Understanding Investments
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1 Understanding Investments Theories and Strategies Nikiforos T. Laopodis j Routledge Taylor & Francis Croup NEW YORK AND LONDON
2 CONTENTS List of Illustrations Preface xxni xxix Parti Chapter 1 INVESTMENT BASICS The Investment Framework Chapter Objectives Introduction The General Financial and Economic Environment Definition of Investments The General Investment Environment Securities Classification of Securities Equity Securities Debt Securities Derivative Securities Types of Investors Financial Markets and Intermediaries The Roles of Financial Markets The Roles of Financial Intermediaries The Objectives and Constraints of Investors Objectives of Investors Constraints of Investors The Investment Management Process The Role of Investment Information vu
3 viii Contents Agency and Ethical Issues in Investing 13 Asymmetric Information 14 The Agent- Principal Problem 15 Ethics in the Marketplace 16 Social Responsibility 17 So Why Study Investments? 18 Chapter Summary 20 The Plan of the Textbook 21 Applying Economic Analysis ' - ~ ' 21 International Focus 22 Lessons of Our Times 23 Key Concepts 23 Questions and Problems 25 Chapter 2 The Investment Decision Process and Investment Strategies 26 Chapter Objectives 26 Introduction 26 The Investment Process 27 The Risk-Return Trade-Off ' 27 The Asset Allocation Step in the Investment Process 28 The Security Selection Step in the Investment Process 30 General Investment Philosophies and Strategies 31 Some Prominent Investment Philosophies 31 Harry Markowitz : 31 % Paul Samuelson 31 John Bogle 32 Warren Buffett 32 What Is Your Investment Philosophy? 34 Some Investment Strategies 35 Top-Down and Bottom-Up Approaches to Investing 35 Active and Passive Investment Strategies 37 Other Investment Strategies 39 Dollar-Cost Averaging 40 Margin Purchases and Short Sales 41 Margin Purchases 41 Short Sales 44 Types of Markets and Orders 45 Types of Trading Markets 45 Direct Market 45 Brokered Market 45 Dealer Market 46 Auction Market 46
4 Contents ix Types of Trading Orders 46 - Market Orders 46 Limit Order 46 Finding the Equilibrium Price of a Share 47 Chapter Summary 49 Applying Economic Analysis 50 International Focus 50 Lessons of Our Times ' 51 Key Concepts 51 Questions and Problems 53 Chapter 3 Fundamentals of Risk and Return 56 Chapter Objectives 56 Introduction 56 Measuring Return 56 Holding Period Return 57 Return over Multiple Periods 58 Arithmetic Mean 59 Geometric Mean. 59 The Effective Annual Rate 60 Yield Definitions and Conventions. 61 Real Rate of Return 61 Expected Rate of Return 63 Measuring Risk 64 Calculating the Risk of a Single Asset 64 Required Returns and Risk Aversion 68 Sources of Risk 69 Risk and Investor Economic Decisions 71 Utility and Risk Aversion 71 Chapter Summary 73 Applying Economic Analysis 74 International Focus 75 Lessons of Our Times, 75 Key Concepts 76 Questions and Problems 11 Appendix: A Brief Review of the Time Value of Money 78 Part II FINANCIAL MARKETS, INTERMEDIARIES, AND INSTRUMENTS Chapter 4 The Global Financial Environment 85 Chapter Objectives 85 Introduction 85 The Functions of the Global Financial Market 86
5 x Contents Economic Function 86 Pricing Function 86 Provision of Services 87 Other Functions 88 * The Securities Exchanges 89 US Organized Stock Exchanges 90 US Over-the-Counter Securities Markets 93 Some US Stock Market Indexes 95 Some International Stock Exchanges 95 The London Stock Exchange 96 The Tokyo Stock Exchange 97 The Prague Stock Exchange 97 The Brazilian Stock Exchange 97 The US Bond Market 97 The International Bond Market 98 Trading on the Exchanges 99 Clearing Procedures 99 Brokerage Services 99 Trading Costs ' 100 Automatic Trading Mechanisms 102 Globalization and Regulatory Structure of International Stock Markets 104 Globalization and Trends 104 Investing Internationally and International Return 105 Regulatory Structures in the US Exchanges 107 Chapter Summary 108 Applying Economic Analysis 108 International Focus 109 Lessons of Our Times 109 Key Concepts 110 Questions and Problems 111 Appendix: Calculating a Stock Market Index 113 Chapter 5 Money and Capital Market Instruments and Strategies 115 Chapter Objectives 115 Introduction 115 The Money Market and Its Instruments 116 The Money Market and Its Characteristics 116 Money Market Instruments 117 Nonmarketable Securities 117 Marketable Securities 117 Treasury Bill 117
