Security Analysis, Portfolio Management,

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1 Security Analysis, Portfolio Management, and Financial Derivatives

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3 Security Analysis, Portfolio Management, and Financial Derivatives Cheng Few Lee Rutgers University, USA Joseph Finnerty University of Illinois, Urbana-Champaign, USA John Lee Center for PBBEF Research, USA Alice C Lee State Street Corp., USA Donald Wort California State University East Bay, USA World Scientific NEW JERSEY LONDON SINGAPORE BEIJING SHANGHAI HONG KONG TAIPEI CHENNAI

4 Published by World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore USA office: 27 Warren Street, Suite , Hackensack, NJ UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. SECURITY ANALYSIS, PORTFOLIO MANAGEMENT, AND FINANCIAL DERIVATIVES Copyright 2013 by World Scientific Publishing Co. Pte. Ltd. All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher. For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy is not required from the publisher. ISBN In-house Editor: Agnes Ng Typeset by Stallion Press enquiries@stallionpress.com Printed in Singapore.

5 Preface In this edition, we have extensively updated and expanded the topics of futures and option. Therefore, we use a new title Security Analysis, Portfolio Management, and Financial Derivatives. The major changes of this edition are described as follows: (A) Update and expansion of the material of original chapters. (B) Update of empirical examples in original chapters. (C) There are 27 chapters in this edition. The new chapters included in this new edition are as follows: Chapter 18 Decision Tree and Microsoft Excel Approach for OPM Chapter 19 Normal, Log-normal Distribution, and Option Pricing Model Chapter 20 Comparative Static Analysis of the Option Pricing Models Chapter 25 Capturing Equity Risk Premia Chapter 26 Simultaneous Equation Models for Security Valuation (D) The chapters in this book fall into five parts: (i) Information and Security Valuation, (ii) Portfolio Theory and Asset Pricing, (iii) Futures and Option, (iv) Applied Portfolio Management, and (v) Special Topics. Based upon our personal teaching experience at various universities, we find that this book can be used in an investment analysis course, portfolio management course, or option and futures course. For an investment analysis course, we suggest instructors cover Chapters 2, 3, 4, 5, 6, 7, 8, 9, 12, 13, 21, 22, 25, and 26. For a portfolio management course, we suggest instructors cover Chapters 3, 4, 5, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 21, 22, 23, 24, and 25. For option and future course, we suggest instructors cover Chapters 14, 15, 16, 17, 18, 19, 20, 22, 23, 24, and 27. v

6 vi Security Analysis, Portfolio Management, and Financial Derivatives We suggest project assignments for Parts I, II, III, and IV. Chapter 25 can be used as a reference for both Project II and Project IV. Chapter 26 can be used as a reference for Project I. Chapter 27 can be used as a reference for Project III. For this edition, we appreciate the comments from our MBA and undergraduate students at Rutgers University, University of Illinois Champaign and Urbana, and California State University, Hayward. In addition, we appreciate the help from our research assistant Hong-Yi Chen, Tzu Tai, and Miranda Lu. In particular, the extensive help from Hong-Yi Chen at National Central University, Taiwan, is most appreciated. Finally, we would like to express our thanks for the financial support from the Wintek Corporation and the Polaris Financial Group that allowed us to write this second edition. There are undoubtedly some errors in the finished product, both typographical and conceptual. We would like to invite readers to send suggestions, comments, criticisms, and corrections to the first author Professor Cheng F. Lee at the Department of Finance and Economics, Rutgers University, Janice H. Levin Building Room 141, Rockafeller Road, Piscataway, NJ , USA (lee@business.rutgers.edu). Cheng Few Lee Joseph Finnerty John Lee Alice C. Lee Donald Wort Any views or opinions presented in this publication are solely those of the authors and do not necessarily represent those of State Street Corporation. State Street Corporation is not associated in any way with this publication and accepts no liability for the contents of this publication.

