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Contents PART 1 Introduction 1 A Brief History of Risk and Return 1.1 Returns Dollar Returns Percentage Returns 1.2 The Historical Record A First Look A Longer Range Look A Closer Look 1.3 Average Returns: The First Lesson Calculating Average Returns Average Returns: The Historical Record Risk Premiums The First Lesson 1.4 Return Variability: The Second Lesson Frequency Distribution and Variability The Historic Variance and Standard Deviation The Historical Record Normal Distribution The Second Lesson 1.5 More on Average Returns Arithmetic versus Geometric Averages Calculating Geometric Average Returns Arithmetic Average Return or Geometric Average Return? 1.6 Risk and Return The Risk-Return Trade-Off A Look Ahead 1.7 Summary and Conclusions 2 Buying and Selling Securities 2.1 Getting Started Choosing a Broker Online Brokers Security Investors Protection Corporation Broker-Customer Relations 2.2 Brokerage Accounts Cash Accounts Margin Accounts A Note on Annualizing Returns Hypothecation and Street Name Registration Other Account Issues 2.3 Short Sales Basics of a Short Sale Short Sales: Some Details 2.4 Investor Objectives, Constraints, and Strategies Risk and Return Investor Constraints Strategies and Policies 2.5 Summary and Conclusions 3 Overview of Security Types 3.1 Classifying Securities 3.2 Interest-Bearing Assets Money Market Instruments Fixed-Income Securities 3.3 Equities Common Stock Preferred Stock Common Stock Price Quotes 3.4 Derivatives Futures Contracts Futures Price Quotes Gains and Losses on Futures Contracts 3.5 Option Contracts Option Terminology Options versus Futures Option Price Quotes Gains and Losses on Option Contracts Investing in Stocks versus Options 3.5 Summary and Conclusions 4 Mutual Funds 4.1 Investment Companies and Fund Types Open-End versus Closed-End Funds Net Asset Value 4.2 Mutual Fund Operations Mutual Fund Organization and Creation Taxation of Investment Companies The Fund Prospectus and Annual Report 4.3 Mutual Fund Costs and Fees Types of Expenses and Fees Expense Reporting Why Pay Loads and Fees? 4.4 Short-Term Funds Money Market Mutual Funds Money Market Deposit Accounts 4.5 Long-Term Funds Stock Funds Taxable and Municipal Bond Funds Stock and Bond Funds Mutual Fund Objectives: Recent Developments 4.6 Mutual Fund Performance Objectives Mutual Fund Performance Information How Useful Are Fund Performance Ratings? Closed Funds 4.7 Closed-End Funds, Exchange-Traded Funds, and Hedge Funds Closed-End Funds Performance Information The Closed-End Fund Discount Mystery Exchange-Traded Funds Hedge Funds 4.8 Summary and Conclusions PART 2 Stock Markets 5 The Stock Market 5.1 The Primary and Secondary Stock Markets The Primary Market for Common Stock The Secondary Market for Common Stock Dealers and Brokers 5.2 The New York Stock Exchange NYSE Membership Types of Members NYSE-Listed Stocks 5.3 Operation of the New York Stock Exchange NYSE Floor Activity Special Order Types 5.4 NASDAQ NASDAQ Operations NASDAQ Participants The NASDAQ System 5.5 NYSE and NASDAQ Competitors 5.6 Stock Market Information The Dow Jones Industrial Average Stock Market Indexes More on Price-Weighted Indexes The Dow Jones Divisors More on Index Formation: Base-Year Values 5.7 Summary and Conclusions 6 Common Stock Valuation 6.1 Security Analysis: Be Careful Out There 6.2 The Dividend Discount Model Constant Dividend Growth Rate Model Constant Perpetual Growth Applications of the Constant Perpetual Growth Model Historical Growth Rates The Sustainable Growth Rate 6.3 The Two-Stage Dividend Growth Model Discount Rates