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Detailed Contents
Preface xvi
PART I
Introduction 1
Chapter
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 10
1.5 Markets Are Competitive 11
The Risk–Return Trade-Off / Efficient Markets
1.6 The Players 13
Financial Intermediaries / Investment Bankers /
Venture Capital and Private Equity / Fintech,
Financial Innovation, and Decentralized
Finance
Robo Advice / Blockchains / Cryptocurrencies /
Digital Tokens / Digital Currency
1.7 The Financial Crisis of 2008–2009 19
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 27
End of Chapter Material 27–30
Chapter
Asset Classes and Financial Instruments 31
2.1 The Money Market 31
Treasury Bills / Certificates of Deposit / Commercial
Paper / Bankers’ Acceptances / Eurodollars / Repos
and
Reverses / Federal Funds / Brokers’ Calls / LIBOR
and
Its Replacements / Yields on Money Market
Instruments /
Money Market Funds
2.2 The Bond Market 37
Treasury Notes and Bonds / Inflation-Protected
Treasury
Bonds / Federal Agency Debt / International Bonds /
Municipal Bonds / Corporate Bonds / Mortgage and
Asset-Backed Securities
2.3 Equity Securities 44
Common Stock as Ownership Shares /
Characteristics of
Common Stock / Stock Market Listings / Preferred
Stock /
Depositary Receipts
2.4 Stock and Bond Market Indexes 47
Stock Market Indexes / Dow Jones Industrial
Average
/ The Standard & Poor’s 500 Index / Russell Indexes
/
Other U.S. Market-Value Indexes / Equally Weighted
Indexes / Foreign and International Stock Market
Indexes
/ Bond Market Indicators
2.5 Derivative Markets 54
Options / Futures Contracts
End of Chapter Material 56–60
Chapter
How Securities Are Traded 61
3.1 How Firms Issue Securities 61
Privately Held Firms / Publicly Traded Companies /
Shelf
Registration / Initial Public Offerings / SPACs versus
Traditional IPOs
3.2 How Securities Are Traded 67
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/DMM Markets
3.3 The Rise of Electronic Trading 72
3.4 U.S. Markets 74
NASDAQ / The New York Stock Exchange / ECNs
3.5 New Trading Strategies 76
Algorithmic Trading / High-Frequency Trading / Dark
Pools / Internalization / Bond Trading
3.6 Globalization of Stock Markets 80
3.7 Trading Costs 81
3.8 Buying on Margin 82
3.9 Short Sales 85
3.10 Regulation of Securities Markets 89
Self-Regulation / The Sarbanes-Oxley Act /
Insider Trading
End of Chapter Material 93–98
Chapter
Mutual Funds and Other Investment
Companies 99
4.1 Investment Companies 99
4.2 Types of Investment Companies 100
Unit Investment Trusts / Managed Investment
Companies / Exchange-Traded Funds / Other
Investment
Organizations
Commingled Funds / Real Estate Investment Trusts
(REITs) / Hedge Funds
4.3 Mutual Funds 104
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 107
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 111
4.6 Exchange-Traded Funds 112
4.7 Mutual Fund Investment Performance:
A First Look 115
4.8 Information on Mutual Funds 116
End of Chapter Material 119–124
PART II
Portfolio Theory
and Practice 125
Chapter
Risk, Return, and the Historical
Record 125
5.1 Measuring Returns over Different Holding
Periods 126
Annual Percentage Rates / Continuous
Compounding
5.2 Interest Rates and Inflation Rates 129
Real and Nominal Rates of Interest / The Equilibrium
Real Rate of Interest / Interest Rates and Inflation /
Taxes and the Real Rate of Interest / Treasury Bills
and
Inflation, 1926–2021
5.3 Risk and Risk Premiums 133
Holding-Period Returns / Expected Return and
Standard
Deviation / Excess Returns and Risk Premiums /
The
Reward-to-Volatility (Sharpe) Ratio
5.4 The Normal Distribution 137
5.5 Deviations from Normality and Tail Risk 140
Value at Risk / Expected Shortfall / Lower Partial
Standard Deviation and the Sortino Ratio / Relative
Frequency of Large, Negative 3-Sigma Returns
5.6 Learning from Historical Returns 143
Time Series versus Scenario Analysis / Expected
Returns
and the Arithmetic Average / The Geometric (Time-
Weighted) Average Return / Estimating Variance
and
Standard Deviation / Mean and Standard Deviation
Estimates from Higher-Frequency Observations
