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The McGraw-Hill/Irwin Series in Finance, Insurance and Real Estate
Stephen A. Ross, Franco Modigliani Professor of Finance and Economics, Sloan School of Management,
Massachusetts Institute of Technology, Consulting Editor
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Boston University

University of California, San Diego

Boston College

Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis
Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City
Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

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To our families with love and gratitude.

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of
the Americas, New York, NY, 10020. Copyright © 2009, 2008, 2005, 2002, 1999, 1996, 1993, 1989 by The
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Library of Congress Cataloging-in-Publication Data
Bodie, Zvi.
Investments / Zvi Bodie, Alex Kane, Alan J. Marcus.—8th ed.
p. cm.—(The McGraw-Hill/Irwin series in finance, insurance and real estate)
Includes index.
ISBN-13: 978-0-07-338237-1 (alk. paper)
ISBN-10: 0-07-338237-X (alk. paper)
1. Investments. 2. Portfolio management. I. Kane, Alex. II. Marcus, Alan J. III. Title.
HG4521.B564 2009

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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

Alan Marcus is professor
of finance in the Wallace E.
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
2 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.


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Part I

Part III




The Investment Environment




The Capital Asset Pricing Model

Asset Classes and Financial Instruments



How Securities Are Traded


Arbitrage Pricing Theory and Multifactor Models
of Risk and Return 319




Mutual Funds and Other Investment
Companies 88

The Efficient Market Hypothesis

Part II

Behavioral Finance and Technical Analysis




Empirical Evidence on Security Returns


Part IV



Learning about Return and Risk from
the Historical Record 113



Risk Aversion and Capital Allocation
to Risky Assets 156

Bond Prices and Yields



Optimal Risky Portfolios

The Term Structure of Interest Rates




Index Models


Managing Bond Portfolios




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Part V

Part VII





Macroeconomic and Industry Analysis 553

Portfolio Performance Evaluation



Equity Valuation Models


International Diversification


Hedge Funds



Part VI

The Theory of Active Portfolio Management

Options Markets: Introduction


Investment Policy and the Framework of the CFA
Institute 950






Futures Markets



Financial Statement Analysis

Option Valuation





Futures, Swaps, and Risk Management



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Municipal Bonds / Corporate Bonds / Mortgages
and Mortgage-Backed Securities

Part I




Chapter 1
The Investment Environment

Real Assets versus Financial Assets


A Taxonomy of Financial Assets


Financial Markets and the Economy

The Investment Process



Stock and Bond Market Indexes 38
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



Derivative Markets

Markets Are Competitive

End of Chapter Material

The Players

How Securities Are Traded


Recent Trends



Globalization / Securitization / Financial Engineering /
Computer Networks

Market Orders / Price-Contingent Orders


Trading Mechanisms
Dealer Markets / Electronic Communication
Networks (ECNs) / Specialist Markets


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

The Bond Market


Types of Orders

Chapter 2
The Money Market

How Securities Are Traded

Direct Search Markets / Brokered Markets / Dealer
Markets / Auction Markets

End of Chapter Material 19–22


How Firms Issue Securities 54

Types of Markets

Outline of the Text 18

Asset Classes and Financial Instruments


Investment Banking / Shelf Registration / Private
Placements / Initial Public Offerings

Financial Intermediaries / Investment Bankers


Chapter 3


The Risk–Return Trade-Off / Efficient Markets


Options / Futures Contracts


Saving, Investing, and Safe Investing


Common Stock as Ownership Shares / Characteristics of
Common Stock / Stock Market Listings / Preferred Stock /
Depository Receipts

The Informational Role of Financial Markets /
Consumption Timing / Allocation of Risk / Separation
of Ownership and Management / Corporate Governance
and Corporate Ethics

Equity Securities


U.S. Securities Markets


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

Treasury Notes and Bonds / Inflation-Protected Treasury
Bonds / Federal Agency Debt / International Bonds /


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Market Structure in Other Countries



London / Euronext / Tokyo / Globalization
and Consolidation of Stock Markets

Trading Costs 70


Buying on Margin


Short Sales


Regulation of Securities Markets 77

Annual Percentage Rates / Continuous Compounding



Bills and Inflation, 1926–2005 121


Risk and Risk Premiums

Self-Regulation / Regulatory Responses to Recent
Scandals / Circuit Breakers / Insider Trading


Mutual Funds and Other Investment
Companies 88
Investment Companies



Types of Investment Companies


Unit Investment Trusts / Managed Investment
Companies / Other Investment Organizations


The Normal Distribution


Deviations from Normality


The Historical Record of Returns on Equities
and Long-Term Bonds 134

Mutual Funds


Investment Policies
Money Market Funds / Equity Funds / Sector Funds /
Bond Funds / International Funds / Balanced Funds /
Asset Allocation and Flexible Funds / Index Funds


Costs of Investing in Mutual Funds


Operating Expenses / Front-End Load / Back-End
Load / 12b-1 Charges


Taxation of Mutual Fund Income



Exchange-Traded Funds


Mutual Fund Investment Performance: A First Look 102


Information on Mutual Funds 105

End of Chapter Material


Chapter 6


Risk Aversion and Capital Allocation
to Risky Assets 156


Risk and Risk Aversion


Risk, Speculation, and Gambling / Risk Aversion
and Utility Values / Estimating Risk Aversion


Part II

Chapter 5
Learning about Return and Risk from
the Historical Record 113
Determinants of the Level of Interest Rates

Long-Term Investments

Value at Risk (VaR) / Conditional Tail Expectation
(CTE) / Lower Partial Standard Deviation (LPSD)

Fees and Mutual Fund Returns / Late Trading and
Market Timing



5.10 Measurement of Risk with Non-Normal
Distributions 148

Fee Structure

End of Chapter Material


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

How Funds Are Sold


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

Commingled Funds / Real Estate Investment
Trusts (REITS) / Hedge Funds

Time Series Analysis of Past Rates of Return

Time Series versus Scenario Analysis / Expected
Returns and the Arithmetic Average / The Geometric
(Time-Weighted) Average Return / Variance and
Standard Deviation / The Reward-to-Volatility
(Sharpe) Ratio


Chapter 4



Holding-Period Returns / Expected Return and
Standard Deviation / Excess Returns and Risk


End of Chapter Material

Comparing Rates of Return for Different Holding
Periods 118


Capital Allocation across Risky and Risk-Free
Portfolios 165


The Risk-Free Asset


Portfolios of One Risky Asset and a Risk-Free
Asset 168


Risk Tolerance and Asset Allocation


Passive Strategies: The Capital Market Line


End of Chapter Material



Appendix A: Risk Aversion, Expected Utility, and the
St. Petersburg Paradox 188


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

Appendix B: Utility Functions and Equilibrium
Prices of Insurance Contracts 192


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Part III

Chapter 7
Optimal Risky Portfolios




Diversification and Portfolio Risk 195


Portfolios of Two Risky Assets


Asset Allocation with Stocks, Bonds, and Bills 204


Chapter 9
The Capital Asset Pricing Model

The Optimal Risky Portfolio with Two Risky Assets
and a Risk-Free Asset

The Markowitz Portfolio Selection Model



Security Selection / Capital Allocation and the Separation
Property / The Power of Diversification / Asset Allocation
and Security Selection

Risk Pooling, Risk Sharing, and Risk in the Long
Run 218


Risk Pooling and the Insurance Principle / Risk Sharing
End of Chapter Material


Appendix A: A Spreadsheet Model for Efficient
Diversification 231
Appendix B: Review of Portfolio Statistics


Chapter 8
Index Models



A Single-Factor Security Market



The Input List of the Markowitz Model / Normality
of Returns and Systematic Risk

The Single-Index Model



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

Arbitrage Pricing Theory and Multifactor Models
of Risk and Return 319

Estimating the Single-Index Model 252

10.1 Multifactor Models: An Overview 320
Factor Models of Security Returns / A Multifactor
Security Market Line
10.2 Arbitrage Pricing Theory 324
Arbitrage, Risk Arbitrage, and Equilibrium / WellDiversified Portfolios / Betas and Expected Returns /
The One-Factor Security Market Line
10.3 Individual Assets and the APT 331
The APT and the CAPM
10.4 A Multifactor APT 332
10.5 Where Should We Look for Factors? 334
The Fama-French (FF) Three-Factor Model
10.6 A Multifactor CAPM and the APT 337

Portfolio Construction and the Single-Index
Model 259

Risk Premium Forecasts / The Optimal Risky Portfolio
Practical Aspects of Portfolio Management
with the Index Model 266

End of Chapter Material


Chapter 11

Is the Index Model Inferior to the Full-Covariance
Model? / The Industry Version of the Index Model /
Predicting Betas / Index Models and Tracking
End of Chapter Material


Chapter 10

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

The Capital Asset Pricing Model 279
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
The CAPM and the Index Model 292
Actual Returns versus Expected Returns / The Index
Model and Realized Returns / The Index Model and the
Expected Return–Beta Relationship
Is the CAPM Practical? 295
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
Econometrics and the Expected Return–Beta
Relationship 299
Extensions of the CAPM 300
The Zero-Beta Model / Labor Income and Nontraded
Assets / A Multiperiod Model and Hedge Portfolios / A
Consumption-Based CAPM
Liquidity and the CAPM 305
End of Chapter Material

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


The Efficient Market Hypothesis


11.1 Random Walks and the Efficient Market
Hypothesis 345



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Competition as the Source of Efficiency / Versions of the
Efficient Market Hypothesis

Dow Theory / Moving Averages / Breadth
Sentiment Indicators

11.2 Implications of the EMH 349

Trin Statistic / Confidence Index / Put/Call Ratio

Technical Analysis / Fundamental Analysis / Active versus
Passive Portfolio Management / The Role of Portfolio
Management in an Efficient Market / Resource Allocation
11.3 Event Studies

A Warning
End of Chapter Material

Chapter 13


11.4 Are Markets Efficient?



Empirical Evidence on Security Returns

The Issues


13.1 The Index Model and the Single-Factor APT 411

The Magnitude Issue / The Selection Bias Issue /
The Lucky Event Issue

The Expected Return–Beta Relationship
Setting Up the Sample Data / Estimating the SCL /
Estimating the SML

Weak-Form Tests: Patterns in Stock Returns
Returns over Short Horizons / Returns over Long

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

Predictors of Broad Market Returns / Semistrong Tests:
Market Anomalies
The Small-Firm-in-January Effect / The NeglectedFirm Effect and Liquidity Effects / Book-to-Market
Ratios / Post–Earnings-Announcement Price Drift

13.2 Tests of Multifactor CAPM and APT
13.3 The Fama-French Three-Factor Model

Strong-Form Tests: Inside Information / Interpreting
the Evidence

13.4 Liquidity and Asset Pricing
13.5 Time-Varying Volatility

The “Noisy Market Hypothesis” and Fundamental

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


Chapter 12

End of Chapter Material

Behavioral Finance and Technical Analysis
12.1 The Behavioral Critique


Part IV




Information Processing
Forecasting Errors / Overconfidence /
Conservatism / Sample Size Neglect and


Behavioral Biases
Framing / Mental Accounting / Regret Avoidance /
Prospect Theory

14.1 Bond Characteristics



Treasury Bonds and Notes

Limits to Arbitrage

Accrued Interest and Quoted Bond Prices

Fundamental Risk / Implementation Costs /Model Risk

Corporate Bonds

Limits to Arbitrage and the Law of One Price

Call Provisions on Corporate Bonds /
Convertible Bonds / Puttable Bonds /
Floating-Rate Bonds

“Siamese Twin” Companies / Equity Carve-outs /
Closed-End Funds
Bubbles and Behavioral Economics / Evaluating the
Behavioral Critique
12.2 Technical Analysis and Behavioral Finance



13.6 Consumption-Based Asset Pricing and the Equity
Premium Puzzle 434

Stock Market Analysts / Mutual Fund Managers /
Survivorship Bias in Mutual Fund Studies / So, Are
Markets Efficient?
End of Chapter Material


Risk-Based Interpretations / Behavioral

Risk Premiums or Inefficiencies? / Anomalies or
Data Mining?

