understanding the securities traded in financial markets and in understanding new securities that will be intro- duced in the future, as well as their effects on global mar- kets. For this reason, we have made this book thematic, meaning we never offer rules of thumb without reference to the central tenets of the modern approach to finance.

The common theme unifying this book is that security markets are nearly efficient, meaning most securities are usually priced appropriately given their risk and return attributes. Free lunches are rarely found in markets as competitive as the financial market. This simple observa- tion is, nevertheless, remarkably powerful in its implica- tions for the design of investment strategies; as a result, our discussions of strategy are always guided by the implications of the efficient markets hypothesis. While the degree of market efficiency is, and always will be, a matter of debate (in fact we devote a full chapter to the behavioral challenge to the efficient market hypothesis), we hope our discussions throughout the book convey a good dose of healthy criticism concerning much conven- tional wisdom.

Distinctive Themes Investments is organized around several important themes:

1. The central theme is the near-informational-efficiency of well-developed security markets, such as those in the United States, and the general awareness that competi- tive markets do not offer “free lunches” to participants.

A second theme is the risk–return trade-off. This too is a no-free-lunch notion, holding that in competi- tive security markets, higher expected returns come only at a price: the need to bear greater investment risk. However, this notion leaves several questions unanswered. How should one measure the risk of an asset? What should be the quantitative trade- off between risk (properly measured) and expected return? The approach we present to these issues is known as modern portfolio theory, which is another organizing principle of this book. Modern portfolio theory focuses on the techniques and implications of efficient diversification, and we devote considerable attention to the effect of diversification on portfolio risk as well as the implications of efficient diversi- fication for the proper measurement of risk and the risk–return relationship.

2. This text places greater emphasis on asset allocation than most of its competitors. We prefer this empha- sis for two important reasons. First, it corresponds to the procedure that most individuals actually follow. Typically, you start with all of your money in a bank account, only then considering how much to invest in something riskier that might offer a higher expected return. The logical step at this point is to consider risky asset classes, such as stocks, bonds, or real estate. This is an asset allocation decision. Second, in most cases, the asset allocation choice is far more important in determining overall investment perfor- mance than is the set of security selection decisions. Asset allocation is the primary determinant of the risk–return profile of the investment portfolio, and so it deserves primary attention in a study of investment policy.

3. This text offers a much broader and deeper treat- ment of futures, options, and other derivative secu- rity markets than most investments texts. These markets have become both crucial and integral to the financial universe. Your only choice is to become conversant in these markets—whether you are to be a finance professional or simply a sophisticated indi- vidual investor.

NEW IN THE TENTH EDITION

The following is a guide to changes in the Tenth Edition. This is not an exhaustive road map, but instead is meant to provide an overview of substantial additions and changes to coverage from the last edition of the text.

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Preface

xviii

concerning the use of financial ratios as tools to evaluate firm performance.

Chapter 21 Option Valuation We have added substantial new sections on risk-neutral valuation methods and their implementation in the bino- mial option-pricing model, as well as the implications of the option pricing model for tail risk and financial instability.

Chapter 24 Portfolio Performance Evaluation New sections on the vulnerability of standard perfor- mance measures to manipulation, manipulation-free mea- sures, and the Morningstar Risk-Adjusted Return have been added.

ORGANIZATION AND CONTENT

The text is composed of seven sections that are fairly inde- pendent and may be studied in a variety of sequences. Because there is enough material in the book for a two- semester course, clearly a one-semester course will require the instructor to decide which parts to include.

Part One is introductory and contains important insti- tutional material focusing on the financial environment. We discuss the major players in the financial markets, provide an overview of the types of securities traded in those markets, and explain how and where securities are traded. We also discuss in depth mutual funds and other investment companies, which have become an increas- ingly important means of investing for individual inves- tors. Perhaps most important, we address how financial markets can influence all aspects of the global economy, as in 2008.

The material presented in Part One should make it possible for instructors to assign term projects early in the course. These projects might require the student to analyze in detail a particular group of securities. Many instructors like to involve their students in some sort of investment game, and the material in these chapters will facilitate this process.

Parts Two and Three contain the core of modern portfolio theory. Chapter 5 is a general discussion of risk and return, making the general point that historical returns on broad asset classes are consistent with a risk–return trade-off, and examining the distribution of stock returns. We focus more closely in Chapter 6 on how to describe investors’ risk preferences and how they bear on asset allocation. In the next two chapters, we turn to portfolio optimization (Chapter 7) and its implementation using index models (Chapter 8).

