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
CONTENTS Acknowledgments Preface About the Australian authors About the authors Digital resources Text at a glance Excel integration and end-of-chapter features U?T 1 Elements of investments Investments: background and issues xii xiii xiv XV xvi xviii XX 3 4 2.3 Equity markets Ordinary shares representing ownership Characteristics of ordinary shares or common stocks Stock market listings Preferred stock Derivative markets Options Futures contracts Contracts for difference (CFDs) 22 22 22 23 24 24 24 26 2 2-29 1.1 Real assets versus financial assets 1.2 Types of financial assets 1.3 The roles of financial markets in the economy Capital allocation Consumption timing Allocation of risk Separation of ownership and management 1.4 The investment process 1.5 The main participants 1.6 Financial intermediaries Investment bankers 1. Outline of the text Asset classes and financial markets 2.1 The money market Certificates of deposit Bank-accepted bills Commercial paper Treasury notes Repos and reverses The UBOR market Yields on money-market instruments 2.2 The bond market Government bonds International bonds Corporate bonds Mortgages and mortgage-backed securities 5 6 8 9 10 11 12 12> 13-14 15 16 16 16 1 1 20 21 21 21 3.1 3.2 3.3 3.4 3.5 Raising capital the primary market Initial equity capital raisings Raising capital equity Trading securities the secondary market Types of secondary markets Types of orders Transaction costs Buying on margin Short sales 4 Managed funds and investment m a i - -* 4.1 4.2 4.3 4.4 4.5 nagememr Investment managers Managed investment structures Listed investment vehicles Unlisted investment vehicles Investment policies Single-asset funds Multi-asset (diversified) funds Investment philosophies Passive management Active management Investing in managed funds How funds are sold Fee structure Fees and manaaed fund returns 30 OU 30 30 32 33 33 34 35 36 38 42-45 46 46 4 4 49 49 49 50 51 51 51 52 52 52 54
4.6 Taxation of managed fund income PART 2 PORTFOLIO THEORY 5 Risk and return: past and prologue 5.1 Rates of return Measuring investment returns over multiple periods Conventions for quoting rates of return 5.2 Risk and risk premiums Scenario analysis and probability distributions The normal distribution Deviation from normality and value at risk Using time series of return Risk premiums and risk aversion The Sharpe (reward-to-volatility) measure 5.3 The historical record Local, regional and global risky stock portfolios 5.4 Inflation and real rates of return The equilibrium nominal rate of interest Australian history of interest rates, inflation and real interest rates 5.5 Asset allocation across risky and risk-free portfolios The risky asset The risk-free asset Portfolio expected return and risk The capital allocation line Risk tolerance and asset allocation 5.6 Passive strategies and the capital market line Historical evidence on the capital market line Costs and benefits of passive investing 6 Efficient diversification 6.1 Diversification and portfolio risk 6.2 Asset allocation with two risky assets Covariance and correlation Using historical data The three rules of two-risky-assets portfolios 54 The risk-return trade-off with two-risky- 55-56 assets portfolios 104 The mean-variance criterion 105 6.3 The optimal risky portfolio with a risk-free asset 108 59 61 62 62 65 66 66 6 69 1 2 3 4 4 6 8 80 80 82 82 83 84 85 85 8 88-93 94 94 9 98 101 103 6.4 Efficient diversification with many risky assets 111 The efficient frontier of risky assets 112 Choosing the optimal risky portfolio 113 The preferred complete portfolio and the separation property 114 Constructing the optimal risky portfolio-. an illustration 114 6.5 A single-index asset market 118 Statistical and graphical representation of the single-index model 120 Diversification in a single-index security market 123 Using security analysis with the index model 125 6.6 Risk of long-term investments 128 Are share returns less risky in the long run? 128 The fly in the 'time diversification' ointment (or more accurately, the snake oil) 129 131-139 Capital asset pricing and arbitrage pricing theory 140.1 The capital asset pricing model 141 Why all investors would hold the market portfolio 142 The passive strategy is efficient 143 The risk premium of the market portfolio 143 Expected returns on individual securities 144 The security market line 146 Applications of the CAPM 148.2 The CAPM and index models "' - 149 The index model, realised returns and the expected return-beta relationship 149 Predicting betas 15.3 The CAPM and the real world 158.4 Multifactor models and the CAPM 160 The Fama-French three-factor model 162 Factor models with macroeconomic variables 165 Multifactor models and the validity of the CAPM 165
