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CONTENTS Part I INTRODUCTION?1 CHAPTER 1 THE INVESTMENT ENVIRONMENT 1.1 Real Assets versus Financial Assets?2 1.2 A Taxonomy of Financial Assets?4 1.3 Financial Markets and the Economy?5 The Informational Role of Financial Markets / Consumption Timing / Allocation of Risk / Separation of Ownership and Management / Corporate Governance and Corporate Ethics 1.4 The Investment Process?9 Saving, Investing, and Safe Investing- 1.5 Markets Are Competitive?10 The Risk?Return Trade-Off / Efficient Markets 1.6 The Players?12 Financial Intermediaries / Investment Bankers 1.7 Recent Trends?15 Globalization / Securitization / Financial Engineering / Computer Networks 1.8 Outline of the Text?19 Summary?19 Key Terms?20 Web Sites?20 E-Investments: Savings and Investing?21 Standard & Poor?s?21 Problems?21 Solutions to Concept Checks?23 CHAPTER 2 ASSET CLASSES AND FINANCIAL INSTRUMENTS 2.1 The Money Market?26 Treasury Bills / Certificates of Deposit / Commercial Paper / Bankers? Acceptances / Eurodollars / Repos and Reverses / Federal Funds / Brokers? Calls / The LIBOR Market / Yields on Money Market Instruments 2.2 The Bond Market?30 Treasury Notes and Bonds / Inflation-Protected Treasury Bonds / Federal Agency Debt / International Bonds / Municipal Bonds / Corporate Bonds / Mortgages and Mortgage-Backed Securities 2.3 Equity Securities?38 Common Stock as Ownership Shares / Characteristics of Common Stock / Stock Market Listings / Preferred Stock / Depository Receipts 2.4 Stock and Bond Market Indexes?41 Stock Market Indexes / Dow Jones Averages / Standard & Poor?s Indexes / Other U.S. Market-Value Indexes / Equally Weighted Indexes / Foreign and International Stock Market Indexes / Bond Market Indicators 2.5 Derivative Markets?47 Options / Futures Contracts Summary?51 Key Terms?52 Web Sites?52 E-Investments: Security Prices and Returns?52 Standard & Poor?s?53 Problems?53 Solutions to Concept Checks?55 CHAPTER 3 HOW SECURITIES ARE TRADED 3.1 How Firms Issue Securities?57 Investment Banking / Shelf Registration / Private Placements / Initial Public Offerings 3.2 How Securities Are Traded?62 Types of Markets Direct Search Markets / Brokered Markets / Dealer Markets / Auction Markets Types of Orders Market Orders / Price-Contingent Orders Trading Mechanisms Dealer Markets / Electronic Communication Networks (ECNs) / Specialist Markets 3.3 U.S. Securities Markets?68 Nasdaq / The New York Stock Exchange Block Sales / SuperDot and Electronic Trading on the NYSE / Settlement Electronic Communication Networks / The National Market System / Bond Trading 3.4 Market Structure in Other Countries?74 London / Euronext / Tokyo / Globalization and Consolidation of Stock Markets 3.5 Trading Costs?76 3.6 Buying on Margin?78 3.7 Short Sales?81 3.8 Regulation of Securities Markets?83 Self-Regulation / Regulatory Responses to Recent Scandals / Circuit Breakers / Insider Trading Summary?88 Key Terms?88 Web Sites?89 E-Investments: Short Sales?89 Standard & Poor?s?90 Problems?90 Solutions to Concept Checks?93 CHAPTER 4 MUTUAL FUNDS AND OTHER INVESTMENT COMPANIES 4.1 Investment Companies?95 4.2 Types of Investment Companies?96 Unit Investment Trusts / Managed Investment Companies / Other Investment Organizations Commingled Funds / Real Estate Investment Trusts (REITS) / Hedge Funds 4.3 Mutual Funds?100 Investment Policies Money Market Funds / Equity Funds / Bond Funds / International Funds / Balanced Funds / Asset Allocation and Flexible Funds / Index Funds / How Funds Are Sold 4.4 Costs of Investing in Mutual Funds?104 Fee Structure Front-End Load / Back-End Load / Operating Expenses / 12b-1 Charges Fees and Mutual Fund Returns / Late Trading and Market Timing 4.5 Taxation of Mutual Fund Income?109 4.6 Exchange-Traded Funds?110 4.7 Mutual Fund Investment Performance: A First Look?111 4.8 Information on Mutual Funds?114 Summary?118 Key Terms?118 Web Sites?118 E-Investments: Choosing a Mutual Fund?119 Standard & Poor?s?119 Problems?119 Solutions to Concept Checks?121 Part II PORTFOLIO THEORY AND PRACTICE CHAPTER 5 LEARNING ABOUT RETURN AND RISK FROM THE HISTORICAL RECORD 5.1 Determinants of the Level of Interest Rates?124 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 5.2 Comparing Rates of Return for Different Holding Periods?128 Annual Percentage Rates / Continuous Compounding 5.3 Bills and Inflation, 1926?2005?131 5.4 Risk and Risk Premiums?133 Holding-Period Returns / Expected Return and Standard Deviation / Excess Returns and Risk Premiums 5.5 Time Series Analysis of Past Rates of Return?136 Time Series versus Scenario Analysis / Expected Returns and the Arithmetic Average / The Geometric (Time- Weighted) Average Return / Variance and Standard Deviation / The Reward-to- Variability (Sharpe) Ratio 5.6 The Normal Distribution?140 5.7 Deviations from Normality?142 5.8 The Historical Record of Returns on Equities and Long-Term Bonds?144 Average Returns and Standard Deviations / Other Statistics of the Risky Portfolios / Sharpe Ratios / Serial Correlation / Skewness and Kurtosis / Estimates of Historical Risk Premiums / A Global View of the Historical Record 5.9 Long-Term Investments?151 Risk in the Long Run and the Lognormal Distribution / The Sharpe Ratio Revisited / Simulation of Long- Term Future Rates of Return / Forecasts for the Long Haul 5.10 Measurement of Risk with Non-Normal Distributions?158 Value at Risk (VaR) / Conditional Tail Expectation (CTE) / Lower Partial Standard Deviation (LPSD) Summary?160 Key Terms?160 Web Sites?160 E-Investments: Analytics Tutorial?161 Standard & Poor?s?161 Problems?161 Solutions to Concept Checks?164 CHAPTER 6 RISK AVERSION AND CAPITAL ALLOCATION TO RISKY ASSETS 6.1 Risk and Risk Aversion?166 Risk, Speculation, and Gambling / Risk Aversion and Utility Values / Estimating Risk Aversion 6.2 Capital Allocation across Risky and Risk-Free Portfolios?174 6.3 The Risk-Free Asset?176 6.4 Portfolios of One Risky Asset and A Risk-Free Asset?177 6.5 Risk Tolerance and Asset Allocation?181 6.6 Passive Strategies: The Capital Market Line?186 Summary?190 Key Terms?191 Web Sites?191 E-Investments: Market Crashes?192 Standard & Poor?s?192 Problems?192 Solutions to Concept Checks?196 Appendix A: Risk Aversion, Expected Utility, and the St. Petersburg Paradox?199 Appendix B: Utility Functions and Equilibrium Prices of Insurance Contracts?202 CHAPTER 7 OPTIMAL RISKY PORTFOLIOS 7.1 Diversification and Portfolio Risk?206 7.2 Portfolios of Two Risky Assets?208 7.3 Asset Allocation with Stocks, Bonds, and Bills?216 The Optimal Risky Portfolio with Two Risky Assets and a Risk-Free Asset 7.4 The Markowitz Portfolio Selection Model?222 Security Selection / Capital Allocation and the Separation Property / The Power of Diversification / Asset Allocation and Security Selection 7.5 Risk Pooling, Risk Sharing, and Risk in the Long Run?231 Risk Pooling and the Insurance Principle / Risk Sharing Summary?234 Key Terms?235 Web Sites?235 E-Investments: Risk Comparisons?236 Problems?236 Solutions to Concept Checks?241 