Ebook Investment analysis & portfolio management (Tenth edition): Part 2

Ebook Investment analysis & portfolio management (Tenth edition): Part 2 presents the following content: Analysis and management of bonds, derivative security analysis, specification and evaluation of asset management, appendix A: how to become a CFA charterholder, appendix B: code of ethics and standards of professional conduct, appendix C: interest tables, appendix D: standard normal probabilities.

WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM PART Analysis and Management of Bonds Chapter 17 Bond Fundamentals Chapter 18 The Analysis and Valuation of Bonds Chapter 19 Bond Portfolio Management Strategies 589 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 590 For most investors, bonds receive limited attention and very little respect This is surprising when one considers that the total market value of the bond market in the United States and in most other countries is substantially larger than the market value of the stock market For example, at the end of 2010 the market value of all publicly issued bonds in the U.S was more than $30 trillion, while the market value of all stocks was about $18 trillion On a global basis, the values are about $61 trillion for bonds versus $43 trillion for stocks Beyond the size factor, bonds have a reputation for low, unexciting rates of return Although this may have been true 40 or 50 years ago, it certainly has not been true during the past 30 years Specifically, the average annual compound rate of return on government/corporate bonds for the period 1980–2010 was over percent versus almost 11 percent for common stocks These rates of return along with corresponding standard deviations (6 percent for bonds versus 16 percent for stocks) and the relatively low correlation between stocks and bonds (about 0.21) indicate that there are substantial opportunities in bonds for individual and institutional investors to enhance their risk-return performance The chapters in this section are intended to provide (1) a basic understanding of bonds and the bond markets around the world, (2) background on analyzing returns and risks in the bond market, (3) insights regarding the valuation of bonds, including numerous new fixedincome securities with very unusual cash flow characteristics, and (4) an understanding of either active or passive bond portfolio management Chapter 17 describes the global bond market in terms of country participation and the makeup of the bond market in major countries Also, we examine characteristics of bonds in alternative categories, such as government, corporate, and municipal We also discuss the many new corporate bond instruments developed in the United States, such as asset-backed securities, zero-coupon bonds, high-yield bonds, and inflation protection securities While the use of these securities globally has generally been limited to the large developed markets, it is certain that they will eventually be used around the world Finally, we consider sources of price information needed by bond investors Chapter 18 is concerned with the analysis and valuation of bonds This includes a detailed discussion of how one values a bond using a single discount rate or using spot rates We also evaluate alternative rate of return measures for bonds Subsequently, we consider what factors affect yields on bonds and what characteristics influence the volatility of bond returns, including the very important concept of bond duration, which is a measure of bond price volatility that is important in active and passive bond portfolio management We also consider bond convexity and the impact it has on bond price volatility Notably, these concepts are examined for option-free securities We also consider how they apply to a growing set of securities with embedded options Chapter 19 considers how to use the background provided in Chapter 17 and Chapter 18 to create and manage a bond portfolio We consider three major categories of portfolio strategies in detail The first is passive portfolio management strategies, which include either a simple buy-and-hold strategy or indexing to one of the major benchmarks The second category includes active management strategies that can involve one of five alternatives: interest rate anticipation, valuation analysis, credit analysis, yield spread analysis, or bond swaps The third category includes matched funding strategies, which include constructing dedicated portfolios, constructing classical or contingent immunization portfolios, or horizon matching The fact that three fairly long chapters are devoted to the study of bonds attests to the importance of the topic and the extensive research done in this area During the past 20 years, there have been more developments related to the valuation and portfolio management of bonds than of stocks This growth of the fixed-income sector does not detract from the importance of equities but certainly enhances the significance of fixed-income securities Finally, readers should keep in mind that this growth in size, sophistication, and specialization of the bond market implies numerous and varied career opportunities in the bond area, including trading these securities, valuation, credit analysis, and domestic and global portfolio management WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM CHAPTER 17 Bond Fundamentals After you read this chapter, you should be able to answer the following questions: • What are some of the basic features of bonds that affect their risk, return, and value? • What is the current country structure of the world bond market, and how has the makeup of the global bond market changed in recent years? • What are the major components of the world bond market and the international bond market? • How does the makeup of the bond market differ in major countries? • What are bond ratings, and what is their purpose? What is the difference between investment-grade bonds and high-yield (junk) bonds? • What are the characteristics of bonds in the major bond categories, such as governments (including TIPS), agencies, municipalities, and corporates? • What are the important characteristics of corporate bond issues developed in the United States during the past decade, such as mortgage-backed securities, other asset-backed securities, zero-coupon and deep discount bonds, high-yield bonds, and structured notes? • How you read the quotes available for the alternative bond categories (e.g., governments, municipalities, and corporates)? The global bond market is large and diverse and represents an important investment opportunity This chapter is concerned with publicly issued, long-term, nonconvertible debt obligations of public and private issuers in the United States and major global markets In later chapters, we consider preferred stock and convertible bonds An understanding of bonds is helpful in an efficient market because the existence of U.S and foreign bonds increases the universe of investments available for the creation of a diversified portfolio In this chapter, we review some basic features of bonds and examine the structure of the world bond market The bulk of the chapter involves an in-depth discussion of the major fixed-income investments The chapter ends with a brief review of the price information sources for bond investors The reader may also want to revisit Chapter 5, which contains a detailed description of the major bond indexes and how they relate to one another 17.1 BASIC FEATURES OF A BOND Public bonds are long-term, fixed-obligation debt securities packaged in convenient, affordable denominations for sale to individuals and financial institutions They differ from other debt, such as individual mortgages and privately placed debt obligations, because they are sold to the public rather than channeled directly to a single lender Bond issues are considered fixed-income 591 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 592 Part 5: Analysis and Management of Bonds securities because they impose fixed financial obligations on the issuers Specifically, the issuer of a bond agrees to: Pay a fixed amount of interest periodically to the holder of record Repay a fixed amount of principal at the date of maturity Normally, interest on bonds is paid every six months, although some bond issues pay in intervals as short as a month or as long as a year The principal is due at maturity; this par value of the issue is rarely less than $1,000 A bond has a specified term to maturity, which defines the life of the issue The public debt market typically is divided into three time segments based on an issue’s original maturity: Short-term issues with maturities of one year or less The market for these instruments is commonly known as the money market Intermediate-term issues with maturities in excess of year but less than 10 years These instruments are known as notes Long-term obligations with maturities in excess of 10 years, called bonds The lives of debt obligations change constantly as the issues progress toward maturity Thus, issues that have been outstanding in the secondary market for any period of time eventually move from long term to intermediate to short term This change in maturity is important because a major determinant of the price volatility of bonds is the remaining life (maturity) of the issue 17.1.1 Bond Characteristics A bond can be characterized based on (1) its intrinsic features, (2) its type, (3) its indenture provisions, or (4) the features that affect its cash flows and/or its maturity Intrinsic Features The coupon, maturity, principal value, and the type of ownership are important intrinsic features of a bond The coupon of a bond indicates the income that the bond investor will receive over the life (or holding period) of the issue This is known as interest income, coupon income, or nominal yield The term to maturity specifies the date or the number of years before a bond matures (or expires) There are two different types of maturity The most common is a term bond, which has a single maturity date Alternatively, a serial obligation bond issue has a series of maturity dates, perhaps 20 or 25 Each maturity, although a subset of the total issue, is really a small bond issue with generally a different coupon Municipalities issue most serial bonds The principal, or par value, of an issue represents the original value of the obligation This is generally stated in $1,000 increments from $1,000 to $25,000 or more Principal value is not the same as the bond’s market value The market prices of many issues rise above or fall below their principal values because of differences between their coupons and the prevailing market rate of interest If the market interest rate is above the coupon rate, the bond will sell at a discount to par If the market rate is below the bond’s coupon, it will sell at a premium above par If the coupon is comparable to the prevailing market interest rate, the market value of the bond will be close to its original principal value Finally, bonds differ in terms of ownership With a bearer bond, the holder, or bearer, is the owner, so the issuer keeps no record of ownership Interest from a bearer bond is obtained by clipping coupons attached to the bonds and sending them to the issuer for payment In contrast, the issuers of registered bonds maintain records of owners and pay the interest directly to the current owner of record Types of Issues In contrast to common stock, companies can have many different bond issues outstanding at the same time Bonds can have different types of collateral and be either senior, unsecured, or subordinated (junior) securities Secured (senior) bonds are backed by a legal claim on some specified property of the issuer in the case of default For example, WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Chapter 17: Bond Fundamentals 593 mortgage bonds can be secured by real estate assets; equipment trust certificates, which are used by railroads and airlines, provide a senior claim on the firm’s equipment Unsecured bonds (debentures) are backed only by the promise of the issuer to pay interest and principal on a timely basis As such, they are secured by the general credit of the issuer Subordinate (junior) debentures possess a claim on income and assets that is subordinated to other debentures Income issues are the most junior type because interest on them is paid only if it is earned Although income bonds are unusual in the corporate sector, they are very popular municipal issues, where they are referred to as revenue bonds Finally, refunding issues provide funds to prematurely retire another issue The type of issue has only a marginal effect on comparative yield because it is the creditworthiness of the issuer that determines bond quality A study of corporate bond price behavior by Hickman (1958) found that whether the issuer pledged collateral did not become important until the bond issue approached default The collateral and security characteristics of a bond influence yield differentials only when these factors affect the bond’s quality ratings Indenture Provisions The indenture is the contract between the issuer and the bondholder specifying the issuer’s legal requirements A trustee (usually a bank) acting on behalf of the bondholders ensures that all the indenture provisions are met, including the timely payment of interest and principal All the factors that dictate a bond’s features, its type, and its maturity are set forth in the indenture Features Affecting a Bond’s Maturity Investors should be aware of the three alternative call option features that can affect the life (maturity) of a bond One extreme is a freely callable provision that allows the issuer to retire the bond at any time with a typical notification period of 30 to 60 days The other extreme is a noncallable provision wherein the issuer cannot retire the bond prior to its maturity.1 Intermediate between these is a deferred call provision, which means the issue cannot be called for a certain period of time after the date of issue (e.g., to 10 years) At the end of the deferred call period, the issue becomes freely callable Callable bonds have a call premium, which is the amount above maturity value that the issuer must pay to the bondholder for prematurely retiring the bond A nonrefunding provision prohibits a call and premature retirement of an issue from the proceeds of a lower-coupon refunding bond This is meant to protect the bondholder