11.5 Mutual Fund and Analyst Performance


A Macro Factor Model

Preferred Stock / Other Issuers / International Bonds /
Innovation in the Bond Market


Inverse Floaters / Asset-Backed Bonds / Catastrophe
Bonds / Indexed Bonds

Trends and Corrections


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14.2 Bond Pricing


16.4 Active Bond Management

Bond Pricing between Coupon Dates
14.3 Bond Yields


End of Chapter Material

Yield to Maturity / Yield to Call / Realized Compound
Return versus Yield to Maturity
14.4 Bond Prices over Time


Yield to Maturity versus Holding-Period Return /
Zero-Coupon Bonds and Treasury Strips / After-Tax

Macroeconomic and Industry Analysis

Junk Bonds / Determinants of Bond Safety / Bond

17.1 The Global Economy

Yield to Maturity and Default Risk




17.6 Industry Analysis


Start-Up Stage / Consolidation Stage / Maturity Stage /
Relative Decline

Bond Pricing
15.2 The Yield Curve and Future Interest Rates


Industry Structure and Performance

The Yield Curve under Certainty / Holding-Period
Returns / Forward Rates
15.3 Interest Rate Uncertainty and Forward Rates

Threat of Entry / Rivalry between Existing
Competitors / Pressure from Substitute Products /
Bargaining Power of Buyers / Bargaining Power
of Suppliers



The Expectations Hypothesis / Liquidity Preference

End of Chapter Material



Chapter 18

15.6 Forward Rates as Forward Contracts 501

Equity Valuation Models


18.1 Valuation by Comparables

Chapter 16
Managing Bond Portfolios


Defining an Industry / Sensitivity to the Business Cycle /
Sector Rotation / Industry Life Cycles




Limitations of Book Value
18.2 Intrinsic Value versus Market Price 589
18.3 Dividend Discount Models 590
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 604


16.1 Interest Rate Risk 513
Interest Rate Sensitivity / Duration / What Determines
Rule 1 for Duration / Rule 2 for Duration / Rule 3
for Duration / Rule 4 for Duration / Rule 5 for

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

Why Do Investors Like Convexity? / Duration and
Convexity of Callable Bonds / Duration and Convexity
of Mortgage-Backed Securities
16.3 Passive Bond Management

17.4 Federal Government Policy

The Business Cycle / Economic Indicators / Other

The Term Structure of Interest Rates

16.2 Convexity


17.5 Business Cycles

Chapter 15

End of Chapter Material


17.3 Demand and Supply Shocks

Fiscal Policy / Monetary Policy / Supply-Side Policies

Credit Risk and Collateralized Debt

15.5 Interpreting the Term Structure



17.2 The Domestic Macroeconomy

Sinking Funds / Subordination of Further Debt /
Dividend Restrictions / Collateral

15.4 Theories of the Term Structure


Chapter 17

14.5 Default Risk and Bond Pricing 467

15.1 The Yield Curve


Part V


End of Chapter Material


Sources of Potential Profit / Horizon Analysis /
Contingent Immunization

Price-to-Book Ratio / Price-to-Cash-Flow Ratio /
Price-to-Sales Ratio
18.5 Free Cash Flow Valuation Approaches 611


Bond-Index Funds / Immunization / Cash Flow Matching
and Dedication / Other Problems with Conventional

Comparing the Valuation Models


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18.6 The Aggregate Stock Market


20.6 Financial Engineering

Explaining Past Behavior / Forecasting the Stock Market
End of Chapter Material

20.7 Exotic Options


Asian Options / Barrier Options / Lookback Options /
Currency-Translated Options / Digital Options

Chapter 19

End of Chapter Material

Financial Statement Analysis


The Income Statement / The Balance Sheet /
The Statement of Cash Flows
19.2 Accounting versus Economic Earnings




21.3 Binomial Option Pricing


21.4 Black-Scholes Option Valuation

19.6 An Illustration of Financial Statement Analysis



19.8 Value Investing: The Graham Technique

21.5 Using the Black-Scholes Formula 737
Hedge Ratios and the Black-Scholes Formula / Portfolio
Insurance / Hedging Bets on Mispriced Options


21.6 Empirical Evidence on Option Pricing


End of Chapter Material

Part VI

22.1 The Futures Contract


The Basics of Futures Contracts / Existing Contracts



The Clearinghouse and Open Interest / The Margin
Account and Marking to Market / Cash versus Actual
Delivery / Regulations / Taxation


Options Trading / American and European Options /
Adjustments in Option Contract Terms / The Options
Clearing Corporation / Other Listed Options

22.3 Futures Markets Strategies


Hedging and Speculation / Basis Risk and Hedging

Index Options / Futures Options / Foreign Currency
Options / Interest Rate Options

22.4 The Determination of Futures Prices


The Spot-Futures Parity Theorem / Spreads / Forward
versus Futures Pricing


Call Options / Put Options / Option versus Stock

22.5 Futures Prices versus Expected Spot Prices 780
Expectation Hypothesis / Normal Backwardation /
Contango / Modern Portfolio Theory


Protective Put / Covered Calls / Straddle / Spreads /
20.5 Option-like Securities


22.2 Mechanics of Trading in Futures Markets

Options Markets: Introduction

20.4 The Put-Call Parity Relationship


Futures Markets

Chapter 20

20.3 Option Strategies


Chapter 22


20.2 Values of Options at Expiration


The Black-Scholes Formula / Dividends and Call Option
Valuation / Put Option Valuation / Dividends and Put
Option Valuation

Inventory Valuation / Depreciation / Inflation and Interest
Expense / Fair Value Accounting / Quality of Earnings /
International Accounting Conventions

20.1 The Option Contract


Two-State Option Pricing / Generalizing the Two-State


End of Chapter Material

21.1 Option Valuation: Introduction

Restrictions on the Value of a Call Option / Early
Exercise and Dividends / Early Exercise of American Puts

Decomposition of ROE / Turnover and Other Asset
Utilization Ratios / Liquidity Ratios / Market Price
Ratios: Growth versus Value / Choosing a Benchmark

19.7 Comparability Problems


21.2 Restrictions on Option Values


19.5 Economic Value Added

Option Valuation

Intrinsic and Time Values / Determinants of Option Values

Past versus Future ROE / Financial Leverage and ROE
19.4 Ratio Analysis


Chapter 21

19.1 The Major Financial Statements 631

19.3 Profitability Measures



End of Chapter Material


Chapter 23


Futures, Swaps, and Risk Management


23.1 Foreign Exchange Futures

Callable Bonds / Convertible Securities /
Warrants / Collateralized Loans / Levered Equity
and Risky Debt



The Markets / Interest Rate Parity / Direct versus Indirect
Quotes / Using Futures to Manage Exchange Rate Risk


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23.2 Stock-Index Futures

24.8 Performance Attribution Procedures


23.3 Interest Rate Futures

End of Chapter Material


International Diversification


25.1 Global Markets for Equities

Swaps and Balance Sheet Restructuring / The Swap
Dealer / Other Interest Rate Contracts / Swap Pricing /
Credit Risk in the Swap Market / Credit Default Swaps
23.5 Commodity Futures Pricing

End of Chapter Material


25.2 Risk Factors in International Investing

25.3 International Investing: Risk, Return, and Benefits
from Diversification 878


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?

Chapter 24
Portfolio Performance Evaluation

25.4 Assessing the Potential of International
Diversification 888


24.1 The Conventional Theory of Performance
Evaluation 823

The Home Bias / The Pursuit of Efficient Diversification /
Diversification Benefits over Time / Active Investors

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 Two Scenarios

25.5 International Investing and Performance
Attribution 892
Constructing a Benchmark Portfolio of Foreign Assets /
Performance Attribution
End of Chapter Material

Jane’s Portfolio Represents Her Entire Risky Investment
Fund / Jane’s Choice Portfolio Is One of Many
Portfolios Combined into a Large Investment Fund

Hedge Funds


26.2 Hedge Fund Strategies 904


Directional and Nondirectional Strategies / Statistical
26.3 Portable Alpha 907


An Example of a Pure Play

The Potential Value of Market Timing / Valuing Market
Timing as a Call Option / The Value of Imperfect

26.4 Style Analysis for Hedge Funds


26.5 Performance Measurement for Hedge Funds 912
Liquidity and Hedge Fund Performance / Hedge Fund
Performance and Survivorship Bias / Hedge Fund
Performance and Changing Factor Loadings / Tail Risk
and Hedge Fund Performance


Style Analysis and Multifactor Benchmarks/Style
Analysis in Excel
24.7 Evaluating Performance Evaluation


26.1 Hedge Funds versus Mutual Funds

24.3 Performance Measurement with Changing Portfolio
Composition 836

24.6 Morningstar’s Risk-Adjusted Rating


Chapter 26

The Role of Alpha in Performance Measures / Actual
Performance Measurement: An Example / Realized
Returns versus Expected Returns
24.2 Performance Measurement for Hedge Funds


Exchange Rate Risk / Country-Specific Risk

Part VII

24.5 Style Analysis



Developed Countries / Emerging Markets / Market
Capitalization and GDP / Home-Country Bias

Pricing with Storage Costs / Discounted Cash Flow
Analysis for Commodity Futures

24.4 Market Timing


Chapter 25

Hedging Interest Rate Risk
23.4 Swaps


Asset Allocation Decisions / Sector and Security Selection
Decisions / Summing Up Component Contributions

The Contracts / Creating Synthetic Stock Positions: An
Asset Allocation Tool / Index Arbitrage / Using Index
Futures to Hedge Market Risk


26.6 Fee Structure in Hedge Funds


End of Chapter Material




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Chapter 27
The Theory of Active Portfolio Management
27.1 Optimal Portfolios and Alpha Values

Life Insurance Companies / Non–Life Insurance
Companies / Banks


28.2 Constraints


Forecasts of Alpha Values and Extreme Portfolio Weights /
Restriction of Benchmark Risk

28.3 Asset Allocation

27.2 The Treynor-Black Model and Forecast
Precision 931

28.4 Managing Portfolios of Individual Investors


The Tax-Deferral Option / Tax-Deferred Retirement
Plans / Deferred Annuities / Variable and Universal
Life Insurance
28.5 Pension Funds

The BL Model as Icing on the TB Cake / Why Not
Replace the Entire TB Cake with the BL Icing?

Investing in Equities / Wrong Reasons to Invest
in Equities


28.6 Investments for the Long Run 970

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

Advice from the Mutual Fund Industry / Target Investing
and the Term Structure of Bonds / Making Simple
Investment Choices / Inflation Risk and Long-Term


End of Chapter Material


Defined Contribution Plans / Defined Benefit Plans /
Alternative Perspectives on Defined Benefit Pension
Obligations / Pension Investment Strategies

27.4 Treynor-Black versus Black-Litterman:
Complements, Not Substitutes 941

27.6 Concluding Remarks


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

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

27.5 The Value of Active Management


Policy Statements / Taxes and Asset Allocation

Adjusting Forecasts for the Precision of Alpha /
Distribution of Alpha Values / Organizational Structure
and Performance
27.3 The Black-Litterman Model


Liquidity / Investment Horizon / Regulations / Tax
Considerations / Unique Needs

End of Chapter Material



Appendix: A Spreadsheet Model for Long-Term
Investing 982

Appendix A: Forecasts and Realizations
of Alpha 948
Appendix B: The General Black-Litterman
Model 948


Chapter 28






Investment Policy and the Framework
of the CFA Institute 950
28.1 The Investment Management Process 951
Objectives / Individual Investors / Personal Trusts /
Mutual Funds / Pension Funds / Endowment Funds /


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of financial economics and find virtually all of the
material in this book to be of great intellectual interest.
Fortunately, we think, there is no contradiction in the field
of investments between the pursuit of truth and the pursuit
of money. Quite the opposite. The capital asset pricing
model, the arbitrage pricing model, the efficient markets
hypothesis, the option-pricing model, and the other centerpieces of modern financial research are as much intellectually satisfying subjects of scientific inquiry as they
are of immense practical importance for the sophisticated
In our effort to link theory to practice, we also have
attempted to make our approach consistent with that of the
CFA Institute. In addition to fostering research in finance,
the CFA Institute administers an education and certification program to candidates seeking the designation of
Chartered Financial Analyst (CFA). The CFA curriculum
represents the consensus of a committee of distinguished
scholars and practitioners regarding the core of knowledge
required by the investment professional. This text also
is used in many certification programs for the Financial
Planning Association and by the Society of Actuaries.
There are many features of this text that make it consistent with and relevant to the CFA curriculum. Questions
from past CFA exams appear at the end of nearly every
chapter, and, for students who will be taking the exam,
those same questions and the exam from which they’ve
been taken, are listed at the end of the book. Chapter 3
includes excerpts from the “Code of Ethics and Standards
of Professional Conduct” of the CFA Institute. Chapter 28,
which discusses investors and the investment process,
presents the CFA Institute’s framework for systematically
relating investor objectives and constraints to ultimate
investment policy.

We wrote the first edition of this textbook two decades
ago. The intervening years have been a period of rapid,
profound, and ongoing change in the investments industry. This is due in part to an abundance of newly designed
securities, in part to the creation of new trading strategies that would have been impossible without concurrent
advances in computer technology, and in part to rapid
advances in the theory of investments that have come out
of the academic community. In no other field, perhaps,
is the transmission of theory to real-world practice as
rapid as is now commonplace in the financial industry.
These developments place new burdens on practitioners
and teachers of investments far beyond what was required
only a short while ago. Of necessity, our text has evolved
along with financial markets.
Investments, Eighth Edition, is intended primarily as a
textbook for courses in investment analysis. Our guiding
principle has been to present the material in a framework
that is organized by a central core of consistent fundamental principles. We make every attempt to strip away unnecessary mathematical and technical detail, and we have
concentrated on providing the intuition that may guide
students and practitioners as they confront new ideas and
challenges in their professional lives.
This text will introduce you to major issues currently
of concern to all investors. It can give you the skills to
conduct a sophisticated assessment of current issues and
debates covered by both the popular media as well as
more-specialized finance journals. Whether you plan to
become an investment professional, or simply a sophisticated individual investor, you will find these skills
Our primary goal is to present material of practical value, but all three of us are active researchers in the science


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In the Eighth Edition, we have further extended our
systematic collection of Excel spreadsheets that give tools
to explore concepts more deeply than was previously possible. These spreadsheets are available on the Web site for
this text (, and provide a taste of
the sophisticated analytic tools available to professional

In the Eighth Edition, we address many of the changes in
the investment environment.
At the same time, many basic principles remain important. We believe that attention to these few important
principles can simplify the study of otherwise difficult
material and that fundamental principles should organize and motivate all study. These principles are crucial
to understanding the securities already traded in financial
markets and in understanding new securities that will be
introduced in the future. For this reason, we have made
this book thematic, meaning we never offer rules of
thumb without reference to the central tenets of the modern approach to finance.
The common theme unifying this book is that security
markets are nearly efficient, meaning most securities are
usually priced appropriately given their risk and return
attributes. There are few free lunches found in markets as
competitive as the financial market. This simple observation is, nevertheless, remarkably powerful in its implications for the design of investment strategies; as a result,
our discussions of strategy are always guided by the
implications of the efficient markets hypothesis. While
the degree of market efficiency is, and always will be, a
matter of debate (and in fact, in this edition, we devote
a full chapter to the behavioral challenge to the efficient
market hypothesis), we hope our discussions throughout
the book convey a good dose of healthy criticism concerning much conventional wisdom.