7 Preface for Security Analysis and Portfolio Management Security Analysis and Portfolio Management integrates the many topics of modern investment analysis. It provides a balanced presentation of theories, institutions, markets, academic research, and practical applications, and presents both basic concepts and advanced principles. Topic coverage is especially broad: in analyzing securities, we look at stocks and bonds, options and futures, foreign exchange, and international securities. The discussion of options and futures includes a detailed analysis of hedging strategies. A unique chapter on market indices teaches students the basics of index information, calculation, and usage and illustrates the important roles that these indices play in model formation, performance evaluation, investment strategy, and hedging techniques. In addition, complete sections on program trading, portfolio insurance, duration and bond immunization, performance measurements, and the timing of stock selection provide realworld applications of investment theory. Security Analysis and Portfolio Management first discusses how finance theory and statistical and mathematical tools can be used effectively to analyze and determine the market value of bonds, stocks, options, futures, and options on futures. Second, based on this information, the text investigates issues related to equity portfolios, bond portfolios, and international portfolios. For equity-portfolio selection, the text discusses Markowitz s full-information methods, Sharpe s index methods, and the performance measure method. Finally, the efficient-market hypothesis, mutualfund timing and selectivity, and portfolio insurance are also explored in detail. The chapters in this book fall into five groups. The material in Chapters 2 7 review and extend the concepts and methods that students have learned from basic corporate finance and investment courses. vii

8 viii Security Analysis, Portfolio Management, and Financial Derivatives Chapters 8 11 present both the theoretical and empirical issues concerning the use of the market model, the CAPM, the APT, and risk diversification in security analysis and portfolio management. Chapters use the theories and methods presented in the first 11 chapters to investigate futures and options. Chapters cover applications of portfolio theories and models developed in the preceding chapters. Finally, Chapter 22 is meant only for advanced students who require an in-depth derivation of the Black Scholes option pricing model in terms of stochastic differential equations. It can be skipped over without loss of continuity. Accounting information is essential for business decision making because it describes both the financial assets and the real assets of a firm. Historical accounting information has been used extensively by security analysis and portfolio managers, while proponents of the semi-strong form of the efficient-market hypothesis regard such information as valueless. In Chapter 2, ratio analysis, regression analysis, and earnings-per-share estimation are considered. The use of financial information in security analysis is emphasized. The role of the investment advisor in evaluating and rating the financial instruments of various companies is employed as an example of the ways that accounting information can be used to make valuation recommendations. Chapter 3 deals with the measurement and the growth determination of rates of return on security investments. In addition to defining the holdingperiod return and the holding-period yield, three alternative methods for calculating average rates of return are discussed. These estimates can be used either to determine historical investment performance or to forecast future performance. It is known that a weighted unbiased estimator can be used to reduce or eliminate the bias in forecasting rates of return. Alternative methods of estimating growth rates are also discussed in Chapter 3. The relative advantages of these alternative methods are explored both theoretically and empirically. Possible applications of growth-rates estimation in security analysis and portfolio management are discussed. Chapter 4 reviews both pre-modigliani and Miller and M&M valuation theories in detail. The basic concepts of the capital asset pricing model (CAPM) and the option pricing model are also explored in order to construct a rectangular theoretical framework of valuation. This chapter reviews basic theories that students have learned from a first course on either financial management or investment. Topics in this chapter can be