5.7 Historic Returns on Risky Portfolios 147
A Global View of the Historical Record
5.8 Normality and Long-Term Investments 156
Short-Run versus Long-Run Risk / Forecasts for the
Long Haul
End of Chapter Material 160–166
Chapter
Capital Allocation to Risky Assets 167
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 173
6.3 The Risk-Free Asset 176
6.4 Portfolios of One Risky Asset and a Risk-Free
Asset 176
6.5 Risk Tolerance and Asset Allocation 179
Non-normal Returns
6.6 Passive Strategies: The Capital Market Line 185
End of Chapter Material 187–195
Appendix A: Risk Aversion, Expected Utility, and the
St. Petersburg Paradox 196
Chapter
Efficient Diversification 201
7.1 Diversification and Portfolio Risk 202
7.2 Portfolios of Two Risky Assets 203
7.3 Asset Allocation with Stocks, Bonds, and Bills
211
Asset Allocation with Two Risky Asset Classes
7.4 The Markowitz Portfolio Optimization Model 216
Security Selection / Capital Allocation and the
Separation Property / The Power of Diversification /
Asset Allocation and Security Selection
7.5 Risk Pooling, Risk Sharing, and Time
Diversification 225
Risk Sharing versus Risk Pooling / Time
Diversification
End of Chapter Material 228–238
Appendix A: A Spreadsheet Model for Efficient
Diversification 238
Appendix B: Review of Portfolio Statistics 243
Chapter
Index Models 251
8.1 A Single-Factor Security Market 252
The Input List of the Markowitz Model / Systematic
versus Firm-Specific Risk
8.2 The Single-Index Model 254
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 261
The Security Characteristic Line for U.S. Steel / The
Explanatory Power of U.S. Steel’s SCL / The
Estimate of
Alpha / The Estimate of Beta / Firm-Specific Risk
Typical Results from Index Model Regressions
8.4 The Industry Version of the Index Model 265
Predicting Betas
8.5 Portfolio Construction Using the Single-Index
Model 268
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 / Correlation and
Covariance
Matrix
Risk Premium Forecasts / The Optimal Risky
Portfolio /
Is the Index Model Inferior to the Full-Covariance
Model?
End of Chapter Material 277–282
PART III
Equilibrium in Capital
Markets 283
Chapter
The Capital Asset Pricing Model 283
9.1 The Capital Asset Pricing Model 283
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 294
Identical Input Lists / Risk-Free Borrowing and the
Zero-Beta Model / Labor Income and Other
Nontraded
Assets / A Multiperiod Model and Hedge Portfolios /
A
Consumption-Based CAPM / Liquidity and the
CAPM
9.3 Issues in Testing the CAPM 304
9.4 The CAPM and the Investment Industry 305
End of Chapter Material 306–314
Chapter
Arbitrage Pricing Theory
and Multifactor Models of Risk
and Return 315
10.1 Multifactor Models: A Preview 316
Factor Models of Security Returns
10.2 Arbitrage Pricing Theory 318
Arbitrage, Risk Arbitrage, and Equilibrium /
Diversification
in a Single-Factor Security Market / Well-Diversified
Portfolios / The Security Market Line of the APT
Individual Assets and the APT
Well-Diversified Portfolios in Practice
10.3 The APT and the CAPM 326
10.4 A Multifactor APT 326
10.5 The Fama-French (FF) Three-Factor Model 329
Estimating and Implementing a Three-Factor SML /
Extensions of the Three-Factor Model: A First Look /
Smart Betas and Multifactor Models
End of Chapter Material 334–340
Chapter
The Efficient Market Hypothesis 341
11.1 Random Walks and Efficient Markets 342
Competition as the Source of Efficiency / Versions of
the
Efficient Market Hypothesis
11.2 Implications of the EMH 346
Technical Analysis / Fundamental Analysis / Active
versus
Passive Portfolio Management / The Role of
Portfolio
Management in an Efficient Market / Resource
Allocation
11.3 Event Studies 351
11.4 Are Markets Efficient? 354
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 Effect / The Neglected-Firm and
Liquidity Effects / Book-to-Market Ratios / Post–
Earnings-Announcement Price Drift / Other
Predictors
of Stock Returns
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 368
Stock Market Analysts / Mutual Fund Managers / So,
Are
Markets Efficient?
