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Investment Analysis &Portfolio Management
TENTH EDITION
F R A N K K R E I L L Y
University of Notre Dame
K E I T H C B R O W N
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Trang 5To my best friend & wife,Therese,and the greatest gifts andsources of our happiness,Frank K III, Charlotte, and LaurenClarence R II, Michelle, Sophie, and Cara
Therese B and Denise Z.
Edgar B., Lisa, Kayleigh, Madison J T., Francesca, and Alessandra—F K R.
Trang 6Preface xiii
Acknowledgments xviiAbout the Authors xxi
PART 1The Investment Background1
CHAPTER 1 The Investment Setting 3
CHAPTER 2 The Asset Allocation Decision 33
CHAPTER 3 Selecting Investments in a Global Market 63
CHAPTER 4 Organization and Functioning of Securities Markets 95
CHAPTER 5 Security-Market Indexes 123
PART 2Developments in Investment Theory147
CHAPTER 6 Efficient Capital Markets 149
CHAPTER 7 An Introduction to Portfolio Management 181
CHAPTER 8 An Introduction to Asset Pricing Models 207
CHAPTER 9 Multifactor Models of Risk and Return 241
PART 3Valuation Principles and Practices269
CHAPTER10 Analysis of Financial Statements 271
CHAPTER11 An Introduction to Security Valuation 327
PART 4Analysis and Management of Common Stocks365
CHAPTER12 Macroanalysis and Microvaluation of the Stock Market 367
CHAPTER13 Industry Analysis 413
CHAPTER14 Company Analysis and Stock Valuation 459
CHAPTER15 Technical Analysis 525
CHAPTER16 Equity Portfolio Management Strategies 549
PART 5Analysis and Management of Bonds589
CHAPTER17 Bond Fundamentals 591
CHAPTER18 The Analysis and Valuation of Bonds 623
CHAPTER19 Bond Portfolio Management Strategies 691
Trang 7CHAPTER21 Forward and Futures Contracts 781
CHAPTER22 Option Contracts 821
CHAPTER23 Swap Contracts, Convertible Securities, and Other Embedded
Derivatives 867
PART 7Specification and Evaluation of Asset Management909
CHAPTER24 Professional Money Management, Alternative Assets, and Industry
Ethics 911
CHAPTER25 Evaluation of Portfolio Performance 959
Appendixes A-D 1009
Comprehensive References List 1017Glossary 1032
Trang 8Contents
Preface xiiiAcknowledgments xviiAbout the Authors xxi
PART 1The Investment Background1
C H A P T E R 1
The Investment Setting 3What Is an Investment? 3
Investment Defined 4
Measures of Return and Risk 5
Measures of Historical Rates of Return 5, ComputingMean Historical Returns 7, Calculating Expected Rates ofReturn 9, Measuring the Risk of Expected Rates of Return12, Risk Measures for Historical Returns 14
Determinants of Required Rates of Return 14The Real Risk-Free Rate 15, Factors Influencing theNominal Risk-Free Rate (NRFR) 15, Risk Premium 17,Risk Premium and Portfolio Theory 20, FundamentalRisk versus Systematic Risk 20, Summary of RequiredRate of Return 20
Relationship between Risk and Return 21
Movements along the SML 22, Changes in the Slope ofthe SML 22, Changes in Capital Market Conditions orExpected Inflation 24, Summary of Changes in theRequired Rate of Return 24
Chapter 1 Appendix:Computation of Variance and Standard
Deviation 30
C H A P T E R 2
The Asset Allocation Decision 33Individual Investor Life Cycle 34
The Preliminaries 34, Investment Strategies over anInvestor’s Lifetime 35, Life Cycle Investment Goals 37The Portfolio Management Process 37
The Need for a Policy Statement 38
Understand and Articulate Realistic Investor Goals 38,Standards for Evaluating Portfolio Performance 39, OtherBenefits 40
Input to the Policy Statement 41
Investment Objectives 41, Investment Constraints 45Constructing the Policy Statement 49
General Guidelines 49, Some Common Mistakes 49
The Importance of Asset Allocation 49
Investment Returns after Taxes and Inflation 51, Returnsand Risks of Different Asset Classes 52, Asset AllocationSummary 53
Chapter 2 Appendix:Objectives and Constraints of
Institutional Investors 58
C H A P T E R 3
Selecting Investments in a Global Market 63The Case for Global Investments 64
Relative Size of U.S Financial Markets 65, Rates of Returnon U.S and Foreign Securities 66, Risk of CombinedCountry Investments 66
Global Investment Choices 71
Fixed-Income Investments 72, International BondInvesting 75, Equity Instruments 76, Special EquityInstruments: Options 78, Futures Contracts 78,Investment Companies 79, Real Estate 81,Low-Liquidity Investments 82
Historical Risk-Returns on AlternativeInvestments 83
World Portfolio Performance 83, Art and Antiques 87,Real Estate 87
Chapter 3 Appendix:Covariance 93
C H A P T E R 4
Organization and Functioning of Securities
Markets 95What Is a Market? 96
Characteristics of a Good Market 96, Decimal Pricing 97,Organization of the Securities Market 98
Primary Capital Markets 98
Government Bond Issues 98, Municipal Bond Issues 98,Corporate Bond Issues 99, Corporate Stock Issues 99,Private Placements and Rule 144A 101
Secondary Financial Markets 101
Why Secondary Markets Are Important 101, SecondaryBond Markets 102, Financial Futures 102, SecondaryEquity Markets 102
Classification of U.S Secondary Equity Markets 105Primary Listing Markets 105, Regional Stock Exchanges109, The Third Market 109, The Significant Transition ofthe U.S Equity Markets 109
Trang 9Market-Makers 117, New Trading Systems 117, ExchangeMerger Mania 118
C H A P T E R 5
Security Market Indexes 123Uses of Security-Market Indexes 124
Differentiating Factors in Constructing MarketIndexes 125
The Sample 125, Weighting Sample Members 125,Computational Procedure 125
Stock-Market Indexes 125
Price-Weighted Index 126, Value-Weighted Index 127,Unweighted Index 129, Fundamental Weighted Index130, Style Indexes 130, Global Equity Indexes 131Bond-Market Indexes 133
U.S Investment-Grade Bond Indexes 135, High-YieldBond Indexes 135, Global Government BondIndexes 135
Composite Stock-Bond Indexes 137Comparison of Indexes over Time 138
Correlations between Monthly Equity Price Changes 138,Correlations between Monthly Bond Index Returns 139,Mean Annual Security Returns and Risk 139
Chapter 5 Appendix:Stock-Market Indexes 144
PART 2Developments in Investment
Theory147
C H A P T E R 6
Efficient Capital Markets 149Why Should Capital Markets Be Efficient? 150
Alternative Efficient Market Hypotheses 151Weak-Form Efficient Market Hypothesis 151,Semistrong-Form Efficient Market Hypothesis 152,Strong-Form Efficient Market Hypothesis 152Tests and Results of Efficient Market Hypotheses 152
Weak-Form Hypothesis: Tests and Results 152,Semistrong-Form Hypothesis: Tests and Results 155,Strong-Form Hypothesis: Tests and Results 165Behavioral Finance 169
Explaining Biases 170, Fusion Investing 171Implications of Efficient Capital Markets 171
Efficient Markets and Technical Analysis 171, EfficientMarkets and Fundamental Analysis 172, Efficient Marketsand Portfolio Management 174
Risk Aversion 182, Definition of Risk 182Markowitz Portfolio Theory 182
Alternative Measures of Risk 183, Expected Rates ofReturn 183, Variance (Standard Deviation) of Returns foran Individual Investment 184, Variance (StandardDeviation) of Returns for a Portfolio 185, StandardDeviation of a Portfolio 190, A Three-Asset Portfolio 197,Estimation Issues 198, The Efficient Frontier 198, TheEfficient Frontier and Investor Utility 200
Chapter 7 Appendix:
A Proof That Minimum Portfolio Variance Occurs withEqual Weights When Securities Have EqualVariance 205
B Derivation of Weights That Will Give Zero Variance WhenCorrelation Equals−1.00 205
C H A P T E R 8
An Introduction to Asset Pricing Models 207Capital Market Theory: An Overview 207
Background for Capital Market Theory 208, Developingthe Capital Market Line 208, Risk, Diversification, and theMarket Portfolio 212, Investing with the CML: AnExample 215
The Capital Asset Pricing Model 216
A Conceptual Development of the CAPM 217, TheSecurity Market Line 218
Relaxing the Assumptions 225
Differential Borrowing and Lending Rates 225,Zero-Beta Model 226, Transaction Costs 227,Heterogeneous Expectations and PlanningPeriods 228, Taxes 228
Additional Empirical Tests of the CAPM 229Stability of Beta 229, Relationship between SystematicRisk and Return 229, Summary of CAPM Risk-ReturnEmpirical Results 231
The Market Portfolio: Theory versus Practice 232
C H A P T E R 9
Multifactor Models of Risk and Return 241Arbitrage Pricing Theory 242
Using the APT 244, Security Valuation with theAPT: An Example 245, Empirical Tests of theAPT 247
Multifactor Models and Risk Estimation 250
Trang 10C H A P T E R 1 0
Analysis of Financial Statements 271Major Financial Statements 272
Generally Accepted Accounting Principles 272, BalanceSheet 273, Income Statement 273, Statement of CashFlows 273, Measures of Cash Flow 275, Purpose ofFinancial Statement Analysis 277
Analysis of Financial Ratios 277
Importance of Relative Financial Ratios 278Computation of Financial Ratios 279
Common Size Statements 279Evaluating Internal Liquidity 279
Internal Liquidity Ratios 280, Inventory Turnover 283Evaluating Operating Performance 284
Operating Efficiency Ratios 285, Operating ProfitabilityRatios 287
Risk Analysis 293
Business Risk 294, Financial Risk 295, External MarketLiquidity Risk 303
Analysis of Growth Potential 304
Importance of Growth Analysis 304, Determinants ofGrowth 305
Comparative Analysis of Ratios 307
Internal Liquidity 307, Operating Performance 307, RiskAnalysis 309, Growth Analysis 309
Analysis of Non-U.S Financial Statements 309The Quality of Financial Statements 309
Balance Sheet 309, Income Statement 310, Footnotes 310The Value of Financial Statement Analysis 310Specific Uses of Financial Ratios 311
Stock Valuation Models 311, Estimating the Ratings onBonds 312, Predicting Insolvency (Bankruptcy) 313,Limitations of Financial Ratios 313
C H A P T E R 1 1
An Introduction to Security Valuation 327An Overview of the Valuation Process 329
Why a Three-Step Valuation Process? 329General Economic Influences 329, IndustryInfluences 331, Company Analysis 332, Does theThree-Step Process Work? 332
Theory of Valuation 333
Stream of Expected Returns (Cash Flows) 333, RequiredRate of Return 333, Investment Decision Process: AComparison of Estimated Values and Market Prices 334Valuation of Alternative Investments 334
Valuation of Bonds 334, Valuation of Preferred Stock 335,Approaches to the Valuation of Common
Discounted Cash Flow Valuation Techniques 339, InfinitePeriod DDM and Growth Companies 343, Valuation withTemporary Supernormal Growth 344, Present Value ofOperating Free Cash Flows 346, Present Value of FreeCash Flows to Equity 347
Relative Valuation Techniques 347