for Dividend Discount Models Observations on Dividend Discount Models 6.4 The Residual Income Model Residual Income The RIM versus the Constant Growth DDM 6.5 Price Ratio Analysis Price-Earnings Ratios Price-Cash Flow Ratios Price-Sales Ratios Price-Book Ratios Applications of Price Ratio Analysis 6.6 An Analysis of the McGraw-Hill Company Using the Dividend Discount Model Using the Residual Income Model Using Price Ratio Analyses 6.7 Summary and Conclusions 7 Stock Price Behavior and Market Efficiency 7.1 Introduction to Market Efficiency 7.2 What Does ?Beat the Market? Mean? 7.3 Foundations of Market Efficiency 7.4 Forms of Market Efficiency 7.5 Why Would a Market Be Efficient? 7.6 Some Implications of Market Efficiency Does Old Information Help Predict Future Stock Prices? Random Walks and Stock Prices How Does New Information Get into Stock Prices? Event Studies 7.7 Informed Traders and Insider Trading Informed Trading Insider Trading 7.8 How Efficient Are Markets? Are Financial Markets Efficient? Some Implications of Market Efficiency 7.9 Market Efficiency and the Performance of Professional Money Managers 7.10 Anomalies The Day-of-the-Week Effect The Amazing January Effect Turn-of-the-Year Effect Turn-of-the-Month Effect The Earnings Announcement Puzzle The Price/Earnings (P/E) Puzzle 7.11 Bubbles and Crashes The Crash of 1929 The Crash of October 1987 The Asian Crash The ?Dot-Com? Bubble and Crash 7.12 Summary and Conclusions 8 Behavioral Finance and the Psychology of Investing 8.1 Introduction to Behavioral Finance 8.2 Prospect Theory Frame Dependence Mental Accounts and Loss Aversion House Money 8.3 Overconfidence Overconfidence and Trading Frequency Overtrading and Gender: ?It?s (basically) a guy thing? What Is a Diversified Portfolio to the Everyday Investor? 8.4 Misperceiving Randomness and Overreacting to Chance Events The ?Hot-Hand? Fallacy The Gambler?s Fallacy 8.5 Sentiment-Based Risk and Limits to Arbitrage Limits to Arbitrage The 3Com/Palm Mispricing The Royal Dutch/Shell Price Ratio 8.6 Technical Analysis Why Does Technical Analysis Continue to Thrive? Dow Theory Elliott Waves Support and Resistance Levels Technical Indicators Relative Strength Charts Charting Fibonacci Numbers Other Technical Indicators 8.7 Summary and Conclusions PART 3 Interest Rates and Bond Valuation 9 Interest Rates 9.1 Interest Rate History and Money Market Rates Interest Rate History Money Market Rates 9.2 Money Market Prices and Rates Bank Discount Rate Quotes Treasury Bill Quotes Bank Discount Yields versus Bond Equivalent Yields Bank Equivalent Yields, APRs, and EARs 9.3 Rates and Yields on Fixed-Income Securities The Treasury Yield Curve Rates on Other Fixed-Income Investments 9.4 The Term Structure of Interest Rates Treasury STRIPS Yields for U.S. Treasury STRIPS 9.5 Nominal versus Real Interest Rates Real Interest Rates The Fisher Hypothesis Inflation-Indexed Treasury Securities 9.6 Traditional Theories of the Term Structure Expectations Theory Maturity Preference Theory Market Segmentation Theory 9.7 Determinants of Nominal Interest Rates: A Modern Perspective Problems with Traditional Theories Modern Term Structure Theory Liquidity and Default Risk 9.8 Summary and Conclusions 10 Bond Prices and Yields 10.1 Bond Basics Straight Bonds Coupon Rate and Current Yield 10.2 Straight Bond Prices and Yield to Maturity Straight Bond Prices Premium and Discount Bonds Relationships among Yield Measures A Note on Bond Price Quotes 10.3 More on Yields Calculating Yields Yield to Call 10.4 Interest Rate Risk and Malkiel?s Theorems Promised Yield and Realized Yield Interest Rate Risk and