from a typical refunding, but it is not foolproof An issue with a nonrefunding provision can be called and retired prior to maturity using other sources of funds, such as excess cash from operations, the sale of assets, or proceeds from a sale of common stock This occurred on several occasions during the 1980s and 1990s when many issuers retired nonrefundable high-coupon issues early because they could get the cash from one of these other sources and felt that this was a good financing decision Another important indenture provision that can affect a bond’s maturity is the sinking fund, which specifies that a bond must be paid off systematically over its life rather than only at maturity There are numerous sinking-fund arrangements, and the bondholder should recognize this as a feature that can change the stated maturity of a bond The size of the sinking fund can be a percentage of a given issue or a percentage of the total debt outstanding, or it can be a fixed or variable sum stated on a dollar or percentage basis Similar to a call feature, sinking fund payments may commence at the end of the first year or may be deferred for or 10 years from date of the issue The amount of the issue that must be repaid before maturity from a sinking fund can range from a nominal sum to 100 percent Like a call, the sinkingfund feature typically carries a nominal premium but is generally smaller than the straight The main issuer of noncallable bonds between 1985 and 2011 was the U.S Treasury Corporate long-term bonds typically have contained some form of call provision, except during periods of relatively low interest rates (e.g., 1994–2001; 2010–2011) when the probability of exercising the option was very low We discuss this notion in more detail in Chapter 18 in connection with the analysis of embedded options WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 594 Part 5: Analysis and Management of Bonds call premium (e.g., percent) For example, a bond issue with a 20-year maturity might have a sinking fund that requires that percent of the issue be retired every year beginning in year 10 The effect of this is that by year 20, half of the issue has been retired and the rest is paid off at maturity Sinking-fund provisions have a small effect on comparative yields at the time of issue but have little subsequent impact on price behavior A sinking-fund provision is an obligation and must be carried out regardless of market conditions Although a sinking fund allows the issuer to call bonds on a random basis, most bonds are retired for sinking-fund purposes through direct negotiations with institutional holders Essentially, the trustee negotiates with an institution to buy back the necessary amount of bonds at a price slightly above the current market price 17.1.2 Rates of Return on Bonds The rate of return on a bond is computed in the same way as the rate of return on stock or any asset It is determined by the beginning and ending price and the cash flows during the holding period The major difference between stocks and bonds is that the interim cash flow on bonds (i.e., the interest) is contractual and accrues over time, as discussed subsequently, whereas the dividends on stock may vary Therefore, the holding period return (HPR) for a bond will be: HPRi,t = 17.1 Pi,t + + Int i,t Pi,t where: HPRi,t = the holding period return for bond i during Period t Pi,t+1 = the market price of bond i at the end of Period t Pi,t = the market price of bond i at the beginning of Period t Inti,t = the interest paid or accrued on bond i during Period t: Because the interest      payment is contractual, it accrues over time, and if a bond owner sells the      bond between interest payments, the sale price includes accrued interest:2 The holding period yield (HPY) is: 17.2 HPY = HPR − Note that the only contractual factor is the amount of interest payments The beginning and ending bond prices are determined by market forces, as discussed in Chapter 11 Notably, the ending price is determined by market forces unless the bond is held to maturity, in which case the investor will receive the par value These price variations in bonds mean that investors in bonds can experience capital gains or losses Interest rate volatility has increased substantially since the 1960s, and this has caused large price fluctuations in bonds.3 As a result, capital gains or losses have become a major component of the rates of return on bonds 17.2 THE GLOBAL BOND MARKET STRUCTURE4 The market for fixed-income securities is substantially larger than the listed equity exchanges (NYSE, TSE, LSE) because corporations tend to issue bonds rather than common stock Figures released by Securities Industry and Financial Markets Association (SIFMA) indicate The concept of accrued interest will be discussed further in Chapter 18, when we consider the valuation of bonds The analysis of bond price volatility is discussed in detail in Chapter 18 For a further discussion of global bond markets, see Ramanathan (2012), “International Bond Markets and Instruments”; Ramanathan, Fabozzi, and Gerard (2012), “International Bond Investing and Portfolio Management”; and Malvey (2012), “Global Credit Bond Portfolio Management,” all in The Handbook of Fixed-Income Securities, 8th ed., ed Frank J Fabozzi (New York: McGraw-Hill, 2012) WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Chapter 17: Bond Fundamentals 595 Exhibit 17.1 Estimated Total Face Value and Percentage of Total for Significant Markets (USD Terms in Millions) 2010 (e) Currency U.S Dollar Euro Japanese Yen Pound Sterling Canadian Dollar Indian Rupee Australian Dollar Swedish Krone Korean Won Danish Krone Swiss Franc All Other Total 2009 (e) $ U.S Percent $ U.S Percent 15,390,400 10,787,740 5,724,500 1,578,720 768,525 220,455 197,600 159,750 158,360 120,458 114,493 354,170 35,575,171 43.26% 30.32% 16.09% 4.44% 2.16% 0.62% 0.56% 0.45% 0.45% 0.34% 0.32% 1.00% 100.00% 14,225,440 10,082,160 5,350,620 1,518,220 725,208 207,092 191,781 150,080 147,936 113,422 106,748 331,141 33,149,848 42.91% 30.41% 16.14% 4.58% 2.19% 0.62% 0.58% 0.45% 0.45% 0.34% 0.32% 1.00% 100.00% Source: Estimated by authors based on data from Bank of America Merrill Lynch Global Research that in the United States during 2010, less than 10 percent of all new security issues were equity, which included preferred as well as common stock Corporations issue less common or preferred stock because firms derive most of their equity financing from internally generated funds (i.e., retained earnings) Also, although the equity market is strictly corporations, the bond market in most countries has four noncorporate sectors: the pure government sector (e.g., the Treasury in the United States), government agencies (e.g., FNMA), state and local government bonds (municipals), and international bonds (e.g., Yankees and Eurobonds in the United States) The size of the global bond market and the distribution among countries can be gleaned from Exhibit 17.1, which lists the dollar value of debt outstanding and the percentage distribution for the major currencies for the years 2009–2010 There has been consistent overall growth, at the rate of to 10 percent a year Also, the currency trends are significant Specifically, the U.S dollar market went from 45 percent of the total world bond market in 2002 to about 43 percent in 2010 A significant change in 1999 was the creation of the Eurozone sector, which includes a large part of Europe (i.e., Germany, Italy, France) with the significant exception of the United Kingdom Notably, this euro currency sector has held at about 30 percent over the last decade 17.2.1 Participating Issuers In a report from Bank of America Merrill Lynch Global Research, there are five different categories of bonds for each currency: (1) sovereign bonds (e.g., the U.S Treasury), (2) quasi and foreign governments (including agency bonds), (3) securitized and collateralized bonds from governments or corporations, (4) directly issued corporate bonds, and (5) high-yield and/or emerging market bonds The division of bonds among these five categories for three large currency markets and the Eurozone during 2010 is contained in Exhibit 17.2 Sovereigns The market for government securities is the largest sector in Japan It involves a variety of debt instruments issued to meet the growing needs of this government It is generally a stable component for other currencies WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 596 Part 5: Analysis and Management of Bonds Exhibit 17.2 Estimated Makeup of Bonds Outstanding by Currency: December 31, 2010 (USD Terms in Millions) 2010 (e) Total Value Percent of Total A U.S Dollars Sovereign Quasi & Foreign Govt Securitized/Collateralized Corporate High-Yield/Emerging Mkt Total 5,309,688 1,939,190 4,247,750 2,801,053 1,108,109 15,405,790 34.5 12.6 27.6 18.2 7.1 100.0 B Euros Sovereign Quasi & Foreign Govt Securitized/Collateralized Corporate High-Yield/Emerging Mkt Total 6,914,941 852,231 1,326,892 1,564,222 140,241 10,798,527 64.1 7.9 12.3 14.5 1.3 100.0 C Japanese Yen Sovereign Quasi & Foreign Govt Securitized/Collateralized Corporate High-Yield/Emerging Mkt Total 4,659,743 429,337 5,724 635,420 5,730,224 81.4 7.5 0.1 11.1 0.0 100.0 D Pound Sterling Sovereign Quasi & Foreign Govt Securitized/Collateralized Corporate High-Yield/Emerging Mkt Total 792,517 202,076 94,723 472,037 17,366 1,578,719 50.2 12.8 6.0 29.9 1.1 100.0 Source: Estimates by authors based on historical data from Bank of America Merrill Lynch Global Research Quasi Governments (Agencies) and Foreign Governments Agency issues have become a major segment in the U.S dollar and pound sterling market (over 12 percent) but are a smaller proportion in other countries (e.g., about percent in Japan) These agencies represent political subdivisions of the government, although the securities are not typically direct obligations of the government The U.S agency market has two types of issuers: government-sponsored enterprises and federal agencies The proceeds of agency bond issues are used to finance many legislative programs Foreign government issues are from a country but not in its own currency (e.g., a Japanese government issue denominated in dollars and sold in the United States) Securitized/Collateralized Issues These can be either government agencies or corporate issues that are backed by cash flow securities such as mortgages or car loans Collateralized securities can include several different issues and structured cash flows As shown in Exhibit 17.2, this has become a major sector in the United States and is fairly strong in the Eurozone countries Therefore, they will be discussed in detail in a subsequent section Corporations The major nongovernmental issuer of debt is the corporate sector The importance of this sector differs dramatically among countries It is a slow growth component in the WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Chapter 17: Bond Fundamentals 597 United States; a smaller sector in Japan and in the euro currency countries, and a significant part of the pound sterling market The market for corporate bonds is commonly subdivided into several segments: industrials, public utilities, transportation, and financial issues The specific makeup varies among countries.5 High-Yield/Emerging Market This section includes both high-yield bonds (noninvestment grade) from corporations in developed countries, and both government and corporate issues from emerging market countries such as China and India, where the bonds can be either investment grade or high yield (noninvestment grade) Notably, the only currency where this sector is significant is the U.S dollar market, where it constitutes over percent The other currencies have only nominal amounts currently, but these sectors are expected to experience significant growth in the future 17.2.2 Participating Investors Numerous individual and institutional investors with diverse investment objectives participate in the bond market Individual investors are a minor portion because of the market’s complexity and the high minimum denominations of most issues Institutional investors typically account for 90 to 95 percent of the trading, although different segments of the market are more institutionalized than others For example, institutions are involved heavily in the agency market, but they are less active in the corporate sector A variety of institutions invest in the bond market Life insurance companies invest in corporate bonds and, to a lesser extent, in Treasury and agency securities Commercial banks invest in municipal bonds and government and agency issues Property and liability insurance companies concentrate on municipal bonds and Treasuries Private and government pension funds are heavily committed to corporates but also invest in Treasuries and agencies Finally, fixed-income mutual funds have experienced significant growth, and their demand spans the full spectrum of the market as they develop bond funds that meet the needs of a variety of investors As we will discuss in Chapter 24, municipal bond funds and corporate bond funds (including high-yield bonds) have experienced significant growth Alternative institutions tend to favor different sectors of the bond market based on two factors: (1) the tax code applicable to the institution, and (2) the nature of the institution’s liability structure For example, because commercial banks are subject to normal taxation and have fairly short-term liability structures, they favor short- to intermediate-term municipals Pension funds are virtually tax-free institutions with long-term commitments, so they prefer high-yielding, long-term government or corporate bonds Such institutional investment preferences can affect the short-run supply and demand of loanable funds and impact interest rate changes 17.2.3 Bond Ratings Agency ratings are an integral part of the bond market because most corporate and municipal bonds are rated by one or more of the rating agencies The exceptions are very small issues and bonds from certain industries, such as bank issues These are known as nonrated bonds There are three major rating agencies: (1) Fitch Investors Service, (2) Moody’s, and (3) Standard and Poor’s This sector of the bond market is described in more detail later in this chapter It is possible to distinguish another sector that exists in the United States but not in other countries—institutional bonds These are corporate bonds issued by a variety of private, nonprofit