Earnings Multiplier Model 347, The Price/Cash FlowRatio 350, The Price/Book Value Ratio 350, The Price/Sales Ratio 351, Implementing the Relative ValuationTechnique 351
Estimating the Inputs: The Required Rate of Returnand the Expected Growth Rate of ValuationVariables 352
Required Rate of Return (k) 352, Estimating theRequired Return for Foreign Securities 354, ExpectedGrowth Rates 356, Estimating Dividend Growth forForeign Stocks 359
Chapter 11 Appendix:Derivation of Constant Growth Dividend
Discount Model (DDM) 364
PART 4Analysis and Management of
Common Stocks365
C H A P T E R 1 2
Macroanalysis and Microvaluation of the StockMarket 367The Components of Market Analysis 367
Macromarket Analysis 368
Economic Activity and Security Markets 368,Economic Series and Stock Prices 369, The CyclicalIndicator Approach 369, Monetary Variables, theEconomy, and Stock Prices 372, Money Supply and theEconomy 372, Money Supply and Stock Prices 373,Monetary Policy and Stock Returns 373, Inflation, InterestRates, and Security Prices 374, Analysis of World SecurityMarkets 376
Microvaluation Analysis 377
Applying the DDM Valuation Model to the Market 377,Market Valuation Using the Free Cash Flow to Equity(FCFE) Model 384
Valuation Using the Earnings Multiplier Approach 387Two-Part Valuation Procedure 387, Importance of BothComponents of Value 387
Estimating Expected Earnings per Share 390Estimating Gross Domestic Product 390, EstimatingSales per Share for a Market Series 391,
Trang 11Determinants of the Earnings Multiplier 400, Estimatingthe Required Rate of Return (k) 400, Estimating theGrowth Rate of Dividends (g) 400, Estimating theDividend-Payout Ratio (D1/E1) 401, Estimating anEarnings Multiplier: An Example 402, Calculating anEstimate of the Value for the Market Series 405, UsingOther Relative Valuation Ratios 406
Microvaluation of World Markets 408
C H A P T E R 1 3
Industry Analysis 413Why Do Industry Analysis? 414
Cross-Sectional Industry Performance 415, IndustryPerformance over Time 416, Performance of theCompanies within an Industry 416, Differences inIndustry Risk 416, Summary of Research on IndustryAnalysis 417, Industry Analysis Process 417
The Business Cycle and Industry Sectors 417
Inflation 419, Interest Rates 419, International Economics419, Consumer Sentiment 419
Structural Economic Changes and AlternativeIndustries 420
Demographics 420, Lifestyles 420, Technology 420,Politics and Regulations 421
Evaluating the Industry Life Cycle 422Analysis of Industry Competition 423
Competition and Expected Industry Returns 423Estimating Industry Rates of Return 425
Valuation Using the Reduced Form DDM 426, IndustryValuation Using the Free Cash Flow to Equity (FCFE)Model 433
Industry Analysis Using the Relative ValuationApproach 435
The Earnings Multiple Technique 435Other Relative Valuation Ratios 446
The Price/Book Value Ratio 446, The Price/Cash FlowRatio 449, The Price/Sales Ratio 449, Summary ofIndustry/Market Ratios 451
Global Industry Analysis 451Chapter 13 Appendix:
A Preparing an Industry Analysis: What Is an Industry? 455B Insights on Analyzing IndustryROAs 456
C H A P T E R 1 4
Company Analysis and Stock Valuation 459Company Analysis versus Stock Valuation 460
Growth Companies and Growth Stocks 460, DefensiveCompanies and Stocks 461, Cyclical Companies and
Analysis 462
Economic and Industry Influences 462, StructuralInfluences 463
Company Analysis 463
Firm Competitive Strategies 464, Focusing a Strategy 465,SWOT Analysis 466, Some Lessons from Lynch 466,Tenets of Warren Buffett 467
Estimating Intrinsic Value 467
Present Value of Dividends 468, Present Value ofDividends Model (DDM) 471, Present Value of FreeCash Flow to Equity 472, Present Value of OperatingFree Cash Flow 474, Relative Valuation RatioTechniques 477
Estimating Company Earnings per Share 480Company Sales Forecast 480, Estimating the CompanyProfit Margin 483
Walgreen Co.’s Competitive Strategies 483
The Internal Performance 483, Importance of QuarterlyEstimates 485
Estimating Company Earnings Multipliers 487Macroanalysis of the Earnings Multiple 487,
Microanalysis of the Earnings Multiplier 488, Making theInvestment Decision 492
Additional Measures of Relative Value 494
Price/Book Value (P/BV) Ratio 494, Price/Cash Flow(P/CF) Ratio 496, Prices/Sales (P/S) Ratio 497, Summaryof Relative Valuation Ratios 499
Analysis of Growth Companies 499
Growth Company Defined 500, Actual Returnsabove Required Returns 500, Growth Companiesand Growth Stocks 500, Alternative Growth
Models 501, No-Growth Firm 501, Long-Run GrowthModels 501, The Real World 504
Measures of Value Added 504
Economic Value Added (EVA) 505, Market ValueAdded (MVA) 507, Relationships between EVA andMVA 507, The Franchise Factor 507, Growth DurationModel 508
Site Visits and the Art of the Interview 512When to Sell 512
Influences on Analysts 513
Efficient Markets 513, Paralysis of Analysis 514, AnalystConflicts of Interest 514
Trang 12Advantages of Technical Analysis 527Challenges to Technical Analysis 528
Challenges to the Assumptions of Technical Analysis 528,Challenges to Technical Trading Rules 529
Technical Trading Rules and Indicators 529
Contrary-Opinion Rules 530, Follow the Smart Money532, Momentum Indicators 533, Stock Price and VolumeTechniques 534
Technical Analysis of Foreign Markets 541
Foreign Stock Market Indexes 541, Technical Analysis ofForeign Exchange Rates 542
Technical Analysis of Bond Markets 542
C H A P T E R 1 6
Equity Portfolio Management Strategies 549Passive versus Active Management 550
An Overview of Passive Equity Portfolio ManagementStrategies 551
Index Portfolio Construction Techniques 552, TrackingError and Index Portfolio Construction 553, Methods ofIndex Portfolio Investing 555
An Overview of Active Equity Portfolio ManagementStrategies 558
Fundamental Strategies 559, Technical Strategies 562,Anomalies and Attributes 563, Forming Momentum-Based Stock Portfolios: Two Examples 565, Tax Efficiencyand Active Equity Management 568
Value versus Growth Investing: A Closer Look 569An Overview of Style Analysis 573
Asset Allocation Strategies 577
Integrated Asset Allocation 578, Strategic Asset Allocation580, Tactical Asset Allocation 581, Insured AssetAllocation 582, Selecting an Active AllocationMethod 583
PART 5Analysis and Management of
Bonds589
C H A P T E R 1 7
Bond Fundamentals 591Basic Features of a Bond 591
Bond Characteristics 592, Rates of Return on Bonds 594The Global Bond Market Structure 594
Participating Issuers 595, Participating Investors 597,Bond Ratings 597
International Bonds 613
Obtaining Information on Bond Prices 614Interpreting Bond Quotes 615
C H A P T E R 1 8
The Analysis and Valuation of Bonds 623The Fundamentals of Bond Valuation 624
The Present Value Model 624, The Yield Model 626Computing Bond Yields 627
Nominal Yield 627, Current Yield 628, Promised Yield toMaturity 628, Promised Yield to Call 630, Realized(Horizon) Yield 631
Calculating Future Bond Prices 632
Realized (Horizon) Yield with Differential ReinvestmentRates 633, Price and Yield Determination on NoninterestDates 635, Yield Adjustments for Tax-Exempt Bonds 635,Bond Yield Books 636
Bond Valuation Using Spot Rates 636What Determines Interest Rates? 638
Forecasting Interest Rates 639, Fundamental
Determinants of Interest Rates 640, The Term Structureof Interest Rates 643
Calculating Forward Rates from the Spot RateCurve 647
Term Structure Theories 650
Expectations Hypothesis 650, Liquidity Preference (TermPremium) Hypothesis 652, Segmented Market Hypothesis652, Trading Implications of the Term Structure 653,Yield Spreads 653
What Determines the Price Volatility for Bonds? 654Trading Strategies 657, Duration Measures 657, ModifiedDuration and Bond Price Volatility 661, Bond Convexity662, Duration and Convexity for Callable Bonds 667,Limitations of Macaulay and Modified Duration 670Yield Spreads with Embedded Options 678
Static Yield Spreads 678, Option-Adjusted Spread 679
C H A P T E R 1 9
Bond Portfolio Management Strategies 691Bond Portfolio Performance, Style, and Strategy 691Passive Management Strategies 694
Buy-and-Hold Strategy 694, Indexing Strategy 695, BondIndexing in Practice: An Example 696
Active Management Strategies 697
Trang 13Matched-Funding Management Strategies 713Dedicated Portfolios 713, Immunization Strategies 715,Horizon Matching 723
Contingent and Structured Management Strategies 724Contingent Immunization 724
Chapter 19 Appendix:Bond Immunization and Portfolio
Rebalancing 737
PART 6Derivative Security
Analysis739
C H A P T E R 2 0
An Introduction to Derivative Markets and
Securities 741Overview of Derivative Markets 742
The Language and Structure of Forward andFuturesMarkets 743, Interpreting Futures PriceQuotations: An Example 744, The Language andStructure of Option Markets 747, Interpreting OptionPrice Quotations: An Example 748
Investing with Derivative Securities 750
The Basic Nature of Derivative Investing 750, Basic Payoffand Profit Diagrams for Forward Contracts 754, BasicPayoff and Profit Diagrams for Call and Put Options 755,Option Profit Diagrams: An Example 758
The Relationship between Forward andOptionContracts 760
Put-Call-Spot Parity 760, Put-Call Parity: An Example762, Creating Synthetic Securities Using Put-Call Parity763, Adjusting Put-Call-Spot Parity for Dividends 764,Put-Call-Forward Parity 765
An Introduction to the Use of Derivatives inPortfolioManagement 767
Restructuring Asset Portfolios with Forward Contracts767, Protecting Portfolio Value with Put Options 768, AnAlternative Way to Pay for a Protective Put 771
C H A P T E R 2 1
Forward and Futures Contracts 781An Overview of Forward and Futures Trading 782
Futures Contract Mechanics 783, Comparing Forwardand Futures Contracts 785
Hedging with Forwards and Futures 786
Hedging and the Basis 786, Understanding Basis Risk 787,Calculating the Optimal Hedge Ratio 787
between Spot and Forward Prices 790
Financial Forwards and Futures: Applications andStrategies 791
Interest Rate Forwards and Futures 792, Long-TermInterest Rate Futures 792, Short-Term Interest RateFutures 796, Stock Index Futures 800, Currency Forwardsand Futures 806
Chapter 21 Appendix:
A A Closed-Form Equation for Calculating Duration 819B Calculating Money Market Implied Forward Rates 820
C H A P T E R 2 2
Option Contracts 821An Overview of Option Markets and
Contracts 822
Option Market Conventions 822, Price Quotations forExchange-Traded Options 823
The Fundamentals of Option Valuation 830The Basic Approach 831, Improving Forecast
Accuracy 832, The Binomial Option Pricing Model 837,The Black-Scholes Valuation Model 839,
Estimating Volatility 842, Problems with Black-ScholesValuation 844
