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ESSENTIALS of INVESTMENTS bod05175_fm_i-xxvi.indd i 9/3/07 4:09:38 PM The McGraw-Hill/Irwin Series in Finance, Insurance and Real Estate Stephen A Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor FINANCIAL MANAGEMENT Adair Excel Applications for Corporate Finance First Edition Block and Hirt Foundations of Financial Management Twelfth Edition Brealey, Myers, and Allen Principles of Corporate Finance Ninth Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Edition First Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Fifth Edition Brooks FinGame Online 5.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Fifth Edition Chew The New Corporate Finance: Where Theory Meets Practice Third Edition DeMello Cases in Finance Second Edition Grinblatt (editor) Stephen A Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Helfert Techniques of Financial Analysis: A Guide to Value Creation Eleventh Edition Higgins Analysis for Financial Management Eighth Edition Kester, Ruback, and Tufano Case Problems in Finance Twelfth Edition bod05175_fm_i-xxvi.indd ii Ross, Westerfield and Jaffe Corporate Finance Eighth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications First Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Sixth Edition Ross, Westerfield and Jordan Fundamentals of Corporate Finance Eighth Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition White Financial Analysis with an Electronic Calculator Sixth Edition INVESTMENTS Adair Excel Applications for investments First Edition Bodie, Kane, and Marcus Essentials of Investments Seventh Edition Bodie, Kane, and Marcus Investments Eighth Edition Hirt and Block Fundamentals of Investment Management Ninth Edition Hirschey and Nofsinger Investments: Analysis and Behavior First Edition Jordan and Miller Fundamentals of Investments: Valuation and Management Fourth Edition FINANCIAL INSTITUTIONS AND MARKETS Rose and Hudgins Bank Management and Financial Services Seventh Edition Rose and Marquis Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace Tenth Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Sixth Edition Saunders and Cornett Financial Markets and Institutions: An Introduction to the Risk Management Approach Third Edition INTERNATIONAL FINANCE Eun and Resnick International Financial Management Fourth Edition Kuemmerle Case Studies in International Entrepreneurship: Managing and Financing Ventures in the Global Economy First Edition REAL ESTATE Brueggeman and Fisher Real Estate Finance and Investments Thirteenth Edition Corgel, Ling and Smith Real Estate Perspectives: An Introduction to Real Estate Fourth Edition Ling and Archer Real Estate Principles: A Value Approach Second Edition FINANCIAL PLANNING AND INSURANCE Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Tenth Edition Altfest Personal Financial Planning First Edition Harrington and Niehaus Risk Management and Insurance Second Edition Kapoor, Dlabay, and Hughes Focus on Personal Finance: An Active Approach to Help You Develop Successful Financial Skills Second Edition Kapoor, Dlabay, and Hughes Personal Finance Eighth Edition 9/3/07 4:09:41 PM ESSENTIALS of INVESTMENTS Seventh Edition ZVI BODIE Boston University ALEX KANE University of California, San Diego ALAN J MARCUS Boston College Boston Burr Ridge, IL Dubuque, IA New York San Francisco St Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto bod05175_fm_i-xxvi.indd iii 9/3/07 4:09:42 PM ESSENTIALS OF INVESTMENTS Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020 Copyright © 2008, 2007, 2004, 2001, 1998, 1995, 1992 by The McGraw-Hill Companies, Inc All rights reserved No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning Some ancillaries, including electronic and print components, may not be available to customers outside the United States This book is printed on acid-free paper WCK/WCK ISBN 978-0-07-340517-9 MHID 0-07-340517-5 Executive editor: Michele Janicek Developmental editor II: Christina Kouvelis Marketing manager: Ashley Smith Managing editor: Lori Koetters Lead production supervisor: Michael R McCormick Senior designer: Cara David Lead media project manager: Cathy L Tepper Cover design: Eric Kass, funnel.tv Interior design: Jenny El-Shamy Typeface: 10/12 Times Roman Compositor: Laserwords Private Limited Printer: Quebecor World Versailles Inc Library of Congress Cataloging-in-Publication Data Bodie, Zvi Essentials of investments / Zvi Bodie, Alex Kane, Alan J Marcus —7th ed p cm — (The McGraw-Hill/Irwin series in finance, insurance, and real estate) Includes index ISBN-13: 978-0-07-340517-9 (alk paper) ISBN-10: 0-07-340517-5 (alk paper) Investments I Kane, Alex II Marcus, Alan J III Title HG4521.B563 2008 332.6—dc22 2007027273 www.mhhe.com bod05175_fm_i-xxvi.indd iv 9/3/07 4:09:44 PM To our wives and eight wonderful daughters bod05175_fm_i-xxvi.indd v 9/3/07 4:09:45 PM ABOUT THE AUTHORS Zvi Bodie Boston University Zvi Bodie is Professor of Finance and Economics at Boston University School of Management He holds a PhD from the Massachusetts Institute of Technology and has served on the finance faculty at Harvard Business School and MIT’s Sloan School of Management Professor Bodie has published widely on pension finance and investment strategy in leading professional journals His books include Foundations of Pension Finance, Pensions in the U.S Economy, Issues in Pension Economics, and Financial Aspects of the U.S Pension System His textbook Investments, co-authored with Alex Kane