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Finance Course: Investment s and Portfolio Volume Instructor: Tatyana Zabotina University of Illinois at Springfield =>? McGraw-Hill/Irwin McGraw−Hill Primis ISBN: 0−390−48886−0 Text: Investments, Sixth Edition Bodie−Kane−Marcus This book was printed on recycled paper Finance http://www.mhhe.com/primis/online/ Copyright ©2003 by The McGraw−Hill Companies, Inc All rights reserved Printed in the United States of America Except as permitted under the United States Copyright Act of 1976, 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 prior written permission of the publisher This McGraw−Hill Primis text may include materials submitted to McGraw−Hill for publication by the instructor of this course The instructor is solely responsible for the editorial content of such materials 111 FINA ISBN: 0−390−48886−0 Finance Volume Bodie−Kane−Marcus • Investments, Sixth Edition Front Matter Preface I Introduction 14 Financial Instruments The Investment Environment How Securities are Traded Mutual Funds and Other Investment Companies 14 48 76 118 II Portfolio Theory 146 History of Interest Rates and Risk Premiums Risk and Risk Aversion Capital Allocation Between the Risky Asset and the Risk−Free Asset Optimal Risky Portfolios 146 III Equilibrium in Capital Markets 286 The Capital Asset Pricing Model 10 Index Models 11 Arbitrage Pricing Theory and Multifactor Models of Risk and Return 12 Market Efficiency and Behavioral Finance 13 Empirical Evidence on Security Returns 286 322 348 374 174 206 231 420 IV Fixed−Income Securities 450 14 Bond Prices and Yields 15 The Term Structure of Interest Rates 16 Managing Bond Portfolios 450 490 521 V Security Analysis 571 17 Macroeconomic and Industry Analysis 18 Equity Valuation Models 19 Financial Statement Analysis 571 604 653 VI Options, Futures, and Other Derivatives 693 20 Options Markets: Introduction 21 Option Valuation 22 Futures Markets 23 Futures and Swaps: A Closer Look 693 741 786 815 iii VII Active Portfolio Management 853 24 Portfolio Performance Evaluation 25 International Diversification 853 896 iv Bodie−Kane−Marcus: Investments, Sixth Edition Front Matter Preface © The McGraw−Hill Companies, 2004 P R E F A C E xviii We wrote the first edition of this textbook more than 15 years ago The intervening years have been a period of rapid and profound change in the investments industry This is due in part to an abundance of newly designed securities, in part to the creation of new trading strategies that would have been impossible without concurrent advances in computer technology, and in part to rapid advances in the theory of investments that have come out of the academic community In no other field, perhaps, is the transmission of theory to real-world practice as rapid as is now commonplace in the financial industry These developments place new burdens on practitioners and teachers of investments far beyond what was required only a short while ago Investments, Sixth Edition, is intended primarily as a textbook for courses in investment analysis Our guiding principle has been to present the material in a framework that is organized by a central core of consistent fundamental principles We make every attempt to strip away unnecessary mathematical and technical detail, and we have concentrated on providing the intuition that may guide students and practitioners as they confront new ideas and challenges in their professional lives This text will introduce you to major issues currently of concern to all investors It can give you the skills to conduct a sophisticated assessment of current issues and debates covered by both the popular media as well as more-specialized finance journals Whether you plan to become an investment professional, or simply a sophisticated individual investor, you will find these skills essential Our primary goal is to present material of practical value, but all three of us are active researchers in the science of financial economics and find virtually all of the material in this book to be of great intellectual interest Fortunately, we think, there is no contradiction in the field of investments between the pursuit of truth and the pursuit of money Quite the opposite The capital asset pricing model, the arbitrage pricing model, the efficient markets hypothesis, the option-pricing model, and the other centerpieces of modern financial research are as much intellectually satisfying subjects of scientific inquiry as they are of immense practical importance for the sophisticated investor In our effort to link theory to practice, we also have attempted to make our approach consistent with that of the Institute of Chartered Financial Analysts (ICFA), a subsidiary of the Association of Investment Management and Research (AIMR) In addition to fostering research in finance, the AIMR and ICFA administer an education and certification program to candidates seeking the title of Chartered Financial Analyst (CFA) The CFA curriculum represents the consensus of a committee of distinguished scholars and practitioners regarding the core of knowledge required by the investment professional This text also is used by the CAIA Association, a nonprofit association that provides education concerning nontraditional investment vehicles and sponsors the Chartered Alternative Investment Analyst designation There are many features of this text that make it consistent with and relevant to the CFA