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Strategy Second Edition Sundaram and Das Derivatives: Principles and Practice Second Edition Investments E L E V E N T H E D I T I O N ZVI BODIE Boston University ALEX KANE University of California, San Diego ALAN J MARCUS Boston College INVESTMENTS, ELEVENTH EDITION Published by McGraw-Hill Education, Penn Plaza, New York, NY 10121 Copyright © 2018 by McGraw-Hill Education All rights reserved Printed in the United States of America Previous editions © 2014, 2011, and 2009 No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning Some ancillaries, including electronic and print components, may not be available to customers outside the United States This book is printed on acid-free paper LWI 21 20 19 18 17 ISBN 978-1-259-27717-7 MHID 1-259-27717-8 Executive Brand Manager: Chuck Synovec Senior Product Developer: Noelle Bathurst Marketing Manager: Trina Maurer Core Content Project Manager: Kathryn D Wright Senior Assessment Content Project Manager: Kristin Bradley Media Content Project Manager: Karen Jozefowicz Senior Buyer: Laura Fuller Senior Designer: Matt Diamond Lead Content Licensing Specialist: Beth Thole Cover Image: © marigold_88 Compositor: SPi Global Printer: LSC Communications All credits appearing on page or at the end of the book are considered to be an extension of the copyright page Library of Congress Cataloging-in-Publication Data Names: Bodie, Zvi, author | Kane, Alex, 1942- author | Marcus, Alan J., author Title: Investments / Zvi Bodie, Boston University, Alex Kane, University of   California, San Diego, Alan J Marcus, Boston College Description: Eleventh edition | New York, NY : McGraw-Hill Education, [2018] Identifiers: LCCN 2017013354 | ISBN 9781259277177 (alk paper) Subjects: LCSH: Investments | Portfolio management Classification: LCC HG4521 B564 2018 | DDC 332.6—dc23 LC record available at https://lccn.loc.gov/2017013354 The Internet addresses listed in the text were accurate at the time of publication The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites mheducation.com/highered About the Authors ZVI BODIE ALEX KANE ALAN J MARCUS Boston University University of California, San Diego Boston College Zvi Bodie is the Norman and Adele Barron Professor of Management at Boston University He holds a PhD from the Massachusetts Institute of Technology and has served on the finance faculty at the Harvard Business School and MIT’s Sloan School of Management Professor Bodie has published widely on pension finance and investment strategy in leading professional journals In cooperation with the Research Foundation of the CFA Institute, he has recently produced a series of Webcasts and a monograph entitled The Future of Life Cycle Saving and Investing Alex Kane is professor of finance and economics at the Graduate School of International Relations and Pacific Studies at the University of California, San Diego He has been visiting professor at the Faculty of Economics, University of Tokyo; Graduate School of Business, Harvard; Kennedy School of Government, Harvard; and research associate, National Bureau of Economic Research An author of many articles in finance and management journals, Professor Kane’s research is mainly in corporate finance, portfolio management, and capital markets, most recently in the measurement of market volatility and pricing of options v Alan Marcus is the Mario J Gabelli Professor of Finance in the Carroll School of Management at Boston College He received his PhD in economics from MIT Professor Marcus has been a visiting professor at the Athens Laboratory of Business Administration and at MIT’s Sloan School of Management and has served as a research associate at the National Bureau of Economic Research Professor Marcus has published widely in the fields of capital markets and portfolio management His consulting work has ranged from new-product development to provision of expert testimony in utility rate proceedings He also spent two years at the Federal Home Loan Mortgage Corporation (Freddie Mac), where he developed models of mortgage pricing and credit risk He currently serves on the Research Foundation Advisory Board of the CFA Institute.  Brief Contents Preface xvi PART III Introduction 1 Equilibrium in Capital Markets 277 The Investment Environment  The Capital Asset Pricing Model  277 PART I 10 Arbitrage Pricing Theory and Multifactor Models of Risk and Return  309 Asset Classes and Financial Instruments  27 11 How Securities Are Traded  57 The Efficient Market Hypothesis  333 12 Mutual Funds and Other Investment Companies 91 Behavioral Finance and Technical Analysis 373 13 PART II Empirical Evidence on Security Returns  397 Portfolio Theory and Practice 117 PART IV Fixed-Income Securities  425 Bond Prices and Yields  425 The Term Structure of Interest Rates  467 Managing Bond Portfolios  495 Risk, Return, and the Historical Record  117 14 Capital Allocation to Risky Assets  157 15 Optimal Risky Portfolios  193 16 Index Models  245 vi Brief Contents PART V PART VII Security Analysis  537 Macroeconomic and Industry Analysis  537 Applied Portfolio Management 811 18 Portfolio Performance Evaluation  811 19 International Diversification  853 17 24 Equity Valuation Models  569 25 Financial Statement Analysis  613 26 Hedge Funds  881 27 PART VI  The Theory of Active Portfolio Management 907 Options, Futures, and Other Derivatives 657 28 Investment Policy and the Framework of the CFA Institute  931 20 Options Markets: Introduction  657 21 REFERENCES TO CFA PROBLEMS  967 Option Valuation  699 GLOSSARY G-1 22 NAME INDEX  I-1 Futures Markets  747 SUBJECT INDEX  I-4 23 Futures, Swaps, and Risk Management  775 FORMULAS F-1 vii Contents Preface xvi and Reverses / Federal Funds / Brokers’ Calls / The LIBOR Market / Yields on Money Market Instruments PART I 2.2 The Bond Market  33 Introduction 1 Treasury Notes and Bonds / Inflation-Protected Treasury Bonds / Federal Agency Debt / International Bonds / Municipal Bonds / Corporate Bonds / Mortgages and Mortgage-Backed Securities Chapter The Investment Environment  2.3 1.1 Real Assets versus Financial Assets  1.2 Common Stock as Ownership Shares / Characteristics of Common Stock / Stock Market Listings / Preferred Stock / Depositary Receipts Financial Assets  1.3 Financial Markets and the Economy  2.4 Stock and Bond Market Indexes  43 The Informational Role of Financial Markets / ­Consumption Timing / Allocation of Risk / Separation of Ownership and Management / Corporate Governance and Corporate Ethics Stock Market Indexes / Dow Jones Industrial Average / The Standard & Poor’s 500 Index / Other U.S MarketValue Indexes / Equally Weighted Indexes / Foreign and International Stock Market Indexes / Bond Market Indicators 1.4 The Investment Process  1.5 Markets Are Competitive  2.5 The Risk–Return Trade-Off / Efficient Markets 1.6 Equity Securities  40 Derivative Markets  50 The Players  11 Options / Futures Contracts Financial Intermediaries / Investment Bankers / Venture Capital and Private Equity End of Chapter Material  52–56 1.7 The Financial Crisis of 2008  15 Chapter Antecedents of the Crisis / Changes in Housing Finance / Mortgage Derivatives / Credit Default Swaps / The Rise of Systemic Risk / The Shoe Drops / The Dodd-Frank Reform Act 1.8 Outline of the Text How Securities Are Traded  57 3.1 How Firms Issue Securities  57 23 Privately Held Firms / Publicly Traded Companies / Shelf Registration / Initial Public Offerings End of Chapter Material  23–26 3.2 How Securities Are Traded  62 Chapter Types of Markets Asset Classes and Financial Instruments  27  Direct Search Markets / Brokered Markets / Dealer Markets / Auction Markets 2.1 The Money Market  27 Types of Orders Treasury Bills / Certificates of Deposit / Commercial Paper / Bankers’ Acceptances / Eurodollars / Repos  Market Orders / Price-Contingent Orders viii Contents PART II Trading Mechanisms  Dealer Markets / Electronic Communication Networks (ECNs) / Specialist Markets Portfolio Theory and Practice 117 3.3 The Rise of Electronic Trading  66 3.4 U.S Markets  68 NASDAQ / The New York Stock Exchange / ECNs Chapter 3.5 New Trading Strategies  70 Risk, Return, and the Historical Record  117 Algorithmic Trading / High-Frequency Trading / Dark Pools / Bond Trading 5.1 Determinants of the Level of Interest Rates  118 3.6 Globalization of Stock Markets  73 3.7 Real and Nominal Rates of Interest / The Equilibrium Real Rate of Interest / The Equilibrium Nominal Rate of Interest / Taxes and the Real Rate of Interest Trading Costs  74 3.8 Buying on Margin  75 3.9 5.2 Comparing Rates of Return for Different Holding Periods 121 Short Sales  78 3.10 Regulation of Securities Markets  82 Annual Percentage Rates / Continuous Compounding Self-Regulation / The Sarbanes-Oxley Act / Insider Trading 5.3 Bills and Inflation, 1926–2015  124 5.4 Risk and Risk Premiums  126 End of Chapter Material  86–90 Holding-Period Returns / Expected Return and Standard Deviation / Excess Returns and Risk Premiums 5.5 Time Series Analysis of Past Rates of Return  129 Chapter Time Series versus Scenario Analysis / Expected Returns and the Arithmetic Average / The Geometric (TimeWeighted) Average Return / Variance and Standard Deviation / Mean and Standard Deviation Estimates from Higher-Frequency Observations / The Reward-to-­ Volatility (Sharpe) Ratio Mutual Funds and Other Investment Companies 91 4.1 Investment Companies  91 4.2 Types of Investment Companies  92 4.3 Unit Investment Trusts / Managed Investment Companies / Other Investment Organizations 5.6 The Normal Distribution  134  Commingled Funds / Real Estate Investment Trusts (REITs) / Hedge Funds 5.7 Deviations from Normality and Alternative Risk ­Measures  136 Value at Risk / Expected Shortfall / Lower Partial ­Standard Deviation and the Sortino Ratio / Relative ­Frequency of Large, Negative 3-Sigma Returns Mutual Funds  95 Investment Policies  Money Market Funds / Equity Funds / Sector Funds / Bond Funds / International Funds / ­Balanced Funds / Asset Allocation and Flexible Funds / Index Funds 5.8 Historic Returns on Risky Portfolios  140 A Global View of the Historical Record 5.9 Normality and Long-Term Investments  147 Short-Run versus Long-Run Risk / Forecasts for the Long Haul How Funds Are Sold 4.4 Costs of Investing in Mutual Funds  98 End of Chapter Material  151–156 Fee Structure  Operating Expenses / Front-End Load / Back-End Load / 12b-1 Charges Chapter Capital Allocation to Risky Assets  157 Fees and Mutual Fund Returns 4.5 Taxation of Mutual Fund Income  102 4.6 6.1 Risk and Risk Aversion  158 Exchange-Traded Funds  103 Risk, Speculation, and Gambling / Risk Aversion and Utility Values / Estimating Risk Aversion 4.7 Mutual Fund Investment Performance: A First Look  106 6.2 Capital Allocation across Risky and Risk-Free Portfolios 164 4.8 Information on Mutual Funds  109 End of Chapter Material  112–116 6.3 The Risk-Free Asset  166 ix Final PDF to printer Subject Index Leading economic indicators, 546 Leakage of information, 345 LEAPS (Long-Term Equity AnticiPation Securities), 660 Lehman Brothers bankruptcy, 8, 14, 21 Lemons problem, 295n Leverage, 632 compound leverage factor, 625 degree of operating leverage (DOL), 554–555 financial leverage and business cycle, 554 futures and, 758 operating leverage, 554 return on equity (ROE) and, 620–622 in risky asset, 169 Leverage ratio, 625 Leverage ratios, 451 Levered equity, 683–684 Liabilities, LIBOR; see London Interbank Offered Rate (LIBOR) Life-cycle funds, 97 Life cycles; see also Industry life cycles life-cycle funds, 97 multistage growth models, 581–585 Life insurance companies, 936 LIFO (last-in, last-out), 636 Limit order book, 64–65 Limit orders, 64 Limited liability, 41 Liquidation value, 571 Liquidity, 20n, 295, 476n, 629, 632, 937 asset pricing and, 414–416 CAPM and, 294–298 efficient market anomalies and, 353 equity premium puzzle, 421 hedge funds and, 882 as investment constraint, 937–938 Liquidity beta, 298 Liquidity preference theory, 478–480 Liquidity premium, 476, 478 Liquidity ratios, 451, 629, 632 Liquidity risk, 287, 944 Liquidity traders, 296 Load, 94 Loadings, 889 Lock-up periods, 882 Log-normal distribution, 148 London Interbank Offered Rate (LIBOR), 15n, 31 LIBOR scandals, 32 short-term LIBOR, T-bill rates, and TED spread (2000-2016), 16 TED spread (2008), 15 London International Financial Futures Exchange (LIFFE), 776 Long hedge, 760 Long position, 51, 748 Long Term Capital Management, 888, 899 Long-term investments, 147–151 forecasts for, 151 inflation risk and, 9955 risk of, 217–221 short-run vs long-run risk, 148–151 target date retirement fund (TDRF), 955 time diversification and, 220–221 Lookback options, 687 Low-load funds, 99 Lower partial standard deviation (LPSD), 139 Lucky event issue, 343–344 M M2 measure, 816–817 Macaulay’s duration, 499 Macro factor model, 406 Macroeconomic analysis, 537 budget deficit, 541 business cycles, 545–546 demand shocks, 542 domestic macroeconomy, 540–541 economic indicators, 541, 546–549 employment/unemployment rate, 541 federal government policy, 542–544 global economy, 537–540 gross domestic product (GDP), 541 inflation, 541 interest rates, 118, 541 sentiment, 