Distinctive Themes
Investments is organized around several important themes:

The central theme is the near-informationalefficiency of well-developed security markets,
such as those in the United States, and the general
awareness that competitive markets do not offer
“free lunches” to participants.
A second theme is the risk–return trade-off. This
too is a no-free-lunch notion, holding that in
competitive security markets, higher expected

returns come only at a price: the need to bear
greater investment risk. However, this notion
leaves several questions unanswered. How should
one measure the risk of an asset? What should be
the quantitative trade-off between risk (properly
measured) and expected return? The approach
we present to these issues is known as modern
portfolio theory, which is another organizing
principle of this book. Modern portfolio theory
focuses on the techniques and implications of
efficient diversification, and we devote considerable
attention to the effect of diversification on portfolio
risk as well as the implications of efficient
diversification for the proper measurement of risk
and the risk–return relationship.
This text places greater emphasis on asset
allocation than most of its competitors. We prefer
this emphasis for two important reasons. First, it
corresponds to the procedure that most individuals
actually follow. Typically, you start with all of your
money in a bank account, only then considering
how much to invest in something riskier that might
offer a higher expected return. The logical step at
this point is to consider other risky asset classes,
such as stock, bonds, or real estate. This is an
asset allocation decision. Second, in most cases,
the asset allocation choice is far more important
in determining overall investment performance
than is the set of security selection decisions.
Asset allocation is the primary determinant of the
risk–return profile of the investment portfolio,
and so it deserves primary attention in a study of
investment policy.
This text offers a much broader and deeper
treatment of futures, options, and other derivative
security markets than most investments texts.
These markets have become both crucial and
integral to the financial universe and are the major
sources of innovation in that universe. Your only
choice is to become conversant in these markets—
whether you are to be a finance professional or
simply a sophisticated individual investor.

The following is a guide to changes in the Eighth Edition.
This is not an exhaustive road map, but instead is meant to
provide an overview of substantial additions and changes
to coverage from the last edition of the text.


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Chapter 3 How Securities Are Traded
This chapter has been largely rewritten to reflect the ongoing transformation of trading practices, the growing dominance of electronic trading, the accelerating consolidation
of securities markets, and continuing regulatory reform,
in particular the response to the Sarbanes-Oxley Act.

Chapter 23 Futures, Swaps, and Risk
We have added new material on credit default swaps to
this chapter. We show how these securities are constructed,
and how they are used to transfer credit risk.

Chapter 26 Hedge Funds

Chapter 7 Optimal Risky Portfolios
This chapter contains additional material on the “art”
of selecting reasonable parameter values for portfolio
construction, and a discussion of what can go wrong
when inputs are derived solely from recent historical

Chapter 9 The Capital Asset Pricing Model
We introduce new material generalizing the intuition of
the simple CAPM to more sophisticated treatments of
risk, for example, consumption risk. We have also updated
the material on liquidity and asset pricing throughout the
set of chapters dealing with portfolio theory.

Chapter 11 The Efficient Market Hypothesis
We critically evaluate recent suggestions for “fundamental indexing” as a response to market errors in security
valuation. We show that these strategies are nothing more
than variations on the value-tilted portfolio strategies discussed earlier in the chapter.

Chapter 13 Empirical Evidence on Security
We add considerable new material on the interpretation of
risk premiums. For example, we examine new evidence
on the relation between the Fama-French risk factors and
more fundamental measures of security risk.

Chapter 14 Bond Prices and Yields
The chapter has new material explaining collateralized
debt obligations (CDOs) as well as the role of credit rating agencies in the recent credit market crisis.

Chapter 19 Financial Statement Analysis
The chapter has been updated to address current issues in
fair value accounting. It also contains additional discussion of the proper interpretation of market-to-book ratios.

Chapter 20 Options Markets
We have added a discussion of options backdating to this

This new chapter covers various hedge fund strategies;
market-neutral investing and portable alpha; performance
evaluation for hedge funds with changing risk exposures;
selection bias in hedge fund performance; tail risk in
hedge fund portfolios; and hedge fund fees.

Chapter 28 Investment Policy and the
Framework of the CFA Institute
This chapter has been updated to reflect the CFA Institute’s expanded rubric for constructing a statement of
investment policy.

The text is composed of seven sections that are fairly
independent and may be studied in a variety of sequences.
Because there is enough material in the book for a twosemester course, clearly a one-semester course will
require the instructor to decide which parts to include.
Part One is introductory and contains important institutional material focusing on the financial environment.
We discuss the major players in the financial markets, provide an overview of the types of securities traded in those
markets, and explain how and where securities are traded.
We also discuss in depth mutual funds and other investment companies, which have become an increasingly
important means of investing for individual investors.
The material presented in Part One should make it
possible for instructors to assign term projects early in
the course. These projects might require the student to
analyze in detail a particular group of securities. Many
instructors like to involve their students in some sort of
investment game, and the material in these chapters will
facilitate this process.
Parts Two and Three contain the core of modern
portfolio theory. Chapter 5 is a general discussion of risk
and return, making the general point that historical returns
on broad asset classes are consistent with a risk–return
trade-off, and examining the distribution of stock returns.
We focus more closely in Chapter 6 on how to describe
investors’ risk preferences and how they bear on asset


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risk–return relationship, as well as liquidity effects on
asset pricing.
Part Four is the first of three parts on security valuation. This part treats fixed-income securities—bond
pricing (Chapter 14), term structure relationships (Chapter 15), and interest-rate risk management (Chapter 16).
Parts Five and Six deal with equity securities and derivative securities. For a course emphasizing security analysis
and excluding portfolio theory, one may proceed directly
from Part One to Part Four with no loss in continuity.
Finally, Part Seven considers several topics important
for portfolio managers, including performance evaluation, international diversification, active management, and
practical issues in the process of portfolio management.
This part also contains a new chapter on hedge funds.

allocation. In the next two chapters, we turn to to portfolio optimization (Chapter 7) and its implementation using
index models (Chapter 8).
After our treatment of modern portfolio theory in Part
Two, we investigate in Part Three the implications of that
theory for the equilibrium structure of expected rates of
return on risky assets. Chapter 9 treats the capital asset
pricing model and Chapter 10 covers multifactor descriptions of risk and the arbitrage pricing theory. Chapter
11 covers the efficient market hypothesis, including its
rationale as well as evidence that supports the hypothesis
and challenges it. Chapter 12 is devoted to the behavioral
critique of market rationality. Finally, we conclude Part
Three with Chapter 13 on empirical evidence on security
pricing. This chapter contains evidence concerning the


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This book contains several features designed to
make it easy for the student to understand, absorb,
and apply the concepts and techniques presented.

New and Enhanced

SERVE TO OUTLINE the upcoming material in the


chapter and provide students with a road map


YOU LEARNED IN Chapter 1 that the process


of building an investment portfolio usually
begins by deciding how much money to allocate to broad classes of assets, such as safe
money market securities or bank accounts,
longer-term bonds, stocks, or even asset
classes like real estate or precious metals.
This process is called asset allocation. Within
each class the investor then selects specific
assets from a more detailed menu. This is
called security selection.
Each broad asset class contains many



of what they will learn.

markets. Money market instruments include
short-term, marketable, liquid, low-risk debt
securities. Money market instruments sometimes are called cash equivalents, or just cash
for short. Capital markets, in contrast, include
longer-term and riskier securities. Securities
in the capital market are much more diverse
than those found within the money market.
For this reason, we will subdivide the capital
market into four segments: longer-term bond
markets, equity markets, and the derivative
markets for options and futures.

A UNIQUE FEATURE of this book! These self-test

questions and problems found in the body

a risky prospect that I believe offers a negative expected profit? The ideal way to resolve
heterogeneous beliefs is for Paul and Mary to “merge their information,” that is, for each
party to verify that he or she possesses all relevant information and processes the information properly. Of course, the acquisition of information and the extensive communication
that is required to eliminate all heterogeneity in expectations is costly, and thus up to
a point heterogeneous expectations cannot be taken as irrational. If, however, Paul and
Mary enter such contracts frequently, they would recognize the information problem in
one of two ways: Either they will realize that they are creating gambles when each wins
half of the bets, or the consistent loser will admit that he or she has been betting on the
basis of inferior forecasts.

of the text enable the students to determine
whether they’ve understood the preceding
material. Detailed solutions are provided at
the end of each chapter.



Assume that dollar-denominated T-bills in the United States and pound-denominated bills in
the United Kingdom offer equal yields to maturity. Both are short-term assets, and both are
free of default risk. Neither offers investors a risk premium. However, a U.S. investor who holds
U.K. bills is subject to exchange rate risk, because the pounds earned on the U.K. bills eventually will be exchanged for dollars at the future exchange rate. Is the U.S. investor engaging in
speculation or gambling?

Risk Aversion and Utility Values
The history of rates of return on various asset classes presented in Chapter 5 as well as
bod8237x_ch02_023-053.indd 23

NUMBERED AND TITLED examples are integrated

throughout chapters. Using the worked-out
solutions to these examples as models, students can learn how to solve specific problems
step-by-step as well as gain insight into general principles by seeing how they are applied


4/7/08 3:20:12 PM

Approximating the Real Rate

If the nominal interest rate on a 1-year CD is 8%, and you expect inflation to be 5% over the
coming year, then using the approximation formula, you expect the real rate of interest to be
⫺ .05 ⫽ .0286, or
r ⫽ 8% ⫺ 5% ⫽ 3%. Using the exact formula, the real rate is r ⫽ .08
1 ⫹ .05
2.86%. Therefore, the approximation rule overstates the expected real rate by only .14% (14
basis points). The approximation rule is more exact for small inflation rates and is perfectly
exact for continuously compounded rates. We discuss further details in the next section.
Before the decision to invest, you should realize that conventional certificates of deposit
offer a guaranteed nominal rate of interest Thus you can only infer the expected real rate

to answer concrete questions.
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With the news that shares of online search giant
Google Inc. (GOOG) had crossed the lofty $400-pershare mark in November 2005, the world may have
witnessed something akin to the birth of a new financial planetary system. Given its market cap of $120
billion, double that of its nearest competitor, Yahoo!,
Google now has the gravitational pull to draw in a
host of institutions and company matchmakers unable
to resist the potential profit opportunities. Google
stock, with a price–earnings ratio of 70, represents
one of the richest dealmaking currencies anywhere.
That heft has attracted a growing galaxy of entrepreneurs, venture capitalists, and investment bankers, all
of whom are orbiting Google in the hopes of selling it
something—a new service, a start-up company, even a
new strategy—anything to get their hands on a little of
the Google gold.
The Google effect is already changing the delicate
balance in Silicon Valley between venture capitalists

SHORT ARTICLES FROM business periodi-

(VCs) and start-up companies. Instead of nurturing the
most promising start-ups with an eye toward taking the
fledgling businesses public, a growing number of VCs
now scour the landscape for anyone with a technology
or service that might fill a gap in Google’s portfolio.
Google itself and not the larger market has become the
exit strategy as VCs plan for the day they can take their
money out of their start-ups. Business founders have felt
the tug as well. “You’re hearing about a lot of entrepreneurs pitching VCs with their end goal to be acquired by
Google,” says Daniel Primack, editor of PE Week Wire,
a dealmaking digest popular in VC circles. “It’s a complete 180 [degree turn] from the IPO craze of five years
ago; now Google is looked at like NASDAQ was then.”
Other entrepreneurs, meanwhile, are skipping the VC
stage altogether, hoping to sell directly to Google.

cals, such as The Wall Street Journal, are
included in boxes throughout the text. The
articles are chosen for real-world relevance
and clarity of presentation.

Source: BusinessWeek Online,
Reprinted from the December 5, 2005, issue of BusinessWeek by
special permission. © 2005 McGraw-Hill Companies, Inc.

