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Ebook Essentials of investments (Seventh edition): Part 2 presents the following content: Chapter 1 investments: background and issues; chapter 2 asset classes and financial instruments; chapter 3 securities markets; chapter 4 mutual funds and other investment companies; chapter 5 risk and return: pastand prologue; chapter 6 efficient diversification; chapter 7 capital asset pricing and arbitrage pricing theory; chapter 8 the efficient market hypothesis; chapter 9 behavioral finance and technical analysis; chapter 10 bond prices and yields; chapter 11 managing bond portfolios.
PART FOUR SECURITY ANALYSIS T ell your friends or relatives that you are studying investments and they will ask you, “What stocks should I buy?” This is the question at the heart of security analysis How analysts choose the stocks and other securities to hold in their portfolios? Security analysis requires a wide mix of skills You need to be a decent economist with a good grasp of both macroeconomics and microeconomics, the former to help you form forecasts of the general direction of the market and the latter to help you assess the relative position of particular industries or firms You need a good sense of demographic and social trends to help identify industries with bright prospects You need to be a quick study of the ins and outs of particular industries to choose the firms that will succeed within each industry You need a good accounting background to analyze the financial statements that firms provide to the public You also need to have mastered corporate finance, since security analysis at its core is the ability to value a firm In short, a good security analyst will be a generalist, with a grasp of the widest range of financial issues This is where there is the biggest premium on “putting it all together.” The chapters in Part Four are an introduction to security analysis We will provide you with a “top-down” approach to the subject, starting with an overview of international, macroeconomic, and industry issues, and only then progressing to the analysis of particular firms These topics form the core of fundamental analysis After reading these chapters, you will have a good sense of the various techniques used to analyze stocks and the stock market CHAPTERS IN THIS PART 12 Macroeconomic and Industry Analysis 13 Equity Valuation 14 Financial Statement Analysis www.mhhe.com/bkm bod05175_ch12_369-400.indd 369 8/17/07 5:33:04 PM CHAPTER 12 Macroeconomic and Industry Analysis AFTER STUDYING THIS CHAPTER YOU SHOULD BE ABLE TO: ➜ ➜ ➜ ➜ fundamental analysis The analysis of determinants of firm value, such as prospects for earnings and dividends Predict the effect of monetary and fiscal policies on key macroeconomic variables such as gross domestic product, interest rates, and the inflation rate Use leading, coincident, and lagging economic indicators to describe and predict the economy’s path through the business cycle Predict which industries will be more or less sensitive to business cycle fluctuations Analyze the effect of industry life cycles and structure on industry earnings prospects over time T o determine a proper price for a firm’s stock, the security analyst must forecast the dividends and earnings that can be expected from the firm This is the heart of fundamental analysis, that is, the analysis of determinants of value such as earnings prospects Ultimately, the business success of the firm determines the dividends it can pay to shareholders and the price it will command in the stock market Because the prospects of the firm are tied to those of the broader economy, however, valuation analyses must consider the business environment in which the firm operates For some firms, macroeconomic and industry circumstances might have a greater influence on profits than the firm’s relative performance within its industry In other words, investors need to keep the big economic picture in mind Therefore, in analyzing a firm’s prospects it often makes sense to start with the broad economic environment, examining the state of the aggregate economy and even the international economy From there, one considers the implications of the outside environment on the industry in which the firm operates Finally, the firm’s position within the industry is examined 370 bod05175_ch12_369-400.indd 370 8/17/07 5:33:11 PM This chapter examines the broad-based aspects of fundamental analysis— macroeconomic and industry analysis The following two chapters cover firmspecific analysis We begin with a discussion of international factors relevant to firm performance and move on to an overview of the significance of the key variables usually used to summarize the state of the economy We then discuss government macroeconomic policy and the determination of interest rates We conclude the analysis of the macroeconomic environment with a discussion of business cycles Next, we move to industry analysis, treating issues concerning the sensitivity of the firm to the business cycle, the typical life cycle of an industry, and strategic issues that affect industry performance Related Web sites for this chapter are available at www.mhhe.com/bkm 12.1 THE GLOBAL ECONOMY A top-down analysis of a firm’s prospects must start with the global economy The international economy might affect a firm’s export prospects, the price competition it faces from foreign competitors, or the profits it makes on investments abroad Certainly, despite the fact that the economies of most countries are linked in a global macroeconomy, there is considerable variation in economic performance across countries at any time Consider, for example, Table 12.1, which presents data on several major economies The table documents striking variation in growth rates of economic output For example, while the Chinese economy grew by 10.4% in 2006 (see last column), output in Japan grew by only 1.6% Similarly, there has been considerable variation in stock market returns in these countries in recent years, as documented in the first two columns of the table These data illustrate that the national economic environment can be a crucial determinant of industry performance It is far harder for businesses to succeed in a contracting economy than in an expanding one This observation highlights the role of a big-picture macroeconomic analysis as a fundamental part of the investment process Stock Market Return (%) TABLE 12.1 Economic performance, 2006 Brazil Britain Canada China France Germany India Japan Mexico Russia Singapore Switzerland Thailand U.S Venezuela In Local Currency In U.S Dollars Growth in GDP (%) 32.9 12.5 12.7 130.6 19.0 23.7 49.1 6.9 49.5 56.3 29.4 17.6 20.9 13.5 162.6 45.2 27.3 12.5 138.4 33.1 38.4 51.3 5.7 47.8 70.7 40.4 26.7 22.5 13.5 99.0 3.2 2.7 2.5 10.4 1.9 2.8 9.2 1.6 4.6 6.5 5.9 2.4 4.7 3.0 10.2 Source: The Economist, January 4, 2007 © 2007 The Economist Newspaper Group, Inc Reprinted with permission Further reproduction is prohibited www.economist.com 371 bod05175_ch12_369-400.indd 371 8/17/07 5:33:17 PM 372 exchange rate The rate at which domestic currency can be converted into foreign currency Part FOUR Security Analysis In addition, the global environment presents political risks of far greater magnitude than are typically encountered in U.S.-based investments In the last decade, we have seen several instances where political developments had major impacts on economic prospects For example, the biggest international economic story in late 1997 and 1998 was the turmoil in several Asian economies, notably Thailand, Indonesia, and South Korea These episodes also highlighted the close interplay between politics and economics, as both currency and stock values swung with enormous volatility in response to developments concerning the prospects for aid for these countries from the International Monetary Fund In August 1998, the shock waves following Russia’s devaluation of the ruble and default on some of its debt created havoc in world security markets, ultimately requiring a rescue of the giant hedge fund Long Term Capital Management to avoid further major disruptions In the current environment, stock prices are highly sensitive to developments in Iraq and the security of energy supplies Other political issues that are less sensational but still extremely important to economic growth and investment returns include issues of protectionism and trade policy, the free flow of capital, and the status of a nation’s workforce One obvious factor that affects the international competitiveness of a country’s industries is the exchange rate between that country’s currency and other currencies The exchange rate is the rate at which domestic currency can be converted into foreign currency For example, in early 2007, it took about 114 Japanese yen to purchase one U.S dollar We would say that the exchange rate is ¥114 per dollar, or equivalently, $0.0088 per yen As exchange rates fluctuate, the dollar value of goods priced in foreign currency similarly fluctuates For example, in 1980, the dollar–yen exchange rate was about $0.0045 per yen Since the exchange rate in 2007 was $0.0088 per yen, a U.S citizen would have needed almost twice as many dollars in 2007 to buy a product selling for ¥10,000 as would have been required