Option Valuation: Extensions and AdvancedTopics 845
Valuing European-Style Put Options 845, ValuingOptions on Dividend-Bearing Securities 845, ValuingAmerican-Style Options 847, Other Extensions of theBlack-Scholes Model 848
Option Trading Strategies 850
Protective Put Options 850, Covered Call Options 852,Straddles, Strips, and Straps 853, Strangles 855, ChooserOptions 856, Spreads 857, Range Forwards 859
C H A P T E R 2 3
Swap Contracts, Convertible Securities, and
Other Embedded Derivatives 867OTC Interest Rate Agreements 868
Forward-Based Interest Rate Contracts 868, Option-BasedInterest Rate Contracts 875
Swap Contracting Extensions 878
Equity Index-Linked Swaps 878, Credit-RelatedSwaps 879
Warrants and Convertible Securities 883
Trang 14Linked Notes 896
Valuing Flexibility: An Introduction to RealOptions 898
Company Valuation with Real Options 899
PART 7Specification and Evaluation of
Asset Management909
C H A P T E R 2 4
Professional Money Management, AlternativeAssets, and Industry Ethics 911The Asset Management Industry: Structure and
Evolution 912
Private Management and Advisory Firms 916Investment Strategy at a Private Money ManagementFirm 918
Organization and Management of InvestmentCompanies 919
Valuing Investment Company Shares 919, Closed-Endversus Open-End Investment Companies 920,Fund Management Fees 923, Investment CompanyPortfolio Objectives 923, Breakdown by Fund
Characteristics 924, Global Investment Companies 927,Mutual Fund Organization and Strategy:
An Example 927
Investing in Alternative Asset Classes 929
Hedge Funds 931, Characteristics of a Hedge Fund 932,Hedge Fund Strategies 933, Risk Arbitrage Investing: ACloser Look 935, Hedge Fund Performance 936, PrivateEquity 938
Ethics and Regulation in the Professional AssetManagement Industry 946
Regulation in the Asset Management Industry 946,Standards for Ethical Behavior 948, Examples of EthicalConflicts 949
What Do You Want from a Professional AssetManager? 950
Early Performance Measurement Techniques 961Portfolio Evaluation before 1960 961, Peer GroupComparisons 961
Composite Portfolio Performance Measures 961Treynor Portfolio Performance Measure 963, SharpePortfolio Performance Measure 965, Jensen PortfolioPerformance Measure 967, The Information RatioPerformance Measure 968, Comparing the CompositePerformance Measures 970
Application of Portfolio Performance Measures 972Portfolio Performance Evaluation: Some Extensions 978
Components of Investment Performance 978,Performance Measurement with Downside Risk 980,Holdings-Based Performance Measurement 982,Performance Attribution Analysis 986, Measuring MarketTiming Skills 989
Factors That Affect Use of Performance Measures 990Demonstration of the Global Benchmark Problem 990,Implications of the Benchmark Problems 992, RequiredCharacteristics of Benchmarks 992
Evaluation of Bond Portfolio Performance 993Returns-Based Bond Performance Measurement 993,Bond Performance Attribution 994
Reporting Investment Performance 997
Time-Weighted and Money-Weighted Returns 997,Performance Presentation Standards 998
Appendix A How to Become a CFA®
Charterholder 1009Appendix B Code of Ethics and Standards of
Trang 15PrefaceThe pleasure of authoring a textbook comes from writing about a subject that we enjoy andfind exciting As authors, we hope that we can pass on to the reader not only knowledge butalso the excitement that we feel for the subject In addition, writing about investments bringsan added stimulant because the subject can affect the reader during his or her entire businesscareer and beyond We hope that what readers derive from this course will help them enjoybetter lives through managing their financial resources properly.
The purpose of this book is to help you learn how to manage your money so you will de-rive the maximum benefit from what you earn To accomplish this purpose, you need to learnabout the many investment alternatives that are available today and, what is more important,to develop a way of analyzing and thinking about investments that will remain with you in theyears ahead when new and different investment opportunities become available.
Because of its dual purpose, the book mixes description and theory The descriptive mate-rial discusses available investment instruments and considers the purpose and operation ofcapital markets in the United States and around the world The theoretical portion detailshow you should evaluate current investments and future opportunities to develop a portfolioof investments that will satisfy your risk-return objectives.
Preparing this tenth edition has been challenging for two reasons First, we continue to experi-ence rapid changes in the securities markets in terms of theory, new financial instruments, innova-tive trading practices, and the fallout from the significant credit and liquidity disruption and thenumerous regulatory changes that followed Second, as mentioned in prior editions, capital marketscontinue to become very global in nature Consequently, early in the book we present the compel-ling case for global investing Subsequently, to ensure that you are prepared to function in a globalenvironment, almost every chapter discusses how investment practice or theory is influenced by theglobalization of investments and capital markets This completely integrated treatment is to ensurethat you develop a broad mindset on investments that will serve you well in the 21st century.
Intended Market
This text is addressed to both graduate and advanced undergraduate students who are lookingfor an in-depth discussion of investments and portfolio management The presentation of thematerial is intended to be rigorous and empirical, without being overly quantitative A properdiscussion of the modern developments in investments and portfolio theory must be rigorous.The discussion of numerous empirical studies reflects the belief that it is essential for alterna-tive investment theories to be exposed to the real world and be judged on the basis of how wellthey help us understand and explain reality.
Key Features of the Tenth Edition
When planning the tenth edition of Investment Analysis and Portfolio Management, we wantedto retain its traditional strengths and capitalize on new developments in the investments areato make it the most comprehensive investments textbook available.
First, the current edition maintains its unparalleled international coverage Investing knowsno borders, and although the total integration of domestic and global investment opportunitiesmay seem to contradict the need for separate discussions of international issues, it, in fact,makes the need for specific information on non-U.S markets, instruments, conventions, andtechniques even more compelling.
Trang 16Third, today’s investing environment includes derivative securities not as exotic anomalies butas standard investment instruments We felt that Investment Analysis and Portfolio Managementmust reflect that reality Consequently, our four chapters on derivatives are written to provide thereader with an intuitive, clear discussion of the different instruments, their markets, valuation,trading strategies, and general use as risk management and return enhancement tools.
Fourth, we have added many new questions and problems to the end-of-chapter material toprovide more student practice on executing computations concerned with more sophisticatedinvestment problems.
Fifth, we have updated and enhanced the collection of Thomson ONE: Business School Edi-tion (BSE) exercises in several end-of-chapter problem sets Thomson ONE: BSE is a profes-sional analytical package used by profesprofes-sionals worldwide Our text allows one-year access forstudents to Thomson ONE: BSE, which contains information on firms, including financialstatement comparisons with competitors, stock price information, and indexes for comparingfirm performance against the market or sector Thomson ONE: BSE is a great package forhands-on learning, which rivals or exceeds that offered by other textbook publishers.
Major Content Changes in the Tenth Edition
The text has been thoroughly updated for currency In addition to these time-related revisions,we have also made the following specific changes to individual chapters:
Chapter 3The updated evidence of returns (through 2010) continues to support global diver-sification, and an updated study on global assets supports the use of a global measure of sys-tematic risk to explain asset returns Also, we consider new investment instruments availablefor global investors, including global index funds and the continued growth of exchange-traded funds (ETFs) for numerous countries and sectors.
Chapter 4Because of the continuing growth in trading volume handled by electronic commu-nications networks (ECNs), this chapter was heavily rewritten to discuss in detail the signifi-cant changes in the market as well as the results of this new environment including the“flashcrash” in 2008 This includes a discussion on the continuing changes on the NYSE during2008–2011 We also consider the rationale for the continuing consolidation of global ex-changes across asset classes of stocks, bonds, and derivatives In addition, we document recentmergers and discuss several proposed and failed mergers Finally, we note that the corporatebond market continues to experience major changes in how and when trades are reportedand the number of bond issues involved.
Chapter 5This chapter contains a discussion of fundamental weighted stock and bond indexesthat use sales and earnings to weight components rather than market value Also included isan updated analysis of the relationship among indexes.
Trang 17and how they are used in valuation models and credit analysis When we apply the extensiveratio analysis to Walgreens, it uncovers several changes in the performance by Walgreens,which highlights the usefulness of the analysis.
Chapter 11Here we emphasize the two alternative approaches to valuation (present value ofcash flows and relative valuation) An updated presentation of the yield spread during the2008–2010 period enforces the importance of the changing risk premium.
Chapter 12This chapter both considers the macroeconomic variables that affect capital mar-kets and demonstrates the microvaluation of these marmar-kets The demonstration was very chal-lenging and insightful due to the economic and market environment in 2008–2011.
Chapter 13We continue to emphasize the importance of the macroanalysis of an industry andthe large impact this has on the subsequent valuation of the industry.