541 supply shocks, 542 Madoff scandal, 900–901 Magnitude issue, 343 Maintenance margin, 75–76, 755 Managed investment companies, 93–94 Margin, 75, 170n, 748 buying on margin, 75–78 Excel application, 77 maintenance margin, 75–76 margin call, 75 turnover vs., 626 Margin account, 754–756 Margin call, 75, 80 Mark-to-market, 639 Mark-to-market accounting, 638 Market anomalies; see also Efficient market hypothesis (EMH) book-to-market ratios, 353 data mining, 357 inside information, 355 interpretation of, 356–358 mutual fund and analyst performance, 359–364 neglected-firm and liquidity effects, 353 over time, 358 post–earnings-announcement price drift, 354–355 risk premiums vs inefficiencies, 356–357 semistrong tests, 351–352 small-firm effect, 352 strong-form tests, 355 style portfolio and GDP growth, 357 weak-form tests, 349–351 Market-book-value (P/B) ratio, 630 Market cap, 570 Market capitalization, 573 developed countries (2015), 855 emerging markets, 856 GDP and, 856–867 Market conversion value, 429 Market efficiency; see also Efficient market hypothesis (EMH) bubbles and, 358–359 competition as source of, 335–337 lucky event issues, 347–348 magnitude issues, 347 market anomalies, 355–358 I-16 bod77178_sidx_I4-I26.indd I-16 04/28/17 03:57 PM Final PDF to printer Subject Index portfolio management in, 341–343 random walk and, 334–335 returns over long horizons, 349–350 returns over short horizons, 349 selection bias issue, 347 semistrong tests, 351–355 strong-form tests, 355 weak-form tests of, 349–351 Market flash crash (May 2010), 71 Market index, 400–401 Market neutral, 884, 886 Market-neutral active stock selection, 788 Market-neutral bet, 788 Market orders, 63 Market portfolio (M), 279 risk premium of, 280–281 Market price, 632 intrinsic value vs., 571–573 Market price of risk, 283 Market psychology; see Behavioral finance Market risk, 195, 944 hedging with index futures, 786–788 Market timing, 830–835 imperfect forecasting, 834–835 potential value of, 832–833 valuing as a call option, 833–834 Market-to-book, 632 Market-value-weighted index, 47 Markets auction markets, 63 brokered markets, 62 as competitive, 9–11 dealer markets, 63 direct search markets, 62 efficient markets, 10–11 risk–return trade-off, 9–10 transparency of, 882 types of, 62–63 Markets and instruments bond market, 33–40 derivative markets, 50–52 equity securities, 40–43 money market, 27–33 stock and bond market indexes, 43–59 Marking to market, 754, 756 Markowitz portfolio optimization model, 208–217 asset allocation and security selection, 216–217 capital allocation and separation property, 211–214 drawbacks of, 245 index model vs., 270–271 input list of, 211, 246–247 international diversification, 232–234 optimal portfolios and nonnormal returns, 218 power of diversification, 214–216 security selection, 208–211 separation property, 212 Maturity stage, 558 Mean absolute deviation (MAD), 238n Mean-beta relationship, 284 Mean estimates, 132 Mean-variance (M-V) criterion, 162 Memory bias, 375 Mental accounting, 376 Minimum-variance frontier, 208–209 Minimum-variance portfolio, 201 Model risk, 380 Modern portfolio theory, 10, 769 Modified duration, 501 Momentum, 385, 413 Momentum effect, 349 Monetary policy, 543–544 Money market, 4, 21n, 27–33 bankers’ acceptances, 30 brokers’ calls, 31 certificates of deposit (CD), 29 commercial paper, 29–30 credit crisis of 2008, 21, 33 Eurodollars, 30 federal funds, 31 LIBOR market, 31 major components of, 28 repos and reverses, 30–31 Treasury bills, 28–29 yields on, 31–33 Money market funds, 96, 96n Money spread, 673 Morningstar’s Mutual Fund Sourcebook, 98, 110 Morningstar’s risk-adjusted return (MRAR), 827–829 Mortgage-backed securities; see Mortgages and mortgagebacked securities Mortgage bond, 454 Mortgage derivatives, 19–20 Mortgage trusts, 95 Mortgages and mortgage-backed securities, 39–40 cash flows in, 18 conforming/conventional mortgages, 18, 39 derivatives, 19–20 duration and convexity of, 510–513 housing finance changes pre-2008 crisis, 17–19 nonconforming subprime mortgages, 18 price-yield curve, 511 securities outstanding (1979-2016), 39 subprime mortgages, 39, 459 Moving averages, 385–387 MSCI (Morgan Stanley Capital International) stock indexes, 49 Multifactor CAPM APT and, 406 early tests of, 406 macro factor model, 406–407 Multifactor models, 309, 311, 403–407 factor models of security returns, 310–312 Fama and French (FF) three-factor model, 324–326 mispricing and arbitrage, 322–323 multifactor ATP, 321–324 multifactor security market line, 322 risk assessment using, 312 tests of, 403–407 Multiplier, 685 Multistage growth models, 586 Excel application, 586 life cycles and, 581–585 Municipal bonds, 35–38 equivalent taxable yield, 37 general obligation bonds, 36 industrial development bond, 36 ratio of yields vs corporate Baarated debt (1953-2016), 38 revenue bonds, 36 tax anticipation notes, 36 tax-exempt debt outstanding (2005-2015), 36 taxable vs tax-exempt yields, 38 I-17 bod77178_sidx_I4-I26.indd I-17 04/28/17 03:57 PM Final PDF to printer Subject Index Mutual fund managers, 360–361, 823 Mutual fund theorem, 280 Mutual funds, 95–98, 935 analyst performance, 359–364 asset allocation and flexible funds, 97 back-end load, 99 balanced funds, 97 bond funds, 96 costs of investing in, 98–102 equity funds, 96 exchange-traded funds (ETFs), 103–106 fee structure, 98–100 fees and net returns, 101 front-end load, 99 hedge funds vs., 882–883 how sold, 97–98 index funds, 97 information on, 109–111 international funds, 96–97 investment classification, 98 investment performance, 106–109 investment policies, 95–96 money market funds, 96 net asset value (NAV), 92 operating expenses, 98–99 returns and fees, 100–102 sector funds, 96 soft dollars, 102 survivorship bias, 894–895 taxation of income on, 102–103 12b-1 charges, 99–100 N NAICS codes, 551–552 Naked option writing, 669 Naked puts, 665 Naked short-selling, 79n NASDAQ Composite index, 48 NASDAQ Stock Market (NASDAQ), 65–66, 68–69 level of subscribers, 69 Negative correlation, 198 Neglected-firm effect, 353 Net asset value (NAV), 92, 382, 382n New York Mercantile Exchange, New York Stock Exchange (NYSE), 41–42, 48, 69–70 market share of trading, 69 Nikkei Average of Tokyo, 43, 48 No-load funds, 99 Noise traders, 296 Nominal interest rate, 118–119 equilibrium nominal rate of interest, 120–121 Non–life insurance companies, 936 Non-normal distributions conditional tail expectation (CTE), 139 expected shortfall, 138–139 lower partial standard deviation (LPSD), 139 relative frequency of large, negative 3-sigma returns, 139 Sortino ratio, 139 