Appendix A: A Spreadsheet Model?244 Appendix B: Review of Portfolio Statistics?249 CHAPTER 8 INDEX MODELS 8.1 A Single-Factor Security Market?258 The Input List of the Markowitz Model / Normality of Returns and Systematic Risk 8.2 The Single-Index Model?260 The Regression Equation of the Single-Index Model / The Expected Return?Beta Relationship / Risk and Covariance in the Single-Index Model / The Set of Estimates Needed for the Single-Index Model / The Index Model and Diversification 8.3 Estimating the Single-Index Model?265 The Security Characteristic Line for Hewlett-Packard / The Explanatory Power of the SCL for HP / Analysis of Variance / The Estimate of Alpha / The Estimate of Beta / Firm-Specific Risk / Correlation and Covariance Matrix 8.4 Portfolio Construction and the Single-Index Model?270 Alpha and Security Analysis / The Index Portfolio as an Investment Asset / The Single-Index-Model Input List / The Optimal Risky Portfolio of the Single-Index Model / The Information Ratio / Summary of Optimization Procedure / An Example Risk Premium Forecasts / The Optimal Risky Portfolio 8.5 Practical Aspects of Portfolio Management with the Index Model?280 Is the Index Model Inferior to the Full-Covariance Model? / The Industry Version of the Index Model / Predicting Betas / Index Models and Tracking Portfolios Summary?286 Key Terms?287 Web Sites?287 E-Investments: Comparing Volatilities and Beta Coefficients?287 Standard & Poor?s?288 Problems?288 Solutions to Concept Checks?291 Part III EQUILIBRIUM IN CAPITAL MARKETS CHAPTER 9 THE CAPITAL ASSET PRICING MODEL 9.1 The Capital Asset Pricing Model?293 Why Do All Investors Hold the Market Portfolio? / The Passive Strategy Is Efficient / The Risk Premium of the Market Portfolio / Expected Returns on Individual Securities / The Security Market Line 9.2 The CAPM and the Index Model?306 Actual Returns versus Expected Returns / The Index Model and Realized Returns / The Index Model and the Expected Return?Beta Relationship 9.3 Is the CAPM Practical??308 Is the CAPM Testable? / The CAPM Fails Empirical Tests / The Economy and the Validity of the CAPM / The Investments Industry and the Validity of the CAPM 9.4 Econometrics and the Expected Return?Beta Relationship?312 9.5 Extensions of the CAPM?313 The Zero-Beta Model / Labor Income and Nontraded Assets / A Multiperiod Model and Hedge Portfolios 9.6 Liquidity and the CAPM?317 Summary?322 Key Terms?323 Web Sites?323 E-Investments: Beta Comparisons?323 Standard & Poor?s?324 Problems?324 Solutions to Concept Checks?328 CHAPTER 10 ARBITRAGE PRICING THEORY AND MULTIFACTOR MODELS OF RISK AND RETURN 10.1 Multifactor Models: An Overview?332 Factor Models of Security Returns / A Multifactor Security Market Line 10.2 Arbitrage Pricing Theory?336 Arbitrage, Risk Arbitrage, and Equilibrium / Well-Diversified Portfolios / Betas and Expected Returns / The One-Factor Security Market Line 10.3 Individual Assets and the APT?342 The APT and the CAPM 10.4 A Multifactor APT?343 10.5 Where Should We Look for Factors??345 10.6 A Multifactor CAPM and the APT?348 Summary?349 Key Terms?350 Web Sites?350 E-Investments: APT versus CAPM?350 Standard & Poor?s?350 Problems?351 Solutions to Concept Checks?354 CHAPTER 11 THE EFFICIENT MARKET HYPOTHESIS 11.1 Random Walks and the Efficient Market Hypothesis?358 Competition as the Source of Efficiency / Versions of the Efficient Market Hypothesis 11.2 Implications of the EMH?361 Technical Analysis / Fundamental Analysis / Active versus Passive Portfolio Management / The Role of Portfolio Management in an Efficient Market / Resource Allocation 11.3 Event Studies?366 11.4 Are Markets Efficient??369 The Issues The Magnitude Issue / The Selection Bias Issue / The Lucky Event Issue Weak-Form Tests: Patterns in Stock Returns Returns over Short Horizons / Returns over Long Horizons Predictors of Broad Market Returns / Semistrong Tests: Market Anomalies The Small-Firm-in-January Effect / The Neglected-Firm Effect and Liquidity Effects / Book-to-Market Ratios / Post?Earnings-Announcement Price Drift Strong-Form Tests: Inside Information / Interpreting the Evidence Risk Premiums or Inefficiencies? / Anomalies or Data Mining? 11.5 Mutual Fund and Analyst Performance?381 Stock Market Analysts / Mutual Fund Managers / Survivorship Bias in Mutual Fund Studies / So, Are Markets Efficient? Summary?387 Key Terms?388 Web Sites?388 E-Investments: Efficient Markets and Insider Trading?388 Standard & Poor?s?389 Problems?389 Solutions to Concept Checks?393 CHAPTER 12 BEHAVIORAL FINANCE AND TECHNICAL ANALYSIS 12.1 The Behavioral Critique?396 Information Processing Forecasting Errors / Overconfidence / Conservatism / Sample Size Neglect and Representativeness Behavioral Biases Framing / Mental Accounting / Regret Avoidance / Prospect Theory Limits to Arbitrage Fundamental Risk / Implementation Costs /Model Risk Limits to Arbitrage and the Law of One Price ?Siamese Twin? Companies / Equity Carve-outs / Closed-End Funds Bubbles and Behavioral Economics / Evaluating the Behavioral Critique 12.2 Technical Analysis and Behavioral Finance?407 Trends and Corrections Dow Theory / Moving Averages / Breadth Sentiment Indicators Trin Statistic / Confidence Index / Put/Call Ratio A Warning Summary?414 Key Terms?415 Web Sites?415 E-Investments: Technical Analysis versus Market Efficiency?415 Standard & Poor?s?415 Problems?416 Solutions to Concept Checks?420 CHAPTER 13 EMPIRICAL EVIDENCE ON SECURITY RETURNS 13.1 The Index Model and the Single-Factor APT?422 The Expected Return?Beta Relationship Setting Up the Sample Data / Estimating the SCL / Estimating the SML Tests of the CAPM / The Market Index / Measurement Error in Beta / The EMH and the CAPM / Accounting for Human Capital and Cyclical Variations in Asset Betas / Accounting for Nontraded Business 13.2 Tests of Multifactor CAPM and APT?433 A Macro Factor Model 13.3 The Fama-French Three-Factor Model?435 Risk-Based Interpretations / Behavioral Explanations 13.4 Liquidity and Asset Pricing?440 13.5 Time-Varying Volatility?443 The Volatility of Nasdaq Stocks 13.6 The Equity Premium Puzzle?446 Consumption Growth and Market Rates of Return / Expected versus Realized Returns / Survivorship Bias / Extensions to the CAPM May Resolve the Equity Premium Puzzle / Behavioral Explanations of the Equity Premium Puzzle Summary?453 Key Terms?454 Web Sites?454 E-Investments: Portfolio Theory?454 Standard & Poor?s?454 Problems?455 Solutions to Concept Checks?456 Part IV FIXED-INCOME SECURITIES CHAPTER 14 BOND PRICES AND YIELDS 14.1 Bond Characteristics?458 Treasury Bonds and Notes Accrued Interest and Quoted Bond Prices Corporate Bonds Call Provisions on Corporate Bonds / Convertible Bonds / Puttable Bonds / Floating-Rate Bonds Preferred Stock / Other Issuers / International Bonds / Innovation in the Bond Market Inverse Floaters / Asset-Backed Bonds / Catastrophe Bonds / Indexed Bonds 14.2 Bond Pricing?464 Bond Pricing between Coupon Dates 14.3 Bond Yields?468 Yield to Maturity / Yield to Call / Realized Compound Return versus