curriculum The end-of-chapter problem sets contain questions from past CFA exams, and, for students who will be taking the exam, Appendix B is a useful tool that lists each CFA question in the text and the exam from which it has been taken Chapter includes excerpts from the “Code of Ethics and Standards of Professional Conduct” of the ICFA Chapter 26, which discusses investors and the investment process, is modeled after the ICFA outline In the Sixth Edition, we have further extended our systematic collection of Excel spreadsheets that give tools to explore concepts more deeply than was previously possible Bodie−Kane−Marcus: Investments, Sixth Edition Front Matter Preface © The McGraw−Hill Companies, 2004 PREFACE xix These spreadsheets are available on the website for this text (www.mhhe.com/bkm), and provide a taste of the sophisticated analytic tools available to professional investors UNDERLYING PHILOSOPHY Of necessity, our text has evolved along with the financial markets In the Sixth Edition, we address many of the changes in the investment environment At the same time, many basic principles remain important We believe that attention to these few important principles can simplify the study of otherwise difficult material and that fundamental principles should organize and motivate all study These principles are crucial to understanding the securities already traded in financial markets and in understanding new securities that will be introduced in the future For this reason, we have made this book thematic, meaning we never offer rules of thumb without reference to the central tenets of the modern approach to finance The common theme unifying this book is that security markets are nearly efficient, meaning most securities are usually priced appropriately given their risk and return attributes There are few free lunches found in markets as competitive as the financial market This simple observation is, nevertheless, remarkably powerful in its implications for the design of investment strategies; as a result, our discussions of strategy are always guided by the implications of the efficient markets hypothesis While the degree of market efficiency is, and always will be, a matter of debate, we hope our discussions throughout the book convey a good dose of healthy criticism concerning much conventional wisdom Distinctive Themes Investments is organized around several important themes: The central theme is the near-informational-efficiency of well-developed security markets, such as those in the United States, and the general awareness that competitive markets not offer “free lunches” to participants A second theme is the risk–return trade-off This too is a no-free-lunch notion, holding that in competitive security markets, higher expected returns come only at a price: the need to bear greater investment risk However, this notion leaves several questions unanswered How should one measure the risk of an asset? What should be the quantitative trade-off between risk (properly measured) and expected return? The approach we present to these issues is known as modern portfolio theory, which is another organizing principle of this book Modern portfolio theory focuses on the techniques and implications of efficient diversification, and we devote considerable attention to the effect of diversification on portfolio risk as well as the implications of efficient diversification for the proper measurement of risk and the risk–return relationship This text places greater emphasis on asset allocation than most of its competitors We prefer this emphasis for two important reasons First, it corresponds to the procedure that most individuals actually follow Typically, you start with all of your money in a bank account, only then considering how much to invest in something riskier that might offer a higher expected return The logical step at this point is to consider other risky asset classes, such as stock, bonds, or real estate This is an asset allocation decision Second, in most cases, the asset allocation choice is far more important in determining overall investment performance than is the set of security selection decisions Asset allocation is the primary determinant of the risk-return profile of the investment portfolio, and so it deserves primary attention in a study of investment policy Bodie−Kane−Marcus: Investments, Sixth Edition xx Front Matter Preface © The McGraw−Hill Companies, 2004 PREFACE This text offers a much broader and deeper treatment of futures, options, and other derivative security markets than most investments texts These markets have become both crucial and integral to the financial universe and are the major sources of innovation in that universe Your only choice is to become conversant in these markets—whether you are to be a finance professional or simply a sophisticated individual investor NEW IN THE SIXTH EDITION Following is a summary of the content changes in the Sixth Edition: The Investment Chapter contains extensive new material on failures in corporate goverEnvironment nance in the boom years of the 1990s and the conflicts of interest that gave (Chapter 1) rise to the many scandals of those years How Securities We have added new material on securities trading including initial public Are Traded (Chapter 3) offerings, electronic trading, and regulatory reforms in the wake of recent corporate scandals to Chapter History of Interest We have extended the