Allocation of Risk
Virtually all real assets involve some risk. When GM builds its auto plants, for example, it
cannot know for sure what cash flows those plants will generate. Financial markets and the
diverse financial instruments traded in those markets allow investors with the greatest taste



THE EIGHTH EDITION has expanded the box-


tions. A sample spreadsheet is presented


in the Investments text with an interactive
version available on the book’s Web site at





St Price
Initial Investment
Initial Stock Price
Number of Shares Sold Short
Ending Stock Price
Cash Dividends Per Share
Initial Margin Percentage
Maintenance Margin Percentage


Return on Short Sale
Capital Gain on Stock
Dividends Paid
Net Income
Initial Investment
Return on Investment


Margin Positions
Margin Based on Ending Price





Price for Margin Call

bod8237x_ch01_001-022.indd 6


different levels of initial and maintenance margins. The
model also includes a sensitivity analysis for ending
stock price and returnt on investment.

he Online Learning Center (
contains this Excel spreadsheet model, built using
the text example for Dot Bomb. The model allows
you to analyze the effects of returns, margin calls, and

es featuring Excel Spreadsheet Applica-




2/15/08 2:41:36 PM


Rates of return expressed as decimals
Purchase Price =




T-bill Rate =






from Mean

from Mean

State of the
Normal growth
SUMPRODUCT(B9:B11, E9:E11) =
Expected value (mean)
SUMPRODUCT(B9:B11, F9:F11)^.5 = 0.1732
Standard deviation of HPR
SUMPRODUCT(B9:B11, G9:G11) =
Risk premium
SUMPRODUCT(B9:B11, H9:H11)^0.5 = 0.1732
Standard deviation of excess return



sheets and are denoted by an icon. They
are also available on the book’s Web site

Please visit us at

Distribution of HPR on the stock-index fund

SELECTED EXHIBITS ARE set as Excel spread-

then sums the products. Here, the number pair is the probability of each scenario and the
rate of return.

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AT THE END of each chapter, a detailed

summary outlines the most important
concepts presented. A listing of related
found on the book’s Web site at www. These sites make it


Web sites for each chapter can also be

easy for students to research topics
further and retrieve financial data and

1. Unit investment trusts, closed-end management companies, and open-end management companies are all classified and regulated as investment companies. Unit investment trusts are essentially unmanaged in the sense that the portfolio, once established, is fixed. Managed investment
companies, in contrast, may change the composition of the portfolio as deemed fit by the portfolio manager. Closed-end funds are traded like other securities; they do not redeem shares for their
investors. Open-end funds will redeem shares for net asset value at the request of the investor.
2. Net asset value equals the market value of assets held by a fund minus the liabilities of the fund
divided by the shares outstanding.
3. Mutual funds free the individual from many of the administrative burdens of owning individual
securities and offer professional management of the portfolio. They also offer advantages that
are available only to large-scale investors, such as discounted trading costs. On the other hand,
funds are assessed management fees and incur other expenses, which reduce the investor’s rate
of return. Funds also eliminate some of the individual’s control over the timing of capital gains


4. Mutual funds are often categorized by investment policy. Major policy groups include money
market funds; equity funds, which are further grouped according to emphasis on income versus
growth; fixed-income funds; balanced and income funds; asset allocation funds; index funds; and
specialized sector funds.

bod8237x_ch04_088-112.indd 108

WE STRONGLY BELIEVE that practice in

solving problems is critical to understanding investments, so a good va-

2/29/08 6:36:31 PM


1. In what ways is preferred stock like long-term debt? In what ways is it like equity?


4. Examine the first 50 stocks listed in the stock market listings for NYSE stocks in your local
newspaper. For how many of these stocks is the 52-week high price at least 50% greater than
the 52-week low price? What do you conclude about the volatility of prices on individual


5. Turn back to Figure 2.4 and look at the first Treasury note maturing in November 2014.

2. Why are money market securities sometimes referred to as “cash equivalents”?
3. What would you expect to happen to the spread between yields on commercial paper and Treasury bills if the economy were to enter a steep recession?

a. How much would you have to pay to purchase one of these notes?
b. What is its coupon rate?
c. What is the current yield of the note?

riety of problems is provided. New

6. Suppose investors can earn a return of 2% per 6 months on a Treasury note with 6 months
remaining until maturity. What price would you expect a 6-month maturity Treasury bill to sell

questions by level of difficulty: Quiz,

7. Find the after-tax return to a corporation that buys a share of preferred stock at $40, sells it at
year-end at $40, and receives a $4 year-end dividend. The firm is in the 30% tax bracket.


to this edition, we separated the
Problems, and Challenge Problems.

8. Turn to Figure 2.8 and look at the listing for General Dynamics.
a. What was the firm’s closing price yesterday?
b How many shares could you buy for $5 000?

Visit us at

1. When the annualized monthly percentage rates of return for a stock market index were regressed
against the returns for ABC and XYZ stocks over a 5-year period ending in 2008, using an ordinary least squares regression, the following results were obtained:


Residual standard deviation


WE PROVIDE SEVERAL questions from recent


CFA examination in applicable chapters.


These questions represent the kinds of

Explain what these regression results tell the analyst about risk–return relationships for each
stock over the sample period. Comment on their implications for future risk–return relationships, assuming both stocks were included in a diversified common stock portfolio, especially
in view of the following additional data obtained from two brokerage houses, which are based
on 2 years of weekly data ending in December 2008.
Brokerage House

Beta of ABC

Beta of XYZ




questions that professionals in the field
believe are relevant to the “real world.“
Located at the back of the book is a listing
of each CFA question and the level and year

2. Assume the correlation coefficient between Baker Fund and the S&P 500 Stock Index is .70.
What percentage of Baker Fund’s total risk is specific (i.e., nonsystematic)?

The correlation between the Charlottesville International Fund and the EAFE Market Index
bod8237x_ch02_023-053.indd 50

of the CFA exam it was included in for easy

2/15/08 4:37:07 PM

reference when studying for the exam.

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c. If you were the specialist, would you want to increase or decrease your inventory of this

Visit us at

Please visit us at

9. You are bullish on Telecom stock. The current market price is $50 per share, and you have
$5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest
rate of 8% per year and invest $10,000 in the stock.


a. What will be your rate of return if the price of Telecom stock goes up by 10% during the next
year? (Ignore the expected dividend.)
b. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30%? Assume the price fall happens immediately.


Please visit us at


Please visit us at

lems, denoted by an icon, specifi-

10. You are bearish on Telecom and decide to sell short 100 shares at the current market price of
$50 per share.

cally linked to Excel templates that

a. How much in cash or securities must you put into your brokerage account if the broker’s
initial margin requirement is 50% of the value of the short position?
b. How high can the price of the stock go before you get a margin call if the maintenance margin is 30% of the value of the short position?

are available on the book’s Web site

11. Suppose that Intel currently is selling at $40 per share. You buy 500 shares using $15,000 of
your own money, borrowing the remainder of the purchase price from your broker. The rate on
the margin loan is 8%.


a. What is the percentage increase in the net worth of your brokerage account if the price of
Intel immediately changes to: (i) $44; (ii) $40; (iii) $36? What is the relationship between
your percentage return and the percentage change in the price of Intel?
b. If the maintenance margin is 25%, how low can Intel’s price fall before you get a margin

SELECTED CHAPTERS CONTAIN problems directly inbod8237x_ch03_054-087.indd 84

Go to and link to Company, then Population. Select
a company of interest to you and link to the Company Research page. Look for the Excel
Analytics section, and choose Valuation Data, then review the Profitability report. Find the
row that shows the historical betas for your firm. Is beta stable from year to year? Go back
to the Company Research page and look at the latest available S&P Stock Report for your
firm. What beta does the report indicate for your firm? Why might this be different from the
one in the Profitability Report? Based on current risk-free rates (available at
.com), and the historical risk premiums discussed in Chapter 5, estimate the expected rate
of return on your company’s stock by using the CAPM.

2/15/08 5:02:13 PM

corporating the Educational Version of Market
Insight, a service based on Standard & Poor’s renowned Compustat database. Problems are based
in market data provided by 1,000 real companies
to gain better understanding of practical business
situations. The site is updated daily to ensure the

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most current information is available.

b. C t que t e c e t s suggest o . scuss ow bot syste at c a d
as the number of securities in a portfolio is increased.

spec c s c a ge



E- I nves tm ents


Go to the Web site to learn
more about diversification, the factors that influence investors’ risk preferences, and
the types of investments that fit into each of the risk categories. Then check out for asset allocation guidelines
for various types of portfolios from conservative to very aggressive. What do you
conclude about your own risk preferences and the best portfolio type for you? What
would you expect to happen to your attitude toward risk as you get older? How
might your portfolio composition change?

simple activities to enhance their experience using the Internet. Easy-to-follow instructions and questions are presented so
students can utilize what they have learned


in class and apply it to today’s Web-driven


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PageOut, and Apple’s iQuiz. Sharing tests with colleagues, adjuncts, TAs is easy! Instant scoring and
feedback is provided and EZ Test’s grade book is
designed to export to your grade book.

Instructor’s Resource CD
ISBN: 978-0-07-3365353-0 MHID: 0-07-336354-5

This comprehensive CD contains all of the following instructor supplements. We have compiled them in
electronic format for easier access and convenience.
Print copies are available through your McGraw-Hill
• Instructor’s Manual Prepared by Sue Hine, Colorado
State University, has been revised and improved for
this edition. Each chapter includes a Chapter Overview, Learning Objectives, and Presentation of Material, which outlines and organizes the material around
the PowerPoint Presentation.
• Test Bank Prepared by Larry Prather, Southeastern
Oklahoma State University, has been revised to
increase the quantity and variety of questions. Each
question is ranked by level of difficulty, which allows
greater flexibility in creating a test and also provides a
rationale for the solution. A computerized format for
Windows is also available.
• Computerized Test Bank A comprehensive bank of test
questions is provided within a computerized test bank
powered by McGraw-Hill’s flexible electronic testing
program EZ Test Online ( You
can select questions from multiple McGraw-Hill test
banks or author your own, and then print the test for
paper distribution or give it online. This user-friendly
program allows you to sort questions by format; edit
existing questions or add new ones; and scramble
questions for multiple versions of the same test. You
can export your tests for use in WebCT, Blackboard,

• PowerPoint Presentation System These presentation
slides, also developed by Sue Hine, contain figures and
tables from the text, key points, and summaries in a
visually stimulating collection of slides. These slides
follow the order of the chapters, but if you have PowerPoint software, you can customize the program to fit
your lecture.
• Solutions Manual Prepared by Bruce Swensen, Adelphi
University, provides detailed solutions to the end-ofchapter problem sets. This supplement is also available
for purchase by your students or can be packaged with
your text at a discount.

Solutions Manual
ISBN: 978-0-07-336357-8 MHID: 0-07-336357-X

Revised by Bruce Swensen, Adelphi University, this
manual provides detailed solutions to the end-of-chapter

Student Problem Manual
ISBN: 978-0-07-336356-1 MHID: 0-07-336356-1

Prepared by Larry Prather, Southeastern Oklahoma State
University, this useful supplement contains problems created to specifically relate to the concepts discussed in each
chapter. Solutions are provided at the end of each chapter
in the manual. Perfect for additional practice in working
through problems!


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up-to-date, the suggested sites as well as their links are
provided online. Each chapter summary contains a reference to its related sites.

Online Learning Center
Find a wealth of information online! At this book’s Web
site instructors have access to teaching supports such as
electronic files of the ancillary materials. Students have
access to study materials created specifically for this text
and much more. All Excel spreadsheets, denoted by an
icon in the text are located at this site. Links to the additional support material, are also included. See below for a
description of some of the exciting assets available to you!

• Online Quizzes These multiple-choice questions are
provided as an additional testing and reinforcement
tool for students. Each quiz is organized by chapter to
test the specific concepts presented in that particular
chapter. Immediate scoring of the quiz occurs upon
submission and the correct answers are provided.