End of Chapter Material 374–380
Chapter
Behavioral Finance and Technical
Analysis 381
12.1 The Behavioral Critique 382
Information Processing
Limited Attention, Underreaction, and Overreaction /
Overconfidence / Conservatism / Confirmation Bias /
Extrapolation and Pattern Recognition
Behavioral Biases
Framing / Mental Accounting / Regret Avoidance /
Affect and Feelings / 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 394
Trends and Corrections
Momentum and Moving Averages / Relative
Strength /
Breadth
Machine Leaning and Technical Analysis /
Sentiment
Indicators
Trin Statistic / Confidence Index / Short Interest /
Put/
Call Ratio
A Warning
End of Chapter Material 401–408
Chapter
Empirical Evidence on Security Returns 409
13.1 Two-Pass Tests of Asset Pricing 410
Testing the Single-Factor SML
Setting Up the Sample Data / Estimating the SCL /
Estimating the SML
The Market Index / Measurement Error in Beta
13.2 Tests of the Multifactor Models 415
Labor Income / Private (Nontraded) Business /
Macroeconomic Risk Factors
13.3 Fama-French-Type Factor Models 419
Size and B/M as Risk Factors / Behavioral
Explanations /
Momentum: A Fourth Factor / The Factor Zoo
13.4 Liquidity and Asset Pricing 427
13.5 The Equity Premium Puzzle 429
Expected versus Realized Returns / Survivorship
Bias /
Extensions to the CAPM May Mitigate the Equity
Premium
Puzzle / Liquidity and the Equity Premium Puzzle /
Behavioral Explanations of the Equity Premium
Puzzle
End of Chapter Material 435–438
PART IV
Fixed-Income Securities 439
Chapter
Bond Prices and Yields 439
14.1 Bond Characteristics 440
Treasury Bonds and Notes
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
Maturity / Inverse Floaters / Asset-Backed Bonds /
Catastrophe Bonds / Indexed Bonds
14.2 Bond Pricing 446
Bond Pricing between Coupon Dates
14.3 Bond Yields 451
Yield to Maturity / Yield to Call / Realized Compound
Return versus Yield to Maturity
14.4 Bond Prices over Time 458
Yield to Maturity versus Holding-Period Return /
Zero-
Coupon Bonds and Treasury Strips / After-Tax
Returns
14.5 Default Risk and Bond Pricing 463
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 474–480
Chapter
The Term Structure of Interest Rates 481
15.1 The Yield Curve 481
Bond Pricing
15.2 The Yield Curve and Future Interest Rates 484
The Yield Curve under Certainty / Holding-Period
Returns / Forward Rates
15.3 Interest Rate Uncertainty and Forward Rates
489
15.4 Theories of the Term Structure 491
The Expectations Hypothesis / Liquidity Preference
Theory / Market Segmentation
15.5 Interpreting the Term Structure 495
15.6 Forward Rates as Forward Contracts 498
End of Chapter Material 500–508
Chapter
Managing Bond Portfolios 509
16.1 Interest Rate Risk 510
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 519
Why Do Investors Like Convexity? / Duration and
Convexity of Callable Bonds / Duration and
Convexity of
Mortgage-Backed Securities
16.3 Passive Bond Management 527
Bond-Index Funds / Immunization / Cash Flow
Matching
and Dedication / Other Problems with Conventional
Immunization
16.4 Active Bond Management 536
Sources of Potential Profit / Horizon Analysis
End of Chapter Material 539–550
PART V
Security Analysis 551
Chapter
Macroeconomic and Industry Analysis 551
17.1 The Global Economy 551
17.2 The Domestic Macroeconomy 554
Key Economic Indicators
Gross Domestic Product / Employment / Inflation /
Interest Rates / Budget Deficit / Sentiment
17.3 Demand and Supply Shocks 556
17.4 Federal Government Policy 557
Fiscal Policy / Monetary Policy / Supply-Side
Policies
17.5 Business Cycles 560
The Business Cycle / Economic Indicators
17.6 Industry Analysis 564
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
Competitors /
Pressure from Substitute Products / Bargaining
Power
of Buyers / Bargaining Power of Suppliers
End of Chapter Material 574–582
Chapter
Equity Valuation Models 583
18.1 Valuation by Comparables 583
Limitations of Book Value
18.2 Intrinsic Value versus Market Price 585
18.3 Dividend Discount Models 587
The Constant-Growth DDM / Convergence of Price
to Intrinsic Value / Stock Prices and Investment
Opportunities / Life Cycles and Multistage Growth
Models / Multistage Growth Models
18.4 The Price–Earnings Ratio 601
The Price–Earnings Ratio and Growth Opportunities
/
P/E Ratios and Stock Risk / Pitfalls in P/E Analysis /
