ESSENTIALS 0/ INVESTMENTS

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1 ESSENTIALS 0/ INVESTMENTS Seventh Edition ZVI BODIE Boston University ALEX KANE University of California, San Diego ALAN J. MARCUS Boston College HOCHSCHULE LIECHTENSTEIN Bibliothek Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

2 CONTENTS Part ONE ELEMENTS OF INVESTMENTS 1 1 Investments: Background and Issues Real Assets versus Financial Assets A Taxonomy of Financial Assets Financial Markets and the Economy 6 The Informational Role of Financial Markets Consumption Timing 6 Allocation of Risk 7 Separation of Ownership and Management 7 Corporate Governance and Corporate Ethics 1.4 The Investment Process Markets Are Competitive 10 ' The Risk-Return Trade-Off 10 Efficient Markets The Players 12 Financial Intermediaries 12 Investment Bankers Recent Trends 15 Globalization 15 Securitization 16 Financial Engineering 17 Computer Networks Outline of the Text 19 Summary 20 2 Asset Classes and Financial Instruments The Money Market 25 Treasury Bills 25 Certificates of Deposit 27 Commercial Paper 28 Bankers' Acceptances 28 Eurodollars 28 Repos and Reverses 28 Brokers'Calls 29 Federal Funds 29 The LIBOR Market 29 Yields on Money Market Instruments The Bond Market 30 Treasury Notes and Bonds 30 Inflation-Protected Treasury Bonds 31 Federal Agency Debt 32 International Bonds 32 Municipal Bonds 32 Corporate Bonds 35 Mortgages and Mortgage-Backed Securities 2.3 Equity Securities 37 Common Stock as Ownership Shares 37 Characteristics of Common Stock Stock Market Listings 38 Preferred Stock 39 Depository Receipts Stock and Bond Market Indexes 40 Stock Market Indexes 40 Dow Jones Averages 40 Standard & Poor's Indexes 44 Other U.S. Market Value Indexes 45 Equally Weighted Indexes 46 Foreign and International Stock Market Indexes 46 Bond Market Indicators Derivative Markets 46 Options 46 Futures Contracts 50 Summary 51 3 Securities Markets How Firms Issue Securities 56 Investment Banking 56 Shelf Registration 57 *'& Private Placements 58 Initial Public Offerings 58 35

3 3.2 How Securities Are Traded 60 Types of Markets 61 > ZttOrt Types of Orders 62 'A\r'ff in- Trading Mechanisms 64 ' 3.3 U.S. Securities Markets 66 >»\wo Nasdaq 66 ^ ^ >.««"«M-VJ The New York Stock Exchange 67 Electronic Communication Networks 70 The National Market System 70 Bond Trading Market Structure in Other Countries 71 London 71 Euronext 72 Tokyo 72 Globalization and Consolidation of Stock Markets Trading Costs Buying on Margin Short Sales Regulation of Securities Markets 79 Self-Regulation 80 ~ Regulatory Responses to Recent Scandals 80 Circuit Breakers 82 \ Insider Trading 82 Summary V , Mutual Funds and Other Investment Companies 89 < Investment Companies 90 xl "? - Types of Investment Companies 91 Unit Investment Trusts 91 Managed Investment Companies 91 Other Investment Organizations 93 Mutual Funds 94 < 'A mvm>nvuan\ Investment Policies 94 How Funds Are Sold 96 Costs of Investing in Mutual Funds 97 Fee Structure 97 Fees and Mutual Fund Returns 99 & Late Trading and Market Timing 101 Other Potential Reforms 102 Taxation of Mutual Fund Income 102 Exchange-Traded Funds 103 -*IMIT.> Mutual Fund Investment Performance: A First Look 104 Information on Mutual Funds Summary 111 f-8 c a intt/2 Part TWO PORTFOLIO THEORY Risk and Return: Past and Prologue Rates of Return 117 ; " Measuring Investment Returns over Multiple Periods 117 Conventions for Quoting Rates of Return Risk and Risk Premiums 120 Scenario Analysis and Probability Distributions 121 Risk Premiums and Risk Aversion 123 The Sharpe ('Reward-to-Volatility) 5.3 Measure 124 The Historical Record 125 Bills, Bonds, and Stocks, Inflation and Real Rates of Return 131 The Equilibrium Nominal Rate of Interest 132 Asset Allocation across Risky and Risk-Free Portfolios 133 The Risky Asset 134 The Risk-Free Asset 135 Portfolio Expected Return and Risk 136 The Capital Allocation Line 137 Risk Tolerance and Asset Allocation Passive Strategies and the Capital Market Line 139 : - V ' 41 * Historical Evidence on the Capital Market Line 140 Costs and Benefits of Passive Investing 141 Summary , Efficient Diversification 149 Diversification and Portfolio Risk 150 Asset Allocation with Two Risky Assets 152 Covariance and Correlation 152 Using Historical Data 155 The Three Rules of Two-Risky-Assets Portfolios 157 * ' The Risk-Return Trade-Off with Two-Risky- Assets Portfolios 157 The Mean-Variance Criterion 159 The Optimal Risky Portfolio with a Risk-Free Asset 164 Efficient Diversification with Many Risky Assets 168 The Efficient Frontier of Risky Assets 168