in 1980 If the Japanese producer were to maintain a fixed yen price for its product, the price expressed in U.S dollars would have to double This would make Japanese products more expensive to U.S consumers, however, and result in lost sales Obviously, appreciation of the yen creates a problem for Japanese producers such as automakers that must compete with U.S producers Figure 12.1 shows the change in the purchasing power of the U.S dollar relative to the purchasing power of several major currencies in the period between 1999 and 2006 The ratio of purchasing powers is called the “real” or inflation-adjusted exchange rate The change in the real exchange rate measures how much more or less expensive foreign goods have become to U.S citizens, accounting for both exchange rate fluctuations and inflation differentials across countries A positive value in Figure 12.1 means that the dollar FIGURE 12.1 Change in real exchange rate: U.S dollar versus major currencies, 1999–2006 U.K Ϫ15.7% Ϫ13.2% Euro 35.6% Japan Canada Ϫ18.7% Ϫ25% bod05175_ch12_369-400.indd 372 Ϫ15% Ϫ5% 5% 15% 25% 35% 8/17/07 5:33:17 PM 12 373 Macroeconomic and Industry Analysis FIGURE 12.2 2,500 S&P 500 Index versus earnings per share Source: Authors’ calculations using data from The Economic Report of the President, 2007 2,000 S&P 500 1,500 1,000 25 ϫ EPS 18 ϫ EPS 500 12 ϫ EPS 2006 2003 2000 1997 1994 1991 1988 1985 1982 1979 1976 1973 1970 has gained purchasing power relative to another currency; a negative number indicates a depreciating dollar Therefore, the figure shows that goods priced in terms of British pounds, euros, or Canadian dollars became more expensive to U.S consumers in the last four years but that goods priced in yen became cheaper Conversely, goods priced in U.S dollars became more expensive to Japanese consumers, but more affordable to Canadian consumers 12.2 THE DOMESTIC MACROECONOMY The macroeconomy is the environment in which all firms operate The importance of the macroeconomy in determining investment performance is illustrated in Figure 12.2, which compares the level of the S&P 500 stock price index to estimates of earnings per share of the S&P 500 companies The graph shows that stock prices tend to rise along with earnings While the exact ratio of stock price to earnings per share varies with factors such as interest rates, risk, inflation rates, and other variables, the graph does illustrate that, as a general rule, the ratio has tended to be in the range of 12 to 25 Given “normal” price-to-earnings ratios, we would expect the S&P 500 Index to fall within these boundaries While the earnings-multiplier rule clearly is not perfect—note the dramatic increase in the P/E multiple in the 1990s—it also seems clear that the level of the broad market and aggregate earnings trend together Thus, the first step in forecasting the performance of the broad market is to assess the status of the economy as a whole The ability to forecast the macroeconomy can translate into spectacular investment performance But it is not enough to forecast the macroeconomy well One must forecast it better than one’s competitors to earn abnormal profits In this section, we will review some of the key economic statistics used to describe the state of the macroeconomy Gross Domestic Product Gross domestic product, or GDP, is the measure of the economy’s total production of goods and services Rapidly growing GDP indicates an expanding economy with ample opportunity for a firm to increase sales Another popular measure of the economy’s output is industrial production This statistic provides a measure of economic activity more narrowly focused on the manufacturing side of the economy bod05175_ch12_369-400.indd 373 gross domestic product (GDP) The market value of goods and services produced over a period of time 8/17/07 5:33:19 PM 374 Part FOUR Security Analysis Employment unemployment rate The ratio of the number of people classified as unemployed to the total labor force The unemployment rate is the percentage of the total labor force (i.e., those who are either working or actively seeking employment) yet to find work The unemployment rate measures the extent to which the economy is operating at full capacity The unemployment rate is a statistic related to workers only, but further insight into the strength of the economy can be gleaned from the employment rate of other factors of production Analysts also look at the factory capacity utilization rate, which is the ratio of actual output from factories to potential output Inflation inflation The rate at which the general level of prices for goods and services is rising Inflation is the rate at which the general level of prices is rising High rates of inflation often are associated with “overheated” economies, that is, economies where the demand for goods and services is outstripping productive capacity, which leads to upward pressure on prices Most governments walk a fine line in their economic policies They hope to stimulate their economies enough to maintain nearly full employment, but not so much as to bring on inflationary pressures The perceived trade-off between inflation and unemployment is at the heart of many macroeconomic policy disputes There is considerable room for disagreement as to the relative costs of these policies as well as the economy’s relative vulnerability to these pressures at any particular time Interest Rates High interest rates reduce the present value of future cash flows, thereby reducing the attractiveness of investment opportunities For this reason, real interest rates are key determinants of business investment expenditures Demand for housing and high-priced consumer durables such as automobiles, which are commonly financed, also is highly sensitive to interest rates because interest rates affect interest payments In Section 12.3 we will examine the determinants of real interest rates Budget Deficit budget deficit The amount by which government spending exceeds government revenues The budget deficit of the federal government is the difference between government spending and revenues Any budgetary shortfall must be offset by government borrowing Large amounts of government borrowing can force up interest rates by increasing the total demand for credit in the economy Economists generally believe excessive government borrowing will “crowd out” private borrowing and investing by forcing up interest rates and choking off business investment Sentiment Consumers’ and producers’ optimism or pessimism concerning the economy are important determinants of economic performance If consumers have confidence in their future income levels, for example, they will be more willing to spend on big-ticket items Similarly, businesses will increase production and inventory levels if they anticipate higher demand for their products In this way, beliefs influence how much consumption and investment will be pursued and affect the aggregate demand for goods and services CONCEPT c h e c k bod05175_ch12_369-400.indd 374 12.1 Consider an economy where the dominant industry is automobile production for domestic consumption as well as export Now suppose the auto market is hurt by an increase in the length of time people use their cars before replacing them Describe the probable effects of this change on (a) GDP, (b) unemployment, (c) the government budget deficit, and (d) interest rates 8/17/07 5:33:21 PM 12 Macroeconomic and Industry Analysis 375 12.3 INTEREST RATES The level of interest rates is perhaps the most important macroeconomic factor to consider in one’s investment analysis Forecasts of interest rates directly affect the forecast of returns in the fixed-income market If your expectation is that rates will increase by more than the consensus view, you will want to shy away from longer term fixed-income securities Similarly, increases in interest rates tend to be bad news for the stock market Unanticipated increases in rates generally are associated with stock market declines Thus, a superior technique to forecast rates would be of immense value to an investor attempting to determine the best asset allocation for his or her portfolio Unfortunately, forecasting interest rates is one of the most notoriously difficult parts of applied macroeconomics Nonetheless, we have a good understanding of the fundamental factors that determine the level of interest rates: The supply of funds from savers, primarily households The demand for funds from businesses to be used to finance physical investments in plant, equipment, and inventories The government’s net supply and/or demand for funds as modified by actions of the Federal Reserve Bank The expected rate of inflation Although there are many different interest rates economywide (as many as there are types of securities), these rates tend to move together, so economists frequently talk as though there were a single representative rate We can use this abstraction to gain some insights into determining the real rate of interest if we consider the supply and demand curves for funds Figure 12.3 shows a downward-sloping demand curve and an upward-sloping supply curve On the horizontal axis, we measure the quantity of funds, and on the vertical axis, we measure the real rate of interest The supply curve slopes up from left to