Maturity Malkiel?s Theorems 10.5 Duration Macaulay Duration Modified Duration Calculating Macaulay Duration Properties of Duration 10.6 Bond Risk Measures Based on Duration Dollar Value of an 01 Yield Value of a 32nd 10.7 Dedicated Portfolios and Reinvestment Risk Dedicated Portfolios Reinvestment Risk 10.8 Immunization Price Risk versus Reinvestment Rate Risk Immunization by Duration Matching Dynamic Immunization 10.9 Summary and Conclusions PART 4 Portfolio Management 11 Diversification and Risky Asset Allocation 11.1 Expected Returns and Variances Expected Returns Calculating the Variance 11.2 Portfolios Portfolio Weights Portfolio Expected Returns Portfolio Variance 11.3 Diversification and Portfolio Risk The Effect of Diversification: Another Lesson from Market History The Principle of Diversification 11.4 Correlation and Diversification Why Diversification Works Calculating Portfolio Risk The Importance of Asset Allocation, Part 1 More on Correlation and the Risk-Return Trade-Off 11.5 The Markowitz Efficient Frontier The Importance of Asset Allocation, Part 2 11.6 Summary and Conclusions 12 Return, Risk, and the Security Market Line 12.1 Announcements, Surprises, and Expected Returns Expected and Unexpected Returns Announcements and News 12.2 Risk: Systematic and Unsystematic Systematic and Unsystematic Risk Systematic and Unsystematic Components of Return 12.3 Diversification, Systematic Risk and Unsystematic Risk Diversification and Unsystematic Risk Diversification and Systematic Risk 12.4 Systematic Risk and Beta The Systematic Risk Principle Measuring Systematic Risk Portfolio Betas 12.5 The Security Market Line Beta and Risk Premium The Reward-to-Risk Ratio The Basic Argument The Fundamental Result The Security Market Line 12.6 More on Beta A Closer Look at Beta Where Do Betas Come From? Why Do Betas Differ? 12.7 Extending CAPM A (Very) Brief History of Testing CAPM The Fama-French Three-Factor Model 12.8 Summary and Conclusions 13 Performance Evaluation and Risk Management 13.1 Performance Evaluation Performance Evaluation Measures The Sharpe Ratio The Treynor Ratio Jensen?s Alpha 13.2 Comparing Performance Measures Sharpe-Optimal :Portfolios 13.3 Investment Risk Management Value-at-Risk 13.4 More on Computing Value-at-Risk 13.5 Summary and Conclusions PART 5 Futures and Options 14 Futures Contracts 14.1 Futures Contracts Basics Modern History of Futures Trading Futures Contract Features Futures Prices 14.2 Why Futures? Speculating with Futures Hedging with Futures 14.3 Futures Trading Accounts 14.4 Cash Prices versus Futures Prices Cash Prices Cash-Futures Arbitrage Spot-Futures Parity More on Spot-Futures Parity 14.5 Stock Index Futures Basics of Stock Index Futures Index Arbitrage Hedging Stock Market Risk with Futures Hedging Interest-Rate Risk with Futures Futures Contract Delivery Options 14.6 Summary and Conclusions 15 Stock Options 15.1 Options on Common Stocks Option Basics Option Price Quotes Stock Option Ticker Symbols 15.2 The Options Clearing Corporation 15.3 Why Options? 15.4 Option ?Moneyness? 15.5 Option Payoffs and Profits Option Writing Option Payoffs Payoff Diagrams Options Profits 15.6 Option Strategies The Protective Put Strategy The Covered Call Strategy Straddles 15.7 Option Prices, Intrinsic Values, and Arbitrage The Upper Bound for a Call Option Price The Upper Bound for a Put Option Price The Lower Bounds on Option Prices 15.8 Employee Stock Options ESO Features ESO Repricing ESOs at The Gap, Inc. 15.9 Put-Call Parity 15.10 Stock Index Options Index Options: Features and Settlement Index Option Price Quotes 15.11 Summary and Conclusions PART 