institutions, such as schools, hospitals, and churches They are not broken out because they are only a minute part of the U.S market and not exist elsewhere WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 598 Part 5: Analysis and Management of Bonds Bond ratings provide the fundamental analysis for thousands of issues The rating agencies analyze the issuing organization and the specific issue to determine the probability of default and inform the market of their analyses through their ratings.6 The primary question in bond credit analysis is whether the firm can service its debt in a timely manner over the life of a given issue Consequently, the rating agencies consider expectations over the life of the issue, along with the historical and current financial position of the company We consider default estimation further when we discuss high-yield (junk) bonds Studies by authors such as Belkaoui (1980) and Gentry, Whitford, and Newbold (1988) have examined the relationship between bond ratings and issue quality as indicated by financial variables The results clearly demonstrated that bond ratings were positively related to profitability, size, and cash flow coverage, and they were inversely related to financial leverage and earnings instability The original ratings assigned to bonds have an impact on their marketability and effective interest rate Generally, the three agencies’ ratings agree When they not, the issue is said to have a split rating.7 Seasoned issues are regularly reviewed to ensure that the assigned rating is still valid If not, revisions are made either upward or downward Revisions are usually done in increments of one rating grade The ratings are based on both the company and the issue After an evaluation of the creditworthiness of the total company is completed, a company rating is assigned to the firm’s most senior unsecured issue All junior bonds receive lower ratings based on indenture specifications Also, an issue could receive a higher rating than justified because of credit-enhancement devices, such as the attachment of bank letters of credit, surety, or indemnification bonds from insurance companies The agencies assign letter ratings depicting what they view as the risk of default of an obligation The letter ratings range from AAA (Aaa) to D Exhibit 17.3 describes the various ratings assigned by the major services Except for slight variations in designations, the meaning and interpretation are basically the same The agencies modify the ratings with + and − signs for Fitch and S&P or with numbers (1-2-3) for Moody’s As an example, an A+ (A1) bond is at the top of the A-rated group, while A− (A3) is at the bottom of the A category The top four ratings—AAA (or Aaa), AA (or Aa), A, and BBB (or Baa)—are generally considered to be investment-grade securities The next level of securities is known as speculative bonds and includes the BB- and B-rated obligations The C categories are generally either income obligations or revenue bonds, many of which are trading flat (Flat bonds are in arrears on their interest payments.) In the case of D-rated obligations, the issues are in outright default, and the ratings indicate the bonds’ relative salvage values.8 17.3 ALTERNATIVE BOND ISSUES We have described the basic features available for all bonds and the overall structure of the global bond market in terms of the issuers of bonds and investors in bonds In this section, we provide a detailed discussion of the bonds available from the major issuers of bonds The presentation is longer than you would expect because when we discuss each issuing unit, such as governments, municipalities, or corporations, we briefly consider the bonds available in several world financial centers, such as Japan, the United Kingdom, and the several major countries in the Eurozone For a detailed listing of rating classes and a listing of factors considered in assigning ratings, see “Bond Ratings” in Levine (1988a) For a study that examines the value of two bond ratings, see Hsueh and Kidwell (1988) An analysis of the bond-rating industry is contained in Cantor and Packer (1995) Split ratings are discussed in Billingsley, Lamy, Marr, and Thompson (1985); Ederington (1985); and Liu and Moore (1987) Studies that consider shopping for ratings, the acquisition of indicative ratings, and ratings bias are Mathis, McAndrews, and Rochet (2009) and Skreta and Veldkamp (2009) Bonds rated below investment grade are also referred to as “high-yield bonds” or “junk” bonds These high-yield bonds are discussed in the subsequent section on corporate bonds WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1044 Glossary Tracking error The standard deviation of the difference in returns between an active investment portfolio and its benchmark portfolio; also called tracking error volatility Trading effect The difference in performance of a bond portfolio from that of a chosen index due to short-run changes in the composition of the portfolio Trading rule A formula for deciding on current transactions based on historical data Trading turnover The percentage of outstanding shares traded during a period of time Transaction cost The cost of executing a trade Low costs characterize an operationally efficient market Treasury bill A negotiable U.S government security with a maturity of less than one year that pays no periodic interest but yields the difference between its par value and its discounted purchase price Treasury bond A U.S government security with a maturity of more than 10 years that pays interest periodically Treasury inflation-protected securities (TIPS) Treasury bonds backed by the faith and credit of the Treasury that provide a promised yield in real terms—that is, the principal and interest payments are indexed to the Consumer Price Index (CPI) published by the Bureau of Labor Statistics Treasury note A U.S government security with maturities of to 10 years that pays interest periodically Treynor composite measure A relative measure of a portfolio’s performance calculated as its average return in excess of the risk-free rate divided by its beta coefficient Trough The culmination of a bear market at which prices stop declining and begin rising 12b-1 plan A fee charged by some funds, named after the SEC rule that permits it Such fees pay for distribution costs, such as advertising, or for brokers’ commissions The fund’s prospectus details any 12b-1 charges that apply V Valuation analysis An active bond portfolio management strategy designed to capitalize on expected price increases in temporarily undervalued issues Valuation process Part of the investment decision process in which you estimate the value of a security Value stocks Stocks that appear to be undervalued for reasons besides earnings growth potential These stocks are usually identified based on high dividend yields, low P/E ratios, or low price-to-book ratios Value-weighted index An index calculated as the total market value of the securities in the sample Market value is equal to the number of shares or bonds outstanding times the market price of the security Variable-rate note A debt security for which the interest rate changes to follow some specified short-term rate, for example, the T-bill rate; see Floating rate note Variable principal redemption (VPR) A class of debt securities whose principal redemption at maturity is not fixed but tied to changes in the value of another economic entity, such as a stock index or commodity price Variance A measure of variability equal to the sum of the squares of a return’s deviation from the mean, divided by the total number of returns Volatility index (VIX) A measure of investor expectations of nearterm volatility in the stock market calculated as a weighted average of the implied volatilities estimated from Standard and Poor’s 500 option contracts W Warrant An instrument that allows the holder to purchase a specified number of shares of the firm’s common stock from the firm at a specified price for a given period of time Weak-form efficient market hypothesis The belief that security prices fully reflect all security market information U Y Underfunded plan A defined benefit pension plan in which the present value of the fund’s liabilities to employees exceeds the value of the fund’s assets Yankee bonds Bonds sold in the United States and denominated in U.S dollars but issued by a foreign firm or government Yield The promised rate of return on an investment under certain assumptions Yield illusion The erroneous expectation that a bond will provide its stated yield to maturity without recognizing the implicit reinvestment assumption related to coupon payments Underweighted A condition in which a portfolio, for whatever reason, includes less of a class of securities than the relative market value alone would justify Unrealized capital gains Capital gains that reflect the price appreciation of currently held unsold assets Unsecured bonds Bonds that promise payments of interest and principal but pledge no specific assets Holders have first claim on the issuer’s income and unpledged assets Also known as debentures Unsystematic risk Risk that is unique to an asset, derived from its particular characteristics It can be eliminated in a diversified portfolio Unweighted index An indicator series affected equally by the performance of each security in the sample regardless of price or market value Also referred to as an equal-weighted series Unwind The negotiated termination of a forward or futures position before contract maturity Yield spread The difference between the promised yields of alternative bond issues or market segments at a given time relative to yields on Treasury issues of equal maturity Yield to worst Given a bond with multiple potential maturity dates and prices due to embedded call options, the practice is to calculate a yield to maturity for each of the call dates and prices and select the lowest yield (the most conservative possible yield) as yield to worst Z Zero coupon bond A bond that pays its par value at maturity but no periodic interest payments Its yield is determined by the difference between its par value and its discounted purchase price Also called original issue discount (OID) bonds WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Index A Abnormal returns market overreaction investment strategies, 562–563 semistrong-form EMH, 155 ABSs (asset-backed securities), 608–609 Accounting change announcements, semistrong-form EMH, 164–165 Accumulation phase, investor life cycle, 35–36 Active bond portfolio management, 697–711 credit analysis, 700–705 example of, 709–711 implementing transactions, 705–709 interest rate anticipation, 698–699 overview, 697–698 valuation analysis, 700 yield spread analysis, 705 Active equity portfolio management, 550, 558–569 anomalies and attributes, 563–565 fundamental analysis, 559–562 momentum-based stock portfolios, 565–568 overview, 558–559 passive versus, 550–551 tax efficiency and, 568–569 technical analysis, 562–563 Actuarial rate of return, 58 Add-on yield (AY), 820 ADRs (American Depository Receipts), 77 Advisory firms See Investment, management, and advisory firms Agency bonds, 596 Eurozone, 604 Japan, 604 overview, 596, 602 price quotes, 617–619 United Kingdom, 604 United States, 73, 602–604 Agency conflict, 946 Aggregate market analysis, efficient capital markets, 172 Aggregate operating profit margin, 393–396 analysis of effects, 395–396 capacity utilization rate, 393–394 foreign competition, 395 overview, 393 rate of inflation, 395 unit labor cost, 394–395 Algorithmic trading (AT), 110–112 Alpha, 931 Alternative asset classes, 929–945 defined, 929 hedge funds, 931–935 overview, 929–931 private equity funds, 938–945 risk arbitrage investing, 935–936 Alternative investment valuation, 334–352 bonds, 334–335 common stock, 336–337 discounted cash flow valuation techniques, 337–347 preferred stock, 335–336 relative valuation techniques, 338, 347–352 AM (arithmetic mean), 7–9, 129–130 American (direct) quotation method, 806 American Depository Receipts (ADRs), 77 American options, 748 American shares, 77 American Stock Exchange (AMEX), 105–107 American-style options, 847–848 Analysis effect, portfolio performance, 995 Analysts and managers analysis of, 173 conflicts of interest, 514 corporate insider trading, 166–167 influence of efficient markets on, 513 overview, 513 paralysis of, 514 performance of, 39–40, 167–169 superior, 174–175 transitioning between, 40 Anchoring, 170 Antiques, 82, 87 APT See Arbitrage pricing theory (APT) Arbitrage, 742, 760–766 Arbitrage-based hedge fund strategies, 934 Arbitrage pricing theory (APT), 242–249 alternative testing techniques, 249 capital asset pricing model versus, 242–244, 249–250 empirical tests of, 247–249 multifactor models, 250–261 overview, 241–244 security valuation with, 245–247 using, 244–245 Arithmetic mean (AM), 7–9, 129–130 Art, 82, 87 Asset allocation, 33–61, 577–583 defined, 33 effect on returns, 50–51 importance of, 49–55 insured, 582–583 integrated, 578–580 investor life cycle, 34–37 overview, 33–34, 577–578 policy statements, 38–49 portfolio management process, 37–38 selecting method of, 583 strategic, 580–581 tactical, 581–582 Asset allocation (flexible portfolio) funds, 924 Asset-backed securities (ABSs), 608–609 Asset classes See also Asset allocation alternative, 929–945 defined, 33 performance attribution analysis, 987 returns and risks of different, 52–53 Asset-liability management, 713 Asset management firms See Investment, management, and advisory firms Asset pricing models, 207–240 arbitrage pricing theory, 242–249, 250–261 capital asset pricing model, 216–225, 229–232 capital market theory, 207–216, 225–229 overview, 207 Assets under management (AUM) approach, 912–915 ASX (Australian Stock Exchange), 119 AT (algorithmic trading), 110–112 At the money, 748 Attribution analysis, 986–989 bond performance, 994–996 example of, 986–988 extensions, 988–989 overview, 986 Auction-rate securities, 609–610 AUM (assets under management) approach, 912–915 Australian Stock Exchange (ASX), 119 Autocorrelation tests, 153 Automobile insurance, purpose of, 34 Average tax rates, 46 AY (add-on yield), 820 B Backwardated markets, 791 Balanced funds, 80, 924 Balance sheets, 273–274 proportion of debt ratios, 298–300 quality of, 309–310 Bankruptcy (insolvency), predicting, 313 Bar charting, 538 Barclays Capital bond indexes, 51–52, 53, 185, 187–189, 696 Barclay’s Global Investors (BGI), 81 Barra