9 Preface for First Edition ix used as a review or as major theoretical background for understanding later chapters of this text. Chapter 5 extends the valuation analysis to the specific case of the debt instruments of corporations. Issues related to the yield curve, the term structure of interest rates, and bonds ratings are carefully analyzed. Chapter 6 discusses the computation of alternative market indices and examines the possible biases associated with using these indexes in investment analysis. The historical behavior of market indices and index forecasting are also explored. The Wilshire 5000 index is discussed in detail. In Chapter 7, sources of risk and basic portfolio analysis are investigated and used as a framework for further analysis of the CAPM and the market model. Chapter 8 discusses utility theory and Markowitz s fullinformation model of portfolio selection in detail. In Chapter 9, the market model and the CAPM are evaluated both theoretically and empirically. The applications of the market model to risk decomposition are analyzed using both fixed-coefficient regression models. Methods of forecasting beta coefficients are explored, using both accounting and market information. Chapter 10 addresses how Markowitz s full-information portfolioselection process can be simplified through the use of index models. In Chapter 11, multi-index models and the arbitrage pricing theory (APT) are discussed from both a theoretical and an empirical basis. Chapter 12 discusses the basic issues of futures markets and futures contracts. In addition, two alternative hedging methods are investigated in detail. Chapter 13 explores the use of commodity futures, financial futures, and stock-index futures. The valuation of these futures and their use in hedging is investigated. Chapters 14 and 15 outline the basic concepts of put and call options, and the option pricing model is derived using a binomial-model approach. Alternative applications of the option pricing theory (OPT) in the making of investment decisions are explored in detail. Chapter 16 deals with the concept of an efficient market and the empirical evidence that supports or refutes this hypothesis. The implications of market efficiency for security analysts and portfolio managers are also stressed. Chapter 17 discusses timing and selectivity of stocks and mutual funds from both a fundamental-analysis and technical-analysis perspective. Some forecasting models are examined, and Fama s breakdown of overall investment performance into several specific components is also covered. Chapter 18 illustrates how the Sharpe and Treynor performance measures can be used to simplify the portfolio-selection procedure. In Chapter 19, issues relating to international diversification, exchange-rate

10 x Security Analysis, Portfolio Management, and Financial Derivatives risk, the international CAPM, and international portfolio-selection methods are investigated in detail. Chapter 20 presents a discussion of the issues involved in the management of a fixed-income portfolio. Both duration and bond immunization are carefully analyzed in this chapter. Chapter 21 examines the use of hedging and portfolio-insurance strategies for equity and bond portfolio. This book is suitable for a second investment course at both the undergraduate and the graduate level. However, because Security Analysis and Portfolio Management addresses both the theoretical and the empirical sides of issues, and because it discusses both basic concepts and more advanced topics, it is suitable for a more quantitatively oriented first course in investment. In the development of this book, we have benefited from the reviews and comments of many individuals, including colleagues and students from the University of Illinois at Urbana-Champaign and other universities. We especially want to acknowledge the insightful comments and corrections of Louis Scott, University of Georgia; Steve Sears, Texas Tech; Cheryl Frohlich-Plumber, University of North Florida; Kent Zumwalt, Colorado State University; Henry R. Oppenheimer, Rhode Island University; A. G. Malliaris, Loyala University; Charles Corrado, Loyala University; Ron Moy, Rutgers University; John C. Lee, Laventhol and Horwath; C. C. Yang, National Taiwan University; and Raymond Altimix, First of America Bank. Cheng Few Lee Joseph Finnerty Donald Wort

11 Contents in Brief Preface v Preface for Security Analysis and Portfolio Management vii 1. Introduction 1 2. Accounting Information and Regression Analysis Common Stock: Return, Growth, and Risk Introduction to Valuation Theories Bond Valuation and Analysis The Uses and Calculation of Market Indexes Sources of Risks and Their Determination Risk-Aversion, Capital Asset Allocation, and Markowitz 265 Portfolio-Selection Model 9. Capital Asset Pricing Model and Beta Forecasting Index Models for Portfolio Selection Performance-Measure Approaches for Selecting Optimum 399 Portfolios 12. The Efficient-Market Hypothesis and Security Valuation Arbitrage Pricing Theory and Intertemporal Capital Asset 469 Pricing Model 14. Futures Valuation and Hedging Commodity Futures, Financial Futures, and Stock-Index 557 Futures 16. Options and Option Strategies Option Pricing Theory and Firm Valuation Decision Tree and Microsoft Excel Approach for Option 705 Pricing Model 19. Normal, Log-Normal Distribution, and Option Pricing Model Comparative Static Analysis of the Option Pricing Models Security Analysis and Mutual Fund Performance 809 xi