The
Cyclically Adjusted P/E Ratio / Combining P/E
Analysis
and the DDM / Other Comparative Valuation Ratios
Price-to-Book Ratio / Price-to-Cash-Flow Ratio /
Price-to-Sales Ratio / Be Creative
18.5 Free Cash Flow Valuation Approaches 611
Comparing the Valuation Models / The Problem with
DCF Models
18.6 The Aggregate Stock Market 615
End of Chapter Material 617–628
Chapter
Financial Statement Analysis 629
19.1 The Major Financial Statements 629
The Income Statement / The Balance Sheet /
The Statement of Cash Flows
19.2 Measuring Firm Performance 634
19.3 Profitability Measures 635
Return on Assets, ROA / Return on Capital, ROC /
Return on Equity, ROE / Financial Leverage and
ROE /
Economic Value Added
19.4 Ratio Analysis 639
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
650
19.6 Comparability Problems 652
Inventor y 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 658
End of Chapter Material 659–672
PART VI
Options, Futures, and Other
Derivatives 673
Chapter
Options Markets: Introduction 673
20.1 The Option Contract 673
Options Trading / American versus 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 679
Call Options / Put Options / Option versus Stock
Investments
20.3 Option Strategies 683
Protective Put / Covered Calls / Straddle / Spreads /
Collars
20.4 The Put-Call Parity Relationship 691
20.5 Option-like Securities 694
Callable Bonds / Convertible Securities /
Warrants / Collateralized Loans / Levered Equity
and Risky Debt
20.6 Financial Engineering 700
20.7 Exotic Options 702
Asian Options / Barrier Options / Lookback
Options / Currency-Translated Options / Digital
Options
End of Chapter Material 703–714
Chapter
Option Valuation 715
21.1 Option Valuation: Introduction 715
Intrinsic and Time Values / Determinants of Option
Values
21.2 Restrictions on Option Values 719
Restrictions on the Value of a Call Option /
Early Exercise and Dividends / Early Exercise of
American Puts
21.3 Binomial Option Pricing 722
Two-State Option Pricing / Generalizing the
Two-State Approach / Making the Valuation Model
Practical
21.4 Black-Scholes Option Valuation 730
The Black-Scholes Formula / Implied Volatility /
Dividends and Call Option Valuation / Put
Option Valuation / Dividends and Put Option
Valuation
21.5 Using the Black-Scholes Formula 738
Hedge Ratios and the Black-Scholes Formula /
Portfolio Insurance / Option Pricing and the
Financial Crisis / Option Pricing and Portfolio
Theory / Hedging Bets on Mispriced
Options
21.6 Empirical Evidence on Option Pricing 750
End of Chapter Material 751–762
Chapter
Futures Markets 763
22.1 The Futures Contract 763
The Basics of Futures Contracts / Existing Contracts
22.2 Trading Mechanics 769
The Clearinghouse and Open Interest / The Margin
Account
and Marking to Market / The Convergence Property /
Cash
versus Actual Delivery / Regulations / Taxation
22.3 Futures Markets Strategies 773
Hedging and Speculation / Basis Risk and Hedging
22.4 Futures Prices 777
The Spot-Futures Parity Theorem / Spreads /
Forward
versus Futures Pricing
22.5 Futures Prices versus Expected Spot Prices
784
Expectations Hypothesis / Normal Backwardation /
Contango / Modern Portfolio Theory
End of Chapter Material 786–790
Chapter
Futures, Swaps, and Risk Management 791
23.1 Foreign Exchange Futures 791
The Markets / Interest Rate Parity / Direct versus
Indirect
Quotes / Using Futures to Manage Exchange Rate
Risk
23.2 Stock-Index Futures 799
The Contracts / Creating Synthetic Stock Positions:
An
Asset Allocation Tool / Index Arbitrage / Using Index
Futures to Hedge Market Risk
23.3 Interest Rate Futures 804
Hedging Interest Rate Risk
23.4 Swaps 806
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 813
Pricing with Storage Costs / Discounted Cash Flow
Analysis for Commodity Futures
End of Chapter Material 817–826
PART VII
Applied Portfolio
Management 827
Chapter
Portfolio Performance Evaluation 827
24.1 The Conventional Theory of Performance
Evaluation 827
Average Rates of Return / Time-Weighted Returns
versus
Dollar-Weighted Returns / Adjusting Returns for Risk
/
Risk-Adjusted Performance Measures / The Sharpe
Ratio
for Overall Portfolios
The M
2
Measure and the Sharpe Ratio
The Treynor Ratio / The Information Ratio / The Role
of Alpha in Performance Measures / Implementing
Performance Measurement: An Example / Realized