characteristic-based risk factors, 254–255 Basis defined, 46, 786 defining, 786–787 hedging and, 786 Basis risk, 787 Bearer bonds, 592 Bear money spreads, 857–858 Behavioral finance, 169–171 defined, 169 explaining biases, 170–171 fusion investing, 171 insights from, 176 overview, 169–170 Belief perseverance, 170 BE/ME (book-to-market equity ratio), 161–162, 231 Benchmark errors, 232, 990 1045 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1046 Index Benchmark portfolio, 40, 968–969 Benchmarks problems with, 990–992 required characteristics of, 992–993 security-market indexes, 124 Best-efforts basis, 100 Beta coefficient defined, 216 stability of, 229 zero-beta model, 226–227 BGI (Barclay’s Global Investors), 81 Bid-ask spread, 749 Binomial option pricing model, 837–839 forecasting price changes, 837–838 generalizing, 838–839 overview, 837 Black-Scholes valuation model, 839–842, 848–850 estimating volatility, 842–844 example of, 841–842 foreign currency options, 849–850 futures options, 850 overview, 839–840, 848 problems with, 844 properties of, 840–841 stock index options, 848–849 Bond analysis and valuation, 334–335, 623–690 calculating future prices, 632–636 computing yields, 627–632 fundamentals of, 624–627 interest rates, 638–647 overview, 623–624 price volatility, 654–678 spot rates, 636–638, 647–649 term-structure theories, 650–654 yield spreads with embedded options, 678–681 Bond books (yield books), 636 Bond funds, 80 Bond ladders, 694–695 Bond-market indexes, 133–137 global government, 135, 137 high-yield, 135 overview, 133–134 U.S investment-grade, 135 yields and returns for, 137 Bond market line, 994–996 Bond markets overview, 594–595 participating investors, 597 participating issuers, 596–597 secondary, 102 technical analysis of, 542–544 Bond portfolio management, 691–738 active, 697–711 contingent and structured, 724–729 core-plus, 711–713 matched-funding, 713–724 overview, 691 passive, 694–696 performance, style, and strategy, 691–694 Bond price volatility, 654–657 callable bonds, 667–670 convexity, 662–667 duration measures, 657–662, 670–678 overview, 654–657 trading strategies, 657 Bonds, 591–622 See also names of specific types of bonds corporate, 606–613 domestic government, 599–602 features of, 591–594 government agency, 602–604 interest rates and prices of, 375 international, 613–614 market structure, 594–598 municipal, 604–606 overview, 591 portfolio performance, 993–996 price information, 614–620 rating of, 14, 23–24, 312, 597–599 Bond swaps overview, 706 pure yield pickup, 706–707 substitution, 706–708 tax, 707–709 Book-to-market equity ratio (BE/ME), 161–162, 231 Book value/market value (BV/MV) ratio See Price/book value (P/BV) ratio Bootstrapping, 645 Borsa Italiana, 118 Break-even time (payback), 889 Brinson Global Security Market Index (GSMI), 84–86, 138 Brokerage accounts credit balances in, 531 debit balances in, 533 Brokers, 100, 117 Buffett, Warren, 467 Bulldog bonds, 76, 614 Bull money spreads, 857–858 Business cycle industry sectors and, 417–419 macroeconomic-based risk factor models, 251–252 stock market and, 418, 560 Business risk, 294–295 adjusting volatility measures for growth, 295 defined, 18 industry analysis, 426 operating leverage, 295 overview, 294 relationship to financial risk, 296 required return for foreign securities, 355 sales variability, 294–295 Butterfly spreads, 858–859 Buy-and-hold strategy, bond portfolio management, 694–695 Buyouts, 941 BV/MV (book value/market value) ratio See Price/book value (P/BV) ratio C Calendar (time) spreads, 857 Calendar effects, 158 Callable bonds convexity of, 670 option-adjusted duration, 669–670 overview, 667–669 Call markets, 104–105 Call money rate, 113 Call options, 78, 742–743 covered, 850, 852–853 defined, 747 payoff and profit diagrams for, 755–758 Call premium, 593 Call provisions, 74 Candlestick charts, 538, 540 Capacity utilization rate, 393–394 Cap agreements, 875–876 Cap-floor-swap parity, 877–878 Capital appreciation, 44 Capital asset pricing model (CAPM), 216–225, 229–232 See also Arbitrage pricing theory (APT); Capital market theory arbitrage pricing theory versus, 242–244, 249–250 conceptual development of, 217 market portfolio, 232 overview, 207, 216–217, 229 relationship between systematic risk and return, 229–231 relaxing assumptions, 225–229 security market line, 218–225 stability of beta, 229 Capital gains, 46, 501 Capital market instruments, 72–74 corporate bonds, 73–74 municipal bonds, 73 overview, 72–73 U.S government agency securities, 73 U.S Treasury securities, 73 Capital market line (CML), 208–212 combining risk-free asset with risky portfolio, 209–210 comparative Sharpe measures, 965–966 covariance with risk-free asset, 209 example of investing with, 215–216 hedge fund performance, 938 overview, 208–209, 210–211 relaxing CAPM assumptions, 226–229 risk measure for, 214–215 risk-return possibilities with leverage, 211–212 separation theorem and, 214 Capital markets effect on nominal risk-free rate, 16–17 effect on risk-return relationship, 24 efficient, 149–180 primary, 98–101 secondary, 101–105 Capital market theory, 207–216 assumptions of, 208 capital market line, 208–212 development of, 208 overview, 207–208 practice versus, 232–234 risk, diversification, and market portfolio, 212–215 Capital preservation, 44 CAPM See Arbitrage pricing theory (APT); Capital asset pricing model (CAPM); Capital market theory CARs (certificates for automobile receivables), 609 Cash conversion cycle, 283–284 Cash flow discounted valuation techniques, 339–346 from financing activities, 276 free, 276–277, 303 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Index free to equity, 277, 338, 384–387, 433–435, 472–474 free to the firm, 277, 474–477 from investing activities, 276 measures of, 275–277 from operating activities, 276 from operations, 303 price/cash flow ratio, 350, 406–407, 449–450, 496 security valuation theory, 333 statements of, 273–275, 276 traditional, 275–276 Cash flow coverage ratio, 301–302 Cash flow-outstanding debt ratios, 302–303 Cash ratio, liquidity, 281–282 Cash reserves, 34 CBOE (Chicago Board Options Exchange), 531–532, 823 CBOT (Chicago Board of Trade), 79, 102, 118, 792–793 CDOs (collateralized debt obligations), 610 CDs See Certificates of deposit (CDs) CDS (credit default swaps), 882–883 Centralized transactions, 109 Certificates for automobile receivables (CARs), 609 Certificates of deposit (CDs) money market funds, 80 overview, 72 taxation, 48 CFA Institute, 997, 999–1000 Change in wealth, Characteristic-based risk factor models extensions of, 254–256 macroeconomic-based, 251–253 microeconomic-based, 253–254 Characteristic line defined, 221 Treynor’s composite performance measure, 963 Characteristic selectivity (CS) performance measure, 984–985 Chicago Board of Trade (CBOT), 79, 102, 118, 792–793 Chicago Board Options Exchange (CBOE), 531–532, 823 Chicago Mercantile Exchange (CME), 79, 102, 118 Chooser options, 856 CI (Confidence Index), 532–533 Classical immunization application of, 720–722 interest rate risk and, 716 Closed-end funds, 79 Closed-end investment companies, 920–923 CME (Chicago Mercantile Exchange), 79, 102, 118 CML See Capital market line (CML) CMOs (collateralized mortgage obligations), 607–608 Code of Ethics and Standards of Professional Conduct, 948–949 Coefficient of variation (CV), 13 Coincident indicators, 369–371 Coins, 83 Collar agreements, 771–772, 876–878 Collateralized debt obligations (CDOs), 610 Collateralized issues, 596 Collateralized mortgage obligations (CMOs), 607–608 Collateral trust bonds, 74, 607 Commingled Real Estate Funds (CREFs), 86–87 Commodity-linked bull and bear bonds, 894–896 Common effect, 17 Common size statements, 279, 280–281, 288 Common stock empirical duration for, 677–678 funds of, 80 overview, 76 valuation of, 336–337 Company analysis, 459–515 competitive strategies, 464–466, 483–487 earnings multipliers, 487–494 earnings per share, 480–482 economic influences on, 462–463 global, 514–515 growth company analysis, 499–504 influences on, 462–463 influences on analysts, 513–514 intrinsic value, 467–479 lessons from Peter Lynch, 466 measures of relative value, 494–499 measures of value added, 504–512 overview, 459–460 security valuation, 332 site visits and interviews, 512 stock valuation versus, 460–462 structural influences on, 463 SWOT analysis, 466 tenets of Warren Buffett, 467 when to sell, 512–513 Competition, in industry analysis, 423–425 Competitive bid sales, 98–99 Competitive environment, 424 Competitive strategy, 423–424 Completely diversified portfolio, 212–213, 215 Completeness funds, 552 Composite leading indicator index, 370 Composite stock-bond indexes, 137–138 Compound annual rate of return, Comptroller of the Currency, 61 Confidence Index (CI), 532–533 Confidence risk, 251–252 Confirmation bias, 170 Consolidated quotations, 109 Consolidation phase, investor life cycle, 35–36 Constant growth FCFE model, 385–386, 433–434 Constant-mix asset allocation, 580 Constant proportion strategy, 583 Construction and development trusts, 81 Consumer sentiment, business cycle and, 419 Contango markets, 790 Contingent, deferred sales loads, 923 Contingent immunization, 724–729 Continual monitoring, 37–38 Continuous markets, 96–97, 104–105 Contract price, forward, 743 Contrarian investment strategy, 562, 581 Contrary-opinion rules, 530–532 Convenience yield, 790 Conversion factors, 793 1047 Conversion parity price, 886 Conversion premium, 886 Conversion ratio, 885–886 Conversion value, 885 Convertible bonds, 74–75, 886–890 Convertible preferred stock, 885–886 Convertible securities, 883–890 convertible bonds, 74–75, 886–890 convertible preferred stock, 885–886 overview, 883, 885 Convexity, bond callable bonds, 670 computation of, 666–667 desirability of, 664–665 determinants of, 665–666 modified-duration-convexity effects, 666 overview, 662 price-yield relationship for bonds, 662–664 Core-plus bond portfolio management, 711–713 Corporate bond markets, 102–103 Corporate bonds, 73–74, 99, 596–597 covered bonds, 608–611 high-yield bonds, 611–613 overview, 596–597, 606 price quotes, 615–617 promised yields, 14–15 United States, 606–608 Corporate events, semistrong-form EMH, 165 Corporate insider trading, 48, 166–167 Corporate net profits, estimating, 392–393 Corporate stock issues, 99–100 Correlation coefficients, 68–70, 93–94 standard deviation of returns for portfolios, 188–190 between stock and bond indexes, 139 Country risk (CR; political risk) defined, 19 global company and stock analysis, 515 industry analysis, 427 required return for foreign securities, 356 Coupon reinvestment risk, 715 Covariance of returns, portfolio analysis, 185–188 Cover basis, 787 Covered bonds asset-backed securities, 608–609 auction-rate securities, 609–610 certificates for automobile receivables, 609 collateralized debt obligations, 610 credit card–backed securities, 609 deep discount bonds, 610–611 overview, 608 variable-rate notes, 610 zero-coupon bonds, 610–611 Covered call options, 850, 852–853 Covered interest arbitrage, 809–811 CR See Country risk (CR; political risk) Credit analysis, 697, 700–705 of high-yield bonds, 700–701 investing in defaulted debt, 701 models of, 701–705 overview, 700 Credit card–backed securities, 609 Credit default swaps (CDS), 882–883 Credit quality, 692 Credit-related swaps, 879–883 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1048 Index CREFs (Commingled Real Estate Funds), 86–87 Cross hedges, 788 Crossover price, 631 Crossover yield, 631 Cross-sectional analysis, 278 Cross-sectional return predictions, semistrongform EMH, 158–161 book value/market value ratio, 161 neglected firms and trading activity, 160–161 overview, 158–159 price-earnings/growth rate ratios, 159 price/earnings ratios, 159 size effect, 159–160 Cross-section distribution, 155 CS (characteristic selectivity) performance measure, 984–985 Currency forwards and futures, 806–812 calculating implied world investment rates, 811–812 interest rate parity and covered interest arbitrage, 809–811 mechanics of, 806–809 overview, 806 Currency sensitivity, 255 Current income, 44 Current ratio, 280–281 Current yield, 628 Cushion bonds, 699 Cushion spread, 725–726 CV (coefficient of variation), 13 Cyclical changes, 417 Cyclical companies, 461–462 Cyclical indicator approach, 369–372 analytical measures of performance, 370–371 categories, 369–370 comparison with previous cycles, 371 composite series and ratio of series, 370 international leading indicator series, 372 leading employment index, 372 leading inflation index, 372 limitations of, 372 long-leading index, 372 overview, 369 surveys of sentiment and expectations, 372 Cyclical stocks, 461–462 D DDM See Dividend discount model (DDM) Dealer market (quote-driven market) system, 104–105 Dealers, 117 Debentures (unsecured bonds), 74–75, 593 Debt-equity ratio, 299 Decimal pricing, 97–98, 110–111 Declining trend channel, 530 Declining yield curves, 644 Dedicated portfolios, 713–715 Dedication with reinvestment, 714 Deep discount bonds, 610–611 Defaulted debt, 701 Default spread, 157 Defensive companies, 461 Defensive competitive strategies, 464 Defensive stocks, 461 Deferred call provision, 593 Defined benefit pension plans, 58 Defined contribution pension plans, 58 Delta, 841 Demographics, alternative industries and, 420 Depth, of markets, 97 Derivative markets and securities, 741–779 defined, 741 forward and futures markets, 743–744 futures price quotations, 744–747 investing with, 750–760 option markets, 747–748 option price quotations, 748–750 overview, 741–743 relationship between forward and option contracts, 760–767 use of derivatives in portfolio management, 767–772 Designated market makers (DMM), 117 Deutsche Borse (German Stock Exchange), 118 Diamonds, 83 Differential borrowing and lending rates, 225–226 Differentiation strategy, 464 Diffusion indexes, 370–371 Direct (American) quotation method, 806 Direct real estate investment, 81 Disability insurance, purpose of, 34 Discount bond pricing, 626 Discounted cash flow valuation techniques dividend discount model, 339–346 overview, 339 present value of free cash flows to equity, 347 present value of operating free cash flows, 346–347 using, 337–338 Discretionary accounts, 48 Display Book, 117 Diversification elimination of unsystematic risk, 213–214 measuring, 213 Dividend-bearing securities, 845–847 Dividend discount model (DDM) combining estimates, 384 current estimate of risk premium and required rate of return, 380 derivation of