12 xii Security Analysis, Portfolio Management, and Financial Derivatives 22. International Diversification and Asset Pricing Bond Portfolios: Management and Strategy Portfolio Insurance and Synthetic Options Capturing Equity Risk Premia Simultaneous Equation Models for Security Valuation Itô s Calculus: Derivation of the Black Scholes Option Pricing Model 1081 Appendix Tables 1117 Acknowledgments 1123 Author Index 1129 Subject Index 1139

13 Preface Contents Preface for Security Analysis and Portfolio Management 1. Introduction Objective of Security Analysis Objective of Portfolio Management Basic Approaches to Security Analysis and Portfolio Management SourceofInformation Structure of the Book Summary Questions and Problems Bibliography for Chapter Part I Information and Security Valuation Accounting Information and Regression Analysis Introduction Financial Statements: A Brief Review Balance Sheet Statement of Earnings Statement of Equity Statement of Cash Flows v vii xiii

14 xiv Security Analysis, Portfolio Management, and Financial Derivatives Interrelationship among Four Financial Statements Annual Versus Quarterly Financial Data Critique of Accounting Information Criticism Methods for Improvement Use of Alternative Information Statistical Adjustments Application of Finance and Economic Theories Static Ratio Analysis and Its Extension Static Determination of Financial Ratios Liquidity Ratios Leverage Ratios Activity Ratios Profitability Ratios Estimation of the Target ofaratio Dynamic Analysis of Financial Ratios Single-Equation Dynamic AdjustmentProcess Simultaneous Determination of Financial Ratios Statistical Distribution of Financial Ratios Cost Volume-Profit Analysis and its Applications Deterministic Analysis Stochastic Analysis Accounting Income Versus Economic Income Summary Questions and Problems Appendix 2A: Simple Regression and Multiple Regression A.1 Introduction A.2 Simple Regression

15 Contents xv Appendix 2B: Instrumental Variables and Two-Stages Least Squares B.1 Errors-in-Variable Problem B.2 Instrumental Variables B.3 Two-Stage, Least-Square Bibliography to Appendix Bibliography for Chapter Common Stock: Return, Growth, and Risk Holding-PeriodReturn Holding-PeriodYield Arithmetic Mean Geometric Mean Weighted Unbiased Mean Common-Stock Valuation Approaches Growth-Rate Estimation and its Application Compound-Sum Method Regression Method One-Period Growth Model Two-Period Growth Model Three-Period Growth Model Risk Definitions of Risk Sources of Risk Firm-Specific Factors Market and Economic Factors Covariance and Correlation Systematic Risk, Unsystematic Risk, and the Market Model Summary Questions and Problems Appendix 3A: Logarithms and their Properties Bibliography for Chapter Introduction to Valuation Theories Discounted Cash-Flow Valuation Theory Bond Valuation

16 xvi Security Analysis, Portfolio Management, and Financial Derivatives Perpetuity Term Bonds Common-Stock Valuation M&M Valuation Theory Review and Extension of M&M Proposition I Miller s Proposition on Debt and Taxes The Tax Reform Act of 1986 and Its Impact onfirmvalue Corporate Response to the Tax Reform Act of Capital Asset Pricing Model Option Valuation Summary Questions and Problems Bibliography for Chapter Bond Valuation and Analysis Bond Fundamentals Type of Issuer U.S. Treasury Federal Agencies Municipalities Corporations Bond Provisions Maturity Classes Mortgage Bond Debentures Coupons Maturity Callability Sinking Funds Bond Valuation, Bond Index, and Bond Beta Bond Valuation Bond Indices Bond Beta Bond-Rating Procedures