right because the higher the real interest rate, the greater the supply of household savings The assumption is that at higher real interest rates, households will choose to postpone some current consumption and set aside or invest more of their disposable income for future use The demand curve slopes down from left to right because the lower the real interest rate, the more businesses will want to invest in physical capital Assuming that businesses rank projects by the expected real return on invested capital, firms will undertake more projects the lower the real interest rate on the funds needed to finance those projects Equilibrium is at the point of intersection of the supply and demand curves, point E in Figure 12.3 The government and the central bank (the Federal Reserve) can shift these supply and demand curves either to the right or to the left through fiscal and monetary policies For example, consider an increase in the government’s budget deficit This increases the government’s borrowing demand and shifts the demand curve to the right, which causes the equilibrium real interest rate to rise to point EЈ That is, a forecast that indicates higher than previously expected government borrowing increases expectations of future interest rates The Fed can offset such a rise through an increase in the money supply, which will increase the supply of loanable funds, and shift the supply curve to the right Thus, while the fundamental determinants of the real interest rate are the propensity of households to save and the expected productivity (or we could say profitability) of firms’ investment in physical capital, the real rate can be affected as well by government fiscal and monetary policies The supply and demand framework illustrated in Figure 12.3 is a reasonable first approximation to the determination of the real interest rate To obtain the nominal interest rate, one needs to add the expected inflation rate to the equilibrium real rate As we discussed in Section 5.4, the inflation premium is necessary for investors to maintain a given real rate of return on their investments bod05175_ch12_369-400.indd 375 8/17/07 5:33:21 PM 376 FIGURE 12.3 Part FOUR Security Analysis Interest rate Supply Determination of the equilibrium real rate of interest E‘ Equilibrium real rate of interest E Demand Equilibrium funds lent Funds While monetary policy can clearly affect nominal interest rates, there is considerable controversy concerning its ability to affect real rates There is widespread agreement that, in the long run, the ultimate impact of an increase in the money supply is an increase in prices with no permanent impact on real economic activity A rapid rate of growth in the money supply, therefore, ultimately would result in a correspondingly high inflation rate and nominal interest rate, but it would have no sustained impact on the real interest rate However, in the shorter run, changes in the money supply may well have an effect on the real interest rate 12.4 DEMAND AND SUPPLY SHOCKS demand shock An event that affects the demand for goods and services in the economy supply shock An event that influences production capacity and costs in the economy bod05175_ch12_369-400.indd 376 A useful way to organize your analysis of the factors that might influence the macroeconomy is to classify any impact as a supply or demand shock A demand shock is an event that affects the demand for goods and services in the economy Examples of positive demand shocks are reductions in tax rates, increases in the money supply, increases in government spending, or increases in foreign export demand A supply shock is an event that influences production capacity and costs Examples of supply shocks are changes in the price of imported oil; freezes, floods, or droughts that might destroy large quantities of agricultural crops; changes in the educational level of an economy’s workforce; or changes in the wage rates at which the labor force is willing to work Demand shocks usually are characterized by aggregate output moving in the same direction as interest rates and inflation For example, a big increase in government spending will tend to stimulate the economy and increase GDP It also might increase interest rates by increasing the demand for borrowed funds by the government as well as by businesses that might desire to borrow to finance new ventures Finally, it could increase the inflation rate if the demand for goods and services is raised to a level at or beyond the total productive capacity of the economy Supply shocks usually are characterized by aggregate output moving in the opposite direction as inflation and interest rates For example, a big increase in the price of imported oil will be inflationary because costs of production will rise, which eventually will lead to increases in prices of finished goods The increase in inflation rates over the near term can lead to higher nominal interest rates Against this background, aggregate output will be falling With raw materials more expensive, the productive capacity of the economy is reduced, as is the ability of individuals to purchase goods at now-higher prices GDP, therefore, tends to fall How can we relate this framework to investment analysis? You want to identify the industries that will be most helped or hurt in any macroeconomic scenario you envision For example, if you forecast a tightening of the money supply, you might want to avoid industries such as automobile producers that might be hurt by the likely increase in interest rates We caution you again that these forecasts are no easy task Macroeconomic predictions are notoriously unreliable And again, you must be aware that in all likelihood your forecast will be made 8/17/07 5:33:22 PM 12 377 Macroeconomic and Industry Analysis using only publicly available information Any investment advantage you have will be a result only of better analysis—not better information 12.5 FEDERAL GOVERNMENT POLICY As the previous section would suggest, the government has two broad classes of macroeconomic tools—those that affect the demand for goods and services and those that affect their supply For much of postwar history, demand-side policy has been of primary interest The focus has been on government spending, tax levels, and monetary policy Since the 1980s, however, increasing attention has also been focused on supply-side economics Broadly interpreted, supply-side concerns have to with enhancing the productive capacity of the economy, rather than increasing the demand for the goods and services the economy can produce In practice, supply-side economists have focused on the appropriateness of the incentives to work, innovate, and take risks that result from our system of taxation However, issues such as national policies on education, infrastructure (such as communication and transportation systems), and research and development also are properly regarded as part of supply-side macroeconomic policy Fiscal Policy Fiscal policy refers to the government’s spending and tax actions and is part of “demand-side management.” Fiscal policy is probably the most direct way either to stimulate or to slow the economy Decreases in government spending directly deflate the demand for goods and services Similarly, increases in tax rates immediately siphon income from consumers and result in fairly rapid decreases in consumption Ironically, although fiscal policy has the most immediate impact on the economy, the formulation and implementation of such policy is usually painfully slow and involved This is because fiscal policy requires enormous amounts of compromise between the executive and legislative branches Tax and spending policy must be initiated and voted on by Congress, which requires considerable political negotiations, and any legislation passed must be signed by the president, requiring more negotiation Thus, while the impact of fiscal policy is relatively immediate, its formulation is so cumbersome that fiscal policy cannot in practice be used to fine-tune the economy Moreover, much of government spending, such as that for Medicare or Social Security, is nondiscretionary, meaning that it is determined by formula rather than policy and cannot be changed in response to economic conditions This places even more rigidity into the formulation of fiscal policy A common way to summarize the net impact of government fiscal policy is to look at the government’s budget deficit or surplus, which is simply the difference between revenues and expenditures A large deficit means the government is spending considerably more than it is taking in by way of taxes The net effect is to increase the demand for goods (via spending) by more than it reduces the demand for goods (via taxes), therefore, stimulating the economy fiscal policy The use of government spending and taxing for the specific purpose of stabilizing the economy Monetary Policy Monetary policy refers to the manipulation of the money supply to affect the macroeconomy and is the other main leg of demand-side policy Monetary policy works largely through its impact on interest rates Increases in the money supply lower short-term interest rates, ultimately encouraging investment and consumption demand Over longer periods, however, most economists believe a higher money supply