Chapter 14We advocate a two-part analysis that first involves a deep analysis of a companyto understand both its business and financial risk and its growth outlook The second part ofthe analysis is a stock valuation component that depends upon the company analysis for in-puts The result is two decisions—one on the company and the second on the stock It is em-phasized that these decisions do not have to be the same (e.g., the stock of a good companymay be a poor stock—it may be overvalued).
Chapter 16This chapter contains an enhanced discussion of the relative merits of passive versusactive management techniques for equity portfolio management focusing on the important role oftracking error Expanded material on measuring the tax efficiency of an equity portfolio has beenintroduced, along with additional analysis of equity portfolio investment strategies, including fun-damental and technical approaches, as well as a detailed description of equity style analysis.Chapter 17Because of the major credit-liquidity problems encountered in the U.S bond mar-ket during 2007–2009, which continue to impact security marmar-kets around the world, severaltopics in the chapter have been added or adjusted This includes discussions on government-sponsored entities (GSEs), bond-rating firms, municipal bond insurance, collateralized debtobligations (CDOs), auction-rate securities, and covered bonds.
Chapter 18 We discuss four specifications of duration including the strengths and problemsfor each of them Similarly, we consider three yield spreads—traditional spreads, static yieldspreads, and option adjusted spreads (OAS)—and the relationships among them.
Chapter 19This chapter on bond portfolio management strategies has been enhanced and revisedto include an extended discussion comparing active and passive fixed-income strategies, as well asnew and updated examples of how the bond immunization process functions Both new and up-dated material on how the investment style of a fixed-income portfolio is defined and measured inpractice has also been included, along with new examples of active bond management strategies.Chapter 20 Expanded discussions of the fundamentals associated with using derivative securities(e.g., interpreting price quotations, basic payoff diagrams, basic strategies) are included in this chap-ter We also provide updated examples of both basic and intermediate risk management applicationsusing derivative positions, as well as new material on how these contracts trade in the marketplace.Chapter 21New and updated examples and applications are provided throughout the chapter,emphasizing the role that forward and futures contracts play in managing exposures to equity,fixed-income, and foreign exchange risk Also included is an enhanced discussion of how fu-tures and forward markets are structured and operate.
Trang 18tions (e.g., swap contracting, convertible securities, structured notes, real options), as well asupdated examples and applications of each of these applications An extensive discussion ofhow credit default derivatives are used in practice has also been updated.
Chapter 24Contained in this chapter is a revised and updated discussion of the organizationand participants in the professional asset management industry Of particular note is an exten-sive update of the structure and strategies employed by hedge funds as well as enhanced anal-ysis of how private equity funds function The discussion of ethics and regulation in the assetmanagement industry that concludes the chapter has also been updated and expanded.Chapter 25An updated and considerably expanded application of the performance measument techniques introduced throughout the chapter is provided, including new material re-garding the calculation of information ratios The discussion emphasizes how the concept of“downside” risk can be incorporated into the performance measurement process and the ex-amination of techniques that focus on the security holdings of a manager’s portfolio, ratherthan the returns that the portfolio generates.
Supplement Package
Preparation of the tenth edition provided the opportunity to enhance the supplement productsoffered to instructors and students who use Investment Analysis and Portfolio Management.The result of this examination is a greatly improved package that provides more than just ba-sic answers and solutions We are indebted to the supplement writers who devoted their time,energy, and creativity to making this supplement package the best it has ever been.
STOCK-TRAK® Thousands of students every year use STOCK-TRAK® to practice invest-ment strategies, test theories, practice day trading, and learn about the various markets A cou-pon for a price reduction for this optional stock simulation is included with the text.
Instructor’s Manual The Instructor’s Manual is available on the IRCD Written by Narendar Raoat Northeastern Illinois University, it contains a brief outline of each chapter’s key concepts andequations, which can be easily copied and distributed to students as a reference tool.
Test BankThe Test Bank, written by Brian Boscaljon at Penn State University–Erie, includesan extensive set of new questions and problems and complete solutions to the testing material.The Test Bank is available on the IRCD For instructors who would like to prepare their examselectronically, the ExamView version contains all the test questions found in the printed ver-sion It is available on the IRCD.
Solutions ManualThis contains all the answers to the end-of-chapter questions and solutions toend-of-chapter problems Edgar A Norton at Illinois State University was ever-diligent in the prepa-ration of these materials, ensuring the most error-free solutions possible It is available on the IRCD.Lecture Presentation SoftwareA comprehensive set of PowerPoint slides created by Yulong Maat California State University, Long Beach, is available on the IRCD Each chapter has a self-contained presentation that covers all the key concepts, equations, and examples within the chap-ter The files can be used as is for an innovative, interactive class presentation Instructors whohave access to Microsoft PowerPoint can modify the slides in any way they wish, adding or delet-ing materials to match their needs.
Trang 19AcknowledgmentsSo many people have helped us in so many ways that we hesitate to list them, fearing that we may miss someone.Accepting this risk, we will begin with the University of Notre Dame and the University of Texas at Austin be-cause of their direct support Reviewers for this edition were:
BOLONG CAO
University of California, San DiegoDONALD L DAVIS
Golden Gate University
DRAGON TANGUniversity of Hong KongELEANOR XU
Seton Hall University
YEXIAO XU
The University of Texas at Dallas
We were fortunate to have the following excellent reviewers for earlier editions:JOHN ALEXANDER
Clemson UniversityROBERT ANGELLEast Carolina UniversityGEORGE ARAGONBoston CollegeBRIAN BELT
University of Missouri-Kansas CityOMAR M BENKATO
Ball State University
ARAND BHATTACHARYAUniversity of CincinnatiCAROL BILLINGHAMCentral Michigan UniversitySUSAN BLOCK
University of California, SantaBarbaraGERALD A BLUMBabson CollegePAUL BOLSTERNortheastern UniversityROBERT E BROOKSUniversity of AlabamaROBERT J BROWNHarrisburg, PennsylvaniaCHARLES Q CAO
Pennsylvania State University
ATREYA CHAKRABORTYBrandeis UniversityHSIU-LANG CHENUniversity of Illinoisat ChicagoDOSOUNG CHOIUniversity of TennesseeROBERT CLARKUniversity of VermontJOHN CLINEBELL
University of Northern ColoradoJAMES D’MELLO
Western Michigan UniversityEUGENE F DRZYCIMSKIUniversity of Wisconsin–OshkoshWILLIAM DUKES
Texas Tech UniversityJOHN DUNKELBERGWake Forest UniversityERIC EMORY
Sacred Heart UniversityTHOMAS EYSSELL
University of Missouri–St LouisHEBER FARNSWORTHWashington University, St LouisJAMES FELLER
Middle Tennessee State University
EURICO FERREIRAClemson UniversityMICHAEL FERRIJohn Carroll UniversityGREG FILBECKUniversity of ToledoJOSEPH E FINNERTYUniversity of IllinoisHARRY FRIEDMANNew York UniversityR H GILMER
University of MississippiSTEVEN GOLDSTEINUniversity of South CarolinaSTEVEN GOLDSTEINRobinson-Humphrey/AmericanExpress
KESHAV GUPTA
Oklahoma State UniversitySALLY A HAMILTONSanta Clara UniversityERIC HIGGINSDrexel University
RONALD HOFFMEISTERArizona State UniversitySHELLY HOWTONVillanova University
Trang 20A JAMES IFFLANDERArizona State UniversitySTAN JACOBS
Central Washington UniversityKWANG JUN
Michigan State UniversityJAROSLAW KOMARYNSKYNorthern Illinois UniversityMALEK LASHGARIUniversity of HartfordDANNY LITT
Century Software Systems/UCLAMILES LIVINGSTON
University of FloridaCHRISTOPHER MATexas Tech UniversityANANTH MADHAVENUniversity of Southern CaliforniaDAVINDER MALHOTRA
Philadelphia College of Textiles andScience
STEPHEN MANN
University of South CarolinaIQBAL MANSUR
Widener UniversityLINDA MARTINArizona State UniversityGEORGE MASONUniversity of HartfordJOHN MATTHYSDePaul UniversityMICHAEL MCBAINMarquette UniversityDENNIS MCCONNELLUniversity of MaineJEANETTE MEDEWITZUniversity of Nebraska–OmahaNICHOLAS MICHASNorthern Illinois UniversityTHOMAS W MILLER JR.University of Missouri–ColumbiaLALATENDU MISRA
University of Texas at San AntonioMICHAEL MURRAY
LaCrosse, WisconsinJONATHAN OHNWagner College
HENRY OPPENHEIMERUniversity of Rhode IslandJOHN PEAVY
Southern Methodist UniversityGEORGE PHILIPPATOSUniversity of TennesseeGEORGE PINCHESUniversity of KansasROSE PRASAD
Central Michigan UniversityLAURIE PRATHERUniversity of Tennessee atChattanoogaGEORGE A RACETTEUniversity of OregonMURLI RAJANUniversity of ScrantonNARENDAR V RAO
Northeastern Illinois UniversitySTEVE RICH
Baylor UniversityBRUCE ROBIN
Old Dominion UniversityJAMES ROSENFELDEmory UniversitySTANLEY D RYALSInvestment Counsel, Inc.
KATRINA F SHERRERDCFA Institute
SHEKAR SHETTY
University of South DakotaFREDERIC SHIPLEYDePaul UniversityDOUGLAS SOUTHARDVirginia Polytechnic InstituteHAROLD STEVENSONArizona State UniversityLAWRENCE S TAILoyola Marymount CollegeKISHORE TANDON
The City University of New York,Baruch College
DONALD THOMPSONGeorgia State UniversityDAVID E UPTON
Virginia Commonwealth UniversityE THEODORE VEIT
Rollins CollegePREMAL VORAKing’s CollegeBRUCE WARDREPEast Carolina UniversityRICHARD S WARR
North Carolina State UniversityROBERT WEIGAND
Trang 21Both of them were extremely careful, dependable, and creative.
Current colleagues have been very helpful: Yu-Chi Chang, Rob Batallio, Mike Hemler, Jerry Langley, and PaulSchultz, University of Notre Dame As always, some of the best insights and most stimulating comments continueto come during too-infrequent walks with a very good friend, Jim Gentry of the University of Illinois.
We are convinced that professors who want to write a book that is academically respectable and relevant, aswell as realistic, require help from the“real world.” We have been fortunate to develop relationships with a num-ber of individuals (including a growing numnum-ber of former students) whom we consider our contacts with reality.