Chapter 1 The Investment Environment This chapter contains updated coverage of the consequences of the financial crisis as well as the Dodd-Frank act.

Chapter 2 Asset Classes and Financial Instruments We devote additional attention to money markets, includ- ing recent controversies concerning the regulation of money market mutual funds as well as the LIBOR scandal.

Chapter 3 How Securities Are Traded We have extensively rewritten this chapter and included new sections that detail the rise of electronic markets, algorithmic and high-speed trading, and changes in mar- ket structure.

Chapter 5 Risk, Return, and the Historical Record This chapter has been updated with considerable attention paid to evidence on tail risk and extreme stock returns.

Chapter 9 The Capital Asset Pricing Model We have streamlined the explanation of the simple CAPM and updated and integrated the sections dealing with extensions of the CAPM, tying together extra-market hedging demands and factor risk premia.

Chapter 10 Arbitrage Pricing Theory The chapter contains new material on the practical feasi- bility of creating well-diversified portfolios and the impli- cations for asset pricing.

Chapter 11 The Efficient Market Hypothesis We have added new material documenting the behavior of market anomalies over time, suggesting how market inef- ficiencies seem to be corrected.

Chapter 13 Empirical Evidence on Security Returns Increased attention is given to tests of multifactor models of risk and return and the implications of these tests for the importance of extra-market hedging demands.

Chapter 14 Bond Prices and Yields This chapter includes new material on sovereign credit default swaps.

Chapter 18 Equity Valuation Models This chapter includes a new section on the practical prob- lems entailed in using DCF security valuation models and the response of value investors to these problems.

Chapter 19 Financial Statement Analysis We have added a new introduction to the discussion of ratio analysis, providing greater structure and rationale

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Preface

xix

After our treatment of modern portfolio theory in Part Two, we investigate in Part Three the implications of that theory for the equilibrium structure of expected rates of return on risky assets. Chapter 9 treats the capital asset pricing model and Chapter 10 covers multifactor descrip- tions of risk and the arbitrage pricing theory. Chapter 11 covers the efficient market hypothesis, including its ratio- nale as well as evidence that supports the hypothesis and challenges it. Chapter 12 is devoted to the behavioral critique of market rationality. Finally, we conclude Part Three with Chapter 13 on empirical evidence on security pricing. This chapter contains evidence concerning the risk–return relationship, as well as liquidity effects on asset pricing.

Part Four is the first of three parts on security valu- ation. This part treats fixed-income securities—bond pricing (Chapter 14), term structure relationships (Chap- ter 15), and interest-rate risk management (Chapter 16). Parts Five and Six deal with equity securities and derivative securities. For a course emphasizing security analysis and excluding portfolio theory, one may pro- ceed directly from Part One to Part Four with no loss in continuity.

Finally, Part Seven considers several topics important for portfolio managers, including performance evalua- tion, international diversification, active management, and practical issues in the process of portfolio management. This part also contains a chapter on hedge funds.

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A Guided Tour This book contains several features designed to make it easy for students to understand, absorb, and apply the concepts and techniques presented.

1 1 AN INVESTMENT IS the current commitment of money or other resources in the expecta- tion of reaping future benefits. For example, an individual might purchase shares of stock anticipating that the future proceeds from the shares will justify both the time that her money is tied up as well as the risk of the investment. The time you will spend studying this text (not to mention its cost) also is an investment. You are forgoing either current leisure or the income you could be earning at a job in the expectation that your future career will be suf- ficiently enhanced to justify this commitment of time and effort. While these two invest- ments differ in many ways, they share one key attribute that is central to all investments: You

Broadly speaking, this chapter addresses three topics that will provide a useful perspec- tive for the material that is to come later. First, before delving into the topic of “investments,” we consider the role of financial assets in the economy. We discuss the relationship between securities and the “real” assets that actually produce goods and services for consumers, and we consider why financial assets are important to the functioning of a developed economy.

Given this background, we then take a first look at the types of decisions that con- front investors as they assemble a portfolio of assets. These investment decisions are made in an environment where higher returns usually can be obtained only at the price of

The Investment Environment

CHAPTER ONE

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NUMBERED EXAMPLES NUMBERED AND TITLED examples are integrated throughout chapters. Using the worked-out solutions to these examples as models, students can learn how to solve specific problems step-by-step as well as gain insight into general principles by seeing how they are applied to answer concrete questions.