value at risk (VaR), 138 Non-normal returns, 175, 217 Nonconforming subprime loans, 18 Nondirectional strategies, 883 Nondiversifiable risk, 195 Nonrecourse loan, 682 Nonrecurring items, 640 Nonsystematic risk, 195 Nontraded assets, 290–291 Normal backwardation, 768–769 Normal distribution, 134–136, 715, 717; see also Non-normal distributions deviations from, 136–139 in Excel, 136 fat-tailed distributions, 137 long-term investments, 147–151 skewed distributions and, 137 North American Industry Classification System (NAICS) codes, 551–552 Notional principal, 791 O October 1987 crash, regional indexes, 867 Off-balance-sheet assets and liabilities, 641 Oil futures, 758 On-the-run yield curve, 470 Open-end funds, 93 Open interest, 754 Operating expenses, mutual funds, 98–99 Operating income, 614 Operating leverage, 554 Optimal complete portfolio, 205–206 determination of, 206 indifference curves and, 173–174 proportions of, 206 steps in, 206 Optimal risky portfolio, 193, 205, 269–270, 911 alpha values and, 907–908 construction and properties of, 909 diversification and portfolio risk, 194–195 non-normal returns, 176, 217 optimization procedure, 922–923 short sales constraint, 236 single-index model, 263–265 spreadsheet (Excel) model, 213, 235–236 two risky assets, 195–202 Optimization portfolio optimization, 922–923 summary of procedure, 267 Option elasticity, 723, 729 Option-like securities, 678–684 callable bonds, 678–679 collateralized loans, 682–683 convertible securities, 679–681 levered equity and risky debt, 683–684 warrants, 682 Options, 50–51 adjustments in contract terms, 661 American options, 661 call options; see Call options collars, 673–675 covered calls, 669–671 European option, 661 exercise (strike) price, 50 exotic options; see Exotic options foreign currency options, 663 futures options, 663 index options, 662 interest rate options, 663 levered equity and risk debt, 682–684 other listed options, 662–663 protective put, 667–669 put-call parity relationship, 675–678 put options; see Put options spreads, 673 stock investments vs., 665–667 straddles, 671–673 strategies, 667–675 time value of, 700 trading options, 659–660 values at expiration, 663–665 Options Clearing Corporation (OCC), 661–662 I-18 bod77178_sidx_I4-I26.indd I-18 04/28/17 03:57 PM Final PDF to printer Subject Index Options valuation binomial option pricing, 706–714 Black-Scholes model, 714–722 assumptions of, 718 dividends and call/put options, 721–722 Excel model for, 719, 724 formula for, 714–716 hedge ratios and, 722–724 portfolio insurance, 725–728 put option valuation, 721–722 synthetic protective put options, 726 call option, 721 delta-neutral options portfolio, 733 determinants of, 700–702 empirical evidence on, 734–735 financial crisis of 2008-2009, 728–729 hedging bets on mispriced options, 730–734 intrinsic and time values, 699–700 portfolio theory, 729–730 protective put strategy, 667–669, 725 restrictions on option values, 703–705 call option, 703–704 early exercise of American puts, 705 early exercise and dividends, 704 risk-neutral economy, 713 two-state option pricing, 706–709 Order types, 63–64 limit orders, 64 market orders, 63 price-contingent orders, 64 Organizational structure and performance, 916–917 Original-issue discount bonds, 447–448 Out of the money, 659 Outstanding shares, 615 Over-the-counter (OTC) market, 65, 659 Overconfidence, 375 Ownership of the firm, P P/E effect, 351 P/E ratio; see Price–earnings (P/E) ratio Pairs trading, 71, 885 Par value, 426 Participation rate, 685 Pass-throughs, 18, 510 Passive bond management, 513–522 bond-index funds, 513–514 cash flow matching and dedication, 521–522 immunization, 515–521 rebalancing, 519–521 Passive investment strategy, 341–342, 495 Passive management, 10 Passive market-index portfolio, 908 Passive portfolio, 263, 265 Passive portfolio management, 241 Passive strategy, 176–178 active vs., 341–342 capital market line and (CML), 176–178 as efficient, 280 index funds, 48, 97, 341, 513–514 Peak, 545 PEG ratio, 589 Pension funds, 935, 951–954 defined benefit plans, 935 defined contribution plans, 935 equity investments, 953–954 immunization, 515 investment strategies, 953 Performance attribution procedures, 835–840, 873–874 asset allocation decisions, 837–838 cash/bond selection, 874 component contributions, 840 country selection, 974 currency selection, 873 Excel application for, 839, 873 international investing and, 871–875 sector and security selection, 838–840 stock selection, 874 Performance evaluation; see Portfolio performance evaluation Personal trusts, 935 Physical settlement, 797 Plowback ratio, 579 Political risk, 868–871, 944 Ponzi scheme, 901 Portable alpha, 886–889 Portfolio, complete portfolio, 165, 205–207 market portfolio (M), 279 minimum-variance portfolio, 162, 201 one risky and a risk-free asset, 167–170 replicating portfolio, 706 risk–return trade-off, 161, 199 two risky assets, 195–202, 207 well-diversified portfolio, 313–315, 318–319 Portfolio construction, 157 Portfolio insurance, 669, 725–728 Portfolio management; see also Active portfolio management efficient market and, 342–343 individual investors, 945–948 investment decisions; see Investment decisions manager’s private views, 920 organizational chart for, 917 passive management, 10, 341–342 role in efficient market, 342–343 Portfolio opportunity set, 202 Portfolio performance evaluation; see also Historic returns on risky portfolios alpha and, 819 average rates of return, 811–812 changing portfolio composition, 826–830 dollar-weighted returns, 812–813 equalizing beta, 818 example of, 819–821 Excel example, 820 hedge funds, 891–899 information ratio, 814, 818–819 international investing, 871–875 Jensen’s measure, 814 M 2 measure of performance, 816 market timing, 830–835 Morningstar’s risk adjusted rating, 827–830 mutual funds, 105–105 performance attribution procedures, 835–840, 873–874 portfolio risk, 826–827 realized return vs expected return, 821–822 risk-adjusted measures, 813–815 Sharpe’s measure, 814–816 style analysis, 823–826 time-weighted returns, 812–813 Treynor’s measure, 814, 817–818 value of imperfect forecasting, 834–835 I-19 bod77178_sidx_I4-I26.indd I-19 04/28/17 03:57 PM Final PDF to printer Subject Index Portfolio risk diversification and, 194–195 number of stocks in portfolio, 194 Portfolio statistics, 237–244 correlation coefficient, 242–243 covariance, 240–242 expected returns, 237–238 portfolio rate of return, 238 portfolio variance, 243 review of, 237–244 variance and standard deviation, 238–240 Portfolio theory, 157; see also Capital allocation option pricing