Returns versus Expected Returns / Selection Bias
and
Portfolio Evaluation
24.2 Style Analysis 839
24.3 Performance Measurement with Changing
Portfolio
Composition 841
Performance Manipulation and the Morningstar Risk-
Adjusted Rating
24.4 Market Timing 845
The Potential Value of Market Timing / Valuing
Market
Timing as a Call Option / The Value of Imperfect
Forecasting
24.5 Performance Attribution Procedures 850
Asset Allocation Decisions / Sector and Security
Selection
Decisions / Summing Up Component Contributions
End of Chapter Material 855–866
Chapter
International Diversification 867
25.1 Global Markets for Equities 867
Developed Countries / Emerging Markets / Market
Capitalization and GDP / Home-Country Bias
25.2 Exchange Rate Risk and International
Diversification 871
Exchange Rate Risk / Investment Risk in
International
Markets / International Diversification / Are Benefits
from International Diversification Preserved in
Bear Markets?
25.3 Political Risk 882
25.4 International Investing and Performance
Attribution 885
Constructing a Benchmark Portfolio of Foreign
Assets /
Performance Attribution
End of Chapter Material 889–894
Chapter
Alternative Assets 895
26.1 Alternative Assets 896
The Alternative Asset Universe
Hedge Funds / Private Equity / Real Assets /
Structured
Products
Alternative Assets versus Traditional Assets
Transparency / Investors / Investment Strategies /
Liquidity / Investment Horizon / Fee Structure
Role of Alternative Assets in Diversified Portfolios /
Growth of Alternative Assets
26.2 Hedge Funds 900
Hedge Fund Strategies / Statistical Arbitrage / High-
Frequency Strategies /
Electronic News Feeds / Cross-Market Arbitrage /
Electronic Market Making / Electronic “Front
Running”
Portable Alpha
26.3 Venture Capital and Angel Investors 905
Angel Investors / Venture Capital / Venture Capital
and
Investment Stages / Fund Life Cycle / Private Equity
Valuation / Venture Syndication / Venture Capital
and
Innovation
26.4 Leveraged Buyout Funds 913
Leveraged Buyout Firm Structure / The Deal / Exits /
Leveraged Buyouts and Innovation
26.5 Performance Measurement for Alternative
Investment Funds 916
Liquidity and Performance
Liquidity and Hedge Fund Performance / Liquidity
and
Private Equity
Survivorship Bias and Backfill Bias / Tail Events /
Historical Hedge Fund Performance / Style Analysis
/
Historical Performance of Private Equity
Grandstanding / Industry Specialization
Efficient Frontier
26.6 Fee Structure in Alternative Investments 926
Incentive Fees / Private Equity Chasing Waterfalls /
Funds of Funds
End of Chapter Material 928–934
Chapter
The Theory of Active Portfolio
Management 935
27.1 Optimal Portfolios and Alpha Values 935
Forecasts of Alpha Values and Extreme Portfolio
Weights /
Restriction of Tracking Risk
27.2 The Treynor-Black Model and Forecast
Precision 942
Adjusting Forecasts for the Precision of Alpha /
Distribution of Alpha Values / Organizational
Structure
and Performance
27.3 The Black-Litterman Model 946
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 951
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 953
A Model for the Estimation of Potential Fees /
Results from the Distribution of Actual Information
Ratios / Results from Distribution of Actual Forecasts
27.6 Concluding Remarks on Active Management
955
End of Chapter Material 955–956
Appendix A: Forecasts and Realizations of Alpha
956
Appendix B: The General Black-Litterman Model
957
Chapter
Investment Policy and the Framework of the
CFA Institute 959
28.1 The Investment Management Process 960
28.2 Investor Objectives 962
Individual Investors
Personal Trusts / Mutual Funds / Pension Funds /
Endowment Funds / Life Insurance Companies /
Non–Life Insurance Companies / Banks
28.3 Investor Constraints 966
Liquidity / Investment Horizon / Regulations / Tax
Considerations / Unique Needs
28.4 Policy Statements 969
Sample Policy Statements for Individual Investors
28.5 Asset Allocation 973
Top-Down Asset Allocation for Institutional Investors
/
Monitoring and Revising the Portfolio
28.6 Managing Portfolios of Individual Investors 975
Investment in Residence / Saving for Retirement
and
the Assumption of Risk / Retirement Planning
Models /
Target Date Funds / Tax Sheltering and Asset
Allocation
The Tax-Deferral Option / Tax-Protected Retirement