leads only to a higher price level and does not have a permanent effect on economic activity Thus, the monetary authorities face a difficult balancing act Expansionary monetary policy probably will lower interest rates and thereby stimulate investment and some consumption demand in the short run, but these circumstances bod05175_ch12_369-400.indd 377 monetary policy Actions taken by the Board of Governors of the Federal Reserve System to influence the money supply or interest rates 8/17/07 5:33:23 PM 378 Part FOUR Security Analysis ultimately will lead only to higher prices The stimulation/inflation trade-off is implicit in all debate over proper monetary policy Fiscal policy is cumbersome to implement but has a fairly direct impact on the economy, while monetary policy is easily formulated and implemented but has a less immediate impact Monetary policy is determined by the Board of Governors of the Federal Reserve System Board members are appointed by the president for 14-year terms and are reasonably insulated from political pressure The board is small enough and often sufficiently dominated by its chairperson that policy can be formulated and modulated relatively easily Implementation of monetary policy also is quite direct The most widely used tool is the open market operation, in which the Fed buys or sells Treasury bonds for its own account When the Fed buys securities, it simply writes a check, thereby increasing the money supply (Unlike us, the Fed can pay for the securities without drawing down funds at a bank account.) Conversely, when the Fed sells a security, the money paid for it leaves the money supply Open market operations occur daily, allowing the Fed to fine-tune its monetary policy Other tools at the Fed’s disposal are the discount rate, which is the interest rate it charges banks on short-term loans, and the reserve requirement, which is the fraction of deposits that banks must hold as cash on hand or as deposits with the Fed Reductions in the discount rate signal a more expansionary monetary policy Lowering reserve requirements allows banks to make more loans with each dollar of deposits and stimulates the economy by increasing the effective money supply While the discount rate is under the direct control of the Fed, it is changed relatively infrequently The federal funds rate is by far the better guide to Federal Reserve policy The federal funds rate is the interest rate at which banks make short-term, usually overnight, loans to each other These loans occur because some banks need to borrow funds to meet reserve requirements, while other banks have excess funds Unlike the discount rate, the fed funds rate is a market rate, meaning that it is determined by supply and demand rather than being set administratively Nevertheless, the Federal Reserve Board targets the fed funds rate, expanding or contracting the money supply through open market operations as it nudges the fed funds to its targeted value This is the benchmark short-term U.S interest rate, and as such has considerable influence over other interest rates in the U.S and the rest of the world Monetary policy affects the economy in a more roundabout way than fiscal policy While fiscal policy directly stimulates or dampens the economy, monetary policy works largely through its impact on interest rates Increases in the money supply lower interest rates, which stimulate investment demand As the quantity of money in the economy increases, investors will find that their portfolios of assets include too much money They will rebalance their portfolios by buying securities such as bonds, forcing bond prices up and interest rates down In the longer run, individuals may increase their holdings of stocks as well and ultimately buy real assets, which stimulates consumption demand directly The ultimate effect of monetary policy on investment and consumption demand, however, is less immediate than that of fiscal policy CONCEPT c h e c k 12.2 Suppose the government wants to stimulate the economy without increasing interest rates What combination of fiscal and monetary policy might accomplish this goal? Supply-Side Policies Fiscal and monetary policy are demand-oriented tools that affect the economy by stimulating the total demand for goods and services The implicit belief is that the economy will not by itself arrive at a full employment equilibrium and that macroeconomic policy bod05175_ch12_369-400.indd 378 8/17/07 5:33:24 PM I-10 Index M M2 (Modigliani-squared) measure of performance, 591–592 Macaulay, Frederick, 337 Macaulay’s duration, 336–343, 337 MacBeth, James, 209 MacKinlay, Craig, 242 Macroeconomic analysis business cycles, 379–385, 387–388 covariance and correlation, 152–155 demand and supply shocks, 376–377 domestic economy, 373–374 economic derivatives markets, 506–507 federal government policy, 377–379 financial markets and the economy, 6–10 global economy, 371–373 industry analysis business cycle sensitivity, 387–388 cyclical/defensive industries, 379–381, 390 introduction, 385–386 life cycles, 389–392 NAICS codes, 386–387 sector rotation, 388–389 structure and performance, 393 interest rates, 374, 375–378 Magellan Fund, 108–110, 254, 597–599 Magnitude issue, 240 Maintenance margin, 75, 560 Maksimovic, V., 263n Malkiel, Burton G., 106–107, 251–252, 335–336, 341 Malkiel’s bond-pricing relationships, 335–336 Managed investment companies, 90–94 Management, corporate, 7–8 Managers; see Portfolio managers Marcus, Alan J., 597n, 645 Margin, 74 buying securities, 74–77 futures contracts, 553, 560 marking to market, 560–561 options trading, 484–485 short sales, 78 Market capitalization rate, 405 Market conversion value, 294 Market crash of October 1987, 489, 541, 645–647 Market makers, 67 Market newsletters, 241 Market orders, 62 Market portfolios, 194–196, 200 Market price, 404–405 Market price ratios, 454–455 Market risk, 151, 177 Market timing, 101, 608–611 Market-to-book-value ratio, 454 Market-value-weighted indexes, 44–45 Marking to market, 560–561 Markowitz, Harry, 11, 149, 169 Marsh, Paul, 126n, 140–141 Matrimony, bequest, and intergenerational transfers, 677–678 Maturity stage, 391–392 Mayers, David, 197 Mazuy, Kay, 611 McDonald, Ian, 110n McDonald, R L., 543n McGee, Suzanne, 574n McGrattan, E R., 141 bod05175_ndx_I1-I18.indd I-10 McNichols, M., 251 Mean return, 121 Mean-variance analysis, 124, 159–164 Media reports and stock prices, 233–234, 246–247 Meeker, Mary, 421 Memory bias, 264 Mendelson, Haim, 209, 245 Mendenhall, R., 246n5 Mental accounting, 265–266 Merck, 10 Merrill Lynch, 14, 46, 71, 289, 684 Merton, Robert C., 215–216, 245, 526n, 527, 609 Microsoft Corporation, 402–403, 541–542, 695 Milken, Michael, 313 Miller, Bill, 241, 254 Miller, M., 429 Minor trend, 274 Mobil, 316–317 Model risk, 269 Modern portfolio theory, 11, 115 Modified duration, 339 Modigliani, Franco, 429, 591 Modigliani, Leah, 591 Momentum effect, 242 Monetary policy, 377–379 Money managers; see Portfolio managers Money market funds, 95, 136 Money market mutual funds, 135–136 Money markets, 25; see also Treasury bills bankers’ acceptances, 28 brokers’ calls, 29 certificates of deposit, 27, 29–30 commercial paper, 28 Eurodollars, 28 Federal funds, 29 LIBOR market, 29 overview, 5, 25–26 repurchase agreements, 28–29 yields, 29 Moody’s Investor Services, 35, 293, 313–314, 316–317 Moral hazard, 677 Morey, Matthew R., 110 Morgan Stanley, 421, 467, 591 Morgan Stanley Capital International (MSCI), 46–47, 637, 651 Morningstar, 60, 97, 108–110, 151, 596, 599–600 Mortgage-backed securities, 16–17, 35–37 Mortgage bonds, 316 Mortgages, 35–37, 675–676, 683 Mortgage trusts, 93 Mossin, Jan, 193 Motorola, 458 Moving averages, 277–279 MSCI (Morgan Stanley Capital International), 46–47, 637, 651 Multifactor models, 211–216 Multistage growth models, 412–417 Mumenthaler, Christian, 297 Municipal bonds, 32–35 Mutual funds, 685 classes, 98 closed-end, 91–93, 270–271 costs, 97–101 exchange-traded funds, 45, 103–104, 201, 238 global and international, 95, 635, 637 information sources, 107–110 investment policies, 94–96 8/28/07 6:29:25 PM Index Mutual funds—Cont late trading and market timing, 101–102 managers, 251–255, 597, 601–606 money market, 135–136 performance, 104–107, 251–255, 597, 601; see also Performance evaluation players, 13–14 pricing, 90 as professional investors, 685, 690 rates of return and expenses, 99–101 ratings, 110 reforms, 101–102 return requirement and risk tolerance, 690 sales and marketing, 96–97 tax issues, 102–103 Mutual Fund Sourcebook (Morningstar), 97, 108 Mutual fund theorem, 195 Myers, S C., 271n7 N NAFTA (North American Free Trade Agreement), 386n NAICS codes, 386–387 Naik, Narayan, 601 Naked options, 488–489, 494 Nasdaq 100 Index, 45 Nasdaq Composite Index, 45 Nasdaq (National Association of Securities Dealers Automatic Quotation) System, 1, 64 Nasdaq Stock Market, 66–67 National Association of Securities Dealers (NASD), 45, 64, 73, 80, 319 National Market System, 70–71 National Stock Exchange (India), 73 NAV (net asset value), 90 Neff, John, 254 Neglected-firm effect, 245 Neiman Marcus, 386 Net asset value (NAV), 90 New issues, 56–60 Newsletters, market, 241 New York Stock Exchange (NYSE) block transactions, 68–69 bond trading, 71 globalization and consolidation, 73 orders, 62–64, 69, 573 overview, 67–69 