.5 Factor models and the arbitrage pricing theory Well-diversified portfolios and arbitrage pricing theory The APT and the CAPM Multifactor generalisation of the APT and CAPM 8 The efficient market hypothesis 8.1 Random walks and the efficient market hypothesis Competition as the source of efficiency Versions of the efficient market hypothesis 8.2 Implications of the EMH Technical analysis Fundamental analysis Active versus passive portfolio management The role of portfolio management in an efficient market 8.3 Are markets efficient? The issues Weak-form tests: patterns in stock returns Predictors of broad market returns Semistrong tests-, market anomalies Strong-form tests: inside information Interpreting the evidence 8.4 The behavioural critique Information processing Behavioural biases Limits to arbitrage Bubbles and behavioural economics Evaluating the behavioural critique 8.5 Technical analysis and behavioural finance So, are markets efficient? PART 3 Debt securities 9 Bond prices and yields 9.1 Bond characteristics Treasury bonds 166 16 169 169 12-19 180 181 182 184 184 184 185 185 186 18 18 189 1 1 6 6 8 9 200 202 203 204 205 205 206-209 211 212 213 Corporate bonds 215 Hybrid securities or preference shares 218 Other issuers 218 Innovation in the bond market 218 9.2 Bond pricing 220 Bond pricing between coupon dates 223 Bond pricing in Excel 224 RBA bond pricing formula 225 9.3 Bond yields 225 Yield to maturity, 226 Yield to call ' 230 Realised compound return versus yield to maturity 231 9.4 Bond prices over time 233 Yield to maturity versus holding-period return 235 9.5 Default risk and bond pricing 236 Determinants of bond safety 236 Yield to maturity and default risk 238 Credit default swaps 240 9.6 The yield curve 241 The expectations theory 242 The liquidity preference theory 244 Market segmentation and preferred habitat theory 245 A synthesis, 246 24-254 10 Managing bond portfolios 255 10.1 Interest rate risk 256 Interest rate sensitivity 256 10.2 Duration 258 What determines duration? 262 10.3 Passive bond management 264 Immunisation ' ~ 264 Cash flow matching and dedication 20 10.4 Convexity 21 Why do investors like convexity? 23 10.5 Active bond management 24 213 Sources of potential profit 2A
Horizon analysis An example of a fixed-income investment strategy JY 25 26 2-286 PART 4 Security analysis 11 Equity valuation 11.1 Valuation by comparables Limitations of book value 11.2 Intrinsic value versus market price 11.3 Dividend discount models The constant-growth DDM Stock prices and investment opportunities Life cycles and multistage growth models Multistage growth models. Limitations of the dividend discount model 11.4 Price earnings ratios The price earnings ratio and growth opportunities P/E ratios and stock risk Pitfalls in P/E analysis Combining P/E analysis and the DDM Other comparative valuation ratios 11.5 Free cash flow valuation approaches Comparing the valuation models 11.6 The aggregate stock market 12 Macroeconomic and industry analysis 12.1 The global economy 12.2 The domestic macroeconomy Cross domestic product Employment Inflation Interest rates Budget deficit Sentiment 12.3 Interest rates 12.4 Demand and supply shocks l 289 290 y\ 000 i.y 293 294 295 ooo zw 302 306 30 30 30 *J\J I O1O O IZ. O1O o \o 315 ' "K\d o \o 316 320 320 322-332 333 334 336 33 33 33. 