• Standard & Poor’s Educational Version of Market
Insight McGraw-Hill/Irwin has partnered exclusively
with Standard and Poor’s to bring you the Educational
Version of Market Insight. This rich online resource provides 6 years of financial data for 1,000 companies in
the renowned COMPUSTAT® database. S&P problems
can be found at the end of relevant chapters of the text.
• Excel Templates Revised by Pete Crabb, Northwest
Nazarene University, templates are available for
selected spreadsheets featured within the text, as well
as those featured among the Excel Applications boxes.
Selected end-of-chapter problems have also been designated as Excel problems, for which the available
template allows students to solve the problem and
gain experience using spreadsheets. Each template
can also be found on the book’s Web site www.mhhe.
• Related Web Sites A list of suggested Web sites is
provided for each chapter. To keep Web addresses

Please contact your McGraw-Hill/Irwin sales representative to find out more about these exciting packaging
options now available for your class.
• BusinessWeek Package Your students can subscribe to
BusinessWeek for a special rate of $8.25 in addition to
the price of the text. Students will receive a pass code
card shrink-wrapped with their new text that refers
them to a registration site to receive their subscription. Subscriptions are available in print copy or digital
• Financial Times Package Your students can subscribe
to the Financial Times for 15 weeks at a specially priced
rate of $10 in addition to the price of the text. Students
will receive a subscription card shrink-wrapped with
their new text that activates their subscriptions once
they complete and submit the card. The subscription
also provides access to


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Throughout the development of this text,
experienced instructors have provided critical feedback and suggestions for improvement. These individuals deserve a special
thanks for their valuable insights and contributions. The following instructors played
a vital role in the development of this and
previous editions of Investments:

L. Michael Couvillion
Plymouth State University

J. Amanda Addkisson
Texas A&M University

Craig Dunbar
University of Western Ontario

Tor-Erik Bakke
University of Wisconsin

David Durr
Murray State University

Richard J. Bauer Jr.
St. Mary’s University

Bjorn Eaker
Duke University

Scott Besley
University of Florida

John Earl
University of Richmond

John Binder
University of Illinois at Chicago

Michael C. Ehrhardt
University of Tennessee at Knoxville

Paul Bolster
Northwestern University

Venkat Eleswarapu
Southern Methodist University

Phillip Braun
Northeastern University

David Ellis
Babson College

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Delaware State University

Andrew Ellul
Indiana University

Charles Chang
Cornell University

Greg Filbeck
University of Toledo

Kee Chaung
SUNY Buffalo

Jeremy Goh
Washington University

Ludwig Chincarini
Pomona College

Richard Grayson
Loyola College

Stephen Ciccone
University of New Hampshire

John M. Griffin
Arizona State University

James Cotter
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Weiyu Guo
University of Nebraska at Omaha

Anna Craig
Emory University
Elton Daal
University of New Orleans
David C. Distad
University of California at Berkeley

Mahmoud Haddad
Wayne State University
Greg Hallman
University of Texas at Austin
Robert G. Hansen
Dartmouth College
Joel Hasbrouck
New York University
Andrea Heuson
University of Miami
Eric Higgins
Drexel University
Shalom J. Hochman
University of Houston
Eric Hughson
University of Colorado
Delroy Hunter
University of South Florida
A. James Ifflander
A. James Ifflander and Associates
Robert Jennings
Indiana University
George Jiang
University of Arizona
Richard D. Johnson
Colorado State University
Susan D. Jordan
University of Kentucky
G. Andrew Karolyi
Ohio State University
Ajay Khorana
Georgia Institute of Technology
Josef Lakonishok
University of Illinois at


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Malek Lashgari
University of Hartford

Herbert Quigley
University of the District of Columbia

Joe Ueng
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Binghamton University

Murli Rajan
University of Scranton

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Jack Li
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University of Pittsburgh

Leonard Rosenthal
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Davinder Malhotra
Philadelphia University

Anthony Sanders
Ohio State University

Tony R. Wingler
University of North Carolina at

Steven Mann
University of South Carolina
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Tennessee Technical University
Jean Masson
University of Ottawa

Gary Sanger
Louisiana State University
Don Seeley
University of Arizona
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Portland State University

Guojun Wu
University of Michigan
Hsiu-Kwang Wu
University of Alabama
Geungu Yu
Jackson State University

Edward C. Sims
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Truman State University

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University of Texas

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University of Texas at Arlington

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University of Southern California

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Rutgers University

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University of San Francisco

Robert Pavlik
Southwest Texas State

Steve Thorley
Brigham Young University

Eileen St. Pierre
University of Northern Colorado

Jack Treynor
Treynor Capital Management

For granting us permission to include
many of their examination questions
in the text, we are grateful to the CFA
Much credit is due to the development
and production team at McGraw-Hill/
Irwin: our special thanks go to Michele
Janicek, Executive Editor; Christina
Kouvelis, Senior Developmental Editor;
Lori Koetters, Managing Editor; Ashley
Smith, Marketing Manager; Jennifer
Jelinski, Marketing Specialist; Michael
McCormick, Senior Production Supervisor; Matthew Baldwin, Designer; and
Lynn Bluhm, Media Project Manager.
Finally, we thank Judy, Hava, and
Sheryl, who contribute to the book with
their support and understanding.

Marianne Plunkert
University of Colorado at Denver

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SUNY Buffalo

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St. John’s University
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University of South Florida

Zvi Bodie
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AN INVESTMENT IS the current commitment

of money or other resources in the expectation of reaping future benefits. For example,
an individual might purchase shares of stock
anticipating that the future proceeds from
the shares will justify both the time that her
money is tied up as well as the risk of the
investment. The time you will spend studying
this text (not to mention its cost) also is an
investment. You are forgoing either current
leisure or the income you could be earning
at a job in the expectation that your future
career will be sufficiently enhanced to justify
this commitment of time and effort. While
these two investments differ in many ways,
they share one key attribute that is central
to all investments: You sacrifice something
of value now, expecting to benefit from that
sacrifice later.
This text can help you become an informed
practitioner of investments. We will focus
on investments in securities such as stocks,
bonds, or options and futures contracts, but
much of what we discuss will be useful in the
analysis of any type of investment. The text will
provide you with background in the organization of various securities markets; will survey

bod8237x_ch01_001-022.indd 1



the valuation and risk-management principles
useful in particular markets, such as those for
bonds or stocks; and will introduce you to the
principles of portfolio construction.
Broadly speaking, this chapter addresses
three topics that will provide a useful perspective for the material that is to come
later. First, before delving into the topic
of “investments,” we consider the role of
financial assets in the economy. We discuss
the relationship between securities and the
“real” assets that actually produce goods
and services for consumers, and we consider
why financial assets are important to the
functioning of a developed economy. Given
this background, we then take a first look at
the types of decisions that confront investors as they assemble a portfolio of assets.
These investment decisions are made in an
environment where higher returns usually
can be obtained only at the price of greater
risk and in which it is rare to find assets that
are so mispriced as to be obvious bargains.
These themes—the risk–return trade-off and
the efficient pricing of financial assets—are
central to the investment process, so it is
worth pausing for a brief discussion of their

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implications as we begin the text. These implications will be fleshed out in much greater detail in
later chapters.
Finally, we conclude with an introduction to the
organization of security markets, the various players that participate in those markets, and a brief


overview of some of the more important changes
in those markets in recent years. Together, these
various topics should give you a feel for who the
major participants are in the securities markets as
well as the setting in which they act. We close with
an overview of the remainder of the text.

The material wealth of a society is ultimately determined by the productive capacity of its
economy, that is, the goods and services its members can create. This capacity is a function
of the real assets of the economy: the land, buildings, machines, and knowledge that can
be used to produce goods and services.
In contrast to such real assets are financial assets such as stocks and bonds. Such
securities are no more than sheets of paper or, more likely, computer entries and do not
contribute directly to the productive capacity of the economy. Instead, these assets are the
means by which individuals in well-developed economies hold their claims on real assets.
Financial assets are claims to the income generated by real assets (or claims on income
from the government). If we cannot own our own auto plant (a real asset), we can still buy
shares in General Motors or Toyota (financial assets) and, thereby, share in the income
derived from the production of automobiles.
While real assets generate net income to the economy, financial assets simply define the
allocation of income or wealth among investors. Individuals can choose between consuming their wealth today or investing for the future. If they choose to invest, they may place
their wealth in financial assets by purchasing various securities. When investors buy these
securities from companies, the firms use the money so raised to pay for real assets, such
as plant, equipment, technology, or inventory. So investors’ returns on securities ultimately
come from the income produced by the real assets that were financed by the issuance of
those securities.
The distinction between real and financial assets is apparent when we compare the balance sheet of U.S. households, shown in Table 1.1, with the composition of national wealth
in the United States, shown in Table 1.2. Household wealth includes financial assets such
as bank accounts, corporate stock, or bonds. However, these securities, which are financial
assets of households, are liabilities of the issuers of the securities. For example, a bond
that you treat as an asset because it gives you a claim on interest income and repayment
of principal from General Motors is a liability of General Motors, which is obligated to
make these payments to you. Your asset is GM’s liability. Therefore, when we aggregate
over all balance sheets, these claims cancel out, leaving only real assets as the net wealth
of the economy. National wealth consists of structures, equipment, inventories of goods,
and land.1

You might wonder why real assets held by households in Table 1.1 amount to $27,086 billion, while total real
assets in the domestic economy (Table 1.2) are far larger, at $48,038 billion. One major reason is that real assets
held by firms, for example, property, plant, and equipment, are included as financial assets of the household
sector, specifically through the value of corporate equity and other stock market investments. Another reason is
that equity and stock investments in Table 1.1 are measured by market value, whereas plant and equipment in
Table 1.2 are valued at replacement cost.


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CHAPTER 1 The Investment Environment


$ Billion

% Total

Real assets
Real estate
Consumer durables


Total real assets

Liabilities and Net Worth

$ Billion

% Total


Consumer credit
Bank and other loans




Security credit
Total liabilities

Financial assets
Life insurance reserves
Pension reserves
Corporate equity
Equity in noncorp.
Mutual fund shares
Debt securities
Total financial assets

$ 6,629










Net worth





TA B L E 1.1
Balance sheet of U.S. households, 2007
Note: Column sums may differ from total because of rounding error.
Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2007.


$ Billion

Nonresidential real estate
Residential real estate
Equipment and software
Consumer durables

$ 9,549


TA B L E 1.2
Domestic net worth

$ 48,038

Note: Column sums may differ from total because of rounding error.
Source: Flow of Funds Accounts of the United States, Board of Governors of
the Federal Reserve System, June 2007.

We will focus almost exclusively
on financial assets. But you shouldn’t
lose sight of the fact that the successes
or failures of the financial assets we
choose to purchase ultimately depend
on the performance of the underlying
real assets.

Are the following assets real or financial?


a. Patents
b. Lease obligations
c. Customer goodwill
d. A college education
e. A $5 bill

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PART I Introduction


It is common to distinguish among three broad types of financial assets: fixed income,
equity, and derivatives. Fixed-income or debt securities promise either a fixed stream
of income or a stream of income that is determined according to a specified formula. For
example, a corporate bond typically would promise that the bondholder will receive a fixed
amount of interest each year. Other so-called floating-rate bonds promise payments that
depend on current interest rates. For example, a bond may pay an interest rate that is fixed
at 2 percentage points above the rate paid on U.S. Treasury bills. Unless the borrower
is declared bankrupt, the payments on these securities are either fixed or determined by
formula. For this reason, the investment performance of debt securities typically is least
closely tied to the financial condition of the issuer.
Nevertheless, fixed-income securities come in a tremendous variety of maturities and
payment provisions. At one extreme, the money market refers to debt securities that are
short term, highly marketable, and generally of very low risk. Examples of money market
securities are U.S. Treasury bills or bank certificates of deposit (CDs). In contrast, the
fixed-income capital market includes long-term securities such as Treasury bonds, as well
as bonds issued by federal agencies, state and local municipalities, and corporations. These
bonds range from very safe in terms of default risk (for example, Treasury securities) to
relatively risky (for example, high yield or “junk” bonds). They also are designed with
extremely diverse provisions regarding payments provided to the investor and protection
against the bankruptcy of the issuer. We will take a first look at these securities in Chapter 2
and undertake a more detailed analysis of the debt market in Part Four.
Unlike debt securities, common stock, or equity, in a firm represents an ownership
share in the corporation. Equityholders are not promised any particular payment. They
receive any dividends the firm may pay and have prorated ownership in the real assets of
the firm. If the firm is successful, the value of equity will increase; if not, it will decrease.
The performance of equity investments, therefore, is tied directly to the success of the firm
and its real assets. For this reason, equity investments tend to be riskier than investments in
debt securities. Equity markets and equity valuation are the topics of Part Five.
Finally, derivative securities such as options and futures contracts provide payoffs that
are determined by the prices of other assets such as bond or stock prices. For example, a
call option on a share of Intel stock might turn out to be worthless if Intel’s share price
remains below a threshold or “exercise” price such as $30 a share, but it can be quite valuable if the stock price rises above that level.2 Derivative securities are so named because
their values derive from the prices of other assets. For example, the value of the call option
will depend on the price of Intel stock. Other important derivative securities are futures and
swap contracts. We will treat these in Part Six.
Derivatives have become an integral part of the investment environment. One use of
derivatives, perhaps the primary use, is to hedge risks or transfer them to other parties. This
is done successfully every day, and the use of these securities for risk management is so
commonplace that the multitrillion-dollar market in derivative assets is routinely taken for
granted. Derivatives also can be used to take highly speculative positions, however. Every

A call option is the right to buy a share of stock at a given exercise price on or before the option’s expiration
date. If the market price of Intel remains below $30 a share, the right to buy for $30 will turn out to be valueless.
If the share price rises above $30 before the option expires, however, the option can be exercised to obtain the
share for only $30.

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CHAPTER 1 The Investment Environment


so often, one of these positions blows up, resulting in well-publicized losses of hundreds
of millions of dollars. While these losses attract considerable attention, they are in fact the
exception to the more common use of such securities as risk management tools. Derivatives will continue to play an important role in portfolio construction and the financial
system. We will return to this topic later in the text.
In addition to these financial assets, individuals might invest directly in some real assets.
For example, real estate or commodities such as precious metals or agricultural products
are real assets that might form part of an investment portfolio.



We stated earlier that real assets determine the wealth of an economy, while financial assets
merely represent claims on real assets. Nevertheless, financial assets and the markets in
which they trade play several crucial roles in developed economies. Financial assets allow
us to make the most of the economy’s real assets.