6 Topics in Investments 16 Option Valuation 16.1 The Black-Scholes-Merton Option Pricing Model 16.2 Valuing Employee Stock Options 16.3 Varying the Option Price Input Values Varying the Underlying Stock Price Varying the Option?s Strike Price Varying the Time Remaining until Option Expiration Varying the Volatility of the Stock Price Varying the Interest Rate Varying the Dividend Yield 16.4 Measuring the Impact of Input Changes on Option Prices Interpreting Option Deltas Interpreting Option Etas Interpreting Option Vegas Interpreting an Option?s Gamma, Theta, and Rho 16.5 Implied Standard Deviations CBOE Implied Volatilities for Stock Indexes 16.6 Hedging Stock with Stock Options Hedging Using Call Options--The Prediction Hedging Using Call Options--The Results Hedging Using Put Options--The Prediction Hedging Using Put Options--The Results 16.7 Hedging a Stock Portfolio with Stock Index Options 16.8 Summary and Conclusions 17 Projecting Cash Flows and Earnings 17.1 Sources of Financial Information 17.2 Financial Statements The Balance Sheet The Income Statement The Cash Flow Statements Performance Ratios and Price Ratios 17.3 Financial Statement Forecasting The Percentage of Sales Approach The Pro Forma Income Statement The Pro Forma Cash Flow Statement The Pro Forma Balance Sheet Scenario One Scenario Two Projected Profitability and Price Ratios 17.4 Starbucks Corporation Pro Forma Income Statement Pro Forma Balance Sheet Valuing Starbucks Using Ratio Analysis Valuing Starbucks Using a Two-Stage Residual Income Model Valuing Starbucks: What Does the Market Say? 17.5 Summary and Conclusions 18 Corporate Bonds 18.1 Corporate Bond Basics 18.2 Types of Corporate Bonds 18.3 Bond Indentures Bond Seniority Provisions Call Provisions Put Provisions Bond-to-Stock Conversion Provisions Graphical Analysis of Convertible Bond Prices Bond Maturity and Principal Payment Provisions Sinking Fund Provisions Coupon Payment Provisions 18.4 Protective Covenants 18.5 Event Risk 18.6 Bonds without Indentures 18.7 Preferred Stock 18.8 Adjustable-Rate Bonds and Adjustable-Rate Preferred Stock 18.9 Corporate Bond Credit Ratings Why Bond Ratings Are Important 18.10 Junk Bonds 18.11 Bond Market Trading 18.12 Summary and Conclusions 19 Government Bonds 19.1 Government Bond Basics 19.2 U.S. Treasury Bills, Notes, Bonds, and STRIPS Treasury Bond and Note Prices Treasury Inflation-Protected Securities 19.3 U.S. Treasury Auctions 19.4 U.S. Savings Bonds Series EE Savings Bonds Series I Savings Bonds 19.5 Federal Government Agency Securities 19.6 Municipal Bonds Municipal Bond Features Types of Municipal Bonds Municipal Bond Credit Ratings Municipal Bond Insurance 19.7 Equivalent Taxable Yield 19.8 Taxable Municipal Bonds 19.9 Summary and Conclusions 20 Mortgage-Backed Securities 20.1 A Brief History of Mortgage-Backed Securities 20.2 Fixed-Rate Mortgages Fixed-Rate Mortgage Amortization Fixed-Rate Mortgage Prepayment and Refinancing 20.3 Government National Mortgage Association GNMA Clones 20.4 Public Securities Association Mortgage Prepayment Model 20.5 Cash Flow Analysis of GNMA Fully Modified Mortgage Pools Macaulay Durations for GNMA Mortgage-Backed Bonds 20.6 Collateralized Mortgage Obligations Interest-Only and Principal-Only Mortgage Strips Sequential Collateralized Mortgage Obligations Protected Amortization Class Bonds 20.7 Yields for Mortgage-Backed Securities and Collateralized Mortgage Obligations 20.8 Summary and Conclusions Appendixes A Answers to Test Your Investment Quotient Questions B Answers to Selected Questions and Problems Index
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