Here are fees for different classes of the Dreyfus High Yield Fund in 2012. Notice the trade-off between the front-end loads versus 12b-1 charges in the choice between Class A and Class C shares. Class I shares are sold only to institutional investors and carry lower fees.

Example 4.2 Fees for Various Classes

Class A Class C Class I

Front-end load 0–4.5%a 0 0 Back-end load 0 0–1%b 0%b

12b-1 feesc .25% 1.0% 0% Expense ratio .70% .70% .70%

a Depending on size of investment. b Depending on years until holdings are sold. c Including service fee.

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CHAPTER OPENING VIGNETTES SERVE TO OUTLINE the upcoming material in the chapter and provide students with a road map of what they will learn.

claim and limited liability features. Residual claim means that stockholders are the last in line of all those who have a

claim on the assets and income of the corporation. In a liquidation of the firm’s assets the shareholders have a claim to what is left after all other claimants such as the tax authorities, employees, suppliers, bondholders, and other creditors have been paid. For a firm not in liquidation, shareholders have claim to the part of operating income left over after inter-

est and taxes have been paid. Management can either pay this residual as cash dividends to shareholders or reinvest it in the business to increase the value of the shares.

Limited liability means that the most shareholders can lose in the event of failure of the corporation is their original investment. Unlike owners of unincorporated businesses, whose creditors can lay claim to the personal assets of the owner (house, car, furniture), corporate shareholders may at worst have worthless stock. They are not personally liable for the firm’s obligations.

Stock Market Listings

a. If you buy 100 shares of IBM stock, to what are you entitled?

b. What is the most money you can make on this investment over the next year?

c. If you pay $180 per share, what is the most money you could lose over the year?

CONCEPT CHECK 2.3

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CONCEPT CHECKS A UNIQUE FEATURE of this book! These self-test questions and problems found in the body of the text enable the students to determine whether they’ve understood the preceding material. Detailed solutions are provided at the end of each chapter.

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Investors Sour on Pro Stock Pickers

Investors are jumping out of mutual funds managed by professional stock pickers and shifting massive amounts of money into lower-cost funds that echo the broader market.

Through November 2012, investors pulled $119.3 billion from so-called actively managed U.S. stock funds accord- ing to the latest data from research firm Morningstar Inc. At the same time, they poured $30.4 billion into U.S. stock exchange-traded funds.

The move reflects the fact that many money manag- ers of stock funds, which charge fees but also dangle the prospect of higher returns, have underperformed the benchmark stock indexes. As a result, more investors are choosing simply to invest in funds tracking the indexes, which carry lower fees and are perceived as having less risk.

The mission of stock pickers in a managed mutual fund is to outperform the overall market by actively trading individual stocks or bonds, with fund managers receiving higher fees for their effort. In an ETF (or indexed mutual fund), managers balance the share makeup of the fund so it accurately reflects the performance of its underlying index, charging lower fees.

Morningstar says that when investors have put money in stock funds, they have chosen low-cost index funds and ETFs. Some index ETFs cost less than 0.1% of assets a year, while many actively managed stock funds charge 1% a year or more.

While the trend has put increasing pressure lately on stock pickers, it is shifting the fortunes of some of the big- gest players in the $14 trillion mutual-fund industry.

Fidelity Investments and American Funds, among the largest in the category, saw redemptions or weak investor interest compared with competitors, according to an anal- ysis of mutual-fund flows done for The Wall Street Journal by research firm Strategic Insight, a unit of New York-based Asset International.

At the other end of the spectrum, Vanguard, the world’s largest provider of index mutual funds, pulled in a net $141 billion last year through December, according to the company.

Many investors say they are looking for a way to invest cheaply, with less risk.

Source: Adapted from Kirsten Grind, “Investors Sour on Pro Stock Pickers” The Wall Street Journal, January 3, 2013.

W O

R D

S FR O

M TH

E STR EET

or a mutual fund company that operates a market index fund. Vanguard, for example, oper- ates the Index 500 Portfolio that mimics the S&P 500 index fund. It purchases shares of the firms constituting the S&P 500 in proportion to the market values of the outstanding equity of each firm, and therefore essentially replicates the S&P 500 index. The fund thus dupli- cates the performance of this market index. It has one of the lowest operating expenses (as a percentage of assets) of all mutual stock funds precisely because it requires minimal managerial effort.