Plans / Deferred Annuities / Variable and Universal
Life Insurance
28.7 Pension Funds 981
Defined Contribution Plans / Defined Benefit Plans /
Pension Investment Strategies
Investing in Equities
End of Chapter Material 984–994
REFERENCES TO CFA PROBLEMS 995
GLOSSARY G-1
NAME INDEX I
SUBJECT INDEX I-4
NOTATION, FORMULAS F-1

NEW IN THE ELEVENTH EDITION

The following is a guide to changes in the Eleventh
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.
Chapter 1 The Investment Environment
This chapter contains additional discussions of
corporate governance, particularly activist investors
and corporate control.
Chapter 3 How Securities Are Traded
We have updated this chapter and included new
material
on trading venues such as dark pools.
Chapter 5 Risk, Return, and the Historical Record
This chapter has been updated and substantially
streamlined. The material on the probability
distribution of security returns has been reworked for
greater clarity, and the
discussion of long-run risk has been simplified.
Chapter 7 Optimal Risky Portfolios
The material on risk sharing, risk pooling, and time
diversification has been extensively rewritten with a
greater
emphasis on intuition.
Chapter 8 Index Models
We have reorganized and rewritten this chapter to
improve
the flow of the material and provide more insight into
the
links between index models, factor models, and the
distinction between diversifiable and systematic risk.
Chapter 9 The Capital Asset Pricing Model
We have simplified the development of the CAPM.
The
relations between the assumptions underlying the
model and their implications are now more explicit.
The links between
the CAPM and the index model are also more fully
explored.
Chapter 10 Arbitrage Pricing Theory and Multifactor
Models of Risk and Return
This chapter has been substantially rewritten. The
derivation of the APT has been streamlined, with
greater
emphasis on intuition. The extension of the APT
from
portfolios to individual assets is now also more
explicit.
Finally, the relation between the CAPM and the APT
has
been further clarified.
Chapter 11 The Efficient Market Hypothesis
We have added new material pertaining to insider
information and trading to this chapter.
Chapter 13 Empirical Evidence on Security Returns
Increased attention is given to tests and
interpretations 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 and the relationship between swap
prices
and credit spreads in the bond market.
Chapter 18 Equity Valuation Models
This chapter includes new material on the practical
problems entailed in using DCF security valuation
models, in
particular, the problems entailed in estimating the
terminal value of an investment, and the appropriate
response
of value investors to these problems.
Chapter 24 Portfolio Performance Evaluation
We have added new material to clarify the
circumstances in
which each of the standard risk-adjusted
performance measures, such as alpha, the Sharpe
and Treynor measures, and
the information ratio, will be of most relevance to
investors.
Chapter 25 International Diversification
This chapter also has been extensively rewritten.
There is
now a sharper focus on the benefits of international
diversification. However, we have retained previous
material
on political risk in an international setting.
ORGANIZATION AND CONTENT
The text is composed of seven sections that are
fairly
independent and may be studied in a variety of
sequences.
Because there is enough material in the book for a
twosemester course, clearly a one-semester course
will
require the instructor to decide which parts to
include.
Part One is introductory and contains important
institutional 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 increasingly
important
means of investing for individual investors. 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).
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
descriptions of risk and the arbitrage pricing theory.
Chapter 11
covers the efficient market hypothesis, including its
rationale 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
valuation. This part treats fixed-income securities—
bond
pricing (Chapter 14), term structure relationships
(Chapter 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 proceed
directly
from Part One to Part Four with no loss in continuity.