4 Choosing the Optimal Risky Portfolio 170 The Preferred Complete Portfolio and the Separation Property A Single-Factor Asset Market 171 Specification of a Single-Index Model of Security Returns 172 Statistical and Graphical Representation of the Single-Index Model 173 Diversification in a Single-Factor Security Market Risk of Long-Term Investments 178 Are Stock Returns Less Risky in the Long Run? 178 The Fly in the "Tune Diversification" Ointment (or More Accurately, the Snake Oil) 179 Summary Capital Asset Pricing and Arbitrage Pricing Theory The Capital Asset Pricing Model 193 Why All Investors Would Hold the Market Portfolio 194 The Passive Strategy Is Efficient 195 The Risk Premium of the Market Portfolio 196 Expected Returns on Individual Securities 196 The Security Market Line 198 Applications of the CAPM The CAPM and Index Models 200 ],t The Index Model, Realized Returns, and the Expected Return-Beta Relationship 201 Estimating the Index Model 202 Predicting Betas The CAPM and the Real World Multifactor Models and the CAPM 211 The Fama-French Three-Factor Model 212 Factor Models with Macroeconomic Variables 215 Multifactor Models and the Validity of the CAPM Factor Models and the Arbitrage Pricing Theory 216 Well-Diversified Portfolios and Arbitrage Pricing Theory 216 The APT and the CAPM 218 Multifactor Generalization of the APT and CAPM 219 Summary The Efficient Market Hypothesis Random Walks and the Efficient Market Hypothesis 232 Competition as the Source of Efficiency 233 Versions of the Efficient Market Hypothesis Implications of the EMH 235 Technical Analysis 235 Fundamental Analysis 237 ^ Active versus Passive Portfolio» r Management 238 The Role of Portfolio Management in an Efficient Market 239 Resource Allocation Are Markets Efficient? 240 The Issues 240 Weak-Form Tests: Patterns in Stock Returns 242 Predictors of Broad Market Returns 243 Semistrong Tests: Market Anomalies 243 Strong-Form Tests: Inside Information 247 Interpreting the Evidence 248 The "Noisy Market Hypothesis" and Fundamental Indexing Mutual Fund and Analyst Performance 250 Stock Market Analysts 250 Mutual Fund Managers 251 Survivorship Bias in Mutual Fund Studies 254 So, Are Markets Efficient? 255 Summary Behavioral Finance and Technical Analysis The Behavioral Critique 263 Information Processing 264.fc Behavioral Biases 265 Limits to Arbitrage 267 Limits to Arbitrage and the Law of One Price 269 Bubbles and Behavioral Economics 271 Evaluating the Behavioral Critique Technical Analysis and Behavioral Finance 273 ; j> Trends and Corrections 273 Sentiment Indicators 280 * ^ h A Warning 281 Summary 282