A second reason to pursue a passive strategy is the free-rider benefit. If there are many active, knowledgeable investors who quickly bid up prices of undervalued assets and force

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eXcel APPLICATIONS: Two–Security Model

The accompanying spreadsheet can be used to mea-sure the return and risk of a portfolio of two risky assets. The model calculates the return and risk for vary- ing weights of each security along with the optimal risky and minimum-variance portfolio. Graphs are automatically generated for various model inputs. The model allows you to specify a target rate of return and solves for optimal combinations using the risk-free asset and the optimal risky portfolio. The spreadsheet is constructed with the

two-security return data from Table 7.1 . This spreadsheet is available at www.mhhe.com/bkm. Excel Question

1. Suppose your target expected rate of return is 11%.

a. What is the lowest-volatility portfolio that provides that expected return?

b. What is the standard deviation of that portfolio? c. What is the composition of that portfolio?

0

Standard Deviation (%)

0 5

5

11

10 15 20 25 3530

Expected

Return (%)A B C D E F

1

2 Expected Standard Correlation

3 Return Deviation Coefficient Covariance

4 Security 1

5 Security 2

6 T-Bill

7

8 Weight Weight Expected Standard Reward to

9 Security 1 Security 2 Return Deviation Volatility

10

11

12

13

14

Asset Allocation Analysis: Risk and Return

0.08 0.12 0.3 0.0072

0.13 0.2

0.05 0

1 0 0.08000 0.12000 0.25000

0.9 0.1 0.08500 0.11559 0.30281

0.8 0.2 0.09000 0.11454 0.34922

0.7 0.3 0.09500 0.11696 0.38474

0.6 0.4 0.10000 0.407710.12264

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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

A B C D E F

Period Implicitly Assumed Probability = 1/5

Squared Deviation

Gross HPR = 1 + HPR

Wealth Index*

2001 .2 −0.1189 0.0196 0.0586 0.0707 0.0077

0.1774

0.0008

0.1983

0.8811 0.8811 0.6864 0.8833 0.9794 1.0275

Check: 1.0054^5=

0.7790 1.2869 1.1088 1.0491

0.0054 1.0275

−0.2210 0.2869 0.1088 0.0491 0.0210 0.0210

HPR (decimal)

.2

.2

.2

.2

2002 2003 2004 2005

Arithmetic average Expected HPR SUMPRODUCT(B5:B9, C5:C9) =

SUMPRODUCT(B5:B9, D5:D9)^.5 = STDEV(C5:C9) = Geometric average return

*The value of $1 invested at the beginning of the sample period (1/1/2001). GEOMEAN(E5:E9) − 1 =

Standard deviation

AVERAGE(C5:C9) =

Spreadsheet 5.2

Time series of HPR for the S&P 500

eXce l Please visit us at www.mhhe.com/bkm

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EXCEL APPLICATIONS THE TENTH EDITION features Excel Spreadsheet Applications with new Excel questions. A sample spreadsheet is presented in the text with an interactive version available on the book’s Web site at www.mhhe.com/bkm .

EXCEL EXHIBITS SELECTED EXHIBITS ARE set as Excel spreadsheets and are denoted by an icon. They are also available on the book’s Web site at www.mhhe.com/bkm .

WORDS FROM THE STREET BOXES SHORT ARTICLES FROM business periodicals, such as The Wall Street Journal, are included in boxes throughout the text. The articles are chosen for real-world relevance and clarity of presentation.

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End-of-Chapter Features

PROBLEM SETS WE STRONGLY BELIEVE that practice in solving problems is critical to understanding investments, so a good variety of problems is provided. For ease of assignment we separated the questions by level of difficulty Basic, Intermediate, and Challenge.

EXAM PREP QUESTIONS PRACTICE QUESTIONS for the CFA ® exams provided by Kaplan Schweser, A Global Leader in CFA ® Education, are available in selected chapters for additional test practice. Look for the Kaplan Schweser logo. Learn more at www.schweser.com .

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C H A P T E R 5 Risk, Return, and the Historical Record 163

Basic

PROBLEM SETS 1. The Fisher equation tells us that the real interest rate approximately equals the nominal rate minus the inflation rate. Suppose the inflation rate increases from 3% to 5%. Does the Fisher equation imply that this increase will result in a fall in the real rate of interest? Explain.

2. You’ve just stumbled on a new dataset that enables you to compute historical rates of return on U.S. stocks all the way back to 1880. What are the advantages and disadvantages in using these data to help estimate the expected rate of return on U.S. stocks over the coming year?