and, 729–730 risk and risk aversion, 158–164 Portfolio variance border-multiplied covariance matrix, 197 bordered covariance matrix, 197 spreadsheet model, 243 Post–earnings-announcement price drift, 354 Posterior distribution, 914 Prediction markets, 752 Preferred stock, 42–43, 429–430 cumulative dividends, 42 DDM and, 575 Premium, 52, 658 see also Equity premium; Risk premiums liquidity premium, 476, 478 Premium bonds, 440 Present value of growth opportunities (PVGO), 580 Price-contingent orders, 64 Price–earnings multiple, 587 Price–earnings (P/E) ratio, 587–595, 630–631 DDM and, 593 earnings management and, 592 growth opportunities and, 587–590 growth rate vs (PEG ratio), 589 industry comparisons, 594 pitfalls in analysis, 590–593 S&P 500 index and inflation (1955–2015), 591 stock risk and, 590 Price–earnings ratio, 42, 632 Price-to-book ratio, 594 Price-to-cash-flow ratio, 594 Price-to-sales ratio, 594 Price value of a basis point (PVBP), 789 Price-weighted average, 44 splits and, 45 Primary market, 14, 57, 62 Prior distribution, 914 Private corporations, 58 Private equity investments, 14–15 Private (nontraded) business, 405–406 Private placement, 58 Privately held firms, 58 Profit margin, 623, 632 Profitability measures, 619–623, 632 economic value added, 622–623 financial leverage and ROE, 620–622 key financial ratios of, 632 return on assets (ROA), 619 return on capital (ROC), 620 return on equity (ROE), 620 Profitability ratios, 451 Program trading, 786 Proprietary trading, 14 Prospect theory, 378 Prospectus, 59 Protective covenants, 453 Protective put, 667–669, 725 stock investment vs., 669 Proxy, 41 Proxy contest, PRS Group (Political Risk Services), International Country Risk Guides, 869–871 Prudent investor rule, 938 Publicly listed firms, 58 Publicly traded companies, 58–59 Pure plays, 884–885 example of, 886–889 risks of, 888 Pure yield curve, 469 Pure yield pickup swap, 523 Put bond, 429 Put-call parity theorem, 675–678 Put options, 50, 658, 664 Black-Scholes put valuation, 721–722 dividends and, 722 early excise of American put, 705 naked puts, 665 profits and losses on, 659 protective put, 667–669, 725 stock price and, 705 synthetic protective put, 726 values at expiration, 665 Put/call ratio, 389 Puttable bonds, 429 PV factor, 433 Q Quality of earnings, 639–641 Quick ratio, 451, 629, 632 Quoted bond prices, 427 R Random walk, 334 Rate anticipation swap, 523 Rate of return; see also Historic returns on risky portfolio actively managed equity funds vs Wilshire 5000 (1971–2015), 108 annual percentage rates (APRs), 34, 123 annualized rates of return, 122 certainty equivalent, 160 continuous compounding, 123–124 different holding periods, 121–123 EAR vs total return, 122 effective annual rate (EAR), 122 expected returns and arithmetic average, 129 geometric (time-weighted) average return, 129–131 hedged stock portfolio, 762 mutual funds, 100–101 portfolio rate of return, 238 required rate of return, 287 reward-to-variability (Sharpe) ratio, 133 time series analysis, 129–133 time series vs scenario analysis, 129 variance and standard deviation, 131–132 Ratio analysis, 623–633; see also Price–earnings (P/E) ratio asset utilization, 627, 632 I-20 bod77178_sidx_I4-I26.indd I-20 04/28/17 03:57 PM Final PDF to printer Subject Index benchmark for, 631–633 comparative valuation ratios, 593–595 decomposition of ROE, 623–626 as default risk predictors, 451 economic value added, 599, 622–623 leverage, 451, 625 liquidity ratios, 451 major industry groups, 633 margin vs turnover, 626 market price ratios, 630–631 price-to-book ratio, 594 price-to-cash-flow ratio, 594 price-to-sales ratio, 59 profitability, 451 summary of key ratios, 632 turnover/other utilization ratios, 627–628 Real assets, financial assets vs., 2–3 Real estate investment trusts (REITs), 95 Real interest rate, 118–119 approximation of, 119 equilibrium real rate of interest, 119–120 statistics for (1926-2015), 125 taxes and, 121 Realized compound return, 442 yield to maturity vs., 442–444 Realized returns, expected return vs., 418–419, 821–822 Rebalancing, 519 Redeemable trust certificates, 93 Refunding, 428 Regional funds, 96 Regression equation, 249 Regression equation of single-index model, 248–250 Regret avoidance, 377 Regulation of securities market, 82–85; see also Securities and Exchange Commission (SEC) futures market, 757 insider trading, 85 as investment constraint, 938 prudent investor rule, 938 Sarbanes-Oxley Act, 83–84 self-regulation, 83 Reinvestment rate risk, 444 Relative decline stage, 558 Relative strength, 387 Relative strength approach, 339 Remaindermen, 935 Replacement cost, 571 Replicating portfolio, 706 Repos (repurchase agreements), 30–31 Representativeness bias, 376 Reproduction cost, 571 Repurchase agreements (repos), 30–31 Reserving practices, 641 Residual, 249 Residual claim, 41 Residual income, 622 Resistance levels, 339 Resource allocation, 343 Retirement assets; see Individual investors; Pension funds Retirement planning models, 946 Return on assets, 451 Return on assets (ROA), 619, 632 Return on capital (ROC), 620 Return on equity (ROE), 451, 583, 620, 631–632 decomposition of, 623–624 financial leverage and, 620–622 industry comparison (2015-2016), 550 major software development firms (2016), 552 Return on sales (ROS), 623, 632 Revenue bonds, 36 Revenue recognition, 640 Reversal effect, 350 Reverse repo, 31 Reversing trade, 753 Reward-to-volatility ratio, 133, 169; see also Sharpe ratio Risk, 117, 126; see also Portfolio risk adjusting returns for, 813–815 allocation of, alternative risk measures, 136–139 basis risk, 760 counterparty risk, 458, 775 country risk, 870 credit risk, 449 default risk; see Default risk deviations from normality, 136–139 diversifiable risk, 195, 254 event risk, 944 exchange rate risk, 857–861 firm-specific, 195, 247 fundamental risk, 379 inflation risk, 944 interest rate risk; see Interest rate risk international investing and, 861–863 investment risk, 117, 150 liquidity risk, 297, 944 market price of risk, 283 market risk, 195, 944 model risk, 380 Morningstar’s risk-adjusted rating, 827–828 nondiversifiable risk, 195 nonsystematic risk, 195 political risk, 868–871, 944 portfolio risk; see Portfolio risk pure play, 888 reinvestment rate risk, 444 risk aversion and, 158–164 risk premiums; see Risk premiums risk–return trade-off, 9–10, 199 short-run vs long-run, 148–151 single-index model, 250 speculation and gambling, 158 stock risk, 590 systematic risk, 195, 247 systemic risk, 15 unique risk, 195 value at risk (VaR), 138, 145–146, 217 Risk arbitrage, 313 Risk averse, 159 Risk