program trading, 573 regulatory roles, 80, 82 settlement, 69 specialists, 65–67 stock market indexes, 45 trading costs, 73–74 Nicoliasen, Donald, 49 Nikkei stock index, 40, 46, 485, 635 Nofsinger, John, 268 “Noisy market hypothesis,” 249–250 No-load funds, 98 Nominal interest rate, 132–133, 375–376, 462 Nondiversifiable risk, 151 Non-life-insurance companies, 687 Nonrecurring items, 464 Nonsystematic risk, 151, 177–178 North American Free Trade Agreement (NAFTA), 386n Notional principal, 577 NYSE-Euronext, 68; see also New York Stock Exchange bod05175_ndx_I1-I18.indd I-11 I-11 O O’Connor, Robert, 489 October 1987 market crash, 489, 541, 645–647 Odean, Terrance, 264, 266, 268, 273 Off-balance-sheet assets and liabilities, 464–465 Official Summary of Security Transactions and Holdings (SEC), 82–83, 248 OneChicago, 556 One Up on Wall Street (Lynch), 392, 420 Open-end funds, 91–93, 92, 271n6 Open interest, 559–560 Open IPOs, 60 Operating earnings, 422 Optimal risky portfolios, 164–167, 165, 170–171 Option Clearing Corporation, 484–485 Option elasticity, 538 Optionlike securities callable bonds, 35, 294, 305–306, 500 collateralized loans, 503–504 convertible securities, 500–502 levered equity and risky debt, 504–505, 534 warrants, 503 Options; see also Call options; Put options American, 484 contracts, 46–49, 480–486 digital, 506–507 European, 484, 527, 533, 535–537 exotic, 505–507 foreign currency, 486 foreign security, 635 futures, 485–486 futures investments versus, 50–51, 556 index, 485 interest rate, 486 markets, 482–485 naked, 488–489, 494 Option Clearing Corporation, 484–485 premium, 51, 481 put/call ratio, 281 stock investments versus, 489–492 values at expiration, 486–489 Option smirk, 543 Option strategies collars, 498 covered calls, 494–495 hedging, 521–522 protective puts, 492–494, 539–540 risk management, 492–493 spreads, 497–499 straddles, 494–497 Option valuation binomial pricing, 520–526 Black-Scholes formula empirical evidence, 542–543 hedge ratios and, 537–538 introduction, 526–533 portfolio insurance, 538–542 put-call parity relationship, 533–536 put option valuation, 536–537 at expiration, 486–489 introduction, 517–520 Order types, 62–64 Oriental Land Company, 296 Original issue discount, 311–312 8/28/07 6:29:25 PM I-12 Index Outlook (Standard & Poor’s), 467 Out of the money, 482 Overconfidence, 264 Over-the-counter (OTC) market, 64 P Paine Webber, 421 Palm, 270 Palmon, Dan, 247 Parity, 269–270 Parmalat, Par value, 291 Passive core strategy, 239, 694 Passive investment strategy, 11, 139, 238 active strategy versus, 238–239, 693–694 bond management cash flow matching and dedication, 349–350 immunization, 343–349, 355–357 capital market line and, 139–141 CAPM and, 195 costs, 141, 637 introduction, 333–334 Passive management, 11 Passive strategy, 139–141 Pass-through securities, 16–17, 36 Patel, Jayendu, 233, 253 Pay-in-kind bonds, 296 Peak, 379 P/E effect, 244 PEG ratio, 420 Pension funds, 344, 685–686, 690 P/E (price-earnings) ratio; see Price-earnings (P/E) multiple or ratio Performance evaluation attribution procedures, 601–606, 649–651 Morningstar risk-adjusted ratings, 599–600 risk-adjusted returns changing portfolio composition and, 594–598 choosing measures of, 592–594 comparison groups, 589 M2 measure of performance, 591–592 methodology, 589–591 style analysis, 598–599, 601 Perold, André, 250n6 Personal trusts, 684–685 Pfizer, 10, 44 PIA (Primary Insurance Amount), 672–673 Pierallini, Fabrizio, 574 Pinkerton, John, 233n Pink Sheets LLC, 66–67 Plowback ratio, 410, 454 PNC Financial, 386 Point and figure charts, 275–277 Political risk, 632–634 Political Risk Services (PRS) Group, 632–635 Pontiff, Jeffrey, 92, 270 Porter, Michael, 393 Portfolio beta, 594, 611 Portfolio insurance, 538–542 Portfolio managers; see also Active investment strategy; Performance evaluation EMH and, 239, 240–241 forecasting by, 264, 430–432, 610 performance, 251–255 bod05175_ndx_I1-I18.indd I-12 Portfolio risk; see also Asset allocation; Diversification asset allocation capital allocation line, 137–138 expected return and risk, 136–137 risk-free assets, 135–136 risk tolerance and, 138–139 risky assets, 134–135 comparison groups, 589 historical returns and, 125–131 mutual funds, 105 risk adjustments with changing portfolio composition, 594–598 Sharpe measure, 124, 127–128 Portfolios; see also Two-risky-assets portfolios active, 613 behavioral finance, 268 complete, 134–138, 166–167, 171 definition and overview, factor, 219 hedge ratios, 537–538 levered complete, 138 market, 194–196 momentum effect, 242 monitoring and revising, 695 optimal risky, 164–167, 170–171 optimization, 612–614 risky, 135, 165 well-diversified, 216–218 Portfolio variance, 157–158 Post-earnings-announcement price drift, 246–247 Poterba, James M., 242 Preferred stock, 39, 295, 407, 500–502 Premium, options, 51, 481 Premium bonds, 305 Present value, 337 Present value of an annuity, 298n Present value of futures price, 567 Present value of growth opportunities (PVGO), 411–412 Presidential futures markets, 557 Price-contingent orders, 62–64 Price continuity, 66 Price-earnings (P/E) multiple or ratio, 417, 455 analysis pitfalls, 422–425 DDM combined with, 425 growth opportunities and, 417–421, 425 introduction, 39 of S&P 500 Index, 422 stock risk and, 421–422 Price risk, 345 Price-to-book ratio, 426, 454 Price-to cash flow ratio, 426 Price-to-sales ratio, 426 Price value of a basis point, 576 Price Waterhouse, 49 Price-weighted average, 40–41 Price-weighted average indexes, 45 Primack, Daniel, Primary Insurance Amount (PIA), 672–673 Primary market, 14–15, 56, 61 Primary trend, 274 Principal Financial Group, 56–57 Private placements, 56, 58 Probability distribution, 121 Procter & Gamble, 289 Producer sentiment, 374 8/28/07 6:29:28 PM Index Product competition, 393 Professional investors, 684–686, 692–693 Profitability measures, 313–314, 447–449 Profit margin, 449–451 Pro forma earnings, 422 Program trades and trading, 69, 82, 573 Progressive tax, 664–668, 665 Property and casualty insurance companies, 687, 691 Prospect theory, 266–267 Prospectus, 56 Protective puts, 492–494, 539–540 Proxy contests, PRS (Political Risk Services) Group, 632–635 Prudent investor rule, 684, 688 Public Accounting Oversight Board, 463 Public offerings, 56 Pure yield pickup swap, 354–355 Put bonds, 294 Put-call parity relationship, 533–536, 534 Put/call ratio, 281 Putnam Funds, 95 Put options, 48, 482 overview, 48–49, 482 portfolio insurance, 538–542 protective, 492–494, 539–540 valuation, 536–537 values at expiration, 482, 488–489 PV factor, 299 PVGO (present value of growth opportunities), 411–412 Q Quality of earnings, 464–465 Quantos, 505–507 “Qubes” (QQQ), 103 Quick ratio, 313, 453 Qwest Communications, R Ramsay, Gordon, 601 Random walk, 232–235 Rate anticipation swap, 354 Rates of return, 117–120; see also Returns Ratings agencies, 35, 293, 313–314 Ratio analysis, 456–457 Ratios; see also Financial statement analysis; Price-earnings ratio bond conversion, 294, 501–502 bond safety, 313–315 book-to-market, 245–246 equity valuation, 410, 420, 422, 426, 430–432 liquidity, 453–454 market price, 454–455 option valuation, 522, 524, 526, 537–538, 540 portfolio construction, 614 reward-to-volatility, 124, 137–138 ROE decomposition, 449–451 summary, 456 technical analysis, 281 turnover, 451–453 Rau, P R., 272 Rauh, J., 463 Real assets, 3–5, Real consumption, 660 Real estate investment trusts (REITs), 93 bod05175_ndx_I1-I18.indd I-13 I-13 Real interest rate, 132, 374–376, 660–661 Realized compound return, 307–308 Realized returns, 201–202 Rebalancing, 347–348 Redeemable preferred stock, 39 Redeemable trust certificates, 91 Red herrings, 56 Redington, F M., 344 Refunding, 294 Regional funds, 95 Registered bonds, 293–294 Regression equation, 173 Regression line, 174 Regret avoidance, 266 Regulation accounting, 423, 463–465 of futures markets, 562 of institutional investors, 688–691 of securities markets, 79–83, 248 Reinganum, Marc R., 245 Reinvestment rate risk, 345 Reinvestment rate risk, 308 REITs (real estate investment trusts), 93 Rekenthaler, John, 151 Relative decline stage, 392 Relative strength, 236, 279–280 Renault, E., 533n Rendleman, R J., 246–247 Replacement cost, 403 Replication, 521–522 Repos, 28–29 Representativeness bias, 265 Repurchase agreements, 28–29 Reserve requirement, 378 Reserving practices, 465 Residual claims, 38 Residual income, 458 Residual standard deviation, 202 Resistance levels, 236 Resource allocation and efficient markets, 239–240 Retirement annuity, 659–660 Retirement plans; see Savings and retirement plans; Tax shelters Return on assets (ROA), 313–314, 447–449 Return on equity (ROE), 313–314, 447–451, 454 Return on sales, 449 Return requirement, 682 Returns; see also Historical returns; Performance evaluation; Risk-return trade-off arithmetic average, 118 asset allocation and, 133–139 dollar-weighted, 119 emerging market investments, 638–639 excess, 123, 172–174 expected, 121, 136–137, 196–202 geometric average, 118–119 holding period, 117–118, 310–311, 320 inflation and, 131–133 mean, 121 over long horizons, 242–243 over multiple periods, 117–119 over short horizons, 242 quoting conventions, 119–120 realized, 201–202 realized compound, 307–308 8/28/07 6:29:29 PM I-14 Index Revenue bonds, 32–33 Revenue