340 12.5 12.6 12. Commonwealth Government policy Fiscal policy Monetary policy Supply-side policies Business cycles The business cycle Economic indicators Other indicators Industry analysis Defining an industry Sensitivity to the business cycle Sector rotation Industry life cycles 340 341 341 343 344 344 345 34 34 348 351 352 353 Industry structure and performance 356 35-363 13 Financial statement analysis 13.1 13.2 13.3 13.4 13.5 The major financial statements The income statement The balance sheet The statement of cash flows Profitability measures Past versus future ROE Financial leverage and ROE Ratio analysis Decomposition of ROE Turnover and other asset utilisation ratios Liquidity ratios Market price ratios Choosing a benchmark Economic value added An illustration of financial statement analysis Accounting conventions, practices and problems Inventory valuation Depreciation Inflation and interest expense Fair value accounting Quality of earnings and accounting practices Accounting versus economic earnings 364 364 364 365 368 30 30 30 32 32 35 36 3 380 381 382 384 386 38 38 388 389 390
13.6 Value investing: the Graham technique 391 392-401 PAiT 5 Derivative markets 403 14 Options and risk management 14.1 The option contract Options trading American and European options Index options Other listed options Call option values at expiration Put option values at expiration Options versus stock investments 14.2 Option strategies Protective put Covered calls ' Straddle Spreads \ Collars 14.3 Option valuation Intrinsic and time values Determinants of option values 14.4 Black-Scholes option valuation The Black-Scholes formula The put-call parity relationship Put option valuation 14.5 Using the Black-Scholes formula Hedge ratios and the Black-Scholes formula Portfolio insurance ~. 15 Futures and risk management 15.1 The futures contract The basics of futures contracts Existing contracts 15.2 Mechanics of trading in futures markets The clearinahouse and ooen interest 405 406 40 409 409 410 410 411 412 414 414 416 4 421 421 423 423 424 425 426 433 436 436 436 438 442-449 450 450 451 453 456 456 Marking to market and the margin account 45 Cash versus actual delivery 459 15.3 Futures market strategies 459 Hedging and speculation 459 Basis risk and hedging 462 15.4 The determination of futures prices 463 Spot-futures parity 463 Spreads. 466 15.5 Financial futures 466 Stock index futures 46 Creating synthetic stock positions 46 Index arbitrage 469 Interest rate futures 40 Contract for difference } 43 43-48 %U1 6 Active investment management 48i Investors and the investment process 482 16.1 The investment management process 482 16.2 Investor objectives 484 Individual investors 484 Professional investors 485 Life insurance companies 486 Banks 486 Endowment funds 48 16.3 Investor constraints 488 Liquidity 488 Investment horizon 488 Regulations 488 Tax considerations _ 489 Unique needs 489 16.4 Investment policies 490 Asset allocation 491 Top-down policies for institutional investors 493 Active versus passive policies 494 16.5 Monitoring and revising investment portfolios 496 49-501
1 Hedge funds 1.1 Hedge funds versus managed funds Regulation Investment strategies Liquidity Compensation structure 1.2 Hedge fund strategies Directional and non-directional strategies Statistical arbitrage 1.3 Portable alpha An example of a pure play 1.4 Style analysis for hedge funds 1.5 Performance measurement for hedge funds Liquidity and hedge fund performance Hedge fund performance and survivorship bias Hedge fund performance and changing factor loadings Tail events and hedge fund performance 1.6 Fee structure in hedge funds 18 Portfolio performance evaluation 18.1 Risk-adjusted returns Investment clients, service providers and objectives of performance evaluation Comparison groups 502 504 504 506 50 50 509 511 512 513 513 516 518 521-524 525 525 525 526 Bas/c performance-evaluation statistics Performance evaluation of entire-wealth portfolios using the Sharpe ratio and M 2 Performance evaluation of fund of funds using the Treynor ratio Performance evaluation of a portfolio added to the benchmark using the information ratio The relation of alpha to performance measures Alpha capture and alpha transport Performance evaluation with a multi-index model 18.2 Style analysis Morningstar's risk-adjusted rating Risk adjustments with changing portfolio composition Risk-adjusted performance of fund managers 18.3 Performance attribution procedures Asset allocation decisions Sector and security selection decisions Summing up component contributions 18.4 Market timing Measurement of market timing performance Glossary Index 52 529 530 531 532 533 536 53 538 540 543 545 546 546-548 549 550 552-556 55 562