constant growth, 364 discounted cash flow valuation approach, 337–338 dividend growth rate, 380–384 equity risk premium, 378–380 infinite period model, 342–344 multiple-year holding period, 341–342 one-year holding period, 340–341 overview, 339–340, 377–378 present value of dividends model, 468–472 reduced form, 378, 426–433 temporary supernormal growth, 344–346 Dividend/payout ratio company analysis, 488 industry analysis, 445 stock analysis, 401–402 Dividend yield, 255 DJIA See Dow Jones Industrial Average (DJIA) Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, 785, 822, 946–948 Dollar-weighted (value-weighted) mean rate of return, Domestic diversification, 70 Domestic government bonds Eurozone, 602 Japan, 601 United Kingdom, 601–602 United States, 599–601 Dow Jones Industrial Average (DJIA), 126–127, 131 bearish sentiment index, 531–532 beta estimates for, 990–991 declines in, 39 industry group performance, 415 Dow Jones Total Stock Market Index, 139, 185–189 Dow Jones Wilshire Global Indexes, 133, 134 Downside risk (DR), 980–982 Dow Theory, 534 Dual currency bonds, 891–892 DuPont System extended, 291–293 overview, 289–291 Duration approach to hedging, 793–794 effective, 671–676 Macaulay, 657–660, 670–678 modified, 657, 661–662, 670–678 negative effective, 674–678 overview, 657–658, 670–671 yield to maturity and, 659–660 Dynamic true growth model, 503–504 E Earnings and cash flow coverage ratios, 300–302 Earnings before interest, taxes, depreciation, and amortization (EBITDA) measure of cash flow, 277, 287 Earnings before interest and taxes (EBIT), 287, 291–292, 300, 393 Earnings momentum strategy, 563–564, 565–568 Earnings multiplier alternative investment valuation, 347–350 company analysis, 487–492, 494 industry analysis, 435–446 microvaluation analysis, 387–404 Earnings per share company profit margin, 482 company sales forecast, 480–482 computing, 485 industry analysis, 435–438 overview, 480 stock management and analysis, 390–399 Earnings retention rate, 428 Earnings surprises, 157, 173, 566 Earnings variability, 255 Earnings yield, 255 EBIT (earnings before interest and taxes), 287, 291–292, 300, 393 EBITDA (earnings before interest, taxes, depreciation, and amortization) measure of cash flow, 277, 287 ECNs (electronic communications networks), 110–111 Economic series, stock prices and, 369–370 Economic value added (EVA) alternative measure of, 507 overview, 505–506 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Index relationship between MVA and, 507 return on capital, 506 Effective duration, 658, 675–676 greater than maturity, 674 negative, 674–678 overview, 671–673 putable bonds, 673–674 Efficient capital markets, 149–180 behavioral finance, 169–171 defined, 149 implications of, 171–176 overview, 149–150 reasons for, 150–151 semistrong-form efficient market hypothesis, 155–165 strong-form efficient market hypothesis, 165–169 weak-form efficient market hypothesis, 152–155 Efficient frontier defined, 198 investor utility and, 200 overview, 198–199 Efficient market hypothesis (EMH), 151, 528–529 semistrong form, 155–165 strong form, 165–169 weak form, 152–155 Electronic communications networks (ECNs), 110–111 Embedded options, bonds with, 667–668 Emerging market bonds, 597 EMH See Efficient market hypothesis (EMH) Empirical duration, 658 for common stock, 677–678 overview, 674–677 Employee Retirement and Income Security Act (ERISA) of 1974, 59, 946–947 Employer-sponsored retirement plans, 49 Ending-wealth value, 629 Enhanced indexing, 711 Equal-weighted indexes, 125 Equipment trust certificates, 74, 607 Equity-based hedge fund strategies, 934 Equity-index linked notes, 892–894 Equity-index-linked swaps (equity swaps), 878–879 Equity instruments, 76–78 acquiring foreign, 77–78 common stock classifications, 76 overview, 76 Equity markets, 102–112 Equity options, 823–825 Equity portfolio management, 549–587 active, 558–569 asset allocation, 577–583 overview, 549 passive, 551–558 style analysis, 573–577 value versus growth investing, 569–573 Equity swaps (equity-index-linked swaps), 878–879 Equity trusts, 81 Equity turnover, 286–287 Equivalent taxable yield (ETY), 635–636 ERISA (Employee Retirement and Income Security Act) of 1974, 59, 946–947 ERR See Exchange rate risk (ERR) Escalation bias, 170–171 ETFs See Exchange-traded funds (ETFs) Eurobonds, 75–76, 613–614 Eurodollar bonds contract mechanics, 796–797 creating synthetic fixed-rate funding, 797–799 market, 614 T-bill/Eurodollar yield spread, 533 European (indirect) quotation method, 806 European options, 748 European-style put options, 845, 847–848 Euroyen bonds, 76, 614 Eurozone agency bonds, 604 domestic government bonds, 602 international bonds, 614 international stock index, 132 EVA See Economic value added (EVA) Event studies, semistrong-form EMH, 155–156, 161–165 announcements of accounting changes, 164–165 corporate events, 165 exchange listing, 163 initial public offerings, 163 overview, 161–162 stock split studies, 162 unexpected world events and economic news, 163–164 Exchange clearinghouses, 782 Exchange listing, semistrong-form EMH, 163 Exchange market-makers, 117 Exchange mergers, 118–119 Exchange rate risk (ERR) defined, 18–19 global company and stock analysis, 515 industry analysis, 427 required return for foreign securities, 356 Exchange-traded funds (ETFs), 77–79, 81 index options, 825–828 origin of, 124 passive equity portfolio management, 555–558 portfolio management, 175–176 purchase or sale of, 77–78 Exercise (striking) price, 78, 747 Expansion model, 502–503 Expectations hypothesis, 650–652 Expected earnings per share, 390–399 aggregate operating profit margin, 393–396 alternative estimates of corporate net profits, 392–393 example of, 398–399 gross domestic product, 390 interest expense, 396–398 overview, 390 sales per share for market series, 391–392 tax rate, 398 Expected growth rate (g) breakdown of ROE, 357–358 company analysis, 490–492 dividend discount model, 380–384 of dividends, 400–401 estimating based on history, 358–359 estimating from fundamentals, 356–357 1049 for foreign stocks, 359–360 industry analysis, 445–446 overview, 356 of returns, 333 Expected rate of inflation effect on nominal risk-free rate, 17 effect on risk-return relationship, 24–25 overview, 353 Expected rate of return, 183–184 calculating, 9–12 risk of, 12–14 for risky assets, 218–219 semistrong-form EMH, 156 Expense ratio, 569 Expiration (maturity) date, 743 External (informational) efficiency, 97 External liquidity, 61 External market liquidity risk, 303–304 External market measure of risk, 20 F Fair game model, 151 Fama-French models, 253–254, 256 Fama portfolio performance measure, 979–980 Fannie Mae (Federal National Mortgage Association), 73, 603 FASB (Financial Accounting Standards Board), 272 Fat finger events, 111–112 FCFE See Free cash flow to equity (FCFE) FCFF (free cash flow to the firm), 277, 474–477 Federal Deposit Insurance Corporation (FDIC), 61 Federal Home Loan Bank (FHLB), 73 Federal Home Loan Mortgage Corporation (FHLMC; Freddie Mac), 73, 603 Federal Housing Administration (FHA), 73 Federal Land Banks (FLBs), 73 Federal National Mortgage Association (FNMA; Fannie Mae), 73, 603 Federal Reserve Board, 61 FHA (Federal Housing Administration), 73 FHLB (Federal Home Loan Bank), 73 FHLMC (Federal Home Loan Mortgage Corporation), 73, 603 Fidelity Investments, 43 FIFO (first-in, first-out) inventory method, 165 Financial Accounting Standards Board (FASB), 272 Financial assets, defined, 72 Financial futures, 79, 102 Financial Industry Regulatory Authority (FINRA), 947–948 Financial leverage See Financial risk (financial leverage) Financial ratios, 277–310 See also names of specific ratios computation of, 279 growth analysis, 309 growth potential, 304–307 importance of relative, 278–279 internal liquidity, 279–284, 307 limitations of, 313 operating performance, 284–293, 307–308 overview, 277–278 risk analysis, 293–304, 309 specific uses of, 311–313 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1050 Index Financial risk (financial leverage), 295–298, 308 capitalizing operating leases, 296–298 defined, 18 industry analysis, 427 lease obligations, 296 overview, 295–296 relationship to business risk, 296 required return for foreign securities, 355 Financial statements, 271–325 See also Financial ratios balance sheets, 273, 309–310 footnotes, 310 generally accepted accounting principles, 272 income statements, 273, 310 measures of cash flow, 275–277 non-U.S., 309 overview, 271–272 purpose of, 277 quality of, 309–310 statements of cash flow, 273–275 value of analyzing, 310–311 Financial Times Stock Exchange (FTSE) indexes, 84, 86 FINRA (Financial Industry Regulatory Authority), 947–948 First-in, first-out (FIFO) inventory method, 165 Fixed-income investments, 72–75 capital market instruments, 72–74 income bonds, 74–75 preferred stock, 75 savings accounts, 72 subordinated bonds, 74 Flash Crashes, 112 Flat trend channel, 530 Flat yield curves, 644 FLBs (Federal Land Banks), 73 Flexible (range) forwards, 859–861 Flexible portfolio (asset allocation) funds, 924 Floating-rate notes (FRNs), 869–870, 873–874 Floor agreements, 875–876 FNMA (Federal National Mortgage Association), 73, 603 Footnotes, financial statement, 310 Forcing conversion, 888 Foreign bonds, 613 Foreign competition, 395 Foreign currency exchange warrants, 884–885 Foreign currency options, 828–829, 849–850 Foreign exchange (FX) transactions, 806–810 Foreign exchange rates, technical analysis of, 542 Foreign government bonds, 596 Foreign markets, technical analysis of, 541–542 Foreign securities, required rate of return for, 354–356 Foreign shares, purchase or sale of, 77 Foreign stock market indexes, technical analysis of, 541–542 Forward-based interest rate contracts, 868–875 forward rate agreements, 868–869 interest rate swaps, 869–875 Forward contracts, 742–743, 781–820 currency forwards, 806–812 defined, 743 futures contracts versus, 785 hedging with, 786–788 interest rate forwards, 792 overview, 781–783 paying to acquire, 750–753 payoff and profit diagrams for, 754–755 relationship between option contracts and, 760–767 relationship between spot and forward prices, 790–791 use of in portfolio management, 767–768 valuation concepts, 788–791 Forward discount, 808 Forward markets, 743–744 Forward premium, 808 Forward rate agreements (FRAs), 792, 868–872 Forward rates, 647–649 401(k) plans, 47–48 Franchise factor concept, 507–508 FRAs (forward rate agreements), 792, 868–872 Freddie Mac (Federal Home Loan Mortgage Corporation), 73, 603 Free cash flow, 276–277, 303 Free cash flow to equity (FCFE), 277, 338 constant growth model, 385–386, 433–434 industry analysis, 433–435 overview, 384 present value of, 347, 472–474 two-stage growth model, 386–387, 434–435 Free cash flow to the firm (FCFF), 277, 474–477 Freely callable provision, 593 FRNs (floating-rate notes), 869–870, 873–874 FTEY (fully taxable equivalent yield), 635–636 FT/S&P-Actuaries World Indexes, 132–133 FTSE (Financial Times Stock Exchange) indexes, 84, 86 Full replication bond portfolios, 695 equity portfolios, 552 Fundamental analysis active equity portfolio management, 559–562 efficient capital markets, 172–174 Fundamental risk, 19–20 Fundamental weighted indexes, 130 Fusion investing, 171 Future consumption, Futures commission merchants, 782 Futures contracts, 78–79, 742–743, 781–820 currency futures, 806–812 defined, 744 financial futures, 79 forward contracts versus, 785 hedging with, 786–788 interest rate futures, 792–800 mechanics of, 783–785 options on, 828–830, 850 overview, 78–79, 781–783 popular, 745 stock index futures, 800–806 valuation concepts, 788–791 Futures markets, 743–744 defined, 744 leading by trading volume, 783 popular, 745 Futures options, 828–830 Futures prices, 744–747 FX (foreign exchange) transactions, 806–810 G G See Expected growth rate (g) GDP (gross domestic product), estimating, 390 Generally accepted accounting principles (GAAP), 272 General obligation bonds (GOs), 73, 604 Geometric Brownian motion, 839 Geometric mean (GM), 7–9, 129–130 German Stock Exchange (Deutsche Borse), 118 GICs (guaranteed insurance contracts), 60 Gifting phase, investor life cycle, 35–36 Gilt-edge securities, 599 Ginnie Mae (Government National Mortgage Association), 73, 602 GIPS (Global Investment Performance Standards), 999 Glass-Steagall Act, 61 Global bond market returns, 66 risks, 68–69 Global company and stock analysis, 514–515 Global equity indexes comparison of world stock indexes, 133 Dow Jones Wilshire Global Indexes, 133–134 FT/S&P-Actuaries World Indexes, 132–133 Morgan Stanley Capital International Indexes, 133 overview, 131–132 Global equity market returns, 66 risks, 69–70 Global funds (international funds), 927 Global government bond indexes, 136 Global investment companies, 927 Global Investment Performance Standards (GIPS), 999 Global investments, 63–94 case for, 64–71 choices, 71–83 historical risk-returns on alternative, 83–88 overview, 63–64 total investable assets in global capital market, 65 Global mutual funds, 77–78 Global stock indexes, 106–107, 132 GM (geometric mean), 7–9, 129–130 GNMA (Government National Mortgage Association), 73, 602 Gold futures contracts, 783 GOs (general obligation bonds), 73, 604 Government bonds domestic, 599–602 foreign, 596 global, 66 issues, 98 promised yields, 14–15 quasi, 73, 596, 602–604, 617–619 secondary markets for, 102 Government National Mortgage Association (GNMA; Ginnie Mae), 73, 602 Government-sponsored enterprises (GSEs), 602–603 Grinblatt-Titman (GT) portfolio performance measure, 982–985 Gross domestic product (GDP), estimating, 390 Gross profit margin, 287 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Index Growth analysis, 304–305, 308–309 Growth companies, 460–461 actual returns above required returns, 500 alternative growth models, 501 defined, 343, 500 growth stocks versus, 500 long-run growth models, 501–504 no-growth firm, 501 overview, 499–500 the real world, 504 Growth duration model alternative use of T, 510–511 computation of, 508–510 factors to consider, 511–512 intraindustry analysis, 510 overview, 508 Growth investing, 462, 569–573 Growth mutual funds, 570 Growth potential, 304–307 determinants of growth, 305–307 importance of growth analysis, 304–305 Growth rate See Expected growth rate (g) Growth stocks, 130–131, 460–461, 500 GSEs (government-sponsored enterprises), 602–603 GSMI (Brinson Global Security Market Index), 84–86, 138 GT (Grinblatt-Titman) portfolio performance measure, 982–985 