Yield to Maturity 14.4 Bond Prices over Time?475 Yield to Maturity versus Holding-Period Return / Zero-Coupon Bonds and Treasury Strips / After-Tax Returns 14.5 Default Risk and Bond Pricing?479 Junk Bonds / Determinants of Bond Safety / Bond Indentures Sinking Funds / Subordination of Further Debt / Dividend Restrictions / Collateral Yield to Maturity and Default Risk Summary?487 Key Terms?487 Web Sites?488 E-Investments: Credit Spreads?488 Standard & Poor?s?488 Problems?488 Solutions to Concept Checks?493 CHAPTER 15 THE TERM STRUCTURE OF INTEREST RATES 15.1 The Yield Curve?495 Bond Pricing 15.2 The Yield Curve and Future Interest Rates?498 The Yield Curve Under Certainty / Holding-Period Returns / Forward Rates 15.3 Interest Rate Uncertainty and Forward Rates?503 15.4 Theories of the Term Structure?505 The Expectations Hypothesis / Liquidity Preference 15.5 Interpreting the Term Structure?507 15.6 Forward Rates as Forward Contracts?512 Summary?515 Key Terms?515 Web Sites?515 E-Investments: Real and Nominal Yield Curves?516 Problems?516 Solutions to Concept Checks?521 CHAPTER 16 MANAGING BOND PORTFOLIOS 16.1 Interest Rate Risk?524 Interest Rate Sensitivity / Duration / What Determines Duration? Rule 1 for Duration / Rule 2 for Duration / Rule 3 for Duration / Rule 4 for Duration / Rule 5 for Duration 16.2 Convexity?534 Why Do Investors Like Convexity? / Duration and Convexity of Callable Bonds / Duration and Convexity of Mortgage-backed Securities 16.3 Passive Bond Management?542 Bond-Index Funds / Immunization / Cash Flow Matching and Dedication / Other Problems with Conventional Immunization 16.4 Active Bond Management?552 Sources of Potential Profit / Horizon Analysis / Contingent Immunization 16.5 Financial Engineering and Interest Rate Derivatives?555 Summary?557 Key Terms?558 Web Sites?558 E-Investments: Collateralized Mortgage Obligations?558 Standard & Poor?s?558 Problems?559 Solutions to Concept Checks?566 Part V SECURITY ANALYSIS CHAPTER 17 MACROECONOMIC AND INDUSTRY ANALYSIS 17.1 The Global Economy?570 17.2 The Domestic Macroeconomy?572 17.3 Demand and Supply Shocks?573 17.4 Federal Government Policy?574 Fiscal Policy / Monetary Policy / Supply-Side Policies 17.5 Business Cycles?576 The Business Cycle / Economic Indicators / Other Indicators 17.6 Industry Analysis?582 Defining an Industry / Sensitivity to the Business Cycle / Sector Rotation / Industry Life Cycles Start-Up Stage / Consolidation Stage / Maturity Stage / Relative Decline Industry Structure and Performance Threat of Entry / Rivalry between Existing Competitors / Pressure from Substitute Products / Bargaining Power of Buyers / Bargaining Power of Suppliers Summary?594 Key Terms?594 Web Sites?594 E-Investments: The Macroeconomy?595 Standard & Poor?s?595 Problems?595 Solutions to Concept Checks?600 CHAPTER 18 EQUITY VALUATION MODELS 18.1 Valuation by Comparables?603 Limitations of Book Value 18.2 Intrinsic Value versus Market Price?605 18.3 Dividend Discount Models?607 The Constant-Growth DDM / Convergence of Price to Intrinsic Value / Stock Prices and Investment Opportunities / Life Cycles and Multistage Growth Models / Multistage Growth Models 18.4 Price?Earnings Ratio?621 The Price?Earnings Ratio and Growth Opportunities / P/E Ratios and Stock Risk / Pitfalls in P/E Analysis / Combining P/E Analysis and the DDM / Other Comparative Valuation Ratios Price-to-Book Ratio / Price-to-Cash-Flow Ratio / Price-to-Sales Ratio 18.5 Free Cash Flow Valuation Approaches?630 Comparing the Valuation Models 18.6 