The Informational Role of Financial Markets
In a capitalist system, financial markets play a central role in the allocation of capital
resources. Investors in the stock market ultimately decide which companies will live and
which will die. If a corporation seems to have good prospects for future profitability, investors will bid up its stock price. The company’s management will find it easy to issue new
shares or borrow funds to finance research and development, build new production facilities, and expand its operations. The nearby box provides an illustration of this process. As
Google’s stock price has surged, it has been able to expand and initiate many new business
prospects. If, on the other hand, a company’s prospects seem poor, investors will bid down
its stock price. The company will have to downsize and may eventually disappear.
The process by which capital is allocated through the stock market sometimes seems
wasteful. Some companies can be “hot” for a short period of time, attract a large flow of
investor capital, and then fail after only a few years. But that is an unavoidable implication of uncertainty. It is impossible to predict with certainty which ventures will succeed
and which will fail. But the stock market encourages allocation of capital to those firms
that appear at the time to have the best prospects. Many smart, well-trained, and well-paid
professionals analyze the prospects of firms whose shares trade on the stock market. Stock
prices reflect their collective judgment.

Consumption Timing
Some individuals in an economy are earning more than they currently wish to spend. Others, for example, retirees, spend more than they currently earn. How can you shift your
purchasing power from high-earnings periods to low-earnings periods of life? One way
is to “store” your wealth in financial assets. In high-earnings periods, you can invest your
savings in financial assets such as stocks and bonds. In low-earnings periods, you can sell
these assets to provide funds for your consumption needs. By so doing, you can “shift”
your consumption over the course of your lifetime, thereby allocating your consumption to
periods that provide the greatest satisfaction. Thus, financial markets allow individuals to
separate decisions concerning current consumption from constraints that otherwise would
be imposed by current earnings.

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With the news that shares of online search giant
Google Inc. (GOOG) had crossed the lofty $400-pershare mark in November 2005, the world may have
witnessed something akin to the birth of a new financial planetary system. Given its market cap of $120
billion, double that of its nearest competitor, Yahoo!,
Google now has the gravitational pull to draw in a
host of institutions and company matchmakers unable
to resist the potential profit opportunities. Google
stock, with a price–earnings ratio of 70, represents
one of the richest dealmaking currencies anywhere.
That heft has attracted a growing galaxy of entrepreneurs, venture capitalists, and investment bankers, all
of whom are orbiting Google in the hopes of selling it
something—a new service, a start-up company, even a
new strategy—anything to get their hands on a little of
the Google gold.
The Google effect is already changing the delicate
balance in Silicon Valley between venture capitalists

(VCs) and start-up companies. Instead of nurturing the
most promising start-ups with an eye toward taking the
fledgling businesses public, a growing number of VCs
now scour the landscape for anyone with a technology
or service that might fill a gap in Google’s portfolio.
Google itself and not the larger market has become the
exit strategy as VCs plan for the day they can take their
money out of their start-ups. Business founders have felt
the tug as well. “You’re hearing about a lot of entrepreneurs pitching VCs with their end goal to be acquired by
Google,” says Daniel Primack, editor of PE Week Wire,
a dealmaking digest popular in VC circles. “It’s a complete 180 [degree turn] from the IPO craze of five years
ago; now Google is looked at like NASDAQ was then.”
Other entrepreneurs, meanwhile, are skipping the VC
stage altogether, hoping to sell directly to Google.
Source: BusinessWeek Online,
Reprinted from the December 5, 2005, issue of BusinessWeek by
special permission. © 2005 McGraw-Hill Companies, Inc.

Allocation of Risk
Virtually all real assets involve some risk. When GM builds its auto plants, for example, it
cannot know for sure what cash flows those plants will generate. Financial markets and the
diverse financial instruments traded in those markets allow investors with the greatest taste
for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater extent,
stay on the sidelines. For example, if GM raises the funds to build its auto plant by selling
both stocks and bonds to the public, the more optimistic or risk-tolerant investors can buy
shares of stock in GM, while the more conservative ones can buy GM bonds. Because the
bonds promise to provide a fixed payment, the stockholders bear most of the business risk
but reap potentially higher rewards. Thus, capital markets allow the risk that is inherent to
all investments to be borne by the investors most willing to bear that risk.
This allocation of risk also benefits the firms that need to raise capital to finance their
investments. When investors are able to select security types with the risk–return characteristics that best suit their preferences, each security can be sold for the best possible
price. This facilitates the process of building the economy’s stock of real assets.

Separation of Ownership and Management
Many businesses are owned and managed by the same individual. This simple organization is well suited to small businesses and, in fact, was the most common form of business
organization before the Industrial Revolution. Today, however, with global markets and
large-scale production, the size and capital requirements of firms have skyrocketed. For
example, at the end of 2006 General Electric listed on its balance sheet about $75 billion
of property, plant, and equipment, and total assets of nearly $700 billion. Corporations
of such size simply cannot exist as owner-operated firms. GE actually has about 625,000
stockholders with an ownership stake in the firm proportional to their holdings of shares.
Such a large group of individuals obviously cannot actively participate in the day-today management of the firm. Instead, they elect a board of directors that in turn hires and
supervises the management of the firm. This structure means that the owners and managers
of the firm are different parties. This gives the firm a stability that the owner-managed
firm cannot achieve. For example, if some stockholders decide they no longer wish to hold

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shares in the firm, they can sell their shares to other investors, with no impact on the management of the firm. Thus, financial assets and the ability to buy and sell those assets in the
financial markets allow for easy separation of ownership and management.
How can all of the disparate owners of the firm, ranging from large pension funds holding hundreds of thousands of shares to small investors who may hold only a single share,
agree on the objectives of the firm? Again, the financial markets provide some guidance.
All may agree that the firm’s management should pursue strategies that enhance the value
of their shares. Such policies will make all shareholders wealthier and allow them all to
better pursue their personal goals, whatever those goals might be.
Do managers really attempt to maximize firm value? It is easy to see how they might
be tempted to engage in activities not in the best interest of shareholders. For example,
they might engage in empire building or avoid risky projects to protect their own jobs or
overconsume luxuries such as corporate jets, reasoning that the cost of such perquisites is
largely borne by the shareholders. These potential conflicts of interest are called agency
problems because managers, who are hired as agents of the shareholders, may pursue their
own interests instead.
Several mechanisms have evolved to mitigate potential agency problems. First, compensation plans tie the income of managers to the success of the firm. A major part of the
total compensation of top executives is often in the form of stock options, which means
that the managers will not do well unless the stock price increases, benefiting shareholders.
(Of course, we’ve learned more recently that overuse of options can create its own agency
problem. Options can create an incentive for managers to manipulate information to prop
up a stock price temporarily, giving them a chance to cash out before the price returns to a
level reflective of the firm’s true prospects. More on this shortly.) Second, while boards of
directors are sometimes portrayed as defenders of top management, they can, and increasingly do, force out management teams that are underperforming. Third, outsiders such as
security analysts and large institutional investors such as pension funds monitor the firm
closely and make the life of poor performers at the least uncomfortable.
Finally, bad performers are subject to the threat of takeover. If the board of directors is lax
in monitoring management, unhappy shareholders in principle can elect a different board.
They can do this by launching a proxy contest in which they seek to obtain enough proxies
(i.e., rights to vote the shares of other shareholders) to take control of the firm and vote in
another board. However, this threat is usually minimal. Shareholders who attempt such a
fight have to use their own funds, while management can defend itself using corporate coffers. Most proxy fights fail. The real takeover threat is from other firms. If one firm observes
another underperforming, it can acquire the underperforming business and replace management with its own team. The stock price should rise to reflect the prospects of improved
performance, which provides incentive for firms to engage in such takeover activity.


The Hewlett-Packard/Compaq Proxy Fight

When Carly Fiorina, then the CEO of Hewlett-Packard, proposed a merger with Compaq
Computer in 2001, Walter Hewlett, son of the company’s founder and member of the HP
board of directors, dissented. The merger had to be approved by shareholders, and Hewlett
engaged in a proxy fight to block the deal. One estimate is that HP spent $150 million to
lobby shareholders to support the merger; even small shareholders of HP reported receiving 20 or more phone calls from the company in support of the deal.3 The merger ultimately was approved in an uncharacteristically close vote. No surprise that less than 1% of
public companies face proxy contests in any particular year.

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PART I Introduction

Corporate Governance and Corporate Ethics
We’ve argued that securities markets can play an important role in facilitating the deployment of capital resources to their most productive uses. But for markets to effectively serve
this purpose, there must be an acceptable level of transparency that allows investors to
make well-informed decisions. If firms can mislead the public about their prospects, then
much can go wrong.
Despite the many mechanisms to align incentives of shareholders and managers, the
3 years between 2000 and 2002 were filled with a seemingly unending series of scandals
that collectively signaled a crisis in corporate governance and ethics. For example, the
telecom firm WorldCom overstated its profits by at least $3.8 billion by improperly classifying expenses as investments. When the true picture emerged, it resulted in the largest
bankruptcy in U.S. history. The second-largest U.S. bankruptcy was Enron, which used
its now-notorious “special-purpose entities” to move debt off its own books and similarly
present a misleading picture of its financial status. Unfortunately, these firms had plenty
of company. Other firms such as Rite Aid, HealthSouth, Global Crossing, and Qwest
Communications also manipulated and misstated their accounts to the tune of billions of
dollars. And the scandals were hardly limited to the United States. Parmalat, the Italian
dairy firm, claimed to have a $4.8 billion bank account that turned out not to exist. These
episodes suggest that agency and incentive problems are far from solved.3
Other scandals of that period included systematically misleading and overly optimistic
research reports put out by stock market analysts. (Their favorable analysis was traded for
the promise of future investment banking business, and analysts were commonly compensated not for their accuracy or insight, but for their role in garnering investment banking
business for their firms.) Additionally, initial public offerings were allocated to corporate
executives as a quid pro quo for personal favors or the promise to direct future business
back to the manager of the IPO.
What about the auditors who were supposed to be the watchdogs of the firms? Here
too, incentives were skewed. Recent changes in business practice had made the consulting businesses of these firms more lucrative than the auditing function. For example, Enron’s (now-defunct) auditor Arthur Andersen earned more money consulting for
Enron than by auditing it; given Arthur Andersen’s incentive to protect its consulting
profits, we should not be surprised that it, and other auditors, were overly lenient in their
auditing work.
In 2002, in response to the spate of ethics scandals, Congress passed the Sarbanes-Oxley
Act to tighten the rules of corporate governance. For example, the act requires corporations
to have more independent directors, that is, more directors who are not themselves managers (or affiliated with managers). The act also requires each CFO to personally vouch for
the corporation’s accounting statements, created an oversight board to oversee the auditing of public companies, and prohibits auditors from providing various other services to
In the wake of these scandals, Wall Street belatedly recognized that markets require
trust to function. The value of reputation is better appreciated, and reliance on more
straightforward incentive structures has increased. As one Wall Street insider put it, “This
is an industry of trust; it’s one of its key assets . . . [Wall Street] is going to have to invest
in getting [that trust] back . . . without that trust, there’s nothing.”4 Ultimately, a firm’s

See “Designed by Committee,” The Economist, June 13, 2002.
“How Corrupt Is Wall Street?” BusinessWeek, May 13, 2002.


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reputation for integrity is key to building long-term relationships with its customers and is
therefore one of its most valuable assets. Indeed, the motto of the London Stock Exchange
is “My word is my bond.” Every so often firms forget this lesson but, in the end, investments in reputation are in fact good business practice.



Saving, Investing, and Safe Investing
Saving means not spending all of your current income on consumption. Investing, on the
other hand, is choosing what assets to hold. You may choose to invest in safe assets, risky
assets, or a combination of both. In common usage, however, the term saving is often taken
to mean investing in safe assets such as an insured bank account. It is easy to confuse
saving with safe investing. To avoid confusion remember this example. Suppose you earn
$100,000 a year from your job, and you spend $80,000 of it on consumption. You are saving $20,000. Suppose you decide to invest all $20,000 in risky assets. You are still saving
$20,000, but you are not investing it safely.
An investor’s portfolio is simply his collection of investment assets. Once the portfolio
is established, it is updated or “rebalanced” by selling existing securities and using the
proceeds to buy new securities, by investing additional funds to increase the overall size of
the portfolio, or by selling securities to decrease the size of the portfolio.
Investment assets can be categorized into broad asset classes, such as stocks, bonds, real
estate, commodities, and so on. Investors make two types of decisions in constructing their
portfolios. The asset allocation decision is the choice among these broad asset classes,
while the security selection decision is the choice of which particular securities to hold
within each asset class.
“Top-down” portfolio construction starts with asset allocation. For example, an individual who currently holds all of his money in a bank account would first decide what
proportion of the overall portfolio ought to be moved into stocks, bonds, and so on. In
this way, the broad features of the portfolio are established. For example, while the average annual return on the common stock of large firms since 1926 has been about 12%
per year, the average return on U.S. Treasury bills has been less than 4%. On the other
hand, stocks are far riskier, with annual returns (as measured by the Standard & Poor’s
500 index) that have ranged as low as –46% and as high as 55%. In contrast, T-bills
are effectively risk-free: you know what interest rate you will earn when you buy them.
Therefore, the decision to allocate your investments to the stock market or to the money
market where Treasury bills are traded will have great ramifications for both the risk and
the return of your portfolio. A top-down investor first makes this and other crucial asset
allocation decisions before turning to the decision of the particular securities to be held
in each asset class.
Security analysis involves the valuation of particular securities that might be included
in the portfolio. For example, an investor might ask whether Merck or Pfizer is more attractively priced. Both bonds and stocks must be evaluated for investment attractiveness, but
valuation is far more difficult for stocks because a stock’s performance usually is far more
sensitive to the condition of the issuing firm.
In contrast to top-down portfolio management is the “bottom-up” strategy. In this process, the portfolio is constructed from the securities that seem attractively priced without

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as much concern for the resultant asset allocation. Such a technique can result in unintended bets on one or another sector of the economy. For example, it might turn out that
the portfolio ends up with a very heavy representation of firms in one industry, from one
part of the country, or with exposure to one source of uncertainty. However, a bottom-up
strategy does focus the portfolio on the assets that seem to offer the most attractive investment opportunities.