Guaranteed insurance contracts (GICs), 60 H Harbor Capital Appreciation (HACAX) mutual fund, 571–572, 576–577 Health insurance, purpose of, 34 Hedge funds, 931–939 characteristics of, 932–933 development of industry, 932 performance of, 936–939 strategies, 933–935 Hedging, 742 duration-based approach to, 793–794 with forward and futures contracts, 786–788 future funding commitments, 794–795 Hedging pressure theory (segmented market hypothesis), 652–653 Heterogeneous expectations and planning periods, 228 High-frequency trading (HFT), 111 High minus low (HML), 253–254, 256–258 High-yield (HY) bonds, 80, 597 credit analysis of, 700–702 distribution of ratings, 612 history of market, 611–612 indexes of, 136 overview, 597, 611 ownership of, 612–613 Hindsight bias, 170 Historical rate of return overview, 5–7 portfolio of investments, risk measures for, 14 single investment, 7–9 HML (high minus low), 253–254, 256–258 Holding period, Holding period returns (HPRs), 6–9 Holding period yields (HPYs), 6–9, 14, 19 Holdings-based performance measurement, 982–985 characteristic selectivity, 984–985 Grinblatt-Titman, 982–984 overview, 982 Home insurance, purpose of, 34 Home purchases, 81 Homogeneity, futures contracts, 744 Horizon matching, 723–724 Horizon yield See Realized (horizon) yield HPRs (holding period returns), 6–9 HPYs (holding period yields), 6–9, 14, 19 Humped yield curves, 644 HY bonds See High-yield (HY) bonds I Immunization strategies, 715–722 alternative view of, 718–720 application of, 720–722 contingent immunization, 724–729 interest rate risk, 715–716 mechanics of, 716–718 overview, 715 Implied volatility, 843 Income bonds, 74–75 Income statements, 273, 275, 310 Indenture provisions, 73–74, 593 Index arbitrage, 800–803 Index-based factor models, 254 Index funds, 80 origin of, 124 passive equity portfolio management, 555 portfolio management, 175–176 Indexing strategy, 694–695, 711 Index mutual funds, 555 Indirect (European) quotation method, 806 Individual retirement accounts (IRAs), 47–48 Industry analysis, 413–457 business cycle and industry sectors, 417–419 competition, 423–425 differences in industry risk, 416 efficient capital markets, 172–173 global, 451–452 industry life cycle, 422–423 overview, 413–414 process of, 417 rates of return, 425–435 reasons for using, 415–416 relative valuation approach, 435–451 structural economic changes and alternative industries, 420–421 summary of research on, 417 Industry-economy relationships, 436 Industry life cycle analysis, 422–423 Industry risk, 416 Inflation aggregate operating profit margin and rate of, 395 business cycle and industry sectors, 419 expected rate of, 17, 24–25, 353 foreign securities and, 354–355 macroeconomic-based risk factor models, 251–252 overview, 374–375 after returns, 51–52 stock prices and, 376 Informational (external) efficiency, 97 1051 Informationally efficient markets, 150 See also Efficient capital markets Information ratio (IR) portfolio performance measure, 968–972, 975–976, 978 Initial basis, 786 Initial public offerings (IPOs), 99–100, 163–164 Input-output analysis, 436 Insider trading, 48, 166–167 Insolvency (bankruptcy), predicting, 313 Institutional theory (segmented market hypothesis), 652–653 Insurance investor life cycle, 34 municipal bonds, 605–606 Insured asset allocation, 582–583 Integrated asset allocation, 578–580 Interest coverage ratio, 300–301 Interest expense aggregate operating profit margin and, 396–398 industry analysis, 439–442 Interest-on-interest, 628 Interest rate anticipation, 697–699 Interest rate collars, 876–877 Interest rate forwards, 792 Interest rate futures, 792 long term, 792–796 short term, 796–800 Interest rate parity, 809–811 Interest rate risk, 715–716 Interest rates bonds and, 375, 638–647 business cycle and industry sectors, 419 overview, 374–375 stocks and, 376 Interest rate sensitivity, 692 Interest rate swaps, 792, 869–875 Intermarket Trading System (ITS), 109–110 Internal efficiency, 97 Internal liquidity, 61 Internal liquidity (solvency) ratios, 279–284, 308 cash ratio, 281–282 compared to other ratios, 307 current ratio, 280–281 inventory turnover, 283–284 overview, 279–280 quick ratio, 281 receivables turnover, 282–283 Internal performance, 483–485 Internal rate of return (IRR), 627, 944–945 International bonds domestic, 76 Eurozone, 614 investing in, 75–76 Japan, 614 overview, 613–614 United Kingdom, 614 United States, 614 International diversification, 70 International domestic bonds, 76 International economics, business cycle and, 419 International funds (global funds), 927 International leading indicator series, 372 International Swap and Derivatives Association, 822, 879–880 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1052 Index Interviews, 512 In the money, 748 Intrinsic value defined, 748 estimates of, 492 overview, 467–468 present value of dividends, 468–472 present value of free cash flow to equity, 472–474 present value of operating free cash flow, 474–477 relative valuation ratio techniques, 477–479 Inventory turnover, 283–284 Investment, defined, Investment, management, and advisory firms, 79–81, 911–957 balanced funds, 80 bond funds, 80 common stock funds, 80 ethics and regulation in, 946–950 exchange-traded funds, 81 index funds, 80 money market funds, 79–80 operating structures of, 912–913 organization and management of, 919–929 overview, 79, 911–912 private firms, 916–919 services of, 912 structure and evolution of, 912–916 Investment Advisers Act of 1940, 946–947 Investment advisory opinions, 531 Investment bankers, relationships with, 100 Investment Company Act of 1940, 946–947 Investment horizon, 715 Investment risk, Investments benefits of early, 35–36 constraints, 45–48 defined, 3–5 goals, 38–39 objectives of, 41–45 overview of process, 329–333 Investment strategy, 37–38, 41, 44–48 Investor analysis, 173 Investor life cycle, 34–37 goals, 37 overview, 34 phases of, 35–36 preliminaries, 34 IPOs (initial public offerings), 99–100, 163–164 IR (information ratio) portfolio performance measure, 968–972, 975–976, 978 IRAs (individual retirement accounts), 47–48 IRR (internal rate of return), 627, 944–945 IShares, 81, 555, 696 ITS (Intermarket Trading System), 109–110 J January anomaly (January effect), 158, 249 Japan agency bonds, 604 domestic government bonds, 601 international bonds, 614 J-curve effect, 944–945 Jensen’s alpha (α) portfolio performance measure, 967–968, 973–978 bond portfolio performance, 993–994 characteristic selectivity versus, 985 compared to other measures, 970–972 demonstration of, 968 overview, 967–968 Junior (subordinate) debentures, 593 Junk bonds, 700–702 K K See Required rate of return (k) L Lagging indicators, 369–371 Land development, 82 Large-cap stocks, 565 Last-in, first-out (LIFO) inventory method, 165 LB (Lehman Brothers) bond indexes, 84, 86 Leading employment index, 372 Leading indicators, 369–372 Leading inflation index, 372 LEAPS (Long-Term Equity Anticipation Securities), 825–826 Leases capitalizing, 296–298 consideration of obligations, 296 Lehman Brothers (LB) bond indexes, 84, 86 Leverage Barra characteristic-based risk factor, 255 financial risk, 295–298, 308 option contracts and, 759–760 LIBOR (London Interbank Offer Rate), 796–800, 820, 868–881, 897–898 Life insurance, as component of financial plan, 34 Lifestyle, alternative industries and, 420 LIFO (last-in, first-out) inventory method, 165 Limited partnerships, 929 Limit orders, 112–113, 117 Liquidity defined, 45 market orders, 112 of markets, 96 needs, 45 of secondary markets, 101 Liquidity preference (term premium) hypothesis, 652 Liquidity risk defined, 18 external market, 303–304 global company and stock analysis, 515 industry analysis, 427 required return for foreign securities, 355 Load open-end funds, 922–923 London Interbank Offer Rate (LIBOR), 796–800, 820, 868–881, 897–898 London Stock Exchange (LSE), 106, 118 Long hedges, 786 Long-leading index, 372 Long position, 743 Long-run growth models capital gain component, 503 dynamic true, 503–504 expansion, 502–503 negative growth, 503 overview, 501 simple growth, 501–502 Long-run real growth rate of economy, 15 Long straddle position, 853–856 Long strangle position, 856 Long strap position, 855 Long strip position, 855 Long-term, high-priority goals, 37 Long-term-care insurance, 34 Long-term debt-total capital ratio, 300 Long-Term Equity Anticipation Securities (LEAPS), 825–826 Long-term interest rate futures, 792–796 duration-based approach to hedging, 793–794 hedging future funding commitments, 794–795 “Notes over Bond” spread, 795–796 T-bond/T-note contract mechanics, 792–793 Low-cost strategy, 464 Lower-priority goals, 37 Low-liquidity investments, 82–83 antiques, 82, 87 art, 82, 87 coins and stamps, 83 defined, 72 diamonds, 83 overview, 82 Low-load funds, 923 LSE (London Stock Exchange), 106, 118 Lynch, Peter, 466 M MA (moving-average) lines, 536–538 Macaulay duration, 657 characteristics of, 658–660 limitations of, 670–678 overview, 658 Macroeconomic-based risk factor models, 250–253 Macromarket analysis, 368–377 company analysis, 487 cyclical indicator approach, 369–372 economic activity and security markets, 368 economic series and stock prices, 369 industry analysis, 444 inflation and interest rates, 374–376 monetary variables, 372–373 overview, 368 world security markets, 376–377 Maintenance margin, 115 Management effect, portfolio performance, 995 Mandatory securities valuation reserve (MSVR), 60 Margin, futures contracts, 78 Margin accounts, 785 Marginal tax rates, 46 Margin calls, 115 Margin debt, 533 Margin requirement, 113–114 Margin transactions, 113–115 Marked-to-market process, 785 Marked-to-market swap value, 874 Marketability, defined, 96 Market multiplier, industry analysis versus, 445 Market orders, 112, 117 Market portfolio capital asset pricing model, 217–219, 226, 250 capital market line, 210–214 defined, 207, 210 proxies for, 221–222, 250 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Index Market risk premium, 217 Market timing, 251–252, 989–990 Market value added (MVA), 507 Market-value-weighted (value-weighted) indexes, 125, 127–129 Markowitz efficient frontier, 210–211 Markowitz portfolio theory, 182–200 alternative measures of risk, 183 assumptions, 183 capital market theory and, 208, 217 efficient frontier, 198–200 estimation issues, 198 expected rates of return, 183–184 overview, 182–183 standard deviation of returns for individual investments, 184–185 standard deviation of returns for portfolios, 185–197 three-asset portfolios, 197–198 Matched-funding bond portfolio management, 713–724 dedicated portfolios, 713–715 horizon matching, 723–724 immunization strategies, 715–722 overview, 713 Maturity (expiration) date, 743 Maturity basis, 786 Maturity spread, 636 Mean rates of return, Mean reversion, 581 Merrill Lynch-Wilshire Capital Markets Index (ML-WCMI), 138 Microeconomic-based risk factor models, 250, 253–254 Microvaluation analysis, 377–409 calculation of relative valuation ratios, 406–408 company analysis, 488–492 dividend discount model, 377–384 earnings multiplier approach, 387–404 free cash flow to equity model, 384–387 industry analysis, 444–445 overview, 377 of world markets, 408–409 Minicoupon bonds, 75, 610–611, 630 ML-WCMI (Merrill Lynch-Wilshire Capital Markets Index), 138 Modified duration, 657 limitations of, 670–678 overview, 661–662 trading strategies using, 662 Modified-duration-convexity effects, 666 Momentum-based stock portfolios, 565–568 Momentum indicators breadth of market, 533–534 overview, 533 stocks above 200-day moving average, 534 Monday trading effect, 158 Monetary policy, stock returns and, 373 Money managers See Analysts and managers Money market, defined, 592 Money market funds, 79–80, 924 Money spreads, 857 Money supply economy and, 372–373 stock prices and, 373 Money-weighted returns, 997–998 Morgan Stanley Capital International (MSCI) indexes, 81, 84, 86, 133 Mortgage bonds, 74, 607 Mortgage pass-through securities, 607–608 Mortgage trusts, 81 Moving average, 534 Moving-average (MA) lines, 536–538 MSCI (Morgan Stanley Capital International) indexes, 81, 84, 86, 133 MSVR (mandatory securities valuation reserve), 60 Multifactor models, 241–267 arbitrage pricing theory, 242–249 overview, 241–242 risk estimation and, 250–261 Multiple discriminant analysis, 701, 703 Multiple hedge fund strategies, 935 Multiple-indicator charts, 538 Multiplier effect, 329 Municipal bonds, 73 equivalent taxable yield, 47 insurance, 605–606 issues of, 98–99 overview, 604–605 price quotes, 619–620 returns after taxes and inflation, 52 secondary markets for, 102 Mutual funds (open-ended funds), 79, 920, 926 cash positions, 531 comparing risk exposures, 257–261 global, 77–78 growth, 570 index, 555 objectives of, 925 organization and strategy, 927–929 value, 570 MVA (market value added), 507 N NAIC (National Association of Insurance Commissioners), 60 NASD (National Association of Securities Dealers), 614–615 NASDAQ (National Association of Securities Dealers Automated Quotations), 107–109, 131 AMEX and, 106 changing dealer inventory, 108 listing requirements for, 107 mergers, 118–119 operation of, 107 OTC Electronic Bulletin Board, 108 overview, 107 sample trade, 107–108 Small-Cap Market, 107–108 technological innovations, 118 National Association of Insurance Commissioners (NAIC), 60 National Association of Securities Dealers (NASD), 614–615 National Market System (NMS), 107, 111 National Quotation Bureau (NQB) Pink Sheets, 108–109 NAV (net asset value), 919–922 NBT (net before tax) profit margin, 392 Near-term, high-priority goals, 37 Negative effective duration, 674–678 1053 Negative-growth model, 503 Neglected firms, trading activity and, 160–161 Negotiated sales, 98 Net asset value (NAV), 919–922 Net before tax (NBT) profit margin, 392 Net fixed asset turnover, 285–286 Net operating profits less applicable taxes (NOPLAT), 277 Net present value (NPV) method, bond valuation, 627 Net profit margin, 287, 359 New issues, 100 New York Stock Exchange (NYSE), 105 24-hour global market, 106 advance-decline index, 533–534 mergers, 118 technological innovations, 117 Nikkei-Dow Jones Average, 127 NMS (National Market System), 107, 111 “NOB” spread (“Notes over Bond” spread) strategy, 795–796 No-growth firm, 501 Noise traders, 170–171 No-load open-end funds, 922–923 Nominal interest rates, 16–17 Nominal risk-free rate (NRFR), 15–17, 20–24, 378 common effect, 17 conditions in capital market, 16–17 defined, expected rate of inflation, 17 overview, 