6 Contents xi Commercial Paper Bankers' Acceptances Repurchase Agreements Federal Funds LIBOR Eurocurrency Yields and Spreads in Money Market Instruments The Capital Market and Its Instruments The Capital Market and Its Characteristics Fixed-Income Securities Government Bonds Municipal Securities Agency Bonds Corporate Bonds Yields and Spreads in Capital Market Instruments Equity Securities Derivative Securities Investment Risks in Financial Markets Some Investment Strategies Some Money Market Investment Strategies Deposit and Liability Management Strategy Market-Neutral Strategy Pairs-Trading Strategy Some Capital Market Investment Strategies Enhanced Cash Management Strategy Top-Down and/or Bottom-Up Strategies Chapter Summary Applying Economic Analysis International Focus Lessons of Our Times Key Concepts Questions and Problems Chapter 6 Investment Bankers and Investment Companies Chapter Objectives Introduction Investment Banking The Primary Market Shelf Registration The Investment Banker Initial Public Offering The Investment Companies Industrv
7 xii Contents Functions of Investment Companies Types of Investment Companies Unit Investment Trust Closed-End Investment Companies Open-End Investment Companies Money Market Mutual Funds Equity Funds Bond Funds Index Funds International Funds Balanced Funds Asset Allocation Funds Fee Structure of Mutual Funds Performance of the Mutual Fund Industry Other Types of Investment Companies Real Estate Investment Funds Hedge Funds Exchange-Traded Funds Some Strategies in Mutual Fund Investments Chapter Summary Applying Economic Analysis International Focus Lessons of Our Times Key Concepts Questions and Problems Part HI Chapter 7 PORTFOLIO THEORY Diversification and Asset Allocation Chapter Objectives Introduction The Diversification Principle Types of Diversification Naive or Random Diversification International Diversification Efficient Diversification Covariance and Correlation The Asset Allocation Decision The Process of Asset Allocation Some Approaches to Asset Allocation Implementing Asset Allocation Approaches Examples of Asset Allocation
8 Contents xiii Risky Portfolios and Combined Portfolios 197 Some Practical Problems for Asset Allocation 201 The Capital Allocation Line 202 Borrowing and Lending Opportunities on the CAL 204 The Capital Market Line and Investment Strategies 206 Asset Allocation and Risk Aversion 207 Some Common Diversification Fallacies 209 The Insurance Principle 209 Time Diversification Chapter Summary 211 Applying Economic Analysis 211 International Focus 212 Lessons of Our Times 213 Key Concepts 213 Questions and Problems 214 Appendix A: Review of Regression Analysis 216 Appendix B: How to Compute the Covariance and Correlation in Excel 219 Chapter 8 Efficient Diversification and Capital Market Theory 221 Chapter Objectives 221 Introduction 221 The Markowitz Diversification Approach 222 The Markowitz Two-Asset Portfolio : 222 % The Optimal Risky Portfolio and the Capital Allocation Line 227 The Efficient Frontier 230 Capital Market Theory 232 The Capital Asset Pricing Model 232 Assumptions of the CAPM 233 Implications of the Assumptions 233 Implication Implication Implication The Capital and Security Market Lines 236 Uses of CAPM 239 Criticism of CAPM 239 The Arbitrage Pricing Theory 240 Comparing the CAPM and the APT 243 Portfolio Performance Evaluation 244 CAPM, APT, and Investment Decisions 246 Chapter Summary 247 Applying Economic Analysis 248