recognition, 464 Revenue sharing, 97 Reversal effect, 243 Reverse repos, 29 Reversing trade, 559 Reward-to-volatility ratio, 124, 137–138 Rising yield curve, 319 Risk; see also Interest rate risk; Portfolio risk allocation of, arbitrage, 267–269 basis, 565 bonds, 35–36, 293, 308, 312–318, 345 country-specific, 631–635 diversification and, 151, 170–171, 177–180, 211 emerging market investments, 635–639 exchange rate, 626–631, 640–641 risk premiums and, 120–124 stock, 421–422 Risk Adjusted Rating (Morningstar), 599–600 Risk-adjusted returns changing portfolio composition and, 594–598 choosing measures of, 592–594 comparison groups, 589 EMH and, 243–244 M2 measure of performance, 591–592 methodology, 589–591 Morningstar ratings, 599–600 style analysis, 598–599, 601 Risk aversion, 123, 682 diversification and, 161, 166–168, 171 in individual investors, 682–685 market portfolio and, 193–196 questionnaire for, 684–685 risk premiums and, 123–124, 196 risk tolerance compared, 138n Risk-free assets, 135–136, 164–167 Risk-free interest rate, 522 Risk-free rate of return, 123 Risk management, 492–493 Risk Management Association, 457 Risk premium, 123 of individual securities, 196–198 inefficiencies versus, 248–249 of market portfolio, 194, 196 risk and, 120–124 wealth index and, 129 Risk-return trade-off, 10–11 asset allocation and portfolio risk, 133–139 historical returns, 125–131 inflation and real rates of return, 131–133 passive strategies and capital market line, 139–141 rates of return, 117–120 risk and risk premiums, 120–124 two-risky-assets portfolios, 157–159 Risk tolerance, 682 asset allocation and, 138–139 in individual investors, 682–685 questionnaire for, 684–685 risk aversion and, 138n risk premiums and, 123–124, 196 Risky assets, 134–135, 168–171 Risky debt, 504–505 Rite Aid, Ritter, Jay R., 59n, 60n, 243, 265 bod05175_ndx_I1-I18.indd I-14 Road shows, 58 ROA (return on assets), 313–314, 447–449 Roberts, Harry, 281–282 ROE (return on equity), 313–314, 447–451, 454 Roge, 684 Roll, Richard, 209, 215–216, 645–647 Roll’s critique, 209 Ross, Stephen A., 215–216, 255, 270, 314n, 526n Roth, Brane v., 492–493 Roth IRAs, 667–668 Royal Dutch Shell, 269–270, 458 Rubinstein, Mark, 542–543 Rydqvist, K., 59n S Saitori, 72 Salomon Smith Barney, 46, 71 Sample size neglect, 265 Samuelson, Paul, 254, 432 Samurai bonds, 32, 295 Sanford Bernstein & Co., 61, 357 Sarbanes-Oxley Act, 9, 80–81 Savings and retirement plans; see also Tax shelters accounting for inflation, 660–662 children’s education, 674–675 home ownership, 675–676 household savings, 3–4, 12–13, 375, 658–660, 670–671 large purchases, 674–675 longevity and other uncertainties, 676–677 matrimony, bequest, and intergenerational transfers, 677–678 sheltered versus unsheltered, 670–671 Social Security, 671–674 tax planning, 662–664 Scenario analysis, 121 Schatsky, 684 Scherbina, A., 141 Schleifer, A., 267n Scholes, Myron, 209, 527 Schroders, 201 SCL (security characteristic line), 174, 203 Scudder Kemper Investments Inc., 684 Seasoned equity offerings, 56 Secondary market, 14, 56 Secondary trend, 274 SEC (Securities and Exchange Commission) accounting requirements, 423, 465 EDGAR database, 402 insider trading and, 82–83, 234–236, 248 National Market System, 70–71 new issues and, 56 regulatory roles, 79–83, 248 Sector funds, 95 Sector rotation, 388–389 Sector selection decisions, 603–604 Securities Act of 1933, 79–80 Securities and Exchange Commission; see SEC Securities Exchange Act of 1934, 79–80 Securities Investor Protection Corporation (SIPC), 80 Securities markets; see also specific topic, e.g., options 2003 returns, 627 bonds; see Bond market buying on margin, 74–77 derivatives, 46–51, 479–480, 506–507 forecasting, 264, 430–432, 610 futures; see Futures markets 8/28/07 6:29:30 PM Index Securities markets; see also specific topic, e.g., options—Cont globalization and consolidation, 15–16, 72–73 international, 71–73 money market; see Money markets options, 482–485 primary, 14–15, 56–61 regulation, 79–83, 248 secondary, 14, 56 short sales, 77–79 stocks; see Stock markets trading, 60–66 trading costs, 73–74 trends and corrections, 273–280 types, 61–62 U.S., 66–71 Securitization, 16–17 Security analysis, 10; see also Equity valuation; Financial statement analysis; Macroeconomic analysis Security Analysis (Graham and Dodd), 466–467 Security characteristic line (SCL), 174, 203 Security market line (SML), 198 Security selection, 10, 24, 603–604 Selection bias issue, 240 Self-destructing price patterns, 237 Self-regulatory organizations (SROs), 80 Semistrong-form EMH, 235, 243–247 Senior debt, 316 Sentiment, consumer and producer, 374 Separation property, 171 Serial bonds, 316 Serial correlation, 242 Settlement date, 69, 301 Seyhun, H Nejat, 247–248 Shanken, Jay, 246n4 Shareholders, 7–8, 37–39 Shareholders’ equity, 444 Sharpe, William F., 11, 137, 171, 192–193, 209, 589, 598–600 Sharpe measure, 124, 127–128, 137, 590–591, 608 Shefrin, Hersh, 266 Shelf registration, 57–58 Shell, Shell Transport, 269–270 Shiller, Robert, 243, 272 Shleifer, Andrei, 248, 270 Short hedge, 564 Short interest, 280 Short positions, 554 Short sales, 63, 77–79 Shumway, Tyler, 266 “Siamese Twin” companies, 269–270 Singer, Brian, 598n Single-factor asset market, 171–178 Single-index model, 172–175 Single stock futures, 556 Sinking funds, 315–316 Sinquefield, Rex, 244n SIPC (Securities Investor Protection Corporation), 80 Sloan, Richard G., 246n4 Small-firm effect, 244–245 Smith, Randall, 61n SML (security market line), 198 Social Security, 671–674 Society of the Financial Analysts Federation, 683 Soft dollars, 100–102 Solnik, B., 627, 644n, 645 bod05175_ndx_I1-I18.indd I-15 I-15 Sotheby’s, 421 Sougiannis, Theodore, 463 Specialists, 65–67 Speculating with derivatives, 6, 49 with futures, 563–566 with hedge funds, 93–94 risk premiums and, 123 Speculative grade bonds, 313–314 Speidell, Lawrence S., 465–466 Sperling, Gene, 384n “Spiders” (SPDRs), 103 “Spinning,” 59 Spitzer, Eliot, 82 Spivack, Avia, 677 Spot-futures parity theorem, 566–570, 568–569 Spread, bid-asked, 27, 62, 73–74 Spreads, 497–499, 566, 570–571 SROs (self-regulatory organizations), 80 Stahlman, Mark, 421 Stambaugh, Robert F., 243, 245 Standard deviation, 122, 127, 593 Standard & Poor’s 100 Index, 485, 489 Standard & Poor’s 500 Index dividend yield, 669 earnings per share versus, 373 financial futures trading, 562, 571–572 global lack of diversification, 621–622 historical returns, 10, 610 index funds, 44–45, 96, 139–140, 238, 694 valuation ratios, 422, 426, 430–432 Standard & Poor’s Corporation credit ratings, 35, 293, 313–314 earnings estimates, 463 indexes, 44–45 industry classifications, 387 as information source, 402, 457, 467 Start-up stage, 391 Statement of cash flows, 445–446 Statman, Meir, 151n, 265–266, 268 Staunton, Mike, 126n, 140–141 Stern Stewart, 458 Stiglitz, Joseph E., 234, 605n Stock exchanges, 67–69; see also specific exchange Stockholders, 7–8, 37–39 Stockholders’ equity, 444 Stock index futures, 571–572 Stock market analysts, 250–251 Stock market forecasting, 264, 430–432, 610 Stock market indexes; see also Standard & Poor’s 500 Index calculating yields, 31 Dow Jones, 40–45, 82, 485 equally-weighted, 46 foreign and international, 46 market-value-weighted, 44–45 Nasdaq, 45 Standard & Poor’s, generally, 44–45 Standard & Poor’s 100 Index, 485, 489 value-weighted, 44–45 Wilshire 5000 Index, 45, 105–106, 238 Stock markets ECNs, 64–65, 70, 73 exchanges, 67–69 mechanisms, 64–66 8/28/07 6:29:31 PM I-16 Index Stock markets—Cont Nasdaq, 66–67 National Market System, 70–71 new issues, 14–15, 56–61 order types, 62–64 types, 61–62 Stock options, employee, 464 Stock prices; see also Equity valuation; Financial statement analysis; Industry analysis earnings announcements and, 233–234, 246–247 investment opportunities and, 409–412 Stock risk, 421–422; see also Beta Stocks ADRs, 15, 39, 414n, 635, 637 common, 37–39 dividends, 293n, 316, 518n historical returns, 10, 121, 125–131, 252 newspaper listings, 38–39 option investments versus, 489–492 preferred, 39, 295, 407, 500–502 synthetic positions, 572–573 value, 108, 466–467 Stock selection, 651–652 Stop-buy orders, 63 Stop-loss orders, 63 Stop orders, 63 Stovall, Sam, 390n Straddles, 494–497 Straight bonds, 500 Strebel, Paul J., 245 Street name, 69 Strike price, 46, 481, 483 STRIPS (Separate Trading of Registered Interest and Principal of Securities), 311–312 Strong-form EMH, 235, 247–248 Stub value, 270 Stulz, R., 263n Style analysis, 598–599, 601 Subordination clauses, 316 Substitution swap, 354 Summers, Lawrence H., 242, 267n, 677–678 Sunbeam, 464 Sun Trust, 386 SuperDot system, 69, 573 Suppliers, bargaining power of, 393 Supply shock, 376–377 Support levels, 236 Survivorship bias, 254–255 Swaps, 354–355, 577–579 Swiss Re, 297 Synthetic protective puts, 539–540 Synthetic stock positions, 572–573 Systematic risk, 151, 177–178, 211 T T Rowe Price Associates, Inc., 684 T2(Treynor-Square) measure of performance, 593–594 Targeted-maturity funds, 95 Taxes accounting for, 662–664 capital gains, 32–33, 102–103, 669–670 equivalent taxable yield, 33–35 flat, 662, 665 futures contracts, 562 investment decisions and, 689 mutual fund income, 102–103 bod05175_ndx_I1-I18.indd I-16 Taxes—Cont original-issue discount bonds, 312 progressive, 665–668 Tax shelters, 