The Aggregate Stock Market?634 Explaining Past Behavior / Forecasting the Stock Market Summary?636 Key Terms?637 Web Sites?638 E-Investments: Equity Valuation?638 Standard & Poor?s?638 Problems?639 Solutions to Concept Checks?647 CHAPTER 19 FINANCIAL STATEMENT ANALYSIS 19.1 The Major Financial Statements?649 The Income Statement / The Balance Sheet / The Statement of Cash Flows 19.2 Accounting versus Economic Earnings?654 19.3 Profitability Measures?654 Past versus Future ROE / Financial Leverage and ROE 19.4 Ratio Analysis?657 Decomposition of ROE / Turnover and Other Asset Utilization Ratios / Liquidity Ratios / Market Price Ratios / Choosing a Benchmark 19.5 Economic Value Added?666 19.6 An Illustration of Financial Statement Analysis?669 19.7 Comparability Problems?671 Inventory Valuation / Depreciation / Inflation and Interest Expense / Quality of Earnings / International Accounting Conventions 19.8 Value Investing: The Graham Technique?676 Summary?678 Key Terms?678 Web Sites?678 E-Investments: Financial Statement Analysis?679 Standard & Poor?s?679 Problems?679 Solutions to Concept Checks?688 PART VI OPTIONS, FUTURES, AND OTHER DERIVATIVES CHAPTER 20 OPTIONS MARKETS: INTRODUCTION 20.1 The Option Contract?692 Options Trading / American and European Options / Adjustments in Option Contract Terms / The Option Clearing Corporation / Other Listed Options Index Options / Futures Options / Foreign Currency Options / Interest Rate Options 20.2 Values of Options at Expiration?698 Call Options / Put Options / Option versus Stock Investments 20.3 Option Strategies?703 Protective Put / Covered Calls / Straddle / Spreads / Collars 20.4 The Put-Call Parity Relationship?711 20.5 Optionlike Securities?714 Callable Bonds / Convertible Securities / Warrants / Collateralized Loans / Levered Equity and Risky Debt 20.6 Financial Engineering?720 20.7 Exotic Options?721 Asian Options / Barrier Options / Lookback Options / Currency-Traded Options / Digital Options Summary?724 Key Terms?725 Web Sites?725 E-Investments: Options and Straddles?725 Standard & Poor?s?726 Problems?726 Solutions to Concept Checks?731 CHAPTER 21 OPTION VALUATION 21.1 Option Valuation: Introduction?737 Intrinsic and Time Values / Determinants of Option Values 21.2 Restrictions on Option Values?740 Restrictions on the Value of a Call Option / Early Exercise and Dividends / Early Exercise of American Puts 21.3 Binomial Option Pricing?744 Two-State Option Pricing / Generalizing the Two-State Approach 21.4 Black-Scholes Option Valuation?750 The Black-Scholes Formula / Dividends and Call Option Valuation / Put Option Valuation 21.5 Using the Black-Scholes Formula?760 Hedge Ratios and the Black-Scholes Formula / Portfolio Insurance / Hedging Bets on Mispriced Options 21.6 Empirical Evidence on Option Pricing?770 Summary?771 Key Terms?772 Web Sites?772 E-Investments: Option Price Differences?773 Standard & Poor?s?773 Problems?773 Solutions to Concept Checks?780 CHAPTER 22 FUTURES MARKETS 22.1 The Futures Contract?784 The Basics of Futures Contracts / Existing Contracts 22.2 Mechanics of Trading in Futures Markets?789 The Clearinghouse and Open Interest / The Margin Account and Marking to Market / Cash versus Actual Delivery / Regulations / Taxation 22.3 Futures Markets Strategies?795 Hedging and Speculation / Basis Risk and Hedging 22.4 The Determination of Futures Prices?799 The Spot-Futures Parity Theorem / Spreads / Forward versus Futures Pricing 22.5 Futures Prices versus Expected Spot Prices?805 Expectation Hypothesis / Normal Backwardation / Contango / Modern Portfolio Theory Summary?807 Key Terms?808 Web Sites?808 E-Investments: Contract Specifications for Financial Futures and Options?809 Standard & Poor?s?809 Problems?809 Solutions to Concept Checks?812 CHAPTER 23 FUTURES AND SWAPS: MARKETS AND APPLICATIONS 23.1 Foreign Exchange Futures?813 The Markets Interest Rate Parity / Direct versus Indirect Quotes / Using Futures to Manage Exchange Rate Risk 23.2 Stock-Index Futures?821 The Contracts / Creating Synthetic Stock Positions: An Asset Allocation Tool / Index Arbitrage / Using Index Futures to Hedge Market Risk 23.3 Interest Rate Futures?827 Hedging Interest Rate Risk 23.4 Hedging and Hedge Funds?829 23.5 Swaps?831 Swaps and Balance Sheet Restructuring / The Swap Dealer / Other Interest Rate Contracts / Swap Pricing / Credit Risk in the Swap Market 23.6 Commodity Futures Pricing?837 Pricing with Storage Costs / Discounted Cash Flow Analysis for Commodity Futures Summary?841 Key Terms?842 Web Sites?842 E-Investments: Equity Swaps?843 Standard & Poor?s?843 Problems?843 Solutions to Concept Checks?849 Part VII APPLIED PORTFOLIO MANAGEMENT CHAPTER 24 PORTFOLIO PERFORMANCE EVALUATION 24.1 The Conventional Theory of Performance Evaluation?851 Average Rates of Return / Time-Weighted Returns versus Dollar-Weighted Returns / Adjusting Returns for Risk / The M2 Measure of Performance / Sharpe?s Measure as the Criterion for Overall Portfolios / Appropriate Performance Measures in Three Scenarios Jane?s Portfolio Represents Her Entire Risky Investment Fund / Jane?s Choice Portfolio Is One of Many Portfolios Combined into a Large Investment Fund The Role of Alpha in Performance Measures / Actual Performance Measurement: An Example / Realized Returns versus Expected Returns 24.2 Performance Measurement for Hedge Funds?863 24.3 Performance Measurement with Changing Portfolio Composition?867 24.4 Market Timing?868 The Potential Value of Market Timing / Valuing Market Timing as a Call Option / The Value of Imperfect Forecasting 24.5 Style Analysis?875 24.6 Morningstar?s Risk-Adjusted Rating?879 24.7 Evaluating Performance Evaluation?879 24.8 Performance Attribution Procedures?881 Asset Allocation Decisions / Sector and Security Selection Decisions / Summing Up Component Contributions Summary?887 Key Terms?887 Web Sites?887 E-Investments: Performance of Mutual Funds?888 Standard & Poor?s?888 Problems?888 Solutions to Concept Checks?895 CHAPTER 25 INTERNATIONAL DIVERSIFICATION 25.1 Global Markets for Equities?898 Developed Countries / Emerging Markets / Market Capitalization and GDP / Home- Country Bias 25.2 Risk Factors in International Investing?902 Exchange Rate Risk / Country-Specific Risk 25.3 International Investing: Risk, Return, and Benefits from Diversification?908 Risk and Return: Summary Statistics / Are Investments in Emerging Markets Riskier? / Are Average Returns in Emerging Markets Greater? / Benefits from International Diversification / Misleading Representation of Diversification Benefits / Realistic Benefits from International Diversification / Are Benefits from International Diversification Preserved in Bear Markets? 