9 xiv Contents t The 130/30 Strategy 249 Lessons of Our Times 250 Key Concepts 250 Questions and Problems 251 Appendix A: How to Find and Graph the Optimal Two-Asset Portfolio Using EXCEL 254 Appendix B: The Single-Index Model 256 Chapter 9 Market Efficiency and Behavioral Finance 261 Chapter Objectives 261 Introduction 261 The Efficient Market Hypothesis 262 The Notion of Market Efficiency 262 The Forms of Market Efficiency 263 Weak Form 264 Semistrong Form 264 Strong Form 264 Implications for the Efficient Market Hypothesis 264 Implications for Technical Analysis Implications for Fundamental Analysis 266 Implications for Active and Passive Investment Strategies 269 Implications for Investment Managers 271 Implications for Asset Pricing Models 271 Anomalies and Tests of Market Efficiency ; 272 * Market Anomalies 273 Return Patterns 273 Day-of-the-Week Effect 273 January Effect 274 Short- and Long-Horizon Returns 274 Size and P/E Effects 276 Announcement Effects 276 Other Effects 278 Summary of Market Efficiency Tests 278 Weak Form of Market Efficiency 278 Semi-strong Form of Market Efficiency 279 Strong Form of Market Efficiency 279 Is the Stock Market Efficient? 279 Behavioral Finance 280 Biases in Information Processing 283 Biases in Behavior 283 Models of Human Behavior 285 Implications for Technical Analysis 286
10 Contents xv Chapter Summary 287 Applying Economic Analysis 288 International Focus 288 Lessons of Our Times 289 Key Concepts 290 Questions and Problems 291 Part IV EQUITY PORTFOLIO MANAGEMENT Chapter 10 Equity and Fundamental Analysis 297 Chapter Objectives 297 Introduction 297 Equity Securities 298 Common Stock Characteristics 298 Shareholder Equity 298 Shareholder Rights 298 Voting Privileges 299 Types of Common Stock 300 Dividends and Splits ' 300 Preferred Stock Characteristics 302 Stock Market Quotations 303 Management of an Equity Portfolio 304 Passive Equity Portfolio Management 304 Individual Investors } 304 ' Institutional Investors 305 Active Equity Portfolio Management 308 Individual Investors 308 Institutional Investors 309 International Equity Investing 310 Fundamental Analysis 311 Macroeconomic Analysis 312 Macroeconomic Magnitudes 313 Economic Policies 314 The Business Cycle 318 Industry Analysis 322 Chapter Summary 325 Applying Economic Analysis 325 International Focus 326 Lessons of Our Times 328 Key Concepts 328 Questions and Problems 330 Appendix: Guidelines for Conducting Industry Analysis 331
11 xvi Contents Chapter 11 Equity Valuation and Investment Strategies 333 Chapter Objectives 333 Introduction 333 Equity Prices and Returns 333 t Some General Valuation Measures 337 Book Value 337 Price/Book Value 338 Price/Sales Value. 338 Liquidation Value ~ " 338 Replacement Value 339 The Dividend Discount Model and Its Variants 340 The Dividend Discount Model 340 The Constant Growth Model 342 The Multistage Dividend Growth Model 345 Using Earnings Instead of Dividends 346 Other Equity Valuation Techniques 352 Present Value of Free Cash Flows 352 Options Valuation Approach 353 Economic Profit 355 Other Issues in Equity Valuation 356 The Impact of Inflation on Stock Values 356 Information Signals/Content of Dividends 356 The P/E Ratio and the Stock Market 357 Some Strategies on When to Buy/Sell Equities > 361 < When to Buy/Sell a Stock 361 Chapter Summary 363 Applying Economic Analysis 364 International Focus 364 Lessons of Our Times 365 Key Concepts 366 Questions and Problems 367 PartV DEBT SECURITIES Chapter 12 Bond Fundamentals and Valuation 373 Chapter Objectives 373 Introduction 373 Overview of the Global Bond Market 374 The International Bond Market 374 The US Bond Market 375 Overview of Bond Basics 376 Features of a Bond 376
12 Contents xvii Bond Types and Characteristics 376. By Type of Issuer 376 Government Bonds 376 Other Government and Government-related Bonds 378 Corporate Bonds 382 International Bonds and Eurobonds 382 By Bond Feature 383 By Other Characteristics 384 Default Risk ' Bond Determinants and Covenants 385 Junk Bonds 385 Bond Pricing 386 Basic Bond Valuation Formulas 386 The Inverse Relationship between Prices and Yields 388 Bond Yield Measures 393 Current Yield 393 Yield to Maturity 393 Yield to Put 394 Yield to Call \ 395 Duration and Convexity 395 Duration 395 Convexity 399 The Yield Curve 400 Theories Explaining the Shape of the Yield Curve 401 ^ Market Expectations Theory 402 Liquidity Preference Theory 403 Market Segmentation Theory. 404 Preferred Habitat Theory 404 Significance of the Yield Curve 404 A Simple Strategy Using the Yield Curve 406 Chapter Summary 407 Applying Economic Analysis 408 International Focus ' 409 Lessons of Our Times 409 Key Concepts 410 Questions and Problems 411 Chapter 13 Bond Portfolio Management and Performance Evaluation 415 Chapter Objectives 415 Introduction 415 Overview of the Bond Invstment Management Process 416 Identification of Investor Objectives and Constraints 416