The following individuals have graciously provided important insights and material:DAVID G BOOTH
Dimensional Fund Advisors, Inc.GARY BRINSONGP InvestmentsKEVIN CASEYCasey CapitalDAVID CHAPMANBoston CollegeDWIGHT D CHURCHILLFidelity InvestmentsABBY JOSEPH COHENGoldman, Sachs
ROBERT CONWAYGoldman, SachsROBERT J DAVISCrimson Capital CompanyPHILIP DELANEY JR.Northern Trust BankMICHAEL DOW
UBS Global Asset ManagementSAM EISENSTADT
Value Line
FRANK J FABOZZI
Journal of Portfolio ManagementKENNETH FISHER
Forbes
JOHN J FLANAGAN JR.Lawrence, O’Donnell, Marcus andCompany
H GIFFORD FONGGifford Fong Associates
MARTIN S FRIDSONFridson Vision, LLC
M CHRISTOPHER GARMANBank of America/Merrill LynchKHALID GHAYUR
Morgan StanleyWILLIAM J HANK
Moore Financial CorporationRICK HANSWalgreens CorporationLEA B HANSENGreenwich AssociatesW VAN HARLOWPutnam InvestmentsBRITT HARRIS
Teacher Retirement System of TexasCRAIG HESTER
Hester Capital ManagementJOANNE HILL
Goldman, SachsJOHN W JORDAN IIThe Jordan CompanyANDREW KALOTAYKalotay AssociatesLUKE KNECHT
Dresdner RCM Capital ManagementWARREN N KOONTZ JR.
Loomis, SaylesMARK KRITZMAN
Windham Capital Management
SANDY LEEDSUniversity of TexasMARTIN LEIBOWITZMorgan Stanley
DOUGLAS R LEMPEREURTempleton Investment Counsel, Inc.ROBERT LEVINE
Nomura SecuritiesAMY LIPTONBankers TrustGEORGE W LONG
Long Investment Management Ltd.SCOTT LUMMER
Lummer Investment ConsultingJOHN MAGINN
Maginn AssociatesSCOTT MALPASSUniversity of Notre DameJACK MALVEY
Barclays CapitalANDRAS MAROSIUniversity of AlbertaDOMINIC MARSHALLPacific Ridge Capital PartnersTODD MARTIN
Timucuan Asset ManagementJOSEPH MCALINDENMorgan StanleyRICHARD MCCABE
Trang 22TERRENCE J MCGLINNMcGlinn Capital MarketsOLEG MELENTYEV
Bank of America/Merrill LynchKENNETH MEYER
Lincoln Capital ManagementJANET T MILLER
Rowland and CompanyBRIAN MOOREU.S Gypsum Corp.SALVATOR MUOIOSM Investors, LPDAVID NELMS
Discover Financial ServicesGEORGE NOYES
Standish Mellon Asset ManagementWIL O’HARA
University of TexasIAN ROSSA O’REILLYWood Gundy, Inc.ROBERT PARRINOUniversity of TexasPHILIP J PURCELL IIIPJP Investments
JOHN C RUDOLF
Summit Capital ManagementGUY RUTHERFORDMorgan StanleyRON RYAN
Asset Liability ManagementMARK RYPZINSKIHenry & Co.
ROBERT F SEMMENS JR.Semmens Private InvestmentsBRIAN SINGER
William Blair & Co.CLAY SINGLETONRollins CollegeDONALD J SMITHBoston UniversityFRED H SPEECE JR.
Speece, Thorson Capital GroupLAURA STARKS
University of TexasWILLIAM M STEPHENSHusic Capital ManagementJAMES STORK
Uitermarkt & Associates
KEVIN TERHAAR
UBS Global Asset ManagementJOSE RAMON VALENTEEconsult
WILLIAM M WADDENLongShip Capital ManagementWILLIAM WAY
University of TexasKEN WILES
Fulcrum Financial GroupROBERT WILMOUTHNational Futures AssociationRICHARD S WILSONConsultant
ARNOLD WOOD
Martingale Asset ManagementHONG YAN
University of South CarolinaBRUCE ZIMMERMANUniversity of Texas InvestmentManagement Company
We continue to benefit from the help and consideration of the dedicated people who are or have been associ-ated with the CFA Institute: Tom Bowman, Whit Broome, Jeff Diermeier, Bob Johnson, Bob Luck, Sue Martin,Katie Sherrerd, and Donald Tuttle.
Professor Reilly would like to thank his assistant, Rachel Karnafel, who had the unenviable task of keeping hisoffice and his life in some sort of order during this project.
As always, our greatest gratitude is to our families—past, present, and future Our parents gave us life andhelped us understand love and how to give it Most important are our wives who provide love, understanding,and support throughout the day and night We thank God for our children and grandchildren who ensure thatour lives are full of love, laughs, and excitement.
Frank K ReillyNotre Dame, Indiana
Keith C BrownAustin, Texas
Trang 23About the Authors
Frank K Reilly is the Bernard J Hank Professor of Finance and former dean of the MendozaCollege of Business at the University of Notre Dame Holding degrees from the University ofNotre Dame (BBA), Northwestern University (MBA), and the University of Chicago (PhD), Pro-fessor Reilly has taught at the University of Illinois, the University of Kansas, and the Universityof Wyoming in addition to the University of Notre Dame He has several years of experience asa senior securities analyst, as well as experience in stock and bond trading A chartered financialanalyst (CFA), he has been a member of the Council of Examiners, the Council on Educationand Research, the grading committee, and was chairman of the board of trustees of the Instituteof Charted Financial Analysts and chairman of the board of the Association of Investment Man-agement and Research (AIMR; now the CFA Institute) Professor Reilly has been president ofthe Financial Management Association, the Midwest Business Administration Association, theEastern Finance Association, the Academy of Financial Services, and the Midwest FinanceAssociation He is or has been on the board of directors of the First Interstate Bank of Wiscon-sin, Norwest Bank of Indiana, the Investment Analysts Society of Chicago, UBS Global Funds(chairman), Fort Dearborn Income Securities (chairman), Discover Bank, NIBCO, Inc., the In-ternational Board of Certified Financial Planners, Battery Park High Yield Bond Fund, Inc.,Morgan Stanley Trust FSB, the CFA Institute Research Foundation (chairman), the FinancialAnalysts Seminar, the Board of Certified Safety Professionals, and the University Club at theUniversity of Notre Dame.
As the author of more than 100 articles, monographs, and papers, his work has appeared innumerous publications including Journal of Finance, Journal of Financial and Quantitative Anal-ysis, Journal of Accounting Research, Financial Management, Financial Analysts Journal, Journalof Fixed Income, and Journal of Portfolio Management In addition to Investment Analysis andPortfolio Management, 10th ed., Professor Reilly is the coauthor of another textbook, Invest-ments, 7th ed (South-Western, 2006) with Edgar A Norton He is editor of Readings and Issuesin Investments, Ethics and the Investment Industry, and High Yield Bonds: Analysis and RiskAssessment.
Professor Reilly was named on the list of Outstanding Educators in America and has receivedthe University of Illinois Alumni Association Graduate Teaching Award, the Outstanding Educa-tor Award from the MBA class at the University of Illinois, and the Outstanding Teacher Awardfrom the MBA class and the senior class at Notre Dame He also received from the CFA Insti-tute both the C Stewart Sheppard Award for his contribution to the educational mission of theAssociation and the Daniel J Forrestal III Leadership Award for Professional Ethics and Stan-dards of Investment Practice He also received the Hortense Friedman Award for Excellencefrom the CFA Society of Chicago and a Lifetime Achievement Award from the Midwest FinanceAssociation He was part of the inaugural group selected as a fellow of the Financial Manage-ment Association International He is or has been a member of the editorial boards of FinancialManagement, The Financial Review, International Review of Economics and Finance, Journal ofFinancial Education, Quarterly Review of Economics and Finance, and the European Journal ofFinance He is included in Who’s Who in Finance and Industry, Who’s Who in America, Who’sWho in American Education, and Who’s Who in the World.
Trang 24Kappa, Phi Kappa Phi, and Omicron Delta Epsilon honor societies He received his MS andPhD in financial economics from the Krannert Graduate School of Management at Purdue Uni-versity Since leaving school in 1981, he has specialized in teaching investment management,portfolio management and security analysis, capital markets, and derivatives courses at the un-dergraduate, MBA, and PhD levels, and has received numerous awards for teaching innovationand excellence, including election to the university’s prestigious Academy of Distinguished Tea-chers In addition to his academic responsibilities, he also serves as President and Chief Execu-tive Officer of The MBA Investment Fund, L.L.C., a privately funded investment companymanaged by graduate students at the University of Texas.
Professor Brown has published more than 40 articles, monographs, chapters, and papers ontopics ranging from asset pricing and investment strategy to financial risk management Hispublications have appeared in such journals as Journal of Finance, Journal of Financial Econom-ics, Review of Financial Studies, Journal of Financial and Quantitative Analysis, Review of Eco-nomics and Statistics, Journal of Financial Markets, Financial Analysts Journal, FinancialManagement, Journal of Investment Management, Advances in Futures and Options Research,Journal of Fixed Income, Journal of Applied Corporate Finance, and Journal of Portfolio Manage-ment In addition to his contributions to Investment Analysis and Portfolio Management, TenthEdition, he is a coauthor of Interest Rate and Currency Swaps: A Tutorial, a textbook publishedthrough the Association for Investment Management and Research (AIMR; now the CFA Insti-tute) He received a Graham and Dodd Award from the Financial Analysts Federation as an au-thor of one of the best articles published by Financial Analysts Journal in 1990, and a Smith-Breeden Prize from the Journal of Finance in 1996.
In August 1988, Professor Brown received his Chartered Financial Analyst designation fromthe CFA Institute and he has served as a member of that organization’s CFA Candidate Curric-ulum Committee and Education Committee, and on the CFA Examination Grading staff Forfive years, he was the research director of the Research Foundation of the CFA Institute, fromwhich position he guided the development of the research portion of the organization’s world-wide educational mission For several years, he was also associate editor for Financial AnalystsJournal and currently holds that position for Journal of Investment Management and Journal ofBehavioral Finance In other professional service, Professor Brown has been a regional directorfor the Financial Management Association and has served as the applied research track chairmanfor that organization’s annual conference.
Trang 25The Investment Background
Chapter 1
The Investment Setting
Chapter 2
The Asset Allocation Decision
Chapter 3
Selecting Investments in a Global Market
Chapter 4
Organization and Functioning of Securities Markets
Chapter 5
Security-Market Indexes
Trang 26• Why do people invest?
• How do you measure the returns and risks for alternative investments?• What factors should you consider when you make asset allocation decisions?• What investments are available?