aversion, 128, 158–164 estimation of, 164 expected utility, 187–190 speculation and, 158 utility values and, 159–162 Risk-free asset, 166–167 risky asset and, 167–179 Risk-free borrowing, 289–290 Risk-free portfolios, capital allocation, 164–166 Risk-free rate, 128 Risk lover, 161 Risk management derivatives and, 669 multifactor models in, 312 I-21 bod77178_sidx_I4-I26.indd I-21 04/28/17 03:57 PM Final PDF to printer Subject Index Risk neutral, 161 Risk-neutral economy, 713 Risk pooling, 217–218 insurance principle and, 218–219 Risk premiums, 126–128 excess returns and, 128 forecasts of, 269 holding-period returns, 126 inefficiencies vs., 356–357 market portfolio, 280–281 Risk–return trade-off, 9–10, 161, 199, 932 Risk sharing, 218–220 Risk structure of interest rates, 456 Risk tolerance, 170, 933 asset allocation and, 170–175 questionnaire for, 163–164, 934 Risky assets capital allocation and, 164–166 efficient frontier of, 208–210 levered equity and risky debt, 683–684 levered position in, 169 risk-free asset and, 167–170 two-security Excel model, 207 utility function and, 171 Risky debt, 683–684 Risky portfolios, 166; see also Optimal risky portfolio historical returns on, 140–147 Rivalry between competitors, 559 Road shows, 60 Roll’s critique, 400–401 Roth plans, 950 S Safe investing; see Bond safety St Petersburg Paradox, 187 Sample size neglect, 376 Samurai bonds, 35, 430 Sarbanes-Oxley Act (2002), 8, 83–85 Scatter diagram, 248 Scenario analysis, 127–129 Seasoned equity offering, 59 Second-pass regression, 398 Secondary market, 14, 57 Sector funds, 96 Sector rotation, 555–556 Sector selection decisions, 838–839 Secured bonds, 39 Securities; see also Convertible securities; Equity securities expected returns on individual securities, 282–285 how firms issue, 57–62 initial public offerings, 60–62 privately held firms, 58 publicly traded companies, 58–59 shelf registration, 59–60 trading; see Securities trading Securities Act of 1933, 82, 882 Securities and Exchange Act of 1934, 82 Securities and Exchange Commission (SEC), 22, 83 EDGAR website, 569–570 insider trading, 346 Investment Adviser Public Disclosure (IAPD), 948 mutual fund prospectus, 109 Office of Credit Ratings, 22 Official Summary of Securities Transactions and Holdings, 355 prospectus disclosure, 59 public offerings, 59 Regulation NMS (National Market System), 67, 70 Rule 10b-5, 338 Rule 144A (private placements), 58 Rule 415 (shelf registration), 59 12b-1 charges, 99–100 Securities Investor Protection Act of 1970, 83 Securities Investor Protection Corporation (SIPC), 83 Securities markets; see also Markets and instruments bond trading, 73 dealer markets, 65–66 electronic trading, 66–68, 70 globalization of, 73–74 how firms issue securities, 57–62 insider trading, 85 NASDAQ, 68–69 new trading strategies, 70–73 New York Stock Exchange, 69–70 regulation of, 82–85 Sarbanes-Oxley Act, 83–85 self-regulation, 83 specialist markets, 66 trading mechanisms, 64–66 types of markets, 62–63 types of orders, 63–64 U.S securities markets, 68–70 Securities trading, 62–66 algorithmic trading, 70–71 auction markets, 63 block sales, 72 bond trading, 73 brokered markets, 62 dark pools, 72–73 dealer markets, 63, 65–66 direct search markets, 62 electronic communication networks (ECNs), 66 electronic trading, 66–68 globalization, 73–74 high-frequency trading, 71–72 insider trading, 85 margin buying, 75–78 market orders, 63 new trading strategies, 70–73 price-contingent orders, 64 regulation of markets, 82–85 self-regulation, 83 short sales, 78–82 specialists markets, 66 trading costs, 74–75 trading mechanisms, 64–65 types of markets, 62–63 types of orders, 63–64 Securitization, 17 Security analysis, alpha and, 262–263 Security Analysis (Graham & Dodd), 642 Security characteristic line (SCL), 255, 825 estimation of, 398 explanatory power of, 255–256 Ford example, 255 Security market line (SML), 285–287 of APT, 315–317 estimation of, 399 multifactor SML, 322 positive-alpha stock and, 286 Security returns empirical evidence on, 397 factor models of, 310–312 single-factor SML, 398–403 I-22 bod77178_sidx_I4-I26.indd I-22 04/28/17 03:57 PM Final PDF to printer Subject Index Security selection, 9, 27, 193 asset allocation and, 216–217 efficient frontier of risky assets, 208 Markowitz portfolio selection model, 208–211 minimum-variance frontier, 209 performance attribution, 838–840 Selection bias issue, 343 Self-regulation, 83 Semistrong-form hypothesis, 338 Sentiment/sentiment indicators, 388–389, 541 confidence index, 388–389 put/call ratio, 389 trin statistic, 388 Separation property, 211–212 Serial bond issue, 453 Serial correlation, 349 Shareholders’ equity, 615 Sharpe ratio, 133, 169, 203–204, 819 diversification and, 220 M2 and, 816 MRAR scores and, 829 overall portfolios, 815 Shelf registration, 59–60 Short hedge, 760 Short position, 51, 748 Short rate, 471–473 Short sale, 79 Short sales, 78–82 cash flows from purchasing vs., 79 example of, 80 Excel application, 81 margin calls on, 80 prohibitions on, 82 Siamese Twin companies, 380 Single-factor model, 247, 310 Single-factor security market, 246–248 Markowitz model input list, 246–247 systematic vs firm-specific risk, 247–248 Single-index model, 248–254 APT and portfolio optimization, 320–321 CAPM and, 287–288 correlation and covariance matrix, 267–269 diversification and, 253–254 estimate of alpha, 256–257 estimate of beta, 257 estimates needed for, 251–252 estimating the model (example), 255–258 expected return–beta relationship, 250, 398–399 firm-specific risk, 257–258 portfolio construction and, 262–271 alpha and security analysis, 262–263 example of, 267 information ratio, 265–267 input list, 264 optimal risky portfolio, 264– 265, 269–270 optimization summary, 267 risk premium forecasts, 269 regression equation of, 248–250 risk and covariance in, 250 security characteristic line, 255, 398 Single-stock futures, 751 Sinking funds, 453 Skew, 137–138 Skewed distributions, 137 Slow growers, 558 Small-firm effect, 352 Soft dollars, 102 Sortino ratio, 139 Special-purpose entities (SPEs), 8, 641 Specialist, 66 Specialist markets, 66 Speculation, 158 on the basis, 761 hedging and, 757–760 mispriced options, 731 oil futures, 758 on the spread, 761 Speculative-grade bonds, 449 Spot-futures parity relationship, 801 Spot-futures parity theorem, 752, 761–764 Spot rate, 471, 473, 475 Spreads, 673, 764–766 bid–ask spread, 28, 63 bullish spread, 673–674 calendar spread, 761 Excel application, 675 futures, 764–766 parity and, 767 speculating on, 761 spread pricing, 766 Stalwarts, 558 Standard & Poor’s 500 index, 47–49 