15–16 Nominal yield, 628 Noncallable provision, 593 Nonestimation indicator, 255 Nonrefunding provision, 593 Non-U.S financial statements, 309 NOPLAT (net operating profits less applicable taxes), 277 Normal portfolios, 992 Notes, defined, 592 “Notes over Bond” spread (“NOB” spread) strategy, 795–796 Notional principal, 868 NPV (net present value) method, bond valuation, 627 NQB (National Quotation Bureau) Pink Sheets, 108–109 NRFR See Nominal risk-free rate (NRFR) NYSE See New York Stock Exchange (NYSE) O OARS (Opening Automated Report Service), 117 OAS (option-adjusted spreads), 679–681 OCC (Options Clearing Corporation), 823 OFCF (operating free cash flow), 337, 346–347, 474–477 Offensive competitive strategies, 464 OID (original-issue discount) bonds, 75, 610–611, 630 130/30 strategy, 562 Open-ended funds See Mutual funds (openended funds) Open-end investment companies, 920–923 Opening Automated Report Service (OARS), 117 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1054 Index Operating efficiency ratios, 285–287 equity turnover, 286–287 net fixed asset turnover, 285–286 overview, 284 total asset turnover, 285 Operating free cash flow (OFCF), 337, 346–347, 474–477 Operating leverage, 295 Operating performance ratios, 284–293, 308 compared to other ratios, 307–308 operating efficiency, 284, 285–287 operating profitability, 284, 287–293 overview, 284 Operating profitability ratios, 287–293, 308 common size income statement, 288 DuPont System, 289–291 extended DuPont System, 291–293 gross profit margin, 287 net profit margin, 287 operating profit margin, 287 overview, 284, 287 return on owner’s equity, 288–289 return on total invested capital, 288 Operating profit margin (OPM), 287, 438–439 Opportunistic hedge fund strategies, 935 Optimal portfolio, 200 Option-adjusted duration, callable bonds, 669–670 Option-adjusted spreads (OAS), 679–681 Option-based interest rate contracts, 875–878 caps and floors, 875–876 collars, 876–878 overview, 875 Option contracts, 821–866 conventions, 822–823 defined, 747 overview, 821–822 paying to acquire, 750–753 payoff and profit diagrams for, 755–760 popular, 749 price quotations for exchange-traded options, 823–830 relationship between forward contracts and, 760–767 trading strategies, 850–861 valuation of, 830–844 Option markets, 747–749 contract terms, 747–748 overview, 747 trading markets, 748 valuation basics, 748 Option premium, 747 Option price quotations, 748–750 Options calls, 78, 742–743, 747, 755–758, 850, 852–853 overview, 78 puts, 78, 742–743, 747, 755–758, 768–771, 845, 847–848, 850–852 warrants, 78 Options Clearing Corporation (OCC), 823 Order-driven market (pure auction market) system, 103 Original-issue discount (OID) bonds, 75, 610–611, 630 Or losses (unrealized capital gains), 46 OTC interest rate agreements See Over-thecounter (OTC) interest rate agreements Out of the money, 748 Overconfidence in forecasts, 170 Overfunded plans, 58 Overreaction hypothesis, 562 Over-the-counter (OTC) interest rate agreements, 868–878 forward-based, 868–875 option-based, 875–878 overview, 868 Overvalued assets, identifying, 219–221 Overweighted, 331 P Par (principal) value, 592 Passive bond portfolio management, 694–696 buy-and-hold strategy, 694–695 example of, 696 indexing strategy, 695 overview, 694 Passive equity portfolio management, 550–558 active versus, 550–551 construction techniques, 552–555 methods of, 555–558 overview, 551–552 Payback (break-even time), 889 P/BV ratio See Price/book value (P/BV) ratio P/CF ratio See Price/cash flow (P/CF) ratio Peer group comparisons, 961 PEG (price-earnings/growth rate) ratio, 159 Pension funds, 54 Pension Protection Act of 2006, 946–947 P/E ratio See Price/earnings (P/E) ratio Percentage of par, 615 Performance presentation standards (PPS), 997 Perpetuities, 335 Plain vanilla interest rate swaps, 872–873 Point-and-figure charts, 538–541 Point estimates, Policy effect, portfolio performance, 995 Policy statements constructing, 49 defined, 38 inputs, 41–48 need for, 38–41 portfolio management process, 33–34, 37–38 questions answered by, 41 questions to ask when constructing, 39 Political risk See Country risk (CR; political risk) Portfolio insurance, 769 Portfolio management, 174–176, 181–206 See also Bond portfolio management; Equity portfolio management asset allocation, 37–38 behavioral finance, 176 exchange-traded funds, 175–176 index funds, 175–176 Markowitz portfolio theory, 182–200 overview, 33, 174, 181–182 risk, defined, 182 risk aversion, 182 with superior analysts, 174–175 use of derivatives in, 767–772 without superior analysts, 175 Portfolio managers See Analysts and managers Portfolio performance, 959–1007 application of, 972–978 attribution analysis, 986–989 bond portfolios, 993–996 components of, 978–980 composite measures of, 961–972 with downside risk, 980–982 early evaluation techniques, 961 factors that affect use of, 990–993 holdings-based measurement of, 982–985 market timing skills, 989–990 overview, 959–960 reporting, 997–1000 requirements of portfolio managers, 960 Portfolios constructing, 37–38 diversification, 64–65, 67 historical rates of return, performance evaluation standards, 39–40 risk premium and, 20 standard deviation of returns for, 185–197 three-asset, 197–198 Portfolio turnover, 568 Potential return, 726–729 PPS (performance presentation standards), 997 Preferred habitat (segmented market hypothesis), 652–653 Preferred stock, 75, 335–336 Premium bond pricing, 626 Present consumption, Present value model, 624–626 Present value of dividends dividend discount model, 471–472 growth rate estimates, 468, 470 overview, 468 required rate of return estimate, 470–471 Present value of free cash flow to equity, 347, 472–474 Present value of operating free cash flow, 346–347, 474–477 Price/book value (P/BV) ratio alternative investment valuation, 350–351 company analysis, 494–495 industry analysis, 446–449 semistrong-form EMH, 161 stock market analysis, 406–407 Price/cash flow (P/CF) ratio alternative investment valuation, 350 company analysis, 496 industry analysis, 449–450 stock market analysis, 406–407 Price continuity, 96–97 Price discovery, 101 Price-driven systems, 103 Price/earnings (P/E) ratio effect on systematic risk, 230–231 industry analysis, 435–446 microeconomic-based risk factor models, 253–254 security valuation, 348–352 semistrong-form EMH, 159 stock market analysis, 387–388, 399–401 Price-earnings/growth rate (PEG) ratio, 159 Price momentum strategy, 563, 565–566, 568 Price risk, 715 Price/sales (P/S) ratio alternative investment valuation, 351 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Index company analysis, 497–499 industry analysis, 449–451 stock market analysis, 406, 408 Price-weighted indexes, 125–127 Price-yield curve, 625–626 Primary capital markets, 98–101 corporate bond issues, 99 corporate stock issues, 99–100 government bond issues, 98 municipal bond issues, 98–99 overview, 98 private placements and Rule 144A, 101 Primary listing markets, 105–109 American Stock Exchange, 105–107 NASDAQ, 107–109 New York Stock Exchange, 105 overview, 105 Principal (par) value, 592 Principal-agent problem, 946 Private equity funds, 938–945 development and organization of market, 940–942 investment process, 942–944 overview, 938–940 returns to, 944–945 Private money management firms, 916–919 See also Investment, management, and advisory firms Private placements, 98–99, 101 Professional money management companies See Investment, management, and advisory firms Profit margin forecast example of, 442–444 interest expense, 439–442 operating profit margin, 438–439 overview, 438 tax rate, 442 Program trading, 800–804 Promised yield to call (YTC), 630–631 Promised yield to maturity (YTM), 628–630 Proportion of debt (balance sheet) ratios, 298–300 debt-equity ratio, 299 long-term debt-total capital ratio, 300 overview, 298–299 Prospect theory, 170 Protective put options, 850–852 Protective puts, 768–772 P/S ratio See Price/sales (P/S) ratio Public bonds, 591–592 Pure auction market (order-driven market) system, 103 Pure cash-matched dedicated portfolios, 713–714 Pure rate of interest, Pure time value of money, 4, 15 Pure yield pickup swaps, 706–707 Putable bonds, 673–674 Put and Call Brokers and Dealers Association, 822 Put-call-forward parity, 765–767 Put-call parity creating synthetic securities using, 763–764 defined, 758 example of, 762–763 Put-call ratio, 531–532 Put-call-spot parity, 760–762, 764–765 Put options, 78, 742–743 defined, 747 European-style, 845, 847–848 payoff and profit diagrams for, 755–758 protective, 850–852 use of in portfolio management, 768–771 Q Quadratic optimization, 552 Quarterly earnings reports, 157–158 Quarterly estimates, 485, 487 Quasi government (agency) bonds, 596 Eurozone, 604 Japan, 604 overview, 596, 602 price quotes, 617–619 United Kingdom, 604 United States, 73, 602–604 Quick ratio, 281 Quote-driven market (dealer market) system, 104–105 R Random walk hypothesis, 151 Range (flexible) forwards (collars), 859–861 Range of returns, 183 Rate anticipation effect, portfolio performance, 995 Rates of return, 21–25 See also Expected rate of return; Historical rate of return; Required rate of return (k) bonds, 594 capital asset pricing model, 219–220 industry analysis, 425–435 overview, on U.S and foreign securities, 66 Raw land, 81–82 Real estate, 81–82 direct real estate investment, 81 land development, 82 raw land, 81–82 real estate investment trusts, 81 rental property, 82 risk-return combination, 87–88 Real estate investment trusts (REITs), 81, 86–87 Realized (horizon) yield computing, 632 with differential reinvestment rates, 633–635 overview, 631–632 Realized capital gains, 46 Real options company valuation with, 899–901 defined, 898 overview, 898–899 Real risk-free rate (RRFR), 15, 17, 20, 22 of economy, 352–353 foreign, 354 Receivables turnover, 282–283 Reduced form DDM, 378, 426–433 Reference entities, 880 Refunding issues, 593 Regional stock exchanges, 104, 109 Registered bonds, 592 Regulation, alternative industries and, 421 REITs (real estate investment trusts), 81, 86–87 Relative-strength (RS) ratios, 538–539 1055 Relative valuation See also names of specific relative valuation techniques company analysis, 494–499 earnings multiplier model, 347–350 implementing, 351–352 industry analysis, 435–451 intrinsic value estimation, 477–479 overview, 347 price/book value, 350–351 price/cash flow ratio, 350 price/sales ratio, 351 using, 338 Rental insurance, purpose of, 34 Rental property, 82 Replicating portfolios, 899 Representativeness, 170 Required rate of return (k), 14–21 company analysis, 488–490 defined, 4, 14 dividend discount model, 380 earnings multiplier approach, 400 expected rate of inflation, 353 for foreign securities, 354–356 fundamental risk versus systematic risk, 20 industry analysis, 426–428, 445 nominal risk-free rate, 15–17 overview, 14–15, 352 real risk-free rate, 15, 352–353 risk premium, 17–20, 353–354 uncertainty of returns, 333–334 Resistance level, 535–536 Retention rates, foreign stocks, 359 Return objectives, 44–45 Return on owner’s equity (ROE), 288–291, 305–307, 357–358, 380–381, 383, 428–432 Return on total assets (ROTA), 288–290, 428, 430 Return on total capital (ROTC), 297–298 Return on total invested capital (ROIC) ratio, 288, 298 Return prediction studies, semistrong-form EMH, 156–158 Returns-based bond performance measurement, 993–994 Revenue bonds, 73, 593 Reverse floating-rate contracts, 897 Reversion concept, 53 RFR See Risk-free rate of return (RFR) Rising trend channel, 530 Rising yield curves, 644 Risk, 960 alternative measures of, 183 capital market line, 214–215 of combined country investments, 66–71 defined, 9, 182 of different asset classes, 52–53 of expected rates of return, 12–14 forward versus futures contracts, 785 interest rate, 715–716 measures and sources of, 21 multifactor models and, 250–261 Risk analysis, 293–304 business risk, 294–295 cash flow-outstanding debt ratios, 302–303 compared to other ratios, 309 earnings and cash flow coverage ratios, 300–302 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1056 Index external market liquidity risk, 303–304 financial risk, 295–298 overview, 293–294 proportion of debt ratios, 298–300 Risk arbitrage investing, 935–936 Risk averse, 12, 182 Risk-free assets combining with risky portfolio, 209–210 covariance with, 209 defined, 208 overview, 208–209 Risk-free rate of interest, 15–16 Risk-free rate of return (RFR) capital asset pricing model, 218, 226, 233 capital market theory, 208–212, 214–215 interest rate determination, 640–642 Riskless arbitrage, 246 Risk premium (RP) changes in, 353–354 changes in slope of SML, 22–24 defined, 4, 18 dividend discount model, 378–380 foreign securities and, 355–356 futures contracts, 790 overview, 17–19, 353 portfolio theory and, 20 proxies, semistrong-form EMH, 156–157 Risk-return relationship, 21–25 between bond portfolios and other asset classes, 691–692 capital market line, 215–216 changes in capital market, 24 changes in expected inflation, 24–25 combining risk-free asset with risky portfolio, 210–212 combining U.S and foreign bonds, 69 global investments, 83–88 overview, 21–22 portfolio managers, expectations of, 960 security market line, 22–24 Risk tolerance, 41–42 Risky assets combining with risk-free assets, 210–211 correlation between risk-free assets and, 209 defined, 208 expected return for, 183–185 ROE (return on owner’s equity), 288–291, 305–307, 357–358, 380–381, 383, 428–432 ROIC (return on total invested capital) ratio, 288, 298 Roll and Ross study, 247–248 ROTA (return on total assets), 288–290, 428, 430 Rotation strategy, 418 ROTC (return on total capital), 297–298 Roth IRAs, 47–48 RP See Risk premium (RP) RRFR See Real risk-free rate (RRFR) RS (relative-strength) ratios, 538–539 Rule 144A, 101 Rule 415, 100 Runs test, 153 Russell 1000 Growth and Value Index, 572–575 S S See Sharpe ratio (S) portfolio performance measure Safety margin, 726–727 Sales forecasts, 436–438, 480–482 Sales per share for market series, estimating, 391–392 Sales variability, 294–295 Sampling, 125, 552 Samurai bonds, 76, 614 Savings accounts, 72 Seasoned equity issues, 99–100 Secondary capital markets, 101–105 bond markets, 102 equity markets, 102–112 financial futures, 102 importance of, 101 overview, 98, 101 Sector ETFs, 555 Sector rotation strategy, 560–561 Secured (senior) bonds, 74, 592–593 Securities Act of 1933, 946–947 Securities analysts See also Analysts and managers analysis of, 173 corporate