historical evidence on security returns to include Rates and Risk international comparisons as well as new approaches to estimating the mean Premiums (Chapter 5) market return We also have added an introduction to value at risk using historic returns as a guideline Arbitrage Pricing Theory and Multifactor Models of Risk and Return (Chapter 11) We have largely rewritten this chapter There is now greater focus on the use of factor models as a means to understand and measure various risk exposures The intuition for the multifactor risk–return relation has been enhanced, and the comparison between the multifactor APT and CAPM has been further developed Market Efficiency and We have fully reworked our treatment of behavioral finance by adding more Behavioral Finance careful development of behavioral hypotheses, their implications for secu(Chapter 12) rity pricing, and their relation to the empirical evidence on security pricing Empirical Evidence on We have updated our discussion of the value and size effects, with an emSecurity Returns phasis on competing interpretations of these premiums (Chapter 13) Bond Prices and Yields We have added new spreadsheet material helpful in analyzing bond prices (Chapter 14) and yields This new material enables students to price bonds between coupon dates Equity Valuation We have added new material on quality of earnings, earnings management, Models (Chapter 18) and the use of accounting data in valuation analysis to this chapter Bodie−Kane−Marcus: Investments, Sixth Edition Front Matter Preface © The McGraw−Hill Companies, 2004 xxi PREFACE Financial Statement We have added new material related to the accounting scandals of the last Analysis (Chapter 19) few years to this chapter It discusses ways in which accounting rules were skirted in the 1990s and ongoing reforms in accounting standards Option Valuation We have extended the binomial option pricing model to a multiperiod exam(Chapter 21) ple to illustrate how the model may be used to obtain realistic prices International We have fully rewritten this chapter, which now contains considerably more Diversification evidence on global financial markets and security returns (Chapter 25) In addition to these changes, we have updated and edited our treatment of topics wherever it was possible to improve exposition or coverage The Process of We have added to this chapter an appendix containing an extensive spreadPortfolio Management sheet model for sophisticated financial planning The spreadsheets (available (Chapter 26) as well at the course website) allow students to study the interaction of taxes and inflation on long-term financial strategies ORGANIZATION AND CONTENT The text is composed of seven sections that are fairly independent and may be studied in a variety of sequences Since there is enough material in the book for a two-semester course, clearly a one-semester course will require the instructor to decide which parts to include Part I is introductory and contains important institutional material focusing on the financial environment We discuss the major players in the financial markets, provide an overview of the types of securities traded in those markets, and explain how and where securities are traded We also discuss in depth mutual funds and other investment companies, which have become an increasingly important means of investing for individual investors The material presented in Part I should make it possible for instructors to assign term projects early in the course These projects might require the student to analyze in detail a particular group of securities Many instructors like to involve their students in some sort of investment game and the material in these chapters will facilitate this process Parts II and III contain the core of modern portfolio theory Chapter is a general discussion of risk and return, making the general point that historical returns on broad asset classes are consistent with a risk–return trade-off We focus more closely in Chapter on how to describe investors’ risk preferences In Chapter we progress to asset allocation and then in Chapter to portfolio optimization After our treatment of modern portfolio theory in Part II, we investigate in Part III the implications of that theory for the equilibrium structure of expected rates of return on risky assets Chapters and 10 treat the capital asset pricing model and its implementation using index models, and Chapter 11 covers multifactor descriptions of risk and the arbitrage pricing theory We complete Part II with a chapter on the efficient markets hypothesis, including its rationale as well as the behavioral critique of the hypothesis, the evidence for and against it, and a chapter on empirical evidence concerning security returns The empirical evidence chapter in this edition follows the efficient markets chapter so that the student can use the perspective of efficient market theory to put other studies on returns in context Part IV is the first of three parts on security valuation This Part treats fixed-income securities—bond pricing (Chapter 14), term structure relationships (Chapter 15), and interestrate risk management (Chapter 16) The next two Parts deal with equity securities and derivative securities For a course emphasizing security analysis and excluding portfolio theory, one may proceed directly from Part I to Part III with no loss in continuity Bodie−Kane−Marcus: Investments, Sixth Edition Front Matter