17 Contents xvii 5.4. Term Structure of Interest Theory Estimation Convertible Bonds and their Valuation Summary Questions and Problems Appendix 5A: Worksheets for Yield Curves Bibliography for Chapter The Uses and Calculation of Market Indexes Alternative Methods for Compilation of Stock andpriceindexes Price-Weighted and Quantity-Weighted Indexes Value-Weighted Indexes Alternative Market Indexes Dow Jones Industrial Average Standard & Poor s Composite 500 Index New York Stock Exchange Composite Index Wilshire 5000 Equity Index Standard & Poor s Composite 100 Index The User and Uses of Market Indexes Historical Behavior of Market Indexes and the Implications of their Use for Forecasting Historical Behavior Implications Market-Index Proxy Errors and their Impact on Beta Estimates and Efficient-Market-Hypothesis Tests Index-Proxy Error, Performance Measure, and the EMH Test Summary Questions and Problems Appendix 6A: Monthly Returns for the Wilshire 5000 Equity Indexes Bibliography for Chapter

18 xviii Security Analysis, Portfolio Management, and Financial Derivatives Project I Financial Statement Analysis and Security Valuation Part II Portfolio Theory and Asset Pricing Sources of Risks and Their Determination Risk Classification and Measurement Call Risk Convertible Risk Default Risk Interest-Rate Risk Management Risk Marketability (Liquidity) Risk Political Risk Purchasing-Power Risk Systematic and Unsystematic Risk Portfolio Analysis and Application Expected Return on a Portfolio Variance and Standard Deviation of a Portfolio The Two-Asset Case Asset Allocation among Risk-Free Asset, Corporate Bond, and Equity The Efficient Portfolio and Risk Diversification The Efficient Portfolio Corporate Application of Diversification The Dominance Principle Three Performance Measures Interrelationship among Three Performance Measures Determination of Commercial Lending Rate The Market Rate of Return and Market Risk Premium Summary Questions and Problems Bibliography for Chapter

19 Contents xix 8. Risk-Aversion, Capital Asset Allocation, and Markowitz Portfolio-Selection Model Utility Theory, Utility Functions, and Indifference Curves Utility Theory Utility Functions Linear Utility Function and Risk Concave Utility Function and Risk Risk Aversion and Asset Allocation Indifference Curves Efficient Portfolios Portfolio Combinations Short Selling Techniques for Calculating the Efficient Frontier with Short Selling The Normal Distribution The Log-Normal Distribution Mathematical Method to Calculate Efficient Frontier Portfolio Determination with Specific Adjustment for Short Selling Portfolio Determination without Short Selling Summary Questions and Problems Appendix 8A. Graphical Analysis in Markowitz Portfolio-Selection Model: Three-Security Empirical Solution Bibliography for Chapter Capital Asset Pricing Model and Beta Forecasting A Graphical Approach to the Derivation of the CAPM

20 xx Security Analysis, Portfolio Management, and Financial Derivatives The Lending, Borrowing, and Market Portfolios The Capital Market Line The Security Market Line The Capital Asset Pricing Model Mathematical Approach to the Derivation of the CAPM The Market Model and Risk Decomposition The Market Model Risk Decomposition Why Beta is Important for Security Analysis Determination of Systematic Risk Growth Rates, Accounting Betas, and Variance in EBIT Sustainable Growth Rates Accounting Beta Variance in EBIT Capital Labor Ratio Fixed Costs and Variable Costs Beta Forecasting Market-Based Versus Accounting-Based Beta Forecasting Some Applications and Implications of the CAPM Summary Questions and Problems Appendix 9A: Empirical Evidence for the Risk Return Relationship A.1 Anomalies in the Semi-Strong Efficient-Market Hypothesis Bibliography for Chapter Index Models for Portfolio Selection The Single-Index Model Deriving the Single-Index Model Expected Return of a Portfolio Variance of a Portfolio Portfolio Analysis and the Single-Index Model