Finally, Part Seven considers several topics
important
for portfolio managers, including performance
evaluation,
international diversification, active management, and
practical issues in the process of portfolio
management.
This part also contains a chapter on hedge funds.

Chapter 1 The Investment Environment

AN INVESTMENT IS the current commitment of
money or other resources in the expecta- tion of
reaping future benefits. For example, you might
purchase shares of stock anticipat- ing that the
future proceeds will justify both the time your money
is tied up as well as the risk of the investment. The
time you will spend study- ing this text (not to
mention its cost) also is an investment. You are
forgoing either current lei- sure or the income you
could be earning at a job in the expectation that your
future career will be sufficiently enhanced to justify
this commitment of time and effort. While these two
investments differ in many ways, they share one key
attribute that is central to all investments: You
sacrifice something of value now, expecting to reap
the benefits later. This text can help you become an
informed practitioner of investments. We will focus
on investments in securities such as stocks, bonds,
or derivatives contracts, but much of what we
discuss will be useful in the analysis of any type of
investment. The text will provide you with
background in the organization of various secu-
rities markets; will survey the valuation and risk
management principles useful in particular markets,
such as those for bonds or stocks; and will introduce
you to the principles of portfolio construction.
Broadly speaking, this chapter addresses sev- eral
topics that will provide perspective 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 dis- cuss the
relationship between securities and the “real” assets
that actually produce goods and ser- vices for
consumers, and we consider why finan- cial 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 confront
inves- tors 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 greater risk and in
which it is rare to find assets that are so mispriced
as to be obvious bargains. These themes—the risk–
return trade-off and the efficient pricing of financial
assets—are central to the investment process, so it
is worth pausing for a brief discussion of their
implications as we begin the text. These implications
will be fleshed out in much greater detail in later
chapters. We provide an overview of the
organization of security markets as well as its key
participants. Finally, we discuss the financial crisis
that began playing out in and peaked in . The crisis
dramatically illustrated the connections between the
financial system and the “real” side of the economy.
We look at the origins of the crisis and the lessons
that may be drawn about systemic risk. We close the
chapter with an overview of the remainder of the
text.

1.1 Real Assets versus Financial Assets

The material wealth of a society is ultimately
determined by the productive capacity of its
economy, that is, the goods and services its
members can create. This capacity is a function of
the real assets of the economy: the land, buildings,
machines, and knowledge that can be used to
produce goods and services. In contrast to real
assets are financial assets such as stocks and
bonds. Such securities historically were no more
than sheets of paper (and today, are far more likely
to be, computer entries), and they do not contribute
directly to the productive capacity of the economy.
Instead, these assets are the means by which
individuals in well-developed econ- omies hold their
claims on real assets. Financial assets are claims to
the income generated by real assets (or claims on
income from the government). If we cannot own our
own auto plant (a real asset), we can still buy shares
in Ford or Toyota (financial assets) and thereby
share in the income derived from the production of
automobiles. While real assets generate net income
to the economy, financial assets simply define the
allocation of income or wealth among investors.
When investors buy securities issued by companies,
the firms use the money so raised to pay for real
assets, such as plant, equip- ment, technology, or
inventory. So investors’ returns ultimately come from
the income produced by the real assets that were
financed by the issuance of those securities. The
distinction between real and financial assets is
appar- ent when we compare the balance sheet of
U.S. households, shown in Table 1.1, with the
composition of national wealth in the United States,
shown in Table 1.2. Household wealth includes
financial assets such as bank accounts, corporate
stock, or bonds. However, these securities, which
are finan- cial assets of households, are liabilities of
the issuers of the securities. For example, a bond
that you treat as an asset because it gives you a
claim on interest income and repay- ment of
principal from Toyota is a liability of Toyota, which is
obligated to make these payments. Your asset is
Toyota’s liability. Therefore, when we aggregate
over all balance sheets, these claims cancel out,
leaving only real assets as the net wealth of the
economy. National wealth consists of struc- tures,
equipment, inventories of goods, and land. 1 1.1
Real Assets versus Financial Assets 1 You might
wonder why real assets held by households in Table
1.1 amount to $44,599 billion, while total real assets
in the domestic economy (Table 1.2) are far larger,
at $86,282 billion. A big part of the difference reflects
the fact that real assets held by firms, for example,
property, plant, and equipment, are included as
financial assets of the household sector, specifically
through the value of corporate equity and other
stock market invest- ments. Also, Table 1.2 includes
assets of noncorporate businesses. Finally, there
are some differences in valuation methods. For
example, equity and stock investments in Table 1.1
are measured by market value, whereas plant and
equipment in Table 1.2 are valued at replacement
cost.