Preface © The McGraw−Hill Companies, 2004 Walkthrough This book contains several features designed to make it easy for the student to understand, absorb, and apply the concepts and techniques presented New and Enhanced Pedagogy Concept Check A unique feature of this book is the inclusion of Concept Checks in the body of the text These self-test questions and problems enable the student to determine whether he or she has understood the preceding material Detailed solutions are provided at the end of each chapter CONCEPT CHECK QUESTION ☞ a Suppose the real interest rate is 3% per year and the expected inflation rate is 8% What is the nominal interest rate? b Suppose the expected inflation rate rises to 10%, but the real rate is unchanged What happens to the nominal interest rate? Bills and Inflation, The Fisher equation predicts a close connection between inflation and the 1963–2002 rate of return on T-bills This is apparent in Figure 5.2, which plots both time series on the same set of axes Both series tend to move together, which is consistent with our previous statement that expected inflation is a significant force determining the nominal rate of interest For a holding period of 30 days, the difference between actual and expected inflation is not large The 30-day bill rate will adjust rapidly to changes in expected inflation induced by observed changes in actual inflation It is not surprising that we see nominal rates on bills move roughly in tandem with inflation over time SOLUTIONS TO CONCEPT CHECKS $2,885.9 Ϫ $2.3 ϭ $7.79 370.4 The net investment in the Class A shares after the 4% commission is $9,600 If the fund earns a 10% return, the investment will grow after n years to $9,600 ϫ (1.10)n The Class B shares have no front-end load However, the net return to the investor after 12b-1 fees will be only 9.5% In addition, there is a back-end load that reduces NAV ϭ Bodie−Kane−Marcus: Investments, Sixth Edition Front Matter © The McGraw−Hill Companies, 2004 Preface Current Event Boxes Short articles from business periodicals are included in boxes throughout the text The articles are chosen for relevance, clarity of presentation, and consistency with good sense SPUN GOLD DID WALL STREET FIRMS BRIBE BOSSES WITH SHARES? Back in 1997, reports that Robertson Stephens, a Silicon Valley investment bank, was “spinning” IPO shares to executives who rewarded them with banking mandates prompted an SEC probe into the practice The probe was soon abandoned The practice boomed, becoming one of the more lucrative ways in which executives combined with Wall Street to abuse ordinary shareholders On August 30th Citigroup told congressional investigators that in 1997–2000 it had allocated IPO shares to Bernie Ebbers that had generated profits of $11m for the former boss of WorldCom, a telecoms firm which was a big Citigroup client, and is now bust thanks to fraud Other WorldCom executives had also benefited Citi claims that these investment-banking business in return Its “host of benign” explanations for why some shares were allocated retrospectively, giving executives a risk-free gain, seems thin So does its claim that Jack Grubman, until last month the bank’s top telecoms analyst, played no part in allocating shares to executives Among the documents that Citigroup sent to Congress was a memo copied to Mr Grubman that listed executives at several telecoms firms who had expressed interest in shares in IPOs Regulators and the courts will have to decide whether allocations of shares to executives were, in effect, bribes If so, the punishment could be severe Nor is Citi the only firm at risk Credit Suisse First Boston gave shares in IPOs Excel Applications The Sixth Edition has expanded the boxes featuring Excel Spreadsheet Applications A sample spreadsheet is presented in the E X C E L A P P L I text with an interactive version and related questions available on the book website at www.mhhe.com/bkm C A T I O N S SHORT SALE This Excel spreadsheet model was built using the text example for DotBomb The model allows you to analyze the effects of returns, margin calls, and different levels of initial and maintenance margins The model also includes a sensitivity analysis for ending stock price and return on investment You can learn more about this spreadsheet model using the interactive version available at our Online Learning Center at www.mhhe.com/bkm A 10 Initial Investment Initial Stock Price Number of Shares Sold Short Ending Stock Price Cash Dividends Per Share Initial Margin Percentage Maintenance Margin Percentage B $50,000.00 $100.00 1,000 $70.00 $0.00 50.00% 30.00% C Action or Formula for Column B Enter data Enter data (B4/B9)/B5 Enter data Enter data Enter data Enter data D Ending St Price $170.00 160.00 150.00 140.00 130.00 120.00 E Return on Investment 58.33% -133.33% -116.67% -100.00% -83.33% -66.67% -50.00% ... with their support and understanding Zvi Bodie Alex Kane Alan J Marcus 13 14 Bodie Kane Marcus: Investments, Sixth Edition I Introduction © The McGraw−Hill Companies, 2004 Financial Instruments... their field of study Bodie Kane Marcus: Investments, Sixth Edition xxviii Front Matter Preface © The McGraw−Hill Companies, 2004 PREFACE Investments Online Introducing Investments Online! For... foreign exchange 10 Bodie Kane Marcus: Investments, Sixth Edition Front Matter PREFACE Preface © The McGraw−Hill Companies, 2004 xxvii For the Student Solutions Manual 007286186X The Solutions Manual,