and Alan Marcus, is the market leader and is used in certification programs of the Financial Planning Association and the Society of Actuaries His textbook Finance is co-authored by Nobel Prize–winning economist Robert C Merton Professor Bodie is a member of the Pension Research Council of the Wharton School, University of Pennsylvania His latest book is Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals Alex Kane University of California, San Diego Alex Kane is Professor of Finance and Economics at the Graduate School of International Relations and Pacific Studies at the University of California, San Diego He has been Visiting Professor at the Faculty of Economics, University of Tokyo; Graduate School of Business, Harvard; Kennedy School of Government, Harvard; and Research Associate, National Bureau of Economic Research An author of many articles in finance and management journals, Professor Kane’s research is mainly in corporate finance, portfolio management, and capital markets Alan J Marcus Boston College Alan Marcus is Professor of Finance in the Wallace E Carroll School of Management at Boston College He received his PhD from MIT, has been a Visiting Professor at MIT’s Sloan School of Management and Athens Laboratory of Business Administration, and has served as a Research Fellow at the National Bureau of Economic Research, where he participated in both the Pension Economics and the Financial Markets and Monetary Economics Groups Professor Marcus also spent two years at the Federal Home Loan Mortgage Corporation (Freddie Mac), where he helped to develop mortgage pricing and credit risk models Professor Marcus has published widely in the fields of capital markets and portfolio theory He currently serves on the Research Foundation Advisory Board of the CFA Institute vi bod05175_fm_i-xxvi.indd vi 9/3/07 4:09:45 PM ESSENTIALS of INVESTMENTS bod05175_fm_i-xxvi.indd i 9/3/07 4:09:38 PM BRIEF CONTENTS Part ONE 13 ELEMENTS OF INVESTMENTS Investments: Background and Issues Asset Classes and Financial Instruments 24 Securities Markets 55 Mutual Funds and Other Investment Companies 89 Part TWO PORTFOLIO THEORY 115 Risk and Return: Past and Prologue 116 Efficient Diversification 149 Capital Asset Pricing and Arbitrage Pricing Theory 192 The Efficient Market Hypothesis 231 Behavioral Finance and Technical Analysis 262 Part THREE DEBT SECURITIES 10 11 14 Equity Valuation 401 Financial Statement Analysis 442 Part FIVE DERIVATIVE MARKETS 15 16 17 479 Options Markets 480 Option Valuation 517 Futures Markets and Risk Management 552 Part SIX ACTIVE INVESTMENT MANAGEMENT 587 18 19 20 21 Performance Evaluation and Active Portfolio Management 588 Globalization and International Investing 621 Taxes, Inflation, and Investment Strategy 657 Investors and the Investment Process 681 Appendixes 289 Bond Prices and Yields 290 Managing Bond Portfolios 333 A References B References to CFA Questions Index 701 707 I-1 Part FOUR SECURITY ANALYSIS 12 369 Macroeconomic and Industry Analysis 370 vii bod05175_fm_i-xxvi.indd vii 9/3/07 4:09:46 PM CONTENTS Part ONE ELEMENTS OF INVESTMENTS 1 Investments: Background and Issues 1.1 1.2 1.3 Real Assets versus Financial Assets A Taxonomy of Financial Assets Financial Markets and the Economy The Informational Role of Financial Markets Consumption Timing Allocation of Risk Separation of Ownership and Management Corporate Governance and Corporate Ethics 1.4 The Investment Process 1.5 Markets Are Competitive 10 The Risk-Return Trade-Off 10 Efficient Markets 11 1.6 The Players 12 Financial Intermediaries 12 Investment Bankers 14 1.7 Recent Trends 15 Globalization 15 Securitization 16 Financial Engineering 17 Computer Networks 18 1.8 Outline of the Text 19 Summary 20 2.1 Asset Classes and Financial Instruments 24 The Money Market 25 Treasury Bills 25 Certificates of Deposit 27 Commercial Paper 28 Bankers’ Acceptances 28 Eurodollars 28 Repos and Reverses 28 Brokers’ Calls 29 Federal Funds 29 The LIBOR Market 29 Yields on Money Market Instruments 29 2.2 The Bond Market 30 Treasury Notes and Bonds 30 Inflation-Protected Treasury Bonds 31 Federal Agency Debt 32 International Bonds 32 Municipal Bonds 32 Corporate Bonds 35 Mortgages and Mortgage-Backed Securities 2.3 Equity Securities 37 Common Stock as Ownership Shares 37 Characteristics of Common Stock 38 2.9 Stock Market Listings 38 Preferred Stock 39 Depository Receipts 39 2.4 Stock and Bond Market Indexes 40 Stock Market Indexes 40 Dow Jones Averages 40 Standard & Poor’s Indexes 44 Other U.S Market Value Indexes 45 Equally Weighted Indexes 46 Foreign and International Stock Market Indexes 46 Bond Market Indicators 46 2.5 Derivative Markets 46 Options 46 Futures Contracts 50 Summary 51 3.1 Securities Markets 35 55 How Firms Issue Securities 56 Investment Banking 56 Shelf Registration 57 Private Placements 58 Initial Public Offerings 58 viii bod05175_fm_i-xxvi.indd viii 9/3/07 4:09:46 PM ... School of International Relations and Pacific Studies at the University of California, San Diego He has been Visiting Professor at the Faculty of Economics, University of Tokyo; Graduate School of. .. Alan Marcus is Professor of Finance in the Wallace E Carroll School of Management at Boston College He received his PhD from MIT, has been a Visiting Professor at MIT’s Sloan School of Management... textbook available! Includes excerpts from the “Code of Ethics and Standards of Professional Conduct” of the CFA Institute Contains the core of modern portfolio theory.For courses emphasizing security