21 Contents xxi The Market Model and Beta Multiple Indexes and the MIM Summary Questions and Problems Appendix 10A: A Linear-Programming Approach to Portfolio-Analysis Models Appendix 10B: Expected Return, Variance, and Covariance foranmim Appendix 10C: Using Microsoft Excel to Calculate Optimal Weights of a Portfolio Bibliography for Chapter Performance-Measure Approaches for Selecting Optimum Portfolios Sharpe Performance-Measure Approach With Short Sales Allowed Treynor-Measure Approach With Short Sales Allowed Treynor-Measure Approach With Short Sales Not Allowed Impact of Short Sales on Optimal-Weight Determination Economic Rationale of the Treynor Performance-Measure Method Summary Questions and Problems Appendix 11A: Derivation of Equation (11.6a) Appendix 11B: Derivation of Equation (11.10) Appendix 11C: Derivation of Equation (11.15) Appendix 11D: Quardratic Programming and Kuhn Tucker Conditions Appendix 11E: Portfolio Optimization with Short-Selling Constraints Bibliography for Chapter The Efficient-Market Hypothesis and Security Valuation Market Value Versus Book Value Assets

22 xxii Security Analysis, Portfolio Management, and Financial Derivatives Liabilities and Owner s Equity Ratios and Market Information Market-to-Book Ratio Market Efficiency in a Market-Model and CAPM Context Market Model Sharpe Lintner CAPM Model Tests for Market Efficiency Weak Form Efficiency Semi-Strong Form Efficiency Strong-Form Efficiency Other Methods of Testing the EMH Random Walk with Reflecting Barriers Variance-Bound Approach Test Hillmer and Yu s Relative EMH Test Random Walk Hypothesis Versus EMH Test Market Anomalies The P/E Effect The Size Effect The January Effect Summary Questions and Problems Bibliography for Chapter Arbitrage Pricing Theory and Intertemporal Capital Asset Pricing Model Multi-Index Models Model Specification of APT Ross s Arbitrage Model Specification Empirical Test Methodology APT: Empirical Results and Implications Identifying the Model Factors APT Versus MPT and the CAPM Intertemporal CAPM Applications of APT Summary Questions and Problems

23 Contents xxiii Appendix 13A: Alternative Specifications of APT Appendix 13B: Lee and Wei s Empirical Results Bibliography for Chapter Project II Market Model, CAPM, and Portfolio Analysis Part III Futures and Option Futures Valuation and Hedging Futures Versus Forward Markets Futures Markets: Overview Components and Mechanics of Futures Markets The Exchanges The Clearinghouse Margin Order Execution A Sample T-bill Futures Transaction The Valuation of Futures Contracts The Arbitrage Argument Interest Costs Carrying Costs Supply and Demand Effects The Effect of Hedging Demand Hedging Concepts and Strategies Hedging Risks and Costs The Classic Hedge Strategy The Working Hedge Strategy The Johnson Minimum-Variance Hedge Strategy The Howard D Antonio Optimal Risk Return Hedge Strategy Other Hedge Ratios Summary Questions and Problems Appendix 14A: Basic Futures Terminology Bibliography for Chapter

24 xxiv Security Analysis, Portfolio Management, and Financial Derivatives 15. Commodity Futures, Financial Futures, and Stock-Index Futures Commodity Futures Futures Quotations Financial Futures Currency Futures Evolution Advantages Pricing Currency Futures The Traditional Theory of International Parity Interest-Rate Parity Purchasing-Power Parity Fisherian Relation Forward Parity Interest-Rate Futures U.S. Treasury Debt Futures Characteristics of T-Bill Futures Pricing T-Bill Futures Contracts Characteristics of T-Note and T-BondFutures The Eurodollar Futures Market Evolution Eurodollar Futures Stock-Index Futures Pricing Stock-Index Futures Contracts Stock-Index Futures: Does the Tail Wag the Dog? Summary Questions and Problems Bibliography for Chapter Options and Option Strategies The Option Market and Related Definitions What is an Option?