cumulative returns (1980-2016), 16 dividend yield (2006-2016), 765 earnings per share vs (1955-2015), 540 implied volatility (1990-2015), 720 as market-value-weighted index, 47–48 P/E ratios and inflation (1955-2015), 591 Standard deviation expected return and, 126–127, 217 higher-frequency observations, 132–133 lower partial standard deviation (LPSD), 139 minimum-variance portfolio, 201 monthly excess return, market index, 142–143 variance and, 131–132 Start-up stage, 557 Statement of cash flows, 617–618 Home Depot example, 617 Statistical arbitrage, 885 Stochastic volatility, 720 Stock exchange, 69 Stock-index futures, 783–788 contracts, 783–784 hedging market risk, 785–788 index arbitrage, 785–786 market-neutral active stock selection, 788 synthetic stock positions, 784–785 Stock market aggregate stock market, 599–601 biggest world stock markets, 74 globalization of, 73–74 international market returns (2015), 859 listings, 41–42 U.S markets, 68–70 volatility, 862 Stock market analysts, 360 I-23 bod77178_sidx_I4-I26.indd I-23 04/28/17 03:57 PM Final PDF to printer Subject Index Stock market indexes, 43–50 Dow Jones Industrial Average, 43–46 equally weighted indexes, 48 foreign and international indexes, 48–49 market-value-weighted indexes, 47 other U.S market-value indexes, 48 price-weighted average, 45 Standard & Poor’s 500 Index, 47 value-weighted indexes, 47 Stock prices convergence to intrinsic value, 578 industry stock price performance (2016), 551 investment opportunities and, 578–581 random walk argument, 334 Stock returns over long horizons, 349–350 over short horizon, 349 Stock selection, 874 Stock splits, price-weighted averages, 45 Stock volatility, 711 Stockholders’ equity, 615 Storage costs, 797–799 Straddle, 671–673, 675 Straight bond, 678 Strike price, 50, 657 Strong-form hypothesis, 338, 355 Structured Investment Vehicle (SIV), 458 Structured products, 19n Style analysis, 823–826 Fidelity’s Magellan Fund (example), 824 hedge funds, 889–891 Style drift, 882 Style portfolios, 144, 357 Subordinated debentures, 39 Subordination clauses, 453 Subprime mortgages, 39 Substitute products, 560 Substitution swap, 523 Supply shock, 542 Supply-side policies, 544 Support levels, 339 Survivorship bias, 419–420, 894–895 Swap dealer, 792–793 Swap pricing, 794–796 Swaps, 790–797 balance sheet restructuring and, 792 bond swap, 523 credit default swaps (CDS), 797 credit risk in, 796–797 foreign exchange swap, 790 forward contract vs., 795 interest rate swap, 791 intermarket spread swap, 523 other interest rate contracts, 793–794 pricing of, 794–796 pure yield pickup swap, 523 rate anticipation swap, 523 substitution swap, 523 swap dealer, 792–793 tax swap, 524 Synthetic protective put options, 726 Synthetic stock positions, 784–785 stock-index futures, 784–785 Systematic risk, 195, 397, 817 firm-specific risk vs., 247–247 Systemic risk, 15 financial crisis of 2008, 20–21 T Tail events, hedge fund performance, 896–899 Tangible fixed assets, 615 Target-date retirement fund (TDRF), 955 Targeted-maturity funds, 97 Tax anticipation notes, 36 Tax-burden ratio, 624 Tax-deferral option, 948 Tax-protected retirement plans, 949 Tax Reform Act of 1986, 121 Tax sheltering, 948–951 deferred annuities, 950–951 tax-deferral option, 948–949 tax-protected retirement plans, 949–950 variable and universal life insurance, 951 Tax swap, 524 Taxes asset allocation and, 944–945 futures and, 757 investment considerations and, 938 mutual fund income, 102–103 OID bonds, 448 real rate of interest and, 121 tax sheltering, 948–951 taxable vs tax-exempt yields, 38 Technical analysis, 339 behavioral finance and, 384–389 breadth, 387–388 cautions on use of, 389–390 confidence index, 388–389 implications of EMH, 339–343 momentum and moving averages, 385–387 put/call ratio, 389 relative strength, 387 resistance/support levels, 339 sentiment indicators, 388–389 trends and corrections, 385–388 trin statistic, 388 TED spread, 15n Term insurance, 936 Term repo, 31 Term structure of interest rates, 467 expectations hypothesis, 477–478 forward inflation rates and, 478 interpretation of, 480–484 liquidity preference, 478–480 theories of, 477–480 uncertainty and forward rates, 475–477 Threat of entry, 559 Tick size, 34 Tick sizes, 66 Time diversification, 220–221 Time series analysis expected returns and arithmetic average, 129 geometric (time-weighted) average return, 129–131 holding-period returns, 130 mean and standard deviation from higher-frequency observations, 132–133 past rates of return, 129–133 reward-to-volatility (Sharpe) ratio, 133 scenario analysis vs., 129 variance and standard deviation, 131–132 Time value of the option, 700 I-24 bod77178_sidx_I4-I26.indd I-24 04/28/17 03:57 PM Final PDF to printer Subject Index Time-weighted average, 812 Time-weighted average return, 130 Time-weighted returns, dollarweighted returns vs., 812–813 Times interest earned, 624, 632 Times-interest-earned ratio, 451 TIPS (Treasury Inflation Protected Securities), 35, 119n, 431–432 Tobin’s q, 571 Top-down portfolio construction, Total asset turnover, 632 Total asset turnover (ATO), 624 Tracking error, 912 Trading costs, 74–75 Trading mechanisms, 64–66; see also Securities trading dealer markets, 65–66 electronic communication networks (ECNs), 66 futures markets, 752–757 options trading, 659–660 specialist markets, 66 Trading strategies, 70–73 algorithmic trading, 70–71 bond trading, 73 dark pools, 72–73 high-frequency trading, 71–72 Tranches, 19, 458 Transparency, 882 Treasury bills (T-bills), 28–29 asset allocation with, 203–207 bank-discount method, 28 bid–ask spread, 28 bond-equivalent yield, 29 inflation and (1926-2015), 124–126 spread between 3-month CD and (1970-2015), 32 statistics for (1926-2015), 125 TED spread, 15 yields on, 29 Treasury bonds; see Treasury notes and bonds Treasury Inflation Protected Securities (TIPS), 35, 119n, 431–432 Treasury notes and bonds, 34, 426–427 inflation-protected Treasury bonds, 35 price volatility of long-term, 483 yield to maturity, 34 Treasury stock, 615 Treasury strips, 121n, 447 Trends and corrections, 385–388 Treynor-Black model, 262, 914–917 Black-Litterman vs., 923–925 distribution of alpha values, 915–916 forecast precision of alpha, 914–915 organizational structure and performance, 916–917 Treynor ratio, 814, 817–819 Trin statistic, 388 Trough, 545 Turnarounds, 559 Turnover, 102, 626–628 12b-1 charges, 99 Two-stage dividend discount model, 583 Two-state option pricing, 706–708 U Underwriters, 14, 59 Unemployment rate, 541 Uniform Securities Act (1956), 83 Unique risk, 195 Unit investment trusts, 93 Units, 95 