13 xviii Contents Establishment of Investment Policy 417 Selection of a Bond Portfolio Management Strategy 419 Monitoring and Evaluating Portfolio Performance 420 Passive Bond Investment Strategies 420 t Buy-and-Hold Portfolio Strategy 421 Indexing Bond Strategies 421 Pure Indexing Strategy 422 Enhanced Indexing Strategy 423 Immunization Strategy '~ ' 423 Rebalancing 425 Dedication Strategy 427 Active Bond Portfolio Strategies 428 Interest Rate-Anticipation Strategy 428 Credit Analysis 429 Valuation Analysis 429 Bond Swap Strategies 429 Substitution Swap ' 430 Yield Swap 431 Yield Curve Strategies 432 Horizon Analysis 433 Other Active Management Strategies 434 Horizon Matching Technique 434 Contingent Immunization 435 Bond Portfolio Performance Measurement and Evaluation 435 ' Bond Portfolio Performance Measures 436 The Arithmetic Average Rate of Return 436 The Geometric Rate of Return 436 The Dollar-Weighted Rate of Return 436 Bond Portfolio Performance Evaluation 437 Performance Attribution Analysis 438 Bond Market Efficiency and Portfolio Management 441 Chapter Summary 441 Applying Economic Analysis 442 International Focus 443 Lessons of Our Times 444 Key Concepts 445 Questions and Problems 446 Part VI DERIVATIVE MARKETS AND INSTRUMENTS Chapter 14 Options Markets and Valuation 451 Chapter Objectives 451 Introduction 451
14 Contents xix Chapter 15 An Overview of the Options Market Basic Option Concepts Call and Put Option Concepts Profits and Losses on Options Options Payoffs at Expiration The Market for Options The Options Clearing Corporation Option Market Participants Options Products ~ Securities with Options Some Option Trading Strategies Covered Call Protective Put Some Practical Issues Collar Straddle Married Put Spread Strategies Speculating with Options Option Valuation Fundamental Option Valuation Concepts Binomial Option Pricing The Black-Scholes-Merton Option Valuation Model Using the Black-Scholes-Merton Formula Put-Call Parity Formula Using Stock Index Options Chapter Summary Applying Economic Analysis International Focus Lessons of Our Times Key Concepts Questions and Problems Futures Markets and Strategies Chapter Objectives Introduction The Futures Contract Elements of Futures Contracts The Clearinghouse Settlement and Margin Reversing Trades An Overview of the Futures Market Economic Functions of the Futures Market
15 xx Contents Price Discovery 498.Risk Reduction 499 Hedging 499 Speculating 499 t Regulation of Futures Markets 500 International Futures Exchanges 502 The Commodity Futures Market 503 Futures and Spot Prices, 505 Spot Futures Parity " 505 Basis Risk 507 Financial Futures Contracts 508 Some Financial Futures Contracts 508 Stock Index Futures 508 Interest Rate Futures 509 Currency Futures 510 Some Useful Information on Financial Futures 512 S&P Futures versus Fair Value 512 Leverage 513 Futures Trading Strategies Hedging 514 Speculating 515 Program Trading and Index Arbitrage 515 Using Currency Futures 517 Arbitrage Trading : Chapter Summary 517 Applying Economic Analysis 518 International Focus 519 Lessons of Our Times 519 Key Concepts 520 Questions and Problems 521 Chapter 16 Other Topics in Investments 524 Chapter Objectives 524 Introduction 524 International Parities and Some Strategies 524 Useful Concepts 525 Interest Rate Parity 525 Carry Trade 526 International Arbitrage 527 Credit Derivatives 528 The Market for Credit Derivatives 529 Credit Default Swap 529
16 Contents xxi Total Return Swap 531 Asset Swap 533 CoUateralized Debt Obligation 533 Alternative Investments 536 { What Are Alternative Investments? 536 Real Estate Investment Trusts 537 Hedge Funds 538 Private Equity 539 Infrastructure Funds " 539 Other Alternative Investments 541 Putting It All Together 542 Chapter Summary 544 Applying Economic Analysis 544 International Focus 546 Lessons of Our Times 546 Key Concepts 547 Questions and Problems 548 Appendix \ 551 Index. 557
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