5 Part THREE DEBT SECURITIES Bond Prices and Yields Bond Characteristics 291 Treasury Bonds and Notes 291 Corporate Bonds 293 Preferred Stock 295 Other Domestic Issuers 295 International Bonds 295 Innovation in the Bond Market Bond Pricing 298 Bond Pricing between Coupon Dates 301 Bond Pricing in Excel Bond Yields 302 Yield to Maturity 303 Yield to Call 305 Realized Compound Return versus Yield to Maturity Bond Prices over Time 308 Yield to Maturity versus Holding-Period Return 310 Zero-Coupon Bonds and Treasury STRIPS 311 After-Tax Returns Default Risk and Bond Pricing 312 Junk Bonds 313 Determinants of Bond Safety 313 Bond Indentures 315 Yield to Maturity and Default Risk The Yield Curve 318 The Expectations Theory 319 The Liquidity Preference Theory 322 A Synthesis 323 Summary Managing Bond Portfolios Interest Rate Risk 334 Interest Rate Sensitivity 334 Duration 336 What Determines Duration? Passive Bond Management 343 Immunization 343 Cash Flow Matching and Dedication Convexity 350 Why Do Investors Like Convexity? Active Bond Management 353 Sources of Potential Profit 353 Horizon Analysis 355 Contingent Immunization 355 An Example of a Fixed-Income Investment Strategy 357 Summary 358 Part FOUR SECURITY ANALYSIS Macroeconomic and Industry Analysis The Global Economy The Domestic Macroeconomy 373 Gross Domestic Product 373 Employment 374 Inflation 374 Interest Rates 374 Budget Deficit 374 Sentiment Interest Rates Demand and Supply Shocks Federal Government Policy 377 Fiscal Policy 377 Monetary Policy 377 Supply-Side Policies Business Cycles 379 The Business Cycle 379 Economic Indicators 381 Other Indicators Industry Analysis 385 Defining an Industry 386 Sensitivity to the Business Cycle 387 Sector Rotation 388 Industry Life Cycles 389 Industry Structure and Performance 393 Summary Equity Valuation 401 ' 13.1 Valuation by Comparables 402 Limitations of Book Value Intrinsic Value versus Market Price Dividend Discount Models 405 The Constant Growth DDM 406 Stock Prices and Investment Opportunities Life Cycles and Multistage Growth Models Multistage Growth Models 416 s* i rip

6 xii 13.4 Price-Earnings Ratios 417 The Price-Earnings Ratio and Growth Opportunities 417 P/E Ratios and Stock Risk 421 Pitfalls in P/E Analysis 422 Combining P/E Analysis and the DDM 425?. Other Comparative Valuation Ratios Free Cash Flow Valuation Approaches 427 Comparing the Valuation Models The Aggregate Stock Market 430 Summary 432 f 14 Financial Statement Analysis The Major Financial Statements 443 The Income Statement 443 The Balance Sheet 444 The Statement of Cash Flows Accounting versus Economic Earnings Profitability Measures 447 Past versus Future ROE 447 Financial Leverage and ROE Ratio Analysis 449 Decomposition of ROE 449 Turnover and Other Asset Utilization Ratios 451 Liquidity Ratios 453 Market Price Ratios 454 Choosing a Benchmark Economic Value Added An Illustration of Financial Statement Analysis Comparability Problems 460 Inventory Valuation 461 Depreciation Inflation and Interest Expense 462 Fair Value Accounting 463 Quality of Earnings and Accounting *W-Practices 464 International Accounting Conventions Value Investing: The Graham Technique 466 Summary 467 f t j Part FIVE DERIVATIVE MARKETS 479 v t! 15 Options Markets The Option Contract 481 Options Trading 482 American and European Options 484 The Option Clearing Corporation 484 Other Listed Options Values of Options at Expiration 486 Call Options 486 % Put Options Options versus Stock Investments 489 Option Strategies 492 Collars 498,, k^v\ 15.3 Optionlike Securities *Q Callable Bonds 500 \ Convertible Securities 500,, Warrants 503 Collateralized Loans 503 Leveraged Equity and Risky Debt Exotic Options 505 >i Asian Options 505 Barrier Options 505 Lookback Options 505 Currency-Translated Options 505 Digital Options 507 Summary Option Valuation Option Valuation: Introduction 518 Intrinsic and Time Values 518 Determinants of Option Values Binomial Option Pricing 520 Two-State Option Pricing 520 Generalizing the Two-State Approach 523,0f MM 16.3 Black-Scholes Option Valuation 526 The Black-Scholes Formula 527 ' d.ot The Put-Call Parity Relationship 533 Put Option Valuation Using the Black-Scholes Formula 537 Hedge Ratios and the Black-Scholes Formula 537 Portfolio Insurance Empirical Evidence 542 Summary rr r.rr Futures Markets and Risk Management 552 -\ ff 17.1 The Futures Contract 553, A \ The Basics of Futures Contracts 553 Existing Contracts Mechanics of Trading in Futures Markets 558 The Clearinghouse and Open Interest 558 Marking to Market and the Margin Account 560