insider trading, 166–167 superior, 174–175 Securities Exchange Act of 1934, 946–947 Securities markets, 95–121 alternative orders, 112–119 characteristics of good, 96–97 decimal pricing, 97–98 organization of, 98 overview, 95–96 primary capital markets, 98–101 secondary financial markets, 101–105 Securitized and collateralized bonds, 596 Securitized issues, 596 Security-market indexes, 123–146 bond-market indexes, 133–137 comparison of over time, 138–139 composite stock-bond indexes, 137–138 factors in constructing, 125 overview, 123–124 stock-market indexes, 125–133 uses of, 124 Security market line (SML), 218–225 calculating systematic risk, 221–222 changes in slope of, 22–24, 25 comparative Treynor measures, 964–965 defined, 21–22 determining expected rate of return for risky asset, 218–219 example of, 222–225 identifying undervalued and overvalued assets, 219–221 industry characteristic lines, 225 movement along, 22, 24 overview, 218 performance measures, 990 relaxing CAPM assumptions, 226–229 shift in, 24–25 theory versus practice, 232–234 Security market plane, 244 Security valuation, 327–364 alternative investments, 334–352 expected growth rates, 356–360 overview, 327–328 required rate of return, 352–356 theory of, 333–334 three-step process, 329–333 Segmented market hypothesis, 652–653 SelectNet, 118 Self-attribution bias, 170 Semistrong-form efficient market hypothesis (EMH), 155–165 adjustment for market effects, 155–156 alternate semistrong tests, 156 cross-sectional return predictions, 158–161 event studies, 161–165 overview, 152, 155 return prediction studies, 156–158 Semivariance, 183 Senior (secured) bonds, 74, 592–593 Sentiment and expectation surveys, 372 Separation theorem, 214 Sequential distribution process, 607–608 Serial obligation bonds, 592 Settlement price, 785 SFR (swap fixed rate), 871 SGX (Singapore Stock Exchange), 119 Sharpe ratio (S) portfolio performance measure, 965–967 application of, 973–975, 978 compared to other measures, 970–972 demonstration of, 966–967 overview, 965 Sortino ratio versus, 981–982 Shelf registrations, 100 Short hedges, 786 Short position, 743 Short sales, 115–117 Short straddle position, 853 Short-term interest rate futures, 796–800 Eurodollar contract mechanics, 796–797 overview, 796 synthetic fixed-rate funding with Eurodollar strip, 797–799 TED spread, 799–800 Simple-growth model, 501–502 Singapore Stock Exchange (SGX), 119 Sinking fund, 74, 593–594 Site visits, 512 Size effect, semistrong-form EMH, 159–160 Skewness, effect on systematic risk, 229–230 Small-cap stocks, 83, 130, 565 Small-firm effect, 160, 248–249 Small minus big (SMB), 253–254, 256–258 Small-Order Execution System (SOES), 118 Smart money behavior Confidence Index, 532–533 debit balances in brokerage accounts, 533 overview, 532 T-bill/Eurodollar yield spread, 533 SMB (small minus big), 253–254, 256–258 SML See Security market line (SML) Social consciousness, 48 Socially responsible investment (SRI) indexes, 131 SOES (Small-Order Execution System), 118 Solvency ratios See Internal liquidity (solvency) ratios Sortino portfolio performance measure, 980– 982 Sovereign bonds, 595–596 Specialists (designated market makers [DMM]), 117 Special orders, 113 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Index Special situations, private equity transactions, 941–942 Speculative companies, 462 Speculative-grade bonds, 597 Speculative stocks, 462 Spending phase, investor life-cycle, 35–36 Split rating, 598 Spot markets, 743–744 Spot prices, 790–791 Spot rates calculating forward rates from spot rate curve, 647–649 creating theoretical spot rate curve, 645–647 defined, 645 overview, 636–638 Spreads, 822, 857–859 SRI (socially responsible investment) indexes, 131 Stamps, 83 Standard & Poor’s 500 Index futures contracts, 744–747 industry group performance, 415 option contracts, 748–751 Standard deviation of returns See Variance (standard deviation) of returns Statements of cash flow, 273–276 from financing activities, 274–275 from investing activities, 273–274 from operating activities, 273 overview, 273 Static yield spreads, 678–679 Stock index arbitrage (index arbitrage), 800–803 Stock-index futures, 800–806 contract fundamentals, 800–801 futures traders bullish on, 532 index arbitrage and, 801–803 isolating unsystematic risk of individual stocks, 803–806 overview, 800 Stock-index options, 825–828, 848–849 Stock market business cycle and, 418, 560 typical price cycle, 529–530 Stock market analysis and valuation, 367–412 company analysis versus, 460–462 components of, 367–368 global, 514–515 macromarket analysis, 368–372, 374–377 microvaluation analysis, 377–409 models of, 311–312 overview, 367 Stock market anomalies, arbitrage pricing theory and, 248–249 Stock-market indexes, 125–133 foreign, 145–146 fundamental weighted, 130 global equity indexes, 131–133 overview, 125 price weighted, 126–127 style indexes, 130–131 summary of, 144–145 unweighted, 129–130 value weighted, 127–129 Stock price and volume techniques bar charting, 538 candlestick charts, 538 Dow Theory, 534 importance of volume, 534–535 moving-average lines, 536–538 multiple-indicator charts, 538 overview, 534 point-and-figure charts, 538–541 relative strength, 538 support and resistance levels, 535–536 Stock prices economic series and, 369 inflation and, 376 interest rates and, 376 money supply and, 373 Stock price trees, 833–835 binomial option pricing model, 837 creating, 832–833 expanding, 835–836 subintervals, 834–835 Stocks common mistakes in trading, 49 monetary policy and returns, 373 percentage of periods that returns trailed T-bill returns, 54 valuation of, 335–337 well-diversified portfolios, 213–214 Stock splits price-weighted indexes, 126–127 value-weighted indexes, 128 Stock split studies, semistrong-form EMH, 162 Stop buy orders, 113 Stop loss orders, 113 Straddles, 822, 853–855 Strangles, 855–856 Straps, 853–855 Strategic asset allocation, 580–581, 582 Stratified sampling, 695 Striking (exercise) price, 78, 747 Strips, 853–855 Strong-form efficient market hypothesis (EMH), 165–169 corporate insider trading, 166–167 money manager performance, 167–169 overview, 152, 165–166 Structural changes, 417 Structured notes commodity-linked bull and bear bonds, 894–896 dual currency bonds, 891–892 equity index linked, 892–894 overview, 890 swap linked, 896–898 Style analysis, 573–577, 578 Style drift, 576–577 Style grids bond portfolios, 692–693 equity portfolios, 573, 575 Style indexes, 130–131 Subordinate (junior) debentures, 593 Subordinated bonds, 74 Substitution swaps, 706–708 Super Dot trading system, 117 Superior analysts, 173 Supplemental Medicare insurance, 34 Support level, 535–536 Sustainable growth potential analysis, 304–307 Swap contracting extensions, 878–883 credit-related swaps, 879–883 1057 equity index-linked swaps, 878–879 overview, 878 Swap fixed rate (SFR), 871 Swap-linked notes, 896–898 Swap spread, 871 SWOT analysis, 466 Synthetic risk-free portfolios, 830–831 Systematic risk, 221–222, 229–231 defined, 20, 212, 215 effect of book-to-market value, 231 effect of market proxy, 221–222 effect of size, P/E, and leverage, 230–231 effect of skewness on relationship, 229–230 effect of time interval, 221 fundamental risk versus, 20 industry analysis, 427–428 overview, 221, 229 security-market indexes, 124 stability of beta, 229 world portfolio performance, 85 T T See Treynor ratio (T) portfolio performance measure Tactical asset allocation (TAA), 560–561, 581–582, 989 Tax cost ratio, 568 Tax efficiency, 568–569 Taxes effect on capital market line and security market line, 228–229 investor concerns, 46–47 municipal bonds, 73 preferred stock, 75 after returns, 51–52 Tax-exempt bonds, 635–636 Tax rate aggregate operating profit margin and, 398 industry analysis, 442 Tax swaps, 707–709 T-bills See Treasury bills (T-bills) T-bonds See Treasury bonds (T-bonds) Technical analysis, 525–547 active equity portfolio management, 562–563 advantages of, 527–528 of bond markets, 542–544 challenges to, 528–529 defined, 525–526 efficient capital markets, 171–172 of foreign markets, 541–542 overview, 525–526 trading rules and indicators, 529–541 underlying assumptions of, 526–527 Technology, alternative industries and, 420–421 TED (Treasury/EuroDollar) spread, 799–800 Term bonds, 592 Term premium (liquidity preference) hypothesis, 652 Term structure of interest rates, 639 Term structure spread, 157 Term-structure theories expectations hypothesis, 650–652 liquidity preference hypothesis, 652 segmented market hypothesis, 652–653 trading implications of, 653 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1058 Index yield spreads, 653–654 Term to maturity defined, 592, 625 Macaulay duration and, 659 Third market, 109 Three-asset portfolios, 197–198 Time (calendar) spreads, 857 Time horizon, 45–46, 251–252 Timely and accurate information, 96 Time premium, 748 Time-series analysis, 155–156, 279 Time-weighted returns, 997–998 TIPS (Treasury Inflation-Protected Securities), 52, 600–601 T-notes See Treasury notes (T-notes) Tokyo Stock Exchange (TSE), 106 Total asset/equity ratio, 360 Total asset turnover, 285, 360 Total return strategy, 44 Total return swaps, 880 Total risk, 19 Tracking error, 695 Trading effect, portfolio performance, 995 Trading symbols, 108 Trading turnover, 304 Traditional cash flow, 275–276 Tranches, 607 Transaction costs, 97, 227–228 Treasury bills (T-bills) maturity, 73 overview, 72, 98, 599–600 percentage of periods that stock returns trailed returns from, 54 quotes, 617–619 T-bill/Eurodollar yield spread, 533 TED spread, 799–800 Treasury bonds (T-bonds) contract mechanics, 792–793 futures, 792, 794–796 maturity, 73 “Notes over Bond” spread, 795–796 overview, 98, 599–600 price quotes, 617–619 quotes, 617–619 secondary markets, 102 Treasury/EuroDollar (TED) spread, 799–800 Treasury Inflation-Protected Securities (TIPS), 52, 600–601 Treasury notes (T-notes) contract mechanics, 792–793 long-term interest rate futures, 792 maturity, 73 “Notes over Bond” spread, 795–796 overview, 98, 599–600 quotes, 617–619 Treasury securities, 73 Treynor ratio (T) portfolio performance measure, 963–965 application of, 972, 974–975, 978 compared to other measures, 970–972 demonstration of, 963–965 overview, 963 Troughs, 530 T Rowe Price matrix, 43 T Rowe Price Value (TRVLX) mutual fund, 571–572, 576–577 TSE (Tokyo Stock Exchange), 106 12b-1 plans, 923 Two-stage growth FCFE model, 386–387, 434–435 U Uncertainty See Risk Underfunded plans, 58 Undervalued assets, identifying, 219–221 Underweighted, 331 Underwriting corporate bonds, 98–99 corporate stocks, 100 municipal bonds, 98–99 Unique risk See Unsystematic (unique) risk United Kingdom domestic government bonds, 601–602 international bonds, 614 quasi-government bonds, 604 United States American shares, 77 corporate bonds, 606–608 domestic government bonds, 599–601 government agency securities, 73 government and municipal bonds, 102 international bonds, 614 quasi government (agency) bonds, 602–604 rates of return on securities, 66 relative size of financial markets, 65–66 secondary equity markets, 105–112 Treasury securities, 73 Unit labor cost, 394–395 Unlisted trading privileges (UTP), 109 Unrealized capital gains (or losses), 46 Unsecured bonds (debentures), 74–75, 593 Unsystematic (unique) risk defined, 20, 212, 215 elimination of, 213–214 of individual stocks, isolating, 803–806 Unweighted indexes, 125, 129–130 Unwinding values, 789 Utility function, 199 UTP (unlisted trading privileges), 109 V Valuation analysis, 697, 700 Value investing, 462, 569–573 Value Line (VL) enigma, 166–167 Value mutual funds, 570 Value stocks, 130–131, 462 Value-weighted (dollar-weighted) mean rate of return, Value-weighted (market-value-weighted) indexes, 125, 127–129 Vanguard 500 Index Fund (VFINX), 555–556, 569 Vanguard Investments, 43 Vanguard Total Bond Index Fund (VBMFX), 696 Variable principal redemption (VPR), 892–894 Variable-rate notes, 610 Variance (standard deviation) of returns, 12 combining risk-free asset with risky portfolio, 209 defined, 183 for individual investments, 184–185 overview, 12 for portfolios, 185–197 risk of expected rates of return, 12–13 total risk, 19 VBMFX (Vanguard Total Bond Index Fund), 696 Venture capital, 941 VFINX (Vanguard 500 Index Fund), 555–556, 569 VIX (Volatility Index), 843 VL (Value Line) enigma, 166–167 Volatility, 255, 842–844 Volatility Index (VIX), 843 VPR (variable principal redemption), 892–894 W WACC (weighted average cost of capital), 337, 344, 346–347, 352, 475–477 Warrants, 74–75, 78, 883–885 Wash sales, 708 Weak-form efficient market hypothesis (EMH), 152–155 overview, 151–152 simulations of trading rules, 153–155 statistical tests of independence, 152–153 Weekend effect, 158 Weighted average cost of capital (WACC), 337, 344, 346–347, 352, 475–477 World portfolio performance, 83–87 asset return and total risk, 85 correlations between asset returns, 85–87 overview, 83–85 return and systematic risk, 85 World security markets macromarket analysis of, 376–377 microvaluation analysis of, 408–409 World stock indexes, comparison of, 133 Y Yankee bonds, 76, 613–614 Yield books (bond books), 636 Yield curve risk, 671 Yield curves, 625–626, 636, 638–639, 643–644 Yield illusion, 629–630 Yield model, 626–627 Yields, defined, 626 Yield spread analysis, 697, 705 Yield spreads, 653–654 defined, 23 with embedded options, 678–681 Yield to call (YTC), 630–631, 668 Yield to maturity (YTM) calculating future bond prices, 632–633 duration and, 659–660 promised, 628–630 Yield to worst, 631 YTC (yield to call), 630–631, 668 YTM (yield to maturity) calculating future bond prices, 632–633 duration and, 659–660 promised, 628–630 Z Z bonds, 607–608 Zero-beta model, 226–227 Zero-coupon bonds, 75, 610–611, 630 Zero coupon equivalent maturity, 819 Zero-stage capital, 943 Zero variance, 208 ... bp 28 :30 29 :27 28 :19 29 :14 28 :09 27 :20 27 :19 28 :14 27 :09 27 :30 26 :30 27 :19 26 :20 27 :07 26 :10 26 :29 26 :18 26 :01 25 :22 26 : 12 25:30 25 :19 28 :30 29 :27 28 :19 29 :14 28 :09 27 :31 27 :20 28 :14 27 :09 27 :30... Jan 20 20 20 21 20 16 20 23 20 12 2041 20 15 20 17 20 41 20 21 20 15 20 15 20 17 20 20 20 12 2016 20 20 20 16 20 21 20 35 20 21 98.131 103.151 101.170 100.984 106.083 105.508 98.503 1 02. 250 104.554 101.3 62 100.8 52. .. 0. 625 1.875 2. 000 1 .25 0 2. 000 1. 625 0.500 1.875 2. 000 0. 125 2. 500 2. 375 2. 625 1. 625 1.375 2. 125 1.875 1.375 1 .25 0 1. 125 2. 375 2. 000 2. 375 1.750 3. 625 2. 500 3.875 3.375 2. 125 2. 125 04/ 12 07/12