664 401k and 403b plans, 668–669 benchmark, 664 IRAs, 667–668 risky investments and capital gains, 669–670 sheltered versus unsheltered, 670–671 tax code effects, 664–666 Tax swaps, 355 Tax-timing option, 669 T-bills; see Treasury bills Technical analysis, 235–237 behavioral finance and, 273 breadth, 279 confidence index, 280 Dow theory, 274–275 Elliott wave theory, 275 fundamental analysis compared, 243, 401–402 Kondratieff waves, 275 moving averages, 277–279 point and figure charts, 275–277 put/call ratio, 281 relative strength, 279–280 short interest, 280 trin statistic, 280 warning, 281–282 Templeton, John, 254 Templeton Funds, 254 Term insurance, 686 Term premium, 215 Term repos, 29 Term structure of interest rates, 318–319 Tertiary trend, 274 Thaler, Richard H., 242, 243, 263n, 264, 266, 269n, 270, 272 Thayer, Peter, 489 Thomas, J., 246n5 Thompson, Rex, 92 3Com, 270 Times-interest-earned ratio, 313, 450 Time value of options, 518 Time-weighted average return, 118–119 Timmerman, A., 254 TIPS (Treasury Inflation-Protected Securities), 31–32, 296–298 Titman, Sheridan, 242 Tobin, James, 171, 404 Tobin’s q, 404 Tokyo Disneyland, 296 Tokyo Stock Exchange, 72, 73 Tombstones, 56–57 Total asset turnover (ATO), 449 Toyota, 3, 239, 354 TRACE (Trade Reporting and Compliance Engine) system, 319 Trade-through rule, 70–71 Trading costs, 73–74 Trading halts, 82 Trading mechanisms, 64–66 Traditional IRAs, 667 Trainer, Francis, 357 Treasury bills, 25–27 historical returns, 10, 125–131 pricing and yields, 27, 29–30, 311–312 as risk-free assets, 123, 135–136 Treasury Inflation Protected Securities (TIPS), 31–32, 296–298 8/28/07 6:29:32 PM Index Treasury notes and bonds, 30–31 characteristics, 291–293 historical returns, 125–131 interest rate futures, 574–576 zero-coupon, 311–312 Treasury STRIPS, 311–312 Treynor, Jack, 193, 589, 611 Treynor-Black Model, 611–614, 612 Treynor measure, 591 Treynor-Square (T2) measure, 593–594 Trin statistic, 280 Trough, 379 Trueman, B., 251 Trusts and trustees, 684–685 TSX index, 46 Turnover, 102, 449–453 Tversky, A., 264, 266n 12b-1 fees, 98 $20 bill story, 255 Two-risky-assets portfolios covariance and correlation, 152–155 historical data and, 155–157 mean-variance criterion, 159–164 risk-return trade-offs, 157–159 three rules, 157 Two-stage DDM, 414 Two-state option pricing, 520–526 U UBS Index of Investor Optimism, 268 Unbundling, 17–18 Underwriters, 56–57 Unemployment rate, 374, 506–507 Uniform Securities Act, 80 Unique risk, 151, 177 U.S Department of Commerce, 457 U.S government agency debt, 32, 295 U.S securities markets, 66–71 U.S Treasury Bills; see Treasury bills Unit investment trusts, 91 Universal life policies, 686 Unmanaged trusts, 91 Unsecured bonds, 316 V VA Linux, 58–59 Valuation ratios, 426; see also Equity valuation; Price-earnings ratios Value Line Investment Survey, 110, 387, 412–417, 428–429, 467 Value stocks and investing, 108, 466–467 Value-weighted indexes, 44–45 VanderHoff, Frank, 489 Vanguard Funds, 95–96, 99, 105, 134, 238, 254, 635, 647 Vanguard Group, 684, 693–694 Variable life policies, 686 Variance, 121–122 Vassalou, M., 249n Verizon, 44 Viacom, Vishny, R., 248, 267n Vivendi Universal, Volatility value of options, 518–520 Vonage, 59 Vontobel Ltd., 574 Voting/nonvoting stocks, 37n, 295 Vuolteenaho, Tuomo, 210 bod05175_ndx_I1-I18.indd I-17 I-17 W W R Grace, 464 W R Hambrecht & Co., 60–61 Wage insurance, 677 Waldmann, R., 267n Wallace, A., 209 Wal-Mart, 458 Walt Disney Corporation, 296 Wang, Zhenyu, 210 Warrants, 503 Watson Wyatt, 201 Weak-form EMH, 235, 242–243 Wealth and risk premium, 129 WEBS (World Equity Benchmark Shares), 15, 103, 637 Weinberger, Alfred, 355 Well-diversified portfolios, 216–218 Wermers, R., 254 Westerfield, Randolph W., 314n Weyns, Guy, 467 Whaley, Robert E., 542 White, A., 533n White, H., 254 Whole-life insurance policies, 686 Wiesenberger, 97, 108 Wiggins, J B., 533n Wilhelm, William, 59n Wilshire 5000 Index, 45, 105–106, 238 Winterthur, 296 Wolfers, J., 506n Wolfson, M A., 233 Womack, K L., 251 Workout period, 354 WorldCom, 9, 423 World Equity Benchmark Shares (WEBS), 15, 103, 637 Writing calls, 481, 487, 494–495 Writing puts, 482, 488 Y Yahoo!, 7, 108, 457 Yankee bonds, 32, 295 Yield bank discount method, 27 bond-equivalent, 27, 303 current, 304 effective annual, 303 equivalent taxable, 33–34 on money market instruments, 29 Yield curve, 318–324 Yield to call, 305–306 Yield to maturity, 303 default risk and, 316–318 holding period return versus, 310–311 overview, 303–305 realized compound return versus, 307–308 Z Zeckhauser, Richard, 253 Zero-beta portfolios, 217–218 Zero-coupon bonds, 291, 311–312 Zero sum game, 554 Ziemba, W T., 263n Zurich Financial Services, 297 Zurich Group Inc., 684 8/28/07 6:29:32 PM bod05175_ndx_I1-I18.indd I-18 8/28/07 6:29:33 PM Digital Classroom Solutions Commonly Used Notation Are you looking for a way to spend less time grading and have more flexibility with the problems you assign? ® ™ Try McGraw-Hill’s Homework Manager or Homework Manager Plus for an answer to your classroom needs This Web-based tool for instructors and students delivers and grades end-of-chapter problems and tests, and provides a limitless supply of self-graded practice for students b Retention or plowback ratio C Call option value CF Select end-of-chapter questions are loaded into the program, instructors select the assignments and set the parameters, and students complete the assignments—which are auto-graded and imported back into the instructor’s grade book Algorithmic versions of the problems are also available as well as the Test Bank for additional practice or use as a test /quiz Duration E Exchange rate Futures price e 2.718, the base for the natural logarithm, used for continuous compounding STOCK-TRAK Portfolio Simulations STOCK-TRAK is the most comprehensive online trading simulation featuring stocks, bonds, mutual funds, options, futures, spots, future options, and international stocks, created specifically for classroom use Students receive $500,000 of hypothetical money in a STOCK-TRAK brokerage account with 24/7 access as well as full tech support, if needed No other simulation can offer all of these features! You customize STOCK-TRAK to fit your class by choosing the starting and ending date of their trading period, initial cash balance, and diversification requirements You also have 24/7 access to your students’ ranking and account detail so you can see student progress, and you receive weekly reports of class performance STOCK-TRAK can be used as homework, end-of-course project, class contest, extra credit, or just as a discussion starter in class! ROE Sp t The risk-free rate of interest The rate of return on the market portfolio Return on equity, incremental economic earnings per dollar reinvested in the firm Reward-to-volatility ratio of a portfolio, also called Sharpe’s measure; the excess expected return divided by the standard deviation Time The firm-specific return, also called the residual return, of security i in period t Tp Treynor’s measure for a portfolio, excess expected return divided by beta f Forward rate of interest V g Growth rate of dividends Intrinsic value of a firm, the present value of future dividends per share H Hedge ratio for an option, sometimes called the option’s delta X Exercise price of an option y Yield to maturity ␣ Rate of return beyond the value that would be forecast from the market’s return and the systematic risk of the security  Systematic or market risk of a security For a complete description of these exciting assets, please refer to the Packaging Options section listed in the Preface of this book Give your students a practical application that will last them a lifetime by subscribing to Expected value of random variable x F ei t Are you looking for a way to get your students involved in real-world investing? rM Cash flow D E(x) rf i Inflation rate k Market capitalization rate, the required rate of return on a firm’s stock ln Natural logarithm function M The market portfolio i j Cumulative normal function, the probability that a standard normal random variable will have value less than d Correlation coefficient between returns on securities i and j Standard deviation N(d) p Probability P Put value PV Present value P/E Price-to-earnings multiple r Cov(ri , rj) Variance Covariance between returns on securities i and j Rate of return on a security; for fixed-income securities, r may denote the rate of interest for a particular period By entering the Promotional code BK0707 students who sign up using the Bodie/Kane/Marcus text will receive $5.00 off the purchase price of STOCK-TRAK Check out the website at www.stocktrak.com for current pricing, a demo of the product, and more ideas on how to use this simulation in class bod05175_fnshts.indd ISBN: 0073405175 Author: Zvi Bodie Title: Essentials of Investments, 7/e 8/13/07 9:22:49 AM Front endsheets Color: 2, PMS 539M and PMS139 Pages: 2,3 Digital Classroom Solutions Commonly Used Notation Are you looking for a way to spend less time grading and have more flexibility with the problems you assign? ® ™ Try McGraw-Hill’s Homework Manager or Homework Manager Plus for an answer to your classroom needs This Web-based tool for instructors and students delivers and grades end-of-chapter problems and tests, and