• How do securities markets function?
• How and why are securities markets in the United States and around the worldchanging?
• What are the major uses of security-market indexes?
• How can you evaluate the market behavior of common stocks and bonds?• What factors cause differences among stock- and bond-market indexes?
In the first chapter, we consider why an individual would invest, how to measure the rates ofreturn and risk for alternative investments, and what factors determine an investor’s requiredrate of return on an investment The latter point will be important in subsequent analyseswhen we work to understand investor behavior, the markets for alternative securities, and thevaluation of various investments.
Because the ultimate decision facing an investor is the makeup of his or her portfolio,Chapter 2 deals with the all-important asset allocation decision This includes specific stepsin the portfolio management process and factors that influence the makeup of an investor’sportfolio over his or her life cycle.
To minimize risk, investment theory asserts the need to diversify Chapter 3 begins our ex-ploration of investments available to investors by making an overpowering case for investingglobally rather than limiting choices to only U.S securities Building on this premise, we dis-cuss several investment instruments found in global markets We conclude the chapter with areview of the historical rates of return and measures of risk for a number of alternative assetgroups.
In Chapter 4, we examine how markets work in general, and then specifically focus on thepurpose and function of primary and secondary bond and stock markets During the last 15years, significant changes have occurred in the operation of the securities market, including atrend toward a global capital market, electronic trading markets, and substantial worldwideconsolidation After discussing these changes and the rapid development of new capital mar-kets around the world, we speculate about how global marmar-kets will continue to consolidate andwill increase available investment alternatives.
Investors, market analysts, and financial theorists generally gauge the behavior of securitiesmarkets by evaluating the return and risk implied by various market indexes and evaluateportfolio performance by comparing a portfolio’s results to an appropriate benchmark Be-cause these indexes are used to make asset allocation decisions and then to evaluate portfolioperformance, it is important to have a deep understanding of how they are constructed andthe numerous alternatives available Therefore, in Chapter 5, we examine and compare a num-ber of stock-market and bond-market indexes available for the domestic and global markets.
Trang 27The Investment Setting
After you read this chapter, you should be able to answer the following questions:• Why do individuals invest?
• What is an investment?
• How do investors measure the rate of return on an investment?• How do investors measure the risk related to alternative investments?
• What factors contribute to the rates of return that investors require on alternative investments?
• What macroeconomic and microeconomic factors contribute to changes in the required rates of return forinvestments?
This initial chapter discusses several topics basic to the subsequent chapters We begin by defin-ing the term investment and discussdefin-ing the returns and risks related to investments This leads toa presentation of how to measure the expected and historical rates of returns for an individualasset or a portfolio of assets In addition, we consider how to measure risk not only for an indi-vidual investment but also for an investment that is part of a portfolio.
The third section of the chapter discusses the factors that determine the requiredrate of return for an individual investment The factors discussed are those that con-tribute to an asset’s total risk Because most investors have a portfolio of investments,it is necessary to consider how to measure the risk of an asset when it is a part of alarge portfolio of assets The risk that prevails when an asset is part of a diversifiedportfolio is referred to as its systematic risk.
The final section deals with what causes changes in an asset’s required rate of returnover time Notably, changes occur because of both macroeconomic events that affect allinvestment assets and microeconomic events that affect the specific asset.
1.1 WHAT IS AN INVESTMENT?
For most of your life, you will be earning and spending money Rarely, though, will your currentmoney income exactly balance with your consumption desires Sometimes, you may have moremoney than you want to spend; at other times, you may want to purchase more than you can af-ford based on your current income These imbalances will lead you either to borrow or to save tomaximize the long-run benefits from your income.
When current income exceeds current consumption desires, people tend to save the excess.They can do any of several things with these savings One possibility is to put the money un-der a mattress or bury it in the backyard until some future time when consumption desiresexceed current income When they retrieve their savings from the mattress or backyard, theyhave the same amount they saved.
Trang 28you do with the savings to make them increase over time is investment.1
Those who give up immediate possession of savings (that is, defer consumption) expect to receivein the future a greater amount than they gave up Conversely, those who consume more than theircurrent income (that is, borrow) must be willing to pay back in the future more than they borrowed.The rate of exchange between future consumption (future dollars) and current consumption (cur-rent dollars) is the pure rate of interest Both people’s willingness to pay this difference for borrowedfunds and their desire to receive a surplus on their savings (i.e., some rate of return) give rise to aninterest rate referred to as the pure time value of money This interest rate is established in the capi-tal market by a comparison of the supply of excess income available (savings) to be invested and thedemand for excess consumption (borrowing) at a given time If you can exchange $100 of certainincome today for $104 of certain income one year from today, then the pure rate of exchange on arisk-free investment (that is, the time value of money) is said to be 4 percent (104/100− 1).
The investor who gives up $100 today expects to consume $104 of goods and services in thefuture This assumes that the general price level in the economy stays the same This price sta-bility has rarely been the case during the past several decades when inflation rates have variedfrom 1.1 percent in 1986 to as much as 13.3 percent in 1979, with a geometric average of 4.4percent a year from 1970 to 2010 If investors expect a change in prices, they will require ahigher rate of return to compensate for it For example, if an investor expects a rise in prices(that is, he or she expects inflation) at the annual rate of 2 percent during the period of invest-ment, he or she will increase the required interest rate by 2 percent In our example, the inves-tor would require $106 in the future to defer the $100 of consumption during an inflationaryperiod (a 6 percent nominal, risk-free interest rate will be required instead of 4 percent).
Further, if the future payment from the investment is not certain, the investor will demandan interest rate that exceeds the nominal risk-free interest rate The uncertainty of the pay-ments from an investment is the investment risk The additional return added to the nominal,risk-free interest rate is called a risk premium In our previous example, the investor would re-quire more than $106 one year from today to compensate for the uncertainty As an example,if the required amount were $110, $4 (4 percent) would be considered a risk premium.
1.1.1 Investment Defined
From our discussion, we can specify a formal definition of an investment Specifically, aninvestmentis the current commitment of dollars for a period of time in order to derive future pay-ments that will compensate the investor for (1) the time the funds are committed, (2) the expectedrate of inflation during this time period, and (3) the uncertainty of the future payments The“inves-tor” can be an individual, a government, a pension fund, or a corporation Similarly, this definitionincludes all types of investments, including investments by corporations in plant and equipment andinvestments by individuals in stocks, bonds, commodities, or real estate This text emphasizes invest-ments by individual investors In all cases, the investor is trading a known dollar amount today forsome expected future stream of payments that will be greater than the current dollar amount today.At this point, we have answered the questions about why people invest and what they want fromtheir investments They invest to earn a return from savings due to their deferred consumption.They want a rate of return that compensates them for the time period of the investment, the ex-pected rate of inflation, and the uncertainty of the future cash flows This return, the investor’srequired rate of return, is discussed throughout this book A central question of this book is howinvestors select investments that will give them their required rates of return.
Trang 29returns to evaluate the suitability of a particular investment Although our emphasis will be on fi-nancial assets, such as bonds and stocks, we will refer to other assets, such as art and antiques.Chapter 3 discusses the range of financial assets and also considers some nonfinancial assets.
1.2 MEASURES OF RETURN AND RISK
The purpose of this book is to help you understand how to choose among alternative invest-ment assets This selection process requires that you estimate and evaluate the expected risk-return trade-offs for the alternative investments available Therefore, you must understandhow to measure the rate of return and the risk involved in an investment accurately To meetthis need, in this section we examine ways to quantify return and risk The presentation willconsider how to measure both historical and expected rates of return and risk.
We consider historical measures of return and risk because this book and other publica-tions provide numerous examples of historical average rates of return and risk measures forvarious assets, and understanding these presentations is important In addition, these historicalresults are often used by investors when attempting to estimate the expected rates of returnand risk for an asset class.
The first measure is the historical rate of return on an individual investment over the timeperiod the investment is held (that is, its holding period) Next, we consider how to measurethe average historical rate of return for an individual investment over a number of time peri-ods The third subsection considers the average rate of return for a portfolio of investments.
Given the measures of historical rates of return, we will present the traditional measures ofrisk for a historical time series of returns (that is, the variance and standard deviation).
Following the presentation of measures of historical rates of return and risk, we turn toestimating the expected rate of return for an investment Obviously, such an estimate containsa great deal of uncertainty, and we present measures of this uncertainty or risk.
1.2.1 Measures of Historical Rates of Return
When you are evaluating alternative investments for inclusion in your portfolio, you will often becomparing investments with widely different prices or lives As an example, you might want tocompare a $10 stock that pays no dividends to a stock selling for $150 that pays dividends of $5a year To properly evaluate these two investments, you must accurately compare their historicalrates of returns A proper measurement of the rates of return is the purpose of this section.
When we invest, we defer current consumption in order to add to our wealth so that wecan consume more in the future Therefore, when we talk about a return on an investment,we are concerned with the change in wealth resulting from this investment This change inwealth can be either due to cash inflows, such as interest or dividends, or caused by a changein the price of the asset (positive or negative).
If you commit $200 to an investment at the beginning of the year and you get back $220 atthe end of the year, what is your return for the period? The period during which you own aninvestment is called its holding period, and the return for that period is the holding periodreturn (HPR) In this example, the HPR is 1.10, calculated as follows:
1.1 HPR = Ending Value of Investment
Beginning Value of Investment
Trang 30decline in wealth, which indicates that you had a negative return during the period An HPRof zero indicates that you lost all your money (wealth) invested in this asset.
Although HPR helps us express the change in value of an investment, investors generallyevaluate returns in percentage terms on an annual basis This conversion to annual percentagerates makes it easier to directly compare alternative investments that have markedly differentcharacteristics The first step in converting an HPR to an annual percentage rate is to derive apercentage return, referred to as the holding period yield (HPY) The HPY is equal to theHPR minus 1.