1.2 Financial Assets

It is common to distinguish among three broad types
of financial assets: fixed income, equity, and
derivatives. Fixed-income or debt securities promise
either a fixed stream of income or a stream of
income determined by a specified formula. For
example, a corporate bond typically would promise
that the bondholder will receive a fixed amount of
interest each year. Other so-called floating-rate
bonds promise payments that depend on current
interest rates. For example, a bond may pay an
interest rate that is fixed at 2 percentage points
above the rate paid on U.S. Treasury bills. Unless
the borrower is declared bankrupt, the payments on
these securities are either fixed or determined by
formula. For this reason, the investment
performance of debt securities typically is least
closely tied to the financial condition of the issuer.
Nevertheless, fixed-income securities come in a
tremendous variety of maturities and payment
provisions. At one extreme, the money market refers
to debt securities that are short term, highly
marketable, and generally of very low risk, for
example, U.S. Treasury bills or bank certificates of
deposit (CDs). In contrast, the fixed-income capital
market includes long-term securities such as
Treasury bonds, as well as bonds issued by federal
agencies, state and local municipalities, and
corporations. These bonds range from very safe in
terms of default risk (e.g., Treasury securities) to
relatively risky (e.g., high-yield or “junk” bonds).
They also are designed with extremely diverse
provisions regarding payments provided to the
investor and protection against the bankruptcy of the
issuer. We will take a first look at these securities in
Chapter 2 and undertake a more detailed analysis of
the debt market in Part Four. Unlike debt securities,
common stock, or equity, in a firm represents an
ownership share in the corporation. Equityholders
are not promised any particular payment. They
receive any dividends the firm may pay and have
prorated ownership in the real assets of the firm. If
the firm is successful, the value of equity will
increase; if not, it will decrease. The performance of
equity investments, therefore, is tied directly to the
success of the firm and its real assets. For this
reason, equity investments tend to be riskier than
investments in debt securities. Equity markets and
equity valuation are the topics of Part Five. Finally,
derivative securities such as options and futures
contracts provide payoffs that are determined by the
prices of other assets such as bond or stock prices.
For example, a call option on a share of Intel stock
might turn out to be worthless if Intel’s share price
remains below a threshold or “exercise” price such
as $30 a share, but it can be quite valuable if the
stock price rises above that level.2 Derivative
securities are so named because their values derive
from the prices of other assets. For example, the
value of the call option will depend on the price of
Intel stock. Other important derivative securities are
futures and swap contracts. We will treat these in
Part Six. Derivatives have become an integral part of
the investment environment. One use of derivatives,
perhaps the primary use, is to hedge risks or transfer
them to other parties. This is done successfully
every day, and the use of these securities for risk
management is so commonplace that the
multitrillion-dollar market in derivative assets is
routinely taken for granted. Derivatives also can be
used to take highly speculative positions, however.
Every so often, one of these positions blows up,
resulting in well-publicized losses of hundreds of
millions of dollars. While these losses attract
considerable attention, they are in fact the exception
to the more common use of such securities as risk
management tools. Derivatives will continue to play
an important role in portfolio construction and the
financial system. We will return to this topic later in
the text. Investors and corporations regularly
encounter other financial markets as well. Firms
engaged in international trade regularly transfer
money back and forth between dollars and other
currencies. In London alone, nearly $2 trillion dollars
of currency is traded each day. Investors also might
invest directly in some real assets. For example,
dozens of commodities are traded on exchanges
such as the New York Mercantile Exchange or the
Chicago Board of Trade. You can buy or sell corn,
wheat, natural gas, gold, silver, and so on.
Commodity and derivative markets allow firms to
adjust their exposure to various business risks. For
example, a construction firm may lock in the price of
copper by buying copper futures contracts, thus
eliminating the risk of a sudden jump in the price of
its raw materials. Wherever there is uncertainty,
investors may be interested in trading, either to
speculate or to lay off their risks, and a market may
arise to meet that demand.

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