25.4 Assessing the Potential of International Diversification?918 The Home Bias / The Pursuit of Efficient Diversification / Diversification Benefits over Time / Active Investors 25.5 International Investing and Performance Attribution?922 Constructing a Benchmark Portfolio of Foreign Assets / Performance Attribution Summary?926 Key Terms?926 Web Sites?926 E-Investments: International Diversification?927 Standard & Poor?s?927 Problems?927 Solutions to Concept Checks?930 Chapter 26 Hedge Funds 26.1 Hedge Funds versus Mutual Funds 26.2 Hedge Fund Strategies Directional and Nondirectional Strategies / Statistical Arbitrage 26.3 Portable Alpha An Example of a Pure Play 26.4 Style Analysis for Hedge Funds 26.5 Performance Measurement for Hedge Funds Liquidity and Hedge Fund Performance / Hedge Fund Performance and Survivorship Bias / Hedge Fund Performance and Changing Factor Loadings / Black Swans and Hedge Fund Performance 26.6 Fee Structure in Hedge Funds Summary Key Terms Problems Sets E-Investments: TITLE TO COME!!!!! Solutions to Concept Checks CHAPTER 27 THE THEORY OF ACTIVE PORTFOLIO MANAGEMENT 27.1 Optimal Portfolios and Alpha Values?975 Forecasts of Alpha Values and Extreme Portfolio Weights / Restriction of Benchmark Risk 27.2 The Treynor-Black Model and Forecast Precision?982 Adjusting Forecasts for the Precision of Alpha / Distribution of Alpha Values / Organizational Structure and Performance 27.3 The Black-Litterman Model?986 A Simple Asset Allocation Decision / Step 1: The Covariance Matrix from Historical Data / Step 2: Determination of a Baseline Forecast / Step 3: Integrating the Manager?s Private Views / Step 4: Revised (Posterior) Expectations / Step 5: Portfolio Optimization 27.4 Treynor-Black versus Black-Litterman: Complements, not Substitutes?991 The BL Model as Icing on the TB Cake / Why Not Replace the Entire TB Cake with the BL Icing? 27.5 The Value of Active Management?994 A Model for the Estimation of Potential Fees / Results from the Distribution of Actual Information Ratios / Results from Distribution of Actual Forecasts / Results with Reasonable Forecasting Records 27.6 Concluding Remarks?997 Summary?998 Key Terms?998 Problems?998 Appendix: The General Black-Litterman Model?998 CHAPTER 28 INVESTMENT POLICY AND THE FRAMEWORK OF THE CFA INSTITUTE 28.1 Making Investment Decisions?934 Objectives / Individual Investors / Personal Trusts / Mutual Funds / Pension Funds / Endowment Funds / Life Insurance Companies / Non?Life Insurance Companies / Banks 28.2 Constraints?937 Liquidity / Investment Horizon / Regulations / Tax Considerations / Unique Needs 28.3 Asset Allocation?940 Policy Statements / Taxes and Asset Allocation 28.4 Managing Portfolios of Individual Investors?942 Human Capital and Insurance / Investment in Residence / Saving for Retirement and the Assumption of Risk / Retirement Planning Models / Manage Your Own Portfolio or Rely on Others? / Tax Sheltering The Tax-Deferral Option / Tax-Deferred Retirement Plans / Deferred Annuities / Variable and Universal Life Insurance 28.5 Pension Funds?948 Defined Contribution Plans / Defined Benefit Plans / Alternative Perspectives on Defined Benefit Pension Obligations / Pension Investment Strategies Investing in Equities / Wrong Reasons to Invest in Equities 28.6 Investments for the Long Run?953 Advice from the Mutual Fund Industry / Target Investing and the Term Structure of Bonds / Making Simple Investment Choices / Framing the Term Structure of Risk with Options Summary?957 Key Terms?958 Web Sites?958 E-Investments: Personal Diversification?958 Problems?959 Solutions to Concept Checks?967 Appendix: A Spreadsheet Model for Long-Term Investing?968 Solutions to Concept Checks?973 APPENDIX?References to CFA Problems?A-1 GLOSSARY?G-1 NAME INDEX?IND-1 SUBJECT INDEX?IND-4

Library of Congress Subject Headings for this publication:

Investments.

Portfolio management.