7 xlii I Cash versus Actual Delivery 562 Regulations 562 Taxation Futures Market Strategies 563 Hedging and Speculation 563 Basis Risk and Hedging The Determination of Futures Prices 566 Spot-Futures Parity 566 Spreads Financial Futures 571 Stock Index Futures 571 Creating Synthetic Stock Positions 572 Index Arbitrage 573 Foreign Exchange Futures 573 Interest Rate Futures Swaps 577 Swaps and Balance Sheet Restructuring 578 The Swap Dealer 578 Summary 579 Part SIX ACTIVE INVESTMENT MANAGEMENT Performance Evaluation and Active Portfolio Management Risk-Adjusted Returns 589 Comparison Groups 589 Risk Adjustments 589 The M 2 Measure of Performance 591 Choosing the Right Measure of Risk 592 Risk Adjustments with Changing Portfolio Composition Style Analysis Morningstar's Risk-Adjusted Rating Performance Attribution Procedures 601 Asset Allocation Decisions 602 Sector and Security Selection Decisions 603 Summing Up Component Contributions The Lure of Active Management 605 Objectives of Active Portfolios Market Timing 608 Valuing Market Timing as an Option 609 The Value of Imperfect Forecasting 610 Measurement of Market Timing Performance Security Selection: The Treynor-Black Model 611 Overview of the Treynor-Black Model 611 Portfolio Construction 612 Summary Globalization and International Investing Global Markets for Equities 622 Developed Countries 622 Emerging Markets 622 Market Capitalization and GDP 625 Home-Country Bias Risk Factors in International Investing 626 Exchange Rate Risk 626 Imperfect Exchange Rate Risk Hedging 631 Country-Specific Risk International Investing: Risk, Return, and Benefits from Diversification 635 Risk and Return: Summary Statistics 635 Are Investments in Emerging Markets Riskier? 635 Are Average Returns Higher in Emerging Markets? 638 Is Exchange Rate Risk Important in International Portfolios? 640 Benefits from International Diversification 641 Misleading Representation of Diversification Benefits 644 Realistic Benefits from International Diversification 644 Are Benefits from International Diversification Preserved in Bear Markets? How to Go About International Diversification and the Benefit We Can Expect 647 Choosing among Efficient Portfolios 647 Choosing Lowest Beta or Covariance Indexes 648 Choosing Largest Capitalization Indexes 648 What We Can Expect from International Diversification International Investing and Performance Attribution 649 Constructing a Benchmark Portfolio of Foreign Assets 649 Performance Attribution 650 Summary Taxes, Inflation, and Investment Strategy Saving for the Long Run 658 A Hypothetical Household 658

8 The Retirement Annuity Accounting for Inflation 660 A Real Savings Plan 660 An Alternative Savings Plan 661 "" Of 20.3 Accounting for Taxes The Economics of Tax Shelters 664 A Benchmark Tax Shelter 664 su 1 *--" i3 The Effect of the Progressive Nature of the Tax Code A Menu of Tax Shelters 667, AX -.,. Individual Retirement Accounts Roth IRA with the Progressive Tax Code 667 ' ". 401k and 403b Plans 668 p Risky Investments and Capital Gains as Tax Shelters 669 Sheltered versus Unsheltered Savings Social Security 671 The Indexing Factor Series 672 The Average Indexed Monthly Income 672 The Primary Insurance Amount Children's Education and Large Purchases Home Ownership: The Rent-versus-Buy Decision Uncertain Longevity and Other Contingencies Matrimony, Bequest, and Intergenerational Transfers 677 Summary Investors and the Investment Process Investors and Objectives 682 ^ (II H l.i I I Individual Investors 682 iwash Professional Investors 684 "\ 15.2 Life Insurance Companies 686 Non-Life-insurance Companies 687 Banks 687 Endowment Funds Investor Constraints 688 Liquidity Investment Horizon 688 Regulations 688 i Tax Considerations 689 '& Unique Needs 689 } 21.3 Objectives and Constraints of Various \ Investors 689 V Objectives 690 Constraints Investment Policies 691 Top-Down Policies for Institutional J Investors 692 -g. Active versus Passive Policies Monitoring and Revising Investment Portfolios 695 : Summary 695 ' Ki i 3VIT JA Annp»nrliv*ac /y^jcjafiam nuuci IUIAC9 A References 701 8f B References to CFA Questions 707 Index ,? hut: Vjj/it/ 1 Ki i Part F DERIVATI \ Jftnmfomfl u mmii'd., I. >. r T.sr

PRINCIPLES of INVESTMENTS

PRINCIPLES of INVESTMENTS Boston University MICHAItL L D\if.\N Griffith University AN UP BASU Queensland University of Technology ALEX KANT; University of California, San Diego ALAN J. AAARCU5 Boston College