The Theory and Practice of investment management FRANK J FABOZZI HARRY M MARKOWITZ EDITORS John Wiley & Sons, Inc Frontmatter Page x Friday, July 26, 2002 10:41 AM Frontmatter Page i Friday, July 26, 2002 10:41 AM The Theory and Practice of investment management Frontmatter Page ii Friday, July 26, 2002 10:41 AM THE FRANK J FABOZZI SERIES Fixed Income Securities, Second Edition by Frank J Fabozzi Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L Grant and James A Abate Handbook of Global Fixed Income Calculations by Dragomir Krgin Managing a Corporate Bond Portfolio by Leland E Crabbe and Frank J Fabozzi Real Options and Option-Embedded Securities by William T Moore Capital Budgeting: Theory and Practice by Pamela P Peterson and Frank J Fabozzi The Exchange-Traded Funds Manual by Gary L Gastineau Professional Perspectives on Fixed Income Portfolio Management, Volume edited by Frank J Fabozzi Investing in Emerging Fixed Income Markets edited by Frank J Fabozzi and Efstathia Pilarinu Handbook of Alternative Assets by Mark J P Anson The Exchange-Traded Funds Manual by Gary L Gastineau The Handbook of Financial Instruments edited by Frank J Fabozzi The Global Money Markets by Frank J Fabozzi, Steven V Mann, and Moorad Choudhry Frontmatter Page iii Friday, July 26, 2002 10:41 AM The Theory and Practice of investment management FRANK J FABOZZI HARRY M MARKOWITZ EDITORS John Wiley & Sons, Inc Frontmatter Page iv Friday, July 26, 2002 10:41 AM Copyright © 2002 by Frank J Fabozzi All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201748-6011, fax 201-748-6008, e-mail: permcoordinator@wiley.com Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books ISBN: 0-471-22899-0 Printed in the United States of America 10 Frontmatter Page v Friday, July 26, 2002 10:41 AM contents ABOUT THE EDITORS ix CONTRIBUTING AUTHORS xi FOREWORD Peter L Bernstein xiii SECTION ONE Foundations of Investment Management CHAPTER Investment Management Frank J Fabozzi and Harry M Markowitz CHAPTER Portfolio Selection Frank J Fabozzi, Harry M Markowitz, and Francis Gupta 15 CHAPTER Applying Mean-Variance Analysis Frank J Fabozzi, Francis Gupta, and Harry M Markowitz 43 CHAPTER Asset Pricing Models Frank J Fabozzi 65 CHAPTER Calculating Investment Returns Bruce Feibel 91 SECTION TWO Investing in Common Stock 119 v Frontmatter Page vi Friday, July 26, 2002 10:41 AM vi Contents CHAPTER Common Stock Markets, Trading Arrangements, and Trading Costs Frank J Fabozzi, Frank J Jones, Robert R Johnson, and Bruce M Collins 121 CHAPTER Tracking Error and Common Stock Portfolio Management Raman Vardharaj, Frank J Jones, and Frank J Fabozzi 163 CHAPTER Common Stock Portfolio Management Strategies Frank J Fabozzi and James L Grant 181 CHAPTER Traditional Fundamental Analysis I: Sources of Information Pamela P Peterson and Frank J Fabozzi 209 CHAPTER 10 Traditional Fundamental Analysis II: Financial Ratio Analysis Pamela P Peterson and Frank J Fabozzi 227 CHAPTER 11 Traditional Fundamental Analysis III: Earnings Analysis, Cash Analysis, Dividends, and Dividend Discount Models Pamela P Peterson and Frank J Fabozzi 275 CHAPTER 12 Security Analysis Using Value-Based Metrics James A Abate and James L Grant 317 CHAPTER 13 Multi-Factor Equity Risk Models Frank J Fabozzi, Frank J Jones, and Raman Vardharaj 343 CHAPTER 14 Equity Derivatives I: Features and Valuation Bruce M.Collins and Frank J Fabozzi 373 CHAPTER 15 Equity Derivatives II: Portfolio Management Applications Bruce M.Collins and Frank J Fabozzi 409 Frontmatter Page vii Friday, July 26, 2002 10:41 AM Contents vii SECTION THREE Investing in Fixed-Income Securities 437 CHAPTER 16 Fixed-Income Securities Frank J Fabozzi 439 CHAPTER 17 Real Estate-Backed Securities Frank J Fabozzi 465 CHAPTER 18 General Principles of Bond Valuation Frank J Fabozzi and Steven V Mann 501 CHAPTER 19 Yield Measures and Forward Rates Frank J Fabozzi and Steven V Mann 525 CHAPTER 20 Valuation of Bonds with Embedded Options Frank J Fabozzi and Steven V Mann 549 CHAPTER 21 Measuring Interest Rate Risk Frank J Fabozzi and Steven V Mann 583 CHAPTER 22 Fixed-Income Portfolio Strategies Frank J Fabozzi 615 CHAPTER 23 Bond Portfolio Analysis Relative to a Benchmark Lev Dynkin, Jay Hyman, and Vadim Konstantinovsky 653 CHAPTER 24 Multi-Factor Fixed-Income Risk Models and Their Applications Lev Dynkin and Jay Hyman 665 Frontmatter Page viii Friday, July 26, 2002 10:41 AM viii Contents CHAPTER 25 Fixed-Income Derivatives and Risk Control Frank J Fabozzi 697 SECTION FOUR Investment Companies and Exchange-Traded Funds 725 CHAPTER 26 Investment Companies Frank J Jones and Frank J Fabozzi 727 CHAPTER 27 Exchange-Traded Funds Gary L Gastineau 747 SECTION FIVE Investing in Real Estate and Alternative Investments 761 CHAPTER 28 Real Estate Investment Susan Hudson-Wilson 763 CHAPTER 29 Hedge Funds Mark J P Anson 785 CHAPTER 30 Private Equity Mark J P Anson 815 SECTION SIX Asset Allocation 839 CHAPTER 31 Active Asset Allocation Robert D Arnott 841 INDEX 859 ... and in speedy communication But that was only the beginning: The computer has been the messenger of the investment revolution If the world’s stock of office equipment still consisted only of the. .. with investment management Investment management also referred to as portfolio management and money management requires an understanding of: T how investment objectives are determined the investment. .. that the criteria proposed by Kritzman involve the risk, return, and the correlation of the return of a potential asset class with that of other asset classes Along with the designation of an investment