Universal banks, 14 Universal life, 936, 951 Utility function, 159 allocation to risky asset, 171 expected utility, 187–190 insurance contracts, 191–192 prospect theory and, 378 Utility scores, 159 evaluating investments by, 160 risk aversion and, 160 Utility values, risk aversion and, 159–162 V Valuation models; see Equity valuation models Value assets, 408n Value at risk (VaR), 138, 145–146, 217 Value investing (Graham technique), 642–643 Value stocks, 110 Value-weighted indexes, 47 Variable annuities, 951 Variable life, 936, 951 Variance portfolio variance, 243 of risky asset in Excel, 239 standard deviation and, 131–132 Vega, 734 Venture capital (VC), 14–15 Volcker Rule, 14, 22 W Wall Street Journal Online closed-end mutual funds, 94 Eurodollar futures, 794 foreign exchange futures, 777 futures listings, 749 market diaries: volume, advancers, decliners, 387 NYSE stock listings, 42 spot/forward prices in foreign exchange, 777 Treasury bill yields, 29 Treasury bonds and notes, 34 Treasury quotes, 426 Treasury yield curve, 468 Warrants, 682 Weak-form hypothesis, 338 Well-diversified portfolio, 313–315, 318–319 Whole-life insurance policy, 936 Wilshire 5000 index, 48 Workout period, 523 Worldcom scandal, Y Yankee bond, 35 Yankee bonds, 430 Yield curve, 467–470 bond pricing, 435 forward rates and slope of, 481 future interest rates and, 470–474 holding-period returns, 446 on-the-run yield curve, 470 pure yield curve, 469 slopes of, 479–480 Treasury yield curves, 468 under certainty, 470–472 I-25 bod77178_sidx_I4-I26.indd I-25 04/28/17 03:57 PM Final PDF to printer Subject Index Yield to call, 440–442 Yield to maturity (YTM), 34, 438–440 default risk and, 454–456 Excel function for, 439 expected vs promised YTM, 455 financial calculator, 439 holding-period return vs., 446 realized compound return vs., 442–444 Yields; see also Bond yields bank-discount method, 28 bond-equivalent yield, 29, 34 equivalent taxable yield, 37 money market instruments, 31–33 spread between 10-year Treasury and Baa-rated corporates, 790 taxable vs tax-exempt, 38 Z Z-score, 452 Zero-beta model, 289–290 Zero-coupon bonds, 426, 447, 472, 498 Zero-sum game, 750 I-26 bod77178_sidx_I4-I26.indd I-26 04/28/17 03:57 PM Commonly Used Notation b Retention or plowback ratio C Call option value CF Duration E Exchange rate Futures price e 2 718, the base for the natural logarithm, used for continuous compounding Forward rate of interest g Growth rate of dividends H Hedge ratio for an option, sometimes called the option’s delta 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 p P t Cumulative normal function, the probability that a standard normal random variable will have value less than d Present value P/E Price-to-earnings multiple Sharpe ratio, also called the rewardto-volatility ratio; the excess expected return divided by the standard deviation Time Intrinsic value of a firm, the present value of future dividends per share X Exercise price of an option y Yield to maturity α Rate of return beyond the value that would be forecast from the market’s return and the systematic risk of the security β Systematic or market risk of a security σ Cov(ri , rj ) F-1 Return on equity, incremental economic earnings per dollar reinvested in the firm V Rate of return on a security; for fixedincome securities, r may denote the rate of interest for a particular period The rate of return on the market portfolio Treynor’s measure for a portfolio, excess expected return divided by beta σ Put value The risk-free rate of interest Tp ρij Probability PV r Sp  he firm-specific return, also called the T residual return, of security i in period t f N(d) ROE Expected value of random variable x F eit rM Cash flow D E(x) rf Correlation coefficient between returns on securities i and j Standard deviation Variance Covariance between returns on securities i and j Useful Formulas Measures of Risk Variance of returns: σ2  =  ​​∑ ​  ​​​  p(s)​​[​​​r(s) − E(r)​​]2​​​ s Standard deviation: σ = ​​√ σ2 ​​  Covariance between returns: Cov(ri, rj)  =  ​​∑ ​  ​​​  p(s)​​[​​​ri(s) − E(ri)​​]​​​​​[​​​rj(s) − E(rj)​​]​​​ s Cov(ri, rM) Beta of security i: βi = ​​  _  ​​    Var(rM) Portfolio Theory n Expected rate of return on a portfolio with weights wi, in each security: E(rp) = ​​  ∑   ​​​​ wi E(ri) Variance of portfolio rate of return: ​​σ​ 2p ​​​  n i = 1 n  = ​​  ∑   ​​​​ ​​  ∑   ​​​w ​  jwi Cov(ri, rj) j = 1 i = 1 Market Equilibrium The CAPM security market line: E(ri) = rf + βi​​[​​​E(rM)  −  rf​​]​​​ K Multifactor security market line (in excess returns): E(Ri) = βiM E(RM) + ​​  ∑   ​​​β​  i  k E(Rk) k = 1 Fixed-Income Analysis Present value of $1:   Discrete period compounding: PV = 1/(1 + r)T   Continuous compounding: PV = ​​e​​  −​r​ ccT​​​​ (1 + yT)T Forward rate of interest for period T : fT = ​​        ​​ − 1 (1 + yT − 1)T − 1 1 + rnom Real interest rate: rreal = ​​  _  ​​ − 1     1 + i  where rnom is the nominal interest rate and i is the inflation rate T CFt Duration of a security: D = ​​  ∑   ​​​t​  × _ ​​   t ​​  /Price (1 + y) t = 1 Modified duration: D∗ = D/(1 + y) F-2 Equity Analysis D1 Constant growth dividend discount model: V0 = ​​  _   ​​  k − g Sustainable growth rate of dividends: g = ROE × b 1 − b Price/earnings multiple: P/E = ​​  _       ​​ k − ROE × b Debt ROE = (1 − Tax  rate)​​ ROA + (ROA − Interest  rate) ​    ​ ​​ [ Equity ] Derivative Assets Put-call parity: P = C − S0 + PV(X + dividends) Black-Scholes formula (with constant dividend yield): C = Se−δTN(d1) − Xe−rTN(d2) ln(S/X) + (r − δ + σ /2)T  ​​ d1 = ​​  _       √ σ​  T ​  d2 = d1 − σ​​√ T ​​  Spot-futures parity: F0 = S0(1 + r − d )T 1 + rUS Interest rate parity (direct exchange rate quotes): F0 = E0​​ ​  _    ​  ​​ ( 1 + rforeign ) T Performance Evaluation ¯r ​ ​  p   − ​ ¯r ​f  Sharpe ratio: Sp = ​​   ​     σp ​ ¯r ​ ​  p   − ​ ¯r ​f  Treynor’s measure: Tp = ​​   ​     βp ​ Jensen’s alpha: αp = ​​ ¯r ​​p   −​​[¯r ​​​​​​​  f  + βp(​​ ¯r ​​M    − ​¯r ​ ​  ​f )​​]​​​ α Information ratio: _ ​​  p   ​​  σ(ep) Geometric average return: rG =​​[​​​(1 + r1)(1 + r2) . . . (1 + rT)​​]1/T ​​​  − 1 F-3 ... Management Sixteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance Twelfth Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Edition Second Edition Brealey,... Ninth Edition Brooks FinGame Online 5.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Eighth Edition Cornett, Adair, and Nofsinger Finance: Applications and Theory Fourth Edition. .. Applications Fifth Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Ninth Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Ninth Edition Saunders