1.2 HPY = HPR− 1
In our example:
HPY = 1:10 − 1 = 0:10= 10%
To derive an annual HPY, you compute an annual HPR and subtract 1 Annual HPR isfound by:
1.3 Annual HPR = HPR1/n
where:
n = number of years the investment is held
Consider an investment that cost $250 and is worth $350 after being held for two years:
HPR = Ending Value of InvestmentBeginning Value of Investment=
$350$250= 1:40Annual HPR = 1:401=n= 1:401=2= 1:1832Annual HPY = 1:1832 − 1 = 0:1832= 18:32%
If you experience a decline in your wealth value, the computation is as follows:
HPR = Ending ValueBeginning Value=
$400$500= 0:80HPY = 0:80 − 1:00 = −0:20 = −20%A multiple-year loss over two years would be computed as follows:
Trang 31100Annual HPR = 1:121=:5= 1:122= 1:2544Annual HPY = 1:2544 − 1 = 0:2544= 25:44%
Note that we made some implicit assumptions when converting the six-month HPY to anannual basis This annualized holding period yield computation assumes a constant annualyield for each year In the two-year investment, we assumed an 18.32 percent rate of returneach year, compounded In the partial year HPR that was annualized, we assumed that the re-turn is compounded for the whole year That is, we assumed that the rate of rere-turn earnedduring the first half of the year is likewise earned on the value at the end of the first sixmonths The 12 percent rate of return for the initial six months compounds to 25.44 percentfor the full year.2Because of the uncertainty of being able to earn the same return in the futuresix months, institutions will typically not compound partial year results.
Remember one final point: The ending value of the investment can be the result of a posi-tive or negaposi-tive change in price for the investment alone (for example, a stock going from $20a share to $22 a share), income from the investment alone, or a combination of price changeand income Ending value includes the value of everything related to the investment.
1.2.2 Computing Mean Historical Returns
Now that we have calculated the HPY for a single investment for a single year, we want to con-sider mean rates of return for a single investment and for a portfolio of investments Over anumber of years, a single investment will likely give high rates of return during some years andlow rates of return, or possibly negative rates of return, during others Your analysis should con-sider each of these returns, but you also want a summary figure that indicates this investment’stypical experience, or the rate of return you might expect to receive if you owned this investmentover an extended period of time You can derive such a summary figure by computing the meanannual rate of return (its HPY) for this investment over some period of time.
Alternatively, you might want to evaluate a portfolio of investments that might include sim-ilar investments (for example, all stocks or all bonds) or a combination of investments (for ex-ample, stocks, bonds, and real estate) In this instance, you would calculate the mean rate ofreturn for this portfolio of investments for an individual year or for a number of years.
Single InvestmentGiven a set of annual rates of return (HPYs) for an individual investment,there are two summary measures of return performance The first is the arithmetic mean re-turn, the second is the geometric mean return To find the arithmetic mean (AM), the sum(Σ) of annual HPYs is divided by the number of years (n) as follows:
1.4 AM =ΣHPY/n
where:
ΣHPY = the sum of annual holding period yields
An alternative computation, the geometric mean (GM), is the nth root of the product of theHPRs for n years minus one.
Trang 32(HPR1) × (HPR2) (HPRn)
To illustrate these alternatives, consider an investment with the following data:
Y e a rB e g i n n i n g V a l u eE n d i n g V a l u eHPRHPY1100.0115.01.150.152115.0138.01.200.203138.0110.40.800.20AM =ẵ0:15ị + 0:20ị + 0:20ị=3= 0:15=3= 0:05 = 5%GM =ẵ1:15ị ì 1:20ị × ð0:80Þ1=3− 1=ð1:104Þ1=3− 1= 1:03353 − 1= 0:03353 = 3:353%
Investors are typically concerned with long-term performance when comparing alternativeinvestments GM is considered a superior measure of the long-term mean rate of return be-cause it indicates the compound annual rate of return based on the ending value of the invest-ment versus its beginning value.3 Specifically, using the prior example, if we compounded3.353 percent for three years, (1.03353)3, we would get an ending wealth value of 1.104.
Although the arithmetic average provides a good indication of the expected rate of returnfor an investment during a future individual year, it is biased upward if you are attemptingto measure an asset’s long-term performance This is obvious for a volatile security Consider,for example, a security that increases in price from $50 to $100 during year 1 and drops backto $50 during year 2 The annual HPYs would be:
Y e a rB e g i n n i n g V a l u eE n d i n g V a l u eHPRHPY
1501002.001.00
2100500.50−0.50
This would give an AM rate of return of:
ẵ1:00ị + 0:50ị=2 = :50=2= 0:25 = 25%
This investment brought no change in wealth and therefore no return, yet the AM rate of re-turn is computed to be 25 percent.
The GM rate of return would be:
2:00 ì 0:50ị1=2 1 = 1:00ị1=2 1= 1:00 1 = 0%
This answer of a 0 percent rate of return accurately measures the fact that there was no changein wealth from this investment over the two-year period.
Trang 33nual changes in the rates of return—that is, more volatility—will result in a greater differencebetween the alternative mean values We will point out examples of this in subsequent chapters.An awareness of both methods of computing mean rates of return is important because mostpublished accounts of long-run investment performance or descriptions of financial research willuse both the AM and the GM as measures of average historical returns We will also use boththroughout this book with the understanding that the AM is best used as an expected value foran individual year, while the GM is the best measure of long-term performance since it measuresthe compound annual rate of return for the asset being measured.
A Portfolio of Investments The mean historical rate of return (HPY) for a portfolio of in-vestments is measured as the weighted average of the HPYs for the individual inin-vestments inthe portfolio, or the overall percent change in value of the original portfolio The weights usedin computing the averages are the relative beginning market values for each investment; this isreferred to as dollar-weighted or value-weighted mean rate of return This technique is demon-strated by the examples in Exhibit 1.1 As shown, the HPY is the same (9.5 percent) whetheryou compute the weighted average return using the beginning market value weights or if youcompute the overall percent change in the total value of the portfolio.
Although the analysis of historical performance is useful, selecting investments for yourportfolio requires you to predict the rates of return you expect to prevail The next section dis-cusses how you would derive such estimates of expected rates of return We recognize thegreat uncertainty regarding these future expectations, and we will discuss how one measuresthis uncertainty, which is referred to as the risk of an investment.
1.2.3 Calculating Expected Rates of Return
Riskis the uncertainty that an investment will earn its expected rate of return In the examplesin the prior section, we examined realized historical rates of return In contrast, an investorwho is evaluating a future investment alternative expects or anticipates a certain rate of return.The investor might say that he or she expects the investment will provide a rate of return of 10percent, but this is actually the investor’s most likely estimate, also referred to as a point esti-mate Pressed further, the investor would probably acknowledge the uncertainty of this pointestimate return and admit the possibility that, under certain conditions, the annual rate of re-turn on this investment might go as low as−10 percent or as high as 25 percent The point is,the specification of a larger range of possible returns from an investment reflects the investor’s
Exhibit 1.1 Computation of Holding Period Yield for a Portfolio
InvestmentNumberofSharesBeginningPriceBeginningMarketValueEndingPriceEndingMarket
ValueHPRHPYWeightMarketaWeightedHPYA100,000$10$1,000,000$12$1,200,000 1.2020%0.050.01B200,000204,000,000214,200,000 1.0550.200.01C500,0003015,000,0003316,500,000 1.10100.750.075Total$20,000,000$21,900,0000.095HPR =21,900,00020,000,000= 1:095HPY = 1:095 − 1 = 0:095= 9:5%
Trang 34lyzing estimates of possible returns To do this, the investor assigns probability values to all pos-sible returns These probability values range from zero, which means no chance of the return, toone, which indicates complete certainty that the investment will provide the specified rate ofreturn These probabilities are typically subjective estimates based on the historical performanceof the investment or similar investments modified by the investor’s expectations for the future.As an example, an investor may know that about 30 percent of the time the rate of return onthis particular investment was 10 percent Using this information along with future expectationsregarding the economy, one can derive an estimate of what might happen in the future.
The expected return from an investment is defined as:
1.6 Expected Return =Xni = 1
ðProbability of Returnị ì Possible ReturnịERiị = ẵP1ịR1ị + P2ịR2ị + P3ịR3ị + + ðPnRnÞEðRiÞ =Xn
i = 1ðPiÞðRiÞ
Let us begin our analysis of the effect of risk with an example of perfect certainty whereinthe investor is absolutely certain of a return of 5 percent Exhibit 1.2 illustrates this situation.
Perfect certainty allows only one possible return, and the probability of receiving that returnis 1.0 Few investments provide certain returns and would be considered risk-free investments.In the case of perfect certainty, there is only one value for PiRi:
E(Ri) = (1.0)(0.05) = 0.05 = 5%
In an alternative scenario, suppose an investor believed an investment could provide severaldifferent rates of return depending on different possible economic conditions As an example, ina strong economic environment with high corporate profits and little or no inflation, the inves-tor might expect the rate of return on common stocks during the next year to reach as high
Trang 35turn during the next year would probably approach the long-run average of 10 percent.The investor might estimate probabilities for each of these economic scenarios based onpast experience and the current outlook as follows:
E c o n o m i c C o n d i t i o n sP r o b a b i l i t yR a t e o f R e t u r n
Strong economy, no inflation0.150.20
Weak economy, above-average inflation0.15−0.20
No major change in economy0.700.10
This set of potential outcomes can be visualized as shown in Exhibit 1.3.The computation of the expected rate of return [E(Ri)] is as follows:
ERiị = ẵ0:15ị0:20ị + ½ð0:15Þð− 0:20Þ + ½ð0:70Þð0:10Þ= 0:07
Obviously, the investor is less certain about the expected return from this investment thanabout the return from the prior investment with its single possible return.
A third example is an investment with 10 possible outcomes ranging from−40 percent to50 percent with the same probability for each rate of return A graph of this set of expectationswould appear as shown in Exhibit 1.4.
In this case, there are numerous outcomes from a wide range of possibilities The expectedrate of return [E(Ri)] for this investment would be:
EðRiÞ = ð0:10Þð−0:40Þ + ð0:10Þð−0:30Þ + ð0:10Þð−0:20Þ + ð0:10Þð−0:10Þ + ð0:10Þð0:0Þ+ð0:10Þð0:10Þ + ð0:10Þð0:20Þ + ð0:10Þð0:30Þ + ð0:10Þð0:40Þ + ð0:10Þð0:50Þ=ð−0:04Þ + ð−0:03Þ + ð−0:02Þ + ð−0:01Þ + ð0:00Þ + ð0:01Þ + ð0:02Þ + ð0:03Þ
+ð0:04Þ + ð0:05Þ= 0:05
The expected rate of return for this investment is the same as the certain return discussed inthe first example; but, in this case, the investor is highly uncertain about the actual rate of
Trang 36return This would be considered a risky investment because of that uncertainty We wouldanticipate that an investor faced with the choice between this risky investment and the certain(risk-free) case would select the certain alternative This expectation is based on the belief thatmost investors are risk averse, which means that if everything else is the same, they will selectthe investment that offers greater certainty (i.e., less risk).