25 Contents xxv Types of Options and Their Characteristics Relationships between the Option Price and the Underlying Asset Price Additional Definitions and Distinguishing Features Types of Underlying Asset Institutional Characteristics Put Call Parity European Options American Options Futures Options Market Application Risk Return Characteristics of Options Long Call Short Call Long Put Short Put Long Straddle Short Straddle Long Vertical (Bull) Spread Short Vertical (Bear) Spread Calendar (Time) Spreads Excel Approach to Analyze the Option Strategies Long Straddle Short Straddle Long Vertical (Bull) Spread Short Vertical (Bear) Spread Protective Put Covered Call Collar Summary Questions and Problems Bibliography for Chapter Option Pricing Theory and Firm Valuation Basic Concepts of Options Option Price Information

26 xxvi Security Analysis, Portfolio Management, and Financial Derivatives 17.2 Factors Affecting Option Value Determining the Value of a Call Option Before the Expiration Date Determining The Value of Options Expected Value Estimation The Black Scholes Option Pricing Model Taxation of Options American Options Option Pricing Theory and Capital Structure Proportion of Debt in Capital Structure Riskiness of Business Operations Option Pricing Approach to Determine the Optimal Capital Structure Warrants Summary Questions and Problems Appendix 17A: Applications of the Binomial Distribution To Evaluate Call Options Bibliography for Chapter Decision Tree and Microsoft Excel Approach for Option Pricing Model Call and Put Options One-Period Option Pricing Model Two-Period Option Pricing Model Using Microsoft Excel to Create the Binomial Option Trees Black Scholes Option Pricing Model Relationship between the Binomial Option Pricing Model and the Black Scholes Option Pricing Model Decision Tree Black Scholes Calculation Summary Questions and Problems Appendex 18A: Excel VBA Code Binomial Option Pricing Model Bibliography for Chapter

27 Contents xxvii 19. Normal, Log-Normal Distribution, and Option Pricing Model The Normal Distribution The Log-Normal Distribution The Log-Normal Distribution and Its Relationship to the Normal Distribution Multivariate Normal and Log-Normal Distributions The Normal Distribution as an Application to the Binomial and Poisson Distribution Applications of the Log-Normal Distribution in Option Pricing The Bivariate Normal Density Function American Call Options Price American Call Options by the Bivariate Normal Distribution Pricing an American Call Option: An Example Price Bounds for Options Options Written on Nondividend-Paying Stocks Options Written on Dividend-Paying Stocks Summary Questions and Problems Appendix 19A: Microsoft Excel Program for Calculating Cumulative Bivariate Normal Density Function Appendix 19B: Microsoft Excel Program for Calculating theamericancalloptions Bibliography for Chapter Comparative Static Analysis of the Option Pricing Models Delta( ) Derivation of Delta for Different Kinds of Stock Options Application of Delta ( ) Theta (Θ)

28 xxviii Security Analysis, Portfolio Management, and Financial Derivatives Derivation of Theta for Different Kinds of Stock Options Application of Theta (Θ) Gamma (Γ) Derivation of Gamma for Different Kinds of Stock Options Application of Gamma (Γ) Vega (ν) Derivation of Vega for Different Kinds of Stock Options Application of Vega (ν) RHO (ρ) Derivation of Rho for Different Kinds of Stock Options Application of Rho (ρ) Derivation of Stock Options with Respect to Exercise Price Relationship between Delta, Theta, and Gamma Summary Questions and Problems Bibliography for Chapter Project III Option Valuation and Strategies Part IV Applied Portfolio Management Security Analysis and Mutual Fund Performance Fundamental Versus Technical Analysis Fundamental Analysis Technical Analysis Dow Theory The Odd-Lot Theory The Confidence Index Trading Volume Moving Average Anomalies and Their Implications Basu s Findings

29 Contents xxix Reinganum s Findings Banz s Findings Keim s Findings Additional Findings Security Rate-of-Return Forecasting Regression Approach Fixed-Coefficient Market Model Time-Varying-Coefficient Market Model Time-Series Approach Component Analysis ARIMA Models Composite Forecasting Value Line Ranking Criteria of Ranking Performance Evaluation Mutual Funds Mutual-Fund Classification Mutual-Fund Manager s Timing and Selectivity Summary Questions and Problems Appendix 21A: Composite Forecasting Method Bibliography for Chapter International Diversification and Asset Pricing Exchange-Rate Risk Theoretical Effects of International Diversification Segmented Versus Integrated World Markets The CAPM and the APT Applied Internationally Inflation and Exchange-Rate Risks Are World Markets Efficient? Empirical Evidence Supporting International Diversification Applied International Diversification