Financial markets are highly competitive. Thousands of intelligent and well-backed analysts constantly scour securities markets searching for the best buys. This competition
means that we should expect to find few, if any, “free lunches,” securities that are so underpriced that they represent obvious bargains. There are several implications of this no-freelunch proposition. Let’s examine two.

The Risk–Return Trade-Off
Investors invest for anticipated future returns, but those returns rarely can be predicted
precisely. There will almost always be risk associated with investments. Actual or realized returns will almost always deviate from the expected return anticipated at the start of
the investment period. For example, in 1931 (the worst calendar year for the market since
1926), the S&P 500 index fell by 46%. In 1933 (the best year), the index gained 55%. You
can be sure that investors did not anticipate such extreme performance at the start of either
of these years.
Naturally, if all else could be held equal, investors would prefer investments with the
highest expected return.5 However, the no-free-lunch rule tells us that all else cannot be
held equal. If you want higher expected returns, you will have to pay a price in terms of
accepting higher investment risk. If higher expected return can be achieved without bearing
extra risk, there will be a rush to buy the high-return assets, with the result that their prices
will be driven up. Individuals considering investing in the asset at the now-higher price
will find the investment less attractive: If you buy at a higher price, your expected rate of
return (that is, profit per dollar invested) is lower. The asset will be considered attractive
and its price will continue to rise until its expected return is no more than commensurate
with risk. At this point, investors can anticipate a “fair” return relative to the asset’s risk,
but no more. Similarly, if returns were independent of risk, there would be a rush to sell
high-risk assets. Their prices would fall (and their expected future rates of return rise) until
they eventually were attractive enough to be included again in investor portfolios. We conclude that there should be a risk–return trade-off in the securities markets, with higherrisk assets priced to offer higher expected returns than lower-risk assets.
Of course, this discussion leaves several important questions unanswered. How should
one measure the risk of an asset? What should be the quantitative trade-off between risk
(properly measured) and expected return? One would think that risk would have something to do with the volatility of an asset’s returns, but this guess turns out to be only
partly correct. When we mix assets into diversified portfolios, we need to consider the
interplay among assets and the effect of diversification on the risk of the entire portfolio.

The “expected” return is not the return investors believe they necessarily will earn, or even their most likely
return. It is instead the result of averaging across all possible outcomes, recognizing that some outcomes are more
likely than others. It is the average rate of return across possible economic scenarios.

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Diversification means that many assets are held in the portfolio so that the exposure to
any particular asset is limited. The effect of diversification on portfolio risk, the implications for the proper measurement of risk, and the risk–return relationship are the topics of
Part Two. These topics are the subject of what has come to be known as modern portfolio
theory. The development of this theory brought two of its pioneers, Harry Markowitz and
William Sharpe, Nobel Prizes.

Efficient Markets
Another implication of the no-free-lunch proposition is that we should rarely expect to find
bargains in the security markets. We will spend all of Chapter 11 examining the theory and
evidence concerning the hypothesis that financial markets process all relevant information
about securities quickly and efficiently, that is, that the security price usually reflects all
the information available to investors concerning the value of the security. According to
this hypothesis, as new information about a security becomes available, the price of the
security quickly adjusts so that at any time, the security price equals the market consensus
estimate of the value of the security. If this were so, there would be neither underpriced nor
overpriced securities.
One interesting implication of this “efficient market hypothesis” concerns the choice
between active and passive investment-management strategies. Passive management calls
for holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis. Active management is
the attempt to improve performance either by identifying mispriced securities or by timing the performance of broad asset classes—for example, increasing one’s commitment to
stocks when one is bullish on the stock market. If markets are efficient and prices reflect
all relevant information, perhaps it is better to follow passive strategies instead of spending
resources in a futile attempt to outguess your competitors in the financial markets.
If the efficient market hypothesis were taken to the extreme, there would be no point in
active security analysis; only fools would commit resources to actively analyze securities.
Without ongoing security analysis, however, prices eventually would depart from “correct”
values, creating new incentives for experts to move in. Therefore, even in environments
as competitive as the financial markets, we may observe only near-efficiency, and profit
opportunities may exist for especially diligent and creative investors. In Chapter 12, we
examine such challenges to the efficient market hypothesis, and this motivates our discussion of active portfolio management in Part Seven. More important, our discussions of
security analysis and portfolio construction generally must account for the likelihood of
nearly efficient markets.



From a bird’s-eye view, there would appear to be three major players in the financial
1. Firms are net borrowers. They raise capital now to pay for investments in plant and
equipment. The income generated by those real assets provides the returns to investors who purchase the securities issued by the firm.
2. Households typically are net savers. They purchase the securities issued by firms
that need to raise funds.
3. Governments can be borrowers or lenders, depending on the relationship
between tax revenue and government expenditures. Since World War II, the U.S.

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government typically has run budget deficits, meaning that its tax receipts have
been less than its expenditures. The government, therefore, has had to borrow funds
to cover its budget deficit. Issuance of Treasury bills, notes, and bonds is the major
way that the government borrows funds from the public. In contrast, in the latter
part of the 1990s, the government enjoyed a budget surplus and was able to retire
some outstanding debt.
Corporations and governments do not sell all or even most of their securities directly
to individuals. For example, about half of all stock is held by large financial institutions
such as pension funds, mutual funds, insurance companies, and banks. These financial
institutions stand between the security issuer (the firm) and the ultimate owner of the
security (the individual investor). For this reason, they are called financial intermediaries.
Similarly, corporations do not market their own securities to the public. Instead, they hire
agents, called investment bankers, to represent them to the investing public. Let’s examine
the roles of these intermediaries.

Financial Intermediaries
Households want desirable investments for their savings, yet the small (financial) size of
most households makes direct investment difficult. A small investor seeking to lend money
to businesses that need to finance investments doesn’t advertise in the local newspaper to
find a willing and desirable borrower. Moreover, an individual lender would not be able
to diversify across borrowers to reduce risk. Finally, an individual lender is not equipped to
assess and monitor the credit risk of borrowers.
For these reasons, financial intermediaries have evolved to bring lenders and borrowers together. These financial intermediaries include banks, investment companies, insurance companies, and credit unions. Financial intermediaries issue their own securities to
raise funds to purchase the securities of other corporations.
For example, a bank raises funds by borrowing (taking deposits) and lending that money
to other borrowers. The spread between the interest rates paid to depositors and the rates
charged to borrowers is the source of the bank’s profit. In this way, lenders and borrowers
do not need to contact each other directly. Instead, each goes to the bank, which acts as an
intermediary between the two. The problem of matching lenders with borrowers is solved
when each comes independently to the common intermediary.
Financial intermediaries are distinguished from other businesses in that both their assets
and their liabilities are overwhelmingly financial. Table 1.3 presents the aggregated balance sheet of commercial banks, one of the largest sectors of financial intermediaries.
Notice that the balance sheet includes only very small amounts of real assets. Compare
Table 1.3 to the aggregated balance sheet of the nonfinancial corporate sector in Table 1.4
for which real assets are about half of all assets. The contrast arises because intermediaries
simply move funds from one sector to another. In fact, the primary social function of such
intermediaries is to channel household savings to the business sector.
Other examples of financial intermediaries are investment companies, insurance companies, and credit unions. All these firms offer similar advantages in their intermediary
role. First, by pooling the resources of many small investors, they are able to lend considerable sums to large borrowers. Second, by lending to many borrowers, intermediaries
achieve significant diversification, so they can accept loans that individually might be too
risky. Third, intermediaries build expertise through the volume of business they do and can
use economies of scale and scope to assess and monitor risk.
Investment companies, which pool and manage the money of many investors, also
arise out of economies of scale. Here, the problem is that most household portfolios are not
large enough to be spread among a wide variety of securities. It is very expensive in terms

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Real assets
Equipment and
Other real estate
Total real assets

Financial assets
Investment securities
Loans and leases
Other financial assets
Total financial assets
Other assets
Intangible assets
Total other assets

$ Billion




% Total



Liabilities and Net Worth


Borrowed funds


Subordinated debt
Federal funds and
repurchase agreements



$ 9,549.1







$ 10,410.9


$ Billion

% Total

$ 6,865.3








Total liabilities

$ 9,361.3


Net worth

$ 1,049.6





TA B L E 1.3
Balance sheet of commercial banks, 2007
Note: Column sums may differ from total because of rounding error.
Source: Federal Deposit Insurance Corporation,, September 2007.


$ Billion

% Total

Real assets
Equipment and software
Real estate

$ 3,764






Total real assets
Financial assets
Deposits and cash
Marketable securities
Trade and consumer credit
Total financial assets






Liabilities and Net Worth

$ Billion

% Total

Bonds and mortgages
Bank loans
Other loans

$ 4,397


Trade debt



Total liabilities



Net worth





TA B L E 1.4
Balance sheet of nonfinancial U.S. business, 2007
Note: Column sums may differ from total because of rounding error.
Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2007.

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of brokerage fees and research costs to purchase one or two shares of many different firms.
Mutual funds have the advantage of large-scale trading and portfolio management, while
participating investors are assigned a prorated share of the total funds according to the size
of their investment. This system gives small investors advantages they are willing to pay
for via a management fee to the mutual fund operator.
Investment companies also can design portfolios specifically for large investors with
particular goals. In contrast, mutual funds are sold in the retail market, and their investment
philosophies are differentiated mainly by strategies that are likely to attract a large number
of clients.
Economies of scale also explain the proliferation of analytic services available to investors. Newsletters, databases, and brokerage house research services all engage in research
to be sold to a large client base. This setup arises naturally. Investors clearly want information, but with small portfolios to manage, they do not find it economical to personally
gather all of it. Hence, a profit opportunity emerges: A firm can perform this service for
many clients and charge for it.



Computer networks have made it much cheaper and easier for small investors to trade for their
own accounts and perform their own security analysis. What will be the likely effect on financial

Investment Bankers
Just as economies of scale and specialization create profit opportunities for financial intermediaries, so do these economies create niches for firms that perform specialized services
for businesses. Firms raise much of their capital by selling securities such as stocks and
bonds to the public. Because these firms do not do so frequently, however, investment
banking firms that specialize in such activities can offer their services at a cost below that
of maintaining an in-house security issuance division.
Investment bankers such as Goldman, Sachs or Merrill Lynch or Citigroup advise the
issuing corporation on the prices it can charge for the securities issued, appropriate interest
rates, and so forth. Ultimately, the investment banking firm handles the marketing of the
security in the primary market, where new issues of securities are offered to the public.
Later, investors can trade previously issued securities among themselves in the so-called
secondary market.
Investment bankers can provide more than just expertise to security issuers. Because
investment bankers are constantly in the market, assisting one firm or another in issuing
securities, it is in their own interest to protect and maintain their reputation for honesty.
Their investment in reputation is another type of scale economy that arises from frequent
participation in the capital markets. An investment banker will suffer along with investors
if the securities it underwrites are marketed to the public with overly optimistic or exaggerated claims; the public will not be so trusting the next time that investment banker participates in a security sale. As we have seen, this lesson was relearned with considerable pain
in the boom years of the late 1990s and the subsequent high-tech crash of 2000–2002. Too
many investment bankers got caught up in the flood of money that could be made by pushing stock issues to an overly eager public. The failure of many of these offerings soured the
public on both the stock market and the firms managing the IPOs. At least some on Wall
Street recognized that they had squandered a valuable asset—reputational capital—and
that the conflicts of interest that engendered these deals were not only wrong but bad for
business as well. An investment banker’s effectiveness and ability to command future business depend on the reputation it has established over time.