1.2.4 Measuring the Risk of Expected Rates of Return
We have shown that we can calculate the expected rate of return and evaluate the uncertainty,or risk, of an investment by identifying the range of possible returns from that investment andassigning each possible return a weight based on the probability that it will occur Althoughthe graphs help us visualize the dispersion of possible returns, most investors want to quantifythis dispersion using statistical techniques These statistical measures allow you to compare thereturn and risk measures for alternative investments directly Two possible measures of risk(uncertainty) have received support in theoretical work on portfolio theory: the variance andthe standard deviation of the estimated distribution of expected returns.
In this section, we demonstrate how variance and standard deviation measure the disper-sion of possible rates of return around the expected rate of return We will work with the ex-amples discussed earlier The formula for variance is as follows:
1.7 Variance2ị =X
n
i = 1
Probabilityị ì PossibleReturn ExpectedReturn
2
=Xni = 1
PiịẵRi ERiị2
VarianceThe larger the variance for an expected rate of return, the greater the dispersion ofexpected returns and the greater the uncertainty, or risk, of the investment The variance forthe perfect-certainty (risk-free) example would be:
Trang 372ị =i = 1PiẵRi ERiị2=ẵ0:15ị0:20 0:07ị2+0:15ị0:20 0:07ị2+0:70ị0:10 0:07ị2=ẵ0:010935 + 0:002535 + 0:00063= 0:0141
Standard DeviationThe standard deviation is the square root of the variance:
1.8 Standard Deviation =ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiXni = 1PiẵRi ERiị2s
For the second example, the standard deviation would be:σ =pffiffiffiffiffiffiffiffiffiffiffiffiffi0:0141
= 0:11874 = 11:874%
Therefore, when describing this investment example, you would contend that you expect a re-turn of 7 percent, but the standard deviation of your expectations is 11.87 percent.
A Relative Measure of Risk In some cases, an unadjusted variance or standard deviationcan be misleading If conditions for two or more investment alternatives are not similar—thatis, if there are major differences in the expected rates of return—it is necessary to use a mea-sure of relative variability to indicate risk per unit of expected return A widely used relativemeasure of risk is the coefficient of variation (CV), calculated as follows:
1.9 Coefficient of Variation ðCVÞ =Standard Deviation of ReturnsExpected Rate of Return= σi
EðRÞThe CV for the preceding example would be:
CV =0:118740:07000= 1:696
This measure of relative variability and risk is used by financial analysts to compare alter-native investments with widely different rates of return and standard deviations of returns Asan illustration, consider the following two investments:
I n v e s t m e n t AI n v e s t m e n t B
Expected return0.070.12
Standard deviation0.050.07
Comparing absolute measures of risk, investment B appears to be riskier because it has a stan-dard deviation of 7 percent versus 5 percent for investment A In contrast, the CV figuresshow that investment B has less relative variability or lower risk per unit of expected returnbecause it has a substantially higher expected rate of return:
CVA=0:050:07= 0:714CVB=0:07
Trang 38ing period yields (HPYs) as follows:1.10 2="Xni = 1ẵHPYi EHPYị2#,nwhere:
2= the variance of the series
HPYi= the holding period yield during period i
EðHPYÞ = the expected value of the holding period yield that is equal to thearithmetic mean ðAMÞ of the series
n = the number of observations
The standard deviation is the square root of the variance Both measures indicate how muchthe individual HPYs over time deviated from the expected value of the series An example com-putation is contained in the appendix to this chapter As is shown in subsequent chapters wherewe present historical rates of return for alternative asset classes, presenting the standard devia-tion as a measure of risk (uncertainty) for the series or asset class is fairly common.
1.3 DETERMINANTS OF REQUIRED RATES OF RETURN
In this section, we continue our discussion of factors that you must consider when selectingsecurities for an investment portfolio You will recall that this selection process involves find-ing securities that provide a rate of return that compensates you for: (1) the time value ofmoney during the period of investment, (2) the expected rate of inflation during the period,and (3) the risk involved.
The summation of these three components is called the required rate of return This is theminimum rate of return that you should accept from an investment to compensate you fordeferring consumption Because of the importance of the required rate of return to the totalinvestment selection process, this section contains a discussion of the three components andwhat influences each of them.
The analysis and estimation of the required rate of return are complicated by the behavior ofmarket rates over time First, a wide range of rates is available for alternative investments at anytime Second, the rates of return on specific assets change dramatically over time Third, the dif-ference between the rates available (that is, the spread) on different assets changes over time.
The yield data in Exhibit 1.5 for alternative bonds demonstrate these three characteristics.First, even though all these securities have promised returns based upon bond contracts, thepromised annual yields during any year differ substantially As an example, during 2009 the av-erage yields on alternative assets ranged from 0.15 percent on T-bills to 7.29 percent for Baa cor-porate bonds Second, the changes in yields for a specific asset are shown by the three-monthTreasury bill rate that went from 4.48 percent in 2007 to 0.15 percent in 2009 Third, an exam-ple of a change in the difference between yields over time (referred to as a spread) is shown bythe Baa–Aaa spread.4The yield spread in 2007 was 91 basis points (6.47–5.56), but the spread in2009 increased to 198 basis points (7.29–5.31) (A basis point is 0.01 percent.)
Trang 39Because differences in yields result from the riskiness of each investment, you must understandthe risk factors that affect the required rates of return and include them in your assessment ofinvestment opportunities Because the required returns on all investments change over time, andbecause large differences separate individual investments, you need to be aware of the severalcomponents that determine the required rate of return, starting with the risk-free rate In thischapter we consider the three components of the required rate of return and briefly discuss whataffects these components The presentation in Chapter 11 on valuation theory will discuss thefactors that affect these components in greater detail.
1.3.1 The Real Risk-Free Rate
The real risk-free rate (RRFR) is the basic interest rate, assuming no inflation and no uncer-tainty about future flows An investor in an inflation-free economy who knew with ceruncer-taintywhat cash flows he or she would receive at what time would demand the RRFR on an invest-ment Earlier, we called this the pure time value of money, because the only sacrifice the inves-tor made was deferring the use of the money for a period of time This RRFR of interest is theprice charged for the risk-free exchange between current goods and future goods.
Two factors, one subjective and one objective, influence this exchange price The subjectivefactor is the time preference of individuals for the consumption of income When individualsgive up $100 of consumption this year, how much consumption do they want a year from nowto compensate for that sacrifice? The strength of the human desire for current consumptioninfluences the rate of compensation required Time preferences vary among individuals, andthe market creates a composite rate that includes the preferences of all investors This compos-ite rate changes gradually over time because it is influenced by all the investors in the econ-omy, whose changes in preferences may offset one another.
The objective factor that influences the RRFR is the set of investment opportunities avail-able in the economy The investment opportunities availavail-able are determined in turn by thelong-run real growth rate of the economy A rapidly growing economy produces more and bet-ter opportunities to invest funds and experience positive rates of return A change in the econ-omy’s long-run real growth rate causes a change in all investment opportunities and a changein the required rates of return on all investments Just as investors supplying capital shoulddemand a higher rate of return when growth is higher, those looking to borrow funds to investshould be willing and able to pay a higher rate of return to use the funds for investment be-cause of the higher growth rate and better opportunities Thus, a positive relationship existsbetween the real growth rate in the economy and the RRFR.
1.3.2 Factors Influencing the Nominal Risk-Free Rate (NRFR)
Earlier, we observed that an investor would be willing to forgo current consumption in orderto increase future consumption at a rate of exchange called the risk-free rate of interest Thisrate of exchange was measured in real terms because we assume that investors want to
Type of Bond2004200520062007200820092010
U.S government 3-month Treasury bills1.37%3.16%4.73%4.48%1.37%0.15%0.14%U.S government 10-year bonds2.793.934.774.943.663.263.22
Aaa corporate bonds5.635.245.595.565.635.314.94
Baa corporate bonds6.396.066.486.477.447.296.04
Trang 40level, as opposed to nominal rates of interest that are stated in money terms That is, nominalrates of interest that prevail in the market are determined by real rates of interest, plus factorsthat will affect the nominal rate of interest, such as the expected rate of inflation and the mon-etary environment It is important to understand these factors.
Notably, the variables that determine the RRFR change only gradually because we are concernedwith long-run real growth Therefore, you might expect the required rate on a risk-free investmentto be quite stable over time As discussed in connection with Exhibit 1.5, rates on three-monthT-bills were not stable over the period from 2004 to 2010 This is demonstrated with additionalobservations in Exhibit 1.6, which contains yields on T-bills for the period 1987–2010.
Investors view T-bills as a prime example of a default-free investment because the govern-ment has unlimited ability to derive income from taxes or to create money from which to payinterest Therefore, one could expect that rates on T-bills should change only gradually In fact,the data in Exhibit 1.6 show a highly erratic pattern Specifically, there was an increase in yieldsfrom 4.64 percent in 1999 to 5.82 percent in 2000 before declining by over 80 percent in threeyears to 1.01 percent in 2003, followed by an increase to 4.73 percent in 2006, and concluding at0.14 percent in 2010 Clearly, the nominal rate of interest on a default-free investment is not sta-ble in the long run or the short run, even though the underlying determinants of the RRFR arequite stable As noted, two other factors influence the nominal risk-free rate (NRFR): (1) the rel-ative ease or tightness in the capital markets, and (2) the expected rate of inflation.
Conditions in the Capital MarketYou will recall from prior courses in economics and fi-nance that the purpose of capital markets is to bring together investors who want to invest sav-ings with companies or governments who need capital to expand or to finance budget deficits.The cost of funds at any time (the interest rate) is the price that equates the current supply anddemand for capital Beyond this long-run equilibrium, change in the relative ease or tightness inthe capital market is a short-run phenomenon caused by a temporary disequilibrium in the sup-ply and demand of capital.
As an example, disequilibrium could be caused by an unexpected change in monetary pol-icy (for example, a change in the target federal funds rate) or fiscal polpol-icy (for example, achange in the federal deficit) Such a change in monetary policy or fiscal policy will producea change in the NRFR of interest, but the change should be short-lived because, in the longer
Exhibit 1.6 Three-Month Treasury Bill Yields and Rates of Inflation
Year3-Month T-billsRate of InflationYear3-Month T-billsRate of Inflation
19875.78%4.40%19994.64%2.70%19886.674.4020005.823.4019898.114.6520013.401.5519907.506.1120021.612.4919915.383.0620031.011.8719923.432.9020041.373.2619933.332.7520053.163.4219944.252.6720064.732.5419955.492.5420074.484.0819965.013.3220081.370.9119975.061.7020090.152.7219984.781.6120100.141.49