30 xxx Security Analysis, Portfolio Management, and Financial Derivatives Direct Foreign Investment Canada Germany Japan Other Pacific-Basin Countries United Kingdom Indirect Foreign Investment American Depository Receipts Foreign bonds and Eurobonds International Mutual Funds Return, Risk, and Sharpe Performance Measure for International Indexes Currency Option and Index Option Currency Option Index Option Summary Questions and Problems Appendix 22A: Objectives and Policies of an International Mutual Fund Bibliography for Chapter Bond Portfolios: Management and Strategy Bond Strategies Riding the Yield Curve Maturity-Structure Strategies Swapping Substitution Swap Intermarket-Spread Swap Interest-Rate Anticipation Swap Pure Yield-Pickup Swap Duration Weighted-Average Term to Maturity WATM Versus Duration Measure Yield to Maturity The Macaulay Model Convexity

31 Contents xxxi 23.4 Contingent Immunization Bond Portfolios: A Case Study Summary Questions and Problems Bibliography for Chapter Portfolio Insurance and Synthetic Options Basic Concepts of Portfolio Insurance Strategies and Implementation of Portfolio Insurance Stop-LossOrders Portfolio Insurance with Listed Put Options Portfolio Insurance with Synthetic Options Portfolio Insurance with Dynamic Hedging Comparison of Alternative Portfolio-Insurance Strategies Synthetic Options Listed Put Options Dynamic Hedging and Listed Put Options Impact of Portfolio Insurance on the Stock Market and Pricing of Equities Regulation and the Brady Report Empirical Studies of Portfolio Insurance Leland (1985) Asay and Edelsburg (1986) Eizman (1986) Rendleman and McEnally (1987) Garcia and Gould (1987) Zhu and Kavee (1988) Perold and Sharpe (1988) Rendleman and O Brien (1990) Loria, Pham, and Sim (1991) Do and Faff (2004) Cesari and Cremonini (2003) Herold, Maurer, and Purschaker (2005)

32 xxxii Security Analysis, Portfolio Management, and Financial Derivatives Hamidi, Jurczenko, and Maillet (2007) Ho, Cadle, and Theobald (2008) Summary Questions and Problems Bibliography for Chapter Project IV Mutual Fund, International Portfolio, and Bond Portfolio Part V Special Topics Capturing Equity Risk Premia Global Equity Risk Model Estimation Universe GEM2 Factor Structure Factor Portfolios Simple Factor Portfolios Pure Factor Portfolios Optimized Factor Portfolios Results Cumulative Factor Returns Summary Statistics Leading Economic Indicators and Barra Factor Returns Summary Questions and Problems Bibliography for Chapter Simultaneous Equation Models for Security Valuation Warren and Shelton Model Johnson & Johnson as a Case Study Data Sources and Parameter Estimations Procedure for Calculating WS Model Francis and Rowell Model FR Model Specification A Brief Discussion of FR S Empirical Results Feltham Ohlson Model for Determining Equity Value

33 Contents xxxiii 26.5 Combined Forecasting Method to Determine Equity Value Summary Questions and Problems Appendix 26A: Procedure of Using Microsoft Excel to Run Finplan Program Appendix 26B: Program of Finplan with an Example Bibliography for Chapter Itô s Calculus: Derivation of the Black Scholes Option Pricing Model The Itô Process and Financial Modeling Itô Lemma Stochastic Differential-Equation Approach to Stock-Price Behavior The Pricing of an Option A Reexamination of Option Pricing Remarks on Option Pricing Summary Questions and Problems Appendix 27A: An Alternative Method to Derive the Black Scholes Option Pricing Model A.1 Assumptions and the Present Value of the Expected Terminal Option Price A.2 Present Value of the Partial Expectation of the Terminal Stock Price A.3 Present Value of the Exercise Price under Uncertainty Bibliography for Chapter Appendix Tables 1117 Acknowledgments 1123 Author Index 1129 Subject Index 1139