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Four important trends have changed the contemporary investment environment: (1) globalization, (2) securitization, (3) financial engineering, and (4) information and computer

If a wider range of investment choices can benefit investors, why should we limit ourselves
to purely domestic assets? Increasingly efficient communication technology and the dismantling of regulatory constraints have encouraged globalization in recent years.
U.S. investors commonly can participate in foreign investment opportunities in several ways: (1) purchase foreign securities using American Depository Receipts (ADRs), which are domestically
traded securities that represent claims to shares of foreign
stocks; (2) purchase foreign securities that are offered in
dollars; (3) buy mutual funds that invest internationally;
and (4) buy derivative securities with payoffs that depend
on prices in foreign security markets.
Brokers who act as intermediaries for American Depository Receipts purchase an inventory of stock from some
foreign issuer. The broker then issues an American Depository Receipt that represents a claim to some number of those
foreign shares held in inventory. The ADR is denominated
in dollars and can be traded on U.S. stock exchanges but is
in essence no more than a claim on a foreign stock. Thus,
from the investor’s point of view, there is no more difference
between buying a British versus a U.S. stock than there is in
holding a Massachusetts-based company compared with a
California-based one. Of course, the investment implication
may differ: ADRs still expose investors to exchange-rate risk.
Exchange-traded funds, or ETFs, are a variation on
ADRs. ETFs also use a depository structure but buy entire
portfolios of stocks. While ETFs may specialize in sectors
as diverse as commodities or individual industries, others
buy shares of firms of one particular country. These funds
thus enable U.S. investors to obtain and trade diversified
portfolios of foreign stocks in one fell swoop. Popular
ETF brands are iShares (marketed by Barclays) or WEBS
(World Equity Benchmark Shares), which are designed to
replicate the investment performance of Morgan Stanley
Capital International (MSCI) country indexes.
A giant step toward globalization took place in 1999
when 11 European countries replaced their existing currencies with a new currency called the euro.6 The idea behind
F I G U R E 1.1 Globalization: A debt issue
denominated in euros
the euro is that a common currency will facilitate trade and
encourage integration of markets across national boundSource: North West Water Finance PLC, April 1999.
aries. Figure 1.1 is an announcement of a debt offering in

The 11 countries are Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, Netherlands, Austria, Portugal, and Finland. Greece and Slovenia later adopted the common currency. Several other countries, primarily in
middle and eastern Europe, have joined the European Union and are likely to adopt the euro in the next few years.

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PART I Introduction
the amount of 500 million euros. (In
early 2008, the euro was worth about
$1.45; the symbol for the euro is €.)





Student loan

In 1970, mortgage pass-through
securities were introduced by the
Credit card
Government National Mortgage
Association (GNMA, or Ginnie
Mae). These securities aggregate
individual home mortgages into
relatively homogeneous pools. Each
pool acts as backing for a GNMA
pass-through security. Investors
who buy GNMA securities receive
prorated shares of all the principal
and interest payments made on the
underlying mortgage pool.
For example, the pool might total
F I G U R E 1.2 Asset-backed securities outstanding
$100 million of 8%, 30-year conventional mortgages. The banks that
Source: The Securities Industry and Financial Markets Association,
originated the mortgages continue
to service them (receiving fee-forservice), but they no longer own the mortgage investment; they pass the cash flows from
the underlying mortgages through to the GNMA security holders.
Pass-through securities represented a tremendous innovation in mortgage markets.
The securitization of mortgages means mortgages can be traded just like other securities.
Availability of funds to homebuyers no longer depends on local credit conditions and is
no longer subject to local banks’ potential monopoly powers; with mortgage pass-throughs
trading in national markets, mortgage funds can flow from any region (literally worldwide)
to wherever demand is greatest.
Securitization also expands the menu of choices for the investor. Whereas it would have
been impossible before 1970 for investors to invest in mortgages directly, they now can
purchase mortgage pass-through securities or invest in mutual funds that offer portfolios
of such securities.
Today, the majority of home mortgages are pooled into mortgage-backed securities. The
two biggest players in the market are the Federal National Mortgage Association (FNMA, or
Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac).
Over $3.5 trillion of mortgage-backed securities are outstanding, making this market larger
than the market for corporate bonds.
Other loans that have been securitized into pass-through arrangements include car loans,
student loans, home equity loans, credit card loans, and debts of firms. Figure 1.2 documents the rapid growth of nonmortgage asset–backed securities since 1996.



bod8237x_ch01_001-022.indd 16













$ Billion

Home equity

When mortgages are pooled into securities, the pass-through agencies (Freddie Mac and
Fannie Mae) typically guarantee the underlying mortgage loans. If the homeowner defaults
on the loan, the pass-through agency makes good on the loan; the investor in the mortgagebacked security does not bear the credit risk. Why does the allocation of risk to the passthrough agency rather than the security holder make economic sense?

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CHAPTER 1 The Investment Environment


Financial Engineering
Financial engineering is the use of mathematical models and computer-based trading
technology to synthesize new financial products. A good example of a financially engineered investment product is the principal-protected equity-linked note. These are securities issued by financial intermediaries that guarantee a minimum fixed return plus an
additional amount that depends on the performance of some specified stock index, such
as the S&P 500.
Financial engineering often involves unbundling securities—breaking up and allocating the cash flows from one security to create several new securities—or bundling—
combining more than one security into a composite security. Such creative engineering of
new investment products allows one to design securities with custom-tailored risk attributes. An example of bundling appears in Figure 1.3.
Boise Cascade, with the assistance of Goldman, Sachs and other underwriters, has
issued a hybrid security with features of preferred stock combined with various call and
put option contracts. The security is structured as preferred stock for 4 years, at which time
it is converted into common stock of the company. However, the number of shares of common stock into which the security can be converted depends on the price of the stock in
4 years, which means that the security holders are exposed to risk similar to the risk they
would bear if they held option positions on the firm.
Often, creating a security that appears to be attractive requires the unbundling of an
asset. An example is given in Figure 1.4.
There, a mortgage pass-through certificate is


Boise Cascade Corporation
7.50% Adjustable Conversion-rate
Equity Security Unit

Price $50 Per Unit

Upon request, a copy of the Prospectus Supplement and the related Prospectus
describing these securities and the business of the Company may be obtained within any
State from the Underwriter who may legally distribute it within such State. The securities
are offered only by means of the Prospectus Supplement and the related Prospectus
and this announcement is neither an offer to sell nor a solicitation of any offer to buy.

Goldman, Sachs & Co.
ABN AMRO Rothschild LLC
Banc of America Securities LLC
Wachovia Securities
December 19, 2001

F I G U R E 1.3 Bundling creates a
complex security
Source: The Wall Street Journal, December 19, 2001.

bod8237x_ch01_001-022.indd 17

FIGURE 1.4 Unbundling of mortgages
into principal- and interest-only
Source: Copyright March 1985 by Goldman, Sachs
& Co. Published by Goldman, Sachs & Co., March
1985. Reprinted by permission.

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PART I Introduction
unbundled into classes. Class 1 receives only principal payments from the mortgage pool,
whereas Class 2 receives only interest payments.

Computer Networks
The Internet and other advances in computer networking have transformed many sectors
of the economy, and few more so than the financial sector. These advances will be treated
in greater detail in Chapter 3, but for now we can mention a few important innovations:
online trading, online information dissemination, and automated trade crossing.
Online trading connects a customer directly to a brokerage firm. Online brokerage firms
can process trades more cheaply and therefore can charge lower commissions. The average
commission for an online trade is below $20, compared to more than $100 at full-service
The Internet has also allowed vast amounts of information to be made cheaply and widely
available to the public. Individual investors today can obtain data, investment tools, and even
analyst reports that just a decade ago would have been available only to professionals.
Electronic communication networks that allow direct trading among investors have
exploded in recent years. These networks allow members to post buy or sell orders and to
have those orders automatically matched up or “crossed” with orders of other traders in the
system without benefit of an intermediary such as a securities dealer.


The text has seven parts, which are fairly independent and may be studied in a variety of
sequences. Part One is an introduction to financial markets, instruments, and trading of
securities. This part also describes the mutual fund industry.
Parts Two and Three contain the core of what has come to be known as “modern portfolio theory.” We start in Part Two with a general discussion of risk and return and the lessons of capital market history. We then focus more closely on how to describe investors’
risk preferences and progress to asset allocation, efficient diversification, and portfolio
In Part Three, we investigate the implications of portfolio theory for the equilibrium
relationship between risk and return. We introduce the capital asset pricing model, its
implementation using index models, and more advanced models of risk and return. This
part also treats the efficient market hypothesis as well as behavioral critiques of theories
based on investor rationality and closes with a chapter on empirical evidence concerning
security returns.
Parts Four through Six cover security analysis and valuation. Part Four is devoted to
debt markets and Part Five to equity markets. Part Six covers derivative assets, such as
options and futures contracts.
Part Seven is an introduction to active investment management. It shows how different
investors’ objectives and constraints can lead to a variety of investment policies. This part
discusses the role of active management in nearly efficient markets and considers how one
should evaluate the performance of managers who pursue active strategies. It also shows
how the principles of portfolio construction can be extended to the international setting and
examines the hedge fund industry.

bod8237x_ch01_001-022.indd 18

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CHAPTER 1 The Investment Environment
1. Real assets create wealth. Financial assets represent claims to parts or all of that wealth. Financial
assets determine how the ownership of real assets is distributed among investors.



2. Financial assets can be categorized as fixed income, equity, or derivative instruments. Top-down
portfolio construction techniques start with the asset allocation decision—the allocation of funds
across broad asset classes—and then progress to more specific security-selection decisions.
3. Competition in financial markets leads to a risk–return trade-off, in which securities that offer
higher expected rates of return also impose greater risks on investors. The presence of risk, however, implies that actual returns can differ considerably from expected returns at the beginning of
the investment period. Competition among security analysts also promotes financial markets that
are nearly informationally efficient, meaning that prices reflect all available information concerning the value of the security. Passive investment strategies may make sense in nearly efficient

5. Investment banking brings efficiency to corporate fund-raising. Investment bankers develop
expertise in pricing new issues and in marketing them to investors.
6. Recent trends in financial markets include globalization, securitization, financial engineering of
assets, and growth of information and computer networks.

real assets
financial assets
fixed-income (debt) securities
derivative securities
agency problem
asset allocation

security selection
security analysis
risk–return trade-off
passive management
active management
financial intermediaries
investment companies
investment bankers

primary market
secondary market
pass-through securities
financial engineering

1. Financial engineering has been disparaged as nothing more than paper shuffling. Critics argue
that resources used for rearranging wealth (that is, bundling and unbundling financial assets)
might be better spent on creating wealth (that is, creating real assets). Evaluate this criticism.
Are any benefits realized by creating an array of derivative securities from various primary
2. Why would you expect securitization to take place only in highly developed capital markets?

Related Web sites for
this chapter are available


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4. Financial intermediaries pool investor funds and invest them. Their services are in demand
because small investors cannot efficiently gather information, diversify, and monitor portfolios.
The financial intermediary sells its own securities to the small investors. The intermediary invests
the funds thus raised, uses the proceeds to pay back the small investors, and profits from the difference (the spread).


3. What is the relationship between securitization and the role of financial intermediaries in the
economy? What happens to financial intermediaries as securitization progresses?
4. Although we stated that real assets comprise the true productive capacity of an economy, it is hard
to conceive of a modern economy without well-developed financial markets and security types.
How would the productive capacity of the U.S. economy be affected if there were no markets in
which one could trade financial assets?
5. Firms raise capital from investors by issuing shares in the primary markets. Does this imply that
corporate financial managers can ignore trading of previously issued shares in the secondary

bod8237x_ch01_001-022.indd 19

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PART I Introduction


6. Suppose you discover a treasure chest of $10 billion in cash.

Is this a real or financial asset?
Is society any richer for the discovery?
Are you wealthier?
Can you reconcile your answers to (b) and (c)? Is anyone worse off as a result of the

7. Lanni Products is a start-up computer software development firm. It currently owns computer
equipment worth $30,000 and has cash on hand of $20,000 contributed by Lanni’s owners. For
each of the following transactions, identify the real and/or financial assets that trade hands. Are
any financial assets created or destroyed in the transaction?
a. Lanni takes out a bank loan. It receives $50,000 in cash and signs a note promising to pay
back the loan over 3 years.
b. Lanni uses the cash from the bank plus $20,000 of its own funds to finance the development
of new financial planning software.
c. Lanni sells the software product to Microsoft, which will market it to the public under the
Microsoft name. Lanni accepts payment in the form of 1,500 shares of Microsoft stock.
d. Lanni sells the shares of stock for $80 per share and uses part of the proceeds to pay off the
bank loan.

Visit us at

8. Reconsider Lanni Products from Problem 7.
a. Prepare its balance sheet just after it gets the bank loan. What is the ratio of real assets to
total assets?
b. Prepare the balance sheet after Lanni spends the $70,000 to develop its software product.
What is the ratio of real assets to total assets?
c. Prepare the balance sheet after Lanni accepts the payment of shares from Microsoft. What is
the ratio of real assets to total assets?
9. Examine the balance sheet of commercial banks in Table 1.3. What is the ratio of real assets to
total assets? What is that ratio for nonfinancial firms (Table 1.4)? Why should this difference be
10. Consider Figure 1.5, which describes an issue of American gold certificates.
a. Is this issue a primary or secondary market transaction?
b. Are the certificates primitive or derivative assets?
c. What market niche is filled by this offering?
11. Discuss the advantages and disadvantages of the following forms of managerial compensation in terms of
mitigating agency problems, that is, potential conflicts of
interest between managers and shareholders.
a. A fixed salary.
b. Stock in the firm.
c. Call options on shares of the firm.
12. We noted that oversight by large institutional investors or
creditors is one mechanism to reduce agency problems.
Why don’t individual investors in the firm have the same
incentive to keep an eye on management?
13. Give an example of three financial intermediaries and
explain how they act as a bridge between small investors
and large capital markets or corporations.
14. The average rate of return on investments in large stocks has
outpaced that on investments in Treasury bills by about 8%
since 1926. Why, then, does anyone invest in Treasury bills?

F I G U R E 1.5

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A gold-backed security

15. What are some advantages and disadvantages of topdown versus bottom-up investing styles?

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