provides a limitless supply of self-graded practice for students b Retention or plowback ratio C Call option value CF Select end-of-chapter questions are loaded into the program, instructors select the assignments and set the parameters, and students complete the assignments—which are auto-graded and imported back into the instructor’s grade book Algorithmic versions of the problems are also available as well as the Test Bank for additional practice or use as a test /quiz Duration E Exchange rate Futures price e 2.718, the base for the natural logarithm, used for continuous compounding STOCK-TRAK Portfolio Simulations STOCK-TRAK is the most comprehensive online trading simulation featuring stocks, bonds, mutual funds, options, futures, spots, future options, and international stocks, created specifically for classroom use Students receive $500,000 of hypothetical money in a STOCK-TRAK brokerage account with 24/7 access as well as full tech support, if needed No other simulation can offer all of these features! You customize STOCK-TRAK to fit your class by choosing the starting and ending date of their trading period, initial cash balance, and diversification requirements You also have 24/7 access to your students’ ranking and account detail so you can see student progress, and you receive weekly reports of class performance STOCK-TRAK can be used as homework, end-of-course project, class contest, extra credit, or just as a discussion starter in class! ROE Sp t The risk-free rate of interest The rate of return on the market portfolio Return on equity, incremental economic earnings per dollar reinvested in the firm Reward-to-volatility ratio of a portfolio, also called Sharpe’s measure; the excess expected return divided by the standard deviation Time The firm-specific return, also called the residual return, of security i in period t Tp Treynor’s measure for a portfolio, excess expected return divided by beta f Forward rate of interest V g Growth rate of dividends Intrinsic value of a firm, the present value of future dividends per share H Hedge ratio for an option, sometimes called the option’s delta X Exercise price of an option y Yield to maturity ␣ Rate of return beyond the value that would be forecast from the market’s return and the systematic risk of the security  Systematic or market risk of a security For a complete description of these exciting assets, please refer to the Packaging Options section listed in the Preface of this book Give your students a practical application that will last them a lifetime by subscribing to Expected value of random variable x F ei t Are you looking for a way to get your students involved in real-world investing? rM Cash flow D E(x) rf i Inflation rate k Market capitalization rate, the required rate of return on a firm’s stock ln Natural logarithm function M The market portfolio i j Cumulative normal function, the probability that a standard normal random variable will have value less than d Correlation coefficient between returns on securities i and j Standard deviation N(d) p Probability P Put value PV Present value P/E Price-to-earnings multiple r Cov(ri , rj) Variance Covariance between returns on securities i and j Rate of return on a security; for fixed-income securities, r may denote the rate of interest for a particular period By entering the Promotional code BK0707 students who sign up using the Bodie/Kane/Marcus text will receive $5.00 off the purchase price of STOCK-TRAK Check out the website at www.stocktrak.com for current pricing, a demo of the product, and more ideas on how to use this simulation in class bod05175_fnshts.indd ISBN: 0073405175 Author: Zvi Bodie Title: Essentials of Investments, 7/e 8/13/07 9:22:49 AM Front endsheets Color: 2, PMS 539M and PMS139 Pages: 2,3 Useful Web Sites General business and finance information www.dowjones.com www.economist.com www.wsj.com www.ft.com www.businessweek.com www.euromoney.com www.forbes.com money.cnn.com/magazines/fortune The Economist The Wall Street Journal The Financial Times BusinessWeek Sources of data on individual companies and industries www.mhhe.com/edumarketinsight Available to users of this text with purchase of a new book, a source of extensive financial statement data as well as stock price histories www.bloomberg.com finance.yahoo.com Stock price and company information money.cnn.com www.hoovers.com www.annualreports.com Annual reports www.sec.gov Annual reports and other financial statements from the EDGAR database Macroeconomic data www.bea.gov www.federalreserve.gov www.fms.treas.gov stats.bls.gov Bureau of Economic Analysis Board of Governors of the Federal Reserve System Links to publications of the Treasury Department Bureau of Labor Statistics Sites with links to other resources www.financewise.com www.investorlinks.com www.finpipe.com www.corpfinet.com www.ceoexpress.com www.cob.ohio-state.edu/fin/journal/jofsites.htm (site maintained by Ohio State University College of Business) bod05175_fnshts.indd ISBN: 0073405175 Author: Zvi Bodie Title: Essentials of Investments, 7/e 8/13/07 9:22:49 AM Front endsheets Color: 2, PMS 539M and PMS139 Pages: Useful Formulas Equity Analysis Constant growth dividend discount model: Sustainable growth rate of dividends: Measures of Risk ∑ p(s)[r(s) Ϫ E(r)]2 Variance of returns: 2 ϭ ϭ Standard deviation: i ϭ ∑ p(s)[ri(s) Ϫ E(ri)] [rj (s) Ϫ E(rj)] Cov(ri , rM) Var (rM) g ϭ ROE ϫ b 1Ϫ b k Ϫ ROE ϫ b Debt ROE ϭ (1 Ϫ Tax rate) ROA ϩ (ROA Ϫ Interest rate ) Equity Derivative Assets Put-call parity: E(rp) ϭ Variance of portfolio rate of return: 2p ϭ ∑ Spot-futures parity: F0 ϭ S0(1 ϩ r Ϫ d )T Interest rate parity: ϩ rUS F0 ϭ E0 ϩ rforeign Market Equilibrium E(ri) ϭ rf ϩ i[E(rM) Ϫ rf] Fixed-Income Analysis ln (S /X ) ϩ (r Ϫ ␦ ϩ /22 )T T d2 ϭ d1 Ϫ T n ∑ ∑ wj wi Cov(ri, rj) j ϭ1 i ϭ1 C ϭ SeϪ␦T N (d1 ) Ϫ XeϪrT N (d2 ) d1 ϭ wi E(ri) i ϭ1 n P ϭ C Ϫ S0 ϩ PV(X ϩ dividends) Black-Scholes formula: n Expected rate of return on a portfolio with weights wi in each security: T Performance Evaluation Present value of $1: Discrete period compounding: Continuous compounding: r ϭ Sharpe’s measure: Sp ϭ Treynor’s measure: Tp ϭ PV ϭ 1/(1 ϩ r)T PV ϭ eϪrT Forward rate of interest for period T: Real interest rate: D1 kϪg s Portfolio Theory The security market line: P /E ϭ 2 Covariance between returns: Cov(ri , rj) ϭ Beta of security i: Price/earnings multiple: s V0 ϭ fT ϭ (1 ϩ yT )T Ϫ1 (1 ϩ yT Ϫ1 )T Ϫ1 1ϩ R Ϫ1 1ϩi rp Ϫ rf p rP Ϫ rf p Jensen’s measure, or alpha: ␣p ϭ rp Ϫ [rf ϩ p(rM Ϫ rf)] Geometric average return: rG ϭ [(1 ϩ r1)(1 ϩ r2) (1 ϩ rT)]1/T Ϫ where R is the nominal interest rate and i is the inflation rate T Duration of a security: D ϭ CF ∑ t ϫ (1 ϩ ty)t /Price t ϭ1 Modified duration: D* ϭ D/(1 ϩ y) bod05175_bnshts.indd ISBN: 0073405175 Author: Zvi Bodie Title: Essentials of Investments, 7/e 8/13/07 9:25:13 AM Back endsheets Color: PMS 539M and PMS139 Pages: 6,7 Useful Formulas Equity Analysis Constant growth dividend discount model: Sustainable growth rate of dividends: Measures of Risk ∑ p(s)[r(s) Ϫ E(r)]2 Variance of returns: 2 ϭ ϭ Standard deviation: i ϭ ∑ p(s)[ri(s) Ϫ E(ri)] [rj (s) Ϫ E(rj)] Cov(ri , rM) Var (rM) g ϭ ROE ϫ b 1Ϫ b k Ϫ ROE ϫ b Debt ROE ϭ (1 Ϫ Tax rate) ROA ϩ (ROA Ϫ Interest rate ) Equity Derivative Assets Put-call parity: E(rp) ϭ Variance of portfolio rate of return: 2p ϭ ∑ Spot-futures parity: F0 ϭ S0(1 ϩ r Ϫ d )T Interest rate parity: ϩ rUS F0 ϭ E0 ϩ rforeign Market Equilibrium E(ri) ϭ rf ϩ i[E(rM) Ϫ rf] Fixed-Income Analysis ln (S /X ) ϩ (r Ϫ ␦ ϩ /22 )T T d2 ϭ d1 Ϫ T n ∑ ∑ wj wi Cov(ri, rj) j ϭ1 i ϭ1 C ϭ SeϪ␦T N (d1 ) Ϫ XeϪrT N (d2 ) d1 ϭ wi E(ri) i ϭ1 n P ϭ C Ϫ S0 ϩ PV(X ϩ dividends) Black-Scholes formula: n Expected rate of return on a portfolio with weights wi in each security: T Performance Evaluation Present value of $1: Discrete period compounding: Continuous compounding: r ϭ Sharpe’s measure: Sp ϭ Treynor’s measure: Tp ϭ PV ϭ 1/(1 ϩ r)T PV ϭ eϪrT Forward rate of interest for period T: Real interest rate: D1 kϪg s Portfolio Theory The security market line: P /E ϭ 2 Covariance between returns: Cov(ri , rj) ϭ Beta of security i: Price/earnings multiple: s V0 ϭ fT ϭ (1 ϩ yT )T Ϫ1 (1 ϩ yT Ϫ1 )T Ϫ1 1ϩ R Ϫ1 1ϩi rp Ϫ rf p rP Ϫ rf p Jensen’s measure, or alpha: ␣p ϭ rp Ϫ [rf ϩ p(rM Ϫ rf)] Geometric average return: rG ϭ [(1 ϩ r1)(1 ϩ r2) (1 ϩ rT)]1/T Ϫ where R is the nominal interest rate and i is the inflation rate T Duration of a security: D ϭ CF ∑ t ϫ (1 ϩ ty)t /Price t ϭ1 Modified duration: D* ϭ D/(1 ϩ y) bod05175_bnshts.indd ISBN: 0073405175 Author: Zvi Bodie Title: Essentials of Investments, 7/e 8/13/07 9:25:13 AM Back endsheets Color: PMS 539M and PMS139 Pages: 6,7 ... 1 .22 0. 123 5 1 .22 20 14 1.36 0. 120 3 1.36 20 15 1. 52 0.1170 1. 52 2016 1.69 0.1138 1.69 20 17 1.88 0.1105 1.88 20 18 2. 08 0.1073 2. 08 20 19 2. 30 0.1040 2. 30 20 20 2. 53 0.1008 2. 53 20 21 2. 78 0.0975 2. 78... index 20 02 2003 20 04 20 05 20 06 20 07 12. 5% 10 .2 12. 0% 12. 4 15.4% 14.6 19.6% 19.9 21 .6% 20 .4 21 .6% 21 .2 28.5ϫ 10 .2 23 .2? ? 12. 4 19.6ϫ 14.6 18.7ϫ 19.9 18.5ϫ 18.1 16 .2? ? 19.1 8.8% 39 .2 8.0% 40.1 12. 1%... Other industries with TABLE 12. 5 Examples of NAICS industry codes NAICS Code 23 23 6 23 61 23 611 23 6115 23 6116 23 6117 23 6118 23 62 23 621 23 621 0 23 622 23 622 0 bod05175_ch 12_ 369-400.indd 387 NAICS Title