Bodie kane marcus investments and portfolio management pdf

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.

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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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Brief Contents

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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viii

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