3. You are considering two alternative 2-year investments: You can invest in a risky asset with a positive risk premium and returns in each of the 2 years that will be identically distributed and uncorrelated, or you can invest in the risky asset for only 1 year and then invest the proceeds in a risk-free asset. Which of the following statements about the first investment alternative (com- pared with the second) are true?

a. Its 2-year risk premium is the same as the second alternative. b. The standard deviation of its 2-year return is the same. c. Its annualized standard deviation is lower. d. Its Sharpe ratio is higher. e. It is relatively more attractive to investors who have lower degrees of risk aversion.

4. You have $5,000 to invest for the next year and are considering three alternatives:

a. A money market fund with an average maturity of 30 days offering a current yield of 6% per year.

b. A 1-year savings deposit at a bank offering an interest rate of 7.5%. c. A 20-year U.S. Treasury bond offering a yield to maturity of 9% per year.

What role does your forecast of future interest rates play in your decisions?

5. Use Figure 5.1 in the text to analyze the effect of the following on the level of real interest rates:

a. Businesses become more pessimistic about future demand for their products and decide to reduce their capital spending.

b. Households are induced to save more because of increased uncertainty about their future Social Security benefits.

c. The Federal Reserve Board undertakes open-market purchases of U.S. Treasury securities in order to increase the supply of money.

Intermediate

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5. Characterize each company in the previous problem as underpriced, overpriced, or properly priced.

6. What is the expected rate of return for a stock that has a beta of 1.0 if the expected return on the market is 15%?

a. 15%. b. More than 15%. c. Cannot be determined without the risk-free rate.

7. Kaskin, Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of .6. Which of the follow- ing statements is most accurate?

a. The expected rate of return will be higher for the stock of Kaskin, Inc., than that of Quinn, Inc. b. The stock of Kaskin, Inc., has more total risk than Quinn, Inc. c. The stock of Quinn, Inc., has more systematic risk than that of Kaskin, Inc.

8. You are a consultant to a large manufacturing corporation that is considering a project with the following net after-tax cash flows (in millions of dollars):

Years from Now After-Tax Cash Flow

Intermediate

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SUMMARY AT THE END of each chapter, a detailed summary outlines the most important concepts presented. A listing of related Web sites for each chapter can also be found on the book’s Web site at www. mhhe.com/bkm . These sites make it easy for students to research topics further and retrieve financial data and information.

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1. Unit investment trusts, closed-end management companies, and open-end management compa- nies are all classified and regulated as investment companies. Unit investment trusts are essen- tially unmanaged in the sense that the portfolio, once established, is fixed. Managed investment companies, in contrast, may change the composition of the portfolio as deemed fit by the portfo- lio manager. Closed-end funds are traded like other securities; they do not redeem shares for their investors. Open-end funds will redeem shares for net asset value at the request of the investor.

2. Net asset value equals the market value of assets held by a fund minus the liabilities of the fund divided by the shares outstanding.

3. Mutual funds free the individual from many of the administrative burdens of owning individual securities and offer professional management of the portfolio. They also offer advantages that are available only to large-scale investors, such as discounted trading costs. On the other hand, funds are assessed management fees and incur other expenses, which reduce the investor’s rate of return. Funds also eliminate some of the individual’s control over the timing of capital gains realizations.

4. Mutual funds are often categorized by investment policy. Major policy groups include money market funds; equity funds, which are further grouped according to emphasis on income versus growth; fixed-income funds; balanced and income funds; asset allocation funds; index funds; and specialized sector funds.

5. Costs of investing in mutual funds include front-end loads, which are sales charges; back-end loads, which are redemption fees or, more formally, contingent-deferred sales charges; fund oper- ating expenses; and 12b-1 charges, which are recurring fees used to pay for the expenses of mar- keting the fund to the public.

6. Income earned on mutual fund portfolios is not taxed at the level of the fund. Instead, as long as the fund meets certain requirements for pass-through status, the income is treated as being earned by the investors in the fund.

SUMMARY

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E-INVESTMENTS BOXES THESE EXERCISES PROVIDE students with simple activities to enhance their experi- ence using the Internet. Easy-to-follow instructions and questions are presented so students can utilize what they have learned in class and apply it to today’s Web-driven world.

EXCEL PROBLEMS SELECTED CHAPTERS CONTAIN prob- lems, denoted by an icon, specifically linked to Excel templates that are available on the book’s Web site at www.mhhe.com/bkm .

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